COMBINATION RATIOS

Each of the financial ratios discussed so far in this chapter is derived from numbers collected from just one of the three basic financial statements.

Rate-of-Return Measures

One of the most valuable types of combination ratios combines earnings with balance sheet figures. Such ratios measure the profit that an enterprise is generating relative to the assets employed or the capital invested in it. This kind of measure provides a link between credit analysis and the economic concept of productivity of capital.

To illustrate, consider Companies A, B, and C, all of which are debt- free. If we look only at net margin, a ratio derived solely from the income statement, Company A is superior to both its direct competitor, Company B, and Company C, which is in a different business. Looking at the com­bination ratio of return on equity, however, we find that Company C ranks highest, notwithstanding that sales margins tend to be narrower in its industry:

To an economist, this result suggests that investors earning 8% to 10% in Company A and Company B’s industry will seek to shift their capital to Company C’s industry, where 12% returns are available.

There are several variants of the rate-of-return combination ratio, each with a specific analytical application. Return on equity, which has already been alluded to, measures a firm’s productivity of equity and therefore pro­vides an indication of its ability to attract a form of capital that provides an important cushion for the debtholders:

In calculating this ratio, analysts most commonly use as the denominator equity as of the final day of the year in which the company earned the in­come shown in the numerator. This method may sometimes produce distor­tions. A company might raise a substantial amount of new equity near the end of the year. The denominator in the return-on-equity calculation would consequently be increased, but the numerator would not reflect the benefit of a full year’s earnings on the new equity because it was employed in the business for only a few days. Under these circumstances, return on equity will compare unfavorably (and unfairly) with that of a company that did not abruptly expand its equity base.

The potential for distortion in the return-on-equity calculation can be reduced somewhat by substituting for end-of-year equity so-called average equity:

(Some analysts prefer this method to the year-end-based calculation, even when sudden changes in the equity account are not an issue.)

Another limitation of combination ratios that incorporate balance­sheet figures is that they have little meaning if calculated for portions of years.

To derive a proper return on equity, it is necessary to annualize the earnings figure. Merely doubling the first half results can introduce some distortion, though, since the company’s earnings may be seasonal. Even if not, there is no assurance that the first-half rate of profitability will be sus­tained in the second half. Accordingly, the best way to annualize earnings is to calculate a trailing 12-months’ figure:

If the analyst is working with the company’s 2001 annual report and 2002 second-quarter statement, 2001 second-half earnings will not be available without some backing out of numbers. For ease of calculation, the numera­tor in the preceding ratio can be derived as follows:

Net income for full year 2001

Less: Net income for first half of 2001

Plus: Net income for first half of 2002

For the credit analyst, return on equity alone may be an insufficient, or even a misleading, measure. The reason is that a company can raise its re­turn on equity by increasing the proportion of debt in its capital structure, a change that reduces credit quality.

Note that Company Y enjoys its edge despite having to pay a higher in­terest rate on account of its riskier financial structure.

Income statement ratios such as net margin and fixed-charge coverage, which point to higher credit quality at Company X, serve as a check against return on equity, which ranks Company Y higher. A later section of this chap­ter explores systematic approaches to reconciling financial ratios that give contradictory indications about the relative credit quality of two or more

EXHIBIT 13.4 Effect of Debt on Return on Equity ($000 omitted)

Company X                                                  Company Y

companies. The more immediately relevant point, however, is that other com­bination ratios can also be used as checks against an artificially heightened return on equity. Using the same figures for Companies X and Y, the analyst can calculate return on total capital, which equalizes for differences in capital structure. On this basis, Company Y enjoys only a negligible advantage re­lated to its slower growth in retained earnings (and hence in capital):

Total debt in this calculation includes short-term debt, current maturi­ties of long-term debt, and long-term debt, for reasons described earlier under “What Constitutes Total Debt?” Similarly, total equity includes both preferred and preference stock.

Turnover Measures

In addition to measuring return on investment, a particular type of combi­nation ratio known as a turnover ratio can provide valuable information about asset quality. The underlying notion of a turnover ratio is that a com­pany requires a certain level of receivables and inventory to support a given volume of sales. For example, if a manufacturer sells its goods on terms that require payment within 30 days, and all customers pay exactly on time, ac­counts receivable on any given day (barring seasonality in sales) will be 30 ÷ 365 or 8.2% of annual sales. Coming at the question from the opposite direction, the analyst can calculate the average length of time that a receiv­able remains outstanding before it is paid (the calculation uses the average amount of receivables outstanding during the year):

This ratio enables the analyst to learn the company’s true average collection period, which may differ significantly from its stated collection period.

