Robert C. Losik

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Robert C. Losik

  1. 1. FINANCIAL RATIO ANALYSIS AS A MANAGEMENT EFFECTIVENESS INDICATOR Robert C. Losik Professor of Organizational Leadership and Strategic Management Dept of Organizational Leadership School of Business Southern New Hampshire University Working Paper No. 2003-05 This is a BETA VERSION (A work in progress). Please report all errors, omissions, and suggestions for improvement to r.losik@snhu.edu 1
  2. 2. Copyright  1999 and 2003 by Robert C Losik, Bow, New Hampshire, 03304 All rights reserved. No part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, faxing, scanner, or by any information storage and retrieval system, without permission in writing from the author. The following persons made major contributions to the book: Timothy P Losik, BS, MBA, CPA, extensive experience in public accounting and corporate finance and accounting. Made major contributions in the areas of technical accuracy, sequencing of material, use of correct terms, content, and metrics. Jennifer A Losik, BS, extensive experience in small business management, comptrollership, and web development and management. Made major contributions in the areas of readability from the perspective of the student, sequencing of material, content, and layout. I also wish to acknowledge the significant contributions of the following persons who took the time and made the effort to review this book. Their contributions have been invaluable. Dr. Burton Kaliski, Professor, SNHU Dr. Laurence Pelletier, Professor, SNHU Mr. Stephen B. Townes, CEO, Keystone Aviation Mr. George D. Livingston, Jr., President and CEO, REALVEST Dr. Martin Bradley, Associate Professor, SNHU Dr. Charles White, Professor, SNHU Dr. Steven Painchaud 2
  3. 3. TABLE OF CONTENTS ITEM PAGE FOREWORD 4-8 CHAPTER 1: SOME THOUGHTS ON RATIOS 9 - 12 CHAPTER 2: THE BALANCE SHEET, INCOME 13 - 19 STATEMENT AND THE STATEMENT OF CASH FLOWS CHAPTER 3: LIQUIDITY RATIOS 20 - 24 The current and quick ratios. CHAPTER 4: ACTIVITY RATIOS 25 - 31 The asset turnover ratio, the inventory turnover ratio, and the average collection period. CHAPTER 5: LEVERAGE OR DEBT RATIOS 32 - 38 The total debt to asset ratio, long term debt to asset ratio, the debt to equity ratio, and the times interest earned ratio. CHAPTER 6: PROFITABILITY RATIOS 39 - 48 The gross profit margin, the operating margin, the net profit margin, return on equity, return on assets as a function of both operating and net profit, return on fixed assets, return on investment, and earnings per share. CHAPTER 7: METRICS 49 - 56 R&D/Net sales, marketing/net sales, administrative expenses/net sales, net sales per employee, net profit per employee, cost of waste per employee, overtime hours as a percent of total hours, cost of quality/net sales, sales per square foot of floor space. APPENDIX A: MITIGATING EXTERNAL FACTORS 57 - 58 APPENDIX B: THE CONSOLIDATED CROMWELL 59-63 COMPANY CASE STUDY WITH FINANCIAL DATA FOR THREE YEARS 3
  4. 4. FOREWORD "Managers must understand accounting, but they must think and act like strategists" This handbook was initially prepared for use by non-accounting majors in appropriate undergraduate business courses at Southern New Hampshire University, Manchester, New Hampshire. It was envisioned that students will use this handbook as a ready reference and refresher for all courses in which financial ratio analysis is a part of the learning or problem-solving process. The goal is for the students to achieve and maintain a high level of proficiency in the use of financial ratio analysis. This will give them a solid understanding of both the financial and management implications of financial ratios from the perspective of a non-accounting major. It may also be of interest to the accounting major who intends to occupy a management position and for managers, particularly of small to medium-sized businesses. The handbook does not purport or pretend to present an exhaustive analysis of financial ratios. Only selected ratios are used, those that in the judgement of the author would be the most commonly used by non-accounting majors. Students and managers seeking additional information on ratio analysis should refer to accounting and finance texts or appropriate accounting and finance references. Finance and accounting are integral parts of management. In most companies of any size, the accountants, as well as all major functions areas, are the management team. Their advice, insights, and recommendations are both sought after and valued. Companies that must operate in highly competitive environments cannot afford the luxury to have the various major management functional areas operate in isolation in their own fiefdoms and fortified "silos." While this handbook explains some financial implications of ratios, its primary purpose is to inform about the MANAGEMENT EFFECTIVENESS INDICATORS OF FINANCIAL RATIOS. By management effectiveness, we mean how the financial condition of the company, as it is interpreted through the use of financial ratios, reflects the management, the decision-making, and the vision of the company, to include how management plans, implements, organizes, leads, and controls. To one degree or another, the ratios that we will discuss reflect the overall performance of the company. They are not simply indicators of the financial health of the company. They are not, because the financial condition of the company is the product of everything that goes right and everything that goes wrong inside of an organization. People, policies, processes, practices, strategies, goals, and procedures determine 4
  5. 5. financial outcomes. Many internal factors determine the financial performance of an organization. These include, but are not limited to the organization’s: a. Mission, long range goals, and the strategies to achieve them; b. Short range objectives and the tactics used to the achieve them; c. Management information and feedback systems; d. Management philosophy; and e. Values, which form its unique "genetic code." Because of the above, students and managers should not look at financial information as sterile, one-dimensional data, which conveys only one meaning. The financial condition is in many respects the pulse and lifeblood of the organization. The hyper-focus that some current business students have on their own majors creates in some students' minds the notion that there is no essential connection between the major disciplines and sub-disciplines of business. They are unaware that virtually all major strategic and tactical decisions, as well as most routine decisions, are based on the financial condition and performance of the organization. They are also unaware that many human resource, management, marketing, production, service, administrative, and information systems decisions are made based on the financial condition of the company as it exists now, and more and more today, as it is projected to exist in the future. Many business majors will work in organizations where "somebody else crunches the numbers." Because of this you could also make the argument that "somebody else interprets the numbers and makes management decisions for the organization." The job of education, however, is to insure that the student achieves, or at least is given the opportunity to achieve, a high level of sophistication in information processing and understanding. We should not be in the business of graduating pieces of the puzzle, but rather students who can solve the puzzle. A failure to understand the management and financial implications of ratio analysis undermines the degree to which students will one day be able to understand their own organization, competitors, suppliers, and clients. The same is true for current managers. In business, graduates will work and hopefully learn. In education, students must not only learn, they must learn how to continue learning. They must learn that ratio analysis is a means to an end that helps them to continue to learn and understand. The ratios are not an end in themselves. They are a means to the end of effective management decision-making and organizational leadership. This learning will then help students make strategic and tactical recommendations for the organizations they are studying, informed decisions about their careers, and even wiser decisions when planning and executing their own financial plans for the future. 5
  6. 6. Business majors and contemporary managers, however, should be able to take the analysis of financial data one step further. They should be able to: 1. Draw tentative inferences about the management effectiveness of the company. Because the financial performance of a company, to a greater or lesser degree, reflects the management decisions of a company, we should be able to make inferences about the effectiveness and the efficiency of management. These inferences, however, must be tentative because unusual business situations and activities, as well as mitigating external factors, can cause misleading interpretations of the data. For examples of external factors beyond the control of the company, see Appendix A. While it is beyond the scope of this book, management's effectiveness is also measured by how well it can anticipate and/or react to these external factors and devise and implement strategies that will attenuate their effect on the organization. Unusual and extraordinary internal activities could also depress or inflate any one or all of the profit margins. With regard to the latter, expenditures for acquisitions, restructuring, or cyclical research and development could dramatically impact revenues and profits. Where these situations seem to exist, the student is obligated to go beyond the raw financial data and examine the footnotes and other explanations in the company's annual report and seek other factors that may have caused these aberrations. 2. Identify potential or actual strengths and weaknesses, which can be attributed to the major management functional areas of the company. These areas include, but are not limited to: management (strategic and human resource), finance, marketing, production and/or delivery of a service, and information technology systems. 3. Use the information to aid in the planning and implementation of both short-range tactics and long range decisions to: a. Improve or solidify the company's financial health and gain for the organization an advantage over its competitors. b. Identify areas in which external factors are impacting on the financial performance of the company. 6
