Chapter 12

Looking at Liquidity

In This Chapter

Calculating various debt and income ratios

Looking at debt in relation to equity and capital

Making money is great, but if a business ties up too much of its money in nonliquid assets (such as factories it can't easily sell) or carries too much debt, it isn't going to be around long to make more money. A company absolutely must have the cash it needs to carry out day-to-day operations and pay its debt obligations if its owners want to stay in business.

Lenders who have money wrapped up in a company follow debt levels closely. They definitely want to be sure they're going to get their money back, plus interest. As an investor, you need to take a close look at a company's debt, too, because your investment can get wiped out if the company goes bankrupt. So if you're investing in a company, you want to be certain that the company is liquid and isn't on the road to debt troubles.

So how do you make sure that the firm you invest in isn't about to spiral down the toilet, taking all your money with it? Well, you need to check out the company's ability to pay its bills and pay back its creditors. But looking at one company doesn't give you much information. Instead, compare the company with similar companies, as well as with the industry average. Doing so gives you a better idea of where the company stands.

In this chapter, I show you how to calculate a company's ability to pay the bills by looking at debt ratios, comparing its debt to its equity, and comparing its debt to its total capital. (If you're starting to sweat and/or your brain is shutting down because of the impending mathlete workout, don't worry — these calculations aren't as difficult as they sound!)

Finding the Current Ratio

One of the most commonly used debt-measurement tools is the current ratio, which measures the assets a company plans to use over the next 12 months with the debts it must pay during that same period. This ratio lets you know whether the company will be able to pay any bills due over the next 12 months with assets it has on hand. You find the current ratio by using two key numbers:

• Current assets: Cash or other assets (such as accounts receivable, inventory, and marketable securities) the company will likely convert to cash during the next 12-month period
• Current liabilities: Debts the company must pay in the next 12-month period, including accounts payable, short-term notes, accrued taxes, and other payments

I talk more about current assets and current liabilities in Chapter 6.

Calculating the current ratio

The formula for calculating the current ratio follows:

Current assets ÷ Current liabilities = Current ratio

Using information from the balance sheets for Mattel and Hasbro, here are their current ratios for the year ending December 2007:

Mattel

• $3,556,805,000 (Current assets) ÷ $1,716,012,000 (Current liabilities)  = 2.07 (Current ratio)

So Mattel has $2.07 of current assets for every $1 of current liabilities.

Hasbro

• $2,508,702,000 (Current assets) ÷ $960,435,000,000 (Current liabilities)  = 2.13 (Current ratio)

So Hasbro has $2.61 of current assets for every $1 of current liabilities.

What do the numbers mean?

The key question to ask is whether a company's current ratio shows that it's able to cover short-term obligations. Generally, the rule of thumb is that any current ratio between 1.2 and 2.0 is sufficient for a business to operate. Keep in mind that the ratio varies among industries.

A current ratio below 1 is a strong danger sign that the company is headed for trouble. A ratio below 1 means the company is operating with negative working capital; in other words, its current debt obligations exceed the amount of money it has available to pay those debts.

A company also can have a current ratio that's too high. Any ratio over 2 means the firm isn't investing its assets well. The company can probably put some of those short-term assets to better use by investing them in growth opportunities.

However, many lenders and analysts believe that the current ratio isn't a good enough test of a company's debt-paying ability because it includes some assets that aren't easy to turn into cash, such as inventory. A company must sell the inventory and collect the money before it has cash to work with, and doing so can take a lot more time than using cash that's already on hand, or just collecting money due for accounts receivable, which represent customer accounts for items already purchased.

Determining the Quick Ratio

Stricter than the current ratio is a test called the quick ratio or acid test ratio, which measures a company's ability to pay its bills without taking inventory into consideration. The calculation includes only cash on hand or cash already due from accounts receivable. Unlike the current ratio, the quick ratio doesn't include money anticipated from the sale of inventory and the collection of money from those sales. To calculate this ratio, you use a two-step process: First, find the assets that a company can quickly turn into cash; then divide those quick assets by the current liabilities.

Calculating the quick ratio

Here's the two-step process you use to find the quick ratio:

1. Determine the quick assets.

   • Quick assets = Cash + Accounts receivable + Short-term investments

2. Calculate the quick ratio.

   • Quick assets ÷ Current liabilities = Quick ratio or acid test ratio

Using information from Mattel's and Hasbro's balance sheets, I take you through the two-step process. Note: I added only two figures to find the quick assets for Mattel and Hasbro because both companies combine cash and short-term investments or marketable securities on their balance sheets.

Mattel

• Quick assets = $1,335,711,000 + $1,226,833,000 = $2,562,544,000

• $2,562,544,000 (Quick assets) ÷ $1,716,012 (Current liabilities)  = 1.49 (Quick ratio)

So Mattel has $1.49 of quick assets for every $1 of current liabilities.

Hasbro

• Quick assets = $849,701+ $1,029,959 = $1,879,660,000

• $1,879,660,000 (Quick assets) ÷ $960,435,000 (Current liabilities)  = 1.96 (Quick ratio)

So Hasbro has $1.96 of quick assets for every $1 of current liabilities.

