ABMF 3174 Assignment

Liquidity Measurement Ratios

Liquidity ratios attempt to measure a company's ability to pay off its short-term
debt obligations. This is done by comparing a company's most liquid
assets (or, those that can be easily converted to cash), its short-term liabilities.

In general, the greater the coverage of liquid assets to short-term liabilities the
better as it is a clear signal that a company can pay its debts that are coming
due in the near future and still fund its ongoing operations. On the other hand,
a company with a low coverage rate should raise a red flag for investors as it
may be a sign that the company will have difficulty meeting running its
operations, as well as meeting its obligations.

Current Ratio

The concept behind this ratio is to ascertain whether a company's short-term

assets (cash, cash equivalents, marketable securities, receivables and
inventory) are readily available to pay off its short-term liabilities (notes
payable, current portion of term debt, payables, accrued expenses and taxes).
In theory, the higher the current ratio, the better.

Formula:

The current ratio is used extensively in financial reporting. However, while

easy to understand, it can be misleading in both a positive and negative sense
- i.e., a high current ratio is not necessarily good, and a low current ratio is not
necessarily bad (see chart below).

When looking at the current ratio, it is important that a company's current

assets can cover its current liabilities; however, investors should be aware that
this is not the whole story on company liquidity. Try to understand the types of
current assets the company has and how quickly these can be converted into
cash to meet current liabilities. This important perspective can be seen
through the cash conversion cycle (read the chapter on CCC now). By digging
deeper into the current assets, you will gain a greater understanding of a
company's true liquidity.

Company Company
--
ABC XYZ
Current
$600 $300
Assets
Current
$300 $300
Liabilities
Working
$300 $0
Capital
Current
2.0 1.0
Ratio

Company ABC looks like an easy winner in a liquidity contest. It has an ample
margin of current assets over current liabilities, a seemingly good current ratio,
and working capital of $300. Company XYZ has no current asset/liability
margin of safety, a weak current ratio, and no working capital.

However, to prove the point, what if: (1) both companies' current liabilities
have an average payment period of 30 days; (2) Company ABC needs six
months (180 days) to collect its account receivables, and its inventory turns
over just once a year (365 days); and (3) Company XYZ is paid cash by its
customers, and its inventory turns over 24 times a year (every 15 days). 

In this contrived example, Company ABC is very illiquid and would not be able

to operate under the conditions described. Its bills are coming due faster than
its generation of cash. You can't pay bills with working capital; you pay bills
with cash! Company's XYZ's seemingly tight current position is, in effect,
much more liquid because of its quicker cash conversion. 

Quick Ratio

he quick ratio - aka the quick assets ratio or the acid-test ratio - is a liquidity
indicator that further refines the current ratio by measuring the amount of the
most liquid current assets there are to cover current liabilities. The quick ratio
is more conservative than the current ratio because it excludes inventory and
other current assets, which are more difficult to turn into cash. Therefore, a
higher ratio means a more liquid current position.

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer

Holdings' quick assets amounted to $756.40 (balance sheet); while current
liabilities amounted to $606.90 (balance sheet). By dividing, the equation
gives us a quick ratio of 1.3.

Variations:
Some presentations of the quick ratio calculate quick assets (the formula's
numerator) by simply subtracting the inventory figure from the total current
assets figure. The assumption is that by excluding relatively less-liquid (harder
to turn into cash) inventory, the remaining current assets are all of the more-
liquid variety. Generally, this is close to the truth, but not always.

Zimmer Holdings is a good example of what can happen if you take the
aforementioned "inventory shortcut" to calculating the quick ratio:

standard Approach: $233.2 plus $524.2 = $756 ÷ $606.9 =1.3

shortcut Approach: $1,575.6 minus $583.7 = $991.9 ÷ $606.9 = 1.6

Restricted cash, prepaid expenses and deferred income taxes do not pass the
test of truly liquid assets. Thus, using the shortcut approach artificially
overstates Zimmer Holdings' more liquid assets and inflates its quick ratio.
Commentary:
As previously mentioned, the quick ratio is a more conservative measure of
liquidity than the current ratio as it removes inventory from the current assets
used in the ratio's formula. By excluding inventory, the quick ratio focuses on
the more-liquid assets of a company. 

The basics and use of this ratio are similar to the current ratio in that it gives
users an idea of the ability of a company to meet its short-term liabilities with
its short-term assets. Another beneficial use is to compare the quick ratio with
the current ratio. If the current ratio is significantly higher, it is a clear
indication that the company's current assets are dependent on inventory.

While considered more stringent than the current ratio, the quick ratio,
because of its accounts receivable component, suffers from the same
deficiencies as the current ratio - albeit somewhat less. To understand these
"deficiencies", readers should refer to the commentary section of the Current
Ratio chapter. In brief, both the quick and the current ratios assume a
liquidation of accounts receivable and inventory as the basis for measuring
liquidity. 

While theoretically feasible, as a going concern a company must focus on the

time it takes to convert its working capital assets to cash - that is the true
measure of liquidity. Thus, if accounts receivable, as a component of the quick
ratio, have, let's say, a conversion time of several months rather than several
days, the "quickness" attribute of this ratio is questionable.

Investors need to be aware that the conventional wisdom regarding both the
current and quick ratios as indicators of a company's liquidity can be
misleading.

Cash Ratio

The cash ratio is an indicator of a company's liquidity that further refines both
the current ratio and the quick ratio by measuring the amount of cash, cash
equivalents or invested funds there are in current assets to cover current
liabilities. 

Formula:
Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer

Holdings' cash assets amounted to $233.20 (balance sheet); while current
liabilities amounted to $606.90 (balance sheet). By dividing, the equation
gives us a cash ratio of 0.4

ommentary:
The cash ratio is the most stringent and conservative of the three short-
term liquidity ratios (current, quick and cash). It only looks at the most liquid
short-term assets of the company, which are those that can be most easily
used to pay off current obligations. It also ignores inventory and receivables,
as there are no assurances that these two accounts can be converted to cash
in a timely matter to meet current liabilities.

Very few companies will have enough cash and cash equivalents to fully cover
current liabilities, which isn't necessarily a bad thing, so don't focus on this
ratio being above 1:1.

