ñòð. 14 |

in liquidity since the net working capital needed to support the expanding sales is tied up in assets that

cannot be realized in time to meet the current obligations. The impact of earning activities on liquidity

is highlighted by comparing cash flow from operations to net income.

If accounts receivable and inventory turn over quickly, the cash flow received from customers can

be invested for a return, thus increasing net income.

Leverage (Solvency, Long-Term Debt) Ratios

Solvency is a companyâ€™s ability to meet its long-term obligations as they become due. An analysis

of solvency concentrates on the long-term financial and operating structure of the business. The degree

of long-term debt in the capital structure is also considered. Further, solvency is dependent upon

profitability since in the long run a firm will not be able to meet its debts unless it is profitable.

When debt is excessive, additional financing should be obtained primarily from equity sources.

Management might also consider lengthening the maturity of the debt and staggering the debt

repayment dates.

Some leverage ratios follow.

Debt Ratio. The debt ratio compares total liabilities (total debt) to total assets. It shows the

percentage of total funds obtained from creditors. Creditors would rather see a low debt ratio because

there is a greater cushion for creditor losses if the firm goes bankrupt.

total liabilities

Debt ratio =

total assets

FINANCIAL ANALYSIS [CHAP. 2

26

For the Ratio Company, in 19x3 the debt ratio is:

$135,400

= 0.62

$220,000

In 19x2, the ratio was 0.63. There was a slight improvement in the ratio over the year as indicated

by the lower degree of debt to total assets.

DebtlEquiV Ratio. The debtlequity ratio is a significant measure of solvency since a high degree

of debt in the capital structure may make it difficult for the company to meet interest charges and

principal payments at maturity. Further, with a high debt position comes the risk of running out of cash

under conditions of adversity. Also, excessive debt will result in less financial flexibility since the

company will have greater difficulty obtaining funds during a tight money market. The debt/equity ratio

is computed as:

total liabilities

Debt/equity ratio =

stockholders' equity

For Ratio Company, the debt/equity ratio was 1.60in 19x3 ($135,400/$84,600)and 1.67in 19x2. The

ratio remained fairly constant. A desirable debt/equity ratio depends on many variables, including the

rates of other companies in the industry, the access for further debt financing, and the stability of

earnings.

Times Interest Earned (Interest Coverage) Ratio. The times interest earned ratio reflects the

number of times before-tax earnings cover interest expense.* It is a safety margin indicator in the sense

that it shows how much of a decline in earnings a company can absorb. The ratio is computed as

follows:

earnings before interest and taxes (EBIT)

Times interest earned ratio =

interest expense

In 19x3, interest of Ratio Company was covered 9 times ($18,000/$2,000), while in 19x2 it was

covered 11 times. The decline in the coverage is a negative indicator since less earnings are available

to meet interest charges.

Profitability Ratios

An indication of good financial health and how effectively the firm is being managed is the

company's ability to earn a satisfactory profit and return on investment. Investors will be reluctant to

associate themselves with an entity that has poor earning potential since the market price of stock and

dividend potential will be adversely affected. Creditors will shy away from companies with deficient

profitability since the amounts owed to them may not be paid. Absolute dollar profit by itself has little

significance unless it is related to its source.

Some major ratios that measure operating results are summarized below.

Gross ProJitMargin. The gross profit margin reveals the percentage of each dollar left over after

the business has paid for its goods. The higher the gross profit earned, the better. Gross profit equals

net sales less cost of goods sold.

gross profit

Gross profit margin =

net sales

The gross profit margin for the Ratio Company in 19x3 is:

Note that some textbooks use @er-tax earnings to calculate this ratio.

27

CHAP. 21 FINANCIAL ANALYSIS

In 19x2 the gross profit margin was 0.41. The decline in this ratio indicates the business is earning

less gross profit on each sales dollar. The reasons for the decline may be many, including a higher relative

production cost of merchandise sold.

Profit Margin. The ratio of net income to net sales is called the profit margin. It indicates the

profitability generated from revenue and hence is an important measure of operating performance. It

also provides clues to a companyâ€™s pricing, cost structure, and production efficiency.

net income

Profit margin =

net sales

In 19x3, the Ratio Companyâ€™s profit margin is:

In 19x2, the ratio was also 0.120. The constant profit margin indicates that the earning power of the

business remained static.

Return on Investment. Return on investment (ROI) is a key, but rough, measure of performance.

Although ROI shows the extent to which earnings are achieved on the investment made in the business,

the actual value is generally somewhat distorted.

There are basically two ratios that evaluate the return on investment. One is the return on total

assets, and the other is the return on ownersâ€™ equity.

The return on total assets (ROA) indicates the efficiency with which management has used its

available resources to generate income.

net income

Return on total assets =

average total assets

For the Ratio Company in 19x3, the return on total assets is:

$9,600

= 0.0457

($220,000 + $200,000)/2

In 19x2, the return was 0.0623. The productivity of assets in deriving income deteriorated in

19x3.

The Du Pont formula shows an important tie-in between the profit margin and the return on total

assets. The relationship is:

Return on total assets = profit margin total asset turnover

X

Therefore,

Net income - net income X net sales

Average total assets net sales average total assets

As can be seen from this formula, the ROA can be raised by increasing either the profit margin or

the asset turnover. The latter is to some extent industry dependent, with retailers and the like having

a greater potential for raising the asset turnover ratio than do service and utility companies. However,

the profit margin may vary greatly within an industry since it is subject to sales, cost controls, and pricing.

The interrelationship shown in the Du Pont formula can therefore be useful to a company trying to raise

its ROA since the area most sensitive to change can be targeted.

For 19x3, the figures for the Ratio Company are:

Return on total assets = profit margin X total asset turnover

0.0457 = 0.120 X 0.381

We know from our previous analysis that the profit margin has remained stable while asset turnover

[CHAP. 2

FINANCIAL ANALYSIS

28

has deteriorated, bringing down the ROI. Since asset turnover can be considerably higher, Ratio

Company might first focus on improving this ratio while at the same time reevaluating its pricing policy,

cost controls, and sales practices.

The return on common equity (ROE) measures the rate of return earned on the common

stockholdersâ€™ investment.

earnings available to common stockholders

Return on common equity =

average stockholdersâ€™ equity

In 19x3, Ratio Companyâ€™s return on equity is:

$9,600

= 0.1203

ñòð. 14 |