Citibank - Ratio Analysis

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UNIT 4: FINANCIAL RATIOS — LIQUIDITY

INTRODUCTION

An analyst uses financial ratios to understand the relationships among various financialstatement accounts. These ratios yield information about a company’s ability to meet short-term obligations on time, remain solvent over a long period, manage assets, and operateefficiently.

In this unit, we demonstrate the calculation of two liquidity ratios: the current ratio and theacid test (or quick asset) ratio. The current ratio tells us the amount of current assets thatare available to cover current liabilities. The acid test accomplishes the same purpose as thecurrent ratio, but it yields more precise information because it considers only the mostliquid assets. Finally, we will look at two situations that demonstrate how a company’sdecisions can affect its liquidity ratios.

UNIT OBJECTIVES

When you complete this unit, you will be able to:

n Recognize the different types of financial ratios

n Calculate a current ratio and an acid test (quick asset) ratio

n Recognize how a company’s decisions can affect its liquidity ratios

4-2 FINANCIAL RATIOS — LIQUIDITY

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FINANCIAL RATIOS

Relationshipswithin accounts

The use of ratios and margins in financial analysis enables the analystto interpret the financial situation of an enterprise in a moremeaningful manner than by just looking at the absolute numbers.Financial ratios consider the relationships that exist within variousaccounts and, thus, facilitate an understanding of a company’s financialcondition with greater depth and clarity.

Ratio analysis is another tool that helps identify changes in acompany's financial situation. A single ratio is not sufficient toadequately judge the financial situation of the company. Several ratiosmust be analyzed together and compared with prior-year ratios, oreven with other companies in the same industry. This comparativeaspect of ratio analysis is extremely important in financial analysis.

It is important to note that ratios are parameters and not precise orabsolute measurements. Thus, ratios must be interpreted cautiouslyto avoid erroneous conclusions. The analyst should attempt to getbehind the numbers, place them in their proper perspective and, ifnecessary, ask the right questions for further clarification.

Types of Financial Ratios

There are several types of ratios or relationships. They are categorizedas follows:

n Liquidity ratios — measure the ability of the enterprise tomeet its short-term financial obligations in a timely manner

n Leverage ratios — measure the solvency or viability of theenterprise on a long-term basis

n Turnover ratios — measure how effectively the company'sassets are managed

FINANCIAL RATIOS — LIQUIDITY 4-3

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n Profitability ratios — measure the efficiency of operationswithin the enterprise

We begin our discussion of financial ratios in this unit with liquidityratios. The remaining ratios are the subject of Units Five throughSeven. For future reference, you will find a Financial Ratio Summarysheet at the end of Unit Seven. You may find it usefulas a quick reference as you work through these units.

LIQUIDITY RATIOS

Liquidity ratios measure the relationship of the more liquid assetsof an enterprise (the ones most easily convertible to cash) to currentliabilities. The most common liquidity ratios are:

n Current ratio

n Acid test (or quick asset) ratio

Current Ratio

Quantitativerelationshipbetween currentassets andcurrentliabilities

The current ratio is frequently used to measure liquidity because itis a quick and easy way to express the quantitative relationshipbetween current assets and current liabilities. It answers thequestion: "How many dollars in current assets are there to covereach $1.00 in current liabilities?" To calculate the current ratio,divide current assets by current liabilities.

Current AssetsCurrent Liabilities

A rule of thumb is that a current ratio close to 2.0 is good, but this is avery generalized statement. Let's look at an example.

Current Ratio =


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COMPANY A COMPANY B COMPANY C

Current Assets $150 $ 80 $400Current Liabilities $100 $110 $180

Current Ratio 1.50 0.73 2.22

Company C has $2.22 in current assets for each $1.00 in current debt.It apparently has more liquidity and, therefore, appears tobe in a better position to pay its short-term debts than either CompanyA or B.

Interpretingthe ratio

The current ratio must be interpreted with caution. An absolutenumber by itself may not present a strong enough basis to drawconclusions. The analyst must attempt to get behind the numbers andverify that the current assets, which substantiate the ratio, are indeedfully realizable. For example, if a relatively high current ratio index isbased on large amounts of trade receivables, the collectabilityof these accounts should be investigated. If a large proportion ofreceivables is delinquent, or if the current economic situation couldadversely affect timely collection efforts, then a high current ratiowill not necessarily indicate strong liquidity.

The same type of analysis should be made for inventories. Whenexcessive inventory levels on the balance sheet are the basis for a highcurrent ratio, the analyst should question whether obsolescence,changes in style, physical deterioration, or changes in market priceshave affected the realization value of this inventory. When it seemsimpossible to realize inventories in full, their value should be reducedand the current ratio adjusted accordingly.

Testingthe ratio

It is advisable to test the strength of the current ratio by carefullyexamining the enterprise's accounts receivable and inventory levels, orby focusing on the turnover ratios discussed in Unit Six. This providesa stronger feeling for the realization value of these two importantcurrent assets.


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Another consideration is the average maturity dates for the currentassets and liabilities. If most of the current liabilities mature nextweek, then significant amounts of trade receivables due in 60 days willnot provide the desired liquidity level. Since maturities of receivablesand payables seldom match, most companies are constantly dealingwith too little or too much liquidity.

The current ratio should, therefore, be used as a rough indicatorand never as an accurate statement of the company's actualability to pay.

Financingpatterns

The financing methodology normal to a sector can also have amajor impact on current ratio levels. This is part of what the analystconsiders in norms for specific sectors. For example, look at twotypes of companies: a shoe producer and a supermarket chain.

Example:Shoe producer

The shoe producer has major needs for inventory — both rawmaterials and finished goods — because the nature of the businessis to produce many styles, sizes, and colors. In the real world, the shoecompany must also sell on a credit basis to entice shoe storesto purchase its product. The business can, thus, be considered workingcapital intensive. In such cases, a significant portion of the company’sown capital may be invested in financing working capital needs —since suppliers will not finance either finished goods or receivables.The shoe producer’s probable current ratio is around 1.5, or maybe alittle higher.

Example:Supermarketchain

The supermarket sells on a cash basis and, therefore, does not havea need to book receivables. The supermarket chain is also in a strongposition on purchasing and can often negotiate longer credit termsthan needed. The supermarket may take 60 day terms and turn over thegoods in 30 days, investing the funds for the other 30 days. Thesupermarket chain’s probable current ratio is around 1.0, since there islittle or none of the supermarket’s own capital invested in currentassets.


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Which of the two companies is more liquid? If you say thesupermarket, you are right because its products (mainly food) canbe sold more quickly than shoes. Yet its “normal” current ratio ofaround 1.0 is much lower than the shoe producer’s 1.5. Be carefulabout coming to quick conclusions about liquidity by looking solely atthe current ratio as a liquidity indicator. The analyst should alsoconsider financing patterns.

Acid Test

Considers mostliquid currentassets

The second commonly used liquidity ratio is the quick asset ratio,often called the acid test. This ratio presents a more precise liquiditytest by considering only the more liquid current assets, therebyexcluding inventories, prepaid expenses, and other current assets fromthe calculation. In this way, the index places greater emphasis on themore immediate conversion of current assets to provide coverage ofshort-term obligations. The rule of thumb for a healthy acid test indexis 1.0.

The calculation for this ratio is:

Cash + Near Cash Assets + Trade ReceivablesCurrent Liabilities

The acid test presumes that trade receivables are more liquid thaninventories. Trade receivables are directly converted to cash;inventories are first converted to trade receivables (if sales aremade on a credit basis) and then to cash. In addition, there is someuncertainty of the value at which inventories will be realized, sincesome items may become damaged, lost, or obsolete.

Two ratios arecomplementary

Let's look at the current ratio example and see how the two ratioscomplement each other.

Acid Test =


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COMPANY A COMPANY B COMPANY C

Current Assets $150 $ 80 $400Inventories $ 20 $ 30 $300Current Liabilities $100 $110 $180

Current Ratio 1.50 0.73 2.22Acid Test 1.30 0.45 0.55

Company C has the highest current ratio, but it relies on realization ofinventories to cover its short-term liabilities. If it is unable to convertthe inventories to cash, it will only have $0.55 (400 – 300 ÷ 180) inquick assets to meet each $1.00 of current liabilities.

Company A probably has the best liquidity of all because it doesnot depend on inventory realization to meet its debts. Even withoutselling inventories, it has $1.30 in current assets to meet every$1.00 in current debt.

Similar to the current ratio, the analyst must attempt to get behind theacid test computed index and verify that the trade receivablessubstantiating the ratio are fully realizable at the agreed upon term.

