A Brief Guide to Engineering Financial Calculations: The Balance Sheet, Working Capital, and Leverage
A short-term lender may put conditions (covenants) on a company requiring it to have a certain amount of Working Capital, or more than a certain Working Capital Ratio, which are calculated from figures on the balance sheet. A low Working Capital Ratio is an indication that the company may have trouble dealing with swings in short-term expenditures.
Working Capital = Current Assets – Current Liabilities.
Working Capital Ratio = Current Assets / Current Liabilities
Most companies require financing. This is done either through equity (money from owners) or debt (money from others). Interest is the cost of debt. A company usually has a mix of both kinds of financing.
In good times, the earning power of the investment is higher than the cost of debt (i.e., interest on the Bank Debt). In that case, the extra value that has been created gets transferred to Equity, thus increasing the Return on Equity.
In bad times, the interest on the debt portion is higher than the earning power of the investment; and so the Return on Equity gets reduced to cover the shortfall. (A negative Return on Equity means that the owners are losing money.)
A number of methods can be used to calculate leverage. In this course, we consider the leverage between Bank Debt (a type of long-term debt) and Equity.
For leverage analysis, we assume Net Income to be the Operating Income minus the interest on the long-term debt (found on the Income Statement). (This is consistent with including interest on long-term debt as a negative entry in Other Income.)
- Bank Debt is found on the Balance Sheet, usually named Long-Term Debt.
- Total Assets and Total Equity are also found on the Balance Sheet.
- The bank interest rate is given information.
Three sets of calculations are made: leverage, net income, and return on equity.
Bank Debt Leverage = Bank Debt / Total Assets (expressed in percent).
Debt Ratio Leverage = Total Liabilities / Total Assets (in percent)
Net Income = Operating Income – (interest rate) x(Bank Debt)
Return on Equity = Net Income / Total Equity. (expressed in percent)
(Here, net income is defined as operating income minus interest paid. This is appropriate for assessing a division of a company, but generally not for the entire company. In reality, an investor would look at Return on Equity for the whole company on after-tax earnings, in which case we use After-Tax Net Income in the calculation. We’ll consider this briefly in the project and in some detail later in the course.)