Ratios and Formulas in Customer Financial Analysis

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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. enerally, financial ratios are calculated for the purpose of evaluating aspects of a company!s operations and fall into the following categories"
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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.





$ ratio can be computed from any pair of numbers. iven the large quantity of variables included in financial statements, a very long list of meaningful ratios can be derived. $ 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. %atio analysis becomes a very personal or company driven procedure. $nalysts are drawn to and use the ones they are comfortable with and understand. Liquidity Ratios Working Capital &or'ing capital compares current assets to current liabilities, and serves as the liquid reserve available to satisfy contingencies and uncertainties. $ high wor'ing 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

)urrent $ssets # )urrent *iabilities Acid Test or Quick Ratio $ measurement of the liquidity position of the business. The quic' ratio compares the cash plus cash equivalents and accounts receivable to the current liabilities. The primary difference between the current ratio and the quic' ratio is the quic' ratio does not include inventory and prepaid expenses in the calculation. )onsequently, a business!s quic' ratio will be lower than its current ratio. +t is a stringent test of liquidity. ( Formula )ash , -ar'etable .ecurities , $ccounts %eceivable )urrent *iabilities Current Ratio Provides an indication of the liquidity of the business by comparing the amount of current assets to current liabilities. $ business!s current assets generally consist of cash, mar'etable securities, accounts receivable, and inventories. )urrent liabilities include accounts payable, current maturities of long#term debt, accrued income taxes, and other accrued expenses that are due within one year. +n general, businesses prefer to have at least one dollar of current assets for every dollar of current liabilities. /owever, the normal current ratio fluctuates from industry to industry. $ current ratio significantly higher than the industry average could indicate the existence of redundant assets. )onversely, a current ratio significantly lower than the industry average could indicate a lac' of liquidity. ( Formula )urrent $ssets )urrent *iabilities Cash Ratio +ndicates 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 )ash 0quivalents , -ar'etable .ecurities )urrent *iabilities

Profitability Ratios
Net Profit Margin (Return on Sales) $ measure of net income dollars generated by each dollar of sales. ( Formula 1et +ncome 2 1et .ales

2 %efinements to the net income figure can ma'e it more accurate than this ratio computation. They could include removal of equity earnings from investments, 3other income3 and 3other expense3 items as well as minority share of earnings and nonrecuring items. Return on Assets -easures the company!s ability to utili4e its assets to create profits. ( Formula 1et +ncome 2 56eginning , 0nding Total $ssets7 8 9 Operating nco!e Margin $ measure of the operating income generated by each dollar of sales. ( Formula Operating +ncome 1et .ales Return on n"est!ent -easures the income earned on the invested capital. ( Formula 1et +ncome 2 *ong#term *iabilities , 0quity Return on #$uit% -easures the income earned on the shareholder!s investment in the business. ( Formula 1et +ncome 2 0quity &u Pont Return on Assets $ 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 1et +ncome 2 .ales $ssets x x .ales $ssets 0quity 'ross Profit Margin +ndicates 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

ross Profit 1et .ales

Financial Leverage Ratio
Total &e(ts to Assets Provides information about the company!s ability to absorb asset reductions arising from losses without jeopardi4ing the interest of creditors. ( Formula Total *iabilities Total $ssets Capitali)ation Ratio +ndicates long#term debt usage. ( Formula *ong#Term :ebt *ong#Term :ebt , Owners! 0quity &e(t to #$uit% +ndicates how well creditors are protected in case of the company!s insolvency. ( Formula Total :ebt Total 0quity nterest Co"erage Ratio (Ti!es nterest #arned) +ndicates a company!s capacity to meet interest payments. ;ses 06+T 50arnings 6efore +nterest and Taxes7 ( Formula 06+T +nterest 0xpense *ong+ter! &e(t to Net Working Capital Provides insight into the ability to pay long term debt from current assets after paying current liabilities. ( Formula *ong#term :ebt )urrent $ssets # )urrent *iabilities

Efficiency Ratios

Cash Turno"er -easures how effective a company is utili4ing its cash. ( Formula 1et .ales )ash Sales to Working Capital (Net Working Capital Turno"er) +ndicates the turnover in wor'ing capital per year. $ low ratio indicates inefficiency, while a high level implies that the company!s wor'ing capital is wor'ing too hard. ( Formula 1et .ales $verage &or'ing )apital Total Asset Turno"er -easures the activity of the assets and the ability of the business to generate sales through the use of the assets. ( Formula 1et .ales $verage Total $ssets ,i-ed Asset Turno"er -easures the capacity utili4ation and the quality of fixed assets. ( Formula 1et .ales 1et Fixed $ssets &a%s. Sales in Recei"a(les +ndicates the average time in days, that receivables are outstanding 5:.O7. +t 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. $n 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 ross %eceivables $nnual 1et .ales 8 <=> Accounts Recei"a(le Turno"er +ndicates the liquidity of the company!s receivables. ( Formula 1et .ales $verage ross %eceivables

