Financial Ratio Tutorial

Debt Ratios: The Debt Ratio 

The debt ratio compares a company's total debt to its total assets, which is used to gain a general idea as to the amount of leverage being used by a company. A low percentage means that the company is less dependent on leverage, i.e., money borrowed from and/or owed to others. The lower the percentage, the less leverage a company is using and the stronger its equity position. In general, the higher the ratio, the more risk that company is considered to have taken on. 
 
Formula: 

 
Components:

 
As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had total liabilities of $1,036.80 (balance sheet) and total assets of $5,721.90 (balance sheet). By dividing, the equation provides the company with a relatively low percentage of leverage as measured by the debt ratio. 
 
Variations: 
None 
 
Commentary: 
The easy-to-calculate debt ratio is helpful to investors looking for a quick take on a company's leverage. The debt ratio gives users a quick measure of the amount of debt that the company has on its balance sheets compared to its assets. The more debt compared to assets a company has, which is signaled by a high debt ratio, the more leveraged it is and the riskier it is considered to be. Generally, large, well-established companies can push the liability component of their balance sheet structure to higher percentages without getting into trouble. 
 
However, one thing to note with this ratio: it isn't a pure measure of a company's debt (or indebtedness), as it also includes operational liabilities, such as accounts payable and taxes payable. Companies use these operational liabilities as going concerns to fund the day-to-day operations of the business and aren't really "debts" in the leverage sense of this ratio. Basically, even if you took the same company and had one version with zero financial debt and another version with substantial financial debt, these operational liabilities would still be there, which in some sense can muddle this ratio. 
 
For example, IBM and Merck, both large, blue-chip companies, which are components of the Dow Jones Index, have debt ratios (FY 2005) of 69% and 60%, respectively. In contrast, Eagle Materials, a small construction supply company, has a debt ratio (FY 2006) of 48%; Lincoln Electric, a small supplier of welding equipment and products, runs a debt ratio (FY 2005) in the range of 44%. Obviously, Zimmer Holdings' debt ratio of 18% is very much on the low side. 
 
The use of leverage, as displayed by the debt ratio, can be a double-edged sword for companies. If the company manages to generate returns above their cost of capital, investors will benefit. However, with the added risk of the debt on its books, a company can be easily hurt by this leverage if it is unable to generate returns above the cost of capital. Basically, any gains or losses are magnified by the use of leverage in the company's capital structure.  

Debt Ratios: Debt-Equity Ratio

The debt-equity ratio is another leverage ratio that compares a company's total liabilities to its total shareholders' equity. This is a measurement of how much suppliers, lenders, creditors and obligors have committed to the company versus what the shareholders have committed.  

To a large degree, the debt-equity ratio provides another vantage point on a company's leverage position, in this case, comparing total liabilities to shareholders' equity, as opposed to total assets in the debt ratio. Similar to the debt ratio, a lower the percentage means that a company is using less leverage and has a stronger equity position.  
 
Formula:

 
Components:

 
As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had total liabilities of $1,036.80 (balance sheet) and total shareholders' equity of $4,682.80 (balance sheet). By dividing, the equation provides the company with a relatively low percentage of leverage as measured by the debt-equity ratio. 
 
Variations: 
A conservative variation of this ratio, which is seldom seen, involves reducing a company's equity position by its intangible assets to arrive at a tangible equity, or tangible net worth, figure. Companies with a large amount of purchased goodwill form heavy acquisition activity can end up with a negative equity position. 
 
Commentary: 
The debt-equity ratio appears frequently in investment literature. However, like the debt ratio, this ratio is not a pure measurement of a company's debt because it includes operational liabilities in total liabilities. 
 
Nevertheless, this easy-to-calculate ratio provides a general indication of a company's equity-liability relationship and is helpful to investors looking for a quick take on a company's leverage. Generally, large, well-established companies can push the liability component of their balance sheet structure to higher percentages without getting into trouble.  
 
