This document discusses liquidity ratios and how they can change based on a company's financial decisions. It defines two key liquidity ratios: the current ratio and acid test ratio. The current ratio measures current assets available to cover current liabilities, while the acid test only considers more liquid current assets. The document then demonstrates how taking on short-term debt or increasing capital can impact these ratios, making liquidity stronger by applying long-term resources to current assets but weaker by using short-term debt for fixed assets.
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UNIT 4: FINANCIAL RATIOS — LIQUIDITY
INTRODUCTION
An analyst uses financial ratios to understand the relationships among various financial
statement accounts. These ratios yield information about a company’s ability to meet short-
term obligations on time, remain solvent over a long period, manage assets, and operate
efficiently.
In this unit, we demonstrate the calculation of two liquidity ratios: the current ratio and the
acid test (or quick asset) ratio. The current ratio tells us the amount of current assets that
are available to cover current liabilities. The acid test accomplishes the same purpose as the
current ratio, but it yields more precise information because it considers only the most
liquid assets. Finally, we will look at two situations that demonstrate how a company’s
decisions can affect its liquidity ratios.
UNIT OBJECTIVES
When you complete this unit, you will be able to:
n Recognize the different types of financial ratios
n Calculate a current ratio and an acid test (quick asset) ratio
n Recognize how a company’s decisions can affect its liquidity ratios
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FINANCIAL RATIOS
Relationships
within accounts
The use of ratios and margins in financial analysis enables the analyst
to interpret the financial situation of an enterprise in a more
meaningful manner than by just looking at the absolute numbers.
Financial ratios consider the relationships that exist within various
accounts and, thus, facilitate an understanding of a company’s financial
condition with greater depth and clarity.
Ratio analysis is another tool that helps identify changes in a
company's financial situation. A single ratio is not sufficient to
adequately judge the financial situation of the company. Several ratios
must be analyzed together and compared with prior-year ratios, or
even with other companies in the same industry. This comparative
aspect of ratio analysis is extremely important in financial analysis.
It is important to note that ratios are parameters and not precise or
absolute measurements. Thus, ratios must be interpreted cautiously
to avoid erroneous conclusions. The analyst should attempt to get
behind the numbers, place them in their proper perspective and, if
necessary, ask the right questions for further clarification.
Types of Financial Ratios
There are several types of ratios or relationships. They are categorized
as follows:
n Liquidity ratios — measure the ability of the enterprise to
meet its short-term financial obligations in a timely manner
n Leverage ratios — measure the solvency or viability of the
enterprise on a long-term basis
n Turnover ratios — measure how effectively the company's
assets are managed
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n Profitability ratios — measure the efficiency of operations
within the enterprise
We begin our discussion of financial ratios in this unit with liquidity
ratios. The remaining ratios are the subject of Units Five through
Seven. For future reference, you will find a Financial Ratio Summary
sheet at the end of Unit Seven. You may find it useful
as a quick reference as you work through these units.
LIQUIDITY RATIOS
Liquidity ratios measure the relationship of the more liquid assets
of an enterprise (the ones most easily convertible to cash) to current
liabilities. The most common liquidity ratios are:
n Current ratio
n Acid test (or quick asset) ratio
Current Ratio
Quantitative
relationship
between current
assets and
current
liabilities
The current ratio is frequently used to measure liquidity because it
is a quick and easy way to express the quantitative relationship
between current assets and current liabilities. It answers the
question: "How many dollars in current assets are there to cover
each $1.00 in current liabilities?" To calculate the current ratio,
divide current assets by current liabilities.
Current Assets
Current Liabilities
A rule of thumb is that a current ratio close to 2.0 is good, but this is a
very generalized statement. Let's look at an example.
Current Ratio =
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COMPANY A COMPANY B COMPANY C
Current Assets $150 $ 80 $400
Current Liabilities $100 $110 $180
Current Ratio 1.50 0.73 2.22
Company C has $2.22 in current assets for each $1.00 in current debt.
It apparently has more liquidity and, therefore, appears to
be in a better position to pay its short-term debts than either Company
A or B.
Interpreting
the ratio
The current ratio must be interpreted with caution. An absolute
number by itself may not present a strong enough basis to draw
conclusions. The analyst must attempt to get behind the numbers and
verify that the current assets, which substantiate the ratio, are indeed
fully realizable. For example, if a relatively high current ratio index is
based on large amounts of trade receivables, the collectability
of these accounts should be investigated. If a large proportion of
receivables is delinquent, or if the current economic situation could
adversely affect timely collection efforts, then a high current ratio
will not necessarily indicate strong liquidity.
The same type of analysis should be made for inventories. When
excessive inventory levels on the balance sheet are the basis for a high
current ratio, the analyst should question whether obsolescence,
changes in style, physical deterioration, or changes in market prices
have affected the realization value of this inventory. When it seems
impossible to realize inventories in full, their value should be reduced
and the current ratio adjusted accordingly.
Testing
the ratio
It is advisable to test the strength of the current ratio by carefully
examining the enterprise's accounts receivable and inventory levels, or
by focusing on the turnover ratios discussed in Unit Six. This provides
a stronger feeling for the realization value of these two important
current assets.
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Another consideration is the average maturity dates for the current
assets and liabilities. If most of the current liabilities mature next
week, then significant amounts of trade receivables due in 60 days will
not provide the desired liquidity level. Since maturities of receivables
and payables seldom match, most companies are constantly dealing
with too little or too much liquidity.
The current ratio should, therefore, be used as a rough indicator
and never as an accurate statement of the company's actual
ability to pay.
Financing
patterns
The financing methodology normal to a sector can also have a
major impact on current ratio levels. This is part of what the analyst
considers in norms for specific sectors. For example, look at two
types of companies: a shoe producer and a supermarket chain.
Example:
Shoe producer
The shoe producer has major needs for inventory — both raw
materials and finished goods — because the nature of the business
is to produce many styles, sizes, and colors. In the real world, the shoe
company must also sell on a credit basis to entice shoe stores
to purchase its product. The business can, thus, be considered working
capital intensive. In such cases, a significant portion of the company’s
own capital may be invested in financing working capital needs —
since suppliers will not finance either finished goods or receivables.
The shoe producer’s probable current ratio is around 1.5, or maybe a
little higher.
Example:
Supermarket
chain
The supermarket sells on a cash basis and, therefore, does not have
a need to book receivables. The supermarket chain is also in a strong
position on purchasing and can often negotiate longer credit terms
than needed. The supermarket may take 60 day terms and turn over the
goods in 30 days, investing the funds for the other 30 days. The
supermarket chain’s probable current ratio is around 1.0, since there is
little or none of the supermarket’s own capital invested in current
assets.
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Which of the two companies is more liquid? If you say the
supermarket, you are right because its products (mainly food) can
be sold more quickly than shoes. Yet its “normal” current ratio of
around 1.0 is much lower than the shoe producer’s 1.5. Be careful
about coming to quick conclusions about liquidity by looking solely at
the current ratio as a liquidity indicator. The analyst should also
consider financing patterns.
Acid Test
Considers most
liquid current
assets
The second commonly used liquidity ratio is the quick asset ratio,
often called the acid test. This ratio presents a more precise liquidity
test by considering only the more liquid current assets, thereby
excluding inventories, prepaid expenses, and other current assets from
the calculation. In this way, the index places greater emphasis on the
more immediate conversion of current assets to provide coverage of
short-term obligations. The rule of thumb for a healthy acid test index
is 1.0.
The calculation for this ratio is:
Cash + Near Cash Assets + Trade Receivables
Current Liabilities
The acid test presumes that trade receivables are more liquid than
inventories. Trade receivables are directly converted to cash;
inventories are first converted to trade receivables (if sales are
made on a credit basis) and then to cash. In addition, there is some
uncertainty of the value at which inventories will be realized, since
some items may become damaged, lost, or obsolete.
Two ratios are
complementary
Let's look at the current ratio example and see how the two ratios
complement each other.
Acid Test =
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COMPANY A COMPANY B COMPANY C
Current Assets $150 $ 80 $400
Inventories $ 20 $ 30 $300
Current Liabilities $100 $110 $180
Current Ratio 1.50 0.73 2.22
Acid Test 1.30 0.45 0.55
Company C has the highest current ratio, but it relies on realization of
inventories to cover its short-term liabilities. If it is unable to convert
the inventories to cash, it will only have $0.55 (400 – 300 ÷ 180) in
quick assets to meet each $1.00 of current liabilities.
Company A probably has the best liquidity of all because it does
not depend on inventory realization to meet its debts. Even without
selling inventories, it has $1.30 in current assets to meet every
$1.00 in current debt.
Similar to the current ratio, the analyst must attempt to get behind the
acid test computed index and verify that the trade receivables
substantiating the ratio are fully realizable at the agreed upon term.
