Earnings or cash flow
ratios are designed to show the earnings or cash that is available to meet the required
interest and lease payments. Debt service ratios.
a.
Interest coverage = operating profit / interest expense = EBIT / I
b.
Total fixed charge coverage = [EBIT + lease payments]/[interest +
lease payments + (preferred dividends/{1-tax rate})]
c.
Cash flow / interest expense
d.
Cash flow coverage = (cash flow + interest expense) / interest
expense
e.
Cash flow / long-term debt.
Measures of a company’s growth potential
Growth analysis: Investors and creditors are interested in the firm’s growth potential.
Investors because high growth means high stock prices, and creditors because high growth
means the firm’s ability to repay its obligations is improved.
1.
Sustainable growth (g) = (earnings retention rate)(ROE), Where: the earnings
retention rate = [1 - (dividends/net income)]
2.
ROE = [EAT/sales][sales/assets][assets/equity]
Example: A firm has a predictable dividend payout ratio of 40%, a net profit margin of 12%,
an asset turnover of 1.3 and an equity multiplier leverage measure of 1.4. Estimate the firm’s
sustainable growth rate.
g = (earnings retention rate)(ROE) = (1 - dividend payout)(EAT/S)(S/A)(A/Eq)
g = (1 - .4)(.12)(1.3)(1.4) = .13 or 13%
Measures of a company’s external liquidity
External liquidity is the relative speed at which you can trade your shares with little impact
on the price. The most important determinant of external market liquidity is the number of
shares traded during the time period. Other measures of liquidity are:
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