Financial Analysis

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Financial management is based on building on a business’s strengths while striving to overcome its weaknesses.  Financial analysis helps answer questions such as:

  • Is the business improving from year to year?
  • Have we borrowed too much?
  • Are we making a decent return for our shareholders?

There are a huge number of ratios that can be calculated from a set of financial statements, but fortunately there are only a few that are really meaningful.  Ratios are based on the principle that patterns and trends emerge in business, which can be measured, interpreted, and used as guides for action.  One should also be aware that in order to compare the ratios of different companies with other companies, with their own history and with the industry averages, the ratios should be calculated in the same manner.  It is therefore important to ascertain how the ratios have been calculated.  It is not so much the detailed manner that is important in the calculation of ratios than it is the trend of a specific ratio.


The return on investment ratio

One ratio ranks far above all others in significance.  This is the return on investment (ROI) ratio, which measures the return earned by the shareholders of a business on the money they invest.  This investment which is sometimes referred to as TOTAL SHAREHOLDERS FUNDS consists of share capital and retained earnings.  This ratio measures the all-important business factor, earning power.

Analysts may use various other acronyms when referring to this measure:

  • Return on capital(ROC)
  • Return on net assets (RONA)
  • Return on shareholders’ funds(ROSF)

Ratio analysis requires comparison against trends. Standards of comparison are:

  • Comparisons of historic performance against current performance.
  • Comparison against budgets or forecasts.
  • Comparison with other firms.
  • Comparison with industry or national averages.

We do not have many published benchmarks for industry ratios in South Africa. A good source is the Bureau for Financial Analysis attached to the University of Pretoria Business School.


Ratios are classified under five headings:

  1. Profitability ratios, which measure the returns generated on sales and investment
  2. Liquidity ratios, which judge whether a business is likely to run out of cash in the short term
  3. Activity ratios, which measure how well the business is using its assets
  4. Leverage ratios, which measure the extent to which a business is using borrowed money
  5. Growth ratios, which measure the business’s rate of growth and assess the potential for future growth



Before calculating any ratio, consider what you would expect from the company being analysed, e.g. a company selling perishable commodities should have a rapid stock turnover.  Then match expectations to actual performance.  This may identify a company which is performing better than it was, but worse than it should be.

Look for a trend.  A comparison of two years is inconclusive; at least 3 years should be analysed.  Bear in mind the purpose for which the analysis is being done. Directors, bankers, creditors, and shareholders have different perspectives and use different ratios.

Ratio analysis is a theoretical exercise, often done without complete knowledge of trading conditions, company policy, etc.  As such, there are dangers to ratio analysis if it is done mechanically.  Some of these are:

  • Ratios can only isolate a problem; they cannot identify the cause.
  • Analysis is an historical exercise. It is meaningless unless it can give pointers to future performance.
  • Accounting policies can have a material influence on financial statements. When in doubt, ask for expert advice.  However, you must first understand your own company’s accounting policies.
  • Changes in accounting policies could materially affect comparisons from year to year.
  • Financial statements often show historical values for fixed assets such as property.  Take the possibility of re-valuation of assets into consideration.
  • There should be different expectations for ratios such as return on assets for companies, which have re-valued property opposed to those companies which have not valued property.
  • The financial year-end may coincide with a period of low activity.  This may not be a true reflection of a company’s business.


This section discusses the different measures of corporate profitability and financial performance.  These ratios, much like the operational performance ratios, give users a good understanding of how well the company utilized its resources in generating profit and shareholder value.

The long-term profitability of a company is vital for both the survivability of the company as well as the benefit received by shareholders.  It is these ratios that can give insight into the all important “profit.”  Bear in mind though, that profit does not equal cash, given your understanding of the cash flow statement.

In this section, we will look at four important profit margins, which display the amount of profit a company generates on its sales at the different stages of an income statement.  The last three ratios covered in this section – Return on Assets, Return on Equity, and Return on Capital Employed – explain how effective a company is at generating income from its resources.

Profitability ratios tell us how well a firm is being managed. The ultimate measure of a business’s success is the rate at which it makes profits from its activities.  Profitability is measured in three ways:

  • Relative to investment (i.e. for every Rand of shareholders’ money invested in the business, how much profit did we make?)
  • Relative to assets (i.e. for every Rand of assets of the business, how much profit did we make?)
  • Relative to sales (i.e. for every Rand of sales, how much profit did we make?)


In the income statement, there are four levels of profit or profit margins – gross profit, operating profit, pre-tax profit and net profit.  The term “margin” can apply to the absolute number for a given profit level and/or the number as a percentage of net sales/revenues.  Profit margin analysis uses the percentage calculation to provide a comprehensive measure of a company’s profitability on a historical basis (3-5 years) and in comparison to peer companies and industry benchmarks.

Basically, it is the amount of profit (at the gross, operating, pre-tax or net income level) generated by the company as a percent of the sales generated.  The objective of margin analysis is to detect consistency or positive/negative trends in a company’s earnings.  Positive profit margin analysis translates into positive investment quality.  To a large degree, it is the quality, and growth, of a company’s earnings that drive its share price.

In order to calculate the ratios, we will be using the financial statements of Pick ‘n Pay for the year ending 28 February 2007.


Gross Profit Margin = Gross Profit / Net Sales (Revenue)

Operating Profit Margin = Operating Profit (EBIT) / Net Sales (Revenue)Pre-tax Profit Margin = Profit Before Tax / Net Sales (Revenue)

Net Profit Margin = Profit After tax / Net Sales (Revenue)



Gross Profit Margin = 6 893.9 / 39 337.1 = 17.53%

Operating Profit Margin = 1 328.8 / 39 337.1 = 3.38%

Pre-tax Profit Margin = 1 205.3 / 39 337.1 = 3.06%

Net Profit Margin = 675.6 / 39 337.1 = 1.72%

All the Rand amounts in these ratios are found in the income statement of 2007 of Pick ‘n Pay.  As of February 28, 2007, with amounts expressed in millions, Pick ‘n Pay had net sales, or revenue, of R39 337.1, which is the denominator in all of the profit margin ratios.  The numerators for Pick ‘n Pay’s ratios are captioned as “gross profit”, “operating profit”, “profit before tax, and profit for the year, respectively.  By simply dividing, the equations give us the percentage profit margins indicated.

It is important to remember that these ratios by themselves mean very little.  You need to calculate the ratios for previous years as well and compare them, as well as against the budget figures set for the company, the industry averages, and the ratios for the competitors.






First, a few remarks about the mechanics of these ratios are in order.  When it comes to finding the relevant numbers for margin analysis, readers are reminded that the terms: “income,” “profits” and “earnings” are used interchangeably in financial reporting.  Also, the account captions for the various profit levels can vary, but generally are self-evident no matter what terminology is used.

Second, income statements in the multi-step format clearly identify the four profit levels. However, with the single-step format the investor must calculate the gross profit and operating profit margin numbers.

To obtain the gross profit amount, simply subtract the cost of sales from net sales/revenues.  The operating profit amount is obtained by subtracting the sum of the company’s operating expenses from the gross profit amount.  Generally, operating expenses would include such account captions as selling, marketing and administrative, research and development, depreciation and amortization, rental properties, etc.

Third, investors need to understand that the absolute numbers in the income statement don’t tell us very much, which is why we must look to margin analysis to discern a company’s true profitability.  These ratios help us to keep score, as measured over time, of management’s ability to manage costs and expenses and generate profits.  The success, or lack thereof, of this important management function is what determines a company’s profitability.  A large growth in sales will do little for a company’s earnings if costs and expenses grow disproportionately.

Lastly, the profit margin percentage for all the levels of income can easily be translated into a handy metric used frequently by analysts and often mentioned in investment literature.  The ratio’s percentage represents the number of cents there are in each Rand of sales. For example, using Pick ‘n Pay’s numbers, in every sales Rand for the company in 2007, there’s roughly 17.5 cents, 3.38 cents, 3.06 cents, and 1.72 cents of gross, operating, pre-tax, and net income, respectively.

Let’s look at each of the profit margin ratios individually:

Gross Profit Margin – A company’s cost of sales, or cost of goods sold, represents the expense related to labour, raw materials and manufacturing overhead involved in its production process.  This expense is deducted from the company’s net sales/revenue, which results in a company’s first level of profit, or gross profit. The gross profit margin is used to analyze how efficiently a company is using its raw materials, labour and manufacturing-related fixed assets to generate profits. A higher margin percentage is a favourable profit indicator.

Gross profit is the reverse of the mark-up, which is the percentage added to cost to obtain the selling price.

Industry characteristics of raw material costs, particularly as these relate to the stability or lack thereof, have a major effect on a company’s gross margin.  Generally, management cannot exercise complete control over such costs. Companies without a production process (e.g. retailers and service businesses) don’t have a cost of sales exactly.  In these instances, the expense is recorded as a “cost of merchandise” and a “cost of services,” respectively.