The analyst also must consider the firm's line of business sincecompanies that sell on a cash basis (such as supermarkets) have noreceivables on the balance sheet. The result is a very low quick assetratio even though the type of inventory sold (food, in the case of asupermarket) may be very liquid. The company's liquidity situationcould be quite good despite a low acid test figure.


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Other Liquidity Indicators

Associated withlevels of cash

Besides the current ratio and acid test, there may be other liquidityindicators. These could be associated with cash levels, such as:

n Cash + Near Cash as % of Current Assets

n Cash + Near Cash as % of Working Capital

n Days Cash

The first two ratios are simple percentages. Days cash is acomparison of cash to sales, with the resulting decimal figuremultiplied by the number of days in the period, 360 days for a yearlycalculation, to get the proportion of cash as of the balance sheet dateto the accumulated yearly sales figure.

The new Citibank spreadsheet includes days cash, along with daysreceivable, days inventory, and days payable as liquidity ratios. Thisrecognizes that the turnover of these current assets is closely linked toa company’s liquidity position.

However, these balance sheet figures in terms of days of sales /production have traditionally been considered turnover ratios, wherethe analyst contrasts these balance sheet accounts with incomestatement figures. We will consider these ratios later.

You have completed the sections on “Current Ratio”, “Acid Test,”(quick asset ratio) and “Other Liquidity Indicators.” Please completethe following Progress Check before continuing a further study ofliquidity ratios.


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HOW LIQUIDITY RATIOS CHANGE

Example There are many factors that can change a company's liquidity. Let'slook at the following example:

ASSETS LIABILITIES & NET WORTH

Current Assets $3,000 Current Liabilities $2,500Fixed Assets 2,000 Net Worth 2,500

TOTAL $5,000 TOTAL $5,000

In this case, the company's current ratio is 1.20. Let's see howdifferent financial decisions can affect this current ratio.

Situation 1:

Short-term loan The company takes a short-term loan of $800, increasing its currentliabilities. Let's see what happens if the company uses the proceeds to(a) purchase inventories or (b) purchase equipment.

a) If the company purchases inventories, current assets willincrease and the balance sheet will look like this:


Current Assets $3,800* Current Liabilities $3,300*Fixed Assets 2,000 Net Worth 2,500


* An $800 increase over the starting point.

The current ratio for this balance sheet is 1.15.

Conclusion: If the current ratio is greater than 1.00, andcurrent assets increase while current liabilities increase bythe same amount, the current ratio decreases.


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b) If the proceeds of the loan are used to buy machinery, fixedassets will increase.


Current Assets $3,000 Current Liabilities $3,300*Fixed Assets 2,800* Net Worth 2,500



The current ratio is now 0.91.

Conclusion: Using short-term loans (current liabilities) to buyfixed assets causes liquidity to deteriorate.

Situation 2:

Increasedcapital

The owners decide to increase capital by $800, thus increasing networth. The proceeds may be used to (a) add to inventories or (b) add tomachinery.

a) If the additional capital is used to purchase inventories, currentassets increase and current liabilities remain the same.


Current Assets $3,800* Current Liabilities $2,500Fixed Assets 2,000 Net Worth 3,300*



The current ratio is now 1.52.

Conclusion: Applying long-term resources (net worth) tocurrent assets improves liquidity.


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b) If the increase in capital is used to purchase machinery, fixedassets increase while current assets and current liabilitiesremain the same.


Current Assets $3,000 Current Liabilities $2,500Fixed Assets 2,800* Net Worth 3,300*



The liquidity ratio is 1.20.

Conclusion: Using long-term sources to finance long-termuses does not affect the current ratio since the ratio onlymeasures current liquidity.

The examples demonstrate that the current ratio may vary according tothe situation. This ratio is only one source of information about acompany's financial status.

Please complete the following Progress Check before continuing toUnit Five: Financial Ratios — Leverage.

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UNIT 5: FINANCIAL RATIOS — LEVERAGE

INTRODUCTION

In general, leverage ratios focus on the sufficiency of assets, or generation from assets,to cover the company’s pending short- and long-term obligations. The liquidity ratiosdiscussed in Unit Four are similar in this regard but they are more concerned with theurgency of coverage; leverage ratios are more concerned with overall volume ofcoverage.

Leverage ratios, also called capital structure ratios or solvency ratios, measure therelationship between outside capital and shareholder capital. Leverage ratios include:

n Total indebtedness ratio, or leverage

n Current and long-term indebtedness ratios

n Fixed assets to net worth ratio

n Interest or debt service coverage ratios

UNIT OBJECTIVES


n Calculate a total indebtedness ratio

n Recognize the significance of a company’s leverage ratios

n Identify generally appropriate leverage figures for different businesses

n Calculate adjusted leverage

5-2 FINANCIAL RATIOS — LEVERAGE

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TOTAL INDEBTEDNESS (LEVERAGE)

The total indebtedness ratio, often called leverage, is one ofthe most important ratios for a banker. It is a good indicator ofcompany solvency (ability to pay all debts) and a general indexof the borrower’s creditworthiness. From a banker’s perspective, thelower the ratio within an appropriate range, the better. A low ratioindicates a greater asset coverage of liabilities and, therefore, agreater “cushion” of capital to cover unforeseen difficulties. Acompany with a low index denotes stronger capitalization whichcan absorb greater risk.

Calculation

Standardleveragecalculation

Outside capital is comprised of current and long-term liabilities thatrepresent resources loaned to the company by third parties. Owncapital is net worth. It represents the resources that stockholders haveinvested and earned in the firm. We divide outside capital by owncapital to determine the total indebtedness of a company.

Calculation: Total Liabilities / Total Net Worth

Asset leverage Another way of computing leverage is:

Total Assets / Total Net Worth

Own CapitalOutside Capital

FINANCIAL RATIOS — LEVERAGE 5-3

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This calculation emphasizes the concept of asset coverage forpayment of a company’s liabilities. It is really a variation on thestandard or normal leverage, rather than a separate ratio. As you cansee in Table 5.1, the result of asset leverage always will be 1.0 morethan the result of standard leverage, so there is little to be gained bycomputing both variations. Banks use one or the other — the greatmajority of banks use the standard leverage calculation.

Company A Company B Company C

AssetsLiabilitiesNet Worth

Standard LeverageAsset Leverage

1000500500

1.02.0

1000600400

1.52.5

1000800200

4.05.0

Table 5.1: Comparison of standard leverage and asset leverage

Leverage Analysis

Leverage should be analyzed within the context of the economicsector of the borrower since the appropriate leverage figure may varyfrom sector to sector.

Incidence of Fixed Assets

The amount of fixed assets on the balance sheet is one of the majordeterminants of appropriate leverage. A heavy industry with majorfixed asset needs will require greater capital levels to sustain itsilliquid assets. The total debt for these types of companies will berelatively low in comparison to net worth, resulting in relativelylow leverage levels. On the other hand, highly liquid companieswith little need for fixed assets (such as wholesalers or tradingcompanies) normally will operate at debt levels that are multiplesof net worth, resulting in leverage of two or three, or perhaps greater.In Table 5.2, we show a comparison of the leverage for these two typesof companies.


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Heavy Industrial Co. Trading Co.

Fixed assets 700 100

Total assets 1000 1000

Liabilities 400 800

Net worth 600 200

Leverage 0.67 4.0

Table 5.2: Leverage relative to the amount of fixed assets

Effect of Seasonality

The leverage figure should also be measured within the contextof seasonal borrowing patterns, if any, since these may distort theanalysis. For example, a food processing company may be forced totake on debt at harvest time to enable payment to farmers. When theprocessed goods are sold, the company can repay the loans.Measuring leverage at the point of higher debt will result in a higherfigure than at other times during the year. So, the timing of thebalance sheet analysis should also be considered. In Table 5.3, youcan see how the leverage ratio for a company with seasonalborrowing needs may vary for different periods during the year.

12/31 3/31 6/30

Total Assets 1000 800 1500

Liabilities 500 300 950

Net Worth 500 500 550

Leverage 1.0 0.6 1.7

Table 5.3: Leverage ratios for different periods


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Financial Leverage

Earlier, we said that from the lender’s perspective, the lower theleverage ratio for a company, the better. But, the borrower’s interest,in the case of capital sufficiency, may differ from the banker’s. Fromthe shareholder’s point of view, if leverage is too low, profits may beinsufficient for the level of equity in the company, resulting in a poorreturn on equity.

Borrower’spoint of view

An obvious way to improve return on equity is to increase earnings.Perhaps a less obvious way is to have less equity or net worth, whichmeans higher leverage. For this reason, from the borrower’s point ofview, it may be more convenient to “leverage up” a business, withinreasonable parameters, in order to improve earnings per share. This isthe concept of financial leverage, which is illustrated in Table 5.4.

