How To Calculate Financial Leverage Ratio

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1 What Do Short-Term Liquidity Ratios Measure? What Is Working Capital? HOCK international HOCK international How Is the Current Ratio Calculated? How Is the Quick Ratio Calculated? HOCK international HOCK international

2 Working capital is calculated as the difference between current assets and current liabilities. A company s working capital bridges the gap between the production process and the collection of cash from the sale of the item. The amount of liquidity a company needs depends upon the length of its operating cycle. The operating cycle is the period from the time cash is committed for investment in goods and services (the purchase of inventory, not the payment for inventory) to the time that cash is received from the investment (from the collection on the sale of the inventory). Short-term liquidity ratios measure the short-term viability of a business, which is its ability to continue operations in the short term by being able to pay its obligations as they come due. A company needs short-term assets to finance its short-term obligations for daily operations. A company should maintain a level of short-term assets sufficient to pay its current obligations. However, at the same time the company does not want to have too much invested in short-term assets because these assets do not provide a return on investment. The Quick Ratio is a more conservative version of the current ratio. The quick ratio measures the firm s ability to pay its short-term debts using its most liquid assets. Inventory is not included in this calculation because if a company uses inventory to pay its liabilities, then there will be no way for the company to generate future cash flows. Therefore, inventory should not be used to pay off short-term liabilities. The quick ratio is calculated as: Cash + Cash Equivalents + Net Receivables + Short-term Securities Current Liabilities The Current Ratio is the most commonly used measure of short-term liquidity, as it relates current assets to the claims of short-term creditors. Whereas net working capital expresses this relationship as a net dollar amount, the current ratio expresses the relationship as a ratio. The current ratio is calculated as: Current Assets Current Liabilities Companies with an aggressive financing policy will have lower current ratios, and conservative financing policies result in higher current ratios. Generally, a firm s current ratio should be proportional to its operating cycle. This means that the shorter the operating cycle, the lower the current ratio can be. This is because the operating cycle will generate new current assets more quickly than a company with a long operating cycle. These new current assets can be used to settle the liabilities.

3 How Is the Cash to Current Liabilities Ratio Calculated? How Is the Cash Flow Ratio Calculated? HOCK international HOCK international How Is the Cash Ratio Calculated? How Is the Inventory Turnover Ratio Calculated? HOCK international HOCK international

4 The Cash Flow Ratio measures how many times greater than the current liabilities the cash flow generated by operations is. If a company has positive working capital but it is not generating enough cash from operations to settle its obligations as they become due, it means the company is borrowing to settle current liabilities. Over the long term, this will lead to solvency problems, because there is a limit to how much financing can be obtained. Therefore, it is much better if the company can generate adequate cash flow from its operations to settle its current liabilities. Annual Cash Flows from Operations The Cash to Current Liabilities Ratio (also called the cash ratio in some sources) is in essence another derivation of the current ratio, but it is even more conservative than the quick ratio. It simply measures the ratio between cash and current liabilities. However, in this measure of cash, we include cash equivalents and short-term securities. Cash + Cash Equivalents + Short-Term Securities Current Liabilities Average Current Liabilities The Inventory Turnover Ratio calculates how many times during the year the company sells its average level of inventory. Annualized Cost of Sales Average Annual Inventory An increase in cost of sales without an equivalent increase in inventory increases the inventory turnover ratio and means inventory is turning over more rapidly. If a company has a high inventory turnover ratio, it can mean the company is using good inventory management and is not holding excessive amounts of inventories. However, it can also mean that the company is not holding enough inventory and is losing sales if prospective customers are unable to make purchases because items are out of stock. The Cash Ratio is also sometimes called the cash to current assets ratio. The cash ratio measures how liquid the company s current assets are. For instance, working capital may be positive, yet inventory and accounts receivable make up most of its current assets. In this case, the cash ratio will be low, indicating a possible liquidity problem. Cash + Cash Equivalents + Marketable Securities Average Current Assets In interpreting this ratio, the analyst should recognize that a company s need for cash may be lower if it has in place cash management procedures which create a highly efficient use of cash. Also, the analyst should recognize that there may be restrictions on the company s cash such as compensating balance requirements by lenders.

