The liquidity ratios are shown over here. We have
already talked about them in the reading on the balance
sheet, but very briefly liquidity ratios give
us an understanding of how easily a company can meet
short-term obligations. The ratio that we didn't
see before is the defensive interval ratio. This
looks up the current assets divided by the daily cash expenditures.
So, if the current asset are 100 and the daily cash
expenditure equals 10, then our defensive interval
ratio is 100/10 which is 10. This essentially means
that we have 10 days worth of short-term assets, so
we can meet 10 days worth of daily expenditures.
Now some interpretation and judgment can come in
if you believe that receivables are not very liquid,
then it might make sense to remove your receivables
number when coming up with the defensive interval
ratio. We can also evaluate the liquidity of a company
by looking at the cash conversion cycle, which is
also called the net operating cycle. This essentially
measures the time between when a company spends
money on inventory till the time that the company
receives money on the sales that it makes. Obviously,
if this period is short that means high liquidity, if this period
is long that means low liquidity. The formula for
calculating the net operating cycle is, days of inventory
on hand plus days of sales outstanding minus number
of days of payables. To understand this formula, let's
look at a simple example. Let's say that a company orders
inventory over here, so this is where the inventory
is received, then the payment for that inventory
happens 10 days later. So, on day 10 is when we make
the payment, so this is where my money goes out. Let
us say, that the days of inventory on hand is 30 which
means that it takes us 30 days to convert this inventory
into product which has sold, that means that on day
30, over here, is where the sale happens and then on
average let's say that it takes 15 days to collect
money. This sale, for example, is a credit sale and on day 45 is
when we receive money. The net operating cycle or
the cash conversion cycle is the time period from here
to here. What is that? If you look at the days of inventory
on hand, that is this point to this point, so that is
30, the days of sales outstanding that is equal
to 15, from here to here, minus the number of days
of payables, which is 10. So, the cash-to-cash cycle
or the cash conversion cycle as you can see from this
picture is 45 minus 10 which is 35, you get the same answer
using the formula. So, 30 and 15 is 45, minus 10, is 35, and again
a relatively high number would mean low liquidity
and a short number means high liquidity, because
the company is getting cash back very fast. Solvency
Ratios. We have discussed when we talked about the
balance sheet. Just as a refresher the ratios are
given again and these ratios measure a company's
ability to pay back long-term debt. If you look at
the debt to asset ratio, then small amount of debt
relative to a large asset base means that the company
is financially strong, the leverage is low. So, we
are not too concerned about whether or not the company
will be able to pay off debts if this number is small.
So, notice that with debt to asset ratio, low is good.
Debt to capital, so capital generally refers to the
total money that has been raised, that is debt as well
as equity. This should be low debt-to-equity ratio
again low is safer. Financial leverage ratios,
this is important. Here we divide total assets...divided
by equity. Now, a higher ratio here means high leverage.
So, in general with these ratios a high ratio means
that there is a high level of debt or high level of
leverage, and as we've discussed before you need
to look at these numbers in the context of the industry,
because in some industries the level of debt leverage
will be high. In other industries, the level of debt or leverage
will be low. Some more solvency ratios,
an extremely important; one is the interest coverage
ratio, which is your operating income or earnings
before interest and taxes divided by interest payments.
This is called the coverage ratio, because if this
ratio, for example is 10, what that means is that your
operating income covers the interest amount
10 times. Here, the higher the better. A high coverage
ratio, means that you are making a lot of operating
income relative to the financial cost which is
interest, in this case. Fixed charge coverage. This is
EBIT plus lease payments divided interest payments plus
lease payments. You will understand this better
when we do the chapter on long-term liabilities
and leases later, but just to give you a very brief
explanation, in the numerator, we use EBIT plus
lease payments because typically EBIT is calculated
after making lease payments, by adding back lease
payments, we are looking at how much money we are
making before the lease payments. Just like over
here, we are looking at how much money we are making
before making interest payments. So, here we have
the amount of money, we make before lease payments
divided by the total payments. Just like interest payments
are a obligation, similarly lease payments are also a obligation.
So, it makes sense to look at the sum of the two numbers.
The profitability ratios that you are looking at
here should seem very familiar, you saw these ratios
when we did the income statement. Essentially higher
the better. Gross profit margin is the gross profit
divided by revenue. Operating profit margin is operating
income over revenue. Pretax margin is earnings before
tax over revenue, and net profit margin is net income
over revenue. Profitability Ratios, where we look at the return on investment.
These are mixed ratios. You will often see this particular
ratio, return on assets. Return on assets is net income,
which you get from the income statement, divided by
average total assets, and the theme that I talked about
earlier, in terms of the income statement number
in the numerator and the average balance sheet number
in the denominator continues over here. Return on
total capital is EBIT divided by average short and long-term
debt. Now, in different textbook, you might see a slightly
different definition of capital, here you see long-term
debt and equity. In other textbooks, the total assets
might be used. Return on equity is net income divided
by average total equity. Return on common equity
looks at the money that is available to common shareholders.
If you recall your EPS calculation, you saw this
expression, there also. The net income minus preferred
dividends is the amount available to common shareholders
divided by average common equity gives you the return
on common equity. Coming now to the DuPont Analysis,
which is important from a testability perspective.
