Home > Economics & Finance > Ratio Analysis (Part III)

Ratio Analysis (Part III)

Activity

12. Asset Turnover = Revenue / Total Assets

Indicates the relationship between assets and revenue.

Things to remember

    * Companies with low profit margins tend to have high asset turnover, those with high profit margins have low asset turnover – it indicates pricing strategy.

    * This ratio is more useful for growth companies to check if in fact they are growing revenue in proportion to sales.

Asset Turnover Analysis:
This ratio is useful to determine the amount of sales that are generated from each dollar of assets. As noted above, companies with low profit margins tend to have high asset turnover, those with high profit margins have low asset turnover. Cory’s Tequila Co.’s asset turnover seems to be relatively low, meaning that it makes a high profit margin on its products. For companies in the retail industry you would expect a very high turnover ratio – mainly because of cutthroat and competitive pricing.

13. Collection Ratio = Accounts Receivable / (Revenue/365)
 
This indicates the average number of days it takes a company to collect unpaid invoices.

Things to remember

    * A high ratio indicates that the company is having problems getting paid for services or products.

    * The ratio is sometimes seasonally affected, rising during busy seasons and falling during the off-season. To account for this seasonality, the average accounts receivable ((beginning + ending accounts receivable)/2) could be used instead.

Collection Ratio Analysis:
This ratio could perhaps be renamed as the "Thug Ratio", it explains the average time it takes to receive payment on sales. The "Thugs" at Cory’s Tequila Co. seem to be doing their job quite well, on average it takes 37 days for customers to clear their invoices. This is quite reasonable since most companies clear pay all of their bills on a monthly basis. If we were really picky we could redo this calculation using only credit sales since cash purchases are received immediately.

14. Inventory Turnover = Cost of Goods Sold / Average or Current Period Inventory

An important and often overlooked ratio that indicates inventory levels.

Things to remember

    * A low turnover is usually a bad sign because products tend to deteriorate as they sit in a warehouse.

    * Companies selling perishable items have very high turnover.

    * For more accurate inventory turnover figures, the average inventory figure, ((beginning inventory + ending inventory)/2), is used when computing inventory turnover. Average inventory accounts for any seasonality effects on the ratio.

Inventory Analysis
Cory’s Tequila Co. inventory has gone up almost 100% since last year, this could mean nothing or something. There could be something fundamentally wrong, perhaps sales are slowing. A change of 100% is quite substantial and should be a cause for concern if sales are slowing. But if we look more closely at Cory’s Tequila Co.’s sales it shows that product sales have increased almost 50% since last year. In other words the higher inventory could simply be a factor of higher demand.

Financing

15. Debt-Asset Ratio = Total Liabilities / Total Assets

Indicates what proportion of the company’s assets are being financed through debt.

Things to remember

    * This ratio is very similar to the debt-equity ratio.

    * A ratio under 1 means a majority of assets are financed through equity, above 1 means they are financed more by debt. Furthermore you can interpret a high ratio as a "highly debt leveraged firm".

Debt/Asset Analysis:
Not a particularly exciting ratio, but a useful one. Cory’s Tequila Co.’s debt/asset ratio is fairly low, meaning that its assets are financed more through equity rather than debt. And if you’ll notice Cory’s Tequila Co. has zero long term debt and shouldn’t have to worry about creditors getting nervous. Companies with high ratios are placing themselves at risk, especially in an increasing interest rate market. Creditors are bound to get worried if the company is exposed to a large amount of debt and may demand that the company pay some of it back.

16. Debt-Equity Ratio = Total Liabilities / Shareholders Equity

Indicates what proportion of equity and debt that the company is using to finance its assets. Sometimes investors only use long term debt instead of total liabilities for a more stringent test.

Things to remember

    * A ratio greater than one means assets are mainly financed with debt, less than one means equity provides a majority of the financing.

    * If the ratio is high (financed more with debt) then the company is in a risky position – especially if interest rates are on the rise.