5 How Is the Number of Days of Sales in Inventory Calculated? How Is the Accounts Receivable Turnover Ratio Calculated? HOCK international HOCK international How Is the Number of Days of Sales in Receivables Calculated? How Are the Operating Cycle and Cash Cycle Calculated? HOCK international HOCK international

6 The Accounts Receivable Turnover Ratio is used to measure the number of times receivables turn over during a year s time. Thus, it tracks the efficiency of a firm s accounts receivable collections and indicates the amount of investment in receivables that is needed to maintain the firm s level of sales. Net Annualized Credit Sales Average Annual Accounts Receivable The days of sales in inventory is another measurement of the efficiency of inventory management. This ratio calculates the number of days that the average inventory item remains in stock before it is sold. This number should be low but not too low, because if it is too low, the company risks lost sales by not having enough inventory on hand. 365, 360 or 300 Inventory Turnover Or Average Inventory Average Daily Cost of Sales The operating cycle is the length of time it takes to convert an investment of cash in inventory back into cash. Operating Cycle = Days Sales in Inventory + Days Sales in Receivables The cash cycle is the length of time it takes to convert an investment of cash in inventory back into cash, recognizing that some purchases are made on credit. Therefore, the number of days in the operating cycle minus the number of days purchases in payables is the cash cycle, also called the net operating cycle. The cash cycle represents the number of days a company s cash is tied up by its current operating cycle. The shorter the cycle, the more efficient the firm s operations and cash management. The days of sales in receivables is another measure of the how efficiently the company is collecting its accounts receivable. It tells us how many days an average receivable is held before it is collected. Or 365, 360 or 300 Receivables Turnover Average Accounts Receivable Average Daily Sales Cash Cycle = Days Sales in Inventory + Days Sales in Receivables Days Purchases in Payables

7 How Is the Number of Days of Purchases in Payables Calculated? What Is the Liquidity Index? HOCK international HOCK international What Is Capital Structure? What Is Solvency? HOCK international HOCK international

8 The liquidity index is a measure of the liquidity of current assets expressed as a weighted average number of days required to convert current assets to cash. Each balance sheet current asset item is assigned a weight representing the average number of days it has to go before becoming cash. Accounts receivable is multiplied by the number of days of sales in receivables, while inventory is multiplied by the sum of the number of days of sales in receivables and the number of days of sales in inventory. The days of purchases in payables is calculated as follows: Average Accounts Payable Average Daily Purchases Since cash is already cash, it is multiplied by zero, and so its weighted value is zero. The weighted values are then summed, and their sum is divided by total current assets. The result is a weighted average number of days that total current assets, including cash assets, are removed from being converted to cash. Solvency is the ability of the company to pay its long-term obligations as they come due. As liquidity is the ability to pay short-term obligations, solvency is the ability to pay long-term obligations. A company with more equity than debt is more stable and solvent than a company with more debt than equity. If a company has a lot of long-term debt relative to its assets, it has lower solvency than a company with lower long-term debt. A company with higher long-term debt is more risky than one with lower long-term debt, because more of the first company s assets will be required to meet the scheduled interest and principal payments. Because these payments must be made whether the company has positive or negative future earnings, a high level of debt financing increases the risk of default and insolvency. Capital structure is how a firm chooses to finance its business. This is the debt-equity question. Should the company obtain financing by issuing debt (bonds) or equity (shares)? Or if both, in what proportion? Equity represents ownership, and it does not need to be repaid. Debt must be repaid, either as interest and principal paid together or interest only with the principal due at the maturity date. The decision that a company makes will influence the company s flexibility and its ability to make certain decisions in the future. If a company chooses to use debt, it will need to service this debt in the future by making regular interest payments. However, if debt is chosen, the owners of the company do not lose any voting control. If additional equity is used, the ownership interest of the present owners will be diluted and they will lose some voting control, but the company does not need to make interest payments.

