# Gearing ratio – 6 of 6 in series on financial ratios

In this last post on financial ratios, I will look at some ratios which are of interest to the providers of debt finance i.e. lenders like banks and investors who buy debt in companies instead of shares. We will look at two ratios, the Debt/Equity ration and Interest Cover.

The Debt/Equity ratio is calculated as follows:

Debt/Equity ratio: Debt

Equity

Debt is long-term debt, which is normally taken to mean long-term bank loans and other debt finance found under the non-current liabilities heading in the statement of financial position (balance sheet). Equity is the shareholders’ equity, or the capital provided by or attributable to shareholders (typically share capital, accumulated profits and other equity reserves). In general, if the gearing ratio is greater than 1:1, then a business is said to be lowly-geared; less than 1:1 makes it highly-geared. For a potential investor or lender, the higher the level of gearing the more risky the business may be. From a potential shareholder’s view, if more cash is needed to pay interest on debt, less is available for dividends. From a lender’s view, if the level of existing debt is high, repaying any additional debt may be problematic. However, high gearing is not necessarily a bad thing. Once monies borrowed are put to good use and earn a return greater than the rate interest paid, overall company profits grow. Managers use investment evaluation techniques to select investments (such as building a new production facility) which will produce returns beyond the cost of borrowing.

The next ratio, Interest Cover, is useful to lenders in particular. It is calculated as follows:

Interest Cover: Operating profit

Interest

The interest cover ratio simply tells us how many times operating profit (which is before interest, tax and dividends) covers interest. From a lenders perspective, a higher level of interest cover is preferred. If the interest cover is low, then a business might have trouble meeting interest payment on borrowings, which certainly would not bode well for repayments of the principal (the amount borrowed).

As in previous posts, let’s now calculate these ratios based on the financial statements of Diageo plc for 2010. The Debt/Equity ratio is as follows:

8177/4786 = 1.7:1 (data from p.108)

This means Diageo plc is a highly geared company. It is however quite successful and generally pays dividends to shareholders, so it most likely uses its debt well.

The interest cover is:

2574/844 = 3.04 times.

This means profit covers interest payments just over three times at current levels, which is reasonable.

# Investment ratios – 5 of 6 in series on financial ratios

As we have seen in an earlier post the ROCE may be useful to shareholders, but there are a number of other ratios which they may find particularly useful as investors. These are Earnings per Share (EPS) and Price Earnings (PE).

EPS represents the profit per individual share. It as calculated as follows:

EPS: Profit after tax, interest and preference dividends

Number of ordinary shares in issue

The top portion of the EPS ratio represents the profit that is available for payout as a dividend. This does not at all mean it will be paid out, but it is the profit available to ordinary shareholders. Given that the bottom portion of the EPS is the number of ordinary shares issued, the EPS is not very comparable between two companies. However, the trend of the EPS of a particular company is an important indicator of how well the company is performing and it is also an important variable in determining a shares price

The PE ratio shows a company’s current share price relative to its current earnings – which assumes the company is a public company and its shares are available for purchases through a stock market. It is calculated as follows:

P/E ratio: Market price per share

Earning per share

It’s usually useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general, or against the company’s own P/E trend. It would not be useful for investors to compare the P/E of a technology company (typically high P/E) to a utility company (typically low P/E) since each industry has very different growth prospects. Care should be taken with the P/E ratio because the bottom part of the ratio is the EPS, which as stated above may not be that comparable between companies. There are some crude yardsticks for the P/E ratio as follows:

- A P/E of less than 5-10 means that company is viewed as not performing so well;
- A ratio of 10-15 means a company is performing satisfactorily;
- A ratio above 15 means that future prospects for a company are extremely good.

Again, as with all such yardsticks, these will vary by industry and depend on other factors which drive share price e.g. bad publicity, the general economic outlook.

As in previous posts, let’s use the accounts of Diageo plc from 2010 to calculate these ratios.

EPS = 1,762,ooo/2,754,000 = £0.64 per share (data from p. 107/150)

PE = 1060/64 = 16.6 times (share price from http://www.diageo.com/en-row/investor/shareprice/Pages/Shareprice-History.aspx. Based on the yardstick mentioned above, the PE for Diageo reflects sound future prospects.

