CATEGORIES OF RATIOS
When we look at companies and their ratios, there are six broad categories of metrics. These six apply to all types of companies, but within each category, there will be measures that are more important for some industries and less so—even disregarded— for others:
- Size
- Liquidity
- Efficiency
- Profitability
- Leverage
- Coverage
EBIT, or earnings before interest and taxes, is an important number in the income statement because it represents the company’s ability to generate operating earnings before interest expense (a cost related to financing decisions, not operating decisions) and taxes (a cost related to running a business in a regulated
economy). This is also called operating profit or operating income.
EBITDA is earnings before interest, taxes, depreciation, and amortization of intangibles. EBITDA is useful for comparing companies within and across industries, because it does not include the effects of many of the factors that differentiate companies in different sectors, such as interest (from different financing profiles), depreciation (from different fixed asset bases), amortization (from different holdings of intangibles), and taxes
(from different tax treatments). Because depreciation and amortization of intangibles are noncash expenses, EBITDA shows the amount of cash a company can generate from its operations. This is the source of cash for any interest payments, so this is a measure that a company’s creditors would examine very closely. Net debt is total debt minus cash and cash equivalents. Cash equivalents are accounts such as short-term investments or marketable securities, which can be easily turned into cash.
Net debt represents the net debt load that a company has to bear after using its cash and cash equivalents. Companies with a large cash position relative to their total debt will have a negative net debt.
For Size
All things being equal, the larger the company as shown by the
measures that follow, the sounder it is.
- Revenues
- Total assets
- Total shareholders’ equity
These measures give an indication of how much of a company’s cash is invested in its current assets. However, they also show how well current assets can cover current liabilities if the company had to liquidate them into cash.
- Working capital
- Operating working capital
- The current ratio, or current assets/current liabilities
- The quick ratio, or (current assets inventory)/current liabilities
Operating working capital (OWC) is a nonstandard term that means current assets without cash minus current liabilities without short-term debt (which includes any current portion of long-term debt).
This measure looks at how much of its cash a company uses in maintaining its day-to-day operations. The higher the operating working capital, the less liquid a company is, because its cash is
tied up in accounts such as accounts receivables and inventory. The current ratio is current assets divided by current liabilities. The ratio measures the multiple by which a company can use its current assets (if it could convert them all to cash) to cover all its current liabilities.
The quick ratio is similar to the current ratio but is a more severe ratio (the ratio will be a lower number than the current ratio) in that it takes inventory out of the numerator. Inventory is very illiquid and usually cannot be turned into cash at a moment’s notice, at least without resorting to deep discounts and ‘‘fire sale’’ prices.
In regard to the last two ratios, both ratios are only indications since they do not include information about when the current liabilities are due. A company that can stretch its accounts payable over a longer period will have a better ability to pay its other bills than a second company with the same ratios but with a shorter payables payment period. These ratios are also more popular in credit analysis than in mergers and acquisitions (M&A) work.
For Efficiency
The ratios that follow indicate how well or efficiently a company makes use of its assets to generate sales. The first five look at the amount of balance sheet accounts that are tied up in the creation of earnings. The last two look at how well the company’s assets are utilized for sales.
- Accounts receivable/sales * 365
- Inventory/cost of goods sold * 365
- Accounts payable/cost of goods sold * 365
- [(Current assets - cash) - (current liabilities - short-term debt)]/sales or Operating working capital/sales
- Change in OWC and Change in OWC/sales
- Sales/net fixed assets
- Sales/total assets
Accounts receivable/sales * 365 shows how many days it takes a company to collect on its receivables. The higher the number of days, the worse its receivables management. If the company has made a sale but has not collected the money from it, it is literally extending an interest-free ‘‘loan’’ to that customer, tying up the cash that could be put to productive use elsewhere. Without the * 365, the ratio shows the fraction of the year’s sales that is still tied up in receivables. By multiplying the number of days in a year into the fraction, we get not a fraction, but the number of days that represents how long the average receivable
remains uncollected. Thus, the result is usually called ‘‘receivable days.’’ (You can use 360 as the number of days, but if you do so, you should use the same number whenever you are calculating portions of years elsewhere in the model.)