  7. 7. The three points listed above, 1., 2., and 3., are the rationale for the writing of this handbook. There is more to ratio analysis than calculating ratios; there is more to ratio analysis than financial analysis. Those same financial ratios also give us insight into management issues in strategic management, human resource management, marketing, production, delivery of a service, and management information systems of an organization. SOME PROCEDURAL REMARKS GRAPHICS: In order to highlight and differentiate certain areas in this handbook, we will use the following graphics for emphasis: GRAPHIC EXPLANATION Indicates the discussion of a topic. I Indicates the calculation of a ratio or other metric. Indicates an example of the topic under discussion. Indicates a tip (suggestion) about the subject matter under discussion. Indicates possible manangement implications of the analysis of the ratio or metric(s). TARGET RATIOS: With regard to the discussion of the ratios and the tabular data that shows the management implications of the ratios, no specific target figures for the ratios are shown. Why? The ideal target number for each of the ratios varies from industry to industry, and within the industry between the size of company. Therefore, 7
  8. 8. the use of comparative industry averages for your analysis is important. It is also important to determine if the company has specific target objectives for its own ratios. The "management implications" tables show possible management weaknesses and strengths in terms of whether the ratios are high (hi) or low (lo) or increasing (inc) or decreasing (dec), without comparison to specific targets. ABBREVIATIONS: Within the "management implications" tables, abbreviations are used to reflect the major management functions within a company. These include: management, which will reflect both strategic management and human resource management, finance, which will include both finance and accounting, marketing, production, the delivery of a service, and management information systems. If you were constructing your own tables, you could break these areas down in finer and more discrete categories. You could create more categories if you wanted your analysis to be more detailed, e.g., PURCHASING = PUR, HUMAN RESOURCE MANAGEMNT = HRM. For the sake of brevity and to facilitate the construction of tables, the following abbreviations are used for the major management functional areas. FUNCTIONAL AREA ABBREVIATION MANAGEMENT MGT FINANCE/ACCOUNTING FIN MARKETING MKT PRODUCTION PRD SERVICE SRV INFORMATION TECHNOLOGY IT 8
  9. 9. CHAPTER ONE The Importance of Ratios and Metrics "The Bottom Line: Make sure that you understand the ratios that you are using and why you are using them and make sure that they are appropriate for the type of company that you are analyzing." In an e-mail to the author, Steve Townes, former CEO and President of ASIG (Aircraft Services International Group) and current president and CEO of Keystone Aviation offered the following contemporary insights about how management uses financial ratios and metrics to improve the performance of a company that operates in a highly competitive environment: "We use extensive metrics in managing our large, far-flung company from a tiny headquarters team. We measure not only the traditional financial ratios and trends, plus comparatives on those to the industry peer group, but also many of the operating statistics and workforce statistics that are the leading indicators that "flag" trend lines long before we see financial statements. We coach for better performance using these tools as the centerpiece of weekly operations and monthly financial budget reviews. I suggest that most good businesses "measure everything" in this manner; the trick is picking what you really need to measure, then measuring properly so the information is valid. For example, our largest manageable cost pool is labor---over 7 million man-hours of paid, rampside, touch labor per annum. You can imagine how many ways we splice, and dice those man hours, comparing cities to one another, historicals, budgets, productivity, turnover, spans of control, and a myriad of other metrics. . . by the way, these things were not in place when we bought ASIG, our largest unit. By using what we call our "Key Measures Program," we have dramatically improved operating performance and profitability. . . yielding award-winning customer service." Steve Townes' description of the use of financial ratio analysis and metrics should be a wake up call to all business students, both accounting and non-accounting majors. Managers use these data as the bases to make major decisions for their companies. Notwithstanding this, many students simply have trouble with the term, "ratio." They 9
  10. 10. either do not fully understand it, feel uncomfortable with it, or they feel that it is an esoteric concept that has no application or value in their lives. At best, it is something to memorize, pass a test, and forget. Because of this, I suggest to students that they may feel more comfortable if they think of ratios as relationships or comparisons. Ratio is a mathematical term; relationship and comparison are analytical terms and may be more understandable. Understanding ratios is complicated by the fact that although they are supposed to be expressed as a fraction, they generally are not. They are not because the denominator is always one. For example, you will frequently see a company's current ratio expressed as 2.25, when it is actually 2.25 to 1. In most textbooks, the denominator, 1, is dropped as a matter of convenience. For a student or manager, who is trying to understand the significance of ratios, there is no reinforcement that they are actually dealing with a ratio, because nothing is being compared. Visually, 2.25 is not a ratio; therefore, the comparison is lost. This may be particularly confusing to students who experience difficulty with math. The notion of a comparison or relationship is reinforced when a ratio is written as 2.25 to 1, communicating to a student that there are 2.25 dollars of current assets for each one dollar of current liabilities. In addition to the term, ratio, there is an aura that ratios are really the primary concern of accounting and finance and that other business majors need only be vaguely familiar with them. This is complicated by the fact that other business majors take introductory accounting with accounting majors, a course that is often taught by accountants for accountants. The primary orientation of the courses is accounting not management decision making. Notwithstanding this, any analytical process that helps anybody in management make better business decisions or any business student make a more thorough analysis should be learned and used. You can magnify the importance of this by never letting yourself forget that the primary reason that profit-making corporations are in business is to make a profit. Better decisions coupled with a profit orientation should keep taking you back to the centrality of understanding the significance of analyzing financial data. Business students are managers-in-training. The primary job of managers is to make decisions and detect and solve problems. Decision making and problem solving are more effective when adequate, reliable, and accurate information is available. However, frequently information is not there for the taking. Facts and data usually are available or at least mineable through the use of various processes. Ratio analysis is one of those processes that helps us convert raw data and facts into information that can be analyzed. Once analyzed, the information is transformed into knowledge. Because comprehensive ratio analysis is one of these processes, we can conclude that it can make students and managers better problem solvers and decision-makers. There is generally a quandary as to what to do with a financial ratio once we calculate it. Most accountants and managers would agree that one ratio, at one 10
  11. 11. point in time, tells us little or nothing about the actual financial condition of a company. A minimum of four criteria should be used to gain a more complete understanding of their meaning. The first is trend analysis. Ratios should be compared over a three to five year period to gain an understanding of the financial health and direction of the organization. If a pro forma balance sheet and income statement are prepared to project the anticipated, future financial condition, ratios should also be calculated for the future years in question so that trends may be observed there also. Trend analysis helps us to understand the financial performance of an organization over time. Keep in mind that time is relative. The time horizon for one trend may be inappropriate to use with another trend. The second is to compare the company's performance with other similar companies by using industry averages. Using industry averages, we get an "idea" as to how our performance compares with others. While this can be useful, there are potentially severe limitations. The industry must be sufficiently populated for the industry averages to be meaningful. In addition, many larger companies are diversified, but their net sales are combined in one balance sheet and income statement. It would be difficult then to compare a company that produces only breakfast cereal with a company that produces breakfast cereal, milk, dish detergent, and vitamins. To do so would lead to faulty, inaccurate, and inappropriate conclusions. This became less of a problem in 1999, when new accounting practices with regard to reporting the financial activities of strategic business units took effect. Companies will have to be more explicit when reporting the profits of its components. There could also be instances where the performance of companies in the industry is affected by regional and seasonal variations, unknown to the analysts. The third is to compare the company's actual performance with its own target ratios. The comparison could be valid, but it could also be misleading. The company's target ratios may be too low, making performance look unrealistically good or vice versa. In addition, many companies, particularly smaller companies and privately owned operations, do not establish performance ratios, making this comparison impossible. The fourth is to check any resource that contains relevant published opinions about the company or that has evaluated its performance. Much of this information is available on the Internet and can be easily accessed. If we are in a situation where industry averages are unusable and the company has no target ratios, we may be limited to trend analysis and the research of sources that have evaluated the company. As managers, we cannot disregard the analysis of financial data because of the inherent limitations and potential inaccuracies. Strategically, we also cannot afford to take the position that unless there is a guaranteed outcome, we will do nothing. There is no "silver bullet or magic wand" that gives us absolute, accurate information. We must learn to live with uncertainty, while trying to reduce it as much as possible. What this all means is that even though there are limitations in the analytical 11
