Chapter 4
Analysis of Financial Statements Using Causal Ratios

Learning objectives

  • Identify which ratios are causal and which are not.
  • Calculate each causal ratio.
  • Recognize how each ratio affects profits, net worth, working capital, and debt.

Introduction

The purpose of this section is to provide a procedure that will tell the user why the firm’s financial statements are changing. The procedure to be used is the analysis of a set of financial ratios. These ratios focus on why the statements are changing and not just on the change itself. The chapter covers the ratios and shows why they are causal in nature. The ratios covered are fixed assets to net worth, the collection period, net sales to inventory, net sales to net worth, the profit margin, and miscellaneous assets to net worth.

Causal ratios

Ratio analysis helps to set limits on the firm’s liquidity, capital structure, and profitability.

What happens when you do the ratio analysis of any firm, XYZ?

The analyst will very likely find XYZ company deficient in several areas, but above average in others. What can we conclude about XYZ? The causal ratios help to provide an answer. By viewing the effect of these six ratios on the firm, we will understand why the firm is in the situation (good or bad) that it is.

An analogy may help at this point. A boy is running down the street. He steps into a pothole and falls. Stepping in the pothole caused him to fall. The fall did not cause him to step in the pothole.

Ratio analysis is very similar to this story. Most ratio analysis programs measure only the fall or the results of some action. Causal ratio analysis shows why the fall occurred.

  • Fixed assets to net worth – measures over-investment in fixed assets
  • Collection period – measures a rise in accounts receivable
  • Net sales to inventory – measures a rise in inventory
  • Net sales to net worth – measures overtrading or unrestrained growth
  • Net profit to net sales – measures profitability
  • Miscellaneous assets to net worth – measures the rise in “other” assets

Each of the causal ratios will be examined individually.

Fixed assets to net worth

When too much capital has been invested in fixed assets, there is less capital available for investment elsewhere. We can measure this potential cause with the ratio of fixed assets to net worth. When this ratio grows and becomes too large in a profitable company, it may be a sign of excessive investment in fixed assets.

It may be difficult to judge whether this ratio is low or high. The ratio may be high (or low) as a result of a management decision. The important thing to understand is the effects that this ratio has elsewhere in the company if it is too high (or low).

Why is this ratio an important causal ratio? If too much net worth is tied up in fixed assets,

  • the firm will have too little working capital.
  • the firm will over-utilize debt.
  • profitability will suffer.

Knowledge check

  1. If fixed assets to net worth increases for a profitable company, the company’s debt ratios will likely
    1. Increase.
    2. Decrease.
    3. Not change.
    4. Debt ratios are unrelated to the fixed assets to net worth ratio.
  2. In the short run, when a profitable company’s ratio of fixed assets to net worth increases, the company’s current ratio will likely
    1. Increase.
    2. Decrease if short-term debt or cash is used to pay for (finance) the new fixed assets.
    3. Not change if long-term debt financing is used.
    4. Both answers b. and c. are correct.

Compare two companies, A and B. The two companies are identical. Examine the effect of a large increase in fixed assets on working capital.

A and B
Current assets $3,500,000
Current liabilities $1,750,000
Current ratio 2 to 1

Now B expands its fixed assets by $1,000,000 without an increase in net worth. A way to accomplish this expansion is to use up working capital in one of the following ways:

  • Decrease current assets to $2,500,000.
  • Increase current liabilities to $2,750,000.
  • Use long-term debt.
  • Combination of the above.

If the B company chooses short-term debt to finance the growth in fixed assets, then its liquidity and leverage risks are increased. We will assume both companies are identical otherwise.

Companies A and B
Net sales $15,000,000
Inventory 1,000,000
Receivables 1,500,000
Net worth $2,750,000

B now has $3,500,000 in current assets and $2,750,000 (not $1,750,000) in current liabilities. The current ratio of B is 1.27, compared to 2.0 before the change.

