The Art of Company Valuation and Financial Statement Analysis: A Value Investor's Guide with Real-life Case Studies

Chapter 3

Ratios for Financial Stability

Change alone is eternal, perpetual, immortal.

Arthur Schopenhauer

 

A long-term investment has to fulfil two fundamental criteria. First, it should yield an appropriate return on the invested capital. Indicators for this were introduced in Chapter 2. Second, a business can operate successfully in the long run only if it has a solid capital structure and sufficient cash flow. The following chapter provides ratios to validate and quantify the financial stability of a company. Although profitability ratios were introduced first, the importance of financial stability can hardly be overestimated. Particularly in the business world, Murphy’s Law is more applicable than ever: anything that can go wrong, will go wrong.

3.1 EQUITY RATIO

Equity ratio indicates which proportion of the total assets is funded by shareholders’ equity.

Companies with high equity ratios are usually considered to be conservatively financed. The higher the equity ratio, the lower the company’s use of leverage. In contrast to shareholders’ equity, debt has the advantage of being tax-deductible, as interest expenses are usually tax-deductible, lowering the company’s tax burden. Moreover, debt is a cheaper source of funding than equity, because in the case of insolvency, creditors’ claims rank senior to equity and hence will be paid back first. Creditors are therefore exposed ...