  12. 12. process, we still use all of these approaches and keep the limitations in mind. We use analysis as a means to an end, and not an end in itself. A tip about calculating ratios whether you are doing them manually, on a calculator, or on a computer: for ease of calculation, rationalize your numbers. To rationalize means to make the number smaller in size without changing its inherent value or the significance of the results when we calculate the ratio. For example, let's say that we are calculating a current ratio. The company that we are analyzing has $1, 937, 424, 653 in current assets and $877, 435, 111 dollars in current liabilities. We could divide the current assets by the current liabilities, using the numbers as they appear and get a result of 2.2 to 1. Or we could simply drop off the last six digits and divide 1937 by 877 and get a result of 2.2 to 1. Even if you divided 19 by 8.7, the result would be 2.18 and that is close enough. You can save yourself a lot of work by making the numbers more manageable, without changing the value of the result or distorting any subsequent analysis that you may make. Here are two important reminders as we close out chapter one: First, it is impossible to understand the significance and value of financial ratios unless you understand the Balance Sheet and Income statement. It is also critical that you understand the Statement of Cash Flows as well as certain other financial facts. Why? Many, but not all, financial ratios are calculated from information contained in the balance sheet and income statements. Most ratios are really nothing more than comparisons or relationships between components within the balance sheet, between components within the income statement, or between components of the balance sheet and the income statement. So, ratios, balance sheets, and income statements go hand in hand. Second, if you are doing a case analysis or any business analysis where financial data are available, always analyze that data before you read the case or situation. Why? You will gain many insights about the financial and management conditions of the company prior to reading the case. Understanding the financial and management implications of ratio analysis gives us clues about the operations and management of the company. Therefore, Chapter Two will deal exclusively with a brief, general review of the balance sheet, the income statement, and the statement of cash flows. 12
  13. 13. CHAPTER TWO The Balance Sheet, Income Statement, and Statement of Cash Flows The following is a brief discussion of the balance sheet, the income statement, and the statement of cash flows. They will be discussed in sufficient detail so that you can understand their primary purpose and also understand the nature of the items that you will generally find in them. Remember, when looking at financial data, you have to look at more than one reporting period, usually a fiscal year. It is wise to examine the financial reports from at least three years and if possible five years ago. Reports that are older than these are historical documents and tell us little about the current operations of the company. This is almost always true, because the nature of the organization and the external environment in which it must function are likely to change dramatically over a five year period, rendering any old financial data useless for anything other than historical purposes. THE BALANCE SHEET: Regardless of your specific academic discipline, it is essential that you understand and commit to memory the meaning and the purpose of the balance sheet, the income statement, and the statement of cash flows. If you can't memorize, then keep using this handout to refresh your memory. An accountant would say that the balance sheet is a picture, "a snapshot", of the financial condition of the company at a point in time. Cool, huh? Maybe it would make more sense to the non-accountant if we said that the balance sheet displays in broad financial categories, the dollar value of what we own and the dollar value of what we owe. The "what we own" part is pretty simple. It includes all of our assets, both current and fixed. Some books call fixed assets long-term assets; others refer to them as plant and equipment. The key is that they are assets that would generally take a longer time to liquidate or turn into cash. They are also the primary assets that the company uses to manufacture its goods and products or with which it delivers or prepares its services for a customer. The notion of liquidity underpins the asset portion of the balance sheet: current assets are relatively easy to turn into cash; fixed assets are generally much more difficult. The asset portion of the balance sheet does not give a detailed listing of all assets. It is not designed to do this. It gives us the dollar value of assets, at the date of purchase, by categories that accountants use. It does not represent the value of the asset today. We can 13
  14. 14. live with that. See Figure 1. For a detailed listing, we would consult other references in the company. The liability/equity portion of CONSOLIDATED the balance sheet is a little more difficult to comprehend. It contains CROMWELL COMPANY, INC two major categories: liabilities and owners' and/or stockholders' equity. THE BALANCE SHEET (000) The liability part is what we owe others. It is broken down into current 2002 and long-term liabilities. The current Cash 5000 portion shows what we have to cover Cert. of Deposit (Cash Equivalent) 0 (payoff) in the near future. The long Accounts Receivable 9000 term is exactly that, liabilities that we Other Current Assets 2950 have accumulated that are due Inventory 15000 (payable) beyond a one year period of Total current Asset 31950 time, like a five year loan on a car or a thirty year mortgage on a house. See Figure 1. Fixed Assets 141742 Accumulated Depreciation -14174 That's easy to understand, but Net Fixed Assets 127568 why is equity on that portion of the balance sheet? And why is it in the Intangible Assets 18000 Accumulated Amortization -2700 same part with liabilities? How can 15300 equity be a liability? You have to stretch your mind a little. It makes Total Assets 174818 more sense to say that everything on the liability/equity part of the balance sheet is really funds, materials, and services that have been invested in the Accounts Payable 8500 company or provided to the company. Notes Payable - Current 10000 That includes money invested by the Other Current Liabilities 12750 stockholders, money obtained from Total Current Liabilities 31250 banks to run the business, and money that we owe to other businesses for materials and services that they have Long Term Debt 75628 provided us. We refer to money that we receive from banks and other Owner Equity 67940 institutions as debt financing. We refer to money that we receive from Total Liabilities and owner Equity 174818 stockholders as equity financing. Figure: 1 But we don't owe anybody the equity in a company, do we? If everything is going well, we don't. If the company is going to go out of business, we do. Under those circumstances, we would sell all the assets in the company, pay off all the 14
  15. 15. liabilities, and what was left would be distributed among the stockholders. Stockholders put the money in the company and that money was used to purchase assets. Therefore, the value of those assets would appear on the asset portion of the balance sheet. To make the balance sheet balance, we have to show a corresponding value on the equity portion. We can't make that entry under liabilities, because the money that stockholders invest is not a liability. So there has to be a separate category for stockholders' investments in the company, which is called stockholders' equity. If it were a non stock company, it would be called owner's equity. See Figure 1 for the balance sheet of Consolidated Cromwell Company, hereinafter called CONCROMCO or simply 3C. It is the example company that will be used in this handbook. So stockholders' equity is really the value of what is left when we subtract the total liabilities from the total assets. But it is only an accounting approximation. That is because it assumes that the assets could be liquidated for the value shown on the balance sheet. In many cases that will not be so. It's the same when you sell your car, a car that you financed through a bank. Let’s say the remainder of the loan is $400. You would try to sell it for as much or more than the remaining bank loan. If you succeeded in selling it for more, let's say $600, you would say that you had $200 equity in the car. In reality, that may not happen. You may have to sell the car for less than the loan outstanding, let's say $400. In this case you would have negative equity of $200, and you would have to make up this amount out of your own pocket. The concept of negative equity daunts some students, when in fact it is simple. Negative equity occurs in a business when liabilities are greater than assets. In other words, when you subtract liabilities from assets and you get a negative number, that number is an expression of the negative equity the stockholders are experiencing or the extent to which the company has not been provided with sufficient equity capital. It may also indicate that it has borrowed beyond its capability to repay. It could eventually mean that the stockholders may have to come up with more money; the company may have to try to make a payoff deal with its creditors that would lessen its debt obligation; or the company may face bankruptcy. While a one-year balance sheet can tell us much, consecutive balance sheets from sequential quarters or years are invaluable. They show us annual trends in the case of sequential years and intra-year trends in the case of quarters. It is, however, quite difficult for the non-accountant to see data specific value from the raw numbers on a balance sheet. We might, for example, see that our receivables increased 100% over the past five years. On the surface, this could be viewed as bad. If our revenues increased by 300% during the same period, then it would be viewed as excellent. Why? Because now, five years later, our receivables are a much smaller portion of our total current assets. That is why we have to understand the limitations of analyzing raw financial data and also understand that the calculation of financial ratios helps us make real financial and management sense out of the data. In a very real sense, ratios turn raw data into usable, analyzable information. 15
