Page 130 - Finance for Non-Financial Managers

Siciliano07.qxd 3/20/2003 11:23 AM Page 111
lender calls you. If you’re
Interest coverage A
invested in a company
measurement of a company’s
with bank debt and a trou- Critical Performance Factors 111
ability to pay the interest on
bling metric here, be pre- its interest-bearing debt through its
pared for the possibility of cash flow (as approximated by its earn-
an announcement about ings before interest,taxes,depreciation,
and amortization—EBITDA).To calcu-
debt restructuring or some
late interest coverage, divide EBITDA
such unless this turns
by interest expense.The lower the
around quickly.
interest coverage, the greater the debt
Return on Equity burden on the company.
Return on equity (ROE) A meas-
The last metric in the
urement of the rate of return of the
financial leverage series is
stockholders’ investment in a pub-
one that is most meaning-
licly owned company. It’s calculated
ful when evaluating pub- by dividing annualized net income by
licly owned companies. stockholders’ equity.
Return on equity measures
the rate of return on the stockholders’ cumulative investment in
the company. Referring this time to both our balance sheet and
Net Income (Annualized) 19,200 x 12
= = 11.6%
Stockholders’ Equity 1,979,000
our income statement, we come up with this calculation:
Unlike some of the other measures, this one is a bit artificial,
for two reasons. First, owners’ equity bears no relation to what
the owners actually paid for their stake in the company. Second,
owners’ equity bears no relation to what they could sell it for
either. Other than that, no problem!
So is the measurement of return on equity useless? Not at
all. It still serves us well as a measure of a company’s earning
power, even if only a theoretical comparison is possible. The
same limitations apply to all companies, so the ratio enables a
company-to-company comparison, which is useful when select-
ing stocks. Also, as with any of these metrics, the pattern of
change over time—see “Trend Reporting” below—enables us to
see a company’s progress against its own history.