Citibank - Ratio Analysis

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 companys ability to meet shortterm 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 companys decisions can affect its liquidity ratios.
UNIT OBJECTIVES
When you complete this unit, you will be able to:

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Recognize the different types of financial ratios Calculate a current ratio and an acid test (quick asset) ratio Recognize how a companys decisions can affect its liquidity ratios
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FINANCIAL RATIOS LIQUIDITY
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 companys 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:
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Liquidity ratios measure the ability of the enterprise to meet its short-term financial obligations in a timely manner Leverage ratios measure the solvency or viability of the enterprise on a long-term basis Turnover ratios measure how effectively the company's assets are managed
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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:
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Current ratio 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 Ratio = 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.
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COMPANY A Current Assets Current Liabilities Current Ratio $150 $100 1.50
COMPANY B $ 80 $110 0.73
COMPANY C $400 $180 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. 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 companys own capital may be invested in financing working capital needs since suppliers will not finance either finished goods or receivables. The shoe producers probable current ratio is around 1.5, or maybe a little higher. 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 chains probable current ratio is around 1.0, since there is little or none of the supermarkets own capital invested in current assets.
Example: Shoe producer
Example: Supermarket chain
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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 producers 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:
Acid Test = 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.
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COMPANY A Current Assets Inventories Current Liabilities Current Ratio Acid Test $150 $ 20 $100 1.50 1.30
COMPANY B $ 80 $ 30 $110 0.73 0.45
COMPANY C $400 $300 $180 2.22 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:
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Cash + Near Cash as % of Current Assets Cash + Near Cash as % of Working Capital 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 companys 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 Current Assets Fixed Assets TOTAL $3,000 2,000 $5,000 LIABILITIES & NET WORTH Current Liabilities Net Worth TOTAL $2,500 2,500 $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 Current Assets Fixed Assets TOTAL $3,800* 2,000 $5,800 LIABILITIES & NET WORTH Current Liabilities Net Worth TOTAL $3,300* 2,500 $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 Current Assets Fixed Assets TOTAL $3,000 2,800* $5,800 LIABILITIES & NET WORTH Current Liabilities Net Worth TOTAL $3,300* 2,500 $5,800
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 Current Assets Fixed Assets TOTAL $3,800* 2,000 $5,800 LIABILITIES & NET WORTH Current Liabilities Net Worth TOTAL $2,500 3,300* $5,800
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 Current Assets Fixed Assets TOTAL $3,000 2,800* $5,800 LIABILITIES & NET WORTH Current Liabilities Net Worth TOTAL $2,500 3,300* $5,800
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 companys 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:
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Total indebtedness ratio, or leverage Current and long-term indebtedness ratios Fixed assets to net worth ratio Interest or debt service coverage ratios
UNIT OBJECTIVES

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Calculate a total indebtedness ratio Recognize the significance of a companys leverage ratios Identify generally appropriate leverage figures for different businesses Calculate adjusted leverage
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FINANCIAL RATIOS LEVERAGE
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 borrowers creditworthiness. From a bankers 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.
Outside Capital Calculation: Own Capital
Total Liabilities / Total Net Worth
Asset leverage
Another way of computing leverage is:

Total Assets / Total Net Worth
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This calculation emphasizes the concept of asset coverage for payment of a companys 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 Assets Liabilities Net Worth Standard Leverage Asset Leverage 1000 500 500 1.0 2.0 Company B 1000 600 400 1.5 2.5 Company C 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. Fixed assets Total assets Liabilities Net worth Leverage 700 1000 400 600 0.67
Trading Co. 100 1000 800 200 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 Total Assets Liabilities Net Worth Leverage 1000 500 500 1.0
3/31 800 300 500 0.6
6/30 1500 950 550 1.7
Table 5.3: Leverage ratios for different periods
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Financial Leverage
Earlier, we said that from the lenders perspective, the lower the leverage ratio for a company, the better. But, the borrowers interest, in the case of capital sufficiency, may differ from the bankers. From the shareholders 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.
Borrowers 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 borrowers 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 Conservative Total Assets Liabilities Net Worth Earnings Leverage Return on Equity 1000 400 600 100 0.67 16.7% Aggressively Leveraged 1000 500 500 100 1.00 20.0% Leveraged 1000 600 400 100 1.50 25.0%
Table 5.4: Financial leverage borrowers perspective
Lenders viewpoint
From the lenders 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:

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Heavy industries less than 1.0 Medium industries about 1.0 to 1.5 Retailers slightly higher, maybe at 2.0 Wholesalers slightly higher than retailers, perhaps 2.5 to 3.0 or higher 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 companys 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
Lets look at an example for Company X:

