To find the data used in the examples in this section, please see the XYZ Technologies Limited’s financial statements given earlier.
Liquidity Measurement Ratios
The first ratios we’ll take a look at are the liquidity ratios. Liquidity ratios attempt to measure a company’s ability to pay off its short-term debt obligations. This is done by comparing a company’s most liquid assets (or, those that can be easily converted to cash) and its short term liabilities.
In general, the greater the coverage of liquid assets to short-term liabilities, the better it is, since it is a clear signal that a company can pay debts that are going to become due in the near future and it can still fund its on-going operations. On the other hand, a company with a low coverage rate should raise a red flag for the investors as it may be a sign that the company will have difficulty meeting running its operations, as well as meeting its debt obligations.
The biggest difference between each ratio is the type of assets used in the calculation. While each ratio includes current assets, the more conservative ratios will exclude some current assets as they aren’t as easily converted to cash. The ratios that we’ll look at are the current, quick and cash ratios and we will also go over the cash conversion cycle, which goes into how the company turns its inventory into cash.
o Current Ratio
The current ratio is a popular financial ratio used to test a company’s liquidity (also referred to as its current or working capital position) by deriving the proportion of current assets available to cover current liabilities. The concept behind this ratio is to ascertain whether a company’s short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities. In theory, the higher the current ratio, the better.
Current Ratio = Current Assets / Current Liabilities
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ’S current assets amounted to 13,041 (balance sheet), which is the numerator; while current liabilities amounted to 4030 (balance sheet), which is the denominator. By dividing, the equation gives us a current ratio of 3.24 which can be considered very healthy.
The current ratio is used extensively in financial reporting. However, while easy to understand, it can be misleading in both a positive and negative sense – i.e., a high current ratio is not necessarily good, and a low current ratio is not necessarily bad (see chart below).
Here’s why: contrary to popular perception, the ubiquitous current ratio, as an indicator of liquidity, is flawed because it is conceptually based on the liquidation of all of a company’s current assets to meet all of its current liabilities. In reality, this is not likely to occur. Investors have to look at a company as a going concern. It’s the time it takes to convert a company’s working capital assets into cash to pay its current obligations that is the key to its liquidity. In a word, the current ratio can be “misleading.”
A simplistic, but accurate, comparison of two companies’ current position will illustrate the weakness of relying on the current ratio or a working capital number (current assets minus current liabilities) as a sole indicator of liquidity (amounts in Rs. crs.) :
Company ABC looks like an easy winner in a liquidity contest. It has an ample margin of current assets over current liabilities, a seemingly good current ratio and working capital of Rs. 300. Company has no current asset/liability margin of safety, a weak current ratio, and no working capital.
However, to prove the point, what if: (1) both companies’ current liabilities have an average payment period of 30 days; (2) Company ABC needs six months (180 days) to collect its account receivables and its inventory turns over just once a year (365 days); and (3) Company is paid cash by its customers, and its inventory turns over 24 times a year (every 15 days). In this contrived example, company ABC is very illiquid and would not be able to operate under the conditions described. Its bills are coming due faster than its generation of cash. You can’t pay bills with working capital; you pay bills with cash! Company’s ‘s seemingly tight current position is, in effect, much more liquid because of its quicker cash conversion. When looking at the current ratio, it is important that a company’s current assets can cover its current liabilities; however, investors should be aware that this is not the whole story on company liquidity. Try to understand the types of current assets the company has and how quickly these can be converted into cash to meet current liabilities. This important perspective can be seen through the cash conversion cycle. By digging deeper into the current assets, you will gain a greater understanding of a company’s true liquidity.
o Quick Ratio
The quick ratio – aka the quick assets ratio or the acid-test ratio – is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. Therefore, a higher ratio means a more liquid current position.
Quick ratio = (Cash & Equivalents + Short term investment + Account receivables) / (Current Liabilities)
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ’S quick assets amounted to 13,041 (balance sheet); while current liabilities amounted to 4,030 (balance sheet). By dividing, the equation gives us a quick ratio of 3.24. XYZ being in the services sector does not have any inventory on its balance sheet and this quick ratio and current ratio come out to be the same.
