| In examining a company's liquidity, one important item | | | | creditors may force the company into bankruptcy. |
| to look at is the inventory. Is it turning over relatively | | | | Evidently, bonds are a more risky method of raising |
| quickly, thereby generating a steady flow of cash? | | | | capital than stock. |
| Or is it stagnant, and in danger of becoming | | | | Why, then, does a company sell any bonds? One |
| obsolete? A convenient measure that is applicable to | | | | reason has to do with the relative expense of these |
| these questions is the inventory turnover. | | | | two sources of capital. Investors are willing to loan |
| Inventory turnover is calculated by dividing the | | | | money to a company with a good credit rating at |
| average cost of goods on hand during the period, i.e., | | | | interest rates of 4% to 6%, whereas stockholders |
| the average inventory into the total cost of goods | | | | expect a return of 10% or more. |
| sold during the period. Thus inventory turnover tells | | | | Evidently, capital raised by selling bonds is less |
| us how many times the inventory was totally | | | | expensive than capital raised by selling stock and is |
| replaced during the period in order to furnish the | | | | more risky for the business. |
| necessary goods sold. | | | | Bonds are noncurrent liabilities. But the same risks to |
| For Bed Linens Company, the average cost of goods | | | | the business apply in the case of current liabilities; i.e., |
| on hand during 2009 may be determined by | | | | if the business fails to meet its current obligations |
| averaging the inventories at the start and close of | | | | when they fall due, the creditors can force the |
| the period. The calculated average cost of goods on | | | | company into bankruptcy. |
| hand for Bed Linens Corporation between December | | | | Thus, all liabilities, current or noncurrent, entail some |
| 31, 2008 and December 31, 2009, was $55,000. Its | | | | risk. We shall use the term debt to mean all liabilities, |
| total cost of goods sold during 2009 was $180,000. | | | | both current and noncurrent. The debt of Bed Linens |
| Inventory turnover is obtained by dividing the | | | | Company was $100,000 on December 31, 2009. |
| average inventory into the cost of goods sold during | | | | It should be mentioned, however, that some analysts |
| the year. Bed Linens Company's average inventory | | | | use the word debt to refer only to noncurrent |
| during 2008 was $55,000, and the total cost of | | | | liabilities. In our use of the term, it refers to both |
| goods sold during 2009 was $180,000. Therefore the | | | | current and noncurrent liabilities. |
| inventory turnover during 2009 was 3.3. | | | | It should be clear from what has been said so far |
| Suppose that having examined the current ratio and | | | | that the higher the proportion of debt in the equities |
| inventory, we decide that Bed Linens Company's | | | | of a business, the greater the risk of bankruptcy in |
| financial condition is satisfactory with respect to its | | | | the event of difficult times. |
| ability to meet its current obligations. We still must | | | | We used the term capital to refer to the balance |
| examine its ability to meet the interest costs and | | | | sheet items that represent owners' equity. The term |
| repayment schedules associated with its long-term | | | | total capital refers to all the equities of a business, |
| debt, i.e., we must examine its solvency. | | | | both those of the owners and those of the creditors. |
| A business obtains permanent capital by selling either | | | | Thus the term total equities is synonymous with the |
| stock or bonds. As to the holders of stock, there are | | | | term total capital. |
| no fixed obligations; i.e., the company need not | | | | Because the term total capital means the same thing |
| declare dividends each year, and when dividends are | | | | as total equities, we might have said, ".. the higher |
| declared there is no minimum amount that they must | | | | the proportion of debt in the total capital of a |
| be. | | | | business, the greater the risk of bankruptcy in the |
| As to the holders of bonds, however, there are two | | | | event of difficult times." |
| fixed obligations that must be met: | | | | If a financial analyst wishes to examine the |
| (1) Payment of interest | | | | proportion of debt in the total capital of a business |
| (2) Repayment of principal | | | | he may use the debt-to-total-capital ratio. This is |
| If the company defaults in meeting its bond | | | | simply debt divided by total capital. |
| obligations either as to interest or principal, the | | | | |