Both companies are identical with respect to sales, inventory, receivables, and long-term debt. But B only has $750,000 in working capital. Further effect of this ratio can be seen in the following ratios:

  A B
Net sales to working capital 10.00× 20.0×
Inventory to working capital 66.67% 133.3%
Receivables to working capital 85.71% 200.0%
Current debt to net worth 54.50% 90.9%
Current ratio 2 to 1 1.27 to 1

We can see the direct impact of the fixed asset to net worth ratio on the firm’s working capital. Traditionally, an analyst would see only the working capital problems. More importantly, we can now see the cause. The cause was not the company’s desire to have a shortage of working capital. The cause was an over-investment in fixed assets or an under-utilization of net worth financing or both.

If long-term debt had been used, then a much larger debt to asset ratio would have resulted. Instead of liquidity problems, the firm would have used up its debt capacity. Therefore, this ratio can affect the firm’s capital structure.

How fixed assets affect profit

The fixed asset to net worth ratio also affects profits through

  • interest expense.
  • increased depreciation. (This may put a firm in violation of its debt covenants.)
  • increased property taxes and insurance costs.
  • reduced working capital (to the point that cash discounts are lost).
  • late charges.
  • inventory stockouts.
  • reduced bank balances (to the point that service charges are incurred).

We would see the effect on profit in any profitability ratios (ROA, ROE, profit margin, and so on). If long-term debt had been used to finance the assets, then increased interest charges would have resulted.

Knowledge check

  1. In the short run, an increase in fixed assets to net worth generally causes profits to
    1. Increase.
    2. Decrease.
    3. Not change.
    4. There is no relationship between fixed assets to net worth and profit.

Ratios that could be changed by the fixed assets to net worth ratio

  • Current ratio
  • Net sales to working capital
  • Inventory to working capital
  • Trade receivables to working capital
  • Long-term debt to working capital
  • Total debt to net worth
  • Long-term liabilities to net worth
  • Net income to net sales
  • Net income to net worth
  • Net sales to net worth
  • Miscellaneous assets to net worth
  • Net sales to fixed assets

All of these ratios are affected by the fixed asset to net worth ratio; thus we can see that it is a causal ratio. These other ratios fall into the category of working capital, profitability, debt, and net worth ratios.

What can we tell our clients about this ratio? Beyond some point fixed asset expansion must be supported by net worth. If profits are sufficient, then perhaps no external equity is required. If profits are insufficient, then outside equity will be required so that the company may grow without growing out of business.

This is a real problem in small “growth” companies, which often expand faster than profits allow. Small companies have limited access to long-term debt or equity markets. The solution may be to reduce expansion, or to expand, but to realize where the liquidity problems are coming from.

Correction procedures

Excessive fixed assets

  • Raising additional capital from existing owners or through attracting equity investors
  • Selling idle machinery and parts, unused vehicles, and unnecessary equipment
  • Arranging sale and leaseback of plant and equipment
  • Restricting further investment in fixed assets
  • Developing compensating advantages
  • Securing long-term loans from banks, finance companies, or factors
  • Resorting to Small Business Administration (SBA) loans or Small Business Investment Company (SBIC) financing
  • Seeking longer terms from key suppliers

Knowledge check

  1. One possible solution for a company with financial troubles that have been caused by a growth in fixed assets (increase fixed assets to net worth ratio) is to
    1. Raise equity capital.
    2. Restrict further investment in fixed assets.
    3. Both of the previous answers.
    4. Neither of the previous answers.

Collection period

images

This ratio is a measure of the credit and collection efficiency of the firm, the probability of bad debt write-off, and the company’s receivable position over time and as compared to the industry. It is computed by dividing trade receivables by credit sales per day.

If this ratio is too high, it can indicate inefficiency or a decision to allow loose credit terms. In either event it affects many other things in the company. So, whether it is too high as a result of inefficiency or as a result of a decision, its causal nature must be understood.

Why is this ratio an important causal ratio?

