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Ratio Analysis: Liquidity, Leverage, Profitability, Productivity: Session I-D

Concept Title: Liquidity

Concept Description: Explains what role the cash position of a firm plays in the financial health of a company.

Liquidity is the ability of a firm to convert its assets as quickly as possible into cash. It’s about having cash available as and when required. We can view liquidity in one other way – in terms of the value of an asset.

Every asset has a life and when it is sold at any point in time, it fetches a certain price. So, the liquidity of an asset is the ability of the asset to be sold at any point in time at a minimal loss. The liquidity of an asset can be determined by comparing the price at which the asset is sold at present to the price it would have realized had it been sold at the maturity. The total liquidity of the firm is, therefore, determined by the combined effect of the liquidity of all the assets.

It is essential for businesses to have adequate liquidity to be able to avail opportunities that may present themselves suddenly. Also, firms need to be able to meet short-term obligations that become due. Therefore, an analysis of a business’ liquidity focuses on the extent to which a firm has enough cash (or assets that can readily and quickly be converted to cash) to pay off its current liabilities, as they become due.

If a firm has an appropriate amount of cash to pay off its obligations on time, it is a solvent or liquid business. If the amount of cash available is not enough, the company may suffer from a short-term crisis called insolvency.

Even though insolvency may be short term it can spell out disaster for a firm, as it can for an individual managing or ‘mis-managing’ his personal finances. It affects the creditworthiness of the firm in the eyes of suppliers, financial institutions and other stakeholders and increases dependence on other sources of financing.

The biggest impact (as well as predictor) of impending insolvency is the increasing reliance on short term financing. Short term financing in large doses, or for continued lengths of time, can be financially disastrous for any business.

It must be quite apparent to you that liquidity is a very important aspect of a firm’s financial health. For this reason the management of any business must spend a great deal of time on understanding and managing its cash. Managing cash has a great deal to do with liquidity.

It is important that a company’s management is able to monitor and match the inflows and outflows of cash during each accounting period. As said earlier, liquidity is the ability of a business to convert assets into cash at short notices, with minimal losses. Cash management is about ensuring that you have access to assets or liabilities that can become sources of cash at short notice.

Let’s move on to another concept now that stems from our discussion on liquidity: Liquidity Risk.

Sometimes a firm is not in a good liquidity position. So, it has to depend on external sources for short-term financing to help it pass through difficult times. The problem with external help is that first, it is not free and second, it is never available when you need it. Even if you are fortunate enough to get good help, the price for the assistance is in direct proportion to how desperately you need it.

Concept Title: Leverage

Concept Description: Explains the impact of debt or leverage on a firm

Leverage is the amount of debt or liabilities that a firm has taken on to finance its assets. We all know that to maintain a certain level of sales or expand existing level of operations additional resources are required. These resources (read: assets) can be financed through equity and/or debt. It is important to analyze and gauge whether a firm has the ability to sustain and support the debt that it has taken on.

Whenever a firm acquires leverage it has to ensure that the benefit of taking on that leverage outweigh the costs. What are the benefits of debt?

  1. A higher upside in returns and productivity is achieved during good times
  2. Debt can also serve as a tax shield. This means that if the business meets certain pre-qualifiers, the use of debt may reduce the tax bill for a business.
  3. The most common reason for using debt is to prevent dilution in shareholders equity. Why should a business take on new owners or new partners when it can get money, at much better terms, from a bank or any other institutional lender?

Equity is always more expensive than debt in terms of the return required and expected. There is also an issue of market signaling. For a publicly traded business, the choice of debt indicates that management feels the business is under valued. If it were not undervalued management would go out and use equity as the financing option. This leads us to the choice of equity. The only reason management should and would use equity, as a financing option, is when they feel they can get the best price for a piece of ownership.

What are the costs?

  1. First in line is the financial charge that will have to be paid along with the principal amount. This obviously changes the fixed cost structure of the firm and has a direct impact on the business’ credit rating. Too much debt, or even the perception of too much debt, can wipe out billions from the market capitalization of firms as well as close any open doors for future credit. Amazon.com and Ravi Suriya’s comments are a case in point. Ravi issued an analyst warning about Amazon’s debt load and its ability to service that debt. Ravi’s comments led to a sharp drop in Amazon’s stock price, which still remains depressed until today.
  2. There is also a question of restrictions on future flexibility. A balance sheet can only support a certain level of debt before a business runs into serious trouble. Once the decision to lever up the balance sheet is taken, it reduces the number of future financing options available to a business.

What do you need to consider when you are evaluating the debt situation at a firm ?

The first step is a look at the profitability of the business. Is the firm earning stable profits or has it experienced extensive fluctuations? This analysis of variation in profits is important because interest expense associated with debt is fixed. These charges have to be paid no matter what. It is the management’s responsibility to make sure that the firm earns enough every year to cover interest expense. This is why stability in income is a very important indicator of whether a firm has the ability to bear the costs of debt.

There are also other questions. Is there too much debt on the balance sheet? What amount of interest is being paid to other creditors? Have the previous payments been on time? Are there limiting clauses that would restrict business decisions or issue of additional debt? Does the current level of earnings allow an increase in debt, that is, will the business have the ability to finance additional charges?

There are various categories of debt that have been identified earlier in the session on definitions and terminology. It is a good idea to stop and go back to the definitions and explanations on various debt instruments to familiarize yourself with the options that are available if you would think of borrowing money for business purposes, either on a long-term basis or otherwise.

Concept Title: Productivity

Concept Description: Helps us see how well a firm is using its resources

Think of a balance sheet as a Chess Board or a football team. How you use the pieces or players you have determines whether you win or lose a game or series. In a business analogy the different components of the balance sheet are the players and the pieces management works with. The Bottom Line on an Income Statement is the performance that management’s actions produce.

As an investor as well as a manager, you must ask the following question:

Are the various components reported on the balance sheet too high, too low or reasonable when you look at the results?

You must compare what a business owns and see whether its presence on the balance sheet is justified by the performance. The basis for comparison could be results of prior years, competitive results or even industry standards.

A good example is comparing sales to assets. This is a turnover ratio, also known as productivity or activity ratio. The two relevant variables here are sales and assets. The question answered is how many units of cash, credit sales, inventory and fixed assets are required to support one unit of sale.

By themselves, these numbers do not mean much but when compared with prior years, competing firms and/or the industry averages a more meaningful analysis is possible. The stress here is on gauging efficiency and productivity. The assumption is that there is an optimal mix between sales and various assets. With the help of ratios we can assess how far away the business is operating from the optimal mix.

Concept Title: Profitability

Concept Description: Explains why it is important for a firm to earn more than it spends

Profitability is a fairly simple question. Do you make money when you do whatever you do?

Profits are reflected in the margins you make at each stage of operations.

  1. Are you selling at a steep discount, at the right price or at premium prices? We use Gross Margins to answer this question.
  2. Do you add value at the production, marketing or distribution stages? Are you spending too much or too less on administrative, support and servicing functions? Both of these questions can be addressed by taking a look at operating margins.
  3. Are your margins not enough / just enough or generous? Net Income or Net profit margin addresses this question.

Profitability is not something that is analyzed in isolation. As with every other ratio, comparisons within and outside the firm add a lot of value. There are numerous factors affecting profitability that also have to analyzed. Are they one-time events (restructuring charges) or will we see repeat occurrences (permanent increase in raw material or labor costs)?

(If you would like to buy the pdf version of the complete course , please see our Ratio Analysis on our store.)

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