Chapter 12

Looking at Liquidity

In This Chapter

Calculating debt ratios

Checking out interest payments

Comparing debt to equity

Looking at the debt-to-capital ratio

Making money is great, but if a company ties up too much of its money in non-liquid assets (such as factories it can’t easily sell) or carries too much debt, it won’t be around long to make more money. A company absolutely must have the cash it needs to carry out day-to-day operations and pay its debt obligations if its owners want to stay in business.

Lenders who have money wrapped up in the company follow debt levels closely. They want to be absolutely sure that they’re going to get their money back, plus interest. As an investor, you need to take a close look at a company’s debt, too, because your investment can get wiped out if the company goes bankrupt. So if you’re investing in a company, you want to be certain that the company is liquid and isn’t on the road to debt troubles.

So how do you make sure that the company you’re investing in, or are about to invest in, isn’t on the verge of spiralling down the drain, taking all your money with it? Well, you need to check out the company’s ability to pay its bills and pay back its creditors. But looking at one company doesn’t give you much information. You need to compare the company with similar companies, as well as the industry average, to get a better idea of where the company stands.

In this chapter, we show you how to calculate a company’s ability to pay its bills by looking at debt ratios, comparing its debt to its equity and its debt to its total capital. (If you’re starting to sweat and/or your brain is shutting down because of the impending mathlete workout, don’t worry – things aren’t as difficult as they sound!)

Finding the Current Ratio

One of the most commonly used debt measurement tools is the current ratio, which measures the assets a company plans to use over the next 12 months with the debts that it must pay during that same period. This ratio lets you know whether a company will be able to pay any bills due over the next 12 months with assets it has on hand. You find the current ratio by using two key numbers:

Current assets: Cash or other assets (such as accounts receivable, inventory, and marketable securities) that the company is likely to convert to cash during the next 12-month period.

Current liabilities: Debts that a company must pay in the next 12-month period. These liabilities include accounts payable, short-term loans, accrued taxes, and any other payments that the company must pay in the next 12-month period.

We talk more about current assets and current liabilities in Chapter 6.

Calculating the current ratio

The formula for calculating the current ratio is:

current assets ÷ current liabilities = current ratio

Using information from the balance sheets for Tesco and Marks and Spencer (see Appendix A), here are their current ratios for the year ending in 2007:

Tesco:

£4,576 (current assets) ÷ £8,152 (current liabilities) = 0.56

So Tesco has 56p of current assets for every £1 of current liabilities.

Marks and Spencer:

£846.40 (current assets) ÷ £1,606.20 (current liabilities) = 0.53

So Marks and Spencer has 53p of current assets for every £1 of current liabilities.

What do the numbers mean?

For most industries, the key question is ‘Does a company’s current ratio show that the company will be able to cover its short-term obligations?’ Generally, the rule is that any current ratio between 1.2 and 2.0 is sufficient for a company to operate. However, keep in mind that the ratio varies among industries, which is particularly true of the retail industry that we are studying.

Think about it: Customers pay both these companies in cash. Debit cards are the same as cash, and credit cards are only a little slower for the payment to hit the retailers’ bank accounts. (Both these companies have their own credit cards so they may not get the cash immediately, but they get a high rate of interest on it a month after the transaction if the customer does not pay off the debt immediately – clever, huh?). They also don’t pay their suppliers in cash (see Chapters 16 and 17). On the contrary, both companies pay as late as they can, thanks to their muscle as major retailers, and they push their suppliers to their limits, and sometimes beyond. As they are in the retail business these companies are operating with very effective current ratios.

If the current ratio is below 1, anywhere apart from a few industries such as retailing, this is a strong danger sign that the company is heading for trouble. A ratio below 1 means that the company is operating with negative working capital; in other words, its current debt obligations exceed the current amount of money it has available to pay those debts.

A company can also have a current ratio that’s too high. Any ratio over 2 means that the company isn’t investing its assets well. The company can probably put some of those short-term assets to better use by investing them in growth opportunities for the company.