The analyst also must consider the firm's line of business since
companies that sell on a cash basis (such as supermarkets) have no
receivables on the balance sheet. The result is a very low quick asset
ratio even though the type of inventory sold (food, in the case of a
supermarket) may be very liquid. The company's liquidity situation
could be quite good despite a low acid test figure.
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Other Liquidity Indicators
Associated with
levels of cash
Besides the current ratio and acid test, there may be other liquidity
indicators. These could be associated with cash levels, such as:
n Cash + Near Cash as % of Current Assets
n Cash + Near Cash as % of Working Capital
n Days Cash
The first two ratios are simple percentages. Days cash is a
comparison of cash to sales, with the resulting decimal figure
multiplied by the number of days in the period, 360 days for a yearly
calculation, to get the proportion of cash as of the balance sheet date
to the accumulated yearly sales figure.
The new Citibank spreadsheet includes days cash, along with days
receivable, days inventory, and days payable as liquidity ratios. This
recognizes that the turnover of these current assets is closely linked to
a company’s liquidity position.
However, these balance sheet figures in terms of days of sales /
production have traditionally been considered turnover ratios, where
the analyst contrasts these balance sheet accounts with income
statement figures. We will consider these ratios later.
You have completed the sections on “Current Ratio”, “Acid Test,”
(quick asset ratio) and “Other Liquidity Indicators.” Please complete
the following Progress Check before continuing a further study of
liquidity ratios.
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HOW LIQUIDITY RATIOS CHANGE
Example There are many factors that can change a company's liquidity. Let's
look at the following example:
ASSETS LIABILITIES & NET WORTH
Current Assets $3,000 Current Liabilities $2,500
Fixed Assets 2,000 Net Worth 2,500
TOTAL $5,000 TOTAL $5,000
In this case, the company's current ratio is 1.20. Let's see how
different financial decisions can affect this current ratio.
Situation 1:
Short-term loan The company takes a short-term loan of $800, increasing its current
liabilities. Let's see what happens if the company uses the proceeds to
(a) purchase inventories or (b) purchase equipment.
a) If the company purchases inventories, current assets will
increase and the balance sheet will look like this:
ASSETS LIABILITIES & NET WORTH
Current Assets $3,800* Current Liabilities $3,300*
Fixed Assets 2,000 Net Worth 2,500
TOTAL $5,800 TOTAL $5,800
* An $800 increase over the starting point.
The current ratio for this balance sheet is 1.15.
Conclusion: If the current ratio is greater than 1.00, and
current assets increase while current liabilities increase by
the same amount, the current ratio decreases.
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b) If the proceeds of the loan are used to buy machinery, fixed
assets will increase.
ASSETS LIABILITIES & NET WORTH
Current Assets $3,000 Current Liabilities $3,300*
Fixed Assets 2,800* Net Worth 2,500
TOTAL $5,800 TOTAL $5,800
* An $800 increase over the starting point.
The current ratio is now 0.91.
Conclusion: Using short-term loans (current liabilities) to buy
fixed assets causes liquidity to deteriorate.
Situation 2:
Increased
capital
The owners decide to increase capital by $800, thus increasing net
worth. The proceeds may be used to (a) add to inventories or (b) add to
machinery.
a) If the additional capital is used to purchase inventories, current
assets increase and current liabilities remain the same.
ASSETS LIABILITIES & NET WORTH
Current Assets $3,800* Current Liabilities $2,500
Fixed Assets 2,000 Net Worth 3,300*
TOTAL $5,800 TOTAL $5,800
* An $800 increase over the starting point.
The current ratio is now 1.52.
Conclusion: Applying long-term resources (net worth) to
current assets improves liquidity.
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b) If the increase in capital is used to purchase machinery, fixed
assets increase while current assets and current liabilities
remain the same.
ASSETS LIABILITIES & NET WORTH
Current Assets $3,000 Current Liabilities $2,500
Fixed Assets 2,800* Net Worth 3,300*
TOTAL $5,800 TOTAL $5,800
* An $800 increase over the starting point.
The liquidity ratio is 1.20.
Conclusion: Using long-term sources to finance long-term
uses does not affect the current ratio since the ratio only
measures current liquidity.
The examples demonstrate that the current ratio may vary according to
the situation. This ratio is only one source of information about a
company's financial status.
Please complete the following Progress Check before continuing to
Unit Five: Financial Ratios — Leverage.
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UNIT 5: FINANCIAL RATIOS — LEVERAGE
INTRODUCTION
In general, leverage ratios focus on the sufficiency of assets, or generation from assets,
to cover the company’s pending short- and long-term obligations. The liquidity ratios
discussed in Unit Four are similar in this regard but they are more concerned with the
urgency of coverage; leverage ratios are more concerned with overall volume of
coverage.
Leverage ratios, also called capital structure ratios or solvency ratios, measure the
relationship between outside capital and shareholder capital. Leverage ratios include:
n Total indebtedness ratio, or leverage
n Current and long-term indebtedness ratios
n Fixed assets to net worth ratio
n Interest or debt service coverage ratios
UNIT OBJECTIVES
When you complete this unit, you will be able to:
n Calculate a total indebtedness ratio
n Recognize the significance of a company’s leverage ratios
n Identify generally appropriate leverage figures for different businesses
n Calculate adjusted leverage
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TOTAL INDEBTEDNESS (LEVERAGE)
The total indebtedness ratio, often called leverage, is one of
the most important ratios for a banker. It is a good indicator of
company solvency (ability to pay all debts) and a general index
of the borrower’s creditworthiness. From a banker’s perspective, the
lower the ratio within an appropriate range, the better. A low ratio
indicates a greater asset coverage of liabilities and, therefore, a
greater “cushion” of capital to cover unforeseen difficulties. A
company with a low index denotes stronger capitalization which
can absorb greater risk.
Calculation
Standard
leverage
calculation
Outside capital is comprised of current and long-term liabilities that
represent resources loaned to the company by third parties. Own
capital is net worth. It represents the resources that stockholders have
invested and earned in the firm. We divide outside capital by own
capital to determine the total indebtedness of a company.
Calculation: Total Liabilities / Total Net Worth
Asset leverage Another way of computing leverage is:
Total Assets / Total Net Worth
Own CapitalOutside Capital
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This calculation emphasizes the concept of asset coverage for
payment of a company’s liabilities. It is really a variation on the
standard or normal leverage, rather than a separate ratio. As you can
see in Table 5.1, the result of asset leverage always will be 1.0 more
than the result of standard leverage, so there is little to be gained by
computing both variations. Banks use one or the other — the great
majority of banks use the standard leverage calculation.
Company A Company B Company C
Assets
Liabilities
Net Worth
Standard Leverage
Asset Leverage
1000
500
500
1.0
2.0
1000
600
400
1.5
2.5
1000
800
200
4.0
5.0
Table 5.1: Comparison of standard leverage and asset leverage
Leverage Analysis
Leverage should be analyzed within the context of the economic
sector of the borrower since the appropriate leverage figure may vary
from sector to sector.
Incidence of Fixed Assets
The amount of fixed assets on the balance sheet is one of the major
determinants of appropriate leverage. A heavy industry with major
fixed asset needs will require greater capital levels to sustain its
illiquid assets. The total debt for these types of companies will be
relatively low in comparison to net worth, resulting in relatively
low leverage levels. On the other hand, highly liquid companies
with little need for fixed assets (such as wholesalers or trading
companies) normally will operate at debt levels that are multiples
of net worth, resulting in leverage of two or three, or perhaps greater.
In Table 5.2, we show a comparison of the leverage for these two types
of companies.
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Heavy Industrial Co. Trading Co.
Fixed assets 700 100
Total assets 1000 1000
Liabilities 400 800
Net worth 600 200
Leverage 0.67 4.0
Table 5.2: Leverage relative to the amount of fixed assets
Effect of Seasonality
The leverage figure should also be measured within the context
of seasonal borrowing patterns, if any, since these may distort the
analysis. For example, a food processing company may be forced to
take on debt at harvest time to enable payment to farmers. When the
processed goods are sold, the company can repay the loans.
Measuring leverage at the point of higher debt will result in a higher
figure than at other times during the year. So, the timing of the
balance sheet analysis should also be considered. In Table 5.3, you
can see how the leverage ratio for a company with seasonal
borrowing needs may vary for different periods during the year.
12/31 3/31 6/30
Total Assets 1000 800 1500
Liabilities 500 300 950
Net Worth 500 500 550
Leverage 1.0 0.6 1.7
Table 5.3: Leverage ratios for different periods
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Financial Leverage
Earlier, we said that from the lender’s perspective, the lower the
leverage ratio for a company, the better. But, the borrower’s interest,
in the case of capital sufficiency, may differ from the banker’s. From
the shareholder’s point of view, if leverage is too low, profits may be
insufficient for the level of equity in the company, resulting in a poor
return on equity.
