Home | Association News | Bankruptcy & Insolvency | Credit & Collections Management | Credit Laws
Focus on Members | Industry & Economic News | Financial Analysis | Professional Development | Glossary

D&B acquires Ethica Credit
 
TD

CIC National Credit Conference

Robert Half

Financial Analysis

Financial Ratios and Related Tools (Part 2)
by Michel Blanchette, FCMA, CA
Professor, Université du Québec en Outaouais

This is the second in a series of two articles written to provide a quick reference on basic financial analysis tools.  This first article presented a five-step approach to financial analysis and focused on liquidity ratios for credit analysis. (For part one, please see the winter 2011 edition of To Your Credit.)  This article will focus on leverage and profitability ratios as well as other qualitative tools that are important when determining a company's credit worthiness.

The ratios presented are frequently used in practice, plus two innovative ones based on the new feature of comprehensive income introduced recently in accounting standards. These latter ratios are adaptations of return-on-asset (ROA) and return-on-equity (ROE) with proposed names of comprehensive-ROA and comprehensive-ROE.  They are explained in more detail in this article.

LEVERAGE

The objective of leverage analysis is to evaluate the financial structure of liabilities versus equity and to see the coverage of interest, fixed charges and dividends.

Debt ratio   =   Total liabilities ÷ Total assets   and
Debt to worth   =   Total liabilities ÷ Shareholders' equity

These are snapshot ratios. They give an idea of the importance of leverage, measured by total liabilities, in relation to total assets or shareholders' equity. In credit analysis, a lower ratio is better because it means less risk. In equity analysis, the interpretation of the ratio depends on the risk-aversion of investors. A higher ratio means more risk, but potentially more return (see "Dupont analysis" in "Other considerations" below). A further analysis is to look at the breakdown of liabilities between short-term and long-term, and to weight them against short-term and long-term assets. Adjustments of numerator for off balance sheet financing may be made (see "Off balance sheet financing" in "Other considerations" below). The denominator should also be adjusted for fair value if possible.

Debt to tangible assets   =   Total liabilities ÷ Tangible assets   and
Debt to tangible net worth   =   Total liabilities ÷ Tangible net worth
(where Tangible assets/net worth = Total assets/Shareholders' equity – Intangible assets)

This is a similar ratio to the debt ratio, except that the denominator is based on the tangible items of the balance sheet. This ratio is of interest to creditors as it shows the level of leverage excluding intangibles which convey much more uncertainty than tangible assets. A higher ratio means more risk. Alike the debt ratio, numerator and denominator should be adjusted for off balance sheet financing and fair value if possible.

Interest coverage ratio   =   EBIT ÷ Interest expense
(where EBIT or Earnings before interest and tax = Net profit + Tax expense + Interest expense)

This is a period ratio. It calculates how many times the interest expense is covered by profit. The interest expense is at denominator and the profit available to repay it at numerator. A higher ratio is better as it means that the interest expense is better covered by profit.

Fixed-charge coverage   =   Profit before fixed charges ÷ Fixed charges
(where Profit before fixed charges = EBIT + Lease expense
            Fixed charges = Interest expense + CMLTD + Lease payments + Dividends on preferred shares
            CMLTD or current maturity of long-term debt = Debt capital repayments due within one year)

This is a period ratio similar to the interest coverage ratio. It calculates how many times some selected fixed charges are covered by the profit available to repay them. Fixed charges are financing payments to be done regularly: interest expense, short-term repayment of debt, lease payments (unless they are included in CMLTD as for financing leases), dividends on preferred shares (included if they are considered as a regular payment, otherwise excluded). The profit available is the profit before fixed charges (EBIT + lease expense; CMLTD and dividends are not added back because they are not included in the expenses of the income statement). A higher ratio is better as it means that the fixed charges are better covered by profit.

Dividend payout   =   Dividends paid or declared ÷ Net profit

This is a period ratio. It gives the percentage of dividends paid or declared in relation to profit. In credit analysis, a lower ratio is better because it means that more profit is retained in the company, providing more ability for debt repayment. In equity analysis, it depends on the investors' objectives: a higher ratio means more dividend revenue but less potential for capital gains; a lower ratio means less dividend revenue but more potential for capital gains.

PROFITABILITY

The objective of profitability analysis is to evaluate the ability to generate sales or profit from the resources of the company. Different measures of profit can be used such as gross profit, operating profit, net profit, profit before abnormal items such as discontinued operations. Efficiency in the utilization of assets and market-based return are also included in this category.

Return on asset (ROA)   =   Net profit ÷ Total assets   and
Return on equity (ROE)   =   Net profit ÷ Shareholders' equity

These are period ratios. The numerator is the bottom line of the income statement: the net profit or net income. The denominator is ideally a weighted average of the total assets (in ROA) or shareholders' equity (in ROE) over the period considered (e.g. one year); but the yearend balance is often used in practice to facilitate calculations. A higher ratio is better as it means that total assets (or net assets) generate higher profit. It should be noted that the ratios can be improved by using fair values at the denominator when available.

