Prentice Hall's one-day MBA in finance & accounting (10 page)

Of course, individual investors may decide not to reinvest their dividends. They may spend their dividend income or put the cash flow into other investments.

Price/Earnings Ratio

The market price of stock shares of a public business is divided by its most recent annual EPS to determine the
price/earnings ratio:

Current market price of stock share

ᎏᎏᎏᎏᎏᎏ

Earnings per share (either basic or diluted EPS)

= price/earning ratio, or P/E

Suppose a company’s stock shares are trading at $60.00

per share and its EPS for the most recent year (called the
trailing
12 months) is $3.00. Thus, its P/E ratio is 20. By the way, the
Wall Street Journal
uses diluted EPS to report P/E

ratios in its stock trading tables. Like the other ratios dis-

cussed in this chapter, the P/E ratio is compared with indus-

trywide and marketwide averages to judge whether it’s too high or too low. I remember when a P/E ratio of 8 was typical.

TEAMFLY

Today P/E ratios of 20 or higher are common.

The stock shares of a privately owned business are not actively traded, and thus the market value of its shares is diffi-

cult to ascertain. When shares do change hands occasionally, the price is usually kept private between the seller and buyer.

Nevertheless, stockholders in these businesses are interested in what their shares are worth. To estimate the value of their stock shares, a P/E multiple can be used. In the example, the company’s EPS is $3.75 for the most recent year (see Figure 4.1). Suppose you own some of the capital stock shares and someone offers to buy your shares. You could establish an offer price at, say, 12 times basic EPS, which is $45 per share.

The potential buyer may not be willing to pay this price, of course. Or he or she might be willing to pay 15 or even 18

times EPS.

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Team-Fly®

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DEBT-PAYING-ABILITY RATIOS

If a business cannot pay its liabilities on time, bad things can happen.
Solvency
refers to the ability of a business to pay its liabilities when they come due. Maintaining solvency (debt-paying ability) is essential for every business. If a business defaults on its debt obligations it becomes vulnerable to legal proceedings by its lenders that could stop the company in its tracks, or at least seriously interfere with its normal operations.

Therefore, investors and lenders are very interested in the general solvency and debt-paying ability of a business.

Bankers and other lenders, when deciding whether to make and renew loans to a business, direct their attention to certain solvency ratios. These ratios provide a useful profile of the business for assessing its creditworthiness and for judging the ability of the business to pay its loans and interest on time.

Short-Term Solvency Test: The Current Ratio

The
current ratio
is used to test the short-term liability-paying ability of a business. The current ratio is calculated by dividing total current assets by total current liabilities. From the data in the company’s balance sheet (Figure 4.2), its current ratio is computed as follows:

$12,742,329 current assets

ᎏᎏᎏᎏ = 2.08 current ratio

$6,126,096 current liabilities

The current ratio is hardly ever expressed as a percent (which would be 208 percent in this case). The current ratio is stated as 2.08 to 1.00 for this company, or more simply just as 2.08. The general expectation is that the current ratio for a business should be 2 to 1 or higher. Most businesses find that their creditors expect them to maintain this minimum current ratio. In other words, short-term creditors generally prefer that a business limit its current liabilities to one-half or less of its current assets.

Why do short-term creditors put this limit on a business?

The main reason is to provide a safety cushion for payment of its short-term liabilities. A current ratio of 2 to 1 means there is $2 of cash and assets that should be converted into cash during the near future to pay each $1 of current liabilities that
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come due in roughly the same time period. Each dollar of short-term liabilities is backed up with two dollars of cash on hand plus near-term cash inflows. The extra dollar of current assets provides a margin of safety.

In summary, short-term sources of credit generally demand that a company’s current assets be double its current liabilities. After all, creditors are not owners—they don’t share in the profit success of the business. The income on their loans is limited to the interest they charge. As creditors, they quite properly minimize their loan risks; they are not compensated to take on much risk.

Acid Test Ratio, or Quick Ratio

Inventory is many weeks away from conversion into cash.

Products usually are held two, three, or four months before being sold. If sales are made on credit, which is normal when one business sells to another business, there’s a second waiting period before accounts receivables are collected. In short, inventory is not nearly as liquid as accounts receivable; it takes a lot longer to convert inventory into cash. Furthermore, there’s no guarantee that all the products in inventory will be sold, or sold above cost.

A more severe test of the short-term liability-paying ability of a business is the
acid test ratio,
which excludes inventory (and prepaid expenses also). Only cash, marketable securities investments (if the business has any), and accounts receivable are counted as sources available to pay the current liabilities of the business. This ratio is also called the
quick ratio
because only cash and assets quickly convertible into cash are included in the amount available for paying current liabilities.

The example company’s acid test ratio is calculated as follows (the business has no investments in marketable securities):

$2,345,675 cash + $3,813,582 accounts receivable

ᎏᎏᎏᎏᎏᎏ

$6,126,096 total current liabilities

= 1.01 acid test ratio

The general expectation is that a company’s acid test ratio should be 1:1 or better, although you find many more exceptions to this rule than to the 2:1 current ratio standard.

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Debt-to-Equity Ratio

Some debt is good, but too much is dangerous. The
debt-to-equity ratio
is an indicator of whether a company is using debt prudently or is overburdened with debt that could cause problems. The example company’s debt-to-equity ratio is calculated as follows (see Figure 4.2 for data):

$13,626,096 total liabilities

ᎏᎏᎏᎏᎏ

$13,188,483 total stockholders’ equity

= 1.03 debt-to-equity ratio

This ratio reveals that the company is using $1.03 of liabilities for each $1.00 of stockholders’ equity. Notice that
all
liabilities (non-interest-bearing as well as interest-bearing, and both short-term and long-term) are included in this ratio. Most industrial businesses stay below a 1 to 1 debt-to-equity ratio.

