Three Common Ratios I Do Not Like

Alternative Means to Effectively Gauge Business Operations and Assist Owners

Three ratios that are widely used have validity because they are either used in business valuations, loan covenants, reports to stockholders in Form 10-Ks, used when financial statement analyses are performed, or have familiarity because they have become entrenched in the system. The author of this article considers reliance on these three ratios as “inadequate in advising clients that need effective information to operate their businesses” and perhaps do not help in isolation valuations drivers that assist managers in operating businesses. The author discusses other metrics that provide better insight.

Three ratios that are widely used have validity because they are either used in business valuations, loan covenants, reports to stockholders in Form 10-Ks, used when financial statement analyses are performed, or have familiarity because they have become entrenched in the system. However, I find them inadequate in advising clients that need effective information to operate their businesses and perhaps do not help in isolation valuations drivers that assist managers in operating businesses.

Quick Ratio or Acid-Test Ratio

This ratio is (Cash + marketable securities + accounts receivable) ÷ current liabilities and is a popular liquidity ratio. For the rest of this article, I will include marketable securities when I refer to cash.

I do not think this ratio is valid and that it provides any better indications than working capital. This is a variation on the working capital ratio in that it only measures immediate debt-paying ability. It does not include inventories and prepaid expenses which are considered, for this calculation, as less liquid. Well, duh, so is accounts receivable. Every business has “embedded” as permanent amounts a certain level of accounts receivable, as well as inventory and accounts payable. Of course, accounts receivable is more readily convertible into cash if it needs to be than inventory, but every going business maintains a level of accounts receivable which remains pretty much constant except when there is growth or (ugh) a downturn cycle.

I think a better indication of bill paying ability is the business’ cash and marketable securities divided by the total monthly payments the organization needs to make times 22 business days which is the number of days’ payments the company has in cash. An illustration is: $100,000 cash ÷ $500,000 of monthly payments = 20%. 20% times 22 business days = 4.4 days cash on hand. Another illustration is: $25,000 cash ÷ $500,000 monthly payments = 5%. 5% x 22 days = 1.1 days cash on hand. In the illustration, I used 22 business days in a month, but you can provide your own number of business days.

The results could get confusing because there might not be a comparable uniform standard to measure this against since every business is different as there is for most business or liquidity ratios. We could all agree that one month cash is excessive, just as one day too little. It is important to consider the nature, dynamics, and credit policies of the business. For instance, a manufacturing company with cash that could cover ten day’s payments might be more than adequate as would a web-based business with one day’s cash all revenue payments are received with the order which is basically before shipment. That latter company would not really need much of a cash balance at all (except if it needed to build the inventory and increase the marketing budget in anticipation of a greater than usual growth or perhaps to prepare for a seasonal upturn in sales).

Another consideration is that when measuring the payments that need to be made you would need to include expense items not yet booked such as monthly rent and anticipated payroll and recognize that not everything is paid equally each day or week. As an average this works well monthly, but the cash amount that is maintained should be on the higher side. As a metric for managing the business, this works much better than the Quick Ratio which can be very misleading especially if the accounts receivable drift behind. The reality is that the only businesses I know that use my cash ratio are those very tight on cash and they do this it out of necessity, but they never use the Quick Ratio; it is the cash that matters! Further, many of those businesses are already on watch lists and ratios do not serve much purpose in this scenario.

For analytical purposes, I would stick with the working capital ratio since it has stood the test of time with its meaning and usage.

If you use the Quick Ratio, then charting the weekly or monthly changes is what I would watch. I try to keep my use of ratios simple and rarely use the Quick Ratio. I could score some points using it since it makes it sound like I know a lot of things the client does not. I could also include this in a valuation report analysis, and it would add some verbiage to it. However, if our role is to provide usable information to clients to help them better operate their businesses or get a firmer grasp on its value drivers, then using this ratio will confuse them and does not provide a usable metric. Bottom line: The Quick Ratio lacks relevance. The cash balance and days payments on hand is what is important.

By the way, there are other ratios that are used that I believe are better suited for valuations and management analysis. These include ratios for accounts receivable and inventory turnover, aging and changes in patterns of larger individual items. The tools are there, and more relevant.

EBITDA

EBITDA is a commonly used acronym for a representation of profits. The letters stand for earnings before interest, taxes, depreciation and amortization.

EBITDA indicates the maximum amount of cash flow from a business’ operations that is available to be reinvested in the business, service debt by paying interest and repaying principal and provide a return on investment to the owners. EBITDA is the starting point for determining the value of many businesses but certainly not the only way and I suggest not a relevant way.

The earnings are the bottom line on the statement of operations: the net income. The other components are deductions that are added back to determine an adjusted profit or cash flow from revenues, i.e., EBITDA. Interest is the amount paid to lenders. Note that each business would have different capital and debt configuration so the add-back sort of creates a uniform playing field. One owner could decide to have no debt while another would want as much as possible making interest payments a function of an ownership decision regarding equity and leverage and not an operational issue. Taxes are paid on profits and are not a measure of operations. Further, taxes are not always consistently applied and depend upon management decisions about debt and level of aggressiveness toward tax elections and credits, and possibly the business’ physical location. Depreciation and amortization are not cash expenditures but the systematic writing off of current and primarily prior capital expenditures.

