Financial Health Multiples

Key Factors for Assessing an Organization’s Financial Health

When evaluating an organization, in addition to making forecasts, we need to observe financial health multipliers. Here are some important metrics to focus on, though it’s crucial to understand their underlying meaning:

Interest Coverage Ratios:

1. EBITA/Interest:

• Measures the organization’s ability to cover interest expenses without reducing capital expenditures (after accounting for depreciation).

2. EBITDA/Interest:

• Indicates the organization’s ability to cover interest expenses from its earnings before accounting for depreciation. This is important for short-term financial health, as reducing capital expenditures is not sustainable in the long term.

3. EBITDAR/Interest:

• Considers operating lease or rental expenses by excluding them from the numerator and adding them to the denominator. This ratio is crucial for industries like retail or aviation, where rental costs are significant.

Assessing Financial Leverage:

In some industries, profitability relative to interest is either too high or too variable, making coverage ratios less meaningful. Instead, metrics like Debt-to-EBITDA are used. This ratio is more stable over time and allows for assessment in case of significant deviations.

Additionally, this metric has become more attractive due to the increased use of hybrid securities (e.g., convertible debt), which are typically repaid through conversion rather than interest payments, artificially inflating interest coverage ratios.

To understand the significance of financial leverage, consider the formula:

ROE = ROIC + [ROIC – (1-T) * r_d] * D/E

Notice how crucial financial leverage is. Increasing ROE can be achieved either by improving ROIC (operations) or by increasing leverage. Both yield the same result, but with higher leverage, ROE becomes more dependent on ROIC, increasing owners’ risk exposure.

Dividend Payout Ratio:

This metric should be evaluated alongside the cash flow reinvestment ratio. If the dividend payout ratio is high relative to profits, and the reinvestment/free cash flow ratio exceeds one, it indicates the organization will increase debt to pay dividends. Conversely, if the situation is reversed, the organization is likely to reduce debt.

Valuation Multiples:

Using valuation multiples like EV-to-EBITDA (or EBIT, Revenue) is also insightful. If a company has higher valuation multiples compared to competitors, we need to identify the reason the market values it this way. Typically, the reasons should be found in the fundamentals.

Source:
Venture Capital & the Finance of Innovation
by Andrew Metrick & Ayako Yasuda, Second Edition