Saturday, 25 January 2014

Financial Ratios and Bankruptcy Predictions

Financial Ratios
There are many financial ratios that can be calculated. Some are more useful than others. You should determine which ratios are the most important in your industry. 


Listed here are thirteen ratios that are most often used by financial analysts. 
Solvency Ratios: Quick Ratio, Current Ratio, Current Liabilities to Net Worth, Total Liabilities to Net Worth; Fixed Assets to Net Worth; Efficiency Ratios: Collection Period, Inventory Turnover, Assets to Sales, Sales to Net Working Capital, Accounts Payable to Sales; Profitability Ratios: Return on Sales, Return on Assets, Return on Equity.

The following is a more complete list of Ratios and synopsis of the information they provide. Commonly applied ratios used in financial analysis are defined below in seven groups for convenience. These groupings should not restrict their usage.

A. Solvency Ratios: Solvency, or liquidity, ratios are used to measure the financial soundness of a business and how well it can satisfy its obligations. They are designed to help measure the degree of financial risk that a business faces. "Financial risk," in this context, means the extent to which the business has debt obligations that must be met, regardless of the cash flow. These ratios are of particular interest to short term creditors.

1. Absolute Liquidity Ratio
This ratio shows how much of a firm’s current liabilities can be covered by its most liquid assets, cash and marketable securities. The liquidity ratio measures the extent to which a company or other entity can quickly liquidate assets and cover short-term liabilities, and therefore is of interest to short-term creditors. Also called cash asset ratio or cash ratio. Current liabilities are payable within one year.

Absolute Liquidity Ratio = (Cash + Marketable Securities) / Current Liabilities

2. Acid Test Ratio
The Acid Test, or Quick, Ratio differs from the Absolute Liquidity Ratio to the extent that net Accounts Receivable is considered. It is another way to determine whether a company can make their day-to-day payments.

Acid Test Ratio = Quick Ratio = (Cash + Marketable Securities + Accounts Receivable (net)) / Current Liabilities

3. Current Ratio
This is also called the working capital ratio. Current or trading assets include items that can be converted to cash within one year of normal operations. They include cash, marketable securities, accounts receivable, as considered in the acid test ratio, while adding the value of inventory. Although short term creditors may feel more comfortable when the debtor firm has a high current ratio in comparison to its competitors, too high of a current ratio may signify inefficiency, since too much may be tied up in non productive assets. Generally, any value of less than 1 to 1 suggests an over-reliance on inventory or other current assets to pay off short-term debt. Higher ratios indicate a better buffer between current obligations and a firm's ability to pay them. The quality of current assets is a critical factor in interpreting this analysis.

Current Ratio = Current Assets / Current Liabilities

4. Accounts Payable to Sales Ratio
This ratio measures how a firm pays its creditors in relation to its sales volume - the speed with which a company pays vendors relative to sales. A low percentage is usually considered healthy. Numbers higher than typical industry ratios suggest that the company is using suppliers to float operations.

Accounts Payable to Sales Ratio = Accounts Payable / Net Sales

5. Accounts Receivable Turnover Ratio
This ratio measures a firm's efficiency in freeing up working capital by providing the rate at which working capital tied up in receivables is converted to cash. The higher the turnover, or number of times in a given period that receivables are turned into cash, the more liquid are the firm's receivables. For industry wide comparison, Net Sales is often used. Some prefer to use Total Credit Sales. Net Sales is the total of the invoices billed during a given period, less any discounts and returns. Average Accounts Receivable is the average of the beginning and ending balances for a given period.

Receivables Turnover = Total Credit Sales / Average Receivables Owing

6. Assets to Sales Ratio
This ratio measures the percentage of investment in assets that is required to generate the current annual sales level. A high percentage may indicate that the firm is not being aggressive enough in its marketing effort, or it is not fully employing its assets. A low percentage may indicate that the firm is selling more than can be safely covered by its as sets.

Assets to Sales Ratio = Total Assets/ Net Sales

7. Average Collection Period
This ratio provides the average period required to collect receivables. It provides an indication of the quality of a firm’s receivables and serves as a measure of the efficiency of its credit department in granting credit and collecting payment. The ratio may be compared to both the firm's credit terms and the industry average to measure effectiveness. If credit transactions vary, such as a retailer selling both on open credit and instalment, this ratio should be calculated for each category. Discounted notes, which create contingent liabilities, must be added back into receivables.

Average Collection Period = 365 (Accounts + Notes Receivable) / Annual Net Credit Sales


8. Collection Index
The collection index provides insight similar to that of the average collection period.

Collection Index = Collections Made During Period / Accounts Receivable Owing at Start of Period

9. Past Due Index
This index can be useful in trend analysis to indicate whether there is improvement or deterioration in collection policies and procedures.

