(182)-SHAREHOLDERS INVESTMENT RATIOS

Shareholders Investment Ratios

These are the ratios which help equity shareholders and other investors to assess the value and quality of an investment in the ordinary shares of the company. They are:

1. Earnings per share
2. Dividend per share
3. Dividend cover
4. Price earning ratio (P/E ratio)
5. Dividend yield
6. Earnings yield

The value of an investment in ordinary share in a listed company is its market value, and so investment ratios must have regard not only to information in the company’s published accounts, but also to the current price, and the fourth, fifth and sixth ratios all involve using the share price.

We will discuss these ratios in our next post.

(181)-CREDITORS TURNOVER RATIO

Creditors Turnover Ratio

Creditor’s turnover ratio is ideally calculated by the formula:

Creditors turnover = (Trade creditors / Purchases) X 365

However, it is rate to find purchases disclosed in published accounts and so cost of sales serves as an approximation. The creditors’ turnover ratio often helps to assess a company’s liquidity; an increase in creditor’s days is often a sign of lack of long-term finance or poor management of current assets, resulting in the use of extended credit from suppliers, increased bank overdraft and so on.

(180)-EFFICIENCY RATIOS - STOCK TURNOVER PERIOD

Efficiency Ratios - Stock Turnover Period

Another ratio worth to calculating is the stock turnover period, or stock days. This is another estimated figure, obtainable from publish accounts, which indicates the average number of days that items of stock are held for. As with the average debt collection period, however, it is only an approximate estimated figure, but one which should be reliable enough for comparing changes year on year.

The number of stock turnover days = (Stock / Cost of sales) X 365

The reciprocal of the fraction:

Cost of sales/stock

Is termed the stock turnover, and is another measure of how vigorously a business is trading. A lengthening stock turnover period from one year to the next indicates:

1. A slowdown in trading
2. A build-up in stock levels, perhaps suggesting that the investment in stocks is becoming excessive

Presumably if we add together the stock days and the debtor’s days, this should give us an indication of how soon stocks are convertible into cash. Both debtor’s days and stock days therefore give us a further indication of the company’s liquidity.

(179)-EFFICIENCY RATIOS - DEBTORS PAYMENT PERIOD

Efficiency Ratios – Debtors Payment Period

A rough measure of the average length of time it takes for a company’s debtors to pay what they owe is the “debtors’ days” ratio, or average debtors’ payment period.

Debtors payment period = (Trade debtors / Sales) X 100

The estimated average debtors’ payment period is calculated as follows.

The figure for sales should be taken as the turnover figure in the profit and loss account. The trade debtors are not the total figure for debtors in the balance sheet, which includes prepayments and non-trade debtors. The trade debtors figure will be itemized in an analysis of the debtor’s total, in a note to the accounts.

The estimate of debtor’s days is only approximate.

• The balance sheet value of debtors might be absolute higher or low compared with the “normal” level the company usually has.
• Turnover in the profit and loss account is exclusively of value added tax (VAT), but debtors in then balance sheet are inclusive of value added tax (VAT). We are not strictly comparing like with like.

Sales are usually made on normal credit terms of payment within 30 days. Debtors’ days significantly in excess of this might be representative of poor management of funds of a business. However, some companies must allow generous credit terms to win customers. Exporting companies in particular may have to carry large amounts of debtors, and so their average collection period might be well in excess of 30 days.

The trend of the collection period (debtor’s days) over time is probably the best guide. If debtor’s days are increasing year on year, this is indicative of a poorly managed credit control function.

(178)-LIQUIDITY RATIOS - QUICK RATIO

Liquidity Ratios – Quick Ratio

Companies are not able to convert their entire current asset into cash very quickly. In particular, some manufacturing companies might hold large quantities of few material stocks, which must be used in production to create finished goods stocks. Finished goods stocks might be warehoused for a long time, or sold on lengthy credit. In such businesses, where stock turnover is slow, most stocks are not very “liquid” assets, because the cash cycle is so long. For these reasons, we calculate an additional liquidity ratio, known as the quick ration or acid ratio.