Comprehensive ROA   =   Comprehensive income ÷ Total assets   and Comprehensive ROE   =   Comprehensive income ÷ Shareholders' equity

The separate reporting of comprehensive income was introduced in the US accounting standards in 1997 (SFAS No. 130 Reporting Comprehensive Income) and in Canadian standards in 2005 (CICA Handbook: Section 1530 Comprehensive income). It is also required in International Financial Reporting Standards or IFRS (IAS 1 Presentation of Financial Statements, revised in 2007). These new proposed ratios are adapted from the traditional ROA and ROE. They are similar to ROA/ROE except that the comprehensive income (disclosed in the statement of comprehensive income) replaces the net profit at numerator. The comprehensive income is the sum of the net income from income statement and the annual unrealised gains and losses recognized directly in shareholders' equity under other comprehensive income (OCI). The OCI adjustments are mainly revaluations coming from the new fair-value orientation of accounting standards. A higher ratio is better as it means that comprehensive profitability is higher as a percentage of assets/equity. A significant difference between ROA/ROE and comprehensive ROA/ROE implies that there is a significant amount of unrealized gains/losses which, in turn, may reveal important risk exposures of the company in currencies, interest rates, pension liabilities, derivatives or other.

Gross profit margin   =   Gross profit ÷ Net sales

This is a period ratio. The numerator is generally the very first sub-total in the income statement: the gross profit (net sales cost of goods sold). The denominator is net sales. The gross profit margin is usually the most important margin ratio to compare with industry peers because it focuses on the direct costs of purchasing (or producing/manufacturing) the goods being sold. But it should be noted that the sub-total gross profit is not always indicated separately on the face of the income statement. Also, there is no uniformity in the components classified as cost of goods sold in practice. For example, some depreciation is sometimes included in cost of goods sold and sometimes presented on a separate line. A higher ratio is better as it means that more profits are left after considering the direct costs.

Operating profit margin   =   Operating profit ÷ Net sales

This is a period ratio. The numerator is a sub-total in the income statement: the operating profit. The denominator is net sales. The operating margin is based on the specific revenues and expenses related to the core business of the company: sales, cost of goods sold, selling and administrative expenses. It does not take into consideration other revenues and expenses such as the interest expense, gains and losses on disposal, other revenues, income tax. But it should be noted that the sub-total operating profit, alike the gross profit, is not always indicated separately on the face of the income statement. Also, the operating profit is not necessarily calculated the same way by different companies; caution should be exercised when comparing the ratio across companies. A higher ratio is better as it means that more profits are earned after considering operating revenues and expenses

Net profit margin   =   Net profit ÷ Net sales

This is a period ratio. The numerator is the bottom line of the income statement: the net profit or net income. The denominator is net sales. The net profit margin incorporates all revenues and expenses recognized in the income statement. For that reason, it is subject to a lot of discretionary adjustments based on accrual accounting and matching (capitalisation, depreciation, provision for bad debts, etc.). A higher ratio is better as it means that more profits are left after considering all revenues and expenses.

EPS or Basic EPS   =   Profit of common shareholders ÷ Weighted average number of common shares   and
Diluted EPS   =   Same as the basic EPS, but adjusted for dilutive instruments
(where EPS = Earnings per share)

These are period ratios normally disclosed at the bottom of the income statement. In the basic EPS, the numerator is the bottom line of the income statement, the net income, adjusted to exclude the share of profits that belongs to preferred shareholders; and the denominator is the weighted average number of common shares outstanding during the period. In the diluted EPS, the formula is adjusted to take into consideration instruments that have a potentially dilutive effect on EPS such as stock options and convertible bonds. The reason is that these instruments will increase the number of shares outstanding if exercised and therefore dilute the EPS. A higher ratio is better as it means that more profit is realized per common share. When the diluted EPS is significantly lower than the basic EPS, it means that there are significant dilutive instruments outstanding, which may reduce the return for common shareholders in the future.

Price-earnings ratio   =   Stock price ÷ Basic EPS   and
Price-to-diluted-earnings ratio   =   Stock price ÷ Diluted EPS

These ratios are period ratios. The numerator is the stock price at yearend. The denominator is the basic or diluted earnings per share. It is a market-based measure showing the number of times that the current stock price covers the profit (or the diluted profit). A higher ratio is better for actual shareholders as it means that their investment is worth more. A lower ratio is not good for actual shareholders but represents a buying opportunity for investors.