The cash ratio is seldom used in financial reporting or by analysts in the

fundamental analysis of a company. It is not realistic for a company to
purposefully maintain high levels of cash assets to cover current liabilities. The
reason being that it's often seen as poor asset utilization for a company to
hold large amounts of cash on its balance sheet, as this money could be
returned to shareholders or used elsewhere to generate higher returns. While
providing an interesting liquidity perspective, the usefulness of this ratio is
limited.

Cash Conversion Cycle

his liquidity metric expresses the length of time (in days) that a company uses
to sell inventory, collect receivables and pay its accounts payable. The cash
conversion cycle (CCC) measures the number of days a company's cash is
tied up in the the production and sales process of its operations and the
benefit it gets from payment terms from its creditors. The shorter this cycle,
the more liquid the company's working capital position is. The CCC is also
known as the "cash" or "operating" cycle.

Formula:

Components:

DIO is computed by:

1. Dividing the cost of sales (income statement) by 365 to get a cost of

sales per day figure; 
2. Calculating the average inventory figure by adding the year's beginning
(previous yearend amount) and ending inventory figure (both are in the
balance sheet) and dividing by 2 to obtain an average amount of
inventory for any given year; and 
3. Dividing the average inventory figure by the cost of sales per day figure.

or Zimmer's FY 2005 (in $ millions), its DIO would be computed with these
figures:

(1) cost of sales

739.4 ÷ 365 = 2.0
per day
536.0 + 583.7 =
(2) average
1,119.7 ÷ 2 =
inventory 2005
559.9
(3) days inventory 559.9 ÷ 2.0 =
 outstanding 279.9

DIO gives a measure of the number of days it takes for the company's
inventory to turn over, i.e., to be converted to sales, either as cash or accounts
receivable.

DSO is computed by:

1. Dividing net sales (income statement) by 365 to get a net sales per day
figure; 
2. Calculating the average accounts receivable figure by adding the year's
beginning (previous yearend amount) and ending accounts receivable
amount (both figures are in the balance sheet) and dividing by 2 to
obtain an average amount of accounts receivable for any given year;
and 
3. Dividing the average accounts receivable figure by the net sales per day
figure.

For Zimmer's FY 2005 (in $ millions), its DSO would be computed with these
figures:

(1) net sales per 3,286.1 ÷ 365 =

day 9.0
(2) average 524.8 + 524.2 =
accounts 1,049 ÷ 2 =
receivable 524.5
(3) days sales 524.5 ÷ 9.0 =
outstanding 58.3

DSO gives a measure of the number of days it takes a company to collect on

sales that go into accounts receivables (credit purchases).

DPO is computed by:

1. Dividing the cost of sales (income statement) by 365 to get a cost of

sales per day figure; 
2. Calculating the average accounts payable figure by adding the year's
beginning (previous yearend amount) and ending accounts payable
 amount (both figures are in the balance sheet), and dividing by 2 to get
an average accounts payable amount for any given year; and
3. Dividing the average accounts payable figure by the cost of sales per
day figure.

For Zimmer's FY 2005 (in $ millions), its DPO would be computed with these
figures:

(1) cost of sales 739.4 ÷ 365

per day = 2.0
131.6 +
(2) average
123.6 =
accounts
255.2 ÷
payable
125.6
(3) days payable 125.6 ÷ 2.0
outstanding = 63

DPO gives a measure of how long it takes the company to pay its obligations
to suppliers.

CCC computed:
Zimmer's cash conversion cycle for FY 2005 would be computed with these
numbers (rounded):

DIO 280 days

DSO +58 days
DPO -63 days
CCC 275 days
Variations:
Often the components of the cash conversion cycle - DIO, DSO and DPO -
are expressed in terms of turnover as a times (x) factor. For example, in the
case of Zimmer, its days inventory outstanding of 280 days would be
expressed as turning over 1.3x annually (365 days ÷ 280 days = 1.3 times).
However, actually counting days is more literal and easier to understand when
considering how fast assets turn into cash. 
Commentary:
An often-overlooked metric, the cash conversion cycle is vital for two reasons.
First, it's an indicator of the company's efficiency in managing its important
working capital assets; second, it provides a clear view of a company's ability
to pay off its current liabilities. 

It does this by looking at how quickly the company turns its inventory into
sales, and its sales into cash, which is then used to pay its suppliers for goods
and services. Again, while the quick and current ratios are more often
mentioned in financial reporting, investors would be well advised to measure
true liquidity by paying attention to a company's cash conversion cycle. 

The longer the duration of inventory on hand and of the collection of

receivables, coupled with a shorter duration for payments to a company's
suppliers, means that cash is being tied up in inventory and receivables and
used more quickly in paying off trade payables. If this circumstance becomes
a trend, it will reduce, or squeeze, a company's cash availabilities. Conversely,
a positive trend in the cash conversion cycle will add to a company's liquidity.

By tracking the individual components of the CCC (as well as the CCC as a
whole), an investor is able to discern positive and negative trends in a
company's all-important working capital assets and liabilities. 

For example, an increasing trend in DIO could mean decreasing demand for a
company's products. Decreasing DSO could indicate an increasingly
competitive product, which allows a company to tighten its buyers' payment
terms. 

As a whole, a shorter CCC means greater liquidity, which translates into less
of a need to borrow, more opportunity to realize price discounts with cash
purchases for raw materials, and an increased capacity to fund the expansion
of the business into new product lines and markets. Conversely, a longer CCC
increases a company's cash needs and negates all the positive liquidity
qualities just mentioned.

Note: In the realm of free or low-cost investment research websites, the only
one we've found that provides complete CCC data for stocks is Morningstar,
which also requires a paid premier membership subscription. 

Current Ratio Vs. The CCC

The obvious limitations of the current ratio as an indicator of true liquidity
clearly establish a strong case for greater recognition, and use, of the cash
conversion cycle in any analysis of a company's working capital position.

Nevertheless, corporate financial reporting, investment literature and

investment research services seem to be stuck on using the current ratio as
an indicator of liquidity. This circumstance is similar to the financial media's
and the general public's attachment to the Dow Jones Industrial Average.
Most investment professionals see this index as unrepresentative of the stock
market or the national economy. And yet, the popular Dow marches on as the
market indicator of choice.

