Documente Academic
Documente Profesional
Documente Cultură
Financial
Analysis
and
Benchmarks
to Outscore
Your
Competition
Copyright ©1999 by Gulf Publishing Company, Houston,
Texas. All rights reserved. This book, or parts thereof, may not
be reproduced in any form without express written permission
of the publisher.
Cashman Dudley
An imprint of Gulf Publishing Company
P.O. Box 2608 Houston, Texas 77252-2608
10 9 8 7 6 5 4 3 2 1
Gildersleeve, Rich.
Winning business : how to use financial analysis and bench-
marks to outscore your competition / Rich Gildersleeve.
p. cm.
Includes bibliographical references and index.
ISBN 0-88415-898-5 (alk. paper)
1. Ratio analysis. 2. Financial statements. 3. Benchmarking
(Management) I. Title.
HF5681.R25G55 1999
658.15′5—dc21 99-13911
CIP
The author and the publisher have used their best efforts in preparing this book. The information and material contained in this
book are provided “as is,” without warranty of any kind, express or implied, including, without limitation, any warranty concern-
ing the accuracy, adequacy, or completeness of such information or material or the results to be obtained from using such informa-
tion or material. Neither Gulf Publishing Company nor the author shall be responsible for any claims attributable to errors, omis-
sions, or other inaccuracies in the information or material contained in this book, and in no event shall Gulf Publishing Company or
the author be liable for direct, indirect, special, incidental, or consequential damages arising out of the use of such information or
material.
iv
Contents
Acknowledgments, xii
Introduction, xiii
Considerations, xv
Chapter 1
Financial Statement Analysis Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1 Using Vertical Analysis to Analyze Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
2 Using Horizontal Analysis to Analyze Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
3 Exploring Variance Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
4 Studying Ratio Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Chapter 2
Income Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
5 Determining Gross Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
6 Examining the Gross Profit Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
7 Calculating Income from Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
8 Examining the Operations Income Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
9 Measuring Pretax Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
10 Evaluating the Pretax Profit Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
11 Calculating Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
12 Comparing Net Income to Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
13 Finding the Percentage of Net Sales and Net Income that are Domestic . . . . . . . . . . . . . . . . . . 23
14 Finding the Percentage of Sales and Net Income that are Foreign . . . . . . . . . . . . . . . . . . . . . . . 24
15 Determining the Cost of Capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
16 Measuring Economic Value Added (EVA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
17 Comparing Economic Value Added (EVA) to Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
18 Examining the Size of Residual Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
19 Comparing Residual Income to Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
20 Determining the Return on Equity (ROE) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
v
21 Finding the Return on Assets (ROA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
22 Determining the Return on Invested Capital (ROIC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
23 Comparing Cash Provided by Operations to Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
24 Comparing Short-Lived Income to Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
25 Determining the Significance of Short-Lived Sales to Net Sales . . . . . . . . . . . . . . . . . . . . . . . . . 39
26 Comparing Cash Flow from Operations to Total Cash Flow. . . . . . . . . . . . . . . . . . . . . . . . . . . 40
27 Comparing Cash Flow from Investing Activities to Total Cash Flow. . . . . . . . . . . . . . . . . . . . . 42
28 Comparing Cash Flow from Financing Activities to Total Cash Flow . . . . . . . . . . . . . . . . . . . . 43
Chapter 3
Investment Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
29 Determining Revenues Earned Per Share of Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
30 Finding the Amount of Earnings Per Share of Common Stock. . . . . . . . . . . . . . . . . . . . . . . . . . 46
31 Examining Dividends Per Common Share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
32 Calculating the Growth Rate of Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
33 Calculating the Growth Rate of Earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
34 Finding the Common Stock Dividend Growth Rate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
35 Determining the Price-to-Earnings (P/E) Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
36 Measuring the Price-to-Earnings-to-Growth-Rate Ratio (PEG) . . . . . . . . . . . . . . . . . . . . . . . . . 55
37 Examining the Earnings Yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
38 Determining the Market Price Return Ratio. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
39 Determining the Common Stock Dividend Return Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
40 Determining the Size of the Common Stock Dividend Payout . . . . . . . . . . . . . . . . . . . . . . . . . . 59
41 Determining the Size of the Dividend Payout in Relation to
Operations Cash Flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
42 Determining the Preferred Dividend Return Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
43 Determining the Size of the Preferred Dividend Payout . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
44 Determining the Size of the Preferred Dividend Payout in
Relation to Operations Cash Flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
45 Determining the Size of the Total Return on Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . 65
46 Computing the Cash Flow Per Share of Outstanding Common Stock . . . . . . . . . . . . . . . . . . . 66
47 Computing the Operating Cash Flow Per Share of Outstanding
Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
48 Determining the Volatility, or Beta, of a Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
Chapter 4
Product and Factory Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
49 Calculating the Total Amount of Direct Costs Per Production Unit . . . . . . . . . . . . . . . . . . . . . 72
50 Determining the Total Labor Cost Per Production Unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
51 Calculating the Total Cost Per Production Unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
52 Examining Variable Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
53 Comparing Variable Costs with Total Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
54 Examining Variable Costs Per Production Unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
55 Examining Fixed Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
56 Comparing Fixed Costs to Total Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
57 Finding the Fixed Cost Per Unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
58 Finding the Contribution Margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
59 Determining the Break-Even Point in Sales Volume . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
60 Determining the Break-Even Point in Sales Dollars . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
61 Finding the Sales Volume Necessary to Generate a Desired
Operating Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
62 Finding the Sales Dollars Necessary to Generate a Desired Operating
Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
63 Finding the Break-Even Plant Capacity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
vi
Chapter 5
Expense Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
64 Comparing the Cost of Goods Sold to Sales and Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . 96
65 Calculating the Amount of Sales and Cost of Goods Sold Per Employee . . . . . . . . . . . . . . . . . 98
66 Determining Sales, Net Income, and the Cost of Goods Sold Per Direct
Labor Employee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
67 Comparing the Cost of Direct Labor and Direct Labor Hours
Worked to Sales, Net Income, and the Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
68 Comparing Direct Labor Costs, Direct Labor Employees, and
Direct Labor Hours Worked to the Cost of All Labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
69 Finding the Labor Cost and Hours Worked Per Direct Employee . . . . . . . . . . . . . . . . . . . . . . . 104
70 Determining the Percentage of All Employees Who Are
Direct Laborers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
71 Determining the Direct Labor Costs Per Production Unit
and Other Direct Labor Efficiency Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
72 Comparing the Direct Overhead Cost to Sales, Net Income,
and the Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
73 Comparing Raw Materials Costs to Sales, Net Income, and the
Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
74 Comparing Other Direct Costs to Sales, Gross Profit, Net Income,
and the Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
75 Comparing R&D Costs to Sales and Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
76 Comparing Selling, General, and Administrative Costs (SG&A)
to Sales and Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
77 Comparing Individual Overhead Expenses to Total Overhead
Expenses and Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
78 Finding Plant Equipment Costs Per Hour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
79 Comparing the Cost of Fixed Asset Maintenance to Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
80 Comparing the Cost of Fixed Asset Maintenance to the Value of
Fixed Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
81 Relating Insurance Costs to Sales Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
82 Relating Insurance Expenses to the Value of Fixed Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
83 Examining Book Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
84 Examining Tax Return Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
85 Relating Book Depreciation Expenses to Sales Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
86 Comparing Book Depreciation Expenses to the Value of Fixed Assets . . . . . . . . . . . . . . . . . . . 125
Chapter 6
Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
87 Determining the Size of Fixed Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
88 Examining the Relationship Between Fixed Assets and Sales . . . . . . . . . . . . . . . . . . . . . . . . . . 128
89 Examining the Relationship Between Fixed Assets and Net Income . . . . . . . . . . . . . . . . . . . . . 129
90 Examining the Relationship Between Fixed Assets and
Operations Cash Flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
91 Comparing Fixed Assets to Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
92 Assessing the Fixed-Asset-to-Equity Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
93 Determining the Relationship Between Fixed Assets and Long-Term Debt . . . . . . . . . . . . . . . . 134
94 Comparing Fixed Assets to Short-Term Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
95 Examining Fixed Asset Turnover . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
96 Assessing the Age of Fixed Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
97 Determining the Turnover Rate of Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
98 Finding the Total Asset Coverage Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
99 Comparing Intangible Assets to Sales Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
100 Comparing Intangible Assets to Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
101 Comparing Intangible Assets to Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
102 Comparing Intangible Assets to Owner’s Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
vii
103 Comparing Changes in Intangible Assets to Changes in Net Income . . . . . . . . . . . . . . . . . . . . 146
104 Comparing Individual Intangible Assets to Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
105 Comparing Individual Intangible Assets to Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
106 Comparing Individual Intangible Assets to Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
107 Measuring the Rate of Fixed Asset Reinvestment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
108 Determining the Productivity of Fixed Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
109 Comparing Fixed Asset Replacement Cost and Book Value . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
110 Comparing High-Risk Assets to Sales Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
111 Relating High-Risk Assets to Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
Chapter 7
Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
112 Comparing Debt to Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
113 Examining the Debt-to-Operating Income Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
114 Examining the Debt-to-Asset Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
115 Examining the Debt-to-Equity Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
116 Comparing Debt to the Market Value of Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
117 Determining Debt Turnover . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
118 Comparing Debt and Total Invested Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
119 Relating Short-Term Debt to Long-Term Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
120 Determining the Cost of Debt Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
Chapter 8
Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
121 Comparing Equity to Sales Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
122 Comparing Equity to Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
123 Comparing Equity to Total Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
124 Determining the Turnover of Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
125 Examining the Turnover of Invested Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170
126 Comparing Net Income to Invested Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
127 Comparing Stock to Invested Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
128 Comparing Retained Earnings to Invested Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
Chapter 9
Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
129 Finding the Current Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
130 Using the Acid Test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
131 Determining the Cash Flow Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
132 Calculating Cash Turnover . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
133 Finding How Many Days of Cash Expenses are Available . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
134 Examining How Many Days of Sales in Cash are Available . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
135 Using Altman’s Z-score to Determine the Probability of Bankruptcy . . . . . . . . . . . . . . . . . . . . 181
136 Comparing Sales to Current Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182
137 Comparing Liquid Assets to Current Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
138 Relating Liquid Assets to Cash Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184
139 Relating Current Debt to Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
140 Comparing Current Debt to Total Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
141 Examining Working Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
142 Finding the Turnover of Working Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
143 Comparing Working Capital to Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189
144 Comparing Working Capital to Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
145 Relating Working Capital to Current Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191
146 Relating Working Capital to Long-Term Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192
147 Relating Working Capital to Total Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
148 Comparing Working Capital to Current Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
viii
149 Comparing Working Capital to Specific Current Assets Such as
Cash and Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
150 Comparing Working Capital to Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196
151 Relating Liquid Assets to Total Current Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
152 Relating Marketable Securities to Total Current Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
153 Comparing Accounts Receivable to Total Current Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
154 Comparing Inventory to Total Current Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
155 Comparing Other Specific Current Asset Accounts to Total Current Assets . . . . . . . . . . . . . . . . 202
156 Comparing Specific Expenses Such as Interest and Taxes to Total
Current Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
Chapter 10
Solvency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
157 Determining How Many Times Interest Expense is Earned . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
158 Comparing Operations Cash Flow Plus Interest to Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
159 Finding How Many Times Debt Expenses are Covered . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207
160 Comparing Operations Cash Flow Plus Debt Expenses to Debt Expenses . . . . . . . . . . . . . . . . 208
161 Finding How Many Times the Long-Term Debt is Covered . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
162 Comparing Operations Cash Flow to Long-Term Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210
163 Finding How Many Times Fixed Costs are Covered . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
164 Comparing Operations Cash Flow Plus Fixed Costs to Fixed Costs . . . . . . . . . . . . . . . . . . . . . 212
165 Determining How Many Times Operating Expenses are Covered . . . . . . . . . . . . . . . . . . . . . . 214
166 Comparing Operations Cash Flow Plus Operating Expenses to
Operating Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215
167 Determining How Many Days of Operating Expense Payables are
Outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
168 Finding How Many Times Asset Additions are Covered . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
169 Comparing Operations Cash Flow to Changes in Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
170 Comparing Retained Earnings to Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
Chapter 11
Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220
171 Comparing Debt to the Market Value of Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
172 Comparing Current Debt to the Market Value of Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
173 Comparing Long-Term Debt to the Market Value of Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
174 Determining the Funded-Capital-to-Fixed-Asset Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
175 Examining Financial Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
176 Examining Operating Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
177 Examining Total Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
Chapter 12
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
178 Comparing Accounts Receivable to Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232
179 Determining the Turnover of Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233
180 Determining How Many Days of Credit Sales are in Accounts Receivable . . . . . . . . . . . . . . . . 234
181 Examining the Ages of Accounts Receivable (Aging Schedule) . . . . . . . . . . . . . . . . . . . . . . . . . 235
182 Determining What Percentage of Current-Period Sales Will Be Collected
in the Current Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236
183 Determining What Percentage of Current-Period Sales Will Not Be
Collected in the Current Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237
184 Examining Bad Debt and Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238
185 Relating Bad Debts to Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239
186 Determining if Credit Discounts Should be Accepted and Offered . . . . . . . . . . . . . . . . . . . . . . 240
187 Examining Accounts Receivable Factoring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
ix
Chapter 13
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
188 Comparing Accounts Payable to Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
189 Finding the Turnover of Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245
190 Calculating the Number of Days of Purchases in Accounts Payable . . . . . . . . . . . . . . . . . . . . . 246
191 Comparing Accounts Payable to Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
192 Finding How Many Days of Purchases Have Been Paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
193 Comparing Accounts Payable Cash Disbursements to Accounts Payable . . . . . . . . . . . . . . . . . 249
194 Comparing Individual Accounts Payable Disbursements to Total Cash Disbursements . . . . . . 250
Chapter 14
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251
195 Relating Inventory and Sales Levels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252
196 Determining the Turnover of the Entire Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
197 Determining How Many Days of Inventory Are On Hand . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254
198 Calculating the Turnover of Finished Product Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
199 Finding How Many Days of Finished Product Inventory Are Available . . . . . . . . . . . . . . . . . . 256
200 Determining the Turnover of Work in Process Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257
201 Calculating How Many Days of Work in Process Are Available . . . . . . . . . . . . . . . . . . . . . . . . 258
202 Determining the Turnover of Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259
203 Examining How Many Days of Raw Materials Inventory Are Available . . . . . . . . . . . . . . . . . 260
204 Determining the Inventory Ordering Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
205 Measuring the Inventory Carrying Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
206 Determining the Optimum Inventory Order Quantity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
207 Determining the Total Cost of Inventory Per Item . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
208 Determining the Timing of Inventory Reorders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265
209 Estimating the Size of Inventory Safety Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266
210 Examining Just-In-Time (JIT) Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
Chapter 15
Product and Service Demand Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
211 Examining Elastic Demand for Goods or Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
212 Examining Inelastic Demand for Goods and Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
213 Understanding Unitary Elasticity for Goods or Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
214 Examining Cross-Elasticity for Goods or Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272
215 Examining Price Elasticity of Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
Chapter 16
Capital Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274
216 Determining the Payback Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
217 Determining the Payback Reciprocal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
218 Finding the Discounted Payback Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
219 Finding the Accounting Rate of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
220 Determining the Net Present Value (NPV) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
221 Finding the Risk-Adjusted Discount Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281
222 Ascertaining the Benefit Cost Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282
223 Finding the Internal Rate of Return (IRR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
224 Finding the Modified Internal Rate of Return (MIRR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
225 Determining the Certainty Equivalent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286
226 Determining the Future Value of $1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
227 Finding the Future Value of an Annuity of $1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
228 Calculating the Future Value of an Annuity Due of $1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
229 Finding the Present Value of $1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291
230 Determining the Present Value of an Annuity of $1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
231 Calculating the Present Value of an Annuity Due of $1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
232 Examining Perpetuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
x
Chapter 17
Investment/Loan Interest Rate Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
233 Examining Simple Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
234 Exploring Compounded Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
235 Examining the Current Yield on Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298
236 Examining the Yield to Maturity on Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
237 Examining the Effective Annual Yield on T-bills . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
238 Exploring the Rule of 72 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
239 Exploring Interest Rates and Their Significance: Federal Funds Rate . . . . . . . . . . . . . . . . . . . . 302
240 Exploring Interest Rates and Their Significance: Discount Rate . . . . . . . . . . . . . . . . . . . . . . . . 303
241 Exploring Interest Rates and Their Significance: Treasury Bills/Notes/Bonds . . . . . . . . . . . . . . . . 304
Chapter 18
External Indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
242 Examining the Index of Leading Economic Indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
243 Examining the Index of Coincident Economic Indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307
244 Examining the Index of Lagging Economic Indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
245 Assessing the Gross Domestic Product (GDP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
246 Examining the Gross National Product (GNP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
247 Examining the Producer Price Index (PPI) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
248 Assessing the Consumer Price Index (CPI) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312
249 Examining the Dow Jones Industrial Average (DJIA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
250 Exploring the Russel 2000 Average . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
251 Exploring the Wilshire 5000 Average . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
Chapter 19
Company Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316
252 Determining the Book Value of a Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
253 Finding the Liquidation Value of a Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
254 Ascertaining the Market Value of a Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
255 Assessing the Price-to-Earnings Value of a Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
256 Valuing a Company on Discounted Future Cash Flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
257 Determining the Value of a Company with No-Earnings-Per-Share Dilution . . . . . . . . . . . . . . . . 322
Appendix A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
Appendix B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
Appendix C . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
Abbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
References and Suggested Readings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327
xi
Acknowledgments
Many thanks to Dr. Kris Jamsa for his vision and encouragement in making this book a reality.
Professor Gun Joh of California State University, San Diego also deserves accolades for his insight-
ful suggestions. I am most appreciative and thankful for the support and love of my wonderful
wife, Tammy, and our great kids, Sean and Tara.
xii
Introduction
Winning Business and its interactive CD-ROM can help monitor, and when applicable, improve company perfor-
business managers, investors, small business owners, and stu- mance in the area of concern. You will also find an example
dents better understand, monitor, and improve company per- with each tip to show you how to calculate the ratio. All
formance. Successful business people use indicators to moni- examples are based on the financial statements of Argo, Inc.,
tor conditions such as return on assets, liquidity, profitability, a fictitious concern, whose financial statements are detailed
and growth. This book helps you determine these critical per- in Appendix A.
formance indicators and supplies you with benchmarks to see Many of the tips also provide industry benchmarks to
how your company stacks up against the competition. enable you to compare your company’s performance with
The book gives you 257 tips conveniently organized in cat- many different-sized companies operating in a variety of
egories so you can quickly focus in on areas of concern. The industries. The companies included in the benchmark tables
categories include income analysis, investment analysis, prod- are shown below. The data comes from the financial state-
uct and factory costs, expense analysis, capital investment, ment information found in each respective company’s annual
liquidity, solvency, accounts payable and receivable, product report. In the sample tables below, Table 1 shows financial
service demand types, investment and loan interest rate infor- information reporting dates and Table 2 shows corresponding
mation, leverage, inventory, assets, debt, equity, and external sales levels for that reporting period.
indicators. Each tip presents a ratio to help you understand,
Table 1. Benchmark companies with financial information reporting dates.
Sector Mid to large cap Financial Small to mid cap Financial Micro to small cap Financial
Reporting Date Reporting Date Reporting Date
Retail Wal-Mart Stores 1-31-98 Bed Bath & Beyond 2-28-98 TCBY Enterprises 11-30-97
Food McDonald’s 12-31-97 Applebee’s Int’l 12-28-97 Garden Fresh Restaurant 9-30-97
Finance Morgan-Stanley Dean Witter 11-30-97 Franklin Resources 9-30-97 AmeriTrade Holding 9-27-97
Healthcare Columbia/HCA Healthcare 12-31-97 Novacare 6-30-97 National Home Health Care 9-31-97
Service Manpower 12-31-97 Air & Water Technologies 10-31-97 Market Facts 12-31-97
xiii
Table 2. Sales levels of benchmark companies at the listed reporting period.
Sector Mid to large cap Sales (M$) Small to mid cap Sales (M$) Micro to small cap Sales (M$)
Retail Wal-Mart Stores 117,958 Bed Bath & Beyond 1,067 TCBY Enterprises 91
Finance Morgan-Stanley Dean Witter 27,132 Franklin Resources 2,163 AmeriTrade Holding 96
Healthcare Columbia/HCA Healthcare 18,819 Novacare 1,066 National Home Health Care 35
Service Manpower 7,259 Air & Water Technologies 456 Market Facts 100
The interactive CD-ROM enables you to input standard Next, assume you are considering your next stock market
company financial statement information, most of which can investment. You could turn to the chapter on investment
be found in annual reports, and then watch as the program quality. There you could pick from several useful ratios such
automatically performs all of the ratio calculations for you. In as earnings growth and dividend payout to analyze the
an instant, you can have a vast array of critical performance investment potential of the company under consideration.
characteristics mapped out for you. Using this information, Finally, let’s suppose you are a business manager consider-
you can determine when performance is high and when ing expanding a business by starting a new product line.
improvement is indicated. The CD-ROM also contains a full You would flip to the chapters on capital investment and
multimedia version of the book. income quality. There you would analyze the potential
The following three examples demonstrate ways in which return on the investment by determining ratios such as the
Winning Business can help managers and investors stay payback period, net present value, and the economic value
ahead of the competition. Suppose you are a business man- added (EVA). These ratios should help you make more
ager concerned with excessive and/or climbing inventory informed and objective decisions regarding the potential of
levels. You could flip to the Winning Business chapter on the product line expansion.
inventory that describes a number of useful ratios such as Winning Business provides you with the tools to improve
inventory turnover and inventory to sales. These ratios will the health of your business and analyze the potential of
help you understand and improve company performance in your investments. Each of the 257 tips will help you under-
that area. After determining the size of these ratios, you can stand, monitor, and improve company performance. With
use the benchmark table to see how your company stacks the interactive CD-ROM, you can easily perform sophisti-
up against others in a variety of industries. The tips offer cated financial and business analysis with a minimum of
potential causes, outcomes, and suggestions for the effort. The tools provided in Winning Business can provide
improvement of high and low inventory levels to help you investors, managers, and students with a blueprint for suc-
take any desired corrective action. cess.
xiv
Considerations
Although ratio analysis can provide the business manager 5. It is always important to consider risk when analyzing
and investor with tremendously helpful information regard- the potential of a business. Higher rewards are not
ing company performance trends, you should weigh a num- necessarily better when there is a disproportionate
ber of factors when employing ratio analysis. Below are degree of risk.
some of the issues to consider when using the information in 6. Financial ratios reflect the past and not necessarily the
this book: present or future.
7. Financial ratios are in large part dependent on the
1. Trends over time are often more insightful than one- reliability of the information found in financial
time values. A high or low one-time value may be the statements. If this information is misleading or
result of an unusual event not likely to reoccur whereas inaccurate, the analysis results will likely also be
a trend is often more indicative of an event that is likely incorrect.
to repeat in the future. 8. Financial ratios are dependent upon the particular
2. The ratios in this book are based upon the latest accounting principles used by the company. Although
balance sheet values instead of an alternative method of most companies adhere to generally accepted accounting
averaging the last two or more balance sheet values. principles, the manner in which these firms report
3. When comparing ratios with other companies, you will financial performance can vary greatly. For example, some
generally realize more accurate and insightful results companies prefer to account for inventory on a last-in,
when comparing companies of similar size and in first-out (LIFO) basis while others prefer a first-in, first-
similar industries. out (FIFO) accounting. In an inflationary period, a given
4. When the value of the ratio indicator that falls in the inventory would likely have a larger value when the
denominator approaches zero, the resulting ratio is very company uses FIFO instead of LIFO inventory methods
high and can give misleading information. even though the same type and volume of inventory are
xv
present. Both accounting methods are acceptable but can 10. The financial statements analysis methods discussed
give seemingly very different inventory perspectives. It is are targeted to U.S. corporations. Extra care should
thus important to check financial statement footnotes be taken when applying these methods for foreign
when comparing companies to account for differences in companies, because varying accounting standards and
accounting methods. definitions may give misleading results.
9. The per-share ratios in this book are based upon the
number of outstanding shares listed in company
balance sheets.
xvi
Argo, Inc.
Financial
Statements
The appendix details the financial statements of a ficti- individual’s salary, living expenses, taxes, and remaining
tious company, Argo, Inc. This information is the basis of balance after the owner has accounted for all forms of
many of the example calculations explained in the book. income and expenses.
The examples help illustrate where you can locate the infor- The balance sheet relays information regarding a compa-
mation on a financial statement and how you can use this ny’s assets, liabilities, and owner’s equity at any given time,
information to determine the ratio under consideration. typically the last day of a company’s fiscal year. While the
The Argo, Inc. financials include three of the most com- income statement covers a time period, the balance sheet
mon instruments employed to communicate a company’s conveys the financial status as a snapshot in time. This
financial state. These instruments are the income statement financial statement is aptly called the balance sheet because
(also known as the profit and loss statement, the statement it “balances” assets, liabilities, and equity according to the
of earnings, and the statement of operations), the balance accounting formula:
sheet (also called the statement of financial condition), and
Assets = liabilities + owner’s equity
the cash flow statement.
The income statement conveys information regarding Assets include all the items a company possesses that have
income streams and expenses over a period of time such as value. They are typically listed according to liquidity. The
yearly, half-yearly, and quarterly. The top lines of an income most liquid assets, such as cash, are listed first, and longer
statement describe the company’s income streams. The state- term, less liquid assets such as buildings, machinery, and
ment lists expenses below the income-related information. other long-term investments are listed further down the bal-
The first expenses listed are most directly associated with ance sheet.
the production of the company’s products or services. You Liabilities include all of the areas in which the company is
find other expenses as you proceed down the income state- indebted to others. Examples include bank loans, investor
ment until all expenses are accounted for, resulting in the loans, trade credit, and taxes. Like the assets section, near-
company’s financial net income, or bottom line, for the time term liabilities such as notes payable to investors and
period. The income statement is in some ways analogous to accounts payable to trade creditors are listed before longer
an organized personal checkbook statement that details an term obligations such as long-term loans.
xvii
The owner’s equity, also called the shareholders’ equity, service contracts, bank loans, and the sale and purchase of
includes primarily all the capital paid to the company by assets. An example may be the best way to describe the use-
shareholders as well as the capital the company has earned fulness of the information contained within the cash flow
that has been reinvested in the company. This latter portion statement. Consider two companies that each experienced
is commonly called retained earnings. an increase in cash of one million dollars. The first generated
Now that we’ve laid a small amount of groundwork, let’s nine million from operations, invested six million in new fac-
explore what the accounting formula, Assets = liabilities + tory equipment, and paid off two million in financed debt (9
owner’s equity, conveys. A company that has a large − 6 − 2 = 1). The second lost five million from operations,
amount of assets must have an equally large amount of lia- sold off another five million in factory equipment, and bor-
bilities and owner’s equity for the equation to balance. If the rowed eleven million in cash (−5 − 5 + 11 = 1). While both
company has an amount of liabilities equal to the amount companies had a net increase in cash of one million, they
of assets, there will be no owner’s equity. In this situation, clearly arrived at that point in vastly different manners.
the company is highly leveraged since all assets are covered Everything else being the same, the first company is in a
by liabilities such as loans from banks and trade creditors. much sounder financial state than the second since opera-
Alternatively if the company has no liabilities, the owner’s tions are supplying a positive stream of cash, with a large
equity portion will be equal to the assets. In this situation, portion of this cash reinvested in the company for future
the company’s assets are fully owned by the owners since growth. The second company, on the other hand, is losing
there is no debt. The second company is in a generally money in operations and selling assets that may be required
sounder financial state since it is not leveraged. However,
for future sales.
this information alone does not mean the second company
In addition to the financial statements there are a number
is, or will be, more successful. It simply means that the com-
of qualitative aspects of the financial report that may pro-
pany, for any variety of reasons, has elected or has not
vide further insight into company performance including
needed to acquire any debt. Many successful companies will
management discussions, auditor’s opinions, and the finan-
acquire debt for assets such as machinery and extra invento-
cial report footnotes. Management discussions help you
ry to help support the growth of the company.
gain an improved understanding of a company’s financial
Rearranging the accounting formula to solve for owner’s
performance because these discussions often disclose the
equity gives
stories behind financial numbers. For example, reduced
Owner’s Equity = assets − liabilities sales levels may be caused by increasing competition,
reduced demand, a fire that destroyed production facilities
This equation shows that the larger the amount of assets and subsequently hampered sales efforts, or any number of
relative to liabilities, the more equity the owners have in the other reasons. An auditor’s opinion typically accompanies
company. When you look at the balance sheet in this man- the financial report and discloses how accurately the state
ner, you can see that it is in many ways similar to an indi- of the business is portrayed. When a negative opinion is
vidual’s net worth statement, in which the difference offered, the financial statement information disclosed can
between all personal assets and liabilities equals the individ- be misleading or totally in error. Extra care is warranted
ual’s net worth. when using such information for business analysis. Foot-
The cash flow statement describes where the company has notes also typically accompany the financial reports. These
generated and used cash over a period of time. Possible footnotes often provide the needed details to better under-
sources and uses of cash include manufacturing operations, stand the numbers disclosed in the financial reports.
xviii
CHAPTER ONE
Financial
Statement
Analysis
Methods
This chapter describes commonly used methods of analyzing
financial statements. You can use these analysis methods with
many of the financial ratios discussed in this book to track
income and expense performance over time and to compare
one financial indicator to another to gain improved insight
regarding company performance.
1
1 Using Vertical Analysis to
Analyze Financial Statements
Vertical analysis is a method of analyzing financial state- When to use indicator: You can use vertical analysis to com-
ments in which you can compare individual line items to a pare trends in the relative performance of any financial state-
baseline item such as net sales from the income statement, total ment line items over time. For example, from the income
assets from the asset section of the balance sheet, and total lia- statement you may want to track the cost of goods sold and
bilities and owner’s equity in the liabilities and owner’s equity the net income as a percentage of sales. These two indicators
section of the balance sheet. The word vertical is used to let you know whether year-to-year costs are becoming unrea-
describe this analysis method because the method generates a sonable and whether net income trends are as desired. By
FINANCIAL STATEMENT ANALYSIS METHODS
vertical column of ratios next to the individual items on the tracking ratios over time, you can observe positive or nega-
financial statements. tive trends so that you can begin any required corrective
actions. You can also use vertical analysis to compare a com-
pany’s performance relative to the performance of other com-
panies operating in similar industries.
Example
Income Statement
Fiscal year ending 31-Dec-97
(dollars in thousands)
2
2 Using Horizontal Analysis to
Analyze Financial Statements
Horizontal analysis is a method of analyzing financial state-
ments in which a manager compares individual line items to their
First, compare the performance of the line items with forecasts to
determine the level of company performance. Some companies
historical values. The word horizontal is used to describe this would consider an 8% increase in net sales a dramatic failure
analysis method because the method generates horizontal rows of while others would consider it a tremendous success; the relation-
data. ship of performance to forecast is the key. Further, the relation-
ship between distinct line items can give you a lot of insight into
When to use indicator: You can use this method to compare the health of the company. In this example, it is likely a very posi-
trends over time of any financial statement line items. For exam- tive indication that net income rose at a much higher rate (12%)
FINANCIAL STATEMENT ANALYSIS METHODS
ple, managers often want to track changes on the income state- than did net sales (8%). When you use horizontal analysis over
ment in net sales and net income over time. If, in a particular time, you can spot positive or negative trends.
reporting period, net sales increased 8% and net income rose 12%
over the prior year, you can learn much information from this.
Example
Income Statement
(dollars in thousands)
3
3
Equation
Exploring Variance Analysis
better returns. Negative variances, and lower returns, occur
when the opposite trends occur.
Variance = standard or budgeted amount − actual amount
Managers use variance analysis to track cost and revenue When to use indicator: Managers use variance analysis to
performance over time. This specific type of horizontal compare performance to standards or budgets over time.
analysis compares items to the budget instead of comparing This tool helps the manager keep on top of company expen-
FINANCIAL STATEMENT ANALYSIS METHODS
items to performance in previous years (see horizontal ditures and incomes by indicating how these items compare
analysis, tip #2). Positive variances occur when actual costs to forecasted standards. When the manager notices sizable
are lower than budgeted costs or when actual revenue variances, he can use the signal to determine if the causes of
exceeds anticipated revenue. Positive variances thus yield the variance are justified or not.
Example
4
4 Studying Ratio Analysis
Note: Argo, Inc.'s values have been added to the fields in this document.
If you would like to enter the values yourself, or if you would like to use your own values,
press the Reset button. Some calculations bring forward values from previous pages.
Please start at the beginning when entering your own values.
Reset
5
CHAPTER TWO
Income Analysis
This chapter details a number of ratios that describe income levels and the quality of income
earned. These ratios include income levels such as gross profit, operations income, pretax profit,
and net income. When you analyze income levels at each of these discrete levels, you can more
readily understand and identify company performance and areas of concern. For example, when
gross profit is low relative to that in similar industries, manufacturing expenses may be out of
control or sales revenues may be too low to support the manufacturing infrastructure. High
gross profit with low pretax income may indicate that expenses are out of line in sales, adminis-
tration, or research and development.
Income quality is concerned not only with the magnitude of income, but with how sustainable
the income stream is and what the levels of return are relative to the investment size. Income
quality tends to increase as income returns become larger relative to the capital investments a
company makes. Income quality also tends to increase when it is long term rather than coming
from one-time orders and when it results from company operations rather than other sources
such as investments or financing.
6
5
Equation
Determining Gross Profit
expenditures. Net sales is total sales minus provisions for profit and increase the total amount of gross profit. For
returns, discounts, damaged goods, and bad debt. Gross example, grocers can be profitable with lower gross prof-
profit is also known as gross margin. its per item because they sell a very large number of items;
however, a manufacturer of an expensive item such as a
When to use indicator: Managers and investors use gross supercomputer must make a large gross profit since they
profit to determine the profit potential of a business, prod- will sell a relatively small number.
uct, or service. Because gross profit includes direct costs
only, it indicates the amount of margin between the price Ways to improve the indicator: Managers can increase gross
of a product and the cost to produce the product. This profits by increasing the volume and/or price of the goods sold
margin does not include all the other expenses required to and by reducing the costs necessary to produce the goods. Vol-
run a company such as selling and product development ume increases not only generate larger gross profits as net sales
costs. When you compare gross profit to the same number increase, but they can provide reduced costs of goods. This is
in previous years or periods, you can spot positive or neg- because operational efficiencies typically increase with increas-
ative trends in product pricing and the cost of goods sold. ing volume.
Sector Mid to large cap Gross Small to mid cap Gross Micro to small cap Gross
Profit Profit Profit
7
Price increases must be acceptable to the marketplace. decrease the cost of goods sold and increase gross profit in
Inflationary effects aside, you typically cannot change prices the short run, but the market will probably reject the prod-
at will without making commensurate changes to the goods uct and leave you with drastically lower sales volumes and
or services offered. You should not increases prices to the gross profit in the long run.
point that reductions in sales more than offset the positive
effects of the price increases and cause a decrease in net
income. Example
You can reduce the cost of goods sold by purchasing less
expensive materials, increasing production efficiency, using Gross profit = net sales − cost of goods sold
cheaper labor, and decreasing overhead. Typically you
should not reduce the cost of goods sold to the detriment Net sales = 85,420
of the goods offered. For example, charging more for a Cost of goods sold = 54,212
product that uses cheaper, less reliable raw materials will
Gross profit = 85,420 − 54,212 = 31,208
31,208
Gross profit = 85,420
net sales − cost of
54,212
goods sold
INCOME ANALYSIS
8
6
Equation
Examining the Gross Profit Ratio
revenue that remains after you deduct all operations
expenses. As gross profit ratios become higher and
Gross profit ratio = gross profit / net sales approach the value of one, profit potential increases. For
where example, a gross profit ratio of 0.36 indicates that, for
every dollar of net sales revenue, 36¢ of gross profit
Gross profit = net sales − cost of goods sold remains after deducting all direct expenses.
You can use the gross profit ratio to find out the size of Ways to improve the indicator: You can increase gross
the margin between your company’s revenue and the direct profit ratios by increasing the volume and/or price of the
costs associated with producing your product or service. goods sold and by reducing the costs necessary to produce
Direct costs, also known as the cost of goods sold, include the goods. Volume increases not only generate larger gross
only the costs that are required directly to produce the profits as net sales increase. They can also reduce the costs
product or service (i.e., raw materials, direct labor, and of goods sold because operational efficiencies typically
direct overhead). The gross profit ratio is also known as the
INCOME ANALYSIS
Sector Mid to large cap Gross Small to mid cap Gross Micro to small cap Gross
9
will decrease the cost of goods sold and increase gross prof- Example
it in the short run. However, the market is likely to reject
the product and cause drastically lower sales volumes and Gross profit ratio = gross profit / net sales
gross profit in the long run. Gross profit = net sales − cost of goods sold
= 85,420 − 54,212 = 31,208
Gross36.53%
profit ratio = 31,208
gross profit / 85,420
net sales
Gross profit ratio = gross profit / net sales
31,208
Gross profit = 85,420
net sales − cost of54,212
goods sold
INCOME ANALYSIS
10
7
Equation
Calculating Income from Operations
and profit. Positive indications include high and preferably
increasing operations income over a number of reporting
Income from operations = Net sales − cost of goods sold − periods. Companies can survive with no operations
R&D expenses − selling expenses − G&A expenses −
income by taking on debt or by selling company equity.
depreciation − amortization − other operational expenses
These actions are necessary in many start-up, high growth,
Income from operations is the amount of income a com- and turn-around companies. However, all for-profit com-
pany generates after it accounts for all direct and indirect panies must ultimately provide positive operations income
operational costs. These costs include only those expenses to remain solvent.
which relate to the product or service. Do not include non-
Ways to improve the indicator: You can improve income
operational expenses such as income on noncompany
from operations by selling more products or services,
investments and income taxes. Direct costs, also known as
increasing the prices of the products or services, or reduc-
the cost of goods sold, include the costs that are required to
ing the direct or indirect costs of producing the goods or
produce the product or service (i.e., raw materials, direct
INCOME ANALYSIS
services.
labor, and direct overhead). Indirect costs include all other
Volume increases may generate larger operational profits
expenses a company must incur in order to deliver a prod-
as net sales increase. They can also reduce costs of goods
uct or service to the customer (i.e., product development,
sold because operational efficiencies typically increase as
selling, advertising, accounting, office rent, and utilities).
volume increases.
When to use indicator: Managers and investors use this Price increases must be acceptable to the marketplace, and
indicator to determine the profit potential from operations inflationary effects aside, you typically should not change
and to examine whether profit trends are positive or nega- prices at will without making commensurate changes to the
tive. Since this ratio takes all operational costs into goods or services offered. Generally, you should not
account, it furnishes a broad picture of the overall health increase prices to the point that volume reductions more
of the business. than offset the positive effects of the price increases and
cause a decrease in net income.
Meaning of result: To survive, companies must ultimately You can reduce the direct costs, or cost of goods sold, by
deliver positive operations income. Operations are the purchasing less expensive materials, increasing production
heart of a business and, in the long run, must provide cash efficiency, using cheaper labor, and decreasing overhead.
Sector Mid to large cap Income from Small to mid cap Income from Micro to small cap Income from
Operations Operations Operations
11
Typically you should not reduce the cost of goods sold to Example
the detriment of the goods offered. For example, if you
charge more for a product that uses cheaper, less reliable Income from operations = net sales − cost of goods sold −
R&D expenses − selling expenses − G&A expenses −
raw materials, you will increase your gross profit; however, depreciation − amortization − other operational expenses
the market will probably reject the product and cause dras-
tically lower sales volumes. Net sales = 85,420
At first glance, it appears that you can reduce indirect Cost of goods sold = 54,212
costs by cutting back on R&D (research and development), R&D expenses = 4,578
selling, G&A (general and administrative), and/or deprecia- Selling and G&A expenses = 15,993
tion expenses. While this is usually true in the short term, Depreciation & amortization = 1,204
you can suffer catastrophic long-term results if you reduce Other operational expenses = 0
expenses such as advertising or product development. In Income from operations = 85,420 − 54,212 − 4,578 −
fact, it is not unusual to increase such expenditures to gen- 15,993 − 1,204 − 0 = 9,433
erate larger future sales and increase operations profit in the
long run. Managers should seek to streamline costs where
true fat exists and to maintain or increase expenses in areas
in which they can realize longer term returns.
INCOME ANALYSIS
12
8
Equation
Examining the
Operations Income Ratio
over time, you can spot trends in product pricing, direct
costs, and indirect costs. The ratio varies between zero and
Operations income ratio = income from operations / one, with higher ratios indicating higher, or more prof-
net sales
itable operations margins.
or Meaning of result: You can use operations income profit
ratios to determine quickly the profitability of a compa-
Operations income ratio = (net sales revenue − cost of goods
sold − R&D expenses − selling expenses − G&A expenses − ny’s operations. The ratio indicates the percentage of every
depreciation − amortization − other operational expenses) / dollar of sales revenue that remains after you deduct all
net sales operations expenses. For example, an operations income
ratio of 0.11 indicates that 11¢ remains as operations
The operations income ratio indicates the margin between profit for every dollar of net sales revenue.
the revenue a company generates and all of the direct and To survive, companies must ultimately deliver positive
INCOME ANALYSIS
indirect costs associated with producing the product or ser- operations income ratios. Operations are the heart of a
vice. The ratio accounts for only those expenses which business and, in the long run, must provide cash and profit.
relate to the product or service. Do not include nonopera- Positive indications include high and preferably increasing
tional expenses such as income on noncompany investments operations income ratios over a number of reporting peri-
and income taxes. Direct costs, also known as the cost of ods. Companies can survive with no operations income by
goods sold, include the costs required to produce the prod- taking on debt or selling company equity. Many start-up,
uct or service (i.e., raw materials, direct labor, and direct high growth, or turn-around companies require these mea-
overhead). Indirect costs include all other expenses a com- sures. However, all companies must ultimately provide posi-
pany incurs in delivering a product or service to the cus- tive operations income ratios to remain solvent.
tomer (i.e., product development, selling, advertising,
accounting, office rent, and utilities). Ways to improve the indicator: You can improve the oper-
ations income ratio by selling more products or services,
When to use indicator: Managers and investors use this increasing the prices of the products or services, or reduc-
ratio to ascertain the operational profit potential for a ing the direct and indirect costs of producing the goods or
business, product, or service. By comparing this indicator services.
Sector Mid to large cap Operations Small to mid cap Operations Micro to small cap Operations
Income Ratio Income Ratio Income Ratio
13
Volume increases may generate larger operational profits ing or product development can be catastrophic. In fact, it is
as net sales increase; they can also reduce the cost of goods not unusual to increase such expenditures to generate larger
sold since operational efficiencies typically increase with future sales and increase operations profit in the long run.
increasing volume. Managers should seek to streamline costs where true fat
The marketplace must accept price increases, so, inflation- exists and to maintain or increase expenses in areas in
ary effects aside, typically you can’t change prices at will which they can realize longer term returns.
without making commensurate changes to the goods or ser-
vices offered. Generally you should not increase prices to Example
the point that reductions in sales more than offset the posi-
Operations income ratio =
tive effects of the price increases and cause a decrease in net income from operations / netsales
income.
You can reduce the direct costs, or cost of goods sold, by Income from operations = net sales − cost of goods sold −
purchasing less expensive materials, increasing production R&D expenses − selling expenses − G&A expenses −
efficiency, using cheaper labor, and decreasing overhead. depreciation − amortization − other operational expenses
You should not generally reduce the cost of goods sold to
Net sales = 85,420
the detriment of the goods offered. For example, by charg- Cost of goods sold = 54,212
ing more for a product that uses cheaper, less reliable raw R&D expenses = 4,578
materials, you will increase your gross profit; however, the Selling and G&A expenses = 15,993
INCOME ANALYSIS
market may reject the product and drastically lower sales Depreciation & amortization = 1,204
volumes may result. Other operational expenses = 0
At first glance, it appears that you can reduce indirect
costs by cutting back on R&D, selling, G&A, and/or depre- Income from operations = 85,420 − 54,212 − 4,578 −
15,993 − 1,204 − 0 = 9,433
ciation expenses. While this is usually true in the short term,
the long-term effects of reducing expenses such as advertis- Operations income ratio = 9,433 / 85,420 = 0.110 = 11.0%
14
9
Equation
Measuring Pretax Profit
Meaning of result: Companies must ultimately deliver pos-
itive pretax profit. Pretax profit is a measure of a compa-
Pretax profit = income from operations + ny’s profit-generating capabilities. Positive indications
nonoperating income − all other expenses other than taxes
include high and preferably increasing profit over a num-
or ber of reporting periods. Companies can survive with no
pretax profit by taking on debt or selling company equity.
Pretax profit = net sales − cost of goods sold − R&D This is required in many start-up, high growth, or turn-
expenses − selling expenses − G&A expenses − depreciation around companies. However, all for-profit companies,
− amortization − other operational expenses + non-operating
income − all other expenses other than taxes including companies in these categories, must ultimately
provide positive pretax profit income to remain solvent.
Pretax profit is the amount of income a company gener-
ates after accounting for all direct operational expenses, Ways to improve the indicator: You can improve pretax
indirect operational expenses, and nonoperational expenses profit by selling more products or services, increasing
INCOME ANALYSIS
and income. Direct costs, also known as the cost of goods prices, reducing the direct and indirect costs required to
sold, include the costs required to produce a product or ser- produce goods or services, increasing nonoperational prof-
vice (i.e., raw materials, direct labor, and direct overhead). it, and reducing nonoperational expenses.
Indirect costs include all other expenses a company must Volume increases may generate larger pretax profits as net
incur in delivering a product or service to the customer (i.e., sales increase. They can also reduce the costs of goods sold
product development, selling, advertising, accounting, office since operational efficiencies typically increase with increas-
rent, and utilities). Nonoperational items include expenses ing volume.
for interest and income from nonoperating activities. The marketplace must accept price increases. Inflationary
effects aside, typically you can’t change them at will without
When to use indicator: Managers and investors use this making commensurate changes to the goods or services
indicator to determine a company’s overall pretax profit offered. Generally, you should not increase prices to the
and evaluate present-period performance. For example, point that reductions in sales more than offset the positive
prior-period tax credits can reduce present-period tax effects of the price increase and cause a decrease in net
expenses and inflate present-period net income results. income.
Sector Mid to large cap Pretax Small to mid cap Pretax Micro to small cap Pretax
Profit Profit Profit
Retail Wal-Mart Stores 5,719,000 Bed Bath & Beyond 121,398 TCBY Enterprises 13,556
Food McDonald’s 2,407,300 Applebee’s Int’l 71,801 Garden Fresh Restaurant 6,435
Finance Morgan-Stanley Dean Witter 4,274,000 Franklin Resources 615,713 AmeriTrade Holding 21,425
Healthcare Columbia/HCA Healthcare 538,000 Novacare 66,801 National Home Health Care 3,134
Service Manpower 249,208 Air & Water Technologies –51,313 Market Facts 9,535
15
You can reduce the direct costs, or cost of goods sold, by being in business, it is often best to resist the temptation to
purchasing less expensive materials, increasing production seek higher income yields with higher risk investments.
efficiency, using cheaper labor, and decreasing overhead. Solid financial performance will allow your company to
Generally, do not reduce the cost of goods sold to the detri- qualify for lower interest rates on debt.
ment of the goods offered. For example, if you charge more
for a product that uses cheaper, less reliable raw materials, Example
you will increase your gross profit; however, the market
Pretax profit = net sales − cost of goods sold − R&D
may reject the product and you may end up with drastically
expenses − selling expenses − G&A expenses − depreciation
lower sales. − amortization − other operational expenses + non-operating
At first glance, it appears that you can reduce indirect income − all other expenses other than taxes
costs by cutting back on R&D, selling, G&A, and/or depre-
ciation expenses. While this is usually true in the short term, Net sales = 85,420
the long-term effects of reducing expenses such as advertis- Cost of goods sold = 54,212
ing or product development can be catastrophic. In fact, it is R&D expenses = 4,578
not unusual to increase such expenditures to generate larger Selling and G&A expenses = 15,993
future sales and to increase operations profit in the long Depreciation & amortization = 1,204
run. Managers should seek to streamline costs where true Other operational expenses = 0
fat exists and to maintain or increase expenses in areas in Nonoperating income = 455
INCOME ANALYSIS
which they can realize longer term returns. Interest expense = 784
Increases in nonoperational income and decreases in inter-
Pretax profit = 85,420 − 54,212 − 4,578 − 15,993 − 1,204 −
est expenses will also increase pretax profit. Since nonoper-
0 + 455 − 784 = 9,104
ational income is not typically part of a firm’s reason for
16
10
Equation
Evaluating the
Pretax Profit Ratio
ing and operational and nonoperational costs and
incomes. The ratio varies between zero and one, with
Pretax profit ratio = pretax profit / net sales higher ratios indicating higher, or more profitable, pretax
or profit margins.
Pretax profit ratio = (net sales − cost of goods sold − R&D Meaning of result: You can use pretax profit ratios to deter-
expenses − selling expenses − G&A expenses − depreciation mine the pretax profitability of a product or company. The
− amortization − other operational expenses + nonoperating ratio indicates the percentage of every dollar of sales revenue
income − all other expenses other than taxes) / net sales that remains after you have accounted for all operational
and nonoperational expenses, except such items as taxes,
The pretax profit ratio indicates the margin between the gains/losses on investments, and extraordinary items. For
revenue a company generates and all of the costs—except- example, a pretax profit ratio of 0.107 indicates that a little
ing such nonoperational items as taxes, gains/losses on
less than 11¢ remains as pretax profit for every dollar of net
investments, and extraordinary items—associated with pro-
INCOME ANALYSIS
sales revenue.
ducing the product or service. Direct costs, also known as
Companies must ultimately deliver positive pretax income
the cost of goods sold, include costs required to produce the
product or service (i.e., raw materials, direct labor, and ratios. The pretax profit ratio indicates a company’s profit-
direct overhead). Indirect costs include all other expenses a generating capabilities. Positive indications include high and
company must incur in delivering a product or service to preferably increasing profit over a number of reporting peri-
the customer (i.e., product development, selling, advertising, ods. Companies can survive with a negative pretax profit
accounting, office rent, and utilities). Nonoperational items ratio by taking on debt or selling company equity. This is
include expenses for interest and income from non-operat- required in many start-up, high growth, or turn-around
ing activities. companies. However, all for-profit companies must ulti-
mately provide positive pretax profit income to remain sol-
When to use indicator: Managers and investors use the vent.
pretax profit ratio to determine a company’s overall pre-
tax profit potential. By evaluating pretax profits, they can Ways to improve the indicator: You can improve pretax
weigh present-period performance. For example, prior- profit ratios by selling more products or services, increas-
period tax credits can reduce present-period tax expenses ing prices, reducing the direct and indirect costs of pro-
and inflate present-period net income results. Comparing ducing your goods or service, increasing nonoperational
this indicator over time can show trends in product pric- profit, or reducing nonoperational expenses.
Sector Mid to large cap Pretax Small to mid cap Pretax Micro to small cap Pretax
Profit Ratio Profit Ratio Profit Ratio
17
Volume increases may generate larger pretax profits as net Example
sales increase; they can also reduce the cost of goods sold
since operational efficiencies typically increase with increas- Pretax profit ratio = pretax profit / net sales
ing volume. or
The marketplace must accept price increases, so, inflation-
ary effects aside, you typically should not change prices at Pretax profit ratio = (net sales − cost of goods sold − R&D
will without making commensurate changes to the goods or expenses − selling expenses − G&A expenses − depreciation
services offered. Generally you should not increase prices to − amortization − other operational expenses + nonoperating
the point that reductions in sales more than offset the posi- income − all other expenses other than taxes) / net sales
tive effects of the price increase and cause a decrease in net Net sales = 85,420
income. Cost of goods sold = 54,212
You can reduce the direct costs, or cost of goods sold, by R&D expenses = 4,578
purchasing less expensive materials, increasing production Selling and G&A expenses = 15,993
efficiency, using cheaper labor, or decreasing overhead. Gen- Depreciation & amortization = 1,204
erally, do not reduce the cost of goods sold to the detriment Other operational expenses = 0
of the goods offered. For example, if you charge more for a Non-operating income = 455
product that uses cheaper, less reliable raw materials you Interest expense = 784
will increase your gross profit, but the market may reject Pretax profit = 85,420 − 54,212 − 4,578 − 15,993 − 1,204 −
INCOME ANALYSIS
the product and you may end up with drastically lower 0 + 455 − 784 = 9,104
sales volumes.
At first glance, it appears that you can reduce indirect Pretax profit ratio = 9,104 / 85,420 = 0.1066 = 10.66%
costs by cutting back on R&D, selling, G&A, and/or depre-
ciation expenses. While this is usually true in the short term,
the long-term effects of reducing expenses such as advertis- Net sales = 85,420
ing or product development can be catastrophic. In fact, it is
not unusual to increase such expenditures to generate larger Cost of goods sold = 54,212
future sales and increase operations profit in the long run. R&D expenses = 4,578
Managers should seek to streamline costs where true fat
exists and to maintain or increase expenses in areas in Selling and G&A expenses = 15,993
which they can realize longer term returns. Depreciation & amortization = 1,204
Increases in nonoperational income and decreases in inter-
est expenses can also increase pretax profit. As nonopera- Other operational expenses = 0
tional income accounts are not typically part of a firm’s rea- Non-operating income = 455
son for being in business, it is often best to resist the
temptation to seek higher income yields with higher risk Interest expense = 784
investments. Solid financial performance can help you
obtain lower interest rates for debts.
Pretax profit ratio
10.66% = pretax
9,104profit / net 85,420
sales
Pretax profit ratio = pretax profit / net sales
18
11
Equation
Calculating Net Income
by nonoperating activities. Extraordinary items include
expenses or income from non-typical events such as the pur-
Net income = pretax profit − taxes + extraordinary items chase of another company or sale of substantial company
assets.
or
When to use indicator: Managers and investors use this
Net income = net sales − cost of goods sold − R&D indicator to determine a company’s profit potential after
expenses − selling expenses − G&A expenses − they consider all sources of income and expenses. This fig-
depreciation − amortization − other operational expenses ure gives a feel for the overall health of a company. Besides
+ nonoperating income − all other expenses other than sales revenue, it is one of the most commonly reported indi-
taxes − taxes + extraordinary items cators.
Net income is the amount of money remaining after you Meaning of result: Companies must ultimately deliver posi-
account for all sources of income and all expenses. It is tive net income. Net income is a measure of company’s
INCOME ANALYSIS
called the bottom line because it literally exists on the last profit-generating capabilities. Positive indications include
line of the income statement. Income sources include net high and preferably increasing net income over a number of
sales, nonoperational sources, and gains on investments. reporting periods. Companies can survive with negative net
Expenses include direct and indirect expenses from opera- income by taking on debt or selling company equity. Many
tions and nonoperational expenses such as interest, losses start-up, high growth, or turn-around companies must use
on investments, and extraordinary items. these measures.
Direct costs, also known as the cost of goods sold, include However, all for-profit companies, including those in these
the costs required to produce your product or service (i.e., categories, must ultimately provide positive net income to
raw materials, direct labor, and direct overhead). Indirect remain solvent.
costs include all other expenses a company incurs in deliver-
ing a product or service to the customer (i.e., product devel- Ways to improve the indicator: You can improve net income
opment, selling, advertising, accounting, office rent, and by selling more products or services, increasing prices, reduc-
utilities). Nonoperational items include expenses for inter- ing the direct and indirect costs of producing your goods or
est, taxes, and investment losses. Nonoperational income- service, increasing nonoperational profit, or reducing nonop-
related items include investment gains and income provided erational expenses.
Sector Mid to large cap Net Small to mid cap Net Micro to small cap Net
Income Income Income
19
Volume increases may generate larger net income as net Example
sales increase, and they can reduce the costs of goods sold
since operational efficiencies typically increase with increas- Net income = net sales − cost of goods sold − R&D expenses
− selling expenses − G&A expenses − depreciation −
ing volume. amortization − other operational expenses + non-operating
The market must accept price increases, so, inflationary income − all other expenses other than taxes − taxes +
effects aside, you typically can’t change prices at will with- extraordinary items
out making commensurate changes to the goods or services
offered. Generally you should not increase prices to the
point that reductions in sales more than offset the positive Net sales = 85,420
effects of the increase and cause a decrease in net income. Cost of goods sold = 54,212
R&D expenses = 4,578
You can reduce the direct costs, or cost of goods sold, by
Selling and G&A expenses = 15,993
purchasing less expensive materials, increasing production Depreciation & amortization = 1,204
efficiency, using cheaper labor, or decreasing overhead. Gen- Other operational expenses = 0
erally do not reduce the cost of goods sold to the detriment Non-operating income = 455
of the goods offered. For example, if you charge more for a Interest expense = 784
product that uses cheaper, less reliable raw materials, you Income taxes = 3,529
will increase your gross profit; however, the market may Extraordinary items = −592
reject the product and drastically lower sales volumes can
INCOME ANALYSIS
result.