Asset turnover   =   Net sales ÷ Total assets   and
Fixed asset turnover   =   Net sales ÷ Fixed assets

These are period ratios. The numerator is net sales from the income statement. The denominator is ideally a weighted average of the total assets (in the asset turnover) or fixed assets (in the fixed asset turnover)over the period considered (e.g. one year); but the yearend balance is often used in practice to facilitate calculations. These ratios give the amount of sales that is generated by each dollar of asset/fixed asset. A higher ratio is better as it means that more sales are generated by the same amount of assets/fixed assets. But the ratios have major limitations. First, the measurement of assets may not be appropriate, especially when the historical cost is applied. Under IFRS, some assets are measured at cost and other at fair value. For example, financial instruments, investment properties, fixed assets and intangibles can all be measured at fair value, but this is mainly optional, not automatic. So the notes attached to financial statements should be verified to see what accounting policies are applied by the company. In the ratios, the asset base should be adjusted to fair value if possible. The second limitation is that the assets recognized on the balance sheet may be incomplete. This may be the case for unconsolidated investments (e.g. special purpose entities or SPEs), off-balance sheet assets under operating leases (same kind of discussion as under "Off balance sheet financing" in "Other considerations" below), and intangibles.


Other Considerations:

Trend analysis and industry comparison

Trend analysis is useful to identify and forecast variations of accounting figures and ratios over time. Industry comparisons are necessary to judge if ratios of one company are favourable or unfavourable in relation to industry standards.

Segment analysis

Consolidated figures should be broken down by segment for ratio analysis. There is normally a footnote attached to financial statements providing selected accounting figures by segment.

Common size financial statements

Financial statements may be changed to a common size format: every item as a percentage of total assets in the balance sheet; every item as a percentage of sales in the income statement. This is useful to analyze trends and identify abnormal variations in the relative weight of items (compare to total assets or sales) over time.

Adjusting for abnormal items

Ratios can be adjusted to reflect ongoing business by excluding items considered not representative of normal operations, such as abnormal or special gains/losses and items relating to discontinued operations. But it should be kept in mind that the measurement of these items is based on estimates made by management, therefore potentially biased within the acceptable range allowed by accounting standards.

Seasonality

The quality of ratios depends on the quality of the inputs used in calculating them. For instance, liquidity ratios are useless (and possibly misleading) if current assets and current liabilities at the balance sheet date are not representative of the normal level throughout the year. If a company operates in a business subject to seasonal fluctuations, then it is important to consider the pattern of seasonality in performing a financial analysis. Interim financial statements can be used to improve liquidity ratios by allowing to calculate the weighted average of items such as receivables, inventory and payables. Projections of sales and cash flows may also be improved by looking at interim statements.

Auditing

Financial statements are primarily under the responsibility of management. Therefore, their reliability depends on the capability and intention of management to apply good financial reporting practices. Auditing can add reliability to financial statements by providing an independent opinion testifying that accounting standards have been followed. In practice, annual financial statements of listed companies are audited and interim statements are not. Financial statements of unlisted companies are sometimes audited but frequently not. The decision of a banker to require audited financial statements from borrowers depends on the cost of auditing vs the value-added of having more reliable financial statements. However, it should be noted that auditing is not perfect as it only provides reasonable assurance whether the financial statements are free of material misstatement.

Off balance sheet financing

Financial activities may be done outside the consolidation scope, through special purpose entities (SPEs) or other arrangements such as lease agreements. In that case, the company may have significant financing not visible on the balance sheet. Accounting policies and other footnotes should provide information to assess these unconsolidated or unrecognized debts: consolidation (or not) of SPEs and other investments; treatment of leases (no problem if finance lease accounting is applied); unrecognized actuarial liabilities on pension plans with defined benefits; potential liabilities described in contingencies.

Dupont analysis         ROE = ROA x leverage       or       Profit/Equity = Profit/Assets x Assets/Equity

The Dupont analysis is a method of breaking down ratios into several components, highlighting relationships between ratios. The breakdown of ROE into two components reveals the conflicting interests of investors/shareholders vs creditors regarding leverage. The first component, the ROA, is not a problem as both investors and creditors prefer higher profit in relation to assets. But the second component, the leverage, is troublesome for creditors as a higher level of debts is boosting the ROE, which is what investors want, while increasing the risk of debt repayment, which is what creditors wish to avoid. Other breakdown can be done in a Dupont analysis, for example: ROA = Net profit margin x Asset turnover or Profit/Assets = Profit/Sales x Sales/Assets.

Projections

Projections are important to see how the financial condition of a company is expected to evolve in the future. Analyzing historical information can be useful to see the trends and to help in forecasting future outcomes. Projections include: projected balance sheets to analyze liquidity and leverage; projected income statements and projected statements of comprehensive income to analyze profitability; projected cash flows to further analyze liquidity and debt repayment. The projected cash flows can be done on an annual basis or on a more frequent basis (e.g. quarterly or monthly) to see the expected needs or excesses of cash in the very short-term.

Top