Profit Margins

         Gross Profit Margin = Gross Profit

                                       Net Revenue

The Gross Profit Margin expresses gross profit as a percentage of sales.  Gross profit is what remains after cost of good sold (or direct costs) are subtracted from revenues.

Note that net (as opposed to gross) revenue is used in the denominator of profit margins.  Sometimes a company will express “gross sales” less “returns and allowances,” equaling “net sales” on their income statement.  When a business presents both gross and net revenues, it is net revenues that are used in profit margins and common size reports.

A higher percentage (or profitability) is obviously desirable for this ratio.  The gross profit margin can be an invaluable indicator of performance and profitability (or pricing strategy) when compared with other firms in the industry.  It is among the most basic and widely used financial ratios.

         Operating Profit Margin = Operating Profit

                                                 Net Revenue

The Operating Profit Margin expresses operating profit (or net sales, less cost of sales, less operating expenses) as a percentage of net sales.  This is also a crucial measure of profitability, which is often compared to industry averages.

Company profit margins are also compared year over year, and trends are studied by management and financial analysts.

In this Street Smarts article on Inc.com, Norm Brodsky argues that the gross profit margin is the most important number on the income statement (http://www.inc.com/magazine/20081001/street-smarts-secrets-of-a-110-million-man.html).

Debt to EBITDA

This multiple compares total debt to one year’s worth of Earnings before Interest, Taxes, Depreciation, and Amortization (or “EBITDA”).  EBITDA is, therefore, a proxy for funds available to service the debt.  The resulting multiple indicates how much EBITDA (or approximately how many periods) it would take to retire the debt with EBITDA.  This ratio is, therefore, a measure of “cash flow leverage”.

Obviously, a lower multiple indicates less leverage and lower risk.  Keep in mind that you are comparing a balance sheet item to an income statement measure with this ratio.  This can be problematic if the debt balance at the end of a given period is unusually high or low or if EBITDA is measured in only a partial year.

Note that total interest-bearing debt should comprise the numerator, and it may also be appropriate to subtract cash and cash equivalents from total debt to construct a more meaningful ratio.

Senior Debt to Tangible Net Worth plus Subordinated Debt

As discussed in the previous post, an analyst may want to exclude intangible assets from the calculation of net equity when constructing a debt to worth ratio.  You subtract net intangible assets from the denominator to make this adjustment.  This results in a higher (but more conservative and maybe also a more accurate) measurement of leverage.

Also described earlier, the debt to worth ratio represents capital contributed by creditors against capital contributed by owners.  If you examine the Smith Heating and Cooling, Inc. balance sheet, you will see that some of the company’s debt is actually due to a company owner.  An analyst might consider this to be a form of owner’s equity and alter the ratio accordingly to take a truer picture of leverage.

To do this, you would subtract loans from owners from total liabilities in the numerator and add the same amount to equity in the denominator.  Only “senior debt” or the bank debt in the first position in the event of liquidation is actually included as liabilities in this case.

Making these adjustments results in a “senior debt to tangible net worth plus subordinated debt” ratio.  For Smith Heating and Cooling, Inc., this ratio is $9.44 to 1, which is still pretty high.  The company is, indeed, highly leveraged.  But, the ratio is more meaningful in this case, and this number can be compared to an industry average to see how it measures up.

Leverage and Debt to Worth

"Leverage" measures the extent to which debt is used to finance a business.  Higher leverage results from greater proportions of debt financing as opposed to equity financing, and greater risk generally accompanies higher leverage.  The most basic measure of leverage is the Debt to Worth Ratio:

          Debt to Worth = Total Liabilities

                                      Net Equity

The debt to worth ratio presents the relationship between capital contributed by lenders and capital contributed by owners.  Higher debt to worth implies more leverage and, therefore, more risk or potential for volatility.  A lower ratio implies that the business may have untapped borrowing capacity.

The debt to worth of Smith Heating and Cooling, Inc. is $234 to 1.  So, one might say that, for every dollar the owners have contributed, the company has borrowed $234 to operate the business.  This amount seems astronomical.  The business is indeed highly leveraged, but their debt to worth ratio is anomalous.  The ratio is not informative.

When equity is very small or negative due to losses on the income statement, the ratio loses its meaning.  A deficit or near zero equity position may be a problem itself, as losses have eroded the capital that was originally contributed by the owners.

Other balance sheet items may throw off the meaning of the debt to worth ratio as well.  For example, heavily depreciated buildings may cause an artificially high debt to worth if their market values are significantly higher than their book values.

The existence of intangible assets may have the opposite effect, by inflating equity with items that have little or no real value.  A solution is to calculate “tangible net worth” by excluding the book value of intangible assets.  You may then calculate a “Debt to Tangible Net Worth” ratio:

          Debt to Tangible Net Worth =             Total Liabilities             

                                                        Net Equity-Net Intangible Assets

Accounts Payable Turnover Ratios

          Accounts Payable Turnover =   Cost of Goods Sold

                                                             Accounts Payable

The Accounts Payable Turnover Ratio represents the average number of times per year that payables “turn over” or get paid with cash.  A higher (more rapid) turnover is generally favorable, since accounts payable are being paid more quickly.

But, paying debts too quickly uses up needed cash.  Many businesses extend these payments as much as possible to make the best use of their cash.  Businesses that manage their payables in this way or which receive extended payment terms from suppliers will, therefore, have lower (less rapid) accounts payable turnover.