They don’t want to take on too much debt, or they cannot convince lenders to put up more than one-half of their assets. On the other hand, some businesses are much more aggressive and operate with large ratios of debt to equity. Public utilities and financial institutions have much higher debt-to-equity ratios than 1 to 1.

Times Interest Earned

To pay interest on its debt a business needs sufficient earnings before interest and income tax (EBIT). To test the ability to pay interest, the
times-interest-earned ratio
is calculated. For the example, annual earnings before interest and income tax is divided by interest expense as follows (see Figure 4.1 for data): $3,234,365 earnings before interest and income tax ᎏᎏᎏᎏᎏᎏ

$795,000 interest expense

= 4.07 times interest earned

There is no standard guideline for this particular ratio, although obviously the ratio should be higher than 1 to 1. In this example the company’s earnings before interest and income tax is more than four times its annual interest expense, which is comforting from the lender’s point of view.

Lenders would be very alarmed if a business barely covered its annual interest expense. The company’s management should be equally alarmed, of course.

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ASSET TURNOVER RATIOS

A business has to keep its assets busy, both to remain solvent and to be efficient in making profit. Inactive assets are an albatross around the neck of the business. Slow-moving assets can cause serious trouble. Investors and lenders use certain
turnover ratios
as indicators of how well a business is using its assets and to test whether some assets are sluggish and might pose a serious problem.

Accounts Receivable Turnover Ratio

Accounts receivable should be collected on time and not allowed to accumulate beyond the normal credit term offered to customers. To get a sense of how well the business is controlling its accounts receivable, the
accounts receivable turnover ratio
is calculated as follows (see Figures 4.1 and 4.2 for data):

$39,661,250 annual sales revenue

ᎏᎏᎏᎏ = 10.4 times

$3,813,582 accounts receivable

The accounts receivable turnover ratio is one of the ratios published by business financial information services such as Dun & Bradstreet, Standard & Poor’s, and Moody’s. In this example, the business “turns” its customers’ receivables a little more than 10 times a year, which indicates that it waits about a tenth of a year on average to collect its receivables from credit sales. This appears reasonable, assuming that the business extends one-month credit to its customers. (A turnover of 12 would be even better.)

Inventory Turnover Ratio

In the business example, the company sells products. Virtually every company that sells products carries an inventory, or stockpile of products, for a period of time before the products are sold and delivered to customers. The holding period depends on the nature of business. Supermarkets have short holding periods; retail furniture stores have fairly long inventory holding periods. Products should not be held in inventory longer than necessary. Holding inventory is subject to several risks and accrues several costs. Products may become obsolete, may be stolen, may be damaged, or may even be misplaced.

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Products have to be stored, usually have to be insured, and may have to be guarded. And the capital invested in inventory has a cost, of course.

To get a feel for how long the business holds its inventory before sale, investors and lenders calculate the
inventory
turnover ratio
as follows (see Figures 4.1 and 4.2 for data): $24,960,750 cost-of-goods sold expense

ᎏᎏᎏᎏᎏ = 4.3 times

$5,760,173 inventories

The inventory turnover ratio is another of the ratios published by business information service organizations. The company’s 4.3 inventory turnover ratio indicates that it holds products about one-fourth of a year before selling them. The inventory turnover ratio is compared with the averages for the industry and with previous years of the business.

Asset Turnover Ratio

The
asset turnover ratio
is a test of how well a business is using its assets overall. This ratio is computed by dividing annual sales revenue by total assets (see Figures 4.1 and 4.2

for data):

$39,661,250 annual sales revenue

ᎏᎏᎏᎏ = 1.5 times

$26,814,579 total assets

This ratio reveals that the business made $1.50 in sales for every $1.00 of total assets. Conversely, the business needed $1.00 of assets to make $1.50 of sales during the year. The ratio tells us that business is relatively asset heavy. The asset turnover ratio is compared with the averages for the industry and with previous years of the business.

s

END POINT

Individual investors, investment managers, stock analysts, lenders, and credit rating services commonly use the financial statement and market value ratios explained in this chapter.

Business managers use the ratios to keep watch on how their business is doing and whether there might be some trouble spots that need attention. Nevertheless, the ratios are not a panacea.

A financial statement ratio is like your body temperature. A
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normal temperature is good and means that probably nothing serious is wrong, though not necessarily. A very high or low temperature means something probably is wrong, but it takes an additional diagnosis to discover the problem. Financial statement ratios are like measures of vital signs such as your pulse rate, blood pressure, cholesterol level, body fat, and so on. Financial ratios are the vital signs of a business.

There’s no end to the number of ratios than can be calculated from financial statements. The trick is to focus on a reasonable number of ratios that have the most interpretive value. Calculating the ratios takes time. Many investors and lenders do not actually calculate the ratios. They do “eyeball tests” instead of computing ratios. They visually compare the two numbers in the ratio and do rough arithmetic in their heads to see if anything appears to be out of whack. For example, they observe that current assets are more than twice current liabilities. They do not bother to calculate the exact measure of the current ratio. This is a practical and time-saving technique as opposed to calculating ratios. Many investors and lenders use the financial statement ratios published by information service providers who compile data and information on thousands of businesses.

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P A R T 2

Assets and

Sources of

Capital