Ratio Interpretation: Big or Small or Nothing at All?

Introduction:? Bigger or Smaller—Which is Better?

Mark Twain once proclaimed:? Continuous improvement is better than delayed perfection.”? We bankers look at improving financial trends and sometimes make lending decisions on the expectations that improvement will continue.? We monitor ratios that document the trends; the improvement is often charted with ratios whose sizes change over time.? We interpret some ratio trends as good if they increase in size, others as they shrink over time.?????? Interpretation can be confusing, but frequent use of financial ratios brings us to the point where we learn how to interpret them without thinking too much about the magnitude.? Still, why do we have these different interpretations, anyway?? ?

Bigger Is Better?? Maybe . . .

If you look at the most widely used ratios, many of them follow the “bigger is better” mantra, e.g., current ratio, return on equity, receivables turnover ratio.? The more current assets relative to current debt, the more liquid the firm.? The higher the profit relative to equity, the more profitable the company.? The higher the receivables turnover ratio, the faster the organization is collecting its receivables, and, therefore, the more liquid the firm.? But is bigger-the-better always the right call?

There are a few ratios that go the other way, i.e., the smaller the ratio, the better off the company.? Leverage ratios fall into this category; a debt/worth ratio of 1.5x is judged to be more favorable than 3.0x.? Of course, point of view plays into the “smaller is better” interpretation; lenders and creditors prefer to see their clients with less debt to service relative to their equity.? On the other hand, investors might prefer to see more debt relative to equity because the cost of debt—interest expense is cheaper than the cost of equity—dividends.? One of my finance professors, a former GE executive, used to remind us to “use the other guy’s money.”? That sounds clever, but most lenders and creditors are not interested in becoming investors—they just want to get paid for the credit they provided.? To make it easier for most of you readers, I am going to assume that lenders and creditors comprise the fan base for this piece.

Some ratio users prefer to convert positive bigger-is-better ratios into negative smaller-is-better ratios.? For example, a 4.0x receivables turnover might be expressed as 90 days receivable to give the analyst a sense of how long it is taking to collect receivables.? If days receivable has decreased over the last 3 months from 90 days to 60 days, it is visually easier to see this positive change.? The days outstanding approach is particularly useful in quantifying the length of the cash cycle by summing days cash outstanding, days inventory outstanding, and days receivable outstanding:

-days cash???????????????????????????????????? 10

-days inventory?????????????????????????? 90

-days receivable???????????????????????? 60

?? ??????????? Total??????????????????? ???????????? 160

This firm takes 160 days for cash to cycle through, and the CFO can consider options for moving cash faster through the cycle such as holding less cash, lowering product prices to sell the inventory more quickly, and/or tightening credit terms.

That the interpretations had been embedded in me over time was evident when I started to work for a bank whose chief credit officer (CCO) had decreed that all ratios should be expressed as positive ratios so the bankers could interpret the ratios more easily.? We were instructed to flip over the debt/worth ratios into worth/debt and only use turnover ratios and stay away from days outstanding.? For those of us not trained to accentuate the positive, it took a while to condition ourselves to flip back the worth/debt ratio and convert the turnover ratios back into days outstanding to better understand the ratio trends, and because the bank was growing rapidly, so many new associates were joining the organization and complaining about these “upside down” ratios that the CCO finally comprised by revising the spread sheets to also include the debt/worth ratio and the days outstanding along with the worth/debt ratio and the turnover ratios.?

Besides, quantity is not necessarily always good.? A lesson from one of the first loan committee meetings I ever attended came from a well-respected senior lender obviously irritated by a brash business banker requesting an extension of his borrower’s loan and supporting the extension by bragging about his customer’s financials, especially the client’s 2.0 current ratio.? After looking at the spread sheet’s days outstanding for inventory, receivables, notes payable and accounts payable, the senior lender asked this question, “So the unsaleable inventory plus the uncollectible receivables are twice the size of the past due bank note and the delinquent trade debt?” As Steve Jobs noted:? “Quality is more important than quantity.? One home run is much better than two doubles."

The Big and Little of Industry Ratios: ?Both Matter

The Risk management Association’s Annual Statement Studies is a good example of the variety of ratios offered for industry comparisons, and RMA provides upper quartile, median, and lower quartile.? First, RMA uses medians and quartiles to eliminate the influence of outliers, i.e., extremely high or low values when compared to the rest of the values.? Each ratio has three points, or “cut-off values,” the upper quartile, lower-middle quartile, and the lower quartile.? The median is the midpoint where half of the array falls above it and half below it.? The lower quartile is the point where one quarter of the array falls between it and the weakest ratio.? The spread between the lower? and upper quarter represents 50% of the ratio values, so anything above the upper quartile or below the lower quartile are likely to reflect unusual values.[i] Now let’s take a closer look at each of the bigger-is-better and smaller-is-better ratios:

?????? Ratio?????????????????????? ?????????????? ???? bigger better????????????????????????? smaller better

1.?????? Current?????????????????????????????? ?????????????? yes

2.?????? Quick? ???????????????????????????????? ?????????????? yes

3.?????? Sales/receivables????????????????? ?????????????? yes

4.?????? Days receivable???????????????????????????????????????????????????? ?????????????? ?????????????? yes

5.?????? Cost of sales/inventory????????? ?????????????? yes

6.?????? Days inventory??????????????????????????????????????? ?????????????? ????????????????????????????? yes

7.?????? Cost of sales/accounts payable ?????? yes

8.?????? Days payable ????????????????????????????????????????????????????????????????????????????????????? yes

9.?????? Sales/working capital???????????????????????????? yes

10.? EBIT/interest???????????????????????????????????????????? yes

11.? (Net profit + D&A)/CMLTD??????????????????? yes

12.?Fixed/worth????????????????????????????????????????????????????????????????????????????????????????????? yes

13.?Debt/worth?????????????????????????????????????????????????????????????????????????????????????????????? yes

14.? % PBT/TNW?????????????????????????????????????????????? yes

15.? % PBT/TA??????????????????????????????????????? ?????????? yes

16.? Sales/NFA????????????????????????????????????????????????? yes

17.? Sales/TA???????????????????????????????????????????????????? yes

18.? % D&A/Sales???????????????????????????????????????????? yes

19.? % Off-Dir-Owner Comp/Sales??????????????????????????????????????????????????????????????????? yes

20.? % Gross Profit/Sales????????????????????????????? ? yes

21.? % PBT/Sales??????????????????????????????????????????????? yes

Most of RMA’s financial ratio benchmarks fall into the bigger-is-better category, but a few are in the smaller-is-better group.? Let’s look at them more closely. Anything above the upper quartile or below the lower quartile are likely to reflect unusual values.[ii]

Next, consider how these ratios are evaluated:

- 1.Current and 2.? Quick ratios.? These two liquidity ratios aim to determine how much in current and quick assets is available to cover current debt, so leaving aside the quality of the current assets, the bigger the better.

- 3. Sales/receivables turnover ratio and 4.? Days receivable outstanding.? The faster the turnover of receivables, the better the quality of receivables is deemed to be, e.g., a 4x turnover is better than 3x, but you have to convert them into days to really understand this ratio.? A 4x ratio infers 90 days vs. a 3x ratio’s 120 days, based on a 360-day year.? That continues to be the drawback to turnover ratios; they are simply not intuitive. As days receivable, one rule of thumb that I learned while employed by Dun & Bradstreet is that days receivable should not exceed 1.33 times its credit terms, so a firm with 30-day terms should not have days receivable above 40 days.? Other Google current guidance on days payable outstanding (DPO) suggests a good range is 30 to 40 days.

-5. Cost of sales/inventory and 6. Days inventory outstanding.? These two ratios replace sales with cost of sales to exclude the gross profit markup and employ the inventory cost that is actually part of cost of sales.? D&B taught that a manufacturer’s turnover should approximate the amount of time it took to make the product, the idea being that the product was sold as soon as it was produced.? Once again, a 4.0x turnover does not mean much until you convert it into days outstanding, e.g. 90 days.? The longer the days inventory outstanding, the more carrying costs the firm incurs, so the faster the better.

-7. Cost of Sales/accounts payable and 8. Days payable outstanding.? Once again, the faster the turnover, the better, but once again, it is easier to understand trade debt turnover when expressed in days outstanding.? Much trade debt is extended on 30-day terms, so if the firm’s days payable is actually running below 30 days, then the firm may actually be taking some trade discounts.? A common trade credit term is 2/10, net 30 which allows the purchaser to reduce the invoice amount by 2% if paid within the first 10 days of the month.? That 2% discount actually works out to be about a 36 annual rate, so borrowing under a line of credit to take the discount is advantageous to the bank lender and the borrower.? Sometimes, a borrower is encouraged to lean on the trade, but why not take the discount and keep your suppliers happy?? In these days of supply chain kinks and few suppliers, it is better advice to maintain positive relationships with vendors.? Slow payments can lead to loss of trade credit and cash on demand (COD) terms.

-9. Sales/working capital.? This ratio is a kind of productivity ratio—how many dollars of sales can a firm generate from a dollar of working capital, but there are downsides to low and high ratios.? A low ratio of 3x may indicate inefficient working capital—stale inventory, slower receivables collection, but too high a ratio, say 12x, is often interpreted as “overtrading” in which trade credit and bank debt are being used to finance inventory purchases and carry receivables, and worse, at some point working capital actually turns negative.? Somewhere between 5 and 10 is usually the sweet spot.? So, the final answer is the bigger the better, up to a point.

