Category MBA

The debt ratio

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A direct measure of debt of the firm is the debt ratio. Debt ratio measures how many of the firm’s assets are financed by debt. The higher the debt ratio the higher the degree of financial leverage (amount of debt) in the capital structure of the enterprise and the higher the risk and potential return.

The formula for the debt ratio is as follows:

Debt Ratio = Total liabilities/Total assets

If the debt ratio is higher than 1 than it means that an enterprise has more debt than assets. If the debt ratio is lower than 1 than it means that an enterprise has more assets than debt.

EXAMPLE:

Assume that ABC’s total liabilities are $1,700,000 and total assets are $4,000,000.

The debt ratio of ABC is as follows: $1,700,000/$4,000,000=42.5%

This means that ABC’s capital structure is 42.5% of debt and 57.5% of equity.

Test yourself

Dillon Corporation has total liabilities of $4,000,000 and total assets of $5,500,000.

Required: Find the debt ratio of Dillon Corporation

Solution:

The ratio is calculated as follows:

$4,000,000/$5,500,000 = 73%

This means that Dillon Corporation’s capital structure is 73% of debt and 27% of equity. A debt ratio of 73% is generally considered to be a very high debt ratio and may indicate a problem of a very high indebtedness and very high financial risk. However, as with all financial ratios, the debt ratio of Dillon Corporation should be compared to the industry average before any conclusions are drawn.

 

Acid-Test Ratio

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The acid-test ratio, along with the current ratio analysis, measures liquidity. Liquidity refers to the ability of the firm to meet its short-term obligations (obligations over the next 12 months) with its current assets (excluding inventory). In other words, the ratio allows us to determine the ease with which business can pay its bills as they come due. It is also sometimes referred to as the quick ratio.

A declining ratio is an indicator of declining liquidity, which usually serves as a warning of potential financial difficulties for the business. Such financial difficulties may even result in bankruptcy. The risk of bankruptcy increases further if the ratio falls significantly below 1. A ratio below 1 indicates a situation whereby current assets (excluding inventory) can no longer cover current liabilities.

The formula for the ratio is as follows:

Acid-test ratio = (Current assets – Inventory)/Current liabilities

Example of an acid-test ratio analysis

Assume Dynasties Inc. has current assets of $550,000, inventory of $300,000 and current liabilities of $300,000. The acid-test ratio of the of Dynasties Inc. is calculated as follows:

$550,000-$300,000/$300,000=0.8

This could indicate a ratio which may be too low. However, acceptable ratio values vary between industries. Therefore, the result must always be used in context via a comparison to industry averages as well as in comparison to the ratio of leading firms in the industry and Dynasties own historical ratio analysis.

Things to note about this ratio

A positive ratio is a must. A ratio of 1 or greater is generally advisable. If a company has a ratio of 1, it means that it has current assets (excluding inventory) which would be able to cover current liabilities once.

An acid-test ratio is similar to the current ratio. However, it differs from the current ratio because the former excludes inventory when calculating current assets. Inventory is excluded as it is seen as the least liquid form of current assets. Therefore, it is assumed the acid-test ratio shows a better representation of a firm’s liquidity for businesses which experience slow conversion of inventory into cash.

It is also important to note the acid-test ratio analysis ignores the timing of how quickly current assets can be converted into cash and how soon current liabilities come due. For example, imagine a situation where the business as an healthy acid-test ratio. However, most of its current assets are in accounts receivable, which can only be converted into cash in 4 months time and most of its current liabilities are due within next 30 days. In such a situation, despite a healthy acid-test ratio, a business’s liquidity may be unsatisfactory to meet short-term commitments of the business.

Lastly, as per the above, one should compare the ratios of individual firms to industry averages to obtain a better understanding. There is a large variability of ratio values between industries. This is because different industries have different operating requirements.

Current Ratio Analysis

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Current ratio analysis, along with the acid-test ratio, measures liquidity. Liquidity refers to the ability of the firm to meet its short-term obligations (obligations over the next 12 months) with its current assets (such as cash, marketable securities and inventory). In other words, current ratio analysis allows us to determine the ease with which business can pay its bills as they come due.