Share Capital Analysis
The shareholder’s capital has risen quite a bit if you compare the balance sheet numbers versus the previous year. Again this could mean a number of things, there are a couple reasons that this could have happened. Perhaps they’ve made acquisitions which were partially paid for through the issue of stock, or maybe they took on additional share capital from another firm. Another possible reason is that they had to issue more shares because they were strapped for cash. For the most part a rise in share capital is better than a rise in debt, but too much of a rise could be cause for alarm.

The Debt/Equity ratio is certainly far from perfect! A low ratio of 0.26 means that the company is exposing itself to a large amount of equity. This is certainly better than a high ratio of 2 or more since this would expose the company to risk such as interest rate increases and creditor nervousness. One way to improve their situation would be to issue more debt and use the cash to buyback some of its outstanding shares. The problem with issuing more and more stock like Cory’s Tequila Co. has done means that outstanding shares become diluted and existing investors receive a smaller ownership portion with each additional share issued.

Note: Some prefer to use only "interest bearing long term debt" instead of total liabilities to get a more precise calculation.

Liquidity Warnings

17. Acid Test (Quick Ratio) = (Cash + Accounts Receivable + Short-term Investments) / Current Liabilities

A stringent test that indicates if a firm has enough short-term assets (without selling inventory) to cover its immediate liabilities. It is similar but a more strenuous version of the "working capital" ratio, indicating whether liabilities could be paid without selling inventory.

Things to remember

    * An extreme version of the working capital ratio because it only uses cash and equivalents.

    * The ratio excludes inventory, which for some companies can make up a large portion of its assets.

Acid Test Analysis:
This ratio is used to determine risk that is not detected by the Working Capital ratio. Cory’s Tequila Co. seems to be all right in this area. Their ratio of 1.08 means that they have just enough liquid assets to cover a unexpected drawdown of liabilities (people wanting their money now). Companies with ratios of less than 1 can not pay their current liabilities and should be looked at with extreme care. Furthermore if the acid ratio is much lower than the working capital ratio it means that current assets are highly dependent on inventory – retail stores are examples of this type of business.

18. Interest Coverage = EBITDA / Interest Expense

Indicates what portion of debt interest is covered by a company’s cash flow situation.

Things to remember

    * A ratio under 1 means that the company is having problems generating enough cash flow to pay its interest expenses.

    * Ideally you want the ratio to be over 1.5.

Interest Coverage Analysis:
If you will notice, Cory’s Tequila Co. doesn’t have any long term debt – therefore you will not find an interest expense. What a great position to be in, practically debt free. Companies with a ratio below 1 could run into serious trouble servicing its loan payments and are considered to be a high risk of defaulting. Because Cory’s Tequila Co. has no interest expense its interest coverage ratio is infinite…obviously the best you could possibly have.

19. Working Capital Ratio (Current Ratio) = Current Assets / Current Liabilities

Indicates if a firm has enough short-term assets to cover its immediate liabilities.

Things to remember

    * If the ratio is less than one then they have negative working capital.

    * A high working capital ratio isn’t always a good thing, it could indicate that they have too much inventory or they are not investing their excess cash.

This ratio indicates whether a company has enough short term assets to cover its short term debt. Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient, Cory’s Tequila Co. seems to be comfortably in this area.

If you wanted to take this ratio a step further then you could try the Acid Test/Quick Ratio – it is a more strenuous version of the W/C, indicating whether liabilities could be paid without selling inventory.

Ratio Analysis: Conclusion

There is a lot to be said for valuing a company, it is no easy task. I hope that we have helped shed some light on this topic, and that you will use this information to make educated investment decisions. If you have any other questions about fundamental analysis please don’t hesitate to contact us.

Let’s recap what we’ve learned:

    * Financial reports are published quarterly and annually.
    * Ratios on their own don’t really tell us a whole lot, but when we compare them against previous years numbers, other companies, industry averages, or the economy in general it can reveal a lot!
    * Every ratio has it’s variations, some people exclude things that others include. Use what you feel comfortable with, but be sure to have consistency when comparing against other companies.

Categories: Economics & Finance
  1. shea
    13 May 2008 at 3:37 AM

    This would have definitely been a helpful guide when we were covering working capital in my business management classes!

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