-10.? EBIT/interest.? The interest coverage ratio harks back to the early days of the stock market when it was more of a bond market, one professor told us.? Many publicly traded companies issued bonds, and analysts worried whether companies could afford to pay bond interest.? Because interest expense is tax deductible, we look at the pool of pre-tax earnings to judge the adequacy of interest coverage.? Firms engaged in monopolies, e.g., electricity, water, gas, could get by with lower coverage ratios than firms engaged in more competitive industries, e.g., groceries, department stores, appliances, where demand was more volatile and fickler.? We were told that 3x to 8x was a good rule of thumb with monopolies at the low end and more competitive industries at the top end.? Firms with very high interest coverage ratios were also possible candidates for more corporate debt, especially if they had low debt/worth ratios.? After all, why not trade a little more on the equity if tax-deductible interest expense was so low?

-11.? (Net profit plus depreciation & amortization)/current maturities of long-term debt.? Some banks still use net profit plus non-cash charges as a proxy for cash flow, and the point of this ratio is to evaluate whether there is enough cash flow to cover the current portion long-term debt.? This cash flow measure’s use of net profit means interest expense has already been paid, so is there remaining cash flow to pay the principal?? Sometimes referred to as traditional cash flow,? ?adding back non-cash charges such as depreciation & amortization results in an accurate measure of cash flow if sales are only seasonal, i.e., working capital assets shrink back to their original positions at the beginning of the fiscal year.? Unfortunately, it overestimates cash flow if the company’s annual sales are growing because growing sales means the firm must increase its working capital assets and fixed assets to support the expanding sales.? Further, using depreciation dollars for debt repayment shortchanges funds set aside for fixed asset replenishment, and even then, in my experience, inflation usually results in depreciation dollars only covering about half of the replacement cost.? Further, long amortizations may put off a large final payment for a while under the premise that restructuring the long-term debt every few years allows the borrower to take advantage of lower rates and extend the term even further.? A way to check this ploy is another rule of thumb that the amortization should be no longer than the useful life of the asset.? Twenty-year amortizations on trucks, for example, will result in very little collateral value to repay the loan in the event of default.

-12. Fixed/Worth and 13. Debt/Worth.? These two ratios fall into the smaller is better category. A lower fixed assets/tangible net worth ratio means the firm’s equity is supporting a smaller fixed asset base and a larger cushion for creditors because less fixed assets suggests more current assets to cover liabilities.? Likewise, a lower debt/tangible net worth ratio indicates creditors are subject to less risk as well as offering the firm more capacity for borrowing in the future.? The fly in the ointment is the use of tangible net worth which might be a negative number for those firms actively acquiring other firms at prices greater than book value.? Ultimately, equity is a financial cushion to absorb shrinkage in asset values, and when fixed assets exceed TNW, it signals that creditors must look to liquidation of some fixed assets to be fully repaid, and this class of assets tends to liquidate for less than their book value.

-14.? % Profit before Taxes/Tangible Net Worth (ROE) and 15.? % Profit before Taxes/Total Assets (ROA).? These two ratios fall into the bigger-is-better category.? RMA uses PBT instead of PAT to remove the distortion of progressive income tax rates that rise as income increases.? Investors like firms that generate more profit on smaller equity bases, but some ways for less profitable companies to achieve higher ROE’s is to borrow more, pay more dividends, and/or buy back treasury stock.? Consequently, bankers are cautious? when looking at borrowers with high ROE’s because these borrowers may have relatively high leverage ratios.? The appeal of the ROA ratio is that it is a kind of productivity ratio measuring the profit-generating ability of all the assets.? Until recently, one drawback to ROA has been that firms that lease large amounts of fixed assets seem to have above average ROA’s, but the Financial Accounting Standards Board (FASB) has implemented the lease capitalization principle (ASC 842) that requires the disclosure of not just the lease obligations as liabilities but also the leased assets as Right of Use (ROU) assets included among the fixed assets.? ?

-16. Sales/Net Fixed Assets and 17.? Sales/Total Assets.? If viewed as productivity ratios, then these measures evaluate the firm’s ability to generate sales from its fixed assets base and its total assets, respectively, and they are bigger-is-better ratios.? The sales/NFA ratio is meaningful for manufacturers but less so for service firms that rely more on human capital than fixed assets.? Even with FASB’s new lease capitalization GAAP (generally accepted accounting principle) rule, service firms still tend to have relatively low fixed asset investment levels.? The sales/total assets ratio works better across the economic sectors, and after using RMA’s Annual Statement Studies over my career, a general rule of thumb I have used to validate sales projections is the 2x rule, i.e., most industries show the sales/asset ratio averaging around 2x.[iii]? A national fried chicken franchisee approached our bank for financing the construction of six new outlets around Lake Okeechobee, and his projections showed positive cash flow repayment, but it was based on an ?8x sales/asset ratio for larger limited service restaurants (NAICS 722211) hovered in the 2.0-2.2x range.? We judged the sales projections to be a little too ambitious for our tastes and the number of outlets too close together to avoid cannibalization, anyway.