ReasonablyAggressively

Conservative Leveraged Leveraged

Total Assets 1000 1000 1000

Liabilities 400 500 600

Net Worth 600 500 400

Earnings 100 100 100

Leverage 0.67 1.00 1.50Return on Equity 16.7% 20.0% 25.0%

Table 5.4: Financial leverage — borrower’s perspective

Lender’sviewpoint

From the lender’s point of view, risk increases as liabilitiessubstitute for equity. Take the case of a heavy industrial company withnorms as listed in the first column of Table 5.4. If the company is wellrun and has a strong position in its market, a lender may tolerate areasonable increase in leverage. However,as the company leverages more aggressively, the banker will be lesstolerant from a risk perspective.


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“Correct”leverage figure

The “correct” leverage figure for each company, then, may varyconsiderably, depending on the liquidity of the assets, stability of theeconomic sector, and factors within the market. But, it is safeto say that the greater the amount of fixed assets, the greater thecapital needs and, therefore, the lower the normal leverage level.

In summary, the normal leverage ratios generally are as follows:

n Heavy industries — less than 1.0

n Medium industries — about 1.0 to 1.5

n Retailers — slightly higher, maybe at 2.0

n Wholesalers — slightly higher than retailers, perhaps 2.5to 3.0 or higher

n Financial services companies — 10.0 times or greater,sometimes as high as 20.0 (not to be confused with capitaladequacy which has its own rules regarding assets that donot require capital backing).These companies tend to operatewith small amounts of fixed assets on their balance sheets(generally less than 5% of total assets).

Informationresources

It is recommended that the analyst look up some figures withinhis/her respective market to confirm these numbers, perhapsbusiness magazine listings of the “top 100” companies in theirmarket. Industry averages, if available, are especially valuable for thispurpose. Whatever the source, it is important for the analyst to get afeeling for the “right” figure for this important ratio to permit greaterdepth in financial analysis and better judgment as to capital adequacyamong different types of borrowers.


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Tangible Net Worth

Net ofnonconvertibleassets

When analyzing a company’s balance sheet, keep in mind that it mayshow assets that are difficult or impossible to convert intocash, such as pre-operating expenses or other intangibles, stalereceivables, obsolete inventories, etc. These assets should bededucted from net worth for calculating leverage in order to present amore realistic or conservative scenario. The result ofthis “write down” is called tangible net worth.

Example Let’s look at an example for Company X:

$MTotal assets 500Current liabilities 200Long-term liabilities 50Net worth 300

Utilizing stated net worth, the total indebtedness ratio is 0.83:

(200 + 50) / 300 = 0.83

However, Company X has some liquidity problems and $50,000 of itsassets cannot be converted into cash. If we calculate tangible networth, we see a different picture of the company:

(200 + 50) / (300 - 50) = 1.00

Utilizing tangible net worth (net of nonconvertible assets), we now getan indebtedness ratio of 1.00. This means that outside capitalrepresents 100% of own capital.


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As we discussed in Unit One, standard financial analysis theoryrecognizes that intangibles may not be convertible into cash andeliminates these assets against net worth for calculating tangible networth. But this “write down” is not automatic. It should be doneonly if the intangibles are determined to be of dubious value andunrealizable. Other intangibles may be very valuable (examples:licenses to produce international brands, goodwill resulting from arecent privatization) and have a defined market value. In these cases, itwould not necessarily be appropriate to net these assets since theymay provide a major support to the net worth and value of thecompany. It is up to the analyst to make this determination.

Revaluation Surplus

Result ofrevaluingfixed assets

Since a revaluation of fixed assets results in a corresponding increasein revaluation surplus (a net worth account), net worth is increased bythe net amount of a revaluation. In many cases, this increase may bejustified by market conditions; but when the practice is unevenlyapplied, it can also lend itself to manipulation of numbers.

Therefore, for purposes of calculating tangible net worth, it also maybe appropriate to “write down” the amount of revaluation surplus. Thisis a judgment call for the analyst. At the very least, an analyst cancalculate leverage with and without revaluation surplus to highlight theimpact of revaluation on the leverage calculation as shown in Table5.5.

Before After Revaluation

Fixed assetsTotal assetsLiabilitiesNet worth

Computed leverageAdjusted leverage

5001,000

500500

1.001.00

7001,200

500700

0.711.00

Table 5.5: Leverage with and without revaluation surplus


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Other Adjustments

Contingentliabilities

Contingent liabilities, such as corporate guarantees, discountedreceivables with recourse, lease obligations, and open foreigncurrency positions, should also be considered by the analyst whenstudying a company’s leverage position. If a certain event occurs,a contingent liability may become direct (for example, a defaultby the principal borrower where the company analyzed is a guarantor).In Table 5.6, you can see that leverage increases if default occurs andthe guarantee becomes a liability.

Before After Default

LiabilitiesNet worth

Corporate guarantee

Leverage

500500

200

1.0

700500

0

1.4

Table 5.6: Increased leverage after default

Operatingleases

A similar situation may occur with operating leases where theacquired assets are not booked on the user company’s balance sheet.By definition, the lease payments are expensed and there is no listedliability. But, if we look at the case of an airline, we see that thecompany cannot operate without the leased aircraft — and leasepayments are really liabilities if the company plans to keep doingbusiness. Omitting these “liabilities” from the balance sheet distortsreality, overstates the capital position, and severely understates thegeneric leverage of the company.

Therefore, from the analyst’s point of view, it probably would beprudent to include several years’ worth of lease obligations on thebalance sheet as a “liability.” How many years? This, again, is ajudgment call, but the Citibank Airlines and Aerospace Unit has usedup to seven years for this type of analysis. You can see the effect ofthis leverage adjustment in Table 5.7.


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Unadjusted Adjusted

Total assetsLiabilitiesNet worth

Annual lease obligationAverage no. of years

Leverage

1,000600400

2007

1.5

2,4002,000

400

5.0

Table 5.7: Effect on leverage of liabilities adjusted for operating leases

In this situation, the shift to adjusted numbers results in major changesin the perception of the capital sufficiency of the company.

Consolidations and Minority Interest

Consolidatedfinancialstatements

Consolidated financial statements present the accounts of a group ofinterrelated companies as if they constitute only one company. Withthis overview, the analyst can assess the financial position andprospects of the entire group.

In the case of consolidated numbers, the auditor lists assets on the leftside, and liabilities, minority interest, and net worth accountson the right side of the balance sheet. But, what is minority interest? Isit debt or equity? What should the analyst do with the minority interestaccount in terms of analysis?

If you said that minority interest represents the portion of thegroup of companies that is owned by minority shareholders, youare correct. But, if this is ownership (i.e. net worth), why is theaccount not included within the net worth section of the consolidatedbalance sheet?


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The answer is that, by accounting conventions, consolidated figuresinclude all the assets under the control of the group, even those thatbelong to third parties. The amount that the third party claims toownership is then segregated on the right side of the balance sheetsince it is not owned or controlled by the majority shareholders. Thestated net worth is the net worth of the controlling shareholders, towhom the auditor’s report is addressed.

The analyst should be careful when considering these numbers —sometimes it appears from the presentation that minority interest isa liability. But, it is not. What should be done with minority interestfor the purposes of calculating leverage? Answer: It should beaggregated to net worth. Minority interest is, after all, legal equity.This aggregation is precisely the methodology used in the newCitibank spreadsheet. Incorrect and correct calculations of leverageare compared in Table 5.8.

Incorrect Correct

Total assetsLiabilitiesMinority interestNet worth

Leverage

1,000500100400

1.50

1,000500100400

1.00

Table 5.8: Aggregating minority interest with net worth tocalculate leverage

The total indebtedness ratio compares outside capital to own capital toindicate a company’s leverage position. From the lender’s point ofview, low leverage indicates strong capitalization and less businessrisk. From the borrower’s point of view, it may be more convenient tobe more highly leveraged. The analyst must “get behind the numbers”to understand the impact of the leverage figure on the perceivedbusiness risk of a company.

In the next section, we discuss two ratios that separate short-termliabilities from long-term liabilities to give a clearer picture of acompany’s financial situation.


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CURRENT AND LONG-TERM INDEBTEDNESS RATIOS

The total indebtedness ratio shows the relationship of totalindebtedness to own capital. The current indebtedness ratio showsthe proportion of current indebtedness to own capital (net worth), andthe long-term indebtedness ratio shows the proportion of long-termindebtedness to own capital. Added together, the figures should equalthe total indebtedness ratio.

Example Let’s look at an example that compares the indebtedness ratiosfor two companies. Even though the total indebtedness ratio isthe same, the current and long-term ratios provide more in-depthinformation about leverage for these companies.

