Corporate Finance

Balance Sheet Ratios (Liquidity)
Current Ratio
Current assets / Current liabilities
Note: Should be above 1; company needs to be able to pay its short-term bills.
Quick Ratio
(Cash + Short term investments + Receivables) / Current liabilities
Note: Should be above 1, or at least close to 1 for the same reason as above.
Cash Ratio
(Cash + Short term investments) / Current liabilities
Note: Desirable cash ratio depends on how liquid the receivables are. (More on this later.)

Balance Sheet Ratios (Solvency / Leverage)

Definitions
Debt
Short-term debt + Long-term debt
Market Value of Equity
Market Capitalization = Share Price * Shares Outstanding
Market Value of Assets
Market value of equity + Total liabilities
Leverage Ratios

Debt / Assets
Note: Ignores other liabilities such as pensions.
Note: May underestimate leverage for some companies.
Note: This is a common metric in the literature, but Heitor dislikes it for the reasons stated above.
Debt / (Debt + Equity)
Note: Considers only financial liabilities.
Note: Use Market Value of Equity, not Book Value of Equity.
Liabilities / Assets
Note: Use Market Value of Assets, not Book Value of Assets.
Interpreting Leverage Ratios
Leverage > 1 means that the company is effectively bankrupt. The debt-holders hold more debt than the company is worth.
Average leverage ratio of US companies is between 25% and 30%.
Optimal leverage ratio will be discussed later in course.
Income Statement Ratios (Profitability)

Definition
Operating Profits After Taxes
OPAT = Operating income – Taxes
Profitability Ratios
Asset Turnover (Revenues-to-Assets)
Revenues / Assets
Note: Use Book value of Assets, not Market value of Assets.
Net Profit Margin
OPAT / Revenues
Return on Assets
ROA = OPAT / Assets
Note: Use Book value of Assets, not Market value of Assets.
Return on Equity
ROE = Net income / Equity
Note: Use Book value of Equity, not Market value of Equity.
Note: Net income in numerator can be manipulated with one-time accounting tricks.
Note: Book Equity is frequently negative so ROE cannot be determined.
Note: This is another of those ratios Heitor doesn’t care for.
Earnings Per Share
EPS = Net income / Shares outstanding
Note: Net income in numerator can be manipulated with one-time accounting tricks.
Note: Shares outstanding can also be manipulated (e.g. stock split).
Note: Not a favored ratio of Heitor’s.

Cash Flow Statement Ratios

Cash Profitability Ratio
CFOA = Operating cash flow / Assets
Note: Similar to ROA, but uses operating cash flows.
Note: Use Book value of Assets, not Market value of Assets.
Valuation Ratios
Note: These ratios essentially reduce to “future value / today’s value,”

Definitions
Market Value of Assets
Market value of equity + Total liabilities
Operating Profits After Taxes
OPAT = Operating income – Taxes
Market-Book Ratios
Market-Book Ratio (Assets)
Market value assets / Book value assets
Note: This is Heitor’s preferred Market-Book Ratio due to the undefined problem when using equity.
Market-Book Ratio (Equity)
Market value equity / Book value equity
Note: Because book equity can be negative, this ratio can be undefined.

Value over Profit Ratios

Value-OPAT Ratio
Market value assets / OPAT
Note: This is Heitor’s preferred Value over Profits Ratio because her prefers OPAT to Net income.
Price-Earnings Ratio
PE ratio = Market value of equity / Net income
Note: Similar to ROE, Net income in numerator can be manipulated with one-time accounting tricks.

Working Capital Ratios

Definitions
Net Work Capital
Receivables + Inventory – Payables
Note: An increase in net working capital is an investment in the business that ties up cash.

Daily Revenue
Annual Revenue / 365

Operating Cost
COGS + SG&A

Daily Operating Cost
Operating Cost / 365

Cash Conversion Cycle
Collection Period + Days in Inventory – Payable Period
Note: This is a measure of how much time it takes for a company to generate cash from its working capital investments.
Collection Period Ratio
Average Collection Period (in days)
Receivables / Daily Revenue
Other Working Capital Ratios
Average Days in Inventory
Inventory / Daily Operating Cost
Average Payable Period (in days)
Accounts Payable / Daily Operating Cost

Present Value Formulas

Definitions
Internal Rate of Return (IRR)
The rate of return of an investment is the discount rate that makes the net present value (NPV) of an investment equal to zero.
Present Value of a Single Future Payment

PV= C_t/〖(1+r)〗^t

PV = Present Value
Ct = Future Payment in Future Dollars
r = discount rate per period
t = number of periods
Present Value of a Perpetuity (infinite stream of payments)

PV= C/(r-g)

PV = Present Value
C = Initial Payment in first period
r = discount rate per period
g = growth rate per period

Incorporating Risk and Measuring Performance

Definitions
Operating Profits After Taxes
OPAT = Operating income – Taxes
Operating Assets
Operating Assets = Book value assets – Cash
Weighted Average Cost of Capital

WACC= r_D×(1-T)×D/V + r_E×E/V

r_D = required return on debt
T = corporate tax rate
D = total debt
r_E = required return on equity
E = market value of equity
V=D+E = company value
Economic Value Added
EVA = OPAT – (WACC x Operating Assets)
Note: EVA measures whether a firm is generating real economic profits after accounting for the required return on capital (WACC).