FINANCIAL RATIOS

Financial ratio relates two pieces of data by dividing one quantity by the other. Financial data
are numbers which can be derived from balance sheet or income statement.
Why bother with a RATIO? Why not simply look at the raw numbers themselves?
We calculate ratios because in this way we get a comparison that may prove more useful than the
raw numbers by themselves.
Illustration:
Suppose that a firm had a net profit figure this year of $1million.
That looks very profitable..
But what if the firm invests its total assets amounting to $200 million? Dividing net profit by total
assets, we get $1m/$200M= 0.005, the firm’s return on total assets.
Return on Assets Ratio is an indicator of how effectively a company is using its assets to generate
earnings before contractual obligations must be paid.
So what does 0.005 means?
The 0.005 figure means that each dollar of assets invested in the firm earned a one-half percent
return.
If a savings account has a savings interest rate of 1.5%, then A savings account provides a better
return on investment than this, and with less risk.
In this example, the ratio proved quite informative. But be careful. You need to be cautious in your
choice and interpretation of ratios. Take inventory and divide it by additional paid-in capital. You
have a ratio, but we challenge you to come up with any meaningful interpretation of the resulting
figure.

Using Financial Ratios

The information contained in the four basic financial statements is of major significance to a
variety of interested parties who regularly need to have relative measures of the company’s
performance. Relative is the key word here, because the analysis of financial statements is
based on the use of ratios or relative values. Ratio analysis involves methods of calculating
and interpreting financial ratios to analyze and monitor the firm’s performance. The basic inputs
to ratio analysis are the firm’s income statement and balance sheet.

Interested Parties in Ratio Analysis of Financial Statement

 Shareholders – Both current and prospective shareholders are interested in the firm’s
current and future level of risk and return, which directly affect share price.

 Creditors – They are interested primarily in the short-term liquidity of the company and
its ability to make interest and principal payments. A secondary concern of creditors is
the firm’s profitability; they want assurance that the business is healthy.
  Management – The firm’s own management like stockholders, is concerned with all
aspects of the firm’s financial situation, and it attempts to produce financial ratios that will
be considered favorable by both owners and creditors. In addition, management uses
ratios to monitor the firm’s performance from period to period.
To evaluate a firm’s financial condition and performance, the financial analyst needs to perform
“check-ups” on various aspects of a firm’s financial health. A tool frequently used during these
check-ups is a financial ratio, or index, which relates two pieces of financial data by dividing one
quantity by the other.

Types of Ratio Comparisons

Ratio analysis is not merely the calculation of a given ratio. More important is the interpretation
of the ratio value. A meaningful basis for comparison is needed to answer such questions as “Is
it too high or too low?” and “Is it good or bad?”
Two types of ratio comparisons can be made, cross-sectional and time-series.
 Cross-Sectional Analysis
Cross-sectional analysis involves the comparison of different firms’ financial ratios at the same
point in time. Analysts are often interested in how well a firm has performed in relation to other
firms in its industry. Frequently, a firm will compare its ratio values to those of a key competitor
or group of competitors that it wishes to emulate. This type of cross-sectional analysis, called
benchmarking, has become very popular.
Comparison to industry averages is also popular. These figures can be found in the Almanac of
Business and Industrial Financial Ratios, Dun & Bradstreet’s Industry Norms and Key Business
Ratios, RMA Annual Statement Studies, Value Line, and industry sources. It is also possible to
derive financial ratios for yourself using financial information reported in financial databases,
such as Compustat.
See table below illustrates a brief cross-sectional ratio analysis by comparing several
ratios as of early 2010 for two select firms to each other and the median value for their particular
industry.
Analysts have to be very careful when drawing conclusions from ratio comparisons. It’s tempting
to assume that if one ratio for a particular firm is above the industry norm, this is a sign that the
firm is performing well, at least along the dimension measured by that ratio. However, ratios
may be above or below the industry norm for both positive and negative reasons, and it is
necessary to determine why a firm’s performance differs from its industry peers. Thus, ratio
analysis on its own is probably most useful in highlighting areas for further investigation.
Illustration:
In early 2013, Mary Boyle, the chief financial analyst at Caldwell Manufacturing, a producer of
heat exchangers, gathered data on the firm’s financial performance during 2012, the year just
ended. She calculated a variety of ratios and obtained industry averages. She was especially
interested in inventory turnover, which reflects the speed with which the firm moves its inventory
from raw materials through production into finished goods and to the customer as a completed
sale. Generally, higher values of this ratio are preferred, because they indicate a quicker
turnover of inventory and more efficient inventory management. Caldwell Manufacturing’s
calculated inventory turnover for 2012 and the industry average inventory turnover were as
follows:

