Using Financial Data for Business Restructuring

Using Financial Data for Business Restructuring
Prof. Nilay Savla, DBIMR

Analysis by using Ratios
Ratio refers to a numerical or quantitative relationship between two items/variables .

In financial analysis, ratio refers to numerical/quantitative relationship between two
items, both of which are found in the financial statements.

A widely used tool of financial analysis

A systematic use of ratios to interpret the financial statement of an enterprise and to
determine the performance of the enterprise

Such ratio analysis helps to make related information comparable

It enables the user of financial statements to draw certain conclusions from his standpoint

Category 1: Financial Ratios
Sub-Categories: Liquidity and
Stability/Solvency

Under this category, the sub-categories are:

L|qu|d|ty kat|os: L|qu|d|ty refers to an enterpr|ses ab|||ty to meet short-term obligations
1. Current Ratio
2. Quick Ratio (or Acid-Test Ratio or Liquid Ratio)
3. Super Quick Ratio (or Cash Ratio)
4. Defensive Interval Ratio (or Interval Measure)
5. Net Working Capital Ratio

Stab|||ty kat|os]So|vency kat|os: So|vency refers to an enterpr|ses ab|||ty to meet |ong-
term obligations
1. Fixed Assets Ratio
2. Fixed Interest Cover (or Interest Coverage Ratio or Times Interest Earned)

Category 1: Sub-Category Liquidity Ratios
Current Ratio:

A crude-and-qulck measure of an enLerprlse's llquldlLy ls Lhe currenL raLlo whlch ls obLalned
by dividing current assets by current liabilities.

Under the regime of Revised Schedule VI, the definitions of current assets and current
llablllLles also conslder a company's operaLlng cycle.

Some analysLs oplne LhaL lL would be prudenL lf currenL asseLs here exclude 'loose Lools' and
'bad debLs ouLsLandlng for over 6 monLhs'.

Prepaid expenses are included in current assets as they represent relief from making future
payment since these expenses have already been paid in advance.

Current assets may decline in value whereas the amount of current liabilities may seldom be
subject to any fall unless any current liability agrees to some reduction


The current ratio indicates the rupee amounts available for every rupee of current liability.
So, Lhe hlgher Lhe raLlo, Lhe larger ls enLerprlse's ablllLy Lo meeL currenL obllgaLlons and Lhe
greater is the safety margin or safety of funds as far as short-term creditors are concerned.

A satisfactory current ratio would enable an enterprise to meet immediate obligations even
when there is a fall in the value of current assets.
The convention is that current ratio should be at least 2:1 so that even if there is a 50% fall in
the value of current assets the enterprise will be exactly able to meet immediate obligations.
A very high current ratio may serve as a great margin of safety to creditors but such a current
ratio may indicate excessive inventories, overextended receivables, and imprudent use of
current borrowing capacity.

A high current ratio due to excessive dependence on long-term financing would lower down
the profitability of the enterprise since long-term liabilities cost more than short-term
liabilities.

This thumb rule, however, should not be applied mechanically.

An enterprise doing business that is characterized by seasonal activity may experience a high
current ratio at one point of time and a low current ratio at some other point of time.

The nature of industry also has a bearing on the current ratio. For instance, public utility
companies would generally have a very low current ratio since these companies generally
have very little need for current assets.

Also, if a country is capital-rich (i.e. long-term funds from capital markets are easily
available), the enterprises depend on current liabilities for financing a very small portion of
their current asset requirements and it is quite normal for an enterprise to finance a most of
its current assets by long-term funding.

However, in underdeveloped countries, an enterprise is compelled to rely heavily on short-
term financing.


Of course, a current ratio of below 1:1 would certainly be undesirable in any industry as
some safety margin is required to protect the interests of creditors and to provide a cushion
to the enterprise in tough times.

Current ratio is an index of quantity since it only focuses on the size (i.e. amount) of current
assets available to meet current liabilities.

It does not focus on the break-up of this amount of current assets.

Since it fails to consider the various components that make up the current assets and their
proportions in relation to total amount of current assets, the current ratio is not an index of
quality.

