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employee from 01.01.2013 until now
Lyubercy, Moscow, Russian Federation
VAC 08.00.10 Финансы, денежное обращение и кредит
VAC 08.00.12 Бухгалтерский учет, статистика
VAC 08.00.13 Математические и инструментальные методы экономики
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UDK 33 Экономика. Экономические науки
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BBK 65 Экономика. Экономические науки
The article discusses the methodology for an in-depth analysis of the financial sustainability of an organization that allows assigning a certain rating to a company.
cash flow return on sales, cash to income ratio, cash flow to sales ratio, cash flow adequacy ratio
Introduction
In the modern market economy, the financial sustainability analysis is one of the most important functions of effective management, required for the successful existence and development of an organization.
The fullest picture of an organization's financial sustainability is obtained by comprehensive financial analysis and not by reducing the analysis only to the accounting (financial) statements. However, the use of a comprehensive financial analysis requires high labour costs and the professional experience of the economists involved. Thus, it is should be emphasized once again that there is a pressing need to develop a methodology for assessing the financial sustainability of organizations. This methodology must take into account the industry specifics and allow analysing both an individual organization and an entire industry in the shortest possible time (Agapova, 2012).
Methodology for Analysing the Financial Sustainability of an Organization
Currently, a sufficient number of methodologies exist for analysing the financial sustainability of an organization, and each methodology has a range of advantages and disadvantages (Dianov, 2018).
Reviews of the studies of well-known economists enabled us to propose a methodology for analysing the financial sustainability of an organization that can be adjusted depending on industry specifics. It is based on calculating the following ratios, divided into two groups:
I. Financial strength indicators of an organization (60% weight in the summary assessment)
1. Current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts. The current ratio is an indication of a firm's market liquidity and ability to meet creditor's demands.
2. Acid-test or quick ratio or liquid ratio measures the ability of a company to use its near cash or quick assets to extinguish or retire its current liabilities immediately.
3. Cash ratio is most commonly used as a measure of company liquidity. It can therefore determine if, and how quickly, the company can repay its short-term debt.
4. Equity ratio is a financial ratio indicating the relative proportion of equity used to finance a company's assets.
5. The debt-to-equity ratio is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets.
6. Debt ratio indicates the relationship between capital supplied by outsiders and capital supplied by shareholders.
7. Non-current assets to Net worth ratio measure the extent of a company's investment in low-liquid non-current assets. It is the ratio of the value of fixed assets to equity capital and reserves, which shows what percentage of its own sources of funds sent to cover the non-current assets (Muzalev, 2016).
8. Capital equity mobility ratio measures share capital invested in current assets.
9. Capitalization ratio measures the debt component of a company's capital structure, or capitalization to support a company's operations and growth.
10. Cash return on sales ratio gives the analysts and investors indications about the ability of a company to generate cash from its sales. In other words, it shows the ability of a company to turn its sales into cash. The higher this ratio is the better it is for the company. Company with such a trend in this ratio is good investment opportunities.
11. Operations index characterizes the financial cycle of the company reflects the management of mutual settlements with contractors.
12. CFO to net income shows the percentage of net income in the form of real money.
13. Cash Flow Return on Assets ratio used to compare a business’s performance among other industry members. The ratio can be used internally by the company's analysts, or by potential and current investors. A high ratio can indicate that a higher return is to be expected and the more cash the company has available for reintegration into the company.
14. OCF to EBITDA shows the real money filling in operating profit before interest and depreciation and amortization
15. Free Cash Flow to Cash Flow from Operations ratio measures the relationship between free cash flow and operating cash flow. The more free cash flows are embedded in the operating cash flows of a company, the better it is.
16. Cash/Sales ratio indicates the effectiveness of the company's credit and collection policies, and the amount of cash required for unexpected delays in cash collection.
17. Cash Interest Coverage ratio is a measure of the number of times a company could make the interest payments on its debt with its earnings before interest and taxes.