Quick ratio, or acid ratio = (Current assets – stocks) / Current liabilities

This ratio should ideally be at least 1 for companies with a slow stock turnover. For companies with a fast stock turnover, a quick ratio can be comfortably less than 1 without suggesting that the company should be in cash flow trouble.

Both the current ratio and the quick ratio offer an indication of the company’s liquidity position, but the absolute figures should not be interpreted too literally. It is often theorized that an acceptable current ratio is 1.5 and an acceptable quick ratio is 0.8, but these should only be used as a guide.

What is important is the trend of these ratios?

From this, one can easily ascertain whether liquidity is improving or deteriorating. If budges has a traded for the last 10 years (very successfully) with current ratios of 0.52 and quick ratios of 0.17 then it should be supposed that the company can continue in business with those levels of liquidity. If in the following year the current ratio were to fall to 0.38 and the quick ratio to 0.09, then further investigation into the liquidity situation would be appropriate. It is relative position that is far more important that the absolute figures.

Don’t forget the other side of the coin either. A current ratio and a quick ratio can get bigger than they need to be. A company that has large volumes of stocks and debtors might be over-investing in working capital, and so tying up more funds in the business than it needs to. This would suggest poor management of debtors (credit) or stocks by the company.

(177)-LIQUIDITY RATIOS - CURRENT RATIO

Liquidity Ratios – Current Ratio

The standard test of liquidity is the current ration. It can be obtained from the balance sheet, and is calculated as follows.

Current ratio = Current assets / Current liabilities

The idea behind that is a company should have enough current assets that give a promise of “cash to come” to meet its future commitments to pay off its current liabilities. Obviously, a ratio in excess of 1 should be expected. Otherwise, there would be the prospect that the company might be unable to pay its debts on time. In practice, a ratio comfortably in excess of 1 should be expected, but what is “comfortable” various between different types of businesses.

(176)-THE CASH CYCLE

The Cash Cycle

To help you to understand liquidity ratios, it is useful to obtain with a brief explanation of the cash cycle. The cash cycle describes the flow of cash out of a business and back into it again as a result of normal trading operations.

Cash goes out to pay for supplies, wages and salaries and other expenses, although payments can be delayed by taking some credit. A business might hold stock for a while and then sell it. Cash will come back into the business fro the sales, although customers might delay payment by themselves taking some credit.

The main points about the cash cycle are as follows.

• The timing of cash flows in and out of a business does not coincide with the time when sales and costs of sales occur. Cash flows out can be postponed by taking credit. Cash flows in can be delayed by having debtors.
• The time between making a purchase and making a sale also affects cash flows. If stocks are held for a long time, the delay between the cash payment for stocks and cash receipts from selling them will also be a long one.
• Holding stocks and having debtors can therefore be seen as two reasons why cash receipts are delayed. Another way of saving this is that if a company invests in working capital, its cash position will show a corresponding decrease.
• Similarly, taking credit from creditors can be seen as a reason why cash payments are delayed. The company’s liquidity position will worsen when it has to pay the creditors, unless it can get more cash in from sales and debtors in the meantime.

The liquidity ratios and working capital ratios are used to test a company’s liquidity, length of cash cycle, and investment in working capital.

(175)-SHORT-TERM SOLVENCY AND LIQUIDITY

Short-term Solvency and Liquidity

Profitability is the amount of course an important aspect of a company’s performance and debt or gearing is another. Neither, however, addresses directly the key issue of liquidity.

Liquidity is the amount of cash a company can put its hands on quickly to settle its debts (and possibly to meet other unforeseen demands for cash payments too).

