Financial Ratios Used in BSG
Earnings Per Share (EPS) is defined as net income divided by the number of shares of stock issued to stockholders. Higher EPS values indicate the company is earning more net income per share of stock outstanding. Because EPS is one of the five performance measures on which your company is graded (see p. 2 of the FIR) and because your company has a higher EPS target each year, you should monitor EPS regularly and take actions to boost EPS. One way to boost EPS is to pursue actions that will raise net income (the numerator in the formula for calculating EPS). A second means of boosting EPS is to repurchase shares of stock, which has the effect of reducing the number of shares in the possession of shareholders—net income divided by a smaller number of shares yields a bigger EPS.
Return On Equity (ROE) is defined as net income divided by the average amount of shareholders’ equity investment—the average amount of shareholders’ equity investment is equal to the sum of shareholder equity at the beginning of the year and the end of the year divided by 2. Total shareholder equity at the end of the year turns out to be larger than total shareholder equity at the beginning of the year whenever the company’s dividend payments are less than its net profits (such that some earnings are retained in the business—all retained earnings add to the amount of shareholders’ equity). Higher ROE values indicate the company is earning more after-tax profit per dollar of equity capital provided by shareholders. Because ROE is one of the five performance measures on which your company is graded (see p. 2 of the FIR), and because your company’s annual target ROE is 15%, you should monitor ROE regularly and take actions to boost ROE. One way to boost ROE is to pursue actions that will raise net income (the numerator in the formula for calculating ROE). A second means of boosting ROE is to repurchase shares of stock, which has the effect of reducing shareholders’ equity investment in the company (the denominator in the ROE calculation), thus producing a higher ROE percentage.
Operating Profit Margin is defined as operating profit divided by net revenues (where net revenues represent the dollars received from footwear sales, after exchange rate adjustments). A higher operating profit margin (shown on p. 5 of the FIR) is a sign of competitive strength and cost competitiveness. The bigger the percentage of operating profit to net revenues, the bigger the margin for covering interest payments and taxes and moving dollars to the bottom-line.
Net Profit Margin is defined as net profit (or net income or after-tax income, all of which mean the same thing) divided by net revenues, where net revenues represent the dollars received from footwear sales after exchange rate adjustments. The bigger a company’s net profit margin (its ratio of net profit to net revenues), the better the company’s profitability in the sense that a bigger percentage of the dollars it collects from footwear sales flow to the bottom-line. A company’s net profit margin represents the percentage of revenues that end up on the bottom line.
The ratios relating to costs and profit as a percentage of net revenues that are at the bottom of page 5 of the FIR are of particular interest because they indicate which companies are most cost efficient and have the best profit margins:
Cost of pairs sold as a percent of net revenues. This ratio is calculated by dividing total costs of goods sold by net sales revenues. A company’s cost of pairs sold includes all production-related costs, any exchange rate adjustments on pairs shipped to distribution warehouses, any tariff payments, and freight charges on pairs shipped from plants to distribution warehouses. Net sales revenues represent the dollars received from both branded and private-label footwear sales after exchange rate adjustments. Low percentages for the cost of pairs sold are generally preferable to higher percentages because they signal that a bigger percentage of the revenue received from footwear sales is available to cover delivery, marketing, administrative, and interest costs, with any remainder representing pre-tax profit. Companies having the highest ratios of production costs to net revenues are candidates for being caught in a profit squeeze, with margins over and above production-related costs that are too small to cover delivery, marketing, and administrative costs and interest costs and still have a comfortable margin for profit. Production costs at such companies are usually too high relative to the price they are charging (their strategic options for boosting profitability are to cut costs, raise prices, or try to make up for thin margins by somehow selling additional units).
Warehouse expenses as a percent of net revenues. This ratio is calculated by dividing total warehouse expenses by net sales revenues. Net sales revenues represent the dollars received from both branded and private-label footwear sales after exchange rate adjustments. A low percentage of warehouse expenses to net revenues is preferable to a higher percentage, indicating that a smaller proportion of revenues is required to cover the costs of warehouse operations (which leaves more room for covering other costs and earning a bigger profit on each unit sold).
