Ratios Used in Equity Analysis and Credit Analysis

Equity analysis involves the evaluation of a company’s equity to determine its relative attractiveness as an investment. Several methods can be used in this evaluation, including valuation ratios, discounted cash flow approaches, and residual income approaches.

In credit analysis, the risk of loss caused by a counterparty’s failure to make a promised payment (credit risk) is evaluated. There are several approaches to credit analysis. The approaches, nonetheless, may vary depending on the purpose of the analysis and the context within which it is being done.

Equity Analysis

Valuation Ratios

The price-to-earnings ratio is also known as the P/E ratio. It is perhaps the most popular valuation ratio used for valuing equity securities. It indicates how much an investor in a company’s common stock is paying per dollar of the company’s earnings. It is computed by dividing a company’s share price by its earnings per share.

Other similar ratios that are oftentimes used include the price to book value (P/B), price to cash flow (P/CF), and price to sales (P/S) ratios. In particular, the P/B ratio is often interpreted as an indicator of market judgment on the relationship between a company’s required rate of return and its actual rate of return.

Other Related Quantities

$$\begin{align}\text{Basic earnings per share (or basic EPS)} &= \frac{\text{(Net income – Preferred dividends)}}{\text{Weighted average number of ordinary shares outstanding}}\\ \text{Diluted EPS} &= \frac{\text{(Adjusted income available for ordinary shares, reflecting the conversion of dilutive securities)}}{\text{Weighted average number of ordinary and potential ordinary shares outstanding}}\\ \text { Retention rate (b) }&=\frac{\text { (Net income attributable to common shares – common share dividends) }}{\text { Net income attributable to common shares }}\\ \text{Sustainable growth rate} &=\text{Retention rate}\times \text{Return on equity}=b \times \text{ROE}\end{align}$$

Credit Analysis

Below is a highlight of the ratios that are most commonly used in credit analysis, especially by credit rating agencies such as Standard & Poor. When analyzing these ratios, rating agencies usually investigate deviations from the median ratios of the universe of companies for which these ratios have already been calculated.

• EBIT Interest Coverage

Computation: EBIT/gross interest (before deductions for capitalized interest or interest income)

• EBITDA Interest Coverage

Computation: EBITDA/gross interest (before deductions for capitalized interest or interest income)

• FFO (Funds from Operations) Interest Coverage

Computation: (FFO + Interest paid – Operating lease adjustments)/ Gross interest (before deductions for capitalized interest or interest income)

• Return on Capital

Computation: EBIT/average capital

Where: Capital = Equity + Non-current deferred taxes + Debt

• FFO (Funds from operations) to debt

Computation: FFO/total debt

• Free operating cash flow to debt

Computation: CFO (adjusted) minus capital expenditures/total debt

• Discretionary cash flow to debt

Computation: (CFO – Capital expenditures – Dividends paid)/Total debt

• Net cash flow to capital expenditures

Computation: (FFO – Dividends)/Capital expenditures

• Debt to EBITDA

Computation: Total debt/EBITDA

• Total debt to total debt plus equity

Computation: Total debt/(Total debt + Equity)

Question 1

Which of the following is a ratio whose increase a creditor would most likely view as positive?

1. Debt to EBITDA.
2. Return on capital.
3. Total debt to total debt plus equity.

Solution

The correct answer is B.

An increase in return on capital indicates that a company is earning more per average capital employed and is making better use of its capital.

Options A and C have debt in the numerator of the ratios. An increase in a company’s debt suggests that the company has a higher risk of default. It is notable that the consequence of a higher risk of default is higher borrowing costs to compensate creditors for the assumed greater credit risk. A decrease in these ratios would be viewed as positive.

Question 2

Thera Associates released the following information in their latest financial reports:

total assets: $2M;

total liabilities: $1.25 M;

net income: $500,000; and

dividends: $200,000.

What is the company’s sustainable growth rate?

1. 20%
2. 30%
3. 40%

Solution

The correct answer is C.

$$\text{Sustainable growth rate = ROE × Retention rate}$$

Where:

$$\text{ROE} = \frac{\text{Net income}}{\text{(Assets – Liabilities)}} = \frac{500,000}{(2 M – 1.25 M)} = 0.67$$

$$\text{Retention rate} = \frac{\text{Earning retained}}{\text{Net income}} = \frac{300,000}{500,000} = 0.6$$

Therefore,

$$\text{Sustainable growth rate = ROE × Retention rate }= 0.67 × 0.6 = 0.4$$