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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 deci-
sions”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

Ratios: Key Performance Indicators 217

operational investments, separate from financing effects. So,
operating working capital is:

Current assets À cash
À °Current liabilities À short-term debtÞ
¼ 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 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 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

Chapter 12

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
EBIT margin, or EBIT/revenue
EBITDA margin, or EBITDA/revenue
Net margin, or net income/revenue
Sales/(accounts receivable þ inventory þ net fixed assets)
EBIT/total invested capital
Return on average common equity
Return on average assets
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

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.

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 þ Inventory þ
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.

Chapter 12

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
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.

Ratios: Key Performance Indicators 221

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 nonannual
periods”for example, if each column contains quarterly data”
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 company™s cash flows to
cover its interest expense or debt obligations.
Times interest earned: EBIT/interest expense
EBITDA/cash interest expense
(EBITDA À 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


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