Imagine that you are a nurse or a physician and you work in the emergency
room of a busy hospital. Patients arrive with all kinds of serious injuries or illnesses,
barely alive or perhaps even dead. Others arrive with less urgent injuries,
minor complaints, or vaguely suspected ailments. Your training and
experience have taught you to perform a quick triage, to prioritize the most
endangered patients by their vital signs—respiration, pulse, blood pressure,
temperature, and ref lexes. A more detailed diagnosis follows based on more
thorough medical tests.
We check the financial health of a company in much the same fashion by
analyzing the financial statements. The vital signs are tested mostly by various
financial ratios that are calculated from the financial statements. These vital
signs can be classified into three main categories:
1. Short-term liquidity.
2. Long-term solvency.
In the emergency room the first question is: Can this patient survive? Similarly,
the first issue in analyzing financial statements is: Can this company survive?
Business survival means being able to pay the bills, meet the payroll, and
come up with the rent. In other words, is there enough liquidity to provide the
cash needed to pay current financial commitments? “Yes” means survival. “No”
means bankruptcy. The urgency of this question is why current assets (which
are expected to turn into cash within a year) and current liabilities (which are
expected to be paid in cash within a year) are shown separately on the balance
sheet. Net current assets (current assets less current liabilities) is known as
working capital. Because most businesses cannot operate without positive
working capital, the question of whether current assets exceed current liabilities
When current assets are greater than current liabilities, there is sufficient
liquidity to enable the enterprise to survive. However, when current liabilities
exceed current assets the enterprise may well be in immanent danger of bankruptcy.
The financial ratio used to measure this risk is current assets divided
by current liabilities, and is known as the current ratio. It is expressed as “2.5
to 1” or “2.5_1” or just “2.5.” Keeping the current ratio from dropping below
1 is the bare minimum to indicate survival, but it lacks any margin of safety. A
company must maintain a reasonable margin of safety, or cushion, because the
current ratio, like all financial ratios, is only a rough approximation. For this
reason, in most cases a current ratio of 2 or more just begins to provide credible
evidence of liquidity.
Long-term solvency focuses on a firm’s ability to pay the interest and principal
on its long-term debt. There are two commonly used ratios relating to servicing
long-term debt. One measures ability to pay interest, the other the ability to
repay the principal. The ratio for interest compares the amount of income
available for paying interest with the amount of the interest expense. This ratio
is called Interest Coverage or Times Interest Earned.
The amount of income available for paying interest is simply earnings before
interest and before income taxes. (Business interest expense is deductible
for income tax purposes; therefore, income taxes are based on earnings after
interest, otherwise known as earnings before income taxes.) Earnings before
interest and taxes is known as EBIT. The ratio for Interest Coverage or Times
Interest Earned is EBIT/Interest Expense. For instance, assume that EBIT is
$120,000 and interest expense is $60,000. This shows that the business has EBIT sufficient to cover 2 times its interest
expense. The cushion, or margin of safety, is therefore quite substantial.
Whether a given interest coverage ratio is acceptable depends on the industry.
Different industries have different degrees of year-to-year f luctuations in
EBIT. Interest coverage of 2 times may be satisfactory for a steady and mature
firm in an industry with stable earnings, such as regulated gas and electricity
supply. However, when the same industry experiences the uncertain forces of
deregulation, earnings may become volatile, and interest coverage of 2 may
prove to be inadequate. In more-turbulent industries, such as movie studios and
Internet retailers, an interest coverage of 2 may be regarded as insufficient.
The long-term solvency ratio that ref lects a firm’s ability to repay principal
on long-term debt is the “Debt to Equity” ratio. The long-term capital structure
of a firm is made up principally of two types of financing: (1) long-term debt and
(2) owner equity. Some hybrid forms of financing mix characteristics of debt
and equity but usually can be classified as mainly debt or equity in nature.
Therefore the distinction between debt and equity is normally clear.
Profitability is the lifeblood of a business. Businesses that earn incomes can
survive, grow, and prosper. Businesses that incur losses cannot stay in operation,
and will last only until their cash runs out. Therefore, in order to assess
business viability, it is important to analyze profitability.
When analyzing profitability, it is usually done in two phases, which are:
1. Profitability in relation to sales.
2. Profitability in relation to investment.