Understanding Business Accounting For Dummies, 2nd Edition (110 page)

Debtors
5,000,000

Total liquid assets £8,500,000

Total current liabilities £7,975,000

Acid-test ratio 1.07

A 1.07 acid-test ratio means that the business would be able to pay off its short-term liabilities and still have a little bit of liquid assets left over. The general rule is that the acid-test ratio should be at least 1.0, which means that liquid assets equal current liabilities. Of course, falling below 1.0 doesn't mean that the business is on the verge of bankruptcy, but if the ratio falls as low as 0.5, that may be cause for alarm.

This ratio is also known as the
pounce ratio
to emphasise that you're calculating for a worst-case scenario, where a pack of wolves (more politely known as
creditors
) has pounced on the business and is demanding quick payment of the business's liabilities. But don't panic. Short-term creditors do not have the right to demand immediate payment, except under unusual circumstances. This is a very conservative way to look at a business's capability to pay its short-term liabilities - too conservative in most cases.

Return on assets (ROA) ratio

As discussed in Chapter 6 (refer to the sidebar ‘Trading on the equity: Taking a chance on debt'), one factor affecting the bottom-line profit of a business is whether it used debt to its advantage. For the year, a business may have realised a
financial leverage gain
- it earned more profit on the money it borrowed than the interest paid for the use of that borrowed money. So a good part of its net income for the year may be due to financial leverage. The first step in determining financial leverage gain is to calculate a business's
return on assets (ROA) ratio
, which is the ratio of EBIT (earnings before interest and tax) to the total capital invested in operating assets.

Here's how to calculate ROA:

EBIT ÷ net operating assets = ROA


Note:
This equation calls for
net operating assets
,
which equals total assets less the non-interest-bearing operating liabilities of the business
.
Actually, many stock analysts and investors use the total assets figure because deducting all the non-interest-bearing operating liabilities from total assets to determine net operating assets is, quite frankly, a nuisance. But we strongly recommend using net operating assets because that's the total amount of capital raised from debt and equity.

Compare ROA with the interest rate: If a business's ROA is 14 per cent and the interest rate on its debt is 8 per cent, for example, the business's net gain on its debt capital is 6 per cent more than what it's paying in interest. There's a favourable spread of 6 points (one point = 1 per cent), which can be multiplied by the total debt of the business to determine how much its total earnings before income tax is traceable to financial leverage gain.

In Figure 14-2, notice that the company has £10 million total interest-bearing debt (£4 million short-term plus £6 million long-term). Its total owners' equity is £15.9 million. So its net operating assets total is £25.9 million (which excludes the three short-term non-interest-bearing operating liabilities). The company's ROA, therefore, is:

£3.55 million earnings before interest and tax ÷ £25.9 million net operating assets = 13.71% ROA


The business earned £1,371,000 (rounded) on its total debt - 13.71 per cent ROA times £10 million total debt. The business paid only £750,000 interest on its debt. So the business had £621,000 financial leverage gain before income tax (£1,371,000 less £750,000). Put another way, the business paid 7.5 per cent interest on its debt but earned 13.71 per cent on this money for a favourable spread of 6.21 points - which, when multiplied by the £10 million debt, yields the £621,000 pre-tax financial gain for the year.

ROA is a useful earnings ratio, aside from determining financial leverage gain (or loss) for the period. ROA is a
capital utilisation
test - how much profit before interest and tax was earned on the total capital employed by the business. The basic idea is that it takes money (assets) to make money (profit); the final test is how much profit was made on the assets. If, for example, a business earns £1 million EBIT on £20 million assets, its ROA is only 5 per cent. Such a low ROA signals that the business is making poor use of its assets and will have to improve its ROA or face serious problems in the future.

The Biz/ed (
www.bized.co.uk/compfact/ratios/index.htm
) and Harvard Business School (
http://harvardbusinessonline.hbsp.harvard.edu/b02/en/academic/edu_tk_acct_fin_ratio.jhtml
) Web sites contain free tools that calculate financial ratios from company accounts. They also provide useful introductions to ratio analysis and definitions of each ratio and the formula used to calculate it. To download their spreadsheet, you first need to register with the Harvard Web site.

By registering (for free) with the Proshare Web site (go to
www.proshareclubs.co.uk
and click on ‘Research Centre' and ‘Performance Tables'), you have access to a number of tools that crunch public company ratios for you. Select the companies you want to look at, and then the ratios you're most interested in (EPS, P/E, ROI, Dividend Yield, and so on). All is revealed within a couple of seconds. You can then rank the companies by performance in more or less any way you want. You can find more comprehensive tools on the Internet, on the Web sites of share traders for example, but Proshare is a great site to cut your teeth on - and the price is right!

Frolicking through the Footnotes