Receivable days that have been increasing reflect declining sales and/or a poorly managed collection system. A similar ratio to this is sales/accounts receivable, reversing the numerator and the denominator. This is a turnover ratio, and it describes how many times receivables turn over in the year (i.e., how many cycles of receivables are fully collected in the year). The higher the ratio, the better, since it would reflect a
faster receivables collection system.
Inventory/Cost of Goods Sold * 365
Inventory/cost of goods sold * 365 shows how many days it takes a company to make use of a piece of inventory. The higher the number of days, the worse it is. Like the receivable days ratio, an ‘‘inventory days’’ ratio shows how long a company’s cash is tied up in its inventory before that inventory is put into a product and sold. A high inventory days number suggests slowing sales and/or an inefficient production system.
Sales is sometimes used as the denominator and can show the same trend. However, if there are changes in the gross margin (i.e., in the relationship between sales and cost of goods
sold), then the trend shown by the ratio using sales will be different from that using cost of goods sold.
Cost of goods sold/inventory is a ratio using the same numbers but in reversed positions, and without the 365 multiplier. This is a turnover ratio; it shows the number of times that inventory is turned over during the year. Think of this as the number of times that the inventory in the warehouse is completely changed during the year.
Accounts Payable/Cost of Goods Sold * 365
Accounts payable/cost of goods sold * 365 shows how many days its takes a company to pay its suppliers. The higher the number of ‘‘payable days,’’ the more favorable it is for the company.
Not paying a supplier means that the company is able to get an interest-free ‘‘loan’’ from its supplier. (This is a receivables collection issue from the supplier’s point of view.)
The denominator is cost of goods sold, and not sales, because the unpaid bills usually relate to purchases of inventory. In production, inventory is used up and that use is recognized as cost of goods sold.
A low payable days number means that the company has an efficient payment system, which is well and good in itself. A higher number can mean that the company has a strong enough buying power to delay its payments and still not have its suppliers abandon it. Beyond a certain limit, and this is a judgment call, a high number can mean the deterioration of its cash position, and therefore its ability to pay its bills.
Cost of goods sold/accounts payable is the payable turnover ratio. It shows how many times in the year that the company has completely repaid its suppliers.
[(Current Assets - Cash) - (Current Liabilities - Short-Term Debt)]/Sales
[(Current assets - cash) - (current liabilities - short-term debt)]/ sales, or Operating working capital/sales, is an interesting ratio and bears some attention. The numerator is almost like working capital, but not quite. This is why I am using the term operating working capital, or OWC.
For highlighting the operating decisions of a company, working capital (or, current assets minus current liabilities) has a flaw. Because it includes cash and cash equivalents and also short-term debt—both of which are related to financing decisions— working capital gives an unclear measure of the purely operating current investments a company has to make in its balance sheet. This is understandable as the original intent of working capital is to show the cushion that it has for meeting its current obligations.
For this reason, it is useful to look at current assets without cash and cash equivalents minus current liabilities without any sort of short-term debt. This will show only the company’s operational investments, separate from financing effects.
Thus the ratio OWC/sales is a measure of how much each dollar of sales is tied up in the current accounts of a company’s balance sheet. OWC management is critical to a company’s success, especially during periods of high growth.
Companies often fail during this growth spurt because their OWC goes out of control. They run out of cash as new buildups of receivables and inventory from the increased sales—combined with additional capital expenditures for expansion—lead to a depletion of their cash holdings, even if they manage to delay
their payments to suppliers. Change in OWC from one accounting period to the next as a dollar number, and change in OWC/sales in percentage are important corollary measures of operating working capital. The
dollar number is the ongoing amount that the company has to invest in its current accounts to sustain its operations. The higher the number, the more cash a company has to find and use. The ratio of the change over sales gives an indication of how well a company continues to manage these required investments as a percentage of its revenue stream. A trend of increasing percentages is a cautionary one as they reflect buildups of OWC that proportionately take up more cash than what sales bring in.
