Financial management and analysis phần 8 docx

For example, if youwant to evaluate how well the firm uses its assets in its operations, you could calculate the return on assets—sometimes called the basic earning power ratio—as the rat

A borrower can go a step further in financing with accounts receivable.Instead of simply using accounts receivable as collateral, the borrower

can sell them outright to another party—called a factor—typically a

bank or a commercial finance company Selling the receivables—called

factoring—may be done with or without recourse In a factoring

arrangement without recourse, the factor performs all the accounts

receivable functions: evaluating customers’ credit, approving credit, andcollecting on accounts receivable If any of the accounts turn out to beuncollectible, the factor bears the bad debt If a borrower has an

arrangement with a factor with recourse and the borrower grants credit

without permission from the factor, the borrower assumes ties for collection of the account

responsibili-There are basically two types of factoring, maturity factoring and ventional factoring They differ with respect to when cash is received for

con-the receivables In maturity factoring, con-the customer sends cash to con-the tor, who then sends the cash (less a commission) to the seller In conven- tional factoring, the factor advances cash to the seller when the accounts

fac-are factored, and then keeps the customers’ payments as they come in.Factors charge a commission of 0.75% to 1.5% of the face value ofthe accounts receivable In addition, if funds are advanced, as in thecase of conventional factoring, the factor charges interest on thosefunds, usually at a rate of 2¹⁄₂ to 3% above the prime rate Because fac-toring is a substitute for having accounts receivable personnel, whether

a firm should use factoring requires comparing what it costs to operatethe receivables function with the factor’s commission

Suppose a firm borrows using conventional factoring for its $10million accounts receivable And suppose the factor charges a fee of 1%

of the face value of the receivables, payable up front, and interest at 3%over prime If the prime rate is 12% APR, what does it effectively costthe firm to borrow under these terms for one month?

If the factor lends the firm $10 million but then charges a fee of 1%

at the beginning of the loan, the borrower has the use of only 99% ofthe $10 million, of $9.9 million Interest is 3% over prime, or 15% ayear As the prime rate is an annual percentage rate, the monthly rate is15%/12 = 1.25% The interest is therefore 1.25% of $10 million, or

$125,000 The effective cost over a month is:

and the effective annual rate is:

$9,900,000 - 0.0227 or 2.27%

EAR = (1 + 0.227)12− 1 = 30.91%

Inventory

Inventory can also be used as collateral for financing since it is a fairlyliquid asset Not all inventory is of equal importance as security: Theamount of funds loaned depends on how easy it is for the lender to turnthe inventory into cash In general,

■ standardized inventory is much better than specialized inventory

■ nonperishable inventory is better than perishable inventory

■ raw materials and finished goods are better than work-in-process

Types of Inventory Financing

There are several different types of loan arrangements that involveinventory as collateral These arrangements differ in terms of the con-trol that the lender has over the location and disposition of the inven-tory

A floating lien is the most flexible type of inventory loan A floating

lien gives the lender a lien on all inventory of the borrower—that is, allinventory is security for the loan Therefore the security of the loanchanges as the borrower buys and sells inventory

A chattel mortgage is a loan secured by specified inventory In other

words, inventory items are uniquely identified, such as by serial number,

as collateral for the loan The borrower retains title of the inventory.And although the borrower still owns the inventory, she or he cannotsell it unless the lender gives permission This type of loan is best suitedfor inventory that consists of large, slow moving items

In a trust receipts loan, the borrower holds the inventory in trust

for the lender As the inventory is sold, the borrower keeps the proceeds

in trust for the lender This type of arrangement is also referred to as

floor planning and is used often with auto dealerships First, the

bor-rower arranges a loan with the finance company The borbor-rower thenorders and receives the inventory, with the finance company paying thesupplier As the borrower sells the inventory items, the borrower remitsthe payments to the finance company, reducing the amount of the loan.Because the finance company is counting on the borrower to maintainthe inventory (keep it in good condition) and send the payments whensales are made, the lender must devise a way to monitor the borrower

In a field warehouse loan the lender has tighter control over the

inventory The collateral (the inventory) is kept in a separate, securedarea within the borrower’s premises and is monitored by a field ware-house agent This agent keeps control over the inventory in this area

and issues receipts to the lender, indicating the existence of the tory As the lender receives these receipts, she makes a loan based on thecollateral value of the inventory This arrangement is more expensivethan the floating lien, chattel mortgage, and trust receipts arrangementsbecause a third party—the field warehouser—must be compensated forhis services This arrangement offers the lender more peace of mind overthe inventory.

inven-Even tighter control over collateral inventory is maintained in a

public warehouse loan arrangement In a public warehouse loan,

collat-eral inventory is kept in a secured area away from the borrower’s mises, such as in a public warehouse, and is only released to theborrower if the lender gives permission The warehouser issues to thelender receipts (similar to the field warehouse arrangement) from whichthe lender acknowledges in the form of money loaned to the borrower

pre-In this arrangement, the lender has title to the goods instead of the

bor-rower

Cost of Inventory Financing

Suppose a firm borrows $1,000,000 for one month under a field housing arrangement And suppose the interest rate on the loan is 12%APR The interest on the loan is therefore 1% of $1,000,000, or

ware-$10,000 If the field warehouse charges a $5,000 fee, payable at the end

of the month, the cost of this financing is:

and:

If the field warehouse charges the $5,000 fee at the beginning of the

month, the cost for the month is more since effectively the firm has onlyborrowed $995,000:

and:

$1,000,000 - 0.0150 or 1.50%

EAR = (1+0.0150)12–1 = 0.1956 or 19.56%

$995,000 - 0.0151 or 1.51%

EXHIBIT 21.9 Annual Cost of Short-Term Financing Alternatives, 1997–2002

Source: Federal Reserve Bank of St Louis

ACTUAL COSTS OF SHORT-TERM FINANCING

The cost of short-term financing is a function of many factors, including

■ prevailing interest rates

■ creditworthiness of borrower (credit rating)

■ length of maturity of borrowing

■ level of seniority

■ collateral

■ backup line of credit

The costs of different forms of financing vary, due to these factors

We can see the difference in the costs of several different forms of term financing in Exhibit 21.9, where the costs of several types offinancing are shown, along with the rate on the 6-month T-Bill—thegovernment’s cost of short-term financing We use the T-Bill rate forcomparison purposes since this is the rate on a short-term security with

short-no risk of default—the U.S government can always print more money

to cover its debts

We see that bankers’ acceptance rates are higher than the T-Billrates This is because there is some default risk with acceptances Com-

mercial paper rates are slightly higher than those for acceptances, sincethey are also considered to have little default risk yet may or may not bebacked by a line of credit The prime rate, which is what banks use as abase rate for their loans, is above the commercial paper rate, reflecting agenerally greater risk associated with the bank loans relative to the com-mercial paper, which are issued by large, creditworthy corporations.

SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT

FOR FINANCIAL INSTITUTIONS

There are special borrowing arrangements for financial institutions such

as commercial banks and securities firms in which the securities ularly, bonds) that they own or want to acquire are used as collateral

(partic-The arrangement is called a repurchase agreement.