Marketing expenses as a percent of net revenues. This ratio is calculated by dividing total marketing costs by net sales revenues. Net sales revenues represent the dollars received from both branded and private-label footwear sales after exchange rate adjustments. A low percentage of marketing expenses to net revenues relative to other companies signals good efficiency of marketing expenditures (more revenue bang for the buck), provided unit sales volumes are attractively high. However, a low percentage of marketing costs, if coupled with low unit sales volumes, generally signals that a company is spending too little on marketing. The optimal condition, therefore, is a low marketing cost percentage coupled with high sales, high revenues, and above-average market share (all sure signs that a company has a cost-effective marketing strategy and is getting a nice bang for the marketing dollars it is spending).
Administrative expenses as a percent of net revenues. This ratio is calculated by dividing administrative costs by net sales revenues. Net sales revenues represent the dollars received from both branded and private-label footwear sales after exchange rate adjustments. A low ratio of administrative costs to net sales revenues signals that a company is spreading administrative costs out over a bigger volume of sales. Companies with a high percentage of administrative costs to net revenues generally need to pursue additional sales or market share or risk squeezing profit margins and being at a cost disadvantage to bigger-volume rivals (although a higher administrative cost ratio can sometimes be offset with lower costs/ratios elsewhere).
Three financial measures are used to determine your company’s credit rating:
The debt-to-assets ratio is defined as all loans outstanding divided by total assets—both numbers are shown on the company’s balance sheet. All loans outstanding include (a) 1-year loans outstanding, (b) long-term bank loans outstanding, (c) the current portion of long-term loans that are due and payable, and (d) any overdraft loans that are due and payable—all these amounts are reported on the company’s balance sheet, as is the amount of total assets (total assets is also reported on page 5 of the FIR). A debt-to-assets ratio of .20 to .35 is considered “good”. As a rule of thumb, it will take a debt-to-assets ratio close to 0.10 to achieve an A+ credit rating and a debt-asset ratio of about 0.25 to achieve an A– credit rating (unless the interest coverage ratios are in the 5 to 10 range and the default risk ratio is above 3.00). Debt-to-asset ratios above 0.50 (or 50%) are generally alarming to creditors and signal “too much” use of debt and creditor financing to operate the business, although such a debt level could still produce a B+ or A– credit rating if a company can maintain with very strong interest coverage ratios (say 8.0 or higher) and default risk ratios above 3.00.
The interest coverage ratio is defined as annual operating profit divided by annual interest payments. Operating profit is reported on the Income Statement and on p. 5 of the FIR; interest payments are reported on the Income Statement. Your company’s interest coverage ratio is used by credit analysts to measure the “safety margin” that creditors have in assuring that company profits from operations are sufficiently high to cover annual interest payments. An interest coverage ratio of 2.0 is considered “rock-bottom minimum” by credit analysts. A coverage ratio of 5.0 to 10.0 is considered much more satisfactory for companies in the footwear industry because of earnings volatility over each year, intense competitive pressures which can produce sudden downturns in a company’s profitability, and the relatively unproven management expertise at each company. It usually takes a double-digit times-interest-earned ratio to secure an A– or higher credit rating, since this credit measure is strongly weighted in the credit rating determination.
The default risk ratio is defined as free cash flow divided by the combined annual principal payments on all outstanding loans. Free cash flow is equal to net profit plus depreciation minus dividend payments. This credit measure also carries a high weighting in the credit rating determination. A company with a default risk ratio below 1.0 is automatically assigned “high risk” status (because it is short of cash to meet its principal payments) and cannot be given a credit rating higher than C+. Companies with a default risk ratio between 1.0 and 3.0 are designated as “medium risk”, and companies with a default ratio of 3.0 and higher are classified as “low risk” because their free cash flows are 3 or more times the size of their annual principal payments).