Borrower’s
point of view
An obvious way to improve return on equity is to increase earnings.
Perhaps a less obvious way is to have less equity or net worth, which
means higher leverage. For this reason, from the borrower’s point of
view, it may be more convenient to “leverage up” a business, within
reasonable parameters, in order to improve earnings per share. This is
the concept of financial leverage, which is illustrated in Table 5.4.
Reasonably
Aggressively
Conservative Leveraged Leveraged
Total Assets 1000 1000 1000
Liabilities 400 500 600
Net Worth 600 500 400
Earnings 100 100 100
Leverage 0.67 1.00 1.50
Return on Equity 16.7% 20.0% 25.0%
Table 5.4: Financial leverage — borrower’s perspective
Lender’s
viewpoint
From the lender’s point of view, risk increases as liabilities
substitute for equity. Take the case of a heavy industrial company with
norms as listed in the first column of Table 5.4. If the company is well
run and has a strong position in its market, a lender may tolerate a
reasonable increase in leverage. However,
as the company leverages more aggressively, the banker will be less
tolerant from a risk perspective.
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“Correct”
leverage figure
The “correct” leverage figure for each company, then, may vary
considerably, depending on the liquidity of the assets, stability of the
economic sector, and factors within the market. But, it is safe
to say that the greater the amount of fixed assets, the greater the
capital needs and, therefore, the lower the normal leverage level.
In summary, the normal leverage ratios generally are as follows:
n Heavy industries — less than 1.0
n Medium industries — about 1.0 to 1.5
n Retailers — slightly higher, maybe at 2.0
n Wholesalers — slightly higher than retailers, perhaps 2.5
to 3.0 or higher
n Financial services companies — 10.0 times or greater,
sometimes as high as 20.0 (not to be confused with capital
adequacy which has its own rules regarding assets that do
not require capital backing).These companies tend to operate
with small amounts of fixed assets on their balance sheets
(generally less than 5% of total assets).
Information
resources
It is recommended that the analyst look up some figures within
his/her respective market to confirm these numbers, perhaps
business magazine listings of the “top 100” companies in their
market. Industry averages, if available, are especially valuable for this
purpose. Whatever the source, it is important for the analyst to get a
feeling for the “right” figure for this important ratio to permit greater
depth in financial analysis and better judgment as to capital adequacy
among different types of borrowers.
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Tangible Net Worth
Net of
nonconvertible
assets
When analyzing a company’s balance sheet, keep in mind that it may
show assets that are difficult or impossible to convert into
cash, such as pre-operating expenses or other intangibles, stale
receivables, obsolete inventories, etc. These assets should be
deducted from net worth for calculating leverage in order to present a
more realistic or conservative scenario. The result of
this “write down” is called tangible net worth.
Example Let’s look at an example for Company X:
$M
Total assets 500
Current liabilities 200
Long-term liabilities 50
Net worth 300
Utilizing stated net worth, the total indebtedness ratio is 0.83:
(200 + 50) / 300 = 0.83
However, Company X has some liquidity problems and $50,000 of its
assets cannot be converted into cash. If we calculate tangible net
worth, we see a different picture of the company:
(200 + 50) / (300 - 50) = 1.00
Utilizing tangible net worth (net of nonconvertible assets), we now get
an indebtedness ratio of 1.00. This means that outside capital
represents 100% of own capital.
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As we discussed in Unit One, standard financial analysis theory
recognizes that intangibles may not be convertible into cash and
eliminates these assets against net worth for calculating tangible net
worth. But this “write down” is not automatic. It should be done
only if the intangibles are determined to be of dubious value and
unrealizable. Other intangibles may be very valuable (examples:
licenses to produce international brands, goodwill resulting from a
recent privatization) and have a defined market value. In these cases, it
would not necessarily be appropriate to net these assets since they
may provide a major support to the net worth and value of the
company. It is up to the analyst to make this determination.
Revaluation Surplus
Result of
revaluing
fixed assets
Since a revaluation of fixed assets results in a corresponding increase
in revaluation surplus (a net worth account), net worth is increased by
the net amount of a revaluation. In many cases, this increase may be
justified by market conditions; but when the practice is unevenly
applied, it can also lend itself to manipulation of numbers.
Therefore, for purposes of calculating tangible net worth, it also may
be appropriate to “write down” the amount of revaluation surplus. This
is a judgment call for the analyst. At the very least, an analyst can
calculate leverage with and without revaluation surplus to highlight the
impact of revaluation on the leverage calculation as shown in Table
5.5.
Before After Revaluation
Fixed assets
Total assets
Liabilities
Net worth
Computed leverage
Adjusted leverage
500
1,000
500
500
1.00
1.00
700
1,200
500
700
0.71
1.00
Table 5.5: Leverage with and without revaluation surplus
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Other Adjustments
Contingent
liabilities
Contingent liabilities, such as corporate guarantees, discounted
receivables with recourse, lease obligations, and open foreign
currency positions, should also be considered by the analyst when
studying a company’s leverage position. If a certain event occurs,
a contingent liability may become direct (for example, a default
by the principal borrower where the company analyzed is a guarantor).
In Table 5.6, you can see that leverage increases if default occurs and
the guarantee becomes a liability.
Before After Default
Liabilities
Net worth
Corporate guarantee
Leverage
500
500
200
1.0
700
500
0
1.4
Table 5.6: Increased leverage after default
Operating
leases
A similar situation may occur with operating leases where the
acquired assets are not booked on the user company’s balance sheet.
By definition, the lease payments are expensed and there is no listed
liability. But, if we look at the case of an airline, we see that the
company cannot operate without the leased aircraft — and lease
payments are really liabilities if the company plans to keep doing
business. Omitting these “liabilities” from the balance sheet distorts
reality, overstates the capital position, and severely understates the
generic leverage of the company.
Therefore, from the analyst’s point of view, it probably would be
prudent to include several years’ worth of lease obligations on the
balance sheet as a “liability.” How many years? This, again, is a
judgment call, but the Citibank Airlines and Aerospace Unit has used
up to seven years for this type of analysis. You can see the effect of
this leverage adjustment in Table 5.7.
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Unadjusted Adjusted
Total assets
Liabilities
Net worth
Annual lease obligation
Average no. of years
Leverage
1,000
600
400
200
7
1.5
2,400
2,000
400
5.0
Table 5.7: Effect on leverage of liabilities adjusted for operating leases
In this situation, the shift to adjusted numbers results in major changes
in the perception of the capital sufficiency of the company.
Consolidations and Minority Interest
Consolidated
financial
statements
Consolidated financial statements present the accounts of a group of
interrelated companies as if they constitute only one company. With
this overview, the analyst can assess the financial position and
prospects of the entire group.
In the case of consolidated numbers, the auditor lists assets on the left
side, and liabilities, minority interest, and net worth accounts
on the right side of the balance sheet. But, what is minority interest? Is
it debt or equity? What should the analyst do with the minority interest
account in terms of analysis?
If you said that minority interest represents the portion of the
group of companies that is owned by minority shareholders, you
are correct. But, if this is ownership (i.e. net worth), why is the
account not included within the net worth section of the consolidated
balance sheet?
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The answer is that, by accounting conventions, consolidated figures
include all the assets under the control of the group, even those that
belong to third parties. The amount that the third party claims to
ownership is then segregated on the right side of the balance sheet
since it is not owned or controlled by the majority shareholders. The
stated net worth is the net worth of the controlling shareholders, to
whom the auditor’s report is addressed.
The analyst should be careful when considering these numbers —
sometimes it appears from the presentation that minority interest is
a liability. But, it is not. What should be done with minority interest
for the purposes of calculating leverage? Answer: It should be
aggregated to net worth. Minority interest is, after all, legal equity.
This aggregation is precisely the methodology used in the new
Citibank spreadsheet. Incorrect and correct calculations of leverage
are compared in Table 5.8.
Incorrect Correct
Total assets
Liabilities
Minority interest
Net worth
Leverage
1,000
500
100
400
1.50
1,000
500
100
400
1.00
Table 5.8: Aggregating minority interest with net worth to
calculate leverage
The total indebtedness ratio compares outside capital to own capital to
indicate a company’s leverage position. From the lender’s point of
view, low leverage indicates strong capitalization and less business
risk. From the borrower’s point of view, it may be more convenient to
be more highly leveraged. The analyst must “get behind the numbers”
to understand the impact of the leverage figure on the perceived
business risk of a company.
In the next section, we discuss two ratios that separate short-term
liabilities from long-term liabilities to give a clearer picture of a
company’s financial situation.
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CURRENT AND LONG-TERM INDEBTEDNESS RATIOS
The total indebtedness ratio shows the relationship of total
indebtedness to own capital. The current indebtedness ratio shows
the proportion of current indebtedness to own capital (net worth), and
the long-term indebtedness ratio shows the proportion of long-term
indebtedness to own capital. Added together, the figures should equal
the total indebtedness ratio.
