Question

Explain the major financial ratios and financial cycles, debt ratio, debt to equity ratio, return on assets, return on equity, current ratio, quick ratio, inventory turnover, days in inventory, accounts receivable turnover, accounts receivable cycle in days, accounts payable turnover, accounts payable cycle in days, earnings per share (EPS), price to earnings ratio (P/E), and cash conversion cycle (CCC) and state the significance of each for financial management. Include examples based on a hypothetical balance sheet and income statement.

Answer 1

What Is a Financial Ratio?

A financial ratio is a metric usually given by two values taken from a company’s financial statements that compared give five main types of insights for an organization. Things such as liquidity, profitability, solvency, efficiency, and valuation are assessed via financial ratios. Those are metrics that can help internal and external management to make informed decisions about the business.

Why Ratio Analysis?

Ratio Analysis allows us to answer questions such as: How profitable is the company? Will the organization be able to meet its obligations in the short and long-term? How effectively is the organization using its resources?

Of course, some of the ratios (such as the profitability ratios) if not assessed against other ratios do not mean anything. Also, if you want to know more about one company you have to analyze it in comparison with other companies which present the same characteristics, such as industry, geography, customers and so on.

For example, if you are performing an analysis on Apple Inc., you cannot compare its ratios with Coca-Cola. Instead, you should compare Apple Inc. with Samsung or Microsoft.

What is liquidity?

Liquidity is the capacity of a business to find the resources needed to meet its obligations in the short-term.

For such reason, the liquidity on the Balance Sheet is measured by the presence of Current Assets in excess of Current Liabilities or the relationship between current assets and current liabilities.

Why do we need to assess the liquidity of a business?

For several reasons; Imagine, you are establishing contact with a new supplier. There is no precedent history between you two. The supplier wants some sort of guarantee that you will be able to meet future obligations.

What are the main liquidity ratios?

Current Ratio

his ratio shows the relationship between the company’s current assets over its current liabilities. It measures the short-term capability of a business to repay for its obligations:

Current Assets / Current Liabilities

Example: Imagine, your organization, in Year-Two has total current assets for $100K and total current liabilities for $75K. Therefore: 100/75= 1.33 times. Your Current ratio is 1.33.

Is it good or bad? Well, it depends.

You have to compare this data with the previous year ratio. Also, it depends on the kind of industry you are operating within. Of course, a clothing store or specialty food store will have a much higher current ratio.

Thereby the current assets will be 4 or 5 times the current liabilities, mainly due to large inventory“>inventories. Other companies, such as the ones operating in the retail industry can have current ratios lower than 1, due to favorable credit condition from their suppliers.

This allows them to operate with a low level of inventory“>inventories. For example, companies such as Burger King will have a ratio as high as 1.5, while companies such as Wal-Mart as low as 0.3.

Quick Ratio (Acid or Liquid Test)

On the Balance Sheet (BS) the items are listed from the most liquid (cash) to the least liquid (inventory“>inventories and prepaid expenses). The first section of the BS shows the current assets subsection (part of the Assets section).

Current Assets are those converted in cash within one accounting cycle. Therefore, while the current ratio tells us if an organization has enough resources to pay for its obligations within one year or so, the Quick ratio or acid test is a more effective way to measure liquidity in the very short-term. Indeed, the quick ratio formula is:

Liquid Assets / Current Liabilities

How do we define liquid assets? Liquid assets are defined as Current Assets – (inventory“>Inventory + Pre-paid expenses). Although inventory and pre-paid expenses are current assets, they are not always turned into cash as quickly as anyone would think.

Example: Imagine that of $100K of current assets. Of which $80K are liquid assets, the remaining portion is inventory“>inventory. The liability stays at $75k.

The quick ratio will be 1.06 times or $80K/$75K. Therefore, the liabilities can be met in the very short-term through the company’s liquid assets. To assess if there was an improvement on the creditworthiness of the business we have to compare this data with the previous year.

Although, a quick ratio of over 1, can generally be accepted, while below one is usually seen as undesirable since you will not be able to pay very short-term obligations unless part of the inventory“>inventories is sold and converted into cash.

What is Solvency?

