Topic 6: Corporate accounts — working capital ratios
Debt structure
In addition to assessing the gearing of a company, careful attention must be paid to the structure of debt. As previously noted, long-term assets should preferably be funded out of equity and long-term borrowings, while working capital needs are best funded by bank overdraft and short-term borrowings. The following definitions apply in all of the following debt structure ratios: • financial debt means gross financial debt. Cash is not deducted in this ratio, as the ability to repay gross indebtedness is being examined • long-term debt is non-current financial debt • short-term debt is current financial debt • secured debt includes secured borrowings and lease liabilities. Secured debt means that the borrower has pledged security to the lender, whereas unsecured debt means that the borrower offers no security to the lender. The proportion of secured and unsecured debt to total debt is very important to lenders.
Topic learning outcomes
On completing this topic, students should be able to: • perform basic ratio analysis based on information in published financial reports • describe the limitations of ratio analysis • calculate some of the most commonly used working capital, capital and debt structure and debt protection ratios • interpret the working capital, capital and debt structure and debt protection ratios calculated • explain the importance of identifying business activities when interpreting ratios • describe how an examination of working capital is an indicator of management efficiency.
Current ratio
The current (or 'working capital') ratio measures the relationship between current assets and current liabilities and is widely used to test the short-term liquidity of a company. The current ratio measures the strength or weakness of the working capital position and is a measure of the company's ability to satisfy current obligations from current assets. The implication is that a high ratio of current assets to current liabilities represents a high degree of assurance that current liabilities can be paid out of current assets. The current ratio is expressed in units of 'times' and is calculated as follows
Inventory turnover ratio
inventory turnover (times) = cost of sales/average inventory Cost of sales: As inventory is listed on the statement of financial position at cost, not selling price, it should be compared with the cost of sales rather than the selling price. Inventory: For the purposes of calculating liquidity ratios, inventory is the total of all current inventory as shown on the statement of financial position. Rarely will there be some inventory items classified as non-current assets. The analyst will need to examine closely the nature of these items to determine whether or not they should be included in these ratios. Generally, non-current inventory is omitted, as the ratio measures short-term liquidity. Average inventory: The simplest average to calculate is the average of the inventory at the start and at end of the current year as follows: Average inventory = Opening inventory + Closing inventory / 2
Acid test ratio (quick ratio)
A more stringent liquidity test is the acid test ratio (also called the 'quick' ratio). This again, compares current assets to current liabilities, but includes only those assets which can more readily be converted to cash in the next month or two to help meet the liabilities due for payment during that period. The acid test ratio is expressed in units of 'times' and is calculated as follows:
Foreign currency exposure
Another factor for the analyst to examine when considering a company's debt structure is the mix of currencies within the borrowings. Normally, a company which has overseas assets or revenue will attempt to remove or reduce that currency exposure by maintaining a similar level of debt in that currency. However, the analyst should question the use of foreign currency borrowings where the company in question has no foreign currency asset or revenue exposure. This may be a legitimate strategy if all such foreign currency borrowings have been swapped back to Australian dollars. If not, then the company is running the risk of a currency loss (or gain). Look for currency hedges in the notes, which act as insurance to reduce the risk of adverse foreign currency movements.
How to interpret days creditors
By delaying or extending the payment of creditors, a company may finance additional asset purchases. If the number of days of creditor turnover is high, then efficient use is being made of creditors and this indicates effective management and a lower cost structure. However, too high a level may mean that the company is not taking advantage of cash discounts on the early payment of creditors. This could be a sign of poor liquidity and an indicator of a company experiencing financial difficulties. Furthermore, too high a level could ultimately result in creditors discontinuing supply. This could necessitate a critical review of the liquidity ratios. The analyst will establish if the company has operated with days creditors at these levels in the past; and if not, attempt to determine why the change has taken place. Another consideration is that creditors will be less inclined to be helpful when they believe their customer is taking an unduly long time to pay, because the creditors' cash flow would be weakened if customers are slow payers. Care should be exercised when using this ratio, because: • the trade creditors figure may contain significant amounts which are unrelated to sales and therefore may produce a misleading figure • the cost of sales is reasonable to use when most of the creditors are related to stock. This could indicate the extent to which creditors finance cost of sales. However, a manufacturer will have high employee costs in its cost of sales, as it would include all costs for the manufacture of the goods sold • the figure for trade creditors taken at the end of the year may not be representative of the typical level of creditors throughout the year (e.g. due to seasonality factors).