Example Let’s look at an example that compares the indebtedness ratios
for two companies. Even though the total indebtedness ratio is
the same, the current and long-term ratios provide more in-depth
information about leverage for these companies.
Company A Company B
Current liabilities
Long-term liabilities
Total liabilities
Net worth
Current indebtedness ratio
Long-term indebtedness ratio
Total indebtedness ratio
100
100
200
200
0.50
0.50
1.00
180
20
200
200
0.90
0.10
1.00
Table 5.9: Indebtedness ratios for two companies
In Table 5.9, Company B may be in a less comfortable situation
because most of its indebtedness is short-term, while Company A has
at least one year to start paying 50% of its debts.
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A high current indebtedness ratio may be a cause for concern if
a large part of it is currently due for payment. Whether it is actually
a cause for concern or not will be dictated by the purpose of the
indebtedness. For example, if indebtedness is financing fixed assets, it
obviously is appropriate for this to be long-term financing. On the
other hand, if a trading company with practically no fixed assets is
financing receivables, it is appropriate for its entire debt to be short-
term. Here we see an overlap between leverage and liquidity concepts.
A higher long-term indebtedness ratio results in greater liquidity as
the amount of short-term obligations are reduced relative to total debt.
FIXED ASSETS COVERED BY OWN RESOURCES
Fixed assets covered by own resources is the ratio that measures the
relationship between fixed assets and net worth.
Calculation: Fixed Assets / Net Worth
Net worth represents a company’s permanent capital and should be
used to support fixed investments. Any excess of net worth over fixed
assets is used to fund working capital. If net worth is lower than fixed
assets, the difference is funded by outside capital. Let’s look at two
situations for Alpha Company.
SITUATION A
Current assets 200 Current liabilities 150
Fixed assets 300 Net worth 350
TOTAL 500 TOTAL 500
Percentage of
net worth funds
working capital
There is a difference of 50 between net worth and fixed assets. Since
net worth is greater, the difference of 50 is used to fund working
capital. In other words, the proportion of fixed assets to own
resources is 86%, and the remaining 14% of net worth is used to fund
the company’s working capital.
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Now, suppose Alpha Company purchases a new plant for 100 that is
funded by long-term loans. The new situation is:
SITUATION B
Current assets 200 Current liabilities 150
Fixed assets 400 Long-term liabilities 100
Net Worth 350
TOTAL 600 TOTAL 600
Current assets
funded by
outside capital
Fixed assets increase from 300 to 400 and total long-term liabilities
increase by 100. Fixed assets are covered by 350 in net worth and by
50 in long-term debt. Since the entire net worth is used to cover fixed
assets, current assets are funded entirely by outside capital.
COVERAGE RATIOS
Coverage ratios indicate the amount of funds generated by operations
to cover interest expense, long-term indebtedness, and
the current portion of long-term debt.
Funds From Operations — Interest Coverage
This calculation finds the coverage existing from gross operating cash
flow (GOCF or FFO, funds from operations) to enable payment of
interest expenses.
Calculation: GOCF / Gross interest expense
Remember, GOCF is operating profit (net sales - cost of goods sold -
selling and administrative expenses) plus depreciation, amortization,
and other non-cash charges. Therefore, GOCF may be significant, in
some cases, despite poor earnings. Capital intensive companies that
generate a great deal of depreciation or amortizations may find these
amounts of greater importance than operating profit.
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High ratio
indicates ability
to cover interest
from operations
The higher the number for this ratio, the better, since it means greater
ease of payment of interest. A number lower than one indicates an
inability to pay out interest expense from operations, requiring non-
operating sources to cover interest needs. An over-leveraged firm will
find this ratio to be low, perhaps near one, leaving it vulnerable to an
increase in interest rates or an economic downturn. Companies that
over leveraged themselves on Wall Street in the 1980s, such as
Macy’s and Bloomingdales, paid a heavy price for this, requiring
Chapter 11 protection from creditors to survive.
Funds From Operations — Long-Term Debt Coverage
This ratio is similar to the previous one, but includes payment of long-
term debt as well:
Calculation: GOCF / (Gross interest expense + Total LTD)
The number here will be greatly influenced by the amount of long-
term debt, if any, on the balance sheet. It measures the coverage of
operational cash generation to contribute to interest and long-term
debt obligations. Since it does not take into consideration the payment
schedule of the long-term debt, this ratio is perhaps less useful than
the following ratio.
Debt Service Ratio
This ratio is similar to the previous two, but includes payment of the
current portion of long-term debt instead of total long-term debt:
Calculation: GOCF / (Gross interest expense + Current portion LTD)
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Here again, the higher the number for this ratio, the better, since
it means greater ease of debt service. A number lower than one
indicates an inability to pay out debt service from operations,
requiring reduction of working capital or non-operating sources
to cover interest needs. In such a case, the funding source will
probably be additional debt, if credit can be obtained. Again,
an over-leveraged firm will find this ratio to be low, leaving it
vulnerable to an increase in interest rates or an economic downturn.
This is precisely the risk of higher leverage for any company.
Summary
Leverage ratios measure the relationship between outside capital and
own capital. They focus on the sufficiency of assets to cover short-
and long-term obligations.
Total indebtedness ratio (leverage) — measures the relationship of
net worth to liabilities or assets.
Total liabilities / Total net worth
Total assets / Total net worth
The analyst may have to adjust the leverage figure for a company to
account for such factors as seasonality and liquidity of the assets.
From the lender’s perspective, a lower ratio indicates lower risk.
Current and long-term indebtedness ratios show the relationship
between net worth and current or long-term debt.
Current liabilities / Total net worth
Long-term liabilities / Total net worth
Fixed assets covered by own resources measure the relationship
between fixed assets and net worth.
Fixed assets / Net worth
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Any excess of net worth over fixed assets is used to fund working
capital.
Coverage ratios measure the amount of funds generated from
operations to cover interest payments and the total or current portion
of long-term debt. The higher the number for these ratios, the greater
the ease of interest and long-term debt service.
Gross operating cash flow (GOCF) / Gross interest expense
GOCF / Gross interest expense + Total long-term debt
GOCF / Gross interest expense + Current portion of long-term debt
You have completed Unit Five: Financial Ratios — Leverage. Please answer the questions
in Progress Check 5 to check your understanding of the material before proceeding to Unit
Six: Financial Ratios — Turnover.
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UNIT 6: FINANCIAL RATIOS — TURNOVER
INTRODUCTION
Liquidity ratios try to answer the question, “What is the degree of coverage of liquid assets
for short-term obligations?” Turnover ratios try to answer the question, “How long does it
take the firm to realize receivables or inventories, or to pay its trade suppliers?”
In this unit, we will see how turnover ratios complement liquidity ratios by informing
the analyst of the time it takes a company to convert trade receivables and inventory into
cash, or the amount of funds that has been provided by trade receivables. Correct reading of
the ratios, along with additional information about a company’s business, may also help the
analyst to evaluate the quality of current assets. This determination is important in judging
liquidity, since current ratio coverage of liquid assets over short-term obligations
presupposes timely liquidation of receivables and inventory.
Some turnover ratios may be calculated in two ways: either as a straight turnover or
converted to days. The commonly used turnover ratios include:
n Receivables turnover, or days receivable
n Inventory turnover, or days inventory
n Payables turnover, or days payable
n Sales to assets turnover
Other turnover ratios may also be calculated, including days cash and securities or days
accruals, but the ratios listed above are the most common.
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UNIT OBJECTIVES
When you complete this unit, you will be able to:
n Calculate the receivables turnover ratio (turnover periods in a year)
n Calculate days receivable (average collection time)
n Calculate the inventory turnover ratio (turnover periods in a year)
n Calculate days inventory (amount of inventory on the balance sheet date relative
to the annual production)
n Calculate the payables turnover ratio (turnover periods in a year)
n Calculate days payable (average payment time)
n Calculate the sales to asset turnover ratio
RECEIVABLES TURNOVER / DAYS RECEIVABLE
Receivables Turnover Ratio
Calculation The receivables turnover ratio is calculated by dividing net credit
sales from the income statement by trade receivables from current
assets in the balance sheet.
Calculation: Net Credit Sales / Trade Receivables
The sales figure should represent the entire year to prevent distortion
and to allow comparison to prior annual figures. For interim
calculations, the sales figure should be annualized, taking into account
any seasonal factors in the sales.
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Net credit sales
not itemized
in income
statement
Notice that the correct figure for sales is net credit sales, not total
net sales, because receivables, by definition, are sales made on a
credit basis. Sales made on a cash basis do not generate accounts
receivable. Yet, the Citibank spreadsheet calculates on the basis of net
sales (as is the case with the spreadsheet of most banks). If this
is technically incorrect, why do banks calculate this way? The reason
is that the income statement does not tell us what percentage of sales
is on a credit basis and what percentage is on a cash basis.
