Chapter 2
Ratio Analysis: The Effect Ratios

Learning objectives

Identify which ratios are effect ratios.
Distinguish what each of these ratios measures.
Calculate each ratio.

Introduction

The effect ratios are used to determine the extent of a company’s problems. Liquidity, leverage, and profitability measures are included.

The purpose of this chapter is to introduce you to the effect ratios. These ratios do not show the reason for a change; they only show that a change has occurred. The ratios show the magnitude of a change but do not record the reason for that change. The chapter does show how a change in any of the causal ratios can change each of the effect ratios. The nine effect ratios are the current ratio, inventory to working capital, receivables to working capital, net sales to working capital, debt to net worth, debt to assets, short-term debt to net worth, times interest earned, and return on equity.

Effect ratios

Liquidity measures

Current ratio
Quick ratio
Defensive interval
Cash conversion cycle
Inventory/working capital
Receivables/working capital
Net sales/working capital
Operating cash flow to current liabilities

Leverage measures

Debt to net worth
Debt to assets
Tangible debt ratios
Short-term debt to net worth
Times interest earned
Cash times interest earned
Fixed charge coverage

Knowledge check

Which ratio is not a liquidity measure?
1. Current ratio.
2. Defensive interval.
3. Times interest earned.
4. All of the above are liquidity measures.

Profitability measures

Return on Equity – Net Income/Net Worth

Three areas of concern are measured by financial statement characteristics. Liquidity is the measurement of how well the firm can meet its obligations in the short run. The second area is leverage. Leverage ratios measure the firm’s debt usage and how well it can afford its debt. The third area is profitability. Profitability ratios are a measure of how profitable a firm is relative to its size.

Liquidity

The concept of liquidity can be easily explained as the ease with which a company can pay its bills. Companies that do not struggle to pay bills have adequate liquidity. Companies can have excessive liquidity since liquid assets tend to earn a low rate of return. Excessive liquidity can hurt profitability.

Four different aspects to liquidity are quantity, timing, quality, and early warning. The quantity of liquidity measures how much liquidity the company carries relative to its size. Timing aspects of liquidity measure how long the liquidity will last. Quality of liquidity is concerned with the makeup of the liquidity. Finally, there is an early warning ratio that measure liquidity in rapidly growing companies.

Liquidity category	Ratios
Quantity of liquidity	Current ratio
	Quick ratio

Timing of liquidity	Defensive interval
	Cash conversion cycle

Quality of liquidity	Inventory/working capital
	Receivable/working capital

Early warning	Net sales/working capital
	Operating cash flow to current liabilities

Quantity of liquidity measures

Two ratios that measure the quantity of liquidity are the current ratio and the quick ratio.

The current ratio is a measure of the quantity of liquidity. Therefore, this ratio only tells you how much liquidity you have. It does not let you know the make-up of the liquidity. A company can have a “sound” current ratio and still have a liquidity problem if its current assets, for example, are composed largely of inventory that cannot be sold or receivables that cannot be collected.

Knowledge check

Select the statement that is most true.
1. A company with a good “solid” current ratio has no liquidity problems.
2. The current ratio measures the quantity of liquidity, so even a company with a good solid current ratio might have liquidity problems.
3. Both answers a. and b. are false.
4. Both answers a. and b. are true.

Do not be overly concerned with the 2-to-1 standard (unless your banker uses this standard in loan covenants).

The quick ratio is also a measure of the quantity of liquidity. We compute this ratio by dividing quick assets by current liabilities. Quick assets are those assets that can be converted to cash without additional sales. They include cash, marketable securities, and accounts receivables. The quick ratio measures the liquidity of the company assuming that no additional sales of inventory can be made. This ratio increases in importance as inventory’s proportion of total assets is large, when inventory becomes obsolete or spoils quickly, and in any circumstances in which the real value of the inventory is questionable.

Knowledge check

Suppose that a company’s current ratio remained stable from last year to this year. However its quick ratio decreased. What likely happened to cause this difference?
1. Inventory increased.
2. Inventory decreased.
3. Receivables increased.
4. Cash increased or decreased.

When we compare the trend in the current ratio to the trend in the quick ratio, we can garner some additional information.