A repurchase agreement, commonly referred to as a repo, is the sale

of a security with a commitment by the seller to buy the same securityback from the purchaser at a specified price at a designated future date.The price at which the seller must subsequently repurchase the security is

called the repurchase price and the date that the security must be chased is called the repurchase date Basically, a repurchase agreement is

repur-a collrepur-aterrepur-alized lorepur-an, where the collrepur-aterrepur-al is the security threpur-at is sold repur-andsubsequently repurchased The term of the loan and the interest rate thatthe securities firm agrees to pay are specified The interest rate is called

the repo rate When the term of the loan is one day, it is called an night repo; a loan for more than one day is called a term repo.

over-The transaction is referred to as a repurchase agreement because itcalls for the sale of the security and its repurchase at a future date Boththe sale price and the purchase price are specified in the agreement Thedifference between the purchase (repurchase) price and the sale price isthe dollar interest cost of the loan

The following illustration describes the mechanics of a repo pose a securities firm wants to purchase for 10 days $10 million of aparticular Treasury security using a repo to finance the purchase Sup-pose further that a customer of the securities firm has excess funds of

Sup-$10 million to invest for 10 days (The customer might be a ity with tax receipts that it has just collected, and no immediate need todisburse the funds, or a mutual fund with cash it wants to invest for 10days.) The securities firm would agree to deliver (“sell”) $10 million ofthe Treasury security to the customer for an amount determined by therepo rate and buy in 10 days (“repurchase”) the same Treasury securityfrom the customer for $10 million the next day Suppose that the over-

municipal-night repo rate is 3% Then, as will be explained below, the securitiesfirm would agree to deliver the Treasury securities for $9,991,667 andrepurchase the same securities in 10 days for $10 million The $8,333difference between the “sale” price of $9,991,667 and the repurchaseprice of $10 million is the dollar interest on the financing.

The following formula is used to calculate the dollar interest on arepo transaction:

Dollar interest = (Dollar principal) × (Repo rate) × (Repo term/360)Notice that the interest is computed on a 360-day basis In ourexample, at a repo rate of 3% and a repo term of 10 days, the dollarinterest is $8,333 as shown below:

The advantage to financial institutions of using the repo market forborrowing on a short-term basis is that the rate is lower than the cost ofbank financing The reason for this is that the borrowing is secured bythe collateral and if the market value of the security declines, the securi-ties firm would be required to put up more collateral or return cash.Four final points about repos First, there is not one repo rate Therate varies from transaction to transaction One factor that affects therepo rate is the term of the borrowing As explained in Chapter 3, there

is a term structure of interest rates The same is true in the repo market.Second, in practice the amount loaned will not be equal to the mar-ket value of the securities Instead, less will be loaned By doing so, thelender reduces credit risk because the loan is overcollateralized (i.e., theamount lent is less than the market value) The difference between themarket value of the security and the amount loaned is called the haircut Third, one can be confused by whether a repurchase agreement is afinancing arrangement or an investment vehicle if one does not under-stand which side of the transaction a party is on For example, in ourillustration we demonstrated how a financial institution can use a repo

to finance the purchase of a security From the perspective of the tomer that loaned the funds, the transaction is a short-term investment.Consequently, repos are referred to as money market instrumentsbecause they have a maturity of less than one year

cus-Finally, some financial institutions earn income by borrowing and ing the same security in a repo transaction with the same maturity This isreferred to as running a “matched book.” For example, suppose that a secu-rities firm enters into a term repo of 10 days with a mutual fund and lendsfunds to a commercial bank for 10 days using a term repo The securities

lend-involved in both transactions are the same If the repo rate on the repo action with the mutual fund is 3.30% and the repo rate on the repotransaction with the commercial bank is 3.25%, then the financial institu-tion is earning a spread of 0.05% (5 basis points).

■ Trade credit arises out of ordinary business transactions, where ers permit firms to pay at some later date The cost of trade credit isfrom any discount not taken

■ Accounts payable management requires us to compare the cost of tradecredit with the cost of other forms of credit We also must weigh thebenefits of paying our accounts later with the costs late payments willhave in the form of our relationship with suppliers

■ Bank financing comes in many forms, including single payment loans,which may arise from simple lending arrangements or from promises

to lend in the form of lines of credit, revolving credit agreements, or ters of credit

■ Short-term financing can also be obtained using loans that create ketable securities, such as commercial paper and bankers’ acceptances.Because these securities have lower risk, due to the creditworthiness ofthe parties that issue the security and backup credit by banks, they arealso lower cost ways of financing

accounts receivable (assignment and factoring), inventory (floatingliens, chattel mortgages, trust receipts, and warehousing), and market-able securities (repurchase agreements)

■ Accounts receivable may be used as collateral in a loan In the ment of receivables, the lender loans funds with the accounts receivable

assign-as collateral As payments are made on the accounts (generally directly

to the lender), the lender accepts these as repayment of the loan In toring, the borrower sells the accounts receivable to the lender, the factor

■ There are several types of loans that involve inventory as collateral.These loans differ in terms of the control that the lender has over the

inventory, ranging from little control (i.e., a floating lien) to tight trol (field warehouse loan).

■ The costs of short-term financing depend on many features of the loan,including the creditworthiness of the borrower, the amount borrowed,any backup line of credit, and the maturity of the loan Generally, com-mercial paper and bankers’ acceptances have lower costs than bankloans and loans secured with accounts receivable or inventory

■ A repurchase agreement is a specialized financing arrangement used byfinancial institutions to finance their purchase of securities

QUESTIONS

1 Consider a single payment loan with interest of 10% and a discountloan with a discount of 10% If the loan amounts and the loan peri-ods are the same for both loans, which loan has a higher effectivecost of financing? Why?

2 If a bank states 5% interest on a 360-day basis, is this stated rate lessthen, equal to, or more than 5% interest on a 365-day basis? Why?

3 Consider two loans with equal maturity and identical face values: adiscount loan that has a discount of 10% and a single payment loanwith a 10% compensating balance requirement Which loan has thehigher interest rate? Explain

4 Consider two loans with equal maturity and identical loanedamounts: a discount loan that has a discount of 10% and a singlepayment loan with no interest but an origination fee of 10% Whichloan has the higher interest rate? Explain

5 Explain the advantages and disadvantages of stretching payments

5% of any usage [Source: OEA 35th Annual Report—1992, page 14].

a What do you need to consider in determining OEA’s cost of the line

of credit?

b How does the compensating balance affect OEA’s cost of borrowing?

8 If there is no stated interest on trade credit, how can there be a cost

to trade credit as a source of short-term financing?

9 In using trade credit, if there is a lower effective cost of paying later,what incentive is there to pay early? What incentive is there to paywithin the net period?