At first glance, it appears that you can reduce indirect Net income = 85,420 − 54,212 − 4,578 −
costs by cutting back on R&D, selling, G&A, and/or depre- 15,993 − 1,204 − 0 + 455 − 784 − 3,529 + −592 =
ciation expenses. While this is usually true in the short term, 4,983
the long-term effects of reducing expenses such as advertis-
ing or product development can be catastrophic. In fact, it is
Net sales = 85,420
not unusual to increase such expenditures to generate larger
future sales and increase operations profit in the long run. Cost of goods sold = 54,212
Managers should seek to streamline costs where true fat 4,578
R&D expenses =
exists and to maintain or increase expenses in areas in
which they can realize longer term returns. Selling and G&A expenses = 15,993
Increases in nonoperational income and decreases in inter- 1,204
Depreciation & amortization =
est expenses will also increase pretax profit. As nonopera-
tional income accounts are not typically part of a firm’s rea- Other operational expenses = 0
son for being in business, it is often best to resist the 455
Non-operating income =
temptation to seek higher income yields with higher risk
investments. Solid financial performance can make lower Interest expense = 784
interest rates available to you. 3,529
Income taxes =
Extraordinary items = 592
Net income = 4,983
20
12
Equation
Comparing
Net Income to Sales
When to use indicator: Managers and investors use this
ratio to determine a company’s overall profit potential. You
Net income to sales = net income / net sales can understand present-period performance by evaluating
the net-income-to-sales ratio. When you compare this indi-
or cator over time, you can spot trends in product pricing and
operational and nonoperations costs and incomes. The ratio
Net income to sales = (net sales − cost of goods sold −
varies between zero and one, with higher ratios indicating
R&D expenses − selling expenses − G&A expenses −
higher, or more profitable, net income margins.
depreciation − amortization − other operational expenses
+ nonoperating income − all other expenses other than Meaning of result: You can use net income ratios to deter-
taxes − taxes + extraordinary items) / net sales mine the profitability of a product or company. The ratio
indicates the percentage of every dollar of sales revenue that
The net income-to-sales ratio indicates the margin
remains after you account for all expenses and other
between the revenues a company generates and all of the
sources of revenue. For example, a net income ratio of
INCOME ANALYSIS
Sector Mid to large cap Net Income Small to mid cap Net Income Micro to small cap Net Income
to Sales to Sales to Sales
21
You can reduce the direct costs, or cost of goods sold, by Net sales = 85,420
purchasing less expensive materials, increasing production Cost of goods sold = 54,212
efficiency, using cheaper labor, or decreasing overhead. Gen- R&D expenses = 4,578
erally do not reduce the cost of goods sold to the detriment Selling and G&A expenses = 15,993
of the goods offered. For example, if you charge more for a Depreciation & amortization = 1,204
product that uses cheaper, less reliable raw materials you Other operational expenses = 0
will increase your gross profit; however, the market may Nonoperating income = 455
reject the product and drastically lower sales volumes may Interest expense = 784
result. Income taxes = 3,529
At first glance, it appears that you can reduce indirect Extraordinary items = −592
costs by cutting back on R&D, selling, G&A, and/or depre-
ciation expenses. While this is usually true in the short term,
the long-term effects of reducing expenses such as advertis- Net income = 85,420 − 54,212 − 4,578 − 15,993 − 1,204 − 0
ing or product development can be catastrophic. In fact, it is + 455 − 784 − 3,529 + − 592 = 4,983
not unusual to increase such expenditures to generate larger
future sales and increase operations profit in the long run. Net income to sales = 4,983 / 85,420 = 0.0583 = 5.83%
Managers should seek to streamline costs where true fat
exists, and to maintain or increase expenses in areas in
INCOME ANALYSIS
22
13
Equation
Finding the Percentage of Net Sales and Net
Income that are Domestic
Meaning of result: Managers often want to ascertain the
effect of strategic actions on both domestic and foreign
Percentage of domestic net sales = net domestic sales / income and sales results. Knowing the amount of domestic
total net sales
revenue and profit is essential in monitoring sales results
and and planning appropriate future strategies. It is typically
beneficial to break down domestic sales and profits even
Percentage of domestic net income = net domestic income / further into more refined regions, such as by sales territory
total net income or state.
The percentage of net domestic sales and income indicates Example
the degree to which a company conducts its business
domestically. Percentage of domestic net sales = net domestic sales / total
net sales
When to use indicator: Managers and investors can use
INCOME ANALYSIS
this indicator to determine the size and, when compared to Net domestic sales = 62,151
Total net sales = 85,420
past performance periods, the rate of change of a compa-
ny’s domestic sales and income. Percentage of domestic net sales = 62,151 / 85,420 = .728 = 72.8%
23
14 Finding the Percentage of Sales and
Net Income that are Foreign
24
15
Equation
Determining the
Cost of Capital
Ways to improve the indicator: You can reduce the cost of
capital by lowering your debt and equity interest rates. In
Cost of capital = (equity / [debt + equity]) × equity interest many cases, you can reduce your debt interest rates with
rate + (debt / [debt + equity]) × debt interest rate ×
increasingly sound financial performance. Signs of perfor-
(1 - tax rate)
mance improvements are increasingly high net incomes,
The cost of capital is a weighted average of the interest a cash flows, and debt coverage and increasingly lower
company must pay on both its equity and its debt. Although debt-to-equity ratios. You can reduce equity interest rates
a company doesn’t physically pay interest to shareholders with positive, consistent, nonvolatile rates of return.
for equity, that interest is considered a real cost because
Example
shareholders expect a return on their investment. The equity
interest rate is also called the required equity dividend. Cost of capital = (equity / [debt + equity]) × equity interest
Interest on a company’s debt is also a component of the cost rate + (debt / [debt + equity]) × debt interest rate ×
of capital, and, as shown in the formula above, it is tax (1 - tax rate)
INCOME ANALYSIS
deductible.
Equity = market value of equity = shares outstanding × share
When to use indicator: The cost of capital allows man- price = 3,600,000 × 22.5 = $81,000,000 = $81,000
agers to determine the overall costs associated with financ- thousands
ing an operation such as a project or a new division. You Debt = interest-bearing debt = notes payable + current
can determine other indicators such as economic value portion of long-term debt and capital leases + long-
added, EVA (tip #16), and residual income (tip #18) when term debt = 1,000 + 650 + 12,513 = $14,163
you know the cost of capital.
Equity interest rate = risk-free, inflation-adjusted interest rate
Meaning of result: The cost of capital indicates a compa- (long-term government bond) + risk
ny’s total funding costs. For example, consider a company premium = 7% + 6.9% = 13.9%
in a 40% tax bracket which has $5 million in equity capi-
Debt interest rate = 8%
tal at 14% and $3.2 million in debt capital at 9% interest.
The cost of capital is 10.6% as determined by the follow- Tax rate = 40%
ing:
Cost of capital = ($5,000,000/[$5,000,000 + $3,200,000]) × Cost of capital = (81,000 / [14,163 + 81,000]) × .139 +
0.14 + ($3,200,000/[$5,000,000 + $3,200,000]) × 0.09 × (1 (14,163 / [14,163 + 81,000]) × .08 × (1 − 0.40) = 0.1255 =
− 0.40) = 0.106 = 10.6% 12.55%
25
16
Equation
Measuring Economic Value
Added (EVA)
tal is 9.5%. The total cost of capital is the product of the total
cost and the cost of capital or $87,400 ($920,000 × .095). Fig-
EVA = after-tax operating profit − (cost of capital × ure the EVA by subtracting the total cost of capital from the
capital employed) operating profit. The result is $37,600 ($125,000 − $87,400).
Since the EVA is positive, the project is viable, unless the man-
Economic value added (EVA) is an overall profitability
ager could apply the money allocated to the project to another
indicator that considers the costs of conducting an opera-
project at no greater risk and, thereby, generate an even larger
tion when determining profitability. Operations add value
EVA. If, in this example, the cost of capital were increased to
only when they provide profit in excess of the cost of the
16%, then you should decline the project because it would cost
money required to capitalize the operation. The cost of cap-
$147,200, which is more than the $125,000 return.
ital is the weighted average of debt and equity financing (see
tip #15). Capital employed items include all factors which Ways to improve the indicator: There are many ways to
cost money and which a company requires to generate improve EVA. You can develop improved products or ser-
income such as property, machinery, floor space, and work- vices, enhance sales and marketing efforts to increase sales
INCOME ANALYSIS
27
18 Examining the Size of
Residual Income
Equation servative method to determine the viability of a project or
company.
Residual income =
net income − (cost of capital × capital employed) Meaning of result: Positive residual income values indicate
successful projects and companies. A company adds value
Residual income indicates overall profitability by consid- only when profit is left over after the company pays all
ering the costs of conducting an operation when determin- project or company expenses. It is possible to show posi-
ing profitability. Operations add value only when they pro- tive net income even with an unsuccessful project or com-
vide net income over the cost of the money required to pany. This is not so with residual income; since residual
capitalize the operation. The cost of capital is the weighted income considers all costs, it is positive only when opera-
average of debt and equity financing (see tip #15). Capital tions are successful.
employed items include all factors which cost money and For example, assume a given project yields an annual net
INCOME ANALYSIS
are necessary for a company to generate income such as income of $125,000. Let’s also assume that the total project
property, machinery, floor space, and working capital. cost is $920,000 and the company’s cost of capital is 9.5%.
The total cost of capital is the product of the total cost and
When to use indicator: Similar to economic value added
the cost of capital or $87,400 ($920,000 × .095). Figure the
(EVA), you use residual income to determine the profit
residual income by subtracting the total cost of capital from
potential of a project, person, department or company. This
the net income. The result is $37,600 ($125,000 −
indicator shows whether you should initiate or scrub pro-
$87,400). Since there is a positive residual income, the pro-
jects, whether you should purchase or pass over companies,
ject is viable unless management could apply the money
and whether you should purchase or sell a company’s stock.
allocated to the project to another project that has no
Generally, positive residual income results are a good sign
greater risk and that generates an even larger residual
while negative results indicate that you should not consider income. If, in this example, the cost of capital were
or should terminate the project or company. As always, you increased to 16%, then management should decline the pro-
should weigh return potentials against risk levels. At times, ject because it would cost $147,200, an amount more than
less profitable operations are preferable when they offer sig- the $125,000 return.
nificantly reduced risks.
The difference between residual income and EVA is that Ways to improve the indicator: You can improve residual
residual income considers net income and EVA considers income in many ways. You can develop improved prod-
after-tax operating income. When you are determining net ucts or services, enhance sales and marketing efforts to
income, you must subtract current-year interest expenses increase sales volumes, and increase operations efficiencies
from operating income. To determine residual income, sub- to drive down product costs. You can also purchase or
tract the annual cost of assets from net income. In this man- develop highly profitable projects or companies, reduce
ner it is possible to count twice the interest required to pay the cost of capital, eliminate redundancy and waste
for assets—first to calculate net income and second to find throughout the company, ensure that all expensive capital-
the residual income. Thus, although EVA and residual income intensive equipment is fully utilized, or sell assets that
are similar, residual income can be a more stringent or con- don’t generate positive residual income.
28
Example
Capital employed = net of property, plant, and equipment + current assets − current liabilities =
10,018 + 44,135 − 12,032 = 42,121
Residual
303income = net 4,983
income − ( cost0.1255
of capital × capital employed )
42,121
Residual income = net income − ( cost of capital × capital employed )
INCOME ANALYSIS
29
19 Comparing Residual Income
to Net Income
Equation rently is earning income at a rate less than its cost of capi-
tal. If management cannot improve that level of perfor-
Residual income to net income = residual income / net income mance, the company and its shareholders would be better
off to dissolve the company and invest the proceeds so
Comparing residual income to net income indicates the that they can achieve acceptable rates of return.
degree to which residual income contributes to net income.
Ways to improve the indicator: There are many ways to
Residual income indicates overall profitability by consider-
improve the ratio of residual income to net income. A
ing the costs of conducting an operation when determining
company can develop improved products or services,
profitability. Operations add value only when they provide
enhance sales and marketing efforts to increase sales vol-
profit over the cost of the money required to capitalize the
umes, or increase operations efficiencies to drive down
operation.
product costs. Companies also can purchase or develop
INCOME ANALYSIS
When to use indicator: Managers and investors can use highly profitable projects or companies, reduce the cost of
this ratio to determine how much value a company or pro- capital, eliminate redundancy and waste throughout the
ject provides over minimum expected returns. company, ensure that all expensive capital-intensive equip-
ment is fully utilized, and sell assets that don’t generate
Meaning of result: Higher residual-income-to-net-income positive residual income.
ratios indicate better company performance. As this ratio
increases, a larger percentage of the company’s net income Example
exceeds the company’s cost of capital. The company is Residual income to net income = residual income / net income
breaking even with the cost of capital when this ratio is
zero. One of a company’s primary financial goals is to
maximize return to shareholders, and this ratio is highly Residual income = 507
indicative of such performance. When a company has a Net income = 5,793
positive net income and a negative residual income, this
Residual income to net income = −303 / 4,983 = −0.0608 = − 6.08%
ratio is less than one and indicates that the company cur-
30
20
Equation
Determining the Return
on Equity (ROE)
pany earns from an equity investment, the better. Share-
holders like to see very large ROEs. High ROEs typically
ROE = net income / shareholder equity drive up share prices since the company is efficiently earn-
ing money with its equity capital. The relationship
or between ROE and net income is apparent from the first
formula; however, that formula does not appreciably help
ROE = (net income/net sales) × (net sales/total assets) ×
(total assets/shareholder equity) management decide what to change to improve the ROE.
Although the second formula yields the identical result for
Also known as ROE = (profitability) × (asset turnover) × ROE, it helps the manager more than the first. In the sec-
(financial leverage) ond formula, ROE is equivalent to profitability multiplied
by asset turnover multiplied by financial leverage. By
or
increasing any of these factors, management can enhance
ROE = (net income / net sales) × (net sales / ROE.
INCOME ANALYSIS
Sector Mid to large cap Return on Small to mid cap Return on Micro to small cap Return on
Equity Equity Equity
31
When a company pays preferred dividends, ROE is some- purchased only to the extent that they contribute positive-
times expressed as the following: ly to net sales and net income. Financial leverage details
what percentage of a company’s total funding equity hold-
ROE = (net income − preferred dividends) / shareholder ers provide. The lower the equity position in relationship
equity.
to total funding, the higher the financial leverage and
Preferred dividends are subtracted from net income since ROE. A company can increase equity turnover by generat-
equity shareholders don’t realize a return from preferred ing larger net sales for a given amount of equity invest-
dividends. ment.
16.03%
ROE = net4,983
income 31,088equity
/ shareholder
ROE = net income / shareholder equity
32
21
Equation
Finding the
Return on Assets (ROA)
Although the second formula yields the identical result for
ROA, it helps the manager more. In the second formula,
ROA = net income / total assets ROA is equivalent to profitability multiplied by asset
or turnover. By increasing either one of these factors, manage-
ment can enhance ROA.
ROA = (net income / net sales) × (net sales / total assets) High ROA values generally indicate good performance
although management should understand the reasons for a
or higher or lower trending ROA. A company may not want
ROA = profitability × asset turnover higher ROAs if the company must assume too high a risk in
its product offering. Higher ROAs indicate that net profit
Return on assets (ROA) is a measure of the return a com- and/or asset turnover are increasing. Increases in net profit
pany generates on its assets. Total assets include all balance are good to the extent that a company has not sacrificed
sheet asset items such as cash, inventory, property, build- growth potential, sales levels, and quality. Increases in asset
INCOME ANALYSIS
ings, and machinery. turnover are good to the extent that sufficient resources
remain available to handle orders and optimize efficiencies.
When to use indicator: Managers and investors can use Instead of using net income for the return portion when
this ratio to determine how productively the company uses determining ROA, some managers and investors prefer to
its assets to generate income. use net income plus after-tax interest expense
Meaning of result: The first formula shows that, for a (net income + (interest × [1 − tax rate]).
given amount of total assets, ROA increases as net income
increases. In other words, the more income a company Some feel that adding back this interest expense to net
earns with its assets, the better. Managers and sharehold- income gives a more realistic indication of the return on
ers like to see very large ROAs. This typically indicates assets. However, because interest payments are often an
efficient management and use of company assets. The rela- integral part of many asset investments, others prefer to
tionship of ROA and net income is apparent from the first include such payments. Since both arguments are reason-
formula; however, it does not offer much help for manage- able, the latter may be the best choice since the formula is
ment in deciding what to change to improve the ROA. less complex.
Sector Mid to large cap Return on Small to mid cap Return on Micro to small cap Return on
Assets Assets Assets
33
Ways to improve the indicator: Increasing profitability Example
and/or asset turnover can increase ROA. Often a company
can maximize profitability by delivering a desired and prop- ROA = net income / total assets
erly priced product or service with controlled operating Net income = 4,983
costs. A company can maximize asset turnover by fully using Total assets = 56,268
company assets. Generating income requires assets but they
should be purchased only to the extent that they contribute ROA = 4,983 / 56,268 = 0.0886 = 8.86%
positively to net sales and net income.
8.86%
ROA = net income
4,983 / 56,268
total assets
ROA = net income / total assets
INCOME ANALYSIS
34
22 Determining the Return on
Invested Capital (ROIC)
Equation Current assets + long-term assets = current liabilities +
long-term liabilities + equity
ROIC = (net income) / (long-term liabilities + equity)
Sector Mid to large cap Return on Small to mid cap Return on Micro to small cap Return on
Invested Capital Invested Capital Invested Capital
35
higher or lower trending ROIC. Higher ROICs may not be Ways to improve the indicator: Increasing either profitability
desirable if the company must assume too high a risk in its or invested capital turnover can increase ROIC. A company
product offering. Higher ROICs indicate that net profit can maximize profitability by delivering a desired and proper-
and/or invested capital turnover are increasing. Increases in ly priced product or service with controlled operating costs. A
net profit are good to the extent that a company does not company can maximize invested capital turnover by fully uti-
sacrifice growth potential, sales levels, and quality. Increases lizing its working capital and long-term assets. Generation of
in invested capital turnover are good to the extent that the income requires assets, but they should be purchased only to
company still has sufficient assets (purchased with invested the extent that they contribute positively to net sales and net
capital) to optimize operations efficiencies. income.
Instead of using net income for the return portion when
determining ROIC, some managers and investors prefer to Example
use net income plus after-tax interest expense. ROIC = (net income) / (long-term liabilities + equity)
Net income + (interest × [1 − tax rate]). Net income = 4,983
Some feel that adding back this interest expense to net Long-term liabilities = Total liabilities − Current liabilities =
income gives a more realistic indication of the return on 25,180 − 12,032 = 13,148
invested capital. However, because interest payments are
Equity = 31,088
INCOME ANALYSIS
ROIC
11.26% = ( net4,983
income ) / ( long-term liabilities +
13,148 31,088equity )
ROIC = ( net income ) / ( long-term liabilities + equity )
36
23
Equation
Comparing Cash Provided by
Operations to Net Income
Note that the absolute value of net income is used for this
comparison. This gives a better indication of the relative
Operations cash flow to net income = sizes of operating cash flow and net income, particularly
cash flow from operations / j net income j
when either value is less than zero.
The ratio of cash flow from operations to net income
Ways to improve the indicator: You can increase opera-
measures the quality of a company’s income flow.
tional cash flow by providing properly priced, highly
When to use indicator: Managers and investors can use demanded products while simultaneously controlling
this indicator to determine the amount of net income that direct and indirect costs.
is generated by operations. Comparing this ratio over time
can show income quality trends. Example
Meaning of result: Higher quality companies tend to gen- Operations cash flow to net income =
cash flow from operations / j net income j
INCOME ANALYSIS
Sector Mid to large cap Operations Cash Flow Small to mid cap Operations Cash Flow Micro to small cap Operations Cash Flow
to Net Income to Net Income to Net Income
37
24
Equation
Comparing Short-Lived
Income to Net Income
Ways to improve the indicator: Pursuing business and cus-
tomer bases that are recurrent can decrease the ratio of
Short-lived income to net income = short-lived income / short-lived income to net income. Since repeat customers
net income
are generally the most cost-effective type of customer, you
This ratio indicates the percentage of net income that is can increase income quality by enlarging that customer
not repetitive. Short-lived income includes sources such as base. However, if your company is not fully using its pro-
one-time contracts and income generated from short-term duction capacity and revenue generated by a short-term
fads. Because this type of income is not repeatable, it is of a contract more than covers variable costs, the company
lower quality than normal, repetitive income. should accept short-term contracts.
Meaning of result: Lower ratios typically indicate higher Short-lived income = 172
quality income streams since this means that little net Net income = 4,983
income is of a short-term, or transitory, nature. Higher
quality income streams are preferable because they are Short-lived income to net income = 172 / 4,983 = 0.0345 = 3.45%
predictable and cost effective. Predictability allows man-
agement to efficiently allocate resources such as direct
labor, raw materials, and advertising.
38
25
Equation
Determining the Significance of
Short-Lived Sales to Net Sales
Ways to improve the indicator: Pursuing business and cus-
tomer bases that are recurrent can decrease the percentage
Short-lived sales to net sales = short-lived sales / net sales of short-lived sales compared to net sales. Pursue business
and customer bases that are recurrent. Since repeat cus-
This ratio indicates the percentage of net sales that are not
tomers are generally the most cost-effective type, you can
repetitive. Short-lived sales include sources such as one-time
increase sales income quality by enlarging that customer
contracts and sales generated from short-term fads. Because
base. However, if a company is not fully using its produc-
these types of sales are not repeatable, they are of a lower
tion capacity, and revenue generated by a short-term con-
quality than normal, repetitive sales.
tract more than covers variable costs, the company should
When to use indicator: Managers and investors can use accept short-term contracts.
this measure to determine the quality and seasonality of a
Example
firm’s sales.
Short-lived sales to net sales = short-lived sales / net sales
INCOME ANALYSIS
39
26
Equation
Comparing Cash Flow from
Operations to Total Cash Flow
in the long term to keep its doors open. Start-up and
growth companies may subsist for a time with low or neg-
Cash flow from operations to total cash flow = ative operating cash percentages by generating cash flow
operating cash flow / j total cash flow j
from other sources such as by issuing more stock for cash
Operating cash flow, one of the three sources of cash flow or by taking on additional debt.
(together with investing and financing cash flow), is one of Note that the absolute value of total cash flow is used for
the more important indicators of a company’s financial this comparison. This gives a better indication of the rela-
health. This indicator compares the relative sizes of operat- tive sizes of operating and total cash flow, particularly when
ing and total cash flow. either cash flow value is less than zero.
When to use indicator: Managers and investors can use Ways to improve the indicator: The main contributors to
this indicator to determine how big a part operations operating cash flow are often net income and depreciation.
plays in generating cash flow. The three manners in which Other factors which affect operating cash flow include
INCOME ANALYSIS
a company uses or generates cash are through its opera- changes in assets and liabilities such as inventory, accounts
tions, its investments, and its financing activities. It is most receivable, and accounts payable. Improving net income is
desirable to generate cash through operations since this is generally the most desirable method of improving operat-
the intent of forming an organization. Operating cash ing cash flow. You can improve net income by providing
flow is a direct indication of how much cash is generated properly priced, highly demanded products or services
from activities core to the company. Examples include a while maintaining good cost control. Operating cash flow
car manufacturer producing and selling cars or a restau- also increases as the depreciation account increases. How-
rant producing and selling meals. Investment activities ever, this amount is not simply found money. Income
include the purchase or sale of machinery for plant use statements count depreciation as an expense in the current
and the buying or selling of securities. Financing activities period. Since you previously purchased the depreciable
include the issuance or purchase of additional stock and item with cash, no additional cash is required in the cur-
the issuance or payment of additional debt. rent period, so you add that amount of money back to net
income to show a more accurate account of the current-
Meaning of result: High percentages of operating cash period operating cash flow. Depreciation expenses are, in
flows are what companies generally desire. Regardless of effect, accounting placeholders.
how promising the short- and long-term potential for any
given firm may be, it needs positive operating cash flows
Sector Mid to large cap Cash Flow from Operations Small to mid cap Cash Flow from Operations Micro to small cap Cash Flow from Operations
to Total Cash Flow to Total Cash Flow to Total Cash Flow
40
Example
Cash flow from operations to total cash flow = operating cash flow / |total cash flow|
Cash flow from operations to total cash flow = 4,820 / 1,017 = 4.739 = 474%
41
27
Equation
Comparsing Cash Flow from
Investing Activities to Total Cash Flow
subsidiaries, or securities investments. Periodically, such
sales may be good management moves. However, when
Cash flow from investing activities to total cash flow = investment cash flows remain high over the long run, the
investment-related cash flow / j total cash flow j
company may liquidate so many assets that it can no longer
When to use indicator: Managers and investors can use this remain a viable concern.
indicator to determine how big a part investment plays in gen- Note that the absolute value of total cash flow is used for
erating cash flow. Investment cash flow is often negative this comparison. This gives a better indication of the rela-
because firms usually purchase more investments than they tive sizes of investing and total cash flow, particularly when
sell. This is particularly true for growing companies that either cash flow value is less than zero.
require additional machinery or are acquiring smaller compa-
Ways to improve the indicator: Successful companies gener-
nies. The main items contained within the investing cash flow
ally invest cash wisely to ensure promising futures. When
group are purchases or sales of property, plant, and equip-
plants and equipment are no longer competitive, you should
ment; acquisitions or sales of subsidiaries; and purchases or
INCOME ANALYSIS
42
28
Equation
Comparing Cash Flow from
Financing Activities to Total Cash Flow
tive sizes of financing and total cash flow, particularly when
either cash flow value is less than zero.
Cash flow from financing activities to total cash flow =
finance-related cash flow / j total cash flow j Ways to improve the indicator: You should maintain finance-
When to use indicator: Managers and investors can use this related cash flow levels that ensure the most promising future
indicator to determine how big a part financing plays in gener- and that are commensurate with the state of the health of the
ating total cash flow. The main items within the finance cash industry in which the company operates and the maturity
flow group are issuance or purchases of equity (company level of the company. To improve this indicator, you can
stock), issuance or repayment of debt, and dividend payments. increase financial cash flow percentages for one company and
decrease them for another. For example, a growing company
Meaning of result: Low or negative percentages of finance- that has shown there is a substantial, and currently undersup-
related cash flow can indicate that the company is not tak- plied, market for its products or services could justify increas-
ing in cash flow in the form of additional debt, stock ing finance-related cash flow in order to invest in items that
INCOME ANALYSIS
issuance, or related activities. Negative finance cash flows will allow the company to serve the market better. Alterna-
typically arise when companies pay off debt or repurchase tively, reductions in finance-related cash flow ratios could jus-
equity. Mature, healthy companies often take these actions tify a company’s operating in a saturated market when it has
when productive operations sources supply their cash flow not identified any other manners or markets in which to
needs. invest its cash.
Higher percentages of finance-related cash flow can indi-
cate a company is raising money via financial means such as Example
issuing stock or taking on more debt. Start-up and growth
companies often require finance-related cash to fuel growth Cash flow from financing activities to total cash flow =
for items such as new equipment or larger inventories. finance-related cash flow / j total cash flow |
Another reason for needing cash from financial activities
might be that operations-related activities are not generating
Finance cash flow = 2,791
sufficient cash.
Total cash flow = 1,017
Note that the absolute value of total cash flow is used for Cash flow from financing activities to total cash flow =
this comparison. This gives a better indication of the rela- 2,791 / 1,017 = 2.744 = 274%
Cash flow from investing activities to total cash flow = investment-related
274.43% 2,791 cash flow / | total1,017
cash flow |
Cash flow from financial activities to total cash flow = financial-related cash flow / | total cash flow |
Sector Mid to large cap Cash Flow from Financing Small to mid cap Cash Flow from Financing Micro to small cap Cash Flow from Financing
Activities to Total Cash Flow Activities to Total Cash Flow Activities to Total Cash Flow
43
CHAPTER THREE
Investment
Analysis
44
29
Equation
Determining Revenues
Earned Per Share of Stock
able, a company with lower revenue per share and higher
profit margins may be more desirable than a company with
Revenues per share = net sales / weighted average of issued and higher revenues per share and lower profit margins. For
outstanding shares of common stock
example, suppose company A generates $100 per share in
Revenues per share describe the amount of net sales a revenues with a 15% profit margin, and company B gener-
company achieves per share of stock issued and outstand- ates $200 per share with a 6% profit margin. Company A
ing. All common stock held by shareholders is considered earns $15 net profit versus $12 net profit for company B.
issued and outstanding. Stock authorized but never sold by
Ways to improve the indicator: Increasing sales prices and vol-
the company as well as stock repurchased by the company
umes can directly increase net sales earned per share. You can
is not considered issued and outstanding; therefore, you do
do this by providing highly demanded products or services or
not use it in most per-share indicators.
by increasing sales efforts with additional promotions, adver-
INVESTMENT ANALYSIS
When to use indicator: Investors can use revenue per share tising, sales personnel, and new distribution channels.
rates to determine how effectively companies generate rev-
Companies can also improve their revenues per share by
enue. By comparing the revenue per share rate with historical
repurchasing outstanding stock. This will decrease the
and forecasted results, investors can determine if stocks are
amount of stock outstanding and, for a fixed amount of
appropriately priced.
revenue, inflate the revenue earned on a per-share basis. If
Meaning of result: Generally, managers prefer higher rev- a company sells additional stock, dilution occurs and the
enue per share values because they indicate the company is opposite effect results; revenue per share figures decline.
selling a larger dollar amount of products or services per
Example
share of stock. Most successful companies seek to generate
increasing sales revenues per share, especially companies that Revenues per share = net sales / weighted average of issued and
sell commodity-type, or low profit margin, products as do outstanding shares of common stock
supermarkets and service stations. Such companies typically
must generate a greater amount of revenue per share than Net sales = 85,420
Weighted average of issued and outstanding shares of
other types of companies since the income generated from
common stock = 3,600
each share of stock is lower than that of higher profit margin
companies. Although higher revenues per share are desir- Revenues per share = 85,420 / 3,600 = $23.73
Revenues per share =
$23.73 net_shares
85,420 / common_shares
3,600
Revenues per share = net sales / common shares
Sector Mid to large cap Revenues Small to mid cap Revenues Micro to small cap Revenues
Per Share Per Share Per Share
45
30
Equation
Finding the Amount of Earnings
Per Share of Common Stock
earnings per share. Higher earnings per share indicate the firm
is generating more income for every dollar invested by its
Earnings per share of common stock = net income applicable to
shareholders. This can lead to higher share prices because
common stock / weighted average of issued and outstanding
shares of common stock investors are generally willing to pay more for higher earnings.
Earnings per share describe the amount of net sales a com- Ways to improve the indicator: Increasing net income can
pany achieves per share of common stock issued and out- directly increase earnings per share. You can achieve this by
standing. All common stock held by shareholders is consid- providing highly demanded products or services in a cost-
ered issued and outstanding. Stock authorized but never sold effective manner. Highly demanded products or services can
by the company as well as stock repurchased by the company increase net sales by causing sales of larger volumes of prod-
is not considered issued and outstanding; therefore it is not ucts or services at premium prices. By producing the product
part of most per-share indicators. When a company has issued or service in a cost-effective manner, you can increase profit
INVESTMENT ANALYSIS
preferred stock, you can determine the net income applicable margins to strengthen earnings.
to common stock by subtracting preferred dividends from net Companies can also improve their earnings per share fig-
income. ures by repurchasing outstanding stock. This will decrease
When to use indicator: Investors use earnings per share the amount of stock outstanding and, for a fixed amount of
rates to determine how effectively companies generate earnings, inflate earnings on a per-share basis. If a company
income per share of stock. By comparing the earnings per sells additional stock, dilution occurs and the opposite effect
share rate with historical and forecasted results, you can results; earnings per share decline.
determine if stocks are appropriately priced. Example
Meaning of result: Earnings per share is perhaps the most fun- Earnings per share of common stock = net income applicable to
common stock / weighted average of issued and outstanding
damental of all stock-related ratios. This indicator describes
shares of common stock
how much money the company earns for each share of com-
mon stock issued and outstanding. Most managers strive for Net income applicable to common stock = 4,953
Weighted average of issued and outstanding shares of
higher earnings per share since this indicates more profit gen-
common stock = 3,600
erated per share of stock. All companies, except unique firms
such as nonprofit organizations, seek to generate increasing Earnings per share of common stock = 4,953 / 3,600 = $1.38
46
31 Examining Dividends
Per Common Share
Equation rewards of income-producing stocks. The dividend ratio sug-
gests potential investment rewards while the dividend payout
Dividends per common share = dividend ratio indicates future dividend payment risk.
dollar amount for common shares / weighted average of
issued and outstanding shares of common stock Ways to improve the indicator: Increasing dividends can
directly increase dividends per share. You can achieve this
Dividends per common share describe the amount of
by either earning more net income or distributing a larger
money distributed to shareholders per share of common
portion of net income to shareholders in the form of divi-
stock issued and outstanding. All common stock held by
dends. Generally the best method of increasing dividend is
shareholders is considered issued and outstanding. Stock
to increase net income by providing highly demanded
authorized but never sold by the company as well as stock
products or services in a cost-effective manner. Distribut-
INVESTMENT ANALYSIS
Sector Mid to large cap Dividends Per Small to mid cap Dividends Per Micro to small cap Dividends Per
Common Share Common Share Common Share
47
Dividends per common share = dividend Dividend dollar amount = 972
dollar amount for common shares / weighted Issued and outstanding shares of common stock = 3,600
average of issued and outstanding shares of
common stock Dividends per common share = 972 / 3,600 = $0.27
48
32
Equation
Calculating the
Growth Rate of Revenues
as dependent on high revenue growth rates for adequate
returns because their worth comes primarily through divi-
Growth rate of revenues = [(net sales, present year / dend disbursements. These companies typically achieve
net sales, n years ago) ^ (1/n)] − 1
steady dividends with consistent net sales and income.
and Simultaneously, dividend payouts should not take too large
a percentage of net income because a company needs capital
Growth rate of revenues/share = [(net sales/share, present available to plow back into such items as machinery
year / net sales/share, n years ago) ^ (1/n)] − 1 upgrades and advertising.
When determining growth rates on a per-share basis,
The growth rate of revenues describes the compounded
determine whether stock splits, or any other significant
annual growth rate of net sales growth a company has
events that affect stock volume, have occurred. Such events
achieved for any given historical period. The growth rate of
may affect growth rate calculations. For example, when a
INVESTMENT ANALYSIS
Sector Mid to large cap Growth Rate Small to mid cap Growth Rate Micro to small cap Growth Rate
of Revenues of Revenues of Revenues
49
Example Growth rate of revenues/share = [(net sales/share, present
year / net sales/share, n years ago) ^ (1/n)] − 1
Growth rate of revenues = [(net sales,
present year / net sales, n years ago) ^ Net sales/share, 1996 = 85,420 / 3,600 = 23.73
(1/n)] − 1 Net sales/share, 1994 (2 years ago) =
63,204/3,420 = 18.48
Net sales, 1996 = 85,420 n=2
Net sales, 1994 (2 years ago) = 63,204
n=2 Annual per share revenue growth rate over the last two years
= [(23.73/18.48) ^ (1/2)] − 1 = 1.1332 − 1 = 0.1332 =
Annual growth rate of revenues over the 13.32% increase
last two years = [(85,420 / 63,204) ^ (1/2)]
− 1 = 1.1625 − 1 = 0.1625 = 16.25% In this example, the per-share revenue growth rate is less
than the overall revenue growth rate because there was dilu-
tion on company stock. Shares outstanding rose from 3,420
to 3,600.
INVESTMENT ANALYSIS
Growth16.25%
rate of revenues = [( net sales, present year / net sales,
85,420.00 n years ago ) ^ (1 /
63,204.00 n
2 )] - 1
Growth rate of revenues = [( net sales, present year / net sales, n years ago ) ^ (1 / n )] - 1
50
33
Equation
Calculating the
Growth Rate of Earnings
Stocks which are selected for income such as utility com-
panies and high-dividend-rate blue chips are generally not
Growth rate of earnings = [(net income applicable to as dependent on high earnings growth rates for adequate
common stock, present year / net income applicable to
returns because their worth generally comes through divi-
common stock, n years ago) ^ (1/n)] − 1
dend disbursements. These companies often achieve steady
and dividends with consistent net sales and income. Simultane-
ously, dividend payouts should not take too large a percent-
Growth rate of earnings/share = [(net income per common age of net income (dividend payout ratio) because a compa-
share, present year / net income per common share, n years ny needs adequate capital to plow back into such items as
ago) ^ (1/n)] − 1
machinery upgrades and advertising.
The earnings growth rate describes the compounded annual When determining growth rates on a per-share basis,
growth rate of net income a company has achieved over any determine whether stock splits or any other significant stock
INVESTMENT ANALYSIS
given historical period. The growth rate of net income per volume events have affected growth rate calculations. For
share determines income, or earnings, growth rates on a per- example, when a stock is split two for one, earnings on a
share basis. The two growth rates will differ when the number per-share basis are halved. If you do not know about this,
of outstanding shares changes over time. the earnings growth rate may be misleading.
When to use indicator: Managers use earnings growth Ways to improve the indicator: Achieve higher present-
rates to determine the effectiveness of their strategies tar- year earnings growth by providing properly priced, highly
geted to generate new sales and maintain profit margins. demanded products or services while using cost controls
Investors use earnings growth rates on a per-share basis to to maintain profit margins.
help ascertain the value of a company’s stock. Companies can also improve their earnings growth rates
on a per-share basis by repurchasing outstanding stock.
Meaning of result: Investors generally expect higher earnings This will decrease the amount of stock outstanding and, for
growth rates from growth companies. In assessing growth a fixed amount of earnings growth, inflate the growth rate
companies, look for strong rates of both revenue and income on a per-share basis. If a company sells additional stock,
growth since stock value in large part depends on these two dilution occurs and the opposite effect results; per-share
key indicators. earnings growth rates decline.
Sector Mid to large cap Annual Growth Rate Small to mid cap Annual Growth Rate Micro to small cap Annual Growth Rate
of Earnings over the of Earnings over the of Earnings over the
Last Two Years Last Two Years Last Two Years
51
Example Growth rate of earnings per share = [(net income per
common share, present year / net income per common share,
Growth rate of earnings = [(net income applicable to n years ago) ^ (1/n)] − 1
common stock, present year / net income applicable to
common stock, n years ago) ^ (1/n)] − 1 Net income per common share, 1996 = 4,953/3,600 = 1.376
Net income per common share, 1994 (2 years ago) =
Net income applicable to common stock, 1996 = 4,953 2,852/3,420 = 0.8339
Net income applicable to common stock, 1994 (2 years ago) n=2
= 2,852
n=2 Annual per-share earnings growth rate over the last two
years = [(1.376/0.8339) ^ (1/2)] − 1 = 1.2846 − 1 = 0.2846 =
Annual earnings growth rate over the last two years = 28.46% increase
[(4,953 / 2,852) ^ (1 / 2)] − 1 = 1.3178 − 1 = 0.3178 =
31.78% In this example, the per-share earnings growth rate is less
than the overall revenue growth rate because there was dilu-
tion on company stock. Shares outstanding rose from 3,420
to 3,600.
INVESTMENT ANALYSIS
Growth 28.46%
rate of revenues = [( net sales,1.376
present year / net sales,0.83
n years ago ) ^ (1 / 2n )] - 1
Growth rate of earnings = [( net income, stock / net income stock, n ) ^ (1 / n )] - 1
52
34
Equation
Finding the Common Stock
Dividend Growth Rate
rate calculations. For example, when a stock is split two for
one, dividends on a per-share basis are halved. If you do not
Growth rate of common stock dividends per share = know this, the dividend growth rate may mislead you.
[(common stock dividends per share, present year /
common stock dividends per share, n years ago) ^ (1/n)] − 1 Ways to improve the indicator: Achieving higher earnings
and income by providing properly priced, highly demand-
The common stock dividend growth rate per share
ed products or services while controlling costs to maintain
describes the compounded annual growth rate of common
profit margins should allow higher dividend growth rates.
stock dividends on a per-share basis over any given histori-
Companies can also improve their dividend growth rates on
cal period.
a per-share basis by repurchasing outstanding stock. This will
When to use indicator: Investors use dividend growth decrease the amount of stock outstanding and, for a fixed
rates on a per-share basis to help ascertain the value of the amount of dividend capital slated for distribution to share-
INVESTMENT ANALYSIS
company’s stock. holders, will inflate the dividend payout and growth rate on a
per-share basis. If a company sells additional stock, dilution
Meaning of result: Stocks which are selected for income such occurs and the opposite effect results; per-share dividend pay-
as utility companies and high-dividend-rate blue chips should outs and growth rates decline.
provide steady dividend streams that preferably increase over
time. You can use the dividend growth rate to determine how Example
effectively companies have performed to this end. Consistent
net sales and income typically produce steady dividends. Divi- Growth rate of common stock dividends per share =
dend payouts should not take too large a percentage of net [(common stock dividends per share, present year /
common stock dividends per share, n years ago) ^ (1/n)] − 1
income (dividend payout ratio) since companies need ade-
quate capital to plow back into such items as machinery Common stock dividends per share, 1996 = 0.27
upgrades and advertising. Smaller percentage dividend pay- Common stock dividends per share, 1994 (2 years ago) =
outs, typically less than 50% of earnings, often indicate a 0.24
higher likelihood of continuing dividend payouts. n=2
When determining dividend growth rates on a per-share Annual common stock dividend growth rate over the last
basis, you should determine whether stock splits or any two years = [(0.27 / 0.24) ^ (1 / 2)] − 1 = 1.061 − 1 = 0.061 = 6.1%
other significant stock volume events have affected growth
6.07%
Growth rate 0.27
of common_stock = [( common stock dividends 0.24per share, n years ago ) ^ (1 / n2
per share, present year / common stock dividends )] - 1
Growth rate of common_stock = [( common stock dividends per share, present year / common stock dividends per share, n years ago ) ^ (1 / n )] - 1
Sector Mid to large cap Annual Growth Rate of Small to mid cap Annual Growth Rate of Micro to small cap Annual Growth Rate of
Dividends Per Share over Dividends Per Share over Dividends Per Share over
the Last Two Years the Last Two Years the Last Two Years
53
35
Equation
Determining the
Price-to-Earnings (P/E) Ratio
time into the future. Because of such positive projections,
investors are willing to pay a higher share price in the
Price-to-earnings ratio = P/E = (share price of common stock hope that sales and earnings growth will fuel further
× weighted average of issued and outstanding shares of
increases in share price.
common stock) / net income applicable to common stock
and Ways to improve the indicator: You can increase P/E ratios
by increasing net sales and net income growth rates.
Price to earnings ratio = P/E = share price of common stock / Increasingly larger profit margins also tend to increase P/E
earnings per share of common stock ratios. You can increase profit margins by controlling
costs and by maintaining optimum pricing by offering
The price-to-earnings (P/E) ratio indicates the degree to competitive, highly desirable products or services.
which investors value a company. When investors pay a
INVESTMENT ANALYSIS
Sector Mid to large cap P/E Small to mid cap P/E Micro to small cap P/E
Ratio Ratio Ratio
54
Measuring the Price-to-Earnings-to-
36
Equation
Growth-Rate Ratio (PEG)
high-flying stocks with very high PEG ratios continue to
climb while other stocks with low PEGs plummet even
Price to earnings to growth rate = PEG = (share price of further. This latter scenario can occur with growth compa-
common stock × weighted average of issued and outstanding nies that fail to continue to meet historically high growth
shares of common stock) / (net income applicable to
common stock × earnings growth rate) rates because of reduced demand or increased competi-
tion. Investors note such trends and force share prices
The price to earnings to growth rate (PEG) compares how down to levels that are more in line with the projected
investors value a company, the P/E ratio, with the compa- lower growth rates. Since published growth rate values are
ny’s growth rate. older and may not consider recent events, very low PEGs
can result, giving false buy indications.
When to use indicator: Since investors value growth stocks
primarily by the degree of their growth, the PEG ratio Example
INVESTMENT ANALYSIS
55
37
Equation
Examining the Earnings Yield
ratio is that higher ratios don’t necessarily indicate better
performing, or more promising, companies and invest-
Per share calculation
ments. When investors see a large degree of future earn-
Earnings yield = net income per share of common stock / ings potential in a stock, they tend to purchase stock and
share price of common stock drive stock prices up. This then causes earnings yields to
decrease in the present per the definition shown above.
or Alternatively, when companies begin to slow down and
show less growth, share prices slip and earnings yields
Dollar amount calculation
rise. This could give the false indication that when compa-
Earnings yield = net income applicable to common stock / nies begin to slow down, it is time to buy.
(share price of common stock × weighted average number of
common stock shares issued and outstanding) Ways to improve the indicator: Increasing net income can
INVESTMENT ANALYSIS
Sector Mid to large cap Earnings Small to mid cap Earnings Micro to small cap Earnings
Yield Yield Yield
56
38
Equation
Determining the
Market Price Return Ratio
Meaning of result: Higher ratios indicate that the invest-
ment achieved higher rates of return. Note that this indica-
Market price return = (sale price/purchase price) ^ (1/time tor, market price return, and dividend return comprise
period held) − 1
total investment return.
The market price return ratio describes the percentage
Example
return an investor generates from market price
appreciation/depreciation of purchased stock. Compute the Market price return = (sale price/purchase price)^(1/time
annualized two-year return for the benchmark-tabled values period held) − 1
by comparing the 1998 midyear share price with the average
1996 share price. Sale price = $22.50
Purchase price = $17.00
When to use indicator: Investors can use this indicator to Time period held (years) = 2
INVESTMENT ANALYSIS
determine the percentage return or loss they would realize Market price return = (22.5/17)^(1/2) - 1 = 1.1504 - 1 =
in selling a stock that they purchased at a given price at a 0.1504 = 15.04%
given time period in the past. This information can help
them determine whether the rate of return on the invest-
ment is appropriate for the investment risk.
Sector Mid to large cap Market Price Small to mid cap Market Price Micro to small cap Market Price
Return Ratio Return Ratio Return Ratio
57
39
Equation
Determining the Common
Stock Dividend Return Ratio
You do this by providing properly priced, highly demand-
ed products or services while controlling costs to maintain
Common stock dividend return = dividend profit margins. By earning higher income, the company
per share of common stock / share price of common stock
may be able to distribute larger dividend payments. How-
The dividend return ratio describes the rate of return ever, when dividend payouts rise, investors are typically
that common stock dividend disbursements yield. willing to pay more for a stock, assuming risk levels have
not risen. This can lead to commensurate increases in the
When to use indicator: Investors can use this ratio to market price of a company’s stock, thus maintaining divi-
determine the dividend return rate offered by a particular dend return ratios at relatively constant levels.
investment. Investors often compare this return rate with Companies can also improve their dividend return rates
the investment risk level to determine the desirability of by repurchasing outstanding stock. This will decrease the
the investment. amount of stock outstanding and, for a fixed amount of
INVESTMENT ANALYSIS
Ways to improve the indicator: You can achieve larger div- Common stock dividend return = 0.27 / 22.50 = 0.012 =1.2%
idend returns by achieving higher present-year net income.
Sector Mid to large cap Common Stock Dividend Small to mid cap Common Stock Dividend Micro to small cap Common Stock Dividend
Return Ratio Return Ratio Return Ratio
58
Determining the Size of the
40
Equation
Common Stock Dividend Payout
the company could declare a lower dividend per share or drive
itself into bankruptcy by distributing more cash than it earns.
Common stock dividend payout = dividends declared per However, higher ratios are more acceptable for mature com-
share of common stock issued and outstanding / net income
panies operating in slow-changing industries, where there is
per share of common stock
less need for significant capital reinvestment.
The common stock dividend payout ratio describes the
Ways to improve the indicator: A manager can decrease the
percentage of net income that is given back to common
ratio by either decreasing the dividend payout or by increasing
stock shareholders in the form of dividends.
the amount of company earnings. The second alternative is
When to use indicator: Investors can use this ratio to deter- generally the preferred way to decrease the payout ratio. A
company can achieve higher earnings by providing properly
mine whether dividend payouts are sustainable.
priced, highly demanded products or services while using cost
INVESTMENT ANALYSIS
Meaning of result: The dividend payout ratio indicates the controls to maintain profit margins.
degree of risk in present and future dividend payments. Small- Companies can also improve their dividend payout ratios
er dividend payout ratios are preferred and indicate a higher by repurchasing outstanding stock. This will decrease the
likelihood of continuing, and potentially increasing, dividend amount of stock outstanding, increase earnings on a per-
share basis, and thus lower the dividend payout ratio. If a
payouts since the company has substantial earning income in
company sells additional stock, dilution occurs and the
excess of dividend disbursements. Higher ratios indicate the
opposite effect results; dividend payout ratios increase.
company may soon have difficulty in meeting its future divi-
dend obligations. As a company pays out a larger percentage Example
of net income to its shareholders in the form of dividends, it
keeps less capital to be reinvested in items such as higher effi- Common stock dividend payout = dividends declared per
ciency machinery and advertising campaigns to launch new share of common stock issued and outstanding / net income
per share of common stock
revenue-producing services or products. This can lead to
declining net income, and if dividend payments are main- Dividends declared per share = 0.27
tained, progressively higher dividend payout ratios. If this Net income per share of common stock = 1.38
cycle continues, one of two undesirable situations can occur: Common stock dividend payout = 0.27 / 1.38 = 0.20 = 20.0%
59
41
Equation
Determining the Size of the Dividend Payout
in Relation to Operations Cash Flow
form of dividends, it keeps less capital to be reinvested in
items such as higher efficiency machinery and advertising
Operations cash flow dividend payout = dividends declared campaigns to launch new revenue-producing services or
per share of common stock issued and outstanding /
products. This can lead to declining operations cash flow,
operations cash flow per share of common stock
and if dividend payments remain static, progressively higher
The operations cash flow dividend payout ratio describes dividend payout ratios result. If this cycle continues, one of
the percentage of operations cash flow that is given back to two undesirable situations can occur: the company could
common stock shareholders in the form of dividends. This declare a lower dividend per share or drive itself into bank-
ratio is similar to the common stock dividend payout ratio ruptcy by distributing more cash than it earns.
but is based on operating cash flow rather than net income.
Ways to improve the indicator: You can decrease the ratio
At times, operating cash flow can give a more accurate indi-
by either decreasing the operations cash flow dividend
cation of the health of a business since net income can
INVESTMENT ANALYSIS
Sector Mid to large cap Operations Cash Flow Small to mid cap Operations Cash Flow Micro to small cap Operations Cash Flow
Dividend Payout Ratio Dividend Payout Ratio Dividend Payout Ratio
60
Example Dividends declared per share = 0.27
Operations cash flow per share = 4,820 / 3,600 = 1.34
Operations cash flow dividend payout = dividends declared
per share of common stock issued and outstanding / Operations cash flow dividend payout =
operations cash flow per share of common stock 0.27 / 1.34 = 0.202 = 20.2%
61
42
Equation
Determining the Preferred
Dividend Return Ratio
return ratio allows the investor to determine if the rate of pre-
ferred dividend return is congruent with the risk level of the
Preferred dividend return = dividends per share of preferred investment. Investors should expect higher dividend return
stock / share price of preferred stock
ratios when there is a greater risk associated with the invest-
The preferred dividend return ratio describes the rate of ment.
return that preferred dividend disbursements yield.
Ways to improve the indicator: You can realize higher pre-
When to use indicator: Investors use this ratio to determine ferred dividend returns by purchasing preferred stock at
the return rate offered by a particular preferred stock invest- lower market prices for a given dividend per preferred
ment. Investors will then typically compare this return rate share.
with the investment risk level to determine the desirability of
Example
the investment.
INVESTMENT ANALYSIS
62
43
Equation
Determining the Size of the
Preferred Dividend Payout
ing net income, and if preferred dividend payments remain
static, progressively higher preferred dividend payout ratios
Preferred dividend payout = dividends per preferred share / result. If this cycle continues, one of two undesirable situa-
net income per preferred share
tions can occur: the company could declare a lower dividend
The preferred dividend payout ratio describes the percent- per share or drive itself into bankruptcy by distributing more
age of net income that shareholders earn in the form of pre- cash than it earns. However, higher ratios are more accept-
ferred dividends. able for mature companies operating in slow-changing
industries where there is less need for significant capital rein-
When to use indicator: Investors use this ratio to deter- vestment.
mine whether preferred dividend payouts are sustainable.
Ways to improve the indicator: You can reduce the ratio
Meaning of result: The preferred dividend payout ratio by increasing the amount of company earnings. A compa-
INVESTMENT ANALYSIS
indicates the degree of risk in present and future preferred ny can achieve higher earnings by providing properly
dividend payments. Smaller preferred dividend payout priced, highly demanded products or services while using
ratios are generally desirable and indicate a higher likeli- cost controls to maintain profit margins.
hood of continuing preferred dividend payouts because
the company is earning income in excess of disbursements. Example
Higher ratios indicate the company may soon have diffi- Preferred dividend payout = dividends per preferred share /
culty in meeting its future preferred dividend obligations. As net income per preferred share
a company pays out a larger percentage of net income to its
preferred shareholders in the form of dividends, it keeps less Dividends per preferred share = 2.00
capital to be reinvested in items such as higher efficiency Net income per preferred share = net income/preferred
machinery and advertising campaigns to launch new rev- shares = 4,983/15 = 332.2
enue-producing services or products. This can lead to declin- Preferred dividend payout = 2.00 / 332.2 = 0.006 = 0.60%
dividend payout =
Preferred 0.60% dividends $2.00
per preferred share / net income per preferred share
$332.20
Preferred dividend payout = dividends per preferred share / net income per preferred share
63
44
Equation
Determining the Size of the Preferred Dividend
Payout in Relation to Operations Cash Flow
dends, it keeps less capital to be reinvested in items such as
higher efficiency machinery and advertising campaigns to
Operations cash flow preferred dividend payout = preferred launch new revenue-producing services or products. This
dividends per share / operations cash flow per preferred
can lead to declining operations cash flow and progressively
share
higher preferred dividend payout ratios. If this cycle contin-
The operations cash flow preferred dividend payout ratio ues, one of two undesirable situations can occur: the com-
describes the percentage of operations cash flow that share- pany could declare a lower dividend per share or drive itself
holders receive in the form of preferred dividends. This ratio into bankruptcy by distributing more cash than it earns.
is similar to the preferred dividend payout ratio but is based However, higher ratios are more acceptable for mature
on operating cash flow rather than net income. At times, companies operating in slow-changing industries where
operating cash flow can give a more accurate indication of there is less need for significant capital reinvestment.
the health of a business because net income can include
INVESTMENT ANALYSIS
64
Determining the Size of the
45
Equation
Total Return on Common Stock
Ways to improve indicator: A company can increase total
common stock return with increasing price and dividend
Total return on common stock = market price return + return yields. Price return increases are generally the result
common stock dividend return
of increasing current and forecasted sales and income.
where Dividend return increases are often the result of similar
increases in financial performance.
Market price return = (market price/purchase price) ^
(1/time period held) −1 Example
Common stock dividend return = Common stock dividend
per share of stock / market price of common stock Total return on common stock = market price return +
common stock dividend return
This ratio describes the total annual percentage return an
Market price return = (market price/purchase price) ^
investor generates from ownership of common stock. Total
(1/time period held) − 1
INVESTMENT ANALYSIS
Meaning of result: Higher ratios indicate larger returns on Dividend per share of common stock = 0.27
common stock investment. Investors should compare Market price of common stock = 22.50
return rates with the risk associated with a particular Common stock dividend return = 0.27 / 22.50 = 0.012 =
investment. Stocks that offer the potential for higher 1.2%
return rates generally present a greater risk of loss of capi-
Total return on common stock = 15.04% + 1.2% = 16.24%
tal.
Sector Mid to large cap Total Return on Small to mid cap Total Return on Micro to small cap Total Return on
Common Stock Common Stock Common Stock
65
46
Equation
Computing the Cash Flow Per Share of
Outstanding Common Stock
with negative cash flows and must tap into cash reserves.
This is acceptable to the point that the reserves don’t
Cash flow per share of common stock = cash flow / become so depleted that insolvency results.
number of shares of issued and outstanding common stock
It is possible to operate with a positive net income, or
Cash flow is one of the most important indicators of the profit, and nevertheless have a negative cash flow. When
financial health of a company. This indicator relates how such situations remain unchecked, bankruptcy can occur.
much cash flow is available per share of common stock. This special situation often arises with growing companies
that require a lot of cash for items such as new capital
When to use indicator: Managers and investors can use equipment and the need to maintain larger inventories.
this indicator to determine whether the company is gener-
ating adequate cash. The three primary areas in which a Ways to improve the indicator: A company improves cash
company uses or generates cash are through its opera- flow when all forms of revenue exceed all forms of expenses
INVESTMENT ANALYSIS
tions, investments, and financing activities. It is most in increasing quantities. Increasing revenue, whether from
desirable to generate cash through operations because this operations, investing, or financing, can help improve this
is the intent of forming an organization. Investment activi- indicator. Revenue enhancements include the generation of
ties include the purchase or sale of machinery for plant use higher operating profits, the sale of obsolete machinery, and
and the buying or selling of securities. Financing activities the issuance of new stock or debt. Decreasing expenses
include the issuance or purchase of additional stock and again—whether from operations, investing, or financing—
the issuance or payment of additional debt. can also increase the cash flow. Expense reductions include
lowering operating expenses such as labor and raw material
Meaning of result: High positive cash flows are what com- costs, reducing investing expenses by actions such as retiring
panies generally desire to achieve. Regardless of how debt and lowering interest payments (however, such an action
promising the short- and long-term potential for any given would likely increase financing expense), and reducing
firm may be, positive cash flow is a continual requirement financing expenses by actions such as issuing smaller dividend
to keep a firm’s doors open. At times companies operate distributions.
Sector Mid to large cap Cash Flow Per Share of Small to mid cap Cash Flow Per Share of Micro to small cap Cash Flow Per Share of
Outstanding Common Stock Outstanding Common Stock Outstanding Common Stock
66
Example Cash flow = 1,017
Number of issued and outstanding shares
Cash flow per share of common stock = of common stock = 3,600
cash flow / number of shares of issued and
outstanding common stock Cash per flow per share of common stock =
1,017 / 3,600 = 0.2825 = $0.28 per share
67
47
Equation
Computing the Operating Cash Flow Per
Share of Outstanding Common Stock
Meaning of result: High positive operating cash flows are
what companies generally desire to achieve. Regardless of
Operating cash flow per share of common stock = operating how promising the short- and long-term potential for any
cash flow / number of shares of issued and outstanding
given firm may be, a company needs positive operating
common stock
cash flows in the long term to remain open for business.
Operating cash flow, one of the three sources of cash flow Start-up and growth companies may subsist for a time
(together with investing and financing cash flow), is one of with negative operating cash flows by generating cash
the more important indicators of a company’s financial flow from other sources such as by issuing more stock for
health. This indicator relates how much operating cash flow cash or by taking on additional debt.
is generated per share of common stock.
Ways to improve the indicator: The main contributors to
When to use indicator: Managers and investors can use this operating cash flow are often net income and depreciation.
