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inventories of raw materials, work in process, and finished goods. These assets are all known as current assets.

The remaining assets on the balance sheet consist of long-term, usually illiquid, assets such as pulp and paper mills, office buildings, and timberlands. The balance sheet does not show up-to-date market values of these long-term assets. Instead, the accountant records the amount that each asset originally cost and then, in the case of plant and equipment, deducts a fixed annual amount for depreciation. The balance sheet does not include all the company’s assets. Some of the most valuable ones are intangible, such as patents, reputation, a skilled management, and a welltrained labor force. Accountants are generally reluctant to record these assets in the balance sheet unless they can be readily identified and valued.

Now look at the right-hand portion of Executive Paper’s balance sheet, which shows where the money to buy the assets came from.3 The accountant starts by looking at the liabilities, that is, the money owed by the company. First come those liabilities that need to be paid off in the near future. These current liabilities include debts that are due to be repaid within the next year and payables (that is, amounts owed by the company to its suppliers).

The difference between the current assets and current liabilities is known as the net current assets or net working capital. It roughly measures the company’s potential reservoir of cash. For Executive Paper in 1999

Net working capital current assets current liabilities900 460 $440 million

The bottom portion of the balance sheet shows the sources of the cash that was used to acquire the net working capital and fixed assets. Some of the cash has come from the issue of bonds and leases that will not be repaid for many years. After all these long-term liabilities have been paid off, the remaining assets belong to the common stockholders. The company’s equity is simply the total value of the net working capital and fixed assets less the long-term liabilities. Part of this equity has come from the sale of shares to investors and the remainder has come from earnings that the company has retained and invested on behalf of the shareholders.

Table 29.2 provides some other financial information about Executive Paper. For example, it shows the market value of the common stock. It is often helpful to compare the book value of the equity (shown in the company’s accounts) with the market value established in the capital markets.

The Income Statement

If Executive Paper’s balance sheet resembles a snapshot of the firm at a particular point in time, its income statement is like a video. It shows how profitable the firm has been over the past year.

Look at the summary income statement in Table 29.3. You can see that during 1999 Executive Paper sold goods worth $2,200 million and that the total costs of producing and selling these goods were $1,980 million. In addition to these out-of- pocket expenses, Executive Paper also made a deduction of $53.3 million for the value of the fixed assets used up in producing the goods. Thus Executive Paper’s earnings before interest and taxes (EBIT) were

3The British and Americans can never agree whether to keep to the left or the right. British accountants list liabilities on the left and assets on the right.

T A B L E 2 9 . 5

Financial ratios for Executive Paper and the paper industry, 1999.

*This ratio is an extra bonus not discussed in Section 29.2.

†1999 ratios for U.S. paper and allied products. Source: Compustat.

•How productively is the company using its assets? Are there any signs that the assets are not being used efficiently?

•How profitable is the company?

•How highly is the firm valued by investors? Are investors’ expectations reasonable?

When you calculate a company’s financial ratios, you need some criteria to decide whether they are a cause for concern or a matter for congratulation. Unfortunately, there is no “right” set of financial ratios to which all companies should aspire. Take, for example, the company’s capital structure. Debt has both advantages and disadvantages, and, even if there were an optimal level of debt for company A, it would not be appropriate for company B.

When managers review a company’s financial position, they often start by comparing the current year’s ratios with equivalent figures for earlier years. It is also helpful to look at how the company’s financial position measures up to that of other firms in the same industry. Therefore, in Table 29.5 we have compared the financial ratios of Executive Paper with those for the U.S. paper industry.6

How Much Has Executive Paper Borrowed?

When Executive Paper borrows, it promises to make a series of fixed payments. Because its shareholders get only what is left over after the debtholders have been paid, the debt is said to create financial leverage. In extreme cases, if hard times come, a company may be unable to pay its debts.

The company’s bankers and bondholders also want to make certain that Executive Paper does not borrow excessively. So, if Executive wishes to take out a new loan, the lenders will scrutinize several measures of whether the company is borrowing too much and will demand that it keep its debt within reasonable bounds. Such borrowing limits are stated in terms of financial ratios.