Past Due Index = Total Amount Past Due / Total Sum Uncollected

10. Bad Debt Loss Index
This index may be calculated on either credit sales or total net sales. An increase in this index is not necessarily bad, if a more relaxed credit policy results in more sales and profit than losses.

Bad Debt Loss Index (BDLI) = Bad Debt Losses / Total Credit Sales

11. Basic Defence Interval
This provides the period of time a firm can cover its cash expenses without additional financing should all revenues cease.

Basic Defence Interval (SDI) = 365 (Cash + Receivables + Marketable Securities) / (Operating Expenses + Interest + Income Taxes)

12. Inventory Turnover Ratio
This ratio provides an indication of the liquidity of inventories. A low ratio may indicate that too much cash has been invested in inventory.

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

13. Net Sales to Inventory Ratio
An annual increase in this ratio is often considered healthy, while a decline may indicate problems. A low ratio may indicate obsolete inventory, over commitment of investment in inventory, poor purchasing policies, or contingency stockpiling.

Sales to Inventory Ratio = Net Sales / Inventory

B. Working Capital Ratios:
Gross working capital describes current assets, while net working capital is current assets minus current liabilities. Inadequate working capital can be corrected by lowering sales or increasing assets by retaining earnings or selling stock.

1. Cash Available to Finance Operations Ratio
This ratio roughly indicates whether there is sufficient cash to finance current operations. It is similar to the basic defence ratio, except the depreciation is omitted from the denominator, since it is not a cash drain.

Cash Available to Finance Operations Ratio = 365 (Cash + Receivables + Marketable Securities) / (Operating Expenses - Depreciation +Interest +Income Taxes)

2. Current Asset Turnover Ratio
This ratio is useful in identifying trends in the turnover and profitability of current assets. The ratio is slightly less accurate, if depreciation is included.

Current Asset Turnover Ratio = (Cost of Good~ Sold + Expenses + Interest + Taxes - Depreciation) / Average Current Assets

3. Current Liabilities to Net Worth Ratio
This ratio measures the proportion of funds current creditors contribute to operations, or the amounts due creditors within a year as a percentage of the shareholders’ investment. An increasing ratio indicates decreasing security for creditors.

Current Liabilities to Net Worth Ratio = Current Liabilities / Tangible Net Worth

4. Current Liabilities to Inventory Ratio
This measures the extent to which a firm relies on sales to generate funds to pay current liabilities.

Current Debt-to-Inventory = Current Liabilities / Inventory

5. Working Capital Ratio 
This is another name for the current ratio, a liquidity ratio. If the ratio is less than one then there is negative working capital. A high working capital ratio is not always a good thing, it could indicate that there is too much inventory or there is not enough investment of excess cash.

Working Capital Ratio= Current Assets / Current Liabilities 

6. Long Term Liabilities to Working Capital Ratio
Normally this ratio should not exceed 100%

Long Term Liabilities to working Capital Ratio = Long Term Debt / Net Working Capital

7. Inventory to Net Working Capital Ratio
Overstocking can lead to bankruptcy. Normally this ratio should not exceed 80%, but should be compared with the industry average. This ratio is often used in conjunction with the inventory turnover ratio.

Inventory to Net Working Capital = Inventory / Net Working Capital

8. Working Capital Turnover Ratio
This ratio indicates whether a firm is over invested in fixed, or slow, assets. It should be compared with the industry average. It complements the sales to net working capital ratio.

Working Capital Turnover = Net Sales / Net Working Capital

9. Sales to Net Working Capital Ratio
This measures the number of times working capital is turned over annually in relation to net sales. A high turnover rate may indicate excessive sales volume in relation to the investment in the business, or extensive reliance on credit. This ratio should be used in conjunction with the working capital turnover ratio.

Sales to Net Working Capital Ratio = Sales / Net Working Capital

C. Leverage Ratios:
These ratios indicate proportionate risk to a firm's owners and creditors. Leverage can increase both earning and losses.

1. Debt and Preferred Ratio
This ratio measures the extent of financing contributed by creditors and preferred owners.

Debt and Preferred Ratio= (Long Term Debt + Preferred Funds) / Total Capital Employed

2. Debt Ratio
This ratio measures the percentage of total funds supplied by creditors. Creditors normally prefer a lower ratio, but management may use leverage to produce a higher ratio.