A declining current ratio is an indicator of declining liquidity, which usually serves as a warning of potential financial difficulties for the business. Such financial difficulties may even result in bankruptcy. The risk of bankruptcy especially increases if the current ratio falls below 1 (a point at which current assets can no longer cover current liabilities). Current ratio analyses is also sometimes referred to as working capital ratio, real ratio, cash ratio, liquidity ratio and cash asset ratio.

The formula for current ratio analyses is as follows:

Current ratio = Current assets/Current liabilities

Example of current ratio analysis

Assume Dynasties Inc. has current assets of $550,000 and current liabilities of $300,000. The current ratio of the of Dynasties Inc. is calculated as follows:

$550,000/$300,000 = 1.8

Current ratio analyses of the Dynasties Inc. could indicate that the ratio may be too low. However, an acceptable current ratio value varies between industries. Therefore, the result must always be assessed in the context of industry averages as well as to current ratios of leading firms in the industry and the Dynasties own historical current ratio analysis.

Things to note about current ratio analysis

A positive current ratio is a requirement. A current ratio of two is generally advisable. If a company has a current ratio of two, it means that it has current assets which would be able to cover current liabilities at least twice.

Current ratio analyses is similar to the acid test ratio. However, an acid-test ratio differs from current ratio because an acid-test ratio excludes inventory in calculating current assets. Inventory is excluded as it is seen as the least liquid form of current assets. Acid-test ratio shows a better representation of firm’s liquidity for businesses which experience slow conversion of inventories into cash.

It is also important to note that current ratio analyses ignores the timing of how quickly current assets can be converted into cash and how soon current liabilities come due. For example, imagine a situation where the business has a healthy current ratio. However, most of its current assets are in inventory which can only be converted into cash in 2 months time and most of its current liabilities are due within next 30 days. In such a situation, despite a healthy current ratio, a business’s liquidity may be unsatisfactory to meet the short-term commitments of the business.

Lastly, as per above, one should always compare the current ratio analyses of individual firms to industry averages, to obtain a better understanding. There is a large variability of current ratio industry averages between industries. This is because different industries have different operations requirements.

Average Payment Period

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Average payment period (APP) is one of the activity ratios which measures the relationship between accounts payable and average purchases per day. Activity ratios help businesses to measure how efficiently various accounts are converted into sales or cash. Other activity ratios include average collection period, total asset turnover and inventory turnover analysis.

APP calculates how efficiently accounts payable are settled. It indicates, on average, how many days does it take to pay off accounts payable. APP is also referred to as the average age of accounts payable or the accounts payable turnover ratio.

The formula to calculate the APP is as follows:

APP = Accounts payable/Average purchases per day

The figure for accounts payable is obtained from the balance sheet and the figure for purchases is indirectly obtained from the income statement. Here the difficulty of calculating APP is highlighted. A figure for purchases is usually not available. Therefore, purchases are usually estimated as a percentage of cost of goods sold, which is in turn obtained from the income statement.

Purchases must be adjusted for credit purchases. This is done by deducting cash purchases. Further, credit purchases must be divided by the number of days per year to finally obtain average purchases per day.

Average credit purchases per day = Credit purchases/365

Example calculation

Assume First Parsons Company has accounts payable of $840,000 and credit purchases of $5,300,000. First Parsons Company was granted credit terms of 30 days by all its creditors. Assume there are 365 days year.

The average payment period of First Parsons Company is calculated as follows:

Firstly, we need to calculate the average credit purchases per day.

Average credit purchases per day = Credit purchases/365

= $5,300,000/365

= $14,520.55

Now, we are ready to calculate APP.

= $840,000/$14,520.55

=57.85 days

= 58 days

The APP of the First Parsons Company is 58 days. It takes on average 58 days to settle the accounts payable. However, the credit terms granted by creditors to First Parsons Company is 30 days. This means that company’s creditors require accounts to be settled within 30 days.

