Profitability Ratios (as reported on pages 2 and5 of the Footwear Industry Report)
Earnings Per Share (EPS) isdefined as net income divided by the number of shares of stockissued to stockholders. Higher EPS values indicate the company isearning more net income per share of stock outstanding. Because EPSis one of the five performance measures on which your company isgraded (see p. 2 of the FIR) and because your company has a higherEPS target each year, you should monitor EPS regularly and takeactions to boost EPS. One way to boost EPS is to pursue actionsthat will raise net income (the numerator in the formula forcalculating EPS). A second means of boosting EPS is to repurchaseshares of stock, which has the effect of reducing the number ofshares in the possession of shareholders—net income divided by asmaller number of shares yields a bigger EPS.
Return On Equity (ROE) is definedas net income divided by the average amount of shareholders’equity investment—the average amount of shareholders’ equityinvestment is equal to the sum of shareholder equity at thebeginning of the year and the end of the year divided by 2. Totalshareholder equity at the end of the year turns out to be largerthan total shareholder equity at the beginning of the year wheneverthe company’s dividend payments are less than its net profits (suchthat some earnings are retained in the business—all retainedearnings add to the amount of shareholders’ equity). Higher ROEvalues indicate the company is earning more after-tax profit perdollar of equity capital provided by shareholders. Because ROE isone of the five performance measures on which your company isgraded (see p. 2 of the FIR), and because your company’s annualtarget ROE is 15%, you should monitor ROE regularly and takeactions to boost ROE. One way to boost ROE is to pursue actionsthat will raise net income (the numerator in the formula forcalculating ROE). A second means of boosting ROE is to repurchaseshares of stock, which has the effect of reducing shareholders’equity investment in the company (the denominator in the ROEcalculation), thus producing a higher ROE percentage.
Operating Profit Margin isdefined as operating profit divided by net revenues (where netrevenues represent the dollars received from footwear sales, afterexchange rate adjustments). A higher operating profit margin (shownon p. 5 of the FIR) is a sign of competitive strength and costcompetitiveness. The bigger the percentage of operating profit tonet revenues, the bigger the margin for covering interest paymentsand taxes and moving dollars to the bottom-line.
Net Profit Margin is defined asnet profit (or net income or after-tax income, all of which meanthe same thing) divided by net revenues, where net revenuesrepresent the dollars received from footwear sales after exchangerate adjustments. The bigger a company’s net profit margin (itsratio of net profit to net revenues), the better the company’sprofitability in the sense that a bigger percentage of the dollarsit collects from footwear sales flow to the bottom-line. Acompany’s net profit margin represents the percentage of revenuesthat end up on the bottom line.
Operating Ratios (as reported on the ComparativeFinancial Performances page of the Footwear Industry Report)
The ratios relating to costs and profit as a percentage of netrevenues that are at the bottom of page 5 of the FIR are ofparticular interest because they indicate which companies are mostcost efficient and have the best profit margins:
Cost of pairs sold as a percent of netrevenues. This ratio is calculated by dividing total costsof goods sold by net sales revenues. A company’s cost of pairssold includes all production-related costs, any exchange rateadjustments on pairs shipped to distribution warehouses, any tariffpayments, and freight charges on pairs shipped from plants todistribution warehouses. Net sales revenues represent thedollars received from both branded and private-label footwear salesafter exchange rate adjustments. Low percentages for the cost ofpairs sold are generally preferable to higher percentages becausethey signal that a bigger percentage of the revenue received fromfootwear sales is available to cover delivery, marketing,administrative, and interest costs, with any remainder representingpre-tax profit. Companies having the highest ratios of productioncosts to net revenues are candidates for being caught in a profitsqueeze, with margins over and above production-related costs thatare too small to cover delivery, marketing, and administrativecosts and interest costs and still have a comfortable margin forprofit. Production costs at such companies are usually too highrelative to the price they are charging (their strategic optionsfor boosting profitability are to cut costs, raise prices, or tryto make up for thin margins by somehow selling additionalunits).