Debt Ratio = (Current + Long Term Debt) / Total Assets

3. Debt to Equity Ratio
This ratio provides the relative positions of creditors and owners.

Debt to Equity Ratio = (Long Term Debt + Preferred) / Common Stockholders' Equity

4. Equity Ratio
This ratio shows the share of the firm's capital provided by equity holders.

Equity Ratio = Common Shareholders' Equity / Total Capital Employed


D. Coverage Ratios: 
These ratios measure the protection offered creditors and a firms ability to attract new shareholders and arrange its debt advantageously.

1. Cash Flow to Liabilities Ratio 
This ratio is used to compare statements with a firm, rather than industry, because of varying depreciation practices. Ideally, liquidity would increase as due dates for debt maturity approach.

Cash Flow to Liabilities Ratio = (Net Income + Depreciation) / Total Liabilities

2. Current Assets to Total Liabilities Ratio
This ratio measures protection for both short and long term liabilities. A ratio in excess of 1OO% indicates that long term creditors may be paid out of working capital if the firm is liquidated.

Current Assets to Total Liabilities Ratio = Current Assets / (Current + Long Term Debt)

3. Dividend Payout Ratio
This ratio is the percentage of earnings received by shareholders during each period.

Payout Ratio = Dividends per Share / Earnings per Share

4. Fixed Assets to Net Worth Ratio
Disproportionate investment in illiquid fixed assets decreases the amount of funds available for daily operations and can leave a firm vulnerable to unexpected hazards and adverse changes in the business climate.

Fixed Assets to Net Worth Ratio = (Fixed Assets (net) - Intangibles) / Tangible Net Worth

5. Shareholder's Equity Ratio
A low ratio of equity to assets may precede difficulty in meeting interest charges and debt obligations.

Equity Ratio = Shareholders' Equity / Total Assets

6. Tangible Net Worth to Total Debt Ratio
This ratio measures the proportion between the shareholders' capital and that contributed by creditors. It is the inverse of the debt ratio.

Tangible Net Worth to Total Debt Ratio = Tangible Net Worth / Total Debt

7. Times Interest Earned Ratio
The margin between income and interest payments is considered a good indication of a firm's ability to meet interest payments.

Times Interest Earned Ratio = Earnings Before Interest and Taxes / Interest Expense

8. Total Liabilities to Net Worth
This ratio relates debt to equity. The higher this ratio, the less protection for creditors. Intangible assets, such as good will or capitalized research and development, should be excluded from net worth.

Total Liabilities to Net Worth Ratio = (Current + Deferred Debt) / Tangible Net Worth


E. Profitability Ratios:
These ratios provide the answer to management's overall effectiveness ranked by returns generated on sales and investments.

Gross profit is the difference between net sales and the cost of goods sold, which is the sum of the expenses required to manufacture, purchase, or service customers.

Net profit after taxes is the basic measure of a firm's operating success. It is gross profit less all expenses directly applicable to the firm’s operations, including income taxes. Any surplus (profit) can be added to retained earnings or distributed to shareholders as dividends. When expenses exceed net sales and a loss occurs, this loss is charged against net worth as a reduction to the equity account.

1. Capital Turn Over Ratio
This ratio indicates whether investment is adequately proportionate to sales and whether a potential credit problem or management problem exists. A high ratio may indicate over trading or under capitalization, while a low ratio may indicate over-capitalization.

Gross Tangible Fixed Assets – Land Ratio = Net Sales / Tangible Net Worth

2. Earnings per Share
It should be noted that all significant aspects of a firm's performance cannot be reduced to a single figure as represented by this highly publicized financial ratio.

Earnings Per Share (EPS) = (Earnings After Taxes - Preferred Dividends) / Average Number of Common Shares Outstanding

3. Earning Power
Earning power is increased by heavier trading on assets, by decreasing cost to lower the break even point, or by increasing sales faster than the accompanying rise in costs. Usually, sales is the key.

Earning Power = Net Sales / Tangible Assets x Earnings After Taxes / Net Sales

4. Gross Profit on Net Sales Ratio
This ratio provides the average mark up, or margin, on goods sold. It can help identify trends in a firm's credit policy, mark-ups, purchasing, and general merchandising. It may vary widely among firms in the same industry, according to sales, location, size, and competition.

Gross Margin Ratio = Gross Margin / Net Sales

Gross Profit Rate = (Net Sales - Cost of Goods Sold) / Net Sales

5. Management Rate of Return
This rate quantifies the efficient use of assets compared with a target rate of return.

Rate of Return = Operating Income / ( Fixed Assets + Net Working Capital)

6. Maintenance and Repairs to Net Sales Ratio
This is an example of an expense ratio by an expenditure category that might be important in a particular industry.

