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SECTION Evaluating the Operations of the Business III Fast food outlets, therefore, turn over inventory at a tremendous rate and generate continuous streams of cash. At any one point, the company may not have large amounts of cash on hand if it is using cash to retire longer-term debt or to acquire additional fixed assets. By comparing the company’s own historic trend in the current ratio, and examining those ratios with other fast food outlets, you can perhaps see that a 1:4 ratio may be even better than a 1:2 ratio. The traditional rule of thumb may not be applicable or representative of the fast food industry. The point of this example is that you should consider those ratios that make sense for the business, give usable management information, and can be obtained on a timely basis. Figure 6.1 shows a balance sheet and statement of earnings that will be used to demonstrate the financial ratios. Types of Financial Ratios Liquidity Ratios Liquidity ratios give an indication of a company’s ability to meet short-term obligations. These ratios give some insight into the present cash solvency and are a measure of the company’s ability to meet adversity. Generally, liquidity ratios look at the short-term assets or resources and the short-term debts and obligations. Current Ratio. ratio of: As discussed in Chapter 5, the current ratio is the Current assets

Current liabilities For Fruit Crate Manufacturing Co., Inc., the current ratio for 2006 is: $276,055

= 2.81:1 $98,294 Supposedly, the higher the ratio, the better the company’s ability to pay bills. However, the ratio does not take into account how 182 Performance Measurement Systems CHAPTER 6 FIGURE 6.1 Sample Balance Sheet and Statement of Earnings Fruit Crate Mfg. Co., Inc. Assets Current Assets Cash and marketable securities Accounts receivables Inventories Prepaid expenses Accumulated prepaid tax Current assets Fixed Assets Fixed assets Less: Accumulated depreciation Net fixed assets Long-term investment Other Assets Goodwill Debenture discount Other assets Total Assets 2006 2005 $21,285 83,473 164,482 2,554 4,261 $20,860 91,155 157,698 2,049 3,475 $276,055 $275,237 $198,760 107,330 $91,430 $192,666 99,030 $93,636 $8,229 $-0- $23,839 751 $23,839 833 $24,590 $24,672 $400,304 $393,545 Liabilities and Net Worth Current Liabilities Bank loans and notes payables Accounts payable Accrued taxes Other accrued liabilities Current liabilities 2006 2005 $53,638 17,560 4,321 22,775 $42,544 16,271 15,186 19,608 $98,294 $93,609 Long-term debt $75,562 $74,262 Stockholders’ equity Common stock @ $1 par value Capital surplus Retained earnings $50,420 43,179 132,849 $50,420 43,016 132,238 Total stockholders’ equity $226,448 $225,674 Total Liabilities and Net Worth $400,304 $393,545 (continued) 183 SECTION Evaluating the Operations of the Business III FIGURE 6.1 (continued) Fruit Crate Mfg. Co., Inc. Statement of Earnings Net sales Cost of goods sold Selling, general and administration expense Depreciation Interest expense Expenses 2006 $492,374 2005 $464,383 $330,383 $311,601 98,475 13,786 10,340 90,555 14,396 8,823 $452,984 $425,375 Earnings before taxes Less: Income taxes $39,390 18,907 $39,008 19,114 Earnings after taxes Less: Cash dividend $20,483 12,495 $19,894 12,732 $7,988 $7,162 Retained earnings liquid the “current” assets really are. For example, if the current assets are mostly cash and current receivables, these are more liquid than if most of the current assets are in inventories. To refine the ratio as a measure, we eliminate the effect of inventories, prepaid expenses, and prepaid tax, which gives us this acid test ratio: Acid Test Ratio Current assets − (Inventories + Prepaids)




Current liabilities For Fruit Crate Manufacturing Co., Inc.: $276,055 − 171,297


= 1.066:1 $98,294 The acid test ratio eliminates the least liquid components of the current assets and therefore focuses on the assets most easily converted to debt payment. Liquidity of Receivables. Analyzing the current assets by components enables the company to detect problems in its liquidity. One thing that can be examined is how current the receivables are. 184 Performance Measurement Systems CHAPTER 6 Receivables are a liquid asset only if they can be collected in a reasonable time. The first of two ratios that examine receivables is average collection period ratio: Receivables × Days in year



Annual credit sales For Fruit Crate Manufacturing Co., Inc., the average collection period rate for 2006 is (assuming all sales are credit sales): 83,473 × 365

= 62 days 492,374 This tells that the average collection period receivables are outstanding, in other words, how long, on average, the company waits to convert receivables to cash. The second basic receivable ratio is the receivable turnover ratio: Annual credit sales