18. Cash Flow Adequacy ratio indicates a company's capability of covering capital expense, debt repayment and dividends from cash flow generated from operating activities. Cash flow adequacy is the primary measure of cash sufficiency.
19. Capital Expenditure ratio measures a company's ability to acquire long term assets using free cash flow. The cash flow to capital expenditures (CF to CAPEX) ratio will often fluctuate as businesses go through cycles of large and small capital expenditures.
20. Dividend Payout ratio provides an idea of how well earnings support the dividend payments. More mature companies tend to have a higher payout ratio.
21. Reinvestment ratio is used to estimate the amount of cash flow that management reinvests in a business.
22. Debt Service Coverage ratio is used in banking to determine a company's ability to generate enough income in its operations to cover the expense of a debt. Indicates that the company’s net operating income is enough to cover only of its annual debt payments.
23. Cash Maturity Coverage ratio indicates the ability to repay long term maturities as they mature and indicates whether long term debt maturities are in time with operating cash flow.
24. Cash Flow to Total Debt ratio provides an indication of a company's ability to cover total debt with its yearly cash flow from operations.
25. Cash debt coverage ratio is an indicator of the possibility of a company to pay interest and principal amounts when they become due. This ratio tells the number of times the financial obligations of a company are covered by its earnings.
26. Years Debt ratio shows the number of years during which the company has possible to pay its debt (Suglobov, 2016).
II. Performance indicators of an organization (40% weight in the summary assessment)
1. Capital turnover is a measure of how well a company uses its stockholders' equity to generate revenue.
2. Inventory turnover is a measure of the number of times inventory is sold or used in a time period.
3. Receivables turnover measures the number of times, on average; receivables are collected during the period.
4. Payables turnover measures show investors how many times per period the company pays its average payable amount.
5. Operating cycle is the amount of time it takes for a company to turn cash used to purchase inventory into cash once again.
6. Cash conversion cycle measures how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales. It is thus a measure of the liquidity risk entailed by growth.
7. Return on sales, % the percentage of sales revenue that gets 'returned' to the company as net profits after all the related costs of the activity are deducted
8. Return on invested capital, % measures the return that an investment generates for those who have provided capital, i.e. bondholders and stockholders. ROIC tells how good a company is at turning capital into profits.
9. Return on assets, % the percentage shows how profitable a company's assets are in generating revenue.
10. Return on equity, % the percentage measures a firm's efficiency at generating profits from every unit of shareholders' equity. ROE shows how well a company uses investment funds to generate earnings growth.
11. Return on net assets, % is a measure of financial performance of a company which takes the use of assets into account. Higher RONA means that the company is using its assets and working capital efficiently and effectively. (Yaremchuk, 2019).
12. Altman’s Model (USA)
13. Liss’s Model (UK)
14. Taffler’s Model (UK)
15. Springate’s Model (USA)
The assessment of a specific indicator is based on three components:
“Past” is an estimate of the mean for the periods preceding the reporting one (25% weight in the summary assessment of the indicator);
“Present” is an assessment of the value for the last period (reporting date) (60% weight in the summary assessment);
“Future” is an assessment of the indicator value a year after the reporting date, obtained by a linear trend (15% weight in the summary assessment).
The values for each indicator are assigned as follows:
“-2” - very bad;
“-1” - bad;
“+1” - good;
“+2” - very good.
Next, the weighted average of each indicator is calculated based on the weight of the three main components. Then the coefficient is determined by multiplying the weight of each indicator in the total volume of the considered coefficients divided into groups by the obtained weighted average.
The financial rating is determined by averaging two comprehensive assessments such as the financial position and financial performance of the organization (in a ratio of 60% to 40%).
The following financial sustainability ratings can be assigned based on the analysis results for an organization:
AAA - excellent;
AA - very good;
A - good;
BBB - positive;
BB - normal;
B - satisfactory;
CAS - unsatisfactory;
SS - bad;
C - very bad;
D - critical.