Sum Spent on Repairs per Dollar of Sales = Maintenance and Repair Costs / Net Sales

7. Net Operating Profit Ratio
When there are significant financial charges, this ratio is preferable to the return on assets ratio. Net profit to net worth is influenced by the method of financing.

Net Operating Profit Ratio = Earnings Before Interest and Taxes / Tangible Net Worth

8. Net Profit to Tangible Net Worth
This ratio measures management's ability to realize an adequate return on the capital invested. It is often compared with an industry average.

Net Profit Rate = Earnings After Taxes / Tangible Net Worth

9. Net Profits to Net Working Capital
Working capital provides the cushion to carry inventories and receivables and finance ordinary business operations.

Net Profits to Net Working Capital = Earnings After Taxes / Net Working Capital

10. Operating Expenses Ratio
This ratio shows management's ability to adjust expense items to changing sales. Trend analysis identifies any problem category. The higher this ratio the more sales are being absorbed by expenses. Total operating expenses include cost of goods sold, selling, administrative, and general expenses.

Operating Expenses Ratio = Total Operating Expenses / Net Sales

11. Operating Ratio
This ratio measures the profitability of normal business operations. It excludes other revenue, or loses, extraordinary items, interest on long term debt, and income taxes. It is usually compared with industry averages.

Operating Ratio = Operating Income / Net Sales

12. Price Earnings Ratio
This ratio is used to compare alternate investment opportunities. It may be interpreted as the value placed on a particular firm's earnings.

Price Earnings Ratio = Market Price Per Share of Common Stock / Earnings Per Share

13. Rate of Return on Common Shareholders' Equity
This ratio is based on book value and is used for comparison with similar firms within the same industry.

Rate of Return = (Earnings After Taxes - Preferred Stock Dividends) / (Tangible Net Worth - Par Value of Preferred Stock)

14. Rate of Return on Total Assets
This measures management's ability to earn a return on the firm's assets without regard to variations in the method of financing.

Rate of Return on Total Assets = (Earnings After Taxes + Interest Expense) / Average Total Assets during the Year

15. Return on Sales
This rate is usually compared with the industry average. The higher the rate, the better the firm is able to survive a downturn. If the rate is low, a high turnover of inventory is required to obtain an adequate return on investment. Normally this rate is fairly constant over time.

Net Profit Rate = Earnings After Taxes / Net Sales

16. Turnover of Total Operating Assets Ratio
This ratio tracks over investment in operating assets. Trend analysis indicates direction of any change.

Turnover of Total Operating Assets = Net Sales / Total Operating Assets

BANKRUPTCY PREDICTION

Financial Jeopardy and the Use of the "Z-Score"

The failure prediction model provides a means to assess a firm's financial health in terms of the probability of future bankruptcy. This model employs a multiple discriminant analysis of five significant financial ratios to calculate an overall "Z- Score."

Z-Score =1/2a + 1.4b +3.3c + 0.6d +1.0e,

where:

a = Working Capital to Total Assets = Net Working Capital

This ratio measures net liquid assets relative to total capitalization. Consistent operating losses will cause shrinking current assets relative to total assets.

b = Retained Earnings to Total Assets = Retained Earnings / Total Assets

This ratio measures a firm's success in using its total asset base to generate earnings. However, manipulated retain earnings data can distort the numerical results.

c = EBIT to Total Assets = EBIT / Total Assets

The earnings before interest and taxes (EBIT) to total assets ratio, or the rate of return on assets, measures the productivity of a firm's assets. Maximizing this rate is not the same as maximizing the rate of return on equity, since different degrees of leverage can affect conclusions.

d = Equity to Debt = (Market Value of Common + Preferred Stock) / (Total Current Debt + Long Term Debt)

This ratio shows the amount a firm's assets can decline in value before liabilities exceed assets and the firm becomes insolvent.

e = Sales to Total Assets = Total Sales / Total Assets

This ratio is a measure of the firm's ability to generate sales.

The "Z-Score" is a test to determine whether additional analysis is required, not an end in itself. It is best to plot the "Z-Score" over time and compare it with averages for the industry. A firm may have had a constantly low "Z-Score" for years and still have performed satisfactorily.

Z- Score Interpretation

Professor Altman's data indicates that:

Z Score Prediction

3.00 or more Little chance of bankruptcy

1.81 to 2.99 Some chance of bankruptcy

1.80 or less Large chance of bankruptcy

It is noted that variants to Professor Altman's "Z-Score" formula have been calculated for a number of industries. The analyst should examine the databases used to develop these models before placing too much reliance on them.
Source: http://guidebook.dcma.mil