Ratio Analysis

Chapter 6
Robinson, Munter, Grant

Learning Objectives
Identify situations in which ratio analysis is useful Understand the purpose of ratio analysis Calculate specific ratios Recognize limitations of accounting data in ratio analysis

Grant, Munter & Robinson

Chapter 6

Ratio Analysis
Cross-sectional and time series analysis Controls for size differences Controls for currency differences Evaluate related components of different financial statements simultaneously Ratios are easily (and commonly) modified
Grant, Munter & Robinson Chapter 6 3

Ratio Analysis Categories

Activity (operations and asset management) Liquidity (meeting short-term obligations) Solvency (meeting long-term obligations) Profitability (earnings and cost coverage) Cash Flow (quality of earnings) Price Multiples (stock price)
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Grant, Munter & Robinson

Activity Ratios
How day-to-day operations function
Inventory management Inventory Turnover
Compares income statement and balance sheet amounts Must average balance sheet figures ((Beg + End)/2) Turnover = COGS/Average total inventory

Days inventory = 365/Turnover

How many days was inventory held before being sold?

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Activity Ratios
Critical operating cash accounts
Accounts receivable turnover
How many times a credit sale is made and subsequently collected [credit sales/average accounts receivable] May have to use total sales rather than credit sales Consistency is important

Days receivable
Number of days between the charge sale and collection [365/accounts receivable turnover]
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Activity Ratios
Critical operating cash accounts
Accounts payable turnover
Number of times a credit purchase is made and subsequently paid [credit purchases/average accounts payable] Often assume all purchases are on credit Purchases = [COGS + Ending Inv. - Beginning Inv.]

Days payable
Number of days between credit purchase and payment [365/accounts payable turnover]
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Activity Ratios
Cash Cycle
Also a measure of liquidity If low, small number of days in operating cycle to finance
[Days inventory + Days receivable - Days payable]

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Chapter 6

Activity Ratios
Asset Turnover
Long-term
Revenues generated by long-term assets [Sales revenue/Average noncurrent assets]

Total assets
Efficiency of generating revenues given total assets [Sales revenue/Average total assets]
Grant, Munter & Robinson Chapter 6 9

Liquidity Ratios
Current ratio
Ability to meet short-term obligations [Current assets/current liabilities]

Quick ratio
Remove less liquid assets Keep cash, liquid investments, A/R
[(Current assets-inventory-ppd expenses-other)/current liabilities] [(Cash+short-term investments + A/R)/current liabilities]
Grant, Munter & Robinson Chapter 6 10

Liquidity Ratios
Defensive interval ratio
Compare 1 days costs to quick assets [((COGS+SGA+RD)/365)/(Cash+short-term investments + A/R)]

For Motorola, defensive interval = .0075

COGS = 21,445 SG&A = 3,703 R&D = 4,318 Quick assets = 10,745 (6,082 + 80 + 4,583)
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Grant, Munter & Robinson

Solvency Ratios
Debt to assets: Total liabilities/Total assets
Proportion of assets financed with debt

Could include interest bearing debt only

[(short term debt + noncurrent debt)/total assets]

Be aware that assets are recorded at historical cost, which may be different from current market value
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Solvency Ratios
Debt to equity: Total liabilities/Total equity
A measure of how assets are financed Or (current debt + noncurrent debt)/Total equity Examine relative sizes of debt and equity financing

Capitalization ratio:
[(current debt+noncurrent debt)/ (current debt+noncurrent debt+total equity)]
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Solvency Ratios
Coverage Ratios
Adequacy of resources for meeting firms contractual obligations Times interest earned
Can the firm cover its interest obligations? (EBIT/Interest expense)

Cash interest coverage

(Cash from ops + interest paid + tax paid)/Interest paid
Grant, Munter & Robinson Chapter 6 14

Solvency Ratios
Coverage Ratios
Target a specific expense
[(EBIT+Rent expense)/(Interest expense+rent expense)]

Target principal on debt that is about to be repaid

[EBIT/(interest expense + principal payments)]

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Profitability Ratios
Common-size
From chapter 5 Income statement
Divide item of interest by sales ROS = Net income/Sales revenue Gross margin = Gross profit/Sales revenue

Balance sheet
Divide item of interest by total assets
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Profitability Ratios
Return Ratios
ROA = Net income/Average total assets Or, [(Net income + After-tax interest expense)/Average total assets] Also, [EBIT/Average total assets] reflects pre-tax, pre-interest return

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Profitability Ratios
Return Ratios
ROE = Net income/Average total equity
Return generated relative to the capital provided by the owners over time

Or, if firm has preferred stock

[(Net income Prfd dividends)/Average total common equity]

ROMVE = Net income/Market value of equity

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Cash Flow Ratios

Quality of earnings
Ability to pay obligations
CFO/Total liabilities CFO = Cash flows from operations

Profitability (cash flow relative to sales)

CFO/Sales revenue

Cash return on assets

CFO/Average total assets
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Cash Flow Ratios

Quality of earnings
Cash flow-earnings index
CFO/Net income

Free cash flow ratio

CFO/Capital expenditures If ratio>1, free cash flow exists

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Price Multiple Ratios

Markets valuation of a firms common stock
P/E = Share price/Earnings per share

Price/book ratio compares stocks price to the recorded value of the net assets
[Share price/(Book value of equity/Share outstanding)]

Price/sales = Share price/Sales per share Also, compare price to cash flow per share
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Ratio Integration
DuPont analysis (decomposition) ROE = ROA x Leverage
Net income Net income Average total assets Average total equity Average total assets Average total equity
Net income Net income Sales Average total assets Average total equity Sales Average total assets Average total equity

And more
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Ratio Integration
ROA = Profitability x Turnover

Net income Net income Sales Average total assets Sales Average total assets

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Analysis
Generally compare 3-5 years Requires 4-6 years of data
Balance sheet numbers may be averaged

Compare Motorola and Nokia

Activity Liquidity Solvency Profitability
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Activity Ratios
2001 2000 1999 Inventory Turns
MOT NOK 5.36 9.77 5.28 9.45 A/R Turns 5.91 6.45
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1998
5.33 6.58

5.54 7.98

MOT
NOK
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5.14
5.51

6.19
5.96

5.94
5.99
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Liquidity Ratios
2001
MOT NOK 1.77 1.62

2000 1999 Current ratio

1.22 1.57 Quick ratio 0.66 1.14
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1998
1.18 1.75

1.36 1.69

MOT
NOK
Grant, Munter & Robinson

1.11
1.24

0.76
1.25

0.58
1.28
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Solvency Ratios
2001
MOT NOK 57.6% 44.7%

2000 1999 Debt-to-assets

54.9% 44.8% 52.6% 47.5%

1998
57.5% 48.5%

MOT
NOK
Grant, Munter & Robinson

Times interest earned -7.54 6.05 5.65 43.38 51.97

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-3.56
13.40
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16.14

Profitability Ratios
2001
MOT NOK -10.4% 10.4%

2000 ROA
3.2% 23.1% ROE 6.9% 42.6%
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1999
2.6% 21.2%

1998
-3.4% 20.5%

MOT
NOK
Grant, Munter & Robinson

-23.7%
18.8%

5.7%
40.7%

-7.6%
40.7%
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Limitations to consider
Historical cost of balance sheet items GAAP vs. IAS rules Accounting method differences
LIFO vs. FIFO inventory valuation

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Summary
Calculate ratios Decompose and interpret results Understand limitations of ratio analysis

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