Financial Ratios - Financial Risk Ratios
Financial Risk - This is risk related to the company's
financial structure.
I. Analysis of a Company's Use of Debt
1. Debt to Total Capital
This measures the proportion of debt used given the total capital structure of the company. A large debt-to-capital ratio indicates that equity holders are making extensive use of debt, making the overall business riskier.
Formula 7.32
I. Analysis of a Company's Use of Debt
1. Debt to Total Capital
This measures the proportion of debt used given the total capital structure of the company. A large debt-to-capital ratio indicates that equity holders are making extensive use of debt, making the overall business riskier.
Formula 7.32
|
Debt to capital = total
debt
total capital
Where:
Total debt = current + long-term debt Total capital = total debt + stockholders' equity |
2. Debt to Equity
This ratio is similar to debt to capital.
Formula 7.33
This ratio is similar to debt to capital.
Formula 7.33
|
Debt to equity = total
debt
total equity |
II. Analysis of the
Interest Coverage Ratio
3. Times Interest Earned (Interest Coverage ratio)
This ratio indicates the degree of protection available to creditors by measuring the extent to which earnings available for interest covers required interest payments.
Formula 7.34
3. Times Interest Earned (Interest Coverage ratio)
This ratio indicates the degree of protection available to creditors by measuring the extent to which earnings available for interest covers required interest payments.
Formula 7.34
|
Times interest earned = earnings
before interest and tax
interest expense |
4. Fixed-Charge
Coverage
fixed charges are defined as contractual committed periodic interest and principal payments on leases and debt.
Formula 7.35
fixed charges are defined as contractual committed periodic interest and principal payments on leases and debt.
Formula 7.35
|
Fixed-charge coverage = earnings
before fixed charges and taxes
fixed charges |
5. Times
Interest Earned - Cash Basis
adjusted operating cash flow is defined as cash flow from operations + fixed charges + tax payments.
Formula 7.36
adjusted operating cash flow is defined as cash flow from operations + fixed charges + tax payments.
Formula 7.36
|
Times interest earned - cash basis = adjusted
operating cash flow
interest expense |
6. Fixed-Charge Coverage Ratio - Cash Basis
Formula 7.37
|
Fixed charge coverage ratio - cash
basis = adjusted operating cash flow
fixed charges |
7. Capital
Expenditure Ratio
Provides information on how much of the cash generated from operations will be left after payment of capital expenditure to service the company's debt. If the ratio is 2, it indicates that the company generates two times what it will need to reinvest in the business to keep operations going; the excess could be allocated to service the debt.
Formula 7.38
Provides information on how much of the cash generated from operations will be left after payment of capital expenditure to service the company's debt. If the ratio is 2, it indicates that the company generates two times what it will need to reinvest in the business to keep operations going; the excess could be allocated to service the debt.
Formula 7.38
|
Capital expenditure ratio = cash flow from operations
capital expenditures |
8. CFO to
Debt
Provides information on how much cash the company generates from operations that could be used to pay off the total debt. Total debt includes all interest-bearing debt, short and long term.
Formula 7.39
Provides information on how much cash the company generates from operations that could be used to pay off the total debt. Total debt includes all interest-bearing debt, short and long term.
Formula 7.39
|
CFO to debt = cash flow
from operations
total debt |
Financial Ratios - Internal Liquidity Ratios
1. Current Ratio
This ratio is a measure of the ability of a firm to meet its short-term obligations. In general, a ratio of 2 to 3 is usually considered good. Too small a ratio indicates that there is some potential difficulty in covering obligations. A high ratio may indicate that the firm has too many assets tied up in current assets and is not making efficient use to them.
Formula 7.3
This ratio is a measure of the ability of a firm to meet its short-term obligations. In general, a ratio of 2 to 3 is usually considered good. Too small a ratio indicates that there is some potential difficulty in covering obligations. A high ratio may indicate that the firm has too many assets tied up in current assets and is not making efficient use to them.
Formula 7.3
|
Current ratio
= current assets
current liabilities |
2. Quick Ratio
The quick (or acid-test) ratio is a more stringent measure of liquidity. Only liquid assets are taken into account. Inventory and other assets are excluded, as they may be difficult to dispose of.
Formula 7.4
The quick (or acid-test) ratio is a more stringent measure of liquidity. Only liquid assets are taken into account. Inventory and other assets are excluded, as they may be difficult to dispose of.