Average receivables For Fruit Crate Manufacturing Co., Inc., the receivables turnover ratio is: $492,374

= 5.90 times $83,473 If there is no figure for the amount of credit sales, you must resort to the total sales figure. Care should be taken to analyze all ratios, especially receivables ratios. Often the numbers available are year-end numbers, which may not recognize seasonal fluctuations or significant, steady growth. If there are significant seasonal sales, the average of the monthly closing balances may be a more appropriate figure to use. If the company is experiencing a steady growth in sales, the year-end receivables will not match accurately with the annual sales figure. If this is the case, the number may be calculated based on the annualized sales from the last six months and the end-of-year level of receivables. Some questions to ask when analyzing these ratios are: • How does the average collection period compare with the sales terms? For Fruit Crate Manufacturing Co., Inc., the credit terms 185 SECTION Evaluating the Operations of the Business III are 2/10, n/60. The bulk of the collections are made around the due date. • How does the collection period compare with others in the industry? This can give some insight into the investment in receivables. • Is the average collection period so low that it may be inhibiting sales? The firm may have an excessively restrictive credit policy. • How old are the receivables? Here you must ask “What does the average tell us?” Fruit Crate Manufacturing Co., Inc., had 433 accounts and found the average collection period ratio was 62 days. But when it grouped the accounts by age it discovered these statistics: Number of Accounts Paid in How Many Days? 110 (25%) 80 (18%) 170 (39%) 73 (18%) 10 30 60 180 days Eighty-two percent of the receivables are collected before or by the due date, and only 18 percent extend beyond the due date. But the late receivables are really late: averaging six months after shipment of goods and four months after payment was due. Adding an aging of receivables provides more usable information than the average collection period ratio alone. This tells: • Where collection efforts need to be concentrated • How much investment the company has in receivables • Accounts that may require discontinuation of service • Whether the terms are speeding up the recovery of receivables Another question the aging would raise is: “Are the good accounts paying in the 10–30 period taking the cash discounts even though they have no right to it?” If the answer is yes, the cash discount terms are really 2/30, n/60. 186 Performance Measurement Systems CHAPTER 6 Debt Ratios Up to now, we have been concerned with short-term liquidity measures. Depending on the use, certain long-term solvency ratios may be of interest to a company and its investors. These ratios give an indication of the company’s ability to meet long-term obligations. Debt to Net Worth. This ratio is computed by dividing the total debt, including current liabilities, by the net worth (total stockholders’ equity). For Fruit Crate Manufacturing Co., Inc.: Total debt $98,294 + 75,562 $173,856

=


=

= .77:1 Net worth $226,448 $226,448 Frequently, intangible assets, if relatively large, are deducted from net worth to obtain the tangible net worth. Note that for the liquidity ratios discussed earlier, we used assets divided by liabilities. Here we are creating debt ratios—putting liabilities over other measures. For liquidity, the higher the number, the “better” the ratio. For debt ratios, the reverse is true: The lower the number, the “better” the ratio. Sometimes in computing this ratio, preferred stock is included with debt instead of net worth. This acknowledges that preferred stock represents a claim superior to the claim of common stockholders. It also points out that when using “comparable ratios,” you must be certain that the calculations are truly comparable; that is, you must compare the definitions of the ratios. The debt to net worth ratio varies from industry to industry. One factor often contributing to this variation is the volatility of cash flows. The more stable and predictable the cash flow, the greater the debt you may be able to service consistently. Because this ratio is a good measure of ability to pay debts over time, it sometimes is used as a measure for approximating financial risk. Debt to Total Capital. Another useful debt ratio is the ratio of total debt to total capital. In this ratio, only the long-term capitalization of the firm is considered. Long-term debt


Total capitalization 187 SECTION Evaluating the Operations of the Business III The total capitalization is composed of long-term debt and net worth. For Fruit Crate Manufacturing Co., Inc.: $75,562 $75,562


