Risk analysis , operating performance and value ratios

ASSET COVERAGE
-enables a debt-holder measure the amount of protection provided by
the company’s tangible assets (i.e., assets other than goodwill,
intellectual property, or similar intangibles) after all liabilities have been
met
i.e. ability to cover its debt obligations with its assets after all liabilities
have been satisfied.
Asset values are usually calculated over a number of years to identify a
trend.

NB: The debtholder’s claim on assets ranks before future income taxes
taxes and non-controlling interest in subsidiaries.
Total assets - Deferred charges - Intangible assets – [Current liabilities less short-
term debt such as bank advances and the current portion of long-term debt]
Total debt outstanding (i.e., short-term debt + long-term debt)
ASSET COVERAGE

PERCENTAGE OF TOTAL CAPITAL RATIOS
Shows what percentage of total invested capital each type of
contributor provided or is entitled to.
Common shareholders are usually entitled to more than they
contributed, because retained earnings have accumulated to their credit
over the years.
Long-term debtholders and preferred shareholders are either entitled
to par value or par plus a small premium.
See next slide for Example.

EXAMPLE: CAPITAL STRUCTURE FRASER INC.
Short-term debt 1,630,000
120,000
+Long-term debt 1,350,000
+Par value of preferred shares 750,000
Common equity
+Stated value of common shares 1,564,000
+Contributed surplus 150,000
+Retained earnings 10,835,000
+Foreign exchange adjustment 60,000
= Invested Capital 16,459,000

• Percentage of capital structure attributable to Debtholders (short-
and long-term):
[(1,630, 000 +120, 000 + 135, 000)/(16 459, 000)] X (100)
= 18.83% (Debtholders- short and long-term)
• Percentage of capital structure attributable to Preferred
Shareholders:
[(750 000)/ (16 459, 000)] X (100) =4.56% ( Preferred Share holders)
*The relationship of debt to total capitalization varies for companies
in different industries.
EXAMPLE: CAPITAL STRUCTURE FRASER INC.

DEBT/EQUITY RATIO
Debt/Equity Ratio shows the proportion of borrowed funds used
relative to the investments made by shareholders in the company.
If the ratio is too high, it may indicate that a company has borrowed
excessively, and this increases the financial risk of the company.
A high debt burden reduces the margin of safety protecting the
debtholder’s capital, increases the company’s fixed charges, reduces
earnings available for dividends, and in times of recession or high
interest rates, could cause a financial crisis.
Total debt outstanding (i.e., short-* and long-term)
Book value of shareholders’ equity

CASH FLOW/TOTAL DEBT OUTSTANDING
Cash flow from operations is a measure of a company’s ability to
generate funds internally.
The cash flow/total debt ratio gauges a company’s ability to repay the
funds it has borrowed.
oBank advances are short-term and must normally be repaid or rolled over within a
year.
oCorporate debt issues commonly have sinking funds requiring annual cash outlays.
A company’s annual cash flow should therefore be adequate to meet
these commitments.

CASH FLOW/TOTAL DEBT OUTSTANDING
Cash flow defined is:
• A company’s net earnings;
• Plus all deductions not requiring a cash outlay, such as amortization,
non-controlling
• interest in subsidiaries and future income taxes;
• Minus all additions not received in cash, such as equity income.
Thus: Cash Flow/Total Debt Outstanding =
Current flow from operations
Total debt outstanding (i.e., short- and long-term)
X 100

INTEREST COVERAGE
It reveals the ability of a company to pay the interest charges on its
debt and indicates how well these charges are covered, based upon
earnings available to pay them
i.e. indicates a margin of safety.
Calculated as:
In general, the lower the ratio the more burdened a company is by
interest expense to cover its debt.
Earnings before interest and taxes (EBIT)
Total interest charges

PREFERRED DIVIDEND COVERAGE RATIO
• Like interest coverage, the preferred dividend coverage ratio
indicates the margin of safety for preferred dividends, measuring
the amount of money a firm has to pay dividends to Preferred
Shareholders.
Calculated as:
Net earnings (before extraordinary items) - equity income + non-controlling
interests in earnings of subsidiaries + all income taxes + total interest charges
Total interest charges + preferred dividend payments before tax

- PROFITABILITY AND EFFICIENCY
TELLS US HOW WELL MANAGEMENT IS
MAKING USE OF THE COMPANY’S
RESOURCES.
Operating Performance Ratios:

GROSS PROFIT MARGIN
Useful both for calculating internal trend lines and making comparisons
with other companies; especially in industries where turnover is high
and competition is stiff.
It is an indication of the efficiency of management in turning over the
company’s goods at a profit after allowing for the cost of goods sold.
Calculated as:
Net sales Cost of goods sold
Net Sales X 100

