Financial Ratios and Statement Analysis: Method

Financial Ratios and Statement Analysis: Definitions, DuPont, Distress Scores and Free Cash Flow

Statements and the lines the tool reads

The tool reads the three statements as pasted text: a header row naming up to five periods, oldest first, then one line item per row with its amount in each period. Every amount is in one currency unit and one scale (thousands, millions); shares are entered in the same scale so that per-share amounts come out in currency units, and the share price in currency units. The income statement lines are revenue, cost of sales, operating expenses, depreciation and amortization (the cash-flow statement figure), operating income, other income or expense, interest expense, income before taxes, income tax and net income; the balance sheet lines are cash, marketable securities, receivables, inventories, total current assets, net property plant and equipment, long-term investments, total assets, accounts payable, short-term debt (including the current portion of long-term debt and commercial paper), total current liabilities, long-term debt, total liabilities, shareholders' equity and retained earnings; the cash-flow lines are cash from operations, capital expenditures, dividends paid and debt repayments. Lines the statements do not give are derived where the arithmetic allows: gross profit = revenue − cost of sales, operating income = gross profit − operating expenses, EBITDA = operating income + depreciation and amortization, income before taxes = operating income − interest + other income, net income = income before taxes − tax; the page names every derived line. A ratio whose lines are missing is printed as n/a rather than estimated.

Averages

A turnover or a return divides a flow of the period by a balance that changes through it. Following the SEC's guide to the inventory turnover, the tool uses the average of the opening and closing balances (the prior period's closing balance is the current period's opening balance) when the prior period is in the data; the first period, having no opening balance in the data, uses its closing balance, and the closing-balance option applies that rule throughout. The DuPont components are built on the same averages so that the product reproduces the return on equity exactly.

Liquidity, leverage and efficiency

The current ratio is current assets over current liabilities; the quick ratio removes inventories and prepaid items by counting only cash, marketable securities and receivables; the cash ratio counts cash and marketable securities alone. Debt is interest-bearing debt, short-term plus long-term; debt to equity, debt to assets and the equity multiplier (total assets over equity) measure the share of the assets financed by others (the SEC guide's debt-to-equity, which uses total liabilities, is the liabilities-to-assets line here). Interest coverage is operating income over interest expense; the debt service coverage ratio of the lender, EBITDA over interest plus scheduled principal repayments, needs the repayments line. Net debt deducts cash and marketable securities. Asset turnover is revenue over average total assets; inventory turnover is cost of sales over average inventory, receivables turnover revenue over average receivables and payables turnover cost of sales over average payables, each converted to days by dividing the days in the period by the turnover. The cash conversion cycle, days inventory + days receivable − days payable, is the number of days between paying suppliers and collecting from customers; a negative cycle means suppliers finance the operation.

Profitability, DuPont and growth

Margins are shares of revenue; return on assets and on equity divide net income by average assets and average equity; return on invested capital divides NOPAT = EBIT (1 − T), at the entered tax rate T, by average invested capital = debt + equity. The three-step DuPont identity writes ROE = (NI / revenue) × (revenue / average assets) × (average assets / average equity), the margin, the turnover and the leverage; the five-step form splits the net margin into the tax burden NI / EBT, the interest burden EBT / EBIT and the operating margin EBIT / revenue. Growth rates are period over period, with the compound annual rate over the whole span; the sustainable growth rate of Higgins (1977) is the growth in sales a firm can finance without issuing equity or changing its debt-to-equity ratio, g* = ROE · b / (1 − ROE · b) with b the retention ratio 1 − payout and ROE on closing equity, which equals ROE on opening equity times b when equity changes only by retained earnings; the internal growth rate replaces ROE by ROA and allows no new borrowing at all.

Market ratios

Earnings per share divides net income by the shares line, so diluted weighted-average shares give the reported diluted EPS; the price-to-earnings ratio is price over EPS (the SEC guide: a $20 share earning $2 sells at 10 times earnings); market capitalization is price times shares, enterprise value adds debt and deducts cash and marketable securities, and EV / EBITDA compares that value with the operating cash earnings before financing and tax; dividend yield is dividends per share over price and payout is dividends over net income.