Thus, the current ratio is not a conclusive index of real liquidity of an enterprise.

Quick Ratio (or Acid Test Ratio or Liquid Ratio):

This ratio addresses a flaw of current ratio by considering the composition (or the mix) of the
current assets of an enterprise.

Culck raLlo counLs ln Lhe numeraLor all currenL asseLs excepL 'prepald expenses' and
'lnvenLorles'.

Prepaid expenses are excluded since they, by their very nature, do not represent amounts
available to pay off current obligations. Basically, prepaid expenses simply go on to reduce
the amount of cash outgo in the present accounting period because of payment in a prior
accounting period.

Inventories are excluded since they are not that very readily/easily convertible into cash.


Some analysts prefer to exclude short-term borrowings from current liabilities for two
reasons:

Reason 1: Quick Ratio is not intended to measure debt servicing capacity. Debt servicing
capacity can be measured by resorting to Fixed Interest Cover (or Interest Coverage Ratio or
Times Interest Earned)

Reason 2: Usually, enterprises renew short-Lerm debLs, Lhereby maklng Lhem 'rolllng' ln
nature. This provides sufficient reason to view such debts as ultimately long-term debts.

Super Quick (or Cash Ratio):

1he mosL rlgorous and conservaLlve LesL of an enLerprlse's llquldlLy, Lhe super qulck raLlo, ls
computed by dividing cash and marketable securities by the current liabilities of the
enterprise.

Some analysts opine that in addition to cash and marketable securities, this ratio could also
conslder 'reserve borrowlng power' as an enLerprlse's real debL paylng ablllLy ls a funcLlon of
not just cash and cash equivalents but also of its capacity to borrow from the market at short
notice.

Defensive Interval Ratio (or Interval Measure):

1hls raLlo examlnes Lhe enLerprlse's llquldlLy poslLlon ln Lerms of lLs ablllLy Lo meeL pro[ecLed
or average daily cash expenses.

It thus relates quick assets to projected or average daily operating cash outflows.

Daily operating cash expenses will be computed as all expenses arising due to operating
activities with the exclusion of non-cash charges (like depreciation, amortization etc) as
divided by the number of days in the year.

Defensive Interval Measure = Quick Assets divided by Projected or Average Daily Operating
Cash Expenses


The higher the ratio, the better it is since it means that for a longer period the enterprise can
finance its operations by using its quick assets.

This helps to comment on the time-span an enterprise can operate on present quick assets
wlLhouL resorLlng Lo fuLure perlod's lncome.

This ratio, some analysts suggest, can be further refined by keeping the denominator as the
total of Average Daily Operating Cash Expenses and Average Daily Finance Charges.

Net Working Capital Ratio:

For the purpose of this ratio, from current assets, when except short-term bank borrowings,
all other current liabilities are deducted, we get the Net Working Capital.

Net Working Capital, as a measure of liquidity, perceives an enterprise having more net
working capital as more capable of meeting its current obligations.

neL worklng caplLal measures an enLerprlse's poLenLlal reservolr of funds.

When Net Working Capital is related to Net Total Assets, we get the Net working Capital
Ratio.

Thus, Net Working Capital ratio = Net Working Capital divided by Net Total Assets

Category 1: Sub-Category
Stability/Solvency Ratios
Fixed Assets Ratio:

This ratio explains whether or not an enterprise has been able to raise adequate financing
through long-term sources to meet its fixed asset requirements.

Fixed Assets Ratio = Net Fixed Assets divided by Long-term Funds

Here, long-term funds include Effective Net Worth and Long-Lerm CuLslders' LlablllLles

This ratio should not exceed 1. If it equals 1, it means all fixed asset requirements were met
by long-term financing. If it is below 1, it shows that some part of working capital has been
financed using long-term sources of funding. In a way, a ratio below 1 is desirable since
working capital to some extent is more or less fixed (this fixed portion of working capital is
called 'Core worklng CaplLal').

So, if the ratio is below 1, it is desirable. And theoretically it is said that the ideal ratio should
be around 0.67.