OPERATING PROFIT MARGIN
A more stringent measure of a company’s ability to manage its
resources, as it takes into account the sales, general, and
administrative expenses incurred in producing earnings.
it makes it possible to compare profit margins between companies
that do not show “cost of goods sold” as a separate figure and for
which, consequently, gross profit margin cannot be calculated
Net sales - (Cost of goods sold + selling, administrative and general expenses)
Net Sales
X 100

PRE-TAX PROFIT MARGIN
By calculating this amount as a percentage of sales over several
years, it is possible to identify trends in the pre-tax profit margin.
A rising trend may indicate improving cost control and efficiency; a
declining trend may indicate the reverse.
Calculated as:
Net income before income taxes
Net Sales
X 100

NET PROFIT MARGIN
Indicator of how efficiently the company is managed after taking
both expenses and taxes into account.
i.e. it effectively sums up management’s ability to run the business
in a single figure. Calculated as:
Net earnings (before extraordinary items)
- Equity income + non-controlling interest in the earnings of subsidiaries
Net Sales
(X 100)

PRE-TAX RETURN ON INVESTED CAPITAL
Correlates income with the invested capital responsible for producing
it, without reference to the source of that capital.
In other words, this ratio shows how well management has employed
the assets at its disposal.
Calculated as:
+ income taxes + total interest charges
Invested capital X 100

NET (OR AFTER-TAX) RETURN ON INVESTED CAPITAL
The differences between net return and the pre-tax return are that
income tax is not included in the numerator in this case, and total
interest charges after tax instead of total interest charges are added to
net earnings (before extraordinary items).
+ total interest charges (after tax
Invested capital
X 100

NET (OR AFTER-TAX) RETURN ON COMMON EQUITY
Return on common equity (ROE) ratio shows the dollar amount
of earnings that were produced for each dollar invested by the
company’s common shareholders.
The trend in the ROE indicates management’s effectiveness in
maintaining or increasing profitability in relation to the common
equity capital of the company.
- preferred dividends
Common equity
X 100

INVENTORY TURNOVER RATIO
Measures the number of times a company’s inventory is turned over in
a year.
It may also be expressed as a number of days required to achieve
turnover, as shown in the example below.
A high turnover ratio is considered good.
Calculated as:
Companies with a high turnover requires smaller investment in
inventory than one producing the same sales with a low turnover.
Cost Of Goods Sold
Inventory

- Measuring The Way The Stock Market Rates A Company By Comparing The
Market Price Of Its Shares To Information In Its Financial Statements – Also
Referred To As Market Ratios.
Value Ratios

VALUE RATIOS
Also referred to as market ratios.
Measures the way the stock market rates a company by comparing the
market price of its shares to information in its financial statements.
- Shows the investor the worth of company shares or the return on owning
them
Value ratios relate share price to dividends and earnings.
Value ratios Include:
• Percentage dividend payout Ratio
• Earnings Per Common Share
• Dividend Yield

PERCENTAGE DIVIDEND PAYOUT RATIOS
• Earnings Ratio or P/E Multiple
• Enterprise Multiple (Enterprise Value to ENTDA)
• Equity Value (Book Value) Per share

These indicate the amount or percentage of the company’s net earnings
that is are paid out to shareholders in the form of dividends.
There are two kinds of payout ratios:
• On combined preferred and common dividends
• On common dividends only
Percentage Dividend Payout Ratio is tied directly to the earnings of the
company, which change from year to year.
Directors try to maintain a steady dividend rate through good and trying
times to preserve the credit rating and investment standing of the
company’s securities.

Contd – Percentage dividend payout ratio – 2 ways of calculation:
NB: Note the difference in the divisor.
Total dividends (preferred + common)
X 100
Dividend on common
Less Preferred dividend
X 100
A.
B.

EARNINGS PER COMMON SHARE
These shows the earnings available to each common
Share.
It assists in establishing an appropriate market price for buying or
selling common stock.
A rising trend in EPS has favorable implications for the price of a stock -
one of the most widely used and well understood ratios. Calculated as:
Net earnings (before extraordinary items) - preferred dividends
Number of common shares outstanding

NB: Close attention should be paid to a stock’s value caused by the
conversion of outstanding convertible securities, the exercise of
warrants, shares issued under employee stock options, and other
changes.
Thus Diluted earnings per share on common stock is calculated as:
If net earnings are high, directors may declare and pay out a good
portion as dividends but if low or the company has suffered a loss,
may not pay dividends on the common shares.
Adjusted net earnings (before extraordinary items)
Adjusted common shares outstanding

Dividend policy varies between companies and within the industry but
estimating the dividend possibilities of a stock may take into account:
• The amount of net earnings for the current fiscal year
• The stability of earnings over a period of years
• The amount of retained earnings and the rate of return on those
earnings
• The company’s working capital
• The policy of the board of directors
• Plans for expanding (or contracting) operations
• Government dividend restraints (if any)