However, many lenders and analysts believe that the current ratio isn’t a good enough test of a company’s debt-paying ability because it includes some assets that aren’t easy to turn into cash, such as inventory. A company must sell the inventory and collect the money before it has cash it can work with, and doing so can take a lot more time than using cash that’s already on hand in the company’s bank accounts or just collecting money due for accounts receivable, which represents customer accounts for items already purchased. Such lenders and analysts prefer the quick ratio.

Determining the Quick Ratio

Stricter than the current ratio is a test called the quick ratio or acid test ratio, which measures a company’s ability to pay its bills without taking inventory into consideration. The calculation includes only cash on hand or cash already due from accounts receivable. Unlike the current ratio, it does not include money anticipated from the sale of inventory and the collection of the money from those sales. To calculate this ratio, you use a two- step process.

Calculating the quick ratio

Here’s the two-step process you use to find the quick ratio:

1. Determine the quick assets

quick assets = current assets – inventory

2. Calculate the quick ratio

quick assets ÷ current liabilities = quick ratio or acid test ratio

Using information from Tesco’s and Marks and Spencer’s balance sheets, we take you through the two-step process.

Tesco:

quick assets = £4,576 – £1,931 = £2,645

£2,645(quick assets) ÷ £8,152 (current liabilities) = 0.32 (quick ratio)

So Tesco has 32p of quick assets for every £1 of current liabilities.

Marks and Spencer:

quick assets = £846.40 – £416.30 = £430.10

£430.10 (quick assets) ÷ £1,606.2 (current liabilities) = 0.27 (quick ratio)

So Marks and Spencer has 27p of quick assets for every £1 of current liabilities.

Marks and Spencer is, strangely enough, in a slightly better position than Tesco based on the quick ratio. They are making even better use of ‘the receive cash pay with credit’ retail strategy. Most companies operate with a quick ratio greater than 1 so that they have no problem paying their bills.

What do the numbers mean?

A company is usually considered to be in a good position as long as its quick ratio is over 1. When the quick ratio falls below 1, it’s a sign that the company will probably have to sell some short-term investments to pay bills or take on additional debt until it sells more stock.

If you’re looking at statements from companies in the retail sector, you’re more likely to see a quick ratio under 1. Retail stores often have a lot more money tied up in inventory than other types of businesses do. As long as the company you’re evaluating is operating at or near the quick ratio of similar companies in the industry, you’re probably not looking at a problem situation, even if the quick ratio is well under 1.

Remember that a quick ratio of less than 1 can be a sign of trouble ahead if the company is not able to sell its inventory quickly. Also, if customers are slow payers, and accounts receivable aren’t collected when billed, these issues can cause problems, too. In Chapters 15 and 16, we take a closer look at how you can assess inventory and accounts-receivable turnover.

Investigating Income Gearing

You also need to check out whether or not a company generates enough income to pay its interest obligations. Although the current and quick ratios look at a company’s ability to pay back creditors by comparing items on the balance sheet, the interest coverage ratio looks at income to determine whether the company is generating enough profits to pay its interest obligations. If the company doesn’t make its interest payments on time to creditors, its ability to get additional credit will be hurt, and eventually, if non-payment goes on for a long time, the company could end up in bankruptcy.

Historic interest gearing uses two figures, one that you can find on the company’s income statement (operating profit; check out Chapter 7 for more information) and one on the cash-flow statement (interest paid – refer to Chapter 8).

Calculating historic income gearing

Here’s the formula for finding income gearing:

interest paid ÷ operating profit = income gearing ratio

Tesco and Marks and Spencer both show the interest paid line separately; so we can calculate interest gearing.

Tesco:

£376 (interest paid) ÷ £2,648 (operating profit) = 0.14 (income gearing)

Tesco uses 14 per cent of its operating profit to pay its interest obligations.

Marks and Spencer:

£145.00 (interest paid) ÷ £1,045.9 (operating profit) = 0.14 (income gearing)

Marks and Spencer also uses 14 per cent of its operating profit to pay its interest obligations.

If you’re trying to use income gearing to consider the company’s ability to meet future interest payments, then you need to be careful to ensure that the interest commitments will continue into the future. In the case of Marks and Spencer, this is not the case. We have included in the interest paid figure an amount of £21.6 million which is recorded in the cash-flow statement (see Appendix A) as ‘exceptional interest paid’. Presumably, this will not continue in the following year and therefore we could recompute the (future) income gearing ratio to be 12 per cent.

