Net Operating Assets can be defined as the assets within a business that is related to the operations of the business. It is simply defined as the difference between the operating assets of the company, and the operating liabilities of the company.
Net Operating Assets are basically the representation of how much assets, and liabilities the business has at a given point in time, that are relevant to the operating activities of the business.
It is important to identify net operating assets, because it discretely segregates the amount that the business has invested in its core operating activities, versus its other activities, which include financial activities of the organization as well.
Net Operating Assets basically involves calculating the amount of assets and liabilities that are the business is operating with.
It mainly comprises of balance sheet restructuring in order to segregate the operating assets from the non-operating assets. However, net operating assets can be calculated in two broader ways:
Firstly, Net Operating Assets can be calculated using the Operating Approach. As far as the operating approach is concerned, it comprises of calculating net operating assets using the following formula:
Net Operating Assets = Operating Assets – Operating Liabilities
However, in order to calculate net operating assets using this approach, the balance sheet must be reformatted in order to accurately calculate operating assets and operating liabilities in an accurate manner. In this regard, operating assets are calculated using the following formula:
Operating Assets = Total Assets – Excess Cash (and Cash Equivalents) – Financial Assets (including the investments carried out by the company)
In the same manner, operating liabilities are also calculated using the following formula:
Operating Liabilities = Accounts Payable + Deferred Operating Expenses (Accruals) + Deferred Taxes on Operating Income + Reserves maintained for Operating Expenses
Alternatively, it can be seen that the financing approach can also be used to calculate the Net Operating Assets. Net Operating Assets calculated using the financing approach have the following formula:
Net Operating Assets = Equity + Short-term and Long-Term Non-Operating Debts (Non-Current Operating Assets) – Financial Assets and investments – Excess cash and cash equivalents
Using the financing approach, it can be seen that the amount of net operating assets is calculated as the net amount of interest-bearing debts.
Usages of Net Operating Assets
Net Operating Assets is considered to be a very useful metric for the organization, since it has a number of advantages for the decision makers of the company.
It is used for the purposes of comparing the net profit of the business with other relevant business models. It shows the net income (or net operating income) that the company has earned, in comparison to the total net operating assets it has.
Given the fact that it mainly ignores the financial benefits that are extrapolated as a result of interest-bearing expenses, the impact of leverage is minimized from the returns.
Hence, this represents the core profits that are generated by the company as a result of their operations, with respect to the operating assets that they have.
In the same manner, Net Operating Assets also stands to be a very viable basis to calculate other subsequent metrics, including Discounted Cash Flows, Free Cash Flows as well as Discounted Operating Earnings. These metrics are considered valuable in terms of estimating value of the company.
However, the greatest usefulness of Net Operating Assets is perhaps the fact that net operating assets are considered to be resourceful is because of the fact it helps to show the operating threshold of the company, in terms of the investment it has made in the existing operations within the company.
Limitations of Net Operating Assets
Where on one hand, net operating assets are representative of the extent to which operations are properly managed, yet it can be seen that the fact that they do not include any analysis pertaining to financial leverage of the organization.
For example, an organization might have higher net operating assets, but their financial asset management might not be that efficient. In this case, relying solely on this metric might be risky from the perspective of the organization.
In the same manner, Net Operating Assets is calculated using the book value of the assets and the liabilities that are mentioned on the balance sheet.
However, this might not be representative of the true and the fair value of the net operating assets, since these figures in the balance sheet might not be aligned with the existing market values for these respective assets and liabilities.
Therefore, it might not a true and fair estimate if used in comparison with other organizations. It is only resourceful if it is analyzed over a course of time, for a single company only.
Price to Earnings Ratio is a very important metric that is used by investors in order to gauge the viability of a particular stock. This particular stock draws a comparison between the price of the particular share and the earnings that the company has reported over the course of time.
This ratio is basically a representation regarding what the market is ready to pay current for the listed stock based on its earnings. These earnings can be both, past and forward PE.
In the case where past earnings are utilized to calculate the PE Ratio, it is referred to as a trailing PE Ratio. On the other hand, if the future estimates and approximations are used in order to calculate the future earnings, it is referred to as a forward PE Ratio.
