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We have discussed the importance of the working capital figure and ratio to a firm's credit standing and overall financial situation. We will now consider working capital in another connection-that of its turnover: the ratio of sales to working capital. We show how this turnover rate may indicate whether or not a company is overtrading, and then go on to discuss the significance of the profit ratios.
A firm that is overtrading is potentially the most dangerous type of credit risk. Often it buys in large amounts and pays its bills promptly. But it has no reserve funds to serve as a cushion against hard times. An unexpected decline in the market for its products, or interrupted operations because of strikes, material shortages, or other causes, can ruin the business practically overnight. And usually you have no warning-in the way of slow trade payments-to enable you to get out of the account before it becomes insolvent.
You saw how a high rate of net worth turnover can serve as a warning of overtrading. In this topic you will see how credit analysts use the rate of working capital turnover- determined by the ratio of net sales to net working capital-for much the same purpose.
Frequently if a firm is in a low net worth position it will also be in a low working capital position, and the turnover rates of both net worth and working capital will be high. This was the case with the Wood Company. Turning back to the Wood Company balance sheet you will notice that both of these turnover rates are well above the median figures for the line: Net Worth Turnover Net Sales ($1,000,000) / Tangible Net Worth ($170,000) = 5.88 (3.25 median) Working Capital Turnover Net Sales ($1,000,000) / Net Working Capital: ($125,000) = 8.00 (4.94 median) In some cases, however, a company that is overtrading will have a normal net worth turnover, and you will not discover the danger until you check the rate of working capital turnover. Consider the case of the Stuart Company, a toy manufacturer (see balance sheet below). The company's rate of net worth turnover is only somewhat above the median figure (3.41) for the line: Net Sales ($400,000) / Tangible Net Worth ($90,000) = 4.44 But its rate of working capital turnover is well above the upper quartile (6.87): Net Sales ($400,000) / Net Working Capital ($40,000) = 10.00 The company, while having sufficient net worth, obviously has far too little working capital to carry on its operations adequately.
On scrutinizing the balance sheet you will see that the problem lies in the fixed asset figure. The Stuart Company has overinvested in machinery and equipment. Notice that its ratio of fixed assets to net worth is a sky-high 88.8 percent as compared to a median figure of 37.8 percent for the line: Fixed Assets ($80,000) / Tangible Net Worth ($90,000) = 88.8% Since such a large portion of its net worth is frozen in fixed assets, the company has been compelled to depend heavily on its creditors for working capital. It is, therefore, a dubious credit risk despite its apparently adequate net worth. Funded Debts to Net Working Capital Ratio The Stuart Company's poor credit strength is also indicated by another working capital ratio-the ratio of funded debt to net working capital.
Funded debt is, by definition, less pressing than current debt, but it is nonetheless an important factor in credit analysis. A customer who has little or no funded debt is, after all, a better risk than one who has already assumed substantial long-term obligations, since there is still the potential of obtaining funds by mortgaging property. Moreover, although funded debt does not represent immediately maturing obligations, it can become burdensome in the long run, particularly in poor years. As a prospective short-term creditor you should make it your business to know how much of a burden a company's working capital must carry in paying the interest and principal on its funded debt. In the case of the Stuart Company this burden is heavy indeed, the ratio of funded debt to working capital being nearly triple the median figure (31.1%) for the line: Funded Debts ($30,000) / Net Working Capital ($40,000) = 75%
Profit Ratios The profit ratios-most importantly the ratios of profit to sales and profit to net worth-are often looked upon as the best indicators of a company's relative efficiency within its field. But financial analysts caution that these ratios are not always reliable indicators. The analysts point out that profit levels are sometimes determined by policy as well as efficiency. An efficient company may lower prices-and earnings-in an effort to expand its markets, while an inefficient company may temporarily enjoy high earnings by charging prices that eventually drive away all its customers. In most cases, however, a company's profit ratios do reflect its efficiency and its credit strength. Usually the ratios of profits to sales and net worth are used in conjunction with one another. You would look for high or low earnings on sales (a high or low profit to sales ratio) to be confirmed by similar earnings on investment (a high or low profit to net worth ratio). But should these two ratios diverge, the one high and the other low, the cause of the divergence is apt to have considerable significance in the firm's credit position.
Suppose, for example, that Jones & Son (a men's and boys' clothing store) reports the following net worth, sales, and profit figures for the year just ended: Net Worth: $40,000 Net Sales: $400,000 Net Profit: $4,000 The store's profit ratios are therefore: Net Profit
($4,000) / Net Sales ($400,000) = 1% Profit to Sales Ratio While the store's profit to sales ratio is below the lower quartile for the line (1.49%), its profit to net worth ratio is above the median (8.82%). (Note: Before these profit ratios can be accurately compared with those established for the line, federal taxes must be deducted from the profit figures given on the balance sheet.)
This combination of low profit to sales and high profit to net worth usually reflects one of three conditions. Either the store is doing good business at cut-rate prices, or it is a not very efficient shoestring operation, or it is an inefficient business which somehow derives income from other sources. You would have to gather more data to decide which description applies to Jones & Son.
A few doors down from Jones & Son is the Harmony Dry Goods Store. Its year-end statement reveals these figures and your calculations reveal these ratios: Net Worth:
$180,000 Net Sales: $240,000 Net Profit: $8,000 In this case the profit to sales ratio is considerably higher than the median figure (2.67%) and the profit to net worth ratio is well below the median figure (6.55%). This combination of high profits to sales and low profits to net worth indicates an efficiently run business with conservative financing-a choice find for any credit manager. |
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