Debt Ratio Financial leverage is usually measured by the ratio of long-term debt to total long-term capital. Since long-term lease agreements also commit the firm to a series of fixed payments, it makes sense to include the value of lease obligations with the long-term debt. For Executive Paper

1 long-term debt value of leases 2

Debt ratio 1 long-term debt value of leases equity 2450/ 1 450 540 2 .45

Another way to say the same thing is that Executive Paper has a debt-to-equity ratio of 450/540 .83:

1 long-term debt value of leases 2

Debt– equity ratio

equity450/540 .83

Notice that this measure makes use of book (i.e., accounting) values rather than market values.7 The market value of the company finally determines whether the debtholders get their money back, so you might expect analysts to look at

6Financial ratios for different industries are published by the U.S. Department of Commerce, Dun and Bradstreet, The Risk Management Association, and others.

7In the case of leased assets accountants try to estimate the present value of the lease commitments. In the case of long-term debt they simply show the face value. This can sometimes be very different from present value. For example, the present value of low-coupon debt may be only a fraction of its face value. The difference between the book value of equity and its market value can be even more dramatic.

the face amount of the debt as a proportion of the total market value of debt and equity. On the other hand, the market value includes the value of intangible assets generated by research and development, advertising, staff training, and so on. These assets are not readily salable, and if the company falls on hard times, their value may disappear altogether. For some purposes, it may be just as good to follow the accountant and ignore these intangible assets. This is what lenders do when they insist that the borrower should not allow the book debt ratio to exceed a specified limit.

Debt ratios are sometimes defined in other ways. For example, analysts may include short-term debt or other obligations such as payables. There is a general point here. There are a variety of ways to define most financial ratios and there is no law stating how they should be defined. So be warned: Don’t accept a ratio at face value without understanding how it has been calculated.

Times-Interest-Earned (or Interest Cover) Another measure of financial leverage is the extent to which interest is covered by earnings before interest and taxes (EBIT) plus depreciation. For Executive Paper,8

The regular interest payment is a hurdle that companies must keep jumping if they are to avoid default. The times-interest-earned ratio measures how much clear air there is between hurdle and hurdler.

Is Executive Paper’s borrowing in the ballpark of standard practice or is it a matter for concern? Table 29.5 provides some clues. You can see that the debt ratio is slightly lower than that of the rest of the paper industry and the times-interest- earned is significantly higher than that of most companies.

How Liquid Is Executive Paper?

If Executive Paper is borrowing for a short period or has some large bills coming up for payment, you want to make sure that it can lay its hands on the cash when it is needed. The company’s bankers and suppliers also need to keep an eye on Executive’s liquidity. They know that illiquid firms are more likely to fail and default on their debts.

Another reason that analysts focus on liquid assets is that the figures are often more reliable. The book value of Executive’s newsprint mill may be a poor guide to its true value, but at least you know what its cash in the bank is worth. Liquidity ratios also have some less desirable characteristics. Because short-term assets and liabilities are easily changed, measures of liquidity can rapidly become out-of- date. You may not know what that newsprint mill is worth, but you can be fairly sure that it won’t disappear overnight.

8The numerator of times-interest-earned can be defined in several ways. Sometimes depreciation is excluded. Sometimes it is just earnings plus interest, that is, earnings before interest but after tax. This last definition seems nutty to us, because the point of interest earned is to assess the risk that the firm won’t have enough money to pay interest. If EBIT falls below interest obligations, the firm won’t have to worry about taxes. Interest is paid before the firm pays taxes.

Current Ratio Executive Paper’s current assets consist of cash and assets that can readily be turned into cash. Its current liabilities consist of payments that the company expects to make in the near future. Thus the ratio of the current assets to the current liabilities measures the margin of liquidity. It is known as the current ratio:

Rapid decreases in the current ratio sometimes signify trouble. However, they can also be misleading. For example, suppose that a company borrows a large sum from the bank and invests it in short-term securities. If nothing else happens, net working capital is unaffected, but the current ratio changes. For this reason it might be preferable to net off the short-term investments and the short-term debt when calculating the current ratio.

Quick (or Acid-Test) Ratio Some assets are closer to cash than others. If trouble comes, inventories may not sell at anything above fire-sale prices. (Trouble typically comes because customers are not buying and the firm’s warehouse is stuffed with unwanted goods.) Thus, managers often focus only on cash, short-term securities, and bills that customers have not yet paid:

1 cash short-term securities receivables 2

Quick ratio

current liabilities

110 440 1.20 460

Cash Ratio A company’s most liquid assets are its holdings of cash and marketable securities. That is why analysts also look at the cash ratio:

Of course, these summary measures of liquidity are just that. They are no substitute for detailed plans to ensure that the company can pay its bills. In the next chapter we will describe how companies forecast their cash needs and draw up a shortterm financial plan to deal with any cash shortage.

