In connection with the last
article we wrote regarding the balance sheet, financial ratios are used by
management to constantly ascertain the condition of the company. For example,
they must ensure that the company has enough funds to meet its debt
obligations, and fixed financial commitments. Ratio analysis, as we will see,
reveals the overall financial condition of the company, it reveals whether the
company is subject to the risk of insolvency, and how well it is doing compared
to the industry and its competitors.
Financial ratios are broken
into categories, like liquidity, profitability and debt. For example, liquidity
ratios test a company’s degree of solvency. Two such ratios are the current
ratio and the quick ratio.
Current ratio = current assets / current liabilities. It’s
a relationship between current assets and current liabilities. It indicates the
margin of safety available to a firm to meet short term liabilities. As usual,
it varies according to industry and type of company. The quick ratio eliminates
less liquid assets (inventories) and concentrates on assets that are more
easily converted to cash. It determines whether the firm can meet its creditor
obligations.
Quick ratio = current assets – Inventories / current
liabilities
So if a company had tied up
large amount of inventories, but its current assets were > its current
liabilities, it would tell us that the firm can easily meet its short term
liabilities by generating cash from other (except money tied in inventory)
current assets.
A company that can generate
cash by converting assets such as inventories or accounts receivables is better
off. One such ratio is the average collection period.
Average collection period = accounts receivables /
(annual credit sales / 360 days)
The average collection period
is how many days it takes a company to collect. If the policy is to extend
credit for say 30 days, and the average collection period is higher, then the
company has a problem collecting on time.
The counterpart to the above
equation is the average payment period.
Average payment period = accounts payable / (annual credit
purchases / 360 days)
Since the annual credit
purchases are not reported on the financial statements, it is determined by the
cost of goods sold that are purchased on credit. Sellers use this to determine
how many days it takes for the firm to pay them. Delaying payment is beneficial
to the firm.
Inventory turnover is
important since inventories are the most illiquid assets (current). It is
advantageous for the firm to sell inventories so as not to tie up money in
inventory and incur carrying costs.
Inventory turnover = cost of goods sold/average inventory
Inventory turnover analyzes
the ability (i.e. 10x) of the firm to convert inventory to cash. Another way is
to determine how many days it takes to convert inventory to cash by using the
inventory conversion period.
Inventory conversion period = 360 days/inventory
turnover
Inventory ratios should be
compared with the industry average by rule of thumb since they vary widely
between industries.
When a firm borrows it does
so to finance working capital or for long term purposes to invest in long term
assets such as equipment and plant. Long term borrowing involves a commitment
to pay a semiannual or annual interest payment, and the principle when the loan
matures. Obviously to be able to do this the firm must able to generate income
to cover the debt payments.
The debt ratio indicates the
percentage of total assets that is financed by debt. The higher the debt ratio
the greater the financial leverage.
Debt ratio = total liabilities / total assets
So a 20% debt ratio means
that debt is financed by 20% of the assets used. But a more well-known ratio is
debt to equity ratio.
D/E = long term debt + value of leases/stockholders’ equity
(SE)
So if the numerator is $2m on
the balance sheet, and SE is $5m, then the D/E is 40%. This is interesting
because companies like utilities with steady flows of periodic income can
afford a high D/E ratio.
The long term debt to total
assets provides information to what degree the firm finances its assets with
long term debt.
LD/TA = long term debt/total assets
Another important factor is
to know how well the company can pay its interest payments, or covered by the
operating income (EBIT) by using the times interest earned ratio (TIE).
TIE = EBIT/annual interest expense
Say a company has EBIT
(earnings before interest and taxes) $8m and $3m in interest charges, the ratio
is 2.67, meaning that income is higher by 2.67 times than interest charges. A
decline in economic activity would reduce EBIT below the interest expenses, and
could lead to default and insolvency.
Profitability ratios will
follow on the next article.