A company plans for its gross profit, by taking its cost of sales and adding to that, its margin.  Therefore, should it sell its goods at the determined price, it should deliver the gross profit margin as calculated.  Should this margin differ from the planned margin, various factors need to be investigated.  Reasons for these changes can include:

  • Theft of stock or cash sales.
  • Changes in sales mix.
  • Increases in discounts given to customers.
  • Stock write-offs.
  • Failure to pass on cost increases to customers.
  • Errors in stock count or stock valuation.

A gross profit percentage, which is consistent from year to year, may not in itself be acceptable.  Detailed analysis of gross profit by product line or by customer may indicate a dangerous bias toward unprofitable lines or exposure to a particular customer.

Irrespective of which of these factors played a role, the variance needs to be investigated, as it frequently reflects upon inventory that is stolen by customers and staff.  This happened to Shoprite a few years ago when about R100 million of inventory were stolen by management in collusion with suppliers.

Operating Profit Margin – By subtracting selling, general and administrative (SG&A), or operating, expenses from a company’s gross profit number, we get operating income.  Management has much more control over operating expenses than its cost of sales outlays.  Therefore investors need to scrutinize the operating profit margin carefully.  Positive and negative trends in this ratio are, for the most part, directly attributable to management decisions.

A company’s operating income figure is often the preferred metric (deemed to be more reliable) of investment analysts, versus its net income figure, for making inter-company comparisons and financial projections.

Pre-tax Profit Margin – Many investment analysts prefer to use a pre-tax income number for reasons similar to those mentioned for operating income.  A company has access to a variety of tax-management techniques, which allow it to manipulate the timing and magnitude of its taxable income.

Net Profit Margin – The so-called bottom line is the most often mentioned when discussing a company’s profitability.  While undeniably an important number, investors can easily see from a complete profit margin analysis that there are several income and expense operating elements in an income statement that determine a net profit margin.  It behoves investors to take a comprehensive look at a company’s profit margins on a systematic basis.


Management Accounts

Profit management is about:

  • A good system which captures , classifies and records transaction data
  • Measurement and analysis of profitability by product line, customer and geographic area
  • Regular and timely management reporting
  • Iron fisted management review and control

How to Manage With Your Management Accounts

Top executives use the review process to spark off discussions on a broad range of related topics.  Some learning points picked up from watching leading players in action:

  • Structure your management reports to show responsibility accounting
  • Spend your time on the big numbers first
  • Understand the key ratios, measures and benchmarks for this industry
  • Distinguish clearly between the hard and the soft numbers
  • Know where the fat is hidden
  • Quantify the link between capacity utilisation and profitability
  • Understand your breakeven economics
  • Distinguish clearly between expenses of today, yesterday, and of tomorrow
  • Understand your capital vs revenue policy
  • Look at the bases of stock and asset valuation (why do we do it this way?)
  • Distinguish between real profits and inflation (stock) profits
  • Show graphs instead of figures

The start point for analysing trading profitability is called common sizing.  In order to understand a company’s business model and determine trends, we restate the income statement figures relative to sales being 100, both horizontally and vertically.  For Pick ‘n Pay, such a common sized statement could look as follows (only selected figures – in practice this should be done for all the lines in the income statement):

2007 2006
Turnover 100% 100%
Cost of Sales 82.48 82.84
Gross Profit 17.52 17.16
Employee Costs 9.69 9.81
Trading Expenses 18.70 18.53
Merchandising and Admin 3.62 3.44
Operating Profit 3.38 3.14
Profit before Tax 3.06 3.10
Profit for the Year 1.72 2.00

Common Sizing


The common sized income statement provides an interesting angle to the stated figures.  Amongst others, this example shows that while the salaries of Pick ‘n Pay were increased by more than R400 million, the figure as a percentage of sales actually decreased from 9.81% of sales to 9.69% of sales.  This is an indication of an increase in the productivity of the people of Pick ‘n Pay, amongst others.  What other deductions can you derive from the above statement?  It is important to determine which line items are moving out of sync and to determine the reasons for this change and then to act upon your findings to redress any negative actions.

The common sized balance sheet of Pick ‘n Pay looks as follows:

2007 2006
Total Assets 100% 100%
Non-current assets 48.4% 45.6%
Property, equipment, vehicles 32.4% 27.7%
Current Assets 51.6% 54.4%
Inventory 30.4% 29.3%
Debtors 12.1% 11.1%
Cash 9.1% 14.0%
2007 2006
Total Equity & Liabilities 100% 100%
Shareholders’ Equity 13.0% 12.6%
Non-current Liabilities 11.5% 13.9%
Current Liabilities 75.5% 73.4%
Accounts Payable 71.9% 68.8%
Short-term Debt 0.7% 1.2%
Tax 2.9% 3.5%

From this common sized balance sheet it is clear that Pick ‘n Pay has been using creditors (accounts payable) as a major strategy in its capital structure.

What do the profitability ratios of Pick ‘n Pay look like for the previous two years, and how do they compare against the same ratios of Shoprite/Checkers and those of the industry?


Return on Assets

This ratio indicates how profitable a company is relative to its total assets. The return on assets (ROA) ratio illustrates how well management is employing the company’s total assets to make a profit.  The higher the return, the more efficient management is in utilizing its asset base.  The ROA ratio is calculated by comparing operating profit (EBIT) to average total assets, and is expressed as a percentage.



Return on Assets = EBIT / Average Total Assets (I prefer personally to use just that use figure and not the average of the last 2 years – it is just easier to calculate)



Return on Assets = 1254.6 / ((6766.9+7793)/2) = 17.23%

As of 28 February 2007, with amounts expressed in millions, Pick ‘n Pay had an EBIT of R1254.6 (income statement), and average total assets of R7279.95 (balance sheet). By dividing, the equation gives us an ROA of 17.23% for FY 2007.



Some investment analysts use the net income figure instead of the operating income figure when calculating the ROA ratio.


The need for investment in current and non-current assets varies greatly among companies.  Capital-intensive businesses (with a large investment in fixed assets) are going to be more asset heavy than technology or service businesses.

In the case of capital-intensive businesses, which have to carry a relatively large asset base, will calculate their ROA based on a large number in the denominator of this ratio.  Conversely, non-capital-intensive businesses (with a small investment in fixed assets) will be generally favoured with a relatively high ROA because of a low denominator number.

It is precisely because businesses require different-sized asset bases that investors need to think about how they use the ROA ratio.  For the most part, the ROA measurement should be used historically for the company being analyzed.  If peer company comparisons are made, it is imperative that the companies being reviewed are similar in product line and business type.  Simply being categorized in the same industry will not automatically make a company comparable.

As a rule of thumb, investment professionals like to see a company’s ROA come in at no less than 5%.  Of course, there are exceptions to this rule.  An important one would apply to banks, which strive to record an ROA of 3% or above.

How does the 2007 ROA figure of Pick ‘n Pay compare with that of the 2 years prior to 2007, as well as with the figure for Shoprite and the industry average?


Return on Equity

This ratio indicates how profitable a company is by comparing its net income to its average shareholders’ equity.  The return on equity ratio (ROE) measures how much the shareholders earned for their investment in the company.  The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better the return is to investors.


Return on Equity = Profit after tax / Average Shareholders’ Equity



Return on Equity = 675.6 / ((854.9+1015.4)/2) = 72.25%

As of 28 February 2007, with amounts expressed in millions, Pick ‘n Pay had net income of R675.6 (income statement), and average shareholders’ equity of R935.2 (balance sheet). By dividing, the equation gives us an ROE of 72.25% for FY 2007.  Pick ‘n Pay used headline earnings to calculate this figure and arrived at a ROE of 88.1%.


If the company has issued preferred stock, investors wishing to see the return on just common equity may modify the formula by subtracting the preferred dividends, which are not paid to common shareholders, from net income and reducing shareholders’ equity by the outstanding amount of preferred equity.



Widely used by investors, the ROE ratio is an important measure of a company’s earnings performance.  The ROE tells common shareholders how effectively their money is being employed.  Peer company, industry and overall market comparisons are appropriate; however, it should be recognized that there are variations in ROEs among some types of businesses.  In general, financial analysts consider return on equity ratios in the 15-20% range as representing attractive levels of investment quality.  Pick ‘n Pay and other food retail companies need to be seen in context.

While highly regarded as a profitability indicator, the ROE metric does have a recognized weakness.  Investors need to be aware that a disproportionate amount of debt in a company’s capital structure would translate into a smaller equity base. Thus, a small amount of net income (the numerator) could still produce a high ROE off a modest equity base (the denominator).

In the case of food retail companies such as Pick ‘n Pay and Shoprite, there is a big difference between the ROA and the ROE.  This is exactly what is referred to in the previous example.  Normally this would indicate a very high level of debt in the capital structure of the company.  In the food retail companies, however, it normally reflects upon the use of creditors as an important, and free, source of funding for the assets.

The lesson here for investors is that they cannot look at a company’s return on equity in isolation.  A high, or low, ROE needs to be interpreted in the context of a company’s debt-equity relationship.  The answer to this analytical dilemma can be found by using the return on capital employed (ROCE) ratio.