The current ratio seems to occupy a similar position with the investment
community regarding financial ratios that measure liquidity. However, it will
probably work better for investors to pay more attention to the cash-cycle
concept as a more accurate and meaningful measurement of a company's
liquidity.

Profitability Indicator Ratios

This section of the tutorial discusses the different measures of
corporateprofitability and financial performance. These ratios, much like the
operational performance ratios, give users a good understanding of how well
the company utilized its resources in generating profit and shareholder value.

the long-term profitability of a company is vital for both the survivability of the
company as well as the benefit received by shareholders. It is these ratios that
can give insight into the all important "profit".

In this section, we will look at four important profit margins, which display the
amount of profit a company generates on its sales at the different stages of
an income statement. We'll also show you how to calculate the effective tax
rate of a company. The last three ratios covered in this section - Return on
Assets, Return on Equity andReturn on Capital Employed - detail how
effective a company is at generating income from its resources.

Profit Margin Analysis

n the income statement, there are four levels of profit or profit margins - gross
profit, operating profit, pretax profit and net profit. The term "margin" can apply
to the absolute number for a given profit level and/or the number as a
percentage of net sales/revenues. Profit margin analysis uses the percentage
calculation to provide a comprehensive measure of a company's profitability
on a historical basis (3-5 years) and in comparison to peer companies and
industry benchmarks. 

Basically, it is the amount of profit (at the gross, operating, pretax or net
income level) generated by the company as a percent of the sales generated.
The objective of margin analysis is to detect consistency or positive/negative
trends in a company's earnings. Positive profit margin analysis translates into
positive investment quality. To a large degree, it is the quality, and growth, of
a company's earnings that drive its stock price.

Formulas:

Components:
All the dollar amounts in these ratios are found in the income statement. As of
December 31, 2005, with amounts expressed in millions, Zimmer Holdings
had net sales, or revenue, of $3,286.10, which is the denominator in all of the
profit margin ratios. The numerators for Zimmer Holdings' ratios are captioned
as "gross profit", "operating profit", "earnings before income taxes, minority
interest and cumulative effect of change in accounting principle", and "net
earnings", respectively. By simply dividing, the equations give us the
percentage profit margins indicated.
Variations:
None

Commentary:
First, a few remarks about the mechanics of these ratios are in order. When it
comes to finding the relevant numbers for margin analysis, we remind readers
that the terms: "income", "profits" and "earnings" are used interchangeably in
financial reporting. Also, the account captions for the various profit levels can
vary, but generally are self-evident no matter what terminology is used. For
example, Zimmer Holdings' pretax (our shorthand for profit before the
provision for the payment of taxes) is a literal, but rather lengthy, description of
the account.

Second, income statements in the multi-step format clearly identify the four
profit levels. However, with the single-step format the investor must calculate
the gross profit and operating profit margin numbers.

To obtain the gross profit amount, simply subtract the cost of sales (cost of
goods sold) from net sales/revenues. The operating profit amount is obtained
by subtracting the sum of the company's operating expenses from the gross
profit amount. Generally, operating expenses would include such account
captions as selling, marketing and administrative, research and development,
depreciation and amortization, rental properties, etc.

Third, investors need to understand that the absolute numbers in the income
statement don't tell us very much, which is why we must look to margin
analysis to discern a company's true profitability. These ratios help us to keep
score, as measured over time, of management's ability to manage costs and
expenses and generate profits. The success, or lack thereof, of this important
management function is what determines a company's profitability. A large
growth in sales will do little for a company's earnings if costs and expenses
grow disproportionately. 

Lastly, the profit margin percentage for all the levels of income can easily be
translated into a handy metric used frequently by analysts and often
mentioned in investment literature. The ratio's percentage represents the
number of pennies there are in each dollar of sales. For example, using
Zimmer Holdings' numbers, in every sales dollar for the company in 2005,
there's roughly 78¢, 32¢, 32¢, and 22¢ cents of gross, operating, pretax, and
net income, respectively.

Let's look at each of the profit margin ratios individually:

Gross Profit Margin - A company's cost of sales, or cost of goods sold,

represents the expense related to labor, raw materials and manufacturing
overhead involved in its production process. This expense is deducted from
the company's net sales/revenue, which results in a company's first level of
profit, or gross profit. The gross profit margin is used to analyze how efficiently
a company is using its raw materials, labor and manufacturing-related fixed
assets to generate profits. A higher margin percentage is a favorable profit
indicator.

Industry characteristics of raw material costs, particularly as these relate to the

stability or lack thereof, have a major effect on a company's gross margin.
Generally, management cannot exercise complete control over such costs.
Companies without a production process (ex., retailers and service
businesses) don't have a cost of sales exactly. In these instances, the
expense is recorded as a "cost of merchandise" and a "cost of services",
respectively. With this type of company, the gross profit margin does not carry
the same weight as a producer-type company.

Operating Profit Margin - By subtracting selling, general and

administrative(SG&A), or operating, expenses from a company's gross profit
number, we get operating income. Management has much more control over
operating expenses than its cost of sales outlays. Thus, investors need to
scrutinize the operating profit margin carefully. Positive and negative trends in
this ratio are, for the most part, directly attributable to management decisions.

A company's operating income figure is often the preferred metric (deemed to

be more reliable) of investment analysts, versus its net income figure, for
making inter-company comparisons and financial projections.

Pretax Profit Margin - Again many investment analysts prefer to use a pretax
income number for reasons similar to those mentioned for operating income.
In this case a company has access to a variety of tax-management
techniques, which allow it to manipulate the timing and magnitude of its
taxable income.

Net Profit Margin - Often referred to simply as a company's profit margin, the
so-called bottom line is the most often mentioned when discussing a
company's profitability. While undeniably an important number, investors can
easily see from a complete profit margin analysis that there are several
income and expense operating elements in an income statement that
determine a net profit margin. It behooves investors to take a comprehensive
look at a company's profit margins on a systematic basis.

Return On Assets

his ratio indicates how profitable a company is relative to its total assets.
Thereturn on assets (ROA) ratio illustrates how well management is
employing the company's total assets to make a profit. The higher the return,
the more efficient management is in utilizing its asset base. The ROA ratio is
calculated by comparing net income to average total assets, and is expressed
as a percentage.

