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).