From the investors’ perspective, it can be seen that investors mostly require and go for shares that have a higher PE Ratio.
This is mainly because of the fact that it shows that the given stock or share has a potential to earn a substantial amount of money in comparison to other stocks with relatively lower PE Ratios.
Hence, this particular metric is highly resourceful because it helps to draw a comparison between different stocks pertaining to their ability to generate profits.
PE Ratios are mostly positive. Positive PE Ratios are indicative of the fact that the company is making profits, and is sustaining itself.
However, in the case where the company is making a loss, or is unable to make decent profits, it can be seen that PE Ratio can also be negative.
It must be noted that there are very cases where companies report negative PE Ratios, because it is not beneficial for them to report them otherwise.
Price to Earnings Ratio is a comparison of the existing price of the stock, relative to the overall earnings it is generating. Therefore, it is calculated using the following formula:
PE Ratio = (Price of the stock) / (Total Earnings of the company or Earnings per Share)
Reasons for negative P/E Ratio:
Despite the fact that in most cases, companies have positive PE Ratios, it can be seen that there are a few instances where the company might end up having negative PE Ratios.
It is mainly because of the fact that the company has reported negative earnings over the recent past, because of which the PE Ratio turns out to be negative. The main reasons for a negative PE Ratio are as following:
Company incurring a loss over the course of time – this means that the company has not reported profits over the recent past, because of which the denominator is negative. This would automatically make the PE Ratio negative.
New projects: In the case of new projects, companies often have negative PE Ratios because they are in the initial phases, and they have not begun generating revenues as yet. This is often the case for newly established businesses, who are incurring initial setup costs as a result of new projects being set up.
In the same manner, it can also be seen that negative PE Ratios often occur because of unprecedented circumstances and situations. A company suffering an unprecedented loss, or an uncalled for expense might be the reason behind the negative PE Ratio.
Implications for Negative PE Ratio:
A negative PE Ratio can often be a cause of an alarm for investors. It might hint that the company is no longer doing well, and might declare bankruptcy in the coming future.
However, it must be seen that a negative PE Ratio that persists across the company’s balance sheet is often a cause of concern for the investors.
On the other hand, if the negative PE Ratio is temporary, and occurs as a one off incident, is not always necessarily a bad thing. Here are a few reasons as to why negative PE Ratio is not always bad:
A negative PE Ratio that occurs because of a one-off incident, like an unprecedented loss or litigation will reduce the earnings for that particular year only. In this case, it is better to realize the fact that negative PE Ratios for that particular year can be relevant to that particular year only. Therefore, it might helpful for investors to consider past (trailing) PE Ratios to get a better idea about the company.
Negative PE Ratios that happen because of the investment in numerous different resources and projects might mean that there are better growth prospects for the company in the future, which are currently unaccounted for. Hence, negative PE Ratios in individuality might not be an accurate representation of the organization’s position.
Gearing Ratio is defined as the financial ratio that draws a comparison between the owner’s equity in the company, to debt, or to the amount of funds that are borrowed by the company. Gearing can be defined as a metric that measures the company’s financial leverage.
Financial leverage basically shows the degree with which the operations, and the overall company if funded with equity financing versus debt financing.
Therefore, to summarize gearing ratios can be defined as a group of financial metrics that are used to compare shareholders’ equity to the existing company’s amount of debt that the company has drawn.
This is considered to be a very important metric to gauge the company’s leverage, as well as financial stability. They are compared with the other gearing ratios that exist in the company in order to get an idea about the existing industry average.
Gearing Ratios are metrics, and in order to calculate gearing ratios, different aspects of the company are included.
The gearing ratios are defined as different ratios that measure different things about the particular organization. Therefore, they are categorized as the following types:
Times Interest Earned = (Earnings before Interest and Tax) / Total Interest
(Times Interest Earned Ratio is a representation of the total earnings of the company, as a percentage of the interest that the company has paid. This helps to show how much the company has earned, against the interest and the financial cost that they had to bear as a result. )
Equity Ratio = Equity / Assets
(Equity Ratio is a representation of the total equity that the company has, as a percentage of the total assets. This shows the amount of assets that the company has, the percentage of those assets, which are backed by equity of the company.)