The debt-equity ratio percentage provides a much more dramatic perspective on a company's leverage position than the debt ratio percentage. For example, IBM's debt ratio of 69% seems less onerous than its debt-equity ratio of 220%, which means that creditors have more than twice as much money in the company than equity holders (both ratios are for FY 2005).  
 
Merck comes off a little better at 150%. These indicators are not atypical for large companies with prime credit credentials. Relatively small companies, such as Eagle Materials and Lincoln Electric, cannot command these high leverage positions, which is reflected in their debt-equity ratio percentages (FY 2006 and FY 2005) of 91% and 78%, respectively.  

Debt Ratios: Capitalization Ratio

The capitalization ratio measures the debt component of a company's capital structure, or capitalization (i.e., the sum of long-term debt liabilities and shareholders' equity) to support a company's operations and growth.  
 
Long-term debt is divided by the sum of long-term debt and shareholders' equity. This ratio is considered to be one of the more meaningful of the "debt" ratios - it delivers the key insight into a company's use of leverage.  
 
There is no right amount of debt. Leverage varies according to industries, a company's line of business and its stage of development. Nevertheless, common sense tells us that low debt and high equity levels in the capitalization ratio indicate investment quality.  
 
Formula:

 
Components:

 
As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had total long-term debt of $81.60 (balance sheet), and total long-term debt and shareholders' equity (i.e., its capitalization) of $4,764.40 (balance sheet). By dividing, the equation provides the company with a negligible percentage of leverage as measured by the capitalization ratio. 
 
Variations: 
None 
 
Commentary: 
A company's capitalization (not to be confused with its market capitalization) is the term used to describe the makeup of a company's permanent or long-term capital, which consists of both long-term debt and shareholders' equity. A low level of debt and a healthy proportion of equity in a company's capital structure is an indication of financial fitness. 
 
Prudent use of leverage (debt) increases the financial resources available to a company for growth and expansion. It assumes that management can earn more on borrowed funds than it pays in interest expense and fees on these funds. However successful this formula may seem, it does require a company to maintain a solid record of complying with its various borrowing commitments.  
 
A company considered too highly leveraged (too much debt) may find its freedom of action restricted by its creditors and/or have its profitability hurt by high interest costs. Of course, the worst of all scenarios is having trouble meeting operating and debt liabilities on time and surviving adverse economic conditions. Lastly, a company in a highly competitive business, if hobbled by high debt, will find its competitors taking advantage of its problems to grab more market share. 
 
As mentioned previously, the capitalization ratio is one of the more meaningful debt ratios because it focuses on the relationship of debt liabilities as a component of a company's total capital base, which is the capital raised by shareholders and lenders. 
 
The examples of IBM and Merck will illustrate this important perspective for investors. As of FY 2005, IBM had a capitalization ratio of 32%, and Merck's was 22%. It is difficult to generalize on what a proper capitalization ratio should be, but, on average, it appears that an indicator on either side of 35% is fairly typical for larger companies. Obviously, Merck's low leverage is a significant balance sheet strength considering its ongoing struggle with product liability claims. Eagle Materials and Lincoln Electric have capitalization ratios (FY 2006 and FY 2005) of 30% and 20%, which most likely fall into the average and low ratio range, respectively. Zimmer Holdings' 2% capitalization ratio needs no further comment.  

Debt Ratios: Interest Coverage Ratio

The interest coverage ratio is used to determine how easily a company can pay interest expenses on outstanding debt. The ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by the company's interest expenses for the same period. The lower the ratio, the more the company is burdened by debt expense. When a company's interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable. 
 
Formula:

 
Components:

 

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had earnings before interest and taxes (operating income) of $1,055.00 (income statement), and total interest expense of $14.30 (income statement). This equation provides the company with an extremely high margin of safety as measured by the interest coverage ratio. 
 
Variations: 
None 
 
Commentary: 
The ability to stay current with interest payment obligations is absolutely critical for a company as a going concern. While the non-payment of debt principal is a seriously negative condition, a company finding itself in financial/operational difficulties can stay alive for quite some time as long as it is able to service its interest expenses. 
 
