Ratio Analysis

Ratio Analysis
Ratios can often be more informative that raw numbers
Puts numbers in perspective with other numbers Helps control for different sizes of firms Ratios provide meaningful relationships between individual values in the financial statements

Ratios can be used to evaluate four different areas of companys performance and conditions

Ratio Analysis - Solvency

Ratio Analysis - Solvency
Analysts employ these ratios to determine the firms ability to pay its shortterm liabilities Current Ratio examines current assets and current liabilities
Higher the current ratio, more likely is that the company will be able to pay its short-term bills

A ratio of less than 1, means that the company has negative working capital and is probably facing liquidity crisis

Quick Ratio adjusts current assets by removing less liquid assets

More stringent measure of liquidity

Ra
Higher the quick ratio, more likely is that the company will be able to pay its short-term bills

Cash ratio relates cash (ultimate liquid asset) to current liabilities

Higher the cash ratio, more likely is that the company will be able to pay its short-term bills

Ratio Analysis - Solvency

Receivables turnover examines the management of accounts receivable
Balance sheet items are taken as average of the account

Average collection period is the average number of days it takes for the companys customer to pay their bills
It is desirable to have a collections period closer to the industry norm

Collection period too high that customers are too slow in paying their bills which implies too much capital is tied up in assets

Inventory turnover measures firms efficiency with respect to its processing and inventory management
Balance sheet items are taken as average of the account

Given the turnover values, you can compute the average inventory processing time
It is desirable to have a collections period closer to the industry norm

Evaluating Solvency Ratios

Payables turnover measures the use of trade credit by the firm
Balance sheet items are taken as average of the account

Given the turnover values, we can compute the average payment period processing time
It is desirable to have a collections payment closer to the industry norm

Cash Conversion Cycle

Rat
Combines information from the receivables turnover, inventory turnover, and accounts payable turnover

High conversion cycle is undesirable Too high conversion cycle implies that company has excessive amount of capital investment in the sales process.

Ratio Analysis Operating

Ratio Analysis Operating Efficiency

Operating Efficiency Ratios
Examines how management uses its assets to generate sales and it considers the relationship between various asset categories and sales

Total Asset Turnover ratio indicates effectiveness of a firms use of its total asset base to produce sales
Different types of industries have different asset turnovers. Infrastructure business are capital intensive and may have Asset Turnover closer to 1, however, retail business might have turnover ratios in double digits.

Low asset turnover may mean that the company has much capital tied up in its asset base

Net Fixed turnover reflects utilization of fixed assets

This number can look temporarily bad if the firm has recently added greatly to its capacity in anticipation of future sales

Equity Turnover measures the employment of owners capital

Equity capital includes all preferred and common stock, paid-in capital and retained earnings

Ratio Analysis Operating Profitability

Operating profitability ratios
Examines how management is doing at controlling costs so that a large proportion of the sales dollar is converted into profit What proportion of the sales dollar is left after cost of goods sold? Is the firm buying inputs (inventory and direct labor) at good prices?

Gross Profit Margin

Gross profit margin measures the rate of return after cost of goods sold

Operating Profit Margin

Ra
Operating profit margin measures the rate of profit on sales after operating expenses

Operating income can be thought of as the bottom line from operations

Net Margin
Shows the combined effect of operating profitability and the firms financing decisions (since net income is after interest and tax payments)

Ratio Analysis Operating Profitability

Ratio Analysis Operating Profitability

Return on total capital relates the firms earnings to all capital invested in the business
This number should not be too low as compared to the industry average

We should consider Gross interest expense in our calculation

Return on total equity indicates the rate of return earned on the capital provided by the stockholders after paying for all other capital used
Total Equity includes preferred stock

Return on owners equity is based only on the common shareholders equity

Preferred dividends are deducted from Net Income as they are a priority claim

Ratio Analysis Operating Profitability

DuPont System divides ROE into several ratios that collectively equal ROE while individually providing insight
Most important term in ratio analysis

Basic algebra for ROE breakdown

Extended DuPont System

Provides additional insights into the effect of financial leverage on the firm and pinpoints the effect of income taxes on ROE

We begin with the operating profit margin ( EBIT divided by sales) and introduce additional ratios to derive an ROE value

Ratio Analysis Operating Profitability

Financial leverage involves acquiring assets with funds at a fixed rate of interest
Op. Profit Margin Asset Turnover Interest exp. rate Financial leverage Tax retention rat

Ra
If Return on Investment in Asset > Fixed rate of borrowing = Positive financial leverage If Return on Investment in Asset < Fixed rate of borrowing = Negative financial leverage

Ratio Analysis Risk

Risk analysis examines the uncertainty of income for the firm and for an investor Total firm risks can be decomposed into three basic sources 1) Business risk 2) Financial Risk 3) External Liquidity Risk

sis
Business Risk
Function of Business variability, Sales variability and Operating leverage Between five to ten years of data should be used for calculating business and sales variability

Also critical is the measure of how much companys production costs are fixed (as opposed to variable)

Greater the use of fixed costs, greater the impact of a change in sales on the operating income of a company and hence, higher is the risk

Ratio Analysis Financial Risk

Financial risk
The added uncertainty in a firms net income resulting from a firms financing decisions (primarily through employing leverage) Interest payments are deducted before we get to net income and these are fixed obligations. Similar to fixed production costs, these lead to larger earnings during good times, and lower earnings during a business decline The use of debt financing increases financial risk and possibility of default while increasing profitability when sales are high

tiAnalys
Two sets of financial ratios help measure financial risk
Balance sheet ratios Earnings or cash flow available to pay fixed financial charges

Balance Sheet Ratios

Ra
How much debt does the firm employ in relation to its use of equity?

How much debt does the firm employ in relation to all long-term sources of funds?

Assessment of overall debt load, including short-term

Ratio Analysis Financial Risk y

Earnings/Cash flow ratios
Relate operating income (EBIT) to fixed payments required from debt obligations Higher ratio means lower risk Interest coverage ratio determines the firms ability to repay its debt obligations

Cash flow to long term debt ratio determines the ability of the firm to meet its long term debt through its cash flows.

Ratio Analysis External Liquidity Risk

External liquidity risk
External market liquidity is a source of risk to investors Market Liquidity is the ability to buy or sell an asset quickly with little price change from a prior transaction assuming no new information The most important factor of external market liquidity is the dollar value of shares traded This can be estimated from the total market value of outstanding securities It will be affected by the number of security owners Numerous buyers and sellers provide liquidity

o Analys

Ratio Analysis Growth

Growth is important to both creditors and owners
Creditors interested in ability to pay future obligations For owners, the value of a firm depends on its future growth in earnings, cash flow, and dividends

If the company doesnt grow, it stands a much greater chance of defaulting on its loans Sustainable growth rate is a function of two variables:
What is the rate of return on equity (which gives the maximum possible growth)? How much of that growth is put to work through earnings retention (rather than being paid out in dividends)? Growth = ROE x Retention rate

Also remember ROE is a function of

Net profit margin Total asset turnover Financial leverage (total assets/equity)

Limitations of Financial Ratios

Limitation of Financial Ratios
Accounting treatments may vary among firms, especially among non-U.S. firms Always consider relative financial ratios. They do not make any sense when viewed in isolation. Firms may have divisions operating in different industries making it difficult to derive industry ratios. Conclusions cannot be made by just looking at only one set of ratios Ratios outside an industry range may be cause for concern