INVESTMENT ANALYSIS
indicator to determine whether a company is generating pos- Other factors which affect operating cash flow are changes in
itive operating cash flow. The three areas in which a compa- assets and liabilities such as inventory, accounts receivable,
ny uses or generates cash are through its operations, invest- and accounts payable. Improving net income is generally the
ments, and financing activities. It is generally most desirable most desirable method of improving operating cash flow. A
to generate cash through operations since this is the intent of company can improve net income by providing properly
forming an organization. Operating cash flow is a direct priced, highly demanded products or services while maintain-
indication of how much cash a company is generating from ing good cost control. Operating cash flow also increases as
activities basic to the company. Examples include a car man- the depreciation account increases. However, this is not simply
ufacturer producing and selling cars or a restaurant produc- found money. The income statement counts depreciation as an
ing and selling meals. Investment activities include the pur- expense in the current period. Since you previously purchased
chase or sale of machinery for plant use and the buying or the depreciable item with cash, you do not need additional
selling of securities. Financing activities include the issuance cash in the current period, so add that amount of money back
or purchase of additional stock and the issuance or payment to net income to show a more accurate account of the current-
of additional debt. period operating cash flow. Thus, you can think of deprecia-
tion expenses as accounting placeholders.
Sector Mid to large cap Operating Cash Flow Small to mid cap Operating Cash Flow Micro to small cap Operating Cash Flow
Per Share of Per Share of Per Share of
Outstanding Common Stock Outstanding Common Stock Outstanding Common Stock
68
Example Operating cash flow = 4,820
Number of issued and outstanding shares
Operating cash flow per share of common of common stock = 3,600
stock = operating cash flow / number of
shares of issued and outstanding common Operating cash flow per share of common
stock stock = 4,820 / 3,600 = 1.3389 = $1.34 per share
69
48
Equation
Determining the Volatility, or
Beta, of a Stock
Higher beta values indicate higher volatility. Investors
who seek high returns and are confident in the direction the
The beta of a stock is published by sources such as Valueline, markets are headed often seek higher beta stocks. Stock
Standard & Poor’s, and Morningstar.
with high beta values will rise at a greater rate than the S&P
Beta is a measure of a stock’s volatility. Investors consider 500 during market upswings and drop at faster rates during
stocks which exhibit larger price changes than the S&P 500 market corrections. For example, an investor holds another
average, on both the up and down sides, as more volatile stock with a beta of 1.4 and the S&P 500 index rises 15%.
and they are assigned larger beta values. This investor can anticipate his stock will rise at a rate of
21%, or 1.4 times the rate of the S&P 500. During market
When to use indicator: Investors use the beta indicator to downswings, the same investor can anticipate losses at a
determine the relative volatility of investments. Depending rate 1.4 times that of the S&P 500.
upon the investor’s goals and the potential return a stock Lower beta values indicate lower volatility and are the
INVESTMENT ANALYSIS
selection may offer, either low or high volatility stocks may be preference of investors who don’t want to risk capital losses
desirable. or are concerned with the direction of the market. With
these stocks, gains are generally smaller than the S&P 500
Meaning of result: Beta values are tied to the performance during market upswings and losses are generally lower than
of one of the primary stock indexes, such as the S&P 500. the S&P 500 during downswings.
When a stock’s price changes are generally equivalent to Negative beta values indicate that the stock tends to move
the average price changes found in the S&P 500, the stock in the opposite direction of the S&P 500.
has a beta of 1.0. For example, suppose an investor holds
a stock with a beta of 1.0 and the S&P 500 index rises Example
15%. The investor could anticipate a rise of 15% in the See published beta values.
value of his stock.
70
CHAPTER FOUR
Product and
Factory Costs
71
49
Equation
Calculating the Total Amount of
Direct Costs Per Production Unit
Ways to improve the indicator: A manager can reduce the
cost of goods sold by investigating the expenses associated
Direct costs per production unit = cost of goods sold / with producing a product or service. He can reduce raw
number of production units produced
material expenses with supplier competitive bidding and
Direct costs per unit indicate the level of direct costs asso- by redesigning product or service lines with more cost-
ciated with the production of the average company unit. effective components. He can reduce direct labor costs by
Direct costs are expenses incurred to manufacture a product improving the efficiency in which products are built.
or supply a service and include labor, raw materials, and Employee training, increased employee motivation,
overhead. Direct labor includes machine operators and improvements in production line setups, and the use of
assemblers in manufacturing firms, hair cutters in salons, more efficient equipment can improve efficiency. Ways to
PRODUCT AND FACTORY COSTS
and draftspersons in architectural firms. Overhead includes reduce direct overhead expenses include negotiating lower
floor space rent for manufacturing or service areas, machin- plant leases, equipment leases, or health insurance rates
ery utilities, and the benefit package given to direct labor and designing more efficient plant layouts to reduce the
employees. need for floor space.
72
50
Equation
Determining the Total Labor
Cost Per Production Unit
Ways to improve the indicator: Maintain a motivated,
well-trained, and cooperative staff. Leadership from all
Total labor cost per production unit = total labor costs / employees, line workers to top executives, in each of these
number of production units produced
areas is critical to improving productivity. Eliminate
Total labor cost per unit describes one of the more costly redundancies. Encourage employees to suggest and devel-
company expenses—labor—and how it is associated with op methods of improving productivity, generating more
the production of the average company unit. Total labor sales, and reducing costs associated with producing prod-
costs include salaries and hourly wages for all company ucts or services.
employees.
Example
PRODUCT AND FACTORY COSTS
When to use indicator: Managers can use this indicator to Total labor cost per production unit = total labor costs /
gain a sense of labor costs and productivity levels. number of production units produced
Meaning of result: Comparing this indicator with histori- Total labor costs = 18,871
cal and forecasted levels can indicate labor expense trends. Number of production units produced = 654
Higher ratios can indicate labor expenses are trending out
of control, changes to higher labor content product or ser- Total labor cost per production unit = 18,871 / 654 = 28.85
= $28.85 per production unit
vice lines, or reductions in the number of units produced.
Managers generally desire lower ratios, which are often
the result of improved operations.
73
51 Calculating the Total Cost
Per Production Unit
Equation Ways to improve the indicator: Maintain a motivated,
well-trained, and cooperative staff. Leadership from all
Total cost per production unit = (cost of goods sold +
employees, line workers to top executives, in each of these
indirect expenses) / number of production units produced
areas is critical to improving productivity. Eliminate
Total cost per unit indicates all direct and indirect costs redundancies. Encourage employees to suggest and devel-
associated with the production of the average company op methods of improving productivity, generating more
unit. Cost of goods sold includes all direct operations sales, and reducing costs associated with producing prod-
expenses such as raw materials and the labor and overhead ucts or services.
PRODUCT AND FACTORY COSTS
used to manufacture the product. Indirect expenses include Seek to reduce all of the expenses associated with the cost
charges not directly involved with the manufacture of prod- of goods sold. Reduce raw material expenses with supplier
ucts such as salaries of office workers, office building rents, competitive bidding and by redesigning product lines with
utilities, insurance, travel, and product development costs. more cost-effective components. Reduce direct labor costs
The only factors not considered are interest expenses, taxes, by improving manufacturing or assembly efficiencies. You
and extraordinary items. can improve efficiencies with employee training, increased
employee motivation, improvements in production line set-
When to use indicator: Managers can use this indicator to ups, and the use of more efficient equipment. You can
gain a general sense of the overall costs of producing reduce direct overhead expenses by negotiating lower plant
goods and trends in expense control and productivity lev- and equipment leases and by designing more efficient plant
els. layouts.
74
52
Equation
Examining Variable Costs
product produced with the equipment will be in demand for
a long time, the company can likely justify the machine cost.
Variable cost = costs that are dependent on the number of However, if demand for the product drops sharply, the com-
goods or services produced
pany cannot easily reduce the fixed costs associated with the
The total cost to produce a product or service consists of machinery and it could suffer greater losses than if it had
variable and fixed costs. Variable costs are those costs that not made the purchase.
change with the quantity of goods or services produced
Ways to improve the indicator: When you desire higher
while fixed costs remain relatively constant regardless of the
variable costs, shift expenses from fixed to variable costs.
quantity produced. Variable costs include raw materials,
You can do this by producing more labor- and material-
direct labor, and the fuel used to operate machinery. Fixed
PRODUCT AND FACTORY COSTS
75
Example
Variable cost = costs that are dependent on the number of goods or services produced
Total cost of goods sold = 54,212
Raw material cost = 31,063
Direct labor = 7,860
Overhead cost = 15,164
Other direct costs = 125
R&D costs = 4,578
SG&A costs = 15,993
Depreciation & amortization = 1,204
Interest = 784
PRODUCT AND FACTORY COSTS
Variable cost = raw material cost + direct labor cost = 31,063+ 7,860 = 38,923
quantity produced. Variable costs include raw materials, variable cost ratios, seek to shift expenses from fixed to
direct labor, and the fuel used to operate machinery. Fixed variable costs. You can do this by producing more labor-
costs include building rent, interest payments, and salaries and material-dependent products or services. You can also
for nonmanufacturing employees such as engineers and outsource or use contractors for design work, manufactur-
accountants. ing, sales and marketing, etc. Contractor use is typically
more variable in nature than the use of in-house, fixed-
When to use indicator: Managers can use this indicator to
cost expertise.
determine the cost makeup and risk level associated with
its products or services. Example
Meaning of result: Higher variable cost ratios indicate that Variable cost to total cost = variable cost / total cost
the costs to produce a product or service are largely
dependent on the volume of products or services pro- Total cost of goods sold = 54,212
duced. There is generally less financial risk with higher Raw material cost = 31,063
variable cost ratios since a company incurs variable costs Direct labor = 7,860
only when it produces products or services. If there is a Overhead cost = 15,164
Other direct costs = 125
business downturn with lower volumes of output, you can R&D costs = 4,578
more readily reduce variable costs than fixed costs. For SG&A costs = 15,993
example, raw material purchase quantities are generally Depreciation & amortization = 1,204
much easier to reduce than the size and lease cost of a Interest = 784
building. Variable cost = raw material cost + direct labor cost =
However, higher variable cost ratios are not always desir- 31,063 + 7,860 = 38,923
able since they may lead to higher total costs. Management Total cost = total cost of goods sold + R&D costs + SG&A
should determine the optimal mix of variable and fixed costs + depreciation + interest expense = 54,212 + 4,578 +
15,993 + 1,204 + 784 = 76,771
costs which controls expenses and minimizes risk. This mix
is dependent on the company and the industry in which it Variable cost to total cost = 38,923 / 76,771 = .5070 = 50.70%
operates. For example, suppose a company purchases a
high-cost fixed asset such as an automated piece of factory
equipment. The equipment helps the company produce a Please see the next page for the interactive calculation
76
Example
77
Example
Variable cost per production unit = costs that are dependent
on the number of goods or services produced / number of production units produced
Interest = 784
Sector Mid to large cap Fixed Small to mid cap Fixed Micro to small cap Fixed
Costs Costs Costs
78
Example
Fixed cost = costs that are independent of the number of goods or services produced
Fixed cost = overhead cost + other direct costs + R&D cost + SG&A cost + depreciation + interest =
PRODUCT AND FACTORY COSTS
79
56
Equation
Comparing Fixed Costs
to Total Costs
ly much easier to reduce than the size and lease cost of a
building.
Fixed cost to total cost = fixed cost / total cost However, lower fixed cost ratios are not always desirable
since they may lead to higher total costs. Management
The total cost to produce a product or service consists of
should determine the optimal mix of variable and fixed
variable and fixed costs. The fixed-to-total-cost ratio indi-
costs which controls expenses and minimizes risk. This mix
cates the percentage of all product or service costs which are
is dependent on the company and the industry in which it
fixed in nature. Fixed costs are those costs that remain rela-
operates. For example, suppose a company purchases a
tively constant regardless of the quantity of goods or ser-
high-cost fixed asset such as an automated piece of factory
vices produced while variable costs are those costs that
equipment. The equipment helps the company produce a
PRODUCT AND FACTORY COSTS
Meaning of result: Higher fixed cost ratios indicate the Ways to improve the indicator: When you desire lower
costs to produce a product or service are independent of fixed costs, shift expenses from fixed to variable costs.
the volume of products or services produced. There is gen- You can do this by producing more labor- and material-
erally more financial risk with higher fixed costs since a dependent products or services. You can also achieve this
company incurs fixed costs regardless of the volume of with outsourcing, using contractors for design work, man-
products or services produced. If there is a business down- ufacturing, sales and marketing, etc. Contractor use is typ-
turn with lower volumes of output required, a company ically more variable in nature than the use of in-house,
can more readily reduce variable costs than fixed costs. fixed-cost expertise.
For example, raw material purchase quantities are general-
Sector Mid to large cap Fixed-to-Total- Small to mid cap Fixed-to-Total- Micro to small cap Fixed-to-Total-
Cost Ratio Cost Ratio Cost Ratio
80
Example
Total cost = total cost of goods sold + R&D costs + SG&A costs + depreciation + interest expense = 54,212 + 4,578 +
15,993 + 1,204 + 784 = 76,771
81
57
Equation
Finding the
Fixed Cost Per Unit
product at a much lower total cost but with lower variable
costs and higher fixed costs. If management is confident the
Fixed cost per unit = costs that are independent of the product produced with the equipment will be in demand for
number of goods or services produced / number of units
a long time, the company can likely justify the machine cost.
produced
However, if demand for the product drops sharply, the com-
The total cost to produce a product or service consists of pany cannot easily reduce the fixed costs associated with the
variable and fixed costs. The fixed-cost-per-unit ratio machinery and it could suffer greater losses than if it had
describes the fixed cost per average production unit. Fixed not made the purchase.
costs are those costs that remain relatively constant regard-
Ways to improve the indicator: When you desire lower
less of the quantity of goods or services produced while
PRODUCT AND FACTORY COSTS
82
Example
Fixed cost per unit = costs that are independent of the number of goods or services produced / number of units produced
Interest = 784
ual products, but they can sometimes describe total compa- margins, such price increases can also reduce sales volumes,
ny performance. Variable costs are those costs that change potentially reducing overall profit. Price increases are thus
with the quantity of goods or services produced while fixed generally acceptable only to the point that overall company
costs remain relatively constant regardless of the quantity profit is maximized.
produced. Variable costs include raw materials, direct labor,
and the fuel used to operate machinery. Fixed costs include Example
building rent, interest payments, and salaries for nondirect
manufacturing employees such as supervisors, engineers, Contribution margin = net sales − variable costs
and accountants. Contribution margin percentage =
(net sales - variable costs) / net sales
When to use indicator: Managers can use these ratios to
determine the degree of income available to pay fixed costs Individual product
and, when those costs are paid in full, to return a profit. Contribution margin = sales price − variable costs
Contribution margin determinations also allow the manager
to figure how many units must be sold to break even, the Sales price per unit = 88
Variable costs per unit = 27
point at which sales revenues equal total costs.
Contribution margin = 88 − 27 = 61
Meaning of result: Higher contribution margin percentages
indicate the company’s variable costs are low and a larger Contribution margin percentage = (sales price − variable costs) /
amount of revenue remains to defray fixed costs. When the sales price
fixed costs are fully paid for, the remaining revenue remains Sales price per unit = 88
as profit. Variable costs per unit = 27
Ways to improve the indicator: Reducing variable costs and Contribution margin percentage = (88 − 27) / 88 = 0.6932 =
increasing sales prices can increase contribution margins. The 69.32%
83
Companywide Contribution margin percentage = (net sales − variable costs)
Contribution margin = net sales − variable costs / net sales
Net sales = 85,420 Net sales = 85,420
Variable costs = costs that are dependent on the number of Variable costs = costs that are dependent on the number of
goods or services produced goods or services produced
Variable costs = raw material cost + direct labor cost = Variable costs = raw material cost + direct labor cost =
31,063 + 7,860 = 38,923 31,063 + 7,860 = 38,923
Contribution margin = 85,420 − 38,923 = 46,497
Contribution margin percentage = (85,420 − 38,923) /
85,420 = 0.5443 = 54.43%
46,497margin =
Contribution net sales
85,420 − variable costs
38,923
PRODUCT AND FACTORY COSTS
84
59
Equation
Determining the Break-Even
Point in Sales Volume
When the sales volume estimates are lower than the
break-even volume, the product or service will not return an
Break-even volume = total fixed costs / operating profit. Generally this indicates that the company
contribution margin per unit
should not sell the product because it will cost the company
= total fixed costs / (net sales price per unit more money than it generates. However, when the offering
− variable costs per unit) of such a product will generate additional sales and/or pre-
vent losses in the sales of other company products, it may
The break-even volume is the volume of products that be beneficial to offer the product. Consider total company
must be sold to pay for all variable and fixed costs. It is the performance in such cases in addition to particular product
point at which total sales equal total costs. Sales volume lev- performance. Also if idle plant or personnel capacity exists,
PRODUCT AND FACTORY COSTS
els above the break-even volume will achieve an operating it may be beneficial to offer the product or service when
profit while sales volume levels below that point will not. sales volumes are projected at below break-even levels as
The contribution margin is the amount of revenue that long as the projected sales volumes allow the coverage of all
remains after you have accounted for all variable costs. variable costs. You can use revenue remaining after you pay
Variable costs are those costs that change with the quantity the variable costs to defray existing fixed cost expenses.
of goods or services produced while fixed costs remain rela-
tively constant regardless of the quantity produced. Variable Ways to improve the indicator: You can lower break-even
costs include raw materials, direct labor, and the fuel used volumes by increasing contribution margins and reducing
to operate machinery. Fixed costs include building rent, fixed costs. Reducing variable costs and increasing sales
interest payments, and salaries for nondirect manufacturing prices can increase contribution margins. The primary
employees such as supervisors, engineers, and accountants. variable cost components are often raw materials and
direct labor for manufacturing and service companies and
When to use indicator: This ratio is useful for managers purchased merchandise for retailers. Negotiating lower
in determining the desirability of offering a product for purchase prices with existing suppliers and finding new,
sale given sales pricing, sales volume estimates, and lower cost suppliers of raw materials and merchandise can
product cost information. increase contribution margins. Increasing direct labor pro-
ductivity to reduce the labor content per unit produced
can also increase contribution margins.
Meaning of result: As the sales volume estimates become
much higher than the break-even volume, the offering of Although increasing sales prices will increase contribution
the particular product becomes more desirable. This is margins, such price increases can also reduce sales vol-
particularly true for higher priced and higher contribution umes, potentially reducing overall profit. Price increases
margin products because each additional unit sold gener- are thus generally acceptable only to the point that they
ates a substantial stream of operating income. maximize overall company profit.
85
Example Net sales = 85,420
Total cost of goods sold = 54,212
Break-even volume Raw material cost = 31,063
= total fixed costs / contribution margin per unit Direct labor = 7,860
Overhead cost = 15,164
= total fixed costs / (net sales price per unit − variable costs Other direct costs = 125
per unit) R&D costs = 4,578
SG&A costs = 15,993
Individual product
Depreciation & amortization = 1,204
Break-even volume = total fixed costs / contribution margin Interest = 784
per unit Variable costs = costs that are dependent on the number of
Sales price per unit = 88 goods or services produced
Variable costs per unit = 27 Variable costs = raw material cost + direct labor cost =
Total fixed costs required to produce the unit (machinery, 31,063 + 7,860 = 38,923
rent, supervision, insurance, etc.) = 91,000 Fixed costs = costs that are independent of the number of
Contribution margin per unit = net sales price per unit −
PRODUCT AND FACTORY COSTS
86
60
Equation
Determining the Break-Even
Point in Sales Dollars
company more money than it generates. However, when
the offering of such a product or service will generate
Break-even sales level = total fixed costs / contribution additional sales and/or prevent losses in the sales of other
margin percentage per unit
company products, it may be beneficial to offer the prod-
= Total fixed costs / ([net sales price per unit − variable costs uct. Consider total company performance in such cases in
per unit] / net sales per unit) addition to particular product performance. Also, if idle
plant or personnel capacity exists, it may be beneficial to
The break-even sales level describes the point at which net offer the product or service when sales levels are projected
sales equal total costs. Total costs include all variable and at below break-even levels as long as the projected sales
fixed costs. Sales volume levels above the break-even sales levels cover all variable costs. You can use revenue remain-
PRODUCT AND FACTORY COSTS
volume will achieve an operating profit while sales volume ing after the variable costs are paid to defray existing fixed
levels below that point will not. The contribution margin is cost expenses.
the amount of revenue that remains after you have account-
ed for all variable costs. The contribution margin percent- Ways to improve the indicator: You can lower break-even
age is the contribution margin divided by net sales. It sales levels by increasing contribution margins and reduc-
describes the size of the contribution margin on a percent- ing fixed costs. Reducing variable costs and increasing
age basis. Variable costs are those costs that change with the sales prices can increase contribution margins. The prima-
quantity of goods or services produced while fixed costs ry variable cost components are often raw materials and
remain relatively constant regardless of the quantity pro- direct labor for manufacturing and service companies and
duced. Variable costs include raw materials, direct labor, purchased merchandise for retailers. Negotiating lower
and the fuel used to operate machinery. Fixed costs include purchase prices with existing suppliers and finding new,
building rent, interest payments, and salaries for nondirect lower cost suppliers of raw materials and merchandise can
manufacturing employees such as supervisors, engineers, increase contribution margins. Increasing direct labor pro-
and accountants. ductivity to reduce the labor content per unit produced
can also increase contribution margins.
When to use indicator: This ratio is useful for managers in Although increasing sales prices will increase contribution
determining the desirability of offering for sale a particular margins, such price increases can also reduce sales levels,
product given sales pricing, sales volume estimates, and potentially reducing overall profit. Price increases are thus
product cost information. generally acceptable only to the point that they maximize
overall company profit.
Meaning of result: As the sales level estimates become
much higher than the break-even sales level, the offering Example
of the particular product or service becomes more and
more desirable. When the sales level estimates are less than Break-even sales level
the break-even sales level, the product or service will not
= Total fixed costs / contribution margin percentage per unit
return an operating profit. Generally this suggests that a = Total fixed costs / ([net sales price per unit − variable costs
company should not sell the product since it will cost the per unit] / net sales per unit)
87
Individual product
Raw material cost = 31,063
Break-even sales level = total fixed costs / Direct labor = 7,860
contribution margin percentage per unit Overhead cost = 15,164
Sales price per unit = 88 Other direct costs = 125
Variable costs per unit = 27 R&D costs = 4,578
Total fixed costs required to produce the unit (machinery, SG&A costs = 15,993
rent, supervision, insurance, etc.) = 91,000 Depreciation & amortization = 1,204
Contribution margin percentage per unit = (net sales price Interest = 784
per unit − variable costs per unit) / net sales price per unit = Variable costs = costs that are dependent on the number of
(88 − 27) / 88 = 0.693 goods or services produced
Variable costs = raw material cost + direct labor cost =
Break-even sales level = 91,000 / 0.693 = 131,279 31,063 + 7,860 = 38,923
Fixed costs = costs that are independent of the number of
Companywide goods or services produced
Fixed costs = overhead cost + other direct costs + R&D costs +
PRODUCT AND FACTORY COSTS
88
61
Equation
Finding the Sales Volume Necessary to
Generate a Desired Operating Income
short of desired profit level, a company may or may not
decide to offer the particular product or service, depending
Volume required to generate a desired operating income upon a number of factors such as the strategic importance
and growth potential of the product line. For example, if
= (total fixed costs + desired operating income) /
contribution margin per unit the offering of such a product will generate additional taga-
long sales or prevent losses in the sales of other company
= (total fixed costs + desired operating income) / products, it may be beneficial to offer the product even in
(net sales price per unit − variable costs per unit) light of lower profit projections. You should consider total
company performance when evaluating the desirability of
This ratio describes the volume of goods or services that individual product or service offerings. Also, if idle plant or
PRODUCT AND FACTORY COSTS
89
Example Desired operating income = 12,000
Net sales = 85,420
Volume required to generate a desired operating income Total cost of goods sold = 54,212
= (total fixed costs + desired operating income) / Raw material cost = 31,063
contribution margin per unit Direct labor = 7,860
= (total fixed costs + desired operating income) / Overhead cost = 15,164
net sales price per unit − variable costs per unit Other direct costs = 125
R&D costs = 4,578
Individual product SG&A costs = 15,993
Depreciation & amortization = 1,204
Volume required to generate a desired operating income =
Interest = 784
(total fixed costs + desired operating income) / contribution
margin per unit Variable costs = costs that are dependent on the number of
goods or services produced
Desired operating income = 44,500
Variable costs = raw material cost + direct labor cost =
Sales price per unit = 88
31,063 + 7,860 = 38,923
Variable costs per unit = 27
Fixed costs = costs that are independent of the number of
PRODUCT AND FACTORY COSTS
90
62 Finding the Sales Dollars Necessary to
Generate a Desired Operating Income
Equation the product or service will generate positive operating
income.
Sales level required to generate a desired operating income When operating income projections are positive but fall
= (total fixed costs + desired operating income) / short of desired profit level, the company may or may not
contribution margin percentage per unit decide to offer the particular product or service, depending
upon a number of factors such as the strategic importance
= (total fixed costs + desired operating income) / ([net sales and growth potential of the product line. For example, if
price per unit − variable costs per unit] / net sales per unit) the offering of such a product will generate additional taga-
PRODUCT AND FACTORY COSTS
This ratio describes the sales levels required to achieve a long sales or prevent losses in the sales of other company
desired level of operating income. The ratio is identical to products, it may be beneficial to offer the product even in
the break-even sales level with the exception of the addition light of lower profit projections. Consider total company
of the desired operating income variable. The contribution performance when evaluating the desirability of individual
margin is the amount of revenue that remains after you product or service offerings. Also, if idle plant or personnel
have accounted for all variable costs. The contribution mar- capacity exists, it may be beneficial to offer the product or
gin percentage is the contribution margin divided by net service when you project sales levels to be well below
sales and describes the size of the contribution margin on a desired levels as long as the projected sales levels cover all
percentage basis. Variable costs are those costs that change variable costs. You can use revenue remaining after you pay
with the quantity of goods or services produced while fixed the variable costs to defray existing fixed cost expenses.
costs remain relatively constant regardless of the quantity
produced. Variable costs include such costs as raw materi- Ways to improve the indicator: You can lower the sales
als, direct labor, and the fuel used to operate machinery. levels required to achieve a desired operating income by
Fixed costs include such costs as building rent, interest pay- increasing contribution margins and reducing fixed costs.
ments, and salaries for nondirect manufacturing employees Reducing variable costs and increasing prices can increase
such as supervisors, engineers, and accountants. contribution margins. The primary variable cost compo-
nents are often raw materials and direct labor for manu-
When to use indicator: This ratio is useful for managers in facturing and service companies and purchased merchan-
determining the desirability of offering a product for sale dise for retailers. Negotiating lower purchase prices with
given sales pricing, sales volume estimates, and product existing suppliers and finding new, lower cost suppliers of
cost information. raw materials and merchandise can increase contribution
margins. Increasing direct labor productivity to reduce the
Meaning of result: When the projected sales level estimate labor content per unit produced can also increase contri-
is greater than the sales level required to achieve a desired bution margins.
operating income, the product or service will return an Although increasing prices will increase contribution mar-
amount of operating income equal to or greater than the gins, such price increases can also reduce sales levels, poten-
desired figure. When this is not the case, operating income tially reducing overall profit. Price increases are thus gener-
projections will fall short of desired levels. However, as ally acceptable only to the point that they maximize overall
long as the projected sales levels cover total fixed costs, company profit.
91
Example Desired operating income = 12,000
Net sales = 85,420
Sales level required to generate a desired operating income Total cost of goods sold = 54,212
Raw material cost = 31,063
= (total fixed costs + desired operating income) / Direct labor = 7,860
contribution margin percentage per unit Overhead cost = 15,164
= (total fixed costs + desired operating income) / ([net sales Other direct costs = 125
price per unit − variable costs per unit] / net sales per unit) R&D costs = 4,578
SG&A costs = 15,993
Depreciation & amortization = 1,204
Individual product Interest = 784
Sales level required to generate a desired operating income = Variable costs = costs that are dependent on the number of
(total fixed costs + desired operating income) / contribution goods or services produced
margin percentage per unit
Desired operating income = 44,500 Variable costs = raw material cost + direct labor cost =
Sales price per unit = 88 31,063 + 7,860 = 38,923
PRODUCT AND FACTORY COSTS
Variable costs per unit = 27 Fixed costs = costs that are independent of the number of
Total fixed costs required to produce the unit (machinery, goods or services produced
rent, supervision, insurance, etc.) = 91,000 Fixed costs = overhead cost + other direct costs + R&D costs
Contribution margin percentage per unit = (88 − 27) / 88 = + SG&A costs + depreciation + interest = 15,164 + 125 +
0.693 4,578 + 15,993 + 1,204 + 784 = 37,848
Average contribution margin percentage per unit = (net sales
Sales level required to generate a desired operating income = − variable costs) / net sales = (85,420 − 38,923) / 85,420 =
(91,000 + 44,500) / 0.693 = 195,526 0.544
92
63
Equation
Finding the
Break-Even Plant Capacity
Meaning of result: Lower ratios indicate that a plant pro-
duces high-margin products and/or products with low
Break-even plant capacity = (fixed costs × current percentage fixed costs. When the break-even point is low, there is
of plant capacity) / (net sales − variable costs)
greater potential for profit as a plant becomes fully uti-
This benchmark roughly estimates the percentage of full lized. When the break-even point is high, there is greater
capacity at which a factory must run to achieve break-even risk of poor financial performance since small amounts of
sales. Break-even corresponds to the point at which total idle capacity may lead to unprofitable operations.
sales equal total costs. Sales volumes above the break-even
Ways to improve indicator: You can reduce break-even
volume will achieve an operating profit while sales volume
plant capacity by increasing contribution margins and
levels below that point will not. The benchmark assumes a
PRODUCT AND FACTORY COSTS
93
Example Variable costs = costs that are dependent on the number of
goods or services produced
Break-even plant capacity = (fixed costs × current percentage
of plant capacity) / (net sales − variable costs) Variable costs = raw material cost + direct labor cost =
31,063 + 7,860 = 38,923
Net sales = 85,420 Fixed costs = Costs that are independent of the number of
Current percentage of plant capacity = 80% = 0.80 goods or services produced
Total cost of goods sold = 54,212 Fixed costs = overhead cost + other direct costs + R&D costs +
Raw material cost = 31,063 SG&A costs + depreciation + interest = 15,164 + 125 +
Direct labor = 7,860 4,578 + 15,993 + 1,204 + 784 = 37,848
Overhead cost = 15,164
Other direct costs = 125 Break-even plant capacity = (37,848 × 0.80) / (85,420 − 38,923) =
R&D costs = 4,578 0.651 = 65.1%
SG&A costs = 15,993
Depreciation & amortization = 1,204
Interest = 784
PRODUCT AND FACTORY COSTS
94
CHAPTER FIVE
Expense
Analysis
95
64
Equation
Comparing the Cost of Goods
Sold to Sales and Net Income
Industries will exhibit ratios unique to their markets. It is
most helpful to compare cost-of-goods-sold indicators with
Cost of goods sold to sales = cost of goods sold / net sales companies operating in similar industries and markets. For
Cost of goods sold to net income = cost of goods sold / example, software companies tend to show low cost-of-
net income goods-sold ratios since there is not a lot of money tied up in
physically producing manuals and CD-ROMs. With these
Cost-of-goods-sold ratios are measures of the direct types of companies, more expenses are tied up in nondirect
expenses a company has incurred to manufacture products costs such as software development. On the other hand, car
and how such expenses relate to trends in sales and profit manufacturers have a tremendous amount of expense asso-
indicators. Cost-of-goods-sold items are all direct opera- ciated with raw materials, purchased parts, and the labor
tional expenses including raw materials and the labor and and overhead required to manufacture vehicles.
overhead used to manufacture a product.
Ways to improve the indicator: By seeking to reduce all of
EXPENSE ANALYSIS
When to use indicator: Managers and investors can use these the expenses associated with cost-of-goods-sold items, you
ratios to track the total direct expenses associated with the may reduce total cost-of-goods-sold expenses. You can
manufacture of products. reduce raw material expenses with supplier competitive bid-
ding and by redesigning products in a manner which
Meaning of result: To maintain or increase a company’s per- requires less expensive materials. You can reduce direct
formance, it is typically useful to maintain expense control labor costs by improving the efficiency with which you pro-
and tracking of the costs associated with the manufacture of duce products. Employee training, increased employee moti-
products. It is often desirable to reduce the cost of goods vation, improvements in production line setups, and the use
sold because this will tend to maximize profit. Exceptions to of more efficient equipment can improve efficiencies. You
this approach include initiating items that reduce customer can reduce direct overhead expenses by negotiating lower
or employee goodwill. For example, suppose a company plant and equipment leases and by designing more efficient
uses a new and cheaper raw material and that this is noticed plant layouts.
and disliked by its customers. Although the cost-of-goods-
sold ratios would decrease, sales volumes would likely suffer
and net profit may be reduced.
Sector Mid to large cap Cost-of-Goods- Small to mid cap Cost-of-Goods- Micro to small cap Cost-of-Goods-
Sold Ratio Sold Ratio Sold Ratio
96
Example Cost of goods sold = 54,212
Net sales = 85,420
Cost of goods sold to sales = cost of goods sold / net sales
Cost of goods sold to sales = 54,212 / 85,420 = 0.6347 =
63.47%
97
65
Equation:
Calculating the Amount of Sales and Cost
of Goods Sold Per Employee
morale. Lower trending sales per employee ratios are often
the result of opposite causes—reduced sales levels or
Sales per employee = net sales / number of employees decreased employee productivity.
Cost of goods sold per employee = cost of goods sold / Lower ratios of cost of goods sold per employee are typi-
number of employees cally desirable and can indicate falling raw materials prices;
lower direct labor costs; lower direct overhead costs; the
Ratios of sales and cost of goods sold per employee are manufacture of new, higher margin products; and increased
measures of employee productivity and the revenue-generat- employee productivity. Higher ratios are generally undesir-
ing and expense-controlling state of the business. able and can indicate the opposite causes.
When to use indicator: Investors and managers can use this Ways to improve the indicator: Maintain a motivated, well-
indicator to determine a number of important issues. First, trained, and cooperative staff. Leadership from all employ-
the sales per employee ratio provides a general sense of the ees, line workers to top executives, in each of these areas is
EXPENSE ANALYSIS
company’s sales-generating capability and trends. This ratio critical to improve productivity. Eliminate redundancies.
can also indicate employee productivity levels. The costs-of- Encourage employees to suggest and develop methods of
goods-sold ratio can indicate expense control effectiveness. improving productivity, generating more sales, and reducing
You can also anticipate required staffing levels through sales costs associated with producing products or services.
level forecasts.
Example
Meaning of result: Higher trending sales per employee are
often the pleasant indication of either higher sales levels or Sales per employee = net sales / number of employees
improving employee productivity. You can improve pro- Net sales = 85,420
ductivity with increased morale, incentives, education, Number of employees = 836
expertise, teamwork, and the use of tools such as computers
to perform more work in less time. Watch that increases in Sales per employee = 85,420 / 836 = $102.2
sales per employee are not the result of excessive overtime, (this is in thousands of dollars)
which could lead to excessive attrition or a lowering of
per employee =
Sales$102.18 net sales
85,420 / number of
836employees
Sales per employee = net sales / number of employees
98
Determining Sales, Net Income, and the Cost of
66
Equation
Goods Sold Per Direct Labor Employee
Meaning of result: Companies generally seek to maximize the
amount of sales per direct employee. Management should
Sales per direct labor employee = net sales / number of direct investigate direct labor expense factors when these ratios are
labor employees trending high or low. When ratio levels are trending higher,
Net income per direct labor employee = net income / number this indicates that production efficiencies could be rising due
of direct labor employees to factors such as increased throughput, increased morale or
Cost of goods sold per direct labor employee = cost of goods incentives, reduced production line downtime, improved
sold / number of direct labor employees equipment, or production layouts. Watch that increased levels
of sales per direct employee are not at the cost of excessive
You can determine companywide performance and direct overtime since this could lead to decreased profit and morale.
labor employee productivity with ratios of sales, income, Industries will exhibit ratios unique to their markets. It is
and cost of goods per direct labor employee. Direct labor typically most beneficial to compare direct labor cost indica-
employees are those employees directly involved in the pro- tors with companies operating in similar industries and mar-
kets. Companies which produce high labor content products
EXPENSE ANALYSIS
100
increased employee motivation and morale, improvements You can increase the ratios of direct labor cost and hours
in production line setups, and the use of more efficient worked to cost of goods sold by reducing the cost-of-goods-
equipment. Eliminate redundancies in direct labor tasks. sold ratio. Some ways to do this are by purchasing raw
Ensure that slack time is kept to a minimum; all direct materials at lower prices, lowering building lease costs, or
employees should have productive tasks to complete at all developing new products or services that use less raw mate-
times. rials.
When sales levels have changed dramatically and will like-
ly remain at the new level for some time and the direct labor Example
hour ratios have changed accordingly, it may be necessary
Direct labor cost to sales = direct labor cost / net sales
to adjust the amount of direct labor staff. Increases in the
ratios of direct labor hours to sales can indicate too many Direct labor cost = 7,860
direct employees are on staff while reductions may indicate Net sales = 85,420
the need for further hiring. When there is excessive use of
overtime, the hiring of additional direct labor employees Direct labor cost to sales = 7,860 / 85,420 = 0.092 = 9.20%
can lower the ratios of cost and hours worked.
EXPENSE ANALYSIS
101
Comparing Direct Labor Costs, Direct Labor Employees,
68
Equation
and Direct Labor Hours Worked to the Cost of All Labor
When to use indicator: Managers and investors use these
ratios to track direct labor expenses and uses. When the ratio
Direct labor cost to total labor cost = direct labor cost / of direct labor to total labor cost is trending too low or high,
total labor cost
this indicator can alert management to investigate direct
Direct labor employees to total labor cost = labor cost factors. Management can also use this ratio to
direct labor employees / total labor cost track the change in direct labor expenses because of addition-
Direct labor hours worked to total labor cost = al direct employee training, experience level, overtime
direct labor hours worked / total labor cost requirements, new product lines, and the installation of new
manufacturing equipment. Direct labor is one of the three
These indicators compare the costs and availability of primary constituents of the cost of goods sold expenses. The
direct labor with a company’s total labor expenditures. The other two items are raw materials and direct overhead
hours-worked ratio is useful in determining the level of expenses.
direct labor available as a percentage of total labor costs.
EXPENSE ANALYSIS
Think of this ratio as the measure of the hours of direct Meaning of result: Higher ratios can be the result of higher
labor available, or the time degree of direct labor horsepow- than usual direct labor hour use or reductions in the use of
er purchased, for every dollar spent on all labor. The inverse nondirect labor. Higher use of direct labor can arise because
of this indicator conveys the amount of money spent on all of increasing sales, increasing direct labor inefficiencies, a
labor per hour of direct labor. Direct labor employees are wave of new hires, or changes in product or service offerings.
those employees directly involved in the production of a Labor inefficiencies can occur from issues such as inadequate
product or service such as machine operators and assemblers training, poor morale, and problematic equipment. You can
in manufacturing firms, hair cutters in salons, and draftsper- reduce the percentage use of nondirect labor through staff
sons in architectural firms. streamlining and increased sales levels. Increasing sales gener-
You can also use these ratios to track the performance of ally require immediate additional direct labor costs to pro-
indirect and other nondirect employees by substituting the duce more products or deliver additional services.
appropriate labor group information. Indirect employees are Industries will exhibit ratios unique to their markets, so it
those operations employees not directly involved in the pro- is best to compare direct labor cost indicators with compa-
duction of the product or service such as warehouse receiving nies operating in similar industries and markets. Companies
employees, production supervisors, and maintenance person- which produce products with a high labor content will tend
nel. Other nondirect employees are employees fully removed to exhibit higher ratios than those that have a lower labor
from work that is directly associated with or in direct support content. For example, a manufacturer of custom, hand-
of producing a company’s primary product or service. Exam- made wooden furniture would likely have higher direct-
ples include employees in human resources, accounting, com- labor-hour ratios than a manufacturer of plastic patio furni-
puter services, R&D, sales, marketing, and customer service. ture that is primarily made with machines.
102
Ways to improve the indicator: You can reduce direct labor the need to hire additional direct labor staff. If there is sim-
cost ratios by improving the efficiency with which you build ply excess direct labor capacity and the extra employees
products or render services. You can improve efficiencies cannot be retrained or relocated for other positions, man-
with employee training, increased motivation and morale, agement may face the uncomfortable choice between layoffs
improvements in production line setups, and the use of and maintaining inefficient operations.
more efficient equipment. Eliminate redundancies in direct
labor tasks. Ensure that slack time is kept to a minimum; all Example
direct employees should have productive tasks to complete
Direct labor cost to total labor cost =
at all times. direct labor cost / total labor cost
When sales levels have changed dramatically and will like-
ly remain at the new level for some time and the direct labor Direct labor cost = 7,860
hour ratios have changed accordingly, it may be necessary Total labor cost = 18,871
to adjust the amount of direct labor staff. Increases in the
Direct labor cost to total labor cost = 7,860 / 18,871 =
ratios of direct labor hours to sales can indicate too many
0.4165 = 41.65%
direct employees are on staff while reductions may indicate
EXPENSE ANALYSIS
103
Finding the Labor Cost and Hours
69
Equation
Worked Per Direct Employee
cause such increases including excessive overtime, rising
wage rates, more labor-intensive work processes, increases
Labor cost per direct employee = direct labor cost / in direct labor inefficiencies, and increases in the use of
direct labor employees
part-time direct staff.
Hours worked per direct labor employee = Higher hours worked ratios generally indicate that a com-
direct labor hours / direct labor employees pany uses direct labor employees on a full-time basis, poten-
tially using a high degree of overtime. Lower ratios can indi-
These ratios allow you to determine the average yearly cate significant use of part-time employees, increases in
salary and hours worked per direct labor employee. Direct direct labor absences, and reductions in direct labor require-
labor employees are those employees directly involved in ments because of factors such as decreasing sales levels or
the production of the product or service such as machine increasing production efficiencies.
operators and assemblers in manufacturing firms, hair cut-
ters in salons, and draftspersons in architectural firms. Ways to improve the indicator: You can reduce ratios of
EXPENSE ANALYSIS
You can also use these ratios to track the performance of direct labor cost and hours worked by improving the effi-
indirect and other nondirect employees by substituting the ciency with which you build products or render services. You
appropriate labor group information. Indirect employees can improve efficiencies with employee training, increased
are those operations employees not directly involved in the employee motivation and morale, improvements in produc-
production of the product or service such as warehouse tion line setups, the use of more efficient equipment, or
receiving employees, production supervisors, and mainte- reengineering products and services to minimize direct labor
nance personnel. Other nondirect employees are employees requirements. Eliminate redundancies in direct labor tasks.
fully removed from work that is directly associated with or Ensure that slack time is kept to a minimum; all direct
in direct support of producing a company’s primary product employees should have productive tasks to complete at all
or service. Examples include employees in human resources, times.
accounting, computer services, R&D, sales, marketing, and When there is excessive use of overtime, it is often benefi-
customer service. cial to hire additional direct employees to lower the labor cost
per employee. This is particularly true when overtime require-
When to use indicator: Managers can use these ratios to ments are not seasonal in nature and when you project over-
determine direct labor salary trends and the manner in time requirements to remain steady or increase in the future.
which the company is using direct labor. The hours worked When a company decreases part-time staffing, there are
ratio can indicate the level of direct labor capacity available, more employees working full-time, which increases the
the degree to which the company uses full-time employees, labor cost per direct employee. However, since these
and the extent to which absences affect direct labor avail- employees contribute more by working additional hours,
ability. You can also use this ratio for long-term direct labor there is essentially no increased cost on an hourly basis,
planning purposes since it can give an accurate portrayal of only on a per-employee basis. However, there may be hid-
the actual hours worked per direct employee. den cost differences when comparing part- and full-time
employees such as variability in productivity, wage rates,
Meaning of result: Higher cost ratios indicate increasing and benefit costs.
direct labor costs per employee. A number of factors can
104
Example
Labor cost per direct employee = direct labor cost / Labor cost per direct employee = 7,860,000 / 512 = $15,351
direct labor employees per direct labor employee
Direct labor cost = 7,860,000 Labor cost per hour per direct employee = 7,860,000 / 768,000 =
Direct labor employees = 512 $10.23
Direct labor hours = 768,000
105
70
Equation
Determining the Percentage of All
Employees Who Are Direct Laborers
be a result of a morale problem, a training issue, or existing
machinery that is becoming more troublesome with age and
Direct labor employee percentage = direct labor employees / requires replacing. Management may also identify events
total employees
that justify the higher trending ratios. For example, higher
You can use this ratio to find the percentage of the total trends could be the result of a wave of new hires who have
work force that represents direct labor employees. Direct less experience and lower productivity levels; a new, more
labor employees are those employees directly involved in labor-intensive product line; or indirect labor productivity
the production of the product or service such as machine increases that have reduced the need for indirect employees.
operators and assemblers in manufacturing firms, hair cut- Reductions in the amount of nondirect employees can
ters in salons, and draftspersons in architectural firms. arise from improvements in nondirect employee efficiencies,
You can also use this ratio to track the performance of cost-cutting measures, and changes in business strategies.
indirect and other nondirect employees by substituting the When you reduce the number of nondirect employees as a
appropriate labor group information. Indirect employees cost-cutting measure, investigate further to be sure such
EXPENSE ANALYSIS
are those operations employees not directly involved in the short-term cost-cutting gains are not at the cost of long-
production of the product or service such as warehouse term revenue and income losses. For example, reductions in
receiving employees, production supervisors, and mainte- sales and R&D staffing can surely save money in the short
nance personnel. Other nondirect employees are employees term but could cripple the potential for future sales and
fully removed from work that is directly associated with or income growth.
in direct support of producing a company’s primary product
Ways to improve the indicator: Depending upon staff size
or service. Examples include employees in human resources,
and business outlook, you may want to increase or
accounting, computer services, R&D, sales, marketing, and
decrease the percentage of direct labor employees.
customer service.
Changes from historical norms of the percentage of direct
When to use indicator: Managers can use this ratio to deter- to total employees can alert you to investigate all potential
mine trends in use of direct labor and to be sure an appro- causes. For example, is a significant change due to increas-
priate amount of direct employees are on the payroll. They ing or decreasing sales? Or excessive or insufficient nondi-
can also use this ratio to track how the number of direct rect employee staffing? Or from changes in direct labor
labor employees varies with changes such as additional efficiencies?
training, experience levels, or the installation of new and Before adding additional direct headcount, management
more productive manufacturing equipment. should ask whether changing, larger workloads can be han-
dled by improving the efficiency with which the company
Meaning of result: Higher ratios indicate growing percent- builds products and provides services? This is typically a
ages of direct labor employees. This can occur when there more cost-effective way to tackle changing workloads than
are increasing direct labor requirements or reductions in through the hiring of more people. You can improve effi-
nondirect employees. Increasing direct labor requirements ciencies with employee training, increased employee motiva-
often result from rising sales levels because increasing tion and morale, improvements in production line or ser-
demand requires additional labor. Higher trends may also vice-related setups and work processes, and the use of more
indicate decreased direct employee productivity. This could efficient equipment. Eliminate redundancies in direct labor
106
tasks. Ensure that slack time is kept to a minimum; all direct Example
employees should have productive tasks to complete at all
times. Direct labor employee percentage = direct labor employees /
total employees
107
Determining the Direct Labor Costs Per Production
71
Equation
Unit and Other Direct Labor Efficiency Ratios
product lines and services as well as for determining overall
company trends.
Direct labor costs per production unit = direct labor costs /
number of units produced Meaning of result: Higher costs per unit and lower units per
employee or hour can indicate decreases in direct labor effi-
Production units per direct labor employee =
number of units produced / direct labor employees ciency, increases in wages, or changes in the type of product
or service offered. New products or service offerings may
Production units per direct labor hour = require more or less direct labor per unit, depending upon
number of units produced / direct labor hours worked the relative complexity of the new process. These ratios will
tend to change temporarily during the initial rollout of new
These ratios describe the level of direct labor efficiency in products or services. This can occur because of extra time
producing a product or service. They can also indicate required for training and skills development.
changes in direct labor requirements because of changing
EXPENSE ANALYSIS
product lines or service offerings. Direct labor employees Ways to improve the indicator: You can improve direct
are those employees directly involved in the production of labor ratios by increasing the efficiency with which your
the product or service such as machine operators and company builds products or renders services. You can
assemblers in manufacturing firms, hair cutters in salons, improve efficiencies with employee training, increased
and draftspersons in architectural firms. employee motivation and morale, improvements in produc-
You can also use these ratios to track the performance of tion line or service-related setups, and the use of more effi-
indirect and other nondirect employees by substituting the cient equipment. Eliminate redundancies in direct labor
appropriate labor group information. Indirect employees are tasks. Ensure that slack time is kept to a minimum; all
those operations employees not directly involved in the pro- direct employees should have productive tasks to complete
duction of the product or service such as warehouse receiving at all times.
employees, production supervisors, and maintenance person-
nel. Other nondirect employees are employees fully removed Example
from work that is directly associated with or in direct support
Direct labor costs per production unit =
of producing a company’s primary product or service. Exam-
direct labor costs / number of units produced
ples include employees in human resources, accounting, com-
puter services, R&D, sales, marketing, and customer service. Direct labor costs = 7,860
Number of units produced = 654
When to use indicator: Managers can use this ratio to deter-
mine trends in the efficiency and costs in fabricating products Direct labor costs per production unit = 7,860 / 654 =
or delivering services. You can use this indicator for distinct $12.02
108
Comparing the Direct Overhead Cost to Sales,
72
Equation
Net Income, and the Cost of Goods Sold
since this will tend to maximize profit. However, more
effective managers also consider factors such as the safety
Direct overhead cost to sales = and productivity that overhead expenses provide. For
direct overhead cost / net sales
example, reducing the amount of lighting will cut overhead
Direct overhead cost to net income = expenses but will likely reduce labor output due to reduced
direct overhead cost / net income vision. Even worse, employee morale and/or safety issues
could arise from such a move. In this example, it may be
Direct overhead cost to cost of goods sold = more cost-effective to increase lighting to improve profit.
direct overhead cost / cost of goods sold Industries will exhibit ratios unique to their markets, so it
Direct overhead cost ratios are measures of the direct is best to compare direct overhead cost indicators to com-
overhead expenses a company incurs to manufacture prod- panies operating in similar industries and markets. Compa-
ucts and of how such expenses relate to trends in sales, nies which produce products in high cost of living locations
tend to exhibit higher ratios than those located in other
EXPENSE ANALYSIS
109
Comparing Raw Materials Costs to Sales,
73
Equation
Net Income, and the Cost of Goods Sold
but it may reduce finished product quality to the point that
customers become dissatisfied. Or a supplier might provide
Raw materials costs to sales = raw materials costs / net sales a superior quality product at a great price but, because of
Raw materials costs to net income = continually late shipments, cause the manufacturer to stop
raw materials costs / net income production lines and lose customers who can’t wait until
they start up again.
Raw materials costs to cost of goods sold = Industries will exhibit ratios unique to their markets, so it
raw materials costs / cost of goods sold is best to compare raw material cost indicators with compa-
nies operating in similar industries and markets. Companies
Raw materials cost ratios are measures of the raw materi-
which produce products with a large degree of purchased
als expenses a company incurs to manufacture products and
parts will tend to exhibit higher raw materials ratios than
of how such expenses relate to trends in sales, profit, and
those that use simple commodity-type raw materials. For
expense indicators.
example, a computer manufacturer that purchases micro-
EXPENSE ANALYSIS
When to use indicator: Managers can use these ratios to processors and other sophisticated parts for its product line
track the raw materials expenses associated with the manu- will likely have higher raw materials ratios than a manufac-
facture of products. These ratios can alert management to turer of surfboards, whose raw materials are basic and most
investigate raw materials expense factors when these ratios of whose costs are associated with the labor required to
trend high or low. Raw materials are one of the three prima- manufacture the product.
ry constituents of the cost of goods sold. The other two
Ways to improve the indicator: You can reduce raw materi-
items are direct labor and direct overhead expenses.
als costs by lowering piece part costs and by redesigning
Meaning of result: To maintain or increase a company’s per- product lines with more cost-effective components. Good
formance, a manager must maintain expense control and negotiating techniques and additional vendor sourcing may
track the costs associated with the manufacture of products. help drive down component costs. Excellent engineering
Raw materials costs are the overhead expenses allocated to should help with redesign efforts.
the purchased parts, assemblies, and raw materials required
Example
to fabricate a company’s products.
Usually you will want to reduce the cost of goods sold, of Raw materials costs to sales = raw material costs / net sales
which raw materials are a main component, because this
will tend to maximize profit. However, more effective man- Raw materials costs = 31,603
agers also consider factors such as the quality, dependabili- Net sales = 85,420
ty, and responsiveness of raw material suppliers. For exam- Raw materials costs to sales = 31,063 / 85,420 = 0.3637 =
ple, using a less expensive raw material will cut expenses, 36.4%
37.00%
Raw materials costs to sales = raw material
31,603 costs / net 85,420
sales
Raw materials costs to sales = raw material costs / net sales
110
74
Equation
Comparing Other Direct Costs to Sales, Gross
Profit, Net Income, and the Cost of Goods Sold
costs associated with the manufacture of products. Other
direct costs are the overhead expenses allocated to direct
Other direct costs to sales = other direct costs / net sales expense items which are not related to either raw materials,
Other direct costs to net income = direct labor, or direct overhead.
other direct costs / net income Most companies prefer to reduce the cost of goods sold,
of which other direct expenses are a component, because
Other direct costs to cost of goods sold = this will tend to maximize profit. Industries will exhibit
other direct costs / cost of goods sold ratios unique to their markets, so it is best to compare other
direct cost indicators with companies operating in similar
Other direct cost ratios are measures of the miscellaneous
direct expenses a company incurs to manufacture products industries and markets.
and of how such expenses relate to trends in sales and profit Ways to improve the indicator: You can reduce other direct
indicators. costs by lowering or eliminating the miscellaneous expenses
EXPENSE ANALYSIS
When to use indicator: Managers use these ratios to track associated with cost of goods sold.
the miscellaneous direct expenses associated with the manu-
Example
facture of products. Other direct costs include all costs
other than those included in the three primary constituents Other direct costs to sales = other direct costs / net sales
of the cost of goods sold expenses: raw materials, direct
labor, and direct overhead. Other direct costs = 125
Net sales = 85,420
Meaning of result: To maintain or increase its performance,
Other direct costs to sales = 125 / 85,420 = 0.0015 = 0.15%
a company must maintain expense control and track the
0.15%
Other direct costs to sales = other direct
125 costs / net85,420
sales
Other direct costs to sales = other direct costs / net sales
111
75
Equation
Comparing R&D Costs
to Sales and Net Income
company growth and net income since new products devel-
oped by R&D may not be ready when needed. Lower
R&D costs to sales = R&D costs / net sales trends could also indicate the company is entering a phase
R&D costs to net income = R&D costs / net income which does not require new products because of lack of
competition or reduced demand for new products.
R&D cost ratios are measures of the R&D expenditures a Higher trending R&D ratios could indicate the develop-
company incurs to develop new products and of how such ment of more product offerings or more complex products
expenditures relate to trends in sales and profit indicators. for a given amount of present-day sales. If you can realize
R&D expenses include salaries, raw material, and equipment commensurate increases in future sales with this additional
for development efforts, travel, and training. R&D outlay, you can justify the increasing trend. Higher
ratios can also indicate R&D expenses are out of control if
When to use indicator: Managers and investors use these the company does not generate additional R&D output. If
ratios to determine whether a company is spending proper this is the case, management should determine the cause of
EXPENSE ANALYSIS
Sector Mid to large cap R&D Costs Small to mid cap R&D Costs Micro to small cap R&D Costs
to Sales Levels to Sales Levels to Sales Levels
Many of the R&D costs to sales levels shown in the table above are zero. Some of these compa-
nies did have R&D expenditures (and commensurate R&D costs to sales ratios) but elected not
to itemize R&D expenditures on their financial statements.
112
30%, then R&D ratios should likely increase by a commen- Example
surate amount to 12% [8% × (30/20)].
Increases in R&D productivity may allow the reduction of R&D costs to sales = R&D costs / net sales
historic spending levels. A company can realize productivity R&D costs = 4,578
increases by using new, more efficient, computer-based design Net sales = 85,420
and management tools; offering additional experience, train-
ing and education; adding incentive programs; and creating R&D costs to sales = 4,578 / 85,420 = 0.0536 = 5.36%
work environments which maximize motivation.
113
76
Equation
Comparing Selling, General, and Administrative
Costs (SG&A) to Sales and Net Income
and coordination—tasks typically performed by such senior
SG&A costs to sales = SG&A costs / net sales level management—future sales-generating capability would
SG&A costs to net income = SG&A costs / net income likely suffer.
Higher trending SG&A ratios can indicate SG&A
Selling, general, and administrative costs (SG&A) ratios expenses are out of control. Examples could include exces-
are measures of the expenditures a company incurs to sell sive discretionary expenses such as travel and executive
and support its product lines and of how such expenditures perks. Higher ratios could also indicate overstaffing in one
relate to trends in sales and profit indicators. Selling expens- or more departments. Overstaffing can result during busi-
es include the costs for sales personnel salaries and sales- ness downturns and from ineffective management. When
related expenses such as travel and advertising. General and company revenue and earning levels decrease with no
administrative expenses include salaries for executives, change in staffing levels, expense ratios rise. Such situations
accountants, human resource personnel, and most other are usually sustainable for short periods, but not typically
indirect employees and for items such as office leases, utili- in the long run. Either revenues must increase or staff levels
EXPENSE ANALYSIS
ties, and insurance. Many companies will report selling must decrease to a level suitable for the new size of the
expenses and G&A expenses as separate line items. company.