10 Explain how the assignment of receivables differs from factoring

11 Distinguish between maturity factoring and conventional factoring

a 1/10, net 30, paying on day 20

b 2/10, net 40, paying on day 30

c 3/15, net 60, paying on day 60

d 5/15, net 50, paying on day 50

14 Calculate the effective annual cost of trade credit for the terms of 1/

10, net 40, if payment is made:

a 9 days after the sale

b 11 days after the sale

c 20 days after the sale

d 30 days after the sale

e 40 days after the sale

15 What is the effective annual cost of a single payment loan thatrequires interest of 6% after three months?

16 What is the effective annual cost of a discount loan that has a count of 5% and a loan period of four months?

dis-17 Calculate the effective annual cost of a six-month loan of $100,000that has a 7% interest rate, and:

a no compensating balance nor loan origination fee

b a 20% compensating balance and no loan origination fee

c a 20% compensating balance and a loan origination fee of $1,000,taken as a discount

18 Calculate the effective annual cost of a three-month loan of $1 lion that has a 16% APR, and:

mil-a no compensating balance nor loan origination fee

Alternative APR Frequency of Compounding

b a 10% compensating balance and no loan origination fee.

c a 10% compensating balance and a loan origination fee of $1,000,paid at the beginning of the loan

19 The Dieu Company had sales of $1 million in 1996, with 60% of itssales made on credit If the average accounts payable are $100,000,what is Dieu’s accounts payable turnover?

20 At the end of 1996, Golden Motors Corporation had $10 billion ofaccounts payable If this balance is representative of GM’s payables,and if it takes GM 30 days to pay on its accounts, how much did

GM have in credit purchases during 1996?

21 Suppose that a factor is willing to lend you $6 million for onemonth, using your firm’s accounts receivable as collateral If theannual percentage rate on this loan is 12%, what is the effectiveinterest rate? If the factor charges an up-front fee of 2%, what is theeffective annual cost of this loan?

22 The Cash Poor Company is considering using its $1 million ofaccounts receivable to secure financing for the next month CashPoor has approached two financing firms, each offering differentarrangements Firm A is willing to lend Cash Poor 75% of the facevalue of the receivables at 60 basis points above the prime rate.Firm B is willing to factor Cash Poor’s receivables, advancing 75%

of the receivables, collecting a fee up front of 1% of all receivables,and charging interest at 30 basis points above the prime rate In thecase of Firm A’s arrangement, Cash Poor continues with its evalua-tion and collection of credit, but in the case of Firm B’s arrange-ment, Firm B performs all the credit functions, saving Cash Poor anestimated $10,000 over the next month If the prime rate is 12%APR, which arrangement is less costly for Cash Poor?

23 What is the effective cost of financing for a six-month inventoryfield warehouse loan of $100,000 that requires interest of $6,000 to

be paid at the end of six months and a warehouse fee of $5,000 to

be paid at the beginning of the loan period?

24 A firm is considering using a field warehousing arrangement as part

of its short-term financing The field warehouse requires a year payment of $10,000, paid at the beginning of the year, no mat-ter how much the firm borrows Interest on the loan is a single pay-ment of 10% per year, paid at the end of the year What is theeffective annual cost of borrowing using field warehousing if theamount borrowed is:

once-a-a $150,000?

b $200,000?

c $300,000?

d $500,000?

25 Evaluate the effective annual cost of each of the following creditterms:

a Trade credit, with terms of 2/10, net 30, paying on the net day

b Bank loan with single payment interest at 5% for six months

c Bank loan with discount interest of 4% for six months

d Bank loan with single payment interest of 2% for three months,with a compensating balance of 10%

e Bank loan with single payment interest of 3% for three months,with a compensating balance of 5%

f A one-year loan secured with accounts receivable, with a service fee

of 5% (payable at the end of the loan) and a 5% rate of interest

26 Which of the following financing arrangements provides the lowesteffective annual cost to the borrower?

27 If the A Company loans the B Company $100,000 for six months,with discount interest of 5%, what is the effective cost of this credit

to B company?

28 Bank C requires all borrowers to maintain a 20% compensatingbalance during the loan periods Company D borrows from Bank Cfor six months at an APR of 10% What is Company D’s effectiveannual cost of borrowing from Bank C?

29 What is the effective annual rate of interest for trade credit with theterms 3/10, net 40, with payment made:

a 20 days after the sale?

b 30 days after the sale?

c 40 days after the sale?

30 Frich Corporation is considering the use a field warehousing loan,which has a fee of $25,000 up front (that is, at the beginning of thethree months of financing) and interest of 8% on all outstandingloans If Armour borrows $2 million for one month with this fieldwarehousing loan, what is the cost of financing for one month?What is the effective annual cost of using this financing?

31 Evaluate the effective annual cost of each of the following creditterms:

a Trade credit, with terms of 2/10, net 30, paying on the net day

b Bank loan with single payment interest of 5% for six months

c Bank loan with discount interest of 4% for six months

Arrangement #1: Commercial paper with a maturity of 91 days

sold at a 14% discount from its face value.Arrangement #2: A bank loan with no compensating balance, but

with discount interest of 14%

Arrangement #3: A one-year bank loan with a 10% compensating

balance and 5% single payment interest

d Bank loan with single payment interest of 2% for three months,with a compensating balance of 10%.

e Bank loan with single payment interest of 3% for three months,with a compensating balance of 5%

f A one-year loan secured with accounts receivable, with a service fee

of 5% (payable at the end of the loan) and a 5% rate of interest

32 Financial institutions typically use a repurchase agreement tofinance the purchase of a security

a What a repurchase agreement?

b What is the advantage of using a repurchase agreement rather thanborrowing from a bank?

c Is a repurchase agreement a lending arrangement or an investmentvehicle?

33 Suppose that a commercial bank wants to purchase $1 million of abond for five days using a repurchase agreement to finance the pur-chase Suppose further that the repo rate is 2.7%

a What is the dollar interest cost of borrowing?

b What is the repurchase price?

c What is the price that the commercial bank will sell the bond for tothe lender in the repurchase agreement?

Six

Financial Statement

Analysis

CHAPTER 22

721

Financial Ratio Analysis

n this chapter, we introduce you to financial ratios—one of the tools offinancial analysis In financial ratio analysis we select the relevantinformation—primarily the financial statement data—and evaluate it

We show how to incorporate market data and economic data in theanalysis and interpretation of financial ratios Finally, we show you how

to interpret financial ratio analysis, warning you of the pitfalls thatoccur when it’s not done properly

Financial analysis is one of the many tools useful in valuationbecause it helps the financial analyst gauge returns and risks We beginthe analysis with a fictitious firm as our example, allowing us to usesimplified financial statements and allowing you to become more com-fortable with the tools of financial analysis After we cover the basics,

we use these same tools with data from an actual firm in an integrativeexample

RATIOS AND THEIR CLASSIFICATION

A ratio is a mathematical relation between two quantities Suppose you

have 200 apples and 100 oranges The ratio of apples to oranges is 200/

100, which we can conveniently express as 2:1 or 2 A financial ratio is

a comparison between one bit of financial information and another.Consider the ratio of current assets to current liabilities, which we refer

to as the current ratio This ratio is a comparison between assets thatcan be readily turned into cash—current assets—and the obligationsthat are due in the near future—current liabilities A current ratio of 2

or 2:1 means that we have twice as much in current assets as we need tosatisfy obligations due in the near future

I

Ratios can be classified according to the way they are constructedand the financial characteristic they are describing For example, we willsee that the current ratio is constructed as a coverage ratio (the ratio ofcurrent assets—available funds—to current liabilities—the obligation)that we use to describe a firm’s liquidity (its ability to meet its immedi-ate needs).

