Anonymous

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*P/T CFO, Business Consultant*)

| Jun 10, 2013This question pertains to many classic financial calculations -- ROE, average shareholder equity, DuPont models, debt to equity ratio, etc. These formulae are fairly easy to interpret and apply for the average company in reasonable health. But generally, how do you deal with such oddball situations as negative equity -- now or in one or two previous periods. e.g. a profitable company should have great ratios, but what if dividends strip all equity on a regular basis, or even take equity negative. Company is still a healthy cash machine. How do these formulae play out then?

e.g. equity at Jan 1 is $2mm; equity at Dec 31 is minus $0.5mm, due to profits less paid dividends being more than $2mm negative, then what is "average shareholder equity"? Or what if equity went negative due to a minority interest buyout at a premium over equity book value, etc. Standard formulae do not apply that easily.

What is the debt to equity ratio if debt is $1mm and the equity is minus $0.25mm?

Similarly for historical losses, -- how do you measure a company's past profitability ratios if they had, say, 5 profit years and 2 loss years -- netting off does not necessarily produce a realistic answer for valuation purposes.

The answers could be long -- but generally, how do you deal with such situations? Does one just assume that standard financial calcs no longer apply? I always wondered if finance students ask such questions in a high level finance class.

## Answers

Gary JohnstoneTitle:Managing DirectorCompany:ValuationVCInstead of using book values (equity).....I would suggest fair value (or fair market value)....in that way, the information provided/used for decision-making is more properly grounded in real economics vs. book (or historical costs). A good appraiser should be able to provide a reliable estimate of value for the company's equity at a reasonable cost (i.e., a cost-effective valuation solution).

Wayne SpivakTitle:President & CFOCompany:SBAConsulting.comLinkedIn Profile

I agree with Gary.

I have found most ratios that target other than current dollar accounts (vs long term assets, etc) problematic. You never get the real at the moment picture. You can argue you get over the long term trends, and I would have to agree, but the FMV of a company, including accurate valuations of all assets will provide the investor andmanagement with a clear, concise guide.

david waltzTitle:Assistant TreasurerCompany:Integrys Energy GroupFor capital structure issues the theories say to use market value rather than book value as you suggest. For financial ratios there is a little more leeway, since they are indirect means of assessing performance rather than valuation measures per se.

The concept underlying the ROIC approach is that investors expecting a return are all one class for purposes of that calculation, and perhaps that can be applied in this respect? This would eliminate ratio distortions due to financing policy, and should make any trend analysis valid over a period of time.

David CollinsTitle:CEOCompany:Glentyde Capital AdvisorsWith respect to some ratios it's a matter of judgement calls, and in particular recognizing that certain ratios are only valid or meaningful over certain ranges or within certain parameters.

Debt : Equity ratio, for example. Graph it as a function of equity, assuming some constant amount of debt, and you see that it blows up as equity approaches zero from either side. As an extreme special case, what's the D/E ratio when debt is 5M and equity is $1? Or 10¢? For a company such as what you've described---one for which it's not unusual for the equity to occasionally range into very low or even negative territory---traditional D/E metrics lose their meaning and usefulness at least over certain ranges.

Then the judgement calls come into play. Perhaps under the right circumstances some portion of that debt should be considered as equity instead, for ratio purposes. A subordinated debt issue that's waaaaay down the seniority totem pole, with a bunch of equity-ish conversion and participation features, and an equity-like payoff profile, might be a candidate for such recharacterization.

Since there exists a huge and diverse collection of ratios, there's no one-size-fits-all answer to your question. It's a matter of first getting a thorough understanding of the ratio in question (what are its ingredients, what's being compared to what, what info does it convey) and then making those judgement calls.