It has been stressed that cash is of primary importance for a company. Without cash, the company would not be able to function, even if it is making substantial amount of paper profits. In order to measure whether the company has sufficient cash reserves or able to convert its’ assets into cash to meet its’ obligation, there are two financial terms that we must be conversant with.
Liquidity refers to the ability of the company to meet its’ short term obligations and commitments (i.e. those liabilities due within a year from the Balance Sheet date). The liquidity ratios discussed earlier, gives an indicator of the how relatively liquid a company is.
Solvency is a gauge of the company’s ability to meet its’ long term liabilities (i.e. commitments exceeding a period of one year from the Balance Sheet date). The Debt Ratios' above are intended to reveal whether the Company is able to meet its’ long term liabilities in the long term. When we say a company is solvent, this means that the Company should be able to repay all its’ long term loans and borrowings and other commitments, in the future, usually due to its’ large assets base and ability to generate favorable operating cash flows.
Effective Interest ratio
We have computed the Effective Interest ratio in Part X. Briefly, the effective interest rate ratio gives an indication of the interest rates incurred by the Company on its’ loans and borrowings. Low interest rates on loans and borrowings, are beneficial to the shareholders as the shareholders will pocket the excess between:
1. The returns generated by the Company using these loans and borrowings; and
2. The interest costs associated to these loans and borrowings.
This concept is also referred to as gearing. There is an additional benefit in that, interest expenses are tax deductible and will reduce tax liabilities due to the Inland Revenue.
Operating Cash to Interest (OCI) ratio
The OCI ratio is crucial as it gauges whether the company can generate sufficient cash from its’ operations to service interest payments on its’ loans and borrowings.
An high OCI ratio (e.g. in excess of 10x) is favorable as this reveals the Company can service its’ debts with ease. If the OCI ratio is 1.5x or lower, its ability to meet interest expenses may be questionable. Once the OCI ratio falls below 1.0x, alarm bells should start ringing, since the Company's operating cash flows are insufficient to service interest payments. What about the repayment of the principal amount?
Debt Service Coverage (DSC) ratio
Whereas the OCI ratio compares the Operating Cash Flows to the Interest Costs, the DSC ratio compares the Net Profit for the Year against the Interest Costs. In effect, we are comparing the book profits against the interest expense. Generally, the higher the ratio, the more favorable it is. The general consensus is that the Company can service its’ interest costs and repay its' loans, if the ratio is 1.35x or more. However, this will vary from industry to industry and care must be taken when attempting to interpret this ratio.
The effective interest ratio appears favorable to Nestlé as it is paying a very low interest of 4.82% (2006: 5.80%) on its’ loans and borrowings. The company’s abilities to obtain such favorable rates is partly due to its’ healthy operating cash flows and strong credit rating.
Analysis of the OCI ratio discloses that there has been deterioration in this ratio by 44.83% to 19.58x (2006: 35.49x). This is mainly due large amounts of cash tied up in inventories as at year end. However, a ratio of 19.58x indicates that that Nestlé should have no problems whatsoever, to service interest on its’ loans and borrowings.
A review of the DSC ratio indicates that this amount has also declined to 19.68x (2006: 26.19x). Still, this indicates that Nestlé is still highly profitable. The profits generated by the Company are more than sufficient (i.e. 20x) to repay interest expenses incurred. This is in line with the OCI ratio.
Generally, Nestlé appears to be liquid and solvent. All indicators suggest that the Company has strong operating cash flows, sufficient to service its' interest costs. Despite the large loans and borrowings due in 2008, there are strong assurances that the Company would be able to refinance such loans and borrowings, for reasons outlined earlier.