Thursday, July 5, 2018

Leverage and Debt to Worth

"Leverage" measures the extent to which debt is used to finance a business.  Higher leverage results from greater proportions of debt financing as opposed to equity financing, and greater risk generally accompanies higher leverage.  The most basic measure of leverage is the Debt to Worth Ratio:

          Debt to Worth = Total Liabilities
                                      Net Equity

The debt to worth ratio presents the relationship between capital contributed by lenders and capital contributed by owners.  Higher debt to worth implies more leverage and, therefore, more risk or potential for volatility.  A lower ratio implies that the business may have untapped borrowing capacity.

The debt to worth of Smith Heating and Cooling, Inc. is $234 to 1.  So, one might say that, for every dollar the owners have contributed, the company has borrowed $234 to operate the business.  This amount seems astronomical.  The business is indeed highly leveraged, but their debt to worth ratio is anomalous.  The ratio is not informative.

When equity is very small or negative due to losses on the income statement, the ratio loses its meaning.  A deficit or near zero equity position may be a problem itself, as losses have eroded the capital that was originally contributed by the owners.

Other balance sheet items may throw off the meaning of the debt to worth ratio as well.  For example, heavily depreciated buildings may cause an artificially high debt to worth if their market values are significantly higher than their book values.

The existence of intangible assets may have the opposite effect, by inflating equity with items that have little or no real value.  A solution is to calculate “tangible net worth” by excluding the book value of intangible assets.  You may then calculate a “Debt to Tangible Net Worth” ratio:

          Debt to Tangible Net Worth =             Total Liabilities             
                                                        Net Equity-Net Intangible Assets

Monday, July 2, 2018

Accounts Payable Turnover Ratios

          Accounts Payable Turnover =   Cost of Goods Sold
                                                             Accounts Payable

The Accounts Payable Turnover Ratio represents the average number of times per year that payables “turn over” or get paid with cash.  A higher (more rapid) turnover is generally favorable, since accounts payable are being paid more quickly.

But, paying debts too quickly uses up needed cash.  Many businesses extend these payments as much as possible to make the best use of their cash.  Businesses that manage their payables in this way or which receive extended payment terms from suppliers will, therefore, have lower (less rapid) accounts payable turnover.

At the same, businesses experiencing cash flow crunches or disputed invoices with their suppliers will also exhibit slower payables turnover.  Additional research is often necessary to determine the cause of slow or slowing accounts payable turnover.  Is it a sign of trouble or a result of good cash flow management?  To learn more, compare payables turnover to the industry average and to the payment terms of vendors.  Explore payables turnover from previous periods, and look for trends.

Like the other turnover ratios, this one compares cost of goods sold over a period of time with the accounts payable balance at a single point in time.  Perhaps the payables balance is inflated due to a seasonal buildup or a big discount from a supplier.  An analyst may compare purchases (as opposed to Cost of Goods Sold) to average accounts payable balances to obtain more meaningful ratios.

Days Payables Outstanding =                            365                   
                                                              Accounts Payable Turnover Ratio

“Days Payables Outstanding” expresses turnover as the average length of time in days between purchases and their payment.  Although, this ratio has the same limitations as the Accounts Payable Turnover Ratio, it may be more intuitive to look at payables turnover in terms of days rather than in number of times per period.

The payables of Smith Heating and Cooling, Inc. turn over 2.33 times per year or every 157 days.  This represents extraordinarily slow payables turnover.  The company’s accounts payable are certainly due in less than an average of 157 days.  An analyst would explore whether the company is experiencing cash flow problems that are resulting in very slow payments.

Thursday, June 28, 2018

Inventory Turnover Ratios

          Inventory Turnover = Cost of Goods Sold

Inventory turnover represents the average number of times per year that inventory "turns over" or that all goods are sold from inventory.  A higher, more rapid turnover is generally favorable, with goods being sold more quickly.  Rapid turnover may result from good inventory management, but it can be a symptom of an inventory shortage as well.

A lower, less rapid turnover may indicate overstocking or the presence of obsolescent goods.  Slow inventory turnover often coincides with liquidity problems, since working capital is tied up in inventory.  Slow inventory turnover may also result from planned seasonal build-ups or from making a large, bulk purchase to obtain a good price.

As with other turnover ratios, this one compares inventory at a single point in time to an entire period’s cost of sales.  To correct for seasonality or other anomaly, consider using average inventory in the denominator instead of the ending balance.

          Days Inventory Outstanding =                365                 
                                                          Inventory Turnover Ratio

This ratio expresses turnover as the average length of time in days between the purchase and the sale of inventory items.  A lower value (more rapid turnover) is generally more favorable, and interpretation and problems are similar to those of the Inventory Turnover Ratio.

The measures of liquidity for Smith Heating and Cooling, Inc. seemed to indicate that the company would be dependent upon inventory turnover to service short-term obligations.  Because of this, their inventory turnover ratios are crucial.

The company’s inventory turnover is only 2.11 times per year, so inventory is outstanding for an average of 173 days.  This is likely to be very problematic.  An analyst would want to explore how these rates compare to those of the company’s recent past as well as to those of other companies in the industry.  It would also be important to know if seasonal fluctuations are affecting the inventory balance and whether the goods are becoming obsolete as they sit.