EBITDA gives the starting point to determine the “real” cash flow from operations and is applied to the following items:

• Funding growth in accounts receivable and inventory in excess of the accounts payable
• Acquiring capital assets such as machinery, equipment, technology, and possibly new facilities or leasehold improvements
• Applying the funds to decrease leverage, i.e., reliance on lenders
• Accumulating funds for future anticipated needs and to fuel growth
• Interest on loans
• Income taxes
• And finally, payments to owners or investors

Valuing a business or providing for the future involves judgments about the continuance of the present mode of operations, anticipated changes and growth, future conditions and projections of liquidity, and cash needs. It is, at its best, a best guess at that moment of time and because of that, needs to be considered on the side of caution. So use EBITDA when you start but do not confuse it with the ending point.

My problem with EBITDA is that it totally ignores costs of physical or fixed assets, such as equipment, that are used in the business and essential to the business. The income statement provides a periodic deduction for physical assets called depreciation. Removing the depreciation from the operating income does not reflect the reality that the business has and uses physical assets and, without considering the fixed assets, the profit is distorted and overstated. There are many arguments about this; particularly, that the annual depreciation deduction is a non-cash expenditure. Anyone can see that by looking at the add back for this on the statement of cash flows. However, ignoring it provides an unrealistic and unattainable profit figure. A suggestion is that if the depreciation is added back then there should be a deduction for new fixed asset additions. I know many of the what ifs, but the reality for most mature businesses with fixed assets is that there are always replacements and additions being made. However, these are not accounted for in EBITDA or in the statement of cash flows from operations.

I offer some choices. Use EDITDA but reduce it by annual fixed asset additions. If you review the financial statements of any 10 established companies in the aggregate, I believe you will find that the total of the previous years fixed asset acquisitions is pretty equivalent to the total of the depreciation deductions for those 10 companies. Sure there will be some outliers, but the reality, as I see it, is that the additions equal the depreciation. So either do not add back depreciation to the income or reduce EBITDA by the fixed asset additions. Another choice is to use free cash flow (FCF), which I discuss in the next section. A third is to use EBITDA without the DA. So just use EBIT, which I believe is a much more realistic representation of the actual operating results from the business. A little secret is that EBIT is actually the net operating income as shown on the financial statement. However, EBIT sounds fancier.

Free Cash Flow

This belongs with the financial statement ratios. Many publicly traded companies are now using FCF or a variation of it as a measure of performance. In some manner, this is a better indication of a company’s profitability than the more typical measures.

FCF shows how much cash a business generated that can be used for expansion, developing new products, reducing debt, or for payments to shareholders either with dividends or by repurchasing stock. When you think about it, how else would you measure profitability or operations?

FCF is the operating cash flow less the capital expenditures. The operating cash flow comes from the bottom line of the first section of the statement of cash flows. The reduction for capital expenditures (which for many companies is the first item in the next section of the statement of cash flows) represents the reality that most businesses with equipment are continuously adding additional equipment making that a normal recurring expenditure. EBITDA, a widely used measure, is clearly off the mark and, in my opinion, irrelevant. FCF compensates for this fatal shortcoming.

I would further adjust a company’s FCF by removing any unusual and nonrecurring gains or losses.

To better understand FCF, I suggest reviewing Forms 10-K for companies you own stock in and seeing its treatment. Some 10-Ks I reviewed have four or five iterations of FCF. This is another measure to use when evaluating a company. The more appropriate data you consider, the better will be your decision.

A comment is that, about 20 years ago, most large company’s showed EBITDA in its 10-Ks. Today, this has pretty much been abandoned and FCF is used instead. You might say the use of EDITDA has not stood the test of time too well and is no longer a relevant metric.

An objection to FCF is that it measures the effect on cash of the changes in the components of the assets and liabilities, but FCF is not really a reflection of net operating income. Annual cash flow is an important measure and helps the manager recognize conceptually as well as practically what can cause the ebbs and flows of the cash. However, cash is what is used to pay the bills and adequate amounts need to be in the bank account when it is necessary to pay the bills. FCF is a report card of past performance, not a usable measure going forward.  

Quality of Earnings

What we are all seeking is a method of valuing a company and providing our clients with usable metrics that should help them manage better and isolate value drives. The starting point for analyses and the ending point is the earnings. The better the calculation of earnings, the more effective the manager could be in making decisions and the better the valuation.

It is important for the advisor to provide the right usable information. In doing this, we also need to understand that businesses are not run in a homogeneous manner but are subject to many decisions as circumstances change or are anticipated. This requires isolating outliers and revenues and expenditures that are not normal for that business at that time, or during that period, or are expected to be nonrecurring.

Liquidity

Cash is the life blood of every business. Determining effective ways to manage cash is essential. Using long established liquidity ratios might serve important purposes for the business’ stability and continuance but might not be the right tools needed to manage that business. I usually start with advising clients with simple ways to manage cash and work up to more complicated methods. I have found that with a responsive client, the simple ways usually work. They need to know the other ways for their covenants and outside users, and perhaps for long term planning, but understanding the daily cash flow is what will help them perform best.

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Edward Mendlowitz, CPA, PFS, ABV, CFF, is emeritus partner with WithumSmith+Brown, PC, in East Brunswick, New Jersey. He has over 40 years of public accounting experience, is a licensed Certified Public Accountant in the states of New Jersey and New York and is one of Accounting Today’s 100 Most Influential People and is an adjunct professor in the Fairleigh Dickinson University MBA program. The author of 29 books, Mr. Mendlowitz has written hundreds of articles for business and professional journals and newsletters and presented over 350 CPE programs. He writes a twice a week blog at www.withum.com/partners-network-blog.

Mr. Mendlowitz can be contacted at (732) 743-4582 or by e-mail to emendlowitz@withum.com.