Net interest
Company accounts should be carefully reviewed to determine whether any interest was capitalised and whether that interest was excluded from interest paid, as disclosed in the finance expense note (other companies may disclose this amount in other notes such as property, plant and equipment). Capitalising means recognising the cost of the interest as an asset, instead of an expense. Therefore, for profitability ratios, any statement of financial position item such as capitalised interest is excluded. However, when looking at total debt or interest commitments or cash flow items, capitalised interest is included as it still has to be paid. Capitalised interest is excluded from the EBIT calculation. As it has not been included as an expense in the calculation of the earnings figure, it would be inconsistent to add it to the EBIT calculation. However, capitalised interest should be included in the denominator of the net interest cover ratio. This is because the net interest cover ratio measures how many times earnings cover interest payments. These interest payments must include capitalised as well as expensed interest because both represent obligations, regardless of how they are treated for accounting purposes.
Calculating the net debt/equity ratio
Equity is 'shareholders' funds', 'shareholders' equity' or 'ordinary equity'. The analyst should check to determine if any adjustments need to be made to reported equity to derive shareholders' funds. Shareholders' funds include non-controlling interests (previously known as minority interests or outside equity interests) because these shareholders are investors in one or more of the subsidiaries that are not fully owned by the parent company. Although these investors do not have a controlling interest in the company, they are nevertheless partly financing the group through their investment in those subsidiaries in which they hold shares.
Interest rate basis
Finally, the analyst should establish, if possible, how much of a company's borrowings have been negotiated on a variable interest rate basis as well as the magnitude of borrowings negotiated on a fixed rate basis. In an environment of rising interest rates, companies with fixed, low interest rates will clearly be at an advantage over those companies which rely solely on variable rate funding. However, the reverse argument operates when reviewing a company that has locked itself into high fixed interest rate loans at a time of falling rates.
Liquidity ratios
Liquidity is commonly used as a measure of the degree to which the assets of a business can be turned into cash. A high degree of liquidity is usually considered a positive sign, since it indicates a capacity to meet short-term obligations and an ability to invest in new directions. The key point is that liquidity is the ability to meet short-term obligations without duress or delay. Failure to pay creditors (including banks) and suppliers can have large and negative impacts on the company. These impacts involve both creditors (banks, investors, etc.) and suppliers (materials suppliers, employees, utility suppliers, etc.) and if left unchecked, can lead to business failure
Shortcomings of the current ratio
Shortcomings include, firstly, that stocks can be difficult to value accurately and may not be highly liquid. This company could still encounter financial difficulty if the $100,000 of current liabilities were all due within a month, but where its inventory could only be sold, without severe loss, over a period of several months. Greater efficiency in working capital management, while a positive step, will cause the ratio to fall. For instance, better stock control and improved inventory turnover will lead to a reduction in this current asset item, and more efficient debtor collections will influence a fall in receivables relative to sales.
Days debtors ratio
Other debtors are excluded, because they are debtors arising from transactions other than sales of inventory or services on credit. Sales revenue is used in this ratio, even though credit sales would be more appropriate, because the latter is rarely published. The ratio is multiplied by the number of days in the financial year to convert it to a daily basis.
Categories of ratio analysis
Ratios commonly used to interpret financial statements fall into the following broad categories: • liquidity ratio: measures the extent to which a company can meet its short-term obligations • working capital management efficiency ratio: considers the efficiency (profitability) of the employment of working capital by management • capital and debt structure ratios: considers the dependence on debt and equity in the financing of the entity. Debt often means liabilities and is the word sometimes used in ratios as a substitution for the word 'liabilities'. In this subject, debt is considered to mean interest-bearing liabilities and this subject uses the term in this context • debt protection (or debt service coverage) ratio: examines the relationship between finance charges and profit before finance charges so as to determine the demand that servicing borrowings makes on earnings • financial gearing or leverage ratio: provides information on the company's longer-term obligations. It assesses the relationship between the rate of return achieved on assets and the cost of borrowing to finance them (further discussed in Topic 7) • profitability ratio: provides information on the profit generating capacity of the company from operating activities. This includes the return on equity (ROE) ratio, the return on assets (ROA) ratio and margins on sales revenue (further discussed in Topic 7).
