148 149
Liquidity ratios
This group of ratios reveals
whether or not a company
has enough cash or equivalent assets
to meet its debt repayments. An
example is the working capital ratio
(also a measure of efficiency), which
indicates whether a company has
enough short-term assets to cover
its short-term debt.
Solvency ratios
While liquidity ratios look at a
company’s short-term ability
to meet loan repayments, solvency
ratios indicate the likelihood of a
company being able to continue
indefinitely with enough cash or
current assets to pay its debts in the
long run. An example is the debt to
equity ratio.
Investment
valuation ratios
Thes ratios are typically used
by investors to gauge the returns they
are likely to get if they buy shares in a
company. An example is the dividend
payout ratio. It indicates how well
earnings support the dividend
payments—more mature companies
tend to have a higher payout ratio.
10–14%
the minimum return on
investment (ROI) needed
to fund a company’s future
HOW FINANCE WORKS
Measuring performance
DIVIDEND
PAYOUT
RATIO
DEBT TO
EQUITY
RATIO
WORKING
CAPITAL
==
=
YEARLY
DIVIDEND
PER SHARE
EARNINGS
PER SHARE
TOTAL
SHAREHOLDERS’
EQUITY
TOTAL
ASSETS
CURRENT
ASSETS
CURRENT
LIABILITIES
Other liquidity ratios
Cash ratio is measured as total cash
(and equivalents) / current liabilities.
It shows whether a company’s short-
term assets could repay its debts. A
high ratio is seen as favorable.
Quick ratio (acid-test ratio) is
measured as current assets minus
inventories / current liabilities. It shows
how easily a company can repay short-
term debt from cash. The higher the
ratio, the more easily it can pay.
Other solvency ratios
Interest coverage ratio is measured
as EBIT (earnings before interest and
tax) / interest expense. It indicates
how easily a company can pay the
interest on its debts. The higher the
ratio, the more easily they can pay.
Debt ratio is measured as total
liabilities / total assets. It indicates
the percentage of the company’s
assets that are financed by debt. A
low ratio is considered favorable.
Other investment valuation ratios
Net profit margin ratio is measured
as profit after tax / revenue. Another
measure of a company’s profitability, it
is also useful for comparing a company
with competitors. The higher the ratio,
the more profitable the company.
Price to earnings ratio is measured
as market value per share / earnings
per share. It indicates the value of the
company’s shares. A high ratio
demonstrates good growth potential.
Investors beware
Ratio analysis must be used over
time—at least four years—to
understand how a company
has reached its current position,
not just what the position is. For
instance, if debt has suddenly
gone up, it could be because the
company is branching out into new
areas of potential profit, or to limit
the damage of a poor past decision.
WARNING
US_148-149_Financial_ratios.indd 149 09/11/2016 11:02
How it works
Forecasting success or failure relies on historical
data—financial statements, financial ratios, and Key
Performance Indicators—that reflect business
operation and can be tracked over time. The tracked
and monitored data can provide an early warning
system for potential problems. For small businesses
and start-ups, accurate forecasts provide a basis for
Forecasting
Predicting future business performance is necessary to estimate
probable sales, income, costs, and profitability and thus gain
investment and maintain confidence in the company.
Forecasting with Z-score models
Realizing that traditional financial ratios, such as the ratio of
costs to revenue, created only a partial picture of a business’s
financial performance, Altman devised a set formula that
combined four or five key ratios to give a Z score. The model
has proven 90 percent accurate in predicting business failure
over one year, and 80 percent accurate over two years.
Retained earnings /
total assets
A measure of leverage: a high ratio
indicates profits are funding growth;
a low ratio indicates growth is
financed by debt.
Market value of equity /
book value of total liabilities
A measure of the market confidence
in the company: a ratio of less than
one means the firm is worth less
than it owes—it is insolvent.
Working capital / total assets
A measure of liquidity: the
more working capital in a company,
the more it is able to pay its bills.
Sales / total assets
A measure of efficiency: the
sales generated by the assets.
Earnings before interest
and taxes / total assets
A measure of return on assets:
it gauges operating income
generated by assets.
Corporate success
Efficiently run companies with a
healthy balance between assets
and liabilities, and profit and debt
inspire confidence in investors.
Each of the above ratios is multiplied by
a specific value, to give them weighting;
results are added together to give Z score.
A score of 0.2 or lower means the
company is highly likely to fail.
A score of 0.3 or higher means the
company is unlikely to fail.