-18.? % Depreciation & amortization/Sales and 19. % (Officers + Directors +Owners Compensation)/Sales.? The higher the % D&A/Sales expense ratio, supposedly the better, but capital-intensive industries are likely to have higher ratios than labor-intensive industries. ?Bankers look at this ratio to as a measure of cash flow because, as mentioned earlier, traditional cash flow adds the D&A expense to profits, so the more depreciation the better.? As noted earlier, including depreciation as cash flow available for debt repayment robs fixed assets of funding for fixed asset replacement and ignores the need for fixed asset replacement to support just current sales levels.? Of course, over time, the depreciation expense will decline as the fixed assets age over their useful lives and are not replaced, so, it may not even be a reliable, steady source of debt repayment cash flow.? Lenders tend to be bothered by company insiders—officers, directors, owners—enriching themselves at the expense of creditors, so this ratio tends to fall into the smaller-is-better basket.? There are several sources to evaluate insider compensation, including the IRS.[iv] However, the downside to below average insider compensation is the possible negative impact on these insiders’ commitment to the firm’s success.?

-20.? Gross Profit/Sales (GPM) and 21.? % Profit Before Taxes (PBT)/Sales.? Both these measures are bigger-is-better ratios but for different reasons.? First, we expect gross profit margins to be positive because if they were negative, that would mean a firm is unable to recoup the cost of its goods.? Some industries operate at very low GPM’s, e.g., supermarkets and big box discount retailers, while others enjoy very big GPM’s, e.g., jewelry stores and high-end fashion boutiques.? A firm operating at a lower GPM than its industry competitors may be competing with lower prices and hoping its PBT/margin is better than its competitors because of tighter controls over operating expenses.? Warehouse-based furniture and flooring retailers often advertise their low prices are possible because they have forsaken the fancy showrooms for just working out of their warehouses.? One additional use of these two ratios is in calculating a firm’s or an industry’s break-even point.? Break-even sales (BES) is calculated by dividing operating expenses (Gross profit? - profit before taxes) by the GPM, so with a little substitution, BES % =( %GPM –% PBT/Sales)/%GPM.? So, the spice and extract manufacturing industry enjoyed a 33% GPM and a 17% PBT/sales ratio:

(33% -17%)/33% = 48% BES % for this industry

The average firm in this industry breaks even at 48% of its sales, so, ironically, the lower the break-even point, the faster a firm is likely to be profitable.

Closing and Summary: Size Matters?

Grace Slick’s White Rabbit reflects the ambiguity of interpretation[v]:

?????????????? “One pill makes you larger and one pill makes you small

?????????????? ? And the ones that mother gives you don’t do anything at all . . .”

?

It may be a bitter pill to swallow, but how you interpret a ratio’s magnitude? depends on your point of view, e.g., whether you are a banker or investor.? We have examined some common ratios employed by financial analysts to evaluate a firm’s financial condition and performance.? Some folks like the bigger-is-better approach to simplify interpretation, bigger numerator, smaller denominator.? Productivity ratios exemplify this approach—the more output in the numerator, the smaller input in the denominator, the more productive and efficient the firm.? The sales/asset ratio is a poster child for this point of view.

On the other side are those ratios that bank observers prefer to be diminutive, the smaller the better, such as the debt/worth ratio and days outstanding for inventory, receivables, and payables.? On the other hand, investors might favor a larger debt/worth ratio and the favorable effect on ROE.

Finally, be careful about interpretations; Mark Twain cautioned:? Whenever you find yourself on the side of the majority, it is time to pause and reflect.”? Quantity is just one dimension; don’t forget my story about the current ratio and its lesson on quality.

[i]Definitions of Ratios Introduction,”? Annual Statement Studies, Risk Management Association, p.11.

[ii]Ibid.

[iii] See my articles, “How Low Can You Go, How High Can You Fly; The Ups and Downs of Revenue Projections,” The RMA Journal, February 2018, pp. 30-35, and “Airing Out Revenue Projections:? Letting Out the Wind in Sales Projections, The RMA Journal, November 2010, pp. 40-45.

[iv] See my article, “Live and Let Live:? Estimating a ?Realistic Living Expense for Global Debt Service Coverage, The RMA Journal, February 2014, pp. 36-43.

[v] “White Rabbit was sung by Grace Slick and released in 1967 by the Jefferson Airplane as part of its Surrealistic Pillow album.