Evaluate Market Strength Sunday, Aug 2 2015 

Market Strength Ratios


PE Ratio

Earnings per share is an important ratio for an investor because of its relationship to dividends and market price. Stockholders hope to earn a return by receiving periodic dividends or eventually selling the stock for more than they paid for it or both.


Market price is the price at which a company’s stock is bought and sold. It indicates how investors view the potential return and risk connected with owning the stock.
It is the desire of investors to relate the earnings of the company to the market price of the stock. Market price by itself is not very informative, however, because  companies have different numbers of shares outstanding, different earnings, and different dividend policies. Thus, market price must be related to earnings by considering the price/earnings (P/E) ratio and the dividends yield. The market price of a share of stock is often expressed as a multiple of earnings to indicate how attractive the market views the stock as an investment.

The price/earnings (P/E) ratio, which measures investors’ confidence in a company, is the ratio of the market price per share to earnings per share. The P/E ratio is useful in comparing the earnings of different companies and the value of a company’s shares in relation to values in the overall market.

Because earnings are based on the most recent evaluation of the company for accounting purposes, it seems logical to use current market price, which is based on the stock market’s current assessment of the company. Therefore, the ratio is computed as follows:

pe

There are different variants of basic P/E Ratio. This depends upon how Price and Earnings are defined.

  • Price: Usually the current price, (Though some would like to use average price over the last 6 months or year).
  • EPS :
    • Time Variants: EPS in most recent financial year (Current), EPS in most recent 4 quarters (Trailing), EPS expected in next fiscal year or next 4 quarters (both called Forward), or EPS in some future year.
    • Primary, diluted or Partially diluted.
    • Before or After extraordinary Items.
    • Measure using different accounting rules (Options expensed or not, Pension fund counted or not…)

Need to Compare the P/E Ratio? we need to consider the following points in mind:

It is difficult to generalize as to what is good or bad. The P/E ratio compares the stock market’s assessment of a company’s performance with the company’s success as reflected on the income statement. A relatively high P/E ratio may indicate that a stock is overpriced by the market; a P/E ratio that is relatively low could indicate that a stock is underpriced.

To do relative valuation, then:

  • We need to identify comparable assets and obtain market value for these assets.
  • Convert Market Value into standardized values, since absolute prices can not be compared – This process of standardizing creates price multiples.
  • Compare the standardized value or multiple for the asset being analyzed to the standardized values for comparable asset, controlling for any differences between the firms that might affect the multiple, to judge whether the asset is Undervalued or Overvalued.

With a higher P/E ratio, the investor obtains less underlying earnings per dollar invested. Despite a decrease in earnings per share from $0.90 in 2007 to $0.43 in 2008, Starbucks’ P/E ratio increased  from 30.1 times in 2007 to 35.5 times in 2008 because the market value of its stock declined from about $27 to about $15. The implication is that investors are expecting  Starbucks to grow faster in the future than it has in the past.


PE Ratios and Fundamentals

  • Proposition 1: Other things held equal, higher growth firms will have higher PE ratios than lower growth firms.
  • Proposition 2: Other things held equal, higher risk firms will have lower PE ratios than lower risk firms.
  • Proposition 3: Other things held equal, firms with lower reinvestment needs will have higher PE ratios than firms with higher reinvestment needs.

Of course, other things are difficult to hold equal, since high growth firms tend to have high risk and high reinvestment needs.

Point: Some investors avoid stocks with high PE ratios under the belief they are “overpriced.” Alternatively, some investors sell these stocks short—hoping for price declines.

  • P-E ratio will be higher if investors think that earnings will increase substantially in the future.
  • High: If investors perceive that the company has good growth opportunities , its earnings are safe and will increase substantially in the future and therefore they are more willing to pay more per share.

The perfect undervalued company…

  • If  you were looking for the perfect undervalued asset, it would be one:
    • With a low PE ratio (it is cheap)
    • With high expected growth in earnings
    • With low risk (and cost of equity)
    • And with high ROE
    • In other words, it would be cheap with no good reason for being cheap
  • In the real world, most assets that look cheap on a multiple of earnings basis deserve to be cheap. In other words, one or more of these variables works against the company (It has low growth, high risk or a low ROE).
  • When presented with a cheap stock (low PE), here are the key questions?
    • What is the expected growth in earnings?
    • What is the risk in the stock?
    • How efficiently does this company generate its growth?


For overall comparison to the market, the average price-earnings ratio for the stocks that constitute the Standard and Poor’s 500 Index (500 largest U.S. firms) in late 2012 was approximately 15.9 times.


The S&P 500 P/E Ratio Is 19, Unless It’s Actually 27

Even Robert Shiller doesn’t know what to make of price-earnings data that make stocks look expensive.

http://www.bloomberg.com/news/articles/2015-06-26/the-s-p-500-p-e-is-19-unless-it-s-actually-27-as-shiller-says

Please refer this article by Nobel Laureate Robert Shiller promotes the CAPE Ratio as a better way to assessing how expensive stocks are.

The P/E ratio is often thought to indicate the “quality” of a company’s earnings.

For example, assume that two companies have identical EPS ratios of $2 per share.

Why should investors be willing to pay $20 per share (or 10 times earnings) for the stock of one company but only $14 per share (or 7 times earnings) for the stock of the other company?

First, we must realize that many factors in addition to the reported earnings of the company affect market prices.

  • General economic conditions,
  • The outlook for the particular industry, and
  • Pending lawsuits
  • The difference in P/E ratios for the two companies may reflect the market’s assessment of the accounting practices of the companies
  • May consider the fact that, to a large extent, earnings reflect the use of historical costs, as opposed to fair market values, in assigning values to assets

These are just three factors that can affect the trading price of a company’s stock.

Assume that the company with a market price of $20 per share uses LIFO in valuing inventory and that the company trading at $14 per share uses FIFO. The difference in prices may indicate that investors believe that even though the companies have the same EPS, the LIFO company is “better off” because it will have a lower amount of taxes to pay. (Recall that in a period of inflation, the use of LIFO results in more cost of goods sold, less income, and therefore lower income taxes.) Finally, aside from the way investors view the accounting practices of different companies, they also consider the fact that, to a large extent, earnings reflect the use of historical costs, as opposed to fair market values, in assigning values to assets. Investors must consider the extent to which a company’s assets are worth more than what was paid for them.

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Book Value per Share


A much-used basis for evaluating net worth is found in the book value or equity value per share of stock.
Book value per share of stock is the amount each share would receive if the company were liquidated on the basis of amounts reported on the balance sheet.

However, the figure loses much of its relevance if the valuations on the balance sheet fail to approximate fair value of the assets.

Book vALUE

Common equity equals total stockholders’ equity less preferred equity.


Book-to-market ratio

The ratio of book value to market value, called the book-to market ratio, is frequently used in investment analysis. The book-to-market ratio reflects the difference between a company’s balance sheet value and the company’s actual market value.


A company’s book-to-market ratio is almost always less than 1.0
. This is so because many assets are reported at historical cost, which is usually less than market value, and other assets are not included in the balance sheet at all. Research has shown that firms with high book-to-market ratios tend to have high stock returns in future years.

Book to MARKET


Some investors rank stocks on the basis of the ratio of book value to market price. To these investors, the higher the ratio, the more attractive the stock.

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Dividend Ratios


Two ratios are used to evaluate a company’s dividend policies: the
dividend payout ratio and the dividend yield ratio. Dividends per share measures the extent to which earnings are being distributed to common shareholders. It is computed as follows:


DPS (Dividend Per Share)

DPS


The yield with Cash dividends is also known as “Payout Ratio”.
Companies that have high growth rates generally have low payout ratios because they reinvest most of their net income into the business.


Dividends per share are often reported with earnings per share.
Comparing the two per-share amounts indicates the extent to which earnings are being retained for use in operations.

If the firm does not pay dividends, then, its stockholders must expect their return to come from increases in the stock’s market value.


Dividend Payout Ratio

DPSEPS


Dividend Yield Ratio

DPSEPS-2

The dividend yield is very important to investors who depend on dividend checks to pay their living expenses.

Utility stocks are popular among retirees because these shares have dividend yields as high as 5%. That is considered a good investment with relatively low risk and some opportunity for gains in the stock price.


On the other hand, investors who want to put money into growing companies are willing to forego dividends if it means the potential for greater price appreciation.

In general, high-growth firms have low dividend payout ratios (Microsoft didn’t begin paying cash dividends to its common stockholders until 2003), and low-growth stable firms have higher dividend payout ratios.


Sustainable Growth Rate = ROE * (1- Dividend Payout ratio)

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EPS (Earnings per Share) Sunday, Aug 2 2015 

Earnings per Share (EPS)


Earnings per share (EPS)
is one of the most quoted statistics for publicly traded companies. Stockholders and potential investors want to know what their share of profits is, not just the total dollar amount.

Presentation of profits on a per-share basis also allows the stockholder to relate earnings to what he or she paid for a share of stock or to the current trading price of a share of stock.

In simple terms EPS (Earnings per Share) is:

EPS

A number of complications can arise in the computation of EPS, and the calculations can become exceedingly complex for a company with many different types of securities in its capital structure.


EPS is the only ratio that must appear on the face of the income statement.
EPS is the amount of net income earned for each share of the company’s outstanding common stock. For those companies with a complex capital structure, both basic and diluted EPS for both income from continuing operations and net income are to be disclosed on the face of the income statement. When earnings of a period include income or loss from discontinued  operations or extraordinary items, EPS amounts for these line items may be presented either on the face of the income statement or in the notes to the financial statements.


Outstanding stock = Issued stock
– Treasury stock

 

Earnings per share is computed by dividing net income available to common stockholders by the number of common shares outstanding during the year. Preferred dividends are subtracted from net income because the preferred stockholders have the first claim to dividends.


Lets chart the Ownership rights of Stockholders

SH


International Note
U.S. and U.K. corporations raise most of their capital through millions of outside shareholders and bondholders. In contrast, companies in Germany, France, and Japan acquire financing mostly from large banks or other financial institutions. Consequently, in the latter environment, shareholders are somewhat less important. We can discuss more about Stocks sometime in upcoming articles.


