### Ratio Analysis Leverage Ratios II

In this section of our ratio analysis case study we discuss coverage ratios. These are:

 Ratio Formula Times Interest Earned Ratio EBIT/Interest Charge Fixed Charge Coverage Ratio (EBIT + Lease Payments + Rentals)/ (Interest + Lease payments + Rentals)

#### Times Interest Earned (Coverage) Ratio

Coverage ratios, in general, are a measure of the degree to which a firm’s fixed expenses are covered by operating income. With earlier ratios (Debt to Equity and Debt to Assets) we were more interested in how much debt a business uses in financing its assets and whether it is being managed efficiently or not. With coverage ratios, we are more interested in whether the firm will be able to pay its fixed financial charges or not.

Times Interest Earned (TIE) ratio is one type of coverage ratio. Fixed Charge Coverage Ratio is the other. The TIE ratio is computed by the following formula:

TIE Ratio =     EBIT / Interest Charges

 1998 1999 EBIT 404,759 413,373 Interest Charges 22,356 26,148 TIE Ratio 18.1 15.8

In 1998, Operating Income or EBIT covered the interest charges 18 times while in 1999 the interest charges were covered only 15.8 times. We see that the operating income has risen, but we also see that interest charges have increased because the firm has taken on additional debt. As is apparent by the ratio given above, the increase in interest charges is higher in proportion to the increase in EBIT, which is why the ratio has fallen.

The TIE ratio helps us in gauging the extent to which operating income can decline before the business is unable to meet its interest charges. If you would like to know the margin of safety within which the business can operate before getting into serious trouble with its creditors, this is the ratio to calculate. The higher the TIE ratio is, the better.

#### Fixed Charge Coverage Ratio

This is also a type of coverage ratio. The difference between this ratio and the TIE is that the Fixed Charge Coverage Ratio includes not only interest charges but includes all financial charges, both short-term and long-term. Examples of these expenses are long-term leases, rental expenses etc.

The Fixed Charge Coverage ratio is computed as follows:

Fixed Charge Coverage = (EBIT + Lease payments + rental expenses) / (Interest + Lease payments + rental expenses

Note: As there are no lease payments and rentals in financial statements of ODP the Fixed Coverage Ratio will be the same as the Times Interest Earned Ratio for both 1998 and 1999.

The Fixed Charge Coverage ratio provides the same information as the TIE ratio except that it includes long-term fixed obligations as well.

### Concept Title: Productivity Ratios

Turnover ratios are known by many names: Productivity ratios, Activity ratios, Asset Utilization ratios etc. As all these names suggest, the ratios tell us how well the business is managing its assets. It’s important for you, as an investor, to try and gauge whether the assets reported in the balance sheet of a firm are adequate as well as appropriate. By studying these ratios, one can determine whether too many or too few resources are being used. The following ratios fall in the category of Turnover ratios:

 Ratio Formula Inventory turnover Sales/Average Inventory of Finished Goods Fixed Asset turnover Sales/Fixed Assets Total Asset Turnover Sales/Total Assets Average Collection period Accounts Receivable/(Total Credit Sales/365) Accounts receivable Turnover Annual Credit Sales/Accounts receivable

### Concept Title: Inventory Turnover

#### Inventory Turnover

The inventory turnover ratio is a measure of the adequacy of inventory and how well it is managed.

A comparison of this ratio with the industry average tells us whether it is selling its inventory slower as compared to the rest of the industry. The ratio shows the number of times that the average amount of inventory has been sold within a given period or how quickly products are moving off the store shelves. This ratio is more significant in industries where products are just purchased and then sold, that is, in merchandising firms like supermarkets, distributors, departmental stores etc. For companies like Office Depot the inventory turnover ratio is very significant.

The ratio is obtained by dividing sales by the average inventory of finished goods over one accounting period.

Inventory Turnover Ratio = Sales / Average Inventory

Average inventory is calculated by the following formula:

Average Inventory of Finished Goods = (Beginning inventory + Ending Inventory) / 2

 1998 1999 Beginning Inventory 1,397,266 1,258,355 Ending Inventory 1,258,355 1,436,879 Average Inventory of Finished Goods 1,327,811 1,347,617

The ratio for inventory turnover, as mentioned earlier, is computed by dividing the figure for sales by the average inventory. This has been done below.