Warehouse expenses as a percent of netrevenues. This ratio is calculated by dividing totalwarehouse expenses by net sales revenues. Net sales revenuesrepresent the dollars received from both branded and private-labelfootwear sales after exchange rate adjustments. A low percentage ofwarehouse expenses to net revenues is preferable to a higherpercentage, indicating that a smaller proportion of revenues isrequired to cover the costs of warehouse operations (which leavesmore room for covering other costs and earning a bigger profit oneach unit sold).
Marketing expenses as a percent of netrevenues. This ratio is calculated by dividing totalmarketing costs by net sales revenues. Net sales revenues representthe dollars received from both branded and private-label footwearsales after exchange rate adjustments. A low percentage ofmarketing expenses to net revenues relative to other companiessignals good efficiency of marketing expenditures (more revenuebang for the buck), provided unit sales volumes areattractively high. However, a low percentage of marketingcosts, if coupled with low unit sales volumes, generally signalsthat a company is spending too little onmarketing. The optimal condition, therefore, is a low marketingcost percentage coupled with high sales, high revenues, andabove-average market share (all sure signs that a company has acost-effective marketing strategy and is getting a nice bang forthe marketing dollars it is spending).
Administrative expenses as a percent ofnet revenues. This ratio is calculated by dividingadministrative costs by net sales revenues. Net sales revenuesrepresent the dollars received from both branded and private-labelfootwear sales after exchange rate adjustments. A low ratio ofadministrative costs to net sales revenues signals that a companyis spreading administrative costs out over a bigger volume ofsales. Companies with a high percentage of administrative costs tonet revenues generally need to pursue additional sales or marketshare or risk squeezing profit margins and being at a costdisadvantage to bigger-volume rivals (although a higheradministrative cost ratio can sometimes be offset with lowercosts/ratios elsewhere).
Credit Rating Ratios (as reported on theComparative Financial Performances page of the Footwear IndustryReport)
Three financial measures are used to determine your company’scredit rating:
The debt-to-assets ratio isdefined as all loans outstanding divided by total assets—bothnumbers are shown on the company’s balance sheet. All loansoutstanding include (a) 1-year loans outstanding, (b) long-termbank loans outstanding, (c) the current portion of long-term loansthat are due and payable, and (d) any overdraft loans that are dueand payable—all these amounts are reported on the company’s balancesheet, as is the amount of total assets (total assets is alsoreported 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 adebt-to-assets ratio close to 0.10 to achieve an A+ credit ratingand 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 andthe default risk ratio is above 3.00). Debt-to-asset ratios above0.50 (or 50%) are generally alarming to creditors and signal “toomuch” use of debt and creditor financing to operate the business,although such a debt level could still produce a B+ or A– creditrating if a company can maintain with very strong interest coverageratios (say 8.0 or higher) and default risk ratios above 3.00.
The interest coverage ratio isdefined as annual operating profit divided by annual interestpayments. Operating profit is reported on the Income Statement andon p. 5 of the FIR; interest payments are reported on the IncomeStatement. Your company’s interest coverage ratio is used by creditanalysts to measure the “safety margin” that creditors have inassuring that company profits from operations are sufficiently highto cover annual interest payments. An interest coverage ratio of2.0 is considered “rock-bottom minimum” by credit analysts. Acoverage ratio of 5.0 to 10.0 is considered much more satisfactoryfor companies in the footwear industry because of earningsvolatility over each year, intense competitive pressures which canproduce sudden downturns in a company’s profitability, and therelatively unproven management expertise at each company. Itusually takes a double-digit times-interest-earned ratio to securean A– or higher credit rating, since this credit measure isstrongly weighted in the credit rating determination.
The default risk ratio is definedas free cash flow divided by the combined annual principal paymentson all outstanding loans. Free cash flow is equal to netprofit plus depreciation minus dividend payments. This creditmeasure also carries a high weighting in the credit ratingdetermination. A company with a default risk ratio below 1.0 isautomatically assigned “high risk” status (because it is short ofcash to meet its principal payments) and cannot be given a creditrating higher than C+. Companies with a default risk ratio between1.0 and 3.0 are designated as “medium risk”, and companies with adefault ratio of 3.0 and higher are classified as “low risk”because their free cash flows are 3 or more times the size of theirannual principal payments).