Fixed Interest Cover (or Interest Coverage Ratio or Times Interest Earned):

This ratio measures the debt servicing capacity of an enterprise insofar as fixed interest on
long-term loan is concerned. Sometimes, for analysis purposes, short-term debts may be
consldered equlvalenL Lo 'long-Lerm debLs' lf Lhere ls evldence of havlng shorL-term debts
renewed or rolled over too often.

Interest Coverage = EBIT divided by Fixed Interest on Long-term Loan

This ratio shows how many times the interest charges are covered by EBIT from which they
will be paid. It indicates the extent to which the EBIT may fall without causing any
embarrassment to the enterprise regarding payment of interest charges.

lor lnsLance, an lnLeresL coverage of 10 Llmes would lmply LhaL even lf Lhe enLerprlse's L8l1
were to fall to one-tenth of present level, the resultant EBIT available would be equivalent to
the long-Lerm caplLal provlder's clalms (l.e. lnLeresL).


lrom such lenders' sLandpolnL, Lhe larger Lhe coverage, Lhe more secure Lhey would be ln
respect of their periodical interest incomes.

However, a very high ratio may indicate that the enterprise is very conservative in using debt
and that it is not using credit to the best advantage of shareholders.

Empirically, enterprises having interest coverage ratio of 3 and above do not end up filing
bankruptcy petition.

In contrast, a low ratio might indicate excessive use of debt and inability to offer assured
payment of interest to the creditors.

Note that Interest Expenses to be used in computing this ratio should not be adjusted for
Interest Income.

Category 2: Activity ratios (or Turnover
Ratios or Efficiency Ratios or Asset
Utilization Ratios):

Under this category, the ratios are:
1. Inventory Turnover Ratio and Inventory Holding Period
2. Receivables Turnover Ratio (or Debtors Turnover Ratio) and Average Collection Period
(or Average Age of Receivables)
3. Creditors Turnover Ratio and Average Payment Period enjoyed (or creditors deferral
period or average age of payables)
4. Current Assets Turnover Ratio
5. Working Capital Turnover Ratio
6. Fixed Assets Turnover Ratio and Asset Intensity Ratio
7. Total Asset Turnover Ratio


Inventory Turnover Ratio and Inventory Holding Period:-

The inventory or stock position is often described as the graveyard of the balance sheet.

The inventory turnover ratio indicates how fast the inventory gets turned over into
receivable amounts or inflows, or the number of times inventory is replaced during the year.
In other words, this ratio signifies the liquidity of the inventory.

Inventory Turnover Ratio = Cost of Goods sold divided by Average Inventory.

In the above formula, the numerator (i.e. COGS) and the denominator (i.e. Average
Inventory) are comparable in the sense that both are valued at cost. Sometimes, however, an
user of Lhe flnanclal sLaLemenLs may be compelled Lo make use of 'Sales' (whlch ls aL markeL
price and not at cost) if he is not able to get the COGS figure from the Statement of Profit
and Loss


A high inventory turnover ratio would indicate that the inventory sells fast and therefore
bodes well from liquidity standpoint.

A low inventory turnover ratio would indicate that the inventory does not sell fast and stays
on the shelf or in the warehouse for long.

However, a very high ratio may indicate underinvestment in, or very low level of, inventory.
A very low level of inventory may adversely affect the ability to meet customer demand
there is risk of the enterprise facing stock-ouL and Lhereby lncurrlng a hlgh 'sLock ouL cosL'. lL
is also likely that the enterprise may be following a policy of replenishing its stock in too
many small slzes. Such a pollcy may derall Lhe enLerprlse's producLlon process due Lo
unavailability of stock of materials.

Also a sudden improvement in the ratio of a particular year would call for further
investigation.