This brings together several ratios that we are
talking about. Return on equity is net income divided
by equity. This is an important ratio, because it tells
us how much net income, we are generating relative
to the equity, or the amount that we have invested.
Let's say that this particular ratio is 20%, that looks
like a good number. Let's say that this is higher
than the industry average which say is 15%. The question
then becomes the following; where is this 20% coming
from? And Dupont helps us with that analysis. We can
think of net income over equity, or return on equity
as the product of return on assets and financial
leverage. Return on assets is net income divided
by total assets and financial leverage, as we have
seen on our earliest slide, is assets divided by equity. Notice that
when you multiply these two expressions, the assets
cancel out and you have net income divided by equity,
so it is possible that we have a higher net income
over equity because of high leverage. High leverage
means that our own equity investment is small, debt
is high which is why even though net income over assets
is a small number, so, let's say that this number is
only 10%, but if assets over equity or financial leverage
is 2, that will give us a net income over equity of
20. By decomposing net income over equity into these
two ratios, we actually see that are 20% number is
coming because of high leverage or high risk. Taking
this one level further, we can say that return on
assets can be written as net profit margin divided by total asset
turnover. So, the net profit margin is net income
divided by sales, and total asset turnover is given
by sales divided by average total assets, and then
the financial leverage term comes down. This has
not been decomposed, so this is still assets over
equity. Now, if you multiply these three ratios you
notice that, again you are left with net income over
equity, because sales and sales cancel, assets and
assets cancel. So again, this tells us that the return
on equity is partly explained by leverage, but this
decomposition, return on assets as a product of net
profit margin and total asset turnover tells us
that the return on assets has these two components.
We have a net profit margin which tells us about our
profitability relative to sales and the asset turnover
which tells us how efficiently we are using our assets
and with a 10% number it might be, because we are using our
assets very efficiently. So, it is possible that
net income over sales is only 5%, but sales divided by assets is
2, which means that our real value is coming, because
of an efficient use of assets and not because we are
very profitable in terms of net income over sales.
Now to summarize what we've discussed so far, I think
from an exam perspective, understanding the two
kinds of viewpoint ratios is extremely important.
So, I will erase what you see over here and just summarize
the two types of DuPont ratios that you must be on
top of. So, return on equity is net income over equity.
This can be written as return on assets which is net
income over assets multiplied by financial leverage, which
is assets over equity, and then decomposed into three
components. We can say, return on equity is net income
over equity which is equal to net income over sales times
sales over assets, that's the total asset turnover,
times the financial leverage which is assets over equity.
While I don't think you are likely to be tested on
this, but you might as well also learn the five form decomposition
of the return on equity. So, here we essentially say
that return on equity is equal to tax burden into
interest burden into EBIT margin, and all these numbers
essentially, are coming from the income statement.
So, we can look at net profit margin as coming from
three sources; one is EBIT margin, which is saying
how efficient operation is. The next is, interest
burden, which tells us about our finance cost. So, if
the finance cost is low, then this ratio will be
high, and tax burden which tells us about the tax.
If the tax is low then this ratio will be high, and
I will create a very simple balance sheet to illustrate
this concept. Notice, that our net profit margin can
be written as the product of these three ratios.
So, net income of a sales is equal to net income over
EBT, earnings before tax, a high number for net income
over EBT means that the tax is low, multiplied by EBT over EBIT,
so this divided by EBIT. A high number for this ratio means
that interest is low, and then EBIT over sales,
this is our operating profit margin. A high number
means that our operating expenses our low. So, the five
form DuPont equation then becomes net income over
EBT, times EBT over operating profit, times operating profit
over sales, times the total asset turnover, which is
sales divided by assets multiplied by the financial leverage, which is
assets over equity. Again, I will emphasize that
you must know these two forms; net income over assets
times assets over equity. And this form that essentially
has three; ratios net profit margin, asset turnover,
and financial leverage. Let us look at a problem
which is a little bit difficult but illustrates
the concepts we have spoken about. Over a 3-year
period, we are looking at the ROE of a company, which
is going up from 19% to 20% to 22%. The return on total assets
is coming down. This tells us that the profitability
of the company is coming down. Total asset turnover
is going up slightly. So, initially it is 2, and then
in 2012 it is 2.1. We need to make an assessment about
the net profit margin and financial leverage and
we'll do this by decomposing the ROE. If you look at
the most basic form of the DuPont equation, that tells
us the return on equity is equal to return on assets
multiplied by financial leverage. Looking at the top row, we know
that ROE is going up. Looking at the second row,
we know that the return on total assets is coming
down, therefore the leverage must be going up. So, the
financial leverage has increased this means that
we can rule out A and answer must be B or C. If you take
net income over assets, or the return on assets, this ratio
can be decomposed into the net profit margin, net
income over sales, multiplied by the asset turnover ratio--sales
over assets. We know that return on assets is coming
down from the second row, net income over sales, that is
the profit margin that we need to evaluate. Sales
over assets, or asset turnover. This has been going
up a little. The only explanation now is that net income
over sales or profit margins must be going down.
So, the correct answer is C; net profit margin has decreased,
but financial leverage has increased.