9 What Is Financial Leverage? How Is the Financial Leverage Ratio Calculated? HOCK international HOCK international How Is the Financial Leverage Index Calculated? How Is the Return on Common Equity Calculated? HOCK international HOCK international

10 The Financial Leverage Ratio is calculated as follows: Average Total Assets Average Common Equity Common equity is total equity minus preferred stock minus any minority interest. This ratio indicates the amount of leverage (use of debt) that a firm has, and therefore also the amount of risk that the company has. The more debt the company has, the higher this ratio will be. As a company increases its debt, it is incurring more fixed charges of interest that must be paid. The more fixed charges, the less income will be available for distribution and also the higher the risk that the company will not be able to service its debt and will default on it. Financial leverage is the use of debt to increase earnings and therefore financial leverage is a part of solvency analysis. Financial leverage magnifies the effect of both managerial success (profits) and failure (losses). Financial leverage ratios measure a company s use of debt to finance its assets and operations. Increased financial leverage increases the risk that the firm may not be able to fulfill its long-term obligations. Thus, the risk borne by all creditors increases with increased financial leverage. The advantages of financial leverage are: If the interest expense paid on the debt capital is less than the return earned from the investment of the debt capital (or less than Return on Assets), the excess return benefits the equity investors. Interest is tax-deductible, which effectively reduces it as an expense. The return on common equity is calculated as follows: Net Income - Preferred Dividends Average Common Equity There is another financial leverage item that you need to be able to calculate. It is called the financial leverage index, or FLI, and it measures how successful the company s use of financial leverage has been. The formula is: Return on Common Equity Return on Assets

11 How Is the Return on Assets Calculated? How Is the Degree of Financial Leverage Calculated? HOCK international HOCK international What Is Operating Leverage? How Is the Degree of Operating Leverage Calculated? HOCK international HOCK international

12 Another measure of financial leverage is degree of financial leverage. The degree of financial leverage is the factor by which net income changes when compared to a change in earnings before interest and tax, since interest on debt is a fixed expense. Degree of financial leverage is meaningful at only one level of income and interest expense. When those levels change, the degree of financial leverage will change as well. The return on assets is calculated as follows: Net Income - Preferred Dividends Average Assets Degree of financial leverage can be calculated in two ways: % Change in Net Income % Change in Earnings Before Interest and Taxes Or Earnings Before Interest and Taxes Earnings Before Taxes Like degree of financial leverage, degree of operating leverage can be calculated two ways: Or % Change in Operating Income % Change in Sales Contribution Margin Operating Income Just as financial leverage uses debt financing and the fixed expense of interest to generate greater returns for equity investors, operating leverage uses all fixed expenses to generate greater returns for equity investors. Operating leverage is the percentage of a company s total expenses that is represented by fixed expenses. Higher fixed expenses as a proportion of total expenses results in higher operating leverage. Until a company s contribution margin (sales minus all variable expenses) is adequate to cover its fixed expenses, the company will operate unprofitably. Once fixed expenses are covered, increases in the contribution margin as a result of increases in sales flow straight to the bottom line, dollar for dollar. This magnifies the effect that increased sales has on profits.

13 This Card Left Blank. How Is the Total Debt to Total Capital Ratio Calculated? HOCK international HOCK international How Is the Total Debt to Equity Capital Ratio Calculated? How Is the Fixed Assets to Equity Capital Ratio Calculated? HOCK international HOCK international

14 The Total Debt to Total Capital Ratio is calculated as follows: Total Liabilities Total Assets Here, total capital is defined as the total of liabilities plus capital, or in other words, the same thing as total assets. The Total Debt to Total Capital Ratio, also called the Total Debt Ratio, measures what proportion of the company s assets are financed by creditors and thus the firm s long-term debt payment ability. Creditors would like this ratio to be as low as possible because it indicates a lower chance of default on the interest payments that the company will owe. Therefore, the higher this ratio is, the higher the company s cost of debt will be, because creditors will demand compensation for the increased risk. This ratio includes all liabilities, including current liabilities such as accounts payable that probably do not require interest or principal payments. This makes it more conservative. The Fixed Assets to Equity Capital Ratio measures the relationship between fixed assets and equity. It indicates the proportion of equity that is committed to fixed assets and thus is not available for operating funds. A ratio below 1.00 indicates a favorable liquidity position. Alternatively, if this ratio is greater than 1.00, this means that not only is all of the equity committed to fixed assets, but debt has been used to finance some of the firm s assets. Net Fixed Assets Total Equity The Total Debt to Equity Capital Ratio is calculated as follows: Total Liabilities Total Equity In the Total Debt to Equity Capital ratio, total liabilities is all liabilities, while total equity consists of all stockholders equity including preferred equity. This ratio is a comparison of how much of the financing of assets comes from creditors and how much comes from owners, in the form of equity. A Total Debt to Equity Capital Ratio of 2.00, or 2:1, for example, means that the company s total debt is twice its total equity, or its debt financing consists of $2.00 of debt for every $1.00 of equity.

