Introduction to Corporate Finance

PArT 1: INTrODuCTION

GPC’s fixed asset turnover in 2016 is 1.91. Stated another way, GPC generates almost $2 in sales for

every dollar of fixed assets. As with other ratios, the level of fixed asset turnover considered normal varies

widely from one industry to another.

The total asset turnover ratio indicates the efficiency with which a company uses all its assets to

generate sales. Like the fixed asset turnover ratio, total asset turnover indicates how many dollars of

sales a company generates per dollar of asset investment. All other factors being equal, analysts favour

a high turnover ratio: it indicates that a company generates more sales (and, ideally, more cash flow for

investors) from a given investment in assets.

GPC’s total asset turnover in 2016 equals 1.34, calculated as follows:

Totalassetturnover===

Sales

Totalassets

$12,843

$9,589

1. 34

When using the fixed asset and total asset turnover ratios, an analyst must be aware that these are

calculated using the historical costs of fixed assets. Because some companies have significantly newer or

older assets than do others, comparing fixed asset turnovers of those companies could be misleading.

Companies with newer assets tend to have lower turnovers than those with older assets, which have

lower book (accounting) values. A naïve comparison of fixed asset turnover ratios for different companies

may lead an analyst to conclude that one company operates more efficiently than another when, in fact,

the company that appears to be more efficient simply has older (more fully depreciated) assets on its

books.

2-3d DEBT rATIOS

Companies finance their assets from two broad sources, equity and debt. Equity comes from shareholders,

whereas debt comes in many forms from many different lenders. Companies borrow from suppliers, banks

and investors who buy publicly traded bonds. Debt ratios measure the extent to which a company uses

money from creditors rather than from shareholders to finance its operations. Because creditors’ claims

must be satisfied before companies can distribute earnings to shareholders, current and prospective

investors pay close attention to the debt on the balance sheet. The more indebted the company, the

higher the probability that it will be unable to satisfy the claims of all its creditors.

Fixed-cost sources of financing, such as debt and preferred shares, create financial leverage that

magnifies both the risk and the expected return on the company’s securities.^6 In general, the more debt a

company uses in relation to its total assets, the greater its financial leverage. That is, the more a company

borrows, the riskier its outstanding shares and bonds and the higher the return that investors require on

those securities. Later in the text, we discuss in detail the effect of debt on the company’s risk, return

and value. This explains our focus on the use of debt ratios when assessing a company’s indebtedness

and its ability to meet the fixed payments associated with debt – a way of quantifying financial leverage.

Broadly speaking, there are two types of debt ratios. One type focuses on how much debt (relative

to other sources of financing) appears on a company’s balance sheet. The other type, known as coverage

ratio, uses data from the income statement to assess the company’s ability to generate sufficient cash flow

to make scheduled interest and principal payments. Investors and credit-rating agencies use both types

of ratios to assess a company’s creditworthiness.

6 By fixed cost, we mean that the cost of this financing source does not vary over time in response to changes in the company’s revenue and

cash flow. For example, if a company borrows money at a variable rate, then the interest cost of that loan is not fixed through time, although

the company’s obligation to make interest payments is ‘fixed’ regardless of the level of the company’s revenue and cash flow.

financial leverage
Using fixed-cost sources of
financing, such as debt and
preferred shares, to magnify
both the risk and the expected
return on a company’s
securities

coverage ratio
A debt ratio that uses data
from the income statement to
assess the company’s ability to
generate sufficient cash flow
to make scheduled interest and
principal payments

total asset turnover

A measure of the efficiency

with which a company uses all

its assets to generate sales;

it is calculated by dividing the

dollars of sales a company

generates by the dollars of

total asset investment