Some presentations of the quick ratio calculate quick assets (the formula’s numerator) by simply subtracting the inventory figure from the total current assets figure. The assumption is that by excluding relatively less-liquid (harder to turn into cash) inventory, the remaining current assets are all of the more-liquid variety. Generally, this is close to the truth, but not always. In some companies, restricted cash, prepaid expenses and deferred income taxes do not pass the test of truly liquid assets. Thus, using the shortcut approach artificially overstates more liquid assets and inflates its quick ratio.
The quick ratio is a more conservative measure of liquidity than the current ratio as it removes inventory from the current assets used in the ratio’s formula. By excluding inventory, the quick ratio focuses on the more-liquid assets of a company. The basics and use of this ratio are similar to the current ratio in that it gives users an idea of the ability of a company to meet its short-term liabilities with its short-term assets. Another beneficial use is to compare the quick ratio with the current ratio. If the current ratio is significantly higher, it is a clear indication that the company’s current assets are dependent on inventory
While considered more stringent than the current ratio, the quick ratio, because of its accounts receivable component, suffers from the same deficiencies as the current ratio – albeit somewhat less. Both the quick and the current ratios assume a liquidation of accounts receivable and inventory as the basis for measuring liquidity. While theoretically feasible, as a going concern a company must focus on the time it takes to convert its working capital assets to cash – that is the true measure of liquidity. Thus, if accounts receivable, as a component of the quick ratio, have, let’s say, a conversion time of several months rather than several days, the “quickness” attribute of this ratio is questionable.
Investors need to be aware that the conventional wisdom regarding both the current and quick ratios as indicators of a company’s liquidity can be misleading.
o Cash Ratio
The cash ratio is an indicator of a company’s liquidity that further refines both the current ratio and the quick ratio by measuring the amount of cash; cash equivalents or invested funds there are in current assets to cover current liabilities.
Cash ratio = (Cash & Equivalents + Short term investment + Invested Funds) / (Current Liabilities)
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ’S cash assets amounted to 9,797 (balance sheet); while current liabilities amounted to 4,030 (balance sheet). By dividing, the equation gives us a cash ratio of 2.43.
The cash ratio is the most stringent and conservative of the three short-term liquidity ratios (current, quick and cash). It only looks at the most liquid short-term assets of the company, which are those that can be most easily used to pay off current obligations. It also ignores inventory and receivables, as there are no assurances that these two accounts can be converted to cash in a timely matter to meet current liabilities. Very few companies will have enough cash and cash equivalents to fully cover current liabilities, which isn’t necessarily a bad thing, so don’t focus on this ratio being above 1:1.
The cash ratio is seldom used in financial reporting or by analysts in the fundamental analysis of a company. It is not realistic for a company to purposefully maintain high levels of cash assets to cover current liabilities. The reason being that it’s often seen as poor asset utilization for a company to hold large amounts of cash on its balance sheet, as this money could be returned to shareholders or used elsewhere to generate higher returns. While providing an interesting liquidity perspective, the usefulness of this ratio is limited.
Profitability Indicator Ratios
These ratios, much like the operational performance ratios, give users a good understanding of how well the company utilized its resources in generating profit and shareholder value. The long-term profitability of a company is vital for both the survivability of the company as well as the benefit received by shareholders. It is these ratios that can give insight into the all important “profit”.
We look at four important profit margins, which display the amount of profit a company generates on its sales at the different stages of an income statement. We’ll also show you how to calculate the effective tax rate of a company. The last three ratios covered in this section – Return on Assets, Return on Equity and Return on Capital Employed – detail how effective a company is at generating income from its resources.
o Profit Margin Analysis
In the income statement, there are four levels of profit or profit margins – gross profit, operating profit, pre-tax profit and net profit. The term “margin” can apply to the absolute number for a given profit level and/or the number as a percentage of net sales/revenues. Profit margin analysis uses the percentage calculation to provide a comprehensive measure of a company’s profitability on a historical basis (3-5 years) and in comparison to peer companies and industry benchmarks. Basically, it is the amount of profit (at the gross, operating, pre-tax or net income level) generated by the company as a percentage of the sales generated. The objective of margin analysis is to detect consistency or positive/negative trends in a company’s earnings. Positive profit margin analysis translates into positive investment quality. To a large degree, it is the quality, and growth, of a company’s earnings that drive its stock price.