Debt Ratio = Total Debt / Total Assets
(Similar to equity ratio, the debt ratio is considered to be a representation of the total assets that the company has, and out of those assets, how much are attributable to the debt that the company has drawn over the recent years)
Is Gearing Ratio similar to Debt-Equity Ratio?
The debt-to-Equity Ratio describes the total debt that is drawn by the company against the total equity that the owners of the company have raised. It directly shows the percentage of the company that is leveraged by debt.
In other words, it shows the amount of debt that is drawn by the company against every $1 of equity raised by the company. It is calculated using the following formula:
Debt-to-equity Ratio = Total Debt / Total Equity
Often this particular ratio is referred to as the gearing ratio. It is mainly because of the fact that it tells about the extent to which the company is reliant on debt, versus the equity that they have raised over the period of time. Therefore, it gives a very useful insight about the leverage position of the company.
Hence, it would not be considered incorrect to say that debt-to-equity ratio is considered to be a category of the gearing ratio. However, gearing can also be measured using other several metrics and ratios, like the ones mentioned above.
How can Gearing Ratio be improved?
Gearing Ratio is considered to be one of the very important metrics of the company. There is no specific ‘ideal’ gearing ratio for the company. It depends from company to company.
As a matter of fact, optimal debt-to equity structure is a factor of a multitude of things, including the weighted average cost of capital of the firm, as well as the cost of equity and cost of debt that the company has.
However, there are costs and benefits associated with being highly geared and lowly geared. Depending on the situation that suits the company best, this can be subsequently prescribed.
In the case where the company is lowly geared, it means that the company has significant amount of resources obtained from equity finances. In order to increase the gearing of the company, they are supposed to get debt.
They can either buy back shares from the existing shareholders (and issue debt against this repurchase), or they can simply take on more debt – in the case where they are looking to finance a particular project.
In the same manner, in the case where the company is highly geared, and they want to reduce the gearing, the company has an option to issue more shares, and pay back the debt. In most cases, servicing the debt, and paying back the liabilities automatically reduces the liability of the company.
The fast paced business environment in the modern day and age poses an increasingly challenging dynamic for investors. This is primarily because of the fact that there are numerous different opt ions that investors have to choose from, and therefore, they ideally look for options that are likely best suited to their investment profile and taste.
In this regard, it is also important to note the fact that investors today are supposed to ensure that they are able to carry out a stringent study of the organization they plan to invest in so that they are able to knowingly invest from the options they have available.
In this regard, investor ratios tend to be highly resourceful for investors, because they are able to impart some extremely valuable information about the organization.
Investor Ratios can simply be defined as ratios that the investors use in order to evaluate the ability of the company to maintain profitability and continue generating positive returns against their investment.
Investor ratios are considered to be extremely important when making investment decisions because of the fact that they provide some useful and valuable insights about the company in context to other companies, or other existing investment options.
Investor Ratios can be categorized into numerous different categories, depending on the different existing ratios that exist.
Types of Investor Ratios
There are a number of investor ratios, which prove to be critical for investors. They are mentioned below:
Earnings per Share
Earnings per Share is a numeric representation of the earnings that the particular organization earned over the course of time. It is calculated using the following formula:
Earnings per Share = Total Earnings / Outstanding Shares of the company
This particular ratio shows the company’s ability to generate profit. From an investor perspective, higher the EPS (Earning per Share), the better the investment prospect.
This ratio is also compared over time. If over the course of time, the company reports higher and higher earnings per share, it means that the future prospects of the company look widely positive.
Price to Earnings Ratio
P/E Ratio (Price to Earnings Ratio) is a comparison of the amount that the company earns, with the price of the particular share. This relationship between the share price, and the earnings that are respectively earned out of that investment are indicative of the value of the company in the existing capital market.
This ratio also tends to be important for the investors because it gives them an idea about what to expect on the fronts of the risk-reward scheme. P/E Ratio of the company is calculated using the following formula:
P/E Ratio = Share Price / Earnings per share
Hence, it can be seen that this particular ratio incorporates both, the share price, and the number of shares that are issued by the organization.