Inventory Turn-over, 2012

Caldwell Manufacturing 14.8
Industry Average 9.7
Mary’s initial reaction to these data was that the firm had managed its inventory significantly
better than the average firm in the industry. The turnover was nearly 53% faster than the
industry average. On reflection, however, she realized that a very high inventory turnover could
be a sign that the firm is not holding enough inventories. The consequence of low inventory
could be excessive stock outs (insufficient inventory to meet customer needs). Discussions with
people in the manufacturing and marketing departments did, in fact, uncover such a problem:
Inventories during the year were extremely low, the result of numerous production delays that
hindered the firm’s ability to meet demand and resulted in disgruntled customers and lost sales.
A ratio that initially appeared to reflect extremely efficient inventory management was actually
the symptom of a major problem.
 Time-Series Analysis
Time-series analysis evaluates performance over time. Comparison of current to past
performance, using ratios, enables analysts to assess the firm’s progress. Developing trends
can be seen by using multiyear comparisons. Any significant year-to-year changes may be
symptomatic of a problem, especially if the same trend is not an industry-wide phenomenon. For
example, the current ratio (the ratio of current assets to current liabilities) for the present year
could be compared with the current ratio for the previous year end. When financial ratios are
arrayed over a period of years on a spreadsheet over a period of years, the analyst can study
the composition of change and determine whether there has been an improvement or
deterioration in the firm’s financial condition and performance over time. In short, we are
concerned not so much with one ratio at one point in time, but rather with that ratio over time.
Cautions about Using Ratio Analysis
Before discussing specific ratios, we should consider the following cautions about their use:
1. Ratios that reveal large deviations from the norm merely indicate the possibility of a
problem. Additional analysis is typically needed to determine whether there is a problem
and to isolate the causes of the problem.
2. A single ratio does not generally provide sufficient information from which to judge the
overall performance of the firm. However, if an analysis is concerned only with certain
specific aspects of a firm’s financial position, one or two ratios may suffice.
3. The ratios being compared should be calculated using financial statements dated at the
same point in time during the year. If they are not, the effects of seasonality may
produce erroneous conclusions and decisions.
4. It is preferable to use audited financial statements for ratio analysis. If they have not
been audited, the data in them may not reflect the firm’s true financial condition.
5. The financial data being compared should have been developed in the same way. The
use of differing accounting treatments—especially relative to inventory and depreciation
—can distort the results of ratio comparisons, regardless of whether cross-sectional or
time-series analysis is used.
6. Be careful when comparing older to newer firms or a firm to itself over a long period of
time.
Categories of Financial Ratios
Financial ratios can be divided for convenience into five basic categories: liquidity, activity, debt,
profitability, and market ratios. Liquidity, activity, and debt ratios primarily measure risk.
Profitability ratios measure return. Market ratios capture both risk and return.
To illustrate the ratios, we will used the balance sheet and income statements of the REX
Manufacturing Company.
 A. Liquidity Ratios
The liquidity of a firm is measured by its ability to satisfy its short-term obligations as they come
due. Liquidity refers to the solvency of the firm’s overall financial position—the ease with which it
can pay its bills. Because a common precursor to financial distress and bankruptcy is low or
declining liquidity, these ratios can provide early signs of cash flow problems and impending
business failure. Clearly it is desirable that a firm is able to pay its bills, so having enough
liquidity for day-to-day operations is important. However, liquid assets, like cash held at banks
and marketable securities, do not earn a particularly high rate of return, so shareholders will not
want a firm to overinvest in liquidity. Firms have to balance the need for safety that liquidity
provides against the low returns that liquid assets generate for investors. The two basic
measures of liquidity are the current ratio and the quick (acid-test) ratio.
 Current Ratio
The current ratio, one of the most commonly cited financial ratios, measures the firm’s ability to
meet its short-term obligations. It is expressed as follows:
Current Assets divided by Current Liabilities
For REX, the ratio for the 2016 year end is
$2,205,687/ $787,873 = 2.80
REX is engaged in making household electrical appliances. Its current ratio is somewhat above
the median ratio for the industry of 2.1. (The median – or middle value – for the industry is taken
from the Risk Management Association, Statement Studies.4) Although comparisons with
industry averages do not always reveal financial strength or weakness, they are meaningful in
identifying companies that are out of line. Where a significant deviation occurs, the analyst will
want to determine the reasons. Perhaps the industry itself is overly liquid, and the company
being examined is basically sound despite a lower current ratio. In another situation, the
company being analyzed may be too liquid, relative to the industry, with the result that it forgoes
additional profitability. Whenever a financial “red flag” is raised, the analyst must search out the
reasons behind it.
The higher the ratio, supposedly, the greater the ability of the firm to pay its bills. The ratio must
be regarded as a crude measure of liquidity, however, because it does not take into account the
liquidity of the individual components of the current assets. A firm having current assets
composed principally of cash and current receivables is generally regarded as more liquid than
a firm whose current assets consist primarily of inventories.' Consequently, we must turn to
"finer" tools of analysis if we are to evaluate critically the liquidity of the firm.