In a more positive sense, prudent borrowing makes sense for most companies, but the operative word here is "prudent." Interest expenses affect a company's profitability, so the cost-benefit analysis dictates that borrowing money to fund a company's assets has to have a positive effect. An ample interest coverage ratio would be an indicator of this circumstance, as well as indicating substantial additional debt capacity. Obviously, in this category of investment quality, Zimmer Holdings would go to the head of the class. 
 
Let's see how the interest coverage ratio works out for IBM, Merck, Eagle Materials and Lincoln Electric: 57, 20, 39 and 20, respectively. By any standard, all of these companies, as measured by their latest FY earnings performances, have very high interest coverage ratios. It is worthwhile noting that this is one of the reasons why companies like IBM and Merck have such large borrowings - because in a word, they can. Creditors have a high comfort level with companies that can easily service debt interest payments. Here again, Zimmer Holdings, in this regard, is in an enviable position.

 
 
Debt Ratios: Cash Flow To Debt Ratio

This coverage ratio compares a company's operating cash flow to its total debt, which, for purposes of this ratio, is defined as the sum of short-term borrowings, the current portion of long-term debt and long-term debt. This ratio provides an indication of a company's ability to cover total debt with its yearly cash flow from operations. The higher the percentage ratio, the better the company's ability to carry its total debt. 
 
Formula:

 
Components:

 

s of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had net cash provided by operating activities (operating cash flow as recorded in the statement of cash flows) of $878.20 (cash flow statement), and total debt of only $1,036.80 (balance sheet). By dividing, the equation provides the company, in the Zimmer example, with a cash flow to debt ratio of about 85%. 
 
Variations: 
A more conservative cash flow figure calculation in the numerator would use a company's free cash flow (operating cash flow minus the amount of cash used for capital expenditures). 
 
A more conservative total debt figure would include, in addition to short-term borrowings, current portion of long-term debt, long-term debt, redeemable preferred stock and two-thirds of the principal of non-cancel-able operating leases. 
 
Commentary: 
In the case of Zimmer Holdings, their debt load is higher than their operating cash flows, giving it a ratio of less than one, however the percentage (being above 80%) is considered high. In this instance, this circumstance would indicate that the company has ample capacity to cover it's debt expenses with its operating cash flow.  
 
Under more typical circumstances, a high double-digit percentage ratio would be a sign of financial strength, while a low percentage ratio could be a negative sign that indicates too much debt or weak cash flow generation. It is important to investigate the larger factor behind a low ratio. To do this, compare the company's current cash flow to debt ratio to its historic level in order to parse out trends or warning signs. 
 
More cash flow to debt relationships are evidenced in the financial positions of IBM and Merck, which we'll use to illustrate this point. In the case of IBM, its FY 2005 operating cash amounted to $14.9 billion and its total debt, consisting of short/current long-term debt and long-term debt was $22.6 billion. Thus, IBM had a cash flow to debt ratio of 66%. Merck's numbers for FY 2005 were $7.6 billion for operating cash flow and $8.1 billion for total debt, resulting in a cash flow to debt ratio of 94%.  
 
If we refer back to the Capitalization Ratio page, we will see that Merck had a relatively low level of leverage compared to its capital base. Thus, it is not surprising that its cash flow to debt ratio is very high. 

Operating Performance Ratios: Introduction

he next series of ratios we'll look at in this tutorial are the operating performance ratios. Each of these ratios have differing inputs and measure different segments of a company's overall operational performance, but the ratios do give users insight into the company's performance and management during the period being measured. 
 
These ratios look at how well a company turns its assets into revenue as well as how efficiently a company converts its sales into cash. Basically, these ratios look at how efficiently and effectively a company is using its resources to generate sales and increase shareholder value. In general, the better these ratios are, the better it is for shareholders. 
 
In this section, we'll look at the fixed-asset turnover ratio and the sales/revenue per employee ratio, which look at how well the company uses its fixed assets and employees to generate sales. We will also look at the operating cycle measure, which details the company's ability to convert is inventory into cash. 
 