  • Sales attainment – If you find a firm with terms of 2/10, net 30 and a 12-day collection period, the firm may be passing up sales. An excessively short collection period may be unprofitable.
  • Profitability – A long collection period may cause receivables write-off, collection costs (collection agencies), and increased interest costs.
  • Borrowing – To finance the increases in receivables when the collection period is large, debt may be used. Higher interest costs will result, reducing the firm’s capacity for future debt financing.

Knowledge check

  1. A growing collection period signals
    1. Customers are taking longer to pay.
    2. Inventory levels are inadequate.
    3. Inventory has increased rapidly.
    4. Fixed assets are growing too quickly.

Collection period: Example

Two firms are identical except that firm X has an 80-day collection period and firm Y has a 40-day collection period. This difference in collection periods is the cause of X’s problems. The effect can be seen in the following ratios:

  Company X Company Y
Cash $100,000 $100,000
Accounts receivable 2,000,000 1,000,000
Inventory 1,200,000 1,200,000
Total current assets $3,300,000 $2,300,000
Total current liabilities $1,700,000 $ 750,000
Long-term liabilities 1,300,000 1,250,000
Total liabilities $3,000,000 $2,000,000
Net worth $3,000,000 $3,000,000
Sales 9,120,000 9,120,000
Current assets to current liabilities 1.9 times 3.1 times
Current liabilities to net worth 56.7% 25.0%
Total liabilities to net worth 100.0% 66.7%
Trade receivables to working capital 125.0% 64.5%

Company X has a reduced quantity and quality of working capital, as evident in the receivables to working capital ratio. Company X has slightly more working capital than company Y but X is really less liquid.

The collection period alone has caused these changes; hence, it is a causal ratio. Its effect goes beyond collections efficiency. Traditional ratio analysis would only have seen these effects without tracing them back to the collection period.

Knowledge check

  1. When a company’s collection period increases (and the increased receivables have been financed with short-term debt), the company’s current ratio (which is 2 to 1 before the change in the collection period) will likely
    1. Increase.
    2. Decrease.
    3. Not change.
    4. It is impossible to determine from the information provided.

Illustrative problem

When the collection period increases, the company’s accounts receivable increases. Because accounts receivables are a current asset and the current asset has increased, how could this reduce the company’s liquidity?

Ratios that could be changed by the collection period

The effect of the collection period can be seen in all of the following ratios. Notice that it affects working capital, profitability, debt, and net worth ratios. Hence it affects the value of the company, that is, risk and return.

  • Current ratio
  • Current liabilities to net worth
  • Total liabilities to net worth
  • Accounts receivables to working capital
  • Net profit to net sales
  • Net profit to net worth
  • Net sales to net worth
  • Net sales to working capital
  • Fixed assets to net worth
  • Inventory to working capital
  • Long-term debt to working capital
  • Miscellaneous assets to net worth

Even if this ratio is too high by decision, the company must understand the problems that it causes.

Correction procedures

Abnormal collection period ratio

  • Selling terms can be either shortened or lengthened to improve sales.
  • Cash discount can be injected into selling terms, or existing cash discount can be increased, or cash discount can be eliminated entirely, thus restricting all sales to a net basis.
  • Greater selectivity in accepting accounts can be imposed, or liberalization of credit policy can be instituted.
  • A more systematic collection follow-up can be established, or a relaxing of arbitrary payment demands can be inaugurated.
  • A professional credit manager can be hired, or the training of the employee now handling credit functions can be initiated.
  • Slow receivables can be factored or discounted with a finance company or bank.
  • Credit insurance can be obtained to protect against abnormal bad debt loss.
  • Compensating advantages can, perhaps, be developed (that is, the other financial characteristics of the company can be improved).