How to interpret the inventory ratios
The inventory ratios show the value of stock held by the company expressed as days. For example, the inventory held by Tesmer Group in 20X1 took, on average, 4.67 days = 5 days (365 divided by 78.1) to sell. (This calculation shows the link between inventory turnover and days inventory). Time is of the essence here. The company's creditors and investors will be most interested in how long a company holds its inventory before it is sold, as that is how efficiently it is using its working capital. The rate at which inventory turns over varies depending on the nature of the business. A rate of 78.1 times may be considered very high for a company like Tesmer. However, a standard rate of 6.0 times would be considered more rapid than expected for a manufacturer of whitegoods. Seasonal sales must also be considered. For example, clothing stores have high inventories in spring and autumn when new season merchandise arrives, with lower inventories in between. In such companies, an annual calculation of inventory turnover has limited meaning, and inventory measured at various seasonal high and low points is of more significance. As the reporting date is at the same time each year, the trend is still useful.
How to interpret debt to gross cash flow
The lower the number of years, the quicker the operating cash flow (if used for nothing else) can repay all interest-bearing debt. Tesmer's debt to gross cash flow ratio has been fairly stable and decreased in 20X1. This stability suggests Tesmer is managing its debt quite well and would take somewhere around one and a half years in 20X1 to repay it all out of operating cash flows. There are some significant differences in the results obtained under each of the two methods in each year. This is explained by the different bases used for the calculations. The gross cash flow method does not consider the impact of accrual accounting on the result with only the 'obvious' non-cash expenses of depreciation, amortisation and impairment being removed from NPAT. In contrast, the method utilising cash flows from operations reflects actual cash flows which reflect movements in accruals such as trade debtors and receivables.
How to interpret the net debt/equity ratio
The net debt to equity ratio may be expressed in various ways. For example, the analyst may say Tesmer Group has a debt/equity ratio of 0.2 to 1.0 in 20X1, also expressed as a gearing ratio of 20.3%. This is considered to be a fairly low level of financial risk and therefore does not pose a cause for potential concern. A company with a high proportion of debt, on the other hand, is said to be highly geared or highly leveraged and may be a cause for concern if the company fails to meet the necessary obligations on time. In broad terms, for a wide range of industrial companies, a net debt/equity ratio of less than 100% is considered to be acceptable, although this ratio can vary widely between industries. For example, companies in a start-up phase or companies in industries with high capital investment requirements (such as mining) may have a ratio higher than 100% and still considered to be soundly geared if their future cash flows are expected to be healthy and sustainable (that is, high enough to meet debt obligations, pay dividends and build up a reserve of retained earnings within the company).
How to interpret the current ratio
The proportion of various types of current assets is important in interpreting the current ratio. For example, a company with a high percentage of its current assets in cash is more liquid than one with a high percentage in inventory, even though both companies may have the same current ratio. The company with the high level of inventory has to convert the inventory to debtors, before it can then be converted to cash. The rule of thumb is that a current ratio of approximately 1.5 times (i.e. $1.50 of current assets for every $1.00 of current liabilities) may be satisfactory. However, any assessment of this ratio must start with an assessment of the nature of the particular industry and the activity cycle of individual businesses. In every business undertaking there is a natural activity cycle. The successive movements in this cycle and the length of the cycle itself will vary between one business and another. The longer the activity cycle, the longer the period one would expect between payments and receipts and therefore the higher the relative liquidity requirements. A longer activity cycle would be typical of the manufacturing industry, whereas the retail industry would have a shorter activity cycle. The nature of these activity cycles is illustrated below.
