In The Complete Beginner’s Guide to Financial Ratios – Part One we covered:
- Why Ratio Analysis?
- Financial Ratio Analysis and interpretation
- Key financial ratios
- Types of financial ratios
- How, why and when to us financial ratios
In this part we’ll cover solvency and valuation.
- What is Solvency?
- What are the main solvency ratios?
- What is efficiency?
- What are the main efficiency ratios?
- What is valuation?
- What are the main valuation ratios?
- Summary and conclusions
What is Solvency?
The solvency ratios also called leverage ratios to help to assess the short and long-term capability of an organization to meet its obligations. In fact, while the liquidity ratios help us to evaluate in the very short-term the health of a business, the solvency ratios have a broader spectrum.
Be reminded that the assets can be acquired either through debt or equity. The relationship between debt and equity tells us the capital structure of an organization. Until debt helps the organization to grow this leads to an optimal capital structure.
When, instead, the debt grows (and interest expenses grow exponentially) too much this can be a real problem. Consequently, the Solvency Ratios help us to answer questions such as: Is the company using an optimal capital structure? If not, is debt or equity the problem?
If the debt is the problem, will the company be able to repay for its contracted debt through its earnings?
What are the main solvency ratios?
The main solvency ratios are:
- Debt to equity ratio
- Interest Coverage Ratio
- Debt to Assets
Debt to equity ratio
This ratio explains how much more significant is the debt in comparison to equity. This ratio can be expressed either as number or percentage. The formula to compute the debt to equity ratio is:
Total Liabilities / Shareholders’ Equity
The debt to equity ratio is also defined as the gearing ratio and measures the level of risk of an organization. Indeed, too much debt generates high-interest payments that slowly erode the earnings.
When things go right, and the market is favorable companies can afford to have a higher level of leverage. However, when economic scenarios change such companies find them in financial distress.
Indeed, as soon as the revenues slow down, they are not able to repay for their scheduled interest payments. Therefore, those companies will have to restructure their debt or face bankruptcy, as happened during the 2008 economic downturn to many businesses.
Imagine that you own a Coffee Shop and in the second year of operations, (after many investments to buy new fancy machines) the balance sheet shows $200K in total liabilities and $50K in equity.
This means that your debt to equity ratio is 4 or 200/50. Is it good or bad? Of course, a gearing ratio of 4 is very high. This means that if things go wrong for a few months, you will not be able to sustain the business operations.
Not all contracted debt is negative. Indeed, debt that allows you to pay fixed interest helps companies to find their optimal capital structure. Instead, any increase in interest payments may result in burdening indebtedness and consequently to financial distress.
A debt to equity ratio of 4 is extremely high although we want to compare it against previous year financials and the leverage of competitors as well. If we go back to the coffee shop example, a debt to equity ratio of 4 is ok if all the other coffee shops in the neighborhood operate with the same level of risk.
It can be that operating margins for the coffee shop are so high that they can handle the debt burden. Imagine the opposite scenario, where all the coffee shops in the area operate with a leverage of 2.
If the price of the raw materials skyrocket, you will have to raise the cost of the coffee cup. This, in turn, will slow down the revenues. While many coffee shops in the neighborhood will be able to handle the situations, your coffee shop with a gearing of 4 will go bankrupt after a while.
Interest Coverage Ratio
This ratio helps us to further investigate the debt burden a business carries. In the previous example, we saw how the leverage could lead to financial distress.
The interest coverage tells us if the earnings generated are enough to cover for the interest expenses. Indeed the interest coverage formula is:
EBIT / Interest Expense
The EBIT (earnings before interest and taxes) has to be large enough to cover for the interest expense. A low ratio means that the company has too much debt and earnings are not enough to pay for its interest expense.
A high ratio means instead the company is safe. Keep in mind that being too safe can be limiting as well. In fact, an organization that is not able to leverage on debt may miss many opportunities or become the target of larger corporations.
Imagine that your coffee shop at the end of the year generated $10K in net income. The Interest expense is $120K and taxes $20K. How do we compute the interest coverage ratio?
1. Take the net income, $10K and add back the interest expense, $120K. This gives you the EBIAT or earnings before interest after tax. The EBIAT is 10 + 120 = 130.