 Quick (Acid-Test) Ratio

The quick (acid-test) ratio is similar to the current ratio except that it excludes inventory, which is
generally the least liquid current asset. The generally low liquidity of inventory results from two
primary factors: (1) Many types of inventory cannot be easily sold because they are partially
completed items, special-purpose items, and the like; and (2) inventory is typically sold on
credit, which means that it becomes an account receivable before being converted into cash. An
additional problem with inventory as a liquid asset is that the times when companies face the
most dire need for liquidity, when business is bad, are precisely the times when it is most difficult
to convert inventory into cash by selling it. The quick ratio is calculated as follows:

Quick ratio = Current Assets less Inventories

Current Liabilities

The quick ratio for REX Company in 2016 is

$ 2,205,687 – $ 1,328,963 = 1.11
$ 787,873
As with the current ratio, the quick ratio level that a firm should strive to achieve depends largely
on the nature of the business in which it operates. The quick ratio provides a better measure of
overall liquidity only when a firm’s inventory cannot be easily converted into cash. If inventory is
liquid, the current ratio is a preferred measure of overall liquidity. REX acid-test ratio is slightly
above the industry median average of 1.1, indicating that it is in line with the industry.
Summary of REX Liquidity
Comparisons of REX current and acid-test ratios with medians for the industry are favourable.
However, these ratios don’t tell us whether accounts receivable and/or inventory might actually
be too high. If they are, this should affect our initial favourable impression of the firm’s liquidity.
Thus we need to go behind the ratios and examine the size, composition, and quality of these
two important current assets. We will look more closely at accounts receivable and inventory
when we discuss activity ratios. We will reserve a final opinion on liquidity until then.
B. Activity Ratios
Activity ratios measure the speed with which various accounts are converted into sales or cash
—inflows or outflows. In a sense, activity ratios measure how efficiently a firm operates along a
variety of dimensions such as inventory management, disbursements, and collections. A
number of ratios are available for measuring the activity of the most important current accounts,
which include inventory, accounts receivable, and accounts payable. As we will see, some
aspects of activity analysis are closely related to liquidity analysis.
In computing activity ratios for the REX, we will use year-end asset levels from the balance
sheet. However, an average of monthly, quarterly, or beginning and year-end asset levels is
often employed with these income statement/balance sheet ratios. The use of an average
balance sheet figure is an attempt to better match the income statement flow item with a
balance sheet stock figure more representative of the entire period, not just year-end.
Receivables Activity
Receivable Turnover Ratio provides insight into the quality of the firm’s receivables and how
successful the firm is in its collections. This ratio is calculated by dividing receivables into annual
net credit sales:

Annual net credit sales

Receivables
If we assume that all 2016 sales for REX are credit sales, this ratio is
$3,992,758 = 5.89
$678,279
This ratio tells us the number of times accounts receivable have been turned over (turned into
cash) during the year. The higher the turnover, the shorter the time between the typical sale and
cash collection. For REX, receivables turned over 5.89 times during 2016.
When credit sales figures for a period are not available, we must resort to using total sales
figures. When sales are seasonal or have grown considerably over the year, using the year-end
receivable balance may not be appropriate. With seasonality, an average of the monthly closing
balances may be the most appropriate to use. With growth, the receivable balance at the end of
the year will be deceptively high in relation to sales. The result is that the receivable turnover
calculated is a biased and low estimate of the number of times receivables turned over during
the course of the year. In this case, an average of receivables at the beginning and end of the
year might be appropriate if the growth in sales was steady throughout the year.
The median industry receivable turnover ratio is 8.1, which tells us that REX receivables are
considerably slower in turning over than is typical for the industry. This might be an indication of
a lax collection policy and a number of past-due accounts still on the books.
In addition, if receivables are far from being current, we may have to reassess the firm’s liquidity.
To regard all receivables as liquid, when in fact a sizable portion may be past due, overstates
the liquidity of the firm being analyzed. Receivables are liquid only insofar as they can be
collected in a reasonable amount of time. In an attempt to determine whether there is cause for
concern, the analyst may reformulate the receivable turnover ratio to produce receivable
turnover in days (RTD), or average collection period.
Receivable turnover in days (RTD), or average collection period, is calculated as
Days in the year
 Receivable turnover
or equivalently
Receivables X Days in the year
Annual credit sales
For REX, whose receivable turnover we calculated to be 5.89, the average
collection period is
365 = 62 days
5.89
This figure tells us the average number of days for which receivables are outstanding before
being collected. Since the median industry receivable turnover ratio is 8.1, the average
collection period for the industry is 365/8.1 = 45 days. The disparity between the industry’s
receivable collection performance and REX is once again highlighted.
However, before concluding that a collections problem exists, we should check the credit terms
offered by REX to its customers. If the average collection period is 62 days and the credit terms
are “2/10, net 30,” a sizable proportion of the receivables are past the final due date of 30 days.
On the other hand, if the terms are “net 60,” the typical receivable is being collected only two
days after the final due date.
Although too high an average collection period is usually bad, a very low average collection
period may not necessarily be good. A very low average collection period may be a symptom of
a credit policy that is excessively restrictive. The few receivables on the books may be of prime
quality, yet sales may be curtailed unduly – and profits less than they might be – because of the
restrictive issuance of credit to customers. In this situation, perhaps credit standards used to
determine an acceptable credit account should be relaxed somewhat.

Aging Accounts Receivable

Another means by which we can obtain insight into the liquidity of receivables and
management’s ability to enforce its credit policy is through aging of accounts receivable. With
this method, we categorize the receivables at a moment in time according to the proportions
billed in previous months. We will have the following hypothetical aging of accounts receivable
at December 31:

August and
Month December November October September before Total
Proportion of
receivables 67% 19% 7% 2% 5% 100%
billed

If the billing terms are 2/10, net 30, this aging tells us that 67 percent of the receivables at
December 31 are current, 19 percent are up to 1 month past due, 7 percent are 1 to 2 months
past due, and so on. Depending on the conclusions drawn from our analysis of the aging, we
may want to examine more closely the credit and collection policies of the company. In the
example, we might be prompted to investigate the individual receivables that were billed in
August and before, in order to determine if any should be charged off as bad debts. The
receivables shown on the books are only as good as the likelihood that they will be collected. An
aging of accounts receivables gives us considerably more information than the calculation of the
average collection period because it pinpoints the trouble spots more specifically.

