that will perform according to expectations. However, they have to also consider the negative consequences of default and liquidation. Lenders and creditors have to carefully assess the risk involved in recovering the funds extended. They therefore have to look for a margin of safety in the assets held by the enterprise. Several ratios are used to evaluate this protection by testing the liquidity of the enterprise. Another set of ratios tests the leverage of the enterprise in order to weigh the position of lenders versus owners. Lastly, there are coverage ratios that relate to the enterprise’s ability to provide debt service from the funds generated by operations.
3.1 Liquidity
Liquidity ratios measure the ability of an enterprise to meet its short-term obligations.
They focus on the liquid assets of the enterprise i.e. current assets that can readily be converted into cash on the assumption that they form a cushion against default. The most commonly used liquidity ratios are the current ratio and acid test ratio.
3.1.1 Current ratio
The current ratio shows the relationship between current assets and current liabilities and is an attempt to show the safety of current debt holders’ claims in the case of default. Current ratio is calculated as follows:
Current ratio = Current assets Current liabilities
The current ratio for Shilowa Enterprises is as follows:
20.9 20.8
Current ratio Current ratio
= Current assets = Current assets
Current liabilities Current liabilities
= R637 900 = R606 600
R475 400 R381 900
= 1,34:1 = 1,59:1
A decline in the ratio (from 1,59:1 to 1,34:1) is largely due to the increase in current liabilities from the previous year. An enterprise with a low current ratio may not be able to convert its current assets into cash to meet maturing obligations. From a debt holder’s point of view, a higher ratio appears to provide a cushion against losses in the event of business failure. A large excess of current assets over current liabilities seems to protect claims. However, from a management point of view a very high current ratio may point towards slack management practices. It may indicate idle cash, high inventory levels that may be unnecessary and poor credit management resulting in overextended accounts receivable.
3.1.2 Acid test ratio
This ratio is a more stringent test of liquidity. The intention of the acid test ratio is to test the collectibility of current liabilities under distress conditions, on the assumption that inventories would have no value at all. In the case of a real crisis creditors may realise little cash from the sale of inventory. The acid test ratio is similar to the current ratio except that the current assets (numerator) are reduced by the value of the inventory. The calculation is done as follows:
Acid test ratio = Current assets – Inventory Current liabilities
Shilowa Enterprises acid test ratio is as follows:
20.9 20.8
Acid test ratio Acid test ratio
= Current assets – Inventory = Current assets – Inventories Current liabilities Current liabilities
= R637 900 – R231 200 = R606 600 – R203 000
R475 400 R381 900
= 0,86:1 = 1,06:1
It is clear that a ratio of less than 1:1 would pose liquidity problems in the event of a crisis. Shilowa Enterprises faces this position at the end of 20.9 as the ratio indicates there only R0,86 of liquid assets is available to settle every R1 of current liabilities.
3.2 Financial leverage
An enterprise increases its financial leverage when it raises the proportion of debt relative to equity to finance the business. The successful use of debt enhances the earnings for the owners of the enterprises since returns on these funds, over and above the interest paid, belongs to the owners, and therefore increases the return on owners’ equity. However, from the point of view of the lender, when earnings are insufficient to cover the interest cost, fixed interest and principal commitments must
proportion of debt in the enterprise. The most common measures of leverage
compare the book value of an enterprise’s liabilities to the book value of its assets or equity.
3.2.1 Debt to assets
Debt to assets is used to reflect the proportion of debt to the total claims against the assets of the enterprise. The greater the ratio, the higher the risk. Debt to asset ratio is expressed as follows:
Debt to assets = Total debt X 100 Total assets 1
The Debt to assets ratio of Shilowa Enterprises is as follows:
20.9 20.8
Debt to assets Debt to assets
= Total debt X 100 = Total debt X 100
Total assets 1 Total assets 1
= R799 100 X 100 = R760 700 X 100
R1 452 200 1 R1 389 600 1
= 55,03% = 54,74%
The ratio indicates that 55,03% of Shilowa Enterprises assets, in book value terms, come from creditors of one type or another.
3.2.2 Debt to equity
This ratio attempts to show the relative proportions of all lenders’ claims to
ownership claims, and is used as a measure of debt exposure. Debt to equity ratio is expressed as follows:
Debt to equity = Total debt X 100 Owners equity 1
The Debt to equity ratio of Shilowa Enterprises is as follows:
20.9 20.8
Debt to equity Debt to equuity
= Total debt X 100 = Total debt X 100
Owners’ equity 1 Owners’ equity 1
= R799 100 X 100 = R760 700 X 100
R653 100 1 R628 900 1
= 122,35% = 120,96%
The ratio indicates that the creditors supply Shilowa Enterprises with 122,35 cents for every Rand supplied by the owners.
3.3 Debt service
The above ratios still don’t reveal a lot about the creditworthiness of the enterprise, which involves the ability of the enterprise to meet its interest and principal on schedule as contractually agreed upon. Our focus will be on interest coverage.
3.3.1 Interest coverage
This ratio is based on the premise that annual operating earnings are the basic source for debt service, and that any major change in this relationship may signal difficulties.
Debt holders often stipulate the number of times the business is expected to cover its debt service obligations. The ratio for interest coverage is as follows:
Interest coverage = Operating profit
Interest expense
Shilowa Enterprises interest coverage ratio is as follows:
20.9 20.8
Interest coverage Interest coverage
= Operating profit = Operating profit Interest expense Interest expense
= R305 800 = R295 600 R11 100 R10 900
= 27,55 times = 27,12 times
Shilowa Enterprises interest coverage of 27, 55 times means that the enterprise’s profit covers its interest obligations 27, 55 times in 20.9; and 27, 12 times in 20.8.
There is a slight increase, in its interest payment cover.