3.6 Debt/Equity ratio analysis

Debt and equity ratios (aka efficiency ratios)

Enable a business to calculate the value of their liabilities + debts against their equity

• These ratios are a measure of the financial stability of the business

4 efficiency ratios

1. Stock turnover

2. Debtor days

3. Creditor days

4. Gearing ratio

Stock turnover ratio (inventory turnover)

Measures the no. of times a business sells its stocks within a year OR the avg no. of days it takes for a business to sell all of its inventory.

How can stock turnover ratio be expressed?

1. No. of times a business sells its stocks within 1 year

2. Avg no. of days for a business to sell all of its inventory

What does the stock turnover ratio indicate?

The speed at which a business sells + replenishes all its stock

Stock turnover ratio equation

(no. of times)

Cost of sales / average stock

Stock turnover ratio equation

(no. of days)

(Average stock / cost of sales) x 365

For stock turnover ratio, is cost of sales or sales turnover used + why?

Cost of sales (COGS)

• Bc stocks are valued at the cost value of the inventory to the business rather than the selling price to the customer

Calculate stock turnover ratio for:

• $100,000 cost of sales

• $20,000 average stock level

1. 100 000 / 20 000 = 5 times

2. (20 000 / 100 000) x 365 = 73 days

Benchmark for stock turnover

1. No. of times = higher the better

2. No. of days = lower the better

BUT diff businesses = diff ST benchmark figures

• So compare similar businesses only

• Eg restaurant much higher ST ratio than luxury vehicle seller

Reasons for stock turnover benchmark

• Higher the better for no. of times

• Lower the better for no. of days

1. More stock sold → business more efficient in generating profit

2. Perishable stocks don’t expire / become outdated

General way to improve stock turnover ratio

Reduce organization’s stock level

Strategies to improve stock turnover ratio

1. Hold lower stock levels → inventories need to be replenished more regularly

2. Divestment (disposal) of slow selling stock (obsolete / unpopular)

3. Reduce range of products being stocked → only keep best selling products

Debtor days ratio

An efficiency ratio that measures the average no. of days it takes for a business to collect the money owed from debtors

Debtors

Customers who have purchased items on trade credit → owe money to the business

Is creditor days or debtor days more important?

Debtor days

Debtor days ratio equation

(Debtors / total sales revenue) x 365

• TSR = approximation of firms total credit sales

Benchmark for debtor days

Lower the better

• Lesser time it takes for customers to pay their debts = better

Why is the benchmark for debtor days the lower the better?

1. Improves cash flow of business

2. Bc of opportunity cost of holding onto money → business can invest this money in other revenue-generating projects

If a debtor days ratio is too high, why is this problematic?

Too long credit period granted → business faces liquidity problems

If a debtor days ratio is too low, why is this problematic?

Uncompetitive credit period → customers seek other suppliers bc clients prefer better credit terms

Credit control

The ability of a business to collect its debts within a suitable timeframe

Benchmark for debtor days for a healthy business

30-60 days

General way to improve debtor days

Reduce debt collection period

Strategies to improve debtor days

1. Impose surcharges on late payers

2. Give debtors incentives to pay earlier

3. Refuse further business with clients until payments are made

4. Threaten legal action

For which businesses is it acceptable to have a higher debt collection period + why?

Suppliers of expensive luxury goods

• Bc rely more on credit sales

Creditor days ratio

An efficiency ratio that measures the average no. of days it takes for a business to pay its creditors

Creditor days equation

(Creditors / cost of goods sold) x 365

• Cost of sales = approximation of firm’s total credit purchases

Calculate creditor days:

• $225 000 owed to suppliers

• $2 000 000 COGS

(225 000 / 2 000 000) x 365 = 41 days

• On avg, business takes 41 days to pay its suppliers

• CD ratio acceptable, bc most businesses provide 30-60 days credit period to customers

Benchmark for creditor days ratio

Lower the better

Why is a lower creditor days ratio the better?

Business avoids late payment penalties to trade creditors

Pros of high creditor days ratio

Repayments are prolonged → helps free up cash in the business for other use (in ST)

Cons of high creditor days ratio

Business taking too long to pay trade creditors → suppliers impose financial penalities for late payments → harms firms cash flow position

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Strategies to improve creditor days

1. Improve debtor days → collect enough cash to pay debtors

2. Negotiate longer TC terms (if struggling bc of too long working capital cycle)

Ideal combination of creditor days ratio + debtor days ratio

• High CD

• Low DD

Enhance efficiency position of business by…

Improving any of its efficiency ratios

• Increase stock turnover

• Reduce debtor days

• Increase creditor days

General- strategies to improve efficiency position of a business

1. Develop closer relationships with customers, suppliers, creditors

2. Introduce JIT production

3. Improve credit control

General strategies to improve efficiency position of a business

1. Develop closer relationships with customers, suppliers, creditors

• Helps reduce debt collection time + extent credit period

2. Introduce JIT production

• Eliminates need to hold large amounts of stock + improves stock control

3. Improve credit control

• Manage risks regarding amount of credit given to debtors

How does developing closer relationships with customers, suppliers, creditors improve the efficency position of a business?

