The purpose of this page is to explain the indicator about safety among the indicators used in the analysis of companies and stocks.
Indicator about safety here means the indicator for avoiding the risk as the stock becomes worthless, among the price fluctuation risk.
For companies, it can be rephrased as financial soundness.
The current ratio is the ratio of current assets to current liabilities.
Both total current assets and total current liabilities can be found on the balance sheet.
Since to do is only comparing which is larger, current assets or current liabilities, you can just look at the differences on the balance sheet.
Current ratio = Current assets Current liabilities
Current assets are assets that can be monetized in the short term, and current liabilities are liabilities that need to be paid in the short term.
Therefore, the higher current ratio, the more room for financing.
On the other hand, a current ratio less than 1 means that current assets are less than current liabilities. A liquidity ratio of less than 1 implies that the company doesn't have ability to meet the obligations due in the near future, which may show that the company is having financial difficulties.
From this point of view, a current ratio of over 1 is the condition that can be the minimum requirement for long-term investment.
However, it should be noted that a high current ratio is not always a good indicator for the company.
For example, if the company has held bad inventory as current assets, it may actually be in a slump.
Therefore, in order to invest more safely, it is better to check not only the current ratio but also the accounts of current assets and current liabilities and operating cash flow.
Current assets and current liabilities are listed in the assets and liabilities section of the balance sheet, respectively.
Here, an example of calculating the current ratio is shown using the following balance sheet.
|
Assets Current assets ・・・ Total current assets 1,300 ・・・ |
Liabilities Current liabilities ・・・ Total current liabilities 1,000 ・・・ Total liabilities |
|
Net assets ・・・ Total net assets |
|
| Total assets | Total liabilities and net assets |
The amount used in the calculation is the total amount of current assets and current liabilities.
Although the amount described on the balance sheet has a unit, it's a ratio so you don't have to care about it.
Therefore, in the example of the balance sheet above, the current ratio is 1.3, which is 130% as a percentage.
Equity ratio is the ratio of equity capital to total capital, which is the entire right side of the balance sheet, as shown in the formula below.
Equity ratio = Equity capital Total capital
Total capital is the entire right side of the balance sheet, that is, the amount of capital of others, and equity capital is the portion that belongs to the shareholders among that.
Therefore, the simplest interpretation of equity ratio can be considered to be the shareholder's share of total assets when a company is liquidated.
However, equity ratio is often used as an indicator of the financial soundness of a company.
The reason is as follows.
Equity has no obligation to repay, but debt has an obligation to repay.
The high equity ratio gives the company more room to withdraw its capital and repay its debt.
Therefore, equity ratio mainly represents the safety factor for lenders of debt such as banks.
On the other hand, if equity ratio is high, it is easy to receive a loan and the possibility of bankruptcy is reduced, which also brings safety benefits to shareholders.
From this point of view, equity ratio represents the financial soundness of a company and can be also considered to be an indicator of investment safety for investers.
However, a high equity ratio may increase the cost of equity, so it does not always lead to a good management evaluation for shareholders.
It should be used in combination with capital efficiency indicators such as ROE, for investment decisions.
Here, an example of calculating the equity ratio is shown using the following balance sheet.
|
Assets ・・・ |
Liabilities ・・・ |
|
Net assets Shareholders' equity ・・・ Total shareholders' equity 25,000 Accumulated other comprehensive income ・・・ Total accumulated other comprehensive income 2,000 ・・・ Total net assets |
|
| Total assets 45,000 | Total liabilities and net assets 45,000 |
The amount of equity capital is the sum of shareholders' equity and accumulated other comprehensive income.
The amount of total capital is stated in total liabilities and net assets.
Although the amount described on the balance sheet has a unit, it's a ratio so you don't have to care about it.
Therefore, in the example of the balance sheet above, the equity ratio is 0.6, which is 60% as a percentage.
Operating cash flow is the CF obtained from the main business stated in the CF statement.
If sales or prfitos are increasing, the current ratio or equity ratio mentioned above will be high, but even such companies may go bankrupt.