Payables Activity

There may be occasions when a firm wants to study its own promptness of payment to suppliers
or that of a potential credit customer. In such cases, it may be desirable to obtain an aging of
accounts payable, much like that just illustrated for accounts receivable. This method of
analysis, combined with the less exact payable turnover (PT) ratio (annual credit purchases
divided by accounts payable), allows us to analyze payables in much the same manner as we
analyze receivables. Also, we can compute the payable turnover in days (PTD) or average
payable period as

Days in the year

Payable turnover
or, equivalently,

Accounts Payable X Days in the year

Annual credit purchases

where accounts payable is the ending (or perhaps, average) balance outstanding for the year
and annual credit purchases are the external purchases during the year. This figure yields the
average age of a firm’s accounts payable.

The average payable period is valuable information in evaluating the probability that a credit
applicant will pay on time. If the average age of payables is 48 days and the terms in the
industry are “net 30,” we know that a portion of the applicant’s payables is not being paid on
time. A credit check of the applicant’s other suppliers will give insight into the severity of the
problem.

Inventory Activity
To help determine how effectively the firm is managing inventory (and also to gain an indication
of the liquidity of inventory), we compute the inventory turnover (IT) ratio:

Cost of goods sold

Inventory

For REX, this ratio for 2016 is

$ 2,680,298 = 2.02
$ 1,328,963

The figure for cost of goods sold used in the numerator is for the period being studied – usually
a year; the inventory figure used in the denominator, though a year-end figure in our example,
might represent an average value. For a situation involving simple growth, an average of
beginning and ending inventories for the period might be used. As is true with receivables,
however, it may be necessary to compute a more sophisticated average when there is a strong
seasonal element. The inventory turnover ratio tells us how many times inventory is turned over
into receivables through sales during the year. This ratio, like other ratios, must be judged in
relation to past and expected future ratios of the firm and in relation to ratios of similar firms, the
industry average, or both.

Generally, the higher the inventory turnover, the more efficient the inventory management of the
firm and the “fresher,” more liquid, the inventory. However, sometimes a high inventory turnover
indicates a hand-to-mouth existence. It therefore might actually be a symptom of maintaining
too low a level of inventory and incurring frequent stock outs. Relatively low inventory turnover is
often a sign of excessive, slow-moving, or obsolete items in inventory. Obsolete items may
require substantial write-downs, which, in turn, would tend to negate the treatment of at least a
portion of the inventory as a liquid asset. Because the inventory turnover ratio is a somewhat
crude measure, we would want to investigate further any perceived inefficiency in inventory
management. In this regard, it is helpful to compute the turnover of the major categories of
inventory to see whether there are imbalances, which may indicate excessive investment in
specific components of the inventory.

REX inventory turnover of 2.02 is in marked contrast to an industry median turnover ratio of 3.3.
This unfavorable comparison suggests that the company is less efficient in inventory
management than is average for the industry, and that REX holds excessive inventory stock. A
question also arises as to whether the inventory on the books is worth its stated value. If not, the
liquidity of the firm is less than the current ratio or quick ratio alone suggests. Once we have a
hint of an inventory problem, we must investigate it more specifically to determine its cause. An
alternative measure of inventory activity is inventory turnover in days (ITD):

Days in the year

Inventory turnover
or, equivalently,

Inventory X Days in the year

Cost of goods sold

For REX, whose inventory turnover we calculated to be 2016, the inventory turnover in days
(ITD) is
365 = 181 days
2.02

This figure tells us how many days, on average, before inventory is turned into accounts
receivable through sales. Transforming the industry’s median inventory turnover of 3.3 into an
inventory turnover in days figure, we get 365/3.3 = 111 days. Thus REX is, on average, 70 days
slower in “turning” its inventory than is typical for the industry.

