Lesson: 70

Topic: Additional ratios, percentages, and statistics

Objectives:

During this class, students will explore additional ratios, percentages, and statistics which can be used to illustrate specific aspects of a business' financial position, these include the:

• 1.Collection Period,
• 2.Inventory Turnover, and the
• 3.Times Interest Earned Ratio,

1.The Collection Period is calculated by using the following formula:

2.Inventory Turnover is calculated by using the following formula:

3.The Times Interest Earned Ratio is calculated by using the following formula:

Times Interest Earned Ratio:

This ratio is simply looking at the company's Net Income as a 
percentage of the total money it spends on interest charges. Interest 
here refers to the total COST associated with carrying the company's 
liabilities. So we are talking about interest we have been charged on 
mortgages, loans, and account payables for the year. Once again, 
consider a personal situation first. What if you had a credit card loan 
that was costing you $100.00 a month in interest alone! Not a very 
good situation. However, if you are able to bring home $2,000.00 a 
month from your salary, you could probably handle it. However, what 
if you discovered that a highschool student had run up the same credit 
card bill, and was being charged the same amount in interest? What if 
this student only earns $80.00 a month from his/her allowance. Do you 
see the problem here? The highschool student doesn't even EARN 
enough money to pay the interest on the debt! These are two extreme 
examples, but they illustrate the point we are looking at. Now let's 
look at two more subtle business examples:

Company A

Net Income: 		$4,000.00/year
Total Liabilities:     $2,000.00
Interest Expense: 	$200.00/year (10% of $2,000.00)


Times Interest Earned 	= 	Net Income
				----------------
				Interest Expense


			
			=	4,000.00
				--------
				  200.00

			=	20.0


This isn't bad at all. It shows us that Company A earns 20 times the 
amount of money which they spend to service their debt. Obviously, 
they can more than afford the debt which they are carrying.


Company B

Net Income: 		$80,000.00/year
Total Liabilities: $400,000.00
Interest Expense: 	$40,000.00/year (10% of $400,000.00)


Times Interest Earned 	= 	Net Income
				----------------
				Interest Expense


			
			=	80,000.00
				---------
				40,000.00

			=	2.0



Yeesh! This is bad! This shows us that company B only earns 2 
times the amount of money which they spend to service their debt! 
Even though this company earns a lot more money than Company A, 
half their Net Income is spent on interest charges! Their debt ratio of 40% 
(see above) didn't look too good, but now that we know how little they 
earn every year in comparison to the money they spend to carry their 
debt, we can clearly see that this company's situation is DESPERATE! 
This company would have an almost impossible time borrowing any 
additional funds. 

Method of Instructions and Evaluation:

i) Open up the spreadsheet you completed for Topics #68 and 69. Use Excel to calculate the following figures based on the financial statements provided:

• 1.Collection Period,
• 2.Inventory Turnover, and
• 3.Times Interest Earned Ratio

Notes:

i) Use Company A from the Income Statement,

ii) use the year 2002 from the Balance Sheet.

iii) Assume that ALL sales are credit sales.

(Save this spreadsheet as "yourname, topic #69")

Reference:

text, chapter #13, pages 606-612