Most companies strive to increase EPS by 10%–15% annually, and leading companies do so.
But even the most successful companies have an occasional bad year.

The firm’s EPS for 2014 and 2013 follow. (Note that Greg’s had 10,000 shares of common stock outstanding throughout both years.)

EPS-2


Sometimes the computation was disclosed in the unaudited section of the annual report along with a message from the company’s president. However, because this measurement was not reviewed by an independent third party, figures used to develop EPS were often different from those attested to by the auditor. The
situation became more complex when some companies and analysts began computing EPS not only on the basis of common shares actually outstanding but also on the basis of what shares would be outstanding if certain convertible securities were converted and if certain stock options were exercised.

FYIeps

Before we go ahead in explaining the calculations of under different circumstances in case of Stock calculations, some of definitions and important terminologies are discussed below as:


Stock Split [ Forward Stock Split & Reverse Stock Split]

A corporate action in which a company divides its existing shares into multiple shares. Although the number of shares outstanding increases by a specific multiple, the total dollar value of the shares remains the same compared to pre-split amounts, because the split did not add any real value. The most common split ratios are 2-for-1 or 3-for-1, which means that the stockholder will have two or three shares for every share held earlier. Also known as a “forward stock split.”

In the U.K., a stock split is referred to as a “scrip issue,” “bonus issue,” “capitalization issue” or “free issue.”


A
reverse stock split is the opposite of a conventional (forward) stock split, which increases the number of shares outstanding. Similar to a forward stock split, the reverse split does not add any real value to the company.


A split ratio is the number of new stocks investors receive for every one stock they currently own.

  • If the stock split ratio is 3:2, investors receive one additional share for every two shares they own.

Reverse stock splits decrease the number of shares you own.

  • If a reverse split ratio is 1:5, then the company takes four shares for every five shares you own.

Calculating Split Ratios


There is no formula for calculating how many shares you receive in a split.
A quick way to determine how many shares you receive in a split is to make the two sides of the ratio even, i.e. Adding to “x” to denominator for making that even means, the number of “x” shares shall be received by investor in that spit, or if the addition required in numerator of the ration (1:4), then company takes out four shares for every number of shares in the denominator.

  • In a 3:2 split, you have to add one additional share to the right hand side of the ratio to make both sides even. You receive one additional share in a 3:2 split.
  • If the split is 5:1, you have to add four additional shares to the right hand side of the ratio to make both sides even. You receive four additional shares for every one share you currently own.

Price Per Share


The formula to calculate the new price per share is current stock price divided by the split ratio.

For example, a stock currently trading at $75 per share splits 3:2. To calculate the new price per share: $75 / (3/2) = $50. If you owned two shares before the split, the value of the shares is $75 x 2 = $150. You received one additional share after the split, but the price per share dropped to $50. The value of your shares has not changed because $50 x 3 = $150.


Now from Market Capitalization and Share price perspective

For example, assume that XYZ Corp. has 20 million shares outstanding and the shares are trading at $100, which would give it a $2 billion market capitalization. The company’s board of directors decides to split the stock 2-for-1. Right after the split takes effect, the number of shares outstanding would double to 40 million, while the share price would be $50, leaving the market cap unchanged at $2 billion.

Why do companies go through the hassle and expense of a stock split?


This is done for a couple of very good reasons:

  • First, a split is usually undertaken when the stock price is quite high, making it pricey for investors to acquire a standard board lot of 100 shares. If XYZ Corp.’s shares were worth $100 each, an investor would need to purchase $10,000 to own 100 shares. If each share was worth $50, the investor would only need to pay $5,000 to own 100 shares.
  • Second, the higher number of shares outstanding can result in greater liquidity for the stock, which facilitates trading and may narrow the bid-ask spread [refer Corporate Finance for Bid-Ask rate].

The fact remains that stock splits by blue chip companies are a great way for the average investor to accumulate an increasing number of shares in these companies. Many of the best companies routinely exceed the price level at which they had previously split their stock, causing them to undergo a stock split yet again.

Wal-Mart, for instance, has split its shares as many as 11 times on a 2-for-1 basis from the time it went public in October 1970 to March 1999. An investor who had 100 shares at Wal-Mart’s IPO would have seen that little stake grow to 204,800 shares over the next 30 years.

No Split


Dilution and Anti-dilution of Earnings / Diluting or Anti-dilutive Securities


Usually, the conversion or exercise terms were very favorable to the holders of these securities, and
EPS would decline if common stock were issued on conversion or exercise. This result, a reduced EPS, is referred to as a dilution of earnings. In some cases, however, the exercise of options or conversion of securities might result in an increased EPS. This result is referred to as an anti-dilution of earnings.


Securities that would lead to dilution are referred to as
dilutive securities, and those that would lead to anti-dilution are referred to as antidilutive securities.


Rational investors would not convert or exercise antidilutive securities because they could do better by purchasing common stock in the marketplace.

These forward-looking computations of EPS attempted to provide information as to what future EPS might be, assuming conversions and exercises took place. Because these “as if” conditions were based on assumptions.

Simple and Complex Capital Structures


Many companies issue different classes of stock in order to attract a wider variety of investors.
In addition, the diversification of common stock types allows the company to approach market conditions with more flexibility.

The use of different forms of securities rather than relying solely on one class of common stock. A company with a complex capital structure might have a combination of several different varieties of common stock classes, with each class carrying different voting privileges and dividend rates.

For example, a company with a complex capital structure might use both Class A and Class B common stock and preferred stock, as well as both callable bonds and non-callable bonds.

Basic

Diluted

Considers only common shares issued and outstanding.

The basic EPS computation uses the results of actual transactions to determine both the numerator and the denominator in the EPS calculation.

Reflects the maximum potential dilution from all possible stock conversions that would have decreased EPS.

Diluted EPS is computed by making assumptions regarding transactions that did not occur.

Simple Capital Structure

Complex Capital Structure

Simple Capital Structure-  The corporation has only common and nonconvertible preferred stock and has no convertible securities, stock options, warrants, or other rights outstanding.

No future-oriented “as if” conditions need to be considered. If net income includes extraordinary gains or losses or other below-the-line items, a separate EPS figure is required for each major component of income, as well as for net income.

Even if convertible securities, stock options, warrants, or other rights do exist, the capital structure may be classified as simple if there is  no potential dilution to EPS from the conversion or exercise of these items.

Complex Capital Structure- The corporation has one or more instruments outstanding that could result in issuance of additional common shares. For example, a firm with potential for per share dilution.

Potential EPS dilution exists if the EPS would decrease or the loss per share would increase as a result of the conversion of securities or exercise of stock options, warrants, or other rights based on the conditions existing at the financial statement date. A company with potential earnings per share dilution is considered to have a complex capital structure.

In other words, diluted EPS provides financial statement users a “worst-case” estimate as to EPS with the computations made by assuming that all events relating to the exercising of existing options or the conversion of existing securities that will likely occur in the future have in fact already occurred.

 

Diluted Earnings per Share- In case of Options, Warrants, and Rights

  • Stock options, warrants, and rights provide no cash yield to investors, but they have value because they permit the acquisition of common stock at specified prices for a certain period of time.
  • Options, warrants, and rights are included in the computation of diluted EPS for a particular period only if they are dilutive.
  • If the price for which stock can be acquired (exercise price) is lower than the ending market price for the period, the options, warrants, or rights probably would be exercised and their effect would be dilutive. If the exercise price is higher than the ending market price, no exercise would take place; thus, there is no potential dilution from these securities.
  • Proceeds from conversion are assumed to be used for purchase of treasury stock at current market price.
  • Treasury stock is assumed to be reissued to option or warrant holders.
  • Any additional shares issued, over treasury stock, are added to “weighted- average shares outstanding.”
  • Exercise is assumed to occur on the first day of the year unless issue date is later.


Diluted Earnings per Share – In case of Convertible securities

    • Potential new shares of common stock that can become actual common shares.
    • There is no need for approval from existing common shareholders.
    • Conversion of these securities can potentially impact the earnings that will flow to the existing shareholders.
    • To make them aware of the magnitude of potential dilution  use the if-converted method for the EPS calculation.


In case of
Multiple Potentially Dilutive Securities

caution

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The Complications arise when
:

  • Issuance or reacquisition of common stock.
  • Stock dividends or stock splits.

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Calculation of Weighted Number of Shares in Case of Issuance or Reacquisition of Common Stock

For example, if a company has 10,000 shares outstanding at the beginning of the year, issues 5,000 more shares on May 1, and reacquires 2,000 shares on November 1, the weighted-average number of shares would be computed as follows. Note that a separate period computation is required each time stock is sold or reacquired.

EPSCalci-1

If stock transactions occurred during a month, the weighted-average computation could be made either on a daily basis or to the nearest month.

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Calculation of Weighted Number of Shares in Case of Stock Dividends & Stock Splits

EPS.-3jpg


When the number of
common shares outstanding has changed during a period as a result of a stock dividend, a stock split, or a reverse split, a retroactive recognition of this change must be made in determining the weighted-average number of shares outstanding.


Without this retroactive recognition, comparing a share of stock at the beginning of the period to a share of stock at the end of the period (after a stock split or stock dividend) would be like comparing
apples and oranges, or perhaps more accurately, like comparing a whole pie to a piece of pie.


Now to illustrate this, consider an example with the following chain of events in case of stock dividends and stock splits:
Always do the retrospective calculations for Stock dividends and Stock splits from the date of these events for a year to have meaningful comparison.

When comparative financial statements are presented, the common shares outstanding for all periods shown must be adjusted to reflect any stock dividend or stock split in the current period.


Only with the retroactive recognition of changes in the number of shares can EPS presentations for prior periods be stated on a basis comparable with the EPS presentation for the current period.
Similar retroactive adjustments must be made even if a stock dividend or stock split occurs after the end of the period but before the financial statements are prepared; disclosure of this situation should be made in a note to the financial statements.