The Return on Capital Employed

The return on capital employed (ROCE) ratio, expressed as a percentage, complements the return on equity (ROE) ratio by adding a company’s debt liabilities, or funded debt, to equity to reflect a company’s total “capital employed”.  This measure narrows the focus to gain a better understanding of a company’s ability to generate returns from its available capital base.

By comparing net income to the sum of a company’s debt and equity capital, investors can get a clear picture of how the use of leverage impacts a company’s profitability.  Financial analysts consider the ROCE measurement to be a more comprehensive profitability indicator because it gauges management’s ability to generate earnings from a company’s total pool of capital.


ROCE = Net Income / Capital Employed

Capital Employed = Average Debt Liabilities + Average Shareholders’ Equity


ROCE = 675.6 / (((826.8+817.7)/2) + ((1015.4+854.9)/2)) = 38.4%

As of 28 February 2007, with amounts expressed in millions, Pick ‘n Pay had net income of R675.6 (income statement).  The company’s average short-term and long-term borrowings were R822.25 and the average shareholders’ equity was R935.15 (all the necessary figures are in the 2007 balance sheet), the sum of which, R1757.4 is the capital employed. By dividing, the equation gives us an ROCE of 38.4% for FY 2007.



Often, financial analysts will use operating income (EBIT) as the numerator.  There are various takes on what should constitute the debt element in the ROCE equation, which can be quite confusing.  Our suggestion is to stick with debt liabilities that represent interest-bearing, documented credit obligations (short-term borrowings, current portion of long-term debt, and long-term debt) as the debt capital in the formula.



The return on capital employed is an important measure of a company’s profitability.  Many investment analysts think that factoring debt into a company’s total capital provides a more comprehensive evaluation of how well management is using the debt and equity it has at its disposal.  Investors would be well served by focusing on ROCE as a key, if not the key, factor to gauge a company’s profitability.  An ROCE ratio, as a very general rule of thumb, should be at or above a company’s average borrowing rate.

Unfortunately, there are a number of similar ratios to ROCE, as defined herein, that are similar in nature but calculated differently, resulting in dissimilar results.

  • First, the acronym ROCE is sometimes used to identify return on common equity, which can be confusing because that relationship is best known as the return on equity or ROE.
  • Second, the concept behind the terms return on invested capital (ROIC) and return on investment (ROI) portends to represent “invested capital” as the source for supporting a company’s assets.  However, there is no consistency to what components are included in the formula for invested capital, and it is a measurement that is not commonly used in investment research reporting.


You can improve a company’s profitability in two ways, i.e. by selling more and spending the same or selling the same whilst spending less. According to Norton and Kaplan, this translates into improving a company’s financial performance by revenue growth and/or productivity.

In order to generate profitable revenue growth, companies can:

  • Deepen their relationships with their existing customers, enabling increased- and cross sales.
  • Offer new products.
  • Sell to customers in other/new segments.

Productivity improvements can be achieved through:

  • Reducing costs by lowering direct and indirect expenses.
  • More efficient use of financial and physical assets in order to reduce fixed and working capital needs.


Your business must be able to meet its short-term debts when they fall due.  Many profitable businesses have failed because they grant too much credit to customers and then cannot pay salaries and suppliers without going over their overdraft limits.  Bankers are paid to ensure that their clients can repay their loans, and so can be expected to be conservative in their lending.

Two financial ratios, the Current Ratio and the Acid Test ratio (also referred to as the quick ratio), were developed by bankers in America early in the last century, as criteria for lending money.  The benchmarks were: a Current ratio of 2:1 and an Acid Test ratio of 1:1, but the acceptable ratio will vary depending on the type of industry in which your company operates, and the banker’s judgement of the realisability of your stocks and debtors.

  • Current Ratio: Current Assets / Current Liabilities
  • Acid Test Ratio: (Current Assets – Stock) / Current Liabilities

Current Ratio

In a liquidity crisis, the banks normally first issue a warning to reduce the overdraft to acceptable levels.  To do this, a emergency reduction in stock and debtors is often required.  At 2: 1, the current ratio represents a 50% (1:2) discount on the face value of stock and debtors under duress.  Bankers would thus judge a 3:1 current ratio to be safer than a 2:1 ratio, all things being equal.  However, we need to see this ratio in the context of the industry in which the company finds itself.

The logic of the current ratio is based on security, and is in direct conflict with normal business practice, where we want to operate with a minimum level of stocks and debtors.  Guard against accepting the current ratio as being the ultimate test for liquidity.  When one identifies the component elements of the current ratio, it is obvious that it can be increased by increasing debtors and/or stock, both which could be bad for cash flow.  One therefore needs to look at the current ratio in context.

In practice, the current ratio reflects your business model and terms of trade.

The current ratio is a popular financial ratio used to test a company’s liquidity (also referred to as its current or working capital position) by deriving the proportion of current assets available to cover current liabilities.

The concept behind this ratio is to ascertain whether a company’s short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes). In theory, the higher the current ratio, the better.  The data for the calculation of both the current ratio and the acid test ratio is derived from the balance sheet, and more specifically the current assets and the current liabilities.


Current Ratio = Current Assets / Current Liabilities


Current Ratio = R4020.2 / R5882.5 = 0.68

As of 28 February 2007, with amounts expressed in millions, Pick ‘n Pay’s current assets amounted to R4 020.2 (balance sheet), which is the numerator; while current liabilities amounted to R5882.5 (balance sheet), which is the denominator. By dividing, the equation gives us a current ratio of 0.68.



The current ratio is used extensively in financial reporting. However, while easy to understand, it can be misleading in both a positive and negative sense – i.e., a high current ratio is not necessarily good, and a low current ratio is not necessarily bad (see chart below).

Here’s why: Contrary to popular perception, the current ratio, as an indicator of liquidity, is flawed because it’s conceptually based on the liquidation of all of a company’s current assets to meet all of its current liabilities. In reality, this is not likely to occur.  Investors have to look at a company as a going concern.  It is the time it takes to convert a company’s working capital assets into cash to pay its current obligations that is the key to its liquidity. In a word, the current ratio can be misleading.

A simplistic, but accurate, comparison of two companies’ current position will illustrate the weakness of relying on the current ratio or a working capital number (current assets minus current liabilities) as a sole indicator of liquidity:

Company ABC Company XYZ
Current Assets R600 R300
Current Liabilities R300 R300
Working Capital R300 R0
Current Ratio 2.0 1.0

Company ABC looks like an easy winner in a liquidity contest.  It has an ample margin of current assets over current liabilities, a seemingly good current ratio, and working capital of R300. Company XYZ has no current asset/liability margin of safety, a weak current ratio, and no working capital.

However, to prove the point, what if: (1) both companies’ current liabilities have an average payment period of 30 days; (2) Company ABC needs six months (180 days) to collect its account receivables, and its inventory turns over just once a year (365 days); and (3) Company XYZ is paid cash by its customers, and its inventory turns over 24 times a year (every 15 days).

In this contrived example, Company ABC is very illiquid and would not be able to operate under the conditions described. Its bills are coming due faster than its generation of cash. You can’t pay accounts with working capital; you pay accounts with cash!  Company’s XYZ’s seemingly tight current position is, in effect, much more liquid because of its quicker cash conversion.  Company XYZ is a proxy for the food retail companies such as Pick ‘n Pay and Shoprite/Checkers.

When looking at the current ratio, it is important that a company’s current assets can cover its current liabilities; however, investors should be aware that this is not the whole story on company liquidity.  Try to understand the types of current assets the company has and how quickly these can be converted into cash to meet current liabilities. This important perspective can be seen through the cash conversion cycle (See the section on Activity Ratios).

By digging deeper into the current assets, you will gain a greater understanding of a company’s true liquidity.

Let’s get back to the current ratio of Pick ‘n Pay for 2007.  The norm has been stated as 2.  The idea is that it leaves the company with the same amount than the current liabilities once it has paid off its current liabilities, to be used as working capital.  Food retail companies are unique.  They do not have debtors as they work on a cash basis.  They also sell off their stock quite fast.  They then take up to 60 days on average to pay their creditors.  This means they have no working capital requirement.  Indeed, we will later see they use creditors to finance a substantial portion of their assets.  It also means that they get away with a current ratio of less than 1, and are still in a great liquidity position, contrary to popular belief.

What does the current ratio for the previous two years look like for Pick ‘n Pay and how does this compare with the industry average and with the ratio for Shoprite/Checkers?  What components in the current assets and current liabilities changed to bring about the change in the current ratio, and what does this mean for the company in general?


The Acid Test Ratio

The quick ratio – aka the quick assets ratio or the acid-test ratio – is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities.  The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash.  Therefore, a higher ratio means a more liquid current position.


Acid Test Ratio = (Current Assets – Stock) / Current Liabilities




Quick Ratio = (4020.2 – 2367.4) / 5882.5 = 0.28

As of 28 February 2007, with amounts expressed in millions, Pick ‘n Pay’s’ quick assets amounted to R1652.8 (balance sheet); while current liabilities amounted to R5882.5 (balance sheet). By dividing, the equation gives us a quick ratio of 0.28.