When to use indicator: Managers and investors use these Ways to improve the indicator: Management should assess
ratios to determine whether a company is spending proper current SG&A expenditure levels and determine in what
amounts of money on SG&A. areas waste or redundancy exists and take appropriate
Meaning of result: Lower SG&A expenditure ratios indicate action to improve efficiencies. Developing expense budgets
less money being spent, on a percentage basis, for sales, gen- should help to identify and correct expenses that are out of
eral, and administrative items. This could be the result of control.
more efficient and effectively run operations or the result of
Example
cost-cutting measures designed to increase near-term profit.
The latter possibility could have adverse short- to long-term SG&A costs to sales = SG&A costs / net sales
effects on company growth and net income when a company SG&A costs = 15,993
reduces income-generating items such as advertising pro- Net sales = 85,420
grams and the number of salespeople. Longer term adverse SG&A costs to sales = 15,993 / 85,420 = 0.1872 = 18.72%
effects could result if, for example, expense reduction took
the form of eliminating all executive level sales and market- SG&A18.72%
costs to sales = SG&A costs / net85,420
15,993 sales
ing positions. With no forward-looking strategic planning SG&A costs to sales = SG&A costs / net sales
Sector Mid to large cap SG&A Small to mid cap SG&A Micro to small cap SG&A
Ratio Ratio Ratio
114
77
Equation
Comparing Individual Overhead Expenses to
Total Overhead Expenses and Sales
curbing or cutting expenses which generate little gain. At
other times, this can mean increasing spending in areas
Individual expense to total overhead expense = individual
where the benefits outweigh the costs. In other words,
expense (i.e., nondirect employee salaries, benefits, travel,
entertainment, utilities) / total overhead expense expense control does not always mean expense reduction.
For example, since nondirect personnel are typically one of
Individual expense to sales = individual expense (i.e., salaries, the most costly overhead expenses, you can exercise consid-
benefits, travel, entertainment, utilities) / net sales erable overhead control keeping nondirect staff numbers at
levels where there is no redundancy or waste. However, it is
These indicators track the size of individual overhead important that management not trim nondirect labor costs
expenses in relation to total overhead expenditures and net to levels so low that critical functions can no longer operate
sales levels. Overhead expenses include all expenses not smoothly. For example, eliminating all sales positions would
directly involved in the fabrication of a product in a manu- certainly cut the amount of nondirect salaries but would
facturing firm or the rendering of a service in a service-relat- also likely cripple sales income, forcing the company into an
EXPENSE ANALYSIS
ed firm. Examples of individual overhead expenses include early bankruptcy. It may even be possible that additional
nondirect employee salaries, health benefits, retirement salespeople should be added to the staff if this allows
plans, travel, entertainment, meals, office rent, and office increases in net sales and profit far in excess of the costs.
utilities.
Ways to improve the indicator: You can lower expenses by
When to use indicator: Managers can use these indicators to negotiating lower individual expenses with the appropriate
determine whether a company is incurring historic and supplier of the overhead item. For example, negotiations
appropriate overhead expenses. By tracking individual over- with landlords, travel companies, advertising agencies, jani-
head expenses, managers can quickly discover unusual
torial services, and healthcare companies may yield lower
expenditure levels and investigate their causes. Individual
expense outlays.
overhead items can be more than or less than appropriate
Increasing sales levels will often lower ratios of individual
expenditure levels. For example, too low a travel expense
overhead to sales because many overhead expenses lag
could indicate sales and marketing personnel are not inter-
behind changes in sales levels. For example, an increase in
acting with customers to an appropriate degree whereas too
sales does not typically immediately translate into signifi-
high a travel expense could indicate excessive travel, which
cant increases in utility, insurance, or building rental rates.
may have generated little additional sales or goodwill.
And as a company continues to grow with increasing sales
Meaning of result: Lower ratios of individual overhead to levels, many overhead items can become less expensive since
sales are generally desirable and are often the result of the company purchases higher volumes. For instance, nego-
rapidly increasing sales levels or lowered expense costs. tiating optimal health plan options and costs can be much
Expense control is the process of determining what expense easier for the 500-employee company than for a sole propri-
levels will offer the greatest benefit. At times, this means etorship.
115
Example Health benefit to total overhead expense =
1,440 / 22,104 = 0.0651 = 6.51%
Health benefit to total overhead expense =
health benefit expense / total overhead expense and
Health benefit expense = 1,440 Health benefit expense to sales = health benefit expense / net sales
Total overhead expense = gross profit − pretax income =
31,208 − 9,104 = 22,104
Health benefit expense to sales = 1,440 / 85,420 = 0.0169 =
Net sales = 85,420 1.69%
116
78
Equation
Finding Plant Equipment
Costs Per Hour
ber of factors such as using obsolete machinery, producing
equipment-intensive products or services, or using improperly
Plant equipment cost per hour = total costs to maintain and maintained machinery that requires frequent repairs.
operate plant equipment / hours of fixed asset operation
When machinery downtime for breakage or maintenance
This ratio details the hourly costs of using and maintain- increases, plant-equipment-per-hour costs rise. This is due
ing plant equipment. Costs include all expenses incurred to to two factors. First, there are costs associated with repair
operate plant equipment such as the labor expense for efforts and replacement parts. Second, since the machinery
machinery maintenance, replacement parts, and utility costs. is not being used during repairs and maintenance, equip-
Plant equipment, one type of fixed asset, includes items such ment operation hours decline and costs per hour increase.
as machinery and tooling. Fixed assets (also referred to on
Ways to improve the indicator: Properly maintaining equip-
the balance sheet as property, plant, and equipment) include
ment to increase useful life and limit downtime for repairs
items with lifetimes of greater than three years such as land,
can improve plant equipment costs per hour. You can also
buildings, machinery, tooling, leasehold improvements,
EXPENSE ANALYSIS
Meaning of result: Higher ratios indicate higher costs to main- Machinery cost per hour = (165 + 855 + 132 + 327 + 94 + 24)/
tain and operate plant equipment. This can result from a num- 1,654 = 1,597 / 1,654 = 0.9655 = $966/hour
117
79
Equation:
Comparing the Cost of
Fixed Asset Maintenance to Sales
assets. However, lower fixed asset maintenance costs can
also indicate the company is using newer, less maintenance-
Fixed asset maintenance to sales = intensive equipment or that fewer fixed asset-intensive
fixed asset maintenance cost / net sales
sources are generating sales.
You should maintain fixed assets properly to maximize When ratios are increasing with time, this can indicate
improved, more costly maintenance procedures. It can also
useful life and minimize downtime. This ratio can be used
indicate the company is using fixed assets past their useful
to determine trends in fixed asset maintenance. Fixed assets lives, which has driven up maintenance costs. Another pos-
include machinery, tooling, and facilities such as buildings sibility is that the company is using new types of equipment
and improvements to properties. that are more maintenance intensive.
Ways to improve the indicator: It is generally desirable to
When to use indicator: Managers, investors, and creditors
maintain fixed assets according to prescribed procedures
can use this indicator to ascertain whether a company is
and at indicated time intervals. Any cutbacks in mainte-
EXPENSE ANALYSIS
performing appropriate amounts of maintenance. nance can have adverse long-term financial impacts.
Meaning of result: Ratios of fixed asset maintenance to Example
sales are highly dependent upon the type of fixed assets
employed and in what industry the business competes. For a Fixed asset maintenance to sales =
given business, decreasing fixed asset maintenance ratios fixed asset maintenance cost / net sales
may indicate the company is not performing necessary
maintenance possibly, as a cost-saving measure to increase Fixed asset maintenance cost = 245
Net sales = 85,420
short-term profit. Such action can have longer term detri-
mental effects because proper maintenance typically Fixed asset maintenance to sales = 245 / 85,420 = 0.0028 =
enhances greatly the useful life and productivity of fixed 0.28%
118
80
Equation
Comparing the Cost of Fixed Asset
Maintenance to the Value of Fixed Assets
can also indicate the company is using newer, less mainte-
nance-intensive equipment or that fewer fixed asset-inten-
Fixed asset maintenance to fixed asset value = sive sources are generating sales.
fixed asset maintenance cost / fixed asset book value
When ratios are increasing with time, this can indicate
A company must properly maintain fixed assets to maxi- improved, more costly maintenance procedures. It can also
mize useful life and minimize downtime. You can use this indicate a company is using fixed assets past their useful
ratio to determine trends in fixed asset maintenance. Fixed lives, which has driven up maintenance costs. Another pos-
assets include machinery, tooling, and facilities such as sibility is that the company is using new types of equipment
buildings and improvements to properties. that are more maintenance intensive.
When to use indicator: Managers, investors, and creditors Ways to improve the indicator: It is generally desirable to
can use this indicator to ascertain if a company is perform- maintain fixed assets according to prescribed procedures and
ing appropriate amounts of maintenance. at indicated time intervals. Any cutbacks in maintenance can
EXPENSE ANALYSIS
119
81
Equation
Relating Insurance Costs to
Sales Revenue
of fixed assets, companies with extensive asset coverage,
and companies that pay higher insurance rates, possibly
Insurance costs to sales revenue = insurance costs / net sales because of a high number of insurance claims.
120
82
Equation
Relating Insurance Expenses
to the Value of Fixed Assets
fully cover assets to reduce the risk associated with the
extension of credit for those assets. High insurance cost
Insurance costs to fixed assets = insurance costs / fixed assets ratios can indicate companies with extensive asset coverage
and companies that pay higher insurance rates, possibly
This ratio compares insurance costs, a significant portion
because of a high number of insurance claims.
of operational expenses, to fixed assets. Insurance costs pro-
tect company assets from partial or total losses arising from Ways to improve the indicator: It is generally desirable to
events such as fires, floods, and machinery breakdowns. maintain proper insurance of company assets, particularly
Fixed assets (also referred to on the balance sheet as proper- when the uninsured asset losses would severely strain finan-
ty, plant, and equipment) include tangible items with life- cial resources.
times of greater than three years such as land, buildings,
machinery, tooling, vehicles, leasehold improvements, furni- Example
ture, and office equipment.
Insurance costs to fixed assets = insurance costs / fixed assets
EXPENSE ANALYSIS
121
83
Equation
Examining Book
Depreciation
actual lifetimes are often greater than depreciation schedule
lifetimes and market values are often larger than book val-
Book depreciation = ues.
depreciation method used in financial reports
When to use indicator: Companies use depreciation meth-
Depreciation is used to amortize the purchase price of ods to account for the gradual consumption of assets.
assets over their useful lifetimes. When you use this tech- Investors can compare asset values to depreciation expenses
nique for financial reporting, it is called book depreciation, to determine the rate at which the company depreciates
and it is often different from the depreciation amounts used assets.
for tax returns. In the United States it is common to depreci-
ate assets more quickly on tax returns using accelerated Meaning of result: A company generally depreciates, or
depreciation schedules. This has the effect of lowering cur- uses up, longer lived assets over longer periods of time.
rent-year tax expenses. The depreciation per year thus tends to be a smaller por-
tion of the purchase price for long-lived assets. Companies
EXPENSE ANALYSIS
Sector Mid to large cap Book Small to mid cap Book Micro to small cap Book
Depreciation Depreciation Depreciation
122
84
Equation
Examining Tax Return
Depreciation
cially true for assets such as factories and buildings for which
actual lifetimes are often greater than depreciation schedule
Tax return depreciation = lifetimes and market values are often larger than book values.
depreciation method used in tax returns
When to use indicator: Companies use depreciation methods
Companies use depreciation to amortize the purchase price
to account for the gradual consumption of assets. Firms will
of assets over their useful lifetimes. Depreciation used for
often use accelerated depreciation schedules to maximize cur-
financial reporting, called book depreciation, is often different
rent-year depreciation expense deductions and minimize cur-
from the depreciation amounts used for tax returns. In the
rent-year taxes.
United States it is common to depreciate assets more quickly
on tax returns using accelerated depreciation schedules. This Meaning of result: When tax return depreciation varies
has the effect of lowering current-year tax expenses. from book value depreciation, you use different asset life-
Depreciation allows companies to demonstrate that assets time schedules. Higher rates of depreciation correspond to
typically decrease in value as they age and as they are used.
EXPENSE ANALYSIS
123
85
Equation
Relating Book Depreciation Expenses
to Sales Revenue
Lower rates of depreciation to sales can indicate reduced
or inadequate asset replacement and acquisition, possibly as
Book depreciation to sales revenue = a short-term, cost-saving measure. When you use assets
book depreciation / net sales
beyond their useful lifetimes, you may compromise opera-
Companies use depreciation to amortize the purchase price tions productivity and efficiency, and long-term growth and
of assets over their useful lifetimes. When you use this tech- income can suffer. Lower ratios can also indicate that you
nique for financial reporting, it is called book depreciation. are using longer term depreciation schedules, which may
Comparing book depreciation with sales levels allows you to also indicate the use of obsolete assets.
determine that the company is incurring expected levels of
Example
depreciation.
Book depreciation to sales revenue =
When to use indicator: Creditors and investors can use this book depreciation / net sales
indicator to determine trends in asset purchase and depreci-
EXPENSE ANALYSIS
ation rates relative to the sales level or company size. Book depreciation = 1,204
Net sales = 85,420
Meaning of result: Higher levels of depreciation to sales can
indicate higher levels of fixed asset investment, reductions in Book depreciation to sales revenue = 1,204 / 85,420 = 0.0141 =
1.41%
depreciation time schedules, and reductions in sales levels.
Book depreciation
1.41% to sales revenue = book depreciation
1,204 / net85,420
sales
Book depreciation to sales revenue = book depreciation / net sales
Sector Mid to large cap Book Depreciation Small to mid cap Book Depreciation Micro to small cap Book Depreciation
Expenses to Sales Revenue Expenses to Sales Revenue Expenses to Sales Revenue
124
86
Equation
Comparing Book Depreciation Expenses
to the Value of Fixed Assets
Lower rates of depreciation to fixed assets can indicate
reduced or inadequate asset replacement and acquisition,
Book depreciation to fixed assets = possibly as a short-term, cost-saving measure. When you
book depreciation / fixed assets
use assets beyond their useful lifetimes, you may compro-
Companies use depreciation to amortize the purchase price mise operations productivity and efficiency, and long-term
of assets over their useful lifetimes. When you use this tech- growth and income can suffer. Lower ratios can also indi-
nique for financial reporting, it is called book depreciation. cate a company is using longer term depreciation sched-
Comparing book depreciation to fixed assets allows you to ules, which may also indicate the use of obsolete assets.
determine that the company is incurring expected levels of
depreciation. Example
Sector Mid to large cap Book Depreciation Small to mid cap Book Depreciation Micro to small cap Book Depreciation
to Fixed Assets to Fixed Assets to Fixed Assets
125
CHAPTER SIX
Assets
126
87
Equation
Determining the
Size of Fixed Assets
that has anticipated higher sales levels and has made early
fixed asset purchases.
Fixed assets = tangible and long-lived assets Low ratios indicate the company is not capital intensive;
that is, the company requires few fixed assets to operate the
This indicator describes the level of fixed assets a business
business. When ratios are trending lower, management
employs. Fixed assets (also referred to on the balance sheet
should determine the cause of the decrease to ensure that
as property, plant, and equipment) include tangible items
events justify the decrease. Possible reasons for increasingly
with lifetimes of greater than three years such as land,
lower fixed asset investment include required asset updating
buildings, machinery, tooling, vehicles, leasehold improve-
and replacement to increase short-term profit; the release of
ments, furniture, and office equipment.
new, lower fixed asset-intensive products or services; and
When to use indicator: Managers and investors can use this reductions in fixed asset investment in anticipation of
indicator to determine the level of fixed asset investments reduced sales levels.
employed to operate the business and how these investment
Ways to improve the indicator: Depending on the state of the
levels have changed with time.
business, it may be desirable to increase, decrease, or hold
Meaning of result: High fixed asset levels indicate the steady the investment level in fixed assets. See previous section
ASSETS
company is capital intensive; that is, the company requires for examples.
a lot of fixed assets to operate the business. When a com-
Example
pany uses fixed assets ineffectively or at less than full
capacity, this indicator will creep to higher levels. Manu- Fixed assets = tangible and long-lived assets
facturing companies tend to have higher ratios than ser-
vice-related companies since they typically require greater
amounts of fixed assets. Net property, plant, and equipment = 10,018
When fixed asset investments are trending higher, the
manager should determine the cause of the increase to Fixed assets = 10,018
ensure that events justify the increase. Possible reasons for
increasingly higher fixed investments include the release of
new products or services that require more than usual, or
more costly, amounts of fixed assets; an infrequent pur-
chase of a building or piece of property; and management
Sector Mid to large cap Size of Small to mid cap Size of Micro to small cap Size of
Fixed Assets Fixed Assets Fixed Assets
127
Examining the Relationship Between
88
Equation
Fixed Assets and Sales
the release of new products or services that require more than
usual, or more costly, amounts of fixed assets; a drop in sales
Fixed assets to sales = fixed assets / net sales
levels; an infrequent purchase of a building or piece of property;
This indicator describes the level of fixed assets employed to gen- and management that has anticipated higher sales levels and has
erate a given amount of net sales. It also indicates trends in fixed made early fixed asset purchases.
asset age and procurement practices. Fixed assets (also referred to Low ratios indicate the company is not capital intensive; that is,
on the balance sheet as property, plant, and equipment) include that to generate sales, the company requires few fixed assets.
items with lifetimes of greater than three years such as land, build- When ratios are trending lower, management should determine the
ings, machinery, tooling, leasehold improvements, office equipment, cause of the decrease to ensure that events justify the decrease.
and vehicles. Possible reasons for increasingly lower ratios include required
The inverse of the equation, net sales divided by fixed assets, is asset updating and replacement to increase short-term profit; the
an indicator known as fixed asset turnover. Fixed asset turnover release of new, lower fixed asset-intensive products or services; an
also describes the relative size of net sales and fixed assets, but increase in sales levels; or reductions in fixed asset investment in
more specifically, how many times a company achieves, or turns anticipation of reduced sales levels.
over, the book value of fixed assets in net sales.
Ways to improve the indicator: Depending on the state of the
When to use indicator: Managers and investors can use this business, it may be desirable to increase, decrease, or hold
indicator to determine the level of fixed asset investment steady the ratio of fixed assets to sales. See previous section for
ASSETS
required to generate every dollar of net sales and how these examples.
investment levels have changed with time. You can use the ratio
as a forecasting tool to estimate fixed asset requirements given
Example
assumed net sales levels. Fixed assets to sales = fixed assets / net sales
Meaning of result: High ratios indicate the company is capital Fixed assets = 10,018
intensive; that is, to achieve sales levels, the company uses a great Net sales = 85,420
deal of fixed assets. When a company uses fixed assets ineffective- Fixed assets to sales = 10,018 / 85,420 = 0.1173 =
ly or at less than full capacity, this ratio will creep to higher levels. 11.73
Manufacturing companies tend to have higher ratios than service-
related companies since they typically require greater amounts of Fixed11.73%
assets to sales = fixed assets
10,018 / net85,420
sales
fixed assets. Fixed assets to sales = fixed assets / net sales
When ratios are trending higher, management should deter-
mine the cause of the increase to ensure that events justify the
increase. Possible reasons for increasingly higher ratios include
Sector Mid to large cap Fixed Assets Small to mid cap Fixed Assets Micro to small cap Fixed Assets
to Sales to Sales to Sales
128
Examining the Relationship Between
89
Equation
Fixed Assets and Net Income
income will have dramatic effects on the fixed asset to net
income indicator.
Fixed assets to net income = fixed assets / net income When ratios are trending higher, management should
determine the cause of the increase to ensure that events jus-
This indicator describes the level of fixed assets employed
tify the increase. Possible reasons for increasingly higher
to generate a given amount of net income. It also indicates
ratios include the release of new products or services that
trends in fixed asset age and procurement practices. Fixed
require more than usual, or more costly, amounts of fixed
assets (also referred to on the balance sheet as property,
assets; a drop in sales levels; a reduction in profit margins;
plant, and equipment) include items with lifetimes of greater
an infrequent purchase of a building or piece of property;
than three years such as land, buildings, machinery, tooling,
and management that has anticipated higher sales levels and
leasehold improvements, office equipment, and vehicles.
has made early fixed asset purchases.
When to use indicator: Managers and investors can use Low ratios indicate the company is not capital intensive
this indicator to determine the level of fixed asset invest- or that the company generates its net income stream with
ment required to generate every dollar of net income and smaller fixed asset requirements. When a company uses
to learn how these investment levels have changed with fixed assets effectively and at full capacity, this ratio will
time. trend toward lower levels. Service-related companies tend to
ASSETS
Sector Mid to large cap Fixed Assets to Small to mid cap Fixed Assets to Micro to small cap Fixed Assets to
Net Income Net Income Net Income
129
Ways to improve the indicator: Depending on the state of the Example
business, it may be desirable to increase, decrease, or hold
steady the ratio of fixed assets to net income. See previous Fixed assets to net income = fixed assets / net income
section for examples. Fixed assets = 10,018
Net income = 4,983
130
Examining the Relationship Between
90
Equation
Fixed Assets and Operations Cash Flow
levels or working capital requirements. It could also indicate
that a company has not purchased any new fixed assets for
Fixed assets to operations cash flow =
fixed assets / cash from operations some time and has reduced the book value of those fixed
assets with depreciation.
This indicator describes the level of fixed assets a compa-
When ratios of fixed assets to operations cash flow are
ny employs to generate a given amount of cash from opera-
trending higher, it could indicate excess fixed asset capacity,
tions. It also indicates trends in fixed asset age and procure-
either because of reduced sales levels or because the compa-
ment practices. Fixed assets (also referred to on the balance
ny has recently made a new fixed asset investment.
sheet as property, plant, and equipment) include items with
lifetimes of greater than three years such as land, buildings, Ways to improve the indicator: You can reduce ratios of
machinery, tooling, leasehold improvements, office equip- fixed assets to operations cash flow by using existing fixed
ment, and vehicles. assets to their fullest extent in the most productive manner
possible. When this is not possible because, for example,
When to use indicator: Managers and investors can use
sales levels don’t warrant additional production, excess
this indicator to determine the level of fixed asset invest-
fixed asset capacity exists and it may be beneficial to sell
ment required to generate cash from operations and to
or lease the unwanted fixed assets.
learn how these investment levels have changed with time.
ASSETS
131
91
Equation
Comparing Fixed Assets
to Total Assets
exhibit a low ratio of fixed assets to total assets. It is likely
to require few fixed assets to operate because it primarily
Fixed assets to total assets = fixed assets / total assets supplies noncapital-intensive products such as guidance,
reports, and drawings.
This indicator describes the portion of all of a company’s
Look for changes in ratios of fixed assets to total assets
assets that are fixed assets. It also indicates trends in fixed
over time and seek to understand the reasons for such
asset age and procurement practices. Fixed assets (also
changes. Are lower ratios due to cost-cutting measures in
referred to on the balance sheet as property, plant, and
which needed fixed asset replacements were passed over? If
equipment) include items with lifetimes of greater than three
this is the case, the company could be entering a severe
years such as land, buildings, machinery, tooling, leasehold
business downturn. Or are the lower ratios due to the use
improvements, office equipment, and vehicles. Total assets
of newer, less costly equipment? Or has the business begun
include fixed assets, current assets, intangible assets, long-
to offer different lines of products or services that require
term security investments, and other noncurrent assets.
different fixed asset investments?
When to use indicator: Managers and investors can use
Ways to improve the indicator: Depending on the state of
this indicator to determine the level of fixed assets to total
the business, it may be desirable to increase, decrease, or
asset investments employed to operate the business and to
ASSETS
hold steady the ratio of fixed assets to total assets. See previ-
learn how these investment levels have changed with time.
ous section for examples.
They can also use the ratio as a forecasting tool to estimate
fixed asset requirements given assumed total asset levels. Example
Meaning of result: Companies with high ratios of fixed assets Fixed assets to total assets = fixed assets / total assets
to total assets employ large amounts of land, buildings,
equipment, and other types of fixed assets. This is typical of Fixed assets = 10,018
manufacturing companies which require a great deal of com- Total assets = 56,268
ponent fabrication and assembly, such as in the automobile
Fixed assets to total assets = 10,018 / 56,268 = 0.1780 = 17.80%
industry. Alternatively, an architectural consulting firm may
Sector Mid to large cap Fixed Assets to Small to mid cap Fixed Assets to Micro to small cap Fixed Assets to
Total Assets Total Assets Total Assets
132
92 Assessing the Fixed-
Asset-to-Equity Ratio
companies such as brokerage firms or temporary help
Equation companies.
Look for changes in ratios of fixed assets to total equi-
Fixed assets to equity = fixed assets / total shareholder equity ty over time and seek to understand the reasons for such
This indicator compares the relative level of fixed asset changes. Are lower ratios due to cost-cutting measures
investment with investor investment. You can think of it as in which needed fixed asset replacements were passed
the portion of shareholders’ equity used for fixed assets. over? If this is the case, the company in question could
Fixed assets (also referred to on the balance sheet as proper- be entering a severe business downturn. Or are the
ty, plant, and equipment) include items with lifetimes of lower ratios due to the use of newer, less costly equip-
greater than three years such as land, buildings, machinery, ment? Or has the business begun to offer different lines
tooling, leasehold improvements, office equipment, and of products or services that require different fixed asset
vehicles. Total shareholder equity includes all equity balance investments?
sheet items, typically the most significant of which are addi- Ways to improve the indicator: Depending on the state of
tional paid-in capital for stock purchases and retained earn- the business, it may be desirable to increase, decrease, or
ings (income generated that the company has reinvested in hold steady the ratio of fixed assets to shareholder equity.
ASSETS
assets to equity =
Fixed 32.22% 10,018
fixed 31,088 equity
assets / total shareholder
Fixed assets to equity = fixed assets / total shareholder equity
Sector Mid to large cap Fixed-Asset-to- Small to mid cap Fixed-Asset-to- Micro to small cap Fixed-Asset-to-
Equity Ratio Equity Ratio Equity Ratio
133
93
Equation
Determining the Relationship Between
Fixed Assets and Long-Term Debt
Such companies will tend to have lower fixed asset-to-debt
ratios simply because they use fewer fixed asset items such
Fixed assets to long-term debt = fixed assets / long-term debt as factories and equipment.
Higher ratios are typical of profitable companies that
The relative level of the book value of fixed assets and
exhibit little or no long-term debt and that finance fixed
long-term debt describes the degree of a company’s fixed
asset acquisitions with operating income.
asset financial leverage. Fixed assets (also referred to on the
balance sheet as property, plant, and equipment) include Ways to improve the indicator: Paying down long-term
items with lifetimes of greater than three years such as land, debt levels to industry standards can reduce the fixed
buildings, machinery, tooling, leasehold improvements, asset-to-long-term debt ratio.
office equipment, and vehicles. Long-term debt is debt that
is due in more than 12 months. Example
When to use indicator: Creditors and managers use this Fixed assets to long-term debt = fixed assets / long-term debt
indicator to determine the risk level associated with long-
term debt. Fixed assets = 10,018
Long-term debt = 13,148
ASSETS
Sector Mid to large cap Fixed Assets to Small to mid cap Fixed Assets to Micro to small cap Fixed Assets to
Long-Term Debt Long-Term Debt Long-Term Debt
134
94
Equation
Comparing Fixed Assets
to Short-Term Debt
the fixed asset, typically at least three years. Since pay-
ments will be lower, this will put less pressure on company
Fixed assets to short-term debt = cash flow.
fixed assets / short-term debt Lower fixed asset-to-short-term debt ratios indicate
potential credit or solvency problems and could preclude
This indicator compares the relative size of the book value
the issuance of further short-term debt. This ratio has less
of fixed assets to the size of short-term debt. You can think
meaning for service-related companies and those companies
of it as the portion of fixed assets that is financed with
that use few fixed assets. Such companies will tend to have
short-term debt. Fixed assets (also referred to on the bal-
lower ratios simply because they use few fixed asset items
ance sheet as property, plant, and equipment) include items
such as factories and equipment.
with lifetimes of greater than three years such as land,
buildings, machinery, tooling, leasehold improvements, Higher ratios are typical of profitable companies that
office equipment, and vehicles. Short-term debt, referred to exhibit little or no short-term debt and finance fixed asset
as current liabilities on the balance sheet, is debt that is due acquisitions with operating income or long-term debt.
in less than one year. It includes notes payable, accounts
Ways to improve the indicator: Paying down short-term
payable, and accrued expenses such as payroll and property
debt levels to industry standards can reduce the fixed-
taxes.
ASSETS
asset-to-short-term-debt ratio.
When to use indicator: Creditors and managers use this
Example
indicator to determine the risk level associated with short-
term debt. Fixed assets to short-term debt = fixed assets / short-term debt
Meaning of result: When companies use short-term debt
to finance fixed assets, banks require higher payments to Fixed assets = 10,018
service the loans since the loans must be paid more quick- Short-term debt = current liabilities = 12,032
ly. Higher payments could put a company into a precari-
ous financial position. It is generally desirable to finance Fixed assets to short-term debt = 10,018 / 12,032 = 0.8326 =
fixed assets with loans that last about as long as the life of 83.26%
to short-term debt =
Fixed assets83.26% 10,018
fixed assets 12,032
/ short-term debt
Fixed assets to short-term debt = fixed assets / short-term debt
Sector Mid to large cap Fixed Assets to Small to mid cap Fixed Assets to Micro to small cap Fixed Assets to
Short-Term Debt Short-Term Debt Short-Term Debt
135
95
Equation
Examining Fixed
Asset Turnover
drop in sales levels; an infrequent purchase of a building
or piece of property; and management that has anticipated
Fixed asset turnover = net sales / fixed assets higher sales levels and has made early fixed asset purchas-
es.
Fixed asset turnover describes the relative size of net sales
Higher ratios indicate the company is not capital inten-
and fixed assets and, more specifically, how many times a
sive; that is, the company requires few fixed assets to gener-
company achieves, or turns over, the book value of fixed
ate a given amount of sales. When ratios are trending high-
assets in net sales. Fixed assets (also referred to on the bal- er, management should determine the cause of the increase
ance sheet as property, plant, and equipment) include items to ensure that events justify the increase. Possible reasons
with lifetimes of greater than three years such as land, for increasingly higher ratios include required asset updat-
buildings, machinery, tooling, leasehold improvements, ing and replacement (short-term profit is enhanced by fore-
office equipment, and vehicles. going asset replacement); the release of new, less fixed asset-
intensive products or services; an increase in sales levels; or
When to use indicator: Managers and investors can use reductions in fixed asset investment in anticipation of
this indicator to determine the level of fixed asset invest- reduced sales levels.
ment required to generate every dollar of net sales and to
ASSETS
learn how these investment levels have changed with time. Ways to improve the indicator: Depending on the state of the
You can also use this indicator to forecast fixed asset business, it may be desirable to increase, decrease, or hold
requirements based on expected future net sales levels. steady fixed asset turnover. See previous section for exam-
ples.
Meaning of result: Low ratios indicate the company is
capital intensive or that the company requires a lot of Example
fixed assets to generate a given amount of sales. When
ratios are trending lower, management should determine Fixed asset turnover = net sales / fixed assets
the cause of the increase to ensure that events justify the
Net sales = 85,420
increase. Possible reasons for increasingly lower ratios Fixed assets = 10,018
include the release of new products or services that require
more than usual, or more costly, amounts of fixed assets; a Fixed asset turnover = 85,420 / 10,018 = 8.53
Sector Mid to large cap Fixed Asset Small to mid cap Fixed Asset Micro to small cap Fixed Asset
Turnover Turnover Turnover
136
96
Equation
Assessing the Age
of Fixed Assets
rapidly changing industries, this typically means the regu-
lar updating of fixed assets. This ratio has less meaning
Fixed asset acquisitions to total fixed assets = for those companies operating in slow-changing indus-
newly purchased fixed assets / fixed assets
tries, such as service or manufacturing companies, that
This indicator describes the age of fixed assets. Fixed warrant less rapid fixed asset replacement.
assets (also referred to on the balance sheet as property,
Ways to improve the indicator: When you can justify fixed
plant, and equipment) include items with lifetimes of greater
asset replacement costs, or when you need additional fixed
than three years such as land, buildings, machinery, tooling,
assets to meet sales demand, you want higher ratios and
leasehold improvements, office equipment, and vehicles.
can achieve them with the purchase of new fixed assets.
When to use indicator: Investors and managers can use
Example
this indicator to gain a sense of the age of fixed assets and
the degree to which fixed asset reinvestment is occurring. Fixed asset acquisitions to total fixed assets =
newly purchased assets / fixed assets
Meaning of result: Higher ratios indicate the quicker
replacement of obsolete or worn out fixed assets with new Newly purchased fixed assets =
ASSETS
fixed assets or that the company is growing at such a fast change in book value of fixed assets = 12,065 − 5,790 = 6,275
rate that the company readily purchases additional fixed Fixed assets = 10,018
assets to keep pace with sales levels. By using fixed assets
that allow the most productive fabrication of products or Fixed asset acquisitions to total fixed assets = 6,275 / 10,018 =
delivery of services, you can minimize production costs. In 0.6264 = 62.64%
62.64%
Fixed asset acquisitions to total fixed assets = newly purchased
6,275 assets / fixed 10,018
assets
Fixed asset acquisitions to total fixed assets = newly purchased assets / fixed assets
Sector Mid to large cap Fixed Asset Acquisitions Small to mid cap Fixed Asset Acquisitions Micro to small cap Fixed Asset Acquisitions
to Total Fixed Assets to Total Fixed Assets to Total Fixed Assets
137
97
Equation
Determining the Turnover
Rate of Total Assets
to keep cash and inventory balances at levels that allow pay-
ment of short-term debt and the delivery of customer orders,
Total asset turnover = net sales / total assets but not so high that there is any degree of excess cash or
inventory. This is because rates of return on cash are generally
Total asset turnover describes the relative size of net sales much lower than the returns that longer term investments,
and total company assets and, more specifically, how many such as fixed assets, can achieve. The return on excess invento-
times a company achieves, or turns over, the book value of ry is even less because idle inventory does not earn a return
all assets in net sales. Total assets include all current and and could be depreciating if the product is in a rapidly chang-
long-term assets such as cash, inventory, accounts receiv- ing industry. Similarly, by maintaining accounts receivable bal-
able, property, plants, equipment, patents, goodwill, and ances at levels which allow credit purchases, but not so high as
investments. to attract dead-beat customers, you can achieve optimal asset
use.
When to use indicator: Managers and investors can use Good long-term asset investments will tend to increase total
this indicator to determine the level of asset investment asset turnover. You should purchase fixed assets when you can
required to generate every dollar of net sales and to learn realize a suitable return from the product or service produced
how these investment levels have changed with time. with the fixed assets. Optimizing total asset turnover can be
ASSETS
Ways to improve the indicator: Optimal use of assets will tend Net sales = 85,420
to improve, or increase, the total asset turnover ratio. Total assets = 56,268
Improved use of current assets such as cash, inventories, and
accounts receivable will enhance asset turnover. It is desirable Total asset turnover = 85,420 / 56,268 = 1.52
1.52turnover =
Total asset 85,420
net sales 56,268
/ total assets
Total asset turnover = net sales / total assets
Sector Mid to large cap Total Asset Small to mid cap Total Asset Micro to small cap Total Asset
Turnover Rate Turnover Rate Turnover Rate
138
98
Equation
Finding the Total Asset
Coverage Ratio
further debt. Higher ratios are typical of profitable compa-
nies that exhibit little or no long-term debt and that
Total asset coverage ratio = total assets / long-term debt finance current and long-term assets with operating
income.
The relative level of the book value of total assets and
long-term debt describes the degree of a company’s financial Ways to improve the indicator: Paying down debt levels
leverage. Total assets include all current and long-term can increase the total asset coverage ratio.
assets such as cash, inventory, accounts receivable, property,
plants, equipment, patents, goodwill, and investments. Example
Long-term debt is debt that is due in more than 12 months.
Total asset coverage ratio = total assets / long-term debt
When to use indicator: Creditors and managers use this
indicator to determine the risk level associated with long- Total assets = 56,268
Long-term debt = 25,180 − 12,032 = 13,148
term debt.
Total asset coverage ratio = 56,268 / 13,148 = 4.28
Meaning of result: Lower ratios indicate potential credit
or solvency problems and could preclude the issuance of
ASSETS
coverage ratio =
Total asset4.28 total assets
56,268 / long-term
13,148debt
Total asset coverage ratio = total assets / long-term debt
Sector Mid to large cap Total Asset Small to mid cap Total Asset Micro to small cap Total Asset
Coverage Ratio Coverage Ratio Coverage Ratio
139
99
Equation
Comparing Intangible
Assets to Sales Revenue
purchase of other companies at prices in excess of their book
value. The difference is considered goodwill, an intangible
Intangible assets to sales = intangible assets / net sales asset, and includes items that justify the excess price paid such
This indicator describes the level of intangible assets a as highly regarded products, brand names and trademarks,
company employs to generate a given amount of net sales. patents, and skilled employees. Typically you should record
intangibles such as goodwill, patents, and copyrights on the
Intangible assets are nonphysical items that have value to
balance sheet only when you purchase them from another
the company such as goodwill associated with brand names, company. For example, there is enormous goodwill associated
trademarks, skilled employees, loyal customers, patents, with the Coca-Cola trademark, but this goodwill is not
copyrights, permits, investments, deferred charges, and recorded as an asset by Coca-Cola. However, if another com-
leasehold improvements. pany purchased Coca-Cola, the purchasing company would
likely pay an amount far in excess of the fair market value of
When to use indicator: Managers and investors can use Coca-Cola’s tangible assets, and this excess would be recorded
this indicator to determine the level of intangible assets a on the purchasing company’s balance sheet as goodwill.
company uses to generate every dollar of net sales and to Low ratios indicate the company has not declared a signifi-
learn how these investment levels have changed with time. cant amount of intangible assets, and there is thus little risk of
intangible asset overstatement.
Meaning of result: High ratios indicate the company
ASSETS
employs a significant level of intangible assets as a percent- Ways to improve the indicator: Depending on the state of,
age of sales. Since intangible assets are harder to liquidate and opportunities presented to, a business, it may be desir-
than tangible assets such as land, buildings, or equipment, able to increase, decrease, or hold steady the ratio of
the investor should be concerned if the level of intangible intangible assets to sales. See previous section for exam-
assets is so high that the intangible assets may be overstated. ples.
However, intangible assets can provide significant sales and
income streams when properly marketed. For example, Example
patents for a highly demanded new product or well-known
trademarks can provide returns far in excess of machinery or Intangible assets to sales = intangible assets / net sales
plant equipment. Intangible assets = 435
When ratios are trending higher, management should deter- Net sales = 85,420
mine the cause of the increase to ensure that events justify the
Intangible assets to sales = 435 / 85,420 = 0.0051 = 0.51%
increase. A possible reason for increasingly higher ratios is the
Intangible assets to sales = intangible
0.51% 435 assets / net sales
85,420
Intangible assets to sales = intangible assets / net sales
Sector Mid to large cap Intangible Assets Small to mid cap Intangible Assets Micro to small cap Intangible Assets
to Sales to Sales to Sales
140
100
Equation
Comparing Intangible
Assets to Net Income
uct or well-known trademarks can provide returns far in
excess of machinery or plant equipment. When net income
Intangible assets to net income = intangible levels are very low or negative, this ratio loses meaning
assets / net income
since small changes in net income will have dramatic
This indicator describes the level of intangible assets effects on the intangible asset-to-net income indicator.
employed to generate a given amount of net income. Intan- When ratios are trending higher, management should
gible assets are nonphysical items that have value to a com- determine the cause of the increase to ensure that events jus-
pany such as goodwill associated with brand names, trade- tify the increase. A possible reason for increasingly higher
marks, skilled employees, loyal customers, patents, ratios is the purchase of other companies at prices in excess
copyrights, permits, investments, deferred charges, and of book value. The difference is considered goodwill, an
leasehold improvements. intangible asset, and includes items that justify the excess
price paid for the company such as highly regarded prod-
When to use indicator: Managers and investors can use ucts, brand names and trademarks, patents, and skilled
this indicator to determine the level of intangible assets employees. Typically you should record intangibles such as
used to generate every dollar of net income and to learn goodwill, patents, and copyrights on the balance sheet only
how these investment levels have changed with time. when you purchase them from another company. For exam-
ASSETS
Sector Mid to large cap Intangible Assets Small to mid cap Intangible Assets Micro to small cap Intangible Assets
to Net Income to Net Income to Net Income
141
Ways to improve the indicator: Depending on the state of, Example
and opportunities presented to, a business, it may be desir-
able to increase, decrease, or hold steady the ratio of Intangible assets to net income = intangible assets / net income
intangible assets to net income. See previous section for
examples. Intangible assets = 435
Net income = 4,983
8.73%
Intangible assets to net income = intangible
435 assets / net income
4,983
Intangible assets to net income = intangible assets / net income
ASSETS
142
101
Equation
Comparing Intangible
Assets to Total Assets
be concerned if the level of intangible assets is so high that
the intangible assets may be overstated. However, intangi-
Intangible assets to total assets = intangible ble assets can provide significant sales and income streams
assets / total assets
when properly marketed. For example, patents for a high-
This indicator describes the portion of all of a company’s ly demanded new product or well-known trademarks can
assets that are intangible assets. It also indicates trends in provide returns far in excess of machinery or plant equip-
intangible asset age and procurement practices. Intangible ment. When net income levels are very low or negative,
assets are nonphysical items that have value to the company this ratio loses meaning since small changes in net income
such as goodwill associated with brand names, trademarks, will have dramatic effects on the intangible asset-to-net
skilled employees, loyal customers, patents, copyrights, per- income indicator.
mits, investments, deferred charges, and leasehold improve- Low ratios indicate the company has not declared a sig-
ments. Total assets include fixed assets, current assets, nificant amount of intangible assets, and there is thus little
intangible assets, long-term security investments, and other risk of intangible asset overstatement.
noncurrent assets. Look for changes in intangible asset-to-total asset ratios
over time and understand their causes. Are higher ratios due
When to use indicator: Managers and investors can use to the overstatement of intangible assets’ worth? If this is
ASSETS
this indicator to determine the level of intangible asset to the case, the company in question could be entering a severe
total asset investments employed to operate the business business downturn. Or are the higher ratios due to pur-
and to learn how these investment levels have changed chased intangible goodwill assets such as patents, brand
with time. names, and trademarks? When a company purchases anoth-
er for a price in excess of its book value, the difference is
Meaning of result: High ratios indicate the company has considered goodwill, an intangible asset. This asset includes
employed a significant level of intangible assets as a per- intangible items that generate excess profit such as highly
centage of all assets available to the company. Since intan- regarded customer knowledge of the company’s products or
gible assets are harder to liquidate than tangible assets services, brand names, and trademarks. Such intangible
such as land, buildings, or equipment, the investor should assets may provide handsome returns.
Sector Mid to large cap Intangible Assets Small to mid cap Intangible Assets Micro to small cap Intangible Assets
to Total Assets to Total Assets to Total Assets
143
Ways to improve indicator: Depending on the state of the Example
business, it may be desirable to increase, decrease, or hold
steady the ratio of intangible assets to total assets. See previ- Intangible assets to total assets = intangible assets / total
assets
ous section for examples.
Intangible assets = 435
Total assets = 56,268
0.77%
Intangible assets to total assets = intangible
435 assets / total56,268
assets
Intangible assets to total assets = intangible assets / total assets
ASSETS
144
Comparing Intangible
102
Equation
Assets to Owner’s Equity
machinery or plant equipment.
Low ratios indicate the company has not declared a signifi-
Intangible assets to equity = intangible assets /
cant amount of intangible assets, and there is thus little risk of
total shareholder equity
intangible asset overstatement.
This indicator compares the relative level of intangible asset Look for changes in intangible asset-to-total asset ratios
investment to investor investment. You can think of it as the over time and understand their causes. Are higher ratios due
portion of shareholders’ equity that the company uses for to the overstatement of intangible assets’ worth? If this is the
intangible assets. Intangible assets are nonphysical items that case, the company in question could be entering a severe
have value to the company such as goodwill associated with business downturn. Or are the higher ratios due to pur-
brand names, trademarks, skilled employees, loyal customers, chased intangible goodwill assets such as patents, brand
patents, copyrights, permits, investments, deferred charges, names, and trademarks? When a company purchases anoth-
and leasehold improvements. Total shareholder equity er for a price in excess of its book value, the difference is
includes all equity balance sheet items. Typically the most sig- considered goodwill, an intangible asset. This asset includes
nificant of these are additional paid-in capital for stock pur- intangible items that generate excess profit such as highly
chases and retained earnings (income generated that the com-
regarded customer knowledge of the company’s products or
pany has reinvested in itself).
services, patents, brand names, and trademarks. Such intan-
ASSETS
When to use indicator: Investors can use this indicator to gible assets may provide handsome returns.
gain a sense of how the company has employed the equity Ways to improve the indicator: Depending on the state of the
invested in the company. business, it may be desirable to increase, decrease, or hold
steady the ratio of intangible assets to shareholder equity. See
Meaning of result: Higher ratios indicate that the compa-
previous section for examples.
ny uses a great deal of equity for intangible asset invest-
ments. Since intangible assets are harder to liquidate than Example
tangible assets such as land, buildings, or equipment, the
Intangible assets to equity = intangible assets /
investor should be concerned if the level of intangible
total shareholder equity
assets is so high that the intangible assets may be overstat-
ed. However, intangible assets can provide significant sales Intangible assets = 435
and income streams when properly marketed. For exam- Total shareholder equity = 31,088
ple, patents for a highly demanded new product or well- Intangible assets to equity = 435 / 31,088 = 0.0140 = 1.40%
known trademarks can provide returns far in excess of
assets to equity = intangible
Intangible1.40% 435 assets / total sharholder
31,088 equity
Intangible assets to equity = intangible assets / total shareholder equity
Sector Mid to large cap Intangible Assets Small to mid cap Intangible Assets Micro to small cap Intangible Assets
to Owner’s Equity to Owner’s Equity to Owner’s Equity
145
Comparing Changes in Intangible
103
Equation
Assets to Changes in Net Income
allocate increases in net income to specific asset pools,
investors must be careful when ascertaining what degree of
Changes in value of intangible assets to changes in net income = the income change was due to asset change. Part of the
change in value of intangible assets / change in net income
change could have been coincidental or because of other
This indicator describes the extent to which changes in changes in operations.
intangible assets provide commensurate changes in net
Ways to improve the indicator: You can improve this ratio
income. Intangible assets are nonphysical items that have
with the acquisition of intangible assets that positively
value to the company such as goodwill associated with
affect the bottom line, net income, at rates of return that
brand names, trademarks, skilled employees, loyal cus-
justify the acquisition. Investigate the liquidation of intan-
tomers, patents, copyrights, permits, investments, deferred
gible assets which generate few returns.
charges, and leasehold improvements.
Example
When to use indicator: Managers and investors can use this
indicator to determine if newly acquired intangible assets are Change in value of intangible assets to changes in net income =
providing reasonable returns. Similarly, this indicator can change in value of intangible assets / change in net income
reveal the effect to net income when a company sells intangi-
ASSETS
ble assets. When changes in net income levels are very low or Change in value of intangible assets = 435 − 500 = −65
Change in net income = 4,983 − 3,588 = 1,395
negative, this ratio loses meaning since small changes in net
income will have dramatic effects on the ratio of change in Change in value of intangible assets to changes in net income
intangible asset to change in net income. = −65 / 1,395 = −0.0466 = −4.66%
Meaning of result: When a company purchases intangible This indicator has little meaning when a company has
assets, management usually desires lower ratios which indicate acquired no new income-producing intangible assets. Since
positive and significant changes in net income occurred at the in the example above the company did not acquire any
time of the asset acquisition. When a company sells intangible intangible assets, the result is of negligible significance. The
assets, investors expect higher ratios which indicate the sale of change in intangible asset value is negative because of
those assets had little effect on net income. As it is difficult to amortization of existing intangible assets.
146
104
Equation
Comparing Individual
Intangible Assets to Sales
either due to the sale or amortization of the intangible
asset. Amortization is the process of writing off a portion
Individual intangible assets to sales = individual intangible of the intangible asset as an expense in the current year.
assets (i.e., goodwill, patents, leasehold improvements) / net
For example, if a purchased patent had five years of useful
sales
life remaining, the company would amortize, or write off,
These indicators track the size of individual intangible 20%, or one fifth, of the cost of the patent as an operating
assets in relation to net sales levels. Intangible assets are expense each year.
nonphysical items that have value to the company such as Higher individual intangible asset-to-sales ratios indicate
goodwill associated with brand names, trademarks, skilled decreasing sales levels or an investment in an individual
employees, loyal customers, patents, copyrights, permits, intangible asset. Since intangible assets are harder to liqui-
investments, deferred charges, and leasehold improvements. date than tangible assets such as land, buildings, or equip-
ment, the investor should be concerned if the level of the
When to use indicator: Managers and investors can use individual intangible asset is so high that it may be overstat-
these indicators to determine the mix of intangible assets ed or that the investment may not realize an adequate
and how the investment levels in specific intangible assets return. However, individual intangible assets can provide
significant sales and income streams. For example, a pur-
ASSETS
Goodwill
0.40%to sales = goodwill
339 / net sales
85,420
Goodwill to sales = goodwill / net sales
147
105
Equation
Comparing Individual Intangible
Assets to Net Income
intangible asset accounts. Liquidation is simply the sale of an
intangible asset such as a patent or a brand name. Amortiza-
Individual intangible assets to net income = tion is the process of writing off a portion of the intangible
individual intangible assets (i.e., goodwill, patents, leasehold
asset as an expense in the current year. For example, if a pur-
improvements) / net income
chased patent had five years of useful life remaining, the
These indicators track the size of individual intangible company would amortize, or write off, 20%, or one fifth, of
assets in relation to net income levels. Intangible assets are the cost of the patent as an operating expense each year.
nonphysical items that have value to the company such as Higher individual intangible asset-to-net income ratios
goodwill associated with brand names, trademarks, skilled indicate decreasing net income levels or an investment in an
employees, loyal customers, patents, copyrights, permits, individual intangible asset. Since intangible assets are harder
investments, deferred charges, and leasehold improvements. to liquidate than tangible assets such as land, buildings, or
equipment, the investor should be concerned if the level of
When to use indicator: Managers and investors can use the individual intangible asset is so high that it may be over-
this indicator to determine the ratio of specific intangible stated or that the investment may not realize an adequate
asset investments to investments in all of the company return. However, individual intangible assets can provide
assets employed to operate the business and to learn how significant sales and income streams. For example, a pur-
ASSETS
these ratios have changed with time. When net income lev- chased patent for a highly demanded new product can pro-
els are very low or negative, this ratio loses meaning since vide returns far in excess of fixed assets such as machinery
small changes in net income will have dramatic effects on or plant equipment.
the specific intangible asset-to-net income indicator.
It may be difficult for the investor to get enough informa- Ways to improve the indicator: Depending on the state of the
tion from resources such as annual reports to get the entire business, it may be desirable to increase, decrease, or hold
breakdown of individual intangible assets. Companies often steady the ratio of individual intangible assets to net income.
lump all intangible assets in a balance sheet group called See previous section for examples.
“other assets” or “intangible assets.” Sometimes the foot-
Example
notes folowing the financial reports disclose useful detailed
intangible asset information. Goodwill to net income = goodwill / net income
Meaning of result: Lower specific individual intangible asset- Goodwill = 339
to-net income ratios are often the result of increasing net Net income = 4,983
income levels or reduced investments in intangible assets.
Liquidation or amortization reduces the value of specific Goodwill to net income = 339 / 4,983 = 0.0680 = 6.80%
to net income =
Goodwill6.80% 339
goodwill 4,983
/ net income
Goodwill to net income = goodwill / net income
148
106
Equation
Comparing Individual Intangible
Assets to Total Assets
fuel future growth.
Individual intangible assets to total assets = individual Liquidation or amortization reduces the value of specific
intangible assets (i.e., goodwill, patents, leasehold intangible asset accounts. Liquidation is simply the sale of
improvements) / total assets an intangible asset such as a patent or a brand name. Amor-
tization is the process of writing off a portion of the intangi-
These indicators track the size of individual intangible ble asset as an expense in the current year. For example, if a
assets in relation to total asset levels. Intangible assets are purchased patent had five years of useful life remaining, the
nonphysical items that have value to the company such as company would amortize, or write off, 20%, or one fifth,
goodwill associated with brand names, trademarks, skilled of the cost of the patent as an operating expense each year.
employees, loyal customers, patents, copyrights, permits, Higher ratios of individual intangible assets to total assets
investments, deferred charges, and leasehold improvements. indicate decreasing total asset levels or increased investment
Total assets include fixed assets, current assets, intangible in an individual intangible asset. Decreasing total asset lev-
assets, long-term security investments, and other noncurrent els indicate businesses in decline or businesses that have sold
assets. assets and distributed the proceeds to shareholders.
When to use indicator: Managers and investors can use Since intangible assets are harder to liquidate than tangi-
this indicator to determine the ratio of specific intangible ble assets such as land, buildings, or equipment, the investor
should be concerned if the level of the individual intangible
ASSETS
Meaning of result: Higher ratios indicate that the procure- Fixed asset reinvestment rate = 6,275 / 1,139 = 5.509 =
ment of new fixed assets has outpaced the liquidation or 551%
150
108
Equation
Determining the
Productivity of Fixed Assets
When fixed asset productivity is dropping, it could be an
indication of excess fixed asset capacity, either because of
Fixed asset productivity = cash from operations / fixed assets reduced sales levels or because a new fixed asset investment
has recently been made and is not yet fully utilized.
Fixed asset productivity is a measure of how much
income a company derives from investments in fixed assets Ways to improve the indicator: You can increase fixed
such as plant equipment, tooling, machinery, land, and asset productivity by using existing fixed assets to their
buildings. fullest extent in the most productive manner possible.
When this is not possible because, for example, sales levels
When to use indicator: Managers and investors can use
don’t warrant additional production, excess fixed asset
this indicator to determine the extent to which a company
capacity exists and it may be beneficial to sell or lease the
uses fixed assets and how effectively those assets return
unwanted fixed assets.
profit.
When rates of return justify new fixed asset investment,
Meaning of result: High ratios indicate companies that you can improve this indicator by updating older fixed
generate substantial amounts of cash with small amounts assets with newer, more productive fixed assets. New
of fixed asset investment. This is common for service-ori- machinery may increase productivity to a point that reduces
ASSETS
ented, rather than manufacturing-intensive, companies the costs associated with producing a product, thereby sig-
since service companies’ fixed asset investments are gener- nificantly increasing cash from operations.
ally lower.
Example
When fixed asset productivity is climbing higher, it could
indicate that the company is using fixed assets more pro- Fixed asset productivity = cash from operations / fixed assets
ductively, with less idle or downtime, or alternatively that
sales levels have risen, thereby increasing cash generated Cash from operations = 4,820
from operations. It could also indicate that the company Fixed assets = 10,018
has not purchased any new fixed assets for some time and
depreciation has reduced the book value of those fixed Fixed asset productivity = 4,820 / 10,018 = 0.4811 = 48.11%
assets.
Sector Mid to large cap Fixed Assets Small to mid cap Fixed Assets Micro to small cap Fixed Assets
Productivity Productivity Productivity
151
109
Equation
Comparing Fixed Asset Replacement Cost
and Book Value
cult for the investor to ascertain since financial reports sel-
dom divulge detailed descriptions of fixed assets.
Fixed asset replacement cost to book value = fixed asset
replacement cost / fixed asset book value Meaning of result: Higher ratios indicate that fixed asset
book values understate the market price for fixed assets.
The ratio of fixed asset replacement costs to book value
This can be particularly true for those fixed assets that
indicates the degree to which fixed asset book values are simi-
were purchased long ago and tend to hold their value, or
lar to market values. Replacement cost is the price one must
even appreciate, such as land and buildings.
pay to purchase similar fixed assets at market rates. Book
Lower ratios indicate overvaluation of the company’s
value is the net value of the fixed assets shown on the balance
fixed assets, which could also indicate overvaluation of the
sheet. You determine this value by deducting all depreciation
company and stock price.
taken to date for the fixed asset from the purchase price.
Fixed assets (also referred to on the balance sheet as property, Example
plant, and equipment) include items with lifetimes of greater
than three years such as land, buildings, machinery, tooling, Fixed asset replacement cost to book value = fixed asset
leasehold improvements, office equipment, and vehicles. replacement cost / fixed asset book value
ASSETS
When to use indicator: Investors and managers can use Fixed asset replacement cost = 14,874
Fixed asset book value = 10,018
this indicator to determine the true, or market, value of
fixed assets. At times, fixed asset levels shown in financial Fixed asset replacement cost to book value = 14,874 /
reports can vary significantly from market, or replacement 10,018 = 1.485 = 148.5%
cost, values. The fixed asset replacement cost can be diffi-
148.5%
Fixed asset replacement cost to book value = fixed asset 14,874 10,018
replacement cost / fixed asset book value
Fixed asset replacement cost to book value = fixed asset replacement cost / fixed asset book value
152
110
Equation
Comparing High-Risk
Assets to Sales Revenue
Meaning of result: Higher ratios indicate the company has
taken on considerable risk and may not be able to gener-
High-risk assets to sales = high-risk assets / net sales ate the returns necessary to warrant the higher rate of risk.
Higher ratios may also indicate overvaluation of the com-
This indicator describes the level of high-risk assets
pany, especially when the company’s value comes from the
employed to generate a given amount of net sales. High-risk
book value of assets rather than from corporate earning
assets are any assets for which there is substantial risk that the
potential.
asset investment may not realize a return. For example, many
managers consider accounts receivable that have gone uncol- Ways to improve the indicator: You can improve this indicator
lected for many months as high risk. Assets that are harder to by investing in assets in which the rate of return on the asset
liquidate tend to be higher risk, such as patents rights or key investment level justifies the risk.
employees of a purchased company.