DIVIDEND YIELD
The yield on common and preferred stock is the annual dividend rate
expressed as a percentage of the current market price of the stock.
It represents the investor’s return on the investment.
Ratio allows quick comparisons b/w shares of different companies. To do
this we look at:
• The differences in the quality and record of each company’s
management
• The proportion of earnings re-invested in each company
Indicated annual dividend per share
Current market price
X 100

Dividend yield contd:
• The proportion of preferred and common shares in each
company’s capitalization
• In the case of preferred shares, the difference in preferred
dividend coverage
DIVIDEND YIELD

PRICE-EARNINGS RATIO OR P/E MULTIPLE
The price-earnings ratio or P/E ratio is probably the most widely used of all financial
ratios.
- combines all the other ratios into one figure.
- represents the ultimate evaluation of a company and its shares by the investing public.
- calculated as:
P/E ratios are calculated only for common stocks, not for preferreds but it is relevant as to
how well preferred dividend is covered. - “preferred dividend coverage ratio” measures this
relevance best.
Current market price of common
Earnings per share (in latest 12-month period)

Main Reason For Calculating EPS is: as indication of dividend
protection and as a comparison with the share’s market price
i.e. shows that a share is selling at so many times its actual or
annual earnings.
Also, helps analysts determine a reasonable value for a common stock
any time in a market cycle assisting selection process.
As a rule, P/E ratios increase in a rising stock market or with rising
earnings – the reverse is the case in falling markets
PRICE-EARNINGS RATIO OR P/E MULTIPLE

ENTERPRISE MULTIPLE
(ENTERPRISE VALUE TO EBITDA)
Commonly used measure of a company’s overall value.
It is a measure of total company value at any given time and is
calculated as the market value of the company’s common equity,
preferred equity, and debt less the value of cash and cash equivalents
recorded on its balance sheet.
That is - It looks at a company’s enterprise value to its earnings before
interest, taxes, depreciation and amortization, or EBITDA.
- regarded as a more appropriate measure of value when comparing
companies, particularly when analyzing companies with different debt
levels.

Market value of common equity 350,000 × N26.25 N9,187,500
+ Market value of preferred shares 15,000 × N55 N825,000
+ Market value of debt N3,100,000
– (Cash and cash equivalents) (N2,169,000)
Enterprise Value N10,943,500
EBITDA is calculated as:
Earnings before extraordinary items N1,086,000
+ Income taxes N880,000
+ Interest N289,000
+ Amortization N556,000
= EBITDA' N2,811,000
ENTERPRISE MULTIPLE: EXAMPLE
EBITDA – Earnings before interest and taxes

ENTERPRISE MULTIPLE: EXAMPLE
Assumption: the current market price of Favi Fortus Retail Stores’ common
stock is N26.25, the market price of its preferred shares is N55.00, and that the
value of the company’s debt is the value recorded on the balance sheet that the
market value of the company’s debt is par.
Enterprise value is calculated as: See detail in table.
Enterprise value 10,943,500 3.89
EBITDA 2,811,000

Higher enterprise multiples generally exist in high-growth industries,
while lower multiples are found in slower growth or mature industries.
ENTERPRISE MULTIPLE
(ENTERPRISE VALUE TO EBITDA)

EQUITY VALUE (OR BOOK VALUE) PER SHARE
Two equity value ratios measure the asset coverage for each
preferred and each common share. They are:
Formula above shows how much each preferred share is backed by
common equity.
Preferred and common share capital contributed surplus + retained
earnings + foreign exchange adjustment
Number of preferred shares outstanding
A.,

• Equity value per common share.
Though a per-share equity (or book) value figure is sometimes used in
appraising common shares, in actual practice the equity value per
common share may be very different from the market value per
common share.
Common share capital + contributed surplus + retained earnings + foreign
exchange adjustment (less preferred dividend arrears, if any)
Number of common shares outstanding
EQUITY VALUE (OR BOOK VALUE) PER SHARE
B.,

ASSESSING PREFERRED SHARE INVESTMENT QUALITY
Preferred shares are evaluated differently from common shares
because they have different characteristics from common shares
i.e. preferred shareholders are entitled to a fixed dividend, they do not
have the right to vote, and the prices of preferred shares act more like
bonds than common stocks.
Assessment of their quality as investments is based on three factors:
• Do the company’s earnings provide ample coverage for preferred
dividends?