Result
Next, we will consider testing the proposed methodology for determining an organization's financial sustainability on the example of Associated British Foods; Dairy Crest Group, which is one of the leading British companies that produces and sells consumer goods, mainly food, beverages, household chemicals, and tobacco products.
In the beginning, we will calculate the proposed indicators and present the result in Table 1.
Table 1. Calculation of the indicators according to the methodology
|
Indicators |
2005-2016 |
2017 |
2018 |
|
Current ratio |
1,28 |
1,65 |
1,37 |
|
Quick ratio |
0,77 |
0,98 |
0,67 |
|
Cash ratio |
0,21 |
0,49 |
0,19 |
|
Equity ratio |
0,57 |
0,66 |
0,64 |
|
Debt-to-equity ratio |
0,57 |
0,52 |
0,58 |
|
Debt- ratio |
0,35 |
0,34 |
0,36 |
|
Non-current assets to Net worth ratio |
0,98 |
0,91 |
1,00 |
|
Equity mobility ratio |
-0,06 |
0,09 |
0,00 |
|
Capitalization ratio |
0,16 |
0,13 |
0,13 |
|
Capital conversion period |
166,31 |
182 |
165,83 |
|
Inventory conversion period |
48,46 |
63 |
66,18 |
|
Receivables conversion period |
34,38 |
31 |
28,92 |
|
Payables conversion period |
38,62 |
45 |
35,79 |
|
Operating cycle |
82,62 |
95 |
94,94 |
|
Cash conversion cycle |
44,08 |
50 |
59,48 |
|
Return on sales |
6,44 |
8,7 |
8,35 |
|
Return on invested capital |
6,60 |
13,54 |
11,08 |
|
Return on assets |
4,96 |
10,01 |
8,14 |
|
Return on equity |
8,01 |
15,59 |
12,86 |
|
Return on net assets |
8,77 |
17,62 |
14,71 |
|
Altman’s Model |
0,45 |
0,62 |
0,61 |
|
Liss’s Model |
0,05 |
0,07 |
0,07 |
|
Taffler’s Model |
-1,55 |
-2,01 |
-1,84 |
|
Springate’s Model |
1,06 |
1,65 |
1,51 |
|
Cash return on sales ratio |
7,23 |
9,61 |
10,79 |
|
Operations index |
94,77 |
110,44 |
131,03 |
|
CFO to net income |
143,19 |
121,84 |
190,73 |
|
Cash Flow Return on Assets ratio |
8,38 |
12,2 |
14,01 |
|
OCF to EBITDA |
74,62 |
71,89 |
100,10 |
|
Free Cash Flow to Cash Flow from Operations ratio |
1,66 |
1,71 |
1,46 |
|
Cash/Sales ratio |
0,04 |
0,07 |
0,04 |
|
Cash Interest Coverage ratio |
0,94 |
1,15 |
1,10 |
|
Cash Flow Adequacy ratio |
-2,67 |
-5,2 |
-6,63 |
|
Capital Expenditure ratio |
-1,30 |
-1,86 |
-2,20 |
|
Dividend Payout ratio |
-0,22 |
-0,17 |
-0,09 |
|
Reinvestment ratio |
-0,08 |
-0,02 |
0,09 |
|
Debt Service Coverage ratio |
50,54 |
1 368,33 |
596,55 |
|
Cash Maturity Coverage ratio |
0,42 |
0,55 |
0,61 |
|
Cash Flow to Total Debt ratio |
0,22 |
0,34 |
0,38 |
|
Cash debt coverage ratio |
0,27 |
0,4 |
0,45 |
|
Years Debt ratio |
2,79 |
2,51 |
1,96 |
Then, we will present the boundary distribution of the proposed indicators and assign each indicator value from “-1” to “+2” (Table 2).
