Professional Designation Ratios: Formulas & Definitions Used in Credit Risk Assessment

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1 Professional Designation Ratios: Formulas & Definitions Used in Credit Risk Assessment Profitability Ratios Measure management's ability to control expenses and to earn a return on the resources committed to the business. Revenue Growth/Decline Is the firm either growing or declining in revenues from year to year? The analysis of changes in revenues can be better understood by examining the factors that affect revenue change. The three factors that can affect changes in sales and cost of sales are price, volume and mix. Current Year Sales - Prior Year Sales Prior Year Sales Sustainable Growth * How much growth can a firm afford? Operating and financial policies and growth objectives must be compatible for growth to be sustained. For a firm in sustainable growth equilibrium, in which it does not issue new equity, the ongoing annual growth in sales, is proportional to the growth in assets, debt, earnings, and equity. However, if sales expand at a rate faster than the sustainable growth rate, something in the company's financial objectives has to give - usually to the detriment of financial soundness. Conversely, if sales grow at a rate less than the sustainable growth rate, a surplus of funds should exist. 1 - p = retention rate; p is the dividend payout ratio Dividends Net Income (1 - p) ROE 1 - (1 - p) ROE Return on Equity (DuPont Model) & Return on Assets * Return on equity and return on assets are two ratios that measure the overall efficiency of the firm in managing its total investment in assets and in generating a return to the shareholders (owners). Return on equity measures the return to the shareholders (owners) while return on assets indicates the amount of profit earned relative to the level of investment in total assets. There are three components that drive return on equity performance: net profit margin (A), total asset turnover (B) and leverage (C). Using cross multiplication, return on equity is simply net income divided by equity and return on assets is simply net income divided by total assets (investments). The return on equity outcome is actually measuring the firms overall margins (A), turnover (B) and use of leverage (C). Return on Equity A B C Net Income = Net Income x Sales x Assets Equity Sales Assets Equity Return on Assets A B Net Income = Net Income x Sales Assets Sales Assets 2013 NACM 1

2 Profitability Ratios (continued) Margins Gross profit margin, operating profit margin and net profit margin represent the firm's ability to translate sales dollars into profits at different stages of measurement. Gross Profit Margin Indicates the relationship between net sales and the cost of goods sold. Measures the ability of a firm to control both input costs associated to inventories as well as pricing and volume factors associated with selling products or services. The gross profit margin indicates the difference between cost and selling price. Management's Discussion and Analysis will indicate those factors affecting changes in both sales and cost of goods sold. The cost of goods sold is the largest single expense of a firm. The factors that can affect changes in sales and cost of goods sold are price, volume and mix. Close attention should be made to changes in gross profit margins and those contributing factors. Any change in gross profit margins of 25 (.25) to 50 (.50) basis points is a major concern worth closer investigation. Gross Profit Operating Profit Margin Measures the overall operating efficiency of a firm. The firm has to control operating expenses associated with those operating decisions in generating sales. An analysis of operating expenses will lead to the determination of those expense items that are impacting operating margins. Close attention should be made to significant changes in operating profit margins. Operating Profit Net Profit Margin (A) Measures profitability after consideration of all revenue and expense items including minority interest, interest expense, taxes and non-operating items. Net profit margin is the first and most important component of the return on equity ratio. The earnings component of any firm whether increasing or decreasing will have a major impact to the return on equity performance compared to the changes in the turnover and leverage components. Net Profit Cash Flow Margin Measures the firm's ability to translate sales into cash. The relationship between cash generated from operations and from sales is another measure of operating performance. Cash Flow Margin is cash profits generated internally from operations. Cash Flow Margin is not accrual accounting profits that a firm needs to service debt financing, pay dividends and invest in new capital assets. Cash Flow from Operating Activities 2013 NACM 2

3 Profitability Ratios (continued) Investor Ratios Earnings Per (Common) Share (EPS Ratio) Shows return to common stock shareholder for each share owned. Net Earnings Average Common Shares Outstanding Price To Earnings (P/E Ratio) * Expresses a level of expectations that the stock market places on a firm's capacity for earnings growth. Market Price of Common Stock Earnings Per Share Dividend Yield * Shows the rate earned by shareholders from dividends relative to the current price of stock. Dividends Per Share Market Price of Common Stock Note: Dividends Per Share = Total dividends / Average common shares outstanding Activity Ratios: Asset Liquidity / Asset Management Efficiency (Turnover) Measure the liquidity of investments in specific assets and management's efficiency of those investment decisions. Total Asset Turnover (B) Measures the efficiency of managing the firm's investment decisions in all of its assets. This ratio assesses management's effectiveness in generating sales from investments in assets. Total asset turnover is the second component of return on equity. Total Sales Total Assets Inventory Turnover Measures the efficiency in turns of the firm in managing and selling inventory. Cost of Goods Sold Inventory 2013 NACM 3