• For how many years has the company paid dividends without
interruption?
• Is there an adequate cushion of equity behind each preferred share?
Four key tests employed assessment:
• Preferred Dividend Coverage (covered preugopiviously in the Risk
Analysis Ratios section)
• Equity (or Book Value) per Preferred Share (covered previously in the
Value Ratios section)

• Record of Continuous Dividend Payments
• An Independent Credit Assessment

DIVIDEND PAYMENTS
• Has the company established a record of continuous dividend
payments to its preferred shareholders?
• This information is obtained from individual company Historical
Reports and The Dividend Records/ publications

CREDIT ASSESSMENT
Like bonds, a company’s preferred shares may be rated by one of the
recognized bond rating services.
If it is, what is the rating and is it high enough to merit investment?
Rating agencies include: Dominion Bond Rating Service (DBRS),
Standard & Poor’s Rating Service

DOMINION BOND RATING SERVICE (DBRS)
Assigns rating classifications to preferred shares ranging from
• Pfd-l (Superior Credit Quality) to (preferreds of the highest
quality) to “D” (in arrears) (the lowest rating provided).

PREFERRED SHARE RATINGS: DBRS
Rating Description
Pfd-1 superior credit quality, supported by entities
with strong earnings and balance sheet characteristics.,
corresponds with companies whose senior bonds are rated
in the “AAA” or “AA” categories.
Pfd-2 satisfactory credit quality, Protection of dividends and
principal is still substantial, but earnings, the balance sheet,
and coverage ratios are not as strong as “Pfd-1” rated
companies, ratings correspond with companies
whose senior bonds are rated in the “A” category

Rating Description
Pfd-3 are of adequate credit quality, though protection of dividends
and principal is still considered acceptable, the issuing entity is more
susceptible to adverse changes in financial and economic conditions
Also, may be other adversities present which detract from debt
protection. Correspond with companies whose senior bonds are rated
the higher end of the “BBB” category
Pfd-4 are speculative, - degree of protection afforded to dividends and
principal is uncertain, particularly during periods of economic adversity.
generally coincide with entities that have senior bond ratings ranging
from the lower end of the “BBB” category through the “BB”
category.

Rating Description
Pfd-5 highly speculative and the ability of the entity to maintain
timely dividend and principal payments in the future is highly
uncertain. Generally coincides with companies with senior bond
ratings of “B” or lower. often have characteristics which, if not
remedied, may lead to default.
D This category indicates preferred shares that are in arrears of
paying either dividends or principal.
An acceptable rating for a preferred helps to confirm the conclusions. An
unexpected downgrading to a lower rating has negative implications. An
upgrading to a higher rating is a favorable development.

SELECTING PREFERREDS
When choosing any equity security, marketability, volume of trading
and research coverage by investment firms should be investigated.
Questions specific to preferreds include:
• What features (e.g., cumulative dividends, sinking funds) and
protective provisions have been built into the issue?
• What is the relation of the preferred’s call price to the market price?
If the market price is above the call price, what is the likelihood of
the preferred being redeemed?
• Is the yield from the preferred acceptable compared to yields from
other, similar investments?

The following should in addition be considered for convertible
preferreds:
• Is the outlook for the common stock positive? A conversion privilege is
valuable only if the market price of the common rises above the
exercise price during the life of the conversion privilege.
• Is the life of the conversion privilege long enough? The longer the life
of the conversion privilege, the greater the opportunity for the market
price of the common and preferred to respond to favorable
developments. Preferably, there should be at least three years before
the conversion privilege expires.

• If there is a premium of conversion cost present, is it reasonable?
• How does the premium compare with premiums on other comparable
convertible preferreds?
• Is the convertible preferred selling above its call price? If so, is it a
candidate for a forced conversion?

HOW PREFERREDS FIT INTO INDIVIDUAL
PORTFOLIOS
Preferred shares provide a link between the bond and debenture
section of a portfolio and the common equity section because of
characteristics of both bonds and equity.
Type of Preferred Type of Investor
Fixed-Rate Preferreds
Top quality Conservative
Medium to high quality Moderately aggressive
Low quality to speculative Aggressive, experienced
investors and speculators

HOW PREFERREDS’ FIT INTO INDIVIDUAL
PORTFOLIOS
Special Types of Preferreds Type of Investor
(High quality assumed)
Convertible Aggressive and moderately aggressive
Retractable Conservative
Variable dividend Aggressive and sophisticated
Preferreds with warrants Aggressive and moderately aggressive
Participating Conservative and moderately aggressive
Foreign-pay Aggressive and sophisticated

REFERENCES:
Canadian Securities Course; CSI Global Education
Money Banking and Financial Markets; Stephen G Cecchetti
Managing Investment Portfolios; John Maginn, Donald Tuttle, Jerald Pinto & Dennis W. Mcleavey
Investments 5th Edition; Bodie Kane-Marcus

Fortuna Favi et Fortus Ltd.,
:118 Old Ewu Road, Aviation Estate, Lagos,
: +234 703 253 0965 www.ffavifortus.com | info@ffavifortus.com

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