Knowledge check

  1. Which may shorten a company’s collection period?
    1. Shorten selling terms.
    2. Eliminating cash discounts.
    3. Reduce its inventory.
    4. Increase sales.
  2. Greater selectivity in accepting accounts will generally cause the collection period to
    1. Increase.
    2. Decrease.
    3. Have no change.
    4. None of the above.
  3. A large collection period adversely affects profits because of the greater likelihood of
    1. Receivables write-off.
    2. Increased collection costs.
    3. Higher interest costs.
    4. All of the above.
  4. Assume that a firm has receivables of $800,000, inventory of $900,000, net sales of $9,000,000, cost of goods sold of $7,000,000 and net profit of $100,000. Calculate its collection period using a 360-day year.
    1. 25.6 days.
    2. 32.0 days.
    3. 75.5 days
    4. There is insufficient information to compute the collection period.

Net sales to inventory (inventory turnover)

This ratio traditionally is used as a measure of the firm’s inventory turnover and its “merchandising efficiency.” A high ratio generally signals that management is able to move the inventory sufficiently. A low ratio often signals inventory problems. However, its effect goes beyond the measurement of inventory problems; therefore, it is our third causal ratio.

Alternate computations:

images

A low ratio can signal

  • deterioration of inventory,
  • obsolescence,
  • seasonal fluctuations in inventory levels,
  • overvaluation of inventory,
  • unsalable inventory, or
  • change in customer preferences.

Through the audit process the auditor is in the best position to see these problems. This is shown in the following example.

Knowledge check

  1. Assume that a firm has receivables of $800,000, inventory of $900,000, net sales of $9,000,000, cost of goods sold of $7,000,000 and net profit of $100,000. Calculate its collection period using a 360-day year. Compute the company’s inventory turnover (with the sales formula).
    1. 10.0 times.
    2. 9.0 times.
    3. 11.5 times
    4. There is insufficient information to compute the inventory turnover.
  2. An increasing inventory turnover ratio often signals
    1. Increasing inventory relative to sales.
    2. Decreasing inventory relative to sales.
    3. Excessive sales growth.
    4. A receivables problem.
  3. A decreasing inventory turnover generally is a sign of ________.
    1. Increasing inventory.
    2. Decreasing inventory.
    3. Decreasing sales.
    4. Either increasing or decreasing inventory.

Net sales to inventory: Example

  Company X Company Y
Cash $1,500 $1,500
Accounts receivable 11,500 11,500
Inventory 12,500 25,000
Total current assets $25,500 $38,000
Current liabilities $13,000 $25,500
Long-term liabilities 3,000 3,000
Total liabilities $16,000 $28,500
Net worth $35,000 $35,000
Sales 100,000 100,000
Current ratio 2.0x 1.5x
Current liabilities to net worth 37.1% 72.9%
Total liabilities to net worth 45.7% 81.4%
Inventory to working capital 100.0% 200.0%
Net sales to inventory 8x 4x

Company X and Y are identical, except that company Y has double the inventory. Its turnover is four while company X has a turnover of eight. Notice that the extra $12,500 is financed with short-term debt.

We can see that slow-moving inventory hurts liquidity, increases debt, and causes over investment in the least liquid of the current assets (inventory), so the quality and quantity of working capital are reduced. If inventory had to be written off, profits would fall at the same time that the firm had a liquidity crunch.

Knowledge check

  1. The reason we consider the inventory turnover to be a causal ratio is that when the ratio decreases, the increased inventory must be financed. The increased inventory is generally financed with a decrease in cash or an increase in short-term debt. Therefore, the company’s quick ratio will generally _________ when the inventory turnover falls.
    1. Increase.
    2. Decrease.
    3. We cannot determine this answer from the information given.
    4. Not change.

Ratios that could be changed by net sales to inventory

The inventory turnover ratio affects ratios that are measures of working capital, debt, profits and net worth. Therefore, it directly affects the value of the firm and is more than a simple measure of “merchandise efficiency.”

  • Current ratio
  • Current liabilities to net worth
  • Total liabilities to net worth
  • Inventory to working capital
  • Net profit to net sales
  • Net profit to net worth
  • Net sales to net worth
  • Net sales to working capital
  • Fixed assets to net worth
  • Accounts receivables to working capital
  • Long-term debt to working capital
  • Miscellaneous assets to net worth

Correction procedures

  • Study of inventory records to detect items no longer used in the present manufacturing or marketing program
  • Review of the turnover rate of the various inventory components
  • Establishment of perpetual inventory records to ensure that articles are not purchased in excessive quantity or in advance of need
  • Delegation of the purchasing and inventory control function to a single responsible person
  • Study of the physical layout and the efficiency of the warehouse and storage areas
  • Improve sales while holding inventory levels constant
  • Development of compensating advantages to offset the competitive disadvantage of slow inventory turnover

Knowledge check

  1. The establishment of perpetual inventory records should cause the inventory turnover to
    1. Increase.
    2. Decrease.
    3. Not change.
    4. Sometimes increase and sometimes decrease depending on sales growth.
  2. A step to take when an inventory turnover has fallen is to
    1. Study which items in inventory are the problem.
    2. Review the turnover rate of inventory components.
    3. Both of the above.
    4. Neither of the above.
  3. Which can cause liquidity to drop?
    1. An increasing fixed assets to net worth ratio.
    2. An increasing collection period.
    3. A decreasing inventory turnover.
    4. All of the above.

Net sales to net worth

The trading ratio

The trading ratio is a measure of the extent to which a company’s sales volume is supported by invested capital (net worth).

images

The undertrader has a low ratio. This company’s most pressing problem is to increase sales.

The overtrader has a substantially higher ratio than average. This company is stretching its invested dollars to the maximum. Generally, it is burdened by excessive debt, and insufficient working capital, and its survival hinges on the long-term continuation of optimum conditions. The overtrader may actually look like a healthy company on the surface.

If the trading ratio is too high, the company may be very profitable, but it is in a very risky position, in which it could easily be forced out of business. In fact, overtrading may be responsible for the demise of many businesses.

Why is this ratio important? Sales and capital are correlated. Only so much turnover can be obtained from each dollar of invested capital. An overtrader generally has expanded its business without putting new equity capital into the firm. It generally has borrowed a lot of money or has underinvested in working capital or both.

To correct the problem, the overtrader must either attract equity capital or hold back sales growth.

Trading ratio: Example

  Company X
200W 200X 200Y 200Z
Cash $50,000 $50,000 $50,000 $50,000
Accounts receivables 350,000 650,000 1,250,000 2,450,000
Inventory 600,000 1,200,000 2,400,000 4,800,000
Total current assets 1,000,000 1,900,000 3,700,000 7,300,000
Fixed assets 450,000 450,000 1,450,000 2,450,000
Miscellaneous assets 50,000 50,000 50,000 50,000
Total assets $1,500,000 $2,400,000 $ 5,200,000 $ 9,800,000
Notes payable $ 0 $ 0 $900,000 $900,000
Trade payables 300,000 1,000,000 1,500,000 4,550,000
Total current liabilities 300,000 1,000,000 2,400,000 5,450,000
Long-term liabilities 0 0 1,000,000 1,750,000
Total liabilities 300,000 1,000,000 3,400,000 7,200,000
Equity/net worth 1,200,000 1,400,000 1,800,000 2,600,000
Total liabilities and net worth $1,500,000 $2,400,000 $5,200,000 $9,800,000
Net sales $3,600,000 $7,200,000 $14,400,000 $28,800,000
Net profit 100,000 200,000 400,000 800,000
Working capital 700,000 900,000 1,300,000 1,850,000

Company X is an example of an overtrader.

  • Sales double each year 200W–200Z.
  • Profit margin is held constant for the example (2.8 percent). In practice it may actually decline because of sales concessions, extensions into unprofitable territories, and so on.
  • All profits are retained in the business. So equity is growing as fast as possible from internal sources.
  • Inventory turnover is held to six times.
  • Collection period is held to 30 days when in fact it will generally increase for an overtrader.
  • All taxes have been paid.

How is the firm doing?

Despite retaining all of the earnings, the company has increased its trading ratio from 3 times in 200W to 11.1 times in 200Z.

There is a sharp increase in debt, and particularly in current debt. The debt is rising almost geometrically. This is a common overtrading problem.