Example
When to use indicator: Investors and managers can use
this indicator to determine the level of higher risk assets High-risk assets to sales = high-risk assets / net sales
used to generate every dollar of net sales and to learn how
these high-risk asset levels have changed with time. The High-risk assets = 520
ASSETS
0.61%
High-risk assets to sales = 520assets
high-risk 85,420
/ net sales
High-risk assets to sales = high-risk assets / net sales
153
111
Equation
Relating High-Risk
Assets to Total Assets
Meaning of result: Higher ratios indicate the company has
taken on considerable risk and may not be able to gener-
High-risk assets to total assets = high-risk assets / total assets ate the returns necessary to warrant the higher rate of risk.
Higher ratios may also indicate overvaluation of the com-
This indicator describes the portion that high-risk assets rep-
pany, especially when the company’s value comes from the
resent of a company’s total assets. High-risk assets are any
book value of assets rather than from corporate earning
assets in which there is substantial risk that the asset invest-
potential.
ment may not realize a return. For example, many managers
consider accounts receivable that have gone uncollected for Ways to improve the indicator: You can improve this indi-
many months as high risk. Assets that are harder to liquidate cator by investing in assets in which the rate of return on
tend to be higher risk, such as patents rights or key employees the asset investment justifies the risk level.
of a purchased company.
Example
When to use indicator: Investors and managers can use
this indicator to determine the level of higher risk assets to High-risk assets to total assets = high-risk assets / total assets
total asset investments employed to operate the business
High-risk assets = 520
ASSETS
High-risk assets
0.92% to total assets = high-risk
520assets / total assets
56,268
High-risk assets to total assets = high-risk assets / total assets
154
CHAPTER SEVEN
Debt
155
112
Equation
Comparing Debt to Sales
ratios climb, creditors may require higher interest rates
or refuse issuance of additional debt.
Debt to sales = debt / sales
Ways to improve the indicator: Paying down debt levels
This ratio describes the degree of financial leverage taken and/or increasing the level of sales revenue can decrease
on relative to the size of the company. the debt-to-sales ratio.
When to use indicator: Creditors, investors, and managers Example
can use this indicator to determine the risk level associated
with a company’s debt burden. Debt to sales = debt / sales
Debt = 25,180
Meaning of result: Higher ratios indicate the company has
Net sales = 85,420
acquired a great deal of debt, which may flag potential dif-
ficulty in meeting existing debt payments. As debt-to-sales Debt to sales = 25,180 / 85,420 = 0.2948 = 29.48%
DEBT
Debt to sales =
29.48% 25,180
debt / sales 85,420
Debt to sales = debt / Net sales
Sector Mid to large cap Debt to Small to mid cap Debt to Micro to small cap Debt to
Sales Sales Sales
156
113
Equation
Examining the Debt-to-
Operating Income Ratio
companies and companies experiencing financial difficulties
will tend to exhibit higher ratios. As debt-to-operating
Debt to operating income = income ratios climb, creditors may require higher interest
total liabilities / operating income
rates or refuse to issue additional debt.
This ratio describes the ability to meet debt requirements
Ways to improve the indicator: Paying down debt levels
with income generated from ongoing operations. Total liabil-
and/or increasing the level of income generated from oper-
ities include all debt such as loans payable to lenders,
ations can decrease the debt-to-operating income ratio.
accounts payable to suppliers, and income taxes payable to
the government. Example
When to use indicator: Creditors, investors, and managers Debt to operating income =
can use this indicator to determine the risk level associated total liabilities / operatingincome
with a company’s debt burden.
Total liabilities = 25,180
Meaning of result: Higher ratios can indicate a potential diffi- Operating income = 9,433
culty in meeting existing debt payments with income generat-
DEBT
ed from operations. Companies often use external financing Debt to operating income = 25,180 / 9,433 = 2.669 =
to service debt when this indicator is at higher levels. Start-up 266.9%
Sector Mid to large cap Debt to Small to mid cap Debt to Micro to small cap Debt to
Operating Income Operating Income Operating Income
157
114
Equation
Examining the
Debt-to-Asset Ratio
gained with debt financing may yield higher returns on
equity investments. You can determine an acceptable level
Debt to asset = total liabilities / total assets of debt by examining the ratio of interest payments to
operating income. In the case of start-ups or companies
This ratio describes the degree to which a company has
experiencing special situations, compare all sources of
financed assets with debt. Total liabilities include all debt
income including additional debt financing with interest
such as loans payable to lenders, accounts payable to sup-
payments to ascertain the acceptability of current debt lev-
pliers, and income taxes payable to the government.
els.
When to use indicator: Creditors, investors, and managers
Ways to improve the indicator: You can decrease the debt-
can use this indicator to determine the risk level associated
to-asset ratio by paying down debt levels and/or purchas-
with a company’s debt burden.
ing future assets with income from operations or equity.
Meaning of result: Higher ratios indicate that a company
Example
has financed a large portion of assets with debt. As debt-
to-asset ratios climb, creditor risk increases because there Debt to asset = total liabilities / total assets
is less margin available if the company must liquidate
DEBT
assets. Creditors may require higher interest rates or refuse Total liabilities = 25,180
to issue additional debt under these circumstances. How- Total assets = 56,268
ever, a certain degree of debt is generally quite acceptable,
especially in the view of investors, because the leverage Debt to asset = 25,180 / 56,268 = 0.4475 = 44.75%
Debt to asset =
44.75% 25,180
total liabilities 56,268
/ total assets
Debt to asset = total liabilities / total assets
Sector Mid to large cap Debt-to- Small to mid cap Debt-to- Micro to small cap Debt-to-
Asset Ratio Asset Ratio Asset Ratio
158
115
Equation
Examining the
Debt-to-Equity Ratio
to meet debt interest payments and because creditors like
to see a substantial investment by the owners. Investors
Debt to equity = total liabilities / total shareholder equity are more likely to view higher ratios in a positive light
since the leverage gained with debt financing may lead to
This ratio describes the relationship between a company’s
greater returns on equity investment.
debt and its equity. Total liabilities include all debt such as
loans payable to lenders, accounts payable to suppliers, and Ways to improve the indicator: Paying down debt levels
income taxes payable to the government. Shareholder equi- with operating income or owner’s equity can reduce the
ty includes all equity balance sheet items, typically the most debt-to-equity ratio. Acquiring additional debt can
significant of which are additional paid-in capital for stock increase the debt-to-equity ratio and thus increase compa-
purchases and retained earnings (income generated that the ny leverage.
company has reinvested to provide additional assets).
Example
When to use indicator: Creditors, investors, and managers
can use this indicator to determine the risk level associated Debt to equity = total liabilities / total shareholder equity
with a company’s debt burden and the degree to which a
company is leveraged with debt. Total liabilities = 25,180
DEBT
Debt to equity =
81.00% 25,180
total liabilities 31,088 equity
/ total shareholder
Debt to equity = total liabilities / total shareholder equity
Sector Mid to large cap Debt-to- Small to mid cap Debt-to- Micro to small cap Debt-to-
Equity Ratio Equity Ratio Equity Ratio
159
116
Equation
Comparing Debt to the
Market Value of Assets
with debt financing may yield higher returns on equity
investments. You can determine an acceptable level of debt
Debt to market value of assets = total liabilities / market by examining the ratio of interest payments to operating
value of total assets
income. In the case of start-ups or companies experiencing
This ratio describes the degree to which a company’s special situations, you can compare all sources of income
assets are financed with debt. Since the market value of including additional debt financing with interest payments
assets can be quite different from the book value of assets, to ascertain the acceptability of current debt levels.
the value shown on the balance sheet, this ratio can give a
Ways to improve the indicator: You can decrease the ratio
more accurate portrayal of debt to assets. Total liabilities
of debt to the market value of assets by paying down debt
include all debt such as loans payable to lenders, accounts
levels and/or purchasing future assets with income from
payable to suppliers, and income taxes payable to the gov-
operations or equity.
ernment.
Example
When to use indicator: Creditors, investors, and managers
can use this indicator to determine the risk level associated Debt to market value of assets = total liabilities / market
with a company’s debt burden. value of total assets
DEBT
Meaning of result: Higher ratios indicate that a company Total liabilities = 25,180
has financed a large portion of assets with debt. As debt- Market value of total assets = market value of debt + market
to-asset ratios climb, creditor risk increases because there value of equity = 25,180 + (3,600 common shares ×
is less margin available if a company must liquidate assets. $22.50/share) + (15 preferred shares × $25.00/share) =
106,555
Creditors may require higher interest rates or refuse to
issue additional debt under these circumstances. However, Debt to market value of assets = 25,180 / 106,555 = 0.2363
a certain degree of debt is generally quite acceptable, espe- = 23.63%
cially in the view of investors, since the leverage gained
Sector Mid to large cap Debt to Market Small to mid cap Debt to Market Micro to small cap Debt to Market
Value of Assets Value of Assets Value of Assets
160
117
Equation
Determining Debt Turnover
This generally is a financially healthy condition and indi-
cates a higher likelihood that the company can meet debt
Debt turnover = net sales / total liabilities interest payments particularly if net income levels are high.
This ratio compares the relative size of all debt with sales Ways to improve the indicator: You can increase debt
revenues and gives a general indication of a company’s abili- turnover by increasing sales levels and/or by paying down
ty to meet its debt obligations. Total liabilities include all debt levels with operating income or the issuance of
debt such as loans payable to lenders, accounts payable to owner’
s equity (stock).
suppliers, and income taxes payable to the government.
Example
When to use indicator: Creditors, investors, and managers
can use this indicator to assess the risk associated with Debt turnover = net sales / total liabilities
current debt levels and with the issuance of additional
debt. Net sales = 85,420
Total liabilities = 25,180
Meaning of result: Higher ratios indicate that a company
generates a great deal of sales for every dollar of debt. Debt turnover = 85,420 / 25,180 = 3.392 = 339.2%
DEBT
Debt turnover =
339.24% net sales
85,420 / total 25,180
liabilities
Debt turnover = net sales / total liabilities
Sector Mid to large cap Debt Small to mid cap Debt Micro to small cap Debt
Turnover Turnover Turnover
161
118
Equation
Comparing Debt and
Total Invested Capital
company. Investors are generally not as adverse to higher
debt levels as long as the company can readily make the
Debt to total invested capital = long-term liabilities / interest payments with income generated from operations.
(total shareholder equity + long-term liabilities)
This is because the leverage gained with debt financing
This ratio indicates the percentage that debt represents of may yield a higher return on investment for shareholders.
a company’s total invested capital. Invested capital, com-
Ways to improve the indicator: You can reduce debt capi-
posed of debt, stock, and retained earnings, is the money
talization by paying down debt levels with operating
used to purchase assets such as inventory, buildings, and
income and/or by issuing additional stock. Increasing
machinery. Long-term liabilities are those debts that are
company profitability to allow increased retained earnings
payable in full in more than 12 months.
also reduces the degree to which a company is capitalized
When to use indicator: Creditors, investors, and managers with debt. Opposite actions will tend to increase leverage
can use this indicator to assess the risk associated with and debt capitalization.
existing debt levels and with the issuance of additional
Example
debt.
Debt to total invested capital = long-term liabilities /
DEBT
Meaning of result: Higher ratios indicate that debt com- (total shareholder equity + long-term liabilities)
prises a larger portion of the money invested in a company
than equity in the form of stock or retained earnings. Long-term liabilities = 25,180 − 12,032 = 13,148
Since a company must pay debt back with interest, higher Total shareholder equity = 31,088
ratios can indicate potential leverage problems. Creditors
Debt to total invested capital = 13,148 / (31,088 + 13,148) =
like to see equity as a good portion of invested capital 0.2972 = 29.72%
since equity does not require interest payments and this
investment tells them there are other stakeholders in the
Sector Mid to large cap Debt to Total Small to mid cap Debt to Total Micro to small cap Debt to Total
Invested Capital Invested Capital Invested Capital
162
119
Equation
Relating Short-Term Debt
to Long-Term Debt
Ways to improve the indicator: Financing assets with
terms, or loan time periods, similar to the useful life of the
Short-term to long-term debt = asset will tend to achieve proper ratios of short- to long-
current liabilities / long-term liabilities
term debt. This should shift inappropriate short-term lia-
Ratios of short- to long-term debt indicate the degree to bilities to a more suitable long term, decrease the short-to-
which a company finances its debt with short-term debt. long-term-debt ratio, and increase cash flow.
Highly profitable companies are often not concerned with
When to use indicator: Creditors, investors, and managers the potential cash flow problems associated with excessive
can use this indicator to assess the risk associated with short-term financing, because they can easily handle the
current short-term debt levels and with the issuance of increased level of loan payments with operating income.
additional debt, either short- or long-term. Example
Meaning of result: Higher ratios indicate that a large por- Short-term to long-term debt =
tion of debt is short-term in nature. This can present cash current liabilities / long-term liabilities
flow problems since short-term debt must be paid off
more quickly than long-term debt. Some companies will Current liabilities = 12,032
Long-term liabilities = 25,180 − 12,032 = 13,148
DEBT
to long-term debt =
Short-term91.51% current liabilities
12,032 / long-term liabilities
13,148
Short-term to long-term debt = current liabilities / long-term liabilities
Sector Mid to large cap Short-Term Debt Small to mid cap Short-Term Debt Micro to small cap Short-Term Debt
to Long-Term Debt to Long-Term Debt to Long-Term Debt
163
120
Equation
Determining the
Cost of Debt Capital
Ways to improve the indicator: You can reduce debt inter-
est rates with increasingly sound financial performance
Cost of debt capital = debt interest paid / debt such as increasingly high sales growth, net incomes, cash
flows, and debt coverage and increasingly lower debt-to-
The interest rate paid to service debt is known as the cost
equity ratios.
of debt capital. Existing debt includes long-term debt, the
current portion of long-term debt, and any other interest- Example
bearing debt such as notes payable.
Cost of debt capital = debt interest paid / debt
When to use indicator: Creditors, managers, and investors can
use this indicator to determine the interest rate paid for debt Debt interest paid = 784
capital. You can also use this indicator to be sure that income Debt = interest-bearing debt = notes payable +
statement interest expenses correlate with balance sheet debt current portion of long-term debt + long-
term debt = 1,000 + 650 + 12,513 =
burdens.
$14,163
Meaning of result: Lower ratios indicate the company has Cost of debt capital = 784 / 14,163 = 0.0554 = 5.54%
achieved excellent interest rate terms, probably because of
DEBT
Sector Mid to large cap Cost of Small to mid cap Cost of Micro to small cap Cost of
Debt Capital Debt Capital Debt Capital
164
CHAPTER EIGHT
Equity
165
121
Equation
Comparing Equity
to Sales Revenue
of shareholder equity. This is generally a good indication
that management has effectively used the capital provided
by equity holders to purchase assets that generate healthy
Equity to sales = total shareholder equity / net sales
sales levels.
Note that successful companies often generate high levels of
Equity to sales is a measure of how effectively a company retained earnings, which boost total shareholder equity and
uses shareholder equity to generate sales revenue. Share- increase the equity-to-sales ratio.
holder equity includes all equity balance sheet items, typi-
Ways to improve the indicator: Effective use of the capital
cally the most significant of which are additional paid-in
provided by shareholders can generate additional sales
capital for stock purchases and retained earnings (income
and increase the equity-to-sales ratio.
generated that a company has reinvested in itself).
Example
When to use indicator: Investors use this indicator to
ascertain a company’s sales-generating potential for a Equity to sales = total shareholder equity / net sales
given amount of equity investment. Total shareholder equity = 31,088
EQUITY
Sector Mid to large cap Equity Small to mid cap Equity Micro to small cap Equity
to Sales to Sales to Sales
166
122
Equation
Comparing Equity
to Total Assets
his home with a mortgage (debt) is much less likely to
default on his payments than a similar owner with a 95%
Equity to assets = total shareholder equity / total assets mortgage. Creditors also like to see higher ratios since
lower debt levels indicate the company is using less money
This indicator compares the relative level of shareholder
to pay existing interest payments, and thus more operating
equity to all company assets. You can think of it as the por-
income remains to service new debt.
tion of assets that were purchased with shareholders’ equity.
Lower ratios indicate the opposite effect—little equity
Total assets include all current and long-term assets such as
investment and larger debt incurred for asset acquisitions.
cash, inventory, accounts receivable, property, plants, equip-
While creditors generally frown upon large debt levels
ment, patents, goodwill, and investments. Shareholder equi-
accompanied by small equity investments for the reason dis-
ty includes all equity balance sheet items, typically the most
cussed above, investors are more likely to view such lower
significant of which are additional paid-in capital for stock
ratios in a positive light because the leverage gained with
purchases and retained earnings (income generated that a
debt financing may lead to greater returns on equity invest-
company has reinvested in itself).
ment.
When to use indicator: Creditors and investors can use
EQUITY
Sector Mid to large cap Equity to Small to mid cap Equity to Micro to small cap Equity to
Assets Assets Assets
167
123
Equation
Comparing Equity
to Total Debt
to meet debt interest payments and because creditors like
to see a substantial investment by the owners. Investors
Equity to debt = total shareholder equity / total liabilities are more likely to view lower ratios in a positive light
since the leverage gained with debt financing may lead to
This indicator compares the relative level of shareholder
greater returns on equity investment.
equity to all company debt. Shareholder equity includes all
equity balance sheet items, typically the most significant of Ways to improve the indicator: Paying down debt levels
which are additional paid-in capital for stock purchases and with operating income or owner’s equity can increase the
retained earnings (income generated that the company has equity-to-debt ratio. Acquiring additional debt can reduce
reinvested in itself). Total liabilities include all debt such as the equity-to-debt ratio, and thus increase company lever-
loans payable to lenders, accounts payable to suppliers, and age.
income taxes payable to the government.
Example
When to use indicator: Creditors and investors can use
this indicator to gauge the manner in which a company is Equity to debt = total shareholder equity / total liabilities
capitalized. Are the company’s assets financed with debt
EQUITY
Sector Mid to large cap Equity to Small to mid cap Equity to Micro to small cap Equity to
Debt Debt Debt
168
124
Equation:
Determining the
Turnover of Equity
indicate, for a given profit margin level, that returns on
equity are also increasing.
Equity turnover = net sales / total shareholder equity Note that successful companies often generate high levels of
retained earnings, which boost total shareholder equity and
This ratio compares the relative size of all shareholder
reduce the equity turnover ratio.
equity to sales revenues and indicates a company’s ability to
use shareholder equity to generate sales. Ways to improve the indicator: Increasing sales levels
and/or reducing equity levels with stock repurchases can
When to use indicator: Investors can use this indicator to
increase the equity turnover ratio.
assess the level of sales return associated with equity
investments. Equity turnover multiplied by profit margin Example
yields a particularly important ratio, the return on share-
holder equity (ROE). Equity turnover = net sales / total shareholder equity
Meaning of result: Higher ratios indicate that a company Net sales = 85,420
generates a great deal of sales for every dollar of equity. Total shareholder equity = 31,088
EQUITY
Equity turnover =
274.8% net85,420
sales 31,088 equity
/ total shareholder
Equity turnover = net sales / total shareholder equity
Sector Mid to large cap Equity Small to mid cap Equity Micro to small cap Equity
Turnover Turnover Turnover
169
125
Equation
Examining the Turnover
of Invested Capital
Note that successful companies often generate high levels
of retained earnings, which boost total shareholder equity
Invested capital turnover = and reduce the invested capital turnover ratio.
net sales / (long-term liabilities + total shareholder equity)
Ways to improve the indicator: Increasing sales levels
This ratio compares the relative size of invested capital
and/or reducing debt and/or reducing equity levels with
to sales revenues and indicates a company’s ability to use
stock repurchases can increase the invested capital
invested capital to generate sales.
turnover.
When to use indicator: Investors can use this indicator to
Example
assess the level of sales return associated with capital invest-
ments. Invested capital turnover multiplied by profit margin Invested capital turnover =
yields a particularly important ratio, the return on invested net sales / (long-term liabilities + total shareholder equity)
capital (ROIC).
Net sales = 85,420
Meaning of result: Higher ratios indicate that a company Long-term liabilities = 25,180 − 12,032 = 13,148
Total shareholder equity = 31,088
EQUITY
Sector Mid to large cap Invested Capital Small to mid cap Invested Capital Micro to small cap Invested Capital
Turnover Turnover Turnover
170
126
Equation
Comparing Net Income
to Invested Capital
Ways to improve the indicator: Investing in assets which
increase company profitability can increase the net
Net income to invested capital = income-to-invested capital ratio.
net income / (long-term liabilities + total shareholder equity)
Example
This ratio describes the ability of a company to generate
income with the capital invested in the company. Net income to invested capital =
net income / (long-term liabilities + total shareholder equity)
When to use indicator: Managers and investors can use
this indicator to determine the effectiveness with which a Net income = 4,983
company uses invested capital to generate income. Long-term liabilities = 25,180 − 12,032 = 13,148
Total shareholder equity = 31,088
Meaning of result: Higher ratios indicate management has
effectively invested its capital in assets that allow the genera- Net income to invested capital = 4,983 / (13,148 + 31,088) =
tion of high net income streams. 0.1126 = 11.26%
EQUITY
to invested capital =
Net income11.26% net income / ( long-term
4,983 liabilities +
13,148 total shareholder
31,088 equity )
Net income to invested capital = net income / ( long-term liabilities + total shareholder equity )
Sector Mid to large cap Net Income to Small to mid cap Net Income to Micro to small cap Net Income to
Invested Capital Invested Capital Invested Capital
171
127
Equation
Comparing Stock
to Invested Capital
ly acceptable as long as the company can pay interest pay-
ments associated with the debt with income generated from
Stock to invested capital = operations. This is because the leverage gained with debt
stock / (long-term liabilities + total shareholder equity)
financing may yield a higher return on investment for share-
This ratio indicates the percentage that stock represents of holders. Increases in retained earnings, desired by both cred-
a company’s total invested capital. Invested capital, com- itors and shareholders, will tend to lower the stock-to-
posed of long-term liabilities and shareholder equity in the invested capital ratio.
form of stock and retained earnings, is the money used to
Ways to improve the indicator: You can increase stock-to-
purchase assets such as inventory, buildings, and machinery.
invested capital ratios by issuing additional stock, reduc-
When to use indicator: Creditors, investors, and managers ing debt levels, or reducing retained earnings with income
can use this indicator to assess the manner in which a generated from operations.
company has financed its assets.
Example
Meaning of result: Higher ratios indicate that stock com- Stock to invested capital =
EQUITY
prises a larger portion of the money invested in a company stock / (long-term liabilities + total shareholder equity)
than debt or equity in the form of retained earnings. Cred-
itors like to see that equity represents a good portion of Stock = 300 + 36 + 12,085 − 55 = 12,366
invested capital since equity does not require interest pay- Long-term liabilities = 25,180 − 12,032 = 13,148
ments and represents other stakeholders in the company. Total shareholder equity = 31,088
Investors are generally not as adverse to lower stock-to-
invested capital ratios. Such lower ratios either indicate sub- Stock to invested capital = 12,366 / (13,148 + 31,088) =
stantial debt financing or retained earnings. Debt is general- 0.2795 = 27.95%
Sector Mid to large cap Stock to Small to mid cap Stock to Micro to small cap Stock to
Invested Capital Invested Capital Invested Capital
172
128
Equation
Comparing Retained Earnings
to Invested Capital
a company can readily make the interest payments associated
with the debt with income generated from operations. This is
Retained earnings to invested capital = retained earnings / because the leverage gained with debt financing may yield a
(long-term liabilities + total shareholder equity)
higher return on investment for shareholders. The issuance of
This ratio indicates the percentage that retained earnings stock is acceptable when the company uses the proceeds for
represent of a company’s total invested capital. Invested assets that offer good rates of return.
capital, composed of debt as well as equity in the form of
Ways to improve the indicator: You can improve retained
stock and retained earnings, is the money used to purchase
earnings capitalization by generating higher percentages of
assets such as inventory, buildings, and machinery.
retained earnings, paying off debt, and repurchasing stock.
When to use indicator: Creditors, investors, and managers You can improve retained earnings generation by provid-
can use this indicator to assess the manner in which a ing highly demanded products or services with large profit
company has financed its assets. margins. You can optimize profit margins with excellent
marketing, product/service design and quality, cost con-
Meaning of result: Higher ratios indicate that retained trol, and customer service.
EQUITY
Liquidity
174
129
Equation
Finding the Current Ratio
much in excess of 2.0, can indicate a company is not using
its assets in an ideal manner. This is because current assets
Current ratio = current assets / current liabilities seldom yield returns as large as long-term assets such as
investments in equipment and subsidiaries.
The current ratio describes the ability of a company to
meet current debt obligations with assets that are readily Ways to improve the indicator: When ratios are too low,
available. Current assets include cash, marketable securities, management can look to increase the level of liquid assets
accounts receivable, inventory, and notes receivable. and/or decrease the level of short-term debt. When ratios
are too high, management can seek to invest a portion of
When to use indicator: Creditors, investors, and managers
excess liquid assets in longer term assets that will generate
can use this indicator to measure the liquidity of a compa-
higher returns on investment.
ny.
Example
Meaning of result: Higher ratios indicate an increased
ability to pay short-term debt obligations such as accounts Current ratio = current assets / current liabilities
payable and interest payments on debt. Lower ratios can
LIQUIDITY
Current ratio =
3.668 current
44,135assets / current12,032
liabilities
Current ratio = current assets / current liabilities
Sector Mid to large cap Current Small to mid cap Current Micro to small cap Current
Ratio Ratio Ratio
175
130
Equation
Using the Acid Test
rule of thumb is that healthy acid test ratios equal or
exceed the value of 1.0. However, very high acid test
Acid test = liquid assets / current liabilities ratios, much in excess of 1.0, can indicate a company is
not using its assets in an ideal manner. This is because liq-
The acid test describes the ability of a company to meet
uid assets seldom yield returns as large as long-term assets
current debt obligations with assets that are readily avail-
such as investments in equipment and subsidiaries.
able. Liquid assets include cash, marketable securities, and
accounts receivable. Liquid assets are sometimes called Ways to improve the indicator: When ratios are too low,
quick assets, and the acid test is at times called the quick management can look to increase the level of liquid assets
ratio. Since the acid test does not include all current assets, and/or decrease the level of short-term debt. When ratios
it is more conservative than the current ratio and yields are too high, management can seek to invest a portion of
lower results. excess liquid assets in longer term assets that will generate
higher returns on investment.
When to use indicator: Creditors, investors, and managers
can use this indicator to measure the liquidity of a compa- Example
ny.
LIQUIDITY
Sector Mid to large cap Acid Small to mid cap Acid Micro to small cap Acid
Test Test Test
176
131
Equation
Determining the
Cash Flow Ratio
very high cash flow ratios can indicate a company is not
using its assets in an ideal manner. This is because liquid
Cash flow ratio = assets seldom yield returns as large as long-term assets
(cash + marketable securities) / current liabilities
such as investments in equipment and subsidiaries.
The cash flow ratio describes the ability of a company to
Ways to improve the indicator: When ratios are too low,
meet current debt obligations with assets that are the most
management can increase the level of liquid assets and/or
readily available. For the cash flow ratio, readily available
decrease the level of short-term debt. When ratios are too
assets include only cash and marketable securities. Since the
high, management can invest a portion of excess liquid
cash flow ratio includes only very liquid current assets, it is
assets in longer term assets that will generate higher
more conservative than the current ratio or acid test ratios
returns on investment.
and yields lower results.
Example
When to use indicator: Creditors, investors, and managers
can use this indicator to measure the liquidity of a compa- Cash flow ratio =
ny. (cash + marketable securities) / current liabilities
LIQUIDITY
Sector Mid to large cap Cash Flow Small to mid cap Cash Flow Micro to small cap Cash Flow
Ratio Ratio Ratio
177
132
Equation
Calculating Cash Turnover
Ways to improve indicator: When ratios are too high,
increasing cash reserves by reducing investments in other
Cash turnover = net sales / cash
types of assets can decrease cash turnover. When ratios are
Cash turnover describes the relationship between cash trending too low, finding manners in which the excessive
balances and sales levels. cash may be invested where returns are higher and risk
levels are acceptable will tend to increase cash turnover.
When to use indicator: Managers, creditors, and investors
can use this indicator to determine if the company holds
an appropriate amount of cash. Example
Meaning of result: Very high ratios can indicate inade- Cash turnover = net sales / cash
quate cash reserves, which may lead to problems in meet-
ing debt obligations such as accounts payable and interest Net sales = 85,420
payments. Very low ratios can indicate excessive cash Cash = 4,139
reserves. In this case, a portion of the cash balance would
LIQUIDITY
better be invested in other types of assets that yield greater Cash turnover = 85,420 / 4,139 = 20.64
returns such as plant equipment and subsidiaries.
Cash turnover =
20.64 net85,420
sales / cash4,139
Cash turnover = net sales / cash
Sector Mid to large cap Cash Small to mid cap Cash Micro to small cap Cash
Turnover Turnover Turnover
178
133
Equation
Finding How Many Days of
Cash Expenses are Available
Ways to improve indicator: When ratios are too low,
increasing cash reserves by reducing investments in other
Days of cash expenses = cash / (year’s cash expenses/365)
types of assets can increase the days of cash expenses
This ratio examines how many days of average daily available. When ratios are trending too high, finding man-
expenses the company can pay with the existing cash bal- ners in which the excessive cash may be invested, where
ance. You can approximate the average daily expenses by returns are higher and risk levels are acceptable, will tend
dividing a full year of expenses by the number of days in a to decrease the days of cash expenses available.
year. Expenses include items such as the cost to produce a
product or service, salaries, interest, and taxes.
Example
When to use indicator: Managers, creditors, and investors
can use this indicator to determine if the company holds Days of cash expenses = cash / (year’s cash expenses/365)
an appropriate amount of cash.
Cash = 4,139
Meaning of result: Very low ratios can indicate inadequate Year’s cash expenses = all expenses −
LIQUIDITY
cash reserves, which may lead to problems in meeting debt depreciation/amortization = cost of goods sold + R&D +
obligations such as accounts payable and interest pay- SG&A + interest + taxes − depreciation/amortization =
ments. Very high ratios can indicate excessive cash 54,212 + 4,578 + 15,993 + 784 + 3,529 − 1,204 = 77,892
reserves. In this case, a portion of the cash balance would
better be invested in other types of assets that yield greater Days of cash expenses = 4,139 / (77,892 / 365) = 19.4 days
returns such as plant equipment and subsidiaries.
cash expenses =
Days of19.4 cash
4,139 / ( year’s cash expenses / 365 )
77,892
Days of cash expenses = cash / ( year’s cash expenses / 365 )
Sector Mid to large cap Days of Cash Small to mid cap Days of Cash Micro to small cap Days of Cash
Expenses Expenses Expenses
179
134
Equation
Examining How Many Days
of Sales in Cash are Available
Ways to improve indicator: When ratios are too low,
increasing cash reserves by reducing investments in other
Days of sales in cash = cash / (net sales/365)
types of assets can increase the days of sales in cash. When
This ratio describes the relationship between cash balances ratios are trending too high, finding manners in which the
and sales levels and examines how many days of average net excessive cash may be invested, where returns are higher
sales are available in cash. and risk levels are acceptable, can decrease the days-of-
sales-in-cash ratio.
When to use indicator: Managers, creditors, and investors
can use this indicator to determine if the company holds
an appropriate amount of cash. Example
When to use indicator: Very low ratios can indicate inade- Days of sales in cash = cash / (net sales/365)
quate cash reserves, which may lead to problems in meet-
ing debt obligations such as accounts payable and interest Cash = 4,139
payments. Very high ratios can indicate excessive cash Net sales = 85,420
LIQUIDITY
Sector Mid to large cap Days of Sales Small to mid cap Days of Sales Micro to small cap Days of Sales
in Cash in Cash in Cash
180
Using Altman’s Z-score to Determine
135
Equation
the Probability of Bankruptcy
Ways to improve the indicator: Increasing short-term
assets such as cash and marketable securities can increase
Altman’s Z-score = (1.2 × working capital/total assets) + (1.4 × the Z-score. Turning around operations to generate posi-
retained earnings/ total assets) + (3.3 × operating income/total
tive and healthy operating income and retained earnings
assets) + (0.6 × market value of common and preferred stock /
total liabilities) + (1.0 × net sales / total assets) can also move the Z-score in a positive direction.
Sector Mid to large cap Probability Small to mid cap Probability Micro to small cap Probability
of Bankruptcy of Bankruptcy of Bankruptcy
181
Altman’s Z-score = (1.2 × working capital / total assets) + ( 1.4 × retained earnings / total
assets) + ( 3.3 × operating income / total assets) + (0.6 × market value of common and
preferred stock / total liabilities) + (1.0 × net sales / total assets)
1.935
Sales to current assets = 85,420
net sales 44,135
/ current assets
Sales to current assets = net sales / current assets
Sector Mid to large cap Sales to Small to mid cap Sales to Micro to small cap Sales to
Current Assets Current Assets Current Assets
182
137
Equation
Comparing Liquid Assets
to Current Liabilities
Ways to improve the indicator: When ratios are too low,
increasing liquid assets by reducing investments in longer
Liquid assets to current liabilities =
liquid assets / current liabilities term assets can increase the liquid-assets-to-current-liabili-
ties ratio. When ratios are trending too high, finding man-
This ratio examines the ability to meet short-term debt ners in which the excessive liquid assets may be invested
with cash-like assets. Liquid assets include cash, marketable where returns are higher and risk levels are acceptable,
securities, and accounts receivable. can reduce this ratio.
Meaning of result: Higher ratios indicate the ability to Liquid assets = quick assets = cash + marketable securities +
LIQUIDITY
meet short-term debt obligations readily with liquid assets accounts receivable = 4,139 + 524 + 24,878 = 29,541
on hand. When ratios are trending too high, however, it Current liabilities = 12,032
may indicate excessive liquid assets on hand that might be Liquid assets to current liabilities = 29,541 / 12,032 = 2.455
better invested in longer term assets that yield greater
returns. Lower ratios can indicate inadequate cash-like
assets to meet short-term debt obligations.
to current liabilities =
Liquid assets 2.455 liquid assets / current
29,541 liabilities
12,032
Liquid assets to current liabilities = liquid assets / current liabilities
Sector Mid to large cap Liquid Assets to Small to mid cap Liquid Assets to Micro to small cap Liquid Assets to
Current Liabilities Current Liabilities Current Liabilities
183
138
Equation
Relating Liquid Assets
to Cash Expenses
Ways to improve the indicator: When ratios are too low,
increasing liquid assets by reducing investments in longer
Liquid assets to cash expenses = term assets can increase the liquid-assets-to-cash-expenses
liquid assets / (year’s cash expenses/365)
ratio. When ratios are trending too high, finding manners
This ratio determines the ability to meet average daily in which the excessive liquid assets may be invested, in
expenditure levels with cash-like assets. Liquid assets which returns are higher and risk levels are acceptable,
include cash, marketable securities, and accounts receivable. can decrease this ratio.
typical expense requirements readily with liquid assets on interest = 54,212 + 4,578 + 15,993 + 784 = 75,567
hand. When ratios are trending too high, however, it may
Liquid assets to cash expenses = 29,541 / (75,567/365) =
indicate excessive liquid assets, some percentage of which 142.7
might be better invested in longer term assets that yield
greater returns. Lower ratios can indicate there may be inade-
quate cash-like assets to meet expense payments.
to cash expenses =
Liquid assets142.7 liquid assets
29,541 / ( year’s cash expenses / 365)
75,567
Liquid assets to cash expenses = liquid assets / ( year’s cash expenses / 365)
Sector Mid to large cap Liquid Assets to Small to mid cap Liquid Assets to Micro to small cap Liquid Assets to
Cash Expenses Cash Expenses Cash Expenses
184
139
Equation
Relating Current
Debt to Sales
nies that are experiencing cash flow problems.
When current debt to sales is increasing, it can indicate
Current debt to sales = current liabilities / net sales slowing sales or slower repayment of creditor debt.
This ratio indicates whether the level of current debt is Ways to improve the indicator: When current debt-to-sales
suitable for the size of the company and the industry in ratios are too high, refinancing shorter term debt with
which it operates. Current liabilities include debt that must long-term debt, preferably matching loan time periods
be paid in full in less than one year such as accounts with the useful life of the assets, can reduce the current-
payable for suppliers and income taxes payable to the gov- debt-to-sales ratio.
ernment.
Example
When to use indicator: Creditors, investors, and managers
can use this indicator to determine the risk level associated Current debt to sales = current liabilities / net sales
with a company’s short-term debt burden.
Current liabilities = 12,032
Meaning of result: Higher ratios indicate a great deal of Net sales = 85,420
LIQUIDITY
debt is due in less than one year. This situation is less trou-
Current debt to sales = 12,032 / 85,420 = 0.1409 = 14.09%
blesome for profitable firms than for start-ups or compa-
Sector Mid to large cap Current Small to mid cap Current Micro to small cap Current
Debt to Sales Debt to Sales Debt to Sales
185
140 Comparing Current Debt
to Total Debt
Equation greater demands on the company to generate the addition-
al income necessary to meet the higher payments required
Current debt to total debt = of short-term debt. This is less troublesome for profitable
current liabilities / total liabilities
firms than for start-ups or companies that are experienc-
This ratio indicates the percentage of total debt that is cur- ing cash flow problems.
rent, or short-term, in nature. Current debt to total debt is
Ways to improve the indicator: When current-debt-to-
also a liquidity indicator since short-term debt repayment
total-debt ratios are too high, refinancing shorter term
requirements are greater because of higher principal repay-
debt with long-term debt, preferably matching loan time
ment demands. Current liabilities include debt that must be
periods with the useful life of the assets, can reduce the
paid in full in less than one year such as accounts payable for
current-debt-to-total-debt ratio.
suppliers and income taxes payable to the government. Total
liabilities include all debt such as loans payable to lenders, Example
accounts payable to suppliers, and income taxes payable to
LIQUIDITY
Sector Mid to large cap Current Debt Small to mid cap Current Debt Micro to small cap Current Debt
to Total Debt to Total Debt to Total Debt
186
141
Equation
Examining Working Capital
Meaning of result: Low amounts of working capital can
indicate the business is insufficiently liquid and could have
Working capital = current assets − current liabilities problems meeting current debt obligations. Very high work-
ing capital accounts could indicate ineffective management
This equation describes the amount of capital used to run
since current assets seldom yield returns as great as long-
day-to-day business operations. Working capital is neces-
term assets.
sary to finance a company’s cash conversion cycle. You can
think of it as a measure of liquidity. The cash conversion Ways to improve the indicator: Firms should seek to main-
cycle describes the process by which a company converts tain working capital levels that provide sufficient current
cash into products and then back into cash again. For a assets to meet short-term debt requirements but in which
manufacturing company, this includes using cash to pur- current asset accounts are not so excessive that overall
chase raw materials; perform the work required to make, company profit margins suffer. When working capital is
inspect, and store the product; sell the product; and ulti- too low, increasing current assets and/or reducing current
mately collect cash from the customer. Current assets liabilities can increase working capital. When working
include cash, marketable securities, accounts receivable, capital is trending too high, investing excess current assets
LIQUIDITY
inventory, and all other assets that are likely to be held less in longer term assets, which yield higher rates of return at
than one year. Current liabilities include accounts payable, acceptable risk levels, can decrease working capital levels.
accrued liabilities such as payroll and property taxes, and
all other debts due in less than one year. Example
When to use indicator: Managers, investors, and creditors Working capital = current assets − current liabilities
use working capital to ensure the company has a proper
degree of liquidity. Current assets = 44,135
Current liabilities = 12,032
Working capital =
32,103 44,135
current assets − current 12,032
liabilities
Working capital = current assets − current liabilities
Sector Mid to large cap Working Small to mid cap Working Micro to small cap Working
Capital Capital Capital
187
142
Equation
Finding the Turnover
of Working Capital
Meaning of result: High working capital turnover can
indicate the business is insufficiently liquid and could have
Working capital turnover = net sales / working capital problems meeting current debt obligations. Low working
where capital turnover can indicate ineffective management since
current assets seldom yield returns as great as long-term
working capital = current assets − current liabilities assets.
This equation describes the relationship between the size Ways to improve the indicator: Firms should seek to main-
of the company and the amount of working capital used to tain the turnover of working capital at levels that provide
run day-to-day business operations. Working capital is nec- sufficient current assets to meet short-term debt require-
essary to finance a company’s cash conversion cycle. You ments but at which current asset accounts are not so
can think of it as a measure of liquidity. The cash conver- excessive that overall company profit margins suffer.
sion cycle describes the process by which a company con- When working capital turnover is too high, increasing cur-
verts cash into products and then back into cash again. For rent assets and/or reducing current liabilities can decrease
a manufacturing company, this includes using cash to pur- working capital turnover levels. When working capital
chase raw materials; perform the work required to make,
LIQUIDITY
When to use indicator: Managers, investors, and creditors Net sales = 85,420
use working capital turnover to ensure the company has a Working capital = 32,103
proper degree of liquidity. Working capital turnover = 85,420 / 32,103 = 2.661 =
266.1%
capital turnover =
Working266.1% net sales
85,420 / working32,103
capital
Working capital turnover = net sales / working capital
Sector Mid to large cap Working Small to mid cap Working Micro to small cap Working
Capital Turnover Capital Turnover Capital Turnover
188
143
Equation
Comparing Working
Capital to Sales
Meaning of result: Low working-capital-to-sales ratios can
indicate the business is insufficiently liquid and could have
Working capital to sales = working capital / net sales problems meeting current debt obligations. High working-
where capital-to-sales ratios can indicate ineffective management
since current assets seldom yield returns as great as long-
working capital = current assets − current liabilities term assets.
This equation describes the relationship between the size Ways to improve the indicator: Firms should seek to main-
of the company and the amount of working capital used to tain working-capital-to-sales ratios at levels that provide suf-
run day-to-day business operations. Working capital to sales ficient current assets to meet short-term debt requirements
is the inverse of working capital turnover. Working capital is but at which current asset accounts are not so excessive that
necessary to finance a company’s cash conversion cycle and overall company profit margins suffer. When working-capi-
is a measure of liquidity. The cash conversion cycle describes tal-to-sales ratios are too low, increasing current assets
the process by which a company converts cash into products and/or reducing current liabilities can increase the ratios.
and then back into cash again. For a manufacturing compa- When working-capital-to-sales ratios are trending too high,
ny, this includes using cash to purchase raw materials; per-
LIQUIDITY
Sector Mid to large cap Working Small to mid cap Working Micro to small cap Working
Capital to Sales Capital to Sales Capital to Sales
189
144
Equation
Comparing Working Capital
to Net Income
Meaning of result: Low working-capital-to-net-income
ratios indicate that a given amount of working capital
Working capital to net income = working capital / net income generates a great deal of income. This is indicative of
either highly profitable businesses or those companies that
where operate with little working capital.
High or negative working-capital-to-net-income ratios can
working capital = current assets − current liabilities
indicate poorly performing companies which generate little or
This ratio describes the relationship between the size and no income and/or those businesses that require a great deal of
earning power of a company and the amount of working working capital.
capital used to run day-to-day business operations. Working
Ways to improve the indicator: To maximize the amount
capital is necessary to finance a company’s cash conversion
of income generated for a given amount of working capi-
cycle. You can think of it as a measure of liquidity. The cash
tal, firms should seek to maintain working capital at levels
conversion cycle describes the process by which a company
that provide sufficient current assets to meet short-term
converts cash into products and then back into cash again.
debt requirements but at which current asset accounts are
For a manufacturing company, this includes using cash to
LIQUIDITY
When to use indicator: Since working capital is a cost of Working capital = 32,103
operating a business, managers can use this ratio to inves- Net income = 4,983
tigate if that cost is generating an acceptable amount of Working capital to net income = 32,103 / 4,983 = 6.443 = 644.3%
profit.
644.3%
Working capital to net income = 32,103
working capital 4,983
/ net income
Working capital to net income = working capital / net income
Sector Mid to large cap Working Capital Small to mid cap Working Capital Micro to small cap Working Capital
to Net Income to Net Income to Net Income
190
145
Equation
Relating Working Capital
to Current Debt
Meaning of result: Low working-capital-to-current-debt
ratios can indicate the business is insufficiently liquid and
Working capital to current debt = could have problems meeting current debt obligations.
working capital / current liabilities
However, when ratios become too high, it can indicate
where ineffective management since current assets seldom yield
returns as great as long-term assets.
working capital = current assets − current liabilities
This ratio describes the relationship between short-term Ways to improve the indicator: Firms should seek to main-
debt and the amount of capital used to run day-to-day busi- tain working-capital-to-current-debt ratios at levels that
ness operations. Working capital is necessary to finance a provide sufficient working capital to meet short-term debt
company’s cash conversion cycle. It is a measure of liquidity. requirements but at which current asset accounts are not
The cash conversion cycle describes the process by which a so excessive that overall company profit margins suffer.
company converts cash into products and then back into cash When working-capital-to-current-debt ratios are too low,
again. For a manufacturing company, this includes using cash increasing current assets and/or reducing current liabilities
to purchase raw materials; perform the work required to can increase the ratios. When working-capital-to-current-
make, inspect, and store the product; sell the product; and ulti-
LIQUIDITY
266.8%
Working capital to current debt = 32,103
working capital 12,032
/ current liabilities
Working capital to current debt = working capital / current liabilities
Sector Mid to large cap Working Capital Small to mid cap Working Capital Micro to small cap Working Capital
to Current Debt to Current Debt to Current Debt
191
146
Equation
Relating Working Capital
to Long-Term Debt
Meaning of result: Low ratios of working capital to long-
term debt can indicate highly leveraged businesses, compa-
Working capital to long-term debt = nies that hold substantial amounts of long-term debt. Low
working capital / long- term liabilities ratios can also indicate situations in which there is insuffi-
cient liquidity.
where High ratios of working capital to long-term debt indicate
working capital = current assets − current liabilities highly liquid businesses and/or businesses that hold little
long-term debt. They also indicate companies that can prob-
This ratio describes the relationship between long-term ably pay off long-term debt balances readily with current
debt and the amount of capital used to run day-to-day busi- assets if so desired.
ness operations. Working capital is necessary to finance a
company’s cash conversion cycle and is a measure of liquidi- Ways to improve the indicator: Firms should seek to main-
ty. The cash conversion cycle describes the process by which tain ratios of working capital to long-term debt at levels
a company converts cash into products and then back into which provide sufficient working capital to meet short-term
cash again. For a manufacturing company, this includes debt requirements. Beyond short-term needs, the relative size
using cash to purchase raw materials; perform the work of long-term debt and working capital is dependent upon the
degree of financial leverage a company can comfortably ser-
LIQUIDITY
Sector Mid to large cap Working Capital Small to mid cap Working Capital Micro to small cap Working Capital
to Long-Term Debt to Long-Term Debt to Long-Term Debt
192
147
Equation
Relating Working Capital
to Total Debt
Meaning of result: Low ratios of working capital to total
debt can indicate highly leveraged businesses, companies
Working capital to total debt =
that hold substantial amounts of debt. Low ratios can also
working capital / total liabilities
indicate situations in which there is insufficient liquidity.
where High ratios of working capital to total debt indicate high-
working capital = current assets − current liabilities ly liquid businesses that can easily service all forms of debt.
They also indicate companies that can probably pay off
This ratio describes the relationship between all forms of
debt balances readily with current assets if so desired.
debt and the amount of capital used to run day-to-day busi-
ness operations. Working capital is necessary to finance a Ways to improve the indicator: Firms should seek to main-
company’s cash conversion cycle and is a measure of liquidi- tain ratios of working capital to total debt at levels that
ty. The cash conversion cycle describes the process by which provide sufficient working capital to meet short-term debt
a company converts cash into products and then back into requirements. Beyond short-term needs, the relative size of
cash again. For a manufacturing company, this includes total debt and working capital is dependent upon the
using cash to purchase raw materials; perform the work degree of financial leverage a company can comfortably
required to make, inspect, and store the product; sell the service. Higher degrees of financial leverage can help
LIQUIDITY
product; and ultimately collect cash from the customer. Cur- improve performance with additional asset procurement,
rent assets include cash, marketable securities, accounts but there is a commensurate increase in risk because of the
receivable, inventory, and all other assets that are likely to be increased levels of debt.
held less than one year. Current liabilities include accounts
payable, accrued liabilities such as payroll and property Example
taxes, and all other debts due in less than one year. Long-
term liabilities are those debts that are payable in full in Working capital to total debt =
more than one year such as with buildings and machinery. working capital / total liabilities
Total liabilities include both current and long-term liabilities.
Working capital = 32,103
When to use indicator: Managers, investors, and creditors Total liabilities = 25,180
use the ratio of working capital to total debt to compare Working capital to total debt = 32,103 / 25,180 = 1.275 =
the relative size of a company’s debt and current assets 127.5%
available.
Working capital to long-term debt =
127.5% working capital
32,103 / long-term liabilities
25,180
Working capital to total debt = working capital / total liabilities
Sector Mid to large cap Working Capital Small to mid cap Working Capital Micro to small cap Working Capital
to Total Debt to Total Debt to Total Debt
193
148
Equation
Comparing Working Capital
to Current Assets
Meaning of result: Low ratios of working capital to cur-
rent assets can indicate situations with insufficient liquidi-
Working capital to current assets =
working capital / current assets ty.
High ratios of working capital to current assets indicate
where highly liquid businesses that can easily service all forms of
working capital = current assets − current liabilities debt. When the ratio becomes excessively high, however, it
can indicate that management is not optimally using all
This ratio describes the relationship between current assets assets available since current assets seldom offer returns as
and the amount of capital used to run day-to-day business great as longer term assets.
operations. Working capital is necessary to finance a compa-
ny’s cash conversion cycle and is a measure of liquidity. The Ways to improve the indicator: Firms should seek to main-
cash conversion cycle describes the process by which a compa- tain ratios of working capital to current assets at levels
ny converts cash into products and then back into cash again. which provide sufficient working capital to meet short-
For a manufacturing company, this includes using cash to pur- term debt requirements. Beyond meeting those debt
chase raw materials; perform the work required to make, requirements, management should seek to invest excess
LIQUIDITY
inspect, and store the product; sell the product; and ultimately current assets in longer term vehicles that offer greater
collect cash from the customer. Current assets include cash, rates of return at acceptable risk levels. Such investments
marketable securities, accounts receivable, inventory, and all might include the purchase of a subsidiary, plant equip-
other assets that are likely to be held less than one year. Cur- ment to produce a new product line, or additional retail
rent liabilities include accounts payable, accrued liabilities floor space to generate additional sales.
such as payroll and property taxes, and all other debts due in
less than one year.
Example
When to use indicator: Managers, investors, and creditors Working capital to current assets =
use ratios of working capital to current assets to determine working capital / current assets
if a company is sufficiently liquid. This ratio allows a fast and
easy method of determining the size of working capital in Working capital = 32,103
relation to current assets. Think of it as the percentage of cur- Current assets = 44,135
rent assets available after a company services all short-term debt. Working capital to current assets = 32,103 / 44,135 = 0.7274 = 72.74%
Working capital
72.74% to current assets = working capital
32,103 / current44,135
assets
Working capital to current assets = working capital / current assets
Sector Mid to large cap Working Capital Small to mid cap Working Capital Micro to small cap Working Capital
to Current Assets to Current Assets to Current Assets
194
Comparing Working Capital to Specific
149
Equation
Current Assets Such as Cash and Inventory
Meaning of result: Low ratios of working capital to specific
current asset accounts indicate that the specific account
Working capital to cash = working capital / cash makes up a considerable portion of working capital. When
Working capital to inventory = working capital / inventory those current assets are more liquid in nature, then working
capital as a whole is more liquid. For example, if there is a
where large cash balance, working-capital-to-cash ratios are low
working capital = current assets − current liabilities and the entire working capital account is more liquid. Con-
versely, low ratios for less liquid current assets such as inven-
This ratio describes the relationship between specific current
tory indicate a high percentage of working capital is tied up
asset accounts and the amount of capital used to run day-to-
in inventory and the entire working capital account is less
day business operations. Working capital is necessary to
liquid.
finance a company’s cash conversion cycle and is a measure of
liquidity. The cash conversion cycle describes the process by Ways to improve the indicator: Firms should seek to main-
which a company converts cash into products and then back tain ratios of working capital to specific current assets at
into cash again. For a manufacturing company, this includes levels that provide sufficient liquid working capital to
LIQUIDITY
using cash to purchase raw materials; perform the work meet short-term debt requirements. Beyond short-term
required to make, inspect, and store the product; sell the prod- needs, the relative size of specific current asset accounts
uct; and ultimately collect cash from the customer. Current and working capital is dependent upon the type of busi-
assets include cash, marketable securities, accounts receivable, ness in question. For example, some companies require
inventory, and all other assets that are likely to be held less higher inventories than others because of the additional
than one year. Current liabilities include accounts payable, time required to produce and sell goods.
accrued liabilities such as payroll and property taxes, and all
other debts due in less than one year. Example
When to use indicator: Managers, investors, and creditors Working capital to inventory = working capital / inventory
use the ratio of working capital to specific current asset Working capital = 32,103
accounts to determine the liquidity level of working capi- Inventory = 13,421
tal. Working capital to inventory = 32,103 / 13,421 = 2.392 = 239.2%
capital to inventory =
Working239.2% 32,103
working capital 13,421
/ inventory
Working capital to inventory = working capital / inventory
Sector Mid to large cap Working Capital Small to mid cap Working Capital Micro to small cap Working Capital
to Inventory to Inventory to Inventory
195
150 Comparing Working Capital
to Total Assets
Equation When to use indicator: Managers, investors, and creditors use
the ratio of working capital to total assets to determine if there
Working capital to total assets = working capital / total assets is sufficient and appropriate working capital given the size and
type of business.
where
Meaning of result: Since total assets are an excellent indication
working capital = current assets − current liabilities of the size of the company in question, comparing working
capital with assets allows the manager to determine the appro-
This ratio describes the relationship between the size of a
priateness of the size of the working capital account. Low
company and the amount of capital used to run day-to-day
ratios of working capital to total assets can indicate insuffi-
business operations. Working capital is necessary to finance
cient liquidity. A manager may want to investigate further
a company’s cash conversion cycle and is a measure of liq-
when this ratio is declining because the company may soon
uidity. The cash conversion cycle describes the process by
have difficulty in meeting its debt payments. Note that the
which a company converts cash into products and then
degree of liquidity, or working capital, required is dependent
LIQUIDITY
Sector Mid to large cap Working Capital Small to mid cap Working Capital Micro to small cap Working Capital
to Total Assets to Total Assets to Total Assets
196
Higher degrees of financial leverage can help improve per- Example
formance with additional asset procurement, but there is a
commensurate increase in risk because of the increased Working capital to total assets = working capital / total assets
levels of debt.
Working capital = 32,103
Total assets = 56,268
197
151
Equation
Relating Liquid Assets to
Total Current Assets
Ways to improve the indicator: When you desire higher
ratios, shifting current asset accounts from less liquid to
Liquid assets to total current assets = more liquid accounts can improve liquidity and allow the
liquid assets / current assets
more ready payment of expenses.
This ratio describes the portion of current assets that are
Example
highly liquid in nature. Liquid assets include cash, mar-
ketable securities, and accounts receivable. Current assets Liquid assets to total current assets =
include liquid assets and inventory, notes receivable, and liquid assets / current assets
other current assets.
Liquid assets = quick assets = cash + marketable securities +
When to use indicator: Managers and creditors can use accounts receivable = 4,139 + 524 + 24,878 = 29,541
this indicator to determine the composition and degree of Current assets = 44,135
liquidity of current assets. Liquid assets to total current assets = 29,541 / 44,135 =
0.6693 = 66.93%
Meaning of result: A high ratio of liquid assets to current
LIQUIDITY
assets indicates that very liquid assets such as cash and cash
equivalents comprise a large part of the current asset
account. Lower ratios indicate that less liquid accounts such
as inventory and notes receivable make up a large part of
current assets.
Sector Mid to large cap Liquid Assets to Small to mid cap Liquid Assets to Micro to small cap Liquid Assets to
Total Current Assets Total Current Assets Total Current Assets
198
152
Equation
Relating Marketable Securities
to Total Current Assets
Ways to improve the indicator: When you desire higher
ratios, shifting other current asset accounts to the mar-
Marketable securities to total current assets = marketable ketable securities account can increase this ratio. Shifting
securities / total current assets
assets from other liquid current asset accounts such as
This ratio describes the portion of current assets repre- cash and cash equivalents will tend to increase rates of
sented by marketable securities. Marketable securities return. Shifting assets from less liquid current asset
include investments that are readily turned into cash and accounts such as inventory will tend to improve liquidity
are likely to be held less than one year. Companies often and allow more ready payment of expenses.
park excess cash in marketable securities to earn a higher
Example
yield than do simple cash checking accounts.
Marketable securities to total current assets = marketable
When to use indicator: Managers and creditors can use securities / total current assets
this indicator to determine the composition and degree of
liquidity of current assets. Marketable securities = 524
Total current assets = 44,135
LIQUIDITY
Marketable securities
1.19%to total current assets = marketable
524securities / total current
44,135assets
Marketable securities to total current assets = marketable securities / total current assets
Sector Mid to large cap Marketable Securities Small to mid cap Marketable Securities Micro to small cap Marketable Securities
to Total Current Assets to Total Current Assets to Total Current Assets
199
153
Equation
Comparing Accounts Receivable to
Total Current Assets
Ways to improve the indicator: When you desire higher
ratios, extending additional credit to customers can
Accounts receivable to total current assets = increase accounts receivable. This generally increases sales
accounts receivable / total current assets levels but may increase the percentage of unrecoverable
This ratio describes the portion of current assets that accounts receivable because more liberal credit policies
accounts receivable represent. Current assets include cash, tend to increase bad debt levels.
marketable securities, accounts receivable, inventory, and all When you desire lower ratios, tightening credit policies
other assets that are likely to be held less than one year. and attempting to shorten customer payment time can
Accounts receivable represent cash due to a company for reduce the levels of accounts receivable. In the short-term,
products or services already delivered to a customer. this should shift a portion of accounts receivable to cash
and thus increase the liquidity of the total current asset
When to use indicator: Managers and creditors can use account.
this indicator to determine the composition and degree of
liquidity of current assets. Example
Meaning of result: A high ratio of accounts receivable to accounts receivable / total current assets
current assets indicates that accounts receivable comprise
a large part of the current asset account. Accounts receiv- Accounts receivable = 24,878
able are generally less liquid than cash and marketable Total current assets = 44,135
securities and more liquid than inventory and notes receiv-
able. Accounts receivable to total current assets = 24,878 / 44,135
= 0.5637 = 56.37%
Sector Mid to large cap Accounts Receivable Small to mid cap Accounts Receivable Micro to small cap Accounts Receivable
to Total Current Assets to Total Current Assets to Total Current Assets
200
154
Equation
Comparing Inventory to
Total Current Assets
Ways to improve the indicator: You can increase liquidity
by shifting inventory account levels to more liquid
Inventory to total current assets = accounts such as cash, marketable securities, and accounts
inventory / total current assets
receivable. When you desire increased liquidity, seek to
This ratio describes the portion of current assets that reduce inventory requirements by improving production
inventory represents. Current assets include cash, mar- planning systems, product quality, supplier delivery sched-
ketable securities, accounts receivable, inventory, and all ules, and the general manner in which your company pro-
other assets that are likely to be held less than one year. duces goods or services.