Liquid funds consist of:

• Cash
• Short-term investments for which there is a ready market
• Fixed-term deposits with a bank or building society, for example, a six month high-interest deposit with a bank
• Trade debtors (because they will pay what they owe within a reasonably short period of time)
• Bills of exchange receivable (because like ordinary trade debtors, these represent amounts of cash due to be received within a relatively short period of time)

In summary, liquid assets are current asset items that will or could soon be converted into cash, and cash itself. Two common definitions of liquid assets are:

• All current assets without exception
• All current assets with the exception of stocks

A company can obtain liquid assets from sources other than sales, such as the issue of shares for cash, a new loan or the sale of fixed assets. But a company cannot rely on these at all times, and in general, obtaining liquid funds depends on marketing sales and profits. Even, so, profits do not always lead to increase in liquidity. This is mainly because funds generated from trading may be immediately invested in fixed assets or paid out as dividends.

The reason why a company needs liquid assets is so that it can meet its debts when they fall due. Payments are continually made for operating expenses and other costs, and so there is a cash cycle from trading activities of cash coming in from sales and cash going out for expenses.

(174)-CASH FLOW RATIO

Cash Flow Ratio

The cash flow ratio is the ratio of a company’s net cash inflow to its total debts.

• Net cash in flow is the amount of cash which the company has coming into the business from its operations. A suitable figure for net cash inflow can be obtained from the cash flow statement.
• Total debts are short-term and long-term creditors, together with provisions for liabilities and charges. A distinction can be made between debts payable within one year and other debts and provisions.

Obviously, a company needs to be earning enough cash from operations to be able to meet its foreseeable debts and future commitments, and the cash flow ratio, and charges in the cash flow ratio from one year to next, provides a useful indicator of a company’s cash position.

(173)-ACCOUNTING RATIO ANALYSIS - INTEREST COVER RATIO

Accounting Ratio Analysis – Interest Cover

The interest cover ratio shows whether a company is earning enough profits before interest and tax to pay its interest costs comfortably, or whether its interest costs are high in relation to size of its profits, so that fall in Profit Before Interest and Tax (PBIT) would when have a significant effect on profits available for ordinary shareholders.

Interest cover = Profit before interest and tax / Interest charges

An interest cover of 2 times or less would be low, and should really exceed 3 times before the company’s interest costs are to be considered within acceptable limits.

Although preference share capital is included as prior charge capital for the gearing ratio, it is usual to exceed preference dividends from “interest” charges. We also look at all interest payments, even interest charges on short-term debt, and so interest cover and gearing do not quite look at the same thing.

(172)-THE IMPLICATIONS OF HIGH OR LOW GEARING

The Implications of High or Low Gearing

We mentioned in earlier posts that gearing is, amongst other things, an attempt to quantify the degree of risk involved in holding equity shares in a company, risk both in terms of the company’s ability to remain in business and in terms of expected ordinary dividends from the company. The problem with a high geared company is that by definition there is a lot of debt. Debt generally carries a fixed rate of investment (or fixed rate of dividend if in the form of preference shares), hence there is a given (and large) amount to be paid out from profits to holders of debt before arriving at a residue available for distribution to the holders of equity.

The more highly geared the company, the greater the risk that little (if anything) will be available to distribute by way of dividend to the ordinary shareholders.

The risk of a company’s ability to remain in business was referred to earlier posts. Gearing is relevant to this. A high geared company has a large amount of interest to pay annually (assuming that the debt is external borrowing rather than preference shares). If those borrowings are “secured” in any way (and debentures in particular are secured), then the holders of the debt are perfectly entitled to force the company to realize assets to pay their interest if funds are not available from other sources. Clearly the more highly geared a company the more likely this is to occur when and if profits fall. Higher gearing may mean higher returns, but also higher risk.

(171)-CAPITAL GEARING RATIO

Capital Gearing Ratio

The capital gearing ratio is a measure of the proportion of a company’s capital that is prior charge capital. It is measured as follows:

Capital gearing ratio = Prior charge capital / Total capital

Prior charge capital is capital carrying a right to fixed return. It will include preference shares and debentures.