Formula:

Components:
As of December 31, 2005, with amounts expressed in millions, Zimmer
Holdings had net income of $732.50 (income statement), and average total
assets of $5,708.70 (balance sheet). By dividing, the equation gives us an
ROA of 12.8% for FY 2005.

Variations:
Some investment analysts use the operating-income figure instead of the net-
income figure when calculating the ROA ratio.

Commentary: 
The need for investment in current and non-current assets varies greatly
among companies. Capital-intensive businesses (with a large investment in
fixed assets) are going to be more asset heavy than technology or service
businesses. 

In the case of capital-intensive businesses, which have to carry a relatively

large asset base, will calculate their ROA based on a large number in the
denominator of this ratio. Conversely, non-capital-intensive businesses (with a
small investment in fixed assets) will be generally favored with a relatively high
ROA because of a low denominator number. 

It is precisely because businesses require different-sized asset bases that

investors need to think about how they use the ROA ratio. For the most part,
the ROA measurement should be used historically for the company being
analyzed. If peer company comparisons are made, it is imperative that the
companies being reviewed are similar in product line and business type.
Simply being categorized in the same industry will not automatically make a
company comparable. Illustrations (as of FY 2005) of the variability of the
ROA ratio can be found in such companies as General Electric, 2.3%; Proctor
& Gamble, 8.8%; and Microsoft, 18.0%.

As a rule of thumb, investment professionals like to see a company's ROA

come in at no less than 5%. Of course, there are exceptions to this rule. An
important one would apply to banks, which strive to record an ROA of 1.5% or
above.

Return On Equity
This ratio indicates how profitable a company is by comparing its net income
to its average shareholders' equity. The return on equity ratio (ROE) measures
how much the shareholders earned for their investment in the company. The
higher the ratio percentage, the more efficient management is in utilizing its
equity base and the better return is to investors.

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer

Holdings had net income of $732.5 (income statement), and average
shareholders' equity of $4,312.7 (balance sheet). By dividing, the equation
gives us an ROE of 17% for FY 2005.

Variations:
If the company has issued preferred stock, investors wishing to see the return
on just common equity may modify the formula by subtracting the preferred
dividends, which are not paid to common shareholders, from net income and
reducing shareholders' equity by the outstanding amount of preferred equity.

Commentary:
Widely used by investors, the ROE ratio is an important measure of a
company's earnings performance. The ROE tells common shareholders how
effectively their money is being employed. Peer company, industry and overall
market comparisons are appropriate; however, it should be recognized that
there are variations in ROEs among some types of businesses. In general,
financial analysts consider return on equity ratios in the 15-20% range as
representing attractive levels of investment quality.

hile highly regarded as a profitability indicator, the ROE metric does have a
recognized weakness. Investors need to be aware that a disproportionate
amount of debt in a company's capital structure would translate into a smaller
equity base. Thus, a small amount of net income (the numerator) could still
produce a high ROE off a modest equity base (the denominator).
For example, let's reconfigure Zimmer Holdings' debt and equity numbers to
illustrate this circumstance. If we reduce the company's equity amount by $2
million and increase its long-term debt by a corresponding amount, the
reconfigured debt-equity relationship will be (figures in millions) $2,081.6 and
$2,682.8, respectively. Zimmer's financial position is obviously much more
highly leveraged, i.e., carrying a lot more debt. However, its ROE would now
register a whopping 27.3% ($732.5 ÷ $2,682.8), which is quite an
improvement over the 17% ROE of the almost debt-free FY 2005 position of
Zimmer indicated above. Of course, that improvement in Zimmer's profitability,
as measured by its ROE, comes with a price...a lot more debt.

The lesson here for investors is that they cannot look at a company's return on
equity in isolation. A high, or low, ROE needs to be interpreted in the context
of a company's debt-equity relationship. The answer to this analytical dilemma
can be found by using the return on capital employed (ROCE) ratio.

Return On Capital Employed

he return on capital employed (ROCE) ratio, expressed as a percentage,

complements the return on equity (ROE) ratio by adding a company's debt
liabilities, or funded debt, to equity to reflect a company's total "capital
employed". This measure narrows the focus to gain a better understanding of
a company's ability to generate returns from its available capital base.

By comparing net income to the sum of a company's debt and equity capital,
investors can get a clear picture of how the use of leverage impacts a
company's profitability. Financial analysts consider the ROCE measurement to
be a more comprehensive profitability indicator because it gauges
management's ability to generate earnings from a company's total pool of
capital.

Formula:
Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer

Holdings had net income of $732.50 (income statement). The company's
average short-term and long-term borrowings were $366.60 and the average
shareholders' equity was $4,312.70 (all the necessary figures are in the 2004
and 2005 balance sheets), the sum of which, $4,679.30 is the capital
employed. By dividing, the equation gives us an ROCE of 15.6% for FY 2005.

Variations:
Often, financial analysts will use operating income (earnings before interest
and taxes or EBIT) as the numerator. There are various takes on what should
constitute the debt element in the ROCE equation, which can be quite
confusing. Our suggestion is to stick with debt liabilities that represent interest-
bearing, documented credit obligations (short-term borrowings, current portion
of long-term debt, and long-term debt) as the debt capital in the formula.

ommentary:
The return on capital employed is an important measure of a company's
profitability. Many investment analysts think that factoring debt into a
company's total capital provides a more comprehensive evaluation of how well
management is using the debt and equity it has at its disposal. Investors
would be well served by focusing on ROCE as a key, if not the key, factor to
gauge a company's profitability. An ROCE ratio, as a very general rule of
thumb, should be at or above a company's average borrowing rate. 