Hasbro is in a better position than Mattel based on the quick ratio, but both companies have a quick ratio of well over 1, so they should have no problem paying their bills.

What do the numbers mean?

A company is usually considered to be in a good position as long as its quick ratio is over 1. A quick ratio below 1 is a sign that the company will likely have to sell some short-term investments to pay bills or take on additional debt until it sells more of its inventory.

If you're looking at statements from companies in the retail sector, you're more likely to see a quick ratio under 1. Retail stores often have a lot more money tied up in inventory than other types of businesses. As long as the company you're evaluating is operating at or near the quick ratio of similar companies in the industry, you're probably not looking at a problem situation, even if the quick ratio is under 1.

Remember that a quick ratio of less than 1 can be a sign of trouble ahead if the company isn't able to sell its inventory quickly. Other issues that can cause problems include slow-paying customers and accounts receivable that aren't collected when billed. In Chapters 15 and 16, I take a closer look at how you can assess inventory and accounts receivable turnover.

Investigating the Interest Coverage Ratio

Although the current and quick ratios look at a company's ability to pay back creditors by comparing items on the balance sheet, the interest coverage ratio looks at income to determine whether the company is generating enough profits to pay its interest obligations. If the company doesn't make its interest payments on time to creditors, its ability to get additional credit will be hurt; eventually, if nonpayment goes on for a long time, the company may end up in bankruptcy.

The interest coverage ratio uses two figures that you can find on the company's income statement: earnings before interest, taxes, depreciation, and amortization (also known as EBITDA; check out Chapter 7 for more information); and interest expense (also in Chapter 7).

Calculating the interest coverage ratio

Here's the formula for finding the interest coverage ratio:

• EBITDA ÷ Interest expense = Interest coverage ratio

Calculating this ratio may or may not be a two-step process. Many companies include an EBITDA line item on their income statements. If a company hasn't included this line item, you have to calculate EBITDA yourself.

Mattel and Hasbro don't have an EBITDA line item, so I show you how to figure that out before you try to calculate the ratio.

Mattel

Mattel reports operating income before it lists its interest and tax expenses. Mattel doesn't have a line item for amortization or depreciation, so you need to look at the cash flow statement to find that amortization totaled $16,746,000 and depreciation totaled $157,536,000. Therefore, in Mattel's case, EBITDA was $945,045 (Income before taxes) + $16,746,000 + $157,536,000 = $1,119,327,000. Then, to get the interest coverage ratio:

• $1,119,327,000 (EBITDA) ÷ $88,835,000 (Interest expense)  = 12.60 (Interest coverage ratio)

Thus, Mattel generates $12.60 income for every $1 it pays out in interest.

Hasbro

Hasbro reports amortization expenses of $50,569,000 on the income statement (I talk more about amortization in Chapters 4 and 6). It also reports $99,718,000 for depreciation of plant and equipment on the statement of cash flows, so you need to add those expenses back in to find the EBITDA:

• $453,402,000 (Income before taxes) + $50,569,000 (Amortization on  income statement) + $99,718,000 (Depreciation of plant and  equipment) = $603,689,000 (EBITDA)
• And then:
• $603,689,000 (EBITDA) ÷ $91,141,000 (Interest expense) = 6.62 (Interest coverage ratio)

Hasbro generates $6.62 for every $1 it pays out in interest.

What do the numbers mean?

Both companies clearly generate more than enough income to make their interest payments. A ratio of less than 1 means a company is generating less cash from operations than needed to pay all its interest.

Lenders believe that the higher the interest coverage ratio is, the better. You should be concerned about a company's fiscal health anytime you see an interest coverage ratio of less than 1.5. This means the company generates only about $1.50 for each $1 it pays out in interest. That's operating on a tight budget. Any type of emergency or drop in sales may make it difficult for the company to make its interest payments.

Comparing Debt to Shareholders’ Equity

How a company finances its operations involves many crucial decisions. When a firm uses debt to pay for new activities, it has to pay interest on that debt, plus pay back the principal amount at some point in the future. If a company uses shareholders’ equity (stock sold to investors) to finance new activities, it doesn't need to make interest payments or pay back investors.

Finding the right mix of debt and equity financing can have a major impact on a company's cost of capital. Too much debt can be both risky and costly. However, if a company has too high a level of equity, investors may believe that it isn't properly leveraging its money. Leverage is the degree to which a business uses borrowed money. For example, a company typically buys a new building by using a combination of a mortgage (debt) and cash (from a new stock issue or retained earnings, which is the equity side of the equation). When a company uses leverage, its cash can go a lot further.

Suppose that you have $50,000 to pay for a home. This amount isn't enough to buy the home you want, so you use that money as a deposit on the home and get a mortgage for the rest of the money due. If the house price is $250,000 and you put down $50,000, you can use the mortgage to leverage that cash so you can afford the home. In this scenario, the mortgage covers 80 percent of the purchase price. Any cash you earn beyond your monthly mortgage payment can go toward paying your other bills and buying food and other things you need or want.