Total assets Current liabilities Long-term liabilities Net worth $M 500 200 50 300
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 Fixed assets Total assets Liabilities Net worth Computed leverage Adjusted leverage 500 1,000 500 500 1.00 1.00 After Revaluation 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 companys 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 Liabilities Net worth Corporate guarantee Leverage 500 500 200 1.0
After Default 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 companys 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 analysts 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 Total assets Liabilities Net worth Annual lease obligation Average no. of years Leverage 1,000 600 400 200 7 1.5
Adjusted 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 auditors 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 Total assets Liabilities Minority interest Net worth Leverage 1,000 500 100 400 1.50
Correct 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 companys leverage position. From the lenders point of view, low leverage indicates strong capitalization and less business risk. From the borrowers 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 companys 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
Lets 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 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
Company B 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 shortterm. 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 companys 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. Lets look at two situations for Alpha Company.
SITUATION A Current assets Fixed assets TOTAL 200 300 500 Current liabilities Net worth TOTAL 150 350 500
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 companys 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 Fixed assets TOTAL 200 400 600 Current liabilities Long-term liabilities Net Worth TOTAL 150 100 350 600
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 nonoperating 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 Macys 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 longterm debt as well:
Calculation: GOCF / (Gross interest expense + Total LTD)
The number here will be greatly influenced by the amount of longterm 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 shortand 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 lenders 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 companys 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 Inventory turnover, or days inventory Payables turnover, or days payable 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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FINANCIAL RATIOS TURNOVER
UNIT OBJECTIVES

n
Calculate the receivables turnover ratio (turnover periods in a year) Calculate days receivable (average collection time) Calculate the inventory turnover ratio (turnover periods in a year) Calculate days inventory (amount of inventory on the balance sheet date relative to the annual production) Calculate the payables turnover ratio (turnover periods in a year) Calculate days payable (average payment time) 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. 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.
Use approximate percentages
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. Lets look at the example of receivables turnover for two companies in Table 6.1.
Examples
Company A Net credit sales Trade receivables Turnover (times per year) 400 100 4.0
Company B 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. 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 one year
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 Net credit sales Trade receivables Calculation Days receivable 400 100 (100 / 400) x 360 90 Company B 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. 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. 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. Lets 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.
Average receivables for the year
Seasonality effect
Example
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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 companys ability to collect them. Judgment should be based on calculations using average numbers for the year, which give a more precise result than using yearend 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
Lets look at an example.
Company X Cost of goods sold Inventory Turnover (times per year) 600 100 6.0
Company Y 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 were 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 Cost of goods sold Inventory Calculation Days inventory 600 100 (100 / 600) 360 60
Company Y 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. 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
Consider type of inventory
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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. 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 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.
Type of company
Selling methodology
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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. 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.
Reasons for higher inventory
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 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
Lets look at an example:
Company E Total purchases Trade payables Turnover (times per year) 1,200 100 12.0
Company F 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 Fs 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. Lets calculate the days payable for the same two companies:
Company E Total purchases Trade payables Calculation Days payable 1,200 100 (100 / 1200) x 360 30 Company F 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. Lets look at the same two companies, but this time we will include a figure for cost of goods sold.
Company E 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%
Company F 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. Lets look at an 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
Example
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!
Changed 07/02/96
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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? 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.
Shorthand funds flow analysis
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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 companys 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 endof-period total assets. If there has been considerable growth in assets during the year, or if the companys 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. Lets look at an example:
Company J Net sales Total assets Turnover (times) 400 320 1.25 Company K 600 720 0.83
Example
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. 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.
Compare with similar firms
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 Return on Assets Return on Equity
UNIT OBJECTIVES

n
Calculate the three profitability ratios: return on sales, return on assets, and return on equity Recognize the DuPont formula for calculating ROE Calculate ROE using the DuPont formula
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FINANCIAL RATIOS PROFITABILITY
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 = Net Sales x 100
Let's compare the profits for Company A and Company B.