A company is considered more creditworthy when its line of credit usage is small (say 5% to 15% of the total credit available) because it has less debt outstanding and greater access to additional credit should the need arise. A company’s creditworthiness is called into serious question when it has used 80% or more of its credit line, especially if it also has a long debt payback period, a relatively high debt-equity ratio, and/or a relatively low times-interest earned ratio. Generally speaking, credit analysts like to see companies using only a relatively small portion of their credit lines over the course of a year (there’s no problem of borrowing more heavily to finance the typically double production levels of the third quarter so long as most of these borrowings are repaid in the fourth quarter when the cash from high third-quarter sales is received). What troubles credit analysts most is a company that calls upon 50% or more of its credit line quarter-after-quarter, year-after-year and seems constantly on the verge of struggling to pay its debt outstanding. Companies that utilize only a small percentage of their credit lines are viewed as good credit risks, able to pay off their debt in a timely manner without financially straining their business.
The interest coverage ratio and the default risk ratio are the two most important measures in determining a company’s credit rating. Thus, as long as a company is financially strong in its ability to service its debt—as measured by the interest coverage ratio and the default risk ratio, then the company can maintain a higher debt-to-assets ratio without greatly impairing its credit rating. However, weakness on just one of the three measures, particularly the two most important ones, can be sufficient to knock a company’s credit rating down a notch. Weakness on two or three can reduce the rating by several notches.
The current ratio equals current assets divided by current liabilities. It measures the company’s ability to generate sufficient cash to pay its current liabilities as they become due. At the least, your company’s current ratio should be greater than 1.0; a current ratio in the 1.5 to 2.5 range provides a much healthier cushion for meeting current liabilities. Ratios in the 5.0 to 10.0 range are far better yet. A bolded number in the current ratio column designates the company with the best/highest current ratio; companies with shaded current ratios need to work on improving their liquidity if the number is below 1.5
Days of inventory equals the number of branded pairs in inventory divided by the number of branded pairs sold times the number of days in the year. In formula terms, this equates to: [number of branded pairs in inventory ÷ number of branded pairs sold] x 365. Fewer days of inventory are usually better up to a point (but keeping too few pairs in inventory impairs the delivery times to footwear retailers and runs the risk of not having enough pairs in inventory to fill retailer orders should sales prove to be higher than expected).
The dividend yield is defined as the dividend per share divided by the company’s current stock price. It shows what return (in the form of a dividend) a shareholder will receive on their investment in the company if they purchase shares at the current stock price. A dividend yield below 2% is considered “low” unless a company is rewarding shareholders with nice gains in the company’s stock price price. A dividend yield greater than 5% is “considered “high” by real world standards and is attractive to investors looking for a stock that will generate sizable dividend income. In GLO-BUS, you should consider the merits of keeping your company’s dividend payments high enough to produce an attractive yield compared to other companies. A rising dividend has a positive impact on your company’s stock price (especially if the dividend is increased regularly, rather than sporadically), but the increases need to be at least $0.05 per share to have much impact on the stock price. However, as explained below, you do not want to boost your dividend so high (just for the sake of maintaining a record of dependable dividend increases) that your dividend payout ratio becomes excessive. Dividend increases should be justified by increases in earnings per share and by the company’s ability to afford paying a higher dividend.
The dividend payout ratio is defined as total dividend payments divided by net profits (or the dividend per share divided by earnings per share—both calculations yield the same result). The dividend payout ratio thus represents the percentage of earnings after taxes paid out to shareholders in the form of dividends. Generally speaking, a company’s dividend payout ratio should be less than 75% of net profits (or EPS), unless the company has paid off most of its loans outstanding and has a comfortable amount of cash on hand to fund growth and contingencies. If your company’s dividend payout exceeds 100% for more than a year or two, then you should consider a dividend cut until earnings improve. Dividends in excess of earnings are unsustainable and thus are viewed with considerable skepticism by investors—as a consequence, dividend payouts in excess of 100% have a negative impact on the company’s stock price.