Why must basic EPS associated with prior periods be adjusted for stock splits or stock dividends that occurred in the current period?

  • Without adjustment, the cash flow impact of stock splits and stock dividends would not be reflected in the EPS numbers.
  • Without adjustment, net income for the current period would be overstated.
  • Without adjustment, the stock splits and stock dividends would not be properly reflected in the Equity section of the balance sheet.
  • Without adjustment, the comparison with prior-year EPS numbers would be misleading.


As an example, consider the disclosure provided by
Nike relating to its EPS: For the fiscal year ended May 31, 2006, the company reported basic EPS of $5.37. In its 2007 annual report, the company reported basic EPS of just $2.69 for the fiscal year ended May 31, 2006. In the notes accompanying its 2007 financial statements (shown in Exhibit), Nike explains the reason for the restatement of EPS for 2006: it split its shares 2-for-1 during fiscal 2007.

NIKE


A
company had 2,600 shares outstanding as of January 1 and the following events affecting common stock occurred during the year:

EPSCalci-2

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Capital Balances

The adjusted income (loss) figures for computing basic EPS are determined as given above.


Continuing the example, EPS for 2010 is shown separately for income from continuing operations, the extraordinary gain, and net income.
The preferred dividends must be deducted from both income from continuing operations and net income in computing EPS for these income components.


For 2011, the reported net loss must be increased by the full amount of the preferred dividend even though the dividend was not declared.


If the preferred stock were noncumulative, no adjustment for the undeclared preferred dividend would be necessary in 2011
.

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Steps in Computing in Earnings per Share

1. Compute basic EPS using a weighted-average number of shares for common stock outstanding during the year.

2. For companies with complex capital structures, determine whether stock options, warrants, rights, and convertible securities are potentially dilutive.

(a) Stock options, warrants, and rights: Dilutive if the exercise price is less than the ending market price of the common stock.

(b) Convertible securities: Compute incremental EPS for each security individually. Those with an incremental value greater than basic EPS after considering any stock options, warrants, or rights are antidilutive and are excluded.


3. Compute diluted EPS:

(a) Include all dilutive stock options, warrants, and rights first. Apply proceeds using the treasury stock method at the ending common stock market price for the period to compute incremental shares.

(b) Include potentially dilutive convertible securities one at a time, beginning with the security that has the smallest incremental EPS.

Compute a new EPS figure. Continue selecting and applying convertible securities until the next security in the list has an incremental EPS value greater than the last computed EPS. Discontinue the process at that point. All other securities in the list are antidilutive for purposes of computing the lowest possible diluted EPS figure.

4. Report basic and diluted EPS on the face of the income statement.

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Financial Statement Presentation

Firms are also required to provide the following disclosure items in the notes to the financial statements:

  • A reconciliation of both the numerators and the denominators of the basic and diluted EPS computations for income from continuing operations. 
  • The effect that preferred dividends have on the EPS computations.
  • Securities (antidilutive for the current year) that could potentially dilute basic EPS in the future that were not included in comparative diluted EPS this period. 
  • Transactions that occurred after the period ended but prior to the issuance of financial statements that would have materially affected the number of common shares outstanding or potentially outstanding.

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Economic Value Added (EVA) Friday, Jul 31 2015 

Economic Value Added (EVA)

Business is about creating value. Value is the monetary worth of a product or asset. The purpose of business is, first, to create value for customers and, second, to extract some of that customer value in the form of profit, thereby creating value for the firm.

Value can be created in two ways: by production and by commerce.

Production creates value by physically transforming products that are less valued by consumers into products that are more valued by consumers—turning clay into coffee mugs, for example. Commerce creates value not by physically transforming products but by repositioning them in space and time. Trade involves transferring products from individuals and places where they are less valued to individuals and locations where they are more valued.

Similarly, speculation involves transferring products from a point in time where the product is valued less to a point in time where it is valued more. Thus, the essence of commerce is creating value through arbitrage across time and space.

major problem of accounting profit is that it combines two types of returns:  the normal return to capital that rewards investors for  the use of their capital; and economic profit, which is the pure surplus available after all inputs (including capital) have been paid for.

Economic profit represents a purer and more reliable measure of profit that is a better measure of performance. To distinguish economic profit from accounting profit, economic profit is often referred to as rent or economic rent.

A widely used measure of economic profit is economic value added (EVA), devised and popularized by the New York consulting firm Stern Stewart & Company. Economic value added is measured as net operating profit after tax (NOPAT) less cost of capital, where cost of capital is calculated as capital employed multiplied by the weighted average cost of capital (WACC).

The difference between the value of a firm’s output and the cost of its material inputs is its value added. Value added is equal to the sum of all the income paid to the suppliers of factors of production. Thus:


Value Added = sales revenue from output—cost of material inputs =

wages/salaries + interest + rent + royalties/license fees + taxes + dividends + retained profit


The 
value added created by firms is distributed among different parties: employees (wages and salaries), lenders (interest), landlords (rent), government (taxes) and owners (profit).

Assuming that firm strategy is directed primarily toward making profit doesn’t mean that we have to accept that profit is the sole motivation driving business enterprises. W should note, the goals driving the architects of the world’s great enterprises—Henry Ford at Ford Motor Company, Bill Gates at Microsoft, and Nicholas Hayek of Swatch—are seldom financial. The dominant drivers tend to be the fulfillment of a vision and the desire to make a difference in the world.

Nevertheless, even when business goals transcend mere money making, their achievement requires enterprises that are commercially successful, this requires the adoption of strategies that generate profit.

Economic profit has two main advantages over accounting profit as a performance measure.

  • First, it sets a more demanding performance discipline for managers. At many capital intensive companies seemingly healthy profits disappear once cost of capital is taken into account.
  • Second, using economic profit improves the allocation of capital between the different businesses of the firm by taking account of the real costs of more capital intensive businesses

EVA-2



Corporate Governance by Joel M. Stern,

Creator of Economic value Added (EVA)

Joel M. Stern is the creator and developer of Economic Value Added (EVA), Chairman and CEO of Stern Stewart & Co. He is well-known for his experience in financial economics, corporate performance measurement, corporate valuation and incentive compensation. Stern graduated in Finance and Economics and holds an MBA from the University of Chicago.


Let’s take a look at an example.


Assume that Company XYZ has the following components to use in the EVA formula:

NOPAT = $3,380,000

Capital Investment = $1,300,000

WACC = .056 or 5.60%

EVA = $3,380,000 -($1,300,000 x .056) = $3,307,200


The positive number tells us that Company XYZ more than covered its cost of capital. A negative number indicates that the project did not make enough profit to cover the cost of doing business.

In addition to using EVA® (Economic Value Added) to determine executive compensation, Target uses it to guide capital investment decisions. The company uses a benchmark of 9 percent for the estimated after tax cost of capital invested in retail operations and a benchmark of 5 percent for capital invested in credit card operations. Target believes that a focus on EVA® fosters its objective of increasing average annual earnings per share by 15 percent or more over time.

EVA


If financial forecasts can only be made for a few years out, then economic profit is usually preferable to free cash flow as a performance indicator. Economic profit shows the surplus being generated by the firm in each year, whereas free cash flow depends on management choices over the level of capital expenditure. Thus, a firm can easily boost its free cash flow by slashing capital expenditures.

Profitability Ratios…Is your Company really Profitable? Friday, Jul 31 2015 

Profitability Ratios : The Higher the Better (Mostly)

How profitable is the company?

  • In relation to sales ?
  • In relation to its investments  ?

Profitability reflects a company’s ability to earn a satisfactory income.

A company’s profitability is closely linked to its liquidity because earnings ultimately produce cash flow.


What Is Profit?

Profit is the surplus of revenues over costs available for distribution to the owners of the firm. But, if profit maximization is to be a realistic goal, the firm must know what profit is and how to measure it. Otherwise, instructing managers to maximize profit offers little guidance.


What is the firm to maximize:
Total profit or rate of profit? & the further questions to be addressed are:

  • Over what time period?
  • With what kind of adjustment for risk?
  • And what is profit anyway —> Accounting profit, cash flow, or economic profit *?

* In the last article we highlighted about EVA and its significance.

The ambiguity is apparent once we consider the profit performance of companies. Table is sorted by ranks of companies by profitability depends critically on how profitability is measured.

Table-1

Investors and creditors are interested in evaluating not only a company’s liquidity, Solvency (or leverage) but also its profitability—that is, its ability to earn a satisfactory income. Profitability is closely linked to liquidity because earnings ultimately produce the cash flow needed for liquidity. The ability to earn profits also depends on the assets the company has available for use in its operations, as reported in its balance sheet. Thus, income statement and balance sheet relationships are often used in evaluating profitability.

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  • Gross Profit Ratio: The gross profit ratio, found by dividing gross profit by net sales, is an important measure of profitability. It indicates a company’s ability to cover operating expenses and earn  a profit.

GP

A 40% gross profit ratio says that for every dollar of sales, Company has a gross profit of 40 cents. In other words, after deducting 60 cents for the cost of the product, the company has 40 cents on the dollar to cover its operating costs and to earn a profit. Too high a Gross margin may result in lost sales.

Gross Margin : Indicates percentage of Revenue available to cover Operating and other Expenses.

Caution in Gross Profit Ratio: Trend lines in gross margin are equally important, because they indicate potential problems.  Say a company announces great sales numbers in one quarter—better than expected—but then its stock drops. How could that be? Perhaps analysts noted that gross margin percentage was heading downward and assumed that the company must have been doing considerable discounting to record the sales it did. In general, a negative trend in gross margin indicates one of two things (sometimes both). Either the company is under severe price pressure and salespeople are being forced to discount, or else materials and labor costs are rising, driving up COGS or COS. Gross margin thus can be a kind of early-warning light, indicating favorable or unfavorable trends in the marketplace.


There are chances that in a year, the
Gross Profit Margin increases, as due to refund of Excise Taxes previously paid on past Sales. In that case, in comparing the Gross Margin ratio, we need to exclude any additional parameters which are not present in other year / company while making comparison.