The sharp-eyed, thorough reader will notice that the exceptional interest figure referred to here (£21.6 million) is not the same as the figure quoted in Chapter 11 (£30.4 million). This is a good example of the accruals principle. The figure in Chapter 11 was taken from the profit and loss account and includes interest owed but not yet paid; the figure in this chapter was taken from the cash-flow statement which only includes interest paid.

What do the numbers mean?

Both companies clearly generate more than enough income to make their interest payments. Obviously, the nearer this figure gets to 1, the more difficulty the company has in paying the interest it owes. A figure of 0.25 and below is low income gearing, 0.50 medium and 0.75 is high gearing.

Lenders believe the lower the interest gearing, the better. You should be concerned about a company’s fiscal health any time you see interest gearing above 0.66. This figure means that the company generates only about £1.50 for each pound it pays out in interest. That’s operating on a tight budget. Any type of emergency or drop in sales could make it difficult for the company to meet its interest payments.

Comparing Debt to Shareholders’ Equity

How a company finances its operations involves many crucial decisions. When a company uses debt to pay for new activities, it has to pay interest on that debt, plus pay back the principal amount at some point in the future. If a company uses shareholders’ equity (shares sold to investors) to finance new activities, it doesn’t need to make interest payments or pay back investors.

Finding the right mix of debt and equity financing can have a major impact on a company’s cost of capital. Too much debt can be both risky and costly. However, if a company has too high a level of equity, investors may believe that a company isn’t properly leveraging its money. Leverage is the degree to which a business uses borrowed money. For example, a company typically buys a new building by using a combination of a mortgage (debt) and cash (from a new share issue or retained earnings, which is the equity side of the equation).When a company uses leverage, its cash can go a lot further.

For example, imagine that you have £50,000 to pay for a home. This amount isn’t enough to buy the home you want, so you use that money as a deposit on the home and get a mortgage for the rest of the money due. If the house price is £250,000, and you put down £50,000, you can use the mortgage to leverage that cash so you can afford the home. In this scenario, the mortgage covers 80 per cent of the purchase price. You can use any cash you earn beyond your monthly mortgage payment to pay your other bills and buy food, as well as other things you want to own.

The real benefit of leverage is seen when the house price goes up with inflation. Suppose that the house value increases by 20 per cent to £300,000 at which point you sell it and pay back the mortgage of £200,000. Your capital has doubled from £50,000 to £100,000.

As an investor, you want to know how a company allocates its debt versus equity. To determine this, use the debt to shareholders’ equity ratio. You also want to check the company’s debt-to-capital ratio (see the upcoming section ‘Determining Debt-to-Capital Ratio’) which lenders use to determine how much they’ll lend. They also use this ratio to monitor a company’s debt level.

Calculating debt to shareholders’ equity

To calculate debt to shareholders’ equity, divide the total liabilities by the shareholders’ equity. This ratio shows you what proportion of the company’s capital assets is paid by debt and what proportion is financed by equity.

Here’s the formula you use to calculate debt to shareholders’ equity:

total liabilities ÷ shareholders’ equity = debt to shareholders’ equity

We use the numbers from Marks and Spencer and Tesco’s last year balance sheets to show you how to calculate the debt to shareholders’ equity ratio.

In the case of Tesco, you first need to add current liabilities £8,152 to non-current liabilities £6.084 to give total liabilities of £14,236.

£14,236 (total liabilities) ÷ £10,571 (shareholders’ equity) = 1.35 (debt to shareholders’ equity)

Tesco used £1.35 from creditors for every £1 it had from investors. Therefore, Tesco depends a bit more on money raised by borrowing than on money raised by selling shares to investors.

Marks and Spencer:

£3,732.80 (total liabilities which is given on the face of the balance sheet) ÷ £1,648.20 (shareholders’ equity) = 2.26 (debt to shareholders’ equity)

Marks and Spencer used £2.26 from creditors for every £1 it had from investors. Therefore, the company used a greater proportion of borrowed money from creditors to operate its company than Tesco did.