Some presentations of the quick ratio calculate quick assets (the formula’s numerator) by simply subtracting the inventory figure from the total current assets figure. The assumption is that by excluding relatively less-liquid (harder to turn into cash) inventory, the remaining current assets are all of the more-liquid variety. Generally, this is close to the truth, but not always.

XYZ Holdings is a good example of what can happen if you take the aforementioned “inventory shortcut” to calculating the quick ratio:

Standard Approach: R233.2 plus R524.2 = R756 ÷ R606.9 = 1.3

Shortcut Approach: R1,575.6 minus R583.7 = R991.9 ÷ R606.9 = 1.6

Restricted cash, prepaid expenses and deferred income taxes do not pass the test of truly liquid assets. Thus, using the shortcut approach artificially overstates XYZ Holdings’ more liquid assets and inflates its quick ratio.



As previously mentioned, the quick ratio is a more conservative measure of liquidity than the current ratio as it removes inventory from the current assets used in the ratio’s formula.  By excluding inventory, the quick ratio focuses on the more-liquid assets of a company.

The basics and use of this ratio are similar to the current ratio in that it gives users an idea of the ability of a company to meet its short-term liabilities with its short-term assets.  Another beneficial use is to compare the quick ratio with the current ratio.  If the current ratio is significantly higher, it is a clear indication that the company’s current assets are dependent on inventory.  In the case of Pick ‘n Pay, the current ratio was 0.68, with the quick ratio 0.28.  This is an indication that inventory is a major component of current assets.

While considered more stringent than the current ratio, the quick ratio, because of its accounts receivable component, suffers from the same deficiencies as the current ratio – albeit somewhat less. To understand these “deficiencies”, readers should refer to the commentary section of the Current Ratio.  In brief, both the quick and the current ratios assume a liquidation of accounts receivable and inventory as the basis for measuring liquidity.

While theoretically feasible, as a going concern a company must focus on the time it takes to convert its working capital assets to cash – that is the true measure of liquidity.  Thus, if accounts receivable (debtors), as a component of the quick ratio, have, let’s say, a conversion time of several months rather than several days, the “quickness” attribute of this ratio is questionable.

Investors need to be aware that the conventional wisdom regarding both the current and quick ratios as indicators of a company’s liquidity can be misleading.


The Cash Ratio

The cash ratio is an indicator of a company’s liquidity that further refines both the current ratio and the quick ratio by measuring the amount of cash, cash equivalents, or invested funds there are in current assets to cover current liabilities.


Cash Ratio = (Cash + Cash equivalents + Invested Funds) / Current Liabilities



Cash Ratio = 709.1 / 5882.5 = 0.121

As of December 31, 2008, with amounts expressed in millions, Pick ‘n Pay’s cash assets amounted to R709.1 (balance sheet); while current liabilities amounted to R5882.5 (balance sheet).  By dividing, the equation gives us a cash ratio of 0.121.



The cash ratio is the most stringent and conservative of the three short-term liquidity ratios (current, quick and cash).  It only looks at the most liquid short-term assets of the company, which are those that can be most easily used to pay off current obligations.  It also ignores inventory and receivables, as there are no assurances that these two accounts can be converted to cash in a timely matter to meet current liabilities.

Very few companies will have enough cash and cash equivalents to fully cover current liabilities, which is not necessarily a bad thing, so do not focus on this ratio being above 1:1.

The cash ratio is seldom used in financial reporting or by analysts in the fundamental analysis of a company.  It is not realistic for a company to purposefully maintain high levels of cash assets to cover current liabilities.  The reason being that it’s often seen as poor asset utilization for a company to hold large amounts of cash on its balance sheet, as this money could be returned to shareholders or used elsewhere to generate higher returns.  While providing an interesting liquidity perspective, the usefulness of this ratio is limited.


Methods of Improving Cash Flow

  • Tighter credit terms (Less time for your debtors to pay your invoice)
  • Reduce stock levels
  • Delay payment to suppliers
  • Forecast cash flows
  • Invoice promptly
  • Improve supplier contract terms
  • Expense controls
  • Regular deposits


The ratios which measure how well a firm uses its assets, all involve comparison between the level of sales and the investment in various asset accounts, particularly current assets.

Every business should try to minimise the value of assets it uses to generate income i.e. generate more turnover, using less assets.  By doing so it will:

  • reduce borrowings
  • reduce interest charges
  • increase return on capital

It would have been great to do everything without the need for any investment in any asset.  However, the real world does not work that way, and companies therefore need to ensure that they optimise the productivity of their assets.

Asset turn ratio

The overall measure of asset efficiency is the ratio of Sales to Total Assets.  This figure shows the amount of sales the company can generate for every R1 in total assets.  By analysing the trend of this ratio, one can determine whether the assets the company is acquiring are productive assets or not, or whether it is taking some time for the assets to kick in.

Formula:                Turnover / Total Assets

Components:                   39 337.1 / 7 793.0 = 5.05

Variation: Some analysts use Fixed Assets in the denominator rather than total assets.

Commentary:  This figure indicates that for every R1 in total assets, Pick ‘n Pay has generated turnover to the value of R5.05.  This is an indication that Pick ‘n Pay is not a capital intensive company, as the mining groups and groups that include hotel chains, are much more capital intensive and require much more assets to generate similar levels of turnover.   It is therefore important to understand the industry the company is competing in before any judgement is made on the basis of this ratio.

This ratio would show that new assets acquired either are kicking in, or are late at kicking in, or will never kick in and should not have been acquired in the first place.

Debtors Period (see cash conversion cycle)

The tool for measuring debtor efficiency is the DEBTORS AGE ANALYSIS.  Factors that may alert an experienced credit controller to potential default include:

  • Amounts in excess of allowed terms i.e. over 30 days
  • Amounts in excess of credit limit
  • Payments in round amounts
  • Excessive queries and delays
  • Rapidly growing purchases
  • Swings (high-lows) in purchase patterns
  • Customer operates in a risky industry

Many people are most comfortable expressing their outstanding debtors in terms of a TIME-RELATED benchmark e.g. a 45-day book. The ratio can be calculated in various ways.

These ratios should be considered relative to the firm’s standard credit terms

Creditors Period (see cash conversion cycle)

This period refers to the number of days you take to pay your creditors.  It is good cash management to extend this period as long as possible.  However, it is not always easy to do this, as your suppliers might be very large and influential.  They could therefore dictate credit terms and you would have no other option but to comply.  Companies such as Pick ‘n Pay would have some suppliers that they would need to pay soon, whilst there would be others that they would take quite a while to pay.  It is never a good thing to pay an invoice on receipt, but rather to wait and pay on the date specified.

Stock management ratios (see cash conversion cycle)

There are significant costs associated with holding excess stock.

  • Warehousing – rent , systems , staff , equipment
  • Interest – on money tied up in stocks
  • Insurance
  • Obsolescence , wastage , shrinkage (theft of stock by employees and customers)

These costs are normally not easy to identify as they are either included under general headings (like salaries) or not specifically highlighted (physical stock counts, thereby automatically excluding shrinkage).

Many private companies are handicapped when evaluating stock efficiency due to lack of timely, regular and accurate information. Factors which adversely affect stock turn are:

  • Bad buying (buying stock that customers don’t want – poor merchandising)
  • Poor storekeeping
  • Accumulation of slow moving product lines
  • Poor co-ordination between sales and production
  • Slow delivery e.g. imports
  • Depressed trading conditions

Raw materials, work in progress and finished goods can be analysed separately.  This is relevant to manufacturing companies.

Significant advances have been made in stock reduction through applied logistics and related approaches such as Just-in-time and World Class Manufacturing.


Just-in-time & Elimination of waste

Just In Time can be summed up as an all-out attack on waste. Seven major categories of waste are recognised:

  • Processing operations which add no value to a product
  • Inventory in excess of immediate needs
  • Over-production to keep people or machines busy
  • Transportation beyond minimum requirements
  • Unnecessary motions by people or equipment
  • Waiting and delays
  • Defective materials at all stages of production

The law of large numbers:

From a financial viewpoint, stock management should concentrate on your high value items.


The working capital cycle

This is the ratio analysts use to review the overall effectiveness of your working capital management.  It combines the 3 major elements, namely stock, debtors and creditors, which were described above.  Reducing the working capital cycle is one of the most effective ways of raising money for your business. Reduction in stocks and debtors can have dramatic and unexpected beneficial results, impacting profits, overdrafts and return on investment.

Other ways in which a business can raise money are:

  • Making profits
  • Issuing shares
  • Borrowing money
  • Selling assets
  • Calling in loans previously granted



This liquidity metric expresses the length of time (in days) that a company uses to sell inventory (inventory period or stock period), collect receivables (debtors period or accounts receivable period), and pay its accounts payable (creditors period).  The cash conversion cycle (CCC) measures the number of days a company’s cash is tied up in the production and sales process of its operations and the benefit it gets from payment terms from its creditors.  The shorter this cycle, the more liquid the company’s working capital position is. The CCC is also known as the “cash” cycle.