The company did find long-term debt sources, but many small- and medium-sized companies would be forced to rely on short-term debt. So this company’s problems would be worse if it had used only short-term debt.

In 200Y and 200Z the growth in sales caused further investments in fixed assets. Despite the new assets, the net sales to fixed assets climbed to 11.76 percent. Overtraders often have additional problems because FA/NW increases.

Unless sales growth is curtailed or new equity sources are found, additional working capital will have to be diverted to fixed assets.

Some of the major symptoms of overtrading are discussed below. Current ratio has declined from 3.33 to 1.34. Without the long-term loans it would be around 1.01. The strain on working capital can be seen several ways.

  • Net sales to working capital – 5.14 times to 15.57 times.
  • Inventory to working capital – 85.7 percent to 259.5 percent.
  • Receivables to working capital – 50 percent to 132 percent, despite a falling collection period.

The ratio of net profit to net worth grew from 8.33 percent to 30.77 percent. Remember that the company appears to be very profitable. Profits doubled every year. This makes overtrading a difficult concept to explain to a client who may only be interested in profits.

Trading ratio: Example

  200W 200X 200Y 200Z
Causal Ratios        
Net sales to net worth 3.0x 5.1x 8.0x 11.0x
Fixed assets to net worth 38% 32% 81% 94%
Collection period 35 days 32.5 days 31.2 days 30.6 days
Net sales to inventory 6.0x 6.0x 6.0x 6.0x
Net profit to net sales 2.8% 2.8% 2.8% 2.8%
Miscellaneous assets to net worth 4.2% 3.6% 2.8% 1.9%
Liquidity Measures
Inventory to working capital 85.7% 133.3% 184.6% 259.5%
Trade receivables to working capital 50.0% 72.2% 96.2% 132.4%
Current assets to current liabilities 3.3x 1.9x 1.5x 1.3x
Leverage Measures
Current liabilities to net worth 25.0% 71.4% 133.3% 209.6%
Total liabilities to net worth 25.0% 71.4% 188.9% 276.9%
Profit Measures
Net profit to net worth 8.33% 14.29% 22.22% 30.77%

Illustrative problem

If a company’s trading ratio increases from 1.25 to 3.0, does that mean that the company will always be an overtrader?

Ratios that could be changed by the trading ratio

  • Current assets to current liabilities
  • Fixed assets to net worth
  • Current liabilities to net worth
  • Total liabilities to net worth
  • Inventory to working capital
  • Accounts receivables to working capital
  • Long-term liabilities to working capital
  • Net profit to net worth
  • Net sales to fixed assets
  • Net sales to net worth
  • Net sales to working capital
  • Miscellaneous assets to net worth

No company ever went out of business just from being an overtrader. Overtrading sets the business up, then some external shock puts it out of business. Overtrading affects the firm’s liquidity, leverage, and profitability.

Overtrading characteristics

  • Company maximizes sales (in other words, sales seems to be the single most important goal)
  • Existing owners are reluctant to assume risk (no new equity)
  • Company is vulnerable to unexpected problems
  • Overtrading may overextend supply lines because of rapid growth
  • Growth is unrestrained

If one of your clients seems overly preoccupied with sales growth and is unwilling to put new equity into the firm, the firm may be an overtrading candidate. Overtraders usually have numerous problems with finances, employees, and other matters. An overtrader’s business will have the appearance of a CPA firm at tax time.

Growth at the micro and macro level is essential for a capitalistic system. However, unrestrained growth (overtrading) can very quickly put a firm out of business.

Excessive growth will be a misleading problem because the overtrader often looks extremely profitable. However, it is the weak balance sheet that harms the company.

