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38 Financial Statement Analysis

Credit Analysis. First, we focus on liquidity. Liquidity refers to the ability of an en-
terprise to meet its short-term financial obligations. An important liquidity ratio is the
current ratio, which measures current assets available to satisfy current liabilities. Col-
gate’s current ratio of 0.95 implies there are 95 cents of current assets available to
meet each $1 of currently maturing obligations. A more stringent test of short-term
liquidity, based on the acid-test ratio, uses only the most liquid current assets: cash,
short-term investments, and accounts receivable. Colgate has 58 cents of such liquid
assets to cover each $1 of current liabilities. Both these ratios suggest that Colgate’s
liquidity situation is cause for concern. Still, we need more information to draw defi-
nite conclusions about liquidity. The length of time needed for conversion of receiv-
ables and inventories to cash also provides useful information regarding liquidity.
Colgate’s collection period for receivables is approximately 42 days, and its days to sell
inventory is 61. Neither of these indicates any liquidity problems. However, these
measures are more useful when compared over time (i.e., changes in these measures
are more informative about liquidity problems than levels). Overall, our brief analysis
of liquidity suggests that while Colgate’s composition of current assets and current
liabilities are cause for concern, its receivables and inventory periods coupled with its
excellent cash flow from operations (see later discussion) indicate that there is not
much cause for concern.

Analysis of Solvency. Solvency refers to the ability of an enterprise to meet its long-
DEBT TRIGGER term financial obligations. To assess Colgate’s long-term financing structure and credit
GM’s bloated pension risk, we examine its capital structure and solvency. Its total debt-to-equity ratio of 5.48 indi-
obligations and poor cates that for each $1 of equity financing, $5.48 of financing is provided by creditors. Its
earnings resulted
in a downgrade of its long-term debt-to-equity ratio is 3.02, revealing $3.02 of long-term debt financing to each
$300 billion in debt. This $1 of equity. Both these ratios are extremely high for a manufacturing company; such
reflects a higher probability high ratios are more typical for a financial institution! On their own, they do raise con-
of default. Debt-rating cerns about Colgate’s ability to service its debt and remain solvent in the long run.
downgrades usually result However, these ratios do not consider Colgate’s excellent profitability. Another ratio
in higher interest rates for
the borrower and can that also considers profitability in addition to capital structure is the times interest earned
trigger bond default. ratio (or interest coverage ratio), which is the ratio of a company’s earnings before inter-
est to its interest payment. Colgate’s 2006 earnings are 13.61 times its fixed (interest)
commitments. This ratio indicates that Colgate will have no problem meeting its fixed-
charge commitments. In sum, given Colgate’s high (and stable) profitability, its solvency
risk is low.

Profitability Analysis. We begin by assessing different aspects of return on investment.
Colgate’s return on assets of 16.51% implies that a $1 asset investment generates 16.51
cents of annual earnings prior to subtracting after-tax interest. Equity holders are espe-
cially interested in management’s performance based on equity financing, so we also
look at the return on equity. Colgate’s return on common equity (or more commonly
termed as return on equity) of 98.04% suggests it earns 98.04 cents annually for each $1
of equity investment. Both of these ratios are significantly higher than the average for
publicly traded companies of approximately 7% and 12%, respectively. Colgate’s return
on equity, in particular, is probably one of the highest among U.S. companies.
Another part of profitability analysis is evaluation of operating performance. This is
done by examining ratios that typically link income statement line items to sales. These
ratios are often referred to as profit margins, for example, gross profit margin (or more
concisely gross margin). These ratios are comparable to results from common-size
income statement analysis. The operating performance ratios for Colgate in Exhibit 1.14