Unfortunately, there are a number of similar ratios to ROCE, as defined

herein, that are similar in nature but calculated differently, resulting in
dissimilar results. First, the acronym ROCE is sometimes used to identify
return on common equity, which can be confusing because that relationship is
best known as the return on equity or ROE. Second, the concept behind the
terms return on invested capital (ROIC) and return on investment (ROI)
portends to represent "invested capital" as the source for supporting a
company's assets. However, there is no consistency to what components are
included in the formula for invested capital, and it is a measurement that is not
commonly used in investment research reporting.
Debt Ratios
The third series of ratios in this tutorial are debt ratios. These ratios give users
a general idea of the company's overall debt load as well as its mix of equity
and debt. Debt ratios can be used to determine the overall level of financial
risk a company and its shareholders face. In general, the greater the amount
of debt held by a company the greater the financial risk of bankruptcy.

he next chapter of this Debt Ratios section (Overview of Debt) will give
readers a good idea of the different classifications of debt. While it is not
mandatory in understanding the individual debt ratios, it will give some
background information on the debt of a company. The ratios covered in this
section include thedebt ratio, which is gives a general idea of a company's
financialleverage as does the debt-to-equity ratio. The capitalization
ratio details the mix of debt and equity while the interest coverage ratio and
the cash flow to debt ratio show how well a company can meet its obligations.

To find the data used in the examples in this section, please see the
Securities and Exchange Commission's website to view the 2005 Annual
Statement of Zimmer Holdings.

Before discussing the various financial debt ratios, we need to clear up the
terminology used with "debt" as this concept relates to financial statement
presentations. In addition, the debt-related topics of "funded debt" and credit
ratings are discussed below.

There are two types of liabilities - operational and debt. The former includes
balance sheet accounts, such as accounts payable, accrued expenses, taxes
payable, pension obligations, etc. The latter includes notes payable and other
short-term borrowings, the current portion of long-term borrowings, and long-
term borrowings. Often times, in investment literature, "debt" is used
synonymously with total liabilities. In other instances, it only refers to a
company's indebtedness. 

The debt ratios that are explained herein are those that are most commonly
used. However, what companies, financial analysts and investment research
services use as components to calculate these ratios is far from standardized.
In the definition paragraph for each ratio, no matter how the ratio is titled, we
will clearly indicate what type of debt is being used in our measurements.
Getting the Terms Straight
In general, debt analysis can be broken down into three categories, or
interpretations: liberal, moderate and conservative. Since we will use this
language in our commentary paragraphs, it's worthwhile explaining how these
interpretations of debt apply.

 Liberal - This approach tends to minimize the amount of debt. It

includes only long-term debt as it is recorded in the balance sheet under
non-current liabilities.
 Moderate - This approach includes current borrowings (notes payable)
and the current portion of long-term debt, which appear in the balance
sheet's current liabilities; and, of course, the long-term debt recorded in
non-current liabilities previously mentioned. In addition, redeemable
preferred stock, because of its debt-like quality, is considered to be
debt. Lastly, as general rule, two-thirds (roughly one-third goes to
interest expense) of the outstanding balance of operating leases, which
do not appear in the balance sheet, are considered debt principal. The
relevant figure will be found in the notes to financial statements and
identified as "future minimum lease payments required under operating
leases that have initial or remaining non-cancel-able lease terms in
excess of one year."
 Conservative - This approach includes all the items used in the
moderate interpretation of debt, as well as such non-current operational
liabilities such as deferred taxes, pension liabilities and other post-
retirement employee benefits.

Note: New accounting standards, which are currently under active

consideration in the U.S. by the Financial Accounting Standards
Board (FASB) and internationally by the International Accounting Standards
Board (IASB), will eventually put the debt principal of operating leases and
unfunded pension liabilities in the balance sheet as debt liabilities. Formal
"Discussion Papers" on these issues are planned by FASB and IASB in 2008,
with adoption of the changes following the discussion phase expected in 2009.
Investors may want to look to the middle ground when deciding what to
include in a company's debt position. With the exception of unfunded pension
liabilities, a company's non-current operational liabilities represent obligations
that will be around, at one level or another, forever - at least until the company
ceases to be a going concern and is liquidated.

lso, unlike debt, there are no fixed payments or interest expenses associated
with non-current operational liabilities. In other words, it is more meaningful for
investors to view a company's indebtedness and obligations through the
company as a going concern, and therefore, to use the moderate approach to
defining debt in their leverage calculations.

o-called "funded debt" is a term that is seldom used in financial reporting.

Technically, funded debt refers to that portion of a company's debt comprised,
generally, of long-term, fixed maturity, contractual borrowings. No matter how
problematic a company's financial condition, holders of these obligations,
typically bonds, cannot demand payment as long as the company pays the
interest on its funded debt. In contrast, long-term bank debt is usually subject
to acceleration clauses and/or restrictive covenants that allow a lender to call
its loan, i.e., demand its immediate payment. From an investor's perspective,
the greater the percentage of funded debt in the company's total debt, the
better.

Lastly, credit ratings are formal risk evaluations by credit agencies - Moody's,
Standard & Poor's, Duff & Phelps, and Fitch - of a company's ability to repay
principal and interest on its debt obligations, principally bonds and commercial
paper. Obviously, investors in both bonds and stocks follow these ratings
rather closely as indicators of a company's investment quality. If the
company's credit ratings are not mentioned in their financial reporting, it's easy
to obtain them from the company's investor relations department.

The debt ratio compares a company's total debt to its total assets, which is

used to gain a general idea as to the amount of leverage being used by a
company. A low percentage means that the company is less dependent on
leverage, i.e., money borrowed from and/or owed to others. The lower the
percentage, the less leverage a company is using and the stronger its equity
position. In general, the higher the ratio, the more risk that company is
considered to have taken on.

Formula: 
Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer

Holdings had total liabilities of $1,036.80 (balance sheet) and total assets of
$5,721.90 (balance sheet). By dividing, the equation provides the company
with a relatively low percentage of leverage as measured by the debt ratio.

Variations:
None

Commentary:
The easy-to-calculate debt ratio is helpful to investors looking for a quick take
on a company's leverage. The debt ratio gives users a quick measure of the
amount of debt that the company has on its balance sheets compared to its
assets. The more debt compared to assets a company has, which is signaled
by a high debt ratio, the more leveraged it is and the riskier it is considered to
be. Generally, large, well-established companies can push the liability
component of their balance sheet structure to higher percentages without
getting into trouble.

However, one thing to note with this ratio: it isn't a pure measure of a
company's debt (or indebtedness), as it also includes operational liabilities,
such as accounts payable and taxes payable. Companies use these
operational liabilities as going concerns to fund the day-to-day operations of
the business and aren't really "debts" in the leverage sense of this ratio.
Basically, even if you took the same company and had one version with zero
financial debt and another version with substantial financial debt, these
operational liabilities would still be there, which in some sense can muddle this
ratio.