Dividend Cover can be defined as the financial ratio that takes into account the number of times the company can pay dividends to the shareholders. This is done by comparing the net income of the company with the dividend that is paid.
Hence, it encapsulates the number of times the company can pay dividends from the net income that is generated by the company. Therefore, it is calculated using the following formula:
Dividend Cover = (Net Income) / (Dividends declared or Paid)
Alternatively, dividend cover can also be calculated by comparing the EPS and the declared dividend by the company for the ordinary shareholders. In this particular scenario, the formula for dividend cover is as follows:
Dividend Cover = EPS / (Dividend Declared per ordinary share)
Dividend Yield can be described as the financial ratio that provides a direct measure that is generated from a return of investments that are made in the shares of the company. This is calculated by comparing the dividend per market share to the existing market price per share.
This particular metric is also frequently used by investors, because it helps them compare and subsequently assess the relative benefits of existing investment opportunities in the market. In the same manner, it can also be seen that this helps to calculate the return on investment, which investors can expect to generate.
Therefore, this is calculated using the following formula:
Dividend Yield = (Dividend per Share) / (Share Price)
The dividend yield is basically a metric that shows the return that can be generated as a result of the investment in the particular company. Hence, this tends to be one of the main factors which investors incorporate, so that they can choose stocks that have a higher dividend yield in comparison.
Loan Loss Reserve Ratio is described as the ratio that is used in the bank in order to represent the reserve that the company has in percentage terms in order to cover the estimated losses that they would have suffered as a result of defaulted loans.
The nature of the Loan Loss account is described as a contra account to gross loan outstanding. This particular ratio is used to identify and measure the performance of the existing loan portfolio of the company, as a comparison to other players in the market.
The Loan Loss Reserve Ratio basically shows the probability of debtors failing to settle their debts in due time. This basically reflects the company’s position in terms of the collection rate.
A higher Loan Loss Reserve Ratio means a lower collection (from the total loans issued), whereas a Lower Loan Loss Reserve Ratio means a higher collection.
Loan Reserve Ratio is calculated using the following formula:
Loan Loss Reserve Ratio = (Loss Loan Reserves) / (Gross Loan Portfolio)
Therefore, this calculation describes the overall probability of customers defaulting, as a percentage of the overall gross loans that are withdrawn on the company.
Additionally, it can also be seen that the lower ratio indicates that the bank or the financial institution is a safer institution to invest in, from the investors’ perspective.
On the other hand, if the bank or the financial institution has a higher loan loss reserve ratio, it means that the organization has a higher risk profile, and therefore, it might not be a suitable investment for risk-averse investors.
In order to further explain the concept of Loan Loss Reserve, the following illustration is given:
Metro Bank has made around $200,000 in loans to various other institutions and individuals. The managers at Metro Bank only lend out loans to individuals that have a low and medium-low risk profile. Therefore, they only handpick individuals they know are going to pay back those loans in time. However, they can still never be certain if all the debtors are going to pay back the amount they had drawn as loans. Therefore, they are supposed to create a loan loss reserve in order to be prudent that the net receivables might not necessarily be equal to the actual amount of loan that was outstanding. In this regard, Metro Bank assumes that the arbitrary percentage that they need to account for around 1% of the total amount of the loans that have been drawn.
In the example mentioned above, it can be seen that the total amount of loan reserves for the company amounts to $2000. This means that out of $200,000 that the organization has given out in loans, Metro Bank expects $2000 to not be recovered at all.
Loss Loan Reserves are mentioned in the balance sheet. They are used to show the amount that is parked as a provision for these loans not being honored by the company.
In this regard, it is imperative to recognize the fact that are considered as provisions that are in place to reflect for circumstances, that might reduce the total collectibles.
Hence, the impact of the loan loss reserve ratio is seen as increasing the amount of loan loss provision, or a decrease in the amount of net-charge offs for the respective year.
Loan Loss Reserve Ratio is created based on the historical default rates of the company, and the statistics that are mentioned for the customer defaults existing within those banks.
Hence, it is a multitude of a number of factors that are based on credit losses existing within the bank, as well as other different factors that impact the collection of the business.