2. Take the EBIAT and add back the tax expense. Therefore you will get the EBIT. The EBIT is 130 + 20 = 150.
3. Take the EBIT and divide it by your interest expense. Therefore, 150: 120 = 1.25 times.
This implies that the EBIT is 1.25 times the interest expense. Therefore the company generates just enough operating earnings to cover for its interest.
However, it is very close to the critical level of 1. Below one the company is risky. Indeed, it may be short of liquidity and close to bankruptcy anytime soon.
Debt to Assets Ratio
This ratio explains how much debt was used in acquiring the company’s assets and it is expressed either in number or percentage. The formula is:
Total liabilities / Total Assets
Imagine your coffee shop shows on the balance sheet $200K of total liabilities and $50K of equity. How do we compute the debt to asset ratio?
1. Compute the total assets: $200K of liabilities + $50K of equity = $250K.
2. Compute the debt to asset ratio: $200 of liabilities / $250 of total assets = 0.8.
This means that 80% of the company’s assets have been financed through debt. A ratio lower than 0.5 or 50% indicates a fair level of risk. A ratio higher than 0.5 or 50% can determine a higher risk of the business. Of course, this ratio needs to be assessed against the ratio from comparable companies.
What is efficiency?
Efficiency is the ability of a business to quickly turn its current assets in cash that can help the business grow. In fact, the way you manage the inventories, accounts receivables and accounts payables that is critical to the short-term business operations.
What are the main efficiency ratios?
They assess if an organization is efficiently using its resources. The primary efficiency ratios are:
- Inventory Turnover
- Accounts Receivable Turnover or collection period
- Accounts Payable Turnover
These ratios are called turnover since they measure how fast current and non-current assets are turned over in cash.
This ratio shows how the well the inventory level is managed and how many times inventory is sold during a period. The faster an organization can turn its inventory in sales, the more efficient and effective it is. This ratio is expressed in number. The formula is:
Cost of Goods Sold / Average Inventory Cost
Imagine that your coffee shop at the end Year Two sold $100K of coffee cups, with a $40K gross income. The inventory at the beginning of the year was $6K and at the end of the year was $8K. How do we compute our inventory turnover ratio?
1. Compute our CoGS. As you know we had $100K in sales and $40K in gross income. Therefore our CoGS will be 100 – 40 = $60K.
2. Compute our average inventory. The beginning and ending balances were respectively $10,000 and $12,000, therefore our average inventory will be: (10,000 + 12,000)/2 = $11,000.
3. Compute the inventory ratio given by COGS/Average inventory, therefore: 60,000/11,000 = 5.45 times.
This means that in one year time the inventory will be sold 5.45 times. How do we know how long it will take for the average inventory to be turned in sales?
Well, to compute the days it will take to turn the inventory in sales, compute the following formula:
365 days/5.45 times = 67 days
Through this ratio, you know that every 67 days your inventory will be turned in sales. A high inventory ratio indicates a fast-moving inventory and a low one indicates a slow-moving inventory.
Of course, a ratio of 5.45 is great since it means no capital is tied up to inventories and you are using the liquidity more efficiency to run the business. However, this ratio needs to be compared within the same industry.
Accounts Receivable Turnover or collection period
This ratio measures how many times the accounts receivable can be turned in cash within one year. Therefore, how many the company was able to collect the money owed by its customers. It is expressed in number, and the formula is:
Sales or Net Credit Sales / Average Accounts Receivable
The net credit sales are those that generate receivable from customers. Indeed, each time a customer buys goods, if the payment gets postponed at a later date, this event generates receivable on the balance sheet.
Therefore, the transaction will be recorded as revenue on the income statement and an account receivable on the balance sheet. Imagine the coffee shop you run sold $100K of coffee bags, of which $50K in gross credit sales. Of the $50K in gross credit sales, $10K of coffee bags was returned.
The accounts receivable previous year balance was $12,000, while this year $10,000. How do we compute the accounts receivable turnover?
1. Compute our nominator, the net credit sales. This is given by the gross credit sales minus the returned product. Therefore: 50,000 – 10,000 = $40K of net credit sales.
2 Compute the average inventory that is given by the average between previous and current year, therefore: (12,000 + 10,000)/2 = $11,000 average receivable.
3. Compute the receivable turnover given by the net credit sales over the average inventory. Therefore: 40,000/11,000 = 3.64 times.