Sector Mid to large cap Inventory to Small to mid cap Inventory to Micro to small cap Inventory to
Total Current Assets Total Current Assets Total Current Assets
201
155
Equation
Comparing Other Specific Current Asset
Accounts to Total Current Assets
Ways to improve the indicator: You can increase liquidity
by shifting current assets from less to more liquid accounts
Notes receivable to total current assets = such as cash, marketable securities, and accounts receivable.
notes receivable / total current assets
When you want increased liquidity, reduce less liquid
This ratio describes the portion of current assets that spe- accounts such as inventory and notes receivable. You can
cific assets such as notes receivable represent. Current assets reduce inventory requirements by improving production
include cash, marketable securities, accounts receivable, planning systems, quality, supplier delivery schedules, and
notes receivable, inventory, and all other assets that are like- the general manner in which your company produces goods
ly to be held less than one year. Notes receivable are funds or services. You can reduce notes receivable accounts by
due to the company in less than one year from persons or selling these accounts for cash or other highly liquid equiva-
companies other than customers. lents.
When to use indicator: Managers and creditors can use
Example
this indicator to determine the composition and degree of
liquidity of current assets. Notes receivable to total current assets =
LIQUIDITY
Meaning of result: A high ratio of a specific current asset notes receivable / total current assets
to total current assets indicates that a specific asset compris-
es a large part of the current asset account. You can deter- Notes receivable = 125
Total current assets = 44,135
mine the degree of current asset liquidity with these ratios
since some current assets are more liquid than others. Notes receivable to total current assets = 125 / 44,135 =
0.0028 = 0.28%
Sector Mid to large cap Notes Receivable to Small to mid cap Notes Receivable to Micro to small cap Notes Receivable to
Total Current Assets Total Current Assets Total Current Assets
202
156
Equation
Comparing Specific Expenses Such as
Interest and Taxes to Total Current Assets
Ways to improve the indicator: When ratios are excessive,
shifting assets to current accounts such as cash can lower
Interest expense to total current assets = the ratio of expense to current assets and increase compa-
interest expense / total current assets
ny liquidity.
This ratio indicates a company’s ability to meet individual
Example
expenses with current assets.
Interest expense to total current assets =
When to use indicator: Managers can use this indicator to interest expense / total current assets
determine the size of individual expenses relative to total
current assets. This information can be useful in ensuring Interest expense = 784
adequate liquid assets are available at times when specific Total current assets = 44,135
expense payments are due such as with tax and interest
Interest expense to total current assets = 784 / 44,135 =
payments. 0.0178 = 1.78%
Meaning of result: Higher ratios indicate individual
LIQUIDITY
Sector Mid to large cap Interest Expense to Small to mid cap Interest Expense to Micro to small cap Interest Expense to
Total Current Assets Total Current Assets Total Current Assets
203
CHAPTER TEN
Solvency
204
157
Equation
Determining How Many Times
Interest Expense is Earned
tial that the leverage gained with the financed debt may
allow enhanced future returns. Less mature companies, espe-
Times interest expense earned = cially start-ups, will tend to exhibit lower ratios. This is
operating income / interest expense
because these companies typically require larger amounts of
Times interest earned is a measure of how readily a com- debt because income generation has not yet reached opti-
pany can meet interest payments with income earned from mum levels and because growth generally requires cash
operations. investments for assets such as inventories and accounts
receivable.
When to use indicator: Managers, investors, and creditors
can use this indicator to determine the solvency and prof- Ways to improve the indicator: You can achieve higher ratios
itability of a company. by paying off debt and reducing interest expense and/or
increasing operations profitability.
Meaning of result: Higher ratios indicate healthy companies
that generate high income streams from operations and/or Example
companies that employ little or no debt. As the times interest Times interest expense earned =
SOLVENCY
earned ratios increase, there is typically less risk to creditors operating income / interest expense
that debt payment schedules will not be met.
Lower ratios indicate highly leveraged firms with signifi- Operating income = 9,433
cant interest expense and/or those firms that generate small Interest expense = 784
income streams from operations. While creditor risk increas-
Times interest expense earned = 9,433 / 784 = 12.03 =
es as times interest earned ratios decrease, there is the poten- 1203%
Sector Mid to large cap Times Interest Small to mid cap Times Interest Micro to small cap Times Interest
Expense Earned Expense Earned Expense Earned
205
158
Equation
Comparing Operations Cash
Flow Plus Interest to Interest
cash flows from operations. While creditor risk typically
increases as the ratio of operations cash flow plus interest to
Operations cash flow plus interest to interest = interest decreases, there is the potential that the leverage
(operations cash flow + interest expense) / interest expense
gained with the financed debt may allow enhanced future
The ratio of operations cash flow plus interest to interest returns. Less mature companies, especially start-ups, will
is a measure of how readily a company can meet interest tend to exhibit lower ratios because these companies typi-
payments with cash flow generated from operations. Opera- cally require larger amounts of debt. This is because income
tions cash flow and operating income can vary significantly generation has not yet reached optimum levels and growth
because a number of factors affect operations cash flow. generally requires cash investments for assets such as inven-
These factors include operations income, depreciation, and tories and accounts receivable.
changes in a number of other asset and liability levels such
Ways to improve the indicator: You can achieve higher ratios
as inventory, accounts receivable, and accounts payable.
by paying off debt, reducing interest expense levels, and/or
When to use indicator: Managers, investors, and creditors increasing operations cash flow.
can use this indicator to determine the solvency and prof-
SOLVENCY
Example
itability of a company.
Operations cash flow plus interest to interest =
Meaning of result: Higher ratios indicate healthy compa- (operations cash flow + interest expense) / interest expense
nies that generate high cash flows from operations and/or
companies that employ little or no debt. As the ratio of Operations cash flow = 4,820
operations cash flow plus interest to interest increases, Interest expense = 784
there is generally less risk to creditors that debt payment
Operations cash flow plus interest to interest = (4,820 + 784)
schedules will not be met. / 784 = 7.148 = 714.8%
Lower ratios indicate highly leveraged firms with signifi-
cant interest expense and/or those firms that generate small
Sector Mid to large cap Operations Cash Flow Small to mid cap Operations Cash Flow Micro to small cap Operations Cash Flow
Plus Interest to Interest Plus Interest to Interest Plus Interest to Interest
206
159
Equation
Finding How Many Times
Debt Expenses are Covered
mature companies, especially start-ups, will tend to exhibit
lower ratios because these companies typically require larg-
Times debt expenses covered = er amounts of debt. This is true because income generation
operating income / debt expenses
has not yet reached optimum levels and growth generally
Times debt expenses covered is a measure of how readily a requires cash investments for assets such as inventories and
company can meet interest and principal payments with accounts receivable.
income earned from operations.
Ways to improve the indicator: You can achieve higher
When to use indicator: Managers, investors, and creditors ratios by paying off debt and reducing interest and princi-
can use this indicator to determine the solvency and prof- pal expenses and/or increasing operations profitability.
itability of a company.
Example
Meaning of result: Higher ratios indicate healthy compa- Times debt expenses covered = operating income / debt expenses
nies that generate high income streams from operations
and/or companies that employ little or no debt. As the Operating income = 9,433
SOLVENCY
times debt expenses ratios increase, there is typically less Debt expenses = interest expense + tax adjusted principal repayment
risk to creditors that debt payment schedules will not be
met. Interest expense = 784
Lower ratios indicate highly leveraged firms with signifi- Tax adjusted principal repayment = principal / (1 - tax rate)
cant principal and interest expense and/or those firms that
generate small income streams from operations. While cred- Principal = current portion of long-term debt = 650
Tax rate = 40%
itor risk increases as times debt expenses covered ratios
decrease, there is the potential that the leverage gained with Times debt expenses covered = 9,433 / (784 + [650/(1 − 0.40)]) =
the financed debt may allow enhanced future returns. Less 5.052 = 505%
debt1,867
expenses = ( Interest
784expense + [ 650
650 / ( 1 - 0.40
0.40 )])
debt expenses = ( Interest expense + [ principal / ( 1 - tax rate )])
Sector Mid to large cap Times Debt Small to mid cap Times Debt Micro to small cap Times Debt
Expenses Covered Expenses Covered Expenses Covered
207
Comparing Operations Cash Flow Plus
160
Equation
Debt Expenses to Debt Expenses
potential that the leverage gained with the financed debt may
allow enhanced future returns. Less mature companies, espe-
Operations cash flow plus debt expenses to debt expenses = cially start-ups, will tend to exhibit lower ratios since these
(operations cash flow + debt expenses) / debt expenses companies typically require larger amounts of debt. This is
true because income generation has not yet reached opti-
Operations cash flow plus debt expenses to debt expenses
mum levels and growth generally requires cash investments
is a measure of how readily a company can meet principal
for assets such as inventories and accounts receivable.
and interest payments with cash flow generated from opera-
tions. Operations cash flow and operating income can vary Ways to improve the indicator: You can achieve higher ratios
significantly since a number of factors affect operations cash by paying off debt, reducing interest expense levels, and/or
flow. These factors include operations income, depreciation, increasing operations cash flow.
and changes in a number of other asset and liability levels
such as inventory, accounts receivable, and accounts Example
payable.
Operations cash flow plus debt expenses to debt expenses =
When to use indicator: Managers, investors, and creditors (operations cash flow + debt expenses) / debt expenses
SOLVENCY
208
161
Equation
Finding How Many Times
the Long-Term Debt is Covered
decrease, there is the potential that the leverage gained with
the financed debt may allow enhanced future returns. Less
Times long-term debt covered = mature companies, especially start-ups, will tend to exhibit
operating income / long-term debt
lower ratios because these companies typically require larg-
Times long-term debt covered is a measure of how readily er amounts of debt. This is true because income generation
a company can pay off long-term debt with income earned has not yet reached optimum levels and growth generally
from operations. requires cash investments for assets such as inventories and
accounts receivable.
When to use indicator: Managers, investors, and creditors can
use this indicator to determine the size of long-term debt rela- Ways to improve the indicator: You can achieve higher
tive to company earning power. ratios by paying off debt and/or increasing operations
profitability.
Meaning of result: Higher ratios indicate healthy compa-
nies that generate high income streams from operations Example
and/or companies that employ little or no debt. As the Times long-term debt covered =
SOLVENCY
times long-term debt ratio increases, there is typically less operating income / long-term debt
risk to creditors that debt payment schedules will not be
met. Operating income = 9,433
Lower ratios indicate highly leveraged firms with signifi- Long-term debt = 25,180 − 12,032 = 13,148
cant amounts of long-term debt and/or those firms that gen-
Times long-term debt covered = 9,433 / 13,148 = 0.7174 =
erate small income streams from operations. While creditor 71.74%
risk increases as times long-term debt covered ratios
Times long-term
71.74% debt covered = operating
9,433income / long-term
13,148debt
Times long-term debt covered = operating income / long-term debt
Sector Mid to large cap Times Long-Term Small to mid cap Times Long-Term Micro to small cap Times Long-Term
Debt Covered Debt Covered Debt Covered
209
162
Equation
Comparing Operations Cash
Flow to Long-Term Debt
erate small cash flows from operations. While creditor risk
typically increases as the ratio of operations cash flow to
Operations cash flow to long-term debt = long-term debt decreases, there is the potential that the
operations cash flow / long-term debt
leverage gained with the financed debt may allow enhanced
Operations cash flow to long-term debt is a measure of future returns. Less mature companies, especially start-ups,
how readily a company can pay off long-term debt with cash will tend to exhibit lower ratios since these companies typi-
flow generated from operations. Operations cash flow and cally require larger amounts of debt. This is true because
operating income can vary significantly since a number of income generation has not yet reached optimum levels and
factors affect operations cash flow. These factors include growth generally requires cash investments for assets such
operations income, depreciation, and changes in a number of as inventories and accounts receivable.
other asset and liability levels such as inventory, accounts
Ways to improve the indicator: You can achieve higher
receivable, and accounts payable.
ratios by paying off debt and/or increasing operations cash
When to use indicator: Managers, investors, and creditors flow.
can use this indicator to determine the size of long-term
SOLVENCY
Example
debt relative to company cash flow generating power.
Operations cash flow to long-term debt =
Meaning of result: Higher ratios indicate healthy compa- operations cash flow / long-term debt
nies that generate high cash flows from operations and/or
companies that employ little or no debt. As the ratio Operations cash flow = 4,820
increases, there is generally less risk to creditors that debt Long-term debt = 25,180 − 12,032 = 13,148
payment schedules will not be met.
Operations cash flow to long-term debt = 4,820 / 13,148 =
Lower ratios indicate highly leveraged firms with signifi- 0.367 = 36.7%
cant amounts of long-term debt and/or those firms that gen-
Operations cash36.7%
flow to long-term debt = operations cash flow / long-term
4,820 13,148debt
Operations cash flow to long-term debt = operations cash flow / long-term debt
Sector Mid to large cap Operations Cash Flow Small to mid cap Operations Cash Flow Micro to small cap Operations Cash Flow
to Long-Term Debt to Long-Term Debt to Long-Term Debt
210
163
Equation
Finding How Many Times
Fixed Costs are Covered
Ways to improve the indicator: You can achieve higher ratios
by lowering fixed costs and/or increasing operations prof-
Times fixed costs covered = operating income / fixed costs itability. You can lower fixed costs by shifting a portion of
fixed costs to variable costs by producing more labor- and
Times fixed costs covered is a measure of the relative sizes
of operating income and the amount of fixed costs material-dependent products or services. You can also
employed to run a business. The total cost to produce a achieve this with outsourcing, using contractors for design
product or service includes variable and fixed costs. Fixed work, manufacturing, sales and marketing, etc. Contractor
costs are those costs that remain relatively constant regard- use is typically more variable in nature than the use of in-
less of the quantity of goods or services produced while house, fixed-cost expertise.
variable costs are those costs that change with volume.
Examples of fixed costs are building rent, interest payments, Example
and salaries for nonmanufacturing employees such as engi-
Times fixed costs covered = operating income / fixed costs
neers and accountants. Variable costs include such items as
raw materials, direct labor, and the fuel used to operate Operating income = 9,433
machinery. Fixed cost = costs that are independent of the number of
goods or services produced
SOLVENCY
When to use indicator: Managers, investors, and creditors Total cost of goods sold = 54,212
can use this indicator to determine the size of fixed costs Raw material cost = 31,063
relative to company earning power. Direct labor = 7,860
Overhead cost = 15,164
Meaning of result: Higher ratios indicate healthy compa- Other direct costs = 125
nies that generate high income streams from operations R&D costs = 4,578
and/or companies that operate with smaller fixed costs. As SG&A costs = 15,993
the times fixed costs covered increases, there is typically Depreciation & amortization = 1,204
Interest = 784
less risk to creditors that debt payment schedules will not
be met. Fixed costs = overhead cost + other direct costs + R&D cost
Lower ratios indicate highly leveraged firms with significant + SG&A cost + depreciation & amortization + interest =
amounts of fixed costs given the size of operating income. 15,164 + 125 + 4,578 + 15,993 + 1,204 + 784 = 37,848
Creditor risk generally increases as times fixed cost covered Times fixed costs covered = 9,433 / 37,848 = 0.249 = 24.9%
ratios decrease since there is greater potential that income gen-
erated from operations may not be sufficient to cover fixed Times fixed costs covered = operating
24.9% 9,433income / fixed costs
37,848
costs. Times fixed costs covered = operating income / fixed costs
Sector Mid to large cap Times Fixed Small to mid cap Times Fixed Micro to small cap Times Fixed
Costs Covered Costs Covered Costs Covered
211
Comparing Operations Cash Flow Plus
164
Equation
Fixed Costs to Fixed Costs
Meaning of result: Higher ratios indicate healthy compa-
nies that generate high cash flows from operations and/or
Operations cash flow plus fixed costs to fixed costs = companies that employ smaller percentages of fixed costs.
(operations cash flow plus fixed costs) / fixed costs
As the ratio increases, there is generally less risk to credi-
Operations cash flow plus fixed costs to fixed costs is a tors that debt payment expenses will not be met.
measure of the relative size of operating cash flow and the Lower ratios indicate highly leveraged firms with signifi-
amount of fixed costs employed to run a business. Opera- cant amounts of fixed costs given the size of cash flow gen-
tions cash flow and operating income can vary significantly erated from operations. Creditor risk generally increases as
since a number of factors affect operations cash flow. These the ratio of operations cash flow plus fixed costs to fixed
factors include operations income, depreciation, and costs decreases since there is greater potential that the cash
changes in a number of other asset and liability levels such generated from operations may not be sufficient to cover
as inventory, accounts receivable, and accounts payable. fixed costs.
The total cost to produce a product or service consists of
Ways to improve the indicator: You can achieve higher ratios
variable and fixed costs. Fixed costs are those costs that
by lowering fixed costs and/or increasing operations cash
remain relatively constant regardless of the quantity of
SOLVENCY
Sector Mid to large cap Operations Cash Flow Small to mid cap Operations Cash Flow Micro to small cap Operations Cash Flow
Plus Fixed Costs Plus Fixed Costs Plus Fixed Costs
to Fixed Costs to Fixed Costs to Fixed Costs
212
Example
Fixed cost = overhead cost + other direct costs + R&D costs + SG&A costs + depreciation & amortization + interest =
15,164 + 125 + 4,578 + 15,993 + 1,204 + 784 = 37,848
SOLVENCY
Operations cash flow plus fixed costs to fixed costs = (4,820 + 37,848) / 37,848 = 1.127 = 112.7%
213
165
Equation
Determining How Many Times Operating
Expenses are Covered
Ways to improve the indicator: You can increase times
operating expenses covered by increasing operating
Times operating expenses covered = income and/or decreasing operating expenses. You can
operating income / operating expenses
decrease operating expenses by reducing the direct costs to
Times operating expenses covered is a measure of the rel- manufacture products or provide services and by reducing
ative size of operating income and the operating expenses other operational expenses such as rent, travel expense,
incurred in running a business. Operating expenses include and interest payments.
all items that are incurred to provide services or manufac-
Example
ture products such as employee salaries, benefits, product
raw materials, building rent, and utilities. Times operating expenses covered =
operating income / operating expenses
When to use indicator: Managers, investors, and creditors
can use this indicator to determine the size of operating Operations income = 9,433
expenses relative to company earning power.
Annual pre-tax operating expenses = cost of goods sold +
SOLVENCY
Meaning of result: Higher ratios can indicate the ready R&D + SG&A + interest + all other operating expenses =
54,212 + 4,578 + 15,993 + 784 = 75,567
ability to pay operating expenses with income generated
from operations. Lower ratios can indicate difficulty in Times operating expenses covered = 9,433 / 75,567 = 0.125
meeting operating expenses with operating income. In = 12.5%
such cases, it is often necessary to finance operating
expenses with debt and/or issuance of stock.
Sector Mid to large cap Times Operating Small to mid cap Times Operating Micro to small cap Times Operating
Expenses Covered Expenses Covered Expenses Covered
214
Comparing Operations Cash Flow Plus
166
Equation
Operating Expenses to Operating Expenses
such cases, it is often necessary to finance operating
expenses with debt and/or issuance of stock.
Operations cash flow plus operating expenses to operating
expenses = (operations cash flow + operating expenses) / Ways to improve the indicator: You can increase the ratio
operating expenses of operations cash flow plus operating expenses to operat-
ing expenses by increasing operations cash flow and/or
The ratio indicates the relationship between cash generat-
decreasing operating expenses. You can increase operating
ed from operations and yearly operational expenses. Opera-
cash flow by selling more high-profit-margin, highly
tions cash flow and operating income can vary significantly
demanded products or services. You can decrease operat-
since a number of factors can affect operations cash flow.
ing expenses by reducing the direct costs to manufacture
These factors include operations income, depreciation, and
products or provide services and by reducing other opera-
changes in a number of other asset and liability levels such
tional expenses such as rent, travel expense, and interest
as inventory, accounts receivable, and accounts payable.
payments.
Operating expenses include all items that are incurred to
provide services or manufacture products such as employee Example
salaries, benefits, product raw materials, building rent, and
SOLVENCY
215
167
Equation
Determining How Many Days of Operating
Expense Payables are Outstanding
artificially inflates net income.
Lower ratios indicate companies that quickly pay off
Days of operating expense payables = operating expenses expense-related debt. Suppliers often extend free credit for
outstanding / (annual pretax operating expenses/365)
30, 60, or more days. Very low ratios can indicate that the
This formula indicates how many days of average operat- company is foregoing this interest-free credit benefit.
ing expenses are as yet unpaid. Operating expenses include
Ways to improve the indicator: You can lower days of
all items that are incurred to provide services or manufac-
payables by paying accounts payable balances more
ture products such as employee salaries, benefits, product
quickly and/or limiting deferred expense accounts such as
raw materials, building rent, and utilities. Operating
salaries and benefits payable. You can increase days of
expenses outstanding include accounts payable and all other
payables by deferring payment of more operating expens-
deferred operating expenses such as unpaid salaries, bene-
es.
fits, and rent. A manager should consider this indicator as
pretax days of payables. By including taxes as an operating Example
expense, you can determine after-tax days of payables.
Days of operating expense payables = operating expenses
SOLVENCY
When to use indicator: Creditors and investors can use outstanding / (annual pretax operating expenses/365)
this indicator to determine the size of operating expense
debt that is outstanding. This ratio can help determine the Operating expenses outstanding = accounts payable + all
other deferred operating expenses = 5,633 + 2,747 (assume
financial health of a company.
here that all accrued liabilities are operating expenses and
Meaning of result: Higher ratios indicate larger portions of that there are no notes payable that were utilized for
operating expenses) = 8,380
outstanding expense-related debt. High and higher trending
ratios can signal the potential for financial difficulties. It may Annual pretax operating expenses = cost of goods sold +
become difficult to receive trade credit when many days of R&D + SG&A + interest + all other operating expenses =
payables are outstanding. High days of payables may be the 54,212 + 4,578 + 15,993 + 784 + 0 = 75,567
result of accounting efforts to increase income statement per-
formance. As a company defers more operating expenses, it Days of operating expense payables = 8,380 / (75,567/365)
= 40.5 days
Sector Mid to large cap Days of Operating Small to mid cap Days of Operating Micro to small cap Days of Operating
Expense Payables Expense Payables Expense Payables
216
168 Finding How Many Times
Asset Additions are Covered
Equation can vary significantly with time because large dollar
amount asset purchases can significantly reduce times
Times asset additions covered = operating income / changes asset additions covered. When there is a net reduction in
in assets
assets, times asset additions covered is not applicable.
Times asset additions covered is a measure of the extent
Ways to improve the indicator: Increasing operating
to which income generated by operations purchased asset
income can increase this ratio, given a fixed amount of
additions. Short-term asset additions include increases in
asset additions. Although asset additions can lower this
accounts such as inventory, cash, marketable securities, and
ratio, this can be a positive signal, assuming the addi-
accounts receivable. Long-term asset additions can include
tional assets help generate larger future income streams.
increases in accounts such as plant equipment, buildings,
and other long-term investments. Example
When to use indicator: Managers, investors, and creditors can Times asset additions covered = operating income /
SOLVENCY
use this indicator to determine the size of asset additions rela- changes in assets
tive to company earning power.
Operating income = 9,433
Meaning of result: Higher ratios indicate high income Changes in assets = 56,268 − 45,464 = 10,804
streams generated from operations and/or smaller increas-
Times asset additions covered = 9,433 / 10,804 = 0.873 =
es in asset additions. 87.3%
Lower ratios can indicate lower or negative operating
income streams and/or larger asset additions. This indicator
Sector Mid to large cap Times Asset Small to mid cap Times Asset Micro to small cap Times Asset
Additions Covered Additions Covered Additions Covered
217
169
Equation
Comparing Operations Cash
Flow to Changes in Assets
Meaning of result: Higher ratios indicate high cash flow
streams generated from operations and/or smaller increas-
Operations cash flow to changes in assets = operating cash es in asset additions.
flow / changes in assets
Lower ratios indicate lower operating cash flow streams
The ratio of operations cash flow to changes in assets is a and/or larger asset additions. This indicator can vary signifi-
measure of the percentage of asset additions that cash gen- cantly with time because large dollar amount asset purchas-
erated from operations can pay. Operations cash flow and es can significantly reduce operations cash flow to asset
operating income can vary significantly since a number of change ratios. When there is a net reduction in assets, oper-
factors affect operations cash flow. These factors include ations cash flow to changes in assets is not applicable.
operations income, depreciation, and changes in a number
Ways to improve the indicator: Increasing operating cash
of other asset and liability levels such as inventory, accounts
flow can increase this ratio, given a fixed amount of asset
receivable, and accounts payable. Asset changes include
additions. Although asset additions can lower this ratio,
both short- and long-term asset additions/reductions. Short-
this can be a positive signal, assuming the additional assets
term asset changes include changes in accounts such as
help generate larger future income streams.
inventory, cash, marketable securities, and accounts receiv-
SOLVENCY
Sector Mid to large cap Operations Cash Flow Small to mid cap Operations Cash Flow Micro to small cap Operations Cash Flow
to Changes in Assets to Changes in Assets to Changes in Assets
218
170
Equation
Comparing Retained
Earnings to Total Assets
Lower ratios indicate larger portions of company
assets are purchased with debt or from cash generated
Retained earnings to total assets = retained earnings / total from the issuance of stock. This is often true of start-up
assets
and less mature companies whose income-generating
This ratio helps managers determine the percentage of capabilities have not yet reached full stride. This can also
company assets that were purchased with retained earnings occur with mature companies that are experiencing diffi-
instead of with other sources of cash such as the issuance of culties in maintaining healthy profit margins.
stock or debt. Retained earnings describe what remains of
Ways to improve the indicator: You can improve this
net income after dividends are paid.
ratio by generating higher percentages of retained earn-
When to use indicator: Investors can use this indicator to ings. You can improve retained earnings generation by
determine a company’s financial performance. Profitable, well- providing highly demanded products or services with
run firms tend to generate healthy quantities of net income large profit margins. You can optimize profit margins
and plow back a portion of this income for the purchase of with excellent marketing, product/service design and
additional company assets. Reinvestment in the company can quality, cost control, and customer service.
SOLVENCY
Sector Mid to large cap Retained Earnings Small to mid cap Retained Earnings Micro to small cap Retained Earnings
to Total Assets to Total Assets to Total Assets
219
CHAPTER ELEVEN
Leverage
Leverage entails using debt in the hope of increasing company revenue and profit. You can
increase revenue and profit by using debt for the purchase of assets such as additional, or more
efficient, machinery and for non-asset-related items such as increased advertising or additional
sales force. The ratios described in this chapter detail a number of ways in which you can moni-
tor leverage levels and types. In addition to studying these ratios, review tip #115, the debt to
equity ratio.
220
171
Equation
Comparing Debt to the
Market Value of Equity
more likely to view higher ratios in a positive light because
the leverage gained with debt financing may lead to
Debt to market value of equity = total liabilities / market greater returns on equity investment.
value of equity
Ways to improve the indicator: Paying down debt levels
This ratio describes the relationship between a company’s
with operating income or owner’s equity can reduce the
debt and its equity. Since equity market values can be quite
debt-to-equity ratio. You can increase the debt-to-equity
different from book values, the values shown on the balance
ratio, and thus increase company leverage, with the acqui-
sheet, this ratio can give a more accurate portrayal of debt
sition of additional debt.
to equity. Total liabilities include all debt such as loans
payable to lenders, accounts payable to suppliers, and Example
income taxes payable to the government.
Debt to market value of equity = total liabilities / market
When to use indicator: Creditors, investors, and managers value of equity
can use this indicator to determine the risk level associated
with a company’s debt burden. Total liabilities = 25,180
Market value of equity = (3,600 common shares ×
LEVERAGE
Meaning of result: Creditors generally frown on higher $22.50/share) + (15 preferred shares × $25.00/share) =
81,375
ratios since this indicates the company may be stretched to
meet debt interest payments and because creditors like to Debt to market value of equity = 25,180 / 81,375 = 0.3094 =
see a substantial investment by the owners. Investors are 30.94%
Sector Mid to large cap Debt to Market Small to mid cap Debt to Market Micro to small cap Debt to Market
Value of Equity Value of Equity Value of Equity
221
172
Equation
Comparing Current Debt to
the Market Value of Equity
investment by the owners. Investors are more likely to
view higher ratios in a positive light since the leverage
Current debt to market value of equity = current liabilities / gained with debt financing may lead to greater returns on
market value of equity
equity investment.
This ratio describes the relationship between a company’s
Ways to improve the indicator: Paying down short-term
short-term debt and its equity. Since equity market values
debt with operating income or owner’s equity can reduce
can be quite different from the book value, the values
the current-debt-to-equity ratio. Usually assets should be
shown on the balance sheet, this ratio can give an accurate
financed over periods close to the anticipated lifetime of
portrayal of short-term debt to equity. Current liabilities
the asset. When a company finances long-lived assets with
include short-term debt such as accounts payable to suppli-
short-term debt, shifting the finance terms on such assets
ers, notes payable to lenders, deferred liabilities, and income
to long-term debt can decrease the current-debt-to-equity
taxes payable to the government.
ratio. You can increase the current-debt-to-equity ratio,
When to use indicator: Creditors, investors, and managers and thus increase company leverage, with the acquisition
can use this indicator to determine the risk level associated of additional short-term debt.
LEVERAGE
Sector Mid to large cap Current Debt Small to mid cap Current Debt Micro to small cap Current Debt
to Market Value to Market Value to Market Value
of Equity of Equity of Equity
222
173
Equation
Comparing Long-Term Debt
to the Market Value of Equity
ratios in a positive light since the leverage gained with
debt financing may lead to greater returns on equity
Long-term debt to market value of equity = long-term debt / investment.
market value of equity
Ways to improve the indicator: Paying down long-term
This ratio describes the relationship between a company’s
debt levels with operating income or owner’s equity can
long-term debt and its equity. Since equity market values can
reduce the long-term-debt-to-equity ratio. Usually assets
be quite different from the book value, the values shown on
should be financed over times close to the anticipated life-
the balance sheet, this ratio can give an accurate portrayal of
time of the asset. When a company finances short-lived
long-term debt to equity. Long-term liabilities are those debts
assets with long-term debt, shifting the finance terms on
that are payable in full in longer than one year.
such assets to short-term debt will decrease the long-term-
When to use indicator: Creditors, investors, and managers debt-to-equity ratio. You can increase the long-term-debt-
can use this indicator to determine the risk level associated to-equity ratio, and thus increase company leverage, with
with a company’s long-term debt burden. the acquisition of additional long-term debt.
LEVERAGE
Sector Mid to large cap Long-Term Debt Small to mid cap Long-Term Debt Micro to small cap Long-Term Debt
to Market Value to Market Value to Market Value
of Equity of Equity of Equity
223
174
Equation:
Determining the Funded-
Capital-to-Fixed-Asset Ratio
capital purchased larger portions of fixed assets. Higher
ratios can also result when funded capital is used to pur-
Funded capital to fixed assets = (long-term liabilities + chase asset types other than fixed assets, such as inventory
owner’s equity) / fixed assets
or intangible assets. Lower ratios can indicate that short-
The ratio of funded capital to fixed assets describes the term debt was used to purchase fixed assets.
percentage of fixed asset purchases that could have been
Ways to improve the indicator: Acquiring additional fixed
made with funded capital. Funded capital consists of long-
assets with capital from sources other than long-term debt or
term liabilities and owner’s equity. Long-term liabilities are
owner’s equity can reduce the funded-capital-to-fixed-asset
those debts that are payable in full in longer than one year.
ratio. Increasing owner’s equity by generating healthy prof-
Owner’s equity, also known as shareholders’ equity,
its, taking on additional long-term debt, or acquiring fewer
includes all equity balance sheet items, typically the most
amounts of fixed assets can increase the funded-capital-to-
significant of which are additional paid-in capital for stock
fixed-asset ratio.
purchases and retained earnings (generated income that a
company has reinvested in itself). Fixed assets (also referred Example
to on the balance sheet as property, plant, and equipment)
LEVERAGE
include items with lifetimes of greater than three years such Funded capital to fixed assets = (long-term liabilities +
as land, buildings, machinery, tooling, leasehold improve- owner’s equity) / fixed assets
ments, office equipment, and vehicles.
Long-term liabilities = total liabilities − current liabilities =
25,180 − 12,032 = 13,148
When to use indicator: Investors and creditors can use this
Owner’s equity = 31,088
ratio to determine the extent to which fixed assets could Fixed assets = 10,018
have been acquired with funded capital.
Funded capital to fixed assets = (13,148 + 31,088) / 10,018 =
Meaning of result: Higher ratios can indicate that funded 4.416 = 441.6%
441.6%
Funded capital to fixed assets = (long-term liabilities + owner’s
13,148 31,088 10,018
equity) / fixed assets
Funded capital to fixed assets = (long-term liabilities + owner’s equity) / fixed assets
Sector Mid to large cap Funded Capital Small to mid cap Funded Capital Micro to small cap Funded Capital
to Fixed Assets to Fixed Assets to Fixed Assets
224
175
Equation
Examining Financial
Leverage
more than cover the costs associated with the financing debt.
If the company instead elects to pay for the equipment with
Financial leverage = change in earnings per share (%) / cash or an additional issuance of common stock, financial
change in operating income (%)
leverage is decreased and positive equity owner returns
Financial leverage entails using debt in an effort to achieved with the equipment will not be magnified to the
increase financial returns to equity owners. As long as the extent realized with debt financing. By increasing financial
financial returns achieved with the debt are greater than the leverage, a company can generate higher equity owner returns
cost of the debt, the financial returns realized by equity as operating incomes rise, but at a greater risk level since poor
owners are increased. If the financial returns achieved with operating income performance can result in lower returns to
the debt do not cover the cost of the debt, financial returns equity owners.
to equity owners are decreased. Financial leverage thus can
Ways to improve the indicator: You can increase financial
increase equity owner returns when things go well, but at
leverage by increasing the level of debt financing relative to
the cost of additional risk if there is poor financial perfor-
equity financing. While increasing financial leverage will
mance when events do not go as planned.
allow greater equity owner profits when operating incomes
LEVERAGE
When to use indicator: Managers can use this indicator to rise, there is greater financial risk when operating incomes
determine the level of financial leverage employed, and fall.
more specifically, the effect of increases or decreases of
Example
operating income on the level of shareholder earnings per
share. This information allows the manager to determine Financial leverage = change in earnings per share (%) /
the magnitude of the benefits and level of risk associated change in operating income (%)
with financial leveraging.
Sales level A = 85,420
Meaning of result: Firms with higher levels of financial lever- Sales level B = 92,581
age will see dramatic increases/decreases in earnings per share Variable expenses at sales level A = 38,923
for a given increase/decrease in operating income. The larger Variable expenses at sales level B = 42,186
the level of debt levels relative to equity, the higher the degree Fixed expenses at sales level A = 37,848
of financial leverage. You can acquire debt in forms such as Fixed expenses at sales level B = 37,848
loans, bonds, and preferred stock. You can increase financial
Interest expense at sales level A = 784
leverage by swapping equity financing for debt financing. For Interest expense at sales level B = 784
example, assume a company has determined to invest in
robotic manufacturing equipment to increase manufacturing Operating income at sales level A = sales at level A − variable
expenses at sales level A − fixed expenses at sales level A +
productivity. The equipment could be purchased either with interest expense at sales level A = 85,420 − 38,923 − 37,848
debt, such as bank financing or the issuance of bonds, or with + 784 = 9,433
equity, such as the issuance of additional common stock or Same for operating income at sales level B = 92,581 − 42,186
cash earned from operations. If the company finances the − 37,848 + 784 = 13,331
acquisition and increases financial leverage, the return to equi- Net income applicable to common stock at sales level A =
ty holders may increase if returns achieved with the equipment 4,953
225
Net income applicable to common stock at sales level B = 8,067
Earnings per share at sales level B = net income applicable to common stock / common shares outstanding =
8,067 / 3,600 = 2.24
Change in operating income = (change in operating income from sales level B to A) / original operating income) × 100 =
[(13,331 − 9,433) / 9,433] × 100 = 41.32%
Change in earnings per share = (change in earnings per share from sales level B to A) / original earnings) × 100 =
[(2.24 − 1.38) / 1.38] ×× 100 = 62.32%
Financial leverage = change in earnings per share (%) / change in operating income (%)
Same for operating income at sales level B = 92,581 − 42,186 − 37,848 + 784 = 13,331
Net income applicable to common stock at sales level A = 4,953
1.51
Financial leverage = change in earnings
62.32 per share (%) / change in operating
41.32 income (%)
Financial leverage = change in earnings per share (%) / change in operating income (%)
226
176
Equation
Examining
Operating Leverage
The trade-off for the increase in efficiencies achieved by
acquiring additional fixed assets is that substantial invest-
Operating leverage = change in operating income (%) / ments must be made in fixed expenses such as the interest
change in sales (%)
payments and maintenance of the robotic equipment. If
Operating leverage entails using fixed expense, instead of the products produced with the robotic equipment fail to
variable, investments in an effort to increase operating generate profitable sales levels, the company may be stuck
income. Companies measure operating leverage by deter- with an expensive and useless fixed expense. By increasing
mining how operating income changes with changes in the operating leverage, a company will generate more operat-
level of sales. ing income as sales levels rise, but it will be at greater risk
as sales levels fall since larger amounts of fixed expenses
When to use indicator: Managers can use this indicator to must be covered.
determine the effect of sales increases or decreases on the Fixed costs remain relatively constant regardless of the
level of operating income. This information allows the quantity of goods or services produced while variable costs
manager to determine the magnitude of operating leverage are those costs that change with the quantity of items pro-
benefits accorded with sales increases and the risk associ- duced. Fixed costs include such items as building rent, fac-
LEVERAGE
ated with sales declines. tory equipment interest payments, and salaries for nondirect
manufacturing employees such as supervisors, engineers,
Meaning of result: Firms with high operating leverage will and accountants. Variable costs include such items as raw
see dramatic increases/decreases in operating income for a materials, direct labor, and the fuel used to operate machin-
given increase/decrease in sales. The larger the level of ery.
fixed expenses to variable expenses and sales levels, the
higher the operating leverage. A manager can increase Ways to improve the indicator: A company can increase
operating leverage by swapping variable expenses for operating leverage by increasing the level of fixed asset
fixed expenses. For example, investments in fixed assets expenditures relative to variable expenses and sales levels.
such as robotic manufacturing equipment will tend to While increasing operating leverage will allow greater
decrease the level of variable expenses because the robots operating profits when sales levels rise, there is greater
can manufacture goods more cheaply than direct laborers. financial risk when sales levels fall.
227
Example Operating income at sales level A = sales at level A − variable
expenses at sales level A − fixed expenses at sales level A +
Operating leverage = change in operating income (%) / interest expense at sales level A = 85,420 − 38,923 − 37,848
change in sales (%) + 784 = 9,433
Same for operating income at sales level B = 92,581 − 42,186
Sales level A = 85,420
− 37,848 + 784 = 13,331
Sales level B = 92,581
Change in sales (%) = [(sales level B − sales level A) / sales
Variable expenses at sales level A = 38,923
level A] × 100 = [(92,581 − 85,420) / 85,420] × 100 = 8.38%
Variable expenses at sales level B = 42,186
Change in operating income (%) = [(operating income at
Fixed expenses at sales level A = 37,848 sales level B − operating income at sales level A) / operating
Fixed expenses at sales level B = 37,848 income at sales level A] × 100 = [(13,331 − 9,433) / 9,433] ×
Interest expense at sales level A = 784 100 = 41.32%
Interest expense at sales level B = 784
Operating leverage = 41.32 / 8.38 = 4.93
Financial
4.93leverage = change in operating
41.32 income (%) / change in8.38sales (%)
Financial leverage = change in operating income (%) / change in sales (%)
LEVERAGE
177
Equation
Examining
Total Leverage
levels of total leverage indicate a company is employing
higher financial and/or operating leverage.
Total leverage = The larger the level of debt levels relative to equity, the
change in earnings per share (%) / change in sales (%) higher the degree of financial leverage. A company can
Total leverage acquire debt in forms such as loans, bonds, and preferred
stock. A company essentially increases financial leverage by
= Financial leverage × operating leverage swapping equity financing for debt financing. For example,
= (change in earnings per share [%] / change in operating assume a company has determined to invest in robotic man-
income [%]) × (change in operating income [%] / change ufacturing equipment to increase manufacturing productivi-
in sales [%]) ty. The company could purchase the equipment either with
debt, such as bank financing or the issuance of bonds, or
Total leverage is a measure of the combined effects of with equity, such as the issuance of additional common
financial and operating leverage. Financial leverage entails stock or cash earned from operations. By financing the
using debt in an effort to increase financial returns to equity acquisition and increasing financial leverage, the return to
owners. As long as the financial returns achieved with the equity holders may increase if returns achieved with the
debt are greater than the cost of the debt, the financial equipment more than cover the costs associated with the
LEVERAGE
returns realized by equity owners is increased. If the financial financing debt. If the company instead elects to pay for the
returns achieved with the debt do not cover the cost of the equipment with cash or an additional issuance of common
debt, financial returns to equity owners are decreased. Finan- stock, financial leverage is decreased, and positive equity
cial leverage thus can increase equity owner returns when owner returns achieved with the equipment will not be
things go well, but at the cost of the additional risk if there is magnified to the extent realized with debt financing. By
poor financial performance when events do not go as increasing financial leverage, a company can generate high-
planned. er equity owner returns as operating incomes rise, but at a
Operating leverage entails using fixed expense, instead of greater risk level since poor operating income performance
variable, investments in an effort to increase operating can result in lower returns to equity owners.
income. Managers measure operating leverage by determin- Firms with high operating leverage will see dramatic
ing how operating income changes with changes in the level increases/decreases in operating income for a given
of sales. increase/decrease in sales. The larger the level of fixed
When to use indicator: Managers can use this indicator to expenses to variable expenses and sales levels, the higher the
determine the level of financial and operating leverage operating leverage. A company increases operating leverage
employed, and more specifically, the effect of changes in by swapping variable expenses for fixed expenses. For
sales levels on the level of shareholder earnings per share. example, investments in fixed assets such as robotic manu-
This information allows the manager to determine the facturing equipment will tend to decrease the level of vari-
magnitude of the benefits and level of risk associated with able expenses because the robots can manufacture goods
financial and operating leveraging. more cheaply than direct laborers. The trade-off for the
increase in efficiencies achieved by acquiring additional
Meaning of result: Firms with higher levels of total lever- fixed assets is that substantial investments must be made in
age will see dramatic increases/decreases in earnings per fixed expenses such as the interest payments and mainte-
share for a given increase/decrease in sales levels. Higher nance required of the robotic equipment. If the products
229
produced with the robotic equipment fail to generate prof- Example
itable sales levels, the company may be stuck with an
expensive and useless fixed expense. By increasing operating Total leverage = change in earnings per share
(%) / change in sales (%)
leverage, a company will generate more operating income as
sales levels rise, but will be at greater risk as sales levels fall Total leverage = financial leverage × operating leverage
since it must cover larger amounts of fixed expenses.
Fixed costs remain relatively constant regardless of the Total leverage
quantity of goods or services produced while variable costs = Financial leverage × operating leverage
= (change in earnings per share [%] / change in operating
are those costs that change with the quantity of items pro- income [%]) × (change in operating income [%]) / change
duced. Fixed costs include such items as building rent, fac- in sales [%])
tory equipment interest payments, and salaries for nondirect Sales level A = 85,420
manufacturing employees such as supervisors, engineers, Sales level B = 92,581
and accountants. Variable costs include such items as raw
Variable expenses at sales level A = 38,923
materials, direct labor, and the fuel used to operate machin- Variable expenses at sales level B = 42,186
ery.
Fixed expenses at sales level A = 37,848
Ways to improve the indicator: A company can increase Fixed expenses at sales level B = 37,848
total leverage by increasing financial and/or operating Interest expense at sales level A = 784
leverage. Increases in total leverage will magnify earnings Interest expense at sales level B = 784
to shareholders when sales levels are high, but will Operating income at sales level A = sales at level A − variable
LEVERAGE
increase risk and reduce financial performance when sales expenses at sales level A − fixed expenses at sales level A +
are down. interest expense at sales level A = 85,420 − 38,923 − 37,848
You can increase financial leverage by increasing the level + 784 = 9,433
Same for operating income at sales level B = 92,581 − 42,186
of debt financing relative to equity financing. While increas- − 37,848 + 784 = 13,331
ing financial leverage will allow greater equity owner profits
Net income applicable to common stock at sales level A =
when operating incomes rise, there is greater financial risk
4,953
when operating incomes fall. You can increase operating Net income applicable to common stock at sales level B =
leverage by increasing the level of fixed asset expenditures 8,067
relative to variable expenses and sales levels. While increas- Common shares outstanding = 3,600
ing operating leverage will allow greater operating profits
when sales levels rise, there is greater financial risk when Earnings per share at sales level A = 1.38
Earnings per share at sales level B = 2.24
sales levels fall.
Change in sales (%) = [(sales level B − sales level A) / sales
level A] × 100 = [(92,581 − 85,420) / 85,420] × 100 = 8.38%
Change in earnings per share = [(earnings per share at sales
level B − earnings per share at sales level A) / earnings per
share at sales level A] × 100 = [(2.24 - 1.38) / 1.38] × 100 =
leverage = Financial
Total7.44 1.51leverage × operating
4.93
leverage 62.32%
Total leverage = Financial leverage × operating leverage Financial leverage = 1.51 (see details in tip #175)
Operating leverage = 4.93 (see details in tip #176)
Total leverage = 7.44
Total leverage = 62.32 / 8.38 = 7.44 (with first formula)
( change in earnings
62.32 per share [%] / change in sales [%] )
8.38
( change in earnings per share [%] / change in sales [%] ) Total leverage = 1.51 × 4.93 = 7.44 (with second formula)
230
C H A P T E R T W E LV E
Accounts
Receivable
231
178
Equation
Comparing Accounts
Receivable to Sales
communication with such customers may increase chances
of full payment. Higher trending ratios may also be the
Accounts receivable to sales = accounts receivable / net sales result of changes in credit policies and/or changes in the
customer base.
The formula is a measure of the relative sizes of accounts
receivable and the size of the company. Accounts receivable Ways to improve the indicator: You can reduce the ratio of
is money due to the company for products or services deliv- accounts receivable to sales by tightening credit policies
ered to a customer. and by more proactively seeking payment of outstanding
accounts. Note that tighter credit policies may have the
When to use indicator: Creditors, investors, and managers
undesirable effect of reducing sales since some customers
can use this indicator to track trends in the size of
are likely to seek other suppliers with more liberal credit.
accounts receivable.
ACCOUNTS RECEIVABLE
Example
Meaning of result: Higher ratios can indicate liberal credit
policies and lenient collection activities. Low ratios can Accounts receivable to sales = accounts receivable / net sales
indicate that management allows little or no credit and
practices timely and/or aggressive collections of accounts Accounts receivable = 24,878
receivable. Management should take particular note of Net sales = 85,420
higher trending accounts receivable. Such trends can signal
Accounts receivable to sales = 24,878 / 85,420 = 0.2912 =
customers experiencing financial difficulties and having 29.12%
problems meeting debt payments. Early identification and
Sector Mid to large cap Accounts Small to mid cap Accounts Micro to small cap Accounts
Receivable Receivable Receivable
to Sales to Sales to Sales
232
179
Equation
Determining the Turnover of
Accounts Receivable
can signal customers experiencing financial difficulties and
having problems meeting debt payments. Early identifica-
Accounts receivable turnover = net credit sales / accounts tion and communication with such customers may
receivable
increase chances of full payment. Lower trending ratios
Accounts receivable turnover describes the relative size of may also be the result of changes in credit policies and/or
net credit sales and accounts receivable, and more specifical- changes in the customer base.
ly, how many times a company achieves, or turns over, the
Ways to improve the indicator: You can increase accounts
value of accounts receivable in net credit sales. Net credit
receivable turnover by tightening credit policies and by more
sales are often essentially the same as net sales; this relation-
proactively seeking payment of outstanding accounts. Note
ship is increasingly accurate as the percentage of credit sales
that tighter credit policies may have the undesirable effect of
to total sales increases. Accounts receivable is money due to
reducing sales since some customers are likely to seek other
ACCOUNTS RECEIVABLE
Meaning of result: Lower ratios can indicate liberal credit Net credit sales ∼ net sales = 85,420
policies and lenient collection activities. High ratios can Accounts receivable = 24,878
indicate that management allows little or no credit and
Accounts receivable turnover = 85,420 / 24,878 = 3.4336 =
practices timely and/or aggressive collections of accounts 343.4%
receivable. Management should take particular note of
lower trending accounts receivable turnover. Such trends
Sector Mid to large cap Accounts Small to mid cap Accounts Micro to small cap Accounts
Receivable Receivable Receivable
Turnover Turnover Turnover
233
180
Equation
Determining How Many Days of Credit
Sales are in Accounts Receivable
difficulties and having problems meeting debt payments.
Early identification and communication with such cus-
Days of credit sales in accounts receivable = accounts tomers may increase chances of full payment. Higher
receivable / average credit sales per day
trending ratios may also be the result of changes in credit
Days of credit in accounts receivable describes the size of policies and/or changes in the customer base.
accounts receivable in terms of how many days’ worth of
Ways to improve the indicator: You can reduce days of cred-
credit sales are outstanding. Average credit sales per day are
it sales in accounts receivable by tightening credit policies
often essentially the same as average net sales per day; this
and by more proactively seeking payment of outstanding
relationship is increasingly accurate as the percentage of
accounts. Note that tighter credit policies may have the
credit sales to total sales increases. Accounts receivable is
undesirable effect of reducing sales since some customers are
money due to the company from customers for products or
likely to seek other suppliers with more liberal credit.
ACCOUNTS RECEIVABLE
Meaning of result: Higher ratios can indicate liberal credit Accounts receivable = 24,878
policies and lenient collection activities. Low ratios can Net sales = 85,420
indicate that management allows little or no credit and Average credit sales per day ∼ average net sales per day = net
sales / 365 = 85,420 / 365 = 234.0
practices timely and/or aggressive collections of accounts
receivable. Management should take particular note of Days of credit sales in accounts receivable = 24,878 / 234 =
higher trending days of credit sales in accounts receivable. 106.3
Such trends can signal customers experiencing financial
Sector Mid to large cap Days of Credit Small to mid cap Days of Credit Micro to small cap Days of Credit
Sales in Accounts Sales in Accounts Sales in Accounts
Receivable Receivable Receivable
234
181
Equation
Examining the Ages of
AccountsReceivable(Aging Schedule)
Meaning of result: Higher percentages of accounts receiv-
able in longer age categories can indicate liberal credit
Age Percentage of accounts receivable
policies and lenient collection activities. Higher percent-
Current 45% ages in shorter age categories can indicate that manage-
1–30 past due 38% ment allows little or no credit and practices timely and/or
31–60 past due 8%
61–90 past due 5% aggressive collections of accounts receivable. Management
over 90 past due 4% should take particular note of higher trending percentages
in longer age categories. Such trends can signal customers
The chart is a visual tool used to describe and communi- experiencing financial difficulties and having problems
cate quickly the status of accounts receivable. You may use meeting debt payments. Early identification and communi-
varying categories for ages. For example, those companies cation with such customers may increase chances of full
with more lenient credit policies may want to track longer payment. Higher trending percentages in longer age cate-
ACCOUNTS RECEIVABLE
term accounts receivable ages such as 91–120 days and gories may also be the result of changes in credit policies
121–180 days. You can use the aging schedule for all and/or changes in the customer base.
accounts (as shown above) as well as for individual cus-
tomers. Accounts receivable is money due to the company Ways to improve the indicator: You can lower percentages of
from customers for products or services delivered to those longer aged accounts receivable by tightening credit policies
customers. and by more proactively seeking payment of outstanding
accounts. Note that tighter credit policies may have the unde-
When to use indicator: Managers can use this tool to track sirable effect of reducing sales since some customers are likely
accounts receivable trends and the effects of changes in to seek other suppliers with more liberal credit.
accounts receivable collection and credit policies. When
used to track individual customers, this tool can alert
management to overdue customers.
235
Determining What Percentage of Current-Period
182
Equation
Sales Will Be Collected in the Current Period
lower trending current-period collection ratios. Such
trends can signal customers experiencing financial difficul-
Percentage of current-period sales collected in current period ties and having problems meeting debt payments. Early
= collected current-period accounts receivable / net sales identification and communication with such customers
current period may increase chances of full payment. Lower trending
This formula indicates the portion of current-period sales ratios may also be the result of changes in credit policies
a company collects from accounts receivable in the same and/or changes in the customer base.
period. Accounts receivable is money due to the company Ways to improve the indicator: You can increase current-
from customers for products or services delivered to those period collection ratios by tightening credit policies and by
customers. more proactively seeking payment of outstanding
accounts. Note that tighter credit policies may have the
ACCOUNTS RECEIVABLE
236
Determining What Percentage of Current-Period
183
Equation
Sales Will Not Be Collected in the Current Period
higher trending current-period collection ratios. Such
trends can signal customers experiencing financial difficul-
Percentage of current-period sales not collected in current ties and having problems meeting debt payments. Early
period = (net sales current period − collected current-period
identification and communication with such customers
accounts receivable) / net sales current period
may increase chances of full payment. Higher trending
This ratio indicates the portion of current-period sales ratios may also be the result of changes in credit policies
that are not collected from accounts receivable in the same and/or changes in the customer base.
period. Accounts receivable is money due to the company
Ways to improve the indicator: You can increase current-
from customers for products or services delivered to those
period collection ratios by tightening credit policies and by
customers.
more proactively seeking payment of outstanding
When to use indicator: Managers can use this ratio to accounts. Note that tighter credit policies may have the
ACCOUNTS RECEIVABLE
determine the average historical change in the size of undesirable effect of reducing sales because some cus-
accounts receivable as a function of sales levels. When tomers are likely to seek other suppliers with more liberal
sales levels are rising, you can use this information to credit.
ensure appropriate cash is available for increases in
Example
accounts receivable according to forecasted sales levels.
This ratio can also indicate trends in accounts receivable Percentage of current-period sales not collected in current
aging. period = (net sales current period − collected current-period
accounts receivable) / net sales current period
Meaning of result: Higher ratios can indicate rising sales
levels, liberal credit policies, and lenient collection activi- Collected current-period accounts receivable = 7,600
ties. Lower ratios can indicate that management allows lit- Net sales current period = 8,100
tle or no credit and practices timely and/or aggressive col-
Percentage of current-period sales not collected in current
lections of accounts receivable. It can also signal falling period = (8,100 − 7,600) / 8,100 = 0.0617 = 6.17%
sales levels. Management should take particular note of
237
184
Equation
Examining Bad Debt and
Accounts Receivable
Ways to improve the indicator: You can reduce bad debt
ratios by tightening credit policies and by more proactive-
Bad debts to accounts receivable = ly seeking payment of outstanding accounts. Note that
bad debt / accounts receivable
tighter credit policies may have the undesirable effect of
The ratio of bad debts to accounts receivable is a measure reducing sales because some customers are likely to seek
of the risk level associated with credit extended to cus- other suppliers with more liberal credit.
tomers. Accounts receivable is money due to the company
Example
from customers for products or services delivered to those
customers. Bad debts to accounts receivable =
bad debt / accounts receivable
When to use indicator: Managers and creditors can use
this indicator to determine the risk level, or dependability, Bad debt = 1,450
ACCOUNTS RECEIVABLE
Meaning of result: Higher ratios indicate larger portions Bad debt to accounts receivable = 1,450 / 24,878 = 0.0583 =
5.83%
of accounts receivable are not collectable. High and higher
trending ratios can alert management to investigate credit
and collection policies.
238
185
Equation
Relating Bad Debts to Sales
Ways to improve the indicator: You can reduce bad debt
ratios by tightening credit policies and by more proactive-
Bad debts to sales = bad debts / net sales ly seeking payment of outstanding accounts. Note that
tighter credit policies may have the undesirable effect of
The ratio of bad debts to net sales is a measure of the risk
reducing sales because some customers are likely to seek
level associated with extending credit to customers.
other suppliers with more liberal credit.
