## How to calculate series: working capital ratios

Calculating financial ratios by itself does not necessarily create a lot of insight, with the true value-accretive steps being the interpretation of said data-points. I covered the definition and interpretation of financial ratios in depth in my book, however I noticed that readers often find it challenging to extract the correct figures from actual financial statement. This is no surprise since no financial statement looks quite like the other and often varying terms are used for one and the same accounting item. This is why this “how to calculate series” focuses squarely on the “calculation” part of the problem, using real financial statements and is mainly aimed at beginners and intermediate readers.

#### Calculating working capital ratios

• Days sales outstanding and days payables outstanding
• Inventory turnover
• Cash conversion cycle

#### Case study: Reece

Reece is the leading Australian distributor of professional plumbing supplies. We will use their fiscal year 2020 financial statement to show how to calculate the aforementioned working capital ratios. The excerpt below shows the company`s balance sheet for fiscal 2020:

In addition to that, Reece recorded net sales of 6,013,741 AUD and associated cost of sales of 4,338,667 AUD in fiscal 2020 as shown in their profit and loss statement:

The days sales outstanding is calculated by dividing the year’s average account receivables times 360 by the net sales. The averaging is needed since we are comparing a yearly figure (net sales) with the receivables which are only shown for one point in time (in this case for the respective fiscal year ended 30 June 2020). Hence the average account receivables are calculated as: (931,628 AUD + 875,324 AUD) /2 = 903,476 AUD. Times 360 and divided by net sales of 6,013,741 AUD yields 54.1 days sales outstanding. In practical terms this can be interpreted as the company’s customers paying Reece on average after 54.1 days.

The counterweight to this ratio, the days payables outstanding, shows how quickly the company pays its own suppliers. This ratio is calculated by dividing the average account payables times 360 by the cost of sales. In this case the average accounts payable is (792,977 AUD + 699,893 AUD) / 2 = 746,435 AUD. Times 360 and divided by cost of sales of 4,338,667 AUD yields 61.9 days payables outstanding.

We can already see, this Reece is paying its own suppliers slower than its own customers settle their bills with Reece. This grants Reece in effect an interest-free loan.

However as a distributor Reece also needs to hold large quantities of inventory that bind capital. It is therefore of interest to see how quickly the company’s inventory turns over. The inventory turnover ratio is calculated by dividing the cost of sales by the average inventory. In this case the average inventory amounts to (967,510 AUD + 955,711 AUD) / 2 = 961,610 AUD which yields an inventory turnover ratio of (4,338,667 AUD / 961,610 AUD) = 4.51. This means that Reece’s inventory base turns over 4.5 times per year.

Dividing 360 by the obtained inventory turnover ratio yields the inventory days number of (360 / 4.51) = 79.8 which can be directly compared to the days sales outstanding and days payables outstanding.

Adding all three ratios together gives us the cash conversion cycle. This number shows for how long working capital is actually tied up within the company: Cash conversion cycle = days sales outstanding + inventory days + days payables outstanding. In this case the cash conversion cycle amounts to 54.1 + 79.8 – 61.9 = 72.0 days.

## How to calculate series: financial stability ratios

Calculating financial ratios by itself does not necessarily create a lot of insight, with the true value-accretive steps being the interpretation of said data-points. I covered the definition and interpretation of financial ratios in depth in my book, however I noticed that readers often find it challenging to extract the correct figures from actual financial statement. This is no surprise since no financial statement looks quite like the other and often varying terms are used for one and the same accounting item. This is why this “how to calculate series” focuses squarely on the “calculation” part of the problem, using real financial statements and is mainly aimed at beginners and intermediate readers.

#### Calculating financial stability ratios

• Equity ratio
• Gearing
• Dynamic gearing
• Cash burn rate

#### Case study: Union Pacific

We will use the 2019 financial statement of Union Pacific, one of North America’s largest railroads, to show how to calculate the aforementioned financial stability ratios. Here is what the balance sheet looked like for fiscal year 2019:

The equity ratio is calculated by dividing total common shareholders’ equity of 18,128m USD by the balance sheet total of 61,673m USD, equating to 29.4 %. (In case there is any non-controlling interest included in the shareholders’ equity, this should be exluded when calculating the equity ratio since this part does not belong to the holders of the common stock).