Finding the Z score
SS Success
US_150-151_Forecasting.indd 150 21/11/2014 16:38
150 151
HOW FINANCE WORKS
Measuring performance
Selling assets
to pay off debts
Bankruptcy
occurs if the
company cannot
pay its debts
Cuts to employee
benefits
Ohlson O score
Alternative to Z score for
predicting failure
Overtrading When a
company’s sales grow
faster than its finance
Undertrading When
a company trades at
low levels compared
to its finance levels
Zeta analysis Second-
generation Z-score model
NEED TO KNOW
20%
the predicted profitability
increase from 2013 to 2017
for organizations using
performance measurement
to make business forecasts
Low profitability, seen in
consistent downslide in profit
on profit-and-loss statements from
consecutive years
Low cash flow, seen in continued
pattern of decline in cash holdings
on balance sheet over consecutive years
High borrowing,
high interest payments,
and dwindling revenue
Repeated
dividend cuts
to shareholders
Top management
resigning and taking
jobs elsewhere
Signs of corporate failure
There are many signs that a company is doing badly
and perhaps sliding into insolvency. These signs make
investors nervous, which is likely to lower share price
if they start selling their shareholding. However, most
companies that fail are in profit, but run out of cash.
raising external financing, while for larger companies,
this information provides an indication of financial
strength for investors and markets. Predictions may
range from conjectured costs and revenue to complex
financial models. One of the most frequently used
predictive models for forecasting business success
is the Z-score model, devised by Edward Altman,
a New York University finance professor, in 1968.
SS Failure
US_150-151_Forecasting.indd 151 15/12/2014 12:57
150 151
HOW FINANCE WORKS
Measuring performance
Selling assets
to pay off debts
Bankruptcy
occurs if the
company cannot
pay its debts
Cuts to employee
benefits
Ohlson O score
Alternative to Z score for
predicting failure
Overtrading When a
company’s sales grow
faster than its finance
Undertrading When
a company trades at
low levels compared
to its finance levels
Zeta analysis Second-
generation Z-score model
NEED TO KNOW
20%
the predicted profitability
increase from 2013 to 2017
for organizations using
performance measurement
to make business forecasts
Low profitability, seen in
consistent downslide in profit
on profit-and-loss statements from
consecutive years
Low cash flow, seen in continued
pattern of decline in cash holdings
on balance sheet over consecutive years
High borrowing,
high interest payments,
and dwindling revenue
Repeated
dividend cuts
to shareholders
Top management
resigning and taking
jobs elsewhere
Signs of corporate failure
There are many signs that a company is doing badly
and perhaps sliding into insolvency. These signs make
investors nervous, which is likely to lower share price
if they start selling their shareholding. However, most
companies that fail are in profit, but run out of cash.
raising external financing, while for larger companies,
this information provides an indication of financial
strength for investors and markets. Predictions may
range from conjectured costs and revenue to complex
financial models. One of the most frequently used
predictive models for forecasting business success
is the Z-score model, devised by Edward Altman,
a New York University finance professor, in 1968.
SS Failure
US_150-151_Forecasting.indd 151 15/12/2014 12:57
How it works
Public companies are required
to have their annual financial
statements audited (checked)
by an independent auditor. It
is typically during this process
that any financial shenanigans—
creative accounting tricks used to
manipulate the figures and improve
the performance of a company in
its financial statements—and
outright fraudulent activity is
uncovered. It is the auditor’s job to
ensure that business records and
statements are accurate and have
been honestly reported. Auditors
carry out a systematic examination
of the company’s records and may
identify any irregularities that may
indicate fraud. If evidence of fraud
is found, the next step is to involve
forensic accountants and criminal
investigators, who may prosecute
the perpetrators.
Tracking fraud
Red flags
indicating fraud
Auditors may be alerted to fraud by a
number of recognized warning signs or
“red flags”; these may be either directly
to do with the behavior of the CEO or
other top executives, or in the form of
irregularities within the financial statements.
Asset stripping Selling off the
assets of a company for a profit
to raise funds, often resulting in
the closure of the business
Tunneling A particular type
of fraud in which assets and
funds are illicitly transferred to
management or shareholders
NEED TO KNOW
For keen observers of financial statements, warning signs that
indicate fraudulent business activities may be detected in overly
optimistic statements and evasive attitudes of senior management.