  16. 16. THE INCOME STATEMENT: The income statement is of more immediate value to the manager than the balance sheet. It shows primary and secondary revenue totals as well as primary and secondary expenses. Primary revenues are those that the company realizes as a result of its primary business activities. For example, a company that produces clothing may generate money from other ventures such as investments, the sale of property, and currency exchange. These incomes have not been gained from its primary business function and must be displayed as such. Stockholders, investors, management, and bankers want to know how well the primary business is performing. You also want to know so that you can gain an accurate picture of the financial results of the company's operations. The income statement shows the manager whether or not the company is on track to meet its objectives and accomplish its mission. It is not uncommon for companies to publish quarterly income statements; all of the CONSOLIDATED CROMWELL publicly traded companies do. COMPANY, INC. These are readily accessible on the Internet. Financial advisors, INCOME STATEMENT (000) investment firms, individual investors, and institutions are 2002 constantly scrutinizing these Net Sales $ 140,000 statements. You should do the Cost of Goods Sold $ 112,000 same when data are available. Gross Profit $ 28,000 Let's look at some of Administrative Expenses $ 9,000 the more common items found Selling Expenses $ 7,500 on the income statement. (See Research and Development $ 1,500 Figure 2.) Most income Reorganization Expenses statements look the same and Currency Exchange $ 500 Write-off of in process R&D $ have a great deal in common. - That does not mean that they all are. Some very complex Income from Operations $ 9,500 companies present their income statements in more detailed Interest Expenses $ 6,000 form. The top line will Income before Taxes $ 3,500 generally be net revenues or net sales. This is income that Income Taxes (Credit) $ 1,400 comes from the company's Net Income $ 2,100 primary business and does not include income from other Figure: 2 sources. It is net sales/revenue, not gross income. It is net because it is the income that we have after all rebates, warranty 16
  17. 17. claims, and returns. It is the "top line." Next we will generally see “cost of sales", "cost of services provided" in the case of a non manufacturing firm, “cost of goods sold" or some variation on this theme. This item will include direct and indirect labor costs, the cost of materials, waste, the cost of operating machinery, the cost of operating the physical plant, and storage costs. Almost all manufacturing companies include the depreciation costs of machinery and physical plant under cost of goods sold. The next item is generally called the "gross margin", "gross income", or "gross profit." We get this amount by subtracting the cost of goods sold from the net sales. It is the first crucial profit line on the income statement. We will discuss more about this when we look at the profitability ratios. The statement will next show the other expenses that we incur as a result of doing business. They are referred to as operating expenses. These expenses can include, but are not limited to, administrative expenses, marketing or sales expenses, officers' salaries, and research and development. Income statements can vary a great deal. Some firms make only one entry: general administrative and sales expenses. Just because a firm fails to list research and development separately does not mean that it has no research and development program. All it means is that it chooses not to publish that detailed figure for common consumption. Another major point should be made here. Many balance sheets and income statements that are published for general consumption are usually heavily summarized and are not intended to be used as a vehicle for in-depth analysis. So you have to do the best that you can or "Go With What You Got" (GWWYG, pronounced Gweegee). Other firms are more generous in the information that they provide. It all depends on the firm and the detail that the firm feels that it must provide to stockholders, investors, and financial institutions. The amount and detail of the information available will enhance or diminish the value of any financial and management analysis made by the student when using the income statement. The next major item is called "operating income", "operating margin", or "operating profit." They all mean the same thing. It is also referred to as earnings before interest and taxes or EBIT. After operating income comes net interest expense or income. Interest expense is subtracted from operating income to get the earnings before taxes or EBT. Logically then, the next item is taxes. When you subtract taxes from income before taxes, you get net income, net profit, or net margin. They all mean the same thing. Income statements can be more complicated. They may also include such items as interest income, extraordinary income or expenses, restructuring charges, and currency exchange losses or gains. Generally accepted accounting practices usually dictate where all entries will be put. Don't be confused by the complexity of the income statement. They all contain the same essential ingredients and to one degree or another are amenable to analysis. Remember that you are a manager, owner, or student who must be able to make sense out of the statements. THE STATEMENT OF CASH FLOWS: 17
  18. 18. The statement of cash flows provides you with additional information about the financial and managerial activities and decision making of the company. It shows you three major things: how the company gets its money, how the company spends its money, and the beginning and ending cash. There is a connection between the statement of cash flows and the balance sheet. The ending cash figure on the statement of cash flows is the same dollar amount as the entry for cash on the balance sheet. So if you want to know how the company wound up with a certain amount of cash at the end of the reporting period, you have only to look at the statement of cash flows. An example of the statement of cash flows is shown at Figure 3. CONSOLIDATED CROMWELL COMPANY, INC STATEMENT OF CASH FLOWS (000) 2002 Cash flows from operating activities: Net Income (loss) $ 2,100 Write-off of in-process R&D $ - Depreciation and Amortization $ 3,479 Increase (decrease) in Working Capital $ (2,775) Net Cash Provided (Used) by Operating Activities $ 2,804 Cash Flows from investing activities: Purchases of fixed assets $ (19,932) Acquisition of XYZ Corporation (net cash payments) $ - Net Cash used in investing activities $ (19,932) Cash Flows from financing activities: Proceeds from issuance of long-term debt $ 20,628 Net cash provided by financing activities: $ 20,628 Net increase (decrease) in cash and cash equivalents $ 3,500 Cash and cash equivalents, Beginning of period $ 1,500 Cash and cash equivalents, End of period $ 5,000 Figure: 3 Again, looking at a statement of cash flow for only one year may provide you with limited information. You have to look at the statements for the past three to five years. The statement of cash flows at Figure 3, above, shows some of the major and 18
  19. 19. minor headings that are used; both of these will vary somewhat depending on the type of business that is reporting the information. You will, however, see a high degree of uniformity between companies because of the uniform reporting standards that have recently been adopted. On 3C's statement of cash flows, you will see three major areas of cash movement in the company. These activities are: a. Net cash from operating activities, b. Net cash from investing activities, and c. Net cash from financing activities. The individual subheadings under each of the above show the more specific cash inflow and outflow that has occurred. If you add each of these "nets" together, you will get the net increase (decrease) in cash and cash equivalents. Then add this to the cash and cash equivalents at the beginning of the period, and you have the cash and cash equivalents at the end of the period. The statement of cash flows is another piece to the puzzle that helps us to understand the nature of the "cash streams" that are financing the operations and other financial activities of the company. It complements the balance sheet and the income statement. Note to the Reader: Except where specifically indicated, all ratios and metrics will use the financial data from the balance sheet, income statement, and statement of cash flows in this chapter. 19
  20. 20. CHAPTER THREE The Liquidity Ratios There are two parts of the balance sheet that we use to calculate the two liquidity ratios, the current ratio and the quick ratio. They are the company's current assets and its current liabilities. See Figure 1, in Chapter 2, page 14 for 3C’s balance sheet: THE CURRENT RATIO: To calculate the current ratio, divide current assets by current liabilities; both items are on the balance sheet: Total Current Assets = The Current Ratio, or Total Current Liabilities Cash + Cash Equivalents + Receivables + Inventory = The Current Ratio Accounts Payable + Notes Payable + Other Current Liabilites Current Ratio: Using the data from Figure 1, in Chapter 2: 31,950,000 1.02 = or simply 31,250,000 1 3195 1.02 = 3125 1 This tells us that for every $1.02 in current assets, 3C has one dollar in current liabilities. From this we can infer that 3C may have sufficient current assets to meet its current obligations. We would have to check the industry averages to see whether or not this is the norm. But there is a clue here. If you had to liquidate all of your assets today to satisfy your creditors, you would have to be able to liquidate your inventory for the full value indicated on the balance sheet. Is that a likely prospect? Similarly, if you were seeking additional credit, a potential loan agency may view a current ratio of 1.02/1 as an unacceptable credit risk. The upside is that the creditor will probably look at the 20