Company A Net income Net sales Ratio Table 7.1: Profit comparison $ 20 $200 10.0% Company B $ 100 $4,000 2.5%
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 = Average Assets x 100
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 = Average Net Worth x 100
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 clients 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 $ 20 $2,000 19X1 $ 60 $2,400
Net income Stockholders equity
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
Lets 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 companys operations how much it makes on every $1.00 of sales. Lets 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 Net Income Net Sales X Turnover Net Sales Total Assets = ROA Net Income i 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 nonproductive 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 Lets take this another step. If we multiply return on assets by asset leverage, we obtain return on equity.
Asset Leverage X Total Assets Net Worth
ROA Net Income Total Assets
ROE
Net Income 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 Turnover Asset Leverage X Total Assets = Net Worth
ROS Net Income X Net Sales
ROA
ROE Net Income Net Worth
Net Sales = Net Income ; Total Assets Total Assets
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Example
Lets 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.
Net Sales Average Assets Average Net Worth Net Income Return on Sales Return on Assets Return on Equity
Company X Company Y Company Z 1000 1000 1000 1500 800 400 900 400 100 180 18.0% 12.0% 20.0% 8.0% 10.0% 20.0% 80 2.0% 5.0% 20.0% 20
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 Company X Company Y Company Z 18.0% 8.0% 2.0%
Net Sales Total Assets 0.67 1.25 2.50
Net Income Total Assets = = = 12.0%; 10.0%; 5.0%;
X Total Assets Net Worth X X X 1.67 2.00 4.00
Net Income Net Worth = = = 20.0% 20.0% 20.0%
X X X
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 Ys multipliers are higher than Xs, but lower than Zs. 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 Zs 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.
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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 LIQUIDITY Current Acid Test OPERATING Days Receivables Days Inventory Days Payables Assets Turnover LEVERAGE Total Indebtedness COVERAGE Interest Coverage Debt Service Ratio PROFITABILITY Return on Sales Return on Assets Return on Equity GOCF I Gross Interest Expense GOCF I Gross Int Exp + Current Portion LTD Net Income Net Sales I x 100 x 100 x 100 The higher, the better The higher, the better Total Liabilities I Tangible Net Worth The lower, the better FORMULA Current Assets Current Liabilities Cash + Near Cash Assets + Trade Receivables Current Liabilities Average Trade Receivables x 360 Net Credit Sales Average Inventories Cost of Goods Sold x 360 x 360 EVALUATION The higher, the better The higher, the better
The lower, the better, generally The lower, the better, generally The higher, the better, generally The higher, the better, generally
Average Trade Payables Total Purchases Net Sales I Average Total Assets
The higher, the better The higher, the better The higher, the better
Net Income I Average Total Assets Net Income I Average Net Worth
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Citibank - Ratio Analysis

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UNIT 4: FINANCIAL RATIOS LIQUIDITY

When you complete this unit, you will be able to:

FINANCIAL RATIOS LIQUIDITY

FINANCIAL RATIOS LIQUIDITY

Profitability ratios measure the efficiency of operations within the enterprise

Current ratio Acid test (or quick asset) ratio

FINANCIAL RATIOS LIQUIDITY

COMPANY B $ 80 $110 0.73

COMPANY C $400 $180 2.22

Testing the ratio

FINANCIAL RATIOS LIQUIDITY

Example: Shoe producer

Example: Supermarket chain

FINANCIAL RATIOS LIQUIDITY

FINANCIAL RATIOS LIQUIDITY

COMPANY B $ 80 $ 30 $110 0.73 0.45

COMPANY C $400 $300 $180 2.22 0.55

FINANCIAL RATIOS LIQUIDITY

Other Liquidity Indicators

FINANCIAL RATIOS LIQUIDITY

HOW LIQUIDITY RATIOS CHANGE

* An $800 increase over the starting point.

The current ratio for this balance sheet is 1.15.

FINANCIAL RATIOS LIQUIDITY

* An $800 increase over the starting point.

The current ratio is now 0.91.

fixed assets causes liquidity to deteriorate.

* An $800 increase over the starting point.

The current ratio is now 1.52.

current assets improves liquidity.

FINANCIAL RATIOS LIQUIDITY

* An $800 increase over the starting point.

The liquidity ratio is 1.20.

UNIT 5: FINANCIAL RATIOS LEVERAGE

When you complete this unit, you will be able to:

FINANCIAL RATIOS LEVERAGE

TOTAL INDEBTEDNESS (LEVERAGE)

Total Liabilities / Total Net Worth

Another way of computing leverage is:

FINANCIAL RATIOS LEVERAGE

Table 5.1: Comparison of standard leverage and asset leverage

FINANCIAL RATIOS LEVERAGE

Trading Co. 100 1000 800 200 4.0

Table 5.2: Leverage relative to the amount of fixed assets

3/31 800 300 500 0.6

6/30 1500 950 550 1.7

Table 5.3: Leverage ratios for different periods

FINANCIAL RATIOS LEVERAGE

Table 5.4: Financial leverage borrowers perspective

FINANCIAL RATIOS LEVERAGE

Correct leverage figure

In summary, the normal leverage ratios generally are as follows:

FINANCIAL RATIOS LEVERAGE

Tangible Net Worth

Lets look at an example for Company X:

Utilizing stated net worth, the total indebtedness ratio is 0.83:

FINANCIAL RATIOS LEVERAGE

Table 5.5: Leverage with and without revaluation surplus

FINANCIAL RATIOS LEVERAGE

After Default 700 500 0 1.4

Table 5.6: Increased leverage after default

FINANCIAL RATIOS LEVERAGE

Adjusted 2,400 2,000 400