Company A Company B

Current liabilitiesLong-term liabilitiesTotal liabilities

Net worth

Current indebtedness ratioLong-term indebtedness ratioTotal indebtedness ratio

100 100

200

200

0.50 0.50

1.00

180 20

200

200

0.90 0.10

1.00

Table 5.9: Indebtedness ratios for two companies

In Table 5.9, Company B may be in a less comfortable situationbecause most of its indebtedness is short-term, while Company A hasat least one year to start paying 50% of its debts.


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A high current indebtedness ratio may be a cause for concern ifa large part of it is currently due for payment. Whether it is actuallya cause for concern or not will be dictated by the purpose of theindebtedness. For example, if indebtedness is financing fixed assets, itobviously is appropriate for this to be long-term financing. On theother hand, if a trading company with practically no fixed assets isfinancing receivables, it is appropriate for its entire debt to be short-term. Here we see an overlap between leverage and liquidity concepts.A higher long-term indebtedness ratio results in greater liquidity asthe amount of short-term obligations are reduced relative to total debt.

FIXED ASSETS COVERED BY OWN RESOURCES

Fixed assets covered by own resources is the ratio that measures therelationship between fixed assets and net worth.

Calculation: Fixed Assets / Net Worth

Net worth represents a company’s permanent capital and should beused to support fixed investments. Any excess of net worth over fixedassets is used to fund working capital. If net worth is lower than fixedassets, the difference is funded by outside capital. Let’s look at twosituations for Alpha Company.

SITUATION A

Current assets 200 Current liabilities 150Fixed assets 300 Net worth 350

TOTAL 500 TOTAL 500

Percentage ofnet worth fundsworking capital

There is a difference of 50 between net worth and fixed assets. Sincenet worth is greater, the difference of 50 is used to fund workingcapital. In other words, the proportion of fixed assets to ownresources is 86%, and the remaining 14% of net worth is used to fundthe company’s working capital.


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Now, suppose Alpha Company purchases a new plant for 100 that isfunded by long-term loans. The new situation is:

SITUATION B

Current assets 200 Current liabilities 150Fixed assets 400 Long-term liabilities 100

Net Worth 350

TOTAL 600 TOTAL 600

Current assetsfunded byoutside capital

Fixed assets increase from 300 to 400 and total long-term liabilitiesincrease by 100. Fixed assets are covered by 350 in net worth and by50 in long-term debt. Since the entire net worth is used to cover fixedassets, current assets are funded entirely by outside capital.

COVERAGE RATIOS

Coverage ratios indicate the amount of funds generated by operationsto cover interest expense, long-term indebtedness, andthe current portion of long-term debt.

Funds From Operations — Interest Coverage

This calculation finds the coverage existing from gross operating cashflow (GOCF or FFO, funds from operations) to enable payment ofinterest expenses.

Calculation: GOCF / Gross interest expense

Remember, GOCF is operating profit (net sales - cost of goods sold -selling and administrative expenses) plus depreciation, amortization,and other non-cash charges. Therefore, GOCF may be significant, insome cases, despite poor earnings. Capital intensive companies thatgenerate a great deal of depreciation or amortizations may find theseamounts of greater importance than operating profit.


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High ratioindicates abilityto cover interestfrom operations

The higher the number for this ratio, the better, since it means greaterease of payment of interest. A number lower than one indicates aninability to pay out interest expense from operations, requiring non-operating sources to cover interest needs. An over-leveraged firm willfind this ratio to be low, perhaps near one, leaving it vulnerable to anincrease in interest rates or an economic downturn. Companies thatover leveraged themselves on Wall Street in the 1980s, such asMacy’s and Bloomingdales, paid a heavy price for this, requiringChapter 11 protection from creditors to survive.

Funds From Operations — Long-Term Debt Coverage

This ratio is similar to the previous one, but includes payment of long-term debt as well:

Calculation: GOCF / (Gross interest expense + Total LTD)

The number here will be greatly influenced by the amount of long-term debt, if any, on the balance sheet. It measures the coverage ofoperational cash generation to contribute to interest and long-termdebt obligations. Since it does not take into consideration the paymentschedule of the long-term debt, this ratio is perhaps less useful thanthe following ratio.

Debt Service Ratio

This ratio is similar to the previous two, but includes payment of thecurrent portion of long-term debt instead of total long-term debt:

Calculation: GOCF / (Gross interest expense + Current portion LTD)


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Here again, the higher the number for this ratio, the better, sinceit means greater ease of debt service. A number lower than oneindicates an inability to pay out debt service from operations,requiring reduction of working capital or non-operating sourcesto cover interest needs. In such a case, the funding source willprobably be additional debt, if credit can be obtained. Again,an over-leveraged firm will find this ratio to be low, leaving itvulnerable to an increase in interest rates or an economic downturn.This is precisely the risk of higher leverage for any company.

Summary

Leverage ratios measure the relationship between outside capital andown capital. They focus on the sufficiency of assets to cover short-and long-term obligations.

Total indebtedness ratio (leverage) — measures the relationship ofnet worth to liabilities or assets.

Total liabilities / Total net worth

Total assets / Total net worth

The analyst may have to adjust the leverage figure for a company toaccount for such factors as seasonality and liquidity of the assets.From the lender’s perspective, a lower ratio indicates lower risk.

Current and long-term indebtedness ratios show the relationshipbetween net worth and current or long-term debt.

Current liabilities / Total net worth

Long-term liabilities / Total net worth

Fixed assets covered by own resources measure the relationshipbetween fixed assets and net worth.

Fixed assets / Net worth


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Any excess of net worth over fixed assets is used to fund workingcapital.

Coverage ratios measure the amount of funds generated fromoperations to cover interest payments and the total or current portionof long-term debt. The higher the number for these ratios, the greaterthe ease of interest and long-term debt service.

Gross operating cash flow (GOCF) / Gross interest expense

GOCF / Gross interest expense + Total long-term debt

GOCF / Gross interest expense + Current portion of long-term debt

You have completed Unit Five: Financial Ratios — Leverage. Please answer the questionsin Progress Check 5 to check your understanding of the material before proceeding to UnitSix: Financial Ratios — Turnover.

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UNIT 6: FINANCIAL RATIOS — TURNOVER

INTRODUCTION

Liquidity ratios try to answer the question, “What is the degree of coverage of liquid assetsfor short-term obligations?” Turnover ratios try to answer the question, “How long does ittake the firm to realize receivables or inventories, or to pay its trade suppliers?”

In this unit, we will see how turnover ratios complement liquidity ratios by informingthe analyst of the time it takes a company to convert trade receivables and inventory intocash, or the amount of funds that has been provided by trade receivables. Correct reading ofthe ratios, along with additional information about a company’s business, may also help theanalyst to evaluate the quality of current assets. This determination is important in judgingliquidity, since current ratio coverage of liquid assets over short-term obligationspresupposes timely liquidation of receivables and inventory.

Some turnover ratios may be calculated in two ways: either as a straight turnover orconverted to days. The commonly used turnover ratios include:

n Receivables turnover, or days receivable

n Inventory turnover, or days inventory

n Payables turnover, or days payable

n Sales to assets turnover

Other turnover ratios may also be calculated, including days cash and securities or daysaccruals, but the ratios listed above are the most common.

6-2 FINANCIAL RATIOS — TURNOVER

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UNIT OBJECTIVES


n Calculate the receivables turnover ratio (turnover periods in a year)

n Calculate days receivable (average collection time)

n Calculate the inventory turnover ratio (turnover periods in a year)

n Calculate days inventory (amount of inventory on the balance sheet date relativeto the annual production)

n Calculate the payables turnover ratio (turnover periods in a year)

n Calculate days payable (average payment time)

n Calculate the sales to asset turnover ratio

RECEIVABLES TURNOVER / DAYS RECEIVABLE

Receivables Turnover Ratio

Calculation The receivables turnover ratio is calculated by dividing net creditsales from the income statement by trade receivables from currentassets in the balance sheet.

Calculation: Net Credit Sales / Trade Receivables

The sales figure should represent the entire year to prevent distortionand to allow comparison to prior annual figures. For interimcalculations, the sales figure should be annualized, taking into accountany seasonal factors in the sales.

FINANCIAL RATIOS — TURNOVER 6-3

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Net credit salesnot itemizedin incomestatement

Notice that the correct figure for sales is net credit sales, not totalnet sales, because receivables, by definition, are sales made on acredit basis. Sales made on a cash basis do not generate accountsreceivable. Yet, the Citibank spreadsheet calculates on the basis of netsales (as is the case with the spreadsheet of most banks). If thisis technically incorrect, why do banks calculate this way? The reasonis that the income statement does not tell us what percentage of salesis on a credit basis and what percentage is on a cash basis.