  21. 21. seasonality of your business and your credit history. The downside is that you may not get the loan. THE QUICK RATIO (THE ACID TEST): The Quick Ratio is also called the Acid Test. The thinking here is that we will have a better idea of a company's liquidity if we eliminate the inventory from consideration. It is the least liquid of the current assets, and it is questionable what value it will actually have, if you must dispose of it quickly. To calculate the quick ratio, subtract the inventory from total current assets and divide by the total current liabilities. All these items are on the balance sheet. You will invariably get a smaller ratio than the current ratio. For companies that have no inventory, the current ratio is the quick ratio. Total Current Assets - Inventory = The Quick Ratio, or Total Current Liabilities Cash + Cash Equivalents - Inventory = The Quick Ratio Accounts Payable + Notes Payable + Other Current Liabilites The Quick Ratio: Using balance sheet data from Figure 1 in Chapter 2: 31,950,000 − 15,000,000 16,950,000 .54 = = or simply 31,250,000 31,250,000 1 1695 .54 = 3125 1 This tells us that for every 54 cents in current assets, 3C has one dollar in current liabilities. Therefore, when we eliminate the inventory from consideration as a liquid asset, it appears that 3C will have substantial difficulty in meeting its current obligations. The liquidity ratios, the current and the quick ratio, provide us with a great deal of information, or at least indicators, about both the financial and management condition of the company. Liquidity analysis, in the form of the quick and current ratios, gives us an idea as to whether we have sufficient current assets to pay those bills. Should you memorize the names of these ratios? The answer is yes. They are part of what a manager should know and what a manager should commit to memory. Accountants say that liquidity refers to the company's ability to meet its current obligations. As managers we can think of it as our ability to pay our bills in the near future. To pay those bills, we are going to need cash. Why? Cash is the most liquid asset 21
  22. 22. that we have and our creditors and suppliers want their bills paid in cash. We are not a barter economy. Liquidity is not a straight-forward issue. Any business has to be liquid enough to pay its bills to continue operating. In this regard, there are factors of which we should be aware. For example, does the company have an effective policy for identifying and controlling uncollectible accounts? If you have a large accounts receivable that contains mostly uncollectable accounts, it will distort the value of your analysis. You can’t easily liquidate uncollectible accounts at their face value. You may not even be able to do that with great difficulty. One thing is certain, if you do not have the money to meet your current obligations, you must pursue options to stay in business. One option is to go to the bank for a short-term loan. Many businesses that have uneven cash flows from month to month must do this. Their liquidity fluctuates wildly with the seasons. Some businesses are so seasonal that they do as much as 70 percent of their annual sales in a three-month period and 30 percent in the remaining nine months, such as Toys R Us and L.L. Bean. They have no alternative but to rely on short-term loans to meet their operating expenses during the slow-sales-part of the year. When we talk about liquidity, we are really talking about either how much cash we have on hand or the assets that we can reasonably convert to cash. Assets are things that we own or that are owed to us by someone else. Some assets are easily turned to cash; others are turned to cash only with some or considerable difficulty. A certificate of deposit is easily turned into cash. Accounts receivable are quite different. Accounts receivable are only as liquid as our ability to collect them. Let’s say that we have numerous accounts receivable that past due for a long period of time, say 45 to 90 days. These accounts may be uncollectable in the next 30-day period. In this case, our accounts receivable are a questionable part of our liquidity, affecting our ability to pay our current bills. Inventory is also an issue. It is only as liquid as our ability to convert it to cash. It is worth only what someone is willing to pay for it. In a worst case scenario, if we sold off or auctioned off all of our inventory for cash to pay our current bills, we would have nothing more to sell and would risk going out of business. There is a contemporary saying in many businesses, particularly those in manufacturing: "More inventory is bad." Manufacturers strive to create a zero inventory situation. Cash tied up in inventory is cash that is not working for the company. Similarly, retailers try to stock products that move quickly. An option for the firm in financial difficulty is to try to restructure its obligations and debt with its suppliers and creditors. It may, for example, pay all of its utility bills each month but work out some sort of a deferred payment plan with its suppliers and creditors. Suppliers usually get nervous when this happens because they have already incurred the financial obligations associated with whatever they 22
  23. 23. provided the firm. Now they, the suppliers, are going to experience problems paying their own current obligations. The supplier has the option of cutting the firm off or insisting on cash payments for future supplies and arranging a negotiated payment each month on the existing debt. Creditors also get nervous and are usually reluctant to extend further credit to the firm, negating the possibility of any further debt financing. Investors who are aware of this also become reluctant to put any money into the company, reducing the probability of equity financing. The Management Effectiveness Indicators of Liquidity Ratios: The liquidity ratios can give us an indication about strengths and weaknesses in management, marketing, finance, production, and management information systems. The following table is a list of possible strengths and weaknesses listed by major management functional area for the results of liquidity ratios. These are possibilities that are designed to help you focus on the management situation within the organization. Remember the analysis caveat in item number 1, which was discussed on page 6. We say that these are "possible" management strengths and weaknesses. You must also check to make sure that the financial condition of the company was not caused by external mitigating factors or unusual internal factors, such as recent acquisitions, divestitures, restructuring, or cyclical expenditures. If the possible strength and weakness indicators were indeed showing us something about the company, we would use them as part of our basis to develop strategies to build on the apparent strengths or develop strategies to minimize the effect of or eliminate the possible weaknesses. In life as in business, information upon which we do not act is a missed opportunity. Some of the possible management strengths listed in the remainder of the handbook will also be listed as weaknesses. This is the case because in one situation, the favorable external factors will permit us to carry out one policy; however, when those same external factors become unfavorable, that policy is no longer justifiable. For example, if interest rates were low and sales were strong, a company could carry more debt, because it could earn more in profit than it paid in interest on that debt. If the external situation changed, however, and interest rates went up, the company may not be able to pay the interest on its debt. Many financial policies are determined by external factors over which the company has no control. Some of these are opportunities for the company to exploit; others are threats, the effects of which it must try to attenuate. For a more detailed list, see Appendix A. 23
  24. 24. POSSIBLE INTERNAL STRENGTH INDICATORS LIQUIDITY STRENGTH MGT AREA CONDITION Hi cash Excess cash available to develop and implement new MGT strategies. Hi inventory Sufficient inventory to meet customer demand. MKT Low cash No excess funds just "sitting around" and not being MGT used. Low cash All invested funds working for the company. MGT Hi receivables Liberal credit policy to stimulate revenue growth. MKT Low Aggressive receivables staff; decisive company policies MGT receivables on credit. POSSIBLE INTERNAL WEAKNESS INDICATORS LIQUIDITY WEAKNESS MGT AREA CONDITION Hi overall Needlessly stockpiling cash and/or inventory. MGT Hi overall "Strategic bunker mentality"; saving for a "rainy day." MGT Hi cash No definite strategic plans. MGT Hi cash Lack of a dividend plan. MGT Hi cash Failure to upgrade current plant and equipment. MGT Hi inventory Lack of inventory control system. IT Hi inventory Loss of market share. MKT Hi inventory Questionable purchasing practices. MKT Hi inventory "If the customer may want it, we have to have it in MKT stock" attitude; trying to be all things to all people without a clearly defined target market. Hi inventory Sales personnel not aggressive. MKT Hi inventory Lack of adequate sales personnel. MKT Hi inventory Lack of “new business development leadership." MGT Hi inventory Ineffective sales manager. MKT Hi inventory Keeping a non-competitive product or service too long. MKT Hi inventory Ineffective strategic plan or lack of strategic plan. MGT Hi inventory Management arrogance, e.g., “They buy what we sell!” MGT Hi receivables Incompetent or ineffective receivables manager. MGT Hi receivables Weak or untrained receivables staff. MGT Hi receivables Lack of effective receivable policy. MGT Hi receivables Indecisive management. MGT 24