As an investor, you want to know how a company allocates its debt versus its equity. To determine this, use the debt to shareholders’ equity (see the following section). You also want to check the company's debt-to-capital ratio (see the upcoming section “Determining Debt-to-Capital Ratio”), which lenders use to determine how much they'll lend and to monitor a company's debt level.

Calculating debt to shareholders’ equity

To calculate debt to shareholders’ equity, divide the total liabilities by the shareholders’ equity. This ratio shows you what portion of a company's capital assets is paid by debt and what portion is financed by equity.

Here's the formula you use to calculate debt to shareholders’ equity:

• Total liabilities ÷ Shareholders’ equity = Debt to shareholders’ equity

I use the numbers from Mattel's and Hasbro's 2007 balance sheets to show you how to calculate the debt to shareholders’ equity ratio.

Mattel

• $3,459,741,000 (Total liabilities) ÷ $3,067,044 (Shareholders’ equity)  = 1.08 (Debt to shareholders’ equity)

Mattel used $1.29 from creditors for every $1 it had from investors. Therefore, Mattel depends a bit more on money it raised by borrowing than on money it raised by selling stock to investors.

Hasbro

• $2,818,008,000 (Total liabilities) ÷ $1,507,379,000 (Shareholders’ equity)  = 1.87 (Debt to shareholders’ equity)

Hasbro used $1.87 from creditors for every $1 it had from investors. Therefore, Hasbro used a greater proportion of borrowed money from creditors to operate its company than Mattel did.

What do the numbers mean?

A debt to shareholders’ equity ratio that's greater than 1 means that the company finances a majority of its activities with debt. A ratio under 1 means that the company depends more on using equity than debt to finance its activities.

In most industries, a 1:1 ratio is best, but it varies by industry. You can best judge how a company is doing by comparing it with similar companies and the industry averages.

As the ratio creeps higher above 1, a firm's finances get more risky, especially if interest rates are expected to rise. Alarm bells tend to sound when you see a company near or above 2. Lenders consider a business that carries a debt load this large a credit risk — which means the company has to pay much higher interest rates to finance its capital activities.

Determining Debt-to-Capital Ratio

Lenders take another look at debt using the debt-to-capital ratio, which measures a company's leverage by looking at what portion of its capital comes from debt financing.

Calculating the debt-to-capital ratio

You use a three-step process to calculate the debt-to-capital ratio:

1. Find the total debt.

   • Total debt = Short-term borrowing + Long-term debt + Current portion of long-term debt + Notes payable

2. Find the capital.

   • Capital = Total debt + Equity

3. Calculate the debt-to-capital ratio.

   • Total debt ÷ Capital = Debt-to-capital ratio

To show you how to calculate the debt-to-capital ratio, I use the information from Mattel's and Hasbro's 2007 balance sheets.

Mattel

First, to find out Mattel's total debt, add up Mattel's short-term and long-term debt obligations:

Next, add the total debt to total equity to figure the number for capital:

• $3,067,044,000 (Equity) + $1,509,844,000 (Debt) = $4,576,888,000 (Capital)

Finally, calculate the debt-to-capital ratio:

• $1,509,844,000 (Total debt) ÷ $4,576,888,000 (Capital) = 0.33 (Debt-to-capital ratio)

So Mattel's debt-to-capital ratio was 0.33 to 1 in 2007.

Hasbro

First, to find out Hasbro's total debt, add up Hasbro's short-term and long-term debt obligations:

Then add the total debt to total equity to find out the number for capital:

• $1,507,379,000 (Equity) + $1,620,786,000 (Debt) = $3,128,165,000 (Capital)

Finally, calculate the debt-to-capital ratio:

• $1,620,786,000 (Total debt) ÷ $3,128,165,000 (Capital) = 0.52 (Debt-to-capital ratio)

So Hasbro's debt-to-capital ratio was higher than Mattel's, at 0.52 to 1.

What do the numbers mean?

Lenders often place debt-to-capital ratio requirements in the terms of a credit agreement for a company to maintain its credit status. If a company's debt creeps above what its lenders allow for the debt-to-capital ratio, the lender can call the loan, which means the business has to raise cash to pay off the loan. Companies usually take care of a call by finding another lender. The new lender likely charges higher interest rates because the company's higher debt-to-capital ratio makes the company appear as though it's a greater credit risk.

Generally, companies are considered to be in good financial shape with a debt-to-capital ratio of 0.35 to 1 or less. If a company's debt-to-capital ratio creeps above 0.50 to 1, lenders usually consider the company a much higher credit risk, which means it has to pay higher interest rates to get loans.

Take note of the ratio and how it compares with the ratios of similar companies in its industry. If the company has a higher debt-to-capital ratio than most of its competitors, lenders probably see it as a much higher credit risk.

A company with a higher-than-normal debt-to-capital ratio faces an increasing cost of operating as it tries to meet the obligations of paying higher interest rates. These higher interest payments can spiral into more significant problems as the cash crunch intensifies. In a worst-case scenario, the company can seek bankruptcy protection from its creditors to continue operating and to restructure its debt. Many times its stock value plummets — and may have no value at all if the company emerges from bankruptcy.