4 Inventory Carrying Period (Also known as Days Inventory Held or Days Inventory Outstanding) Measures the efficiency in days of the firm in managing and selling inventory. This ratio also gauges the liquidity of a firm's investment in inventory. The inventory carrying period is the first component of the operating (trade) cycle as well as the cash conversation cycle (see liquidity ratios). An examination of the cash flow from operating activities will indicate if inventory is generating or using cash for the period and how much. Inventory Cost of Goods Sold / 360 Accounts Receivable Carrying Period - Days Sales Outstanding (DSO) (Also known as Average Collection Period) Measures the efficiency of the firm in managing its collection of credit sales. This ratio helps gauge the liquidity of the firm's investment in accounts receivable as well as the ability to collect from customers. It may also provide information about a firm's credit policies. The ratio should be compared with the firm's stated credit terms of sale. The accounts receivable carrying period is the second component of the operating (trade) cycle as well as the cash conversation cycle (see liquidity ratios). An examination of the cash flow from operating activities will indicate if accounts receivable is generating or using cash for the period and how much. Accounts Receivable Sales / 360 Accounts Payable Deferral Period (Also known as Days Payable Outstanding) Measures the efficiency of the firm in paying for its inputs related to inventory. This ratio helps gauge how the firm is paying its bills. It may also provide information about a firm's cash management policies. The accounts payable deferral period is the third component of the cash conversation cycle (see liquidity ratios). An examination of the cash flow from operating activities will indicate if accounts payable is generating or using cash for the period and how much. Account Payable Cost of Goods Sold / 360 Fixed Asset Turnover Measures the efficiency of managing the firm's long-term investment decisions specifically those investments in long-lived assets. Net Property, Plant, Equipment 2013 NACM 4

5 Leverage Ratios Measures the extent of debt financing (creditors) relative to equity financing (owners) and its ability to cover interest expense. The amount and proportion of debt financing in a firm's capital structure is extremely important due to the trade-off between risk and return. Leverage (C) Measures the proportion of all assets that are financed with equity. This leverage ratio is the third component of the return on equity ratio. Leverage through the owners' perspective indicates the proportion of equity financing compared to the total investments of the firm. A closer examination of this relationship indicates debt is the missing component. When equity increases, leverage goes down and when equity decreases, leverage goes up. Total Assets Equity Financial Leverage Index (FLI) * Measures how effectively the firm is using financial leverage. When the Financial Leverage Index is greater than 1, an indication that return on equity exceeds return on assets, the firm is employing debt beneficially. A FLI of less than 1 means the firm is not using debt successfully. Return on Equity Adjusted Return on Assets Note: Net earnings + Interest expense (1 - tax rate) = Adjusted Return on Assets Total assets Debt to Equity Measures the risk in doing business with a firm based on its capital (financing) structure in terms of the relationship between the funds supplied by creditors (debt) and investors (equity). The higher the proportion of debt, the greater is the degree of risk. While debt implies risk, it also introduces the potential for increased benefits to the firm's owners. When debt is employed effectively -- if operating earnings are more than sufficient to cover the fixed charges associated with debt -- the returns to shareholders are magnified through financial leverage. Total Debt (liabilities) Stockholders' Equity Debt Ratio Measures the proportion of all assets that are financed with debt. Total Debt (liabilities) Total Assets 2013 NACM 5

6 Long-term Debt to Total Capitalization Reveals the extent to which long-term debt is used for the firm's permanent financing (both long-term debt and equity). Long-term Debt Long-term Debt + Stockholders' Equity Leverage Ratios Long-term Debt to Net Working Capital Provides insight into the ability of a firm to pay long-term debt from current assets after paying current liabilities. Long-term Debt Current Assets - Current Liabilities Times Interest Earned Measures how many times a firm can cover its annual interest expense (cost of debt) from operating earnings. In order for a firm to benefit from debt financing, the fixed interest payments that accompany debt has to be more than satisfied from operating earnings. Operating Profit Interest Expense Liquidity Ratios: Short-term Solvency Measures a firm's ability to meet cash requirements (out-flows) as they arise. Net Working Capital Measures the dollar amount by which the current investment in assets exceeds the current debt financing obligations (current assets less current liabilities). Current Assets - Current Liabilities Cash Flow from Operating Activities (Cash Profits) Measures the amount of cash generated or used internally from operations. This figure should be compared to net income (accrual profits) to determine the difference between cash profits and accrual profits. Cash Flow from Operating Activities is equal to or greater than Accrual (Accounting) Profits Cash Flow Liquidity Ratio Measures short-term solvency of a firm and considers cash flow from operating activities (CFO). This ratio uses in the numerator, as an approximation of cash resources: cash and marketable securities, which are truly liquid 2013 NACM 6

7 current assets; and cash flow from operating activities, which represents the amount of cash generated internally from the firm's operations, such as the ability to sell inventory and collect the cash. Cash + Marketable Securities + CFO Current Liabilities Trade Cycle / Operating Cycle Measures the time between the acquisition of inventory and the cash collected from accounts receivable. Accounts Receivable + Inventory Sales / 360 Cost of Goods Sold / 360 Cash Conversion Cycle Measures the operating cycle in days of a firm that consists of purchasing or manufacturing inventory, with some purchases on credit and the creation of accounts payable; selling inventory, with some sales on credit and the creation of accounts receivable; and collecting the cash. The cash conversion cycle should be compared to the cash flow from operating activities to understand why cash flow generation has improved or deteriorated by analyzing the key operating accounts on the balance sheet - inventory, accounts receivable and accounts payable. Accounts Receivable + Inventory - Accounts Payable Sales / 360 Cost of Goods Sold / 360 Cost of Goods Sold / 360 Current Ratio Measures the short-term solvency of a firm and the ability to meet its debt financing requirements as they come due. Current Assets Current Liabilities Quick or Acid-Test Ratio Is a more rigorous test of short-term solvency of a firm and the ability to meet its debt financing requirements as they come due. This ratio eliminates inventory from the numerator due to the fact that inventory is often considered the least liquid current asset and the most likely source of losses. Current Assets - Inventory Current Liabilities 2013 NACM 7