Useapproximatepercentages

Many companies that sell on credit terms do so for 100% of theirsales. In these cases, net credit sales and total net sales are the same.If an analyst studies the financial statements of a company withsignificant amounts of both credit and cash sales, he/she should findout the approximate percentages and calculate an adjusted turnover.

Another point worth noting is the effect of value added taxes. If salestaxes are included within the sales figure, then these must be nettedout as well.

Net out otherreceivables

Note, also, that we use trade receivables for this calculation. Thismeans that other receivables, those not generated from normal tradeoperations of the company, should be netted out to avoid distortion ofthe numbers.

Examples Let’s look at the example of receivables turnover for two companiesin Table 6.1.

Company A Company B

Net credit salesTrade receivablesTurnover (times per year)

4001004.0

72060

12.0

Table 6.1: Receivables turnover for two companies


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From these numbers, we can see that Company A turns over its tradereceivables four times per year while Company B turns over its tradereceivables twelve times per year. Therefore, Company B collectsmuch faster than Company A.

Days Receivable

Expressesturnover interms of days

Most banks prefer to calculate days receivable, instead of receivableturnover. Days receivable is another way of stating the sameinformation, but perhaps in more useful form. This methodology takesthe turnover number and expresses it in terms of the number of days ina year.

Period ofone year

Taking the example in Table 6.1, a turnover of 4.0 means 90 days,because 90 days is 1/4 of a year. A turnover of 12 times means 30days, because 30 is 1/12 of a year. So days can be calculated bydividing 360 by the turnover.

The following calculation is a more direct approach:

(Trade Receivables / Net Credit Sales) x 360

Period of lessthan one year

If we are calculating turnover for a period of less than one year, wesubstitute the appropriate number of days in the period for the 360.For example, if the period is six months, we substitute 180 in theformula.

In Table 6.2, you can see the calculation of days receivable for thecompanies from Table 6.1.

Company A Company B

Net credit salesTrade receivablesCalculationDays receivable

400100

(100 / 400) x 36090

72060

(60 / 720) x 36030

Table 6.2: Calculation of days receivable for two companies


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The figure for days receivable represents the collection period foreach company.

Collectionperiod relativeto credit terms

In studying the companies, the analyst should compare these numbersto the average credit terms granted by the company. If Company A inthe example, grants credit terms of 90 days and Company B grants 30days, then both are collecting well and probably have good qualityreceivables on the balance sheet. However, if Company A grants termsof 60 days, but is collectingin 90 days, then we question the quality of the receivables —apparently there are significant amounts of past due accounts withinthe balance sheet.

Averagereceivablesfor the year

Note that these calculations are based on year end numbers. Useof average numbers for the year would be more precise, and wouldprovide the average collection period for the year. If we have monthlybalance sheets, we can obtain a more precise average receivablesfigure during the year for this computation — but an analyst rarely hasthe luxury of monthly figures.

Seasonalityeffect

We can calculate averages from quarterly figures, which is morepractical, or from beginning and ending year figures. This lattercalculation is not too helpful because it does not capture anyseasonality during the year. In practical terms, most banks,including Citibank, simply use year-end figures for calculating daysreceivable. The resulting figure can be affected by seasonal factors,which, conceivably, can lead to a wrong interpretation of the result.

Example Let’s look at an example.

Omega Company produces clothing and sells to distributors on 90-dayterms. All sales are on a credit basis. Total annual sales are 12,000,but sales in the October to December quarter constitute 40% of totalannual sales. These sales are spaced evenly per month, i.e. 1,600 inOctober, 1,600 in November, and 1,600 in December.


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With this information, we know that accounts receivable at 12/31should be entirely constituted by sales for the 90-day period betweenOctober to December, i.e. 4,800. If we do a spreadsheet analysis ofthe 12/31 balance sheet, what is the calculation for days receivable?

Calculation: (4800 / 12,000) x 360 = 144 days

In judging this number, the analyst can easily compare it to the90-days credit terms and conclude there are problems withcollectibility of receivables. Wrong conclusion!

What we see here is the effect of seasonality. We have sales in thisquarter greater than the average sales per quarter for the year. Thesales total of 4,800 in the last quarter constitutes 4.8 months (144days) of the total sales of the year, but they are collected in only 3.0months. During other quarters, the sales are less than the average forthe year. In these other months, the days receivable calculation couldbe 54 days (quarterly sales of 1,800), 72 days (quarterly sales of2,400), or other numbers.

The analyst should recognize that the calculation of the daysreceivable figures by the spreadsheet software could be misleadingand should interpret the numbers accordingly. In particular, the analystshould understand whether the last quarter sales figures are average orout of the ordinary.

Summary

Receivables turnover tells us how many turnover periods forreceivables a company has in one year. The calculation is:

Net Credit Sales / Trade Receivables


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A more direct approach is to calculate the number of days in onecollection period. The calculation is:

(Trade Receivables / Net Credit Sales) x 360

This figure is significant when compared to the credit terms granted bya company. The analyst can draw some conclusions about the qualityof the receivables on the balance sheet and the company’s ability tocollect them. Judgment should be based on calculations using averagenumbers for the year, which give a more precise result than using year-end figures.

You have now completed the section on “Receivables Turnover / Days Receivable.” Pleasecomplete Progress Check 6.1 before continuing on to the next section, “Inventory Turnoveror Days Inventory.”


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INVENTORY TURNOVER OR DAYS INVENTORY

Inventory Turnover

Number oftimesinventories arereplenished

The inventory turnover ratio indicates the number of timesinventories are replenished during the period. It is calculated bydividing cost of goods sold (an income statement account) byinventory (a current asset account).

Calculation: Cost of Goods Sold / Inventory

Notice that when we calculate receivables turnover we measure againstsales, whereas inventory turnover is calculated against costof sales. Why is this?

Receivables literally are sales made on a credit basis; they must bebooked at the sales price. But inventories have not been sold. Byaccounting convention, these are carried on the balance sheet atcost. Therefore, we calculate inventory turnover against cost.

Example Let’s look at an example.

Company X Company Y

Cost of goods soldInventoryTurnover (times per year)

6001006.0

9003003.0

Table 6.3: Inventory turnover for two companies

From these numbers, we can see that Company X turns over itsinventory twice as fast as Company Y.


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The comments about average and year-end figures made in thereceivables discussion apply equally to inventory. Averaged monthlyfigures are ideal, but the analyst rarely has this luxury — quarterlyor semiannual figures may be more feasible. Yet, the Citibankspreadsheet calculations are based on year-end figures only. Why?It is simply more convenient to program it this way. If the analyst hasadditional information (for example, quarterly figures) he/she canmake the calculation manually and compare it to the year-endinventory figure.

Days Inventory

Inventory interms of days

Most banks prefer to calculate days inventory instead of inventoryturnover. Days inventory is another way of stating the sameinformation in a more useful format. This methodology takes theturnover number and expresses it in terms of the number of days ina year.

Taking the previous example, a turnover of 6.0 means 60 days, because60 days is 1/6 of a year. A turnover of 3.0 times means 120 days,because 120 is 1/3 of a year. So, days can be calculated by dividing360 by the turnover.

As with receivables, there is a more direct approach.

(Inventory / Cost of Goods Sold) % 360

However, if we’re dealing with a period of less than one year, then wesubstitute the appropriate number of days in the period for the 360.For example, for six month figures, we substitute 180 in the formula.


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Example In Table 6.4, we calculate the days inventory for the same twocompanies that we saw in the inventory turnover example.

Company X Company Y

Cost of goods soldInventoryCalculationDays inventory

600100

(100 / 600) × 36060

900300

(300 / 900) × 360120

Table 6.4: Days inventory for two companies

Length of timecompany canoperate withoutproduction

The figure for days inventory represents the amount of inventoryat the balance sheet cutoff date relative to annual production costs.This indicates approximately how many days the company can operatewithout additional production before closing its doors. Fora commercial company where the entire inventory is finished goods,this approximate number may be close to reality — as long as thereare no major seasonal effects. For an industrial company, this is a veryrough estimate because inventory is composed of both finished goodsand raw materials.

Consider typeof inventory

Actually, for an industrial company, the type of inventory shouldbe considered in the calculation of days inventory because the costelement is different. Finished goods are valued at cost of goods sold(raw material, labor, and overhead), but raw materials are valued atpurchase cost (or market, whichever is lower). This means that ifinventory is composed mostly of finished goods, the traditionalcalculation can be quite accurate. If the inventories are essentially rawmaterials (RM), the following calculation may be more appropriate:

(Raw Material Inventory / (Initial RM + Purchases - End RM)) % 360


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Where most of the inventories are raw materials, this is a moreaccurate calculation. However, it is not the formula calculated by bankspreadsheets because the income statement normally does not indicatethe amount of annual purchases of raw materials. If the analyst canobtain this information, in some cases it may be usefulto make this extra calculation for a more precise evaluation of thenumbers.