Operating Cycle versus Cash Cycle

A direct result of our interest in both liquidity and activity ratios is the concept of a firm’s
operating cycle. A firm’s operating cycle is the length of time from the commitment of cash for
purchases until the collection of receivables resulting from the sale of goods or services. It is as
if we start a stopwatch when we purchase raw materials and stop the watch only when we
receive cash after the finished goods have been sold. The time appearing on our watch (usually
in days) is the firm’s operating cycle. Mathematically, a firm’s operating cycle is equal to

Inventory turnover in days (ITD) + Receivable turnover in days (RTD)

We stress the fact that our stopwatch starts at the commitment of cash for purchases rather
than from the actual cash outlay itself. The reason for this subtle distinction is that most firms do
not pay for raw materials immediately but rather buy on credit and incur an account payable.
However, if we want to measure the length of time from the actual outlay of cash for purchases
until the collection of cash resulting from sales, it is a simple matter. We would subtract the
firm’s payable turnover in days (PTD) from its operating cycle and thus produce the firm’s cash
cycle:

Operating cycle (ITD+RTD) – Payable turnover in days (PTD)

Why even worry about the firm’s operating cycle? The length of the operating cycle is an
important factor in determining a firm’s current asset needs. A firm with a very short operating
cycle can operate effectively with a relatively small amount of current assets and relatively low
current and acid-test ratios. This firm is relatively liquid in a “dynamic” sense – it can produce a
product, sell it, and collect cash for it, all in a relatively short period of time. It does not have to
rely so heavily on high “static” levels of liquidity as measured by the current or acid-test ratio.
This is very similar to judging the “liquidity” of a garden hose. This liquidity depends not only on
the “static” amount of water in the hose at any one time but also the velocity with which the
water moves through the hose.
The operating cycle, by focusing on ITD and RTD, provides a summary activity measure. For
example, a relatively short operating cycle generally indicates effectively managed receivables
and inventory. But, as we have just discussed, this measure provides supplementary
information on a firm’s liquidity as well. A relatively short operating cycle would thus also reflect
favorably on a firm’s liquidity. In contrast, a relatively long operating cycle might be a warning
sign of excessive receivables and/or inventory, and would reflect negatively on the firm’s true
liquidity.
Comparing REX operating cycle with that of the median industry average, we have:

REX Median Industry Average

Operating Cycle 243 days 156 days

The cumulative effect of both a sluggish inventory turnover and receivable turnover for REX is
clearly apparent; relative to the typical firm in the industry, it takes REX an extra 87 days to
manufacture a product, sell it, and collect cash from sales. The length of the firm’s operating
cycle should also cause us to have second thoughts about the firm’s liquidity. We have not said
very much, so far, about the firm’s cash cycle. One reason is that one must be extremely careful
in trying to analyze this measure. On the surface, it would seem that a relatively short cash
cycle would be a sign of good management. Such a firm is quick to collect cash from sales once
it pays for purchases. The catch is that this measure reflects both operating and financing
decisions of the firm, and mismanagement in one or both of these decision areas might be
overlooked. For example, one way to arrive at a short cash cycle is simply never to pay your
bills on time (a poor financing decision). Your payable turnover in days figure will become large,
and subtracted from your operating cycle, it will produce a low (perhaps even negative!) cash
cycle. The operating cycle, by focusing strictly on the effects of operating decisions on inventory
and receivables, provides clearer signals for the analyst to consider.

Few companies can claim negative cash cycles without resort to poor operating and/or payables
decisions. However, there are a few firms that can do it – and do it well. They generally use a
“just-in-time” approach to inventory, manage receivables tightly, and, because of strong
purchasing power, secure generous credit terms from suppliers.
A Second Look at REX Liquidity
As you may remember, REX current and acid test ratios compared favorably with industry
median ratios. However, we decided to reserve a final opinion on liquidity until we had
performed a more detailed examination of the firm’s receivables and inventory. The turnover
ratios for both of these assets, and the resulting operating cycle, are significantly worse than the
industry median values for these same measures. These findings suggest that the two assets
are not entirely current, and this factor detracts from the favorable current and quick ratios. A
sizable portion of receivables is slow, and there appear to be inefficiencies in inventory
management. On the basis of our analysis, we conclude that these assets are not particularly
liquid in the sense of turning over into cash in a reasonable period of time.