Common-size and index statements

Common-size (vertical) statements express each income statement line as a percentage of revenue and each balance sheet line as a percentage of total assets, so that firms of different size and the same firm in different years can be compared line by line; liabilities and equity together must come to 100 percent, which the tool prints as a check. The index (horizontal, trend) statement sets each line of the first period to 100 and expresses the later periods relative to it.

Altman Z-scores

Altman's 1968 discriminant function for publicly traded manufacturers combines five ratios of total assets: working capital (X₁), retained earnings (X₂), earnings before interest and taxes (X₃), the market value of equity over total liabilities (X₄) and sales (X₅): Z = 1.2 X₁ + 1.4 X₂ + 3.3 X₃ + 0.6 X₄ + 1.0 X₅ in the convenient form, with firms below 1.81 classified as distressed, above 2.99 as safe and the zone between as the zone of ignorance (the original cutoff 2.675 minimized the classification error). Altman's 2000 restatement re-estimates the model with book equity in X₄ for private firms, Z′ = 0.717 X₁ + 0.847 X₂ + 3.107 X₃ + 0.420 X₄ + 0.998 X₅ with the grey zone 1.23 to 2.90, and drops the industry-sensitive asset turnover for non-manufacturers and emerging-market issuers, Z″ = 6.56 X₁ + 3.26 X₂ + 6.72 X₃ + 1.05 X₄ with the grey zone 1.10 to 2.60; the emerging-market score adds a constant of 3.25 so that zero corresponds to a defaulted bond and maps the result to bond-rating equivalents. The scores are the published coefficients applied as arithmetic; the tool offers no re-estimation. Z needs the market value of equity (share price and shares), the other two the book value, and all three the retained earnings line.

Beneish M-score

Beneish (1999) estimated a probit model on a sample of firms found to have manipulated earnings, using eight indices that compare the current year with the prior one: the days' sales in receivables index DSRI, the gross margin index GMI (prior margin over current), the asset quality index AQI (the share of assets that are neither current nor fixed nor investments, current over prior), the sales growth index SGI, the depreciation index DEPI (prior depreciation rate over current, each rate being depreciation over depreciation plus net PP&E), the SG&A index SGAI, the leverage index LVGI (long-term debt plus current liabilities over total assets, current over prior) and total accruals to total assets TATA (income from continuing operations less cash from operations, over total assets). The score is M = −4.84 + 0.920 DSRI + 0.528 GMI + 0.404 AQI + 0.892 SGI + 0.115 DEPI − 0.172 SGAI + 4.679 TATA − 0.327 LVGI; a value above −1.78 flags a probability of manipulation worth a closer look, and the stricter −2.22 of the later five-variable form is sometimes used. The tool takes operating expenses for SG&A, depreciation and amortization for depreciation, net income for income from continuing operations and the long-term investments line for the securities of the asset quality index, and prints the indices from the second period on. The model was estimated on manufacturers; it is a screen, not a finding.

Free cash flow, EBITDA and working capital

Free cash flow to the firm is the cash available to all capital providers: from the cash-flow statement, FCFF = cash from operations + interest (1 − T) − capital expenditures; free cash flow to equity deducts the whole of interest (already in cash from operations) and adds net borrowing, FCFE = cash from operations − capital expenditures + (debt_t − debt_t−1). The operating route, FCFF = EBIT (1 − T) + depreciation and amortization − capital expenditures − increase in operating working capital, is printed beside the cash-flow route; the two differ by the non-cash charges and other operating items that the cash-flow statement carries and the operating route does not. The EBITDA reconciliation walks from net income through tax, interest and other income to operating income and adds back depreciation and amortization. The working-capital bridge shows receivables, inventories and payables and their period-to-period changes: an increase in operating working capital absorbs cash, which is why the cash-flow statement carries it with the opposite sign.

Benchmarks

A ratio means little without the industry: the SEC guide notes that desirable ratios vary by industry, and the MBDA guide's rules of thumb (a current ratio above 2, a quick ratio above 1) are starting points. Industry medians by size class are published by the Risk Management Association (Annual Statement Studies) and Dun and Bradstreet (Industry Norms and Key Business Ratios); both are proprietary, so the tool ships no benchmark table and compares the latest period against medians the analyst enters, one per line.

Not included

Lease capitalization and other analyst adjustments, segment analysis, quarterly seasonality, bank and insurance ratios (the statements differ), valuation from the free cash flows (the DCF Valuation tool) and earnings quality beyond the Beneish screen.