15 How Is the Net Tangible Assets to Long-Term Debt Ratio Calculated? How Is the Total Liabilities to Net Tangible Assets Ratio Calculated? HOCK international HOCK international How Is Times Interest Earned Calculated? How Is Earnings to Fixed Charges Calculated? HOCK international HOCK international

16 The Total Liabilities to Net Tangible Assets Ratio is another means of measuring the relationship between a company s debt and its investment in operating assets. Total Liabilities Total Assets - Intangible Assets - Current Liabilities The Net Tangible Assets to Long-term Debt Ratio measures the coverage provided by assets for the company s long-term obligations. By including only net tangible assets, the numerator in this ratio excludes intangible assets that may have questionable liquidation values. Net working capital is included in net tangible assets. The ratio assumes that the tangible assets have liquidation values equal to their net book values, which may not be the case. The liquidation value of inventory may be significantly below its book value; and the liquidation value of fixed assets may be different from their book values, which are net of depreciation. Total Assets - Intangible Assets - Total Liabilities Long-term Debt The Earnings to Fixed Charges Ratio makes adjustments to both the numerator and the denominator of the times interest earned ratio to include these operating lease obligations. Thus, it gives an indication of the company s ability to meet all of its fixed financing expenses, including both interest on debt and estimated interest on long-term operating leases. Earnings Before Interest & Taxes + Estimate of Operating Lease Interest Interest Expense + Estimate of Operating Lease Interest The Times Interest Earned Ratio, also called the interest coverage ratio, compares the funds available to pay interest (i.e., earnings before interest and taxes) with the amount of interest expense on the income statement. This ratio gives an indication of how much the company has available for the payment of its fixed interest expense. A high ratio is desirable. An interest coverage ratio of greater than 3.0 is excellent. When the interest coverage ratio gets down to 1.5, a company has a heightened risk of default, which becomes higher the further the ratio declines below 1.5. Earnings Before Interest and Taxes Interest Expense

17 How Is Cash Flow to Fixed Charges Calculated? How Is Return on Invested Capital Calculated? HOCK international HOCK international How Is Invested Capital Determined? How Is the DuPont Equation Calculated? HOCK international HOCK international

18 This ratio essentially measures how much return the company receives on the capital it has invested in assets. The higher this ratio, the better, or more effectively, the company is using its assets. Net Income Average Invested Capital The Cash Flow to Fixed Charges Ratio is similar to the earnings to fixed charges ratio, in that it adjusts for estimated interest on long-term operating leases. However, this ratio uses the cash flows from operations instead of accrual income in the numerator to relate to the company s fixed charges to be covered in the denominator. This recognizes the fact that fixed charges must be paid in cash, whereas net income includes various accruals that do not necessarily generate cash or require the payment of cash. Furthermore, changes in working capital may generate cash or require cash; and those changes are not reflected in net income, but are reflected in cash flows from operations. Pre-tax Operating Cash Flow + Interest Expense + LT Operating Lease Interest Interest Expense + LT Operating Lease Interest The DuPont Equation breaks up ROA into its two components, which are multiplied together to calculate Return on Assets: 1) Profit Margin on Sales 2) Asset Turnover Ratio Net Income After Interest and Taxes Sales Sales Total Average Assets Invested capital, the denominator, can be defined as Total Assets, (or Total Liabilities plus Total Equity). If this measure is used, it reflects the company s return from all the assets it has under its control. The invested capital as used in the denominator can adjust Total Assets as follows: Only operating assets may be included, with investments, intangible assets and other assets excluded. Current liabilities may be netted out in order to put the emphasis on long-term capital. Debt and preferred stock may be netted out in order to include only equity capital. Invested capital (both debt and equity capital) may be stated at market value instead of book value, since the market value of intangible assets is not recognized in financial statements.