Ratio analysis process
The ratio analysis process involves three steps: Step 1: Calculation of a number of ratios. Step 2: Comparative analysis to ascertain whether the ratios are satisfactory or otherwise. Step 3: Interpretation of the results obtained. The absolute ratios resulting from the calculation provide limited information. They need to be rated as favourable or unfavourable and hence they need to be measured against chosen yardsticks. Analysts use various comparisons including: • intra-industry (comparing the particular company with other companies in the same industry) • inter-industry (comparing the particular company with other companies in different industries) • intra-company (comparing the particular company's ratios across time to identify trends or other relationships) • over time (comparing a company's results for the current financial year with its results in the previous year, and where possible over a number of years) • indicative standards (comparing the particular company's ratios to 'traditional' standards or benchmarks which are indicative 'rules of thumb' (often based on long term trend data for an industry as a whole). The application of these standards requires some caution as they often include an arbitrary element in their calculation.
Effect of inflation
The usefulness of the ratios depends on how well they reflect reality. The accounting measurement process ignores inflation. In periods of inflation, the asset values disclosed in financial statements may be significantly understated and any ratios based on these values will be misleading. While there has been much research on inflation (for example by Professor Raymond Chambers of the University of Sydney), most of this has failed to be adopted in the Accounting Standards. Given that Australia has had low inflation for a number of years, this is now less of a problem than in the 1970's.
Treatment of lease payments
There are two types of leases: • operating • finance. When leasing is in reality a means of purchasing assets (i.e. the lessee substantially enjoys the benefits and assumes all the risk of the property, plant or equipment), it is termed a finance lease and appears on the statement of financial position as an asset and liability. In the income statement, the expenses are finance lease charges (the equivalent of interest on a loan) included in the borrowing costs or shown separately, and lease amortisation expenses (the equivalent of depreciation and impairment on owned assets) included in depreciation expenses and perhaps shown separately. Under the current AASB for leases, when leasing is not a means of purchasing assets (i.e. a right to use, but not to 'own') it is termed an operating lease and the total lease payments are recorded as an expense in the income statement. There is no impact on the statement of financial position. Operating lease charges can constitute an important fixed charge, particularly for large retailers, which lease most of their retail space
Net debt/equity
This ratio is called 'gearing' or 'leverage' and measures the extent to which a company is financed by debt (explained in Topic 4). It refers to the amount of interest-bearing debt in a company and is an important indicator of a company's stability on a long-term basis. Financial debt is simply interest-bearing liabilities (i.e. liabilities on which interest is payable). The separate disclosure of interest-bearing debt on the statement of financial position makes it easy to identify and use in the ratio. Whether a liability is interest bearing or not may be indicated, in a relevant note, where the liability appears (see note 9 in Tesmer Group's 20X1 Annual report); or it may be determined from the interest rate risk disclosures provided in the note on financial instruments or financial risk management. The interest rate profile of financial assets and liabilities will normally be detailed in a table showing interest rate risk disclosures. This may include a column entitled 'Non-interest-bearing' which can be used to determine which liabilities are non-interest-bearing. Items such as trade creditors, other creditors, other non-current liabilities and various provisions (e.g. provision for deferred tax liabilities) are not included unless it is known that they are interest bearing. It is important not to include any non-interest bearing liabilities in the figures used for financial debt. Financial debt includes finance leases, as they are, by definition, a form of financing with an interest component that must be disclosed in company accounts.
How to interpret debt structure ratios
Warning signs are created when longer-term cash flow cycles are funded predominantly by short-term borrowings. Large manufacturing operations should have a blend of short-term debt (to finance working capital needs, usually between 20% and 40% of total debt) and longer-term borrowings (to finance capital expenditure programs which have longer cash flow cycles). Maturities of borrowings should be well spread, so that there is no 'bunching' effect. If the bulk of a company's borrowings fall due at one time and the availability of funds at that time is difficult or economically disadvantageous to the company, then refinancing may create problems. With a spread of maturities, the risk of the need to refinance in a depressed period is reduced. For the unsecured lender, the level of secured borrowings to total borrowings is an important ratio. If the bulk of assets of a company are secured, then the unsecured lender, whose priority ranks after the secured lender, must rely heavily on the quality and stability of cash flow to ensure repayment. The level of secured borrowings in a company's statement of financial position also tells the analyst something about the level of risk that lenders attach to that company. Where risks are high, lenders will tend to demand security