There are as many different financial ratios as there are possiblecombinations of items appearing on the income statement, balance sheet,and statement of cash flows We can classify ratios according to howthey are constructed or according to the financial characteristic that theycapture

Ratios can be constructed in the following four ways:

1 As a coverage ratio A coverage ratio is a measure of a firm’s ability to

“cover,” or meet, a particular financial obligation The denominatormay be any obligation, such as interest or rent, and the numerator isthe amount of the funds available to satisfy that obligation

2 As a return ratio A return ratio indicates a net benefit received from a

particular investment of resources The net benefit is what is left overafter expenses, such as operating earnings or net income, and theresources may be total assets, fixed assets, inventory, or any otherinvestment

3 As a turnover ratio A turnover ratio is a measure of how much a firm

gets out of its assets This ratio compares the gross benefit from anactivity or investment with the resources employed in it

4 As a component percentage A component percentage is the ratio of

one amount in a financial statement, such as sales, to the total ofamounts in that financial statement, such as net profit

In addition, we can also express financial data in terms of time—say, how many days’ worth of inventory we have on hand—or on a pershare basis—say, how much a firm has earned for each share of commonstock Both are measures we can use to evaluate operating performance

or financial condition

When we assess a firm’s operating performance, we want to know if

it is applying its assets in an efficient and profitable manner When weassess a firm’s financial condition, we want to know if it is able to meetits financial obligations We can use financial ratios to evaluate fiveaspects of operating performance and financial condition:

1 Return on investment

2 Liquidity

3 Profitability

4 Activity

5 Financial leverage

There are several ratios reflecting each of the five aspects of a firm’soperating performance and financial condition We apply these ratios tothe Fictitious Corporation, whose balance sheets, income statements,and statement of cash flows were discussed in Chapter 6 and were pre-sented in Exhibits 6.1, 6.4, and 6.6 of that chapter The ratios we intro-duce now are by no means the only ones that can be formed usingfinancial data, though they are some of the more commonly used Afterbecoming comfortable with the tools of financial analysis, you will beable to create ratios that serve your particular evaluation objective

RETURN-ON-INVESTMENT RATIOS

Return-on-investment ratios compare measures of benefits, such as

earn-ings or net income, with measures of investment For example, if youwant to evaluate how well the firm uses its assets in its operations, you

could calculate the return on assets—sometimes called the basic earning power ratio—as the ratio of earnings before interest and taxes (EBIT) (also known as operating earnings) to total assets:

For Fictitious Corporation, for 1999:

For every dollar invested in assets, Fictitious earned about 18 cents in

1999 This measure deals with earnings from operations; it does notconsider how these operations are financed

Another return-on-assets ratio uses net income—operating earningsless interest and taxes—instead of earnings before interest and taxes:1

1

In actual application the same term, return on assets, is often used to describe both ratios It is only in the actual context or through an examination of the numbers themselves that we know which return ratio is presented We use two different terms

to describe these two return-on-asset ratios in this chapter simply to avoid any fusion.

con-Basic earning power Earnings before interest and taxes

Total assets -

=

$11,000,000 - 0.1818 or 18.18%

For Fictitious in 1999:

Thus, without taking into consideration how assets are financed, thereturn on assets for Fictitious is 18% Taking into consideration howassets are financed, the return on assets is 11% The difference is due toFictitious financing part of its total assets with debt, incurring interest

of $400,000 in 1999; hence, the return-on-assets ratio excludes 1999taxes of $400,000 from earnings in the numerator

If we look at Fictitious’ liabilities and equities, we see that the assetsare financed in part by liabilities ($1 million short term, $4 million longterm) and in part by equity ($800,000 preferred stock, $5.2 millioncommon stock) If we look at the information as investors, we may not

be interested in the return the firm gets from its total investment (debt

plus equity), but rather shareholders are interested in the return the firm

can generate on their investment The return on equity is the ratio of the

net income shareholders receive to their equity in the stock:

For Fictitious Corporation, there is only one type of shareholder:common For 1999:

Recap: Return-on-Investment Ratios

The return-on-investment ratios for Fictitious Corporation for 1999 are:

These return-on-investment ratios tell us:

Basic earning power = 18.18%

Total assets -

=

$11,000,000 - 0.1091 or 10.91%

Book value of shareholders’ equity -

=

$6,000,000 - 0.2000 or 20.00%

Financial Ratio Analysis 725

from its assets

■ Shareholders earn 20% from their investment (measured in book valueterms)

These ratios do not tell us:

■ Whether this return is due to the profit margins (that is, due to costsand revenues) or to how effectively Fictitious uses its assets

■ The return shareholders earn on their actual investment in the firm,that is, what shareholders earn relative to their actual investment, notthe book value of their investment For example, you may invest $100

in the stock, but its value according to the balance sheet may be greaterthan or, more likely, less than $100

The Du Pont System

The returns on investment ratios give us a “bottom line” on the mance of a company, but don’t tell us anything about the “why” behindthis performance For an understanding of the “why,” the analyst mustdig a bit deeper into the financial statements A method that is useful in

perfor-examining the source of performance is the Du Pont system The Du Pont system is a method of breaking down return ratios into their com-

ponents to determine which areas are responsible for a firm’s mance To see how it’s used, let’s take a closer look at the first definition

perfor-of the return on assets:

Suppose the return on assets changes from 20% in one period to10% the next period We do not know whether this decreased return isdue to a less efficient use of the firm’s assets—that is, lower activity—or

to less effective management of expenses (i.e., lower profit margins) Alower return on assets could be due to lower activity, lower margins, orboth Because we are interested in evaluating past operating performance

to evaluate different aspects of the management of the firm and to dict future performance, knowing the source of these returns is valuable.Let’s take a closer look at the return on assets and break it downinto its components: measures of activity and profit margin We do this

pre-by relating both the numerator and the denominator to sales activity.Divide both the numerator and the denominator of the basic earningpower by sales:

Basic earning power Earnings before interest and taxes

Total assets -

=

which is equivalent to:

This says that the earning power of the company is related to ity (in this case, operating profit) and a measure of activity (total assetturnover)

profitabil-Basic earning power = (Operating profit margin) (Total asset turnover)

If we are analyzing a change in basic earning power, we thereforeknow that we could look at this breakdown to see the change in its com-ponents: operating profit margin and total asset turnover

This method of analyzing return ratios in terms of profit margin andturnover ratios, referred to as the Du Pont System, is credited to the E.I

Du Pont Corporation, whose management developed a system of ing down return ratios into their components.2

break-Let’s look at the return on assets of Fictitious for 1998 and 1999 Itsreturns on assets were 20% in 1998 and 18.18% in 1999 We candecompose the firm’s returns on assets for the two years, 1998 and

1999, to obtain:

We see that operating profit margin declined from 1998 to 1999, yetasset turnover improved slightly, from 0.9000 to 0.9091 Therefore, thereturn-on-assets decline from 1998 to 1999 is attributable to lowerprofit margins

The return on assets can be broken down into its components in asimilar manner:

2American Management Association, Executive Committee Control Charts, AMA

Management Bulletin No 6, 1960, p 22.