The fluctuation in Gross profit may also occur due to Product Mix, as,
Wal-Mart once stated, “Because food items carry a lower gross margin than our other merchandise, increasing food sales tends to have an unfavorable impact on our total gross margin.” 


In case of products which are a low-margin, high-volume operation,
a point requiring more attention, which is related to the Trade-off between Sales Volume and Gross Profit.

If Gross Margin is improving, signals strong future performance, which further implies that:

  • COGS has fallen down – Production Efficiency.
  • Sales has increased may be the price – Quality Advantage.

Now, we can think of the impacts, when Gross Margin is declining ? Low Ratio ?

Strategy:

A firm adopting low cost strategy likely to have lower Gross Margin than firm adopting differentiated product strategy

  • 1995-1997: Dell (Low cost PC provider) had Lower Gross Margin but lower Operating expense (R&D, Selling ) than Compaq (Brand name PC provider)
  • Net profit margin similar

Bollywood

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  • Operating Profit Margin: This is the ratio of Operating profit (EBIT) and net Sales, i.e. Income without concern for Interests and Taxes. Operating Margin is a Common Measure of operating performance.


If Operating Profit Margin
ratio deteriorates -> indicates deteriorating control over operating costs.

The rate earned on operating assets is sometimes computed when there are large amounts of non-operating income and expense.


Caution in Operating Margin
: Operating margin can be a key metric for managers to watch, and not just because many companies tie bonus payments to operating-margin targets. The reason is that nonfinancial managers don’t have much control over the other items—interest and taxes—that are ultimately subtracted to get net profit margin. So operating margin is a good indicator of how well managers as a group are doing their jobs. A downward trend line in operating margin should be a flashing yellow light. It shows that costs and expenses are rising faster than sales, which is rarely a healthy sign (The same was mentioned in earlier Financial Analysis Section). As with gross margin, it’s easier to see the trends in operating results when you’re looking at percentages rather than raw numbers. A percentage change shows not only the direction of the change but how great a change it is.


If Gross Margin and Operating Margin
differ significantly then:

It may indicate reasons of high operating costs like SG&A, disproportionate to selling prices.

  • Profit Margin Ratio [Or Net Profit Margin (or Return on Sales ROS)]: The profit margin ratio measures the percentage of each dollar of sales that results in net income. We compute this ratio by dividing net income (i.e. after Interests and Taxes ) by net sales (revenue) for the period. Both “Profit Margin” and “Total asset turnover” (Efficiency Ratio) make up the two basic components of operating efficiency. These ratios reflect on management because managers are ultimately responsible for operating efficiency.

A decline in Net Profit margin might suggest that

  • Sales volume has declined because lesser number of units sold or decline in sales price or both or
  • Gross margin might have come down due to higher COGS
  • Disproportionate Increase in Operating Expense


Although we have used net income in computing profitability ratios ,
net income (or Profit) is not always a good indicator of a company’s  sustainable earnings. For instance:

  • If a company has discontinued operations, income from continuing operations may be a better measure of sustainable earnings.
  • For a company that has one-time items on its income statement—such as restructurings, gains, or lossesincome from operations before these items may be a better measure.

Some analysts like to use earnings before interest and taxes, or EBIT, for the earnings measure because it excludes the effects of the company’s borrowings and the tax rates from the analysis. Whatever figure one uses for earnings, it is important to try to determine the effects of various components on future operations.


Net profit is the
proverbial bottom line, so net margin is a bottom-line ratio. But it’s highly variable from one industry to another. Net margin is low in most kinds of retailing, for example, In some kinds of manufacturing it can be relatively high. The best point of comparison for net margin is a company’s performance in previous time periods and its performance relative to similar companies in the same industry.


Operating margin (or EBIT) and net margin (or Net income) measure a firm’s ability to extract profit from its sales,
but for comparing firms’ performance, these ratios reveal little because margins vary so much between different sectors.

OM


How does Wal-Mart compare to its competitors?

Its profit margin ratio was lower than Target’s in 2009 and was less than the industry average. Thus, its profit margin ratio does not suggest exceptional profitability. However, we must again keep in mind that an increasing percentage of Wal-Mart’s sales is from low-margin groceries.


Profit margins vary across industries. Businesses with high turnover, such as grocery stores (
Safeway and Kroger) and discount stores (Target and WalMart), generally experience low profit margins. Low-turnover businesses, such as high-end jewelry stores (Tiffany and Co.) or major drug manufacturers (Merck), have high profit margins. Illustration shows profit margin ratios from a variety of industries.

PM


How do the gross profit rate and profit margin ratio differ?

The gross profit rate measures the margin by which selling price exceeds cost of goods sold. The profit margin ratio measures the extent by which selling price covers all expenses (including cost of goods sold). A company can improve its profit margin ratio by either increasing its gross profit rate and/or by controlling its operating expenses and other costs. For example, at one time


Radio Shack
reported increased profit margins which it accomplished by closing stores and slashing costs. While its total sales have been declining, its profitability as measured by its profit margin has increased.

Strategic errors

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Return to whom?

Every return ratio is a measure of the relationship between the income earned by the company and the investment made in the company by various groups, or In business, the term return is used broadly as a measure of profitability

  • Return on Assets (ROA): The broadest rate of return ratio is the return on assets ratio because it considers the investment made by all providers of capital, from short-term creditors to bondholders to stockholders. Two groups finance a company’s assets:
    • Creditors have loaned money to the company, and they earn interest.
    • Shareholders have invested in stock, and their return is net income.


ROA measures a firm’s performance in using assets to generate net income independent of how those assets are financed (that is, with debt versus equity)
. ROA differs from ROE because ROE measures profitability for a specific form of financing—the portion provided by shareholders.


Therefore, the denominator, or base, for the return on assets ratio is average total liabilities and stockholders’ equity—
which, of course, is the same as average total assets.


The numerator of a return ratio will be some measure of the company’s income for the period.
The income selected for the numerator must match the investment or base in the denominator. For example, if average total assets is the base in the denominator, it is necessary to use an income number that is applicable to all providers of capital.


Therefore, the income number used in the rate of return on assets is income
after interest expense is added back. This adjustment considers creditors as one of the groups that has provided funds to the company. In other words, we want the amount of income before creditors or stockholders have been given any distributions (i.e., interest to creditors or dividends to stockholders). Interest expense must be added back on a net-of-tax basis. Because net income is on an after-tax basis, for consistency purposes, interest must also be placed on a net, or after-tax, basis. The return on assets ratio is as follows:

ROA

Point:

  • Many analysts add back Interest Expense* (1 – Tax Rate) to net income in computing return on total assets.

The rate of return on assets measures profitability well because it combines the effects of profit margin and asset turnover.

This relationship has very important strategic implications for management. We can see that if a company wants to increase its return on assets, it can do so in two ways:

  1. By increasing the margin it generates from each dollar of goods that it sells (the profit margin ratio), or
  2. By increasing the volume of goods that it sells (the asset turnover).


For example, most grocery stores have very low profit margins, often in the range of 1 or 2 cents for every dollar of goods sold. Grocery stores, therefore, focus on asset turnover: They rely on high turnover to increase their return on assets. Alternatively, a store selling luxury goods, such as expensive jewelry, doesn’t generally have a high turnover. Consequently, a seller of luxury goods focuses on having a high profit margin. Recently,
Apple decided to offer a less expensive version of its popular iPod. This new product would provide a lower margin, but higher volume, than Apple’s more expensive version.

ROA-1


(Net profit / Total Assets): ROA has another idiosyncrasy by comparison with the income statement ratios mentioned earlier.
It’s hard for gross margin or net margin to be too high; you generally want to see them as high as possible. But ROA can be too high. An ROA that is considerably above the industry norm may suggest that the company isn’t renewing its asset base for the future—that is, it isn’t investing in new machinery and equipment. If that’s true, its long-term prospects will be compromised, however good its ROA may look at the moment. (In assessing ROA, however, remember that norms vary widely from one industry to another. Service and retail businesses require less in terms of assets than manufacturing companies; then again, they usually generate lower margins.)


Another possibility if ROA is very high is that executives are playing fast and loose with the balance sheet, using various accounting tricks to reduce the asset base and therefore making the ROA look better
. Remember Enron, the energy-trading company that collapsed in 2001? Enron had set up a host of partnerships partially owned by CFO Andrew Fastow and other executives, and then it “sold” assets to the partnerships. The company’s share of the partnerships’ profits appeared in its income statement, but the assets were nowhere to be found on its balance sheet. Enron’s ROA was great, but Enron wasn’t a healthy company.

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Return on Investment (ROI)

Why isn’t ROI included in our list of profitability ratios?

The reason is that the term has a number of different meanings. Traditionally, ROI was the same as ROA: return on assets. But these days it can also mean return on a particular investment, like:

  • What is the ROI on that machine?
  • What’s the ROI on our training program?
  • What’s the ROI of our new acquisition?

These calculations will be different depending on how people are measuring costs and returns.

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  • Return on Common Stockholder’s Equity (or Return on Common Stock Equity) or ROE (or RONW -> Return on Net Worth):  A measure of a company’s success in earning a return for the common stockholders. Because we are interested in the return to the common stockholder, our base is no longer average total assets, but average common stockholders’ equityAnalysts use stockholders’ equity ratios to evaluate a company’s profitability and long-term solvency.


The appropriate income figure for the numerator
is net income less preferred dividends because we are interested in the return to the common stockholder after all claims have been settled. Income taxes and interest expense have already been deducted in arriving at net income, but preferred dividends have not been because dividends are a distribution of profits, not an expense. The another logical reason for deduction of preferred stock is, because, preferred stockholders rank ahead of the common stockholders in their claim on earnings, any preferred dividends are subtracted from net income in computing the rate earned on common stockholders’ equity. In the numerator, the dividends on cumulative preferred stock are subtracted whether they are declared or are in arrears. If preferred stock is noncumulative, its dividends are subtracted only if declared.

