3.6 Debt/Equity ratio analysis HL

EFFICIENCY

a measure of how well assets are used

includes which 4

stock turnover creditor days debtor days gearing ratio

Stock turnover

Measures the number of times a firm sells its stock completely within a time period (usually 1 year)

Indicates the speed of sales & replenishment

Higher turnover

Higher no. of times / lower no. of days

More stock sold & more profit generated

Very efficient stock management – such as the use of the just-in-time system – will give a high inventory turnover ratio

Ensuring that perishable stocks don’t expire / durable stocks not obsolete

Low turnover

Lower no. of times / higher no. of days

Less stock sold & less profit generated

Indicate poor customer satisfaction

comparing stock turnover

Compare like with like!

Different businesses have different benchmark figures for stock turnover

Stock turnover has little relevance for service providers...

ways to improve the ratio turnover

Hold low stock levels – replenish stock more regularly

Divestment (disposal) of stocks which are slow to sell

Reduce the range of products being stocked

debtor days

Measures the number of days it takes a firm on average to collect money from its debtors (trade credit given)

Ways to improve (shorten) debtor days

Provide debtors early payment discounts

Impose surcharges on late payers

Encourage debtors to use autopay.

Refuse any further business with a client until payment is made.

Threaten legal action – especially for debtors who repeatedly pay late.

CREDITOR DAYS

The number of days it takes, on average, for a business to pay its trade creditors

higher or lower better for creditor

The higher the more desirable!

Reduces the firm’s cash outflow to pay suppliers in the short term.

Too high may imply that suppliers may impose financial penalties for late payment

imroving creditor days (lengthen)

Developing closer relationships with suppliers and creditors, thereby helping extend the credit period.

GEARING RATIO

How much of the firm’s capital is financed by long-term liabilities

e.g. mortgage, debentures

Assess a firm’s long-term liquidity position

gearing interpretation

higher = more dependent on long-term loans

More susceptible to interest rate fluctuations

Over 50% is considered highly geared

GEARING: STAKEHOLDERS’ INTERPRETATION

Creditors

Highly geared = Less likely to lend money to firms as they are seen as higher risk

Shareholders, investors and potential investors

Assess the level of risk —> Loans are repaid before dividends!

…However, if the profitability of the firm is high, then potential returns can be very attractive even in highly geared firms.

what is acceptable for gearing

The size and status of the business - Positive correlation between a firm’s size and status and its ability to repay long-term debts.

The level of interest rates - Low interest rates means that businesses are less vulnerable (at least in the short term) even with high gearing.

Potential profitability - Good profit potentials make it less risky if gearing is high.

debt and equity ratios

calculate liability against equity

show efficiency (of resouces use)

measures financial stabiliy

debtor days short or long good and why

short

improve cash flow

opportunity - invest money

it is important to compare between

like with like

however if debtor days too short

not competitive since customers might seek another offering better credit terms

insolvency

unable settle debts due to lack of funds or cash in bank

includes balance sheet insolvency and cash flow insolvensy

cash flow insolvency

cannot pay creditors not enough cash

balance sheet insolvency

liability exceeds assets

bankruptcy

formal and legal declaration of a firms inability to settle debts

working capital

current asset- current liability

capital cycle

cash - production costs - sale

delay in between

profit quality

ability of firm to earn profit in foreseeable future