Knowledge check

  1. An undertrader is a company with a ______ ratio of sales to net worth.
    1. Large.
    2. Small.
    3. Average.
    4. Either large or small.
  2. The solution to the overtrading and undertrading problems is
    1. Exactly the same.
    2. Similar.
    3. Completely different.
    4. None of the above.
  3. Select the statement that is most true.
    1. Overtraders generally have very strong balance sheets.
    2. Overtraders generally have very weak balance sheets.
    3. Overtraders often have balance sheets that are about average in strength.
    4. Overtrading has no impact on a company’s balance sheet.
  4. Overtraders often are companies that are attempting to maximize
    1. Sales.
    2. Their current ratios.
    3. Managerial leisure time.
    4. Their debt ratios.
  5. Assume that a firm has current assets of $2,500,000, fixed assets of $1,500,000, current liabilities of $900,000, long-term liabilities of $600,000, net sales of $9,000,000 and net profit of $300,000. Compute its trading ratio.
    1. 1.50 times.
    2. 3.60 times.
    3. 5.55 times
    4. Some other number.

Correction procedures

Overtrading or undertrading

  • When undertrading is a problem, the analyst must consider the degree of profitability currently enjoyed.
  • Whether the fault be overtrading or undertrading, borrowing from financial institutions or securing longer credit terms can provide temporary relief.
  • Raising outside equity.
  • Reducing payout ratios and owner’s salaries.
  • Improving cost control and the profit margin.
  • Raising prices slightly to cut demand and improve the per unit profit margin.

Knowledge check

  1. Select the statement that is most true.
    1. Raising external equity can improve an overtrader’s financial condition.
    2. Raising external equity will hurt an overtrader’s financial condition.
    3. Raising external equity will have no impact on an overtrader’s financial condition.
    4. All of the above can be correct.
  2. Which will improve an overtrader’s problems?
    1. Reducing the payout to owners.
    2. Decreasing the company’s prices.
    3. Both of the above.
    4. Neither of the above.
  3. Which will improve an overtrader’s financial problems?
    1. Improving cost control.
    2. Obtaining short-term loans to finance the growth.
    3. Both of the above.
    4. Neither of the above.

The profit margin

Every company has profit as its goal. This ratio is a measure of the percentage of sales kept as profits (the number of pennies kept per dollar of sales).

Why is this ratio a causal ratio? The difference between sales and profit is the company’s expenses. This ratio is a measure of how well a company is controlling its expenses. The company must be able to reinvest profits back into the firm. If profits are not available to increase net worth, then working capital and/or debt problems often result.

  Company Q
  201X 201Y
Cash $300,000 $150,000
Receivables 700,000 700,000
Inventory 3,550,000 3,550,000
  • Total current assets
 4,550,000 4,400,000
Fixed assets 1,600,000 1,500,000
Other assets 300,000 300,000
  • Total assets
 $6,450,000 $6,200,000
Notes payable $750,000 $850,000
Accounts payable 1,000,000 950,000
Total current liabilities 1,750,000 1,800,000
Long-term liabilities 1,150,000 1,100,000
Net worth 3,550,000 3,300,000
  • Total liabilities and net worth
 $6,450,000 $6,200,000
Sales $12,000,000 $12,000,000
Working capital 2,800,000 2,600,000
Net profit 400,000 (250,000)

The profit margin: Example

In 201X and 201Y, the inventory turnover and collection period have been held constant. But in 201Y, we have a loss, bringing a direct reduction in net worth.

  201X 201Y
Current ratio 2.6x 2.4x
Current liabilities to net worth 49.3% 54.6%
Inventory to working capital 127.0% 137.0%
Net profit to net sales 3.33% (2.08%)
Net sales to net worth 3.38x 3.64x
Net sales to inventory 3.38x 3.38x
Collection period 21 days 21 days

The negative profit margin is a problem by itself. However, it causes this firm’s drop in liquidity and increase in leverage. These problems will continue and worsen until the firm can increase its profitability:

  • The current ratio declined – Reduction of liquidity
  • Current liabilities to net worth has risen – Risk has increased
  • Inventory to working capital has increased – Reduced quality of working capital; risk has increased
  • Trading ratio has risen, even with a constant sales amount

This ratio affects virtually all other ratios; therefore, it is a causal ratio. Traditional ratio analysis would only have examined the changes in liquidity and debt without ever revealing their cause.