What do the numbers mean?

When you see a debt to shareholders’ ratio that’s greater than 1, it means that the company finances a majority of its activities with debt. If you see a ratio under 1, it means that the company depends more on using equity than debt to finance its activities.

In most industries, a 1:1 ratio is best, but it varies by industry. You can best judge how a company is doing by comparing it with similar companies and the industry averages.

As the ratio creeps higher and higher above 1, a company’s finances get more risky, especially if interest rates are expected to rise. Alarm bells should sound when you see a company near or above 2. Lenders consider a company that carries a debt load this large a credit risk – which means the company has to pay much higher interest rates to finance its capital activities.

Determining Debt-to-Capital Ratio

Lenders take another look at debt using the debt-to-capital ratio, which measures a company’s leverage by looking at what portion of its capital comes from debt financing. This ratio is concerned only with borrowings and does not include other long-term liabilities such as liabilities to meet future pensions.

Calculating the ratio

You use a three-step process to calculate the debt-to-capital ratio:

1. Find the total debt.

total debt = short-term borrowing + long-term debt + current portion of long-term debt + notes payable

2. Find the capital.

capital = total debt + equity

3. Calculate the debt-to-capital ratio.

total debt ÷ capital = debt-to-capital ratio

To show you how to calculate the debt-to-capital ratio, we use the information from Tesco and Marks and Spencer’s 2007 balance sheets.

To find out Tesco’s total debt, add up Tesco’s short-term and long-term debt obligations:

short-term borrowings £1,554 current portion of long-term debt £0 long-term debt £4,146

Total debt £5,700

Next, add the total debt to total equity to figure the number for capital:

£10,571 (equity) + £5,700 (debt) = £16,271 (capital)

Finally, calculate the debt-to-capital ratio:

£5,700 (total debt) ÷ £16,271 (capital) = 0.35 (debt-to-capital ratio)

So Tesco’s debt-to-capital ratio was 0.35 to 1 in 2007. This ratio is often expressed as a percentage – for example, 35 per cent of total capital is debt.

To find out Marks and Spencer’s total debt, add up Marks and Spencer’s short-term and long-term debt obligations:

short-term borrowings £461.00 current portion of long-term debt £0 long-term debt £1,234.50

Total debt £1,695.50

Then add the total debt to total equity to find out the number for capital:

£1,648.20 (equity) + £1,695.50 (debt) = £3,343.70 (capital)

Finally, calculate the debt-to-capital ratio:

£1,695.5 (total debt) ÷ £3,343.7 (capital) = 0.51 (debt-to-capital ratio)

So Marks and Spencer’s debt-to-capital ratio of 51 per cent is higher than Tesco’s at 35 per cent. Notice, however, that in the previous year, Marks and Spencer had a debt-to-capital ratio of 64 per cent; so it’s improving rapidly.

Remember that both these companies have a strong and long history so their credit ratings are probably as good as you can get and their debt-to-capital ratios are reasonably low. Look at smaller and newer companies with a bit more scepticism.

What do the numbers mean?

Lenders often place debt-to-capital ratio requirements in the terms of a credit agreement for a company to maintain its credit status. (Some companies indicate that requirement in their notes to the financial statements.) If a company’s debt creeps above what its lenders allow for the debt-to-capital ratio, the lender can call the loan, which means the company has to raise cash to pay off the loan. Usually companies take care of a call by finding another lender. The new lender is likely to charge higher interest rates because the company’s higher debt-to-capital ratio makes the company appear as though it’s a greater credit risk.

Generally, companies are considered to be in good financial shape with a debt-to-capital ratio of 35 per cent or less. Once a company’s debt-to-capital ratio creeps above 50 per cent, lenders usually consider the company a much higher credit risk, which means the company has to pay higher interest rates to get loans.

Take note of the ratio and how it compares with the ratios of similar companies in its industry. If the company has a higher debt-to-capital ratio than most of its competitors, lenders probably see it as a much higher credit risk.

A company with a higher than normal debt-to-capital ratio faces an increasing cost of operating as it tries to meet the obligations of paying higher interest rates. These higher interest payments can spiral into more significant problems as the cash crunch intensifies.