 

Operating Performance Ratios: Fixed-Asset Turnover

his ratio is a rough measure of the productivity of a company's fixed assets (property, plant and equipment or PP&E) with respect to generating sales. For most companies, their investment in fixed assets represents the single largest component of their total assets. This annual turnover ratio is designed to reflect a company's efficiency in managing these significant assets. Simply put, the higher the yearly turnover rate, the better. 
 
Formula:

 
Components:

 

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had net sales, or revenue, of $3,286.10 (income statement) and average fixed assets, or PP&E, of $668.70 (balance sheet - the average of yearend 2004 and 2005 PP&E). By dividing, the equation gives us a fixed-asset turnover rate for FY 2005 of 4.9. 
 
Variations: 
Instead of using fixed assets, some asset-turnover ratios would use total assets. We prefer to focus on the former because, as a significant component in the balance sheet, it represents a multiplicity of management decisions on capital expenditures. Thus, this capital investment, and more importantly, its results, is a better performance indicator than that evidenced in total asset turnover. 
 
Commentary: 
There is no exact number that determines whether a company is doing a good job of generating revenue from its investment in fixed assets. This makes it important to compare the most recent ratio to both the historical levels of the company along with peer company and/or industry averages.  
 
Before putting too much weight into this ratio, it's important to determine the type of company that you are using the ratio on because a company's investment in fixed assets is very much linked to the requirements of the industry in which it conducts its business. Fixed assets vary greatly among companies. For example, an internet company, like Google, has less of a fixed-asset base than a heavy manufacturer like Caterpillar. Obviously, the fixed-asset ratio for Google will have less relevance than that for Caterpillar. 
 
As is the case with Zimmer Holdings, a high fixed-asset turnover ratio is more the product of a relatively low investment in PP&E, rather than a high level of sales. Companies like Zimmer Holdings are fortunate not to be capital intensive, thereby allowing them to generate a high level of sales on a relatively low base of capital investment. Manufacturers of heavy equipment and other capital goods, and natural resource companies do not enjoy this luxury.  
 
Operating Performance Ratios: Sales/Revenue Per Employee

 
s a gauge of personnel productivity, this indicator simply measures the amount of dollar sales, or revenue, generated per employee. The higher the dollar figure the better. Here again, labor-intensive businesses (ex. mass market retailers) will be less productive in this metric than a high-tech, high product-value manufacturer. 
 
Formula:

Components:

 
 

As of December 31, 2005, Zimmer Holdings generated almost $3.3 billion in sales with an average personnel complement for the year of approximately 6,600 employees. The sales, or revenue, figure is the numerator (income statement), and the average number of employees for the year is the denominator (annual report or Form 10-K). 
 
Variations: 
An earnings per employee ratio could also be calculated using net income (as opposed to net sales) in the numerator. 
 
Commentary: 
Industry and product-line characteristics will influence this indicator of employee productivity. Tracking this dollar figure historically and comparing it to peer-group companies will make this quantitative dollar amount more meaningful in an analytical sense. 
 
For example, Zimmer Holdings' sales per employee figure of $497,878 for its 2005 fiscal year compares very favorably to the figure for two of its direct competitors - Biomet, Inc. (NYSE:BMET) and Stryker Corp. (NYSE:SYK). For their 2005 fiscal years, these companies had sales per employee figures of only $320,215 and $293,883, respectively. 
 
The comparison of Microsoft (Nasdaq:MSFT) and Wal-Mart (WMT), two businesses in very different industries, illustrates how the sales per employee ratio can differ because of this circumstance. Microsoft relies on technology and brain power to drive its revenues, and needs a relatively small personnel complement to accomplish this. On the other hand, a mega-retailer like Wal-Mart is a very labor-intensive operation requiring a large number of employees. These companies' respective sales per employee ratios in 2005 were $670,939 and $172,470, which clearly reflect their industry differences when it comes to personnel requirements. 
 
The sales per employee metric can be a good measure of personnel productivity, with its greatest use being the comparison of industry competitors and the historical performance of the company. 
 
 
Operating Performance Ratios: Operating Cycle