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Financial Ratios Used In BSG-Online

Profitability Ratios (as reported on pages 2 and 5 of the Footwear


Industry Report)

• 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 average equity (ROE) 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. A company with
a bolded number for the operating profit margin shown in the bottom section of page
5 of the FIR has the best operating profit margin of any company in the industry.
Companies whose operating profit margin numbers are shaded have sub-par
margins, thus signaling a need for management to work on improving profitability.
• 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. A company
with a bolded number for the net profit margin shown in the bottom section of page 5
of the FIR signifies the best net profit margin of any company in the industry.
Companies with shaded numbers have sub-par net profit margins, thus signaling a
need for management to work on improving profitability.

Operating Ratios (as reported on the Comparative Financial


Performances page of the Footwear Industry Report)

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).

Bolded numbers in any of the four cost/expense ratio columns at the bottom of page 5 of
the FIR signify companies with industry-best ratios. Ratios that are shaded designate
companies with sub-par ratios and generally indicate that management needs to work on
improving that measure of cost competitiveness.

Credit Rating Ratios (as reported on the Comparative Financial


Performances page of the Footwear Industry Report)

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).

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.

If any of the credit rating measures for your company have a shaded or
highlighted background, then you and you co-managers need to take calculated
action to get those ratios up as rapidly as possible.

Bolded numbers on the credit rating measures indicate credit rating strength
relative to rival companies.

Other Financial Ratio Measures (as reported on the Comparative


Financial Performances page of the Footwear Industry Report)

• 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 at the end of
the year divided by the number of branded pairs sold per day in the prior year. In
formula terms, this equates to: number of branded pairs in inventory ÷ [number of
branded pairs sold ÷ 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.