The solvency ratios also called leverage ratios to help to assess the short and long-term capability of an organization to meet its obligations. In fact, while the liquidity ratios help us to evaluate in the very short-term the health of a business, the solvency ratios have a broader spectrum.

What are the main solvency ratios?

The main solvency ratios are:

• Debt to equity ratio
• Interest Coverage Ratio
• Debt to Assets

Debt to equity ratio

This ratio explains how much more significant is the debt in comparison to equity. This ratio can be expressed either as number or percentage. The formula to compute the debt to equity ratio is:

Total Liabilities / Shareholders’ Equity

The debt to equity ratio is also defined as the gearing ratio and measures the level of risk of an organization. Indeed, too much debt generates high-interest payments that slowly erode the earnings.

When things go right, and the market is favorable companies can afford to have a higher level of leverage. However, when economic scenarios change such companies find them in financial distress.

Indeed, as soon as the revenues slow down, they are not able to repay for their scheduled interest payments. Therefore, those companies will have to restructure their debt or face bankruptcy, as happened during the 2008 economic downturn to many businesses.

Imagine that you own a Coffee Shop and in the second year of operations, (after many investments to buy new fancy machines) the balance sheet shows $200K in total liabilities and $50K in equity.

This means that your debt to equity ratio is 4 or 200/50. Is it good or bad? Of course, a gearing ratio of 4 is very high. This means that if things go wrong for a few months, you will not be able to sustain the business operations.

Not all contracted debt is negative. Indeed, debt that allows you to pay fixed interest helps companies to find their optimal capital structure. Instead, any increase in interest payments may result in burdening indebtedness and consequently to financial distress.

A debt to equity ratio of 4 is extremely high although we want to compare it against previous year financials and the leverage of competitors as well. If we go back to the coffee shop example, a debt to equity ratio of 4 is ok if all the other coffee shops in the neighborhood operate with the same level of risk.

It can be that operating margins for the coffee shop are so high that they can handle the debt burden. Imagine the opposite scenario, where all the coffee shops in the area operate with a leverage of 2.

If the price of the raw materials skyrocket, you will have to raise the cost of the coffee cup. This, in turn, will slow down the revenues. While many coffee shops in the neighborhood will be able to handle the situations, your coffee shop with a gearing of 4 will go bankrupt after a while.

What is efficiency?

Efficiency is the ability of a business to quickly turn its current assets in cash that can help the business grow. In fact, the way you manage the inventories, accounts receivables and accounts payables that is critical to the short-term business operations.

What are the main efficiency ratios?

They assess if an organization is efficiently using its resources.  The primary efficiency ratios are:

• Inventory Turnover
• Accounts Receivable Turnover or collection period
• Accounts Payable Turnover

These ratios are called turnover since they measure how fast current and non-current assets are turned over in cash.

Inventory Turnover

This ratio shows how the well the inventory level is managed and how many times inventory is sold during a period. The faster an organization can turn its inventory in sales, the more efficient and effective it is. This ratio is expressed in number. The formula is:

Cost of Goods Sold / Average inventory“>Inventory Cost

Imagine that your coffee shop at the end Year Two sold $100K of coffee cups, with a $40K gross income. The inventory“>inventory at the beginning of the year was $6K and at the end of the year was $8K. How do we compute our inventory turnover ratio?

1. Compute our CoGS. As you know we had $100K in sales and $40K in gross income. Therefore our CoGS will be 100 – 40 = $60K.

2. Compute our average inventory“>inventory. The beginning and ending balances were respectively $10,000 and $12,000, therefore our average inventory“>inventory will be: (10,000 + 12,000)/2 = $11,000.

3. Compute the inventory ratio given by COGS/Average inventory, therefore: 60,000/11,000 = 5.45 times.

This means that in one year time the inventory“>inventory will be sold 5.45 times. How do we know how long it will take for the average inventory“>inventory to be turned in sales?

Well, to compute the days it will take to turn the inventory“>inventory in sales, compute the following formula:

  365 days/5.45 times = 67 days

Through this ratio, you know that every 67 days your inventory“>inventory will be turned in sales. A high inventory ratio indicates a fast-moving inventory and a low one indicates a slow-moving inventory“>inventory.