Total Asset (or Capital) Turnover

The total asset turnover indicates the efficiency with which the firm uses its assets to generate
sales. Total asset turnover is calculated as follows:

Total Asset Turn-over = Net sales

Total Assets
REX total asset turnover for fiscal year ended 2016 is

$ 3,992,758 = 1.24
$ 3,215,277
The median total asset turnover for the industry is 1.66, so it is clear that REX generates less
sales revenue per dollar of asset investment than does the industry, on average. The total asset
turnover ratio tells us the relative efficiency with which a firm utilizes its total assets to generate
sales. REX is less efficient than the industry in this regard. From our previous analysis of REX
receivables and inventory activity, we suspect that excessive investments in receivables and
inventories may be responsible for a large part of the problem. If REX could generate the same
sales revenue with fewer dollars invested in receivables and inventories, total asset turnover
would improve.

C. Debt Ratios
The debt position of a firm indicates the amount of other people’s money being used to generate
profits. In general, the financial analyst is most concerned with long-term debts because these
commit the firm to a stream of contractual payments over the long run. The more debt a firm
has, the greater its risk of being unable to meet its contractual debt payments. Because
creditors’ claims must be satisfied before the earnings can be distributed to shareholders,
current and prospective shareholders pay close attention to the firm’s ability to repay debts.
Lenders are also concerned about the firm’s indebtedness. In general, the more debt a firm
uses in relation to its total assets, the greater its financial leverage. Financial leverage is the
magnification of risk and return through the use of fixed-cost financing, such as debt and
preferred stock. The more fixed-cost debt a firm uses, the greater will be its expected risk and
return.

Illustration:
Patty Akers is in the process of incorporating her new business. After much analysis she
determined that an initial investment of $50,000—$20,000 in current assets and $30,000 in fixed
assets—is necessary. These funds can be obtained in either of two ways. The first is the no-
debt plan, under which she would invest the full $50,000 without borrowing. The other
alternative, the debt plan, involves investing $25,000 and borrowing the balance of $25,000 at
12% annual interest.
Patty expects $30,000 in sales, $18,000 in operating expenses, and a 40% tax rate. The no-
debt plan results in after-tax profits of $7,200, which represent a 14.4% rate of return on Patty’s
$50,000 investment. The debt plan results in $5,400 of after-tax profits, which represent a
21.6% rate of return on Patty’s investment of $25,000. The debt plan provides Patty with a
higher rate of return, but the risk of this plan is also greater, because the annual
$3,000 of interest must be paid whether Patty’s business is profitable or not.

The example demonstrates that with increased debt comes greater risk as well as higher
potential return. Therefore, the greater the financial leverage, the greater the potential risk and
return.

There are two general types of debt measures: measures of the degree of indebtedness and
measures of the ability to service debts. The degree of indebtedness measures the amount of
debt relative to other significant balance sheet amounts. A popular measure of the degree of
indebtedness is the debt ratio.
The second type of debt measure, the ability to service debts, reflects a firm’s ability to
make the payments required on a scheduled basis over the life of debt.

The term to service debts simply means to pay debts on time. The firm’s ability to pay certain
fixed charges is measured using coverage ratios. Typically, higher coverage ratios are preferred
(especially by the firm’s lenders), but a very high ratio might indicate that the firm’s management
is too conservative and might be able to earn higher returns by borrowing more. In general, the
lower the firm’s coverage ratios, the less certain it is to be able to pay fixed obligations. If a firm
is unable to pay these obligations, its creditors may seek immediate repayment, which in most
instances would force a firm into bankruptcy. Most commonly used as coverage ratios is the
times interest earned ratio.