Year Basic Earning Power Operating Profit Margin Total Asset Turnover

Basic earning power Earnings before interest and taxes Sales⁄

Total assets Sales⁄ -

Financial Ratio Analysis 727

or

Return on assets = (Net profit margin) (Total asset turnover)

We can relate the basic earning power ratio to the return on assets,recognizing that:

Net income = Earnings before tax (1 − Tax rate)

equity’s share of earnings tax retention %The ratio of earnings before taxes to earnings before interest andtaxes reflects the interest burden of the company, where as the term (1 −tax rate) reflects the company’s tax burden Therefore,

or

The breakdown of a return-on-equity ratio requires a bit more position because instead of total assets as the denominator, we want to useshareholders’ equity Because activity ratios reflect the use of all of theassets, not just the proportion financed by equity, we need to adjust theactivity ratio by the proportion that assets are financed by equity (i.e., theratio of the book value of shareholders’ equity to total assets):

Net income = Earnings before interest and taxes

Earnings before taxesEarnings before interest and taxes

Return on assets = (Operating profit margin) Total asset turnover( )

Equity’s share of earnings

×

equity multiplierThe ratio of total assets to shareholders’ equity is referred to as the

equity multiplier The equity multiplier, therefore, captures the effects

of how a company finances its assets, referred to as its financial age Multiplying the total asset turnover ratio by the equity multiplierallows us to break down the return-on-equity ratios into three compo-nents: profit margin, asset turnover, and financial leverage For example,the return on equity can be broken down into three parts:

lever-Return on equity = (Net profit margin)(Total asset turnover)

(Equity multiplier)Applying this breakdown to Fictitious for 1998 and 1999:

We see that the return on equity decreased from 1998 to 1999 because

of a lower operating profit margin and less use of financial leverage

We can decompose the return on equity further by breaking out theequity’s share of before-tax earnings (represented by the ratio of earningsbefore and after interest) and tax retention percent:

Year

Return on

Equity

Net Profit Margin

Total Asset Turnover

Total Debt

to Assets

Equity Multiplier

×

This decomposition allows the financial analyst to take a closer look

at the factors that are controllable by a company’s management (e.g.,asset turnover) and those that are not controllable (e.g., tax retention)

As you can see, the breakdowns lead the analyst to information on boththe balance sheet and the income statement And this is not the onlybreakdown of the return ratios—further decomposition is possible

LIQUIDITY

Liquidity reflects the ability of a firm to meet its short-term obligations

using those assets that are most readily converted into cash Assets thatmay be converted into cash in a short period of time are referred to as

liquid assets; they are listed in financial statements as current assets Current assets are often referred to as working capital, since they repre-

sent the resources needed for the day-to-day operations of the firm’slong-term capital investments Current assets are used to satisfy short-term obligations, or current liabilities The amount by which current

assets exceed current liabilities is referred to as the net working capital.

The Operating Cycle

How much liquidity a firm needs depends on its operating cycle The

operating cycle is the duration from the time cash is invested in goods

and services to the time that investment produces cash For example, afirm that produces and sells goods has an operating cycle comprisingfour phases:

1 Purchase raw materials and produce goods, investing in inventory

2 Sell goods, generating sales, which may or may not be for cash

3 Extend credit, creating accounts receivable

4 Collect accounts receivable, generating cash

The four phases make up the cycle of cash use and generation Theoperating cycle would be somewhat different for companies that pro-duce services rather than goods, but the idea is the same—the operating

cycle is the length of time it takes to generate cash through the

invest-ment of cash.

What does the operating cycle have to do with liquidity? The longerthe operating cycle, the more current assets are needed (relative to cur-rent liabilities) since it takes longer to convert inventories and receiv-ables into cash In other words, the longer the operating cycle, thegreater the amount of net working capital required

To measure the length of an operating cycle we need to know:

1 The time it takes to convert the investment in inventory into sales (that

is, cash → inventory → sales → accounts receivable)

2 The time it takes to collect sales on credit (that is, accounts receivable

→ cash)

We can estimate the operating cycle for Fictitious Corporation for

1999, using the balance sheet and income statement data The number ofdays Fictitious ties up funds in inventory is determined by the totalamount of money represented in inventory and the average day’s cost ofgoods sold The current investment in inventory—that is, the money

“tied up” in inventory—is the ending balance of inventory on the

bal-ance sheet The average day’s cost of goods sold is the cost of goods sold

on an average day in the year, which can be estimated by dividing thecost of goods sold (which is found on the income statement) by the num-ber of days in the year The average day’s cost of goods sold for 1999 is:

In other words, Fictitious incurs, on average, a cost of producing goodssold of $17,808 per day

Fictitious has $1.8 million of inventory on hand at the end of theyear How many days’ worth of goods sold is this? One way to look atthis is to imagine that Fictitious stopped buying more raw materials andjust finished producing whatever was on hand in inventory, using avail-able raw materials and work-in-process How long would it take Ficti-tious to run out of inventory?

We compute the number of days of inventory by calculating the ratio

of the amount of inventory on hand (in dollars) to the average day’s cost

of goods sold (in dollars per day):

In other words, Fictitious has approximately 101 days of goods on hand

at the end of 1999 If sales continued at the same price, it would takeFictitious 101 days to run out of inventory

365 days -

=

$6,500,000

365 days - =$17,808 per day

=

Average day’s cost of goods sold -

=

$1,800,000

$17,808 per day -=101 days

=

If the ending inventory is representative of the inventory throughoutthe year, then it takes about 101 days to convert the investment ininventory into sold goods Why worry about whether the year-endinventory is representative of inventory at any day throughout the year?Well, if inventory at the end of the fiscal year-end is lower than on anyother day of the year, we have understated the number of days of inven-tory Indeed, in practice most companies try to choose fiscal year-endsthat coincide with the slow period of their business That means the

ending balance of inventory would be lower than the typical daily

inventory of the year To get a better picture of the firm, we could, forexample, look at quarterly financial statements and take averages ofquarterly inventory balances However, here for simplicity we make anote of the problem of representatives and deal with it later in the dis-cussion of financial ratios.3

We can extend the same logic for calculating the number of daysbetween a sale—when an account receivable is created—to the time it iscollected in cash If we assume that Fictitious sells all goods on credit,

we can first calculate the average credit sales per day and then figure

out how many days’ worth of credit sales are represented by the endingbalance of receivables

The average credit sales per day are:

Therefore, Fictitious generates $27,397 of credit sales per day With

an ending balance of accounts receivable of $600,000, the number of days of credit in this ending balance is calculated by taking the ratio of

the balance in the accounts receivable account to the credit sales per day:

Credit sales per day Credit sales

365 days

- $10,000,000

365 days - $27,397 per day

Credit sales per day -

=

$600,000

$27,397 per day -=22 days

=

If the ending balance of receivables at the end of the year is sentative of the receivables on any day throughout the year, then ittakes, on average, approximately 22 days to collect the accounts receiv-able In other words, it takes 22 days for a sale to become cash.

repre-Using what we have determined for the inventory cycle and cashcycle, we see that for Fictitious:

We also need to look at the liabilities on the balance sheet to seehow long it takes a firm to pay its short-term obligations We can applythe same logic to accounts payable as we did to accounts receivable andinventories How long does it take a firm, on average, to go from creat-ing a payable (buying on credit) to paying for it in cash?