Debtor’s Period + Stock Period – Creditor’s Period.

The Debtor’s Period + Stock Period is an indication of the duration of your operating period.



DIO (stock period) is computed by:

  1. Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure;
  2. Calculating the average inventory figure by adding the year’s beginning (previous yearend amount) and ending inventory figure (both are in the balance sheet) and dividing by 2 to obtain an average amount of inventory for any given year; and
  3. Dividing the average inventory figure by the cost of sales per day figure.

For Pick ‘n Pay’s FY 2007 (in R millions), its DIO would be computed with these figures:

(1) cost of sales per day 32443.2 ÷ 365 = 88.885
(2) average inventory 2007 1984.2+2367.4 = 4351.6 ÷ 2 = 2175.8
(3) days inventory outstanding 2175.8 ÷ 88.885 = 24.48 days

DIO gives a measure of the number of days it takes for the company’s inventory to turn over, i.e., to be converted to sales, either as cash or accounts receivable.

An alternative method is to use the following formula:

Stock Period = (Average Stock*365)/Cost of Sales

= ((1984.2+2367.4)/2) * 365) / 32443.2

= 24.48 days

I personally use the latter method as it is far easier for me to do so.

DSO (debtors period) is computed by:

  1. Dividing net sales (income statement) by 365 to get a net sales per day figure;
  2. Calculating the average accounts receivable figure by adding the year’s beginning (previous yearend amount) and ending accounts receivable amount (both figures are in the balance sheet) and dividing by 2 to obtain an average amount of accounts receivable for any given year; and
  3. Dividing the average accounts receivable figure by the net sales per day figure.

For Pick ‘n Pay’s FY 2007 (in R millions), its DSO would be computed with these figures:

(1) net sales per day 39337.1 ÷ 365 = 107.773
(2) average accounts receivable 750.7 + 943.7 = 1694.4 ÷ 2 = 847.2
(3) days sales outstanding 847.2 ÷ 107.773 = 7.861

DSO gives a measure of the number of days it takes a company to collect on sales that go into accounts receivables (credit purchases).

An alternative method to calculate the debtor’s period is by using the following formula:

Debtor’s period = (Average debtors * 365) / Net Sales

= ((750.7+943.7)/2) * 365 / 39337.1

= 7.86 days

This figure is interesting for Pick ‘n Pay as it sells strictly on cash.  This figure represents therefore the period it takes for Pick ‘n Pay to collect money due to them from suppliers for rebates, etc.

DPO (creditors period) is computed by:

  1. Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure;
  2. Calculating the average accounts payable figure by adding the year’s beginning (previous yearend amount) and ending accounts payable amount (both figures are in the balance sheet), and dividing by 2 to get an average accounts payable amount for any given year; and
  3. Dividing the average accounts payable figure by the cost of sales per day figure.

For Pick ‘n Pay’s FY 2007 (in R millions), its DPO would be computed with these figures:

(1) cost of sales per day 32443.2 ÷ 365 = 88.885
(2) average accounts payable 4654.1 + 5605.4 = 10259.5 ÷ 2 = 5129.75
(3) days payable outstanding 5129.75 ÷ 88.885 = 57.71

DPO gives a measure of how long it takes the company to pay its obligations to suppliers.

An alternative method to calculate the creditors’ period would be to use the following formula:

Creditor’s Period = (Average creditors * 365) / Cost of Sales

= (5129.75 * 365) / 32443.2

=57.71 days

One sees here the beauty of the food retail industry at work.  It sells on a strictly for cash basis and turns its stock over every 25 days.  Yet on average, they take 58 days to pays their creditors.

CCC computed:

Pick ‘n Pay’s cash conversion cycle for FY 2007 would be computed with these numbers (rounded):

DIO 25 days
DSO +8 days
DPO -58 days
CCC -25 days


The negative number indicates that Pick ‘n Pay has no need for any additional external sources of working capital as it funds its operating cycle with creditors.  This also indicates that it can basically grow at any rate it wants to without any fear of running into working capital problems.  This is typical of the food retail industry.  How would this compare with the situation in the retail clothing industry where Edcon is a major player?



Often the components of the cash conversion cycle – DIO, DSO and DPO – are expressed in terms of turnover as a times (x) factor. For example, in the case of Pick ‘n Pay, its days inventory outstanding of 25 days would be expressed as turning over 14.6x annually (365 days ÷ 25 days = 14.6 times). However, actually counting days is more literal and easier to understand when considering how fast assets turn into cash.


An often-overlooked metric, the cash conversion cycle is vital for two reasons.

First, it’s an indicator of the company’s efficiency in managing its important working capital assets;

Second, it provides a clear view of a company’s ability to pay off its current liabilities.  It does this by looking at how quickly the company turns its inventory into sales, and its sales into cash, which is then used to pay its suppliers for goods and services. Again, while the quick and current ratios are more often mentioned in financial reporting, investors would be well advised to measure true liquidity by paying attention to a company’s cash conversion cycle.

The longer the duration of inventory on hand and of the collection of receivables, coupled with a shorter duration for payments to a company’s suppliers, means that cash is being tied up in inventory and receivables and used more quickly in paying off trade payables.  If this circumstance becomes a trend, it will reduce, or squeeze, a company’s cash availabilities.  Conversely, a positive trend in the cash conversion cycle will add to a company’s liquidity.

By tracking the individual components of the CCC (as well as the CCC as a whole), an investor is able to discern positive and negative trends in a company’s all-important working capital assets and liabilities.

For example, an increasing trend in DIO could mean decreasing demand for a company’s products.  Decreasing DSO could indicate an increasingly competitive product, which allows a company to tighten its buyers’ payment terms.

As a whole, a shorter CCC means greater liquidity, which translates into less of a need to borrow, more opportunity to realize price discounts with cash purchases for raw materials, and an increased capacity to fund the expansion of the business into new product lines and markets. Conversely, a longer CCC increases a company’s cash needs and negates all the positive liquidity qualities just mentioned.


Current Ratio versus the CCC

The obvious limitations of the current ratio as an indicator of true liquidity clearly establish a strong case for greater recognition, and use, of the cash conversion cycle in any analysis of a company’s working capital position.

Nevertheless, corporate financial reporting, investment literature and investment research services seem to be stuck on using the current ratio as an indicator of liquidity.  The current ratio seems to occupy a similar position with the investment community regarding financial ratios that measure liquidity.  However, it will probably work better for investors to pay more attention to the cash-cycle concept as a more accurate and meaningful measurement of a company’s liquidity.




Before discussing the various financial debt ratios, we need to clear up the terminology used with “debt” as this concept relates to financial statement presentations.

There are two types of liabilities – operational and debt.  The former includes balance sheet accounts, such as accounts payable, accrued expenses, taxes payable, pension obligations, etc.  The latter includes notes payable and other short-term borrowings, the current portion of long-term borrowings, and long-term borrowings.  Often, in investment literature, “debt” is used synonymously with total liabilities.  In other instances, it only refers to a company’s indebtedness.

The debt ratios that are explained herein are those that are most commonly used.  However, what companies, financial analysts and investment research services use as components to calculate these ratios is far from standardized.  In the definition paragraph for each ratio, no matter how the ratio is titled, we will clearly indicate what type of debt is being used in our measurements.


Getting the Terms Straight

In general, debt analysis can be broken down into three categories, or interpretations: liberal, moderate and conservative.  Since this language will be used in the commentary paragraphs, it’s worthwhile explaining how these interpretations of debt apply.

  • Liberal – This approach tends to minimize the amount of debt. It includes only long-term debt as it is recorded in the balance sheet under non-current liabilities.
  • Moderate – This approach includes current borrowings (notes payable) and the current portion of long-term debt, which appear in the balance sheet’s current liabilities; and, of course, the long-term debt recorded in non-current liabilities previously mentioned.  In addition, redeemable preferred stock, because of its debt-like quality, is considered to be debt.  Lastly, as general rule, two-thirds (roughly one-third goes to interest expense) of the outstanding balance of operating leases, which do not appear in the balance sheet, are considered debt principal.  The relevant figure will be found in the notes to financial statements and identified as “future minimum lease payments required under operating leases that have initial or remaining non-cancel-able lease terms in excess of one year.”
  • Conservative – This approach includes all the items used in the moderate interpretation of debt, as well as such non-current operational liabilities such as deferred taxes, pension liabilities and other post-retirement employee benefits.



Leverage measures the funds supplied by shareholders relative to the funds supplied by lenders.  If owners supply only a small portion of total funds, the risks of the business are borne mainly by outsiders.  By borrowing from outsiders, the owners can maintain control with a relatively limited investment.  Also, if a business earns more on borrowed money than it has to pay out in interest, the return to the owners is magnified.  This effect, which is known as GEARING, is shown in the following example.

  • Company has R100 to invest and it uses this asset to generate a profit of R30.  It therefore has a return on investment of 30%.
  • Company B only has R10.  It borrows R90 at 15% interest.  It also generates a profit of R30, of which it has to use R13.50 to pay the interest.  Given that it only used R10 of its own money, the return is 165% (16.50/10* 100).