Accounts Recei"a(le Turno"er in &a%s +ndicates the liquidity of the company!s receivables in days. ( Formula $verage ross %eceivables $nnual 1et .ales 8 <=> &a%s. Sales in n"entor% +ndicates the length of time that it will ta'e to use up the inventory through sales. ( Formula 0nding +nventory )ost of oods .old 8 <=> n"entor% Turno"er +ndicates the liquidity of the inventory. ( Formula )ost of oods .old $verage +nventory n"entor% Turno"er in &a%s +ndicates the liquidity of the inventory in days. ( Formula $verage +nventory )ost of oods .old 8 <=> Operating C%cle +ndicates the time between the acquisition of inventory and the reali4ation 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 $ccounts %eceivable Turnover in :ays , +nventory Turnover in :ay &a%s. Pa%a(les Outstanding +ndicates how the firm handles obligations of its suppliers. ( Formula 0nding $ccounts Payable Purchases 8 <=> Pa%a(les Turno"er +ndicates the liquidity of the firm!s payables.

( Formula Purchases $verage $ccounts Payable Pa%a(les Turno"er in &a%s +ndicates the liquidity of the firm!s payables in days. ( Formula $verage $ccounts Payable Purchases 8 <=>

Additional Ratios
Alt!an /+Score The ?#score model is a quantitative model developed in @A=B by 0dward $ltman to predict ban'ruptcy 5financial distress7 of a business, using a blend of the traditional financial ratios and a statistical method 'nown as multiple discriminant analysis. The ?#score is 'nown to be about ACD accurate in forecasting business failure one year into the future and about BCD accurate in forecasting it two years into the future. ( Formula ? E @.9 x 5&or'ing )apital 8 Total $ssets7 ,@.F x 5%etained 0arnings 8 Total $ssets7 ,C.= x 5-ar'et Galue of 0quity 8 6oo' Galue of :ebt7 ,C.AAA x 5.ales 8 Total $ssets7 ,<.< x 506+T 8 Total $ssets7 ?#score Probability of Failure less than @.B Gery /igh greater than @.B@ but less than 9.AA 1ot .ure greater than <.C ;nli'ely 0ad+&e(t to Accounts Recei"a(le Ratio 6ad#debt to $ccounts %eceivable ratio measures expected uncollectibility on credit sales. $n increase in bad debts is a negative sign, since it indicates greater reali4ation ris' in accounts receivable and possible future write#offs. ( Formula 6ad :ebts $ccounts %eceivable 0ad+&e(t to Sales Ratio 6ad#debt ratios measure expected uncollectibility on credit sales. $n increase in bad debts is a negative sign, since it indicates greater reali4ation ris' in accounts receivable and possible future write#offs.

( Formula 6ad :ebts .ales 0ook 1alue per Co!!on Share 6oo' value per common share is the net assets available to common stoc'holders divided by the shares outstanding, where net assets represent stoc'holders! equity less preferred stoc'. 6oo' value per share tells what each share is worth per the boo's based on historical cost. ( Formula 5Total .toc'holders! 0quity # *iquidation Galue of Preferred .toc's # Preferred :ividends in $rrears7 )ommon .hares Outstanding Co!!on Si)e Anal%sis +n 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 @CCD and each asset is stated as a percentage of total assets. .imilarly, total liabilities and stoc'holder!s equity are assigned @CCD, with a given liability or equity account stated as a percentage of total liabilities and stoc'holder!s equity. On the income statement, @CCD 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 ta'ing credit terms extended for a business transaction. )redit terms usually express the amount of the cash discount, the date of its expiration, and the due date. $ typical credit term is 9 8 @C, net 8 <C. +f payment is made within @C days, a 9 percent cash discount is allowed" otherwise, the entire amount is due in <C days. The cost of not ta'ing the cash discount can be substantial. ( Formula D :iscount <=C x @CC # D :iscount )redit Period # :iscount Period Example On a H@,CCC invoice with terms of 9 8@C net <C, the customer can either pay at the end of the @C day discount period or wait for the full <C days and pay the full amount. 6y waiting the full <C days, the customer effectively borrows the discounted amount for 9C days. H@,CCC x 5@ # .C97 E HABC This gives the amount paid in interest as" H@,CCC # ABC E H9C This information can be used to compute the credit cost of borrowing this money.

D :iscount <=C x @CC # D :iscount )redit Period # :iscount Period E 9 <=C x E .<=I< AB 9C $s this example illustrates, the annual percentage cost of offering a 98@C, net8<C trade discount is almost <ID. Current+*ia(ilit% Ratios )urrent#liability ratios indicate the degree to which current debt payments will be required within the year. ;nderstanding 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 )urrent to 1on#current E )urrent *iabilities 1on#current *iabilities )urrent to Total E )urrent *iabilities Total *iabilities

Rule of 23 $ rule of thumb method used to calculate the number of years it ta'es to double an investment. ( Formula I9 %ate of %eturn Example Paul bought securities yielding an annual return of A.9>D. This investment will double in less than eight years because, I9 E I.IB years A.9>
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