First, we need to determine the amount of an average day’s purchases

on credit If we assume all the Fictitious purchases are made on credit,

then the total purchases for the year would be the cost of goods sold lessany amounts included in cost of goods sold that are not purchases Forexample, depreciation is included in the cost of goods sold yet is not apurchase Since we do not have a breakdown on the company’s cost ofgoods sold showing how much was paid for in cash and how much was

on credit, let’s assume for simplicity that purchases are equal to cost ofgoods sold less depreciation The average day’s purchases then become:

The number of days of purchases represented in the ending balance

in accounts payable is calculated as the ratio of the balance in theaccounts payable account to the average day’s purchases:

For Fictitious in 1999:

Operating cycle= Number of days of inventory+Number of days of credit

101 days+22 days= 123 days

=

365 days -

=

365 days -=$15,068 per day

=

Average day’s purchases -

=

$15,068 per day - 33 days

This means that on average Fictitious takes 33 days to pay out cash for

a purchase

The operating cycle tells us how long it takes to convert an

invest-ment in cash back into cash (by way of inventory and accounts

receiv-able) The number of days of payables tells us how long it takes to pay

on purchases made to create the inventory If we put these two pieces ofinformation together, we can see how long, on net, we tie up cash Thedifference between the operating cycle and the number of days of pur-

chases is the net operating cycle:

Net operating cycle = Operating cycle − Number of days of payables

Or, substituting for the operating cycle,

Net operating cycle = Number of days of inventory + Number of days of credit − Number of payablesThe net operating cycle for Fictitious in 1999 is:

Net operating cycle = 101 + 22 − 33 = 90 daysThe net operating cycle is how long it takes for the firm to get cashback from its investments in inventory and accounts receivable, consid-ering that purchases may be made on credit By not paying for pur-chases immediately (that is, using trade credit), the firm reduces itsliquidity needs Therefore, the longer the net operating cycle, the greaterthe required liquidity

Measures of Liquidity

We can describe a firm’s ability to meet its current obligations in several

ways The current ratio indicates the firm’s ability to meet or cover its

current liabilities using its current assets:

For the Fictitious Corporation, the current ratio for 1999 is theratio of current assets, $3 million, to current liabilities, the sum ofaccounts payable and other current liabilities, or $1 million

Current liabilities -

=

$1,000,000 - 3.0 times

The current ratio of 3.0 indicates that Fictitious has three times asmuch as it needs to cover its current obligations during the year How-ever, the current ratio groups all current asset accounts together, assum-ing they are all as easily converted to cash Even though, by definition,current assets can be transformed into cash within a year, not all currentassets can be transformed into cash in a short period of time.

An alternative to the current ratio is the quick ratio, also called the acid-test ratio, which uses a slightly different set of current accounts to

cover the same current liabilities as in the current ratio In the quickratio, the least liquid of the current asset accounts, inventory, isexcluded Hence:

We typically leave out inventories in the quick ratio because tories are generally perceived as the least liquid of the current assets Byleaving out the least liquid asset, the quick ratio provides a more conser-vative view of liquidity

inven-For Fictitious, in 1999:

Still another way to measure the firm’s ability to satisfy short-term

obligations is the net working capital-to-sales ratio, which compares

net working capital (current assets less current liabilities) with sales:

This ratio tells us the “cushion” available to meet short-term tions relative to sales Consider two firms with identical working capital

obliga-of $100,000, but one has sales obliga-of $500,000 and the other sales obliga-of

$1,000,000 If they have identical operating cycles, this means that thefirm with the greater sales has more funds flowing in and out of its cur-rent asset investments (inventories and receivables) The firm with morefunds flowing in and out needs a larger cushion to protect itself in case

of a disruption in the cycle, such as a labor strike or unexpected delays

in customer payments The longer the operating cycle, the more of acushion (net working capital) a firm needs for a given level of sales

Current liabilities -

Net working capital-to-sales ratio Net working capital

Sales -

=

For Fictitious Corporation:

The ratio of 0.20 tells us that for every dollar of sales, Fictitious has 20cents of net working capital to support it

Recap: Liquidity Ratios

Operating cycle and liquidity ratio information for Fictitious, using datafrom 1999, in summary, is:

Given the measures of time related to the current accounts—theoperating cycle and the net operating cycle—and the three measures ofliquidity—current ratio, quick ratio, and net working capital-to-salesratio—we know the following about Fictitious Corporation’s ability tomeet its short-term obligations:

■ Inventory is less liquid than accounts receivable (comparing days ofinventory with days of credit)

■ Current assets are greater than needed to satisfy current liabilities in ayear (from the current ratio)

■ The quick ratio tells us that Fictitious can meet its short-term tions even without resorting to selling inventory

■ The net working capital “cushion” is 20 cents for every dollar of sales(from the net working capital-to-sales ratio.)

What don’t ratios tells us about liquidity? They don’t provide uswith answers to the following questions:

$10,000,000 -

=0.2000 or 20%

=

■ How liquid are the accounts receivable? How much of the accountsreceivable will be collectible? Whereas we know it takes, on average,

22 days to collect, we do not know how much will never be collected

■ What is the nature of the current liabilities? How much of current bilities consists of items that recur (such as accounts payable and wagespayable) each period and how much consists of occasional items (such

lia-as income taxes payable)?

■ Are there any unrecorded liabilities (such as operating leases) that arenot included in current liabilities?

PROFITABILITY RATIOS

We have seen that liquidity ratios tell us about a firm’s ability to meet itsimmediate obligations Now we extend our analysis skills by addingprofitability ratios, which help us gauge how well a firm is managing its

expenses Profit margin ratios compare components of income with

sales They give us an idea of which factors make up a firm’s income andare usually expressed as a portion of each dollar of sales For example,the profit margin ratios we discuss here differ only in the numerator It’s

in the numerator that we can evaluate performance for different aspects

of the business

For example, suppose the analyst wants to evaluate how well duction facilities are managed The analyst would focus on gross profit(sales less cost of goods sold), a measure of income that is the directresult of production management Comparing gross profit with sales

pro-produces the gross profit margin:

This ratio tells us the portion of each dollar of sales that remains afterdeducting production expenses For Fictitious Corporation for 1999:

For each dollar of sales, the firm’s gross profit is 35 cents Looking

at sales and cost of goods sold, we can see that the gross profit margin isaffected by:

Gross profit margin Sales Cost of goods sold–

Sales -

0.3500 or 35%

=

■ Changes in sales volume, which affect cost of goods sold and sales.