Gross Profit Margin = (Gross Profit)/ (Net Sales)
Operating Profit Margin = (Operating Profit)/ (Net Sales)
Pretax Profit Margin = (Pretax Profit)/ (Net Sales)
Net Profit Margin = (Net Profit)/ (Net Sales)
All the amounts in these ratios are found in the income statement. As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net sales, or revenue, of 21,140, which is the denominator in all of the profit margin ratios. The equations give us the percentage profit margins as indicated.
Operating Profi t Margin = 35%
Pre-tax Profi t Margin = 31%
Net Profi t Margin = 23%
Second, income statements in the multi-step format clearly identify the four profit levels. However, with the single-step format the investor must calculate the gross profit and operating profit margin numbers. To obtain the gross profit amount, simply subtract the cost of sales (cost of goods sold) from net sales/revenues. The operating profit amount is obtained by subtracting the sum of the company’s operating expenses from the gross profit amount. Generally, operating expenses would include such account captions as ‘selling’, ‘marketing and administrative’, ‘research and development’, ‘depreciation and amortization’, ‘rental properties’ etc.
Third, investors need to understand that the absolute numbers in the income statement don’t tell us very much, which is why we must look to margin analysis to discern a company’s true profitability. These ratios help us to keep score, as measured over time, of management’s ability to manage costs and expenses and generate profits. The success, or lack thereof, of this important management function is what determines a company’s profitability. A large growth in sales will do little for a company’s earnings if costs and expenses grow disproportionately. Lastly, the profit margin percentage for all the levels of income can easily be translated into a handy metric used frequently by analysts and often mentioned in investment literature. The ratio’s percentage represents the number of paises there are in each rupee worth of sales. For example, using XYZ’S numbers, in every sales rupee for the company in 2010, there’s roughly 35, 31, and 23 paisa of operating, pre-tax, and net income, respectively. Let’s look at each of the profit margin ratios individually:
o Gross Profit Margin
A company’s cost of sales, or cost of goods sold, represents the expense related to labour, raw materials and manufacturing overhead involved in its production process. This expense is deducted from the company’s net sales/revenue, which results in a company’s first level of profit or gross profit. The gross profit margin is used to analyse how efficiently a company is using its raw materials, labour and manufacturing-related fixed assets to generate profits. A higher margin percentage is a favourable profit indicator. Industry characteristics of raw material costs, particularly as these relate to the stability or lack thereof, have a major effect on a company’s gross margin. Generally, management cannot exercise complete control over such costs. Companies without a production process (ex., retailers and service businesses) don’t have a cost of sales exactly. In these instances, the expense is recorded as a “cost of merchandise” and a “cost of services”, respectively. With this type of company, the gross profit margin does not carry the same weight as a producer type company.
o Operating Profit Margin
By subtracting selling, general and administrative, or operating expenses from a company’s gross profit number, we get operating income. Management has much more control over operating expenses than its cost of sales outlays. Thus, investors need to scrutinize the operating profit margin carefully. Positive and negative trends in this ratio are, for the most part, directly attributable to management decisions. A company’s operating income figure is often the preferred metric (deemed to be more reliable) of investment analysts, versus its net income figure, for making inter-company comparisons and financial projections.
o Pre-tax Profit Margin
Again, many investment analysts prefer to use a pre-tax income number for reasons similar to those mentioned for operating income. In this case a company has access to a variety of tax-management techniques, which allow it to manipulate the timing and magnitude of its taxable income.
o Net Profit Margin
Often referred to simply as a company’s profit margin, the so-called bottom line is the most often mentioned when discussing a company’s profitability. While undeniably an important number, investors can easily see from a complete profit margin analysis that there are several income and expense operating elements in an income statement that determine a net profit margin. It behoves investors to take a comprehensive look at a company’s profit margins on a systematic basis.
o Effective Tax Rate
This ratio is a measurement of a company’s tax rate, which is calculated by comparing its income tax expense to its pre-tax income. This amount will often differ from the company’s stated jurisdictional rate due to many accounting factors, including foreign exchange provisions. This effective tax rate gives a good understanding of the tax rate the company faces.
