Financial Ratio Analysis

(c) 2001 Contemporary Engineering Economics

1www.izmirekonomi.edu.tr

Asst. Asst. Prof. Dr. Prof. Dr. Mahmut Ali Mahmut Ali GÖKÇE, Izmir University of EconomicsGÖKÇE, Izmir University of Economics

SpringSpring, 2007, 2007

Financial Ratio Analysis

(c) 2001 Contemporary Engineering Economics www.izmirekonomi.edu.tr



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1. Liquidity ratios

2. Activity ratios

3. Leverage ratios

4. Profitability

5. Trends and graphs to spot problems

6. Using an Excel template for instant “can’t miss” financial analysis

E. Ratio Analysis Calculations and What the Numbers Really Means




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Using Financial Ratios




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Net incomeReutrn on Equity (ROE) =

Shareholders' equity

Net incomeROE =

Shareholders' equity

Net income Sales Assets

Sales Assets Shareholders' equity

(Profit margin) (Asset turnover) (Financial leverage)

= (6.59%) (2.20 times) (2.16 times)

= 31.33%

Return on Equity




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Return on Equities (ROE) and Levels of Performance for 10 Diverse Companies

Return on Equity

(%)

Profit margin

(%)

Asset Turnover (times)

Financial Leverages

(times)

Analog Devices 18.2 12.7 0.94 1.53

BankAmerica Co. 13.2 13.1 0.09 11.49

Duke Power 14.9 15.3 0.35 2.79

Exxon Co 16.0 5.3 1.33 2.26

Food Lion 15.7 2.1 3.10 2.40

Hewlett-Packard 20.6 7.7 1.29 2.06

Nike 20.4 8.4 1.51 2.60

Nordstrom Inc. 11.6 4.0 1.51 1.92

Southwest Airline 12.8 6.4 0.88 2.28

Tiffany & Company 14.8 4.9 1.23 2.48




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Debt Management Analysis

Leverage ratios that show how a firm uses debt financing and its ability to meet debt repayment obligations

Debt ratio Debt to equity ratio Times-interest-earned

ratio




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Indicates how a firm finances its capital

Debt Ratio

Total debtDebt ratio=

Total assets$10,597

$15,470

68.50%




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Measures the extent to which earnings can decline without defaulting debt service.

EBITTimes Interest Earned =

Interest Charges

$3,027 $17

17179

Note: Dell issued $500 million worth of senior notes and long-term bonds with a combined interest rate of 6.8%.

Times Interest Earned




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Liquidity Analysis

Ratios that show the relationship of a firm’s cash and other assets to its current liabilities (short-term obligations)

Current ratio Quick ratio Cash (liquidity) ratio




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Measures a firm’s short-term solvency.

Formula:

Current AssetsCurrent Ratio =

Current Liabilities$8,924

$8,933

1.00

Current Ratio




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Excludes inventories and prepaid expenses

Formula:

Cash + A/RQuick Ratio =

Current Liabilities$8,924 $306

$8,933

0.96

Quick Ratio




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An indication of a firm’s immediate liquidity

Formula:

Cash+Cash Equ. Liquidity Ratio =

Current Liabilities$4,232 $406

$8,933

0.52

Liquidity Ratio




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Asset Management Analysis

A set of ratios which measure how effectively a firm is managing its assets

Inventory turnover ratio Days sales outstanding

ratio Total assets turnover ratio




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Activity Ratios

Measure how effectively the firm is using its resources

Days Sales Outstanding (DSO)

Inventory turnover (DSI)

Total asset turnover Return on Assets

(ROA)




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Highlights the rate at which the inventory is being sold.

SalesInventory Turnover =

Average Inventory

$35,404

($278 $306) / 2

121.24 times

The typical item sits in inventory almost 0.10 months (12 months/121.24) or 3 days before being sold

Inventory Turnover Ratio




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Alternate Definition for Inventory Turnover Ratio

Cost of goods soldInventory turnover ratio =

Ending inventory

$29,05594.95 times

$306




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Determines whether receivables are being collected aggressively enough.

A/RDSO =

Average sales per day

$2,586

$35,404 / 365

26.66 days

Days Sales Outstanding (DSO)




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Days Sales in Inventory

• What It Measures: The amount of inventory (stock) expressed in days of sales. For example, if 2 items a day are sold and 20 items are held in inventory, this represents 10 days' (20/2) sales in inventory.

