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.