3.6 Debt/equity ratio analysis

Full video class on YouTube, summary and notes on Instagram, class extracts on TikTok, text below. Have fun!

The main point of this class is to learn how to calculate efficiency ratios and to distinguish insolvency and bankruptcy.

Ratio analysis is a quantitative financial analysis tool for judging the financial performance of the business based on financial statements: balance sheet and profit & loss account. There are different types of ratios: profitability, liquidity and efficiency. The first two types of ratios were covered in the previous class, and efficiency ratios are covered here in this class for HL students only.

Efficiency ratios examine organisation’s performance in terms of how it uses its resources (i.e. assets and liabilities). The four types of efficiency ratios are stock turnover, debtor days, creditor days and gearing.

In the following paragraphs we’ll learn how to calculate and interpret these ratios. In addition, we’ll learn some strategies that can be used to improve these ratios and we'll learn how to evaluate them by discussing their pros and cons. For each ratio, I will suggest two strategies: one “regular” low-risk strategy (that does not have substantial implications) and one “extreme” high-risk strategy (that has substantial implications and can be used as last resort). As you read, please fill in the table below in order to make sure you know how to evaluate strategies to improve efficiency ratios.

Stock turnover ratio shows how quickly the organisation sells and replenishes its stock. Stock here refers to stock of finished goods. There are two ways to calculate stock turnover: by number of times per year and by number of days. The corresponding formulae of stock turnover ratio are:

Stock turnover (number of times) = cost of sales ÷ average stock

Stock turnover (number of days) = average stock ÷ cost of sales ⨉ 365

Average stock = (opening stock + closing stock) ÷ 2

If you forgot what cost of sales is, then please review profit & loss account, see how to calculate gross profit, see what cost of sales (or COGS) is and see what opening/closing stock is. All the answers are in class 3.4. If you remember all of the things I mentioned above, move on and keep reading.

The lower the stock turnover ratio is, the faster organisation sells its stock and thus the more efficient it is in generating profits. For example, if COGS is $100 and average stock level is $20, then stock turnover is either 5 times a year or every 73 days, depending on whether it’s by number of times or by number of days accordingly.

The low-risk strategy to improve stock turnover ratio is to hold lower stock levels. This can be achieved in different ways, for example by selling goods with a discount in order to speed up sales. The downside of this strategy is that revenues and profits might decrease despite the increase in speed of generating profits.

The high-risk strategy to improve stock turnover is to introduce just-in-time production (JIT), that we’ll learn in detail in Unit 5. Basically, JIT means holding zero stocks of raw materials and finished goods by ordering supplies of raw materials only when needed and only in the amount that is needed to meet short-term production targets. JIT works only when suppliers are reliable and infrastructure is perfect and allows for speedy delivery. The downside is that you rely too much on other businesses (suppliers) and that you might not be able to meet the demand in case there is a sudden increase in it.

Debtor days ratio (receivables) shows how long it takes to collect debts. This usually applies to customers who bought goods from you using trade credit, i.e. when they got their goods at the time of purchase, but they pay for them later, within the credit period. In this relationship, you are a creditor, and your customers are debtors. The formula of debtor days ratio is:

Debtor days = debtors ÷ sales revenue x 365

The lower debtor days ratio is, the more likely customers are to look for other suppliers, because it might mean that you are a demanding creditor who requests early payments and offers a short credit period. The higher it is, the more likely organisation is to face liquidity problems. Benchmark for this ratio is 30~60 days, but of course it depends on the industry. For example, if debtors are $100 and revenue is $500, debtor days ratio is 73 days. It takes 73 days on average to collect debt from customers who bought items using trade credit.

The low-risk strategy to improve debtor days ratio is to offer discounts to customers in exchange for early payments. This way, they will be motivated to pay earlier and you might avoid the situation of bad debt. However, discount always means lower revenues, so it is really important to keep balance and make sure that discount is significant enough to motivate early payments, but insignificant enough to have a negative effect on revenues.

The high-risk strategy is to threaten your customers (debtors) with a lawsuit in case they miss the payment deadline. In the short term, you will definitely get your debts back because the law will be on your side (if there is an a contract with your customers that clearly states credit period). On the other hand, in the long term, after threatening someone with legal action, it would be hard to maintain a good trustworthy relationship... So, your customers might be looking for other suppliers, if you threaten to sue them too often.

Creditor days ratio (payables) shows how long it takes to pay creditors. This is quite the opposite of debtor days ratio. In this relationship, you are a debtor, and your suppliers are creditors. The formula for creditor days ratio is:

Creditor days = creditors ÷ cost of sales x 365

The higher creditor days ratio is, the more time you have to pay for current liabilities, but the worse your relationship with the suppliers might be because it takes you a very long time to pay for their supplies. For example, $100 owed to suppliers and $500 worth of cost of sales mean that creditor days ratio is 73 days. It takes you 73 days on average to pay to your suppliers for items that you purchased using trade credit.