For example, if the funds required for sales are continuously covered by debt, accounts receivable cannot be collected, which may lead to financial difficulties.
Despite growing profits each year, companies with continuously negative operating CF often go bankrupt.
This pattern can be seen relatively common in industries which have a long cycle from financing to selling items and collecting funds, such as the real estate industries.
Therefore, it is not necessary for the operating CF to be positive every year, but if it continues to be negative, you shoukd be careful.
You can avoid the serious situation that the stock price becomes 0 yen just by checking the CF in operation at a glance.
It is desirable that the operating CF is positive, but it can also be considered that management that only accumulates cash is reducing returns to shareholders.
In addition to the positive operating CF, it is better to check whether the CF has led to investment to growth or dividends increase.
Working capital is the funds required in short-term to continuously operate a business.
Companies repeat the process from purchasing to sales, that is, the normal operating cycle.
Figure 2-2-1(a) shows this normal operating cycle.
In this process, the purchase comes first and the sale comes later.
Therefore, the payment of trade payables is usually made first, and the collection of trade receivables comes later.
If this cycle is repeated, the trade receivables, inventories, and trade payables on the balance sheet will be as shown in Figure 2-5-1 (a).
Assuming a company with stable business, even if the company pays for its trade payables by the cash collected from trade receivables, it needs to purchase again in order to make new sales.
So, the trade payables will not be reduced even if it is paid.
And trade receivables and inventories are also stable.
As described in the explanation of cost of sales, inventories represent cost amounts.
In addition, trade receivables are uncollected sales amounts, and the sales amounts are divided into costs and profits.
Therefore, although it depends on the gross profit margin, trade receivables and inventories consist mostly of costs.
These assets, mainly composed of costs, should have been built up by the company paying cash.
Although the source of cash can be either the company's own funds or borrowings, Such short-term funding is usually covered by borrowing.
Profits are often used for investments or distributions.
Companies require funds in the short term to operate their businesses on an ongoing basis.
In the explanation so far, the amount required corresponds to the sum of receivables and inventories.
Net working capital (NWC) is the shortfall to that amount required, and is the difference between these current assets and current liabilities.
Net working capital is often referred to simply as working capital (WC).
Since profits are usually smaller than costs, and profit margins also vary from company to company, net working capital can be expressed by the following formula when profits are ignored.
Trade receivables is uncollected cash in sales proceeds, which is typically notes and accounts receivable-trade.
Trade Payables is unpaid cash in the purchase price, which is typically notes and accounts payable-trade.
Inventories is goods that the company possesses for the purpose of selling, such as merchandise and finished goods, work in process, and raw materials.
NWC = Trade Receivables + Inventories − Trade Payables
Next, consider the case where each term in this formula changes.
Trade receivables are the portion that a company has not yet been able to collect as cash, among the sales.
And, most of trade receivables are costs.
Therefore, if inventories and trade payables remain constant and trade receivables increase, the funds required will increase accordingly.
More simply, you can also think of it as a decline in the cash collection rate from sales.
The amount of inventries is the cost of inventories that have not yet been sold.
Inventory increases by being added or not sold.
Therefore, if trade receivables and trade payables remain constant and inventories increase, the funds required will increase or the cash required for payment will decrease.
Trade receivables are the portion that a company has not yet paid cash, among the purchases.
Trade payables turn into inventories, and inventories turn into sales.
Therefore, if trade receivables and inventories remain constant and trade payables increase, the cash collected from sales will increase accordingly.
More simply, you can also think of it as a decrease of the payment for the debt.
If considering about covering this funds required with own funds rather than borrowing, working capital can be understood more succinctly in terms of cash flows.
An increase in trade receivables and inventories leads to an increase in cash outflow or a decrease in cash intflow.
increasing trade receivables is pleasure event from a sales perspective, but it means a decrease in cash from a cash flow perspective.
An increase in trade receivables leads to an increase in cash inflow or a decrease in cash outflow.
decreasing trade payables is welcome event from the perspective of debt reduction, but it means a decrease in cash from a cash flow perspective.