19 How Is Return on Equity Calculated? How Is the Extended DuPont Equation Calculated? HOCK international HOCK international How Is Return on Common Equity Calculated? How Is the Equity Growth Rate Calculated? HOCK international HOCK international

20 The Extended Du Pont Equation breaks up ROE into its three components, which are multiplied together to calculate Return on Assets: 1) Profit Margin on Sales 2) Asset Turnover Ratio Net Income After Interest and Taxes Sales Sales Total Average Assets This formula is very similar to the return on assets. It measures the return that is received from the business by the equity in the business. This formula can be broken apart to develop what is called the Extended DuPont Equation, and from this we will see the components that influence return on equity. The return on equity formula is as follows: Net Income After Interest and Taxes Average Total Equity 3) Equity Multiplier Average Total Assets Total Average Equity The equity growth rate implies the percentage growth rate that the company can grow per year without increasing its current level of financing. Net Income - Preferred Dividends - Dividend Payout Average Common Stockholders Equity The return on common equity formula is as follows: Net Income After Interest and Taxes - Preferred Dividends Average Common Equity Note that when we use common equity in the denominator, we must subtract preferred dividends from Net Income in the numerator. This is because we are interested only in income that is available to common shareholders.

21 How Is the Dividend Payout Ratio Calculated? How Is the Return on Shareholders Investment Calculated? HOCK international HOCK international What Are the Source, Stability and Trend of Revenues? What Is Earnings Persistence? HOCK international HOCK international

22 Return on Shareholders Investment is different from Return on Equity. Return on Equity uses book values on the balance sheet for equity. In contrast, Return on Shareholders Investment measures the return to individual shareholders on their personal investments in the company s common stock. Cash Dividends Per Share + Market Value of Reinvested Earnings Share Price The dividend payout ratio measures what percentage of distributable earnings are actually distributed. In the early years of a business (or a growth phase of a business), this will be lower because more of the profits of the company are reinvested in the growth of the company. The Dividend Payout Ratio is calculated as follows: Cash Dividends Per Common Share Earnings Per Share Earnings persistence is an important concept related to income. It is a measure of the constancy of the earnings of a company over time. The more constant and the more persistent a company s earnings are over time, the greater the market value of the shares of that company will be. The Management s Discussion and Analysis, which is a part of several SEC filings made by a public company, can be used to analyze persistence in revenues. Several disclosures required by the SEC can aid in evaluating earnings persistence by providing useful information. When determining earnings persistence, unusual, erratic and nonrecurring items are excluded. By looking at the trend of the persistent earnings over time, a more realistic projection of future earnings can be made. The source of the revenue is especially important when the analysis is for a diversified company, where the company has several markets or product lines. Each market or product line will need separate analysis, because each one will have its own characteristics. The analysis must segregate and interpret the contribution of each of the business segments on the company as a whole. If there is a constant source of revenue, a company is in a better position than if it needs to go find new sources of revenue every period. Long-term contracts and long-term customer relations help secure stability of revenue. The trend of the revenue is the way in which the level of revenue moves from one year to the next. A consistent level of growth is preferable to volatility, i.e., some years of great growth and some years of great decline.

23 How Is Gross Profit Margin Calculated? How Is Book Value per Share Calculated? HOCK international HOCK international How Is Operating Cash Flow to Income Calculated? What Is Earnings Quality? HOCK international HOCK international

24 Technically, Book Value per Share is calculated as follows: Stockholders Equity Number of Shares Outstanding However, in financial analysis, Book Value per Share is more than stockholders equity on the balance sheet divided by number of shares outstanding. It must be calculated separately for preferred stock and common stock, and the book value of common equity and preferred equity are both adjusted before calculating book value per share. Gross profit margin is revenues less cost of goods sold. It is frequently reported as a percentage, or ratio. Net Sales - Cost of Goods Sold Net Sales The total of the common stock equity accounts is reduced by the following items, which may not appear on the balance sheet, and the total of the preferred stock accounts is increased by them: Any senior claims, such as preferred dividends in arrears; Liquidation premiums, if any, on preferred stock; and Other asset preferences that preferred shares are entitled to. Earnings quality relates to the source of the profits of the company. Increased Earnings due to increased sales and cost controls are of a higher quality than artificial profits created by inflation of inventory or other asset prices. Determinants of earnings quality include the company s business environment, its selection and application of accounting principles and the character of its management. Cash flows from operations are related to net income as a means of assessing the quality of the net income. The income statement is designed to meet certain needs of users, and the cash flow statement is designed to meet other needs of users. Cash flow from operations focuses on liquidity of operations, whereas accrual income measures the profitability of the company s operations for a period. Both are important, and evaluating the relationship between them can provide insights into operations. The ratio relates the level of cash from operations to net income. If this number is high, it could indicate that the company s cash flow is coming from sources other than operating activities. Cash Flows from Operating Activities Net Income

