An accounting ratio is made by dividing one account item into another. The aim is to obtain a comparison that is easy and beneficial to interpret.
Financial stability ratios are tools for gauging ability to meet long-term obligations with enough working capital left to operate.
Debt ratio
| Debt ratio | = | total liabilities total assets |
Assets are service potential or future economic benefits resulting from past transactions. Assets are:
- tangible
exist physically:- land
- buildings
- machinery
- other equipment
- stock or inventory
- patent rights
- intangible
do not exist physically:- accounts receivable (money owed by customers)
- patent rights
- intellectual property, copyright
- legal claims
Liabilities are future sacrifices of future economic benefits obliged as a result of past transactions. Liabilites are:
- accounts payable
- bills payable, mortgages payable:
- overdraft (short-term: payable within next financial year)
- loans (long-term: not due within next financial year)
- securities, debentures
- wages & salaries payable
- other:
- legal claims (eg James Hardie for asbestos)
debts to creditors for goods or services purchased on credit
In case of liquidation, creditors are paid off before assets are distributed to shareholders so creditors need a meazure of how much cover they have in liquidation. They want to know the ratio of liabilities (money owed to them) over assets (to be liquidated to repay them). The smaller the ratio the safer they are.
The debt ratio is more useful to creditors than to shareholders.
The debt ratio shows how much security the assets offer to the creditor.
The debt ratio does not measure the security for shareholders.
Equity ratio or proprietorship ratio
| Equity ratio | = | total shareholders’ equity trade creditors |
Shareholders’ equity consists of:
- share capital
amount invested by shareholders - retained profits or accumulated losses
accumulated profits/losses earned and retained in the business
‘Trade creditors’ is the sum of monies owed by the business for purchases on credit.
Sometimes used instead of the debt ratio, this equity ratio is said to gauge long-term stability.
It is supposed to meazure the margin of safety for creditors at liquidation.
If preference shareholders’ equity is considered a liability then subtract it from the numerator.
To me, the margin of safety depends, not on shareholders’ equity, but on saleable assets, since some of the shareholders’ equity may be tied up on poor investments, as was done by AMP in England, Telstra in Hong Kong, BHP in Vietnam, NAB. (All these were around 1990-2004). These examples show that ‘blue-chip’ companies may survive their follies, but shareholders pay the price.
Therefore, equity is not a reliable guide to stability.
I prefer the unrecognized cents-per-dollar ratio:
| centsperdollar ratio | = | total assets – total liabilities – preference shares number of ordinary shares |
We can do several things with this:!!!!!!!!!Remind me to tune this!!!!!!
- see the true value per share
- divide this by how much we paid for the shares, to indicate the maximum cents in the dollar that we might hope for, if the company fails.
One also hopes the total assets are undervalued, since the glittering assets of an apparently-thriving business suddenly, when in liquidation, become rusty second-hand assets of no value. - divide by par-value (+ inflation) to gauge increased value
- divide by buy-back price to see if buy-back offer is low, correct or high.
If it is high, the management is buying their shares with our assets, and we should sell.
One proviso is that I would subtract from total assets, those assets attributed to recently purchased overseas companies. Generally, the managements of our Australian companies are too naive and gullible to survive overseas. They become too wrapped up by a company’s figures, and fail to understand the cultural matrix which enmeshes all dealings with, and the running of, foreign companies.
Gearing ratio or capitalization ratio
| Gearing ratio | = | total assets total (or ordinary) shareholders’ equity |
The equity ratio is said to indicate the extent that assets are financed by shareholders’ equity. A ratio of 2:1 indicates 0.5 equity, 0.5 debt. Watching the trend reveals management policy for financing expansion with long-term debt. The next ratio to supplement this, is extra-interest-paid/extra-return-received (if you can get the figures).
Times interest earned or interest coverage ratio
| Times interest earned | = | operating profits before income tax + interest expense interest expense |
This indicates the ability to meet periodic interest payments from current profits.
Thus tax and interest are added back into the ability to pay.
Roughly, the profits should be 3 to 4 times the interest, but this reading should be coupled with other trends.
Asset turnover ratio
| Asset turnover ratio | = | net sales revenue average total assets |
This indicates the return on each asset dollar; that is, the degree of capital intensity.
From this we see the relationship between return-on-assets ratio and asset-turnover ratio:
| Return on total assets | = | operating profit average total assets |
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| = | operating profit net sales revenue |
x | net sales revenue average total assets |
|
| = | profit margin | x | asset turnover |
Thus, to maximize return on assets, maximize both profit margin and asset turnover.
Asset turnover may be increased by lowering profit margin may increase.
A decrease of 0.10 (10%) in the profit margin requires an increase of 0.11 (11%) in the asset turnover to break even (keep the return equal).
Increasing the profit margin may lead to reduced turnover, sufficient to damage the return.
A common ploy is to lower profit margins on popular items, like bread and milk, to bring in the customers who then buy other goods at raised profit margins.
These raised profit margins must also cover any expensive advertising of the cheaper goods.
We move on to the return on ordinary shareholders’ equity as a function of the return on assets and the capitalization ratio:
| Return on ord equity | = | operating profit average ord equity |
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| = | operating profit net sales revenue |
x | net sales revenue aver total assets |
x | aver total assets aver ord equity |
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| = | profit margin | x | asset turnover | x | capitalization ratio | ||
| = | return on assets | x | capitalization ratio |
We can see here that to maximize the return on ordinary shareholders’ equity we must maximize the profit margin, the asset turnover and the debt finance (capitalization ratio or gearing). It shows the importance of debt finance, which, however increases interest expense and increases risk of instability. Does this mean high risk, high return on shareholders’ equity? Certainly, shareholders are advised that an unusually high return on their investment is usually associated with high risk. In contrast, the higher instability of debt finance may lead to higher turnover, and then greater profits, which may lead to lower instability.
Cash sufficiency ratios
There are 6 cash-sufficiency ratios. These ratios meazure the relative ability to meet cash flow needs from operations. The main needs are:
- debt payment
- acquisitions of assets
- dividend payment
To be useful the ratios should be compared with previous years and across the industry, to assess changing relative performance. Graphing trends should help identify future strengths and weaknesses.
Correlating shifts with changes in management policies may show relative significance of decision-making, such as multiplier effects. [I advocate long-term graphing to illustrate hidden detail and stimulate poor memories of past changes. Nonetheless, using graphs to predict the future (extrapolating) is pure hubris. We look back at old predictions and laugh or perhaps, weep.
Extrapolating assumes there will be no changes in oil prices, tax rates, currency valuations, national growth rates; that there will be no wars, terrorism, earthquakes, or storms.
Has life ever been that boring?]
Cash flow adequacy
| Cash flow adequacy | = | cash from operations long-term debt paid + assets acquired + dividends paid |
This ratio meazures the relative ability to meet the main cash requirements from operations:
- debt payment
- acquisitions of assets
- dividend payment
Assets acquired is only non-current assets because the inventories (stock) acquisition is already within the cash flow from operations.
Roughly a ratio of 1 (100%) or more, consistent over years, indicate ability to fulfil the main cash requirements.
The next 4 ratios give more information on this ability to meet main cash outflows:
- long-term debt repayment ratio
Long-term debt repayment = long-term debt repayments
cash from operations - dividend payment ratio
Dividend repayment = dividends paid
cash from operations - reinvestment ratio
Reinvestment = non-current asset payments
cash from operations - debt coverage ratio
Debt coverage = total long-term debt
cash from operationsThis gives the number of years to repay the debt, ignoring interest.
Cash flow efficiency ratios
Cash flow to sales ratio
| Cash flow to sales | = | cash from operations * 100% net sales revenue |
This should approximately equal the profit margin over time. Any difference indicates the efficiency in turning accrual-based profits into operating cash flows.
Operations index
| Operations index | = | cash from operations operating profit after tax |
The operations index tries to gauge the efficiency of generating cash from its operations. Compare over time and across the industry.
Cash flow return on assets
| Cash flow return on assets | = | cash from operations + tax paid + interest paid average total assets |
The cash flow return on assets finds the total cahs flow (including that lost to tax and interest) per dollar asset.