CH 4 Financial Ratios

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Balance Sheet for ZMZ Company

Dec 31, 2005 Dec 31, 2006

Cash 4,000 17,000AR 5,000 9,000

Inventory 10,000 12,000

Net Fixed Assets 27,000 40,000

Total Assets 46,000 78,000

AP 5,000 3,000

NP 2,000 5,000

L.T. Debt 10,000 18,000

Common Stock 25,000 40,000RE 4,000 12,000

Total Liab & Equity 46,000 78,000

For the year ending 2006, Net Income was 26,000,Depreciation on fixed assets was 2,000 and Dividends paid was 18,000


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Chapter 4

Financial Statement Analysis


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Learning Objectives

Prepare a common size income statement and a commonsize balance sheet

Calculate liquidity, asset utilization, debt utilization andprofitability ratios. These are listed in Table 4.1

Discuss uses and limitations of financial ratios


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Chapter 4 Intro

Objective of financial statement analysis

Fraud vs. Earnings Management

Tools: common size statements and financial ratios


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Common Size Statements---Why?

Allow for cross sectional comparisons among firms in the sameindustry

e.g., Did the company do better or worse than firms in the same

industry (industry average)?

Allow for comparisons over time

e.g., Did the company improve on last years profits?


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Examples

Net Sales $12,186,000

COGS $ 9,627,000

Gross profit $ 2,559,000

COGS as % of Net Sales = $9,627,000 / $12,186,000 = 79%

The direct costs (COGS) associated with every $1 of net sales are79 cents.


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Net Sales and COGS

Year COGS Net Sales Percent

2003 9,627 12,186

2004 11,846 14,538

2005 14,484 17,751

2006 18,499 22,698

Another way to say it: For every $1 of revenue, it costs thecompany XX cents to purchase the item sold.

Markup

Is the time trend good or bad?


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Examples

Cash $135,600

Total Assets $1,384,000

Cash as % of Total Assets = $135,600 / $1,384,000 = 9.8%

How does 9.8% cash holding compare to the industry average?

Does it vary over time?


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Inventory and Total Assets

Year Inventory Total Assets Percent

2003 136 1,384

2004 176 1,626

2005 251 1,915

2006 321 2,308

Is the time trend good or bad?


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Case Study

S-A-S Beers: Microbrewery

Sold each unit for the following prices:$2.75 in 2004 $3.50 in 2005 $4.50 in 2006

Given the income statement and balance sheet (Table 4.2), constructthe common size financial statements

For each item, discuss whether the trend is good or bad


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Financial Ratios

We use Balance Sheet accounts and Income Statement items tocalculate ratios that measure

Liquidity (solvency)

Activity (asset utilization , turnover)

Debt utilization (leverage)

Profitability


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Liquidity Ratios

Measure how well the company can meet its short-termobligations

Large values imply that the firm has cash to pay its bills ontime low probability of insolvency

Quick ratio is more conservative because it does not assumethat inventories can be turned into cash

Current assetsCurrent ratio =

Current liabilities

Current assets - InventoriesQuick ratio =

Current liabilities


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Activity Ratios

It is also called Turnover Ratios, Asset Utilization Ratios

Measures of business activity and efficiency within the firm

Assets should be actively and efficiently used to generatereturns

If you can use the same assets more efficiently in yourbusiness then improve efficiency, if you can use them more

efficiently elsewhere then free those assets for better uses


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Activity Ratios

Average collection period (ACP): how many days it takes thecompany to collect payments from credit sales

Payables period: how many days it takes the company to payits trade accounts (suppliers)

ARAverage collection period = * 360

Annual Credit Sales

APPayables period = * 360

Cost of goods sold


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Activity Ratios

Inventory turnover ratio: an industry specific inventory efficiencymeasure (higher values higher efficiency)

Inventory conversion period: how many days the company keeps

inventory items in stock before they are sold

Total asset turnover ratio: an industry specific total assets efficiency

measure (higher values

higher efficiency)

InventoriesInventory conversion period = * 360

Cost of goods sold

Cost of goods soldInventory turnover ratio =

Inventories

SalesTotal assets turnover ratio =

Total assets


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Debt Utilization Ratios

It is also called leverage ratios

Measure the extent to which the firm uses borrowed fundsto finance its operations

In general, we consider self (equity) financing as a goodsign and an increase in debt financing as a bad sign


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Debt Utilization Ratios

If debt levels are high

high risk of default

difficulties raising new debt

Total liabilities DDebt ratio = =

Total liabilities and equity D + E

Total liabilities D

Debt to equity ratio = Equity E


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Profitability Ratios

Profitability ratios compare the firms earnings to factors thathelp generate those earnings

Balance Sheet profitability ratios:

Net incomeReturn on Assets = ROA =Total assets

Net income

Return on Equity = ROE = Stockholder's Equity


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Profitability Ratios

Income Statement profitability ratios:

Gross profitGross profit margin =

Net sales

Operating profitOperating profit margin =

Net sales

Net profit

Net profit margin = Net sales


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Combination Ratios: (CCC)

Cash Conversion Cycle (CCC ) is the number of daysbetween cash expenditures and cash collections

Cash expenditures: spending money to produce goods for sale or

to buy goods for resale

Cash collections: collecting money from customers

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Cash expenditure Cashcollection

Time

Cash conversion cycle


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Combination Ratios: (CCC)

Cash Conversion Cycle (CCC) =

+ Inventory conversion period

+ Average collection period

- Payables period

Firms should strive to shorten their CCC without harming

business operations

23


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Case Study

S-A-S Beers: Microbrewery

Sold each unit for the following prices:$2.75 in 2004 $3.50 in 2005 $4.50 in 2006

Given the income statement and balance sheet (Table 4.2), constructthe financial ratios we discussed in class

For each item, discuss whether the trend is good or bad


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Extended DuPont Equation

ROE =

Net

Income

Equity

ROE =

Net

Income X

Sales

X

Total

Assets

SalesTotal

AssetsEquity


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Tools at Managements Disposal

Operating Efficiency (Margin): Amount of income generatedfrom each sale (think Mercedes-Benz)

Asset Use Efficiency (Turnover): Sales generated from eachasset (think Wal-Mart)

Financial Leverage (Equity Multiplier): Increasing leverage

will result in a larger equity multiplier. More borrowing canfund more assets which can generate returns to shareholders

(think Bank of America)


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Limitations of Ratio Analysis

Balance sheet values are stock measures - the values of assetsand liabilities are captured on a specific date

Ratios using balance sheet values may not reflect thecompanys state on other days of the year

Example: A company that reports $1 million in cash on the last

day of the fiscal year may have only $100k two days later,after paying salaries and suppliers


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The ratios are calculated using accounting data, not marketvalues

Accounting data is based on an assets historical costs

Market values are based on the assets market value

Example: if inventory value declines below historical cost butmanagement did not adjust for thisevery ratio involving

total assets will be inaccurate.


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There are no standard values for each ratio

E.g., what value is considered to be a good current ratio?

Should we use the industry average ratio as the standard?

Not necessarily. Deviations from the industry average are not

always a bad sign.


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Summary

Common size financial statements

4 types of ratios: liquidity, activity, debt utilization,profitability

Cash conversion cycle DuPont Analysis

Limitations of ratio analysis

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CH 4 Financial Ratios

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