It means that the receivables were turned into cash 3.64 times in one year.
To know how many days it took to collect the money lumped in the receivable we will use the formula below:
365/3.64 = 100
The receivables were turned into cash in 100 days. This is a good receivables level it means that you can collect money from your customers on average every 100 days.
When the receivable level is too low, usually companies turn their attention to the collection department and make sure they make the collection period as short as possible. Indeed, this will give additional liquidity to the business.
Accounts Payable Turnover Ratio
This ratio shows how many times the suppliers were paid off within one accounting cycle. This ratio is expressed in number, and the formula is:
Credit Purchases / Average Accounts Payable
The payable turnover ratio is the flip side of the receivable ratio. The credit purchases are those, which generate payable on the company’s balance sheet.
Therefore, each time purchase on credit is made, this will show as CoGS on the income statement and an account payable on the balance sheet. Imagine that at the end of the year were purchased $25K of raw materials from suppliers, although, $5K was returned.
The accounts payable was $5K on the previous year and $7K this year. How do we compute the accounts payable turnover?
1. Compute the net purchase amount given by the gross purchase amount minus the returned supplies, therefore: 25K – 5k = $20K of net purchases.
2. Compute the average payable. In year one the payable was $5K and $7K in year two. Therefore: (5K + 7K)/2 = $6K in accounts payable.
3. Compute the payable turnover given by the net purchases over the average accounts payable = 20K/6K = 3.3 Times.
The supplier during the current year was paid 3.3 times; it means that every 110 days (365/3.3) the debt with the suppliers has been paid off. Keeping a high payable turnover is crucial to conduct business.
Indeed, suppliers will assess whether or not to entertain business with an organization based on its capability to quickly repay for its obligations.
What is valuation?
Valuation is a very tricky part of finance. Indeed, valuing a company means assessing how much that is worth. Valuing is so hard since the resources a company has been organized in a way for which it becomes challenging to determine the final value.
In addition, we have the human capital aspect that is also very difficult to assess. For such reason, valuation can be considered more of an art than a science. We are going to list the main valuation ratios here.
Indeed, it is essential as well to know what are the main valuation ratios also to understand whether a company is over or undervalued. In other words, valuation ratios assess the perception of the market of a certain company.
This does not mean that “Mr. Market” is always right. Quite the opposite; for instance, if we find a company that is doing extremely well regarding profitability, liquidity, leverage, and efficiency but Mr. Market does not like it; it might be useful to understand why.
If the reason stands behind things that Mr. Market knows and we don’t, I still would not buy it. On the other hand, if Mr. Market simply does not like that stock because it considers it “boring,” then I would give a thought about buying it.
What are the main valuation ratios?
The primary valuation ratios are:
- Earnings per Share
- Dividend Yield
- Payout Ratio
This ratio tells us what is the return for every single share. The formula is given by:
(Net Income – Preferred Dividends) / Weighted Average Number of Common Shares
When the ratio is increasing over time it means that the company may represent a good investment for its shareholders (although it must be weaved with other ratios before we can assess whether it is a good investment).
This ratio tells us how many times over its earnings the market is valuing the stock:
(Net Income – Preferred Dividends) / Weighted Average Number of Common Shares
A higher Price/Earnings ratio can be useful to a certain extent. For instance, technological companies tend to have a higher P/E ratio compared to others. Although, when the P/E is too high this may be due to speculations.
This ratio tells us how much of the stock value has been paid toward dividends. In other words, how much (in percentage) shareholders are getting back from their investment in stocks:
Dividends per Share (Dividends/Outstanding Shares) / Stock Price
Indeed a higher Dividend Yield is a good sign, and it means that the company is rewarding its shareholders. Also, stocks with historically high dividend yields have often been sought as good securities by stock market investors. But how do we assess whether the dividends yield is high enough?
This ratio tells us whether a company is paying enough dividends to its shareholders, and its formula is:
Dividends per Share / Earnings per Share
The payout ratio must be assessed case by case on the one hand. On the other side, a meager payout ratio is less attractive for investors, who are looking for higher returns.
Summary and conclusions
In this guide, we saw how all the main financial ratios work and how to use them. Tha main aim is to kame informed decision about a business. Those ratios can be used either internally, by the management. Or externally, by analysts or competitors to assess a business performance.