# Working capital management ratios – 4 in series of 6 on financial ratios

In this post, I’ll detail some ratios which can helps a business manage its working capital (working capital is current assets less current liabilities). A business can calculate a ratio for each of inventory, trade receivables, and trade payables which help interpret how well working capital is managed. In my previous post, I showed some ratios which help determine liquidity and solvency; with the ratios below, we have all elements of working capital covered (including cash) .

The first ratio is inventory turnover, which is calculated as follows:

Inventory turnover: Cost of sales

Average inventory

This ratio tells us how many times a year inventory is sold. You’ll notice the bottom line says “average inventory”, which might be a simple average of the inventory at the start of the year and the end of the year, or a rolling average. The reason for using an average is to try to remove seasonal variations.

The next ratio reflects how well trade receivables are managed:

Average period of credit given: Trade receivables x 365

Credit sales

This ratio tells how many days credit, on average, is given to customers. The top line is multiplied by 365 to give the answer in days. If you want it in months, multiply by 12 instead. If the period of credit given is getting longer, this could be problematic, as cash is not collected as fast by the business.

Now let’s see the average period of credit taken. This is very like the previous one, except it relates to suppliers. It is calculated as follows:

Average period of credit taken: Trade payables x 365

Credit purchases

One thing to note about this ratio is that it may not always be possible to obtain the credit purchases figure from published financial statements. The period of credit taken should not be too long either. If it is getting longer, it may be a sign of cash flow problems.

As in my previous posts, I’ll now calculate the above ratios using the figures from the 2010 annual report of Diageo plc.

The inventory turnover is: 4099 (3281+3078)/2 = (data from p.106/108) =1.2 times per annum. This means the company sells its inventory just over once per year. This probably seem really low if you think about how quickly beer and other alcohol sells in a retail sense. However, if we look at the detailed notes on inventory in the annual report, we can see that about 2/3 of the inventory is deemed “maturing” inventory.

The average period of credit given is: 1495 x365/9780 = 56 days (data from p.106/140). This seems a reasonable period of credit.

The average period of credit taken is: 843 X 365/4099 ) =75 days (data from p.106/148). Note that I am using the cost of sales figure as a substitute for the credit purchases figure – which is typically not available in published accounts. Again this figure seems reasonable and is longer than the period of credit given, which makes logical sense.

In summary from the figures above, the working capital of Diageo plc seems well managed.

# Liquidity ratios – 3 in series of 6 on financial ratios

Your have probably heard the terms liquidity and solvency. **Liquidity **refers to the ability to convert assets to cash. For example, inventories may be more liquid (i.e. can be sold for cash quicker) than a non-current asset like a building. **Solvency** refers to the ability of a business to pay debts as they fall due. Liquidity and solvency are closely related concepts. If assets cannot be converted to cash, debts like loan repayments or payments to suppliers may not be met. To be unable to pay debts as they fall due means a business is insolvent, which can mean business failure. There are two useful ratios to help us assess the state of a businesses’ liquidity – the current ratio and the quick (or acid-test) ratio. The current ratio is:

Current ratio: Current assets

Current liabilities

The basic idea the current ratio is that for a company to be able to pay its debts as they fall due, current assets should cover current liabilities by a multiple. Generally a current ratio of at least 2:1 is good. This means that current assets are twice current liabilities. So, even if some stock could not be sold or some trade receivables not paid, current liabilities would still be covered for payment. However, the 2:1 figure is only a guideline. If we calculate the current ratio for Diageo plc for 2010 (from the statement of financial position on p. 108), we get:

6,952/3,944 = 1.76 : 1.

Although not 2:1, it should not be a major problem. Think about the type of business and the inventory it has – can you imagine Diageo having difficulty selling it’s stock of Guinness for example.