• How You Compute: The ratio computed by dividing inventory by cost of sales, and multiplied the result by 365

InventoryDSI (Days Sales in Inventory)=

Average Cost of Sales per day

$306

$29,955 / 365

3.84 days




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The Business Operating Cycle Days Sales Outstanding = 26.66 days

+ Days Sales in Inventory = 3.84 days

Total Days Operating Cycle = 30.50 days




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Indicates whether a company is generating a sufficient volume of business for the size of its asset investment.

Net SalesTotal Asset Turnover =

Total Assets$35,404

$15,470

2,29

Total Asset Turnover Ratio




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Profitability Analysis

A set of ratios which show the combined effects of liquidity, asset management, and debt on operating results

Profit margin on sales Return on total assets Return on common equity




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Profitability Ratios

Measure management’s overall effectiveness as shown by the returns generated on sales and investment

Return on equity (return on investment)

Gross margin Net margin Book value per share Earnings per share Price to earnings ratio

(P/E ratio)




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Indicates the profitability of the sales effort.

Gross Margin ($)Gross Margin Ratio =

Net Sales$6,349

$35,404

17.93%

Gross Margin




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Illustrates what percentage of each sales dollar is retained in earnings.

Net Income ($)Net Margin Ratio =

Net Sales$2,122

$35,404

6.0%

Net Margin




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Measures the rate of return on the owner’s investment.

Net IncomeReturn on Equity =

Average Total Equity

$2,122

($4,694 $4,873) / 2

44.36%

Return on Equity (ROE)




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How the Debt to Equity Ratio Impacts Return on Equity This is an example of a

healthy company that might not have a spectacular ROE because there is so much equity in the company.

This an example of a highly leveraged company that might have a spectacular ROE because the owners have put so little of their own resources into the company.

Assets

Liabilities

EquityAssets

Liabilities

Equity

=

=




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Market Trend Analysis

A set of ratios that relate the firm’s stock price to its earnings and book value per share

P/E ratio Market/book ratio




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Earnings Per Share (EPS)

Indicates earnings attributable to each share of stock.

Widely used indicator of a corporation’s performance

Net IncomeEPS =

Shares of Stock Outstanding

$2,122

2,644

$0.80

Net income available for distribution $2,122

Common shares outstanding 2,644

Earnings per share (EPS): $0.80




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Price to Earnings Ratio

Indicates how many times a corporation is able to multiply its earnings in terms of asking price per share of stock.

Share price: $32 as of August 22, 2003

Price per shareP/E ratio =

EPS$32

0.8040




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Book Value/Share

Indicates what the value of a share of stock is according to the books (financial statements).

Equity - Preferred stockBook Value/Share =

Shares of Stock Outstanding

$4,873

2,644

$1.84

Total Assets $15,470Total liabilities 10,597Stockholders’ equity 4,873Preferred stock obligation 0Net worth assigned to common stockholders 4,873

Common shares outstanding 2,644

Net worth (Book value): $1.84




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Market/Book Ratio

What It Measures: Indicates how investors regard the company – a higher ratio indicates that investors are willing to bet a higher return on investment

How You Compute: The ratio of a stock’s market price to its book value

Market price per shareMarket/book ratio=

Book value per share

$32.00

$1.8417.39 times




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Trends and Graphs to Spot Problems Trends analysis, where one plots a ratio

over time, is important, because it reveals whether the firm’s ratios are improving or deteriorating over time.




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Limitations of Financial Ratios Ratio analysis is useful,

but analysts should aware of ever-changing market conditions and make adjustments necessary.

It is difficult to generalize about whether a particular ratio is good or bad.

Ratio analysis based on any one year may not represent the true business condition.

(c) 2001 Contemporary Engineering Economics

34www.izmirekonomi.edu.tr



Quick Financial Analysis

Horizontal versus Vertical Analysis




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Horizontal Analysis

Determine the total dollar change (variance) from year to the next.

Determine the percent change (variance) from one year to the next

2001 2000

Dollar Change

Percent Change

(%)

Cash

A/R

50,000

30,000

40,000

50,000

10,000

(20,000)

25%

(40%)




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Vertical Analysis

For the balance sheet, determine what percent of total assets each line item totals.

For the income statement, determine what percent of total sales each line item totals.

2001 2000

2001

(%)

2000

(%)

Cash

A/R

Total

Assets

50,000

30,000

200,000

40,000

50,000

180,000

25%

15.0%

100%

22.2%

27.8%

100%

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Financial Ratio Analysis

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