A very low ratio may indicate excessive inventory or overinvestment in inventory. Carrying
excessive inventory involves cost in terms of interest on funds blocked, rental of space,
possible deterioration, etc. A low ratio may also indicate presence of inferior quality goods,
overvaluation of closing inventory, stock of unsaleable/obsolete goods and deliberate
excessive purchases in anticipation of future price hikes, etc

While commenting on inventory turnover ratio, care must be taken regarding the following
factors:
(a) Price trends: If the enterprise anticipates price hikes in raw material prices, it may make
excess purchases of raw material inventory and if it anticipates a fall in raw material price, it
may delay its raw material purchases till the time prices become low.
(b) Business volume trends: In case there is an observable trend of sales being greater than
previous sales, the enterprise may maintain a higher level of inventory to meet the
increasing demand

(c) Supply conditions: In case raw materials are scarce in supply, the enterprise may choose
to maintain higher level of inventory to support future requirements

(d) Seasonal conditions: Seasonal conditions also result into an inventory turnover ratio
which may, prima facie, not appear good

The computation of inventory turnover ratio for individual components of inventory may
help to detect imbalanced investments in the various inventory components. So, inventory
Turnover ratio can be decomposed as follows:


Here, raw material turnover ratio indicates whether there is overstocking of materials, work-
in-process turnover ratio indicates whether there is undue accumulation of work at different
points and finished goods turnover ratio indicates the effectiveness of sales vis--vis finished
goods stock.

Corresponding to Inventory Turnover ratio, one can calculate the Inventory Holding Period
which is = Months or Weeks or Days in the year divided by Inventory Turnover Ratio
Similarly, for each of the inventory components (i.e. raw material, work-in-process, and
finished goods) the holding or conversion period can be calculated.

Raw Material Conversion Period = Months or Weeks or Days in the year divided by Raw
Material Turnover Ratio
Work-in-process Conversion Period = Months or Weeks or Days in the year divided by Work-
in-Process Turnover Ratio
Finished Goods Conversion Period = Months or Weeks or Days in the year divided by
Finished Goods Turnover Ratio


Receivables Turnover Ratio (or Debtors Turnover Ratio) and Average Collection Period (or
Average Age of Receivables)

Pere, recelvables or debLors wlll lnclude noL only 'debLors' and buL also 'bllls recelvables'
because 'bllls recelvables' are ulLlmaLely debLors only.

ecelvables, whlch are creaLed ln an enLerprlse's books of accounLs due Lo credlL sales,
represent current assets. Receivables are convertible into cash over a short period. An
enLerprlse's llquldlLy poslLlon depends a loL on Lhe quallLy of lLs recelvables.

Receivables Turnover Ratio is determined by dividing Net Credit Sales (Gross Credit Sales
minus Returns) by Average Receivables Outstanding during the year.


1hls raLlo ls a LesL of llquldlLy of an enLerprlse's recelvables (l.e. debLors and bllls recelvables)
since it measures how rapidly monies are collected from the receivables. That is, how quickly
the receivables are turned over or converted into cash.

A high ratio indicates shorter time-lag between credit sales and cash collection. The higher
the ratio, the better is trade credit management and the better is the liquidity of debtors. A
low ratio indicates that monies are not collected rapidly from receivables.

AnoLher measure of Lhe llquldlLy of an enLerprlse's debLors ls Lhe average collecLlon perlod
or the average age of receivables. This is interrelated with and dependent upon the
receivables turnover ratio.

Average Collection Period (or Average Age of Receivables)
= Months or Weeks or Days in the year divided by Receivables Turnover Ratio


The average collection period indicates the speed of collection of receivables.

A short collection period (meaning high turnover ratio) would mean prompt payment by
receivables and better quality of receivables in terms of their liquidity. However, a very short
collection period may be indicative of restrictive credit and collection policy of the enterprise
wherein the enterprise, in order to avoid bad debts, sells only to those customers who are
flnanclally very sound and very prompL ln maklng paymenL. Pere, Lhe enLerprlse's sales may
be restricted and there may be less opportunities to make profits.

In contrast, a long collection period (indicating low turnover ratio) indicates delayed
paymenLs by recelvables and blockage of Lhe enLerprlse's funds ln lLs recelvables. lL lmplles a
very liberal and inefficient credit or/and collection performance. Here, there are increased
chances of bad debts occurring. There is also an interest cost involved in maintaining a high
level of receivables.