The low-risk strategy to improve creditor days is to develop good trustworthy relationship with your suppliers, so that they do not freak out when you ask them to extend credit period. The downside is that if you take advantage of their trust, you might end up never having any extensions.

The high-risk strategy is to abandon your current suppliers and look for others that may offer more favourable credit terms to you. However, it takes time to find trustworthy suppliers and there is no guarantee that the new supplier will be better than the previous one.

Gearing ratio shows the extent of organisation's reliance on loan capital. Highly geared organisations might be a high-risk investment but might have a higher growth potential. Low geared organisations are the opposite: they might be low-risk investment but have lower growth potential. Highly geared firms are also less likely to pay dividends, because they have to pay for their long-term debt obligations first. The formula for gearing is:

Gearing = loan capital ÷ capital employed ⨉ 100

You can find all the data for gearing ratio in the balance sheet. Loan capital is the same as non-current liabilities. Capital employed is a sum of non-current liabilities and equity. Equity in for-profit organisations consists of retained earnings and share capital, for non-profit organisations it consists of retained earnings only. Try to find all these things in the balance sheet below:

The higher gearing ratio is, the more dependent on long-term borrowing and interest payments organisation is and therefore the lower net profits are (because interest payments are an expense). High gearing is considered to be above 50%, low gearing is considered to be below 50%. For example, $100 of non-current liabilities and $500 of capital employed mean that gearing ratio is 20%. This means that 1/5 of sources of finance comes from external sources. It also means that the organisation grows slowly but has lower risks.

The low-risk strategy to improve gearing ratio is to look for free sources of finance such as share capital. On the one hand, this will bring more finance into organisation without having to pay interest rate. On the other hand, increase in share capital means issuing more shares and more shareholders, which might result in loss of control.

The high-risk strategy to improve gearing ratio is to stop paying dividends. This way, organisation will retain more earnings, thus increasing its capital employed. But the downside is that it might result is dissatisfied shareholders, who might end up selling their shares, that decreasing the company’s value.

By now, you should know 8 strategies to improve efficiency ratios: 4 low-risk “regular” strategies and 4 high-risk “extreme” last-resort strategies. Hopefully, by now you have filled in the “pros and cons” section of the table below:

Keep in mind that these are not the only strategies. There can be many more ways to improve ratios. Maybe you can think of some and extend the table.

First of all, have a look at the table below. If you feel that you understand everything, then there is no point in reading any further. If the table is unclear, then please continue reading in order to make sense of it.

Insolvency is a situation when an organisation is not able to pay its debts on time. This is a kind of situation when current liabilities exceed current assets. The ratios that indicate insolvency are current ratio and acid test ratio. When these two ratios are less than 1:1, it is clearly an evidence of liquidity problems and insolvency.

Even though insolvency doesn’t sound like fun and is clearly a problem, it is not “the end of the world” kind of situation and there are ways out of insolvency. The main solution to it is to negotiate with creditors and ask them to extend the credit period and allow to pay at a later date in exchange for, let’s say, a higher payment. There is no one right way in this negotiation, it all depends on the relationships between debtors and creditors.

Another solution to insolvency could be liquidation of some assets, i.e sale of assets. This can help to generate some short-term cash to pay for current liabilities.

The extreme solution to insolvency, when none of the ways seem to work, is bankruptcy.

Bankruptcy is a process that organisation goes through when it is not able to pay its debts at all. Similar to insolvency, the indicator of inability to pay debts is current and acid test ratios that are lower than 1:1, which means that current liabilities are greater than current assets.

Unlike insolvency, bankruptcy is the last resort. Negotiation with creditors cannot be a solution to bankruptcy, because it is already too late to negotiate. If insolvency is flexible in terms of how it can be resolved, then bankruptcy is inflexible. Usually bankruptcy implies legally enforced liquidation of organisation’s assets. All the funds generated through liquidation go to creditors in order to relieve their debts, fully or partially.

Bankruptcy also leaves some room for unethical or even fraudulent practices. Some “entrepreneurs” (aka criminals) start businesses that promise outstanding results and products, while in fact they just want people to invest. Then they spend all investment onto their salaries and bonuses and claim bankruptcy, leaving investors with nothing. This kind of scam is as old as the world. In this article you can read about some examples of bankruptcy scandals from 15 century up to now.

Hopefully, by now the table above makes perfect sense.

Make sure you can define all of these:

1. Ratio analysis
2. Efficiency ratios
3. Stock turnover ratio
4. Debtor days ratio (receivables)
5. Creditor days ratios (payables)
6. Gearing
7. Loan capital
8. Capital employed
9. Insolvency
10. Bankruptcy