Total capital is ordinary share capital and reserves plus prior charge capital plus any long-term liabilities or provisions. In group accounts we would also include minority interests. It is easier to identify the same figure for total capital as total assets less current liabilities, which you will find given to you in the balance sheet.

As with the debt ratio, there is no absolute limit to what a gearing ratio ought to be. A company with a gearing ratio of more than 50% is said to be high geared (where low gearing means a gearing ratio of less than 50%). Many companies are high geared, but if a high geared company is becoming increasingly high geared, it is likely to have difficultly in the future when it wants to borrow even more, unless it can also boost its shareholders’ capital, either with retained profits or by a new share issue.

A similar ration to the gearing ratio is the debt/equity ratio, which is calculated as follows.

Debt/equity ratio = Prior charge capital / Ordinary share capital and reserves

This gives us the same sort of information as the gearing ratio, and a ratio of 100% or more would indicate high gearing.

(170)-GEARING RATIO

Gearing Ratio

Capital gearing is concerned with a company’s long-term capital structure. We can think of a company as consisting of fixed assets and current assets (working capital, which is current assets minus current liabilities). These assets must be financed by long-term capital of the company, which is either:

• Share capital and reserves (shareholders’ funds) which can be divided into: Ordinary share plus reserves, and preference shares.
• Long-term debt capital: creditors: amounts falling due after more than one year.

Preference share capital is not debt. It would certainly not be included as debt in the debt ratio. However, like loan capital, preference share capital has a prior claim over profits before interest and tax, ahead of ordinary shareholders. Preference dividends must be paid out of profits before ordinary shareholders are entitled to an ordinary dividend, and so we refer to preference share capital and loan capital as prior charge capital.

(169)-DEBT RATIO

Debt Ratio

The debt ration is the ratio of a company’s total debts to its total assets.

Debt ratio = Total debts / Total assets

• Assets consist of fixed assets at their balance sheet value, plus current assets.
• Debt consists of all creditors, whether amounts falling due within one year or after more than one year.

You can ignore long-term provisions and liabilities, such as deferred taxation.

(168)-LONG TERM SOLVENCY: DEBT AND GEARING RATIOS

Long Term Solvency: Debt and Gearing Ratios

Debt ratios are concerned with how much the company owes in relation to its size, whether it is getting into heavier debt or improving its situation, and whether its debt burden seems heavy or light.

• When a company is heavily in debt banks and other potential lenders may be unwilling to advance further funds.
• When a company is earning only a modest profit before interest and tax, and has a heavy debt burden, there will be very little profit left over for shareholders after the interest changes have been paid. And so if interest rates were to go up (on bank overdrafts and so on) or the company was to borrow even more, it might soon be incurring interest changes in excess of PBIT. This might eventually lead to the liquidation of the company.

There are two big reasons why companies should keep their debt burden under control. There are four ratios that are particularly worth looking at, the debt ratio, gearing ratio, interest cover and cash flow ratio.

(167)-ACCOUNTING RATION ANALYSIS

Return on Shareholders’ Capital (ROSC)

Another measure of profitability and return is the return on shareholders’ capital (ROSC)

ROSC = Profit on ordinary activities before tax / Share capital and reserves

It is intended to focus on the return being made by the company for the benefit of its shareholders.

Return on shareholders capital (ROSC) is not a widely-used ratio, however, because there are more useful ratios that give an indication of the return to shareholders, such as earnings per share, dividend per share, dividend yield and earnings yield.

Analyzing profitability

We often sub-analyze return on capital employed (ROCE), to find out more about why the ROCE is high or low, or better or worse than last year. There are two factors that contribute towards a return on capital employed, both related to sales turnover.

• Profit margin. A company might make a high or low profit margin on its sales.
• Asset turnover. Asset turnover is a measure of how well the assets of a business of a business are being used to generate sales.

ROCE = Profit margin X Asset turnover