Business — Banking — Management — Marketing & Sales

Activity/Profitability/Liquidity/Gearing



Category: Financial Risk Management

There are an extremely large number of ratios which can be calculated from any given set of financial statements. However, the lending banker will primarily be concerned with those ratios which give an indication of the stability of the business and its ability to generate repayment capacity.

We will consider the measurement of repayment capacity in a little more detail shortly, but for the present we will look at the ratios of most interest to the banker under the four headings show next.

Relevant ratio categories:

— Activity

— Profitability

— Liquidity

— Gearing

Activity

Under this heading, we measure the growth in Sales, usually by expressing the increase in Sales between two accounting periods as a percentage of the Sales in the first period.

It may be useful to use a flipchart to illustrate the formula:

It is important for the lending banker to find out what is behind a given increase in Sales.

Has volume increased in addition to price?

In what manner have prices changed?

With general level of inflation?

Change in product mix

Price strategy being pursued to increase volume OR increased competition forcing low prices and low sales.

The major concern for the banker is the likely trend of sales volumes and price in the future. We must examine the past trend from that point of view and try to understand as much as possible what is happening to the market in which the business is operating.

Profitability

As we stated in Session 1, profitability ratios give an indication of the efficiency of the operation of the business. This reflects on management and from the banker’s point of view the better the management the better the prospects for repayment of our loans. While profit is not necessarily cash, the level of profit being earned can be the first indication of cash flow to follow.

Typically, we might calculate Gross Profit Margin, Operating Profit Margin and Net Profit Margin. In each case, we express the relevant profit figure as a percentage of Sales.

Each ratio may give us valuable additional information about the business or, more likely, prompt us to investigate further. We will consider each of them briefly in turn.

Next shows some of the main points to consider about the Gross Profit Margin.

Gross profit margin:

— Comparisons between accounting periods useful

— Varies from business to business

— Several explanations for a drop in the margin.

In normal circumstances it is assumed that this ratio figure should be reasonably constant over time if pricing policy and command over the market is both consistent and proactive. Significant changes between accounting periods should be investigated.

We would expect similar businesses to have similar gross profit margins, and would expect significant variations between different industries. For instance, we would expect many manufacturers with low volume unit sales to have relatively high margins, while retail businesses with high volume unit sales would typically have low margins.

Where gross profit margin falls, the following would be among the possible explanations (Trainees might be asked if they can mention possible explanations before proceeding):

— Prices reduced to maintain or increase market share

— Poor control of direct costs and/or inefficiencies in the production process

— Changes in the mix of products sold

— Increased cost of sales that could not be passed on to customers (because of substitutes, competition etc.)

Next highlights some relevant points to consider about the Operating Profit Margin.

Operating profit margin:

— Measures ability to control overhead costs

— Distinguish between temporary and permanent deterioration

— For explanations, investigate individual expenses.

Operating expenses should be relatively fixed within a certain range of activity. As sales volume increases, we would not expect operating expenses to increase at the same rate. If they do, it may signal an inability or unwillingness of management to control them.

Of course, a deteriorating ratio may be the result of a temporary or non-recurring expense. It is important to isolate any such factors before making any judgment.

To get a very good view on cost control, it is advisable to check any major increases in individual expenses with a view to establishing reason for the deterioration.

Was increase in an individual expense necessary for the survival of the business and/or improved trading performance and/or reflecting deterioration in cost control?

What action is being taken to eliminate unnecessary costs?

Our final measure of profitability, the Net Profit Margin, is the most important but, often, the most difficult to interpret.

It is the most important because it is the best indicator of overall efficiency and, therefore, the firm’s ability to survive and meet all of its obligations.

The difficulty in interpretation comes from the fact that so many factors can affect this “bottom line” performance. Next highlights the principal factors which may negatively influence Net Profit, and the banker must examine the facts to see which are most important.

Factors reducing net profit:

— Disimprovement in gross profit margin

— Increase in Sales, General and Administration expenses

— Increase in Interest costs

— Increase in Tax charge.

Liquidity Ratios

Returning to the Balance Sheet, Liquidity ratios help to determine the ability of a business to meet its day to day obligations. Since these obligations will often include repayment of bank loans, this can be very important for the banker.

Initially, we generally calculate two simple liquidity ratios, as illustrated next, from the balance sheet.