Inventoryjudgingappropriatelevels

In studying the numbers, the analyst likes to compare them tosomething. The days receivable number is compared to creditterms. What can days inventory be compared to? This is a difficultquestion, but there are some factors to consider. The analyst must firstunderstand the business fundamentals to judge inventory sufficiency.

Type ofcompany

The type of company will determine the inventory an analyst shouldconsider. A shoe producer may have different styles, sizes, and colorsof products in stock, besides considerable amounts of raw materials. Itis a working capital intensive business. Commercial companies alsoare inventory intensive, by nature, so these types of companies willtend to have greater amounts of inventory on their balance sheets. Onthe other hand, transport companies, and other service companies suchas hotels, have little need for inventory and will, therefore, have lowerlevels on their balance sheet.

Sellingmethodology

Selling methodology also has an impact. Does the firm sell on aspecific contract basis, or does it sell from stock? The first case mayinvolve little need for finished goods, while the second will havegreatly increased needs.

When considering the appropriate level of inventory, the analyst mustalso take into account any potential seasonality. Clients that sell,purchase, and produce the same amount every month are rare, soinventory levels for most companies will vary from month to month orquarter to quarter. The analyst should try to understand these seasonaleffects to more accurately interpret the days inventory figure at thebalance sheet date.


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There are no easy answers to enable precision in judging theappropriate level of inventory for a company. The analyst should get afeeling for what is appropriate from management and then look atsimilar firms for comparison, remembering that no two firms areexactly alike.

Generally,less inventoryis better

We do know that within reasonable limits, from a financial perspective,it is better to operate with less inventory. Why? Inventory has carryingcosts (space, control systems, pilferage, obsolescence, security,insurance, etc.) and it also has financing costs — either debt interest orequity expectations. Therefore, holding inventory is an expensiveproposition; and that is why the theory of “just in time inventory” wasdeveloped.

Reasons forhigher inventory

Some clients say they prefer to maintain higher inventory levels “toprotect themselves against inflation,” “to get volume discounts onpurchases,” or “to nail down a lower exchange rate.” All of these may betrue in specific cases, if the savings from lower prices at purchasecompensate for inventory carrying and financial costs. With the currentsignificantly reduced inflation levels and greater economic stability inLatin America, these client comments are heard less and less.

Summary

The inventory turnover ratio calculates the number of timesinventories are replenished during the period. The calculation is:

Cost of Goods Sold / Inventory

Days inventory is another way of stating the same information, butis the number most banks prefer to use. It expresses the turnovernumber in terms of days in a year. The calculation is:

(Inventory / Cost of Goods Sold) % 360


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For periods of less than one year, the correct number of days is usedin place of 360.

In assessing the days inventory number, the analyst must consider thefollowing issues:

n Type of inventory — finished goods or raw materials

n Appropriate level of inventory — depends on type of company,selling methodology, and seasonality

You have now completed the section on “Inventory Turnover or Days Inventory.” Pleasecomplete Progress Check 6.2 before continuing on to the next section, “Payables Turnoveror Days Payable.”


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PAYABLES TURNOVER OR DAYS PAYABLE

Payables Turnover

Measuredagainstpurchases

Payables turnover indicates the number of times that payables are rotatedduring the period. It is best measured against purchases, since purchasesgenerate accounts payable.

Calculation: Total Purchases / Trade Payables

The purchases figure should represent the entire year, or the ratio willbe distorted and not comparable to prior annual figures. For interimcalculations, the purchases figure should, therefore, be annualized,taking into account any seasonal factors in purchasing.

Example Let’s look at an example:

Company E Company F

Total purchasesTrade payablesTurnover (times per year)

1,200100

12.0

9601606.0

Table 6.5: Payables turnover for two companies

Company E has a higher rotation than Company F. This means thatCompany F’s trade suppliers probably offer more generous creditterms.


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Days Payable

Most banks prefer to calculate days payable, instead of payableturnover. Days payable is another way of stating the same information ina more useful form. This methodology takes the turnover number andexpresses it in terms of the number of days in a year.

In the previous example, a turnover of 12.0 means 30 days, because 30days is 1/12 of a year. A turnover of 6.0 times means 60 days, because60 is 1/6 of a year. So, days can be calculated by dividing 360 by theturnover.

As with the other turnover ratios, there is a more direct approach.

(Trade Payables / Total Purchases) x 360

However, if we are dealing with a period of less than one year, wesubstitute the appropriate number of days in the period for the 360.For example, we substitute 180 in the formula for six month figures.

Let’s calculate the days payable for the same two companies:

Company E Company F

Total purchasesTrade payables

CalculationDays payable

1,200100

(100 / 1200) x 36030

960160

(160 / 960) x 36060

Table 6.6: Days payable for two companies

Averagepaymentperiod

The figure for days payable represents the average payment periodfor the company. In studying the companies, the analyst would like tocompare these numbers to the average credit terms received by thecompany.


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Common Variation

The days payable calculation is correct in theory, yet more often(including the Citibank spreadsheet) we see the less precisecalculation for days payable:

Calculation: (Trade Payables / Cost of Goods Sold) x 360

Substitutes costof goods sold

The reason is that the figure for purchases normally is not specified inthe income statement, so we use the second best alternative as adefault. Notice that for a commercial firm this distinction is notrelevant. There is no processing of the goods and, therefore, the figurefor purchases is essentially the same as cost of goods sold.For an industrial firm, there may be a significant difference. Let’s lookat the same two companies, but this time we will include a figure forcost of goods sold.

Company E Company F

Cost of goods soldTotal purchasesTrade payables

Calculation #1Days payable (purchase basis)

Calculation #2Days payable (cgs basis)

Variance from # 1

1,8001,200

100

(100 / 1200) x 36030

(100 / 1800) x 36020

33%

1,200960160

(160 / 960) x 36060

(160 / 1200) x 36048

20%

Table 6.7: Comparison of days payable calculation using purchasesas a basis vs. using cost of goods sold as a basis

Notice that these numbers are quite reasonable for industrialcompanies. For Company E, purchases is 67% of CGS; forCompany F, the figure is 80%.


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Implicit errorusing CGS basis

In the first case, the variance, or implicit error in calculating bythe CGS basis, is 33%, in the second case, it is 20%. The analyst,therefore, must understand how the spreadsheet calculates andrecognize this implicit error when interpreting the spreadsheetcalculations. This applies to days payable for industrial companies orfor any other companies that have a significant amount of value addedto their products.

Seasonality

Similar to the situation with receivables, payables figures can besignificantly impacted by seasonality. Average payables figures areuseful but, as a practical matter, most banks (including Citibank)simply use year-end figures for calculating days payable on thespreadsheet.

Purchasingfrequencyvaries

Many companies, especially retailers, purchase several times duringthe year at specified intervals, instead of making equal purchases everymonth. The resulting days receivable figure, therefore, can be affectedconsiderably by seasonal factors. Conceivably, this may lead to anincorrect interpretation of the result. Let’s look at an example.

Example Theta Company sells clothing to the general public. All purchasesare on a credit basis, with average terms of 60 days. Total annualpurchases are 1,000, but purchases in November and Decembertogether constitute 30% of this total.

With this information, accounts payable at 12/31 should beconstituted by the November and December purchases, i.e. 300.If we do a spreadsheet analysis of the 12/31 balance sheet, whatis the calculation for days payable?

Calculation: (300 / 1000) x 360 = 108 days

In judging this number, the analyst can easily compare it to the creditterms of 60 days and conclude that there are problems with paymentof receivables. Wrong conclusion!

Changed 07/02/96


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What we see here is the effect of seasonality. The purchase total of300 in the last quarter constitutes 3.6 months (108 days) of the totalpurchases of the year, but these are made in only 2.0 months. In otherwords, we have purchases in November and December greater than theaverage purchases for any other two months of the year. During othertwo month periods, the purchases are less than the average for theyear, and the days payable calculation may vary — for example, 36days (two month purchases of 100), 48 days (two month purchases of133), etc.

Spreadsheetcalculationsmay bemisleading

As with the receivables calculation, the analyst should be carefulbecause the calculation of the days payable figures by the spreadsheetsoftware may be misleading. The analyst must understand this effectand interpret the numbers accordingly. In particular, the analyst shouldunderstand whether the last months’ purchase figures are average orout of the ordinary.

Interpreting the Number

Recognizereasons behindthe numbers

The higher the days payable, the better from a funds flow point of view.However, if the numbers for this ratio, adjusted for seasonality, are toohigh, this may indicate delayed payments to suppliers, possibly due tocash flow difficulties. This could indicate serious trouble in a veryshort period of time. A very low number should also be analyzed todetermine why this usually cheaper source of funding is not beingmaximized. Are suppliers cutting back on credit? If so, what is thereason for this?