Formula 7.4
|
Quick ratio = (cash+
marketable securities + accounts receivables)
current liabilities |
3. Cash Ratio
the cash ratio reveals how must cash and marketable securities the company has on hand to pay off its current obligations.
Formula 7.5
the cash ratio reveals how must cash and marketable securities the company has on hand to pay off its current obligations.
Formula 7.5
|
Cash ratio = (cash +
marketable securities)
current liabilities |
4. Cash Flow
from Operations Ratio
Poor receivables or inventory-turnover limits can dilute the information provided by the current and quick ratios. This ratio provides a better indicator of a company's ability to pay its short-term liabilities with the cash it produces from current operations.
Formula 7.6
Poor receivables or inventory-turnover limits can dilute the information provided by the current and quick ratios. This ratio provides a better indicator of a company's ability to pay its short-term liabilities with the cash it produces from current operations.
Formula 7.6
|
Cash flow from operations ratio
= cash flow from operations
current liability |
5. Receivable
Turnover Ratio
This ratio provides an indicator of the effectiveness of a company's credit policy. The high receivable turnover will indicate that the company collects its dues from its customers quickly. If this ratio is too high compared to the industry, this may indicate that the company does not offer its clients a long enough credit facility, and as a result may be losing sales. A decreasing receivable-turnover ratio may indicate that the company is having difficulties collecting cash from customers, and may be a sign that sales are perhaps overstated.
Formula 7.7
This ratio provides an indicator of the effectiveness of a company's credit policy. The high receivable turnover will indicate that the company collects its dues from its customers quickly. If this ratio is too high compared to the industry, this may indicate that the company does not offer its clients a long enough credit facility, and as a result may be losing sales. A decreasing receivable-turnover ratio may indicate that the company is having difficulties collecting cash from customers, and may be a sign that sales are perhaps overstated.
Formula 7.7
|
Receivable turnover = net
annual sales
average receivables
Where:
Average receivables = (previously reported account receivable + current account receivables)/2 |
6. Average
Number of Days Receivables Outstanding (Average Collection Period)
This ratio provides the
same information as receivable turnover except that it indicates it as number
of days.
Formula 7.8
Formula 7.8
|
Average number of days receivables
outstanding = 365 days_
receivables turnover |
7. Inventory
Turnover Ratio
This ratio provides an indication of how efficiently the company's inventory is utilized by management. A high inventory ratio is an indicator that the company sells its inventory rapidly and that the inventory does not languish, which may mean there is less risk that the inventory reported has decreased in value. Too high a ratio could indicate a level of inventory that is too low, perhaps resulting in frequent shortages of stock and the potential of losing customers. It could also indicate inadequate production levels for meeting customer demand.
Formula 7.9
This ratio provides an indication of how efficiently the company's inventory is utilized by management. A high inventory ratio is an indicator that the company sells its inventory rapidly and that the inventory does not languish, which may mean there is less risk that the inventory reported has decreased in value. Too high a ratio could indicate a level of inventory that is too low, perhaps resulting in frequent shortages of stock and the potential of losing customers. It could also indicate inadequate production levels for meeting customer demand.
Formula 7.9
|
Inventory turnover = cost
of goods sold
average inventory
Where:
Average inventory = (previously reported inventory + current inventory)/2 |
8. Average
Number of Days in Stock
This ratio provides the same information as inventory turnover except that it indicates it as number of days.
Formula 7.10
This ratio provides the same information as inventory turnover except that it indicates it as number of days.
Formula 7.10
|
Average number of days in stock
= 365
inventory turnover |
9. Payable
Turnover Ratio
This ratio will indicate how much credit the company uses from its suppliers. Note that this ratio is very useful in credit checks of firms applying for credit. Payable turnover that is too small may negatively affect a company's credit rating.
Formula 7.11
This ratio will indicate how much credit the company uses from its suppliers. Note that this ratio is very useful in credit checks of firms applying for credit. Payable turnover that is too small may negatively affect a company's credit rating.
Formula 7.11
|
Payable turnover = Annual
purchases
Average payables
Where:
Annual purchases = cost of goods sold + ending inventory - beginning inventory Average payables = (previously reported accounts payable + current accounts payable) / 2 |
10. Average
Number of Days Payables Outstanding (Average Age of Payables)
This ratio provides the same information as payable turnover except that it indicates it by number of days.