 Debt Ratio
The debt ratio measures the proportion of total assets financed by the firm’s creditors. The
higher this ratio, the greater the amount of other people’s money being used to generate profits.
The ratio is calculated as follows:

Debt Ratio = Total Liabilities

Total Assets

The debt ratio for REX in 2016 is

$1,418,656 / $3,215,277 = 0.44 = 44%

This value indicates that the company has financed close to half of its assets with debt. The
higher this ratio, the greater the firm’s degree of indebtedness and the more financial leverage it
has. It highlights the relative importance of debt financing to the firm by showing the percentage
of the firm’s assets that is supported by debt financing. Thus 44 percent of the firm’s assets are
financed with debt (of various types), and the remaining 56 percent of the financing comes from
shareholders’ equity. Theoretically, if the firm were liquidated right now, assets could be sold to
net as little as 44 cents on the dollar before creditors would face a loss. Once again, this points
out that the greater the percentage of financing provided by shareholders’ equity, the larger the
cushion of protection afforded the firm’s creditors. In short, the higher the debt ratio, the greater
the financial risk; the lower this ratio, the lower the financial risk.

 Times Interest Earned Ratio

The times interest earned ratio, sometimes called the interest coverage ratio, measures the
firm’s ability to make contractual interest payments. The higher its value, the better able the firm
is to fulfill its interest obligations. The times interest earned ratio is calculated as follows:

Times interest earned ratio = Earnings before interest and taxes / taxes

Applying this ratio to REX yields the following 2016 value:

Time interest earned ratio = $511,065/ $113,040 = 4.52

This ratio serves as one measure of the firm’s ability to meet its interest payments and thus
avoid bankruptcy. In general, the higher the ratio, the greater the likelihood that the company
could cover its interest payments without difficulty. It also sheds some light on the firm’s capacity
to take on new debt. With an industry median average of 4.0, REX ability to cover annual
interest 4.71 times with operating income (EBIT) appears to provide a good margin of safety.
In assessing the financial risk of a firm, then, the financial analyst should first compute
debt ratios as a rough measure of financial risk. Depending on the payment schedule of the
debt and the average interest rate, debt ratios may or may not give an accurate picture of the
firm’s ability to meet its financial obligations. Therefore we augment debt ratios with an analysis
of coverage ratios. Additionally, we realize that interest and principal payments are not really
met out of earnings per se, but out of cash. Therefore it is also necessary to analyze the cash
flow ability of the firm to service debt.

Time Series Analysis of REX Financial Ratios

Selected financial ratios for REX Manufacturing Company over the 2014 to 2016 period along
with industry median figures for 2016.
Industry Median
 2014 2015 2016 2016
Current ratio 2.55 2.64 2.80 2.10
Acid-test ratio 1.30 1.14 1.11 1.10
Receivable Turnover 4.95 5.02 5.89 6.5
Average Collection Period 74 days 73 days 62 days 56 days
Inventory Turn-over in days 136 days 180 days 181 days 111 days
Total Asset Turnover 1.25 1.17 1.24 1.66
Debt Ratio 0.43 0.45 0.44 0.44
Interest Coverage 5.95 7.09 4.52 4.0
As can be seen, the current and acid-test ratios have fallen off somewhat over time but still
exceed industry norms in 2016. The figures for average collection period and inventory turnover
in days have grown since 2014 and exceed the current industry median levels. The trends here
tell us that there has been a relative buildup in receivables and inventories. The turnover of
each has slowed, which raises questions as to the quality and liquidity of these assets. When a
trend analysis of receivables and inventory is coupled with a comparison with median ratios for
the industry, the only conclusion possible is that a problem exists. The analyst would want to
investigate the credit policies of REX, the company’s collection experience, and its bad-debt
losses. Moreover, one should investigate inventory management, obsolescence of inventory,
and any imbalances in the makeup of inventory (i.e., raw material versus work-in-process
versus finished goods). Thus, despite above average levels of current and acid-test ratios, the
apparent deterioration in receivables and inventory is a matter of concern and needs to be
investigated in depth.
The stability of the firm’s leverage (debt) ratios coupled with a present relative debt level
typical of the industry would be viewed favorably by creditors. From our analysis of activity
ratios, we know that the primary cause has been the large and growing relative amounts of
receivables and inventory.