[The calculation for numerator for this ratio, as, Lincoln Company had $150,000 of 6% preferred stock outstanding on December 31, 2014 and 2013. Thus, preferred dividends of $9,000 ($150,000 × 6%) are deducted from net income.]


The denominator Common equity is total stockholders’ equity minus preferred equity.  In this computation,
it is the book value of common equity (minority interest is often included in common equity for this ratio). We deduct the par value of preferred stock (or call price, if applicable) from the Total Stock Holder’s equity to get Common stockholder’s equity. So, the denominator must be taken care for the Average of Common Stockholder’s equity only while calculating ROE.


The
return on common stockholders’ equity ratio is computed as follows:

ROE


When preferred stock is present, income available to common stockholders equals net income less preferred dividends.
Similarly, the amount of common stock equity used in this ratio equals total stockholders’ equity less the par value of preferred stock.


This ratio shows how many dollars of net income the company earned for each dollar invested by the owners.
Return on equity (ROE) also helps investors judge the worthiness of a stock when the overall market is not doing well. For example, Best Buy shares dropped nearly 40 percent, along with the broader market in 2001–2002. But a review of its return on equity during this period and since shows a steady return of 20 to 22 percent while the overall market ROE declined from 16 percent to 8 percent. More importantly, Best Buy and other stocks, such as 3M and Procter & Gamble, recovered their lost market value, while other stocks with less robust ROEs stayed in the doldrums.


A rate of return on common stockholders’ equity of 15%–20% year after year is considered good in most industries.


From 2008 to 2009, Nike’s return on common shareholders’ equity decreased from 25.4% to 18%.
As a company grows larger, it becomes increasingly hard to sustain a high return. In Nike’s case, since many believe the U.S. market for expensive sports shoes is saturated, it will need to grow either along new product lines, such as hiking shoes and golf equipment, or in new markets, such as Europe and Asia.

Trading

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An important Note:
Trading on Equity

A company can improve its return on common stock equity through the prudent use of debt or preferred stock financing.


Trading on the equity
describes the practice of using borrowed money or issuing preferred stock in hopes of obtaining a higher rate of return on the money used. Shareholders win if return on the assets is higher than the cost of financing these assets. When this happens, the rate of return on common stock equity will exceed the rate of return on total assets.

Considering an example, Greg’s rate of return on common stockholders’ equity of 14.2% is higher than its rate of return on total assets of 10.1%. This difference results from borrowing at one rate—say, 8%—and investing the money to earn a higher rate, such as the firm’s 14.2% return on equity. This practice is called trading on the equity, or using leverage.


We know,
leverage is a double-edged sword“- increasing profits during good times but compounding losses during bad times.

ROE-2

ROE (Trading on Equity) is directly related to the debt ratio. The higher the debt ratio, the higher the leverage. Companies that finance operations with debt are said to leverage their positions. During good times, leverage increases profitability. But, leverage can have a negative impact on profitability as well.


In short, the company is “
trading on the equity at a gain” means that the company has borrowed money at a lower rate of interest than it is able to earn by using the borrowed money. In this situation, the money obtained from bondholders or preferred stockholders earns enough to pay the interest or preferred dividends and leaves a profit for the common stockholders. On the other hand, if the cost of the financing is higher that the rate earned on the assets, the company is trading on equity at a loss and stockholders lose.

_____________


This short note on Trading on Equity leading to leverage connectivity with ROE, is directing the discussion to understand the decision to be taken related to
“Debt versus Equity decision”

When obtaining long-term capital, corporate managers must decide whether to issue bonds or to sell common stock. Bonds have three primary advantages relative to common stock, as shown:


In the 3rd point,
the denominator of ROE gets decreased when no additional common stocks are issued, resulting to increased ROE.

The above shows that the return on common stockholders’ equity is affected by the return on assets ratio and the amount of leverage a company uses—that is, by the company’s reliance on debt (often measured by the debt to total assets ratio). If a company wants to increase its return on common stockholders’ equity, it can either increase its return on assets or increase its reliance on debt financing.


Notes, bonds, and preferred stock are the primary sources of capital other than common stock
. Accounts payable and taxes payable represent interest-free loans to the company from suppliers and the government. Although the Accounts payable (depends upon creditors) and Taxes payable are for a short duration (could be 30 days).

Now we shall define Leverage more explicitly; Leverage The use of borrowed funds and amounts contributed by preferred stockholders to earn an overall return higher than the cost of these funds.


Illustrating the potential effect of debt financing on the return on common stockholders’ equity

Assume that Microsystems Inc. currently:

  • Has 100,000 shares of common stock outstanding issued at $25 per share and no debt.
  • It is considering two alternatives for raising an additional $5 million:
    • Plan A involves issuing 200,000 shares of common stock at the current market price of $25 per share.
    • Plan B involves issuing $5 million of 12% bonds at face value.
  • Income before interest and taxes will be $1.5 million; income taxes are expected to be 30%.

The alternative effects on the return on common stockholders’ equity are shown:

actual cost of borrowing


Implying Return on Equity (ROE) OR Return on Common Stockholder’s Equity is higher in case of debt financing.


If a
n average cost for borrowed money of 9%, the actual cost of the borrowed money is 5.4% [9% × (100% – 40%)] after taxes, considering tax rate of 40%.

In the above table: The rate of interest on debt financing is 12%, with the tax rate of 30%, so, actual cost of borrowing comes at;

Actual Cost of Borrowing=Interest Rate * (1 – Tax rate) = 12%*(1 – 30%) = 8.4%


In general, as long as the return on assets rate exceeds the rate paid on debt, a company will increase the return on common stockholders’ equity by the use of debt.

Leverage


If the use of Debt increases the Return on Equity, then, Why don’t companies rely almost exclusively on debt financing rather than equity? The below answers to this tricky question.


Debt has one major disadvantage:
Debt reduces solvency. The company locks in fixed payments that it must make in good times and bad. The company must pay interest on a periodic basis and must pay the principal (face value) of the bonds at maturity. A company with fluctuating earnings and a relatively weak cash position may experience great difficulty in meeting interest requirements in periods of low earnings. In the extreme, this can result in bankruptcy. With common stock financing, on the other hand, the company can decide to pay low (or no) dividends if earnings are low.

  • If ROE > Cost of Equity ->  Generating value for Shareholders
  • ROE is not comparable across firms with different degrees of leverage
  • Return on Equity (Net profit / Shareholder’s Equity): As with the other profitability ratios, ROE can be used to compare a company with its competitors (and, indeed, with companies in other industries). Still, the comparison isn’t always simple.

ROE-3

Now comparing the two companies, for instance:


Company A may have a higher ROE than Company B because it has borrowed more money—that is, it has greater liabilities and proportionately less equity invested in the company.
Is this good or bad?


The answer depends on whether Company A is taking on too much risk or whether, by contrast, it is using borrowed money judiciously to enhance its return.
That gets us into ratios such as debt-to-equity.


From an investor’s perspective, ROE is a key ratio
. Depending on interest rates, an investor can probably earn 2, 3, or 4 percent on a treasury bond, which is about as close to a risk-free investment as you can get. So if someone is going to put money into a company, he’ll want a substantially higher return on his equity.


ROE doesn’t specify how much cash he’ll ultimately get out of the company, since that depends on the company’s decision about dividend payments and on how much the stock price appreciates until he sells
.

But it’s a good indication of whether the company is even capable of generating a return that is worth whatever risk the investment may entail.


The rate earned on stockholders’ equity is normally higher than the rate earned on total assets.
This is because of the effect of leverage.

ROE-4

PM -> Profit Margin; ATO-> Asset Turnover; FLM-> Financial Leverage Measure

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Decomposition of ROA and ROE (
Overcomes the limitations of Individual Ratios)


We have studied the dependency parameters of ROA and ROE in the above sections, however, the naming to this decomposition of ROE was named by
DuPont, as DuPont framework (named after a system of ratio analysis developed internally at DuPont around 1920) provides a systematic approach to identifying general factors causing ROE to deviate from normal. The DuPont system also provides a framework for computing financial ratios to yield more in-depth analysis of a company’s areas of strength and weakness.


We shall take up ROA decomposition:

  • Combines Profit Margin (PM) and Asset Turnover (ATO)
  • Overcomes the limitations of both PM & ATO.

ROA-3

The insight behind the DuPont framework is that ROE can be decomposed into three components (Profitability, Efficiency & Leverage) as shown in Exhibit

DuPont

This preliminary DuPont analysis is only the beginning of a proper ratio analysis. If a DuPont analysis suggests problems in any of the three ROE components, there are further ratios in each area that can shed more light on the exact nature of the problem.

Complete DuPont Decomposition

DuPont-2

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VARIATIONS ON A THEME: RONA, ROTC, ROIC, AND ROCE

Interpreting probability ratios requires benchmarks. Longitudinal comparisons examine whether a profitability ratio is improving or deteriorating. Inter-firm comparisons tell us how a firm is performing relative to a competitor, relative to its industry average, or relative to firms in general (for example, the average for the Fortune 500 or FT 500). Another key benchmark is cost of capital.

Many businesses use somewhat more complex profitability ratios to gauge their performance. These include:

  • Return on net assets (RONA),
  • Return on total capital (ROTC),
  • Return on invested capital (ROIC), and
  • Return on capital employed (ROCE).

Individual businesses use different formulas to calculate these ratios, but they all measure essentially the same thing: how much return the business generated relative to its outside investment and financing. In other words, they answer this question: Did the company earn enough of a profit to justify the amount of “other people’s money” it is using Invested capital comes from two main sources:

  • Interest bearing debt and
  • Shareholders’ equity.
  • Interest-bearing debt is money the company borrows from banks and from those who purchase its bonds.
  • Shareholders’ equity is the money raised from selling shares to the public, plus earnings that have been retained by the company in prior years and are available to fund current investments.

ROIC measures the effectiveness with which a company is using the capital funds that it has available for investment. As such, it is recognized to be an excellent measure of the value a company is creating. Remember that a company’s ROIC can be decomposed into its constituent parts.