Of course, a ratio of 5.45 is great since it means no capital is tied up to inventory“>inventories and you are using the liquidity more efficiency to run the business. However, this ratio needs to be compared within the same industry.

Accounts Receivable Turnover or collection period

This ratio measures how many times the accounts receivable can be turned in cash within one year. Therefore, how many the company was able to collect the money owed by its customers.  It is expressed in number, and the formula is:

Sales or Net Credit Sales / Average Accounts Receivable

The net credit sales are those that generate receivable from customers. Indeed, each time a customer buys goods, if the payment gets postponed at a later date, this event generates receivable on the balance sheet.

Therefore, the transaction will be recorded as revenue on the income statement and an account receivable on the balance sheet. Imagine the coffee shop you run sold $100K of coffee bags, of which $50K in gross credit sales. Of the $50K in gross credit sales, $10K of coffee bags was returned.

The accounts receivable previous year balance was $12,000, while this year $10,000. How do we compute the accounts receivable turnover?

1. Compute our nominator, the net credit sales. This is given by the gross credit sales minus the returned product. Therefore: 50,000 – 10,000 = $40K of net credit sales.

2 Compute the average inventory“>inventory that is given by the average between previous and current year, therefore: (12,000 + 10,000)/2 = $11,000 average receivable.

3. Compute the receivable turnover given by the net credit sales over the average inventory. Therefore: 40,000/11,000 = 3.64 times.

It means that the receivables were turned into cash 3.64 times in one year.

To know how many days it took to collect the money lumped in the receivable we will use the formula below:

365/3.64 = 100

The receivables were turned into cash in 100 days. This is a good receivables level it means that you can collect money from your customers on average every 100 days.

When the receivable level is too low, usually companies turn their attention to the collection department and make sure they make the collection period as short as possible. Indeed, this will give additional liquidity to the business.

Accounts Payable Turnover Ratio

This ratio shows how many times the suppliers were paid off within one accounting cycle. This ratio is expressed in number, and the formula is:

Credit Purchases / Average Accounts Payable

The payable turnover ratio is the flip side of the receivable ratio. The credit purchases are those, which generate payable on the company’s balance sheet.

Therefore, each time purchase on credit is made, this will show as CoGS on the income statement and an account payable on the balance sheet. Imagine that at the end of the year were purchased $25K of raw materials from suppliers, although, $5K was returned.

The accounts payable was $5K on the previous year and $7K this year. How do we compute the accounts payable turnover?

1. Compute the net purchase amount given by the gross purchase amount minus the returned supplies, therefore: 25K – 5k = $20K of net purchases.

2. Compute the average payable. In year one the payable was $5K and $7K in year two. Therefore: (5K + 7K)/2 = $6K in accounts payable.

3. Compute the payable turnover given by the net purchases over the average accounts payable = 20K/6K = 3.3 Times.

The supplier during the current year was paid 3.3 times; it means that every 110 days (365/3.3) the debt with the suppliers has been paid off. Keeping a high payable turnover is crucial to conduct business.

Indeed, suppliers will assess whether or not to entertain business with an organization based on its capability to quickly repay for its obligations.

What Is Return on Assets—ROA?

Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets. ROA gives a manager, investor, or analyst an idea as to how efficient a company's management is at using its assets to generate earnings. Return on assets is displayed as a percentage.

RETURN ON ASSETS = NET INCOME /TOTAL ASSETS

Return on Equity

This is the relationship between net income and shareholder equity or, the amount of revenue generated by the shareholder’s investment in the organization. This is one of the most used ratios in finance. The formula for the ROE is:

(Net Income / Shareholders Equity) x 100%

Imagine the net income of Company XYZ in Year-Two was $20K and you invested $100K. Therefore the ROE is (20/100) x 100% = 20%.  Also, an increasing ROE is a good sign.

It means that the shareholders are getting rewarded overtime for their risky investment. This leads to more future investments by other shareholders and the appreciation of the stock.

The ROE itself is often used without caution. In fact, the problem of this ratio lies in its denominator. Indeed, the management can control Shareholders’ Equity.

How? For instance, the Net Income is produced through assets that the company bought. Assets can be acquired either through Equity (Capital) or Debt (Liability).

