What Is? Defining Financial Terms and Concepts: Financial Ratio Analysis

LEVERAGE RATIOS:

Businesses use debt to finance operations. Financial leverage ratios measure the extent to its use. More leverage becomes problematic in a business downturn if profitability (or operating losses) are not sufficient to cover debt servicing requirements (periodic repayments of the debt and loan agreement covenants).

It is a risk to carry too much debt. However, the use of debt can act as an earnings accelerator when times are good. In addition, financing operations with debt preserves the use of the company’s ownership equity, which is an important consideration to shareholders and the value of their shares in the business.

Some well-known ratios:

  • Debt to Equity = [Total Liabilities] / [Shareholders’ Equity]
    • Generally, a ratio greater than two is considered risky to investors in the stock, and to lenders; but this varies by industry.
  • Debt to Capital = [Total Liabilities] / [Total Liabilities + Shareholders’ Equity]
    •  Measures the % of debt in the company’s capital structure.
    •  Operating leases are capitalized and counted as debt, and preferred shares and minority interest are counted in equity to get a complete picture of the company’s leverage.
  • Degree of Financial Leverage = [% Change in EPS] / [% Change in EBIT]
    •  EPS = (Net) Earnings Per Share
    •  EBIT = Earnings Before Interest and Taxes (generally, operating earnings)
    •  Measures the sensitivity of EPS to operating earnings, which is affected by the use of leverage.
  •  Debt to EBITDA = [Total Debt] / EBITDA
    •  EBITDA = Earnings Before Interest, Taxes, Depreciation and Amortization
    •  EBITDA is a measure of cash generated by the business which is available to pay the debt servicing requirements.
    •  Banks often use this measurement (and set specific targets) in the loan agreement (called covenants) with the company.
    • The higher this ratio, the greater the risk to the lender. So it is watched and is important in banking.

LIQUIDITY RATIOS:

  •  Quick Ratio = [Cash + A/R + Marketable Securities] / [Current Liabilities]
    •  Measures a company’s most liquid position. Used to evaluate the company’s ability to quickly pay off any and all its current bills. Its also known as the “Acid Test” and provides a general indicator of how well the company is prepared to service its operating needs.
    • A ratio of 1.0+ is considered healthy. However, too much in Accounts Receivables (A/R) could artificially bump up this ratio. If a lot of that A/R is with a few customers, there could still be problems to liquidity if certain customers delay their payments to the company. SO the “age” and payment terms of the receivables should be considered as well when determining what a healthy Quick Ration might be for the company.

 

 

Accounting for Stock BuyBack and Retirement (ASC 505-30)

When a company buys back its stock from investor(s), there are two basic approaches depending on whether their intention is to hold those shares in the treasury for future use/reissue, or permanently retire them. Guidance on recording this is found in US GAAP (Accounting Standards Codification) ASC 505-30 which covers treatment of Treasury Stock.

SCENARIO: A company returns repurchased shares to its treasury.

Such purchases are not considered assets because companies, as a rule, do not invest in their own stock. Rather, this return of stock to the treasury is treated as a reduction against its shareholders’ equity account on the balance sheet, since these shares are no longer outstanding. Therefore, the repurchase of shares is a ‘contra-equity’ account.

Such transactions are dealt with on the Balance Sheet (and the related Statement of Shareholders’ Equity). Generally, the transaction does not result in any gains or losses running through the income statement. Any gains on these shares are credited to the Additional Paid-in Capital (A.P.I.C.) account, and losses are charged against any previous gains first, and then any remainder is charged directly to Retaining Earnings.

These moves bypass the income statement altogether.

A convenient and brief bullet-point list of all of ASC 505 (including section 30) is found here: http://www.accountinginfo.com/financial-accounting-standards/asc-500/505-30-treasury-stock. Of course, it is more fully found in the US GAAP codes.

Two Accounting Method:

[1]  Cost Method– This method is used when holding the shares in treasury for later resale (or later retirement). Often, such share repurchases are used for stock option exercises or other types of incentive stock compensation.

Journal Entry to record the transaction:

DR: Treasury Stock (at cost of the buy back: # shares x $ price paid/share)
CR: Cash (for same)

[2]   Constructive Retirement Method – Shares repurchased are immediately retired (no plan to reissue):

Journal Entry to record the transaction:

DR: Common Stock (C.S.) at par
DR: A.P.I.C. (using the price the stock was originally sold for)
DR: Retained Earnings (difference, if repurchase price > original issue price), OR
CR: Contributed Capital from Retired Shares (a)
CR: Cash (amount paid in the repurchase)

Note (a): If there is a credit to balance this transaction; no new equity is created, but the source of the credit is a form of APIC and could be presented separately on the balance sheet in the Shareholders’ Equity section (In fairness, most choose no distinction, while others do separate it as its own APIC account.) In any case, the details of the repurchase is presented in the Statement of Shareholders’ Equity.

Corporate Governance / Legal Considerations:

Of course, there are some formal Board of Directors actions / resolutions needed to authorize the repurchase and/or retirement as dictated in the corporations article and bylaws.

In addition, there may also be a requirement to report these stock transactions to the SEC and state of incorporation. But these matters are not part of this article.