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.

 

 

Baby Steps: The Benefit of Micro Savings

A while ago, I read something that really struck me. It was about a comedian, W.C. Fields. He was a successful guy but he lived during the Great Depression and, it seems, was very concerned about saving a few bucks whenever he could. A sensible thing. And of course, one learned the hard way during the worst of economic times.

W.C. toured many cities and towns with his comedy act. And everywhere he went, he would open bank accounts to deposit his earnings, so that he always had some money handy no matter where he was. Of course, there was a problem after a while –  keeping track of where the cash was. It is said that when he died, there were a bunch of these accounts scattered around the country abandoned.

Well, that is what the Great Depression can do to you I suppose. You can never have enough cash stashed to feel a little secure.

If W.C. was alive today, he would surely love how easy it is to set up savings accounts and keep track of them – all from your phone!

I think I have that ‘insecurity’ gene that W.C. carried. I feel the constant need to put a few bucks away. For emergencies or unexpected needs.

So I have really embraced some of these financial services (banks, brokers, funds) that allow you to start with any amount (spare change really) to open an account, and then have regular deposits automatically pulled from your bank account – all before you see it or spend it.

I’m a firm believer it the ‘out of sight-out of mind’ approach to saving. So these services have allowed me to set up what I call little micro-accounts, all drawing little amounts out of my bank account, weekly and/or monthly. Its truly painless and I don’t even miss the money I’m saving because I set the amounts so low and it all happens automatically.

In short order, these accounts are now beginning to grow, which gives me further incentive to continue, or even increase these little savings programs.

The services I am using for this purpose are:

  •  Acorns. This service rounds-up to the next dollar all transaction activity in my bank account, and invests this spare change into a stock fund. So, for example, when I buy groceries and the charge is $34.75, Acorns with take $0.25 and move it into my little savings account with them. All they do is round up all my spending and save the difference for me automatically.
  •  Robinhood. This service allows me to buy stock with money I deposit in this account. No commissions too; except I suspect they take their cut from the price I pay for the stock. Anyway, I have been socking away a few dollars through an auto-deposit each week into this account, and buying stocks, even only 1 share, based on my own research, or impulse. I like this account because it allows me to but only a few shares so I can start to watch a stock before I really commit bigger amounts to it. And I must admit, I do occasional buy stocks on impulse, like LYFT after its IPO. Yikes! But at least the damage is contained.
  •  Marcus Bank (which is actually Goldman Sachs). This is a straight savings account which offers 2.15% (as of Aug. 1, 2019) interest on your savings. This is a better place to sock away my “safety net” money that leaving it in my regular bank with its 0.15% annual interest! So, again, I have set up a simply weekly automatic swept from my bank to this bank.

All three of these accounts were set up online and linked to my current bank account to pull out automatic investments and to draw back money should I need to. There are others, of course. These work for me for putting away money that might have been in a cookie jar in my kitchen. And, as I see the balances grow in these three accounts, it spurs me to add more and more savings to reach savings goals, which I continue to revise higher.

I think W.C. Fields would love this new way of saving.

 

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.

IPO’s – San Francisco Real Estate and Southern California

In March, a New York Times article observed that the rush of announced IPO’s, logjammed to go public in the second quarter of 2019, might have a staggering effect on the price of homes in the San Francisco area, where many of these companies are based.

Hundreds of Billions of Dollars could be unleashed as various “unicorns” (defined as $1 Billion plus private value companies) suddenly become liquid public companies, giving their insiders, and the local economy, an enormous windfall. Such companies on the docket, or expected, include Uber, Airbnb, Lyft, Pinterest among others. As of this writing, Uber, Lyft and Pinterest have gone public, along with several others. But more unicorn listings are still to come.

The Times article posits a few interesting expectations of this new money on a rather small slice of real estate:

  • Estimated 10,000 instant millionaires created, many will be looking to spend on an upgrade to their homes and cars (Tesla anyone?);
  • Average home prices could exceed $5 million in San Francisco (and I’ll bet that’s for a “tear-down” because its about the location, not the home itself that is being purchased);

The article further notes that these millennial buyers prefer to stay in the city where upscale eateries and entertainment abounds; thus reducing the geography in which buyers will hunt for homes.

So, the simple rules of supply and demand will surely drive up prices. Keeping pressure on the home market are the sellers, some of whom are holding houses off the market until after the IPO money flows.

As it is now, the article points out, the rental market is already red hot. The current average rent for a one bed / one bath flat ranges from $3,550 – $3,690 a month. Its no wonder that renters use the common space in apartments as an additional room to rent, in order to hold down the cost somewhat for all occupants. Even closets might be rented out! So I have heard first hand.

Look to Southern California Next:

My observations about this comes from my southern California home, and occasional business trips to the Bay. The high rents and limited office spaces and homes available in the San Francisco-Silicon Valley market has some start-ups and tech firms looking to the south to relocate or add new offices. The west side of Los Angeles-Santa Monica area has their own “Silicon Beach” scene with businesses such as Snap, Hulu, Google/YouTube among others making their mark in this “relatively” more affordable market.

But it doesn’t stop there. Continuing south on the 405 and you arrive at Irvine and the “OC” (Orange County), also attracting unicorns like Houzz.

And not to be left out, San Diego, all the way down the 5 near the border,  is already home to Qualcomm and its own tech “halo” effect, plus a host of biopharma companies, and is now seeing some of the fleeing Silicon Valley businesses add new campuses in the area, like Apple, in order to find convenient and affordable (again, a relative term) housing for workers, new local engineer talent (Qualcomm poaching); and a better quality of life. The extra sunshine and milder climate is an added bonus.

Commuting from Southern Cal:

It was only a matter of time before Silicon Valley would have to look beyond the Bay for business expansion. After all, flight from San Diego to San Jose, the hub for Silicon Valley, is a little over an hour, which is not that bad.

I used to make that “commute”, in my case flying up to San Jose on Mondays ands returning to San Diego on Fridays. I would see a lot of regulars on the same flights doing the same.

The difference this time is that more offices are locating in the various southern California coastal communities, reducing the need for regular commuters like this. It will be interesting to see it unfold.