Consequently, when companies decide to finance their assets through Debt, usually revenue accelerate at a higher speed compared to interest expenses. This leads to a higher Net Income, although a lower Shareholders’ Equity.

That, in turn, generates an artificially high Return on Equity.  For such reason, it is important to use this ratio cautiously and in conjunction with other leverage ratios as well (such as the Debt to Equity ratio).

What is valuation?

Valuation is a very tricky part of finance. Indeed, valuing a company means assessing how much that is worth. Valuing is so hard since the resources a company has been organized in a way for which it becomes challenging to determine the final value.

In addition, we have the human capital aspect that is also very difficult to assess. For such reason, valuation can be considered more of an art than a science. We are going to list the main valuation ratios here.

Indeed, it is essential as well to know what are the main valuation ratios also to understand whether a company is over or undervalued. In other words, valuation ratios assess the perception of the market of a certain company.

This does not mean that “Mr. Market” is always right. Quite the opposite; for instance, if we find a company that is doing extremely well regarding profitability, liquidity, leverage, and efficiency but Mr. Market does not like it; it might be useful to understand why.

If the reason stands behind things that Mr. Market knows and we don’t, I still would not buy it. On the other hand, if Mr. Market simply does not like that stock because it considers it “boring,” then I would give a thought about buying it.

What are the main valuation ratios?

The primary valuation ratios are:

• Earnings per Share
• Price/Earnings
• Dividend Yield
• Payout Ratio

Earnings Per Share

This ratio tells us what is the return for every single share. The formula is given by:

(Net Income – Preferred Dividends) / Weighted Average Number of Common Shares

When the ratio is increasing over time it means that the company may represent a good investment for its shareholders (although it must be weaved with other ratios before we can assess whether it is a good investment).

Price/Earnings Ratio

This ratio tells us how many times over its earnings the market is valuing the stock:

(Net Income – Preferred Dividends) / Weighted Average Number of Common Shares

A higher Price/Earnings ratio can be useful to a certain extent. For instance, technological companies tend to have a higher P/E ratio compared to others. Although, when the P/E is too high this may be due to speculations.

What Is the Cash Conversion Cycle (CCC)?

The cash conversion cycle (CCC) is a metric that expresses the time (measured in days) it takes for a company to convert its investments in inventory and other resources into cash flows from sales. Also called the Net Operating Cycle or simply Cash Cycle, CCC attempts to measure how long each net input dollar is tied up in the production and sales process before it gets converted into cash received.

The Formula for CCC

Since CCC involves calculating the net aggregate time involved across the above three stages of the cash conversion lifecycle, the mathematical formula for CCC is represented as:

CCC=DIO+DSO−DPO

where:DIO=Days of inventory outstanding(also known as days sales of inventory)DSO=Days sales outstandingDPO=Days payables outstanding​

Calculating CCC

A company’s cash conversion cycle broadly moves through three distinct stages. To calculate CCC, you need several items from the financial statements:

• Revenue and cost of goods sold (COGS) from the income statement;
• Inventory at the beginning and end of the time period;
• Account receivable (AR) at the beginning and end of the time period;
• Accounts payable (AP) at the beginning and end of the time period; and
• The number of days in the period (e.g. year = 365 days, quarter = 90).

DIO, also known as DSI, is calculated based on cost of goods sold (COGS), which represents the cost of acquiring or manufacturing the products that a company sells during a period. Mathematically,

DSI = (AVG. INVENTORY / COGS) X 365 DAYS

The second stage focuses on the current sales and represents how long it takes to collect the cash generated from the sales. This figure is calculated by using the Days Sales Outstanding (DSO), which divides average accounts receivable by revenue per day. A lower value is preferred for DSO, which indicates that the company is able to collect capital in a short time, in turn enhancing its cash position.

DSO = AVG. ACCOUNTS RECEIVALE / REVENUE PER DAY

The third stage focuses on the current outstanding payable for the business. It takes into account the amount of money the company owes its current suppliers for the inventory and goods it purchased, and represents the time span in which the company must pay off those obligations. This figure is calculated by using the Days Payables Outstanding (DPO), which considers accounts payable. A higher DPO value is preferred. By maximizing this number, the company holds onto cash longer, increasing its investment potential.

DPO = AVG. PAYABLES / COGS PER DAY