When assessing a company’s financial strength and its ability to withstand financial crises, we need to examine financial ratios that provide a snapshot of its financial stability on the one hand, and on the other hand, to examine how these ratios affect the level of risk in a quantitative and measurable way, using the Cowley model to estimate the increase in risk and its implications for valuation under the discounted cash flow (DCF) method or the multiples method.
Financial ratios
Db – financial debt – the company’s total interest-bearing financial liabilities
Ds – supplier debt – total non-interest-bearing liabilities to suppliers
Ab – the company’s total interest-bearing financial assets
Ac – total non-interest-bearing assets from customers and receivables (excluding inventory)
Dn – net financial debt, consisting of total interest-bearing financial liabilities less interest-bearing financial assets
E – the company’s book (accounting) equity
Ef – the company’s economic equity, adjusted for all assets and liabilities revalued to market value as of the review date. Note: adjustments should be made when the financial statements are reported under IFRS standards, which change the way certain assets are recorded – such as leases presented as an asset against a financial liability, where the reduction of the liability is recorded as a financing expense.
CAP – the company’s book equity plus the company’s net financial debt. It should be checked whether, in capital-market records, some of the statements report financial debt on a gross rather than a net basis, i.e., without deducting interest-bearing assets (Dn). It is also recommended to use an economic rather than an accounting equity ratio, due to reporting gaps (such as using the market-value figure published on capital-market websites).
CAPf – the company’s economic equity plus the company’s net financial debt
Financial ratios and the Cowley model
The higher the ratio between the company’s Dn and its CAPf, the more leveraged the company is. And although the shareholders thereby free up personal equity for themselves, which represents a higher ownership stake, there is still a risk that in periods of financial crisis the company will face a higher risk due to its debt-service ratio.
The Cowley model makes it possible to examine the additional risk by calculating the current cash flow between current assets (excluding inventory) and current liabilities (the quick ratio), and entering them into the final formula, which tests the risk impact of the company’s expected cash-flow component as of the review date, without future changes that may alter this ratio.
In conclusion – it is recommended to use accepted measures of the CAP ratio, which is intended to determine a qualitative level of risk at a given point in time, while also examining, according to the Cowley model, the quantitative risk rate as a function of the company’s internal risk rate, which is an integral part of the discount rate.