Which company is better?

Although profits are lower for Company B (it has to pay interest on the loan), the return on shareholders’ investment is nearly 5 times greater due to the gearing!  This happened because the company was able to borrow at 15% to earn a return of 33% on the funds borrowed.  Can you show this calculation?

There is a risk attached to excessive gearing, however.  Assume in the following year the profit before interest dropped to nil. The balance sheet at the end of that year will show a considerable shortfall as the company would still need to pay the interest in spite of having made no profit!

Firms with low outside borrowings have less risk of loss in bad economic times, but have lower expected returns in good times.  Conversely, firms with high outside borrowings run the risk of large losses but have a chance of making much higher profits.  Decisions about gearing must always balance higher returns against increased risk.  In deciding the extent to which a company should borrow, assessment of BUSINESS RISK is most important.  Debt is always cheaper than shareholders money.  Shareholders require an after tax return at least equal to what they can get on an equally risky investment – currently around 20% after tax.  The after tax cost of debt is currently around 10-11%.

However, the more risky you are (i.e. the more likely your profits are to fluctuate from year to year), the greater the risk to the lender that you will be unable to meet your obligations in bad times. The penalty for this is insolvency.

In deciding whether and how much to lend you, bankers will consider:

  • Consistency of profits past and future.
  • Economic environment anticipated and its effect on your business.
  • Market environment.
  • Customer loyalty.
  • Impact of technological change.
  • Existing fixed financial commitments – HP’s, loans, fixed charges.
  • Growth prospects.

The Total 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.


Total Debt Ratio = (Total Assets – Equity) / Total Assets



Total Debt Ratio = (7793-1015.4) / 7793 = = 87%

As of 28 February 2007, with amounts expressed in millions, Pick ‘n Pay had total liabilities of R6777.6 (balance sheet) and total assets of R7793 (balance sheet).  By dividing, the equation provides the company with a seemingly high percentage of leverage as measured by the debt ratio.

Again, this figure should be seen in context, as the food retail industry is unique in this regard.  Do you agree and can you explain why I am saying this?





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 they are not really “debt” 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.  It is therefore that one also finds an interest-bearing debt ratio.  What would this ratio look like for Pick ‘n Pay?


Interest-bearing debt ratio: Interest-bearing debt / Total assets

= (181.8 + 51.6) / 7793

= 2.99%

In this instance I elected to leave out the operating lease liability from the definition of debt.  The interest-bearing debt ratio of 3% compared to the total debt ratio of 87%, tells us that the real debt position of Pick ‘n Pay is negligible.  Again the reason for this must be looked for in the large portion of creditors that food retail companies have that they use to fund their assets.

Even if we were more conservative and included the operating lease liability as a debt, the ratio would only increase to 10.5%, which is very far removed from the 87% total debt ratio.

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. 

The debt/equity ratio

This ratio is the traditional gearing ratio and measures the relative contributions of lenders and owners to the firm’s total financing.  Acceptable ratios for bankers are currently between 1:1 (for strong companies) and 1:5:1 for the rest.  Again this will be determined in the final instance by the industry within which the company operates.

The debt-equity ratio is really a measure of security – a 1:1 ratio represents a 50% discount on asset value on liquidation.

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 percentage means that a company is using less leverage and has a stronger equity position.  This reduces the risk, but does deny the company the opportunity to capitalise on the leverage effect of debt.


Debt-Equity Ratio = (Total Assets – Equity) / Equity



Debt – Equity Ratio = 6777.6 / 1015.4 = 6.68

As of 28 February 2007, with amounts expressed in millions, Pick ‘n Pay had total liabilities of R6777.6 (balance sheet) and total shareholders’ equity of R1015.4 (balance sheet). By dividing, the equation provides the company with a relatively low measure of leverage as measured by the debt-equity ratio.



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 from heavy acquisition activity can end up with a negative equity position.


What does goodwill refer to? It basically refers to the premium above the intrinsic value of the assets purchased.  You buy a company for R100 million.  The assets are worth R60 million.  Goodwill is R40 million.



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.

What do the debt-equity ratios for Pick ‘n Pay look like for the previous 2 years, and how do they compare with those of Shoprite and the industry?




The Interest Cover Ratio

In recent years another ratio has developed to measure a company’s borrowing ratios, based on profit rather than balance sheet structure. It is called the Interest Cover ratio and is calculated as follows:

Interest cover ratio = Profit before interest and tax paid / Interest paid

An interest cover of 6 times for example, means that profits would have to decline 6 times before the business would be unable to pay its interest out of profits. A healthy interest cover is 5 or 6 times. The lower the ratio, the greater the cause for concern.

The reason why EBIT is used, is that the interest burden is tax deductible.

Component: 1328.8 / 49.3 = 26.9


This figure is a clear indication that Pick ‘n Pay is a very healthy company and that it has very little interest-bearing debt.  This ratio therefore provides a better scenario of the leverage position of Pick ‘n Pay than the Total Debt Ratio or the Debt/Equity Ratio.

Also remember that EBIT is a profit measure and not a cash measure.  The true ability of the company to pay its interest burden can be significantly different from that indicated by the Interest Cover.  See the page on Cash Flow.

Should a company have a poor leverage scenario, it can take the following steps to rectify a weak cash flow to total debt ratio:

  • Avoid expansion (which normally increases gearing).
  • Increase margins even at lower volumes.
  • Concentrate on profitable lines.
  • Trim overheads.
  • Raise additional capital.

Businesses heading for failure will exhibit many of the following symptoms:

1.       Bad management

  • Autocratic chief executive
  • Chief executive is also chairman
  • Unbalanced skill and knowledge on the board
  • Passive or weak board
  • Weak finance director
  • Lack of professional managers / unprofessional management practices

2.       Poor systems and lack of control

  • Management accounts presented too late for action
  • Bad cash flow forecasting
  • Weak budgeting and cost control
  • No costing systems – don’t know product and customer profitability
  • Poor corporate governance

3. Poor response to change , particularly not understanding changes in customer wants

4.       Expanding faster than cash availability (over trading)

5.       Borrowing too much money (loans, bank overdraft and creditors)

6.       Big project not working out

7.       Symptoms

  • Deteriorating ratios and / or window dressing the accounts
  • Resignations , rumours , poor morale
  • Decline in product quality


The DuPont Analysis is a wonderful synthesis of the different ratios to end up with the Return on Equity (ROE).  When one is confronted with the ROE on its own, it can de a bit daunting to identify what issues need to be addressed in order to manage the ROE upwards.  The DuPont Analysis provides a more comprehensive view of the component parts of the ratio.


Based on this Figure, it is clear that ROE is driven by the following factors:

  • Operating profitability of the company
    • Driven by sales volume and price
    • Cost of Sales and purchasing price
    • Operating Expenses – they need to be optimised
  • The asset productivity of the company, as indicated by the Asset Turnover
    • Assets need to be sweated
    • This includes formulating optimal policies regarding debtors, stock, and creditors
    • Fixed asset investments also need to be optimised
  • The gearing of the company
    • The capital structure of the company must be optimised
    • The interest rate regime needs to be monitored continuously
  • The ability to utilise non-interest bearing debt, as indicated by the financial cost ratio
  • The ability to manage the company’s tax base to minimise its taxable income.


A more elabourate view of the Du Pont model can be seen as below.  This figure reflects upon the calculation of Return on Assets.

In order to move from RoA to RoE, we need to provide for the introduction of the gearing of the company, i.e. the use of debt in the capital structure.  We use the ratio of Equity Multiplier.  We calculate this by taking Total Assets (or Equity plus Liabilities), and divide it by Equity.  The Du Pont analysis would do it the following way:

Creditors + Overdraft + Short-term Debt + Taxes Payable = Total Current Liabilities

Total Current Liabilities + Long-Term Liabilities = Total Liabilities

Total Liabilities + Owners Capital (Equity) = Total Equity & Total Liabilities

(Total Equity & Total Liabilities) / Total Equity = Gearing (or Equity Multiplier)

When we now the Return on Assets and multiply it with the Gearing Ratio, we arrive at Return on Equity.

How has Pick ‘n Pay been managing the component parts of the ROE for the last 3 years and how does it compare with the industry averages and the ratios for Shoprite?


The Price/Earnings Ratio

The price to earnings ratio (or PE ratio) relates market price to earnings per share.

Formula: Market Price of the share / Anticipated headline earnings per share

Earnings per share:  Net Income / Number of shares outstanding


In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E.  However, the P/E ratio does not tell us the whole story by itself.  It’s usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company’s own historical P/E.  It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects.The P/E is sometimes referred to as the “multiple”, because it shows how much investors are willing to pay per rand of earnings. If a company were currently trading at a multiple (P/E) of 15, the interpretation is that an investor is willing to pay R15 for R1 of current earnings.

It also may be seen that if the earnings remain at R1, it will take 15 years for the investor to get his money back.  This view obviously ignores the fact that one could sell the share and retrieve one’s investment, and that the share price could increase due to expectations of an improved performance.