For example, IBM and Merck, both large, blue-chip companies, which are
components of the Dow Jones Index, have debt ratios (FY 2005) of 69% and
60%, respectively. In contrast, Eagle Materials, a small construction supply
company, has a debt ratio (FY 2006) of 48%; Lincoln Electric, a small supplier
of welding equipment and products, runs a debt ratio (FY 2005) in the range of
44%. Obviously, Zimmer Holdings' debt ratio of 18% is very much on the low
side.
The use of leverage, as displayed by the debt ratio, can be a double-edged
sword for companies. If the company manages to generate returns above their
cost of capital, investors will benefit. However, with the added risk of the debt
on its books, a company can be easily hurt by this leverage if it is unable to
generate returns above the cost of capital. Basically, any gains or losses are
magnified by the use of leverage in the company's capital structure.

he debt-equity ratio is another leverage ratio that compares a company's total

liabilities to its total shareholders' equity. This is a measurement of how much
suppliers, lenders, creditors and obligors have committed to the company
versus what the shareholders have committed. 

To a large degree, the debt-equity ratio provides another vantage point on a

company's leverage position, in this case, comparing total liabilities to
shareholders' equity, as opposed to total assets in the debt ratio. Similar to the
debt ratio, a lower the percentage means that a company is using less
leverage and has a stronger equity position. 

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer

Holdings had total liabilities of $1,036.80 (balance sheet) and total
shareholders' equity of $4,682.80 (balance sheet). By dividing, the equation
provides the company with a relatively low percentage of leverage as
measured by the debt-equity ratio.

Variations:
A conservative variation of this ratio, which is seldom seen, involves reducing
a company's equity position by its intangible assets to arrive at a tangible
equity, or tangible net worth, figure. Companies with a large amount of
purchasedgoodwill form heavy acquisition activity can end up with a negative
equityposition.

Commentary:
The debt-equity ratio appears frequently in investment literature. However, like
the debt ratio, this ratio is not a pure measurement of a company's debt
because it includes operational liabilities in total liabilities.

Nevertheless, this easy-to-calculate ratio provides a general indication of a

company's equity-liability relationship and is helpful to investors looking for a
quick take on a company's leverage. Generally, large, well-established
companies can push the liability component of their balance sheet structure to
higher percentages without getting into trouble. 

The debt-equity ratio percentage provides a much more dramatic perspective

on a company's leverage position than the debt ratio percentage. For
example, IBM's debt ratio of 69% seems less onerous than its debt-equity
ratio of 220%, which means that creditors have more than twice as much
money in the company than equity holders (both ratios are for FY 2005). 

Merck comes off a little better at 150%. These indicators are not atypical for
large companies with prime credit credentials. Relatively small companies,
such as Eagle Materials and Lincoln Electric, cannot command these high
leverage positions, which is reflected in their debt-equity ratio percentages (FY
2006 and FY 2005) of 91% and 78%, respectively.

Operating Performance Ratios

Each of these ratios have differing inputs and measure different segments of a
company's overall operational performance, but the ratios do give users
insight into the company's performance and management during the period
being measured.

These ratios look at how well a company turns its assets into revenue as well
as how efficiently a company converts its sales into cash. Basically, these
ratios look at how efficiently and effectively a company is using its resources
to generate sales and increase shareholder value. In general, the better these
ratios are, the better it is for shareholders.

In this section, we'll look at the fixed-asset turnover ratio and the
sales/revenue per employee ratio, which look at how well the company uses
its fixed assets and employees to generate sales. We will also look at the
operating cycle measure, which details the company's ability to convert is
inventory into cash.

To find the data used in the examples in this section, please see the
Securities and Exchange Commission's website to view the 2005 Annual
Statement of Zimmer Holdings.

his ratio is a rough measure of the productivity of a company's fixed

assets(property, plant and equipment or PP&E) with respect to generating
sales. For most companies, their investment in fixed assets represents the
single largest component of their total assets. This annual turnover ratio is
designed to reflect a company's efficiency in managing these significant
assets. Simply put, the higher the yearly turnover rate, the better.

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer

Holdings had net sales, or revenue, of $3,286.10 (income statement) and
average fixed assets, or PP&E, of $668.70 (balance sheet - the average of
yearend 2004 and 2005 PP&E). By dividing, the equation gives us a fixed-
asset turnover rate for FY 2005 of 4.9.

Variations:
Instead of using fixed assets, some asset-turnover ratios would use total
assets. We prefer to focus on the former because, as a significant component
in the balance sheet, it represents a multiplicity of management decisions on
capital expenditures. Thus, this capital investment, and more importantly, its
results, is a better performance indicator than that evidenced in total asset
turnover.

Commentary:
There is no exact number that determines whether a company is doing a good
job of generating revenue from its investment in fixed assets. This makes it
important to compare the most recent ratio to both the historical levels of the
company along with peer company and/or industry averages. 

Before putting too much weight into this ratio, it's important to determine the
type of company that you are using the ratio on because a company's
investment in fixed assets is very much linked to the requirements of the
industry in which it conducts its business. Fixed assets vary greatly among
companies. For example, an internet company, like Google, has less of a
fixed-asset base than a heavy manufacturer like Caterpillar. Obviously, the
fixed-asset ratio for Google will have less relevance than that for Caterpillar.

As is the case with Zimmer Holdings, a high fixed-asset turnover ratio is more
the product of a relatively low investment in PP&E, rather than a high level of
sales. Companies like Zimmer Holdings are fortunate not to be capital
intensive, thereby allowing them to generate a high level of sales on a
relatively low base of capital investment. Manufacturers of heavy equipment
and other capital goods, and natural resource companies do not enjoy this
luxury.

Operating Performance Ratios: Operating Cycle

xpressed as an indicator (days) of management performance efficiency, the

operating cycle is a "twin" of the cash conversion cycle. While the parts are
the same - receivables, inventory and payables - in the operating cycle, they
are analyzed from the perspective of how well the company is managing these
critical operational capital assets, as opposed to their impact on cash.