Helps:

• Reduce debt collection time

• Extend credit period

How does introducing JIT production improve the efficiency position of a business?

• Eliminates need to hold large amounts of stock

• Improves stock control

Gearing ratio

Measures the percentage of an organization's capital employed that comes from external sources (NCL)

• Eg mortgages

What does the gearing ratio assess?

Firm's LT liquidity position

2 equations for gearing ratio

1. (NCL / capital employed) x 100

2. (Loan capital / capital employed) x 100

Capital employed equation

Non current liabilities + equity

Equity equation

Share capital + retained earnings

What does it mean the higher a firms gearing ratio is…

The larger the firm’s dependence on LT sources of borrowing

Highly geared firm

Gearing ratio of 50% or above

Cons of high gearing ratio

1. Business incurs higher costs due to debt financing (interest repayments) → limits profit

2. Vulnerable to increases in interest rates

3. Difficult to seek external SoF from other financiers

4. Downturn in economy / recession → loan repayments remain high but cash inflow from sales fall

If a firm has a high gearing ratio, why is it difficult for them to seek external SoF?

Lenders / financiers concerned about default risks bc of their large loan commitments

Which stakeholders are interested in a firms gearing ratio?

1. Creditors

2. Investors + potential investors

3. Shareholders

Gearing ratio assesses level of?

Riak

Why are shareholders interested in gearing ratio of firms?

• Financiers need to be repaid first, with interest

• → reduces amt paid to shareholders + retained profit

• But if business has high profitability → high potential returns, even if highly geared

Benchmark for gearing ratio

Why shouldn’t a gearing ratio be too low?

Wasted potential

• Need external finance to fund expansion, despite it increasing gearing level

What does the level of gearing acceptable to a business depend on?

1. Size + status of a business

   • Greater size + status of firm → more ability to repay LT debts

2. Level of interest rates

   • Low IR → business less vulnerable (in ST)

3. Potential profitability

   • Business with good profit quality (LT prospects of earning profit) → high gearing less of an issue

   • Esp for high tech industries that invest in R&D

   • Need external finance to fund expenditure on R&D, but potential for high returns minimises their exposure to gearing

Insolvency

A financial state where an individual / business entity is unable to pay its debts on time

• If insolvency cannot be resolved, this can lead to bankruptcy

2 causes of insolvency

1. Cash flow insolvency

2. Balance sheet insolvency

Cash flow insolvency

When an insolvent firm can’t make a payment owed to creditors bc it doesn’t have enough cash

Balance sheet insolvency

When the liabilities (debts) of the firm exceed its assets

Solutions to resolve insolvency

1. Borrow money

   • But depends on firm's gearing ratio

2. Cut costs

3. Sell NCA

   • So can raise funds to pay debts

4. Negotiate a debt payment / settlement plan with creditors

Cons of negotiating a debt payment / settlement plan with creditors

Likely to damage their future credit ratings

Bankruptcy

Formal + legal declaration of a firm’s inability to settle / pay its debts.

• Legal process declared by the courts

• Business can’t continue trading

Is bankruptcy a first or last resort?

Last resort

• Firm owes sm that selling all assets won’t cover debts owed

• Business

Order of insolvency + bankruptcy

1. 1st insolvent

2. 2nd bankrupt

Liquidity

How easily an asset can be turned into cash

Highly liquid assets

Can be converted into cash quickly + easily w/o losing their monetary value

Are RM liquid or illiquid CA?

lliquid CA

Inadequate working capital →

Insolvency

• Forces business into liquidation

Liquidation

Business sells off its assets to repay as much of the money owed to its creditors

Working capital (aka net CA) equation

CA - CL

Profit quality

The ability of a business to earn profit in the foreseeable future

• B w good profit quality = can earn profit in the LR

Cons of declaring bankruptcy

Severely damage credit rating of the owners

• Hinders ability borrow money for many years ahead

Working capital cycle

The interim period betw cash payments for costs of production and cash receipts from customers

• Delay betw paying for CoP + receiving cash from sale of goods → firm needs to manage WC carefully to avoid insolvency

Can a firm recover from insolvency?

Yes

Can a firm recover from bankruptcy?

No