Use
approximate
percentages
Many companies that sell on credit terms do so for 100% of their
sales. In these cases, net credit sales and total net sales are the same.
If an analyst studies the financial statements of a company with
significant amounts of both credit and cash sales, he/she should find
out the approximate percentages and calculate an adjusted turnover.
Another point worth noting is the effect of value added taxes. If sales
taxes are included within the sales figure, then these must be netted
out as well.
Net out other
receivables
Note, also, that we use trade receivables for this calculation. This
means that other receivables, those not generated from normal trade
operations of the company, should be netted out to avoid distortion of
the numbers.
Examples Let’s look at the example of receivables turnover for two companies
in Table 6.1.
Company A Company B
Net credit sales
Trade receivables
Turnover (times per year)
400
100
4.0
720
60
12.0
Table 6.1: Receivables turnover for two companies
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From these numbers, we can see that Company A turns over its trade
receivables four times per year while Company B turns over its trade
receivables twelve times per year. Therefore, Company B collects
much faster than Company A.
Days Receivable
Expresses
turnover in
terms of days
Most banks prefer to calculate days receivable, instead of receivable
turnover. Days receivable is another way of stating the same
information, but perhaps in more useful form. This methodology takes
the turnover number and expresses it in terms of the number of days in
a year.
Period of
one year
Taking the example in Table 6.1, a turnover of 4.0 means 90 days,
because 90 days is 1/4 of a year. A turnover of 12 times means 30
days, because 30 is 1/12 of a year. So days can be calculated by
dividing 360 by the turnover.
The following calculation is a more direct approach:
(Trade Receivables / Net Credit Sales) x 360
Period of less
than one year
If we are calculating turnover for a period of less than one year, we
substitute the appropriate number of days in the period for the 360.
For example, if the period is six months, we substitute 180 in the
formula.
In Table 6.2, you can see the calculation of days receivable for the
companies from Table 6.1.
Company A Company B
Net credit sales
Trade receivables
Calculation
Days receivable
400
100
(100 / 400) x 360
90
720
60
(60 / 720) x 360
30
Table 6.2: Calculation of days receivable for two companies
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The figure for days receivable represents the collection period for
each company.
Collection
period relative
to credit terms
In studying the companies, the analyst should compare these numbers
to the average credit terms granted by the company. If Company A in
the example, grants credit terms of 90 days and Company B grants 30
days, then both are collecting well and probably have good quality
receivables on the balance sheet. However, if Company A grants terms
of 60 days, but is collecting
in 90 days, then we question the quality of the receivables —
apparently there are significant amounts of past due accounts within
the balance sheet.
Average
receivables
for the year
Note that these calculations are based on year end numbers. Use
of average numbers for the year would be more precise, and would
provide the average collection period for the year. If we have monthly
balance sheets, we can obtain a more precise average receivables
figure during the year for this computation — but an analyst rarely has
the luxury of monthly figures.
Seasonality
effect
We can calculate averages from quarterly figures, which is more
practical, or from beginning and ending year figures. This latter
calculation is not too helpful because it does not capture any
seasonality during the year. In practical terms, most banks,
including Citibank, simply use year-end figures for calculating days
receivable. The resulting figure can be affected by seasonal factors,
which, conceivably, can lead to a wrong interpretation of the result.
Example Let’s look at an example.
Omega Company produces clothing and sells to distributors on 90-day
terms. All sales are on a credit basis. Total annual sales are 12,000,
but sales in the October to December quarter constitute 40% of total
annual sales. These sales are spaced evenly per month, i.e. 1,600 in
October, 1,600 in November, and 1,600 in December.
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With this information, we know that accounts receivable at 12/31
should be entirely constituted by sales for the 90-day period between
October to December, i.e. 4,800. If we do a spreadsheet analysis of
the 12/31 balance sheet, what is the calculation for days receivable?
Calculation: (4800 / 12,000) x 360 = 144 days
In judging this number, the analyst can easily compare it to the
90-days credit terms and conclude there are problems with
collectibility of receivables. Wrong conclusion!
What we see here is the effect of seasonality. We have sales in this
quarter greater than the average sales per quarter for the year. The
sales total of 4,800 in the last quarter constitutes 4.8 months (144
days) of the total sales of the year, but they are collected in only 3.0
months. During other quarters, the sales are less than the average for
the year. In these other months, the days receivable calculation could
be 54 days (quarterly sales of 1,800), 72 days (quarterly sales of
2,400), or other numbers.
The analyst should recognize that the calculation of the days
receivable figures by the spreadsheet software could be misleading
and should interpret the numbers accordingly. In particular, the analyst
should understand whether the last quarter sales figures are average or
out of the ordinary.
Summary
Receivables turnover tells us how many turnover periods for
receivables a company has in one year. The calculation is:
Net Credit Sales / Trade Receivables
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A more direct approach is to calculate the number of days in one
collection period. The calculation is:
(Trade Receivables / Net Credit Sales) x 360
This figure is significant when compared to the credit terms granted by
a company. The analyst can draw some conclusions about the quality
of the receivables on the balance sheet and the company’s ability to
collect them. Judgment should be based on calculations using average
numbers for the year, which give a more precise result than using year-
end figures.
You have now completed the section on “Receivables Turnover / Days Receivable.” Please
complete Progress Check 6.1 before continuing on to the next section, “Inventory Turnover
or Days Inventory.”
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INVENTORY TURNOVER OR DAYS INVENTORY
Inventory Turnover
Number of
times
inventories are
replenished
The inventory turnover ratio indicates the number of times
inventories are replenished during the period. It is calculated by
dividing cost of goods sold (an income statement account) by
inventory (a current asset account).
Calculation: Cost of Goods Sold / Inventory
Notice that when we calculate receivables turnover we measure against
sales, whereas inventory turnover is calculated against cost
of sales. Why is this?
Receivables literally are sales made on a credit basis; they must be
booked at the sales price. But inventories have not been sold. By
accounting convention, these are carried on the balance sheet at
cost. Therefore, we calculate inventory turnover against cost.
Example Let’s look at an example.
Company X Company Y
Cost of goods sold
Inventory
Turnover (times per year)
600
100
6.0
900
300
3.0
Table 6.3: Inventory turnover for two companies
From these numbers, we can see that Company X turns over its
inventory twice as fast as Company Y.
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The comments about average and year-end figures made in the
receivables discussion apply equally to inventory. Averaged monthly
figures are ideal, but the analyst rarely has this luxury — quarterly
or semiannual figures may be more feasible. Yet, the Citibank
spreadsheet calculations are based on year-end figures only. Why?
It is simply more convenient to program it this way. If the analyst has
additional information (for example, quarterly figures) he/she can
make the calculation manually and compare it to the year-end
inventory figure.
Days Inventory
Inventory in
terms of days
Most banks prefer to calculate days inventory instead of inventory
turnover. Days inventory is another way of stating the same
information in a more useful format. This methodology takes the
turnover number and expresses it in terms of the number of days in
a year.
Taking the previous example, a turnover of 6.0 means 60 days, because
60 days is 1/6 of a year. A turnover of 3.0 times means 120 days,
because 120 is 1/3 of a year. So, days can be calculated by dividing
360 by the turnover.
As with receivables, there is a more direct approach.
(Inventory / Cost of Goods Sold) % 360
However, if we’re dealing with a period of less than one year, then we
substitute the appropriate number of days in the period for the 360.
For example, for six month figures, we substitute 180 in the formula.
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Example In Table 6.4, we calculate the days inventory for the same two
companies that we saw in the inventory turnover example.
Company X Company Y
Cost of goods sold
Inventory
Calculation
Days inventory
600
100
(100 / 600) × 360
60
900
300
(300 / 900) × 360
120
Table 6.4: Days inventory for two companies
Length of time
company can
operate without
production
The figure for days inventory represents the amount of inventory
at the balance sheet cutoff date relative to annual production costs.
This indicates approximately how many days the company can operate
without additional production before closing its doors. For
a commercial company where the entire inventory is finished goods,
this approximate number may be close to reality — as long as there
are no major seasonal effects. For an industrial company, this is a very
rough estimate because inventory is composed of both finished goods
and raw materials.
Consider type
of inventory
Actually, for an industrial company, the type of inventory should
be considered in the calculation of days inventory because the cost
element is different. Finished goods are valued at cost of goods sold
(raw material, labor, and overhead), but raw materials are valued at
purchase cost (or market, whichever is lower). This means that if
inventory is composed mostly of finished goods, the traditional
calculation can be quite accurate. If the inventories are essentially raw
materials (RM), the following calculation may be more appropriate:
(Raw Material Inventory / (Initial RM + Purchases - End RM)) % 360
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Where most of the inventories are raw materials, this is a more
accurate calculation. However, it is not the formula calculated by bank
spreadsheets because the income statement normally does not indicate
the amount of annual purchases of raw materials. If the analyst can
obtain this information, in some cases it may be useful
to make this extra calculation for a more precise evaluation of the
numbers.