Table 2. Defining the boundaries of the proposed indicators
|
Indicators |
-2 |
-1 |
+1 |
+2 |
|
Current ratio |
<0.75 |
>1.73 |
0.75-1.24 |
1.24-1.73 |
|
Quick ratio |
<0.54 |
>0.93 |
0.54-0.74 |
0.74-0.93 |
|
Cash ratio |
<0.2 |
>0.29 |
0.2-0.25 |
0.25-0.29 |
|
Equity ratio |
<0.29 |
0.29-0.35 |
0.35-0.41 |
>0.41 |
|
Debt-to-equity ratio |
> 8.50 |
4.25-8.50 |
1-4.25 |
<1 |
|
Debt- ratio |
>0.71 |
0.65-0.71 |
0.59-0.65 |
<0.59 |
|
Non-current assets to Net worth ratio |
>6.29 |
3.65-6.29 |
1-3.65 |
<1 |
|
Equity mobility ratio |
<1 |
>2.42 |
1-1.21 |
1.21-2.42 |
|
Capitalization ratio |
>0.61 |
0.41-0.56 |
0.56-0.61 |
≤0.41 |
|
Capital conversion period |
>212 |
181-212 |
101-181 |
<101 |
|
Inventory conversion period |
>144 |
62-144 |
47-62 |
<47 |
|
Receivables conversion period |
>60 |
33-60 |
31-33 |
<31 |
|
Payables conversion period |
>99 |
42-99 |
21-42 |
<21 |
|
Operating cycle |
>114 |
99-114 |
83-99 |
<83 |
|
Cash conversion cycle |
>81 |
5-81 |
0-5 |
<0 |
|
Return on sales |
<4.24 |
4.24-8.25 |
8.25-12.37 |
>12.37 |
|
Return on invested capital |
<5.86 |
5.86-10.96 |
10.96-16.95 |
>16.95 |
|
Return on assets |
<4.32 |
4.32-8.12 |
8.12-11.26 |
>11.26 |
|
Return on equity |
<7.43 |
7.43-12.81 |
12.81-30.95 |
>30.95 |
|
Return on net assets |
<7.93 |
7.93-14.43 |
14.43-22.69 |
>22.69 |
|
Altman’s Model |
<0.1 |
0.1-0.2 |
0.2-0.3 |
>0.3 |
|
Liss’s Model |
<0.25 |
0.025-0.037 |
0.037-0.05 |
>0.05 |
|
Taffler’s Model |
<-2 |
-2-(-0.3) |
-0.3-0.3 |
>0.3 |
|
Springate’s Model |
<0.5 |
0.5-0.862 |
0.862-1.5 |
>1.5 |
|
Cash return on sales ratio |
<0 |
0-1 |
1-9.68 |
>9.68 |
|
Operations index |
<0 |
0-1 |
1-117.79 |
>117.79 |
|
CFO to net income |
<0 |
0-1 |
1-159.28 |
>159.28 |
|
Cash Flow Return on Assets ratio |
<0 |
0-1 |
1-12.10 |
>12.10 |
|
OCF to EBITDA |
<0 |
0-1 |
1-86.27 |
>86.27 |
|
Free Cash Flow to Cash Flow from Operations ratio |
<0 |
0-1 |
1-1.70 |
>1.70 |
|
Cash/Sales ratio |
<0 |
0-0.05 |
0.05-1 |
>1 |
|
Cash Interest Coverage ratio |
<0 |
0-1 |
1-1.12 |
>1.12 |
|
Cash Flow Adequacy ratio |
<0 |
0-1 |
1-5.05 |
>5.05 |
|
Capital Expenditure ratio |
<0 |
0-1 |
1-1.87 |
>1.87 |
|
Dividend Payout ratio |
<0 |
0-1 |
0,17 |
>60 |
|
Reinvestment ratio |
<0 |
0-0.01 |
0.01-1 |
>1 |
|
Debt Service Coverage ratio |
<0 |
0-1 |
1-711.22 |
>711.22 |
|
Cash Maturity Coverage ratio |
<0 |
0-0.55 |
0.55-1 |
>1 |
|
Cash Flow to Total Debt ratio |
<0 |
0-0.33 |
0.33-1 |
>1 |
|
Cash debt coverage ratio |
<0 |
0-0.39 |
0.39-1 |
>1 |
|
Years Debt ratio |
<0 |
0-1 |
1-2.57 |
>2.57 |
Now, we will analyse the calculated data for the company in question and present the result in Table 3.