Effective Tax Rate = (Income Tax Expense)/ (Pretax Income)
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had a provision for income taxes in its income statement of 1,717 (income statement) and pre-tax income of 7,520 (income statement). By dividing, the equation gives us an effective tax rate of 23% for FY 2010.
The variances in this percentage can have a material effect on the net-income figure. Peer company comparisons of net profit margins can be problematic as a result of the impact of the effective tax rate on net profit margins. The same can be said of year-over-year comparisons for the same company. This circumstance is one of the reasons some financial analysts prefer to use the operating or pre-tax profit figures instead of the net profit number for profitability ratio calculation purposes.
One could argue that any event that improves a company’s net profit margin is a good one. However, from a quality of earnings perspective, tax management manoeuvrings (though may be legitimate) are less desirable than straight-forward positive operational results.
Tax provision volatility of a company’s finances makes an objective judgment of its true or operational net profit performance difficult to determine. Techniques to lessen the tax burden are practiced, to one degree or another, by many companies. Nevertheless, a relatively stable effective tax rate percentage and resulting net profit margin, would seem to indicate that the company’s operational managers are more responsible for a company’s profitability than the company’s tax accountants.
o Return On Assets
This ratio indicates how profitable a company is relative to its total assets. The return on assets (ROA) ratio illustrates how well management is employing the company’s total assets to make a profit. The higher the return, the more efficient management is in utilizing its asset base. The ROA ratio is calculated by comparing net income to average total assets, and is expressed as a percentage.
ROA = (Net Income)/ (Average Total Assets)
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net income of 5,803 (income statement), and average total assets of 19,922 (balance sheet). By dividing, the equation gives us an ROA of 29% for FY 2010. The need for investment in current and noncurrent assets varies greatly among companies. Capital-intensive businesses (with a large investment in fixed assets) are going to be more asset heavy than technology or service businesses. In the case of capital-intensive businesses, which have to carry a relatively large asset base, will calculate their ROA based on a large number in the denominator of this ratio. Conversely, non-capital-intensive businesses (with a small investment in fixed assets) will be generally favoured with a relatively high ROA because of a low denominator number. It is precisely because businesses require different-sized asset bases that investors need to think about how they use the ROA ratio. For the most part, the ROA measurement should be used historically for the company being analysed. If peer company comparisons are made, it is imperative that the companies being reviewed are similar in product line and business type. Simply being categorised in the same industry will not automatically make a company comparable. As a rule of thumb, investment professionals like to see a company’s ROA come in at no less than 5%. Of course, there are exceptions to this rule. An important one would apply to banks, which typically have a lower ROA.
o Return On Equity
This ratio indicates how profitable a company is by comparing its net income to its average shareholders’ equity. The return on equity ratio (ROE) measures how much the shareholders earned for their investment in the company. The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to investors.
ROE = (Net Income)/ (Average Share holder’s Equity)
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net income of 4,845 (income statement), and average shareholders’ equity of 19,922 (balance sheet). By dividing, the equation gives us an ROE of 24.3% for FY 2010. XYZ on account of being a debt free company has its ROE equal to ROA. If a company has issued preferred stock, investors wishing to see the return on just common equity may modify the formula by subtracting the preferred dividends, which are not paid to common shareholders, from net income and reducing shareholders’ equity by the outstanding amount of preferred equity.
Widely used by investors, the ROE ratio is an important measure of a company’s earnings performance. The ROE tells common shareholders how effectively their money is being employed. Company peers and industry and overall market comparisons are appropriate; however, it should be recognized that there are variations in ROEs among some types of businesses. In general, financial analysts consider return on equity ratios in the 15-20% range as representing attractive levels of investment quality.
While highly regarded as a profitability indicator, the ROE metric does have a recognized weakness. Investors need to be aware that a disproportionate amount of debt in a company’s capital structure would translate into a smaller equity base. Thus, a small amount of net income (the numerator) could still produce a high ROE off a modest equity base (the denominator).