Sales/Net Fixed Assets
Sales/net fixed assets measures sales as a percentage of the net fixed assets (i.e., gross fixed assets less accumulated depreciation). The higher the ratio, the more productively a company is making use of its fixed assets. This ratio is called the fixed asset turnover ratio. Another name for it is the asset intensity ratio. In general, industrial companies have lower ratios than service companies.
Sales/Total Assets
Sales/total assets measures sales as a percentage of the total assets of the company. This is the asset turnover ratio. The higher the ratio, the more productive the company. Comparing this ratio across companies in different industries is not particularly useful, as different industries can have vastly different average levels.
For Profitability
- Gross margin, or gross profit/revenues
- EBIT margin, or EBIT/revenue
- EBITDA margin, or EBITDA/revenue
- Net margin, or net income/revenue
- Sales/(accounts receivableþinventoryþnet fixed assets)
- EBIT/total invested capital
- Return on average common equity
- Return on average assets
The final four items listed above look at earnings relative to the balance sheet for a more complete picture and show how the earnings are relative to the investments that have been made to support those earnings. They define profitability in terms of returns on investment and compare earnings to different groups of balance sheet accounts. If revenues are small compared to the amount of assets on the balance sheet, this would indicate the company is making an unproductive use of its assets.
Gross Margin
The gross margin shows how much as a percentage of sales the company can make after paying for the raw materials that go into sales. The raw materials expense is seen as a cost of goods sold.
EBIT Margin
The EBIT margin is the percentage of sales that the company can make after paying other operating expenses such as SG&A (sales, general, and administrative expenses). This is also called operating margin.
EBITDA Margin
The EBITDA margin is the percentage of sales that the company can make on the EBITDA basis, with the noncash depreciation and amortization expenses added to the EBIT measure.
Net Margin
The net margin is the percentage of sales that the company clears after payments of taxes. Sales/(Accounts Receivables + Inventory + Net Fixed Assets)
This ratio shows the relationship between sales and the operating and investment assets. (Receivables, inventory, and net fixed assets are often called the core assets.) Accounts receivable is an operating investment, essentially the amount of cash ‘‘invested’’ in customers who have not paid for their purchases. Likewise, inventory represents the ‘‘investment’’ in the amount of goods already purchased and kept in storage ready for production.
Net fixed assets are the capital equipment required to produce the company’s products, net of depreciation. Return on Average Common Equity The return on average common equity, sometimes just called return on equity (ROE), is based on the average of the starting and ending common equity for the year. (The starting common equity is equivalent to the ending number for the prior year.) This is because the earnings accrue over the year, so the return should be calculated over the common equity level that holds over the same period. The average of the beginning and ending numbers is the best proxy for this.
Return on Average Assets
Likewise, the return on average assets, sometimes just called return on assets (ROA), uses the same approach of using an average for the denominator.
For Leverage
The following ratios measure leverage, or the amount of debt that the company has relative to investments or to its earnings flow. In either case, the higher the ratio, the higher the leverage and the higher the chances for default.
Cash is the measure of things for repaying debt, which is why EBITDA is the preferred number for leverage ratios.
- Total debt/shareholders’ equity
- Net debt/shareholders’ equity
- Total debt/total invested capital
- Bank debt/EBITDA
- Senior debt/EBITDA
- Total debt/EBITDA
- Net debt/EBITDA
Total debt/shareholders’ equity shows the ratio of debt to equity. A high ratio, within limits, is not necessarily bad. You would have to look at it in the context of the company’s ability to generate cash flow to cover its debt service (interest payments and principal repayments).
