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Financial Statements AnalysisRatio Analysis
EBD 481, Fall 2007Instructor: Galbraith
Adapted from William Messier, Jr., Financial Ratios
Financial Ratios The cornerstone of financial statement analysis is
the use of ratios. In entrepreneurship used extensively in
developing and analyzing business plan pro-formas and for purposes of valuation
Financial ratios are generally grouped into four categories: Short-term liquidity ratios Long-term solvency ratios Profitability ratios Market price and dividends ratios
Financial Ratios Financial analysis using ratios is useful to
investors because the ratios capture critical dimensions of the economic performance of the company.
Managers use ratios to guide, measure, and reward workers. Often companies base employee bonuses on a
specific financial ratio or a combination of some other performance measure and a financial ratio.
Financial RatiosShort-term liquidity ratios
Name of Ratio Numerator Denominator
Current ratio Current assets Current liabilities
Quick ratio Cash + Marketable securities + Receivables
Current liabilities
Average collection period in days
Average accounts receivable x 365
Sales
Inventory turnover Cost of goods sold Average inventory at cost
Financial RatiosLong-term solvency ratios
Name of Ratio Numerator Denominator
Total debt to total assets Total liabilities Total assets
Total debt to equity Total liabilities Stockholders' equity
Interest coverage Income before interest and taxes
Interest expense
Financial RatiosProfitability ratios
Name of Ratio Numerator Denominator
Return on stockholders' equity
Net income Average stockholders' equity
Gross profit rate or percentage
Gross profit or gross margin Sales
Return on sales Net income Sales
Asset turnover Sales Average total assets available
Pretax return on operating assets
Operating income Average total assets available
Earnings per share Net income less dividends on preferred stock, if any
Average common shares outstanding
Financial RatiosMarket price and dividend ratios
Name of Ratio Numerator Denominator
Price-earnings Market price of common stock
Earnings per share
Dividend yield Dividends per common share
Market price of common stock
Dividend-payout Dividends per common share
Earnings per share
Another important ratio for small business Discretionary Cash Flow/Sales
Discretionary Cash Flow = net income + owners compensation + non-cash expenses (most often depreciation)
Why is this sometimes a better measure of performance than “net-income” for small firms?
Evaluating Financial Ratios Financial ratios are evaluated using three
types of comparisons. Time-series comparisons - comparisons of a
company’s financial ratios with its own historical ratios
Benchmarks - general rules of thumb specifying appropriate levels for financial ratios
Cross-sectional comparisons - comparisons of a company’s financial ratios with the ratios of other companies or with industry averages
Ratios Ratios mean different things to different groups.
A creditor might think that a high current ratio is good because it means that the company has the cash to pay the debt.
However, a manager might think that a high current ratio is undesirable because it could mean that the company is carrying too much inventory or is allowing its receivables to get too high.
Because financial ratios may be interpreted differently by different users, the users of the financial ratios must understand the company and the business before drawing conclusions.
Operating Performance andFinancial Performance Measures of profitability are affected by
both financing and operating decisions. Financial management is concerned with where
the company gets cash and how it uses that cash.
Operating management is concerned with the day-to-day activities that generate revenues and expenses.
Ratios that assess operating efficiency should not be affected by financial management performance.
Operating Performance Rate of return on investment - evaluates
the overall success of an investment by comparing what the investment returns with the amount of investment initially made
capital Invested
IncomeRate of return
on investment
Operating Performance Income may be defined differently for
alternative purposes. Net earnings Pretax income from operations Earnings before interest and taxes (EBIT)
Invested capital may also be defined differently. Stockholders’ equity Total capital provided by both debt and equity
sources
Operating Performance Operating performance is best measured
by pretax operating rate of return on total assets, often referred to as return on total assets.
available assets totalAverage
income Operating
Pretax operatingrate of returnon total assets
Operating Performance The expanded expression of pretax
operating rate of return on total assets highlights that operating income percentage and asset turnover will each increase the rate of return on assets. Using these two ratios allows manipulation of
either one to determine what happens to the rate of return under different scenarios.
Operating Performance
Pretax Returnon Total Assets
Operating Income% on Sales
Total AssetTurnover
OperatingIncome
Sales
Sales
Average TotalAssets
x
Operating Performance This decomposition of return on total
assets can also be applied to the return on equity. This is often referred to as the DuPont analysis.
equity Average
assets totalAverage
assets totalAverage
Sales
Sales
incomeNet ROE
LeverageoverAsset turnsaleson Return ROE or
Financial Performance Debt and equity financing must be balanced in
order to achieve good financial performance. Firms must choose how much debt is appropriate. The firms must also choose how to split their
debt between short-term debt and long-term debt.
The prudent use of debt is a major part of intelligent financial management.
Is there a difference in the appropriate use of debt by small entrepreneurial firms and larger corporations?
Is there a difference in the appropriate use of debt by small entrepreneurial firms and larger corporations? Higher interest rates paid by smaller firms More security needed by smaller firms Stricter qualification rules by banks Inability to access the bond market Personal guarantees by founders often
required Need to maintain debt capacity for growth
Financial Performance Short-term debt must be repaid or
refinanced in a short period of time. If a company has trouble repaying the debt, it
will also generally have trouble refinancing the debt.
Naturally, lenders like healthy borrowers, not troubled borrowers.
Financial Performance Long-term debt or equity are generally
used to finance long-term investments. Debt financing is more attractive than equity
financing because: Interest payments are deductible for income tax
purposes, but dividends are not deductible. The ownership rights to voting and profits are kept by
the present shareholders. Then why do so many small companies prefer
to raise money by equity (selling stock to friends and families)?
Net profit Margin
Net profit Margin
ROEROE
Return on Assets (Profitability)
Return on Assets (Profitability)
Financial leverage
Financial leverage
Asset turnover
Asset turnover
LiquidityLiquidity
SolvencySolvency
Net incomeNet income SalesSales//
SalesSales Total costTotal cost——
Cost of goods soldCost of goods sold
SG&ASG&A
R&DR&D
Interest expenseInterest expense
Income taxesIncome taxes
SalesSales Total assetsTotal assets//
Current assets
Current assets
Noncurrentassets
Noncurrentassets++
LandLand
BuildingBuilding
EquipmentEquipment
IntangiblesIntangibles
OthersOthers
CashCash
Acc. ReceivablesAcc. Receivables
InventoryInventory
OtherOther
Financial Performance
Trading on the Equity General comments about leveraging:
A debt-free, or unleveraged, company has identical return on assets (ROA) and return on equity (ROE).
When a company has a ROA greater than the interest rate it is paying its lenders, ROE exceeds ROA.
This is called favorable financial leverage. When a company is unable to earn at least the
interest rate on the money borrowed, the return on equity will be lower than it would be for a debt-free company.
The more stable the income, the less dangerous it is to trade on the equity.
Economic Value Added The idea behind economic value added
(EVA) is that a company must earn more than it must pay for capital if it is to increase in value. Capital is considered both debt and equity. The cost of capital in EVA is a weighted average
of interest cost and the returns required by equity investors.
If a company has positive EVA, the company is adding value; if a company has negative EVA, the company is losing value and might be better off liquidating.
Income tax effects Complicates analysis, but not really
important for start-up companies. Why?