In light of this information, it is evident that payment of accounts payable is inadequately managed. If First Parsons Company will not attend to this issue in a timely manner, the current payment practices may lead to a number of harmful effects. Such harmful effects may include the inability to buy on credit from current suppliers, damage to the credibility of the business and a significantly deteriorating credit rating. This will be very harmful for the firm due to the further limitations it will impose on obtaining credit.

Things to note about this ratio

The average payment period analysis is only relevant when compared to credit terms granted to the business.

APP allows businesses to gain a better understanding of the cash outflows to be anticipated. Understanding of cash outflows is vital for successful operation of the business.

Average payment period analysis also identifies trends in the payment of the accounts payable. This can bring to management’s attention important variables that must be investigated to ensure successful operation of the business. For example, if the APP of the business increased from 30 to 68 days over 1 year while credit terms extended to the business remained the same at 30 days, a further investigation will be required to understand such a large increase in this ratio.

Further, to obtain a better understanding, one should compare the APP ratio to industry averages, to the ratio of leading firms in the industry and to the firm’s own historical results.

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Average Collection Period

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The average collection period is one of the activity ratios which measures the relationship between accounts receivable and average credit sales per day. Activity ratios help businesses to measure how efficiently various accounts are converted into sales or cash. Other activity ratios include average payment period, total asset turnover and inventory turnover analysis.

It calculates how efficiently accounts receivable are collected. It indicates the quality of debtors of the business (how promptly debtors pay their bills as they come due). It is also referred to as the average age of accounts receivable, debtors collection period ratio or a collection ratio.

The formula to calculate the average collection period ratio is as follows:

Average Collection Period = Accounts receivable/Average sales per day

The figure for accounts receivable is obtained from the balance sheet and the figure for sales is obtained from the income statement. Sales must be further adjusted to credit sales, by excluding cash sales. Further, credit sales must be divided by the number of days per year to finally obtain average sales per day (average credit sales per day).

Average sales per day = Credit sales/365

Example calculation

Assume Heroic Company has accounts receivable of $750,000 and credit sales of $4,050,000. Heroic Company has credit terms of 30 days. Assume 365 days year.

The average collection period of Heroic Company is calculated as follows:

Average sales per day = Credit sales/365

= $4,050,000/365

= $11,095.89

Average collection period = $750,000/$11,095.89=67.6 days = 68 days.

It takes on average 68 days to collect the accounts receivable. However, the credit terms of Heroic Company is 30 days. This means that company’s customers have 30 days to settle their accounts.

In light of this information, it is evident that collection of accounts receivable and/or process of granting the credit to customers is inadequately managed. The performance and processes of credit and collection departments should be investigated to draw further conclusions.

Things to note about this ratio

Results are only relevant when compared to a company’s credit terms.

The average collection period ratio therefore allows business to gain a better understanding of the cash inflows to be anticipated. Understanding of cash inflows are vital for successful operation of the business.

It also allows to identify trends in the collection of the accounts receivable. This can bring to management’s attention important variables that must be investigated to ensure successful operation of the business. For example, if the average collection period of the business increased from 30 to 68 days over 1 year, a further investigation will be required to understand such a large increase in this ratio.

Furthermore, to obtain a better understanding, one should compare the average collection period ratio to industry averages, to the ratio of leading firms in the industry and to the firms own historical results.

 

Inventory Turnover Analysis

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Inventory turnover analysis measure the liquidity of a firm’s inventory. It measures how many times the company turns over (sells, uses or replaces) its inventory during a period, such as the financial period.

It is calculated by dividing cost of goods sold by inventory. The formula is as follows.

Inventory Turnover = Cost of goods sold/Inventory

The results can be conveniently used to calculate the average age of inventory (also called average number of days sales in inventory or inventory turnover days) with the following formula:

Average age of inventory = 365/Inventory Turnover

Example of inventory turnover analysis

Assume Gold Co. has cost of goods sold of $1,850,000 and inventory of $680,000. Assume there are 365 days in the year. The inventory turnover analysis and average age of inventory analysis for the Gold Company is conducted as follows:

Inventory turnover analysis:

$1,850,000/$680,000=2.7

This indicates the business turns over its inventory 2.7 times per year.

