Wholesale credit analysis is a very labor intensive process. Although there are many quantitative models, so far real intelligence analyzing the financials is still the most effective method. This is because there are so many different things that can affect a company differently from another one in a different industry, or even in the same industry.
Definitions
| Term | Calculation |
|---|---|
| Operating income | Sales - COGS (including despreciation) - SG&A - other operating expense + other operating income |
| EBIT | Income before taxes + interest expense |
| EBITDA | Net i ncome before taxes + interest expense + depreciation & amortization |
| Capital | Total debt + minority interest + preferred stock + owners’ equity |
Cash Flow Measures
In wholesale credit analysis, it is important to analyze cash flow.
EBITDA is one of the most important measures of profitability (eg. EBITDA margin = EBITDA/revenue).
Charlie Munger famously said that he dislike EBITDA because interest rate and taxes are real expenses that a business must pay. For equity investors, EBITDA may not be a good measure of how good a company is at making money. But for banks, EBITDA is often used. This is because interest is the piece that goes to the bank, and that tax liablities are usually not very signficant.
| Cash Flow Measures | |||
|---|---|---|---|
| Name | Calculation | What it Measures | How to Use |
| EBITDA | Income before taxes + interest expense + D&A | Near-cash operating income; Igores other non-cash items, changes in working capital, and capex. May include non-operatingincome & expenses | Profitability, leverage, and coverage analysis; Multiples valueation; Debt covenants |
| Cash Flow from Operations | Net income + D&A +/-other non-cash items +/- change in net working capital | Cash net income; Includes interest and tax expenses and other non-operating income and expenses | Key source of cash over the long term |
| Free Cash Flow | Cash flow from operations - capex - dividends | Net cash generated or used by all regular strategic business & financial activities except debt repayment; Excludes exceptional sources and uses like acquisitions & divestitures, special dividends, or special share buyback | Cash flow availabel for all other business & financial uses, includng acquisitions, special dividends, share buyback and debt repayment |
| Internal Cash Flow | (Income before taxes + interest expense)x(1 - tax rate) + D&A - capex - change in net working capital | Cash generated before any payment to or from debt or equity | Discounted cash flow method of firm valuation |
Profitability Ratios
| Name | Calculation | What it Measures | How to Use |
|---|---|---|---|
| Gross Margin | (Sales - COGS)/Sales | Production efficiency; buyer power (product prices) & supplier power (input costs) | Use for all companies especially relevant to retailers, wholesalers, and commodity producers |
| Operating Margin | (Operating income)/Sales | Overall operating efficiency including production efficiency and overhead efficiency | Use for all companies, especially to industries that are driven by marketing or product development |
| EBIT margin | EBIT/Sales | Operating efficiency + impact of non-operating income & expenses before interest & taxes | Use when non-operating income or expenses are material & recurring |
| EBITDA margin | EBITDA/Sales | Near-cash operating & non-operating efficiency before interest & taxes | Use for all companies esp. when EBIT margins are low, interest or tax expenses are high, or D&A is high |
| Net margin | (Net income)/Sales | Operating, financial, and tax efficiency | Use for all companies esp. for valuation analysis |
| Return on Assets | (Net income)/(Total assets) | Efficiency of the total investment in the firm | Esp. useful in asset-intensive industries |
| Return on Equity | (Net income)/(Owner’s equity) | Efficiency of the shareholders’ investment in the firm | Esp. useful in valuation analysis |
| Return on Capital | EBIT/Capital | Efficiency of the debt & equity capital investment in the firm | Esp. useful in valuation analysis |
Coverage Ratios
| Name | Calculation | What it Measures | How to Use |
|---|---|---|---|
| X Interest Earned | EBIT/Interest | A company’s ability to make interest payments from operating & non-operating income before interest and taxes | Use for all companies |
| EBITDA Coverage | EBITDA/Interest | A company’s ability to make interest payments from near-cah income before interest & taxes | Use for all companies, especially when D&A, interest or tax expense is high |
| EBIT margin | EBIT/Sales | Operating efficiency + impact of non-operating income & expenses before interest & taxes | Use when non-operating income or expenses are material & recurring |
| EBITDA margin | EBITDA/Sales | Near-cash operating & non-operating efficiency before interest & taxes | Use for all companies esp. when EBIT margins are low, interest or tax expenses are high, or D&A is high |
| Net margin | (Net income)/Sales | Operating, financial, and tax efficiency | Use for all companies esp. for valuation analysis |
| Return on Assets | (Net income)/(Total assets) | Efficiency of the total investment in the firm | Esp. useful in asset-intensive industries |
| Return on Equity | (Net income)/(Owner’s equity) | Efficiency of the shareholders’ investment in the firm | Esp. useful in valuation analysis |
| Return on Capital | EBIT/Capital | Efficiency of the debt & equity capital investment in the firm | Esp. useful in valuation analysis |