At the same, businesses experiencing cash flow crunches or disputed invoices with their suppliers will also exhibit slower payables turnover.  Additional research is often necessary to determine the cause of slow or slowing accounts payable turnover.  Is it a sign of trouble or a result of good cash flow management?  To learn more, compare payables turnover to the industry average and to the payment terms of vendors.  Explore payables turnover from previous periods, and look for trends.

Like the other turnover ratios, this one compares cost of goods sold over a period of time with the accounts payable balance at a single point in time.  Perhaps the payables balance is inflated due to a seasonal buildup or a big discount from a supplier.  An analyst may compare purchases (as opposed to Cost of Goods Sold) to average accounts payable balances to obtain more meaningful ratios.

Days Payables Outstanding =                            365                   

                                                              Accounts Payable Turnover Ratio

“Days Payables Outstanding” expresses turnover as the average length of time in days between purchases and their payment.  Although, this ratio has the same limitations as the Accounts Payable Turnover Ratio, it may be more intuitive to look at payables turnover in terms of days rather than in number of times per period.

The payables of Smith Heating and Cooling, Inc. turn over 2.33 times per year or every 157 days.  This represents extraordinarily slow payables turnover.  The company’s accounts payable are certainly due in less than an average of 157 days.  An analyst would explore whether the company is experiencing cash flow problems that are resulting in very slow payments.

Inventory Turnover Ratios

          Inventory Turnover = Cost of Goods Sold

                                               Inventory

Inventory turnover represents the average number of times per year that inventory "turns over" or that all goods are sold from inventory.  A higher, more rapid turnover is generally favorable, with goods being sold more quickly.  Rapid turnover may result from good inventory management, but it can be a symptom of an inventory shortage as well.

A lower, less rapid turnover may indicate overstocking or the presence of obsolescent goods.  Slow inventory turnover often coincides with liquidity problems, since working capital is tied up in inventory.  Slow inventory turnover may also result from planned seasonal build-ups or from making a large, bulk purchase to obtain a good price.

As with other turnover ratios, this one compares inventory at a single point in time to an entire period’s cost of sales.  To correct for seasonality or other anomaly, consider using average inventory in the denominator instead of the ending balance.

          Days Inventory Outstanding =                365                 

                                                          Inventory Turnover Ratio

This ratio expresses turnover as the average length of time in days between the purchase and the sale of inventory items.  A lower value (more rapid turnover) is generally more favorable, and interpretation and problems are similar to those of the Inventory Turnover Ratio.

The measures of liquidity for Smith Heating and Cooling, Inc. seemed to indicate that the company would be dependent upon inventory turnover to service short-term obligations.  Because of this, their inventory turnover ratios are crucial.

The company’s inventory turnover is only 2.11 times per year, so inventory is outstanding for an average of 173 days.  This is likely to be very problematic.  An analyst would want to explore how these rates compare to those of the company’s recent past as well as to those of other companies in the industry.  It would also be important to know if seasonal fluctuations are affecting the inventory balance and whether the goods are becoming obsolete as they sit.

Activity Ratios and Accounts Receivable Turnover

“Activity ratios” measure "turnover" or the rates at which current assets and current liabilities are used-up or paid-off through ordinary business operations.  Quicker turnover ratios generally imply greater efficiency and better management.  The first such ratio is the accounts receivable turnover ratio:

          Accounts Receivable Turnover = Annual Net Revenue

                                                               Accounts Receivable

Accounts receivable turnover represents the average number of times per year that trade receivables "turn over" or are converted to cash.  Higher, more rapid turnover is favorable, since sales on credit are being converted to cash more quickly.  Lower, less rapid turnover is unfavorable since default becomes more likely as receivables remain uncollected, and since conversion to cash is necessary to service obligations or to earn interest.

A problem with this ratio is the fact that it compares accounts receivable at a single point in time to an entire year of sales.  If the accounts receivable balance is unusually high or low on the date of the financial statements due to seasonal variations or other factors, then this measurement may not provide an accurate picture.  Substituting average receivable balances over the year in the denominator, may help correct this.

Another potential problem exists when cash sales represent a large percentage of total revenues.  The ratio will be very favorable in this case.  A more useful measure may be taken by considering only credit sales in the numerator.  Such a ratio is probably best used only in comparison with the company’s own historical turnover and with the actual payment terms the business requires of its customers.

Another way to look at accounts receivable turnover is in days:

          Days Receivables Outstanding=               365                           

                                                                Receivables Turnover Ratio

This ratio expresses the average length of time in number of days between sales and the cash collection of receivables.  The average number of days that receivables are outstanding can seem like a more intuitive measure than turnover expressed in number of times per year.  In this case, a lower value (or fewer days) is favorable because it represents more rapid turnover.

For Smith Heating and Cooling, Inc., accounts receivable turnover is 11.27 times per year, and the average number of days that receivables are outstanding is 32.39.  To put these numbers into better context, an analyst would compare them to receivables turnover from prior years, receivables turnover from similar businesses, and the company’s payment terms.  If Smith Heating and Cooling requires its customers to pay in thirty days, then receivables turnover is a bit slow.  If some customers pay cash at the time of service, then receivables collection may be really slow for those customers who pay on account.