■ Changes in sales price, which affect sales

■ Changes in the cost of production, which affect cost of goods sold.Any change in gross profit margin from one period to the next is caused

by one or more of those three factors Similarly, differences in grossmargin ratios among firms are the result of differences in those factors

To evaluate operating performance, we need to consider operatingexpenses in addition to the cost of goods sold To do this, we remove oper-ating expenses (e.g., selling and general administrative expenses) fromgross profit, leaving us with operating profit, also referred to as earnings

before interest and taxes (EBIT) The operating profit margin is therefore:

For Fictitious in 1999:

Therefore, for each dollar of sales, Fictitious has 20 cents of operatingincome The operating profit margin is affected by the same factors asgross profit margin, plus operating expenses such as:

■ Office rent and lease expenses

■ Miscellaneous income (for example, income from investments)

■ Advertising expenditures

■ Bad debt expense

Most of these expenses are related in some way to sales, though they arenot included directly in the cost of goods sold Therefore, the differencebetween the gross profit margin and the operating profit margin is due

to these indirect items that are included in computing the operatingprofit margin

Both the gross profit margin and the operating profit margin reflect acompany’s operating performance But they do not consider how these

operations have been financed To evaluate both operating and financing

decisions, we need to compare net income (that is, earnings after deducting

interest and taxes) with sales Doing so, we obtain the net profit margin:

Operating profit margin Sales Cost of goods sold– –Operating expenses

Sales -

=Earnings before interest and taxes

Sales -

=

$10,000,000 - 0.20 or 20%

The net profit margin tells us the net income generated from eachdollar of sales; it considers financing costs that the operating profit mar-gin doesn’t consider For Fictitious, for 1999:

For every dollar of sales, Fictitious generates 12 cents in profits

Recap: Profitability Ratios

The profitability ratios for Fictitious in 1999 are:

They tell us the following about the operating performance of tious:

■ Each dollar of sales contributes 35 cents to gross profit and 20 cents tooperating profit

■ Every dollar of sales contributes 12 cents to owners’ earnings

■ By comparing the 20-cent operating profit margin with the 12-cent netprofit margin, we see that Fictitious has 8 cents of financing costs forevery dollar of sales

What these ratios do not tell us about profitability is the sensitivity

of gross, operating, and net profit margins to:

■ Changes in the sales price

■ Changes in the volume of sales

Looking at the profitability ratios for one firm for one period gives

us very little information that can be used to make judgments regardingfuture profitability Nor do these ratios give us any information aboutwhy current profitability is what it is We need more information tomake these kinds of judgments, particularly regarding the future profit-

Operating profit margin = 20%

Sales -

=

$10,000,000 - 0.12 or 12%

ability of the firm For that, we turn to activity ratios, which are sures of how well assets are being used.

mea-ACTIVITY RATIOS

Activity ratios—for the most part, turnover ratios—can be used to

eval-uate the benefits produced by specific assets, such as inventory oraccounts receivable or to evaluate the benefits produced by the totality

of the firm’s assets

Inventory Management

The inventory turnover ratio indicates how quickly a firm has used

inventory to generate the goods and services that are sold The tory turnover is the ratio of the cost of goods sold to inventory:4

inven-For Fictitious, for 1999:

This ratio tells us that Fictitious turns over its inventory 3.61 timesper year On average, cash is invested in inventory, goods and servicesare produced, and these goods and services are sold 3.6 times a year.Looking back to the number of days of inventory, we see that this turn-over measure is consistent with the results of that calculation: We have

101 calendar days of inventory on hand at the end of the year; dividing

365 days by 101 days, or 365/101 days, we find that inventory cyclesthrough (from cash to sales) 3.61 times a year

Accounts Receivable Management

In much the same way we evaluated inventory turnover, we can evaluate

a firm’s management of its accounts receivable and its credit policy The

4 A common alternative to this is the ratio of sales to inventory But there is a lem with this alternative: The numerator is in terms of sales (based on selling prices), whereas the denominator is in terms of costs By including the sales price in the nu- merator, the result is not easily interpreted.

prob-Inventory turnover ratio Cost of goods sold

Inventory -

=

$1,800,000 - 3.61 times

accounts receivable turnover ratio is a measure of how effectively a firm

is using credit extended to customers The reason for extending credit is

to increase sales The downside to extending credit is the possibility ofdefault—customers not paying when promised The benefit obtained

from extending credit is referred to as net credit sales—sales on credit

less returns and refunds

Looking at the Fictitious Corporation income statement, we see anentry for sales, but we do not know how much of the amount stated is

on credit This is often the case when we analyze companies from theoutside looking in Let’s assume that the entire sales amount representsnet credit sales For Fictitious, for 1999:

Therefore, almost 17 times in the year there is, on average, a cycle thatbegins with a sale on credit and finishes with the receipt of cash for thatsale In other words, there are 17 cycles of sales to credit to cash duringthe year

The number of times accounts receivable cycle through the year isconsistent with the number of days of credit (22) that we calculated ear-lier—accounts receivable turn over 17 times during the year, and theaverage number of days of sales in the accounts receivable balance is

365 days/16.67 times = 22 days

Overall Asset Management

The inventory and accounts receivable turnover ratios reflect the fits obtained from the use of specific assets (inventory and accountsreceivable) For a more general picture of the productivity of the firm,

bene-we can compare the sales during a period with the total assets that erated these sales

gen-One way is with the total asset turnover ratio which tells us how

many times during the year the value of a firm’s total assets is generated

in sales:

Accounts receivable -

=

$600,000 - 16.67 times

Total assets -

=

For Fictitious Corporation in 1999:

The turnover ratio of 0.91 indicated that during 1999, every dollarinvested in total assets generates 91 cents of sales Or, stated differently,the total assets of Fictitious “turn over” almost once during the year.Because total assets include both tangible and intangible assets, thisturnover tells us how efficiently all assets were used

An alternative is to focus only on fixed assets, the long-term,

tangi-ble assets of the firm The fixed asset turnover is the ratio of sales to

fixed assets:

For Fictitious Corporation for 1999:

Therefore, for every dollar of fixed assets, Fictitious is able to generate

$1.43 of sales

Recap: Activity Ratios

The activity ratios for Fictitious Corporation are:

From these ratios we can determine that:

■ Inventory flows in and out almost four times a year (from the inventoryturnover ratio)

■ Accounts receivable are collected in cash, on average, 22 days after asale (from the number of days of credit) In other words, accountsreceivable flow in and out almost 17 times during the year (from theaccounts receivable turnover ratio)

Accounts receivable turnover ratio = 16.67 times

$11,000,000 - 0.91 times

Fixed assets -

=

$7,000,000 - 1.43 times

What these ratios do not tell us about the firm’s use of its assets:

■ The number of sales not made because credit policies are too stringent

■ How much of credit sales is not collectible

■ Which assets contribute most to the turnover

FINANCIAL LEVERAGE RATIOS

A firm can finance its assets with equity or with debt Financing withdebt legally obligates the firm to pay interest and to repay the principal

as promised Equity financing does not obligate the firm to pay anythingbecause dividends are paid at the discretion of the board of directors.There is always some risk, which we refer to as business risk, inherent inany business enterprise But how a firm chooses to finance its opera-tions—the particular mix of debt and equity—may add financial risk on

top of business risk Financial risk is risk associated with a firm’s ability

to satisfy its debt obligations, and is often measured using the extent towhich debt financing is used relative to equity

Financial leverage ratios are used to assess how much financial risk

the firm has taken on There are two types of financial leverage ratios:component percentages and coverage ratios Component percentagescompare a firm’s debt with either its total capital (debt plus equity) orits equity capital Coverage ratios reflect a firm’s ability to satisfy fixedfinancing obligations, such as interest, principal repayment, or leasepayments

Component Percentage Ratios

A ratio that indicates the proportion of assets financed with debt is the

debt-to-assets ratio, which compares total liabilities (short-term +

long-term debt) with total assets:

For Fictitious in 1999:

Total assets -

=

$11,000,000 - 0.4546 or 45.46%

This ratio tells us that 45% of the firm’s assets are financed with debt(both short-term and long-term).

We may also look at the financial risk in terms of the use of debt

rel-ative to the use of equity The debt-to-equity ratio tells us how the firm

finances its operations with debt relative to the book value of its holders’ equity:

share-For Fictitious, for 1999, using the book-value definition:

For every one dollar of book value of shareholders’ equity, Fictitioususes 83 cents of debt

Both of these ratios can be stated in terms of total debt, as above, or

in terms of long-term debt And it is not always clear which form—total

or long term debt—the ratio is calculated Additionally, it is often thecase that the current portion of long-term debt is excluded in the calcu-lation of the long-term versions of these debt ratios

Book Value versus Market Value

One problem with using a financial ratio based on the book value ofequity to analyze financial risk is that there is seldom a strong relation-ship between the book value and market value of a stock We can seethe distortion in values on the balance sheet by looking at the bookvalue of equity and comparing it with the market value of equity Thebook value of equity consists of:

1 The proceeds to the firm of all the stock issues since it was first porated, less any stock repurchased by the firm

incor-2 The accumulative earnings of the firm, less any dividends, since it wasfirst incorporated

Let’s look at an example of the book value versus the market value

of equity IBM was incorporated in 1911, so the book value of its equityrepresents the sum of all its stock issued and all its earnings, less anydividends paid since 1911 As of the end of 2002, IBM’s book value wasapproximately $21 billion, yet its market value was $137 billion

Book value of shareholders’ equity -

=

$6,000,000 - 0.8333 or 83.33%

Book value generally does not give a true picture of the investment

of shareholders in the firm because:

1 Earnings are recorded according to accounting principles, which maynot reflect the true economics of transactions

2 Due to inflation, the earnings and proceeds from stock issued in thepast do not reflect today’s values

Market value, on the other hand, is the value of equity as perceived byinvestors It is what investors are willing to pay So why bother withbook value? For two reasons: First, it is easier to obtain the book valuethan the market value of a firm’s securities, and second, many financialservices report ratios using book value rather than market value.However, any of the ratios presented in this chapter that use thebook value of equity can be restated using the market value of equity.For example, instead of using the book value of equity in the debt-to-equity ratio, you can use the market value of equity to measure thefirm’s financial leverage

Coverage Ratios

The ratios that compare debt to equity or debt to assets tell us about theamount of financial leverage, which enables us to assess the financialcondition of a firm Another way of looking at the financial conditionand the amount of financial leverage used by the firm is to see how well

it can handle the financial burdens associated with its debt or otherfixed commitments

One measure of a firm’s ability to handle financial burdens is the

interest coverage ratio, also referred to as the times interest-covered ratio This ratio tells us how well the firm can cover or meet the interest

payments associated with debt The ratio compares the funds available

to pay interest (that is, earnings before interest and taxes) with the est expense:

inter-The greater the interest coverage ratio, the better able the firm is to payits interest expense For Fictitious, for 1999:

Interest expense -

=

$400,000 - 5 times

An interest coverage ratio of 5 means that the firm’s earnings beforeinterest and taxes are five times greater than its interest payments.The interest coverage ratio tells us about a firm’s ability to cover theinterest related to its debt financing However, there are other costs that

do not arise from debt but which nevertheless must be considered in thesame way we consider the cost of debt in a firm’s financial obligations.For example, lease payments are fixed costs incurred in financing opera-tions Like interest payments, they represent legal obligations

What funds are available to pay debt and debt-like expenses? We

can start with EBIT and add back expenses that were deducted to arrive

at EBIT The ability of a firm to satisfy its fixed financial costs—its fixed

charges—is referred to as the fixed charge coverage ratio One

defini-tion of the fixed charge coverage considers only the lease payments:

For Fictitious Corporation, for 1999:

This ratio tells us that Fictitious’ earnings can cover its fixed charges(interest and lease payments) more than two times over

What fixed charges to consider is not entirely clear-cut For ple, if the firm is required to set aside funds to eventually or periodically

exam-retire debt—referred to as sinking funds—is the amount set aside a fixed

charge? As another example, since preferred dividends represent a fixedfinancing charge, should they be included as a fixed charge? From theperspective of the common shareholder, the preferred dividends must becovered to enable either the payment of common dividends or to retainearnings for future growth Because debt principal repayment and pre-ferred stock dividends are paid on an after-tax basis—paid out of dol-lars remaining after taxes are paid—we must translate this fixed chargeinto equivalent before-tax dollars The fixed charge coverage ratio can

be expanded to accommodate the sinking funds and preferred stock idends as fixed charges

div-Up to now we considered earnings before interest and taxes as fundsavailable to meet fixed financial charges The EBIT we have used thusfar included noncash items such as depreciation and amortization.Because we are trying to compare funds available to meet obligations, a

Fixed charge coverage ratioEarnings before interest and taxes+Lease expense

Interest+Lease expense -

better measure of available funds is cash flow from operations, which

we can find in the statement of cash flows A ratio that considers cashflows from operations as funds available to cover interest payments is

referred to as the cash flow interest coverage ratio.

The amount of cash flow from operations that is in the statement ofcash flows is net of interest and taxes So we have to add back interestand taxes to cash flow from operations to arrive at the cash flow

amount before interest and taxes in order to determine the cash flow

available to cover interest payments

For Fictitious Corporation in 1999:

This coverage ratio tells us that, in terms of cash flows, Fictitious has6.5 times more cash than is needed to pay its interest This is a better pic-ture of interest coverage than the five times reflected by EBIT Why thedifference? Because cash flow considers not just the accounting income,but noncash items as well In the case of Fictitious, depreciation is a non-cash charge that reduced EBIT but not cash flow from operations—it isadded back to net income to arrive at cash flow from operations

Recap: Financial Leverage Ratios

Summarizing, the financial leverage ratios for Fictitious Corporation for

1999 are:

These ratios tells us Fictitious uses its financial leverage as follows:

Cash flow interest coverage ratioCash flow from operations+Interest+Taxes

Interest -

=

$400,000 -

=

$2,600,000

$400,000 -=6.5 times

=