Cash flows that are negative
for three quarters, then
suddenly and dramatically
become positive
Sudden increase in gross
margin, at odds with
industry average and
company’s previous
performance pattern
Large sales to companies
with dubious track records
Sales recorded before
they have been made
Made-up, nonexistent
sources of revenue
Expenses moved from one
company to another, or
classified as assets
Ongoing, long-term growth
of earnings per share
High payments to executives
compared to base salary
Suspicious figures on financial statements
How to detect fraud
Procedures should be in place to
hold accountable anyone who handles
expenses. When these fall short,
internal and external auditors need
to take more drastic measures.
Applying ratio
analysis to
reveal key
long-term
trends (see
pp.148–149)
89%
of US corporate
fraud cases in
2010 typically
involved the
company’s
CEO or CFO
US_152-153_Tracking_fraud.indd 152 21/11/2014 16:24
152 153
how finance works
Measuring performance
LINE-UP: TOP FIVE NOTORIOUS FRAUDS
CEObehavior
Evasive behavior by executives
over important financial details
Attempts by CEO to steer auditors
away from certain documents
Technicalities
Late entry of sales or earnings
adjustments
Missing approvals or signatures
Photocopied documents presented
in place of originals
Using element of
surprise, such as
undertaking an
aggressive internal
audit without prior
warning
Data mining with
auditing software
to detect any mismatch
between past patterns
and current statements
Setting up confidential
hotline for current and
past employees or others
with knowledge of the
company
Conducting a
surprise cash count
to determine whether
current cash flow
matches statements
Some of the worst frauds stem from the most prestigious companies.
Enron was one of the top seven US companies, while JPMorgan Chase
& Co. was the largest American bank when measured by assets.
SECURITIES
EXCHANGE CO.
In 1919, Charles Ponzi
began a pyramid
scheme in Boston,
selling postal reply
coupons. He pledged
investors 50 percent
return within 45 days,
which he paid from
new investors’ funds.
JPMORGAN CHASE
& CO.
For 10 years from
2002, the company
approved thousands
of home loans to
ineligible recipients.
The employee who
blew the whistle was
awarded $64 million.
WORLDCOM
US communications
company WorldCom
declared bankruptcy
in 2002 after it
improperly accounted
for $3.8 billion in
expenses. Auditors
Arthur Andersen
were held liable
for not noticing.
BARINGS BANK
The UK merchant
bank collapsed
in 1995 after
unauthorized
trading by employee
Nick Leeson racked
up losses of
$1.3billion. He had
been allowed to
bypass internal audits.
ENRON
Energy company
Enron declared
bankruptcy in 2001
although it had
never shown a loss
in its financial
statements. External
auditors were accused
of failing to properly
review accounts.
US_152-153_Tracking_fraud.indd 153 02/12/2014 14:57
152 153
how finance works
Measuring performance
LINE-UP: TOP FIVE NOTORIOUS FRAUDS
CEObehavior
Evasive behavior by executives
over important financial details
Attempts by CEO to steer auditors
away from certain documents
Technicalities
Late entry of sales or earnings
adjustments
Missing approvals or signatures
Photocopied documents presented
in place of originals
Using element of
surprise, such as
undertaking an
aggressive internal
audit without prior
warning
Data mining with
auditing software
to detect any mismatch
between past patterns
and current statements
Setting up confidential
hotline for current and
past employees or others
with knowledge of the
company
Conducting a
surprise cash count
to determine whether
current cash flow
matches statements
Some of the worst frauds stem from the most prestigious companies.
Enron was one of the top seven US companies, while JPMorgan Chase
& Co. was the largest American bank when measured by assets.
SECURITIES
EXCHANGE CO.
In 1919, Charles Ponzi
began a pyramid
scheme in Boston,
selling postal reply
coupons. He pledged
investors 50 percent
return within 45 days,
which he paid from
new investors’ funds.
JPMORGAN CHASE
& CO.
For 10 years from
2002, the company
approved thousands
of home loans to
ineligible recipients.
The employee who
blew the whistle was
awarded $64 million.
WORLDCOM
US communications
company WorldCom
declared bankruptcy
in 2002 after it
improperly accounted
for $3.8 billion in
expenses. Auditors
Arthur Andersen
were held liable
for not noticing.
BARINGS BANK
The UK merchant
bank collapsed
in 1995 after
unauthorized
trading by employee
Nick Leeson racked
up losses of
$1.3billion. He had
been allowed to
bypass internal audits.
ENRON
Energy company
Enron declared
bankruptcy in 2001
although it had
never shown a loss
in its financial
statements. External
auditors were accused
of failing to properly
review accounts.
US_152-153_Tracking_fraud.indd 153 02/12/2014 14:57
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