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CHAPTER 13:
FINANCING RATIOS – INDEBTNESS OF THE BUSINESS

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Equity Multiplier
Debt-to-Equity Ratio
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CHAPTER 13:
FINANCING RATIOS – INDEBTNESS OF THE BUSINESS  

Financing ratios measure how the company’s operation is being funded, either by the company’s own resources or loans. There are a few versions, and one of the most common I use is Equity Multiplier.

Equity Multiplier

First, a recap on the accounting equation we discussed earlier.

 Assets   =  Liabilities  +  Shareholders’ Equity
(the assets owned by the company) (external parties that the company owes money to) (the amount the company owed the shareholders)

It shows whatever assets that the company owns are either financed by loans from third parties or capital contributed by the shareholders. Now let’s look at the formula for Equity Multiplier.

Equity Multiplier = Total Assets
  Shareholders’ Fund

Back to the example of Apex and Pharmaniaga:

Table 1: Equity Multiplier

Formula = Total Assets X 100%
Shareholders’ Fund
Apex = RM418.4 m X 100%
RM312.4 m
= 133.9%
Pharmaniaga = RM1,683.1 m X 100%
RM559.4 m
= 300.9%

What this means is that Pharmaniaga uses more leverage compared to Apex. However, if one were to look at the Table 1, it shows Pharmaniaga’s leverage comes from short term borrowings and creditors (in the form of Trade Payables). Also recall that Pharmaniaga on average takes a longer time to pay its creditors compared with Apex (81 days for Pharmaniaga vs 62 days for Apex in terms of Days Trades Payable).

Table 1: Selected Financial Data Extracted from 2015 & 2016 Annual Reports (in RM million)
Apex Pharmaniaga
  2015 2016 2015 2016
Income Statement
Revenue/Sales 526.9 581.3 2,189.3 2,189.0
Cost of sales 407.1 452.9 1,836.5 1,845.8
Net Profit 34.2 35.0 84.0 45.6
Balance Sheet
Opening inventories* 51.7 60.9 427.0 539.9
Closing Inventories 60.9 65.8 539.9 532.2
Trade Receivables 123.1** 132.9** 147.7 161.3
Total Assets 390.2 418.4 1,495.6 1,683.1
Trade Payables 74.4*** 80.1*** 435.9 378.1
Short term borrowings – – 399.6 616.7
Long term borrowings – – 0.6 0.3
Shareholders’ fund 288.7 312.4 560.0 559.4
*Opening inventories are the closing inventories in the previous financial year.

**Page 121 of Apex’s 2016 annual report, under notes to the accounts 20. Trade and Other Receivables

 ***Page 127 of Apex’s 2016 annual report, under notes to the accounts 25. Trade and Other Payables.

 

Debt-to-Equity Ratio

The second common financing ratio is Debt-to-Equity ratio.

 
Debt-to-Equity = Total Debts
  Shareholders’ Fund
   
   

Table 3: Debt-to-Equity Ratio

Formula = Total Debts X 100%
Shareholders’ Fund
Apex = 0 X 100%
RM312.4 m
= Zero debts
`
Pharmaniaga = RM616.7 m + RM0.3 m X 100%
RM559.4 m
= 110.3%

 

As Apex does not have any borrowings, Debt-to-Equity ratio does not apply to Apex. However, the conclusion is the same as the earlier Equity Multiplier ratio, which shows that Pharmaniaga has greater leverage of debts compared with Apex.

 In the next posting, we will look at Return on Equity and Du Pont Model.

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