  • ROIC (Return on Invested Capital) or ROCE (Return on Capital Employed) should be compared with WACC (Weighted Average Cost of Capital), and
  • ROE (Return on Equity) compared with the cost of equity capital.


ROIC is also referred to as return on capital employed (ROCE).

Decompose

Note: For further discussion, see T. Koller, M. Goedhart, and D. Wessels, Valuation, 4th edn (New York: John WiIey&Sons Inc., 2005)

A generic version of the formula used in calculating these ratios looks like :

formula


The numerator is often called
NOPAT, which stands for net operating profit after tax. It shows how much money the company would have made if it: had no debt and thus had no interest costs but had to pay taxes on all of its operating profits. (Interest on debt is deductible for tax purposes.)

  • In the RONA or net assets approach, the denominator is total assets minus all assets financed by non-interest-bearing liabilities, such as accounts payable and accrued expenses.
  • In the ROCE, ROIC, or ROTC approach, shown in the equation above, the denominator is total equity plus all interest-bearing debt.

Fundamentally, the various approaches amount to the same thing. You are separating out the liabilities you have to pay interest on from those you don’t. The separation reflects the fact that some of the financing necessary to run a business comes from such items as accrued liabilities, accounts payable, and deferred taxes. These will ultimately wind up as charges on the income statement, but the people to whom the money is owed don’t expect a return.

Using this sample from income statement and balance sheet, we can calculate these ratios as follows. We have left out the zeroes for simplicity’s sake:

  • Calculate the company’s income before taxes. This is just operating income or EBIT less interest expenses: $652 – $191 = $461.
  • Determine the company’s tax rate. It shows a charge on the income statement of $213 for taxes, and $213/$461 = 46 percent. This is a bit higher than most US businesses, which usually pay between 30 percent and 40 percent.
  • Determine the tax liability on the company’s operating profit: $652 × 46% = $301. NOPAT or net operating profit after tax is $652 – $301 or $351. This is the numerator of all the ratios.
  • Calculate the denominator. First add up all the interest-bearing debt on the balance sheet. In this case the category includes the credit line of $100, the current portion of long-term debt of $52, and the long-term debt of $1,037. The total is $1,189. The other liabilities on the balance sheet don’t carry interest—though in the real world you might need to study them to make sure that is the case. Usually it is.
  • Now add this figure to total equity: $1,189 + $2,457 = $3,646. This is the all the capital that outsiders have provided plus whatever the company has retained from profits. It is the denominator of the ratio.
  • Finally, calculate the RONA, ROTC, ROIC, or ROCE for this business

formula-1

What does it all mean? For every dollar tied up in this company, the return in the past year was 9.6 percent. If the ratio is higher than expected, stakeholders with money in the business are happy. If it is lower, they might want to look elsewhere. These ratios are essential for measuring the return on the business’s overall capital.

One note on all such ratios: you’ll notice that they compare a profit number taken from the income statement to a capital number taken from the balance sheet. This creates a potential problem: NOPAT represents money earned during an entire year, but the denominator—total capital—is shown for a single point in time, the end of the year. Many financial folks prefer to take an average of several balance sheets during the year to get an “average” total capital figure rather than using just year-end numbers.


Whether you’re calculating simple profitability ratios or more complex ones, do remember one thing:

  • The numerator is some form of profit, which is always an estimate.
  • The denominators, too, are based on assumptions and estimates. The ratios are useful, particularly when they are tracked over time to establish trend lines. But we shouldn’t be lulled into thinking that they are impervious to artistic effort.


Some other additional Ratios used in MFI (Micro Finance Institutions)


How Service Industry (Banks and NBFC’S) view profitability in terms of Lending Business


Portfolio yield

Portfolio yield measures how much an MFI has earned through its lending operations. Income used to calculate yield includes all cash interest and fee payments, but does not include interest accruals. The following formula calculates the yield:

Portfolio

The portfolio yield is particularly useful in demystifying the actual cashflow of the various interest and fee structures on microfinance loans. It measures the amount of actual income from lending for the period and compares it to the period average outstanding portfolio that produced it. As such, Portfolio Yield is an initial indicator of an MFI’s ability to generate the required income to become sustainable. As an average, portfolio yield represents a measure of yield over a given period, and not a particular moment or on a particular loan product.


Operational Self-Sufficiency (OSS)

Donors and MFI management use this benchmark to assess how far an MFI has come in covering its operating expenses with its operating income. Two variants of OSS exist. The first includes the actual cash cost of funds in its calculations, as follows:

OSS

Expenses in this calculation include all cash and non-cash expenses from the income statement, such as depreciation and loan loss provision expenses, as well as any cash costs of funds, such as interest and fees actually paid on debt or to savers with voluntary deposits.


Some analysts prefer to use a different version of OSS, which excludes the cash cost of funds from total operating expenses
:

OSS-1

From a comparative perspective, this formula has one distinct advantage: it does not penalize MFI’s that have accessed commercial financial markets, through debt or voluntary deposit taking, to fund their portfolios. As MFI’s have different debt/ equity structures, or funding structures, two institutions with similar performance as measured in Average ROA, could have greatly varying OSS if one funded its portfolio mostly from equity and the other from liabilities. Both these versions of OSS use data over a given period. Unlike other indicators, such as Average ROA, which compare Income Statement accounts to Balance Sheet accounts, the calculation of OSS does not require period averages in the denominator. Rather, since both the amounts in the numerator and the denominator come from the Income Statement, the total amount at the end of the period is used.


Financial Self-Sufficiency (FSS)

Financial self-sufficiency (FSS) also measures the extent to which operating profits cover an MFI’s costs. FSS, however, measures how much coverage exists on an adjusted basis. These adjustments are similar to those made for Average ROA and Average ROE, and attempt to show how the financial picture of the MFI would look on an unsubsidized basis, where funds would be raised on the commercial market, rather than through donor grants or subsidized capital. As such, FSS is measured as follows:

FSS

FSS calculations require adjustments to the operating expenses of an MFI. Customer deposits (savings) and debt must be adjusted to reflect market rates on loans and deposits. Likewise, as inflation erodes the value of equity, financial equity balances must be adjusted for inflation. If an MFI receives subsidies or in-kind donations, these too must be accounted for in the adjustments. Cash donations must be excluded from operating income.

Notice that FSS, like OSS, is an indication of performance over a period and not at a given point in time.

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PerformanceManagement

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The Impact of Exchange Rates on Profitability

Sometimes operating managers have no control over factors that affect profit. An example is exchange rates—which, in our global economy, loom ever larger in many companies’ calculations.


An exchange rate is just the price of one currency expressed in terms of another currency
. An American visiting Hong Kong in autumn 2011, for example, could have bought about 7.8 Hong Kong dollars (HKD) for one US dollar. The price of those 7.8 HKD, in other words, is $1.00. However, exchange rates vary significantly over time. The fluctuations depend on trade flows, government budgets, relative interest rates, and a host of other variables.


Whenever a company from one country does business in another, the profitability of its operations will be affected by fluctuations in exchange rates
.

In the simplest case, imagine that a US manufacturer sells machines in Hong Kong for 780,000 HKD, or about $100,000 (in late 2011). Then suppose that the US dollar declines in value relative to the HKD—that is, you now need more than $1.00 to buy 7.8 HKD. Let’s say the new rate is 6.8 HKD to the dollar. The manufacturer receives the same 780,000 HKD for its machines, but that money is now worth $114,706. Other things equal, those sales are 14.7 percent more profitable than they used to be. The manufacturer can pocket the difference, or it can decide to reduce prices to increase demand. The opposite will hold true, of course, if the US dollar increases in value relative to the HKD. In that case, people and companies who buy from Hong Kong will gain, and those who sell there will lose.

Many companies, of course, have highly complex overseas operations. They produce some products at home and some in foreign countries. They ship goods in both directions, and from one foreign country to another. Every international transaction involves some risk that exchange rates will fluctuate in the wrong direction, and that profits on the transaction will be less than expected.


Though operating managers can’t do much about exchange rates themselves, the financial folks can and do take action to protect themselves against these risks
, For example, they can purchase financial instruments that allow them to buy or sell certain currencies at predetermined prices, thus locking in exchange rates. This kind of hedge, as it is known in the financial world, helps protect against unexpected rate changes. Of course, hedges cost money, and they don’t always work perfectly. So while a company can reduce the effects of exchange rates on profitability, it can rarely eliminate them.

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Earnings per Share (EPS)

Earnings per share (EPS) is one of the most quoted statistics for publicly traded companies. Stockholders and potential investors want to know what their share of profits is, not just the total dollar amount. Presentation of profits on a per-share basis also allows the stockholder to relate earnings to what he or she paid for a share of stock or to the current trading price of a share of stock.

In simple terms EPS (Earnings per Share) is:

EPS

A number of complications can arise in the computation of EPS, and the calculations can become exceedingly complex for a company with many different types of securities in its capital structure, please refer this article for more reading.


International Note
U.S. and U.K. corporations raise most of their capital through millions of outside shareholders and bondholders. In contrast, companies in Germany, France, and Japan acquire financing mostly from large banks or other financial institutions. Consequently, in the latter environment, shareholders are somewhat less important.

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 All Ratios

Gauging the Market Strength, which is one of the last important article on the series of “Financial Ratios” shall be taken up now…..Hope, most of us are on the path of learning and thereby more armed with these financial tools to assist and guide your business partners & endeavouring to achieve financial objectives of the organization.

I would be grateful for any feedback on the articles published till now!

Cheers!

Solvency (or Leverage) Ratios… Is your Company overburdened with Debt? Monday, Jul 27 2015 

Solvency (or Leverage) Ratios

What should be the right combination of Debt & Equity in a Company decides many important concerns, out of which one is sustainability related to financial structure. In this article, we shall discuss upon the various ratios which indicate the important metrics considering long term liabilities and stockholder’s equity. It is necessary to understand some of the important terms, like Leverages & Solvency.

First of all We shall take leverages.


Leverage: 
leverage is a double-edged sword“- increasing profits during good times but compounding losses during bad times.

The term leverage is actually defined in two ways in business, the ideas in the two are related but different:

  • Operating leverage and
  • Financial leverage.