For example, let’s reconfigure XYZ’S debt and equity numbers to illustrate this circumstance. If we reduce the company’s equity amount by Rs. 9,922 crores and increase its long-term debt by a corresponding amount, the reconfigured debt-equity relationship will be (figures in Rs. crores) 9,922 and 10,000, respectively. XYZ’S financial position is obviously much more highly leveraged, i.e., carrying a lot more debt. However, its ROE would now register a whopping 58% (5,803 ÷ 10,000), which is quite an improvement over the 29% ROE of the almost debt-free FY 2010 position of XYZ indicated above. Of course, that improvement in XYZ’S profitability, as measured by its ROE, comes with a price…a lot more debt and thus a lot more risk.
The lesson here for investors is that they cannot look at a company’s return on equity in isolation. A high or low ROE needs to be interpreted in the context of a company’s debt-equity relationship. The answer to this analytical dilemma can be found by using the return on capital employed (ROCE) ratio.
o Return On Capital Employed
The return on capital employed (ROCE) ratio, expressed as a percentage, complements the return on equity (ROE) ratio by adding a company’s debt liabilities, or funded debt, to equity to reflect a company’s total “capital employed”. This measure narrows the focus to gain a better understanding of a company’s ability to generate returns from its available capital base. By comparing net income to the sum of a company’s debt and equity capital, investors can get a clear picture of how the use of leverage impacts a company’s profitability. Financial analysts consider the ROCE measurement to be a more comprehensive profitability indicator because it gauges management’s ability to generate earnings from a company’s total pool of capital.
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net income of 5,803 (income statement). The company’s average short-term and long-term borrowings were 0 and the average shareholders’ equity was 19,922 (all the necessary figures are in the 2009 and 2010 balance sheets), the sum of which, 19,922, is the capital employed. By dividing, the equation gives us an ROCE of 29% for FY 2010.
Often, financial analysts will use operating income (earnings before interest and taxes or EBIT) as the numerator. There are various takes on what should constitute the debt element in the ROCE equation, which can be quite confusing.
Our suggestion is to stick with debt liabilities that represent interest-bearing, documented credit obligations (short-term borrowings, current portion of long-term debt, and long-term debt) as the debt capital in the formula.
Debt Ratios
These ratios give users a general idea of the company’s overall debt load as well as its mix of equity and debt. Debt ratios can be used to determine the overall level of financial risk a company and its shareholders face. In general, the greater the amount of debt held by a company the greater the financial risk of bankruptcy. The ratios covered in this section include the debt ratio, which is gives a general idea of a company’s financial leverage as does the debt-to-equity ratio. The capitalization ratio details the mix of debt and equity while the interest coverage ratio and the cash flow to debt ratio show how well a company can meet its obligations.
Overview Of Debt
Before discussing the various financial debt ratios, we need to clear up the terminology used with “debt” as this concept relates to financial statement presentations. In addition, the debtrelated topics of “funded debt” and credit ratings are discussed below.
There are two types of liabilities – operational and debt. The former includes balance sheet accounts, such as accounts payable, accrued expenses, taxes payable, pension obligations, etc. The latter includes notes payable and other short-term borrowings, the current portion of long-term borrowings, and long-term borrowings. Often times, in investment literature, “debt” is used synonymously with total liabilities. In other instances, it only refers to a company’s indebtedness.
The debt ratios that are explained herein are those that are most commonly used. However, what companies, financial analysts and investment research services use as components to calculate these ratios is far from standardized.
In general, debt analysis can be broken down into three categories, or interpretations: liberal, moderate and conservative.
• Liberal – This approach tends to minimize the amount of debt. It includes only long-term debt as it is recorded in the balance sheet under non current liabilities.
• Moderate – This approach includes current borrowings (notes payable) and the current portion of long-term debt, which appear in the balance sheet’s current liabilities; and of course, the long-term debt. In addition, redeemable preferred stock, because of its debt-like quality is considered to be debt. Lastly, as a general rule, two-thirds (roughly one-third goes to interest expense) of the outstanding balance of operating leases, which do not appear in the balance sheet, are considered debt principal. The relevant figure will be found in the notes to financial statements and identified as “future minimum lease payments required under operating leases that have initial or remaining non-cancelable lease terms in excess of one year.”
• Conservative – This approach includes all the items used in the moderate interpretation of debt, as well as such non-current operational liabilities such as deferred taxes, pension liabilities and other post-retirement employee benefits.