Net Debt/Shareholders’ Equity
Net debt/shareholders’ equity is a ratio similar to total debt/ shareholders’ equity. Net debt is total debt minus cash and cash equivalents. Cash equivalents are accounts such as short-term investments or marketable securities that can be turned easily into cash. Net debt shows the debt load of a company as if it has used its available cash to repay some of its debt. Companies with a large cash position relative to their total
debt will have a negative net debt.
Total Debt/Total Invested Capital
The denominator is total invested capital—the combination of shareholders’ equity, total debt, and minority interests.
Bank Debt/EBITDA; Senior Debt/EBITDA;
Total Debt/EBITDA; Net Debt/EBITDA
These ratios with debt measures in the numerator and EBITDA in the denominator show the size of each debt measure relative to the cash operating earnings of the company. In an annual model, the EBITDA will be the annual earnings, so each ratio is a way of expressing that the debt is equivalent to so many
years’ earnings. If you start building models that have non-annual periods—for example, if each column contains quarterly data— these ratios will not be useful unless the quarterly EBITDA numbers
are annualized. For quarterly EBITDA numbers, the easy way is simply to multiply them by 4.
For Coverage
Coverage refers to the ability of the company’s cash flows to
cover its interest expense or debt obligations.
- Times interest earned: EBIT/interest expense
- EBITDA/cash interest expense
- (EBITDA - capital expenditures)/cash interest expense
- Fixed charge coverage
- Cash fixed charge coverage
- Operating cash flow/total debt
- Operating cash flow/net debt
- Operating cash flow/average total liabilities
Times interest earned (TIE) is a ratio that compares the company’s EBIT to its interest expense. This ratio is important to the lending decisions made by banks. If a company has a TIE of 3.0x, this means that its EBIT is enough to pay its interest expense three times over. Put another way, EBIT has to shrink more than twothirds
before it defaults, or cannot pay its interest payments.
Lending banks want to see a high ratio because it means there is less likelihood that a loan to the company will become a ‘‘nonperforming’’ loan.
EBITDA/Cash Interest Expense
EBITDA/cash interest expense is TIE on a cash basis. EBITDA is the cash earnings that a company has. The denominator uses the interest expense that is cash, as there are forms of debt where the interest is not paid out in cash but instead added to the outstanding debt. This kind of debt is called accreting debt. It is also called payment-in-kind (or PIK, pronounced ‘‘Pick’’) debt. Thus, the denominator is total interest (which may have both cash and noncash interest) less noncash interest.
This ratio gives an extra measure of insight for coverage analysis, because EBITDA is a more accurate measure of the cash earnings a company has for paying its interest costs. (EBITDACapital Expenditures)/Cash Interest Expense (EBITDA - capital expenditures)/cash interest - expense is a
coverage measure of the ability to repay cash interest based on cash earnings after what usually is a required expense: capital expenditures. Capital expenditures do not appear in the income statement by accounting convention. By subtracting these expenditures from EBITDA, the ratio shows the company’s ability to pay its cash interest expense. It may be that a company can reduce or defer its capital expenditures in order to pay its interest.
But if it does so, it is likely to suffer diminished productivity in the long run (as its fixed assets age and fall into increasing disrepair) and, thus, interest-paying ability.
Fixed Charge Coverage
(EBIT þ rent expense)/(interest expense þ preferred dividends þ rent expense). This ratio is more important in analyzing retail companies.
Cash Fixed Charge Coverage
This is similar to the ratio above, but we use (EBITDA + rent expense)/(cash interest expense þ preferred dividends + rent expense). The cash interest expense makes a distinction between
interest payments that are cash and those that are noncash.
Operating Cash Flow Ratios
Operating cash flow is an item from the cash flow statement and is the sum of net income (the first item on the statement) plus all the addbacks of noncash expenses. Put another way, this is net income on a cash basis and represents the cash earnings after interest and taxes from operations.
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