=

= .25:1 $75,562 + 226,448 $302,010 This ratio shows the importance of long-term debt financing relative to other financing in the capital structure. When computing this ratio, it may be more informative to use market values instead of book values for the stock components. (Book values were used in the preceding calculation.) If market values of stock are available, this computation may indicate a very different leverage factor. Coverage Ratios Coverage ratios are used to examine the relationship between finance charges and a company’s ability to service them. One of the traditional coverage ratios is the interest coverage ratio. To compute this ratio for a given period, divide the annual earnings before interest and taxes by the interest charges for the period. Different coverage ratios use different interest charges in the denominator. For example: The overall coverage method considers all fixed interest regardless of the seniority of the claim. By ignoring the seniority of some debt, the implication is that senior debt obligations are only as secure as the ability to meet all debt servicing. A method that gives some consideration to the seniority of debt is the cumulative deduction method. For cumulative deduction methods, assume these hypothetical data: Fruit Crate Manufacturing Co., Inc., has: $49,730 = earnings before interest and taxes ($39,390 + 10,340) $4,210 = interest on 7% senior notes. $6,130 = interest on 9% junior notes. The coverage on the senior notes would be: $49,730
= 11.81 times $4,210 188 Performance Measurement Systems CHAPTER 6 The coverage on the junior notes, after the senior debt has been covered, is: $49,730 − 4,210

= 4.40 times $10,340 Using this method, the coverage ratio on the junior notes takes into consideration the fact that there are outstanding senior obligations. Both of these methods ignore the fact that the payment of interest is only part of the obligation covered by debt service. Debt service includes payment of both interest and principal. And because these payments are made from cash, a more appropriate ratio may be the cash flow coverage ratio. One adjustment should be made in computing this ratio. Interest payments are accounted for before taxes, whereas principal payments are treated as after-tax dollars. To adjust for the tax effect, you must adjust the principal by the factor [1/(1 − t)], where t is the effective tax rate. So: Annual cash flow before interest and taxes Cash flow coverage ratio =



Interest and principal [1/(1 − t)] If you had a $10,000/year principal payment and a 46 percent tax rate, it would require: $10,000 × [1/(1 − .46)] or $10,000 × (1.85), or $18,500 in before-tax dollars to meet that principal obligation This type of analysis can, in some cases, be expanded to consider other fixed obligations, such as dividends on preferred stock, lease payments, and long-term essential capital expenditures. Debt ratios or coverage ratios may not give an accurate picture of the company’s ability to meet obligations. Because of the timing of the payment of debt obligations, the average interest rates, and other factors, you may wish to calculate other ratios showing the relationship of profitability to sales or to investment. 189 SECTION Evaluating the Operations of the Business III Profitability Ratios When the profitability on sales ratio and the profitability on investment ratios are considered, they can give an indication of your efficiency of operation. The first such ratio is the gross profit margin. For Fruit Crate Manufacturing Co., Inc., the gross profit margin is: $492,374 − 330,383 $161,991


=

= 33% $492,374 $492,374 This ratio gives the percentage of profit relative to the sales after deducting the cost of goods sold. A more reflective ratio of profitability is the net profit margin: Net profit (after taxes)


Sales For Fruit Crate Manufacturing Co., Inc., the net profit margin is: $20,483

= 4.2% $492,374 This ratio gives a measure of overall efficiency after taking into consideration expenses and taxes but not extraordinary charges. With these two ratios you can, over time, evaluate operational changes. For example, if the gross profit margin remained relatively constant over time, but the net profit margin declined, it shows that either the tax rate has changed or selling and administrative expenses have increased. The relative change between these ratios can identify areas where management attention may be necessary. As another example, if the gross profit margin declines, the cost of goods sold has increased. This could signal several things: • The firm may have had to lower its product prices to be competitive. • The cost of labor, materials, or purchased components may have increased. • Overall efficiency may have declined. 190 Performance Measurement Systems CHAPTER 6 Another group of profitability ratios relate profits to investment. For example, the formula for the rate of return on common stock equity is: Net profit after taxes − Preferred stock dividend





Net worth − Par value of preferred stock For Fruit Crate Manufacturing Co., Inc. (no preferred stock involved): $20,483

= 0.90 or 9% $226,448 This ratio gives an indication of the earning power on the book investment of the shareholders’ interest. A more general ratio used to analyze profitability is the return on assets ratio. Use this formula to calculate this ratio: Net profits (after taxes)


Total assets (tangible) For Fruit Crate Manufacturing Co., Inc.: $20,483

= 5.5% $375,714 Profits are considered after interest is paid to creditors; to some extent this ratio may be inappropriate because some of these same creditors provide the means by which part of the assets are supported. When the finance charges are large, it may be better for comparative purposes to calculate a different ratio. An arguably more appropriate ratio may be the net operating profit rate of return. It is calculated as follows: Earnings before interest and taxes



Total assets (tangible) For Fruit Crate Manufacturing Co., Inc.: $49,730

= 13.24% $375,714 191