Formula:
Components:

DIO is computed by:

1. Dividing the cost of sales (income statement) by 365 to get a cost of

sales per day figure;
2. Calculating the average inventory figure by adding the year's beginning
(previous yearend amount) and ending inventory figure (both are in the
balance sheet) and dividing by 2 to obtain an average amount of
inventory for any given year; and
3. Dividing the average inventory figure by the cost of sales per day figure.

For Zimmer Holdings' FY 2005 (in $ millions), its DIO would be computed with
these figures:

(1) cost of sales 739.4 ÷ 365 =

per day 2.0
536.0 + 583.7
(2) average
= 1,119.7 ÷ 2
inventory 2005
= 559.9
(3) days
559.9 ÷ 2.0 =
inventory
279.9
outstanding

DSO is computed by:

1. Dividing net sales (income statement) by 365 to get net sales per day
figure;
2. Calculating the average accounts receivable figure by adding the year's
beginning (previous yearend amount) and ending accounts receivable
amount (both figures are in the balance sheet) and dividing by 2 to
obtain an average amount of accounts receivable for any given year;
and
3. Dividing the average accounts receivable figure by the net sales per day
figure.
For Zimmer Holdings' FY 2005 (in $ millions), its DSO would be computed
with these figures:

(1) net sales per 3,286.1 ÷ 365

day = 9.0
524.8 +
(2) average
524.2 =
accounts
1,049 ÷ 2 =
receivable
524.5
(3) days sales 524.5 ÷ 9.0 =
outstanding 58.3
DPO is computed by:

 Dividing the cost of sales (income statement) by 365 to get a cost of

sales per day figure;
 Calculating the average accounts payable figure by adding the year's
beginning (previous yearend amount) and ending accounts payable
amount (both figures are in the balance sheet), and dividing by 2 to get
an average accounts payable amount for any given year; and
 Dividing the average accounts payable figure by the cost of sales per
day figure.

For Zimmer Holdings' FY 2005 (in $ millions), its DPO would be computed
with these figures:

(1) cost of sales 739.4 ÷ 365

per day =2.0
131.6 +
(2) average
123.6 =
accounts
255.2 ÷
payable
125.6
(3) days payable 125.6 ÷ 2.0
outstanding = 63

Computing OC
Zimmer Holdings' operating cycle (OC) for FY 2005 would be computed with
these numbers (rounded):

DIO 280
DSO +58
DPO -63
OC 275

Variations:
Often the components of the operating cycle - DIO, DSO and DPO - are
expressed in terms of turnover as a times (x) factor. For example, in the case
of Zimmer Holdings, its days inventory outstanding of 280 days would be
expressed as turning over 1.3x annually (365 days ÷ 280 days = 1.3 times).
However, it appears that the use of actually counting days is more literal and
easier to understand. 

Commentary:
As we mentioned in its definition, the operating cycle has the same makeup as
the cash conversion cycle. Management efficiency is the focus of the
operating cycle, while cash flow is the focus of the cash conversion cycle.

To illustrate this difference in perspective, let's use a narrow, simplistic

comparison of Zimmer Holdings' operating cycle to that of a competitive peer
company, Biomet. Obviously, we would want more background information
and a longer review period, but for the sake of this discussion, we'll assume
the FY 2005 numbers we have to work with are representative for both
companies and their industry.

Days Sales Outstanding

(DSO):
Zimmer 58 Days
Biomet 105 Days

Days Inventory Outstanding

(DIO):
Zimmer 280 Days
Biomet 294 Days
 Days Payable Outstanding
(DPO):
Zimmer 63 Days
Biomet 145 Days

Operating Cycle:
Zimmer 275 Days
Biomet 254 Days

When it comes to collecting on its receivables, it appears from the DSO

numbers, that Zimmer Holdings is much more operationally efficient than
Biomet. Common sense tells us that the longer a company has money out
there on the street (uncollected), the more risk it is taking. Is Biomet remiss in
not having tighter control of its collection of receivables? Or could it be trying
to pick up market share through easier payment terms to its customers? This
would please the sales manager, but the CFO would certainly be happier with
a faster collection time.

Zimmer Holdings and Biomet have almost identical days inventory

outstanding. For most companies, their DIO periods are, typically,
considerably shorter than the almost 10-month periods evidenced here. Our
assumption is that this circumstance does not imply poor inventory
management but rather reflects product line and industry characteristics. Both
companies may be obliged to carry large, high-value inventories in order to
satisfy customer requirements.

Biomet has a huge advantage in the DPO category. It is stretching out its
payments to suppliers way beyond what Zimmer is able to do. The reasons for
this highly beneficial circumstance (being able to use other people's money)
would be interesting to know. Questions you should be asking include: Does
this indicate that the credit reputation of Biomet is that much better than that of
Zimmer? Why doesn't Zimmer enjoy similar terms?

horter Is Better?
In summary, one would assume that "shorter is better" when analyzing a
company's cash conversion cycle or its operating cycle. While this is certainly
true in the case of the former, it isn't necessarily true for the latter. There are
numerous variables attached to the management of receivables, inventory
and payables that require a variety of decisions as to what's best for the
business. 

For example, strict (short) payment terms might restrict sales. Minimal
inventory levels might mean that a company cannot fulfill orders on a timely
basis, resulting in lost sales. Thus, it would appear that if a company is
experiencing solid sales growth and reasonable profits, its operating cycle
components should reflect a high degree of historical consistency.

Cash Flow Indicator Ratios: Cash Flow Coverage Ratios

his ratio measures the ability of the company's operating cash flow to meet its
obligations - including its liabilities or ongoing concern costs. 

The operating cash flow is simply the amount of cash generated by the
company from its main operations, which are used to keep the business
funded.

The larger the operating cash flow coverage for these items, the greater the
company's ability to meet its obligations, along with giving the company more
cash flow to expand its business, withstand hard times, and not be burdened
by debt servicing and the restrictions typically included in credit agreements.

Formulas:

Components:
As of December 31, 2005, with amounts expressed in millions, Zimmer
Holdings had no short-term debt and did not pay any cash dividends. The only
cash outlay the company had to cover was for capital expenditures, which
amounted to $255.3 (all numbers for the cash flow coverage ratios are found
in the cash flow statement), which is the denominator. Operating cash is
always the numerator. By dividing, the operative equations give us a coverage
of 3.4. Obviously, Zimmer is a cash cow. It has ample free cash flow which, if
the FY 2003-2005 period is indicative, has steadily built up the cash it carries
in itsbalance sheet. 