It is important that investors note an important problem that arises with the P/E measure, and to avoid basing a decision on this measure alone.  The denominator (earnings) is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number.

The higher the P/E ratio, the more expensive the share is considered to be.  However, a share with a P/E of 15 might be viewed as a better buy than a share with a P/E of 8.  Under what circumstances would this be?

Also bear in mind that we frequently use a historical P/E ratio, by using the existing price and the current EPS.  It also makes sense to calculate the forward P/E.  This is somewhat more technical and will not be dealt with here.

The following extract comes from the Moneyweb website (

“People often find P/E ratios a little confusing, for good reason.  The P/E of a company is its price to earnings ratio. It is calculated by dividing the current share price of the stock with the headline earnings per share of that same share. The P/E not only measures the company’s past performance but its future performance too; the expected future growth of the firm is reflected in the current share price.

Unfortunately the P/E ratio can mean many different things, and it is therefore very important to look at more than just this particular ratio when making your decision.

The P/E ratio, like all other ratios, is most useful when compared to:

  • The stock’s own historical P/E
  • Industry P/E
  • The P/E of the particular sector the stock is in
  • The overall market P/E

For example:

If we look at short-term insurer Santam (JSE: SNT); it currently has a P/E of 6.63; this means that investors are willing to pay R6.63 for every R1 that the company generates in earnings.  Santam is in the Financials – Insurance sector along with Mutual and Federal (JSE: MAF).  Mutual and Federal’s P/E is currently 6.7.  Therefore investors are willing to pay R6.70 for every R1 that the company generates.  The P/E’s of both companies are similar; however Mutual and Federal’s share price is around R25 and Santam’s share price is around R102.

The P/E of the financial sector overall is 10.64.  This is higher than both Santam’s and M&F’s P/E ratios.  The weighted average P/E of the All Share Index is 14.51.

This seems to suggest that both of these insurance stocks are cheap.  Instead of waiting 10 or 14 years to recoup your investment, you would wait just under 7.

However, before you rush off and buy Mutual and Federal or Santam shares there are two things you must consider:

  1. The companies’ growth rates
  2. The industry the companies are in.

Both company’s growth rates can only be found once their financials are released, and the insurance industry is very cyclical, heavily dependent on the performance of financial assets like equities, as well as on consumer and business-to-business spending.

Thus, one should also look at the general economy when analysing P/E ratios.  Currently interest rates are increasing in South Africa and expected to rise again over the next few months. Furthermore, the world economy is suffering thanks to the credit crunch and this directly affects the South African economy, possibly causing share prices to drop.  This drop in share prices obviously affects P/E, and expectations for the industry.

P/E ratios are helpful, but only when used in context; the P/E ratio of a stock should not be the only tool used.  Interpreting the P/E of a company is dependent on the sector the company is in, the risks associated with the sector and the company, and even the country in which the share is listed (for example, US stocks generally have slightly higher P/E’s than emerging market stocks).  All of this must thus form part of your analysis of a company.”

The Market-to-Book Ratio

This ratio is used by the analysts to determine whether the share is undervalued (therefore its price is expected to rise in the future) or overvalued (it is a popular growth share).  Also called price to book ratio, it is applied to firms that have lots of fixed assets.

Formula: Market value of outstanding stock ÷ Book value of assets.

A ratio used to compare a stock’s market value to its book value.  It is calculated by dividing the current closing price of the stock by the latest book value per share.  It is also known as the “price-equity ratio”.

Calculated as:

P/B Ratio = Market capitalisation/ (Assets –intangible assets + liabilities)

As a quick reference, analysts also use shareholders equity on the balance sheet as the denominator.

A lower P/B ratio could mean that the share is undervalued. However, it could also mean that something is fundamentally wrong with the company.  Why? As with most ratios, be aware that this varies by industry.

This ratio also gives some idea of whether you’re paying too much for what would be left if the company went bankrupt immediately.

Calculate the P/B ratio for Pick ‘n Pay for the last 3 years, and compare it to both the industry and Shoprite.  What are your deductions?



The Dividend Yield

P/E ratios only show the profit made by the business.  To compare its cash generating ability we use dividend yield, the other important tool when measuring a share’s relative rating.

In their classical form, dividend yield reflects the actual cash generated for a shareholder on the stock they have selected.  This makes the share directly comparable with alternatives such as bank deposits, Government bonds, even property.

In its most basic form, calculating the dividend yield of a share is arrived at by expressing the annual cash paid to shareholders as a percentage of the current share price.  So a company which declared a dividend of 5c a share in the past year would have a dividend yield of 5% when its shares trade at 100c each.  As with P/E ratios, dividend yields change as the share price moves.

Dividend yields are always historic, that is based on what was actually distributed in the past 12 months.  Although the past is a good guide (companies hate reducing their annual dividends) the coming year’s payout depends on how well the company performs and how much of the profit is distributed.

The proportion of profits paid out is called “dividend cover”, itself linked to the strategy of the business.  Rapidly growing enterprises or those with conservative boards tend to pay out proportionately less of their profits, so have high dividend cover.  An advantage in this instance is that though the payment might be relatively small, it’s more likely to be maintained into the future than a company which pays out most of its annual profits.  Why would this be the case?

What has been the dividend yield for Pick ‘n Pay over the last 3 years, and how do they compare with that of the industry and Shoprite?

The Earnings Yield

The Earnings Yield is calculated by dividing the earnings per share for the most recent 12-month period by the current market price per share.  The earnings yield (which is the inverse of the P/E ratio) shows the percentage of each rand invested in the share that was earned by the company.

The earnings yield is used by many investment managers to determine optimal asset allocations.

Money managers often compare the earnings yield of a broad market index (such as the All Share Index on the JSE) to prevailing interest rates, such as the current R153 yield.  If the earnings yield is less than the rate of the R153 yield, shares as a whole may be considered overvalued.  If the earnings yield is higher, shares may be considered undervalued relative to bonds.

Classical theory suggests that investors in equities should demand an extra risk premium of several percentage points above prevailing risk-free rates (such as T-bills) in their earnings yield to compensate them for the higher risk of owning shares over bonds and other asset classes.




The growth of a business is a very important element thereof.  The larger an organization, the more viable it can be.  However, there are limits as to the rate at which an organization can grow.  One of the important issues entails the financing of this growth.  Bye now, you have already seen the impact of working capital requirements on the cash flow of the business.  In this section, we will take the principle a bit further.

When we forecast the financing needs of the business, we need to take the projected income statement and balance sheets into consideration.  According to John Stretch, the sequence of activities is as follows:

Income Statement: Estimate Sales Growth:

  • Forecast variable expenses as a % of sales.
  • Keep fixed expenses roughly fixed.
  • Assume interest expenses to be fixed.
  • Carry retained earnings through to the Balance Sheet.

Balance Sheet:

  • Forecast current assets as same % of Sales.
  • Keep fixed assets roughly fixed.
  • Balance the balance sheet with the debt figure
  • Re-iterate the interest figure to ensure it is reasonable.

Many businesses have experienced the financing problems which can accompany growth; at its worst referred to as overtrading.  Overtrading occurs when the profits earned by the business are not sufficient to produce the working capital necessary to generate growth.

Consider the following:

In 2009, Streetwalk & Seemore’s balance sheet looked more or less as follows:

Streetwalk & SeemoreBalance Sheet as at 31 Dec 2009 All figures in R000s
Assets Financing
Fixed Assets                         200Stock                                    600

Debtors                              200

Shareholder Funds                700Loan                                     150

Creditors                              150

Total                                 1000 Total                                  1000

The turnover for the year was 1200 and profit after tax 2.5% of turnover or 30.

The owner of S&S, Johan Burger, wants to grow sales by 20% next year – to 1440 – and to achieve the same profit margin, i.e. 2.5% of 1440 = 36.

What will next year’s balance sheet look like?

Balance Sheet as at 31 Dec 2010 All figures in R000s
Assets Financing
Fixed Assets                        200Stock (grow 20%)                720

Debtors (grow 20%)             240

Shareholder Funds                      700Plus Profits for 2009                      36

Loan                                                  150

Creditors (grow 20%)                 1880

Shortfall                                        94

Total                                  1160 Total                                         1160

As long as stock, debtors, and creditors grow in direct proportion to sales, the shortfall will compound itself annually, and gearing will worsen annually.

Businesses susceptible to overtrading are those that operate on low profit margins and have fairly high net working capital requirements relative to sales.

A simple formula enables you to estimate the rate at which your business can grow through internally generated profits:

C = 100 x [A/ (W-A)]


C = the critical growth rate expressed as a % increase in Sales

A = the % net profit after tax to sales

W = the net balance sheet items that vary directly with sales expressed as a % of sales.  This is normally ([Stock + Debtors – Creditors] x 100) / Sales.

The rate at which your business can grow from internally generated funds, is therefore driven by 2 factors:

  • Net profit to Sales
  • Net Working capital to Sales

A business with low profit margins and high stock and debtors automatically has a low critical growth rate.