Shorthandfunds flowanalysis

The days payable number is often analyzed in tandem with daysreceivable and days inventory for a shorthand funds flow analysis. Thisvery generalized analysis may be used to estimate the working capitalrequirements for a company. Remember, this is very generalizedbecause, all of these funds flows may be measured against a differentbase (i.e. receivables vs. sales, inventory vs.cgs, payables vs. purchases) so that each of the “days” has adifferent value.


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+ Days receivable+ Days inventory- Days payable= Operational working capital

Summary

Payables turnover is the average number of payment periods in a yearand should be measured against purchases.

The calculation is:

(Total Purchases / Trade Payables)

Days payable is the average payment period for a company and may becompared to credit terms to evaluate a company’s payment ofreceivables.

The most common calculation is:

(Trade Payables / Cost of Goods Sold) × 360

A more accurate calculation is:

(Trade Payables / Total Purchases) × 360


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SALES TO ASSETS TURNOVER RATIO

Efficiency ofasset utilization

The asset turnover ratio is a comparison of sales to total assets.This ratio is used less frequently in financial analysis than theother turnover ratios, but is nonetheless very useful. It providesa shorthand indicator of the efficiency with which assets are beingutilized in the business.

Calculation: Total Net Sales / Total Assets

Spreadsheetcalculation

It is best calculated against average total assets but, here again,spreadsheets usually make a trade-off by calculating against end-of-period total assets. If there has been considerable growth inassets during the year, or if the company’s business is very seasonal,resulting in major swings in asset totals during the year, then theanalyst should obtain some additional numbers to enable calculatingaverage figures.

Example Let’s look at an example:

Company J Company K

Net salesTotal assets

Turnover (times)

400320

1.25

600720

0.83

Table 6.8: Use of assets to support sales

Company K sells more, but Company J is more efficient because itneeds less asset resources per $1.00 of sales.


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Interpreting the Ratio

The higher,the better

Generally, the higher the asset turnover the better — more sales areachieved with a given amount of asset resources. Where the turnoveris higher, there is greater operational efficiency.

Compare withsimilar firms

Companies probably experience relatively little fluctuation in thisratio from year to year. It is often best to measure this ratio againstsimilar firms in the market for a comparison of how efficientindividual companies are in using available resources.

The indicator may vary considerably from sector to sector, dependingon certain factors such as whether the firm must offer credit, and howmuch. Perhaps the most significant factor is, as in the case withleverage, the incidence of fixed assets. Companies that need a greatdeal of fixed assets will have low ratios, and vice versa. Fixed assetswill act as a drag on this ratio and, in many cases, the actual numbersfor this ratio will be similar to the leverage figure.

It should be noted that leased assets off the balance sheet will distortthe asset turnover ratio by reporting a higher turnover than a “real”figure would indicate. Therefore, if significant amounts of such assetsare used by the company, the analyst should adjust the balance sheet byincluding these assets and recalculating this ratio.

You have completed Unit Six: Financial Ratios — Turnover. Please answer the questionsin Progress Check 6.4 to check your understanding of the material before proceeding toUnit Seven: Financial Ratios — Profitability.

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UNIT 7: FINANCIAL RATIOS — PROFITABILITY

INTRODUCTION

Companies are in business for one purpose — to make profits. If a company accumulatesconsiderable losses year after year, it will not stay in business for long. Profits are thedriving force of growth and are the main source for repaying loans, making newinvestments, and providing an adequate return to owners so they retain their interestand financial backing.

Profits are important for another reason — they measure the relative success of a companyand can readily be compared to other companies and to the capital market. Therefore,profits reflect (and profit ratios measure) the effectiveness and efficiencyof management. The common profitability ratios are:

n Return on Sales

n Return on Assets

n Return on Equity

UNIT OBJECTIVES


n Calculate the three profitability ratios: return on sales, return on assets,and return on equity

n Recognize the DuPont formula for calculating ROE

n Calculate ROE using the DuPont formula

7-2 FINANCIAL RATIOS — PROFITABILITY

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PROFITABILITY RATIOS

Return on Sales

Dollar profit per$100 in sales

The return on sales ratio (profit on sales) measures how manydollars of profit are made for every $100 in net sales. The figure isa percentage and is calculated as:

Net IncomeReturn on Sales = x 100

Net Sales

Let's compare the profits for Company A and Company B.

Company A Company B

Net incomeNet salesRatio

$ 20$200

10.0%

$ 100$4,000

2.5%

Table 7.1: Profit comparison

We can see that Company A earned $20 for every $200 in sales,a profit of 10%. Profits earned by Company B were higher inmonetary terms; but at 2.5% of net sales, they were proportionallylower than those earned by Company A. Therefore, Company Agenerates more income on each $1.00 in sales than Company B. Thisis an indication that Company A generates profits more efficiently.

Moreconservativecalculation

A conservative way to evaluate sales profit is to exclude extraordinaryitems from net income. For example, if Company A had extraordinaryincome of $5 and we subtracted this amount from net income, theprofit on sales would decrease to 7.5%.

FINANCIAL RATIOS — PROFITABILITY 7-3

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Return on Assets

Relationshipbetween profitsand resourcesinvested

Return on assets is a good indicator of the productivity of the firm andof management's abilities and efficiency. The index measures therelationship between profits and total resources invested. It is apercentage and is computed as:

Net IncomeReturn on Assets = x 100

Average Assets

Since asset values vary during the year, the best measure is based on anaverage of beginning-of-year assets and end-of-year assets. Let's lookat an example and compare the ratios calculated two ways.

End-of-yearassets

First, we calculate the return on assets based on end-of-year assetsonly.

For 19X1, $ 150 / $ 6,000 = 2.5%

Average ofbeginning andending assets

The more accurate method is to calculate return on assets based on theaverage of beginning-of-year and end-of-year figures.

For 19X1, $ 150 / [($ 4,000 + $ 6,000) / 2] = 3.0%

However, as a practical matter, this ratio often is calculated based onyear-end figures only. This avoids calculating year one on a year-endbasis and subsequent years on an average basis, since averages cannotbe computed for year one. The Citibank spreadsheet calculates againstbeginning totals.

For calculations utilizing interim figures, net income should beannualized. In seasonal situations, this factor should be consideredin the annualization to avoid distortions in the full year net incomefigure.


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The higher,the better

Return on assets is best measured against prior period results from thesame firm or against similar enterprises. The higher the result, thebetter, since a good return on assets indicates efficient use of thefirm's resources.

Return on Equity (Return on Capital)

Profitsgenerated byeach $1invested

Return on equity (ROE) measures the profits generated by each dollaraccumulated in the business by stockholders. The figure isa percentage and is computed as:

Net IncomeReturn on Equity = x 100

Average Net Worth

Return tostockholders

Determining return on equity is important for measuring the degree towhich the profits of the firm provide a return to the shareholders. Thefigure can be compared to a marginal investment rate in thecommunity, such as a time deposit rate in a local bank. ROE measureswhether the enterprise can produce an amount sufficient to cross thishurdle rate and provide an incentive to take on additional risks ofequity investment.

If the ROE figure is very low in comparison to time deposit rates, theowner is further ahead to liquidate the company's assets and depositthe money in a bank. In these situations, the creditor should questionthe owner's commitment to the firm, especially if the financialsituation deteriorates further.

Understand theclient’s situation

In order to avoid some distortion in interpreting the figure, thepractical situation of the client should be understood. For example,in a family enterprise, the analyst should consider (dependingon the market) that profits may be underestimated for tax purposes. Inthese situations, the ROE figure is negatively impacted, andcomparison to other potential investments will be less valid.


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On the other hand, in situations where farms or valuable propertieshave been held for many years and are undervalued on a balance sheet,the net worth figure may be understated with reference to present landvalues. In these situations, an adjusted return on equity figure may beworse than what has been computed and what other market alternativesprovide.

Since the income was generated during the whole period, andnot just at the end, the average net worth should be used whencomputing the figure. However, if prior period figures are notavailable, ending period figures may be applied instead. For interimfigures, net income should be annualized. In seasonal situations,this factor should be considered within the annualization to avoiddistortions in the net income figure.

Example Let's look at the difference between using only the ending balanceand an average of the beginning and ending balance .

19X0 19X1Net income $ 20 $ 60Stockholders’ equity $2,000 $2,400

First method (using ending balance only):

For 19X1, $60 / $2,400 = 2.5%

Second method (using averages):

For 19X1, $60 / [($2,000* + $2,400*) / 2] = 2.73%

* Since the beginning value is $ 2,000 and the ending value $ 2,400, we maypresume that the owners' investment for the year averaged $ 2,200.

