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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 debtâ€”both of which are related to financing deci-

sionsâ€”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 companyâ€™s

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operational investments, separate from financing effects. So,

operating working capital is:

Current assets Ã€ cash

Ã€ Ã°Current liabilities Ã€ short-term debtÃž

Â¼ Operating working capital

Thus the ratio OWC/sales is a measure of how much each

dollar of sales is tied up in the current accounts of a companyâ€™s

balance sheet. OWC management is critical to a companyâ€™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 salesâ€”combined

with additional capital expenditures for expansionâ€”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 percent-

ages 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 deprecia-

tion). 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.

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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 par-

ticularly useful, as different industries can have vastly different

average levels.

For Profitability

Gross margin, or gross profit/revenues

1.

EBIT margin, or EBIT/revenue

2.

EBITDA margin, or EBITDA/revenue

3.

Net margin, or net income/revenue

4.

Sales/(accounts receivable Ã¾ inventory Ã¾ net fixed assets)

5.

EBIT/total invested capital

6.

Return on average common equity

7.

Return on average assets

8.

The first four items listed above are metrics within the

income statement. They look at how well the company manages

its expenses relative to the revenues from sales, or, alternatively,

how well its pricing strategies are working. They define profit-

ability in terms of earnings after expenses.

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.

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Ratios: Key Performance Indicators 219

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 Ã¾ Inventory Ã¾

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 â€˜â€˜investedâ€™â€™

in customers who have not paid for their purchases. Likewise,

inventory represents the â€˜â€˜investmentâ€™â€™ 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 companyâ€™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.

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220

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/shareholdersâ€™ equity

1.

Net debt/shareholdersâ€™ equity

2.

Total debt/total invested capital

3.

Bank debt/EBITDA

4.

Senior debt/EBITDA

5.

Total debt/EBITDA

6.

Net debt/EBITDA

7.

Total Debt/Shareholdersâ€™ Equity

Total debt/shareholdersâ€™ 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 companyâ€™s ability to

generate cash flow to cover its debt service (interest payments

and principal repayments).

Net Debt/Shareholdersâ€™ Equity

Net debt/shareholdersâ€™ equity is a ratio similar to total debt/

shareholdersâ€™ 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.

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Ratios: Key Performance Indicators 221

Total Debt/Total Invested Capital

The denominator is total invested capitalâ€”the combination of

shareholdersâ€™ 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

yearsâ€™ earnings. If you start building models that have nonannual

periodsâ€”for example, if each column contains quarterly dataâ€”

these ratios will not be useful unless the quarterly EBITDA num-

bers 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 companyâ€™s cash flows to

cover its interest expense or debt obligations.

Times interest earned: EBIT/interest expense

1.

EBITDA/cash interest expense

2.

(EBITDA Ã€ capital expenditures)/cash interest expense

3.

Fixed charge coverage

4.

Cash fixed charge coverage

5.

Operating cash flow/total debt

6.

Operating cash flow/net debt

7.

Operating cash flow/average total liabilities

8.

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