Liquidity ratios:

Liquidity ratios

The current ratio indicates the ability of the business to meet short term obligations from current assets. However, this involves making the broad assumption that current assets can be converted in a relatively short time into cash if required to meet some or all of the current liabilities.

We may find it useful to look at the trend in this ratio over time or compare the ratio from a particular business with an accepted safe norm for the industry. Broadly speaking, manufacturing industries should have a much stronger current ratio (2 is often considered a safe norm) than a cash business such as a retail shop or restaurant.

The Quick Asset Ratio eliminates the reliance on sale of stock in discharging liabilities to short term creditors. A low or deteriorating ratio should at least prompt us to ask questions about the ability of the business to withstand any liquidity problems.

Before drawing any definitive conclusions from an assessment of these primary liquidity ratios, it is advisable to examine Stock, Debtors and Creditors in more detail. These are the main determinants of the need for Working Capital, so ratios involving these items are often called the Working Capital Ratios.

Working Capital Ratios

We can easily calculate three working capital ratios as shown next (based on a financial year of 365 days)

Working capital ratios:

— Accounts Receivable Days = Accounts Receivable / Sales x 365 days

— Inventory Turnover Days = Inventory / Cost of Sales x 365 days

— Accounts Payable Days = Accounts Payable / Cost of Sales x 365 days

Accounts Receivable Days can be a key ratio for interpreting how a business is performing. Not only does it measure how long, on average, it took the business to collect from it’s trade debtors, but it may also be a good indicator of the quality and collectability of the debtors. Generally, the longer that debts are outstanding the more likely they are to be irrecoverable. The banker will be particularly interested in the trend from accounting period to period and, if possible, a comparison with industry norms. A lengthening of debtor collection days may indicate poor administration, individual debtors having cash flow problems, or over reliance on an individual customer who is able to dictate payment terms.

Inventory Turnover Days represents money tied up in stock. Again the banker will, if possible, examine trends and make comparison with industry norms. A lengthening of inventory turnover days may indicate an increase in obsolete or damaged inventory which may ultimately be unsellable, a change in the mix of inventory held, production inefficiencies (a manufacturing firm), or my be for quite innocent reasons (e.g. once off effect such as a special order).

Accounts Payable Period has a beneficial impact on cash flow when increasing, however, it may reflect problems such as inability to pay creditors on time. A shortening of the payment period might indicate increased pressure for earlier payment, disimproved credit terms, or over-dependence on a supplier who can dictate terms.

Gearing

Of major importance to the lending banker is the financial structure, or gearing, of the customer. High gearing can be potentially very rewarding for the owners of a business but it carries with it a much higher risk of failure.

We might calculate three gearing ratios and these are shown next.

Gearing ratios:

— Total Gearing = Total Liabilities / Tangible Net Worth

— Bank Gearing = Total Bank Liabilities / Tangible Net Worth

— Short Term Debt/Working Capital = Short Term Bank Debt / (Stocks + Trade Debtors – Trade Creditors)

All other things being equal, the higher the Total Gearing the less secure the business is in the face of future adversity. However, all other things are never equal and we should not think that there is one level of gearing that is appropriate for all firms in all circumstances.

Firms with a high level of sustainable profits and the ability to generate cash can sustain quite high levels of gearing without undue risk. On the other hand, highly geared firms that are not particularly profitable are in severe danger if creditors withdraw their support.

If Total Gearing increases over time we would hope to see that this was the result of deliberate policy by management of investment in assets that will yield good profits and cash flow in the near future.

The interpretation of Bank Gearing is similar to Total Gearing. It highlights the relative contributions of banks and the owners to financing the business.

Apart from being vulnerable to changes in existing profit and cash generating ability, a company with high Bank Gearing will also be vulnerable to interest rate changes.

As a back up to this ratio, banks often calculate the extent to which operating profit covers interest on borrowing.

The final gearing ratio in Slide?? measures the extent to which bank short term debt is funding net working capital at Balance Sheet date. As a general rule, we would not like to see this ratio too near 100%.

Summary

All of these ratios we have been looking at tell us a little bit more about the business we are analysing. It is almost impossible in advance to know which ratio will be most important for us in any given situation. By calculating the ratios, and asking searching questions which arise as a result, we get a better overall view of the business and the risks involved in lending it money.

By making a systematic analysis of a large number of businesses, a banker usually develops a good sense of judgment about the factors which need most investigation.


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