By the way, when calculating working capital, there are cases where it is better to include accounts such as accounts receivable-other, prepaid expenses, accounts payable-other, and accrued expenses.
These accounts are similar to trade receivables or trade payables in that they are assets or liabilities that will generate cash flow in the near future.
Therefore, if the amount is large, it is necessary to take these factors into consideration.
However, since these accounts are usually smaller in scale than trade receivables and trade payables, this website will not use them.
The following formula may also be used to calculate net working capital.
This is a more general formula, that includes more accounts than trade receivables, inventories, and trade payables, used for in the formula above.
NWC = Current Assets (excluding cash and deposits) − Current Liabilities (excluding interest-bearing debt)
However, this website emphasizes on cash increases and decreases from main business, and will use the previous formula to calculate net working capital.
As explained so far, an increase in trade receivables or a decrease in trade payables will increase working capital, which lead to a decrease in cash.
This amount of change is called the change in Working Capital (ΔWC)
ΔWC = Working capital for the current period − Working capital in the previous period
A positive ΔWC means that the funds required to operate the business have increased.
The positive ΔWC leads to a decrease in the free cash flow of the company.
In the cases that inventories builds up, or that the collection of trade receivables is slower than the payment of accounts payable, ΔWC will be positive, and free cash flow will decrease.
Conversely, a negative ΔWC indicates that the company has improved its cash flow.
The increase in working capital suggests that a rapid expansion of a business without cash inflow is also dangerous for a company to continue its business.
If the working capital for the current period and for the previous period are obtained, the amount of ΔWC can be obtained from the difference.
This website calculates working capital using the following formula:
WC = Trade Receivables + Inventories − Trade Payables
Trade receivables is typically notes and accounts receivable-trade.
Trade Payables is typically notes and accounts payable-trade.
Inventories is merchandise and finished goods, work in process, and raw materials.
To be precise, there are some cases that working capital is calculated to include accounts such as accounts receivable, prepaid expenses, accounts payable, and accrued expenses.
In addition, there are also some cases that different formulas is used to calculate working capital.
WC = Current assets (excluding cash and deposits) − Current liabilities (excluding interest-bearing debt)
But, on this website, working capital will be calculated using the formula and account, described at the beginning.
Here, an example of the calculation of ΔWC is shown using the following balance sheet.
In order to make it easier to understand the difference between the current period and the previous period, the assets, liabilities, and net assets of each fiscal year are arranged in a vertical column.
The unit of the balance sheet is 1 billion yen.
| At end of previous period | At end of current period |
|
Assets Current assets ・・・ Notes and accounts receivable-trade 350 ・・・ Merchandise and finished goods 200 Work in process 150 Raw materials and supplies 100 ・・・ Total current assets ・・・ |
Assets Current assets ・・・ Notes and accounts receivable-trade 450 ・・・ Merchandise and finished goods 250 Work in process 150 Raw materials and supplies 150 ・・・ Total current assets ・・・ |
| Total assets | Total assets |
|
Liabilities Current Liabilities Notes and accounts payable-trade 140 ・・・ Total current liabilities ・・・ Total liabilities Net assets ・・・ Total net assets |
Liabilities Current Liabilities Notes and accounts payable-trade 180 ・・・ Total current liabilities ・・・ Total liabilities Net assets ・・・ Total net assets |
| Total liabilities and net assets | Total liabilities and net assets |
In the working capital formula, "accounts receivable-trade" is applied as trade receivables, "merchandise and finished goods", "work in process" and "raw materials and supplies" are applied as inventories, and "notes and accounts payable-trade" is applied as trade payables.
Supplies have different properties from inventories, but since the amount of supplies is smaller than that of inventories, they are ignored here and counted.
Although supplies has different properties from inventories, since the amount of supplies is smaller than that of inventories, it is ignored and counted here.
Therefore
With a unit, ΔWC in the example of the balance sheet above is 160 billion yen.
By the way, ΔWC was calculated from the account based on Japanese GAAP here.
But IFRS balance sheet make easier to calculate because it contains accounts that represent trade receivables, inventories, and trade payables.