25 What Is Earnings Persistence? What Is Earnings Variability? HOCK international HOCK international How Is the Price/Book Ratio Calculated? How Is the Price/Earnings Ratio Calculated? HOCK international HOCK international

26 Earnings variability, or fluctuation in earnings caused by the business cycle, causes stock price fluctuations and is therefore undesirable. Earnings variability can be measured using standard variability measures. In addition, earnings variability can be assessed by determining average earnings over a period of 5 to 10 years, or by using minimum earnings over a period as a worst-case scenario. Closely related to earnings quality is earnings persistence. Earnings management can make income seem more stable and predictable than it really is. Therefore, the analyst needs to be able to identify the persistent components or the components of earnings that are stable and predictable of a company s earnings, and recast the earnings so that the stable and continuing elements are distinguished from the random and unusual elements. Recasting earnings involves rearranging the earnings components within an income period to create meaningful classifications for analysis. Adjusting earnings goes along with recasting earnings. Adjusting earnings attempts to identify current earnings that should be included in the operating earnings of prior periods, so adjusting earnings involves moving items to different periods. The P/E Ratio gives an indication of what shareholders are paying for continuing earnings per share. Investors view it as an indication of what the market considers to be the firm s future earning power. Market Price of a Share Diluted Earnings Per Share The P/E ratio is greatly influenced by where a company is in its cycle. A company in a growth stage will usually have a high P/E ratio because of the market s expectations of future profits (which makes the market price higher) despite the fact that at the current time, profits may be low. Companies with low growth generally have lower P/E ratios. The Price/Book Ratio is calculated as follows: Market Price of a Share Book Value of a Share This ratio should be greater than 1.0 for the simple fact that the market value of the share takes into account fair market value, while the book value of the share takes into account only the book value. Given that assets that appreciate in value are not written up in the accounting books, the fair market value of a share should be more than the book value of a share. The Price/Book Ratio will be higher if the market expects abnormally high earnings in the future; and it will be lower if the market expects abnormally low earnings in the future.

27 How Is the Earnings Yield Calculated? How Is the Dividend Yield Calculated? HOCK international HOCK international How Is the Dividend Payout Ratio Calculated? What Are Vertical Common Size and Horizontal Trend Financial Statements? HOCK international HOCK international

28 The dividend yield measures how much of the market price was paid in dividends. Thus, it is the cash return received by a shareholder on one share of stock, based on the stock s current price and current dividend. If the company keeps the dividend payout low in order to retain profits in the company for future growth, the dividend yield will be low. If the company is able to invest the retained earnings profitability, the price of the company s stock should rise, providing return to investors in the form of capital gain rather than in the form of dividends. The earnings yield measures the income-producing power of one share of common stock at the current price. It is the inverse of the P/E Ratio. Diluted Earnings Per Share Current Market Price of a Share Annual Dividends Per Common Share Current Market Price Per Share A simple vertical common-size financial statement covers one year s operating results and expresses each component as a percentage of a total. This means that fixed assets will not be stated as a dollar amount, but may be stated as a percentage of total assets. However, common-size financial statements do not have to relate each balance sheet item to total assets. The analysis might focus on the company s inventory, and calculate what percentages raw materials, work in process, and finished goods are of total inventory. Or it might focus on the composition of the company s investments, both short-term and long-term. The Dividend Payout Ratio measures the proportion of earnings that are paid out as dividends to common stockholders. Generally, a new company or a company that is growing will have a low or no dividend payout, because it is retaining earnings in the company to finance its growth. Annual Dividends Per Common Share Diluted Earnings Per Share Horizontal trend analysis is used to evaluate trends over a period of several years for a single business. The first year is the base year, and amounts for subsequent years are presented not as dollar amounts but as percentages of the base year amount, with the base year assigned a value of 100%, or 100.