The Liquid ratio, and it is calculated as follows:

Liquid ratio: Current assets – inventory

Current liabilities

This ratio is also called the Quick ratio or the Acid Test ratio. It is very similar to the Current ratio, except that inventory is deducted from current assets. This is because inventory is typically regarded as being the least liquid current asset. Often the yardstick for the Liquidity ratio is 1:1, but this depends on the type of business. For example, large retailers may have relatively low stock and almost no receivables, which will skew the figure well below zero if we assume suppliers give credit.

If we calculate the current ratio for Diageo plc for 2010 (from the statement of financial position on p. 108), we get:

6,952-3,281/3,944 = 1.12 : 1

The Current and Liquid ratios serve as useful indicators of the liquidity/solvency or a business. However, as with other ratios, the trend over time is important. Any business may face short-term liquidity problems which could skew either of the above ratios. Short-term liquidity problems may arise if, for example, customers are slow to pay or inventories can’t be sold. Such problems are normally overcome through the management of inventory and receivables, which I’ll deal with in the next post.

*(Image above from withfriendship.com)*

# Gross Profit Margin – 2 of 6 in series on financial ratios

Let’s now look at a second useful profitability ratio (see the previous post also). The Gross Profit Margin is a simple ratio which shows the percentage profit made on sales before deducting business expenses. It is calculated as follows:

Gross Profit x 100

Sales

The Gross Profit Margin will vary by business sector. For example, some businesses/sectors may make quite a large Gross Profit Margin on each, but have lots of overheads to pay e.g. the hospitality sector, like pubs and clubs. Other sectors may have a much lower figure. The Gross Profit Margin is usually closely watched by business owners in particular. If you remember that Gross Profit is Sales less Cost of Sales, and Cost of Sales in turn includes opening/closing inventories and purchases. With any abnormal changes in these figures the Gross Profit Margin will change.It might be something simple like an increased purchase price which has not yet been passed on to customers through a price increase, or it could be something more sinister like theft or stock or unrecorded sales.

As in the last post, let’s use the accounts of Diageo plc as an example. Based on their 2010 Income Statement (p.106 of the annual report), the Gross Profit Margin is;

5681 x 100 = 57.5%

9870

If you do the same figure for 2009 it’s 58.1%, which is in a similar range. Most business managers will know what their average Gross Profit Margin is. Although the Diageo figure seems high, there are lost of expenses to be paid out of the Gross Profit. You can also calculate a Net Profit Margin, which use the Net Profit before tax instead of Gross Profit in the above formula. This is not as useful as the business expenses tend to be more variable from year to year, although it is still widely used.

# Return on capital employed – 1 of 6 in series on financial ratios

This is the first in a series of seven posts looking at some common ratios used to analyse financial statements.

The Return on Capital Employed (ROCE) ratio is defined as follows

Operating profit before interest x 100

Capital employed

**Capital employed** is the amount of money (capital) which is invested (employed) in a business. It can be calculated from the balance sheet (statement of financial position) as total equity plus non-current liabilities or total assets (current and non-current) less current liabilities.

There is a potential problem with the ROCE, which is what capital employed figure to use in the calculation. Normally, the year end figure is used, but might be higher than the capital employed at the beginning of the year. Some companies use a simple average figure, taking the average of the capital employed at the start and end of the year. Others use a rolling average, which might be best in a highly seasonal business. Whatever capital employed figure is used is a matter of judgement for the business. The important thing is to be consistent from one year to another with the calculations.

The ROCE tells us the return made on capital employed before any distributions of profits (e.g. taxation, dividends or interest). It can be compared to risk free returns like putting money on deposit. Normally anyone investing in a company would expect a reasonable return – approximately 15% – or more if the business is seen as risky.

As an example, you can get the 2010 annual report of Diageo ( owner of brand such as Guinness, Bailey’s and Bushmills) here. If I look at the income statement (p.106), I can see a profit before interest of £2,574m. Looking at the statement of financial position (balance sheet) (p.108), I can work out capital employed as total equity (£4,786m) plus borrowings from non-current liabilities (£8,177m) – I am keeping it simple and ignoring other non-current liabilities. This would give an ROCE as follows:

2,574 x 100

4,786+8,177

This equals 19.9%, which is quite a good return.