Commentary:
The short-term debt coverage ratio compares the sum of a company's short-
term borrowings and the current portion of its long-term debt to operating cash
flow. Zimmer Holdings has the good fortune of having none of the former and
only a nominal amount of the latter in its FY 2005 balance sheet. So, in this
instance, the ratio is not meaningful in the conventional sense but clearly
indicates that the company need not worry about short-term debt servicing in
2006.

The capital expenditure coverage ratio compares a company's outlays for

itsproperty, plant and equipment (PP&E) to operating cash flow. In the case of
Zimmer Holdings, as mentioned above, it has ample margin to fund the
acquisition of needed capital assets. For most analysts and investors, a
positive difference between operating cash flow and capital expenditures
defines free cash flow. Therefore, the larger this ratio is, the more cash assets
a company has to work with. 
The dividend coverage ratio provides dividend investors with a narrow look at
the safety of the company's dividend payment. Zimmer is not paying a
dividend, although with its cash buildup and cash generation capacity, it
certainly looks like it could easily become a dividend payer. 

For conservative investors focused on cash flow coverage, comparing the

sum of a company's capital expenditures and cash dividends to its operating
cash flow is a stringent measurement that puts cash flow to the ultimate test. If
a company is able to cover both of these outlays of funds from internal
sources and still have cash left over, it is producing what might be called "free
cash flow on steroids". This circumstance is a highly favorable investment
quality.

Dividend Payout Ratio

This ratio identifies the percentage of earnings (net income) per common
share allocated to paying cash dividends to shareholders. The dividend
payout ratio is an indicator of how well earnings support the dividend
payment. 

Here's how dividends "start" and "end." During a fiscal year quarter, a
company's board of directors declares a dividend. This event triggers the
posting of a current liability for "dividends payable." At the end of the quarter,
net income is credited to a company's retained earnings, and assuming
there's sufficient cash on hand and/or from current operating cash flow, the
dividend is paid out. This reduces cash, and the dividends payable liability is
eliminated. 

The payment of a cash dividend is recorded in the statement of cash flows

under the "financing activities" section.

Formula:

Components:
Note: Zimmer Holdings does not pay a dividend. An assumed dividend
amount, as of December 31, 2005, is provided to illustrate the ratio's
calculation:

0.80 ÷ 2.96 = 27% 

The numerator (annual report or Form 10-K) represents the annual dividend
per share paid in cash and the denominator (income statement) represents
the net income per share for FY 2005.

Variations:

At the bottom of the income statement, after the stated amount for net income
(net earnings), the per share amounts for "basic" net income per common
share and "diluted" net income per common share are provided. The basic per
share amount does not take into consideration the possible effects of stock
options, which would increase the number of shares outstanding. The diluted
per share amount does take into account precisely this possible dilution.
Conservative analysis would use the diluted net income per share figure in the
denominator.

In another version of the dividend payout ratio, total amounts are used rather
than per share amounts. Nevertheless, an investor should arrive at the same
ratio percentage. 

Note: In the U.K. there is a similar dividend payout ratio, which is known as
"dividend cover". It's calculated using earnings per sharedivided by dividends
per share.

Commentary:
Our first observation states the obvious - you only use this ratio with dividend-
paying companies. Investors in dividend-paying stocks like to see consistent
and/or gradually increasing dividend payout ratios. It should also be noted that
exaggerated (i.e. very high) dividend ratios should be looked at skeptically. 

The question to ask is: Can the level of dividends be sustained? Many
investors are initially attracted to high dividend-paying stocks, only to be
disappointed down the road by a substantial dividend reduction (see remarks
below). If this circumstance happens, the stock's price most likely will take a
hit.
Secondly, dividend payout ratios vary widely among companies. Stable, large,
mature companies (i.e. public utilities and "blue chips") tend to have larger
dividend payouts. Growth-oriented companies tend to keep their cash for
expansion purposes, have modest payout ratios or choose not to pay
dividends.

Lastly, investors need to remember that dividends actually get paid with cash -
not earnings. From the definition of this ratio, some investors may assume that
dividend payouts imply that earnings represent cash, however, with accrual
accounting, they do not. A company will not be able to pay a cash dividend,
even with an adequate unrestricted balance in retained earnings, unless it has
adequate cash. 

In view of this accounting treatment of dividends, it is incumbent upon

investors to check a company's dividend payout ratio against an adequate
margin of free cash flow to ensure that the payout percentage (ratio) is
sustainable.

Dividend Yield

 stock's dividend yield is expressed as an annual percentage and is calculated

as the company's annual cash dividend per share divided by the current price
of the stock. The dividend yield is found in the stock quotes of dividend-paying
companies. Investors should note that stock quotes record the per share
dollar amount of a company's latest quarterly declared dividend. This quarterly
dollar amount is annualized and compared to the current stock price to
generate the per annum dividend yield, which represents an expected return. 

Income investors value a dividend-paying stock, while growth investors have

little interest in dividends, preferring to capture large capital gains. Whatever
your investing style, it is a matter of historical record that dividend-paying
stocks have performed better than non-paying-dividend stocks over the long
term. 

Formula:
Components:

Zimmer Holdings does not pay a dividend, so the $1.00 dividend per share
amount is being used for illustration purposes. In the company's stock quote
the latest quarterly dividend would be recorded as $0.25 (per share) and the
share price as $67.44 as of yearend 2005. On this basis, the stock would have
a dividend yield of 1.48%.

Variations:
None

Commentary:
A stock's dividend yield depends on the nature of a company's business, its
posture in the marketplace (value or growth oriented), its earnings and cash
flow, and its dividend policy. For example, steady, mature businesses, such as
utilities and banks, are generally good dividend payers. REIT stocks, with their
relatively stable inflow of rental payments, are also recognized for their
attractive dividend yields. If you're an income investor, a stock's dividend yield
might well be the only valuation measurement that matters to you. On the
other hand, if you're in the growth stock camp, dividend yield (or the lack of
one) will be meaningless.