  25. 25. CHAPTER FOUR The Activity Ratios "Ahhhh, what's up doc?" (Attributed to Bugs Bunny) There are four activity ratios with which you should be concerned. They are the asset turnover ratio, the inventory turnover ratio, and the average collection period. Not surprisingly, they give us an indication of how well we are managing our assets, how well we are managing our inventory, and how well we are managing those to whom we have sold a product, performed a service, or extended credit for that product or service. Based on the repetitive use of the word "managing", we can conclude that the activity ratios will tell us a great deal about the management of the firm. These ratios are easy to calculate. THE TOTAL ASSET TURNOVER RATIO: Net Sales = Total Asset Turnover Ratio (Asset Turns) Total Assets Total Asset Turnover Ratio: Let's calculate the asset turnover ratio for 3C using total assets. Get the net sales and total assets from the income statement and balance sheet in Chapter 2. 140,000,000 .8 = or simply 174,818,000 1 140 .8 = 174 1 This gives us a total asset turn ratio of .8 to 1 (.8/1). The ratio tells us that for each dollar in assets, there is eighty cents in sales. This ratio has to be tracked over time and compared with similar other companies. Experience and comparison will tell us whether this is an acceptable outcome. 25
  26. 26. THE NET FIXED ASSET TURNOVER RATIO: Net Sales = Fixed Asset Turnover Ratio Net Fixed Assets Net Fixed Asset Turnover Ratio: To calculate the net fixed asset turnover ratio for 3C: 140,000,000 1.09 140 1.09 = or simply = 127,568,000 1 128 1 This gives us a fixed asset turn ratio of 1.09 to 1 (1.09/1). This tells us that for every dollar in fixed assets, there is one dollar and nine cents in net sales. The fixed asset turnover ratio is a variation of the asset turnover ratio. Here we divide net sales by total fixed assets (our plant, machinery, and equipment). The argument here would be that it would be a useful indicator to know just how our well our fixed assets are performing. It’s a good argument. Many manufacturing firms prefer to use this ratio instead of the "total asset turnover ratio." The total asset turnover ratio and net fixed asset turnover ratio tell us how many dollars or fractions thereof we are making for each dollar in total assets or fixed assets that the firm owns. We spend money to buy assets so that those assets can make money for the company. This ratio gives us an idea of how our assets are performing. Industry averages and trend analysis are important in determining the significance of the ratio. Use the ratio that makes the most sense or use both. I prefer net sales/total assets because total assets represent all of the money that is invested in the company. THE INVENTORY TURNOVER RATIO: Cost of Goods Sold = Inventory Turnover Ratio Inventory Inventory Turnover Ratio: Referring to Figure 1and 2 for 3C, in Chapter 2, we would divide the cost of goods sold from the income statement by the inventory from the current assets section of the balance sheet. 112,000 7.46 112 7.46 = or = 15,000 1 15 1 26
  27. 27. The inventory turnover ratio is an artificial way of telling us how many times we have sold our inventory based on the dollar value of that inventory shown on the balance sheet. Another way of saying this is: "How many times has the inventory has turned over?" Inventory turns vary wildly from industry to industry. A convenience store may turn its inventory 12 times a year, or once each month. A franchised recreational vehicle dealership might turn its inventory only once a year. To be more accurate, before we calculate this ratio, we actually should get the dollar value of the inventory at four separate times during the year. Then average these figures and use the average to calculate inventory turns. Does the answer that we get when we calculate this ratio mean that we have sold the entire inventory exactly the same number of times? No! Part of the inventory may be turning over very rapidly, while part of the inventory may be turning over slowly. For example, in a franchised auto dealership's service department, the spark plug inventory may turnover 98 times a year, while the alternator inventory may turn over only four times a year. What is financially sound? How many inventory turns does it take to keep the company in business and making money for the owners or stockholders? It is not as simple as this. From a financial perspective, the number of inventory turns needed to insure financial health varies greatly from industry to industry. The company's target market and overall strategy has to be taken into consideration. The inventory turn ratio has comparative analytical value. We can compare ourselves to other firms in the industry. We can see trends over years in the number of times that we turn the inventory over. By doing this, we convert raw data, inventory turns, into information. This information can be used in management decision-making, the results of which become knowledge we can apply again or modify as appropriate. A slowing down in turns could indicate that too much money is tied up in inventory that does not move quickly. Or it could be caused by external factors. A recession or federal government fiscal policies could cause a lowering of demand. If the company is involved in international trade, declining demand in overseas markets, increased competition, or a strengthening of the U.S. dollar could also account for a slowing down of net sales and hence a decline in the number of inventory turns. There is a lesson to be learned here. Because of the interdependence of the economies of countries, both large and small, economic changes in other countries can dramatically affect the performance of domestic companies. A significant increase in the number of inventory turns does not mean that a company is enjoying prosperity. Sometimes, firms have no choice but to get rid of inventory at bargain prices, causing inventory turns to be up but net profit to be stagnant or show a decline. So, there no virtue in winning the “inventory turnover contest” if you wind up losing money. 27
  28. 28. Caution: This ratio is meaningless for companies that do not have saleable products in inventory. Most service firms have a small inventory of office and maintenance supplies. YOU SHOULD NOT calculate an inventory turn ratio for these firms. It is irrelevant to calculate how many times your inventory of copy paper, paper napkins, mops and brooms, and bathroom tissue turn over in a year. That inventory may be turning over, but it does not represent sales. THE AVERAGE COLLECTION PERIOD: First, we have to calculate average daily sales. To do this, divide net sales by 360: STEP ONE Annual Net Sales = Average Daily Sales 360 Then we have to divide the receivables by the average daily sales. Receivables STEP TWO = AverageCollection Period Average Daily Sales The Average Collection Period: Calculate these ratios for 3C using the data from the balance sheet and income statement in Chapter 2: 140,000,000 STEP ONE : Calculate Average Daily Sales = 388,889 360 9,000,000 STEP TWO : Calcualte Average Collection Period = 23 days 388,889 What we have actually calculated is the dollar amount of the average daily sales for which we have not as yet been paid. Remember, this is just a daily average that is calculated for analytical purposes; it does not necessarily represent 23 actual days of sales. If our average collection period is 23 days, it means that, on average, we have 23 days of sales for which we have not been paid. The only way that we can calculate the actual average collection period is to sum the age of all accounts receivable and divide that total by the number of accounts receivable. The key is that we have not yet been paid for products delivered or services rendered. We are in fact extending an interest free loan to those accounts. You should not be surprised to learn that at the operational level, companies know the "age" of every account. In fact, the credit history of every client is well documented. 28
  29. 29. Most companies have a system for showing the "age" of their accounts receivable. They will, for example, group together accounts that are equal to or less than 30 days old; have a separate group for accounts that are 31 to 45 days old; have a group for accounts that are 46 to 60 days old; and a final group for accounts receivable that are more than 60 days old. The accounts receivable entry on the balance sheet tells us how much money we are owed for the goods and/or services that we have already provided to someone. If the average collection period for these accounts gets too long, the company may have difficulty in paying its current obligations. Insufficient cash flow can force the company to take out short-term loans to meet cash requirements. In an acute situation where the company is too heavily in debt, the lending institutions could cut off this credit. In a worst case scenario, the company could become insolvent and be forced into bankruptcy. A company that is overly reliant on debt financing and does not have adequate equity financing would be most vulnerable under these circumstances. The Management Effectiveness Indicators of Activity Ratios: There are many factors within an organization that contribute to its success or failure. There are also a number of factors, from a management perspective, that should be taken into consideration when trying to understand the implications of the activity ratios. With this in mind, tables have been constructed to illustrate some of the major internal factors that contribute to asset turns, inventory turns, and average collection period from a management perspective. Remember, assets just don't "turn" by themselves. People, policies, practices, strategies, procedures, and leadership cause assets to turn. There are also external factors, over which the company has no control, that may be the primary mitigating factors. These factors could determine asset turns, inventory turns, or the average collection period regardless of the internal strengths and weaknesses of the organization. They include: economic recession, economic growth, change in consumer demand for better or worse, the opening up of new, lucrative markets, increased competition from higher quality and lower priced products, or a sudden decline in viable competition. A longer list of external factors that can affect business operations is shown at Appendix A. 29