How Productively Is Executive Paper Using Its Assets?

Financial analysts employ another set of ratios to judge how efficiently the firm is using its investment in current and fixed assets. Later in the chapter we will look at the financial implications of Executive’s ambitious plans to expand output, but understanding the investment in fixed assets and working capital that is needed to support Executive Paper’s current output may help to uncover any inconsistencies in these plans for the future.

Assets here are measured as the sum of current and fixed assets. Notice that since assets are likely to change over the course of a year, we use the average of the assets at the beginning and end of the year. Averages are commonly used whenever a flow figure (in this case, sales) is compared with a stock or snapshot figure (total assets).

Notice that for each dollar of investment Executive generates $1.55 of sales, a much higher figure than other paper companies. There are several possible explanations: (1) Executive uses its assets more efficiently; (2) Executive is working close to capacity, so that it may be difficult to increase sales without additional invested capital; or (3) compared with its rivals, Executive produces high volume, low margin products.9 You need to dig deeper to know which explanation is correct. Remember our earlier comment—financial ratios help you to ask the right questions, not to answer them.

Instead of looking at the ratio of sales to total assets, managers sometimes look at how hard particular types of capital are being put to use. For example, it turns out that Executive’s ratio of sales to current assets is less than that of other paper companies. It is the ratio of Executive’s sales to its fixed assets that sets it apart from its rivals.

Days in Inventory The speed with which a company turns over its inventory is measured by the number of days that it takes for the goods to be produced and sold. First convert the cost of goods sold to a daily basis by dividing by 365. Then express inventories as a multiple of the daily cost of goods sold:

Notice that Executive Paper appears to have a relatively low rate of inventory turnover. Perhaps there is scope for economizing on the company’s investment in inventories.

Average Collection Period The average collection period measures how quickly customers pay their bills:

The collection period for Executive Paper is somewhat longer than the industry average. The company may have a conscious policy of offering attractive credit terms to lure business, but it is worth looking at whether the credit manager is lax in chasing up the slow payers.

9We will see shortly that this last explanation does not hold up. The paper industry in 1999 earned a negative profit margin.

How Profitable Is Executive Paper?

Net Profit Margin If you want to know the proportion of sales that finds its way into profits, you look at the profit margin. Thus10

Return on Assets (ROA) Managers often measure the performance of the firm by the ratio of income to total assets (income is usually defined as earnings before interest but after taxes). This is known as the firm’s return on assets (ROA) or return on investment (ROI):11

1 EBIT tax 2 Return on assets 1 average total assets 2

1 166.7 49.7 2

1 1, 380.8 1, 450 2 /2 .083, or 8.3%

Another measure focuses on the return on the firm’s equity:

1 earnings available for common stockholders 2

Return on equity 1 ROE 2

average equity

74.5

1 509.3 540 2 /2 .142, or 14.2%

Executive Paper’s return on assets and equity is in sharp contrast to the rest of the industry, which provided a negative return in 1999.

It is natural to compare the return earned by Executive Paper with the opportunity cost of capital. Of course, the assets in the financial statements are shown at net book value, that is, original cost less depreciation.12 So a low ROA does not necessar-

10Net profit margin is sometimes measured as net income sales. This ignores the profits that are paid out to debtholders as interest and should therefore not be used to compare firms with different capital structures.

When making comparisons between firms, it makes sense to recognize that firms which pay more interest pay less tax. We suggest that you calculate the tax that the company would pay if it were all- equity-financed. To do this you need to adjust taxes by adding back interest tax shields (interest payments marginal tax rate). Using an assumed tax rate of 40 percent,

11When comparing the returns on total assets of firms with different capital structures, it makes sense to add back interest tax shields to tax payments (see footnote 10). This adjusted ratio then measures the returns that the company would have earned if it were all-equity-financed.

One other point about return on assets. Since profits are a flow figure and assets are a snapshot figure, analysts commonly divide profits by the average of assets at the start and end of the year. The reason that they do this is that the firm may raise large amounts of new capital during the year and then put it to work. Therefore part of the year’s earnings is a return on this new capital.

However, this measure is potentially misleading and should not be compared closely with the cost of capital. After all, when we defined the return that shareholders require from investing in the capital market, we divided expected profit by the initial outlay, not by an average of starting and ending values.

12More careful comparisons between the return on assets and the cost of capital need to recognize the biases in accounting numbers. We discussed these biases in Chapter 12.