Loan Loss Reserve Ratio, is often used alongside Loan Loss Provisions in order to estimate the existing risk profile of the bank, or the financial institution.
However, it must be noted that loan loss provision is also expensed in the Income Statement, and therefore, it reduces the net income of the organization.
The main usage of this ratio is mainly from a stakeholder perspective. It shows the existing risk profile of the business, and the ability of the business to successfully manage all the due collections.
When the financial statements are issued, investors, as well as the board of directors gauge the risk profile by directly comparing the loan loss reserve ratio of the bank with other competitors.
Having a lower loan reserve ratio is favorable, but it should not come at a cost of compromising on the prudence principle in accounting.
Financial Self-Sufficiency is a ratio that is used in order to evaluate if the company is able to generate enough revenue to cover its costs while ensuring that the equity value is sustained, after incorporating for inflation, and other cost of capital.
This particular ratio is considered to be a very useful metric in terms of assessing long-term measurement.
In this regard, it is also important to highlight the fact that this specific metric is used by investors, as well as other financial stakeholders, in order to calculate the overall financial standing of the company in terms of its ability to meet its expenses, and ensure that they are able to sustain themselves in the longer run.
Financial Self-Sufficiency is calculated using the following formula:
Financial Self-Sufficiency = Operating Income / (Operating Expenses + Financial Cost + Loan Loss Provision + Cost of Capital (imputed))
In the formula above, it can be seen that operating income includes interest, fees, and other relevant commission income that the company has earned over the course of time.
In the same manner, operating expenses mainly include administrative expenses, and the costs that are incurred to make sure that company is able to sustain itself in a positive manner.
In the same manner, it can also be seen that financial cost includes interest that are paid by the company against the financial instruments that they have drawn on, as well as the fee expenses that are incurred on financing.
As far as the imputed cost of capital is concerned, it can further be seen that it is the figure that can be calculated using metrics like inflation, and the market rate of equity in the discussion.
Example and How to Calculate?
The calculation of financial self-sufficiency can be calculated using the following example:
Elgar Co. has the following finances from the year ended 31st December 2020.
Loan Loss Provision
Net Profit Before Tax
Tax on Profit
Net Profit After Tax
Furthermore, the imputed cost of capital calculated was 40,000 based on the inflation rate of 5%.
Depending on the following information mentioned above, it can be seen that following:
Operating Income: Financial Income = 400,000
Operating Expenses = 50,000
Financial Costs = 200,000
Loan Loss Provision = 40,000
Cost of Capital (Impute) = 40,000
Financial Self-Sufficiency = Operating Income [400,000] / (Operating Expenses [50,000] + Financial Cost [200,000] + Loan Loss Provision [40,000] + Cost of Capital (imputed) [40,000])
The Financial Self-Sufficiency Ratio mentioned above is proof of the fact that the company is doing well enough to be earn their self-sufficient operating revenues in order to meet their expenses. Therefore, this is a positive sign, and shows that the company would be fine in the short run.
Financial self-sufficiency is something that is really integral for the very survival of the business. As a matter of fact, it can be seen that financial self-sufficiency results in businesses and companies being able to meet their expenses, and cover all the liquidity related expenses.
In the same manner, it having a clear idea about financial self-sufficiency somewhat ensures that businesses can keep their investors and their investment on board.
In retrospect, financial self-sufficiency can also help businesses save considerable money by avoiding costly finance charges, which would otherwise be substantial because of the existing high level of risk for the company.
Therefore, this particular metric can act as a signaling effect, which goes in favor of the business.
Regardless of the fact that financial self-sufficiency is considered a very useful tool for gauging the operational efficiency of the firm, yet there is no doubt to the fact that it has certain implications that also need to be accounted when using this matrix.
In certain cases, for example, a higher self-sufficiency ratio is also indicative of the fact that the organization can further expand their operations and resources in order to get a better return.
In the same manner, it can also be seen that as far as financial self-sufficiency is concerned, there might be a tradeoff between growth, and self-sufficiency.
A business with limited growth and sustained operations might be self-sufficient in terms of operations, but it might not always hold a promising future for the people. Hence, this opportunity cost needs to be accounted for, so that companies can decide what is better for them, strategically.