  30. 30. Possible Internal Strength Indicators RATIO CONDITION MGT AREA Asset Turns Hi Well-defined target market.* MKT Hi Growing demand for product.* MKT Hi Aggressive sales force.* MKT Hi Well- defined goals, strategies, and objectives.* MGT Hi Management encourages creativity and change. MGT Hi Effective total quality management program.* MGT Hi Shared values and expectations.* MGT Hi Assets appropriate for the mission. MGT Hi Effective human resource management policies. MGT Hi Motivated, committed work force. MGT Hi High levels of productivity. MGT Hi Efficient, up-to-date physical plant. PRD Hi Effective maintenance and replacement policy. PRD Hi Effective and efficient waste control program. PRD Hi Effective and efficient quality control programs. PRD Hi Effective system for collecting, analyzing, and distributing IT information throughout the organization. Inventory Turns * The asterisked management and marketing factors listed above also apply to inventory turns. Hi Responsiveness to market demand. MKT Hi Responsiveness to customer needs. MKT Hi Efficient distribution system. MKT Hi Effective working relationship with suppliers. MKT Hi Efficient, computerized, inventory control system. IT Hi Prompt return to suppliers of unused or slow moving PRD inventory. Hi Effective and efficient inventory control policies. PRD Hi Efficient purchasing policies. PRD Average Some of the factors will be identical to the receivable factors Collection under the liquidity ratios. They are worth repeating because of Period the importance of this activity to management. The average collection period is the specific ratio that deals with the collection receivables. Lo Decisive collection policies. FIN Lo Aggressive accounts receivable staff. FIN Lo Excellent accounts receivable record keeping. FIN 30
  31. 31. Lo Competent receivables manager. FIN Lo Effective relationships with clients. MGT Lo A high-quality list of clients. MGT Lo Appropriate incentives for early or on-time payment. MGT* Lo Appropriate credit terms for appropriate clients, in other MGT* words, firm doesn't have a credit policy that encourages late payment or that gives credit to non-deserving clients. Possible Internal Weakness Indicators RATIO CONDITION MGT AREA The possible internal weaknesses that we could associate with low asset turns, low inventory turns, and a high average collection period are the reverse of those items that were listed under strengths. Therefore, they will not be repeated for the sake of showing this reversal. Students and managers can easily do these themselves. There are several weaknesses, however, that are not readily apparent by reversing the strengths, particularly for the average collection period. Average Collection Period Lo Excessively stringent credit policy. MGT Lo Over reliance on cash and cash equivalent payments. MGT Lo A "cash on delivery" policy for all clients. MGT 31
  32. 32. CHAPTER FIVE The Leverage or Debt Ratios There are three leverage ratios with which we should concern ourselves: the debt to asset ratio, the debt to equity ratio, and the times interest earned ratio. They are important because they give us an idea about how the company is being financed, the degree to which it relies on debt financing, and its ability to generate sufficient revenue to discharge its debt obligations. These ratios help us determine whether or not the company can attract debt financing and its vulnerability to an economic downturn. The financial implications of the leverage ratios can be far-reaching and can affect the continued viability of the company. First, few companies can afford to do business without borrowing money. Major sources of loans are banking institutions. Banks are primarily interested in their own profits; therefore, banks need to determine the financial health of their client companies. They want to know if the companies can "carry the debt", that is, make the payments on the loan in a timely manner. Simply put, when the bank loans money, it wants it back with interest and on time. Banks are profit-making organizations; they are accountable to their stockholders just like any other company. Before we go into how the ratios are calculated, we should discuss the term "leverage." Why use the term leverage? The answer to that question is tied to the discipline of physics. In physics we learn that we can use a bar (lever) and a fulcrum to create a mechanical advantage that helps us to move heavy objects more easily. Similarly, in business we can use the assets of a company, its growth potential, and/or its management prowess as a lever and a fulcrum to attract debt financing for the company. When we have reached a point that banks are no longer willing to loan us any more money, we tend to say that the company is "leveraged out" as far as it can go. That means that banks feel that the company is incapable of satisfying the obligations of any more debt. It may also mean that the bank feels that the assets of the company will not be able to generate enough money if they are sold to cover any additional debt. The bank may say that we do not have sufficient collateral to cover the debt. When we say that a company is in a strong leverage position, we mean that it can afford to take on more debt financing. The reverse is true for a company in a weak leverage position. Leverage then is directly tied to a company's ability to either attract financing or take on the obligation of additional debt. Debt is debt. It doesn't make any difference whether it is short term or long term, or whether it is from a bank or obtained through the issuance of bonds. A debt is any obligation that a company incurs that must be paid back, almost always with interest. If the owner of a business or the uncle or aunt of the owner gives the business a loan, that is also debt. 32
  33. 33. THE DEBT TO ASSET RATIO AND LONG TERM DEBT TO ASSET RATIO: The total debt to asset ratio, also called The Debt Ratio: Total Debt (Liabilities) = Total Debt to Asset Ratio, The Debt Ratio Total Assets The Debt to Asset Ratio: Again we get 3C’s debt and asset information from the company's balance sheet in Chapter 2. 106,878,000 .61 107 .61 = or simply = 174,818,000 1 175 1 The ratio tells us that for every dollar in assets, we have 61 cents in debt. This ratio is meaningful as a comparison of the relationship of our debt to our assets. It could have ultimate value to a lending institution that wants its loans secured by assets. If that were the case, in this situation we could only use 39% of our assets to secure additional debt. The debt to asset ratio shows management and the banks the relationship between the assets of the company and the amount of debt owed by the company. It does not show the amount of assets that were actually purchased by debt financing. In reality, equity financing could have purchased all of the assets. Assets are either purchased with cash, debt or equity financing. The ratio actually shows us how much of the debt of the company is covered by assets. So, if we have a situation where there are 200,000 dollars in assets and 100,000 dollars in debt, we will have a debt ratio of .5 to 1. We divided the total assets by total debt. The .5 tells us that for each 50 cents in debt, there is one dollar in assets. Is this good or bad? It all depends on the industry. It could also depend on the current activities of the company. For example, a company like 3C, our case company for this handbook, recently used debt financing for a substantial acquisition. In this case, we should expect that for a period of time its debt ratio would be higher than the industry average. We would also expect that over time, the company would be engaged in strategies to improve its leverage position as it "digested" the acquisition and made it an integral part of the company. 33
  34. 34. The long term debt (long term liabilities) to asset ratio: Total Long Term Debt = Total Long Term Debt to Asset Ratio Total Assets The Long term Debt to Asset Ratio: Now we'll calculate 3C’s long-term debt to asset ratio: 75,628,000 .43 76 .43 = or simply = 174,818,000 1 175 1 This ratio tells us that for every dollar in assets we have about 43 cents in long-term debt. About 43% of our assets are covered by long term debt. The long term debt to asset ratio is an alternative or complement to the total debt to asset ratio. Be careful when you use it. It can provide a misleading picture of the company's liability structure, particularly when a company is heavily reliant on short- term debt and not on long term debt. Eliminating the short-term debt from your analysis in this case can lead to a false or inaccurate interpretation. When in doubt, use both ratios. That will give you a more complete understanding of the leverage position of the company. It is also obvious from our analysis that while the company is heavily reliant on long-term debt (.43/1), it also has substantial short-term debt. We know this because the two ratios are dissimilar, .61/1 for the total debt to asset ratio versus .43/1 for the long- term debt to asset ratio. By subtracting .43 from .61, we can see that the company also has 18 cents in short term debt for every dollar in assets (or .18/1). We can verify this figure by dividing the total current liabilities by total assets, 31,250,000 by 174,818,000 (or simply 31,250 by 174,818). This also gives us a ratio of .1787 to 1, or rounding off, .18/1. THE DEBT TO EQUITY RATIO: Total Debt = The Debt to Equity Ratio Total Stockholders' or Owners' Equity 34
  35. 35. Debt to Equity Ratio: Let's calculate the debt to equity ratio for 3C. Again, we refer to the balance sheet in Chapter 2. 106,878,000 1.57 107 1.57 = or simply = 67,940,000 1 68 1 This means that for every dollar and fifty-seven cents of borrowed money (debt) there is one dollar in money invested by 3C’s stockholders (equity). Conclusion: the bank has more money invested and at risk in the company than the stockholders. Borrowing additional money will be very difficult for this company. The debt to equity ratio shows us the comparison of the amount of money that the company has borrowed from creditors to the amount of money that the stockholders/owners have put in the company. The ratio is important because it gives lenders an idea of the financial vulnerability of the company, as well as inability to attract additional equity financing. Lending institutions get increasingly concerned when debt financing exceeds equity financing. Why? Because it means that the lending institution has more invested in the company than the stockholders/owners of the business. Banks are not philanthropic institutions; they want reasonable safeguards that the money that they are lending will be repaid. As an aside, remember that stockholders of the bank also want to enjoy a profit on their investment. Banks are accountable to their stockholders for the financial health of the bank. The debt ratio is not an issue if the company does not intend to borrow. However, reality for most companies is that at some point, they must borrow money to operate. As part of the lending process, and as a result, banks will look at the amount of money that the stockholders/owners have invested in the company. They will also look at the amount that the company has borrowed from banks or acquired with other loan instruments. For example, if the company has $2,500,000 in debt and $1,000,000 in equity, the debt to equity ratio would be 2.5 to 1. That means that for every $2.50 cents in debt, there is one dollar in equity in the company. Who cares? The banks do; any serious investor in the company should care. What this means is that the banks have two and one half times more money invested in the company than the stockholders. A company that is heavily in debt, with a debt to equity ratio of 2.5to 1, is very vulnerable to changes in the domestic and, if applicable, the international economic environments, specifically to adverse changes in the prime interest rate. That could prove to be a very vulnerable position for the bank. Banks will generally loan out money at an interest rate that is either at or above the prime rate. The interest they charge will depend on the creditworthiness of the borrower. The prime rate is the rate that banks charge their most creditworthy customers. Usually, the interest rate on the loan varies as the prime rate varies; it is not "locked in" for the life of the loan. If your company can comfortably borrow $10,000,000 at 1 35