The gearing is calculated by dividing the net financial debt by total shareholders’ equity. Net financial debt is the sum of Union Pacific’s financial debt less its cash and cash equivalents. The latter amount to 831m USD, where the financial debt equals 1,257m USD (“debt due within one year”) plus 23,943m USD (“debt due after one year”). In total this equates to net debt of 24,369m USD. Divided by total common shareholders’ equity of 18,128m USD gives a gearing of 134.4 %.

Equity ratio and gearing both yield static numbers. Dynamic gearing states the number of years necessary to delever the business completely on a cash basis by dividing the net financial debt by the annual free cashflow. We already obtained the net financial debt of 24,369m USD above. Free cashflow is calculating by simply subtracting net capex (in this case 3,453m USD – 74m USD = 3,379m USD) from the operating cashflows of 8,609m USD, yielding a free cashflow figure of 5,230m USD. Based on these numbers we can calculate the dynamic gearing or the time it would take to delever the business in full at 4.6 years (24,369m USD / 5,230m USD).

#### Case study : Nikola

There are different definitions for the cash burn rate, but the most common looks at the relationship between (negative) free cashflow and total shareholders equity. Another feasible calculation would be to look at (negative) free cashflow as a percentage of cash equivalents. Going with the former definition we need to obtain total shareholders equity as well as free cashflow for Nikola. Shareholders’ equity before non-controlling interest amounts to 881.5m USD as per 30 June 2020:

For the half-year 2020, the company shows operating cashflows of -45.7m USD as well as CAPEX of -3.8m and -2.4m USD, giving a free cash(out)flow of -51.9m USD.

This free cash(out)flow figure has of course to be annualized in order to calculate the cash burn rate with: 881.5m USD / -103.8m USD = -8.5 years. This means that if the free cashflow remains steady around -103.8m USD, the company would burn through its shareholders’ equity base with eight to nine years.

## How to calculate series: profit margins

Calculating financial ratios by itself does not necessarily create a lot of insight, with the true value-accretive steps being the interpretation of said data-points. I covered the definition and interpretation of financial ratios in depth in my book, however I noticed that readers often find it challenging to extract the correct figures from actual financial statement. This is no surprise since no financial statement looks quite like the other and often varying terms are used for one and the same accounting item. In my book I tried to solve this issue by presenting the raw financial statement data as true-to-reality as possible, but I feel that a blog – with the ability to display the actual financial statement excerpts – might be a real value add. This is why this “how to calculate series” focuses squarely on the “calculation” part of the problem, using real financial statements and is mainly aimed at beginners and intermediate readers.

#### Calculating profit margins

• Gross profit margin
• EBITDA margin
• EBIT margin
• Net profit margin

We will use two real-life examples below to calculate the different profit margins listed above.

#### Case study: Alphabet

Google’s holding company Alphabet shows the following profit & loss statement for fiscal year 2019:

The gross profit margin is defined as gross profit divided by revenues. In this case the gross profit is not shown directly in the profit and loss statement, but can be derived easily by subtracting the cost of revenues from the revenue line. This yields a gross profit of 161,857m USD – 71,896m USD = 89,961m USD. Dividing this figure by the stated revenues yields a gross profit margin of 89,961m USD / 161,857m USD = 55.6 %.

The EBITDA margin is defined as EBITDA divided by revenues. In order to calculate the EBITDA margin we first have to calculate the EBITDA figure. Our starting point is the reported EBIT, which in this case is reported as “income from operations” of 34,231m USD. To this we need to add the depreciation and amortization expense (the “DA” part of EBITDA) which in the case of Alphabet has been allocated towards the different expense categories and hence cannot be found directly in the profit and loss statement. However, being a non-cash expense, the depreciation and amortization number can be easily found in the cash flow statement, in this case 10,856m USD and 925m USD respectively:

Adding EBIT to depreciation and amortization yields an EBITDA of 46,012m USD, which results in an EBITDA margin of 28.4 %.

Given the EBITDA margin derivation makes calculating the EBIT margin straight forward: simply divide the stated EBIT (“Income from operations”) by the revenues, et volia: 34,231m USD / 161,857m USD = 21.1 %.

Finally, the net profit margin is defined as net profit dividend by revenues, which in this case means dividing the net profit of 34,343m USD by total revenues of 161,857m USD, giving a net profit margins of 21.2 %. Note that in this unusual case the net profit margin exceeds the EBIT margin because of the significant “other income” line below EBIT.

#### Case study: Heineken

Heineken, the world’s second largest brewer, reports the following profit and loss statement for fiscal year 2019: