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# Ratios and formulas in customer financial analysis

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### Ratios and formulas in customer financial analysis

1. 1. Ratios and Formulas in Customer Financial AnalysisFinancial statement analysis is a judgmental process. One of the primary objectives isidentification of major changes in trends, and relationships and the investigation of thereasons underlying those changes. The judgment process can be improved byexperience and the use of analytical tools. Probably the most widely used financialanalysis technique is ratio analysis, the analysis of relationships between two or moreline items on the financial statement. Financial ratios are usually expressed inpercentage or times. Generally, financial ratios are calculated for the purpose ofevaluating aspects of a companys operations and fall into the following categories: liquidity ratios measure a firms ability to meet its current obligations. profitability ratios measure managements ability to control expenses and to earn a return on the resources committed to the business. leverage ratios measure the degree of protection of suppliers of long-term funds and can also aid in judging a firms ability to raise additional debt and its capacity to pay its liabilities on time. efficiency, activity or turnover ratios provide information about managements ability to control expenses and to earn a return on the resources committed to the business.A ratio can be computed from any pair of numbers. Given the large quantity ofvariables included in financial statements, a very long list of meaningful ratios can bederived. A standard list of ratios or standard computation of them does not exist. Thefollowing ratio presentation includes ratios that are most often used when evaluatingthe credit worthiness of a customer. Ratio analysis becomes a very personal orcompany driven procedure. Analysts are drawn to and use the ones they arecomfortable with and understand.Liquidity RatiosWorking CapitalWorking capital compares current assets to current liabilities, and serves as the liquidreserve available to satisfy contingencies and uncertainties. A high working capitalbalance is mandated if the entity is unable to borrow on short notice. The ratioindicates the short-term solvency of a business and in determining if a firm can pay itscurrent liabilities when due. Formula Current Assets - Current Liabilities
2. 2. Acid Test or Quick RatioA measurement of the liquidity position of the business. The quick ratio compares thecash plus cash equivalents and accounts receivable to the current liabilities. Theprimary difference between the current ratio and the quick ratio is the quick ratio doesnot include inventory and prepaid expenses in the calculation. Consequently, abusinesss quick ratio will be lower than its current ratio. It is a stringent test ofliquidity. Formula Cash + Marketable Securities + Accounts Receivable Current LiabilitiesCurrent RatioProvides an indication of the liquidity of the business by comparing the amount ofcurrent assets to current liabilities. A businesss current assets generally consist ofcash, marketable securities, accounts receivable, and inventories. Current liabilitiesinclude accounts payable, current maturities of long-term debt, accrued income taxes,and other accrued expenses that are due within one year. In general, businesses preferto have at least one dollar of current assets for every dollar of current liabilities.However, the normal current ratio fluctuates from industry to industry. A current ratiosignificantly higher than the industry average could indicate the existence ofredundant assets. Conversely, a current ratio significantly lower than the industryaverage could indicate a lack of liquidity. Formula Current Assets Current LiabilitiesCash RatioIndicates a conservative view of liquidity such as when a company has pledged itsreceivables and its inventory, or the analyst suspects severe liquidity problems withinventory and receivables. Formula Cash Equivalents + Marketable Securities Current LiabilitiesProfitability RatiosNet Profit Margin (Return on Sales)A measure of net income dollars generated by each dollar of sales.
3. 3. Formula Net Income * Net Sales* Refinements to the net income figure can make it more accurate than this ratiocomputation. They could include removal of equity earnings from investments, "otherincome" and "other expense" items as well as minority share of earnings andnonrecuring items.Return on AssetsMeasures the companys ability to utilize its assets to create profits. Formula Net Income * (Beginning + Ending Total Assets) / 2Operating Income MarginA measure of the operating income generated by each dollar of sales. Formula Operating Income Net SalesReturn on InvestmentMeasures the income earned on the invested capital. Formula Net Income * Long-term Liabilities + EquityReturn on EquityMeasures the income earned on the shareholders investment in the business. Formula Net Income * EquityDu Pont Return on AssetsA combination of financial ratios in a series to evaluate investment return. The benefitof the method is that it provides an understanding of how the company generates itsreturn.
4. 4. Formula Net Income * Sales Assets x x Sales Assets EquityGross Profit MarginIndicates the relationship between net sales revenue and the cost of goods sold. Thisratio should be compared with industry data as it may indicate insufficient volume andexcessive purchasing or labor costs. Formula Gross Profit Net SalesFinancial Leverage RatioTotal Debts to AssetsProvides information about the companys ability to absorb asset reductions arisingfrom losses without jeopardizing the interest of creditors. Formula Total Liabilities Total AssetsCapitalization RatioIndicates long-term debt usage. Formula Long-Term Debt Long-Term Debt + Owners EquityDebt to EquityIndicates how well creditors are protected in case of the companys insolvency. Formula Total Debt Total EquityInterest Coverage Ratio (Times Interest Earned)Indicates a companys capacity to meet interest payments. Uses EBIT (EarningsBefore Interest and Taxes) Formula
5. 5. EBIT Interest ExpenseLong-term Debt to Net Working CapitalProvides insight into the ability to pay long term debt from current assets after payingcurrent liabilities. Formula Long-term Debt Current Assets - Current LiabilitiesEfficiency RatiosCash TurnoverMeasures how effective a company is utilizing its cash. Formula Net Sales CashSales to Working Capital (Net Working Capital Turnover)Indicates the turnover in working capital per year. A low ratio indicates inefficiency,while a high level implies that the companys working capital is working too hard. Formula Net Sales Average Working CapitalTotal Asset TurnoverMeasures the activity of the assets and the ability of the business to generate salesthrough the use of the assets. Formula Net Sales Average Total AssetsFixed Asset TurnoverMeasures the capacity utilization and the quality of fixed assets. Formula Net Sales Net Fixed Assets
6. 6. Days Sales in ReceivablesIndicates the average time in days, that receivables are outstanding (DSO). It helpsdetermine if a change in receivables is due to a change in sales, or to another factorsuch as a change in selling terms. An analyst might compare the days sales inreceivables with the companys credit terms as an indication of how efficiently thecompany manages its receivables. Formula Gross Receivables Annual Net Sales / 365Accounts Receivable TurnoverIndicates the liquidity of the companys receivables. Formula Net Sales Average Gross ReceivablesAccounts Receivable Turnover in DaysIndicates the liquidity of the companys receivables in days. Formula Average Gross Receivables Annual Net Sales / 365Days Sales in InventoryIndicates the length of time that it will take to use up the inventory through sales. Formula Ending Inventory Cost of Goods Sold / 365Inventory TurnoverIndicates the liquidity of the inventory. Formula Cost of Goods Sold Average InventoryInventory Turnover in DaysIndicates the liquidity of the inventory in days.
7. 7. Formula Average Inventory Cost of Goods Sold / 365Operating CycleIndicates the time between the acquisition of inventory and the realization of cashfrom sales of inventory. For most companies the operating cycle is less than one year,but in some industries it is longer. Formula Accounts Receivable Turnover in Days + Inventory Turnover in DayDays Payables OutstandingIndicates how the firm handles obligations of its suppliers. Formula Ending Accounts Payable Purchases / 365Payables TurnoverIndicates the liquidity of the firms payables. Formula Purchases Average Accounts PayablePayables Turnover in DaysIndicates the liquidity of the firms payables in days. Formula Average Accounts Payable Purchases / 365Additional RatiosAltman Z-ScoreThe Z-score model is a quantitative model developed in 1968 by Edward Altman topredict bankruptcy (financial distress) of a business, using a blend of the traditionalfinancial ratios and a statistical method known as multiple discriminant analysis.
8. 8. The Z-score is known to be about 90% accurate in forecasting business failure oneyear into the future and about 80% accurate in forecasting it two years into the future. Formula Z = 1.2 x (Working Capital / Total Assets) +1.4 x (Retained Earnings / Total Assets) +0.6 x (Market Value of Equity / Book Value of Debt) +0.999 x (Sales / Total Assets) +3.3 x (EBIT / Total Assets) Z-score Probability of Failure less than 1.8 Very High greater than 1.81 but less than 2.99 Not Sure greater than 3.0 UnlikelyBad-Debt to Accounts Receivable RatioBad-debt to Accounts Receivable ratio measures expected uncollectibility on creditsales. An increase in bad debts is a negative sign, since it indicates greater realizationrisk in accounts receivable and possible future write-offs. Formula Bad Debts Accounts ReceivableBad-Debt to Sales RatioBad-debt ratios measure expected uncollectibility on credit sales. An increase in baddebts is a negative sign, since it indicates greater realization risk in accountsreceivable and possible future write-offs. Formula Bad Debts SalesBook Value per Common ShareBook value per common share is the net assets available to common stockholdersdivided by the shares outstanding, where net assets represent stockholders equity lesspreferred stock. Book value per share tells what each share is worth per the booksbased on historical cost. Formula
9. 9. (Total Stockholders Equity - Liquidation Value of Preferred Stocks - Preferred Dividends in Arrears) Common Shares OutstandingCommon Size AnalysisIn vertical analysis of financial statements, an item is used as a base value and allother accounts in the financial statement are compared to this base value.On the balance sheet, total assets equal 100% and each asset is stated as a percentageof total assets. Similarly, total liabilities and stockholders equity are assigned 100%,with a given liability or equity account stated as a percentage of total liabilities andstockholders equity.On the income statement, 100% is assigned to net sales, with all revenue and expenseaccounts then related to it.Cost of CreditThe cost of credit is the cost of not taking credit terms extended for a businesstransaction. Credit terms usually express the amount of the cash discount, the date ofits expiration, and the due date. A typical credit term is 2 / 10, net / 30. If payment ismade within 10 days, a 2 percent cash discount is allowed: otherwise, the entireamount is due in 30 days. The cost of not taking the cash discount can be substantial. Formula % Discount 360 x 100 - % Discount Credit Period - Discount PeriodExampleOn a \$1,000 invoice with terms of 2 /10 net 30, the customer can either pay at the endof the 10 day discount period or wait for the full 30 days and pay the full amount. Bywaiting the full 30 days, the customer effectively borrows the discounted amount for20 days. \$1,000 x (1 - .02) = \$980This gives the amount paid in interest as: \$1,000 - 980 = \$20This information can be used to compute the credit cost of borrowing this money. % Discount 360 x 100 - % Discount Credit Period - Discount Period = 2 x 360 = .3673
10. 10. 98 20As this example illustrates, the annual percentage cost of offering a 2/10, net/30 tradediscount is almost 37%.Current-Liability RatiosCurrent-liability ratios indicate the degree to which current debt payments will berequired within the year. Understanding a companys liability is critical, since if it isunable to meet current debt, a liquidity crisis looms. The following ratios arecompared to industry norms. Formulas Current to Non-current = Current Liabilities Non-current Liabilities Current to Total = Current Liabilities Total LiabilitiesRule of 72A rule of thumb method used to calculate the number of years it takes to double aninvestment. Formula 72 Rate of ReturnExamplePaul bought securities yielding an annual return of 9.25%. This investment willdouble in less than eight years because, 72 = 7.78 years 9.25Copyright 1999 Credit Research FoundationAll material on this site, CRFONLINE.COM, is created or provided by CREDIT RESEARCHFOUNDATION, including text, graphics, logos, icons, and images, are the property of CREDITRESEARCH FOUNDATION or its content providers, and are protected by United States and foreignintellectual property laws. The compilation of all the content on this Site is the exclusive property ofCREDIT RESEARCH FOUNDATION and is also protected by United States and foreign intellectualproperty laws. You may download, view, copy, and print the materials on this Site for personal use only,provided that you do not remove or alter any trademark, service mark, or logo, or any copyright or otherintellectual property notices. Except as provided above, you may not download, view, copy, print,reproduce, distribute, republish, display, post, transmit, or modify any material, or portion thereof, locatedon the Site in any form or by any means without the prior written consent of CREDIT RESEARCHFOUNDATION. CREDIT RESEARCH FOUNDATION reserves the right to revoke any of the rightsgranted in these Terms of Use at any time, and those rights automatically terminate if you violate any ofthese Terms of Use. Upon revocation or termination of such rights, you must destroy any digital or printed
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