Illustrative problem

Suppose that a company’s current ratio was 2.5 last year and decreased to 2.0 this year. Last year’s quick ratio was 1.0 and stayed constant this year. What does this trend suggest?

Timing of liquidity measures

There are two measures of the timing of liquidity. They are the defensive interval and the cash conversion cycle.

The defensive interval measures the length of time a company can continue to operate on its liquid assets without any new sales. To compute this ratio, divide quick assets by daily cash operating expenses. Daily cash operating expenses include all expenses listed above operating income on the income statement except for noncash items such as depreciation and amortization. It focuses on the need for liquidity. A longer defensive interval implies greater liquidity. This ratio, however, ignores the possibility of future cash inflows.

The cash conversion cycle measures the amount of time it takes from the start of the company’s process when the company first begins disbursing cash until the company collects cash from its customers. A long cash conversion cycle implies that it is taking a long time to convert the company’s product into cash. The cash conversion cycle is the sum of the inventory conversion period and the receivables conversion period less the payables deferral period. To improve its cash conversion, a company could reduce inventory conversion time, reduce receivables conversion time, or increase payables deferral time.

Inventory to working capital

Working capital is the margin of protection a company provides for the payment of current obligations. It is measured in terms of “quantity” by the current ratio. This ratio, inventory to working capital, is a measure of the quality of working capital. It measures the dependency of the company’s working capital on inventory.

Working capital can be defined as current assets, less current liabilities. Generally, if a firm has positive working capital, its liquid assets exceed its near term liabilities. In this ratio one may use current assets in the denominator when net working capital is negative.

Historically, inventory problems have caused a lot of firms to go under. When this ratio becomes large, then the firm becomes more susceptible to problems caused by inventory that will not sell.

For example, both of these companies operate in the same industry. Company A is below average, and B is way above average.

	Company
	A	B
Cash	$2,000	$10,000
Accounts receivable	16,000	40,000
Inventory	10,000	60,000
Total	28,000	110,000
Current liabilities	10,000	80,000
Working capital	$18,000	$30,000

Inventory to working capital	56%	200%
Industry average	60%	60%

Suppose that their inventory values are cut by one-half. Company A would lose $5,000 but would still have $13,000 of working capital. The current ratio would drop from 2.8 to 2.3.

Company B would lose $30,000 and have no working capital. Its current ratio would be 1. Clearly, company B is more vulnerable to problems caused by inventory troubles. Unless the receivables and other current assets were in excellent shape, an inventory problem could put company B out of business.

Knowledge check

When a company’s inventory to working capital ratio increases, we can argue that the ________________ of liquidity has decreased.
1. Quantity.
2. Timing.
3. Quality.
4. Dollar amount.

Accounts receivables to working capital ratio

This ratio is a measure of working capital quality; that is the extent of the company’s reliance on receivables for its working capital. When this ratio becomes large, the quality of the company’s liquidity is said to be poor.

This is a very important ratio for small firms. They generally do not subscribe to credit reporting or credit interchange services. Often these small firms do not have anyone special to handle their receivables. A build-up of receivables can be a signal of collection problems.

	Company
	H	J
Cash	$1,000	$5,000
Trade receivables	6,000	50,000
Inventory	7,000	30,000
Total current assets	14,000	85,000
Total current liabilities	4,000	55,000
Working capital	$10,000	$30,000
Trade receivables to working capital	60.0%	166.7%
Industry average	75.0%	75.0%

If these companies lost all of their receivables to default, company H would still have positive working capital. Hence this company has some ability to withstand such a problem.

Company J is in serious straits. Receivables are greater than working capital by $20,000, leaving a very low margin for error. If customers slowed down their payments, Company J would be in a bind.

Suppose that company J’s collection period increased by 50 percent. Receivables would rise by 50 percent to $75,000. If this rise were financed by current liabilities (which would rise to $80,000), working capital would remain at $30,000, but the current ratio would drop to 1.375 from 1.545. Receivables to working capital would rise to 250 percent.

The trade receivables to working capital ratio is generally not reported in industry sources. We can construct this ratio from other data provided by the ratio services. We will construct an industry ratio from Robert Morris and Dun and Bradstreet data.