Investors may want to look to the middle ground when deciding what to include in a company’s debt position. With the exception of unfunded pension liabilities, a company’s non-current operational liabilities represent obligations that will be around, at one level or another, forever – at least until the company ceases to be a going concern and is liquidated. Also, unlike debt, there are no fixed payments or interest expenses associated with non-current operational liabilities. In other words, it is more meaningful for investors to view a company’s indebtedness and obligations through the company as a going concern, and therefore, to use the moderate approach to defining debt in their leverage calculations. Funded debt is a term that is seldom used in financial reporting. Technically, funded debt refers to that portion of a company’s debt comprised, generally, of long-term, fixed maturity, contractual borrowings. No matter how problematic a company’s financial condition, holders of these obligations, typically bonds, cannot demand payment as long as the company pays the interest on its funded debt. In contrast, long-term bank debt is usually subject to acceleration clauses and/or restrictive covenants that allow a lender to call its loan, i.e., demand its immediate payment. From an investor’s perspective, the greater the percentage of funded debt in the company’s total debt, the better.
Lastly, credit ratings are formal risk evaluations by credit agencies such as CRISIL, ICRA, CARE, and Fitch – of a company’s ability to repay principal and interest on its debt obligations, principally bonds and commercial paper. Obviously, investors in both bonds and stocks follow these ratings rather closely as indicators of a company’s investment quality. If the company’s credit ratings are not mentioned in their financial reporting, it’s easy to obtain them from the company’s investor relations department.
o The Debt Ratio
The debt ratio compares a company’s total debt to its total assets, which is used to gain a general idea as to the amount of leverage being used by a company. A low percentage means that the company is less dependent on leverage, i.e., money borrowed from and/or owed to others. The lower the percentage, the less leverage a company is using and the stronger its equity position. In general, the higher the ratio, the more risk that company is considered to have taken on.
Debt Ratio = (Total Liabilities)/ (Total Assets)
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had total liabilities of 1,995 (balance sheet) and total assets of 22,036 (balance sheet). By dividing, the equation provides the company with a low leverage as measured by the debt ratio of 9%. The easy-to-calculate debt ratio is helpful to investors looking for a quick take on a company’s leverage. The debt ratio gives users a quick measure of the amount of debt that the company has on its balance sheets compared to its assets. The more debt compared to assets a company has, which is signalled by a high debt ratio, the more leveraged it is and the riskier it is considered to be. Generally, large, well-established companies can push the liability component of their balance sheet structure to higher percentages without getting into trouble. However, one thing to note with this ratio: it isn’t a pure measure of a company’s debt (or indebtedness), as it also includes operational liabilities, such as accounts payable and taxes payable. Companies use these operational liabilities as going concerns to fund the day-to-day operations of the business and aren’t really “debts” in the leverage sense of this ratio. Basically, even if you took the same company and had one version with zero financial debt and another version with substantial financial debt, these operational liabilities would still be there, which in some sense can muddle this ratio. The use of leverage, as displayed by the debt ratio, can be a double-edged sword for companies. If the company manages to generate returns above their cost of capital, investors will benefit. However, with the added risk of the debt on its books, a company can be easily hurt by this leverage if it is unable to generate returns above the cost of capital. Basically, any gains or losses are magnified by the use of leverage in the company’s capital structure.
o Debt-Equity Ratio
The debt-equity ratio is another leverage ratio that compares a company’s total liabilities to its total shareholders’ equity. This is a measurement of how much suppliers, lenders, creditors and obligors have committed to the company versus what the shareholders have committed. To a large degree, the debt-equity ratio provides another vantage point on a company’s leverage position, in this case, comparing total liabilities to shareholders’ equity, as opposed to total assets in the debt ratio. Similar to the debt ratio, a lower the percentage means that a company is using less leverage and has a stronger equity position
Debt Equity Ratio = (Total Liabilities)/ (Share Holder’s Equity)
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had total liabilities of 1,995 (balance sheet) and total shareholders’ equity of 22,306 (balance sheet). By dividing, the equation provides the company with a relatively low percentage of leverage as measured by the debt-equity ratio at 9%. A conservative variation of this ratio, which is seldom seen, involves reducing a company’s equity position by its intangible assets to arrive at a tangible equity, or tangible net worth, figure. Companies with a large amount of purchased goodwill form heavy acquisition activity can end up with a negative equity position. The debt-equity ratio appears frequently in investment literature. However, like the debt ratio, this ratio is not a pure measurement of a company’s debt because it includes operational liabilities in total liabilities. Nevertheless, this easy-to-calculate ratio provides a general indication of a company’s equity-liability relationship and is helpful to investors looking for a quick take on a company’s leverage. Generally, large, well-established companies can push the liability component of their balance sheet structure to higher percentages without getting into trouble.
