Guide to Financial Ratio Analysis


Liquidity Ratios

A liquidity shortage, or liquidity squeeze, or short squeeze, is the condition that can shut a business down when most participants thaought the company was doing fine. The liquidity shortage can affect a manufacturer, retailer, or service company all equally. It is the situation when the business has insufficient cash and is unable to pay current liabilities coming due, and if it is an important payment like to a key supplier, then the supplies coming in to complete a job will stop. If the job cannot be completed, then the company ceases to be paid and the liquidity situation continues to deteriorate. Thus, the Credit Analyst needs to be able to accurately determine a company's liquidity position, and its abaility to convert assets into cash to meet payment demands.


Working Capital (measures the amount of cushion that current assets provide)

Current Assets - Current Liabilities


Current Ratio (should be greater than 1 : 1 to provide better coverage)

Current Assets
---------------------------
Current Liabilities


Quick Ratio (should be greater than 1 : 1 to provide better coverage; cash + marketable securities + receivables)

Current Assets - Inventory
---------------------------
Current Liabilities


Cash Ratio

Cash + Marketable Securities
---------------------------------------------
Current Liabilities


Receivables Collection Period (measures the length of time it takes to convert receivables to cash)

Period End Receivables x Days in Period
---------------------------
Sales for Period


Days in Inventory

Period End Receivables x Days in Period
-------------------------------------------
Cost of Goods Sold for Period



Days Payables

Period End Accounts Payables x Days in Period
-------------------------------------------
Cost of Goods Sold for Period



Cash Conversion Cycle

Days Inventory + Collection Days - Days Payables




Asset Quality



Average Assets

Total assets (previous year) + Total assets (present year)
-----------------------------------------
2


Net Charge-offs to Loans (Charge-offs net of recoveries)

Net Charge-offs
------------------
Total Loans


Net Charge-offs to Total Assets (Charge-offs net of recoveries)

Net Charge-offs
------------------
Total Assets




Profitability / Earnings




Sales Growth Rate

Sales in Period 2 - Sales in Period 1
-----------------------------------------------------
Sales in Period 1


Gross Profit Margin

Gross Profit (Sales minus Cost of Goods Sold)
--------------------------------
Sales


Operating Profit Margin

Operating Profit
-------------------------
Sales


Pretax Profit Margin

Income before Taxes
------------------------------
Sales


Return on Sales (Net Income Margin)

Annual or period net income
-----------------------------------------
Sales


Return on Average Assets (ROAA) (measures how effectively an institution utilized its assets)

Annual or period net income
----------------------------------------
Total Average Assets


Return on Average Equity (ROAE) (measures what an institution earned on its shareholders' investment)

Annual or period net income
----------------------------------------
Total Average Shareholders' Equity

ROAE can be manipulated by increasing net income from asset sales (a one-time event) or by reducing equity through share buy-backs or write-downs. When a company purchases another company and creates intangible goodwill, the equity side of the balance sheet also increases.



DuPont ROA

EBIT - Tax
-------------------
Assets


DuPont ROE

EBIT - (Taxes + Interest)
-------------------------------
Shareholder's Equity




Cash Flow




Cash Flow

Net Income before + Depreciation Expense


Operating Cash Flow

Income before Interest and after Taxes + Depreciation


Interest Coverage

Operating Cash Flow
------------------------------
Interest Expense


Debt Service

Operating Cash Flow
------------------------------
Interest + Principal


Debt Service after Non-discretionary CAPEX (Capital Expenditures)

Operating Cash Flow Net of CAPEX
----------------------------------
Interest + Principal




Capitalization




Average Equity

Total stockholder's equity (previous year) + Total stockholder's equity (present year)
-----------------------------------------
2


Book Value per Common Share

Shareholders' Equity at the end of a period
---------------------------------------------------------------
Number of common shares outstanding at the end of that period



Leverage


There are several ways to determine Leverage. One ratio is Total Liabilities to Equity. Overall, the ratio indicates what proportion of equity and debt the company is using to finance its assets. The higher the debt/equity ratio is then the greater amount od debt that the company is using to finance its growth. The credit is that in an economic down turn the company will not generate sufficient earnings to pay interest or amortizing principal. This ratio can be very high for financial institutions, however its is important to adjust the liabilities for matched repurchase agreement / reverse REPO financing.

Debt to Equity

Total Liabilities
---------------
Equity


Another is Total Debt (all short-term and long-term interest bearing debt, including commercial paper, bonds and bank borrowings) to Equity.

Total Debt
---------------
Equity


Another is Long-term Debt to Equity.

Total Long-Term Debt (Total Debt less Short-Term Debt)
-----------------------------------------------
Equity


Another is Senior Debt to Capital

Total Liabilities - Subordinated Debt
-----------------------------------------
Equity + Subordinated Debt


Another is Debt plus Preferred Securities (due to their debt-like interest payments and long-term maturity feature) to Capital

Total Debt + Preferred Securities
-----------------------------------------
Equity - Preferred Securities


Another is "Gearing", which is the U.K. term for this same ratio. Similarly, a high gearing ratio indicates a high level of debt as a percentage to equity. The U.K. balance sheet terms may look something like:

Loan Capital (Debt)
-----------------------------------------
Capital Employed (Shareholders Equity)



Market Valuation


Price Earnings Ratio (P/E) (Historically, a stock's price has been a multiple of 14 to 15 times earnings; Suggests the number of years necessary for a company to earn its present market capitalization; The "earnings" denominator includes items that do not affect cash flow, such as depreciation, thus the figure is somewhat misleading)

Market Price per Share
---------------------------
Earnings per Share


Dividend Yield

Dividends per Share
---------------------------
Price per Share


Market to Book Value

Market Price per Share
-------------------------------
Book value per share


Tobin's Q

Market Value of Assets
------------------------------------
Estimated Replacement Cost


Merger and Acquisition Value (Theoretical takeover price relative to generated cash)

Enterprise Value (Company's market capitalization + Debt - Cash)
--------------------------------------------------------------
EBITDA


S.G. Warburg originally developed an Enterprise Value (EV) defined as the sum of the company's debt and the market value of its equity less the market value of non-core assets, all compared to cash flow before interest and depreciation.