Knowledge check

If a company’s ratio of receivables to working capital increases, we argue that the company’s quality of liquidity has
1. Increased.
2. Decreased.
3. Not changed.
4. Receivables to working capital has no impact on the quality or quantity of liquidity.

Net sales to working capital (working capital turnover)

	Company
	V	W
Current assets	$25,000	$25,000
Current liabilities	24,000	11,000
Working capital	1,000	14,000
Sales	$150,000	$150,000
Sales to working capital	150 times	10.7 times
Industry average	10 times	10.0 times

This ratio indicates the demands made upon working capital in support of the sales volume. The higher the sales in comparison to working capital, the greater the strain a company encounters in satisfying creditors while meeting payroll and taxes.

This ratio is particularly useful when a company is experiencing rapid sales growth. It may signal a working capital problem before the other liquidity ratios do.

In the example, firm V has insufficient working capital to support its sales, and would be more susceptible to an external shock.

Knowledge check

The liquidity measure that is particularly useful in periods of rapid sales growth is
1. Current ratio.
2. Net sales to working capital.
3. Quick ratio.
4. Debt to assets ratio.

Operating cash flow to current liabilities

This ratio measures the extent that cash flow from the company’s operations covers the company’s current liabilities (averaged over the time period). A larger ratio implies greater liquidity. Some companies with regular and predictable cash flow find that if this ratio is sufficient, that they can get by with smaller amounts of current assets (such as a lower current ratio).

Debt ratios

The debt to asset ratio and the debt to equity ratio are measures of the same thing. An analyst need only compute one or the other. Both ratios are measures of financial risk. When a firm’s debt ratios increase, its financial risk increases. In fact, these ratios are generally one of the major determinants of a company’s eligibility for a “new” loan and a determinant of borrowing rates. With these ratios it is particularly important to know what limits our lenders have placed on us. This limit becomes our debt capacity. Furthermore, it is useful to monitor industry averages to be sure that we do not deviate from the norm.

These two ratios are perfectly redundant. They measure the same thing but use a different scale, so if you know one ratio, you can compute the other.

Illustrative problem

If a company has a debt to asset ratio of 40 percent, what is its debt to equity ratio?

Tangible debt ratios

Tangible debt ratios are often used by lenders. They are particularly useful when the market value of the intangible assets is questionable. Lenders want the debt ratios based upon assets that they can actually sell or receive value.

Knowledge check

Lenders often examine tangible debt ratios. If a company has a material amount of intangible assets, its tangible debt to asset ratio will be ___________ its ordinary debt ratio.
1. Larger than.
2. Smaller than.
3. The same as.
4. Unrelated to.

Current liabilities to net worth

Small businesses must often rely upon short-term financing. This ratio is a measure of the extent to which the small firm uses short-term financing rather than net worth.

Short-term debt, when used as “permanent” financing, can increase a company’s risks beyond the risks of long-term debt. The increased risks include rollover risks and interest rate risks.

A company with a low current liability to net worth ratio is generally free from creditor demands. If this ratio is high, the management must spend excessive amounts of time dealing with creditors. This excessive time robs the company of initiative.

	D	F
Company ratio	40%	145%
Industry ratio	75%	75%

In the example, Company D and F are in the same industry and have ratios of 40 percent and 145 percent, respectively. Company D has ample coverage to permit prompt payment. Creditors will have few restrictions. Company F is nearly twice the industry average. This company has excessive short-term borrowing. Generally this company would have very severe restrictions from its creditors: restricted current ratio, salaries, and operations.

Rollover risk is the chance that a firm cannot renew a loan. Short-term debt usage increases this risk because rollover occurs more frequently. Short-term debt has more volatile interest rates than long term debt and the rate must be renegotiated more often. This reduces the predictability of interest costs and increases risk.

Knowledge check

The type of debt with the greatest “rollover” risk is
1. Short-term debt.
2. Long-term debt.
3. Bonds.
4. Mortgages on fixed assets.
Select the statement that is most true.
1. Short-term debt can be used as permanent financing, but must be continually renegotiated. This increases the company’s “rollover risk.”
2. When short-term debt that is used as permanent financing, the predictability of interest expense over the long run has been reduced and the faces higher interest rate risk.
3. Both of the previous answers are true.
4. Both of the previous answers are false.

Times interest earned

This ratio is a measure of the firm’s ability to pay its long-term debt obligations. If this ratio is adequate, then there is little danger of default. Companies with a large and stable times interest earned ratio have no trouble when it is time to “roll over” their debt.

Since causal ratios directly influence profit and debt usage, the times interest earned ratio is directly related to and affected by all of the ratios. A manager must be able to look beyond this ratio.

Since this ratio is a measure of risk, its influence on value should be apparent.

This ratio measures the same thing as the times interest earned; however it bases the computation on cash flow. Here, we are measuring how many times cash flow covers cash interest payments. Lenders often use the cash flow approach.

This ratio measures the number of times that earnings cover all financial obligations. The denominator can also include preferred stock dividends (Preferred Stock Dividend/1 – Tax Rate) on a before-tax basis, as well as sinking fund payments (Sinking Fund Payment/1 – Tax Rate).

Knowledge check

The primary difference in the interpretation of the times interest earned ratio and fixed charge coverage ratio is
1. The fixed chargre coverage ratio recognizes that there may be other financial obligations besides interest payments.
2. The fixed charge coverage ratio is not appropriate for companies that use leasing as a form of financing.
3. There is no real difference in the ratios.
4. Fixed charge coverage measures liquidity and times interest earned measures the ability to afford debt.

Net profit to net worth (return on equity)

This ratio is a measure of the return on the equity investment in the firm. If this ratio is too low, then profits are insufficient. If this ratio is excessively high, then the firm is using too much debt and too little equity.

	Company
	A	B
Net sales	$2,000,000	$2,000,000
Net profit	20,000	100,000
Net worth	80,000	1,000,000
Net profit to net sales	1%	5%
Industry average	3.3%	3.3%
Net profit to net worth (ROE)	25%	10%
Industry average	8.8%	8.8%

Both companies have above average return on equity (ROE). Company A has a substandard profit margin. This suggests that A is deficient in net worth (uses too much debt). Its sales are too high given its net worth, so it will be an overtrader. Company B, on the other hand, has an above average profit margin and ROE ratios. Company B is a profitable company even though its ROE is below that of company A.

This ratio can be affected by all of the causal ratios since each of the causal ratios can affect the use of debt and profitability.

Knowledge check

The ratio that measures the amount of time a company could survive without new sales is
1. The defensive interval.
2. Return on equity.
3. Net sales to working capital.
4. Debt to assets ratio.

Effect ratio summary

Current ratio – if small, indicates inadequate liquidity
Quick ratio – if small, indicates inadequate liquidity
Defensive interval – if small, implies the company could not survive very long in a financial crisis
Inventory to working capital – if large, indicates poor quality of liquidity
Receivables to working capital – if large, indicates poor quality of liquidity
Net sales to working capital – if large, indicates inadequate liquidity to support sales
Debt to net worth – if large, indicates increased financial risk
Debt to assets – if large, indicates increased financial risk
Tangible debt ratio – measures debt usage proportionate to tangible assets
Short-term debt to net worth – if large, implies extremely high-risk situation
Times interest earned – if small, indicates insufficient financial solvency or high financial risk. May also be computed as a cash flow ratio.
Fixed charge coverage – measures how many times earnings cover all financial obligations
Return on equity – the key profitability ratio is a measure of the return on owners’ investment in the firm

Review questions

Of what is the current ratio a measure? Why is the current ratio an effect ratio? Why is it not a causal ratio?
How can an increase in a firm’s collection period affect the current liabilities to net worth ratio?
Why is the debt to assets ratio so important?
How does the fixed charge coverage ratio differ from the times interest earned ratio?
What information does the inventory to working capital ratio give?
What does the trade receivables to working capital ratio tell you? How can the collection period affect this ratio?
Show how you calculate the net profit to net worth ratio. What is the most common, but potentially most dangerous, way to increase this ratio?
What role does the net sales to fixed assets ratio play in calculating the return on fixed assets? How could an increase in the fixed assets to net worth ratio affect this ratio?
Why is the net sales to working capital ratio an effect ratio and not a causal ratio?