Inventory
judging
appropriate
levels
In studying the numbers, the analyst likes to compare them to
something. The days receivable number is compared to credit
terms. What can days inventory be compared to? This is a difficult
question, but there are some factors to consider. The analyst must first
understand the business fundamentals to judge inventory sufficiency.
Type of
company
The type of company will determine the inventory an analyst should
consider. A shoe producer may have different styles, sizes, and colors
of products in stock, besides considerable amounts of raw materials. It
is a working capital intensive business. Commercial companies also
are inventory intensive, by nature, so these types of companies will
tend to have greater amounts of inventory on their balance sheets. On
the other hand, transport companies, and other service companies such
as hotels, have little need for inventory and will, therefore, have lower
levels on their balance sheet.
Selling
methodology
Selling methodology also has an impact. Does the firm sell on a
specific contract basis, or does it sell from stock? The first case may
involve little need for finished goods, while the second will have
greatly increased needs.
When considering the appropriate level of inventory, the analyst must
also take into account any potential seasonality. Clients that sell,
purchase, and produce the same amount every month are rare, so
inventory levels for most companies will vary from month to month or
quarter to quarter. The analyst should try to understand these seasonal
effects to more accurately interpret the days inventory figure at the
balance sheet date.
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There are no easy answers to enable precision in judging the
appropriate level of inventory for a company. The analyst should get a
feeling for what is appropriate from management and then look at
similar firms for comparison, remembering that no two firms are
exactly alike.
Generally,
less inventory
is better
We do know that within reasonable limits, from a financial perspective,
it is better to operate with less inventory. Why? Inventory has carrying
costs (space, control systems, pilferage, obsolescence, security,
insurance, etc.) and it also has financing costs — either debt interest or
equity expectations. Therefore, holding inventory is an expensive
proposition; and that is why the theory of “just in time inventory” was
developed.
Reasons for
higher inventory
Some clients say they prefer to maintain higher inventory levels “to
protect themselves against inflation,” “to get volume discounts on
purchases,” or “to nail down a lower exchange rate.” All of these may be
true in specific cases, if the savings from lower prices at purchase
compensate for inventory carrying and financial costs. With the current
significantly reduced inflation levels and greater economic stability in
Latin America, these client comments are heard less and less.
Summary
The inventory turnover ratio calculates the number of times
inventories are replenished during the period. The calculation is:
Cost of Goods Sold / Inventory
Days inventory is another way of stating the same information, but
is the number most banks prefer to use. It expresses the turnover
number in terms of days in a year. The calculation is:
(Inventory / Cost of Goods Sold) % 360
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For periods of less than one year, the correct number of days is used
in place of 360.
In assessing the days inventory number, the analyst must consider the
following issues:
n Type of inventory — finished goods or raw materials
n Appropriate level of inventory — depends on type of company,
selling methodology, and seasonality
You have now completed the section on “Inventory Turnover or Days Inventory.” Please
complete Progress Check 6.2 before continuing on to the next section, “Payables Turnover
or Days Payable.”
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PAYABLES TURNOVER OR DAYS PAYABLE
Payables Turnover
Measured
against
purchases
Payables turnover indicates the number of times that payables are rotated
during the period. It is best measured against purchases, since purchases
generate accounts payable.
Calculation: Total Purchases / Trade Payables
The purchases figure should represent the entire year, or the ratio will
be distorted and not comparable to prior annual figures. For interim
calculations, the purchases figure should, therefore, be annualized,
taking into account any seasonal factors in purchasing.
Example Let’s look at an example:
Company E Company F
Total purchases
Trade payables
Turnover (times per year)
1,200
100
12.0
960
160
6.0
Table 6.5: Payables turnover for two companies
Company E has a higher rotation than Company F. This means that
Company F’s trade suppliers probably offer more generous credit
terms.
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Days Payable
Most banks prefer to calculate days payable, instead of payable
turnover. Days payable is another way of stating the same information in
a more useful form. This methodology takes the turnover number and
expresses it in terms of the number of days in a year.
In the previous example, a turnover of 12.0 means 30 days, because 30
days is 1/12 of a year. A turnover of 6.0 times means 60 days, because
60 is 1/6 of a year. So, days can be calculated by dividing 360 by the
turnover.
As with the other turnover ratios, there is a more direct approach.
(Trade Payables / Total Purchases) x 360
However, if we are dealing with a period of less than one year, we
substitute the appropriate number of days in the period for the 360.
For example, we substitute 180 in the formula for six month figures.
Let’s calculate the days payable for the same two companies:
Company E Company F
Total purchases
Trade payables
Calculation
Days payable
1,200
100
(100 / 1200) x 360
30
960
160
(160 / 960) x 360
60
Table 6.6: Days payable for two companies
Average
payment
period
The figure for days payable represents the average payment period
for the company. In studying the companies, the analyst would like to
compare these numbers to the average credit terms received by the
company.
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Common Variation
The days payable calculation is correct in theory, yet more often
(including the Citibank spreadsheet) we see the less precise
calculation for days payable:
Calculation: (Trade Payables / Cost of Goods Sold) x 360
Substitutes cost
of goods sold
The reason is that the figure for purchases normally is not specified in
the income statement, so we use the second best alternative as a
default. Notice that for a commercial firm this distinction is not
relevant. There is no processing of the goods and, therefore, the figure
for purchases is essentially the same as cost of goods sold.
For an industrial firm, there may be a significant difference. Let’s look
at the same two companies, but this time we will include a figure for
cost of goods sold.
Company E Company F
Cost of goods sold
Total purchases
Trade payables
Calculation #1
Days payable (purchase basis)
Calculation #2
Days payable (cgs basis)
Variance from # 1
1,800
1,200
100
(100 / 1200) x 360
30
(100 / 1800) x 360
20
33%
1,200
960
160
(160 / 960) x 360
60
(160 / 1200) x 360
48
20%
Table 6.7: Comparison of days payable calculation using purchases
as a basis vs. using cost of goods sold as a basis
Notice that these numbers are quite reasonable for industrial
companies. For Company E, purchases is 67% of CGS; for
Company F, the figure is 80%.
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Implicit error
using CGS basis
In the first case, the variance, or implicit error in calculating by
the CGS basis, is 33%, in the second case, it is 20%. The analyst,
therefore, must understand how the spreadsheet calculates and
recognize this implicit error when interpreting the spreadsheet
calculations. This applies to days payable for industrial companies or
for any other companies that have a significant amount of value added
to their products.
Seasonality
Similar to the situation with receivables, payables figures can be
significantly impacted by seasonality. Average payables figures are
useful but, as a practical matter, most banks (including Citibank)
simply use year-end figures for calculating days payable on the
spreadsheet.
Purchasing
frequency
varies
Many companies, especially retailers, purchase several times during
the year at specified intervals, instead of making equal purchases every
month. The resulting days receivable figure, therefore, can be affected
considerably by seasonal factors. Conceivably, this may lead to an
incorrect interpretation of the result. Let’s look at an example.
Example Theta Company sells clothing to the general public. All purchases
are on a credit basis, with average terms of 60 days. Total annual
purchases are 1,000, but purchases in November and December
together constitute 30% of this total.
With this information, accounts payable at 12/31 should be
constituted by the November and December purchases, i.e. 300.
If we do a spreadsheet analysis of the 12/31 balance sheet, what
is the calculation for days payable?
Calculation: (300 / 1000) x 360 = 108 days
In judging this number, the analyst can easily compare it to the credit
terms of 60 days and conclude that there are problems with payment
of receivables. Wrong conclusion!
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What we see here is the effect of seasonality. The purchase total of
300 in the last quarter constitutes 3.6 months (108 days) of the total
purchases of the year, but these are made in only 2.0 months. In other
words, we have purchases in November and December greater than the
average purchases for any other two months of the year. During other
two month periods, the purchases are less than the average for the
year, and the days payable calculation may vary — for example, 36
days (two month purchases of 100), 48 days (two month purchases of
133), etc.
Spreadsheet
calculations
may be
misleading
As with the receivables calculation, the analyst should be careful
because the calculation of the days payable figures by the spreadsheet
software may be misleading. The analyst must understand this effect
and interpret the numbers accordingly. In particular, the analyst should
understand whether the last months’ purchase figures are average or
out of the ordinary.
Interpreting the Number
Recognize
reasons behind
the numbers
The higher the days payable, the better from a funds flow point of view.