Formula 7.12
This ratio provides the same information as payable turnover except that it indicates it by number of days.
Formula 7.12
|
Average number of days payables
outstanding = 365_____
payable turnover |
II. Other
Internal-Liquidity Ratios
11. Cash Conversion Cycle
this ratio will indicate how much time it takes for the company to convert collection or their investment into cash. A high conversion cycle indicates that the company has a large amount of money invested in sales in process.
Formula 7.13
11. Cash Conversion Cycle
this ratio will indicate how much time it takes for the company to convert collection or their investment into cash. A high conversion cycle indicates that the company has a large amount of money invested in sales in process.
Formula 7.13
|
Cash conversion cycle = average
collection period + average number of days in stock - average age of payables
|
Cash conversion cycle = average collection period + average
number of days in stock - average age of payables
12. Defensive Interval
This measure is essentially a worst-case scenario that estimates how many days the company has to maintain its current operations without any additional sales.
Formula 7.14
12. Defensive Interval
This measure is essentially a worst-case scenario that estimates how many days the company has to maintain its current operations without any additional sales.
Formula 7.14
|
Defensive interval = 365 * (cash
+ marketable securities + accounts receivable)
projected expenditures
Where:
Projected expenditures = projected outflow needed to operate the company |
Financial Ratios - Operating Profitability
Ratios
Operating Profitability
can be divided into measurements of return on sales and return on investment.
I. Return on Sales
1. Gross Profit Margin
this shows the average amount of profit considering only sales and the cost of the items sold. This tells how much profit the product or service is making without overhead considerations. As such, it indicates the efficiency of operations as well as how products are priced. Wide variations occur from industry to industry.
Formula 7.15
I. Return on Sales
1. Gross Profit Margin
this shows the average amount of profit considering only sales and the cost of the items sold. This tells how much profit the product or service is making without overhead considerations. As such, it indicates the efficiency of operations as well as how products are priced. Wide variations occur from industry to industry.
Formula 7.15
|
Gross profit margin = gross
profit
net sales
Where:
Gross profit = net sales - cost of goods sold |
2. Operating
Profit Margin
This ratio indicates the profitability of current operations. This ratio does not take into account the company's capital and tax structure.
Formula 7.16
This ratio indicates the profitability of current operations. This ratio does not take into account the company's capital and tax structure.
Formula 7.16
|
Operating profit margin = operating
income
net sales
Where:
Operating income = earnings before tax and interest from continuing operations |
3. EBITDA Margin
This ratio indicates the profitability of current operations. This ratio does not take into account the company's capital, non-cash expenses or tax structure.
Formula 7.17
This ratio indicates the profitability of current operations. This ratio does not take into account the company's capital, non-cash expenses or tax structure.
Formula 7.17
|
EBITDA margin = earnings
before interest, tax, depreciation and amortization
net sales |
4. Pre-Tax
Margin (EBT margin)
This ratio indicates the profitability of Company's operations. This ratio does not take into account the company's tax structure.
Formula 7.18
This ratio indicates the profitability of Company's operations. This ratio does not take into account the company's tax structure.
Formula 7.18
|
Pre-tax margin = Earning
before tax
sales |
5. Net Margin
(Profit Margin)
This ratio indicates the profitability of a company's operations.
Formula 7.19
This ratio indicates the profitability of a company's operations.
Formula 7.19
|
Net margin = net income
sales |
6. Contribution Margin
This ratio indicates how much each sale contributes to fixed expenditures.
Formula 7.20
This ratio indicates how much each sale contributes to fixed expenditures.
Formula 7.20
|
Contribution margin = contribution
sales
Where:
Contributions = sales - variable cost |
Financial Ratios - Business Risk Ratios
Business Risk - This is risk related a company's income
variance. There is a simple method and more complex method:
I. Simple Method
The following four ratios represent the simple method of business risk calculations. Business risk is the risk of a company making less money, or worse, losing money if sales decrease. In the declining-sales environment, a company would lose money mainly because of its fixed costs. If a company only incurred variable costs, it would never have negative earnings. Unfortunately, all businesses have a component of fixed costs. Understanding a company's fixed-cost structure is crucial in the determination of its business risk. One of the main ratios used to evaluate business risk is the contribution margin ratio.