The Citibank spreadsheet calculates this ratio against beginning equity.Assuming profitable operations, this results in a higher figure thancalculating an average equity.


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The appropriate level for return on capital is determined by relativefactors such as economic benchmarks, inflation, and local bankdeposit rates. Normally, the higher the ratio, the better the return oncapital. However, an abnormally high return-on-equity figure mightsimply indicate deficiencies in the amount of capital within the firm.

Before proceeding to the final section of this unit, “IntegratedAnalysis,” please check your understanding by completing ProgressCheck 7.1.


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INTEGRATED ANALYSIS

Integratefinancial ratioconcepts

Let’s consider some theories used to integrate several of the mainconcepts encountered in the units covering financial ratios. Theseideas also will tie together the profitability ratios we have justconsidered. They are taken from financial relationships known asa DuPont Analysis.

Return on Assets

We have seen that return on sales informs us of the profitability ofa company’s operations — how much it makes on every $1.00 ofsales. Let’s take this a step further and consider this along with sales /assets turnover. As formulas, we put the two together and see that bymultiplying, we obtain return on assets.

Asset ROS Turnover ROA

Net Income X Net Sales = Net Income i Net Sales Total Assets Total Assets

Operationalleverage

ROS can be considered cost efficiency, while asset turnover can beconsidered a multiplier to achieve asset efficiency (which is ROA).So, the higher the asset turnover, the greater the ROA. This is theconcept of operational leverage.

Note that asset turnover is increased either by increasing sales relativeto assets, or reducing assets relative to sales, or both. This is onereason why it is better to operate with less assets — less cash, lessreceivables, less inventory, etc. This is also why it is so harmful tohave past due receivables, excessive levels of inventory, or non-productive assets on the balance sheet. These act as a brake on assetturnover and, hence, as a brake on ROA.


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Return on Equity

Let’s take this another step. If we multiply return on assets by assetleverage, we obtain return on equity.

Asset ROA Leverage ROE

Net Income X Total Assets = Net IncomeTotal Assets Net Worth Net Worth

Financialleverage

Here, again, we see that the beginning figure is multiplied by the nextcolumn (in this case leverage) to obtain the final column, in this caseROE. By multiplying ROA to obtain a figure for ROE, we can clearlysee how greater debt levels actually “leverage” earnings. This is theconcept of financial leverage.

From this formula, we can appreciate that greater leverage will achievegreater earnings. This is correct as long as ROS is not adverselyaffected by greater interest expense. Remember your vantage point.The borrower uses this as an excuse to operate with greater debtlevels. The lender is more interested in reducing risk. If the investorleverages up by taking on greater debt to finance capital expansion,this may yield greater financial returns, but leave the firm vulnerableto an economic downturn and/or higher interest rates.The credit risk increases.

Application of DuPont Formulas

In total, the DuPont formulas can be summarized as follows:

Asset Asset ROS Turnover ROA Leverage ROE i

Net Income X Net Sales = Net Income X Total Assets = Net Income Net Sales Total Assets Total Assets Net Worth Net Worth

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Example Let’s apply these concepts to some numbers to see if we can obtain anidea of what is appropriate in terms of ROS, ROA, and ROE fordifferent companies through the DuPont insights. Consider thefollowing numbers for Companies X, Y, and Z.

Company X Company Y Company ZNet Sales 1000 1000 1000Average Assets 1500 800 400Average Net Worth 900 400 100

Net Income 180 80 20

Return on Sales 18.0% 8.0% 2.0%Return on Assets 12.0% 10.0% 5.0%Return on Equity 20.0% 20.0% 20.0%

Table 7.2: Profitability ratios for three companies

What insights can we get from these numbers using the DuPontformat? We have included the same numbers below. Remember,the figure for asset leverage is 1.0 more than the standard debt / equityleverage figure.

Net Income Net Sales

X Net Sales Total Assets

Net IncomeTotal Assets

X Total Assets Net Worth

Net IncomeNet Worth

Company X 18.0% X 0.67 = 12.0%; X 1.67 = 20.0%

Company Y 8.0% X 1.25 = 10.0%; X 2.00 = 20.0%

Company Z 2.0% X 2.50 = 5.0%; X 4.00 = 20.0%

Company X

Why does Company X have the same ROE as Y and Z despite having thehighest ROS by a wide margin? Because it has low multipliers — assetturnover is low. Why is it low? The reason is probably due to the natureof the company. It may be a heavy industry with heavy fixed asset needsthat operate as a brake on the ROE ratio. Leverage is also low (debt /equity is 0.67), probably for the same reason.

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Lesson: We can see that heavy industries, or other companies with anintensive use of fixed assets, need high margins to compensate forpoor multipliers.

Company Y

Company Y’s multipliers are higher than X’s, but lower than Z’s. Why?It is probably a different type of company. With these numbers, it lookslike a medium industry, with asset turnover just greater than 1.0 andleverage about the same (note: debt / equity = 1.00).

Lesson: The multipliers are better, so margins can be lower thanheavy industries to achieve the same ROE.

Company Z

Company Z’s multipliers are very high, enabling an equal ROE despitea very low margin. Why? It is probably a company withlow fixed asset needs and high liquidity of assets, permitting higherleverage (equivalent debt / equity = 3.00). As such, there are probablylow barriers to entry in the business, which means it is probably ahighly competitive sector with low margins. It probablyis a wholesaler or trading company.

Lesson: Low margins can mean good profits overall if the asset andleverage multipliers can be managed properly.

Conclusions

What is anappropriateROS?

We have been able to draw some conclusions from this analysis interms of what is appropriate for ROS. If a company, by nature, has lowmultipliers, ROS must be high to achieve an acceptable ROE. Asmultipliers increase, ROS may be reduced, as well, and still achieve anacceptable ROE.

Answer: The appropriate ROS depends on the multipliers.

Changed 07/02/96


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It should be obvious that companies do not willingly reduce their ROS;this occurs as a result of competition. If Company Z can achieve aROS of 10% and maintain the same multipliers, its owners will be veryhappy with its resulting ROE of 100%. This undoubtedly will attractthe attention of potential competitors, and eventually drive down theROS figure.

AppropriateROEdetermined bycapital markets

From this viewpoint we also can appreciate that ROE sets the tone forthe other ratios. The appropriate figure for ROS depends on themultipliers. The appropriate figure for ROA depends on the leveragemultiplier. What is appropriate for ROE? Capital markets determinethis, not multipliers. An acceptable ROE will be similar for allcompanies in the market (higher for riskier sectors), regardless ofthe multipliers. In the final analysis, the ROE figure will determinewhich company has the best earnings.

Summary

In summary, integrated analysis helps us understand not only therelationships between earnings ratios and operational and financialleverage, but also provides insights into what is appropriate for returnon sales for different types of companies. This knowledge thenpermits the analyst to obtain a deeper interpretation of the numbers,and a better appreciation of what is appropriate, so that he/she mayjudge the sufficiency of the numbers.

You have completed Unit Seven: Financial Ratios — Profitability. Please answer thequestions in Progress Check 7.2 to check your understanding of these concepts. Followingthe Progress Check is a summary chart of the financial ratios we have presented in thisworkbook. Use it as a review for the final unit, Applied Financial Analysis – Case Studies,and also as a handy reference in the future.


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The following chart is a summary of the financial ratios covered in the Financial StatementAnalysis Workbook. Please review the chart before continuing to Unit Eight: AppliedFinancial Analysis — Case Studies. Also, use it as a convenient reference in the future.

SUMMARY OF FINANCIAL RATIOS

RATIO FORMULA EVALUATION

LIQUIDITY

Current

Acid Test

Current AssetsCurrent Liabilities

Cash + Near Cash Assets + Trade ReceivablesCurrent Liabilities

The higher, the better


OPERATING

Days Receivables

Days Inventory

Days Payables

Assets Turnover

Average Trade Receivables x 360Net Credit Sales

Average Inventories x 360Cost of Goods Sold

Average Trade Payables x 360Total Purchases

Net Sales IAverage Total Assets

The lower, the better,generally

The lower, the better,generally

The higher, the better,generally

The higher, the better,generally

LEVERAGE

Total Indebtedness Total Liabilities ITangible Net Worth

The lower, the better

COVERAGE

Interest Coverage

Debt Service Ratio

GOCF IGross Interest Expense

GOCF IGross Int Exp + Current Portion LTD



PROFITABILITY

Return on Sales

Return on Assets

Return on Equity

Net Income INet Sales

Net Income IAverage Total Assets

Net Income IAverage Net Worth



The higher, the betterx 100

x 100

x 100

Documents

Citibank - Ratio Analysis