o Capitalization Ratio
The capitalization ratio measures the debt component of a company’s capital structure, or capitalization (i.e., the sum of long-term debt liabilities and shareholders’ equity) to support a company’s operations and growth. Long-term debt is divided by the sum of long-term debt and shareholders’ equity. This ratio is considered to be one of the more meaningful of the “debt” ratios – it delivers the key insight into a company’s use of leverage. There is no right amount of debt. Leverage varies according to industries, a company’s line of business and its stage of development. Nevertheless, common sense tells us that low debt and high equity levels in the capitalization ratio indicate investment quality.
Capitalization Ratio = (Long Term Debt)/ (Long Term Debt + Share Holder’s Equity)
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had total long-term debt of 0 (balance sheet), and total long-term debt and shareholders’ equity (i.e., its capitalization) of 22,036 (balance sheet). By dividing, the equation provides the company with a zero leverage as measured by the capitalization ratio. A company’s capitalization (not to be confused with its market capitalization) is the term used to describe the makeup of a company’s permanent or long-term capital, which consists of both long-term debt and shareholders’ equity. A low level of debt and a healthy proportion of equity in a company’s capital structure is an indication of financial fitness.
Prudent use of leverage (debt) increases the financial resources available to a company for growth and expansion. It assumes that management can earn more on borrowed funds than it pays in interest expense and fees on these funds. However, successful this formula may seem, it does require a company to maintain a solid record of complying with its various borrowing commitments.
A company considered too highly leveraged (too much debt) may find its freedom of action restricted by its creditors and/or have its profitability hurt by high interest costs. Of course, the worst of all scenarios is having trouble meeting operating and debt liabilities on time and surviving adverse economic conditions. Lastly, a company in a highly competitive business, if hobbled by high debt, will find its competitors taking advantage of its problems to grab more market share. As mentioned previously, the capitalization ratio is one of the more meaningful debt ratios because it focuses on the relationship of debt liabilities as a component of a company’s total capital base, which is the capital mobilized by shareholders and lenders.
o Interest Coverage Ratio
The interest coverage ratio is used to determine how easily a company can pay interest expenses on outstanding debt. The ratio is calculated by dividing a company’s earnings before interest and taxes (EBIT) by the company’s interest expenses for the same period. The lower the ratio, the more the company is burdened by debt expense. When a company’s interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable.
Interest Coverage Ratio = (EBIT)/ (Interest Expense)
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had earnings before interest and taxes (operating income) of 7,520 (income statement), and total interest expense of 0 (income statement). This equation provides the company with an Infinite margin of safety due to lack of leverage. The ability to stay current with interest payment obligations is absolutely critical for a company as a going concern. While the non-payment of debt principal is a seriously negative condition, a company finding itself in financial/operational difficulties can stay alive for quite some time as long as it is able to service its interest expenses. In a more positive sense, prudent borrowing makes sense for most companies, but the operative word here is “prudent.” Interest expenses affect a company’s profitability, so the cost-benefit analysis dictates that borrowing money to fund a company’s assets has to have a positive effect. An ample interest coverage ratio would be an indicator of this circumstance, as well as indicating substantial additional debt capacity. Obviously, in this category of investment quality, XYZ would go to the head of the class.
o Cash Flow To Debt Ratio
This coverage ratio compares a company’s operating cash flow to its total debt, which, for purposes of this ratio, is defined as the sum of short-term borrowings, the current portion of long-term debt and long-term debt. This ratio provides an indication of a company’s ability to cover total debt with its yearly cash flow from operations. The higher the ratio, the better is the company’s ability to carry its total debt.