A company is considered more creditworthy when its line of credit usage is small (say 5% to 15% ofthe total credit available) because it has less debt outstandingand greater access to additional credit should the need arise. Acompany’s creditworthiness is called into serious question when ithas used 80% or more of its credit line, especially if it also hasa long debt payback period, a relatively high debt-equity ratio,and/or a relatively low times-interest earned ratio. Generallyspeaking, credit analysts like to see companies using only arelatively small portion of their credit lines over the course of ayear (there’s no problem of borrowing more heavily to finance thetypically double production levels of the third quarter so long asmost of these borrowings are repaid in the fourth quarter when thecash from high third-quarter sales is received). What troublescredit analysts most is a company that calls upon 50% or more ofits credit line quarter-after-quarter, year-after-year and seemsconstantly on the verge of struggling to pay its debt outstanding.Companies that utilize only a small percentage of their creditlines are viewed as good credit risks, able to pay off their debtin a timely manner without financially straining theirbusiness.
The interest coverage ratio and the default risk ratio arethe two most important measures in determining a company’s creditrating. Thus, as long as a company is financially strong in itsability to service its debt—as measured by the interest coverageratio and the default risk ratio, then the company can maintain ahigher debt-to-assets ratio without greatly impairing its creditrating. However, weakness on just one of the threemeasures, particularly the two most important ones, can besufficient to knock a company’s credit rating down a notch.Weakness on two or three can reduce the rating by severalnotches.
Other Financial Ratio Measures (as reported onthe Comparative Financial Performances page of the FootwearIndustry Report)
The current ratio equals currentassets divided by current liabilities. It measures the company’sability to generate sufficient cash to pay its current liabilitiesas they become due. At the least, your company’s current ratioshould be greater than 1.0; a current ratio in the 1.5 to 2.5 rangeprovides a much healthier cushion for meeting current liabilities.Ratios in the 5.0 to 10.0 range are far better yet. A bolded numberin the current ratio column designates the company with thebest/highest current ratio; companies with shaded current ratiosneed to work on improving their liquidity if the number is below1.5
Days of inventory equals thenumber of branded pairs in inventory divided by the number ofbranded pairs sold times the number of days in the year. In formulaterms, this equates to: [number of branded pairs in inventory ÷number of branded pairs sold] x 365. Fewer days of inventory areusually better up to a point (but keeping too few pairs ininventory impairs the delivery times to footwear retailers and runsthe risk of not having enough pairs in inventory to fill retailerorders should sales prove to be higher than expected).
The dividend yield is defined asthe dividend per share divided by the company’s current stockprice. It shows what return (in the form of a dividend) ashareholder will receive on their investment in the company if theypurchase shares at the current stock price. A dividend yield below2% is considered “low” unless a company is rewarding shareholderswith nice gains in the company’s stock price price. A dividendyield greater than 5% is “considered “high” by real world standardsand is attractive to investors looking for a stock that willgenerate sizable dividend income. In GLO-BUS, you should considerthe merits of keeping your company’s dividend payments high enoughto produce an attractive yield compared to other companies. Arising dividend has a positive impact on your company’s stock price(especially if the dividend is increased regularly, rather thansporadically), but the increases need to be at least $0.05 pershare to have much impact on the stock price. However, as explainedbelow, you do not want to boost your dividend so high (just for thesake of maintaining a record of dependable dividend increases) thatyour dividend payout ratio becomes excessive. Dividend increasesshould be justified by increases in earnings per share and by thecompany’s ability to afford paying a higher dividend.
The dividend payout ratio isdefined as total dividend payments divided by net profits (or thedividend per share divided by earnings per share—both calculationsyield the same result). The dividend payout ratio thus representsthe percentage of earnings after taxes paid out to shareholders inthe form of dividends. Generally speaking, a company’s dividendpayout ratio should be less than 75% of net profits (or EPS),unless the company has paid off most of its loans outstanding andhas a comfortable amount of cash on hand to fund growth andcontingencies. If your company’s dividend payout exceeds 100% formore than a year or two, then you should consider a dividend cutuntil earnings improve. Dividends in excess of earnings areunsustainable and thus are viewed with considerable skepticism byinvestors—as a consequence, dividend payouts in excess of 100% havea negative impact on the company’s stock price.
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