Inventory Turnover =    Sales / Average Inventory

 1998 1999 Sales 8,997,738 10,263,280 Average Inventory 1,327,811 1,347,617 Inventory Turnover 6.78 7.62

The inventory turnover ratio for ODP increases from 1998 to 1999, from 6.78 to 7.62. This implies that ODP has improved its inventory management and is now servicing increasingly higher levels of sales with approximately the same level of inventory.

We must be able to compare these ratios with industry averages to determine whether the ratio is adequate or not.

If, for example, a certain brand of printers is not moving (selling) as much as other brands available, management can take the necessary steps to ensure that the turnover of the product improves. Most common methods include investing in sales promotions, discounts and price cuts.

The adequacy of the ratio is also dependent on the nature of the industry. High-ticket and high profit margin items (heavy machinery, cars, luxury products, furniture, etc) normally have a lower turnover. Low-ticket items (cosmetics, household products, office products, etc) normally have a high turnover.

How much is invested in inventory is an important aspect of managing a business. It depends a great deal on the type of business and the timing of sales. Certain products experience seasonal demands (for example, the sales of quilts, pullovers and other items of warm clothing, will be higher during the winter) and inventory levels are adjusted accordingly throughout the year.

Generally the Cost of Goods Sold or the Cost of Sales is taken in the numerator instead of Sales. The rationale behind this is that sales are booked at market price while the cost of sales is a measure of cost, which makes it consistent with the inventory figure in the denominator. Both these figures are then based on cost. When the sales figure is used the turnover rate would be overstated.

Another problem that arises with the inventory turnover ratio is the fact that sales occur over the entire year while inventory is usually taken at a certain point in time. This is why the average inventory figure is used rather than inventory at beginning or end of the year.

#### Fixed Asset Turnover

The fixed asset turnover ratio tells us about the productivity of a firm and the utilization of fixed assets like plant, property and equipment with respect to a unit of sales. This ratio is computed by dividing Sales by the amount of Fixed Assets that a company possesses.

Fixed Asset Turnover =    Sales / Fixed Asset

 1998 1999 Sales 8,997,738 10,263,280 Fixed Assets 1,244,848 1,645,131 Fixed Asset Turnover 7.23 6.24

The Fixed Asset Turnover ratio has declined from 7.23 in 1998 to 6.24 in 1999. Although the level of sales increased significantly, the amount of fixed assets needed to generate those sales also increased. Notice, however, that the ratio indicates that in 1998 fixed assets were used more efficiently than they were used in 1999 when additional fixed assets were acquired.

A potential problem can arise when this ratio is used to compare different firms. We must remember that all assets except cash and accounts receivable are based on their historical cost. Inflation has caused the value of many assets to be understated as time passes. Second, older assets are obviously depreciated by higher amounts as compared to newer ones, regardless of the actual impact of age on the value of the assets. If we compare an old firm with a new one the fixed asset turnover ratio would be higher for the older firm.

#### Total Asset Turnover

The Total Asset Turnover ratio is calculated similar to the fixed Asset Turnover ratio. The only difference is the replacement of Fixed Assets by Total Assets. The calculations are given below.

Total Asset Turnover =        Sales / Total Assets

 1998 1999 Sales 8,997,738 10,263,280 Total Assets 4,025,283 4,276,183 Total Asset Turnover 2.24 2.40

Again, the ratio shows us that the efficiency in the overall use of assets is improving in ODP. This could be due to the improvement in the use of current assets; we know that the fixed asset turnover is declining. A more likely reason is an over all reduction in current assets that has lead to a better Total Asset Turnover.

As stated earlier, the total asset turnover ratio signifies how efficiently the total resources of a firm are being used. It is like a “summary” of the turnover ratios as all of the other turnover ratios are included in, and therefore affect the value of this ratio.

If the total Asset Turnover ratio is not adequate it tells us that given the level of total investments made, the sales generated are not enough. Management can either take measures to generate more sales (by using assets more efficiently) or it can dispose of certain assets.

#### Average Collection period

This ratio is calculated as follows:

Average Collection period =    Accounts Receivable / Average Daily Credit Sales

Where

Average Daily Credit Sales = Total Credit Sales / 365

Let us assume that all sales are on credit. For 1998 and 1999:

 1998 1999 Accounts Receivable 721,446 849,478 Total Sales/365 24,651 28,119 Average Collection Period 29 days 30 days

This ratio tells us the average period of time, in days, that it takes a firm to collect dues that have resulted from credit sales. If the length of time is too long then it depicts the firm’s lax credit and collection policy, thereby spelling out liquidity problems in the future.

Look at the figures for ODP. The collection period was 29 days in 1998 and in 1999 the average collection period has gone up to 30 days.

#### Accounts Receivable Turnover

The Accounts Receivable turnover is calculated by dividing the Annual Credit Sales by Accounts Receivable.

Accounts Receivable Turnover =    Annual Credit Sales / Accounts receivable

The accounts receivable turnover ratio shows us how many times in a year the receivables were converted to cash. Again, the ratio reflects upon the credit and collection policies of a firm. Obviously, if the firm has too many resources tied up in receivables it is creating cash flow problems for itself. The higher the turnover rate, the better because it indicates that a company’s receivables are liquid. What do the figures say for ODP? Again, we will assume that all sales are on credit.

 1998 1999 Annual Credit Sales 8,997,738 10,263,280 Accounts Receivable 721,446 849,478 Accounts Receivable Turnover 12.5 12.08

We can see that the turnover rate has declined from 12.5 to 12.08 between 1998 and 1999. This shows that the rate at which receivables are being converted into cash is falling, which may be an indication of a deteriorating liquidity condition. This is in line with the information that we obtained from the liquidity ratios themselves.

### Concept Title: Profitability Ratios I

We know that absolute profitability of Office Depot has been rising between 1998 and 1999.

• Net Profits rose by \$ 24 million
• Operating Profits rose by \$8.6 million and
• Gross Profits rose by \$ 299.7 million

Why calculate profitability ratios when we can see that profits have been rising? We need to see whether profits have risen in proportion to the increase in sales, and also in relation to the operations in general. What would be the point if sales increase by \$100 but profits increase only by \$ 1? We know that between 1998 and 1999 sales for ODP have risen by \$ 1.27 billion. Then why have net profits increased by only \$ 24 million? Should profits increase by a higher amount given the history of earnings of ODP, and given management and investors’ expectations? There has to be a range within which we expect ODP’s profitability to rise with sales.

We calculate profitability ratios because they help us compare the business’ situation at different points in time. We need to have some kind of indicators about whether expectations are being met.

Profitability ratios depict the profit and earning potential of a business. Profitability ratios are a measure of a management’s overall effectiveness and efficiency as shown by returns generated on sales, investments and equity. They show the combined effects of liquidity, leverage and turnover ratios. It is the management of all these aspects, or should I say the ‘proper management’, that actually leads to the generation of desirable profits.

Profits are a measure of the overall effectiveness of all activities and operations. A common set of profitability ratios are given below:

 Ratio Formula Gross profit margin Gross profit/Sales Operating profit margin Operating profit/Sales Net profit margin Net Income/Sales Return on Assets Net Income/Assets Return on Equity Net Income/ Equity Basic earning power ratio EBIT/Total Assets

Let’s calculate the ratios for ODP for 1998 and 1999 and see if we can see a trend.

#### Gross Profit Margin

The gross profit figure is obtained from the income statement. It is a result of the deduction of cost of sales or cost of goods sold from the sales figure. When the gross profit figure is expressed as a percentage of sales it results in the Gross Profit Margin.

Gross Profit Margin =    Gross Profit / Sales

 1998 1999 Gross Profit 2,513,274 2,812,970 Sales 8,997,738 10,263,280 Gross Profit Margin 28% 27%

We can see that the Gross Profit margin for ODP has gone down by 1 percentage point.

Sales have increased between 1998 and 1999; however, the cost of sales has also increased and at a higher proportion, which is why the margin has declined.

The gross profit margin ratio gives us an insight into what percentage of each dollar of sales is left for covering the remaining expenses (operating, interest) and taxes to yield a profit. We can see that in 1998 only 28% of total revenues were available for expenses, taxes and profits, while in 1999 only 27% was available.

Profits are shrinking! Is this a sign that management is losing control? Why is the total cost of sales moving upwards? Maybe vendors of office supplies have increased the per unit price? Maybe the delivery and shipping charges are increasing? Or is the price competition between ODP, Staples and Office Max driving unit prices down? Whatever the reason, it is apparent that the management has experienced a higher cost of sales in 1999 as compared to 1998. Let’s investigate further to see what is happening at the level of operating profits.

#### Operating Profit Margin

Operating profits are obtained after deducting the cost of operations from gross profits. These costs include the cost of sales and the operating expenses (general & administrative, marketing and sales, etc).

The operating income can be expressed as a percentage of sales to arrive at the Operating Profit Margin

Operating Profit Margin =    Operating Profit / Sales

 1998 1999 Operating Profit 404,759 413,373 Sales 8,997,738 10,263,280 Operating Profit Margin 4.5% 4%

The operating profit margin is declining. Sales have increased considerably and operating profits have also shown an increase of around \$8 million. However, the operating profit has increased at a lower proportion as compared to sales, which is why the ratio has declined. What does this tell us? Growth is not profitable… and if the trend is not changed, additional growth in sales could actually drive down ODP’s profitability in the future.

The operating profit margin identifies the operating profits obtained on each dollar of sales. ODP generated an operating profit of 4.5 cents for each dollar of sales in 1998 and an operating profit of 4 cents to each dollar of sales in 1999. It indicates how well costs and expenses have been controlled and how effective sales and pricing policy have been. The most viable explanation at this point is the industry structure and the competition ODP has been facing in 1999.

The key take away is that a profitability ratio depicts the overall efficiency and effectiveness of management.

From a closer look at the income statement of Office Depot, we see that all operating costs have increased except “Merger and Restructuring Costs”. Considering Office Depot’s strategy of cutting down on the number of stores that it already has, a new operating expense is being incurred, which is “Store closure and relocation costs”.

We can also see that advertising expenses have increased considerably. This is due to the increasing competition that the company is facing as well as the management’s efforts towards entering new markets.

#### Net Profit Margin

We know that Net Profit is the bottom line that is obtained in the income statement after deducting all expenses from the sales figure. When we express the net income or net profit as a percentage of sales, we arrive at the figure for Net Profit Margin.

Net Profit Margin =     Net Income

Sales

 1998 1999 Net Income 233,196 257,638 Sales 8,997,738 10,263,280 Net Profit Margin 2.6% 2.5 %

The net profit margin ratio is the percentage of each dollar of sales that is available as profits for the company. Even though net income, on the whole, has increased by \$24 million the net profit margin is showing a decline. Although net profits are increasing, the rise is not proportionate to the increase in sales, which is why net profits have declined slightly.

The profitability ratios tell us that to view the figures for net profit, gross profit or operating profit in isolation is not right. In isolation, these figures can be misleading. However, when the profits are seen in relation to sales and are compared to past performance, the true situation of a company comes to light. Let’s move on and see what the rest of the profitability ratios tell us about ODP.

### Concept Title: Profitability Ratios II

#### Return on Assets (ROA)

Return on assets is calculated by dividing the Net Income by the figure that is present in the Balance Sheet for assets. This figure can either be that of Total Assets, Current Assets or Fixed Assets depending on what the requirement is.

Return on Assets (ROA) =    Net Income / Assets

 1998 1999 Net Income 233,196 257,638 Assets 4,025,283 4,276,183 Return on Assets (ROA) 5.8% 6%

ROA is a measure of profitability per unit of assets. In short, it shows how much profit has been generated per dollar assets, which in turns tell us how well assets have been utilized.

The ratio has risen from 5.8% to 6.0% between 1998 and 1999. This is in line with the Total Asset Turnover ratio (ratio of sales to total assets), which also showed an increase. Both these ratios collectively show that the utilization of assets has improved.

#### Return on Equity (ROE)

The Return on Equity is simple to calculate. You can divide the figure available for Net Income by that of Stockholders’ Equity to arrive at the figure.

Return on Equity =    Net Income / Equity

In 1998, Shareholder equity was \$2,028 million while in 1999 it was \$ 1,907 million.

The ROE for the two years, 1998 and 1999 is given below:

 1998 1999 Net Income 233,196 257,638 Equity 2,028,879 1,907,720 Return on Equity 11.5% 13.5%

The ROE tells us how well the firm has performed, in terms of profitability and in relation to what the investment owners have made. It shows how much profit has been earned per dollar of equity.