Be sure that your client understands the full impact of continual losses, particularly if your client wants to make large withdrawals from the firm while the firm is losing money.

Correction procedures

Low or negative profit margin

  • If sales are declining, then a low or negative profit margin may be the result. Correcting this problem means either generating more sales (sometimes easier said than done) or downsizing; that is, reducing the size of the firm and selling off assets.
  • If sales are increasing or stable, a low or negative profit margin is a cost control problem. Compute a common size income statement with all expenses listed as a percent of sales. Compare this to the industry’s “Robert Morris” size income statement to determine which expenses are out of line.

Knowledge check

  1. When a company’s profit margin becomes negative, its debt ratios will generally
    1. Increase.
    2. Decrease.
    3. Not change.
    4. The profit margin is unrelated to the debt ratios.
  2. If sales are decreasing, then correcting a profit margin problem would entail
    1. Downsizing.
    2. Restoring the original level of sales.
    3. Either of the above would work.
    4. Raising prices.
  3. When sales are stable or increasing, correcting a profit margin problem involves
    1. Increasing prices or cutting costs.
    2. Downsizing.
    3. Both of the above.
    4. Neither of the above.

Miscellaneous assets to net worth

  • Affects working capital
  • Affects profitability
  • Affects net worth

Miscellaneous assets include

  • loans to officers,
  • advances to subsidiaries,
  • prepaid expenses,
  • investments in other than marketable securities,
  • mortgage receivables,
  • cash value of life insurance, and
  • office supplies.

This ratio should not be too large. These assets generally earn less than a market rate of return so they cost the firm potential profits. This ratio is often a problem in small companies where the owner lends money to employees—the “one big happy family” syndrome.

This ratio can affect working capital and debt, because the miscellaneous assets have to be financed by something. Profits are also hurt.

Be sure to counsel your client that the miscellaneous assets to net worth ratio can cause all of the problems that the other causal ratios can. At least your clients should be made to understand that they should charge market rates of interest on these investments.

Knowledge check

  1. When a company’s miscellaneous assets to net worth ratio increases, the company’s liquidity ratios will
    1. Generally improve.
    2. Generally deteriorate.
    3. Improve or deteriorate depending on sales growth.
    4. Not be affected.

Correction procedures

Investment in miscellaneous assets

  • Collect loans to officers.
  • Call in advances to subsidiaries.
  • Charge interest on these loans.
  • Use term life insurance or market-rate paying whole life.

Causal ratio summary

images

How would you respond?

You are the CFO of a medium sized manufacturing company. The company sales have increased by an average of 15 percent per year for the past five years. Debt is at an all-time high. The newly promoted CEO (formerly the VP of marketing) wants to expand into new markets overseas that have the potential to double sales fairly quickly. The CEO has asked your opinion.

How would you respond? Things to consider…

  • Debt is already high, will the expansion require additional debt?
  • What would the cost of the new debt be?
  • How profitable would the expansion be?
  • Is now the time to expand with debt at record levels?

Review questions

  1. Why is each ratio discussed a causal ratio?

     

     

     

  2. Explain in detail how a change in the fixed assets to net worth ratio could affect a firm’s working capital.

     

     

     

  3. What would you tell your client about the fixed assets to net worth ratio?

     

     

     

  4. How can a change in the firm’s collection period affect its capital structure?

     

     

     

  5. Of what is the net sales to inventory ratio a measure? How can a change in this ratio affect the firm’s liquidity?

     

     

     

  6. What is overtrading? Why is overtrading so deceptive? What are the major problems overtrading can cause?

     

     

     

  7. What are the characteristics of an overtrader? How does overtrading destroy the firm? What are the cures for overtrading?

     

     

     

  8. How can a change in a firm’s net profit to net sales ratio affect the firm’s net worth?

     

     

     

  9. Make a list of you firm’s miscellaneous assets. Why might an increase in this asset category be bad?