Thus, an enterprise should have a receivables turnover ratio which is neither too low nor too
high but which is reasonable.

The reasonableness of the turnover ratio (and thereby, the collection period) can be judged
in two ways:

First, the collection period in case of the enterprise can be compared with the industry
averages and notable divergence should be investigated.

Second, the collection period may be more appropriately examined in relation to the credit
terms and the policy of the enterprise itself.


Creditors Turnover Ratio and Average Payment Period enjoyed (or creditors deferral period
or average age of payables)

1he Lrade credlLors of an enLerprlse represenL 'sponLaneous sources of flnanclng'. 1hese
creditors allow credit facilities to the enterprise.

The creditors turnover ratio is a ratio between Net Credit Purchases (i.e. Gross Credit
Purchases less Returns) and the average amount of payables outstanding during the year (i.e.
average of creditors outstanding at the beginning and at the end of the year).

This ratio is an important tool of analysis as an enterprise can reduce its requirement of
currenL asseLs by relylng on suppller's credlL.


A low ratio reflects liberal credit terms granted by suppliers while a high ratio indicates that
the suppliers are being paid promptly.

A high ratio helps build the creditworthiness of the enterprise. But a high ratio may also
polnL Lo Lhe enLerprlse's lnablllLy Lo Lake full advanLage of credlL faclllLles allowed by Lhe
suppliers.

Creditors deferral period or average age of payables is calculated as =Months or Weeks or
Days in the year divided by Creditors Turnover Ratio

It shows how well the enterprise is taking advantage of the credit facility granted to it by its
suppliers


Current Assets Turnover Ratio:

1hls raLlo reflecLs an enLerprlse's efflclency ln uLlllzlng lLs currenL asseLs for generaLlng sales.

This ratio is calculated by dividing Sales by Current Assets.

This ratio shows the amount of sales generated for every rupee of current assets used by the
enterprise.

This ratio is therefore an indicator of operating efficiency or utilization of the current assets
of the enterprise and the higher this ratio the better it would be.


Working Capital Turnover Ratio:

An enterprise may also relate net current assets or working capital to sales.

This ratio is calculated by dividing Sales by Working Capital.

Working capital turnover ratio cannot be calculated for companies operating with negative
working capital.

This ratio shows the amount of sales generated for every rupee of net current assets or
working capital used by the enterprise.

This ratio is therefore an indicator of operating efficiency or utilization of the net current
assets of the enterprise and the higher this ratio the better would be the operating efficiency
or uLlllzaLlon of Lhe enLerprlse's neL currenL asseLs.


Fixed Assets Turnover Ratio and Asset Intensity Ratio:

The fixed assets figure in the balance sheet does not provide any insight. However, that is
used to measure the productivity of fixed assets.

Analysts calculate fixed asset turnover ratio to know the total sales per rupee of investment
in fixed assets.

Thus, fixed assets turnover ratio is calculated as Net Sales divided by Net Fixed Assets.
Some analysLs calculaLe Lhe reclprocal raLlo called as 'asseL lnLenslLy raLlo' (raLlo of asseLs Lo
sales) to estimate the investment required by a company to achieve the desired growth.

Asset intensity differs across industries.

If fixed assets turnover ratio is higher, the asset intensity ratio will be lower and vice-versa

Asset intensity of a company that gets its products manufactured under contract
manufacturing should be lower than that of a company which produces its own products.

For instance, telecommunication industry is highly capital intensive and hence enterprises
belonging to this industry have high fixed-asset intensity ratios.


Total Asset Turnover Ratio:

1hls raLlo shows Lhe enLerprlse's ablllLy Lo generaLe sales from all flnanclal resources
committed to total assets.

Powever, here whlle compuLlng LoLal asseLs, 'Long-Lerm lnvesLmenLs' are noL Lo be lncluded.

Fixed Assets are taken at net values.

Current assets are taken as they are i.e. without adjusting current liabilities.

This ratio has Sales in the numerator. Denominator consists of Current Assets and Net Fixed
Assets


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Using Financial Data for Business Restructuring

Prof. Nilay Savla, DBIMR

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