Ratios and Formulas in Customer Financial Analysis

Financial statement analysis is a judgmental process. One of the primary objectives is identification of major changes in trends, and relationships and the investigation of the reasons underlying those changes. The judgment process can be improved by experience and the use of analytical tools. Probably the most widely used financial analysis technique is ratio analysis, the analysis of relationships between two or more line items on the financial statement. Financial ratios are usually expressed in percentage or times. Generally, financial ratios are calculated for the purpose of evaluating aspects of a company’s operations and fall into the following categories:

  • liquidity ratios measure a firm’s ability to meet its current obligations.
  • profitability ratios measure management’s ability to control expenses and to earn a return on the resources committed to the business.
  • leverage ratios measure the degree of protection of suppliers of long-term funds and can also aid in judging a firm’s ability to raise additional debt and its capacity to pay its liabilities on time.
  • efficiency, activity or turnover ratios provide information about management’s ability to control expenses and to earn a return on the resources committed to the business.

A ratio can be computed from any pair of numbers. Given the large quantity of variables included in financial statements, a very long list of meaningful ratios can be derived. A standard list of ratios or standard computation of them does not exist. The following ratio presentation includes ratios that are most often used when evaluating the credit worthiness of a customer. Ratio analysis becomes a very personal or company driven procedure. Analysts are drawn to and use the ones they are comfortable with and understand.

Liquidity Ratios

Working Capital

Working capital compares current assets to current liabilities, and serves as the liquid reserve available to satisfy contingencies and uncertainties. A high working capital balance is mandated if the entity is unable to borrow on short notice. The ratio indicates the short-term solvency of a business and in determining if a firm can pay its current liabilities when due.

Formula

Current Assets
– Current Liabilities

Acid Test or Quick Ratio

A measurement of the liquidity position of the business. The quick ratio compares the cash plus cash equivalents and accounts receivable to the current liabilities. The primary difference between the current ratio and the quick ratio is the quick ratio does not include inventory and prepaid expenses in the calculation. Consequently, a business’s quick ratio will be lower than its current ratio. It is a stringent test of liquidity.

Formula

Cash + Marketable Securities + Accounts Receivable
Current Liabilities

Current Ratio

Provides an indication of the liquidity of the business by comparing the amount of current assets to current liabilities. A business’s current assets generally consist of cash, marketable securities, accounts receivable, and inventories. Current liabilities include accounts payable, current maturities of long-term debt, accrued income taxes, and other accrued expenses that are due within one year. In general, businesses prefer to have at least one dollar of current assets for every dollar of current liabilities. However, the normal current ratio fluctuates from industry to industry. A current ratio significantly higher than the industry average could indicate the existence of redundant assets. Conversely, a current ratio significantly lower than the industry average could indicate a lack of liquidity.

Formula

Current Assets
Current Liabilities

Cash Ratio

Indicates a conservative view of liquidity such as when a company has pledged its receivables and its inventory, or the analyst suspects severe liquidity problems with inventory and receivables.

Formula

Cash Equivalents + Marketable Securities
Current Liabilities

Profitability Ratios

Net Profit Margin (Return on Sales)


A measure of net income dollars generated by each dollar of sales.

Formula

Net Income *
Net Sales

* Refinements to the net income figure can make it more accurate than this ratio computation. They could include removal of equity earnings from investments, “other income” and “other expense” items as well as minority share of earnings and nonrecuring items.

Return on Assets

Measures the company’s ability to utilize its assets to create profits.

Formula

Net Income *
(Beginning + Ending Total Assets) / 2

Operating Income Margin

A measure of the operating income generated by each dollar of sales.

Formula

Operating Income
Net Sales

Return on Investment

Measures the income earned on the invested capital.

Formula

Net Income *
Long-term Liabilities + Equity

Return on Equity

Measures the income earned on the shareholder’s investment in the business.

Formula

Net Income *
Equity

Du Pont Return on Assets

A combination of financial ratios in a series to evaluate investment return. The benefit of the method is that it provides an understanding of how the company generates its return.

Formula

Net Income *
Sales
x Sales
Assets
x Assets
Equity

Gross Profit Margin

Indicates the relationship between net sales revenue and the cost of goods sold. This ratio should be compared with industry data as it may indicate insufficient volume and excessive purchasing or labor costs.

Formula

Gross Profit
Net Sales

Financial Leverage Ratio

Total Debts to Assets

Provides information about the company’s ability to absorb asset reductions arising from losses without jeopardizing the interest of creditors.

Formula

Total Liabilities
Total Assets

Capitalization Ratio

Indicates long-term debt usage.

Formula

Long-Term Debt
Long-Term Debt + Owners’ Equity

Debt to Equity

Indicates how well creditors are protected in case of the company’s insolvency.

Formula

Total Debt
Total Equity

Interest Coverage Ratio (Times Interest Earned)


Indicates a company’s capacity to meet interest payments. Uses EBIT (Earnings Before Interest and Taxes)

Formula

EBIT
Interest Expense

Long-term Debt to Net Working Capital

Provides insight into the ability to pay long term debt from current assets after paying current liabilities.

Formula

Long-term Debt
Current Assets – Current Liabilities

Efficiency Ratios

Cash Turnover

Measures how effective a company is utilizing its cash.

Formula

Net Sales
Cash

Sales to Working Capital (Net Working Capital Turnover)


Indicates the turnover in working capital per year. A low ratio indicates inefficiency, while a high level implies that the company’s working capital is working too hard.

Formula

Net Sales
Average Working Capital

Total Asset Turnover

Measures the activity of the assets and the ability of the business to generate sales through the use of the assets.

