© 2000 John Petroff
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© 2000 John Petroff |
What such ratios must show is the extent to which fixed assets are financed with debt. One method would be to compare proportions of assets and debt (on the right and left sides) of a normalized balance sheet. For example, the proportions of debt of Company X in Table T-11.1 (i.e. 20%, 30% …, 80%) can be compared to the projected proportion of needed assets (e.g. 50% of total assets, for instance). This has already been undertaken in Chapter 10.
A more direct comparison is to modify the proportion of debt in total assets by including only fixed assets:
Debt to fixed assets = Debt / Fixed Assets
In this comparison, short term debt ought to be excluded because it is used to finance current assets:
Debt to fixed assets = Long term debt / Fixed assets
The closer the ratio is to one, the more the company is using debt to finance its fixed assets, and therefore, the more the company is potentially exposed to financial risk. But, the assessment is not complete unless debt and fixed assets are also compared to total assets or to equity (i.e. if both debt and fixed assets are small, there is nothing to worry about).
The ratio of long term debt to fixed assets should be less than one in most industries because a portion of fixed assets must be financed with equity. A ratio of less than one also offers greater cushion for lenders. It goes without saying that fixed assets must never be financed by short term liabilities. However, in industries where there is little need for large fixed assets, the ratio can be greater than one because long term debt can be financing working capital, inventory in particular.
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We will use three different companies to illustrate the use of this ratio. First we calculate the ratio for The Timken Company. From Table T-6.2 - The Timken Company - Balance Sheets 1998-99, we take the amounts of long term debt $ 327 millions and of net fixed assets of $ 1,381 millions in 1999. This gives a debt to fixed assets ratio of Debt to fixed assets = 327 / 1,381 = 0.24 This ratio of 0.24 shows that Timken uses little debt to finance its fixed assets, when compared to values of 0.57 and 0.54 for the steel and auto parts industries respectively (the ratios are derived from RMA Annual Statement Studies normalized balance sheet statistics). Next we look at the debt to fixed assets ratio of Bell Atlantic. The amounts of long term debt of $ 17,646 millions and fixed assets of $ 36,816 are taken from Table T- 6.6 - Bell Atlantic Corporation - Balance Sheets. This gives a ratio of Debt to fixed assets = 17,646 / 36,816 = 0.48 Bell Atlantic ratio is more conservative than 0.62 obtained for the telephone industry in RMA. But the fixed assets of Bell Atlantic are unusually large 57% of total assets compared to an average of 40% for the industry. Moreover, long term debt is 36% of total assets compared to an average of 25% for the industry. This indicates that even if the debt to fixed assets is moderate, the correct interpretation is that both operating leverage and financial leverage are high. Finally, we calculate the debt to fixed assets ratio of J.C. Penney. The amounts of long term debt of $ 7,143 millions and fixed assets of $ 5,458 are taken from Table T-6.10 - J.C. Penney Company Inc. - Balance Sheets. This gives Debt to fixed assets = 7,143 / 5,458 = 1.31 Notwithstanding our observation of a high J.C. Penney's financial leverage previously noted, this debt to fixed assets ratio is surprisingly high. Compared to the department stores ratio of .81, it does not look as bad, but it still looks high. |
Note that in the calculation of debt to fixed assets ratio, it is naturally long term debt that should be used in the ratio, without any deferred taxes, post-retirement benefits, provisions or other non-current liabilities because none of the latter are specifically obtained to finance fixed assets and these amount could not cause the company to go into default. But, in some cases, it is not possible to isolate long term debt, and the analyst is forced to use non-current liability total instead. The analysis can still be performed, but care must be exercised that all comparative statistics are configured in the same manner.
A complement to debt to fixed assets ratio is to compare equity to fixed assets. It is most commonly found in the inverse formulation of
Fixed assets to equity = Average fixed assets / Average equity
Note that assets are sometime averaged to take out the effect of discontinued operations and changes in depreciation that may take place between the beginning and end of the year. Equity is likewise averaged. This ratio is used in long run comparison. For short run analysis, end of year net fixed assets would be better. In addition, a more precise ratio would require that equity in the denominator be net of intangibles, and it is then designated as tangible net worth (i.e. total assets minus all liabilities and intangible assets)
Fixed to worth = Net Fixed Assets / Tangible net worth
This is the formula used in Robert Morris Associates "Annual Statement Studies".
If the fixed to worth ratio is high it indicates that little equity is financing fixed assets. Consequently, it is likely to be financed with debt, which is more risky for lenders as well as for the company. Thus, a lower ratio is preferable.
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Let us take the same three companies as for the debt to fixed assets ratio to illustrate fixed to worth ratio. For Timken the amount of 1999 equity of $ 1,046 millions is reduced by intangibles of $154 millions to give a net worth of $ 892 millions (from Table T-6.2 - The Timken Company - Balance Sheets 1998-99). Dividing that into fixed assets of $ 1,381 millions, gives a fixed to worth ratio of Fixed to worth = 1,381 / 892 = 1.54 Timken fixed to worth ratio is high when compared to median values of .9 for both the steel and auto parts industries. But we remember that the debt to fixed assets ratio also smaller. Together these ratios indicate that Timken has a lot of operating risk, but only little financial risk. However, because Timken faces a cyclical demand and foreign competition, even a modest financial risk can be a problem when combined with a large operating risk. In 1998, Bell Atlantic has an equity of $ 13,025 millions, fixed assets of $ 36,815, and no intangibles reported on the balance sheet (as shown in Table T- 6.6 - Bell Atlantic Corporation - Balance Sheets). The fixed to worth ratio is therefore Fixed to worth = 36,815 / 13,025 = 2.82 Bell Atlantic's fixed to worth ratio is very high when compared to the median for the telephone industry of 1.5 (and an upper quartile of 3.7). This indicates Bell Atlantic does not have enough equity. We remember that the conclusion of the debt to fixed assets ratio revealed high operating leverage and financial leverage. Together with insufficient equity, this points to trouble. Bell Atlantic has been facing a stable and somewhat protected market, and has not yet experienced financial difficulties as a result of its precarious position. That may change as the telecommunication sector is in turmoil with entry of new competitors, such as cable, internet, microwave, satellite, cellular and x-ray companies. For J.C. Penney, Table T-6.10 - J.C. Penney Company Inc. - Balance Sheets, shows that fixed assets amount to $ 5,458 millions, while equity is $ 7,169 millions net of $ 2,933 millions gives a net worth of $ 4,236. The fixed to worth ratio is Fixed to worth = 5,458 / 4,236 = 1.29 J.C. Penney fixed to worth ratio is also very high: is is almost as high as the upper quartile of 1.3 for the department stores industry (the median is only .8). The situation appears to be somewhat distorted by the large goodwill resulting from a recent purchase. But the insufficient equity is confirmed by a proportion of equity in total assets of only 30% compared to 40% or more for the industry. In fact, fixed assets are also relatively small with 22% compared to 28% for the industry. Putting things together with the previously noted very high debt to fixed assets ratio, leads to the same conclusion that J.C. Penney has a high financial risk, but its operating risk is less a problem. It remains to be seen if J.C. Penney faces a sufficiently stable market and has sufficient size to be insulated from the burden of its long term debt. |
See review questions Q-11D3.1 and Q-11D3.2.
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