When to use indicator: Managers and creditors can use
Example
this indicator to determine the risk level, or dependability,
of account receivable assets. Bad debts to sales = bad debts / net sales
Meaning of result: Higher ratios indicate larger portions Bad debts = 1,450
of accounts receivable are not collectable. High and higher Net sales = 85,420
ACCOUNTS RECEIVABLE
1.70%
Bad debts to sales = bad
1,450 85,420
debts / net sales
Bad debts to sales = bad debts / net sales
239
186
Equation
Determining if Credit Discounts
Should be Accepted and Offered
Meaning of result: You may want to consider accepting
credit discount policies from suppliers when such a move
Credit discount annualized interest rate = [discount % / will increase profits. In general, you will want to accept
(100% − discount %)] × [360 / (normal credit term −
trade credit offerings when the discount rate is greater
discount credit term)]
than what must be paid on bank loans. By paying the
This formula can help you determine whether it is cost- trade account early, you may use bank loans to finance the
effective to accept credit discounts from suppliers and particular purchase. Conversely, you should decline trade
extend credit discounts to customers. It is common to credits when the discount rate is lower than available
induce customers to pay bills promptly by offering a bank loans.
monetary incentive to do so. An example is 2/10, net 60 You can offer trade credit when you need to improve cash
credit, which means customers can take a 2% discount if flow and when it is financially profitable. At times compa-
nies will offer attractive trade credit rates to solidify cash
ACCOUNTS RECEIVABLE
240
Example Savings from offering plan = cost of company credit × change
in accounts receivable balance because of offered discount
Should trade credit be taken terms = (0.09) × (24,878 − 13,609) = 1,014
Credit discount annualized interest rate = [discount % /
(100% − discount %)] × [360 / (normal credit term −
Net cost/savings to offer plan = 1,014 − 854 = 160
discount credit term)]
241
187
Equation:
Examining Accounts
Receivable Factoring
borrower credit ratings but can also arise because of issues
such as small account sizes, noncompetitive rates offered
Accounts receivable factoring annualized interest rate = by the factoring company, and a factoring company’s
(factor % / [100% − factor %]) × (360 / [normal credit term
unfamiliarity with the companies and industries involved.
− factor payment term])
Ways to improve the indicator: Seeking competitive bids
Factoring is the process of selling accounts receivable to a
with a number of factoring companies and then establish-
third party, known as a factoring company, to receive cash
ing a history with the selected company should help keep
quickly for those accounts receivable. Companies often fac-
factoring rates competitive. Maintaining a customer base
tor to increase cash flow and, in essence, to use an indepen-
with excellent payment trends should also help to reduce
dent company as a collections department. The factoring
interest rates since the factoring company’s uncollectable
company makes money since it purchases the accounts
account losses due to nonpayment should decrease.
receivable at a discount to the actual money owed and then
ACCOUNTS RECEIVABLE
collects the full amount of the money owed from the bor- Example
rower. The discount rate is dependent on a number of issues
such as the credit rating of the borrower, the size and age of Accounts receivable factoring annualized interest rate =
the account receivable, and the track record the factor has (factor % / [100% − factor %]) × (360 / [normal credit term
had with the selling company and the borrower. − factor payment term])
242
CHAPTER THIRTEEN
Accounts
Payable
243
188
Equation
Comparing Accounts
Payable to Sales
Low ratios indicate management has not used supplier
credit to a significant degree, either by choice or because
Accounts payable to sales = accounts payable / net sales suppliers have elected to withhold credit.
This ratio of accounts payable to sales is a measure of the Ways to improve the indicator: A company can increase
relative sizes of accounts payable and the size of the compa- the ratio of accounts payable to sales by seeking addition-
ny. Accounts payable is the money owed by the company al trade credit and extending payment timing to the maxi-
for goods and services provided on credit by suppliers. mum limit offered by suppliers. A company can reduce the
ratio of accounts payable to sales by paying invoices soon-
When to use indicator: Creditors, investors, and managers
er and by foregoing the offering of credit altogether and
can use this indicator to track trends in the size of
paying suppliers in cash.
accounts payable.
Example
Meaning of result: Higher ratios indicate the company is
ACCOUNTS PAYABLE
taking advantage of credit extended by suppliers. Since Accounts payable to sales = accounts payable / net sales
this credit is often interest free, many companies seek to
keep accounts payable at high levels to maximize profit. Accounts payable = 5,633
When ratios become too high, however, it can indicate Net sales = 85,420
companies that are experiencing difficulty in paying bills
Accounts payable to sales = 5,633 / 85,420 = 0.0659 =
when due, which may result in adverse credit ratings and 6.59%
bankruptcy.
Sector Mid to large cap Accounts Small to mid cap Accounts Micro to small cap Accounts
Payable Payable Payable
to Sales to Sales to Sales
244
189
Equation
Finding the Turnover
of Accounts Payable
when due, which may result in adverse credit ratings and
bankruptcy.
Accounts payable turnover = total purchases / accounts Higher ratios indicate that management has not used sup-
payable
plier credit to a significant degree, either by choice or
Accounts payable turnover describes the relative size of because suppliers have elected to withhold credit.
total company purchases and accounts payable, and more
Ways to improve the indicator: You can reduce accounts
specifically, how many times a company achieves, or turns
payable turnover by seeking additional trade credit and
over, the value of accounts payable in total purchases.
extending payment timing to the maximum limit offered
Accounts payable is the money owed by the company for
by suppliers. You can increase accounts payable turnover
goods and services provided on credit by suppliers.
by paying invoices sooner and by foregoing the offering of
When to use indicator: Creditors, investors, and managers credit altogether and paying suppliers in cash.
can use this indicator to track trends in the size of
ACCOUNTS PAYABLE
Example
accounts payable.
Accounts payable turnover = total purchases / accounts
Meaning of result: Lower ratios indicate the company is payable
taking advantage of credit extended by suppliers. Since
this credit is often interest free, many companies seek to Total purchases = 37,200
reduce accounts payable turnover to maximize profit. Accounts payable = 5,633
When ratios become too low, however, it can indicate
Accounts payable turnover = 37,200 / 5,633 = 6.60
companies that are experiencing difficulty in paying bills
245
190
Equation
Calculating the Number of Days of
Purchases in Accounts Payable
ings and difficulty in obtaining future credit lines.
Lower ratios indicate that management has not used sup-
Days of purchases in accounts payable = accounts payable / plier credit to a significant degree, either by choice or
average purchases per day
because suppliers have elected to withhold credit.
Days of purchases in accounts payable describes the size
Ways to improve the indicator: You can increase days of
of accounts payable in terms of how many days’ worth of
purchases in accounts payable by seeking additional trade
purchases are outstanding. Accounts payable is the money
credit and extending payment timing to the maximum limit
owed by the company for goods and services provided on
offered by suppliers. You can reduce days of purchases in
credit by suppliers.
accounts payable by paying invoices sooner and by forego-
When to use indicator: Creditors, investors, and managers ing the offering of credit altogether and paying suppliers in
can use this indicator to track trends in the size of cash.
ACCOUNTS PAYABLE
accounts payable.
Example
Meaning of result: Higher ratios indicate the company is Days of purchases in accounts payable = accounts payable /
taking advantage of credit extended by suppliers. Since average purchases per day
this credit is often interest free, many companies seek to
increase days of purchases in accounts payable to maxi- Accounts payable = 5,633
mize profit. When ratios become too high, however, it can Average purchases per day = 37,200 / 365 = 101.9
indicate companies that are experiencing difficulty in pay-
Days of purchases in accounts payable = 5,633 / 101.9 =
ing bills when due, which may result in adverse credit rat- 55.3 days
246
191
Equation
Comparing Accounts
Payable to Purchases
ings and bankruptcy.
Lower ratios indicate that management has not used sup-
Accounts payable to purchases = accounts payable / total plier credit to a significant degree, either by choice or
purchases
because suppliers have elected to withhold credit.
The ratio of accounts payable to purchases describes the
Ways to improve the indicator: You can increase the ratio of
size of accounts payable as the percentage of yearly pur-
accounts payable to purchases by seeking additional trade
chases that are outstanding. Accounts payable is the money
credit and extending payment timing to the maximum limit
owed by the company for goods and services provided by
offered by suppliers. You can reduce accounts payable to
suppliers.
purchases by paying invoices sooner and by foregoing the
When to use indicator: Creditors, investors, and managers offering of credit altogether and paying suppliers in cash.
can use this indicator to track trends in the size of
Example
ACCOUNTS PAYABLE
accounts payable.
Accounts payable to purchases = accounts payable / total
Meaning of result: Higher ratios indicate the company is purchases
taking advantage of credit extended by suppliers. Since
this credit is often interest free, many companies seek to Accounts payable = 5,633
increase days of purchases in accounts payable to maxi- Total purchases = 37,200
mize profit. When ratios become too high, however, it can
Accounts payable to purchases = 5,633 / 37,200 = 0.151 =
indicate companies that are experiencing difficulty in pay- 15.1%
ing bills when due, which may result in adverse credit rat-
247
192
Equation
Finding How Many Days of
Purchases Have Been Paid
Ways to improve the indicator: You can reduce the days-
of-purchases-paid ratio by delaying payment of payables
Days of purchases paid = accounts payable cash until the last minute and by increasing the amount of pur-
disbursements / average purchases per day
chases. You can increase this ratio by the opposite action,
This ratio describes how the size of accounts payable has paying invoices promptly and reducing purchases.
changed with recent payment and purchase trends.
Example
When to use indicator: Managers and creditors can use Days of purchases paid = accounts payable cash
this indicator to determine accounts payable payment and disbursements / average purchases per day
purchase trends.
Accounts payable cash disbursements = 34,488
Meaning of result: When the days of purchases paid are less Average purchases per day = 37,200 / 365 = 101.9
than the days in the time period (i.e., 26 days in a 30-day
ACCOUNTS PAYABLE
time period, 338 days in a 365-day time period), it indicates Days of purchases paid = 34,488 / 101.9 = 338.4
the company is using accounts payable trade credit to a high-
er degree. Since trade credit is generally interest free, this
action tends to increase overall company profitability. How-
ever, when payables become delinquent because they are
much too low relative to purchases, credit ratings and further
credit offerings may suffer.
Days of purchases
338.4 paid = accounts payable cash disbursements / average purchases
34,488 102 per day
Days of purchases paid = accounts payable cash disbursements / average purchases per day
248
193
Equation
Comparing Accounts Payable Cash
Disbursements to Accounts Payable
When companies experience high levels of sales growth,
purchase levels and accounts payable balances generally
Accounts payable cash disbursement turnover = accounts increase. Since cash disbursements lag behind actual pur-
payable cash disbursements / accounts payable
chases and since, in this scenario, purchases are on the rise,
Accounts payable cash disbursement turnover describes cash disbursements tend to be lower than current purchases
the relative size of accounts payable payments and accounts and the disbursement turnover ratio falls.
payable, and more specifically, how many times a company Higher ratios indicate management has not used supplier
achieves, or turns over, the value of accounts payable in credit to a significant degree, either by choice or because
total payments. Accounts payable is the money owed by the suppliers have elected to withhold generous credit terms.
company for goods and services provided on credit by sup- Higher ratios can also indicate downturns in sales levels,
pliers. meaning current purchase levels are lower than historical
trends.
ACCOUNTS PAYABLE
6.12
Accounts payable cash 34,488
disbursement turnover = accounts payable 5,633
cash disbursements / accounts payable
Accounts payable cash disbursement turnover = accounts payable cash disbursements / accounts payable
249
194
Equation
Comparing Individual Accounts Payable
Disbursements to Total Cash Disbursements
Ways to improve the indicator: Higher percentage pay-
ment ratios may be the result of normal operations and/or
Individual accounts payable cash disbursements to total cash changes in the type of product or service offered. Howev-
disbursements = individual accounts payable cash
er, high ratios can also be the result of price gouging. In
disbursements / accounts payable cash disbursements
this case, it is often beneficial to request supplier rebids,
Individual accounts payable cash disbursement ratios noting the excessive costs. Competitive bids from other
indicate expense trends companies incur. Accounts payable suppliers may help to bring higher trending payments in
is the money owed by the company for goods and services line with industry standards.
provided on credit by suppliers.
Example
When to use indicator: Managers can use this indicator to
Individual accounts payable cash disbursements to total cash
determine areas to investigate further. For example, the disbursements = individual accounts payable cash
ratios can highlight accounts with excessively increasing
ACCOUNTS PAYABLE
13.21%
Individual accounts payable cash disbursements to total cash disbursements
Individual accounts payable cash disbursements to total cash disbursements
= individual accounts payable
4,555 cash disbursements
= individual accounts payable cash disbursements
/ accounts payable cash disbursements
34,488
/ accounts payable cash disbursements
250
CHAPTER FOURTEEN
Inventory
251
195
Equation
Relating Inventory
and Sales Levels
accustomed to, and excessive manufacturing costs may
result if short production runs of out-of-stock inventory
Inventory to sales = inventory / net sales become necessary.
This ratio compares the size of inventory levels to the size Ways to improve the indicator: Lower inventory levels gener-
of the company. Inventory includes finished goods, work in ally increase company profitability since a company can use
process, and the raw materials used to manufacture finished the cash normally tied up in inventory for higher return
goods. investments. Lower inventory levels are easier to accommo-
date by improving a number of factors. These include pro-
When to use indicator: Managers, creditors, and investors
duction planning, scheduling, capacity planning, product
can use this indicator to check that inventory levels are
quality, equipment quality, relations with raw materials sup-
appropriate given sales levels and historic inventory levels.
pliers, and inventory planning. Simply reducing inventory lev-
Inventory levels will tend to vary depending upon the
els without improvement in these critical areas can lead to
industry in which the company competes.
disastrous results.
Meaning of result: Higher ratios can indicate inventory
INVENTORY
Example
levels are getting out of control. Since there is a significant
cost associated with the stocking of inventory, manage- Inventory to sales = inventory / net sales
ment should proactively seek methods to keep inventory
levels to a minimum. However, problems can arise when Inventory = 13,421
inventory levels are too low. Customers may not receive Net sales = 85,420
the desired and prompt delivery of products they are Inventory to sales = 13,421 / 85,420 = 0.1571 = 15.71%
Sector Mid to large cap Inventory Small to mid cap Inventory Micro to small cap Inventory
to Sales to Sales to Sales
252
196
Equation
Determining the Turnover
of the Entire Inventory
the desired and prompt delivery of products that they are
accustomed to and excessive manufacturing costs may
Inventory turnover = cost of goods sold / average inventory arise if short production runs of out-of-stock inventory
Inventory turnover describes the relative size of the cost of become necessary.
goods sold and inventory, and more specifically, how many Ways to improve the indicator: Higher inventory turnover
times a company achieves, or turns over, the value of inven- ratios generally increase company profitability since a
tory in the cost to produce goods that have been sold. company can use the cash normally tied up in inventory
Inventory includes finished goods, work in process, and the for higher return investments. Higher inventory turnover
raw materials used to manufacture finished goods. Cost of is easier to accommodate by improving a number of fac-
goods sold includes the costs required to produce the prod- tors. These include production planning, scheduling,
uct or service (i.e., raw materials, direct labor, and direct capacity planning, product quality, equipment quality,
overhead). relations with raw materials suppliers, and inventory plan-
When to use indicator: Managers, creditors, and investors ning. Simply increasing inventory turnover without
improvement in these critical areas can lead to disastrous
INVENTORY
Inventory
404%turnover = cost of goods sold / average
54,212 inventory
13,421
Inventory turnover = cost of goods sold / average inventory
Sector Mid to large cap Inventory Small to mid cap Inventory Micro to small cap Inventory
Turnover Turnover Turnover
253
197
Equation
Determining How Many Days
of Inventory Are On Hand
too low. Customers may not receive the desired and
prompt delivery of products that they are accustomed to
Days of inventory = average inventory / cost of goods sold and excessive manufacturing costs may result if short pro-
used per day duction runs of out-of-stock inventory become necessary.
Days of inventory describes the size of inventory in terms Ways to improve the indicator: Fewer days of inventory
of how many days of inventory use are available. Inventory on hand generally increase company profitability since a
includes finished goods, work in process, and the raw mate- company can use the cash normally tied up in inventory
rials used to manufacture finished goods. Cost of goods for higher return investments. Fewer days of inventory lev-
sold includes the costs required to produce the sold product els are easier to accommodate by improving a number of
or service (i.e., raw materials, direct labor, and direct over- factors. These include production planning, scheduling,
head). capacity planning, product quality, equipment quality,
When to use indicator: Managers, creditors, and investors relations with raw materials suppliers, and inventory plan-
can use this indicator to check that inventory levels are ning. Simply lowering days of inventory without improve-
ment in these critical areas can lead to disastrous results.
INVENTORY
inventory = average
Days of90.4 inventory / cost of goods148.5
13,421 sold used per day
Days of inventory = average inventory / cost of goods sold used per day
Sector Mid to large cap Days of Small to mid cap Days of Micro to small cap Days of
Inventory Inventory Inventory
254
198
Equation
Calculating the Turnover of
Finished Product Inventory
to keep such inventory levels to a minimum. However, prob-
lems can arise when finished product inventory levels are too
Finished product inventory turnover = cost of goods sold / low. Customers may not receive the desired and prompt
average finished product inventory
delivery of products that they are accustomed to and exces-
Finished product inventory turnover describes the relative sive manufacturing costs may result if short production runs
size of the cost of goods sold and finished product invento- of out-of-stock finished product inventory become necessary.
ry, and more specifically, how many times a company
Ways to improve the indicator: Higher finished product
achieves, or turns over, the value of finished product inven-
inventory turnover ratios generally increase company
tory in the cost to produce goods that have been sold.
profitability since the company can use the cash normally
Inventory includes finished goods, work in process, and the
tied up in inventory for higher return investments. Higher
raw materials used to manufacture finished goods. Finished
finished product inventory turnover is easier to accommo-
goods are fully manufactured products that are in stock and
date by improving a number of factors. These include pro-
ready for delivery. Cost of goods sold includes the costs
duction planning, scheduling, capacity planning, product
required to produce the product or service (i.e., raw materi-
quality, equipment quality, relations with raw materials
INVENTORY
255
199
Equation
Finding How Many Days of Finished
Product Inventory Are Available
tomers may not receive the desired and prompt delivery of
products that they are accustomed to and excessive manu-
Days of finished product inventory = finished product facturing costs may result if short production runs of out-
inventory / cost of goods sold used per day
of-stock inventory become necessary.
Days of finished product inventory describes the size of
Ways to improve the indicator: Fewer days of finished
that inventory in terms of how many days of finished prod-
product inventory on hand generally increase company
ucts are available in inventory. Inventory includes finished
profitability since the company can use the cash normally
goods, work in process, and the raw materials used to man-
tied up in inventory for higher return investments. Fewer
ufacture finished goods. Finished goods are fully manufac-
days of finished product inventory levels are easier to
tured products that are in stock and ready for delivery. Cost
accommodate by improving a number of factors. These
of goods sold includes the costs required to produce the
include production planning, scheduling, capacity plan-
product or service (i.e., raw materials, direct labor, and
ning, product quality, equipment quality, relations with
direct overhead).
raw materials suppliers, and inventory planning. Simply
lowering days of finished product inventory without
INVENTORY
256
200
Equation
Determining the Turnover of
Work in Process Inventory
to keep inventory levels to a minimum. However, prob-
lems can arise when work in process inventory levels are
Work in process inventory turnover = cost of goods too low. Customers may not receive the desired and
manufactured / average work in process inventory
prompt delivery of products that they are accustomed to
Work in process inventory turnover describes the relative and excessive manufacturing costs may result if short pro-
size of the cost of goods manufactured and work in process duction runs of out-of-stock inventory become necessary.
inventory, and more specifically, how many times a compa- Lower ratios can also indicate actual or anticipated
ny achieves, or turns over, the value of work in process increasing sales levels. In this case, management often
inventory in the cost to produce goods that have been man- increases work in process levels in anticipation of near-term
ufactured. Inventory includes finished goods, work in decreases in finished goods inventory.
process, and the raw materials used to manufacture finished
Ways to improve the indicator: Higher inventory turnover
goods. Partially manufactured products are considered
ratios generally increase company profitability since the
work in process. Cost of goods manufactured includes the
company can use the cash normally tied up in inventory
costs required to produce the product or service (i.e., raw
for higher return investments. Higher work in process
INVENTORY
Meaning of result: Lower ratios can indicate work in Cost of goods manufactured = 55,642
process inventory levels are getting out of control. Since Average work in process inventory = 5,845
there is a significant cost associated with the stocking of
Work in process inventory turnover = 55,642 / 5,845 = 9.52
inventory, management should proactively seek methods
257
Calculating How Many Days of
201
Equation
Work in Process Are Available
are too low since this can lead to depleted finished prod-
uct inventory levels. Customers may not receive the
Days of work in process inventory = average work in process desired and prompt delivery of products that they are
inventory / cost of goods manufactured per day
accustomed to and excessive manufacturing costs may
Days of work in process inventory describes the size of that result if short production runs of out-of-stock inventory
inventory in terms of how many days of work in process are become necessary.
available. Inventory includes finished goods, work in process, Higher ratios can also indicate actual or anticipated
and the raw materials used to manufacture finished goods. increasing sales levels. In this case, management often
Partially manufactured products are considered work in increases work in process levels in anticipation of near-term
process. Cost of goods manufactured includes the costs decreases in finished goods inventory.
required to produce the product or service (i.e., raw materi-
Ways to improve the indicator: Lower days of work in
als, direct labor, and direct overhead).
process inventory generally increases company profitabili-
The cost of goods sold and cost of goods manufactured
ty since the cash normally tied up in inventory can be used
are different in that the cost of goods sold is composed only
for higher return investments. Lower days of work in
INVENTORY
Days of work38.4
in process inventory = average work in process inventory / cost of goods manufactured
5845 152.4 per day
Days of work in process inventory = average work in process inventory / cost of goods manufactured per day
258
202
Equation
Determining the Turnover
of Raw Materials Inventory
inventory, management should proactively seek methods
to keep raw material inventory levels to a minimum. How-
Raw materials inventory turnover = ever, problems can arise when raw materials inventory lev-
cost of raw materials used / average raw material inventory
els are too low. Customers may not receive the desired and
Raw materials inventory turnover describes the relative prompt delivery of products that they are accustomed to
size of the cost of raw materials used to produce products when finished products are out-of-stock and there is inad-
and the raw materials inventory. More specifically, this ratio equate raw materials inventory for the manufacture and
describes how many times a company achieves, or turns replenishment of finished goods inventories.
over, the value of average raw material inventory in the raw
Ways to improve the indicator: Higher raw materials
material costs to produce goods that have been sold. Inven-
inventory turnover ratios generally increase company
tory includes finished goods, work in process, and the raw
profitability. Higher raw materials inventory turnover is
materials used to manufacture finished goods. Raw materi-
easier to accommodate by improving a number of factors.
als inventory is the portion of total inventory that consists
These include production planning, scheduling, capacity
of purchased raw materials, components, and assemblies.
planning, product quality, equipment quality, relations
INVENTORY
Meaning of result: Lower ratios can indicate that raw Cost of raw materials used = 31,063
materials inventory levels are getting out of control. Since Average raw material inventory = 3,308
there is a significant cost associated with the stocking of
Raw materials inventory turnover = 31,063 / 3,308 = 9.39
Raw materials9.39
inventory turnover = cost of raw materials used / average raw material
31,063 3,308 inventory
Raw materials inventory turnover = cost of raw materials used / average raw material inventory
259
203
Equation
Examining How Many Days of
Raw Materials Inventory Are Available
when raw materials inventory levels are too low. Cus-
tomers may not receive the desired and prompt delivery
Days of raw materials inventory = average raw materials
of products that they are accustomed to when finished
inventory / cost of raw materials used per day
products are out-of-stock and there is inadequate raw
Days of raw material inventory describes the size of that materials inventory for the manufacture and replenish-
inventory in terms of how many days of raw materials are ment of finished goods inventories.
available in inventory. Inventory includes finished goods,
Ways to improve the indicator: Fewer days of raw materials
work in process, and the raw materials used to manufacture
inventory on hand generally increase company profitability.
finished goods. Raw materials inventory is the portion of
You can reduce days of raw materials inventory levels by
total inventory that includes purchased raw materials, com-
improving a number of factors. These include production
ponents, and assemblies. Cost of raw materials is the raw
planning, scheduling, capacity planning, product quality,
materials cost portion of cost of goods sold and includes
equipment quality, relations with raw materials suppliers,
purchased raw materials, components, and assemblies.
and inventory planning. Simply lowering days of raw mate-
rial inventory without improvement in these critical areas
INVENTORY
260
204
Equation
Determining the
Inventory Ordering Cost
Meaning of result: Higher ordering costs can be the result
of extensive, redundant, and/or inefficient ordering,
Average inventory ordering cost = all costs associated with inspection, shipping, handling, and payment systems.
ordering new raw materials or retail inventory / number of
new orders Ways to improve the indicator: Lowering the expenses
associated with acquiring inventory can lower average
Inventory ordering costs include costs of ordering new inventory order costs. Improved and/or computerized sys-
raw materials or, for retailers, ordering new stock. The costs tems may help streamline purchasing, accounting, and
may include salaries and expenses for order placement, payment operations and reduce the amount of employee
computerized inventory control, accounts payable, tele- input and expense required to purchase, receive, and pay
phones, shipping, handling, and inspection. The average for inventory.
inventory order cost gives the manager a general indication Example
of the costs associated with individual orders of new inven-
tory. Average inventory ordering cost = all costs associated with
ordering new raw materials or retail inventory / number of
When to use indicator: Managers can use this indicator to new orders
INVENTORY
261
Average inventory ordering cost = all costs associated with ordering new raw
materials or retail inventory / number of new orders
Purchasing costs
(salaries, office space, overhead, etc. used in ordering inventory) = 67,500
Accounting = 6,400
Accounts payable costs = 3,000
Telephone costs = 1,460
Computer and forms costs = 15,280
Handling = 5,800
Shipping = 16,433
Inspecting = 8,697
Other miscellaneous costs = 7,520
Number of new orders = 3,540
Average inventory ordering cost = 37.31
Example
INVENTORY
determine the costs associated with carrying inventory and associated with storing the inventory item
as an input parameter in determining the optimum size of
inventory orders when using techniques such as the Eco- Expenses for a particular inventory item per unit per year
nomic Ordering Quantity (EOQ) method. By using inven- Time period = 1 year
tory control methods such as the EOQ, manufacturers and Cost per unit = 54
retailers may be able to optimize the trade-off between Warehouse costs (rent, utilities, insurance, etc.) = 18.00
inventory ordering costs and inventory carrying costs. One Inventory capital costs = (cost per unit) × (cost of capital per
year) = 54 × 0.1263 = 6.82
of the more popular theories regarding inventory control Handling = 1.54
is the Just-In-Time (JIT) inventory control method, in Obsolescence = 3.40
which improvements in inventory control, vendor rela- Other miscellaneous costs = 0.88
tions, and manufacturing methods allow for cost reduc-
tions associated with carrying less inventory. Inventory carrying cost per unit per year = 18.00 + 6.82 +
1.54 + 3.40 + 0.88 = 30.64
262
206
Equation
Determining the Optimum
Inventory Order Quantity
ordering and carrying inventory. Although the EOQ is useful
in helping determine inventory order size, the method has a
Optimum inventory order quantity (EOQ) = number of shortcomings. Among these limitations and
[(2 × inventory order cost × total inventory usage per
assumptions are constant and predictable inventory usage
period)/inventory carrying cost]^0.5
rates, carrying costs that are directly proportional to inven-
One technique for determining the optimum purchase tory size, constant ordering costs, inventory depletions to
quantity of individual inventory items is the Economic zero with no safety stock, and lack of consideration of vol-
Ordering Quantity (EOQ) method. This method attempts ume discounts.
to optimize the trade-off between inventory ordering costs
Ways to improve the indicator: You can increase the EOQ
and inventory carrying costs and thus minimize the expens-
by lowering carrying costs and increasing ordering costs and
es associated with ordering and carrying inventory. Invento-
inventory usage rates. You can decrease the EOQ by increas-
ry ordering costs per unit of inventory decrease with
ing carrying costs and decreasing ordering costs and invento-
increased order size while inventory carrying costs increase
ry usage rates.
with larger orders.
INVENTORY
263
Optimum inventory order quantity (EOQ) = 3.89
[(2 × inventory order cost × total inventory
45.00 usage per period)
2,400
[(2 × inventory order cost × total inventory usage per period)
/ inventory carrying cost]^0.5
45.00
/ inventory carrying cost]^0.5
INVENTORY
207
Equation
Determining the Total
Cost of Inventory Per Item
costs that are equivalent to inventory carrying costs. You
can minimize total inventory costs by using the EOQ
Total cost of inventory item per period = ordering costs per method when the ordering and carrying costs are equal.
item per period + carrying costs per item per period
Lowering the expenses associated with acquiring invento-
You can estimate the costs associated with inventory by ry can lower average inventory order costs. Improved
adding the expenses associated with ordering and carrying and/or computerized systems may help streamline purchas-
inventory. Manufacturers realize inventory ordering costs ing, accounting, and payment operations and reduce the
when they order new raw materials; retailers when they amount of employee input and expense required to pur-
order new stock. The costs may include salaries and expens- chase, receive, and pay for inventory.
es for order placement, computerized inventory control, Lowering the expenses associated with storing and han-
accounts payable, telephones, shipping, handling, and dling inventory can lower average inventory carrying costs.
inspection. Manufacturers realize inventory carrying costs Maintaining inventory at minimum required levels and effi-
when they store raw materials; retailers when they have ciently making use of warehouse space can reduce ware-
available stock on-hand. Carrying costs may include ware- house costs. You can reduce handling expenses by providing
inventory personnel with the tools and training to receive,
INVENTORY
264
Total cost of inventory per item per period = 2253
ordering costs1,119
per item per period + carrying costs1,134
per item per period
ordering costs per item per period + carrying costs per item per period
INVENTORY
208
Equation
Determining the Timing
of Inventory Reorders
inventory lead times are long. Reorder point volumes are
also high when working days per period are low and
Inventory reorder point = (total inventory grouped together since this increases inventory usage rates
usage per period / days per period) × inventory lead time
and results in the need for a large inventory supply.
Inventory reorder point with safety stock = inventory reorder Ways to improve the indicator: You can lower inventory
point + safety stock reorder points by decreasing inventory lead times and
inventory usage rates. Eliminating periodic spiked invento-
The inventory reorder point defines the timing of place- ry use and flattening inventory demand will also allow for
ment of new inventory orders. By considering the amount lower inventory reorder points.
of inventory required and the lead time required to replen-
ish depleted inventories, a manager can determine the tim- Example
ing on reorders. The volume of existing inventory remaining
Inventory reorder point = (total inventory usage per period /
in stock is the timing trigger for new order placement. This
days per period) × inventory lead time
technique is a simple method of determining only rough
INVENTORY
reorder points since the technique as described does not Total inventory usage per period = 2,400 units per year
allow for any safety stock or variations in demand. The Inventory lead time = 7 days
method assumes new inventory arrives just when existing Days per period = 365 days
inventory is depleted, which could increase the potential of
Inventory reorder point = (2,400 / 365) × 7 = 46 units
running out of inventory. Improvements to this method
account for safety stock estimations. More sophisticated
techniques use probability curves to define safety stock Inventory reorder point with safety stock = inventory reorder
requirements more precisely. point + safety stock
When to use indicator: Managers can use this indicator to Assume safety stock = 50 units
determine the timing of placing new inventory orders.
Inventory reorder point with safety stock = 46 + 50 = 96
units
Meaning of result: Higher inventory reorder point vol-
umes occur when inventory usage rates are high and
265
209
Equation
Estimating the Size of
Inventory Safety Stock
Example
Safety stock = demand variability over lead time × service Safety stock = demand variability over lead
level factor time × service level factor
The historical demand and variability of inventory and Desired service level factor = 95%
the level of service a company wishes to provide its cus- Total inventory usage per period = 2,400 units per year
tomers determines this method of safety stock. By comput- Mean demand per day = 6.58 units
Standard deviation demand per day = 3.24 units
ing the mean and standard deviation of demand, you can
Inventory lead time = 7 days
determine the demand variability. If the demand for the par- Days per period = 365 days
ticular inventory items follows a normal distribution, you
can use probability curves to determine a service level factor
that corresponds to the percentage of time there will be suf- Table of service level factors
ficient stock to meet demand. You should add the safety
Service level Factor
stock amount to the mean amount required during the lead
INVENTORY
time for inventory receipt to determine the reorder point. 50% 0.0
75% 0.67
When to use indicator: Managers can use this indicator to 90% 1.28
determine the timing of new inventory orders. By adding a 95% 1.64
safety stock to inventory levels, you can reduce the proba- 99% 2.33
bility of running out of inventory.
99.9% 3.30
266
Inventory reorder 60.1
point with safety stock
Inventory reorder point with safety stock
= ([total inventory 365period] × inventory7 lead time)
usage per period / days per
2,400
= ([total inventory usage per period / days per period] × inventory lead time)
+ safety14stock
+ safety stock
8.57
267
CHAPTER FIFTEEN
Product and
Service Demand
Types
268
211
Equation
Examining Elastic Demand
for Goods or Services
be less elastic because customers generally aren’t as con-
cerned with the price change. For example, customers
Demand elasticity = (change in quantity demanded / would be more likely to purchase a candy bar at a price that
base volume) / (change in price / base price)
is 40% higher than normal than they would a car or a
Demand elasticity, also known as price elasticity of house.
demand, describes how the level of customer demand When there is great need for the product or service,
changes with changes in price. You can think of demand demand tends to be less elastic because customers are more
elasticity as the responsiveness of demand to price changes. willing to pay higher prices. The time period after which a
PRODUCT AND SERVICE DEMAND TYPES
When the demand for a product or service is elastic, the size price change has been made will also affect elasticity. If a
of the demand is very dependent on the pricing of the prod- grocery store were to raise the price of milk significantly,
uct or service. For very elastic products or services, price demand in the short term may not drop off dramatically
increases will result in large demand decreases while price since many shoppers may not notice the price change or
cuts will result in large demand increases. For elastic prod- may not want to make an unscheduled additional trip to
ucts or services, total revenues (price × quantity) decrease as buy milk at another store on the way home. However, in
prices increase and increase as prices decrease. the longer term, as more shoppers notice the higher price
and make other plans to purchase the milk, demand will
When to use indicator: It is useful for managers to under- probably drop more sharply. Another longer term example
stand the elasticity of the goods or services being offered of the time effect is the events that took place during the oil
when developing pricing and product line strategies. crisis of the 1970s. When gasoline prices first rose, many
consumers paid the higher prices because they had little
Meaning of result: Products are considered elastic when alternative. However, with time, carpools began and manu-
the demand elasticity has an absolute value greater than facturers produced more efficient cars to reduce the
1.0. Absolute values much higher than 1.0 indicate even demand for gasoline.
greater elasticity. You can determine elasticity by a number
of factors including the amount and the availability of Example
substitute products or services, the percentage of income
Highly elastic example
the purchaser uses to purchase the product or service, the
purchaser’s need for the product or service, and the length Demand elasticity = (change in quantity demanded /
of time the purchase is made after the company changes base volume) / (change in price / base price)
the price.
Price A = $75
When there are few or no substitute products available, Volume at price A = 450 units
demand tends to be less elastic, or less responsive to price Price B = $81
changes, since customers have little choice but to pay higher Volume at price B = 310 units
prices when prices rise. When the product or service takes a
smaller part of the customer’s income, demand also tends to Demand elasticity = [(310 − 450) / 450] / [(81 − 75) / 75] =
−3.89
269
212
Equation
Examining Inelastic Demand
for Goods and Services
elastic because customers generally aren’t as concerned with
the price change. For example, customers would be more
Demand elasticity = (change in quantity demanded / likely to purchase a candy bar at a price that is 40% higher
base volume) / (change in price / base price)
than normal than they would a car or a house.
Demand elasticity, also known as price elasticity of When there is great need for the product or service,
demand, describes how the level of customer demand demand tends to be less elastic because customers are more
changes with changes in price. You can think of demand willing to pay higher prices. The time the customer purchas-
elasticity as the responsiveness of demand to price changes. es the product or service after a price change will also affect
PRODUCT AND SERVICE DEMAND TYPES
When the demand for a product or service is inelastic, the elasticity. If a grocery store were to raise the price of milk
size of the demand is independent of the pricing of the significantly, demand in the short term may not drop off
product or service. For inelastic products or services, price dramatically since many shoppers may not notice the price
increases will result in small demand decreases and price change or may not want to make an unscheduled additional
cuts will result in small demand increases. For inelastic trip to buy milk at another store on the way home. Howev-
products or services, total revenues (price × quantity) er, in the longer term, as more shoppers notice the higher
increase as prices increase and decrease as prices decrease. price and make other plans to purchase the milk, demand
will probably drop more sharply. Another longer term
When to use indicator: It is useful for managers to under- example of the time effect is the events that took place dur-
stand the elasticity of the goods or services being offered ing the oil crisis of the 1970s. When gasoline prices first
when developing pricing and product line strategies. rose, many consumers paid the higher prices because they
had little alternative. However, with time, carpooling began
Meaning of result: Products are considered inelastic when and manufacturers produced more efficient cars to reduce
the demand elasticity has an absolute value less than 1.0. the demand for gasoline.
Absolute values much less than 1.0 indicate even greater
inelasticity. You can determine elasticity by a number of Example
factors including the amount and the availability of substi-
Inelastic example
tute products or services, the percentage of income the
purchaser uses to purchase the product or service, the pur- Demand elasticity = (change in quantity demanded /
chaser’s need for the product or service, and the length of base volume) / (change in price / base price)
time the purchase is made after the price changes. Price A = $75
When there are few or no substitute products available, Volume at price A = 450 units
demand tends to be less elastic, or less responsive to price Price B = $81
changes, because customers have little choice but to pay Volume at price B = 435 units
higher prices when prices rise. When the product or service
takes a smaller part of the customer’s income, demand also Demand elasticity = [(435 − 450)/450] / [(81 − 75)/75] =
tends to be less −0.42
270
213
Equation
Understanding Unitary Elasticity
for Goods or Services
would be more likely to purchase a candy bar at a price that
is 40% higher than normal than they would a car or a
house.
Demand elasticity = (change in quantity demanded /
base volume) / (change in price / base price) When there is great need for the product or service,
demand tends to be less elastic because customers are more
Demand elasticity, also known as price elasticity of willing to pay higher prices. The length of time a purchase is
demand, describes how the level of customer demand made after a price change will also affect elasticity. If a gro-
changes with changes in price. You can also think of demand cery store were to raise the price of milk significantly,
PRODUCT AND SERVICE DEMAND TYPES
elasticity as the responsiveness of demand to price changes. demand in the short term may not drop off dramatically
When the demand for a product or service is unitary elastic, because many shoppers may not notice the price change or
may not want to make an unscheduled additional trip to
percentage changes in price result in equal percentage
buy milk at another store on the way home. However, in
changes in demand. For unitary elastic products or services,
the longer term, as more shoppers notice the higher price
total revenues (price × quantity) remain the same as prices
and make other plans to purchase the milk, demand will
increase or decrease.
possibly drop more sharply. Another longer term example
When to use indicator: It is useful for managers to under- of the time effect is the events that took place during the oil
crisis of the 1970s. When gasoline prices first rose, many
stand the elasticity of the goods or services being offered
consumers paid the higher prices, because they had little
when developing pricing and product line strategies.
alternative. However, with time, carpooling began and man-
Meaning of result: Products are considered unitary elastic ufacturers produced more efficient cars to reduce the
when the demand elasticity has an absolute value of 1.0. demand for gasoline.
You can determine elasticity by a number of factors
Example
including the amount and the availability of substitute
products or services, the percentage of income the pur- Unitary elastic example
chaser uses to purchase the product or service, the pur-
Demand elasticity = (change in quantity demanded /
chaser’s need for the product or service, and the length of
base volume) / (change in price / base price)
time the purchase is made after the price changes.
When there are few or no substitute products available, Price A = $75
demand tends to be less elastic, or less responsive to price Volume at price A = 450 units
changes, because customers have little choice but to pay Price B = $81
higher prices when prices rise. When the product or service Volume at price B = 414 units
takes a smaller part of the customer’s income, demand also
Demand elasticity = [(414 − 450)/450] / [(81 − 75)/75] =
tends to be less elastic because customers generally aren’t as
−1.0
concerned with the price change. For example, customers
271
214
Equation
Examining Cross-Elasticity
for Goods or Services
butter and margarine can be high since large price changes
in one will significantly affect the demand for the other.
Cross-elasticity = (change in quantity demanded for product When products have a cross-elasticity of less than 0.0,
X / base volume of product X) / (change in price of product
they are considered complements to each other. An example
Y / base price of product Y)
of complementary products is ski boots and skis. When the
Cross-elasticity describes how the level of customer price of skis rise, the demand for ski boots will tend to
demand for product X changes with changes in price of decrease.
product Y. You can think of cross-elasticity as a measure of
PRODUCT AND SERVICE DEMAND TYPES
Example
the substitutability of similar products.
Cross-elastic example
When to use indicator: Managers need to understand the
degree of cross-elasticity of the goods or services a compa- Cross-elasticity = (change in quantity demanded for product
X / base volume of product X) / (change in price of product
ny offers when developing pricing and product line strate-
Y / base price of product Y)
gies.
Product Y price A = $75
Meaning of result: Products or services are considered Volume of product X at product Y price A = 450 units
cross-elastic when the cross-elasticity has a value larger Product Y price B = $81
than 0.0. Larger values indicate greater degrees of cross- Volume of product X at product Y price B = 525 units
elasticity. You can determine cross-elasticity primarily by
the substitutability, or competitiveness, of comparable Cross-elasticity = [(525 − 450)/450] / [(81 − 75)/75] = 2.08
products or services. For example, the cross-elasticity of
Cross-elasticity
2.08 =( 525 − antity dema / base 450
450 volume ) / ( 81 − antity75deman / base75
price )
Cross-elasticity = ( change in quantity demanded / base volume ) / ( change in price / base price )
272
215
Equation
Examining Price
Elasticity of Supply
vices, price increases will result in large supply increases
while price cuts will result in large supply decreases.
Elasticity of supply = (change in quantity supplied / For example, mountain bike manufacturers want to pro-
base volume) / (change in price / base price) duce many more bikes when sales prices rise dramatically.
Supply elasticity describes how the level of supplied goods Conversely, falling sales prices lead to lower mountain bike
or services changes with changes in price. The concept is supplies as some manufacturers cannot compete and cease
similar to demand elasticity except that the elasticity of sup- production.
ply occurs along the supply curve versus the demand curve.
PRODUCT AND SERVICE DEMAND TYPES
Example
When to use indicator: Managers need to understand the Elasticity of supply = (change in quantity supplied /
elasticity of their company’s goods or services when devel- base volume) / (change in price / base price)
oping pricing and product line strategies.
Price A = $75
Meaning of result: You can think of supply elasticity as Volume at price A = 450 units
the willingness of producers to provide products or ser- Price B = $81
vices at varying price points. When the supply for a prod- Volume at price B = 580 units
uct or service is elastic, the willingness of producers to
supply goods or services is very dependent on the pricing Elasticity of supply = [(580 − 450)/450] / [(81 − 75)/75] =
3.61
of the product or service. For very elastic products or ser-
Elasticity
3.61of supply = ( change in quantity
130 supplied / base450 volume ) / ( change6in price / base75
price )
Elasticity of supply = ( change in quantity supplied / base volume ) / ( change in price / base price )
273
CHAPTER SIXTEEN
Capital
Investment
274
216
Equation
Determining the
Payback Period
investment quickly if everything goes according to fore-
casts. In general, shorter payback times reduce risk since a
Payback period = investment / cash flow from investment per company projects that investment capital will be returned
period
quickly and because shorter term revenue projections are
The payback period is one of the easiest methods of deter- often more reliable than longer term forecasts.
mining the financial desirability of an investment. This ratio
Ways to improve the indicator: You can obtain shorter
describes the amount of time required to generate a cash
payback periods on projects that offer greater amounts of
flow equal to the initial investment. Cash flow is the differ-
cash-generating capability and low initial investment
ence between cash inflows as a result of the investment and
requirements.
cash expenses needed to perform the work associated with
the investment. When the cash flow generated per year is Example
constant, a manager can determine the payback period
CAPITAL INVESTMENT
directly by dividing the initial investment by the cash flow Even cash flows
generated per year. When there are uneven cash flow esti- Payback period = investment / cash flow from investment per
mates per year, you can determine the payback period by period
adding up the full year cash flows that are required to pay
back the initial investment. Then you determine the percent- Project investment = 135,000
Cash flow per year = 52,000
age of the remaining year of cash flow required to pay back
the initial investment fully to find the total payback period. Payback period = 135,000 / 52,000 = 2.6 years
When to use indicator: Managers can use this ratio to help Uneven cash flows
determine the viability of proposed projects. Although the Payback period = investment / cash flow from investment per
payback period ratio is a very crude analysis tool, its sim- period
plicity makes it a good method for roughly gauging the
potential of proposals. Drawbacks of the payback period Project investment = 135,000
benchmark are that it does not take into consideration the Year one cash flow = 52,000
time value of money and the cash flows received after the Year two cash flow = 58,000
Year three cash flow = 61,000
initial investment is paid in full.
Payback period = 1 year (52,000) + 1 year (58,000) +
Meaning of result: Shorter payback periods are generally [135,000 − (52,000 + 58,000)] / 61,000 = 2.41 years
desirable and indicate the company will pay off the initial
2.60period = investment
Payback 135,000 / cash flow from52,000
investment per period
Payback period = investment / cash flow from investment per period
275
217
Equation
Determining the
Payback Reciprocal
initial investment quickly if everything goes according to
forecasts. In general, shorter payback times reduce risk since
Payback reciprocal = cash flow from investment per period / the company projects that investment capital will be
investment
returned quickly and because shorter term revenue projec-
The payback reciprocal, the inverse of the payback period, tions are often more reliable than longer term forecasts.
is another easy method of determining the financial desir-
Ways to improve the indicator: You can obtain higher pay-
ability of an investment. Cash flow is the difference between
back reciprocal ratios on projects that offer greater
cash inflows as a result of the investment and cash expenses
amounts of cash-generating capability and low initial
needed to perform the work associated with the investment.
investment requirements.
When to use indicator: Managers can use this ratio to help
Example
determine the viability of proposed projects. Although the
CAPITAL INVESTMENT
payback reciprocal ratio is a very crude analysis tool, its Payback reciprocal = cash flow from investment per period /
simplicity makes it a good method for roughly gauging the investment
potential of proposals. A primary drawback of the pay-
back reciprocal benchmark is that it does not consider the Cash flow per year = 52,000
Project investment = 135,000
time value of money.
Payback reciprocal = 52,000 / 135,000 = 0.3852 = 38.52%
Meaning of result: Higher payback reciprocal ratios are gen-
erally desirable and indicate the company will pay off the
276
218
Equation
Finding the Discounted
Payback Period
However, like the payback period, the discounted payback
Discounted payback period = investment / discounted cash also ignores the cash flows received after the initial invest-
flow from investment per period ment is paid in full, a significant drawback.
The discounted payback period, another method of determin- Meaning of result: Shorter payback periods are generally
ing the financial desirability of an investment, is similar to the desirable and indicate the company will pay off the initial
payback period ratio and also takes into account the time value investment quickly if everything goes according to fore-
of money. The discounted payback period describes the amount casts. In general, shorter payback times reduce risk since
of time required to generate a discounted cash flow equal to the investment capital is projected to be returned quickly and
initial investment. By discounting future cash flows, you realize because shorter term revenue projections are often more
a more accurate measure of the value of the investment. Dis- reliable than longer term forecasts.
counted future cash flows consider that cash flow generated in
the future will be worth less in today’s dollars when there is a Ways to improve the indicator: You can obtain shorter
cost associated with the money used to fund an investment. payback periods on projects that offer greater amounts of
CAPITAL INVESTMENT
When a company or individual has no cash on hand for an cash-generating capability and low initial investment
investment, the discount rate is considered the cost of capital. requirements.
The cost of capital is a weighted average of debt and equity
financing. Alternatively, when there is a ready supply of avail- Example
able cash, the discount rate is considered as the rate of return Discounted payback period = investment / discounted cash
that alternative investments can earn. flow from investment per period
Cash flow is the difference between cash inflows as a result Project investment = 135,000
of the investment and cash expenses needed to perform the Cash flow per year = 52,000
work associated with the investment. When there are uneven Discount rate = 9%
cash flow estimates from year to year, as there are almost Yearly discount rates found by using table in Appendix B or
always for discounted payback period analyses, a manager tip #229
determines the discounted payback period by adding up the Year one discount rate = 0.917
full year discounted cash flows that are required to pay back Year two discount rate = 0.842
the initial investment. Then the manager determines the per- Year three discount rate = 0.772
centage of the remaining year of discounted cash flow Year four discount rate = 0.708
required to pay back the initial investment fully in order to Year one discounted cash flow = 0.917 × 52,000 = 47,684
find the total discounted payback period. The yearly discount Year two discounted cash flow = 0.842 × 52,000 = 43,784
rates for future cash flows can be found by using an account- Year three discounted cash flow = 0.772 × 52,000 = 40,144
ing table that lists the present value of $1 to be received in the Year four discounted cash flow = 0.708 × 52,000 = 36,816
future a given amount of years (see Appendix B). This factor First three years discounted cash flow = 47,684 + 43,784 +
can also be determined by using tip #229: Finding the Present 40,144 = 131,612
Value of $1. Percentage of fourth year required to complete payback of
When to use indicator: Managers can use this ratio to help initial investment = (135,000 − 131,612) / 36,816 = 0.092
determine the viability of proposed projects. This bench- years = 1.1 months
mark is more sophisticated than the payback period Discounted payback period = 3 + 0.092 = 3.092 years = 37.1
because this ratio accounts for the time value of money. months
Please see the next page for the interactive calculation
277
Discounted 1.03
payback period = investment
135,000 / discounted cash flow from investment per period
131,612.00
Discounted payback period = investment / discounted cash flow from investment per period
Example
Discounted payback period = investment / discounted cash
flow from investment per period
Project investment = 135,000
Cash flow per year = 52,000
Discount rate = 9%
CAPITAL INVESTMENT
Meaning of result: Higher accounting rates of return are Accounting rate of return = 32,000 / 135,000 = 0.2370 =
generally desirable and indicate the company will pay off 23.7%
the initial investment quickly if everything goes according
278
220
Equation
Determining the
Net Present Value (NPV)
cash flow estimates, and the salvage value of the invest-
ment.
Net present value = sum of discounted future cash flows −
initial investment Meaning of result: Larger net present values are generally
desirable and indicate that the company may receive high
The net present value is used to determine the financial returns on the initial investment if everything proceeds
desirability of an investment. It is the difference between the according to forecast. However, the analyst must consider
sum of the discounted future cash flows and the initial invest- other factors such as risk and the amount of capital avail-
ment. In general, projects are acceptable when the net present able when deciding whether to pursue a project. Capital
value is greater than zero. However, the analyst must consider limitations often allow the selection of only one of many
other factors such as risk and the amount of capital available investment alternatives. This circumstance is commonly
in deciding whether to pursue a project. Since the net present known as a mutually exclusive investment selection. In
value benchmark considers the time value of money, all esti- such a case, the project with the highest net present value
CAPITAL INVESTMENT
mated future cash flows, and the salvage value of the invest- for a given initial investment is often the project selected
ment, it can be an excellent indicator of investment desirabili- for implementation. However, this is not always the case;
ty. a much lower risk project with a slightly lower net present
Cash flow is the difference between cash inflows as a value may be the better choice for investment.
result of the investment and cash expenses needed to per-
form the work associated with the investment. By discount- Ways to improve the indicator: You can obtain larger net
ing future cash flows, a manager can determine a more present values projects on projects that offer greater
accurate measure of the value of the investment. Discounted amounts of cash-generating capability and low initial
future cash flows consider that cash flow generated in the investment requirements.
future will be worth less in today’s dollars when there is a
cost associated with the money used to fund an investment. Example
When a company or individual has no cash on hand for an
Net present value = sum of discounted future cash flows −
investment, the discount rate can be taken as the cost of initial investment
capital. The cost of capital is a weighted average of debt
and equity financing. Alternatively, when there is a ready Project investment = 135,000
supply of available cash, the discount rate can be taken as Cash flow per year = 52,000
the rate of return that alternative investments can earn. The Life of project = 6 years
yearly discount rates for future cash flows can be found by Value of investment at end of project = 15,000
using an accounting table that lists the present value of $1 to Discount rate = 9%
be received in the future a given amount of years (see Appen- Yearly discount rates found by using table in Appendix B or
dix B). This factor can also be determined by using tip #229: tip #229
Finding the Present Value of $1. Year one discount rate = 0.917
Year two discount rate = 0.842
When to use indicator: Managers can use this ratio to help Year three discount rate = 0.772
determine the viability of proposed projects. This bench- Year four discount rate = 0.708
mark is a reasonably sophisticated method of capital eval- Year five discount rate = 0.650
uation because it considers the time value of money, all Year six discount rate = 0.596
279
Year one discounted cash flow = 0.917 × 52,000 = 47,684
Year two discounted cash flow = 0.842 × 52,000 = 43,784
Year three discounted cash flow = 0.772 × 52,000 = 40,144
Year four discounted cash flow = 0.708 × 52,000 = 36,816
Year five discounted cash flow = 0.650 × 52,000 = 33,800
Year six discounted cash flow = 0.596 × (52,000 + 15,000) =
39,932
Since cash flows are equal in future years (before the dis-
count rate is applied), the sum of the discounted future cash
flows can also be determined by using a table for the present
value of an annuity for a term of six years (Appendix C) or
by using tip #230.
Present value of an annuity for six years at a discount rate of
CAPITAL INVESTMENT
9% = 4.486
Year six discount rate for salvage value of investment =
0.596
280
221
Equation
Finding the Risk-Adjusted
Discount Rate
Initial investment = 76,000
Cash flow per year = 52,000
Risk-adjusted discount rate = risk-free discount rate + risk Life of project = 3 years
premium Value of investment at end of project = 12,000
Risk-free discount rate = 6%
You can adjust discount rates for the risk associated with Risk-adjusted discount rate = Risk-free discount rate + risk
projects by adding a risk premium to the risk-free discount premium
rate. In a similar manner, when a company uses its cost of Risk-free discount rate = 6%
capital for a discount rate, higher-than-normal risk projects Risk premium = 8%
may warrant adding a risk premium to that rate. By adding
Risk-adjusted discount rate = 6 + 8 = 14%
a risk premium to the discount rate, the financial analyst Present value of $1 received annually for three years at a
may better be able to determine the merits of pursuing pro- discount rate of 6% = 2.673
jects since she is factoring risk into her analysis. Year three discount rate for salvage value of investment at a
CAPITAL INVESTMENT
Meaning of result: Higher-risk projects will have higher Net present value at risk-free discount rate of 6%
risk premiums and risk-adjusted discount rates. These Net present value = ([cash flow per year] × [present value of
higher rates will reduce net present values and internal $1 received annually for 3 years at the specified discount
rates of return since the risk associated with the projects rate]) + ([salvage value of investment] × [present value of $1
will make them less attractive. Alternatively, lower risk received in 3 years at the specified discount rate])
projects will have lower risk premiums, lower risk-adjust- Net present value = (52,000 × 2.673) + (12,000 × 0.840) −
ed discount rates, and higher net present values and inter- 76,000 = 73,076
nal rates of return.
Net present value at risk-adjusted discount rate
Ways to improve the indicator: You realize lower risk-adjusted of 14%
discount rates when you select projects with little or no risk. Net present value = ([cash flow per year] × [present value of
However, depending upon the cash flows offered by project $1 received annually for 3 years at the specified discount
alternatives and the financial health of the company in ques- rate]) + ([salvage value of investment] × [present value of $1
tion, it may be desirable to select projects with higher risk- received in 3 years at the specified discount rate])
adjusted discount rates when those higher-risk projects offer
Net present value = (52,000 × 2.322) + (12,000 × 0.675) −
substantially greater returns.
76,000 = 52,844
Example
The additional risk associated with this project has the
Risk-adjusted discount rate = risk-free discount rate + risk effect of reducing the net present value from 73,076 to
premium 52,844.
Please see the next page for the interactive calculation
281
discount rate = risk-free 0.06
14.00%
Risk-adjusted discount rate + risk premium
0.08
Risk-adjusted discount rate = risk-free discount rate + risk premium
CAPITAL INVESTMENT
222
Equation
Ascertaining the
Benefit Cost Ratio
Project investment = 135,000
Cash flow per year = 52,000
Benefit cost ratio = present value of cash inflows / Life of project = 6 years
present value of cash outflows Value of investment at end of project = 15,000
Discount rate = 9%
Managers use the benefit cost ratio, also known as the
profitability index, to determine the financial desirability of Since cash flows are equal in future years, you can deter-
investment projects and to select the best choice of mutually mine the sum of the discounted future cash flows by using
exclusive projects. the table for the present value of an annuity for a term of
six years (Appendix C).
When to use indicator: Managers can use this ratio to help
determine the viability of proposed projects and the best Present value of an annuity for 6 years at a discount rate of
manner in which to invest limited amounts of capital. 9% = 4.486
Year six discount rate for salvage value of investment =
CAPITAL INVESTMENT
283
Discount rate = 9% Discount rate = 35%
Present value of an annuity for 6 years at a discount rate of Present value of an annuity for 6 years at a discount rate of
9% = 4.486 35% = 2.385
Year six discount rate for salvage value of investment = Year six discount rate for salvage value of investment =
0.596 0.165
Sum of discounted cash flows = (52,000 × 4.486) + (15,000 Sum of discounted cash flows = (52,000 × 2.385) + (15,000
× 0.596) = 242,212 × 0.165) = 126,495
Net present value = 242,212 − 135,000 = 107,212 Net present value = 126,495 − 135,000 = –8,505
Discount rate = 20% Discount rate = 30%
Present value of an annuity for 6 years at a discount rate of Present value of an annuity for 6 years at a discount rate of
20% = 3.326 30% = 2.643
Year six discount rate for salvage value of investment = Year six discount rate for salvage value of investment =
0.335 0.207
Sum of discounted cash flows = (52,000 × 3.326) + (15,000 Sum of discounted cash flows = (52,000 × 2.643) + (15,000
× 0.335) = 177,977 × 0.207) = 140,541
Net present value = 177,977 − 135,000 = 42,977 Net present value = 140,541 − 135,000 = 5,541
CAPITAL INVESTMENT
Discount rate = 40% From these calculations it is seen that the internal rate of
Present value of an annuity for 6 years at a discount rate of return falls between 30% and 35%. The actual value is
40% = 2.168 31.9%, which you can determine with further iterations or
Year six discount rate for salvage value of investment = with a contemporary spreadsheet program.