Cash flow to Debt Ratio = (Operating Cashflow)/ (Total Debt)
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net cash provided by operating activities (operating cash flow as recorded in the statement of cash flows) of 5,876 (cash flow statement), and total debt of 0 (balance sheet). By dividing, the equation provides the company with infinite margin of debt coverage. A more conservative cash flow figure calculation in the numerator would use a company’s free cash flow (operating cash flow minus the amount of cash used for capital expenditures).
A more conservative total debt figure would include, in addition to short-term borrowings, current portion of long-term debt, long-term debt, redeemable preferred stock and two-thirds of the principal of non-cancel-able operating leases. In the case of XYZ, their debt load is nil so the resulting cash flow to debt ratio percentage is off the chart. In this instance, this circumstance would indicate that the company has ample capacity to borrow a significant amount of money, if it chose to do so, as opposed to indicating its debt coverage capacity. Under more typical circumstances, a high double-digit percentage ratio would be a sign of financial strength, while a low percentage ratio could be a negative sign that indicates too much debt or weak cash flow generation. It is important to investigate the larger factor behind a low ratio. To do this, compare the company’s current cash flow to debt ratio to its historic level in order to parse out trends or warning signs.
Operating Performance Ratios
The next series of ratios we’ll look at are the operating performance ratios. Each of these ratios have differing inputs and measure different segments of a company’s overall operational performance, but the ratios do give users insight into the company’s performance and management during the period being measured. These ratios look at how well a company turns its assets into revenue as well as how efficiently a company converts its sales into cash. Basically, these ratios look at how efficiently and effectively a company is using its resources to generate sales and increase shareholder value. In general, the better these ratios are, the better it is for shareholders.
In this section, we’ll look at the fixed-asset turnover ratio and the sales/revenue per employee ratio, which look at how well the company uses its fixed assets and employees to generate sales.
o Fixed-Asset Turnover
This ratio is a rough measure of the productivity of a company’s fixed assets (property, plant and equipment or PP&E) with respect to generating sales. For most companies, their investment in fixed assets represents the single largest component of their total assets. This annual turnover ratio is designed to reflect a company’s efficiency in managing these significant assets. Simply put, the higher the yearly turnover rate, the better.
Fixed Asset Turnover Ratio = (Net Sales)/ (Property, Plant & equipments)
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net sales, or revenue, of (income statement) and average fixed assets, or PP&E, of 2,342 (balance sheet – the average of yearend 2009 and 2010 PP&E). By dividing, the equation gives us a fixed-asset turnover rate for FY 2010 of 5.6. Instead of using fixed assets, some asset-turnover ratios would use total assets. We prefer to focus on the former because, as a significant component in the balance sheet, it represents a multiplicity of management decisions on capital expenditures. Thus, this capital investment, and more importantly, its results, is a better performance indicator than that evidenced in total asset turnover. There is no exact number that determines whether a company is doing a good job of generating revenue from its investment in fixed assets. This makes it important to compare the most recent ratio to both the historical levels of the company along with peer company and/or industry averages. Before putting too much faith into this ratio, it’s important to determine the type of company that you are using the ratio on because a company’s investment in fixed assets is very much linked to the requirements of the industry in which it conducts its business. Fixed assets vary greatly among companies. For example, an IT company, like XYZ, has less of a fixed-asset base than a heavy manufacturer like BHEL. Obviously, the fixed-asset ratio for XYZ will have less relevance than that for BHEL.
o Sales/Revenue per Employee
As a gauge of personnel productivity, this indicator simply measures the amount of rupee sales, or revenue, generated per employee. The higher the figure the better. Here again, labour-intensive businesses (ex. mass market retailers) will be less productive in this metric than a high-tech, high product-value manufacturer.
Sales Per Employee = (Net Sales)/ (Average No of Employees)
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had generated 22,098 in net sales with an average personnel component for the year of approximately 85,000 employees. The sales, or revenue, figure is the numerator (income statement), and the average number of employees for the year is the denominator (annual report) and Sales Per Employee come out to be Rs. 2,500,000.
An ‘Earnings per Employee’ ratio could also be calculated using net income (as opposed to net sales) in the numerator.
Industry and product-line characteristics will influence this indicator of employee productivity. Tracking this figure historically and comparing it to peer-group companies will make this quantitative amount more meaningful in an analytical sense.