However, if the numbers for this ratio, adjusted for seasonality, are too
high, this may indicate delayed payments to suppliers, possibly due to
cash flow difficulties. This could indicate serious trouble in a very
short period of time. A very low number should also be analyzed to
determine why this usually cheaper source of funding is not being
maximized. Are suppliers cutting back on credit? If so, what is the
reason for this?
Shorthand
funds flow
analysis
The days payable number is often analyzed in tandem with days
receivable and days inventory for a shorthand funds flow analysis. This
very generalized analysis may be used to estimate the working capital
requirements for a company. Remember, this is very generalized
because, all of these funds flows may be measured against a different
base (i.e. receivables vs. sales, inventory vs.
cgs, payables vs. purchases) so that each of the “days” has a
different value.
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+ Days receivable
+ Days inventory
- Days payable
= Operational working capital
Summary
Payables turnover is the average number of payment periods in a year
and should be measured against purchases.
The calculation is:
(Total Purchases / Trade Payables)
Days payable is the average payment period for a company and may be
compared to credit terms to evaluate a company’s payment of
receivables.
The most common calculation is:
(Trade Payables / Cost of Goods Sold) × 360
A more accurate calculation is:
(Trade Payables / Total Purchases) × 360
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SALES TO ASSETS TURNOVER RATIO
Efficiency of
asset utilization
The asset turnover ratio is a comparison of sales to total assets.
This ratio is used less frequently in financial analysis than the
other turnover ratios, but is nonetheless very useful. It provides
a shorthand indicator of the efficiency with which assets are being
utilized in the business.
Calculation: Total Net Sales / Total Assets
Spreadsheet
calculation
It is best calculated against average total assets but, here again,
spreadsheets usually make a trade-off by calculating against end-
of-period total assets. If there has been considerable growth in
assets during the year, or if the company’s business is very seasonal,
resulting in major swings in asset totals during the year, then the
analyst should obtain some additional numbers to enable calculating
average figures.
Example Let’s look at an example:
Company J Company K
Net sales
Total assets
Turnover (times)
400
320
1.25
600
720
0.83
Table 6.8: Use of assets to support sales
Company K sells more, but Company J is more efficient because it
needs less asset resources per $1.00 of sales.
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Interpreting the Ratio
The higher,
the better
Generally, the higher the asset turnover the better — more sales are
achieved with a given amount of asset resources. Where the turnover
is higher, there is greater operational efficiency.
Compare with
similar firms
Companies probably experience relatively little fluctuation in this
ratio from year to year. It is often best to measure this ratio against
similar firms in the market for a comparison of how efficient
individual companies are in using available resources.
The indicator may vary considerably from sector to sector, depending
on certain factors such as whether the firm must offer credit, and how
much. Perhaps the most significant factor is, as in the case with
leverage, the incidence of fixed assets. Companies that need a great
deal of fixed assets will have low ratios, and vice versa. Fixed assets
will act as a drag on this ratio and, in many cases, the actual numbers
for this ratio will be similar to the leverage figure.
It should be noted that leased assets off the balance sheet will distort
the asset turnover ratio by reporting a higher turnover than a “real”
figure would indicate. Therefore, if significant amounts of such assets
are used by the company, the analyst should adjust the balance sheet by
including these assets and recalculating this ratio.
You have completed Unit Six: Financial Ratios — Turnover. Please answer the questions
in Progress Check 6.4 to check your understanding of the material before proceeding to
Unit Seven: Financial Ratios — Profitability.
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UNIT 7: FINANCIAL RATIOS — PROFITABILITY
INTRODUCTION
Companies are in business for one purpose — to make profits. If a company accumulates
considerable losses year after year, it will not stay in business for long. Profits are the
driving force of growth and are the main source for repaying loans, making new
investments, and providing an adequate return to owners so they retain their interest
and financial backing.
Profits are important for another reason — they measure the relative success of a company
and can readily be compared to other companies and to the capital market. Therefore,
profits reflect (and profit ratios measure) the effectiveness and efficiency
of management. The common profitability ratios are:
n Return on Sales
n Return on Assets
n Return on Equity
UNIT OBJECTIVES
When you complete this unit, you will be able to:
n Calculate the three profitability ratios: return on sales, return on assets,
and return on equity
n Recognize the DuPont formula for calculating ROE
n Calculate ROE using the DuPont formula
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PROFITABILITY RATIOS
Return on Sales
Dollar profit per
$100 in sales
The return on sales ratio (profit on sales) measures how many
dollars of profit are made for every $100 in net sales. The figure is
a percentage and is calculated as:
Net Income
Return on Sales = x 100
Net Sales
Let's compare the profits for Company A and Company B.
Company A Company B
Net income
Net sales
Ratio
$ 20
$200
10.0%
$ 100
$4,000
2.5%
Table 7.1: Profit comparison
We can see that Company A earned $20 for every $200 in sales,
a profit of 10%. Profits earned by Company B were higher in
monetary terms; but at 2.5% of net sales, they were proportionally
lower than those earned by Company A. Therefore, Company A
generates more income on each $1.00 in sales than Company B. This
is an indication that Company A generates profits more efficiently.
More
conservative
calculation
A conservative way to evaluate sales profit is to exclude extraordinary
items from net income. For example, if Company A had extraordinary
income of $5 and we subtracted this amount from net income, the
profit on sales would decrease to 7.5%.
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Return on Assets
Relationship
between profits
and resources
invested
Return on assets is a good indicator of the productivity of the firm and
of management's abilities and efficiency. The index measures the
relationship between profits and total resources invested. It is a
percentage and is computed as:
Net Income
Return on Assets = x 100
Average Assets
Since asset values vary during the year, the best measure is based on an
average of beginning-of-year assets and end-of-year assets. Let's look
at an example and compare the ratios calculated two ways.
End-of-year
assets
First, we calculate the return on assets based on end-of-year assets
only.
For 19X1, $ 150 / $ 6,000 = 2.5%
Average of
beginning and
ending assets
The more accurate method is to calculate return on assets based on the
average of beginning-of-year and end-of-year figures.
For 19X1, $ 150 / [($ 4,000 + $ 6,000) / 2] = 3.0%
However, as a practical matter, this ratio often is calculated based on
year-end figures only. This avoids calculating year one on a year-end
basis and subsequent years on an average basis, since averages cannot
be computed for year one. The Citibank spreadsheet calculates against
beginning totals.
For calculations utilizing interim figures, net income should be
annualized. In seasonal situations, this factor should be considered
in the annualization to avoid distortions in the full year net income
figure.
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The higher,
the better
Return on assets is best measured against prior period results from the
same firm or against similar enterprises. The higher the result, the
better, since a good return on assets indicates efficient use of the
firm's resources.
Return on Equity (Return on Capital)
Profits
generated by
each $1
invested
Return on equity (ROE) measures the profits generated by each dollar
accumulated in the business by stockholders. The figure is
a percentage and is computed as:
Net Income
Return on Equity = x 100
Average Net Worth
Return to
stockholders
Determining return on equity is important for measuring the degree to
which the profits of the firm provide a return to the shareholders. The
figure can be compared to a marginal investment rate in the
community, such as a time deposit rate in a local bank. ROE measures
whether the enterprise can produce an amount sufficient to cross this
hurdle rate and provide an incentive to take on additional risks of
equity investment.
If the ROE figure is very low in comparison to time deposit rates, the
owner is further ahead to liquidate the company's assets and deposit
the money in a bank. In these situations, the creditor should question
the owner's commitment to the firm, especially if the financial
situation deteriorates further.
Understand the
client’s situation
In order to avoid some distortion in interpreting the figure, the
practical situation of the client should be understood. For example,
in a family enterprise, the analyst should consider (depending
on the market) that profits may be underestimated for tax purposes. In
these situations, the ROE figure is negatively impacted, and
comparison to other potential investments will be less valid.
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On the other hand, in situations where farms or valuable properties
have been held for many years and are undervalued on a balance sheet,
the net worth figure may be understated with reference to present land
values. In these situations, an adjusted return on equity figure may be
worse than what has been computed and what other market alternatives
provide.
Since the income was generated during the whole period, and
not just at the end, the average net worth should be used when
computing the figure. However, if prior period figures are not
available, ending period figures may be applied instead. For interim
figures, net income should be annualized. In seasonal situations,
this factor should be considered within the annualization to avoid
distortions in the net income figure.
Example Let's look at the difference between using only the ending balance
and an average of the beginning and ending balance.
19X0 19X1
Net income $ 20 $ 60
Stockholders’ equity $2,000 $2,400
First method (using ending balance only):
For 19X1, $60 / $2,400 = 2.5%
Second method (using averages):
For 19X1, $60 / [($2,000* + $2,400*) / 2] = 2.73%
* Since the beginning value is $ 2,000 and the ending value $ 2,400, we may
presume that the owners' investment for the year averaged $ 2,200.