Table 3. The analysis result based on the proposed methodology
|
Indicators |
2005-2018 |
Вес показателя |
Past |
Present |
Future |
Average |
Score |
|
I. Rating of the company's financial position |
|||||||
|
Current ratio |
1,48 |
0,00132 |
+2 |
+2 |
+2 |
2,00 |
0,0026 |
|
Quick ratio |
0,83 |
0,00074 |
+2 |
-1 |
+1 |
0,05 |
0,0000 |
|
Cash ratio |
0,31 |
0,00028 |
+2 |
-1 |
-2 |
-0,40 |
-0,0001 |
|
Equity ratio |
0,64 |
0,00057 |
+2 |
+2 |
+2 |
2,00 |
0,0011 |
|
Debt-to-equity ratio |
0,57 |
0,00051 |
+2 |
+2 |
+2 |
2,00 |
0,0010 |
|
Debt- ratio |
0,36 |
0,00032 |
+2 |
+2 |
+2 |
2,00 |
0,0006 |
|
Non-current assets to Net worth ratio |
0,99 |
0,00088 |
+1 |
+2 |
+1 |
1,60 |
0,0014 |
|
Equity mobility ratio |
0,01 |
0,00001 |
-2 |
-2 |
-2 |
-2,00 |
0,0000 |
|
Capitalization ratio |
0,15 |
0,00013 |
+2 |
+2 |
+2 |
2,00 |
0,0003 |
|
Cash return on sales ratio |
9,68 |
0,00867 |
+1 |
+1 |
+2 |
1,15 |
0,0100 |
|
Operations index |
117,78 |
0,10559 |
+1 |
+1 |
+2 |
1,15 |
0,1214 |
|
CFO to net income |
159,28 |
0,14279 |
+2 |
+1 |
+2 |
1,40 |
0,1999 |
|
Cash Flow Return on Assets ratio |
12,10 |
0,01085 |
+1 |
+2 |
+2 |
1,75 |
0,0190 |
|
OCF to EBITDA |
86,27 |
0,07734 |
+2 |
+1 |
+2 |
1,40 |
0,1083 |
|
Free Cash Flow to Cash Flow from Operations ratio |
1,70 |
0,00153 |
+2 |
+2 |
+1 |
1,85 |
0,0028 |
|
Cash/Sales ratio |
0,05 |
0,00005 |
+1 |
+1 |
-1 |
0,70 |
0,0000 |
|
Cash Interest Coverage ratio |
1,12 |
0,00100 |
+1 |
+2 |
+1 |
1,60 |
0,0016 |
|
Cash Flow Adequacy ratio |
5,05 |
0,00453 |
-2 |
-2 |
-2 |
-2,00 |
-0,0091 |
|
Capital Expenditure ratio |
1,87 |
0,00168 |
-2 |
-2 |
-2 |
-2,00 |
-0,0034 |
|
Dividend Payout ratio |
0,17 |
0,00015 |
-2 |
-2 |
-2 |
-2,00 |
-0,0003 |
|
Reinvestment ratio |
0,01 |
0,00001 |
-2 |
-2 |
+1 |
-1,55 |
0,0000 |
|
Debt Service Coverage ratio |
711,22 |
0,63759 |
+1 |
+2 |
+1 |
1,60 |
1,0201 |
|
Cash Maturity Coverage ratio |
0,55 |
0,00050 |
-1 |
+1 |
+1 |
0,50 |
0,0002 |
|
Cash Flow to Total Debt ratio |
0,33 |
0,00030 |
-1 |
+1 |
+1 |
0,50 |
0,0001 |
|
Cash debt coverage ratio |
0,39 |
0,00035 |
-2 |
+1 |
+1 |
0,25 |
0,0001 |
|
Years Debt ratio |
2,57 |
0,00230 |
+2 |
+1 |
+1 |
1,25 |
0,0029 |
|
Total |
1115,49 |
1,00000 |
|
|
|
|
1,48085 |
|
II. Rating of the company's financial performance |
|||||||
|
Capital conversion period |
0,50 |
0,08455 |
-1 |
-1 |
+1 |
-0,70 |
-0,0592 |