Average age of inventory:

365/2.7=135.2

Things to note about inventory turnover analysis

The results are only meaningful when used in comparison. It can be compared to industry averages, to the firm’s past inventory ratios and to ratios of competitors.

Industry averages differ significantly between industries for this ratio. This ratio is positive (higher than zero) as long as the firm has any inventory. Generally, a high ratio is considered to be a good indicator.

However, the norm would differ significantly between industries. If the ratio is too high when compared to the norm within the industry, it may mean the company keeps too little inventory and, therefore, may lose some sales. On the other hand, a low ratio may indicate excess inventory and inferior sales. Excess inventory is usually considered to be undesirable as inventory is an investment without return, holding inventory implies costs and prices of goods to be sold may start decreasing.

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Total Asset Turnover

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Total asset turnover is one of the activity ratios indicating the relationship between assets and sales (revenue). Activity ratios help businesses to measure how efficiently various accounts are converted into sales or cash. Other activity ratios include average payment period, average collection period and inventory turnover analysis.

It calculates how efficiently assets are used to produce sales or revenue. In other words, how efficiently the balance sheet is managed. It shows how many dollars of revenue is earned per each dollar of assets. It is also referred to as asset turnover or asset turnover ratio.

The formula to calculate the ratio is as follows:

= Sales(Revenue)/Total assets

The health of this ratio is an important factor which contributes to a healthy return on investment (ROI/ROA).

Example of total asset turnover ratio analysis

Assume Heroic Company has sales of $750,000 and total assets of $880,000. The total asset turnover of Heroic Company is calculated as follows:

$750,000 /$880,000=0.85 or 0.9

This indicates that Heroic Company turns over its assets 0.85 (0.9) times per year.

Things to note about total asset turnover ratio

Usually the higher the asset turnover number the more efficiently assets of the business are utilized.

Further, to obtain a better understanding, one should compare the ratio of individual firms to industry averages, to that of leading firms in the industry and to historical results.

Earnings Available for Common Stockholders

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In summary, to calculate earnings available for common stockholders, we need to subtract cost of goods sold, operating expenses, and interest, tax and preferred stock dividends from sales revenue.

To calculate these earnings available, we need to understand the format of the income statement.

Income Statement Format

Sales revenue

LESS: Cost of goods sold

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

Therefore, to calculate earnings available for common stockholders, all we need to do is to subtract cost of goods sold, operating expenses, interest, tax and preferred stock dividends from the sale revenue.

Knowing the the earnings available for common stockholders is very important. Among other uses, it allows us to do the following:

1 – It allows you to calculate EPS:

Calculating EPS allows us to understand how much dollars were earned on each outstanding share of common stock.

2 – It also allows you to calculate the net profit margin ratio:

Net Profit Margin ratio = Earnings Available for Common Stockholders / Sales.

Net profit margin ratio measures how much of each sales dollar remains after all costs are deducted. In other words it measures how successful the firm is in terms of its earnings on sales.

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Calculating net profit after tax

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In summary, to calculate net profit after tax, we need to subtract cost of goods sold, operating expenses, interest and tax from the sales revenue.

To make this calculation, we need to understand the format of the income statement.

Income Statement Format

Sales revenue

LESS: Cost of goods sold

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

Therefore, to calculate net profit after tax, all we need to do is to subtract cost of goods sold, operating expenses, taxes and interest from sales revenue.

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Calculating net profit before tax

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In summary, to calculate net profit before tax, we need to subtract cost of goods sold, operating expenses and interest from sales revenue. We need to understand the format of the income statement.

Income Statement Format

Sales revenue

LESS: Cost of goods sold

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

Therefore, to calculate net profit before tax, all we need to do is to subtract cost of goods sold, operating expenses and interest from sales revenue.

Blogbschool.com is powered by www.firmsconsulting.com. Firmsconsulting is a training company that finds and nurtures tomorrow’s leaders in business, government and academia via bespoke online training to develop one’s executive presence, critical thinking abilities, high performance skill-set, and strategy, operations and implementation capabilities. Learn more at www.firmsconsulting.com.

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