1. Contribution Margin Ratio
this ratio indicates the incremental profit resulting from a given dollar change of sales. If a company's contribution ratio is 20%, then a $50,000 decline in sales will result in a $10,000 decline in profits.
Formula 7.28
I. Simple Method
The following four ratios represent the simple method of business risk calculations. Business risk is the risk of a company making less money, or worse, losing money if sales decrease. In the declining-sales environment, a company would lose money mainly because of its fixed costs. If a company only incurred variable costs, it would never have negative earnings. Unfortunately, all businesses have a component of fixed costs. Understanding a company's fixed-cost structure is crucial in the determination of its business risk. One of the main ratios used to evaluate business risk is the contribution margin ratio.
1. Contribution Margin Ratio
this ratio indicates the incremental profit resulting from a given dollar change of sales. If a company's contribution ratio is 20%, then a $50,000 decline in sales will result in a $10,000 decline in profits.
Formula 7.28
|
Contribution margin ratio = contribution
sales = 1 - (variable cost / sales) |
2. Operation
Leverage Effect (OLE)
the operating leverage ratio is used to estimate the percentage change in income and return on assets for a given percentage change in sales volume. Return on sales is the same as return on assets.
If a company has an OLE greater than 1, then operating leverage exists. If OLE is equal to 1 then all costs are variable, so a 10% increase in sales will increase the company's ROA by 10%.
the operating leverage ratio is used to estimate the percentage change in income and return on assets for a given percentage change in sales volume. Return on sales is the same as return on assets.
If a company has an OLE greater than 1, then operating leverage exists. If OLE is equal to 1 then all costs are variable, so a 10% increase in sales will increase the company's ROA by 10%.
Formula 7.29
|
Operation leverage effect = contribution
margin ratio
return on sales (ROS)
Where:
ROS = Percentage change in income (ROA) = OLE x % change in sales |
3. Financial
Leverage Effect (FLE)
Companies that use debt to finance their operations, thus creating a financial leverage effect and increasing the return to stockholders, represent an additional business risk if revenues vary. The financial leverage effect is used to quantify the effect of leverage within a company.
Formula 7.30
Companies that use debt to finance their operations, thus creating a financial leverage effect and increasing the return to stockholders, represent an additional business risk if revenues vary. The financial leverage effect is used to quantify the effect of leverage within a company.
Formula 7.30
|
Financial leverage effect = operating
income
net income |
If a company has an FLE
of 1.33, an increase of 50% in operating income would result in a 67% shift in
net income.
4. Total Leverage Effect (TLE)
By combining the OLE and FLE, we get the total leverage effect (TLE), which is defined as:
Formula 7.31
4. Total Leverage Effect (TLE)
By combining the OLE and FLE, we get the total leverage effect (TLE), which is defined as:
Formula 7.31
|
Total leverage effect = OLE x
FLE
|
In our previous example,
sales increased by $50,000, the OLE was 20% and FLE was 1.33. The total
leverage effect would be $13,333, i.e. net income would increase by $13,333 for
every $50,000 in increased sales.
II. Complex Method
Business risk can be analyzed by simply looking at variations in sales and operating income (EBIT) over time. A more structured approach is to use some statistics. One common method is to gather a date set that's large enough (five to 10 years) to calculate the coefficient of variation.
With this approach:
- Business risk = standard deviation of operating income / mean of operating income
- Sales variability = standard deviation of sales / sales mean
- Another source of variability of operating income is the difference between fixed and variable cost. This is referred to as "operating leverage". A company with a large variable structure is less likely to create a loss if revenues decline. The calculation of variability of operating income is complex and beyond CFA level 1.
II. Complex Method
Business risk can be analyzed by simply looking at variations in sales and operating income (EBIT) over time. A more structured approach is to use some statistics. One common method is to gather a date set that's large enough (five to 10 years) to calculate the coefficient of variation.
With this approach:
- Business risk = standard deviation of operating income / mean of operating income
- Sales variability = standard deviation of sales / sales mean
- Another source of variability of operating income is the difference between fixed and variable cost. This is referred to as "operating leverage". A company with a large variable structure is less likely to create a loss if revenues decline. The calculation of variability of operating income is complex and beyond CFA level 1.
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