Formula

Net Sales
Average Total Assets

Fixed Asset Turnover

Measures the capacity utilization and the quality of fixed assets.

Formula

Net Sales
Net Fixed Assets

Days’ Sales in Receivables

Indicates the average time in days, that receivables are outstanding (DSO). It helps determine if a change in receivables is due to a change in sales, or to another factor such as a change in selling terms. An analyst might compare the days’ sales in receivables with the company’s credit terms as an indication of how efficiently the company manages its receivables.

Formula

Gross Receivables
Annual Net Sales / 365

Accounts Receivable Turnover

Indicates the liquidity of the company’s receivables.

Formula

Net Sales
Average Gross Receivables

Accounts Receivable Turnover in Days

Indicates the liquidity of the company’s receivables in days.

Formula

Average Gross Receivables
Annual Net Sales / 365

Days’ Sales in Inventory

Indicates the length of time that it will take to use up the inventory through sales.

Formula

Ending Inventory
Cost of Goods Sold / 365

Inventory Turnover

Indicates the liquidity of the inventory.

Formula

Cost of Goods Sold
Average Inventory

Inventory Turnover in Days

Indicates the liquidity of the inventory in days.

Formula

Average Inventory
Cost of Goods Sold / 365

Operating Cycle

Indicates the time between the acquisition of inventory and the realization of cash from sales of inventory. For most companies the operating cycle is less than one year, but in some industries it is longer.

Formula

Accounts Receivable Turnover in Days
+ Inventory Turnover in Day

Days’ Payables Outstanding

Indicates how the firm handles obligations of its suppliers.

Formula

Ending Accounts Payable
Purchases / 365

Payables Turnover

Indicates the liquidity of the firm’s payables.

Formula

Purchases
Average Accounts Payable

Payables Turnover in Days

Indicates the liquidity of the firm’s payables in days.

Formula

Average Accounts Payable
Purchases / 365

Additional Ratios

Altman Z-Score

The Z-score model is a quantitative model developed in 1968 by Edward Altman to predict bankruptcy (financial distress) of a business, using a blend of the traditional financial ratios and a statistical method known as multiple discriminant analysis.

The Z-score is known to be about 90% accurate in forecasting business failure one year into the future and about 80% accurate in forecasting it two years into the future.

Formula

Z = 1.2+1.4+0.6+0.999+3.3 xxxxx (Working Capital / Total Assets)(Retained Earnings / Total Assets)(Market Value of Equity / Book Value of Debt)(Sales / Total Assets)(EBIT / Total Assets)

Z-score Probability of Failure
less than 1.8greater than 1.81 but less than 2.99greater than 3.0 Very HighNot SureUnlikely

Bad-Debt to Accounts Receivable Ratio

Bad-debt to Accounts Receivable ratio measures expected uncollectibility on credit sales. An increase in bad debts is a negative sign, since it indicates greater realization risk in accounts receivable and possible future write-offs.

Formula

Bad Debts
Accounts Receivable

Bad-Debt to Sales Ratio

Bad-debt ratios measure expected uncollectibility on credit sales. An increase in bad debts is a negative sign, since it indicates greater realization risk in accounts receivable and possible future write-offs.

Formula

Bad Debts
Sales

Book Value per Common Share

Book value per common share is the net assets available to common stockholders divided by the shares outstanding, where net assets represent stockholders’ equity less preferred stock. Book value per share tells what each share is worth per the books based on historical cost.

Formula

(Total Stockholders’ Equity – Liquidation Value of Preferred Stocks – Preferred Dividends in Arrears)
Common Shares Outstanding

Common Size Analysis

In vertical analysis of financial statements, an item is used as a base value and all other accounts in the financial statement are compared to this base value.

On the balance sheet, total assets equal 100% and each asset is stated as a percentage of total assets. Similarly, total liabilities and stockholder’s equity are assigned 100%, with a given liability or equity account stated as a percentage of total liabilities and stockholder’s equity.

On the income statement, 100% is assigned to net sales, with all revenue and expense accounts then related to it.

Cost of Credit

The cost of credit is the cost of not taking credit terms extended for a business transaction. Credit terms usually express the amount of the cash discount, the date of its expiration, and the due date. A typical credit term is 2 / 10, net / 30. If payment is made within 10 days, a 2 percent cash discount is allowed: otherwise, the entire amount is due in 30 days. The cost of not taking the cash discount can be substantial.

Formula

% Discount100 – % Discount x 360Credit Period – Discount Period


Example
On a $1,000 invoice with terms of 2 /10 net 30, the customer can either pay at the end of the 10 day discount period or wait for the full 30 days and pay the full amount. By waiting the full 30 days, the customer effectively borrows the discounted amount for 20 days.

    $1,000 x (1 – .02) = $980

This gives the amount paid in interest as:

    $1,000 – 980 = $20

This information can be used to compute the credit cost of borrowing this money.

% Discount100 – % Discount x 360Credit Period – Discount Period
= 2 98 x 36020 = .3673

As this example illustrates, the annual percentage cost of offering a 2/10, net/30 trade discount is almost 37%.

Current-Liability Ratios

Current-liability ratios indicate the degree to which current debt payments will be required within the year. Understanding a company’s liability is critical, since if it is unable to meet current debt, a liquidity crisis looms. The following ratios are compared to industry norms.

Formulas

Current to Non-current = Current LiabilitiesNon-current Liabilities
Current to Total = Current LiabilitiesTotal Liabilities

Rule of 72

A rule of thumb method used to calculate the number of years it takes to double an investment.

Formula

72
Rate of Return

Example

Paul bought securities yielding an annual return of 9.25%. This investment will double in less than eight years because,

729.25 = 7.78 years

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