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Operating Leverage


Operating leverage
is the ratio between fixed costs and variable costs; increasing your operating leverage means adding to fixed costs with the objective of reducing variable costs. Cost structure (Ratio of Fixed and Variable expenses) can affect company’s profitability and Operating Risk.

Though, we focus more on this “Operating Leverage” in “Cost Accounting”, however, we need to have an understanding on this, while analyzing Financial Statements.


Operating leverage
which is related to many aspects in business and help us in assessing:

  • How sensitive a company’s operating income is to a change in sales.
  • It is used to evaluate the break even point of a business, &
  • The likely profit levels on individual sales.


Companies with large costs tied up in production equipment will often have relatively small amounts of assembly labor costs
. While investments in machinery generate depreciation—a fixed cost, fewer production employees result in lower labor costs—which are variable. Because fixed costs are incurred regardless of the level of sales, companies with higher fixed costs find it difficult to reduce these costs in the short-run. As a result:

  • High Operating Leverage: Companies with higher proportions of fixed costs have higher operating leverage and are considered to have more risky operations. In this case, the firm earns a large profit on each incremental sale, but must attain sufficient sales volume to cover its substantial fixed costs. If it can do so, then the entity will earn a major profit on all sales after it has paid for its fixed costs.
  • Low Operating Leverage:  In this case, a large proportion of the company’s sales are variable costs, so it only incurs these costs if there is a sale. In this case, the firm earns a smaller profit on each incremental sale, but does not have to generate much sales volume in order to cover its lower fixed costs. It is easier for this type of company to earn a profit at low sales levels, but it does not earn outsized profits if it can generate additional sales. Companies with a cost structure consisting of significant amounts of production labor with fewer capital assets have lower fixed costs and higher variable costs. Variable costs are easier to reduce on a short-term basis, which in turn, implies lower operating leverage and less risky operations.

A retailer that occupies a bigger, more efficient store and a manufacturer that builds a bigger, more productive factory are both increasing their fixed costs. But they hope to reduce their variable costs, because the new collection of assets is more efficient than the old. These are examples of operating leverage.

For example, a software company has substantial fixed costs in the form of developer salaries, but has almost no variable costs associated with each incremental software sale; this firm has high operating leverage. Conversely, a consulting firm bills its clients by the hour, and incurs variable costs in the form of consultant wages. This firm has low operating leverage.

The DOL indicates the number of times that the contribution margin exceeds the company’s operating income. A company with higher DOL has more extreme fluctuations in operating income than a company with a lower DOL when a change in sales revenue occurs.

  • A high DOL implies a more risky operating structure because of the volatility of the change in profit.
  • Conversely, a lower DOL amount implies a less risky operating structure.

The following table summarizes the relationship between cost structure, risk, profit fluctuations, and the degree of operating leverage.

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Suppose Marsh Company has a contribution margin of $495,000 and operating income of $110,000. Its DOL is $495,000 divided by $110,000, or 4.50. The DOL of 4.50 indicates that each dollar increase in sales revenue is expected to generate a $4.50 increase in profit. In isolation, the DOL does not provide much insight. However, as a comparison with prior periods or against other companies, the DOL enables managers and investors to evaluate a company’s operating risk.

If Marsh’s DOL was 3.4 the prior year, we can conclude that Marsh is becoming more risky since its DOL has risen.

More on Operating Leverage can be read through this section.

Now, we shall move forward to Financial Leverage.

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Financial Leverage [ or Financial Gearing]


Financial leverage
, by contrast, simply means the extent to which a company’s asset base is financed by debt.


Leverage of either kind makes it possible for a company to make more money,
but it also increases risk. The airline industry is an example of a business with high operating leverage—all those airplanes!—and high financial leverage, since most of the planes are financed through debt. The combination creates enormous risk, because if revenue drops off for any reason, the companies are not easily able to cut those fixed costs. That’s pretty much what happened after September 11, 2001. The airlines were forced to shut down for a couple of weeks, and the industry lost billions of dollars in just that short time

Given the risks involved, we may wonder why a business would want to take on leverage [or gearing (that is, to borrow)]. One reason may be that the owners have insufficient funds, so the only way to finance the business adequately is to borrow from others. Another reason is that Financial Leverage [gearing] can be used to increase the returns to owners. This is possible provided that the returns generated from borrowed funds exceed the cost of paying interest.

The right cap­ital structure will depend on tax policy, high corporate rates favour debt, high personal tax rates favour equityon bankruptcy costs, and on overall corporate risk.


In particular, if we are concerned about bankruptcy possi­bilities, the long-run solvency or leverage of the firm may be important
.


In other words, Leverage ratios are an indication of the extent to which a company is using other people’s money to purchase assets.
Solvency refers to a company’s long run financial viability and its ability to cover long—term obligations. The individuals like Long term creditors and stockholder’s are interested in company’s long term solvency.


Note:
Liquidity (which we discussed earlier articles) is a firm’s ability to meet its current obligations; solvency is its ability to meet maturing obligations as they come due without losing the ability to continue operations.


Leverage is borrowing so that a company can Purchase more assets than the stockholders are able to pay for through their own investment
. Higher leverage increases return on equity through the following chain of events:

  • More borrowing means that more assets can be purchased without any additional equity investment by stockholders.
  • More assets means that more sales can be generated.
  • More sales means that net income should increase.


Investors generally prefer high leverage to increase the size of their company without increasing their investment
, but lenders prefer low leverage to increase the safety of their loans. In the field of corporate finance deals with how to optimally balance these opposing tendencies and choose the perfect capital structure for a firm.


As a general rule of thumb
, most large U.S. companies borrow about half the funds they use to purchase assets.

All of a company’s business activities— financing, investing, and operating—affect its solvency. Analysis of solvency is long term and uses less precise but more encompassing measures than liquidity.


One of the most important components of solvency analysis is the composition of a company’s capital structure
. Capital structure refers to a financing sources of firm & it’s strategies. The balance between debt and equity is called the capital structure. The optimal capital structure is determined by the individual company. Capital Structure ranges from relatively permanent equity financing to riskier or more temporary short term financing.


The analyst evaluates how those financial sources change [Debt & Equity] and how they compare with other firms in the same industry.
The analyst then tries to gain insight into the firm’s decisions about capital sources in order to predict future capital financing decisions. An investor would surely like to know whether the firm is likely to issue new debts or sell additional shares of stock. Identifying shifts in capital structure over time may indicate how the firm will make future decisions about sources of capital.


Assets represent security for financiers, ranging from loans secured by specific assets to the assets available as general security to unsecured creditors
.

Long-term solvency has to do with a company’s ability to survive for many years. The aim of evaluating long-term solvency is to detect early signs that a company is headed for financial difficult. Increasing amounts of debt in a company’s capital structure mean that the company is becoming more heavily leveraged. This condition has a negative effect on long-term solvency because it represents increasing legal obligations to pay interest periodically and the principal at maturity. Failure to make those payments can result in bankruptcy.


A company is said to be highly leveraged if it uses more debt than equity, including stock and retained earnings.
Debt has a lower cost because creditors take less risk; they know they will get their interest and principal. However, debt can be risky to the firm because if enough profit is not made to cover the interest and principal payments, bankruptcy can result.


It is debatable whether the apparent low interest rates really are beneficial to the shareholders. Some argue that since borrowing increases the risk to shareholders, there is a hidden cost of borrowing. What are not illusory, however, are the benefits to the shareholders of the tax-deductibility of interest on borrowings.

Motivation for Debt-> Less Expensive than equity financing

If fixed interest paid < Return earned from using the debt fund:

  • The excess return increases Stockholder’s wealth
  • Trading on Equity

Interest is tax deductible, while dividends are not.

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In this case, the total amount of Return is more for where debt financing is availed, i.e. by Risky Inc.

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The effect of gearing is like that of two intermeshing cogwheels of unequal size (see Figure). The movement in the larger cog (operating profit) causes a more than proportionate movement in the smaller cog (returns to ordinary shareholders).

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Gearing levels vary from sector to sector as well. Oil companies prefer low levels given their exposure to the volatility of oil prices. BP’s net debt-shareholders’ funds ratio of 21 per cent  is at the low end of a 20 to 30 per cent range it considers prudent.

Miners’ gearing is on a clear downward trend already. Xstrata, the mining group, stressed last month that its £4.1 billion rights issue would cut gearing from 40 per cent to less than 30 per cent. A week later, BHP said its $13 billion of first-half cash flows had cut gearing to less than 10 per cent. Rio Tinto, which had gearing of 130 per cent at the last count in August  2008, is desperately trying to cut it by raising fresh equity.

Utilities tend to be highly geared because they can afford to borrow more against their typically reliable cash flows. But even here the trend is downwards. Severn Trent, the UK water group, says its appropriate long-term gearing level is 60 per cent.

But ‘given ongoing uncertainties . . . it is prudent in the near term to retain as much liquidity and flexibility as possible’. It does not expect to pursue that target until credit markets improve.

Reducing gearing is not easy, especially for the most indebted companies that need to the most: shareholders will be more reluctant to finance replacement equity in companies with  highly leveraged balance sheets.

The supply of fresh equity will also be constrained, not only by a glut of demand from companies but by the squeeze on investor money from a wave of government bond issuance.

Richard Jeffrey, chief investment officer at Cazenove Capital Management, says there is a risk of the government making it more difficult to raise money to improve balance sheets.

‘That is of extreme concern because that could become a limitation, longer term, in the capital that companies have to fund investment.’

Source: ‘Gearing levels set to plummet’, Jeremy Grant, Financial Times, 10 February 2009.

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We can have a comparison on to have more differences in between Equity and Debt Financing are as:

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An effect of financial leverage [Financial gearing] is that returns to shareholders become more sensitive to changes in operating profits. For a highly geared business, a change in operating profits will lead to a proportionately greater change in the ROSF [Return on Ordinary Shareholder’s Funds] ratio. So, for a highly geared business, a small decline in operating profit will bring about a much greater decline in the returns to shareholders.