The Citibank spreadsheet calculates this ratio against beginning equity.
Assuming profitable operations, this results in a higher figure than
calculating an average equity.
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The appropriate level for return on capital is determined by relative
factors such as economic benchmarks, inflation, and local bank
deposit rates. Normally, the higher the ratio, the better the return on
capital. However, an abnormally high return-on-equity figure might
simply indicate deficiencies in the amount of capital within the firm.
Before proceeding to the final section of this unit, “Integrated
Analysis,” please check your understanding by completing Progress
Check 7.1.
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INTEGRATED ANALYSIS
Integrate
financial ratio
concepts
Let’s consider some theories used to integrate several of the main
concepts encountered in the units covering financial ratios. These
ideas also will tie together the profitability ratios we have just
considered. They are taken from financial relationships known as
a DuPont Analysis.
Return on Assets
We have seen that return on sales informs us of the profitability of
a company’s operations — how much it makes on every $1.00 of
sales. Let’s take this a step further and consider this along with sales /
assets turnover. As formulas, we put the two together and see that by
multiplying, we obtain return on assets.
Asset
ROS Turnover ROA
Net Income X Net Sales = Net Income i
Net Sales Total Assets Total Assets
Operational
leverage
ROS can be considered cost efficiency, while asset turnover can be
considered a multiplier to achieve asset efficiency (which is ROA).
So, the higher the asset turnover, the greater the ROA. This is the
concept of operational leverage.
Note that asset turnover is increased either by increasing sales relative
to assets, or reducing assets relative to sales, or both. This is one
reason why it is better to operate with less assets — less cash, less
receivables, less inventory, etc. This is also why it is so harmful to
have past due receivables, excessive levels of inventory, or non-
productive assets on the balance sheet. These act as a brake on asset
turnover and, hence, as a brake on ROA.
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Return on Equity
Let’s take this another step. If we multiply return on assets by asset
leverage, we obtain return on equity.
Asset
ROA Leverage ROE
Net Income X Total Assets = Net Income
Total Assets Net Worth Net Worth
Financial
leverage
Here, again, we see that the beginning figure is multiplied by the next
column (in this case leverage) to obtain the final column, in this case
ROE. By multiplying ROA to obtain a figure for ROE, we can clearly
see how greater debt levels actually “leverage” earnings. This is the
concept of financial leverage.
From this formula, we can appreciate that greater leverage will achieve
greater earnings. This is correct as long as ROS is not adversely
affected by greater interest expense. Remember your vantage point.
The borrower uses this as an excuse to operate with greater debt
levels. The lender is more interested in reducing risk. If the investor
leverages up by taking on greater debt to finance capital expansion,
this may yield greater financial returns, but leave the firm vulnerable
to an economic downturn and/or higher interest rates.
The credit risk increases.
Application of DuPont Formulas
In total, the DuPont formulas can be summarized as follows:
Asset Asset
ROS Turnover ROA Leverage ROE i
Net Income X Net Sales = Net Income X Total Assets = Net Income
Net Sales Total Assets Total Assets Net Worth Net Worth
;
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Example Let’s apply these concepts to some numbers to see if we can obtain an
idea of what is appropriate in terms of ROS, ROA, and ROE for
different companies through the DuPont insights. Consider the
following numbers for Companies X, Y, and Z.
Company X Company Y Company Z
Net Sales 1000 1000 1000
Average Assets 1500 800 400
Average Net Worth 900 400 100
Net Income 180 80 20
Return on Sales 18.0% 8.0% 2.0%
Return on Assets 12.0% 10.0% 5.0%
Return on Equity 20.0% 20.0% 20.0%
Table 7.2: Profitability ratios for three companies
What insights can we get from these numbers using the DuPont
format? We have included the same numbers below. Remember,
the figure for asset leverage is 1.0 more than the standard debt / equity
leverage figure.
Net Income
Net Sales
X Net Sales
Total Assets
Net Income
Total Assets
X Total Assets
Net Worth
Net Income
Net Worth
Company X 18.0% X 0.67 = 12.0%; X 1.67 = 20.0%
Company Y 8.0% X 1.25 = 10.0%; X 2.00 = 20.0%
Company Z 2.0% X 2.50 = 5.0%; X 4.00 = 20.0%
Company X
Why does Company X have the same ROE as Y and Z despite having the
highest ROS by a wide margin? Because it has low multipliers — asset
turnover is low. Why is it low? The reason is probably due to the nature
of the company. It may be a heavy industry with heavy fixed asset needs
that operate as a brake on the ROE ratio. Leverage is also low (debt /
equity is 0.67), probably for the same reason.
;
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Lesson: We can see that heavy industries, or other companies with an
intensive use of fixed assets, need high margins to compensate for
poor multipliers.
Company Y
Company Y’s multipliers are higher than X’s, but lower than Z’s. Why?
It is probably a different type of company. With these numbers, it looks
like a medium industry, with asset turnover just greater than 1.0 and
leverage about the same (note: debt / equity = 1.00).
Lesson: The multipliers are better, so margins can be lower than
heavy industries to achieve the same ROE.
Company Z
Company Z’s multipliers are very high, enabling an equal ROE despite
a very low margin. Why? It is probably a company with
low fixed asset needs and high liquidity of assets, permitting higher
leverage (equivalent debt / equity = 3.00). As such, there are probably
low barriers to entry in the business, which means it is probably a
highly competitive sector with low margins. It probably
is a wholesaler or trading company.
Lesson: Low margins can mean good profits overall if the asset and
leverage multipliers can be managed properly.
Conclusions
What is an
appropriate
ROS?
We have been able to draw some conclusions from this analysis in
terms of what is appropriate for ROS. If a company, by nature, has low
multipliers, ROS must be high to achieve an acceptable ROE. As
multipliers increase, ROS may be reduced, as well, and still achieve an
acceptable ROE.
Answer: The appropriate ROS depends on the multipliers.
Changed 07/02/96
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It should be obvious that companies do not willingly reduce their ROS;
this occurs as a result of competition. If Company Z can achieve a
ROS of 10% and maintain the same multipliers, its owners will be very
happy with its resulting ROE of 100%. This undoubtedly will attract
the attention of potential competitors, and eventually drive down the
ROS figure.
Appropriate
ROE
determined by
capital markets
From this viewpoint we also can appreciate that ROE sets the tone for
the other ratios. The appropriate figure for ROS depends on the
multipliers. The appropriate figure for ROA depends on the leverage
multiplier. What is appropriate for ROE? Capital markets determine
this, not multipliers. An acceptable ROE will be similar for all
companies in the market (higher for riskier sectors), regardless of
the multipliers. In the final analysis, the ROE figure will determine
which company has the best earnings.
Summary
In summary, integrated analysis helps us understand not only the
relationships between earnings ratios and operational and financial
leverage, but also provides insights into what is appropriate for return
on sales for different types of companies. This knowledge then
permits the analyst to obtain a deeper interpretation of the numbers,
and a better appreciation of what is appropriate, so that he/she may
judge the sufficiency of the numbers.
You have completed Unit Seven: Financial Ratios — Profitability. Please answer the
questions in Progress Check 7.2 to check your understanding of these concepts. Following
the Progress Check is a summary chart of the financial ratios we have presented in this
workbook. Use it as a review for the final unit, Applied Financial Analysis – Case Studies,
and also as a handy reference in the future.
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The following chart is a summary of the financial ratios covered in the Financial Statement
Analysis Workbook. Please review the chart before continuing to Unit Eight: Applied
Financial Analysis — Case Studies. Also, use it as a convenient reference in the future.
SUMMARY OF FINANCIAL RATIOS
RATIO FORMULA EVALUATION
LIQUIDITY
Current
Acid Test
Current Assets
Current Liabilities
Cash + Near Cash Assets + Trade Receivables
Current Liabilities
The higher, the better
The higher, the better
OPERATING
Days Receivables
Days Inventory
Days Payables
Assets Turnover
Average Trade Receivables x 360
Net Credit Sales
Average Inventories x 360
Cost of Goods Sold
Average Trade Payables x 360
Total Purchases
Net Sales I
Average Total Assets
The lower, the better,
generally
The lower, the better,
generally
The higher, the better,
generally
The higher, the better,
generally
LEVERAGE
Total Indebtedness Total Liabilities I
Tangible Net Worth
The lower, the better
COVERAGE
Interest Coverage
Debt Service Ratio
GOCF I
Gross Interest Expense
GOCF I
Gross Int Exp + Current Portion LTD
The higher, the better
The higher, the better
PROFITABILITY
Return on Sales
Return on Assets
Return on Equity
Net Income I
Net Sales
Net Income I
Average Total Assets
Net Income I
Average Net Worth
The higher, the better
The higher, the better
The higher, the betterx 100
x 100
x 100