Tuesday, June 26, 2018

Activity Ratios and Accounts Receivable Turnover

“Activity ratios” measure "turnover" or the rates at which current assets and current liabilities are used-up or paid-off through ordinary business operations.  Quicker turnover ratios generally imply greater efficiency and better management.  The first such ratio is the accounts receivable turnover ratio:

          Accounts Receivable Turnover = Annual Net Revenue
                                                               Accounts Receivable

Accounts receivable turnover represents the average number of times per year that trade receivables "turn over" or are converted to cash.  Higher, more rapid turnover is favorable, since sales on credit are being converted to cash more quickly.  Lower, less rapid turnover is unfavorable since default becomes more likely as receivables remain uncollected, and since conversion to cash is necessary to service obligations or to earn interest.

A problem with this ratio is the fact that it compares accounts receivable at a single point in time to an entire year of sales.  If the accounts receivable balance is unusually high or low on the date of the financial statements due to seasonal variations or other factors, then this measurement may not provide an accurate picture.  Substituting average receivable balances over the year in the denominator, may help correct this.

Another potential problem exists when cash sales represent a large percentage of total revenues.  The ratio will be very favorable in this case.  A more useful measure may be taken by considering only credit sales in the numerator.  Such a ratio is probably best used only in comparison with the company’s own historical turnover and with the actual payment terms the business requires of its customers.

Another way to look at accounts receivable turnover is in days:

          Days Receivables Outstanding=               365                           
                                                                Receivables Turnover Ratio

This ratio expresses the average length of time in number of days between sales and the cash collection of receivables.  The average number of days that receivables are outstanding can seem like a more intuitive measure than turnover expressed in number of times per year.  In this case, a lower value (or fewer days) is favorable because it represents more rapid turnover.

For Smith Heating and Cooling, Inc., accounts receivable turnover is 11.27 times per year, and the average number of days that receivables are outstanding is 32.39.  To put these numbers into better context, an analyst would compare them to receivables turnover from prior years, receivables turnover from similar businesses, and the company’s payment terms.  If Smith Heating and Cooling requires its customers to pay in thirty days, then receivables turnover is a bit slow.  If some customers pay cash at the time of service, then receivables collection may be really slow for those customers who pay on account.

Sunday, June 24, 2018

Quick Ratio or Acid Test

          Quick Ratio = Cash & equivalents + Current Accounts & Notes Receivable
                                                            Total Current Liabilities

The quick ratio or “acid test” is a more conservative measure of liquidity than the current ratio.  The numerator includes only the most liquid assets, and it excludes inventory and other accounts such as prepaid expenses.

Some accounting and finance experts simply present the quick ratio numerator as “Current Assets minus Inventory.”  This is the most basic way to calculate the quick ratio.  The quick ratio presented here is actually more conservative, since its assets include only cash, cash equivalents, and accounts and notes receivable due within a year.

A quick ratio below one implies that the business will be dependent upon turning its inventory to service short-term debts.  This may be problematic for a business that is susceptible to seasonal or cyclical fluctuations, a manufacturer with significant unfinished goods, or any business holding obsolete inventory.  If inventory is an issue for a business, then you may study their inventory and accounts receivable turnover ratios to learn more about their ability to turn inventory into cash.

For Smith Heating and Cooling, Inc., their quick ratio is 0.43 versus a current ratio of 1.12.  It appears that the company will, indeed, be dependent upon inventory turnover to service its short-term obligations.  For this reason, it will be important to carefully study the quality of the company’s inventory as well as their turnover ratios to perform a complete financial analysis.

Liquidity, Working Capital, and the Current Ratio

"Liquidity" (or "current position") is the measurement of a firm’s ability to service its short-term obligations through the "liquidation" of current assets.  Liquidation refers to the act of turning assets into cash, that is, selling inventory and collecting receivables and amounts due to the business.

The simplest measure of liquidity is “working capital,” or total current assets minus total current liabilities.  This measurement yields a dollar amount.  If the number is positive, then the business has a cushion of current assets over current liabilities.  A working capital shortfall may imply that a problem servicing obligations will arise during the upcoming year.

Perhaps the most commonly used measurement of liquidity is the “current ratio.”

Current Ratio = Total Current Assets / Total Current Liabilities

The current ratio is analogous to the calculation of working capital.  The difference is that the cushion between current assets and current liabilities is measured as a ratio instead of a dollar amount.

A current ratio above one implies that a cushion exists between current assets and current liabilities.  The higher the ratio, the greater the liquidity, since the coverage of current liabilities by current assets becomes larger.

It is also important to analyze the composition and quality of current assets.  Are they comprised primarily of cash and liquid assets?  Or, are most of the liquid assets comprised of receivables that may be difficult to collect or inventory which may be difficult to sell?

Liquidity ratios may also be affected by accounting policies such as whether a borrower uses LIFO, FIFO, or some other inventory valuation method.

Keep in mind that liquidity ratios are affected by seasonality and that the cash conversion cycle or the makeup of the balance sheet may affect liquidity ratios.  For example, a business with a high concentration of fixed assets financed by long-term debt, but with no inventory or receivables, may appear to have liquidity issues (due to the current portion of long-term debt within the denominator of the current ratio).  If fixed assets (as opposed to sales from inventory) generate consistent cash flow, then this income may be sufficient to service the debt and current obligations.  In such a case, an analysis of the cash flows and the debt service coverage ratios may be a better indicator of liquidity.

For Smith Heating and Cooling, Inc., current assets total $309,000, while current liabilities add up to $275,000.  This means that the company has working capital of $34,000 and a current ratio of 1.12.

In this Street Smarts article on, Norm Brodsky argues that paying attention to working capital and the current ratio are essential to success in business.

Sample Income Statement