  36. 36. percentage point over a prime rate of 6.5%, it may not be able to afford the cost of carrying the debt if the prime rate goes to 15%. Why? Because the interest charges on that loan have more than doubled. Your "rapid-fire" response to this may be something like: "We'll pass the additional debt service cost on to the consumer." That’s great if you can do it; most businesses cannot afford to do that because there is simply too much regional, national, and international competition. In 1979-80, when the prime rate hovered near 20%, new car sales plummeted in the United States as consumers bought more affordable, less expensive, used cars. Home sales also dropped dramatically for the same reason. Many new car dealers were forced out of business because they could not pay the principal and the vastly greater amount of interest on their loans. What's the bottom financial line for a company? The higher the debt to equity ratio, the less likely that the company will be able to attract debt financing, the more vulnerable it is during an economic downturn. The latter condition presumes that the company has competitors and/or is under pressure to deliver a high quality product or service at a reasonable price within its market niche. THE TIMES INTEREST EARNED RATIO (THE NUMBER OF TIMES THAT THE INTEREST IS COVERED): Operating Income (EBIT) Times Interest Earned or = Interest Expense Times the Interest is Covered Times Interest Earned Ratio: Calculate this ratio for 3C with the operating income and interest expense from the income statement in Chapter 3. 9,500,000 1.58 95 1.58 = or simply = 6,000,000 1 60 1 This means that for every dollar and fifty-eight cents in operating income, 3C has one dollar in interest expense, or its operating income is 1.75 times its interest expense. It has earned its interest 1.75 times. Is this sufficient to satisfy 3C's creditors? We would have to know what the creditors' expect in this area. We would also have to check the pertinent industry averages. The ramifications of the times interest earned ratio are closely tied to the debt to equity ratio and the total debt to asset ratio. The financial implications of this ratio are pretty straightforward. It tells lenders about the relative ability of the company to pay the interest on its debt obligations. Looking at it realistically, when you divide the operating income by the interest on the debt, if you come up with a figure that is less than one, it means that there is not enough operating income being generated to pay the interest on the debt. This sends up a red flag for the lender and suggests that the 36
  37. 37. company may not be financially strong enough to carry more debt. It is also a signal to the company that it may have to develop strategies to change its debt and/or equity structure or to reduce its cost of sales or operating expenses. THE MANAGEMENT EFFECTIVENESS INDICATORS OF LEVERAGE RATIOS Not only does debt affect the financial situation of the company, it has clear implications for management and management decision-making. Most strategies cost money to implement; some much more than others. An organization must either have the money to implement or it must be able to attract financing. If it does not have the financial wherewithal and cannot attract it, the consequences for the company are serious. The debt to asset ratio and the debt to equity ratio are strongly correlated with each other. If you have a high debt to asset ratio, you will almost always have a high debt to equity ratio. The same is not true for the times interest earned ratio. You could have a low debt to asset and a low debt to equity and still have a low or unfavorable times interest earned ratio. That is because the times interest earned ratio is dependent on a healthy income statement, while the other two ratios are dependent on a healthy balance sheet. Possible Internal Strength Indicators RATIO CONDITION MGT AREA Debt to Asset Lo Company able to assume more debt. FIN Lo May be able to get most favorable interest rate. FIN Lo Can contemplate goals and strategies that are unavailable MGT without additional financing. Lo Can contemplate expanding into new geographic areas-usually MKT a high cost strategy. Lo Can consider purchasing or buying into companies that are MGT their primary suppliers-a high cost strategy. Lo Makes the company more attractive as a strategic partner. MGT Debt to Equity Lo Company is more attractive to lenders because FIN stockholders/owners have a large stake in the company. Lo Can contemplate a wider range of strategic options because MGT debt financing is a viable option. Hi Company is using borrowed money. In a strong economy with FIN 37
  38. 38. low interest rates, this means that the return on equity for stockholders will be higher. Lo Makes the company more attractive as a strategic partner. MGT Times Interest earned Hi Company is attractive to lenders. FIN Hi Company is attractive to potential investors. FIN Possible Internal Weakness Indicators RATIO CONDITION MGT AREA Debt to asset Hi Company will be unable to upgrade or replace expensive PRD means of production. Hi Companies unappealing to both lenders and investors. FIN Hi Moderate and high cost strategies cannot be contemplated, MGT restricting the strategic options of the company. Hi May not be able to aggressively pursue strategic opportunities MGT as they develop because of lack of financing. Lo Possible takeover target, because the company is in an MGT excellent leverage position. Debt to equity Hi Lenders and investors view the company as high risk. FIN Hi Either there is too much debt or too little equity in the FIN company, forcing the company to pursue equity financing. If company is in an unfavorable leverage position; it will not get sufficient equity financing. Hi In a weak economy with rising interest rates, company will FIN probably lose money. Lo Possible takeover target because the company may not be MGT highly leveraged. Times interest earned Lo Unattractive to investors and lenders. FIN Lo Restricts the strategic options of the company. MGT 38
  39. 39. CHAPTER SIX The Profitability Ratios There are six profitability ratios with which we must be concerned. They are the gross profit, operating profit, net profit, return on equity, return on assets, and the earnings per share. You could make a powerful argument that profitability is really the only thing that counts. While that may be true, you will not be profitable unless you can pay your bills (liquidity), are generating an adequate amount of business (activity), and have a viable debt position (leverage). THE PROFIT MARGINS: GROSS PROFIT MARGIN: Gross Margin = answer × 100 = Gross Margin as a Percent of Net Sales Net Sales The Gross Profit Margin: To calculate the gross margin for 3C: 28,000,000 28 = .20 × 100 = 20% or simply = .20 × 100 = 20% 140,000,000 140 The result of this operation is very significant. It tells us that 80% of the money from our net sales has been used to manufacture 3C's products. Only 20% is left for all of the other expenses that the company incurs. OPERATING PROFIT MARGIN: Operating Profit = Answer × 100 = Operating Profit as a Percent of Net Sales Net Sales 39
  40. 40. The Operating Profit Margin: To calculate 3C’s operating margin: 9,500,000 95 = .0678 × 100 = 6.78% or simply = .0678 × 100 = 6.78% 140,000,000 1400 This tells us that 13.22% of the money from our net sales (gross margin, 20%, minus operating margin, 6.78%) is being used for operating expenses. This figure seems high and should be a concern to us. Think about this: If we could reduce our operating expenses to ten percent of net sales, it would improve our operating profit by 3.22% to 8.8%. That is a 3.22% increase in operating profit. Net profit, after taxes, would increase by .0202% (.0322 times .40, the tax rate, = .012; .0322 minus .012 = 0202), resulting in a new net profit for 3C of 3.52% (1.5% + 2.02%) without manufacturing or selling any additional product. That would put a small smile, or perhaps a large smile, on the stockholders' faces. NET PROFIT MARGIN: Net Profit = Answer × 100 = Net Profit Margin as a Percent of Net Sales Net Sales The Net Profit Margin: To calculate the net profit margin for 3C: 2,100,000 21 = .015 × 100 = 1.5% or simply = .015 × 100 = 1.5% 140,000,000 1400 This seems rather low, but we can't be sure. This result, however, should act as a "red flag" that signals us to look for answers or ask questions. Is this normal for companies in this industry? Have any unusual external factors conspired to cause this to happen? Have any unusual activities internal to the company contributed to the seemingly low margin? What about the leadership of the company? Are we going in the right direction? Or is this an anomaly caused by the recent acquisition? The profit margins: From a financial point of view, the profit margins give us an opportunity to view the income and costs of a company that are associated with its primary business operations and with extraordinary financial occurrences in an 40

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