|
Inventory conversion period |
0,17 |
0,02910 |
+1 |
-1 |
-1 |
-0,50 |
-0,0145 |
|
Receivables conversion period |
0,09 |
0,01553 |
-1 |
+2 |
+2 |
1,25 |
0,0194 |
|
Payables conversion period |
0,12 |
0,01967 |
-1 |
-1 |
-1 |
-1,00 |
-0,0197 |
|
Operating cycle |
0,26 |
0,04473 |
+1 |
+1 |
+1 |
1,00 |
0,0447 |
|
Cash conversion cycle |
0,15 |
0,02513 |
-1 |
-1 |
-1 |
-1,00 |
-0,0251 |
|
Return on sales |
0,08 |
0,01407 |
-1 |
+1 |
+1 |
0,50 |
0,0070 |
|
Return on invested capital |
0,11 |
0,01869 |
-1 |
+1 |
+1 |
0,50 |
0,0093 |
|
Return on assets |
0,08 |
0,01384 |
-1 |
+1 |
+1 |
0,50 |
0,0069 |
|
Return on equity |
0,13 |
0,02183 |
-1 |
+1 |
+1 |
0,50 |
0,0109 |
|
Return on net assets |
0,14 |
0,02460 |
-1 |
+1 |
+1 |
0,50 |
0,0123 |
|
Altman’s Model |
0,59 |
0,10061 |
+2 |
+2 |
+2 |
2,00 |
0,2012 |
|
Liss’s Model |
0,07 |
0,01143 |
+2 |
+2 |
+2 |
2,00 |
0,0229 |
|
Taffler’s Model |
1,90 |
0,32352 |
+1 |
+1 |
+1 |
1,00 |
0,3235 |
|
Springate’s Model |
1,48 |
0,25271 |
+1 |
+2 |
+2 |
1,75 |
0,4422 |
|
Total |
5,87 |
1,00000 |
|
|
|
|
0,98195 |
|
TOTAL |
1,2813 |
||||||
As it is shown in Table 3, the final sum obtained in the analysis was 1.2813. Now we will compare the obtained result with the table value and assign a financial sustainability rating to the company under study (Table 4).
Table 4. Determining the financial sustainability rating
|
Score |
Rating |
Financial performance |
|
|
from |
before |
||
|
1,6 |
2 |
AAA |
Excellent |
|
1,2 |
1,6 |
AA |
Very good |
|
0,8 |
1,2 |
A |
Good |
|
0,4 |
0,8 |
BBB |
Positive |
|
0 |
0,4 |
BB |
Normal |
|
-0,4 |
0 |
B |
Satisfactory |
|
-0,8 |
-0,4 |
CCC |
Unsatisfactory |
|
-1,2 |
-0,8 |
CC |
Adverse |
|
-1,6 |
-1,2 |
C |
Bad |
|
-2 |
-1,6 |
D |
Critical |
Based on the analysis results, an AA rating can be assigned, corresponding to a high level of financial sustainability and indicating the company's sustainable financial condition and its stable market position.
Conclusion
The study proposed a methodology to determine a company's rating by its financial sustainability. The methodology will not only enable the company's management to evaluate their financial condition as accurately as possible but also allow the main groups of stakeholders to assess the financial sustainability of the organization in more detail.
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