The following example shows the relative sensitivity of the critical growth rate:

Case 1 Case 2
Sales 5 000 000 5 000 000
Net Profit after Tax 200 000 250 000
Stock + debtors – creditors 2 000 000 1 500 000
Therefore A =W = 4%40% 5%30%
Critical growth rate 100 x 4/36 100 x 5/25
= 11% = 20%

Through an awareness of these relationships in their own organizations, managers can plan and control real growth.  It is easy to state growth strategy in real terms, such as a % increase in sales or market share, without considering the financial implications.  Equally, the importance of iron-fisted working capital and margin management for a company’s future growth rate is clearly illustrated in the above example.

Inflation is part of financial growth.  Inflation growth has exactly the same effect on a company’s financial resources as real growth.  Accordingly, a company’s growth rate is directly influenced by the rate of inflation.

From a finance view, a high growth rate has 2 important consequences:

  • Financial resources may be inadequate to fund this growth
  • Gearing may be weakened.

The extent to which further outside borrowing may be needed as a result of a high sales growth (including the proportion due to inflation and exchange rates) is given by a second formula:

F = (W x I) – (A x S)


F = Additional funding required

W = The net balance sheet items that vary directly with sales, expressed as a % of sales (as per the previous formula)

A = the % net profit after sales to sales (as per the previous formula)

I = Increase in Sales (in Rands) over the last year

S = Total sales forecast for this year

Applying the formula to Case 1 above, and assuming a forecast in sales of 15% over last year, the extra finance you will have to raise will be R70 000, calculated as follows:

(0.4 x 750 000) – (0.04 x 5 750 000)

= 300 000 – 230 000

= 70 000

So the business requires an extra R70 000 to finance sales growth of R750 000.  This level of growth means an increase in stock, debtors less creditors of R300 000, and the profit for the year is R230 000.  The balance will have to be raised externally.

Deciding how fast to grow is, like most business decisions, an assessment of risk and return.  Many businesses do not give enough attention to the risk element of this equation, because the underestimate the financial implications of growth in a world of changing inflation and exchange rates.  The formulas given here are rough cut calculations, assuming linear relationships between sales, profits, and working capital.  Your own circumstances may be different, and could require more detailed financial projections where the underlying relationships are considered item by item.

(The source of information on Growth is the unpublished notes of John Stretch, 2009.  John Stretch is a consultant in strategy and finance, and I consider him to be a guru in his field.)


In the field of finance, there are a number of financial factors that drive value.  They are referred to as the financial drivers of value.

We would like to do the following:

  • Growth Duration.  This element requires management to accept projects that would bring about a long period of high growth.  The reality is that if management does nothing at all in terms of growth, the company’s growth rate would at best mirror the growth rate of the economy at large.  This would mean that there would be opportunities that are not being tapped into.  The value of the company would therefore be less than the potential.  Companies such as this are then prime targets for takeovers, in which case management would be the first to lose their jobs.  The longer the period of abnormal growth the management could unlock, the better off the company would be.

  • Sales Growth.  A high sales growth rate, all else being equal, will unlock value for the shareholders and other stakeholders such as employees and the government.  Sales is a factor of volume and price.  These again are typically driven by:
    • The market segments the company has chosen to serve.  The nature of the customers will determine what you can charge.
    • The nature of the industry.  What products are being sold?
    • The competitive situation in the industry.  How many competitors are there?  How strong is the competition?
    • How elastic are the prices and demand curves in the industry?
    • The strategic posture the company has selected in the industry.  Have you elected to be a low cost provider or a differentiator?

  • Profit Growth.  Profit is a factor of price and costs/expenses.  How high can you raise your prices without losing customers?  How can you optimise your costs and expenses?  Can you pass on price increases from your suppliers to your customers, or do you need to absorb them yourself?

  • Cash Tax.  Large companies pay a considerable amount of tax.  A lot of them would ideally not want to pay tax at all.  Unfortunately this is not possible.  However, companies do appoint experts to manage their tax base to the benefit of the company.  Banks also try and benefit from the tax base of their clients.

  • Working Capital Investment.  Ideally speaking we would want to require no working capital at all.  Food retail companies such as Pick ‘n Pay, Shoprite, Carrefour, Tesco’s, and Wal-Mart, however, have a great benefit in that their working capital requirement is negative.  As a matter of fact, Pick ‘n Pay finances about 70% to 75% of their total assets with their creditors.  The advantage of this is that this form of financing is free, and they therefore need very little equity, which is the most expensive form of financing.  Not all industries are so lucky however, and management needs to optimise their working capital policies.

  • Fixed Asset Investment.  The same situation as for working capital is true for fixed assets.  You would love to do everything without needing any investment in fixed assets.  However, companies such as mines require a substantial investment in fixed assets in the form of ore reserves, plants, equipment, etc.  The same is true for hotel companies.  The ideal is to optimise your asset use – “sweat your assets.”
  • Capital Structure.  This you will remember refers to the combination of debt and equity you use to finance your investments in assets.  There is an optimal combination that will result in the lowest possible weighted average cost of capital.  Remember that debt brings along some powerful advantages in the form of leverage, where Return on Assets is levered upward by the good use of debt, to a higher Return on Equity (see the Pick ‘n Pay example).

These 7 financial drivers of value need to be driven to the respective levels within the company.


At a non-financial level, the following typical shared value-drivers are typical:

  • Vision: for growth – ambitious, well defined and communicated
  • Strategy: clear and focused – to protect, stretch and leverage the core
  • Culture: promotes customer service -open, empowered, communicative, competitive
  • Leadership: structured to promote high growth – multinational, cross-functional teams and a broad range of experience
  • Structures and organisational processes – e.g. IT; pay linked to growth
  • Resources: invest in competencies, in good and bad times
  • Customer interaction – constantly seek new ways to interact…directly
  • Relationship networks: with many external parties

Customer satisfaction is extremely important.  In order to get optimal profits and returns, the organization needs customers that are loyal, committed, and satisfied.  Organizations frequently state that they are customer centric, but then do not really understand who the customer is and what they value and do not value.  This is why the first element of importance in the building of your business model should be the customer segments you serve.

Understanding the suppliers of your company is equally important.  Understanding what your suppliers are doing and how they can create value is important in order to optimise the industry value chain and the supply chain.  A lot of value can be unlocked by dealing with this issue in a judicious manner.

We also need to understand that shareholders are another important stakeholder.  They would want stable company performance with sustainable profits and high returns, again on a sustainable basis.

Another grouping of people that are very important in the total value-creation process is the employees.  Without their commitment and dedication, nothing will happen to create sustainable value.  The factors that need to managed to create value for them, are issues such as market-related remuneration packages, development opportunities, and a highly energised leadership.

We also need to bear in mind that the organization functions within a society.  Society at large also needs to receive value from the activities of the organization.


An instrument that brings together the picture of both financial and non-financial drivers of value, is the Return on Strategic Effectiveness (ROSE).  The elements of ROSE are as follows:

  • Financial Capital

This block is related to a company’s capital structure and its use of funds from investors and vendors.  Resources related to a company’s financial capital include the company’s:

  • Borrowing capacity
  • Ability to raise capital
  • Retention of prior earnings
  • Sustainable growth rate

  • Human Capital

This building block is related to the company’s employees, the assets that walk out the door each night or at the end of each shift.  These measures focus on the employees’ capabilities to perform their responsibilities and to work together as a coordinated team.  Resources related to a company’s human capital include the employees’:

  • Education & training
  • Knowledge
  • Commitment
  • Leadership ability
  • Trust
  • Integrity
  • Experience

  • Physical Capital

This is related to all the tangible resources owned or leased by the company.  These measures are focused on the company’s utilization and management of the tangible assets.  Resources related to the company’s physical capital include the company’s:

  • Productive capacity
  • Capital expenditures
  • Maintenance quality
  • Flexibility and mixed use of fixed assets
  • Technological commitment
  • Location, location, location (access to suppliers, customers, and human capital)

  • Organisational Capital

This is related to company’s group attributes, such as its culture, creativity, public image, and organisational structure.  Resources related to the company’s organisational capital include its:

  • Employee loyalty
  • Employee teamwork
  • Reputation
  • Product innovation
  • Speed and quality of decision making

  • Systems Capital

This is related to the effectiveness of the company’s identifiable operating systems.  Resources related to the company’s system capital include the company’s:

  • Computer systems and information systems
  • Customer relationship management systems
  • Communication systems
  • Shop floor systems
  • Inventory control systems
  • Sales & marketing systems
  • Accounting systems
  • Project management systems

  • Customer Capital

This is related to the company’s relationship to its customers and the acceptance of its products by its customers and potential customers.  Resources related to the company’s customer capital include:

  • Customer services
  • Customer loyalty
  • Market penetration
  • Information access

It is important to align the different building blocks of the ROSE in order to ensure that sustainable value is created.  Equally important is the need to measure what the different Key Performance Areas and Indicators are turning up.

I trust that this page has provided you with some food for thought on how to analyse the financial performance of a company.