By inverting the first portion of the average days of receivables calcula­tion, one can determine how many times per year the company turns over its receivables:

As long as a company continues to sell on the same terms, its required re­ceivables level will rise as its sales rise, but the ratio between the two should not change.

Another asset quality problem that can be detected with a combination ratio involves unsalable inventory. A fashion retailer’s leftover garments from the preceding season or an electronics manufacturer’s obsolete fin­ished goods can be worth far less than their balance sheet values (historical cost). If the company is postponing an inevitable write-off, it may become apparent through a rise in inventory without a commensurate rise in sales, resulting in a decline in inventory turnover:

where IBY = Inventory at beginning of year

IEY = Inventory at end of year

A drop in sales is another possible explanation of declining inventory turnover. In this case, the inventory may not have suffered a severe reduc­tion in value, but there are nevertheless unfavorable implications for credit quality. Until the inventory glut can be worked off by cutting back produc­tion to match the lower sales volume, the company may have to borrow to finance its unusually high working capital, thereby increasing its financial leverage. Profitability may also suffer as the company cuts its selling prices, accepting a lower margin to eliminate excess inventory.

One objection to the preceding inventory-turnover calculation involves the variability of selling prices. Suppose that the price of a commodity chemical suddenly shoots up as the result of a temporary shortage. A chem­ical producer’s annual sales—and hence its inventory turnover—may rise, yet the company may not be physically moving its inventory any faster than before. Conversely, a retailer may respond to a drop in consumer demand and cut its prices to avoid a buildup of inventory. The shelves and back room have no more product than previously, yet the ratio based on annual sales indicates that turnover has declined.

To prevent such distortions, the analyst can use the following variant ratio:

This version should more closely capture the reality of a company’s phys­ical turnover. Cost of goods sold and inventory are both based on historical cost, whereas selling prices fluctuate with market conditions, causing a mis­match between the numerator and denominator of the turnover calculation.

Total-Debt-to-Cash-Flow Ratio

A final combination ratio that is invaluable in credit analysis is the ratio of total debt to cash flow:

This ratio expresses a company’s financial flexibility in a most interest­ing way. If, for the sake of illustration, a company has total debt of $60 mil-

lion and cash flow from operations of $20 million, it has the ability to liqui­date all its debt in three years by dedicating 100% of its cash flow to that purpose. This company clearly has greater financial flexibility than a com­pany with $80 million of debt and a $10-million annual cash flow, for an eight-year debt-payback period. In the latter case, flexibility would be par­ticularly limited if the company’s debt had an average maturity of signifi­cantly less than eight years, implying the possibility of significant refinancing pressure under tight credit conditions.

All very interesting, one might say, but in reality how many companies dedicate 100% of their cash flow to debt retirement? The answer is “very few,” but total debt to cash flow is still a good ratio to monitor for credit quality. It enjoys distinct advantages over some of the more frequently in­voked credit-quality measures, which are derived from the balance sheet or income statement alone. The total-debt-to-total-capital ratio has the inher­ent flaw that equity may be understated or overstated relative to its eco­nomic value. After all, the accounting rules do not permit a writeup of assets unless they are sold, nor do the rules require a writedown until some­one makes the often subjective determination that the assets have fallen in value. In comparison, total debt is an objective number, a dollar amount that must contractually be repaid. Fixed-charge coverage, too, has a weak­ness, for it is based on earnings, which are subject to considerable manipu­lation. Cash flow eliminates one major opportunity for manipulation: underdepreciation. If a company inflates its reported earnings by writing down its fixed assets more slowly than economic reality dictates, it is merely taking money out of one cash flow pocket and putting it into the other. Cash flow, then, puts companies on equal footing, whatever their deprecia­tion policies.

Built from two comparatively hard numbers, the ratio of total debt to cash flow provides one of the best single measures of credit quality. Analysts should not worry about whether its literal interpretation—the period re­quired for a total liquidation of debt—is realistic, but instead focus on its analytical value.