. 39
( 62 .)


equity, but obviously one is healthy while the other one is dire
straits. In such a case, you may want to use an IF statement that
will calculate the ratio only if the denominator is positive and,
if not, return a text message of ˜˜n/a™™ (for ˜˜not applicable™™).
Here is another example, with a negative dividend payout
ratio (dividend/net income):
Company G Company H

Dividend $10,000 $10,000
Net income $50,000 ($50,000)
Payout ratio 20% (20%)

A negative payout ratio does not mean that Company H has
a lower payout ratio than Company G. If anything, Company H
has an exorbitantly high payout ratio, as seen from the fact that it
is paying out more than what it can afford, from the net income
point of view.

When we look at companies and their ratios, there are six broad
categories of metrics. These six apply to all types of companies,

Chapter 12

but within each category, there will be measures that are more
important for some industries and less so”even disregarded”
for others:






Some Important Terms
EBIT, or earnings before interest and taxes, is an important
number in the income statement because it represents the com-
pany™s ability to generate operating earnings before interest
expense (a cost related to financing decisions, not operating deci-
sions) and taxes (a cost related to running a business in a regu-
lated economy). This is also called operating profit or operating
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 com-
panies in different sectors, such as interest (from different financ-
ing profiles), depreciation (from different fixed asset bases),
amortization (from different holdings of intangibles), and taxes
(from different tax treatments). Because depreciation and amorti-
zation 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 mea-
sure 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 mar-
ketable 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.

Ratios: Key Performance Indicators 213

For Size
All things being equal, the larger the company as shown by the
measures that follow, the sounder it is.
1. Revenues
2. Total assets
3. Total shareholders™ equity

For Liquidity
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 com-
pany 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 À inventory)/current
Working capital (sometimes also called net working capital) is
current assets minus current liabilities. Working capital is a mea-
sure of the cushion that a company has for meeting obligations
within the ordinary operating cycle of the business.
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 liabil-
ities. 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

Chapter 12

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 indi-
cations 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 À cash) À (current liabilities À short-term
Operating working capital/sales
5. Change in OWC and Change in OWC/sales
6. Sales/net fixed assets
7. Sales/total assets

Accounts Receivable/Sale * 365
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

Ratios: Key Performance Indicators 215

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

Chapter 12

number of ˜˜payable days,™™ the more favorable it is for the com-
pany. 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 À Cash) À (Current Liabilities À
Short-Term Debt)]/Sales
[(Current assets À cash) À (current liabilities À short-term debt)]/
sales, or Operating working capital/sales, is an interesting ratio
and bears some attention. The numerator is almost like working


. 39
( 62 .)