0.133
Sum of discounted cash flows = (52,000 × 2.168) + (15,000
× 0.133) = 114,731
Net present value = 114,731 − 135,000 = – 20,269
Net present
5,541 value = Sum of discounted future cash flows − initial
140,541 investment
135,000
Net present value = Sum of discounted future cash flows − initial investment
284
224
Equation
Finding the Modified Internal
Rate of Return (MIRR)
mark is a reasonably sophisticated method of capital eval-
uation because it considers the time value of money, all
MIRR = Discount rate when cash flow estimates, returns generated from reinvested
Net present value = 0 cash flows, and the salvage value of the investment.
or Meaning of result: Larger MIRRs are generally desirable
Sum of discounted future cash flows − initial investment = 0 and indicate that the company may receive high returns on
the initial investment if everything proceeds according to
You can use the modified internal rate of return (MIRR) forecast. However, the analyst must consider other factors
to determine the financial desirability of an investment. The such as risk factors and the amount of capital available
MIRR is similar to the internal rate of return (IRR) but con- when deciding whether to pursue a project. Capital limita-
siders, at distinct interest rates, the cost of finance capital tions often allow the selection of only one of many invest-
CAPITAL INVESTMENT
and the rates of return from reinvestment of positive cash ment alternatives. This is commonly known as a mutually
flows. In general, projects are acceptable when the MIRR is exclusive investment selection. In such a case, the project
in excess of the minimum acceptable level of return on with the highest MIRR for a given initial investment is
investment the company expects. However, the analyst must often the project selected for implementation. However,
consider other factors such as risk and the amount of capi- this is not always the case; a much lower-risk project with
tal available in deciding whether to pursue a project. Since a slightly lower MIRR may be the better choice for invest-
the MIRR benchmark considers the time value of money, all ment.
estimated future cash flows, returns on reinvested cash
flows, and the salvage value of the investment, it can be an Ways to improve the indicator: You can obtain higher
excellent indicator of investment desirability. MIRRs on projects that offer greater amounts of cash-gen-
Discounted future cash flows consider that cash flow gen- erating capability, low initial investment requirements, and
erated in the future will be worth less in today’s dollars high reinvestment return rates on positive cash flows.
when there is inflation. In other words, the present value of
future cash flows is less than the dollar amount of those Example
future cash flows. By discounting future cash flows, you can Project investment = 135,000
realize a more accurate measure of the value of the invest- Cash flow per year = 52,000
ment. Cash flow is the difference between cash inflows as a Life of project = 6 years
result of the investment and cash expenses needed to per- Value of investment at end of project = 15,000
form the work associated with the investment. Finance rate = 9%
Reinvestment rate = 7%
When to use indicator: Managers can use this ratio to help
determine the viability of proposed projects. This bench- MIRR = 19.2% using a contemporary spreadsheet program
285
225
Equation
Determining the
Certainty Equivalent
Example
Determine the certainty equivalent and normal net present
Certainty equivalent cash flow = certainty equivalent
values and compare results.
coefficient × projected risky future cash flow
Certainty Certainty
Managers can use certainty equivalent benchmarks when Projected risky equivalent equivalent
determining the net present value and internal rate of return Year cash flow coefficient cash flow
of an investment. The certainty equivalent factors allow the 1 52,000 .90 46,800
analyst to consider the risk associated with future cash flow 2 65,000 .75 48,750
estimates. These factors are found by determining where the 3 72,000 .50 36,000
financial analyst is indifferent in choosing between a certain,
no-risk future cash flow and an uncertain but risky future Initial investment = 76,000
cash flow. Multiplying the risky future cash flow by a certain- Life of project = 3 years
CAPITAL INVESTMENT
ty equivalent coefficient will give the certainty equivalent cash Value of investment at end of project = 12,000
flow. Higher-risk projects thus have lower certainty equiva- Risk-free discount rate = 6%
Normal discount rate = 9%
lent coefficients. Use a risk-free discount rate, such as received
from U.S. treasury bill investments, when determining cer- Certainty equivalent net present value determination
tainty equivalent net present value calculations and internal Certainty equivalent net present value = sum of discount-
rates of return. Use the risk-free discount rate since the cash ed certain equivalent future cash flows − initial investment
flows received from the investment are considered risk-free.
Discount rate = 6%
When to use indicator: Managers can use the certainty Yearly discount rates found by using table in Appendix B
equivalent to make better decisions in evaluating and or tip #229
selecting capital projects since they take into consideration
the risk associated with project alternatives. Year one discount rate = 0.943
Year two discount rate = 0.890
Meaning of result: Higher-risk projects will yield lower Year three discount rate = 0.840
certainty equivalent coefficients and lower certainty equiv- Year one discounted cash flow = 0.943 × 46,800 = 44,132
alent cash flow estimates. The certainty cash flow esti- Year two discounted cash flow = 0.890 × 48,750 = 43,387
mates are lower since it is more likely the project will fail Year three discounted cash flow = 0.840 × 36,000 = 30,240
to meet forecasted cash flow estimates. Alternatively, Sum of discounted certain equivalent future cash flows =
lower-risk projects will yield higher certainty equivalent 117,759
coefficients and higher certainty equivalent cash flows. Certainty equivalent net present value = 117,759 − 76,000 =
Ways to improve the indicator: You realize higher certain- 41,759
ty equivalent coefficients when you select projects with lit-
tle or no risk. Depending upon the certainty equivalent
cash flows offered by project alternatives and the financial
health of the company in question, it may be desirable to
select projects with high or low certainty equivalent coeffi-
cients.
286
Normal net present value determination Year three discounted cash flow = 0.772 × 72,000 = 55,584
Net present value = sum of discounted future cash flows − Sum of discounted future cash flows = 157,998
initial investment
Discount rate = 9% Net present value = 157,998 − 76,000 = 81,998
Year one discount rate = 0.917 In this case, the certainty equivalent net present value of
Year two discount rate = 0.842 41,759 is about half that of the normal present value of
Year three discount rate = 0.772 81,998 indicating there is a substantial amount of risk asso-
Year one discounted cash flow = 0.917 × 52,000 = 47,684 ciated with the projected cash flows.
Year two discounted cash flow = 0.842 × 65,000 = 54,730
287
226
Equation
Determining the
Future Value of $1
Example
Future value in n years = present value × ([1 + interest rate] ^ Future value in n years = present value × ([1 + interest rate] ^
[n years]) [n years])
288
227
Equation
Finding the Future Value
of an Annuity of $1
Meaning of result: You can achieve higher future values
when interest rates are higher and when the time periods
Future value of an annuity of $1 for n years = 1 + annuity × are longer to allow for interest compounding.
(1 + interest rate)^1 + annuity × (1 + interest rate)^2 + . . . +
annuity × (1 + interest rate)^(n–1) Example
The future value of an annuity is the amount accumulated Future value of an annuity of $1 for n years = 1 + annuity ×
on a series of annuity payments. An annuity is a series of (1 + interest rate)^1 + annuity × (1 + interest rate)^2 + . . . +
equal, periodic payments given or received at the end of each annuity × (1 + interest rate)^(n–1)
time period for a specified amount of time. The difference
between an annuity and an annuity due is the timing in which Annuity = $1
Interest rate = 9%
the equal, periodic payments are given or received; annuities
n = 3 years
are paid at the end of the period and annuities due are paid at
CAPITAL INVESTMENT
289
228
Equation
Calculating the Future Value
of an Annuity Due of $1
Example
Future value of an annuity due of $1 for n years = annuity × Future value of an annuity due of $1 for n years = annuity ×
(1 + interest rate)^1 + annuity × (1 + interest rate)^2 + . . . + (1 + interest rate)^1 + annuity × (1 + interest rate)^2 + . . . +
annuity × (1 + interest rate)^n annuity × (1 + interest rate)^n
and annuities due are paid at the beginning of the period. Future value of an annuity due of $1 in three years at an
interest rate of 9% is $3.57.
When to use indicator: Managers and investors can use
this indicator to determine the future value of investments
and loans.
$3.57
Future value of an annuity due of $1 for 3 years
= annuity
1.00 × ( 1 + interest
0.09rate )^1 + annuity
1.00 × ( 1 + interest
0.09rate )^2 + annuity
1.00 × ( 1 + interest
0.09rate )^3
= annuity × ( 1 + interest rate )^1 + annuity × ( 1 + interest rate )^2 + annuity × ( 1 + interest rate )^3
290
229
Equation
Finding the Present
Value of $1
Example
Present value = future value / ([1 + interest rate] ^ [n years]) Using formula
Present value = future value / ([1 + interest rate] ^ [n years])
The present value is the value in today’s dollars of a sum
of money received in the future. In present value determina- Future value in 3 years = $1
tions, the annually compounded interest rate is also known Interest rate = 9%
as the discount rate or the rate of return. n = 3 years
When to use indicator: Managers and investors can use Present value = 1 / (1.09^3) = 0.772
this indicator to determine the present value of future cash
Present value of $1 received in three years at an interest rate
flows generated/paid from items such as investments, lot- of 9% is $0.77.
tery winnings, dividends, and loans.
CAPITAL INVESTMENT
Using tables
Meaning of result: You can achieve higher present values
Discount rate = 0.772 = $0.77 = present value of $1 received
when interest rates are lower and when investment time- in three years
frames are shorter. When interest rates are low, as in times
of low inflation, present values of sums of money received
in the future are high since there is a lack of inflationary
effects that can quickly erode the value of money.
291
230
Equation
Determining the Present
Value of an Annuity of $1
inflation, present values of sums of money received in the
future are high since there is a lack of inflationary effects
Present value of an annuity received/paid for n years = that can quickly erode the value of money.
annuity / (1 + interest rate)^1 + annuity / (1 + interest
rate)^2 + . . . + annuity / (1 + interest rate)^n Example
The present value of an annuity is the value in today’s dol- Using formula
lars of the sum of the annuity payments. An annuity is a series
Present value of an annuity received/paid for n years =
of equal, periodic payments given or received at the end of annuity / (1 + interest rate)^1 + annuity / (1 + interest
each time period for a specified amount of time. The differ- rate)^2 + . . . + annuity / (1 + interest rate)^n
ence between an annuity and an annuity due is the time in
which the equal, periodic payments are given or received; Annuity = $1
annuities are paid at the end of the period and annuities due Interest rate = 9%
CAPITAL INVESTMENT
are paid at the beginning of the period. The interest rate in n = 3 years
present value determinations is also known as the discount Present value of an annuity = 1 / (1.09^1) + 1 / (1.09^2) + 1
rate or the rate of return. / (1.09^3) = 2.531
When to use indicator: Managers and investors can use Present value of an annuity of $1 received for three years at
this indicator to determine the present value of annuities. an interest rate of 9% is $2.53.
Annuities are commonly used with investments, insurance
payments, lottery winnings, dividends, and loans.
Using tables
Meaning of result: You can achieve higher annuity present Discount rate = 2.531 = present value of an annuity of $1
values with lower discount rates and more annuity pay- received for three years
ments. When interest rates are low, as in times of low
292
231 Calculating the Present Value
of an Annuity Due of $1
Equation Meaning of result: You can achieve higher annuity due
present values with lower discount rates and more annuity
Present value of an annuity due of $1 received/paid for n due payments. When interest rates are low, as in times of
years = (1 + interest rate) × [annuity / (1 + interest rate)^1 +
low inflation, present values of sums of money received in
annuity / (1 + interest rate)^2 + . . . + annuity / (1 + interest
rate)^n] the future are high since there is a lack of inflationary
effects that can quickly erode the value of money.
Or
Present value of an annuity due of $1 received/paid for n Example
years = 1 + [annuity / (1 + interest rate)^1 + annuity / (1 +
interest rate)^2 + . . . + annuity / (1 + interest rate)^(n–1)] Using formula
Present value of an annuity due of $1 received/paid for n
CAPITAL INVESTMENT
The present value of an annuity due is the value in today’s years = (1 + interest rate) × [annuity / (1 + interest rate)^1 +
dollars of the sum of the annuity due payments. An annuity annuity / (1 + interest rate)^2 + . . . + annuity / (1 + interest
due is a series of equal, periodic payments given or received rate)^n]
at the beginning of each time period for a specified amount
Annuity = $1
of time. The difference between an annuity and an annuity
Interest rate = 9%
due is the time at which the equal, periodic payments are n = 3 years
given or received; annuities are paid at the end of the period
and annuities due are paid at the beginning of the period. Present value of an annuity due of $1 = (1 + 0.09) × [1 /
The interest rate in present value determinations is also (1.09^1) + 1 / (1.09^2) + 1 / (1.09^3)] = 2.759
known as the discount rate or the rate of return.
Present value of an annuity due of $1 received for three years
When to use indicator: Managers and investors can use at an interest rate of 9% is $2.76.
this indicator to determine the present value of annuities Using tables
due. Annuities due are commonly used with investments,
Discount rate = 1.759 = present value of an annuity of $1
insurance payments, lottery winnings, dividends, and
received for 2 years at a discount rate of 9%
loans.
Present value of an annuity due of $1 = 1 + 1.759 = 2.759
293
232
Equation
Examining Perpetuities
Meaning of result: Higher perpetuity present values can be
achieved with lower discount rates. When interest rates
Present value of a perpetuity of $1 = annuity / interest rate are low, as in times of low inflation, present values of
sums of money received in the future are high since there
The present value of a perpetuity is the value in today’s
is a lack of inflationary effects that can quickly erode the
dollars of the sum of the annuity due payments. A perpetu-
value of money.
ity is a series of equal, periodic payments given or received
at the end of each time period; it lasts forever. The perpetu- Example
ity is thus a special form of annuity in which the annuity
payments continue without end. The interest rate in present Present value of a perpetuity of $1 = annuity / interest rate
value determinations is also known as the discount rate or
the rate of return. Annuity = 1
Interest rate = 9%
CAPITAL INVESTMENT
294
CHAPTER SEVENTEEN
Investment/Loan
Interest Rate
Information
295
233
Equation
Examining
Simple Interest
When to use indicator: Managers, investors, and creditors
use simple interest calculations to determine returns on
Simple interest earned = principal × simple interest rate × simple interest investments and payments on simple inter-
time
est loans.
Simple interest is an easy method of charging or receiving
INVESTMENT/LOAN INTEREST RATE INFORMATION
296
234
Equation
Exploring
Compounded Interest
Examples
Compound interest earned = principal × {[1 + (interest rate / Compound interest earned = principal × {[1 + (interest rate /
compounding episodes per year)](compounding episodes per year × compounding episodes per year)](compounding episodes per year ×
investment time frame) − 1}
investment time frame) − 1}
Principal = 1,000
INVESTMENT/LOAN INTEREST RATE INFORMATION
Annual compound interest rate = [1 + (interest rate / Interest rate = 8.5% per year
compounding episodes per year)]compounding episodes per year − 1 Compounding episodes per year = 365 (daily)
Investment time frame = 1 year
Compound interest is a common method of charging and
Compound interest earned = 1,000 × {[1 + (0.085/365)](365 ×
receiving interest on an investment. With compound inter- 1) – 1} = 88.71
est, investments grow exponentially because interest is
earned on the principal investment plus the interest earned Annual compound interest rate = [1 + (interest rate /
previously during the term of the investment. The com- compounding episodes per year)]compounding episodes per year − 1 =
[1 + (0.085/365)]365–1 = 0.0887 = 8.87%
pounded interest rate is also known as the effective yield
and the interest rate yield. Principal = 1,000
Interest rate = 8.5% per year
When to use indicator: Managers, investors, and creditors Compounding episodes per year = 365 (daily)
can use compound interest calculations to determine Investment time frame = 2 years
returns on compound interest investments and payments Compound interest earned = 1,000 × {[1 + (0.085/365)](365 ×
2)–1} = 185.28
on compound interest loans.
Principal = 1,000
Meaning of result: You can earn higher amounts of com- Interest rate = 8.5% per year
pound interest with larger principal investments, higher Compounding episodes per year = 12 (monthly)
compound interest rates, and longer investment terms. Investment time frame = 1 year
Compound interest earned = 1,000 × {[1 + (0.085/12)](12 ×
1)–1} = 88.39
88.39
Compound interest earned
Compound interest earned
= principal
1,000 × {[1 + ( interest
0.085 rate / compounding 12
episodes per year )]( compounding episodes
12 per year × investment1time frame ) − 1}
= principal × {[1 + ( interest rate / compounding episodes per year )]( compounding episodes per year × investment time frame ) − 1}
297
235
Equation
Examining the Current
Yield on Bonds
When to use indicator: Managers, investors, and creditors
can use this indicator to determine the current, or market
Current yield = annual interest / market price of bond price, yield on bonds.
The current yield is the yield on a bond based upon the Meaning of result: Current yields increase relative to the
current market price for that bond. Bonds are corporate or
INVESTMENT/LOAN INTEREST RATE INFORMATION
coupon rate as the market prices for bonds fall, and they
government debt obligations that return the principal invest- decrease relative to the coupon rate as the market prices
ment amount upon maturity and pay interest at typically for bonds increase.
regular intervals and/or are discounted at inception. The
interest rate stated on a bond is called the coupon rate or Example
nominal yield. When general interest rates rise, market prices
on existing bonds fall since the lower interest rate bonds are Current yield = annual interest / market price of bond
attractive only at lower prices. Conversely, when general
Stated rate of interest on bond = 8.5%
interest rates fall, market prices for existing bonds rise since Annual interest = 100 × stated rate of interest = 85
the higher interest rate on bonds becomes more attractive Market price of bond = 1,200
and can demand higher prices. Bonds that sell at prices high-
er than the original issue price, or par value, are said to sell Current yield = 85 / 1,200 = 0.0708 = 7.08%
at a premium. Bonds that sell at prices lower than par value
are said to sell at a discount.
7.08%
Current yield = annual interest / market 1,200
85.000 price of bond
Current yield = annual interest / market price of bond
298
236
Equation
Examining the Yield
to Maturity on Bonds
Meaning of result: The yield to maturity increases relative
to the coupon rate as the market prices for bonds fall, and
If bond is purchased at a discount
they decrease relative to the coupon rate as the market
Yield to maturity = (annual interest + annual capital gain) / prices for bonds increase.
average of purchase price and redemption price
INVESTMENT/LOAN INTEREST RATE INFORMATION
Example
If bond is purchased at a premium
Yield to maturity = (annual interest − annual capital loss) / If bond is purchased at a premium
average of purchase price and redemption price Yield to maturity = (annual interest − annual capital loss) /
average of purchase price and redemption price
The yield to maturity is the yield on a bond based upon
both the annual interest earned by the bond and the capital Stated rate of interest on bond = 8.5%
gains or losses that occur when someone purchases a bond Annual interest = 100 × stated rate of interest = 85
Purchase price of bond = 1,200
at a discount or premium. Bonds are corporate or govern- Redemption price of bond = 1,000
ment debt obligations that return the principal investment 20-year bond
amount upon maturity and pay interest typically at regular Annual capital loss = (purchase price − redemption price) / term of
intervals and/or are discounted at inception. The interest bond = (1,200 − 1,000)/20 = 10
Average price of bond = (purchase price of bond + redemption price
rate stated on a bond is called the coupon rate or nominal
of bond) / 2 = (1,200 + 1,000)/2 = 1,100
yield. When general interest rates rise, market prices on
existing bonds fall since the lower interest rate bonds are Yield to maturity = (85 − 10) / 1,100 = 0.0682 = 6.82%
attractive only at lower prices. Conversely, when general
interest rates fall, market prices for existing bonds rise since If bond is purchased at a discount
the higher interest rate bonds become more attractive and Yield to maturity = (annual interest + annual capital gain) /
can demand higher prices. Bonds that sell at prices higher average of purchase price and redemption price
than the original issue price, or par value, are said to sell at
a premium. Bonds that sell at prices lower than par value If bond is purchased at a discount, the annual capital gain
are said to sell at a discount. is added to the annual interest instead of subtracted from it
as in the previous example.
When to use indicator: Managers, investors, and creditors
can use this indicator to determine the yield to maturity on
bonds.
Yield 6.82%
to maturity
Yield to maturity
= ( annual interest + annual capital
85.000 10 gain)
= (annual interest + annual capital gain)
/ average of purchase price
1100and redemption price
/ average of purchase price and redemption price
299
237
Equation
Examining the Effective
Annual Yield on T-bills
Meaning of result: Larger discount amounts and shorter
days to maturity can increase the effective annual T-bill
Effective annual T-bill yield = [(par value − initial investment) yield.
× 365] / (initial investment × number of days to maturity)
Example
The U.S. Treasury sells debt obligations to the public in
INVESTMENT/LOAN INTEREST RATE INFORMATION
the form of bills, notes, and bonds. T-bills are sold at a dis- Effective annual T-bill yield = [(par value − initial investment)
count to par, with the full par value being paid at maturity. × 365] / (initial investment × number of days to maturity)
This formula allows an investor to use the discount infor-
mation to determine the effective annual yield of T-bills. Par value = 10,000
Discount = 2.3% = 230
When to use indicator: Investors can use this indicator to Initial investment = par value − discount = 10,000 − 230 =
9,770
determine effective annual T-bill yields when given the dis-
Number of days to maturity = 181
count amounts, days to maturity, and the par value of the
T-bill. Effective annual T-bill yield = [(10,000 − 9,770) × 365] /
(9,770 × 181) = 0.0475 = 4.75%
4.75%T-bill yield
Effective annual
Effective annual T-bill yield
= [(par value − initial9,770
10,000 investment) × 365]
= [(par value − initial investment) × 365]
investment × number of days
/ (initial 9,770 181 to maturity)
/ (initial investment × number of days to maturity)
300
238
Equation
Exploring the
Rule of 72
Example
Estimate of the time to double your money = 72 / interest Estimate of the time to double your money = 72 / interest
rate yield rate yield
Interest rate yield = 8%
This indicator is commonly used to estimate roughly the
INVESTMENT/LOAN INTEREST RATE INFORMATION
amount of time required to double your money given an Estimate of the time to double your money = 72 / 8 = 9 years
annual interest rate yield.
Estimate of the time to double your money = 72 / interest
When to use indicator: Managers, creditors, and investors rate yield
can use this indicator when examining the desirability of
investments, loans, and any other vehicles which pay or Interest rate yield = 12%
receive interest. Estimate of the time to double your money = 72 / 12 = 6
years
Meaning of result: It takes longer to double investments
when interest rates are lower. The time required to double The federal funds rate is the interest charged for loans
an investment decreases as the rate of interest increases.
301
239 Exploring Interest Rates
and Their Significance: Federal Funds Rate
between banks that belong to the Federal Reserve System Meaning of result: The Fed is charged with maintaining
(Fed). The Fed requires all banks within the system, the vast high levels of employment, stable prices, and moderate
majority of U.S. banks, to maintain a certain percentage of long-term interest rates in the U.S. economy. At the Fed’s
assets on reserve with the Fed. When a bank has excess disposal are a number of tools it can use in an attempt to
reserves on deposit at the Fed, the system allows it to lend achieve these goals including the ability to control short-
INVESTMENT/LOAN INTEREST RATE INFORMATION
those reserves to other banks within the system at the feder- term interest rates and the capacity to control bank
al funds rate. When a bank has not met the minimum reserves by buying and selling Treasury bills in the open
deposit requirement at the Fed, it may borrow money from market. The Fed can control short-term interest rates
banks with excess reserves at this same rate. Most of these with the federal funds rate and the discount rate. The
loans are for one day only. Fed will tend to increase short-term rates when it fore-
casts future price instability because of an anticipated
When to use indicator: Managers, creditors, and investors overheated, and potentially inflationary, economy. The
can use this benchmark to help predict the state of the Fed will tend to decrease short-term rates when it fore-
economy in the near future. This information may aid in sees the potential of a sluggish economy with increasing
determining the timing and benefits of company acquisi- unemployment levels.
tions/sales, capital investments/sales, marketing programs, The discount rate is the interest rate charged by the Fed-
and product development projects. eral Reserve System (Fed) to its member banks on funds
borrowed from the Fed by those banks.
302
240 Exploring Interest Rates
and Their Significance: Discount Rate
When to use indicator: Managers, creditors, and investors reserves by buying and selling Treasury bills in the open
can use this benchmark to help predict the state of the market. The Fed can control short-term interest rates with
economy in the near future. This information may aid in the federal funds rate and the discount rate. The Fed will
determining the timing and benefits of company acquisi- tend to increase short-term rates when it forecasts future
tions/sales, capital investments/sales, marketing programs, price instability because of an anticipated overheated, and
INVESTMENT/LOAN INTEREST RATE INFORMATION
and product development projects. anticipated inflationary, economy. The Fed will tend to
decrease short-term rates when it foresees the potential of
Meaning of result: The Fed is charged with maintaining a sluggish economy with increasing unemployment levels.
high levels of employment, stable prices, and moderate The U.S. Treasury sells debt obligations to the public in
long-term interest rates in the U.S. economy. At the Fed’s the forms of bills, notes, and bonds. The primary differences
disposal are a number of tools it can use in an attempt to between bills, notes, and bonds are the terms to maturity:
achieve these goals including the ability to control short- bills mature in one year or less, notes mature in 2 to 10
term interest rates and the capacity to control bank
303
241 Exploring Interest Rates and Their
Significance: Treasury Bills/Notes/Bonds
years, and bonds mature in 10 years and longer. Most an anticipated overheated, and potentially inflationary,
investors consider U.S. treasuries the safest type of invest- economy. The Fed will tend to decrease short-term rates
ment possible because they are backed by the full faith and when it foresees the potential of a sluggish economy with
credit of the U.S. government. increasing unemployment. The Fed can also control short-
term interest rates by buying and selling Treasury bills in
INVESTMENT/LOAN INTEREST RATE INFORMATION
When to use indicator: Managers, creditors, and investors the open market. Longer-term Treasury notes and bond
can use this benchmark to help predict the state of the rates tend not to be as closely linked to the short-term
economy in the near future. This information may aid in actions of the Fed. High and higher trending longer term
determining the timing and benefits of company acquisi- rates can indicate anticipated inflation while lower long-
tions/sales, capital investments/sales, marketing programs, term rates, particularly when the yield curve is inverted,
and product development projects. can indicate a higher likelihood of recession. Inverted yield
curves occur when short-term interest rates are higher
Meaning of result: Short-term rates often closely track the
than long-term rates.
Federal Reserve’s (Fed’s) policy with regard to the two
short-term rates it controls: the federal funds rate and the
discount rate. The Fed will tend to increase short-term
rates when it forecasts future price instability because of
304
CHAPTER EIGHTEEN
External
Indicators
305
242 Examining the Index of
Leading Economic Indicators
The index of leading economic indicators, published When to use indicator: Managers, creditors, and investors
monthly by the Conference Board, a leading business mem- can use this benchmark to help predict the state of the
bership and research organization, is designed to indicate economy in the near future. This information may aid in
the state of the near-future economy by signaling high and determining the timing and benefits of company acquisi-
low points in the business cycle. This index is composed of tions/sales, capital investments/sales, marketing programs,
10 individual indicators that tend to lead changes in the and product development projects.
state of economy. While all of the indicators generally tend Meaning of result: High and/or rising leading economic
to lead the economy, it is common for one to a number of index values indicate the probability of a healthy economy
the individual indicators to give false forecasts regarding in the near-term future. Low and/or falling values can
the direction of the economy. The number of unique eco- indicate near-term future downturns for the business econ-
nomic predictors in the index improves its reliability. The omy. The index tends to be more reliable in forecasting
10 leading economic indicators are 1) average weekly hours
EXTERNAL INDICATORS
306
243 Examining the Index of
Coincident Economic Indicators
The index of coincident economic indicators, published When to use indicator: Managers, creditors, and investors can
monthly by the Conference Board, a leading business mem- use this benchmark to help confirm the current state of the
bership and research organization, is designed to verify the economy. This information may aid in determining the timing
state of the economy and location in the business cycle. and benefits of company acquisitions/sales, capital invest-
Four individual indicators comprise this index. They tend to ments/sales, marketing programs, and product development
occur at the same time as do changes in the state of econo- projects.
my. While all of the indicators generally trend in this man-
ner, it is common for one to a number of the individual Meaning of result: High and/or rising coincident economic
indicators to give false forecasts regarding the state of the index values can indicate a currently healthy economy.
economy. The number of unique economic predictors Low and/or falling values can indicate current low points
improves the reliability of the index. The four coincident in the business cycle.
economic indicators are 1) employees on nonagricultural It is often best to follow indicator trends over a number of
EXTERNAL INDICATORS
payrolls, 2) personal income, 3) industrial production, and months to reduce the possibility of false economic readings.
4) manufacturing and trade sales. Trends become more reliable when they become longer in
duration, larger in percentage change, and broader in eco-
nomic scope.
307
244 Examining the Index of
Lagging Economic Indicators
The index of lagging economic indicators, published When to use indicator: Managers, creditors, and investors
monthly by the Conference Board, a leading business can use this benchmark to help confirm the near-past state
membership and research organization, is designed to of the economy. This information, while not as obviously
verify the state of the past economy and high or low beneficial as predictors of the future state of the economy,
points in the business cycle. This index is composed of may aid in determining the timing and benefits of compa-
six individual indicators that tend to lag behind ny acquisitions/sales, capital investments/sales, marketing
changes in the state of the economy. While all of the programs, and product development projects.
indicators generally trend in this manner, it is common
for one to a number of the individual indicators to give Meaning of result: High and/or rising lagging economic
false forecasts regarding the state of the economy. The index values indicate a near-past healthy economy. Low
number of unique economic predictors increases its and/or falling values can indicate near-past low points in
reliability. The six lagging economic indicators are 1) the business cycle.
EXTERNAL INDICATORS
unemployment duration, 2) inventory-to-sales ratio for It is often best to follow indicator trends over a number of
manufacturing and trade, 3) manufacturing labor cost months to reduce the possibility of false economic readings.
per unit of output, 4) installment credit outstanding- Trends become more reliable when they become longer in
to-personal income ratio, 5) prime rate, and 6) changes duration, larger in percentage change, and broader in eco-
in the consumer price index. nomic scope.
308
245 Assessing the Gross
Domestic Product (GDP)
The gross domestic product (GDP) is a measure of all of Meaning of result: Higher percentage increases in GDP levels
the goods and services earned by a country within its often indicate a growing and healthy economy. When the
boundaries whereas the gross national product (GNP) economy becomes overheated and the percentage increases in
includes earnings produced both domestically and interna- GDP become unsustainably high, however, there is often a
tionally. tendency for higher rates of inflation and an economic down-
turn.
When to use indicator: Managers, creditors, and investors
can use this benchmark to help determine the state of the
economy.
EXTERNAL INDICATORS
309
246 Examining the Gross
National Product (GNP)
The gross national product (GNP) is a measure of all of Meaning of result: Higher percentage increases in GNP
the goods and services earned by a country, both domesti- levels often indicate a growing and healthy economy.
cally and internationally. When the economy becomes overheated and the percent-
age increases in GNP become unsustainably high, howev-
When to use indicator: Managers, creditors, and investors er, there is often a tendency for higher rates of inflation
can use this benchmark to help determine the state of the and an economic downturn.
economy.
EXTERNAL INDICATORS
310
247 Examining the Producer
Price Index (PPI)
The producer price index (PPI) is a group of indexes that economic series. Another use of the PPI is for price escala-
measures the average change over time of selling prices that tion in long-term contracts. For example, a supplier that
domestic goods manufacturers and service providers uses aluminum sheeting in manufacturing a product may
receive. Each month more than 10,000 PPIs are released for base the contract financial terms on the PPI pricing for
individual products and groups of products. aluminum.
When to use indicator: Managers, creditors, and investors Meaning of result: Higher percentage increases in the PPI
can use this benchmark to help determine the state of the indicate climbing prices for the individual or group of
economy. The PPI can also be used to deflate other eco- products in question. As producers can realize changes in
nomic indicators to negate the effects of inflation. This prices before retailers and consumers, the PPI can indicate
allows the easier communication of real changes in those future changes in the state of the economy.
EXTERNAL INDICATORS
311
248 Assessing the Consumer
Price Index (CPI)
The consumer price index (CPI) is a measure of the aver- sales and hourly earnings in order to negate the effects of
age change over time of prices paid by domestic consumers inflation. This allows for the easier communication of real
for a fixed basket of goods and services. Each month prices changes in those economic series. The CPI is also used for
for about 90,000 consumer goods and services are taken adjusting dollar values such as adjusting Social Security
from around the country as data in determining the CPI. payments and determining cost-of-living wage adjust-
ments.
When to use indicator: Managers, creditors, and investors
can use this benchmark to help determine the state of the Meaning of result: Higher percentage increases in the CPI
economy and the rate of inflation. The CPI can also be indicate climbing prices for the consumer’s basket of
used to deflate other economic indicators such as retail goods and services, an indication of rising inflation.
EXTERNAL INDICATORS
312
249 Examining the Dow Jones
Industrial Average (DJIA)
The Dow Jones Industrial Average (DJIA) is one of the Investors often use the DJIA as a comparative tool, or
most popular stock market indicators. Although only 30 benchmark, in determining the performance of other
companies comprise the DJIA, and it is widely criticized as investments.
too narrow in scope when compared with broader indexes
such as the S&P 500, the DJIA often tracks the overall per- Meaning of result: High percentage increases in the DJIA
formance of the market quite closely. result from market price increases of the 30 industrial
companies that comprise the DJIA. Market price increases
When to use indicator: Managers, creditors, and investors can be the result of anticipated increases in corporate
can use this benchmark to help predict the state of the earnings, which may result from an expanding economy.
economy in the near future since many economists indi- DJIA increases can also result from falling interest rates;
cate the DJIA tends to lead economic activity. This infor- when interest rates fall, investors tend to look for alterna-
mation may aid in determining the timing and benefits of tives that may generate higher yields. The result is often
EXTERNAL INDICATORS
company acquisitions/sales, capital investments/sales, increased demand for securities, which drives up market
marketing programs, and product development projects. prices for stocks and increases the DJIA.
313
250 Exploring the
Russel 2000 Average
The Russel 2000 is one of the most popular indicators of determining the performance of small company invest-
small company stocks. It is considered the small stock ments.
equivalent of the Dow Jones Industrial Average (DJIA)
although significantly more companies comprise the Russel Meaning of result: High percentage increases in the Russel
2000 than the 30 industrials which comprise the DJIA. 2000 result from market price increases of the 2,000 compa-
nies that comprise the index. Market price increases can be the
When to use indicator: Managers, creditors, and investors result of anticipated increases in corporate earnings, which
can use this benchmark to help predict the state of the may result from an expanding economy. Russel 2000 increas-
economy in the near future. This information may aid in es can also result from falling interest rates; when interest rates
determining the timing and benefits of company acquisi- fall, investors tend to look for alternatives that may generate
tions/sales, capital investments/sales, marketing programs, higher yields. The result is often increased demand for securi-
and product development projects. Investors often use the ties, which drives up market prices for stocks and increases the
EXTERNAL INDICATORS
314
251 Exploring the
Wilshire 5000 Average
The Wilshire 5000 average is a popular indicator of the Wilshire 5000 as a comparative tool, or benchmark, in
overall performance of the stock market, from the largest to determining the performance of company investments.
very small companies. It is considered the overall stock
equivalent of the Dow Jones Industrial Average (DJIA). Meaning of result: High percentage increases in the
Since significantly more companies comprise the Wilshire Wilshire 5000 result from market price increases of the
5000 than the 30 industrials which comprise the DJIA, it 5,000 companies that comprise the index. Market price
should more closely track the performance of the total mar- increases can be the result of anticipated increases in cor-
ket. porate earnings, which may result from an expanding
economy. Wilshire 5000 increases can also result from
When to use indicator: Managers, creditors, and investors falling interest rates; when interest rates fall, investors tend
can use this benchmark to help predict the state of the to look for alternatives that may generate higher yields.
economy in the near future. This information may aid in The result is often increased demand for securities, which
EXTERNAL INDICATORS
determining the timing and benefits of company acquisi- drives up market prices for stocks and increases the
tions/sales, capital investments/sales, marketing programs, Wilshire 5000.
and product development projects. Investors often use the
315
CHAPTER NINETEEN
Company
Valuation
316
252
Equation
Determining the
Book Value of a Company
reductions in liabilities. The book value of a company can
be far from the company’s market value. Investors can value
companies with excellent current and forecasted earnings
Book value of a company = balance sheet value of owner’s potential much in excess of book value while they may
equity value those that are experiencing difficulties less than book
Book value per share = book value of value.
company / number of common shares issued Example
and outstanding
Book value of a company = balance sheet value of owner’s
The book value of a company is equal to the owner’s equi- equity
ty portion of the balance sheet. You can determine it by Balance sheet value of owner’s equity = total shareholder
COMPANY VALUATION
subtracting liabilities and preferred stock commitments equity − liquidation value of preferred stock − preferred
from total company assets. stock dividends in arrears = 31,088 − 375 − 0 = 30,713
When to use indicator: Managers, creditors, and investors
can use this indicator to help determine the value of a com- Book value of a company = 30,713
pany. This information can be a basis for pricing the com-
pany for acquisition or sale, for creditworthiness, and for Book value per share = book value of company / number
stock investment analysis. It is generally desirable to use a of common shares issued and outstanding
number of valuation techniques in arriving at a company
value. Book value of a company = 30,713
Number of common shares issued and outstanding =
Meaning of result: Higher book values often indicate com- 3,600
panies with strong balance sheets. Such companies have
often had a history of excellent earnings and have plowed Book value per share = 30,713 / 3,600 = 8.53
those earnings back into additional company assets and
Sector Mid to large cap Book Value Small to mid cap Book Value Micro to small cap Book Value
Per Share Per Share Per Share
317
253
Equation
Finding the Liquidation
Value of a Company
Example
Liquidation value of company = cash + marketable Liquidation value of company = cash + marketable
securities + (70% of inventory, accounts receivable, and securities + (70% of inventory, accounts receivable, and
prepaid expenses) + (50% of other assets) − total prepaid expenses) + (50% of other assets) − total
liabilities liabilities
Liquidation value per share = liquidation value of Cash = 4,139
company / number of common shares issued and Marketable securities = 524
outstanding 70% of inventory, accounts receivable, and prepaid
expenses = 0.7 × (13,421 + 24,878) = 26,809
The liquidation value is the money that remains after a
50% of other assets = 0.5 × other assets = 0.5 × (56,258 −
company sells all of its assets and pays all of its debts. Liq-
4,139 − 524 − 13,421 − 24,878) = 0.5 × (13,296) = 6,648
uidation value is generally pertinent only when a company
COMPANY VALUATION
Sector Mid to large cap Liquidation Value Small to mid cap Liquidation Value Micro to small cap Liquidation Value
Per Share Per Share Per Share
318
Liquidation value per share = 12,940 / 3,600 = 3.59
Liquidation3.59
value per share = liquidation12,940
value of company / number of common shares
3,600issued and outstanding
Liquidation value per share = liquidation value of company / number of common shares issued and outstanding
COMPANY VALUATION
254
Equation
Ascertaining the
Market Value of a Company
Meaning of result: Companies with excellent current and fore-
casted revenues and earnings growth are generally valued
highly in the marketplace, oftentimes much in excess of book
Market value of company = market price per share ×
value. Growth of revenues and earnings can occur when a
number of common shares issued and outstanding
company provides highly demanded products or services at
Market value per share = market value per share competitive prices, yet maintains good profit margins.
Sector Mid to large cap Market Value Small to mid cap Market Value Micro to small cap Market Value
Per Share Per Share Per Share
319
255
Equation
Assessing the Price-to-
Earnings Value of a Company
Example
320
256
Equation
Valuing a Company on
Discounted Future Cash Flow
future income streams will increase as long as the growth
rate exceeds the discount rate. Growth of revenues and
Discounted future cash flow valuation: determined by earnings can occur when a company provides highly
applying the discounting method to a future estimated demanded products or services at competitive prices, yet
value of the company and maintains good profit margins. High earnings growth will
a stream of revenue such as cash flow, operating income, also tend to increase the future estimate of company value,
or net income further increasing the discounted future cash flow valua-
tion.
You can value companies by discounting future estimates
of company value and revenue streams. The revenue streams Example
used in these estimates can be operating income, net income,
operating cash flow, or any other indicator that fairly repre- Discounted future cash flow valuation: determined by
sents the income-generating capability of a company. As a applying the discounting method to a future estimated value
COMPANY VALUATION
company’s value is in large part due to the income it gener- of a company and a stream of revenue such as cash flow,
ates, this method of company valuation can yield solid operating income, or net income
results as long as the estimates of future income generation
Year one operating income estimate = 9,433
and company value are accurate.
Year two operating income estimate = 10,848
Discounted future cash flows consider that cash flow gen-
Year three operating income estimate = 12,475
erated in the future will tend to be worth less in today’s dol-
Year four operating income estimate = 13,723
lars. By estimating future cash flows and company value
Year four value of company = 120,000
estimates, and then applying the discounting method to
those estimates, you can make a valuation of the worth of Discount rate = 9%
the company in today’s dollars. When a company or indi- Yearly discount rates found by using table in Appendix B
vidual has no cash on hand for an investment, you can con- or tip #229
sider the discount rate as the cost of capital. The cost of
capital is a weighted average of debt and equity financing. Year one discount rate = 0.917
Alternatively, when there is a ready supply of available cash, Year two discount rate = 0.842
you can consider the discount rate as the rate of return an Year three discount rate = 0.772
alternative investment could earn. Year four discount rate = 0.708
Year one discounted operating income = 0.917 × 9,433 =
When to use indicator: Managers, creditors, and investors 8,650
can use this indicator to help determine the value of a com- Year two discounted operating income = 0.842 × 10,848 =
pany. This information can be a basis for pricing the compa- 9,134
ny for acquisition or sale, for creditworthiness, and for stock Year three discounted operating income = 0.772 × 12,475 =
investment analysis. It is generally desirable to use a number 9,631
of valuation techniques in arriving at a company value. Year four discounted operating income = 0.708 × (13,723 +
120,000) = 94,676
Meaning of result: With this valuation method, investors
generally highly value companies with excellent current and Discounted future cash flow valuation = 8,650 + 9,134 +
forecasted earnings growth because the present value of the 9,631 + 94,676 = 122,091
321
257 Determining the Value of a Company with
No-Earnings-Per-Share Dilution
Equation Example
When one company acquires another, one method of val- Company #1, purchaser of company #2
uation is to maintain equivalent earnings per share of the
new, larger company after the acquisition. This is often a Earnings = 7,864
very rough estimate of valuation since the valuation of the Shares = 5,150
acquiring company may have little correlation with that of Earnings per share = 7,864 / 5,150 = 1.527
Share price = 25.75
COMPANY VALUATION
When to use indicator: Managers, creditors, and investors Company #2, company being acquired
can use this indicator to help determine the value of a com-
pany. This information can be a basis for pricing the compa- Earnings = 4,953
ny for acquisition or sale, for creditworthiness, and for stock Shares = 3,600
investment analysis. It is generally desirable to use a number Earnings per share = 4,953 / 3,600 = 1.376
of valuation techniques in arriving at a company value.
No-earnings-per-share-dilution-value = (4953 / 1.527) ×
Meaning of result: Higher no-earnings-per-share-dilution 25.75 = 83523
valuations can indicate the company to be acquired is
earning high profits and/or the acquiring company’s earn-
ings per share are low and share prices are low. Converse-
ly, when a profitable company acquires a company with
poor earnings performance, the no-earnings-per-share-
dilution valuation will tend to be lower.
322
Appendix A
Argo, Inc. Financial Statements
Balance sheet 31-Dec-97
(dollars in thousands)
Cash 4,139
Marketable securities 524
Accounts receivable 24,878
Inventories 13,421
raw materials 3,308
work in process 5,845
finished goods 4,268
Notes receivable 125
Other current assets 1,048
Total current assets 44,135
Property, plant, equipment 12,065
Less accumulated depreciation 2,047
Net Property, plant, equipment 10,018
Other noncurrent assets 45
Deferred charges 88
Intangibles 520
Less accumulated amortization 85
Net intangibles 435
Deposits and other assets 1,547
Total assets 56,268
Notes payable 1,000
Accounts payable 5,633
Current portion of long-term debt 650
Current portion of capital leases 0
Accrued liabilities (payroll, vacation pay, property taxes) 2,747
Income taxes payable 1,420
Other current liabilities 582
Total current liabilities 12,032
Deferred charges/income taxes 185
Long term debt, less current charges 12,513
Other long-term liabilities 450
Total liabilities 25,180
Preferred stock 300
Common stock, $.01 par value: 36
5,000,000 shares authorized
3,600,000 issued and outstanding
Additional paid-in capital 12,085
Retained earnings 18,722
Less treasury stock 55
Other equities 0
Total shareholder equity 31,088
Total liabilities and net worth 56,268
323
Appendix A (continued)
Income Statement Cash flow statement
(dollars in thousands) (dollars in thousands)
Fiscal year ending 31-Dec-97 Fiscal year ending 31-Dec-97
Net sales 85,420 Cash flow by operations
Cost of goods sold 54,212
Net income (loss) 4,953
Gross profit 31,208 Depreciation/amortization 1,204
Net increase (decrease) assets/liabilities –1,337
R&D expenses 4,578
Cash provided (used) by discontinued operations 0
Selling, G&A expenses 15,993
Other adjustments, net 0
Depreciation & amortization 1,204
Net cash provided (used) by operations 4,820
Operating income 9,433
Cash flow by investing
Non-operating income 455
Interest expense 784 (Increase) decrease in property, plant, and equipment –6,275
(Acquisition) disposal of subsidiaries, businesses 0
Pre-tax income 9,104
(Increase) decrease in securities investments 2
Provision for income taxes 3,529 Other cash inflow (outflow) –321
Net income before extraordinary items 5,575 Net cash provided (used) by investing –6,594
324
Appendix B
Present Value of $1 Received in n Years
Discount rate (%)
1 2 3 4 5 6 7 8 9 10 12 15 20 25 30
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.893 0.870 0.833 0.800 0.769
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 0.797 0.756 0.694 0.640 0.592
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 0.712 0.658 0.579 0.512 0.455
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 0.636 0.572 0.482 0.410 0.350
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 0.567 0.497 0.402 0.328 0.269
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 0.507 0.432 0.335 0.262 0.207
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 0.452 0.376 0.279 0.210 0.159
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 0.404 0.327 0.233 0.168 0.123
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 0.361 0.284 0.194 0.134 0.094
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 0.322 0.247 0.162 0.107 0.073
Years 11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 0.287 0.215 0.135 0.086 0.056
(n) 12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 0.257 0.187 0.112 0.069 0.043
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 0.229 0.163 0.093 0.055 0.033
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 0.205 0.141 0.078 0.044 0.025
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 0.183 0.123 0.065 0.035 0.020
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 0.163 0.107 0.054 0.028 0.015
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 0.146 0.093 0.045 0.023 0.012
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 0.130 0.081 0.038 0.018 0.009
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164 0.116 0.070 0.031 0.014 0.007
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149 0.104 0.061 0.026 0.012 0.005
25 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092 0.059 0.030 0.010 0.004 0.001
30 0.742 0.552 0.412 0.308 0.231 0.174 0.131 0.099 0.075 0.057 0.033 0.015 0.004 0.001 0.000
40 0.672 0.453 0.307 0.208 0.142 0.097 0.067 0.046 0.032 0.022 0.011 0.004 0.001 0.000 0.000
50 0.608 0.372 0.228 0.141 0.087 0.054 0.034 0.021 0.013 0.009 0.003 0.001 0.000 0.000 0.000
Appendix C
Present Value of $1 Received Annually for n Years
References and
Suggested Reading
Robert C. Higgins. Analysis for Financial Management, 4th Edition.
Chicago: Irwin, 1995.
Jae K. Shim, Ph.D. and Joel G. Siegel, Ph.D., CPA. Handbook of Financial
Analysis, Forecasting and Modeling. Paramus, New Jersey: Prentice
Hall, 1988.
Susan M. Jacksack, J.D., editor. Start, Run and Grow a Successful Small
Business, 2nd Edition. Chicago: CCH, 1998.
Michael R. Tyran. The Vest-Pocket Guide to Business Ratios. Paramus,
New Jersey: Prentice Hall, 1992.
Jae K. Shim, Ph.D., Joel G. Siegel, Ph.D., CPA, and Abraham J. Simon,
Ph.D., CPA. The Vest-Pocket MBA, 2nd Edition. Paramus, New Jersey:
Prentice Hall, 1997.
John A. Tracy, CPA. Accounting for Dummies. Foster City, CA: IDG
Books, 1997.
Robert N. Anthony, James S. Reece, and Julie H. Hertenstein. Accounting:
Text and Cases, 9th Edition. Chicago: Irwin, 1995.
The Conference Board. www.conference-board.org (web page for The
Conference Board). Internet web page, 1998.
326
Index
A Book depreciation, 122
Book value, 152, 317
Abbreviations, 326 Bottom line, 19
Absolute value, 269 Break-even plan capacity, 93–94
Accounting rate of return, 278 Break-even ratio, 89–90
Accounts payable, 40, 243–250 Break-even sales level, 87–88, 91
Accounts payable cash disbursement turnover, Break-even volume, 85–86
249–250
Accounts payable ratios, 244, 247 C
Accounts payable turnover, 245
Accounts receivable, 40, 200, 231–242 Capital employed items, 26
Accounts receivable factoring, 242 Capital investment, 274–294
Accounts receivable ratio, 232 Carrying cost, 262
Accounts receivable turnover, 233 Cash balance, 179
Acid test, 176 Cash conversion cycle, 187, 188, 189
After-tax operating income, 28 Cash expenses, 184
Age of fixed assets, 137 Cash flow, 66–67
Aging schedule, 235 Cash flow ratios, 37, 66–67, 177
Altman’s Z-score, 181 Cash reserves, 178
Amortization, 148 Cash turnover, 178
Annual cost of assets, 28 Certainty equivalent, 286–287
Annuity, 289 Certainty equivalent coefficient, 286
Annuity due, 289 Common stock, 46
Annuity, present value of, 292, 293 Common stock dividend growth rate, 53
Asset additions, 218 Common stock dividend payout ratio, 59, 60
Asset additions, times covered, 217 Common stock dividend return ratio, 58, 65
Assets, 126–154 Company valuation, 316–322
Assets, annual cost of, 28 Compounded interest, 297
Conference Board, 306
B Consumer price index, 312
Contribution margin, 83–84
Bad debt, 238–239 Cost of capital, 25, 277
Bankruptcy, probability of, 181 Cost of debt capital, 164
Benefit cost ratio, 282 Cost of goods sold, 7
Beta, 70 Cost-of-goods-sold ratios, 96–98
Bonds, 298 Coupon rate, 298
Credit discounts, 240–241
327
Cross-elasticity, 272 Dividend return ratio, 47, 58
Current assets ratio, 182, 194, 195, 198–203 Dividends per common share, 47–48
Current debt ratios, 185, 186, 222 Dow Jones Industrial Average (DJIA), 313
Current liabilities, 183
Current period sales, 236–237 E
Current ratio, 175
Current yield, 298
Earnings growth rate, 51–52
Earnings per share, 46
D Earnings yield, 56
Economic Ordering Quantity (EOQ), 261
Days of credit in accounts receivable, 234
Economic value added (EVA), 26–27, 28
Days of finished product turnover, 256
Effective annual T-bill yield, 300
Days of inventory turnover, 254
Effective yield, 297
Days of operating expense payables, 216
Elasticity, price, of demand, 269
Days of purchases in accounts payable, 246
Elasticity ratios, 268
Days of purchases paid, 248
Elasticity, supply, 273
Days of raw material inventory, 260
Elasticity, unitary, 271
Days of sales in cash, 180
Equity, 165–173
Days of work in process inventory, 258
Equity financing, 26
Debt, 155–164
Equity interest rate, 25
Debt, bad, 238–239
Equity ratios, 133, 159, 166–169, 222–223
Debt expenses, 208
Equity, shareholder, 31, 145, 166
Debt expenses, times covered, 207
Equity to sales, 166
Debt ratios, 156–160, 162
Equity turnover, 169
Debt to market value of equity, 221
Expenses, 21
Debt turnover, 161
Demand elasticity, 269
Depreciation, book, 122 F
Depreciation expenses, 41, 123, 124–125
Desired operating income, 89–92 Federal funds rate, 302
Direct cost ratios, 111 Federal Reserve System, 302
Direct costs, 7 Financial leverage, 31, 225–226
Direct costs per production unit, 72 Financing cash flow, 40, 43
Direct labor, 72, 99 Finished goods, 255
Direct labor employee percentage, 106–107 Finished product inventory turnover, 255
Direct labor ratios, 99–105, 108 Fixed asset, 117, 121, 127
Direct operations expenses, 74, 96 Fixed asset age, 137
Direct overhead, 109 Fixed asset maintenance ratios, 118–119
Direct overhead cost ratios, 109 Fixed asset productivity, 151
Discount rate, 277, 291, 303 Fixed asset ratios, 128–135, 224
Discount rate, risk-adjusted, 281 Fixed asset reinvestment rate, 150
Discounted cash flow, 277 Fixed asset replacement costs, 152
Discounted future cash flow valuation, 321 Fixed asset turnover, 128, 136
Discounted future cash flows, 277 Fixed cost ratios, 80–82
Discounted payback period, 277 Fixed costs, 75, 78–79, 211–213
Dividend disbursements, 49 Funded capital, 224
Dividend growth rates, 53 Future value, 288
Dividend payout ratio, 47 Future value of an annuity, 289, 290
328
G J
General and administrative expenses, 114 Just-In-Time (JIT) inventory control method,
Goodwill, 140 261, 267
Gross domestic product (GDP), 309
Gross margin, 7
Gross margin ratio, 9–10
Gross national product (GNP), 310
L
Gross profit, 7–8
Gross profit ratio, 9–10
Leverage, 220–230
Growth rate of earnings, 51–52
Liquid assets ratios, 183–184, 198
Growth rate of revenues, 49–50
Liquidation value, 318
Liquidity ratios, 174–203
H Long-term asset additions, 217
Long-term debt, 134, 162, 163, 209, 210, 223
High risk assets, 153–154
Horizontal analysis, 3
M
Hours-worked ratios, 102–105
Market capitalization, 319
I Market price return, 65
Market price return ratio, 57
Income from operations, 11–12
Market value, 319
Index of coincident economic indicators, 307
Marketable securities, 199
Index of lagging economic indicators, 308
Maturity, yield to, 299
Index of leading economic indicators, 306
Modified internal rate of return (MIRR), 285
Indirect costs, 11
Mutually exclusive investment selection, 279
Indirect labor, 99
Individual intangible assets, 147
N
Individual intangible assets ratios, 147–149
Individual overhead expenses, 115–116
Net income, 19–20
Inelastic demand, 270
Net income-to-sales ratio, 21–22
Insurance cost ratios, 120–121
Net present value, 279–280
Intangible assets, 140
Net sales ratios, 23–24
Intangible assets ratios, 140–146
No-earnings-per-share dilution value, 322
Interest earned, times, 205
Nominal yield, 298
Interest expenses, 203, 205
Non-operational items, 15
Interest rate yield, 297
Notes receivable, 202
Interest rates, 295–304
Internal rate of return (IRR), 283–284
O
Inventory, 40, 201, 251–267
Inventory carrying cost, 262
Operating expenses outstanding, 216
Inventory ordering costs, 261
Operating expenses, times covered, 214
Inventory ratios, 252
Operating income, 157
Inventory reorder point, 265
Operating leverage, 227–228
Inventory turnover, 253
Operational expenses, 120, 214–215
Invested capital ratios, 171–173
Operations cash flow, 37, 40–41, 60, 68–69, 131,
Invested capital turnover, 170
206, 210
Investing cash flow, 40, 42
Operations cash flow dividend payout, 60–61, 64
Investment capital, 35
Operations cash flow dividend payout ratio, 64
329
Operations income ratio, 13–14 Raw materials inventory turnover, 259
Optimum inventory order quantity, 263 Replacement cost, 152
Overhead, 72, 110 Required equity dividend, 25
Overhead expenses, 115–116 Research and development (R&D) cost ratios,
Owner’s equity, 145, 224 112–113
Research and development (R&D) expenses, 112
P Residual income, 28–30
Retained earnings, 166, 173, 219
Par value, 298 Return on assets (ROA), 33–34, 35
Payback period, 275 Return on equity (ROE), 31–32, 35, 56, 169
Payback reciprocal, 276 Return on invested capital (ROIC), 35–36, 170
Perpetuity, 294 Revenues, 21
Plant equipment costs, 117 Revenues per share, 45
Preferred dividend payout ratio, 63, 64 Risk-adjusted discount rate, 281
Preferred dividend return ratio, 62 Rule of 72, 301
Preferred dividends, 46 Russel 2000 average, 314
Present value, 291
Present value of an annuity, 292, 293 S
Pretax profit, 15–16, 22
Pretax profit ratio, 17–18 Safety stock, 266
Price elasticity of demand, 269 Selling expenses, 114
Price-to-earnings ratio (P/E), 54, 56, 320 Selling, general, and administrative costs (SG&A)
Price-to-earnings-to-growth-rate ratio (PEG), 55 ratios, 114
Probability of bankruptcy, 181 Shareholder equity, 31, 145, 166
Producer price index (PPI), 311 Short-lived income, 38
Production unit ratios, 108 Short-lived sales, 39
Profitability index, 282 Short-term asset additions, 217
Projected sales volume estimate, 89 Short-term debt, 135, 163, 183
Simple interest, 296
Q Simple rate of return, 278
Solvency ratios, 204–219
Quick assets, 176 Supply elasticity, 273
Quick ratio, 176
R
Rate of return, 291
Ratio analysis, 5
Raw materials, 110
Raw materials cost ratios, 110
Raw materials inventory, 259
330
T V
331
About the
Author
Rich Gildersleeve, a registered professional mechanical engineer in Califor-
nia, is the director of engineering at dj Orthopedics, LLC in California. In
1997, he earned his MBA from San Diego State University. He also has a
master’s degree in mechanical engineering, which he earned while concur-
rently working as an engineer for General Dynamics Corporation. He
holds nine U.S. patents and has authored various technical articles.