This section describes the tools of solvency analysis. Our analysis focuses on a company’s ability to both meet its obligations and provide security to its creditors over the long run. Indicators of this ability include:

  • Debt Ratios
    • Debt Ratio or (Liabilities to Assets Ratio): Total Liabilities to Total Assets
    • Debt and equity ratio, or Ratio of Total Liabilities to Stockholder’s Equity
    • Long term Debt and equity ratio: Ratio of Long term Liabilities (or Debt) to Stockholder’s Equity
    • Long term Debt Ratio: Ratio of Long term Liabilities (or debt) to Total Assets
    • Long term Liabilities to Net Worth: Debt to Tangible Net Worth Ratio
  • Time Interest Turned Ratio (or Interest Coverage Ratio): The company’s capacity to earn sufficient income to pay fixed interest charges.
  • Times earned Preferred Dividends are earned: The number of times preferred dividend are earned.
  • Debt Service Coverage Ratio (DSCR): The company’s capacity to earn sufficient income to pay debt.
  • Cash Debt Coverage Ratio
  • Cash Flow from Operations to Total Liabilities Ratio
  • Cash Flow from Operations to Capital Expenditures Ratio


Other Long term Debt Paying Ability Ratios

  • Current Debt to Net Worth Ratio: indicates a relationship between current liabilities and funds contributed by shareholders. The higher the proportion of funds provided by current liabilities, the greater the risk.
  • Total Capitalization Ratio: This compares long-term debt to total capitalization. Total capitalization consists of long-term debt, preferred stock, and common stockholders’ equity. The lower the ratio, the lower the risk.
  • The relation between pledged assets and secured liabilities, and
  • Ratio of Fixed Assets to Long term liabilities (or debt)
  • Ratio of Fixed Assets to Stockholder’s Equity Ratio: indicates the extent to which shareholders have provided funds in relation to fixed assets. Some firms subtract intangibles from shareholders’ equity to obtain tangible net worth. This results in a more conservative ratio. The higher the fixed assets in relation to equity, the greater the risk.


Total liabilities includes short-term liabilities, reserves, deferred tax liabilities, non-controlling interests, redeemable preferred stock, and any other noncurrent liability. It does not include stockholders’ equity.

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If debt is risky, why have any?

The answer is that the level of debt is a matter of balance. Despite its riskiness, debt is a flexible means of financing certain business operations. The interest paid on debt is tax-deductible, whereas dividends on stock are not. Because debt usually carries a fixed interest charge, the cost of financing can be limited, and leverage can be used to advantage. If a company can earn a return on assets greater than the cost of interest, it makes an overall profit.

In addition, being a debtor in periods of inflation has advantages because the debt, which is a fixed dollar amount, can he repaid with cheaper dollars. However, the company runs the risk of not earning a return on assets equal to the cost of financing the assets, thereby incurring a loss.

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  • Debt Ratio: It is the ratio of Total Liabilities to Total Assets.

Debt Ratio =(Total Liabilities)/(Total Assets)

If the debt ratio is 1, then all the assets are financed with debt. A debt ratio of 50% means that half the assets are financed with debt and the other half are financed by the owners of the business. The higher the debt ratio, the higher the company’s financial risk.


The lower the ratio, the more equity “buffer” there is available to the creditors.
Thus, from the creditors’ point of view, a low ratio of debt to assets is usually desirable.


The adequacy of this ratio is often judged in the light of the company’s earnings.
Generally, companies with relatively stable earnings (such as public utilities) have higher debt to assets ratios than cyclical companies with widely fluctuating earnings (such as many high-tech companies).


The Risk Management Association reports that the average debt ratio for most companies ranges from 57% to 67%, with relatively little variation from company to company.
If debt ratio is 54.8%, then it indicates a fairly low-risk position compared with the industry average debt ratio (example) of 69%.


The debt ratio should be compared with competitors and industry averages,
however, this comparison can be misleading if one firm has substantial hidden assets, or liabilities that other firms do not (such as substantial land carried at historical cost).


Some thought What to Include in Liabilities


In practice, substantial disagreement occurs on the details of the formula to compute the debt ratio. Some of the disagreement revolves around whether short-term liabilities should be included. Some firms exclude short-term liabilities because they are not long-term sources of funds and are, therefore, not a valid indication of the firm’s long-term debt position. Other firms include short-term liabilities because these liabilities become part of the total source of outside funds in the long run. For example, individual accounts payable are relatively short term, but accounts payable in total becomes a rather permanent part of the entire sources of funds.

  • Debt and equity ratios: The debt-to-equity ratio measures the proportion of a company’s debt to its equity. It is computed as total liabilities divided by total stockholders’ equity. It shows the proportion of total liabilities relative to the proportion of total equity that is financing the company’s assets. Thus, this ratio measures financial leverage.


Long-term liabilities are a component of the “capital structure” of the company
and are included in the calculation of the debt-to-equity ratio:

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where Total Borrowings = Short  term and Long term debt (Interest bearing)


Debt-Equity Ratio: It measures  capital structure and leverage by showing the amount of a company’s assets provided by creditors in relation to the amount provided by stockholders


If the debt to equity ratio is greater than 1, then the company is financing more assets with debt than with equity. If the ratio is less than 1, then the company is financing more assets with equity than with debt.
The higher the debt to equity ratio, the higher the company’s financial risk.

It is also required to compare this ratio with the competition or the Industry Average, to make it more relevant to derive any business conclusions.

  • Long term Liabilities to Net Worth: Debt to Tangible Net Worth Ratio: The debt to tangible net worth ratio also determines the entity’s long-term debt-paying ability. This ratio also indicates how well creditors are protected in case of the firm’s insolvency. As with the debt ratio and the debt/equity ratio, from the perspective of long-term debt-paying ability, it is better to have a lower ratio.

The debt to tangible net worth ratio is a more conservative ratio than either the debt ratio or the debt/equity ratio. It eliminates intangible assets, such as goodwill, trademarks, patents, and copyrights, because they do not provide resources to pay creditors—a very conservative position. Compute the debt to tangible net worth ratio as follows:

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  • Ratio of Fixed Assets to Long term liabilities (or The relation between pledged assets and secured liabilities, ): The ratio of fixed assets to long-term liabilities provides a measure of whether note holders or bondholders will  be paid. Since fixed assets are often pledged as security for long-term notes and bonds, it is computed as follows:
  • Coverage of Fixed Charges: A measure of the company’s ability to meet all of its fixed-charge obligations.
  • Time Interest Turned Ratio (or Interest Coverage Ratio)
  • Times earned Preferred Dividends are earned: The number of times preferred dividend are earned.
  • Debt Service Coverage Ratio (DSCR)
  • Cash Debt Coverage Ratio (or Cash Flow from Operations to Total Liabilities Ratio)

The debt ratio and debt to equity ratio say nothing about the ability to pay interest expense. Analysts use the times-interest-earned ratio to relate Earnings before interest and taxes (EBIT) to interest expense. This ratio is also called the interest-coverage ratio.

It measures the number of times EBIT can cover (pay) interest expense. A high interest coverage ratio indicates ease in paying interest expense; a low ratio suggests difficulty.

  • Time Interest Turned Ratio (or Interest Coverage Ratio): The company’s capacity to earn sufficient income to pay fixed interest charges. One can criticize the interest coverage ratio as a measure of long-term liquidity risk because it uses income rather than cash flows in the numerator. Firms pay interest and other fixed payment obligations with cash, not with income. When the ratio is relatively low, the analyst should use some measure of cash flows, such as cash flow from operations, in the numerator. The appropriate level of times interest earned represents a balancing of the desire  of investors to leverage their investment with the desire of creditors for safety concerning the collection of their loans.

Analysts typically view an interest coverage ratio below 3.0 as risky, although they prefer a ratio that is stable over time to one that is somewhat higher on average but fluctuates. A benchmark value of 3.0 means that the firm has three times as much income before interest expense and income taxes as it needs to pay current interest charges.

  • Times earned Preferred Dividends are earned: The number of times preferred dividend are earned. Since dividends are paid after taxes, net income is used in computing the number of times preferred dividends are earned. The higher the ratio, the more likely preferred dividend payments will be paid if earnings decrease.
  • Debt Service Coverage Ratio (DSCR): The company’s capacity to earn sufficient income to pay debt. The debt service coverage ratio is a measure of the amount of cash that is generated from operating activities during the year and that is available to repay interest due and any maturing principal amounts (i.e., the amount available to “service” the debt)

    Some analysts use an alternative measure in the numerator of this ratio called EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization. Whether EBITDA is a good substitute for cash flow from operations before interest and tax payments depends on whether there were significant changes in current assets and current liabilities during the period. If significant changes in these accounts occurred during the period, cash flow from operations before interest and tax payments is a better measure of a company’s ability to cover interest and debt payments.

  • Cash Flow from Operations to Total Liabilities Ratio Debt ratios do not consider the availability of cash to service debt (that is, to pay interest and principal when due). The cash flow from operations to total liabilities ratio overcomes this deficiency. This cash flow ratio resembles the one for assessing short-term liquidity risk, but here the denominator includes all liabilities (both current and  noncurrent). A mature, financially healthy company typically has a cash flow from operations to total liabilities ratio of 20% or more.

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Lenders want to be sure that borrowers can pay the interest and repay the principal on a loan. The preceding ratios reflect the degree to which a company can make its debt payment out of current cash flow.

  • Cash Flow from Operations to Capital Expenditures Ratio: One final measure is useful in assessing the solvency of a business. The cash flow from operations to capital expenditures ratio measures a company’s ability to use operations to finance its acquisitions of productive assets. To the extent that a company  is able to do this, it should rely less on external financing or additional contributions by the owners to replace and add to the existing capital base. The ratio is computed as follows:

Cash Flow with Capital Expenditures

Note that the numerator of the ratio measures the cash flow after all dividend payments are met.

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Warning Signals – Altman “Z-Score” for Predicting Financial Distress

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In the Next article we shall be discussing about Profitability Ratios, till then,…..Smile

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