Foundations of Business

Financial Ratios & Ratio Analysis

to Evaluate and Compare Company
Performance
 Financial Ratios
• Ratios are meaningful relationships between 2
numbers (or among several numbers).

• 5 Types of Financial Ratios:

1. Liquidity ratios
2. Operating ratios
3. Debt management ratios
4. Profitability ratios
5. Valuation ratios
 Champ Creemee Company
Liquidity Ratios
• The higher the Liquidity ratio, the better the company’s ability to
pay current obligations with current assets.
• The higher the Liquidity ratio, the more liquid the company is.
1. Current Ratio: CurrentAssets
CurrentLiabilities
Cash + accounts receivable + inventory $15,190
  6.1X
Accounts Payable + other payables + ST Debt $2,500

2. Quick Ratio:
CurrentAssets  Inventory $15,190 - $3,500
  4.7 X
CurrentLiabilities $2,500
Creemee Creemee
Balance Sheet Income Statement
 Liquidity:
Trends and What If ???
2006 2007
Current Ratio 18.5 X 6.1 X
Quick Ratio 14.3 X 4.7 X We have a lot
of money tied
What If … ?? up in inventory!

 Current Ratio 6.1 X

 Quick Ratio .6 X
The Current Ratio should be 1X or higher so
that the company is able to pay its current We may have to sell
liabilities with current assets. inventory to pay our
company’s debts!
 Champ Creemee Company
Operating Ratios
• How efficiently a company uses assets
• The higher the ratio, the more efficient
The Total Assets
1. Total Assets Turnover Turnover ratio must be
compared with other
AnnualSales  $3,000  0.2 X companies in the
TotalAssets $18,190 industry.

2. Inventory Turnover
 How many times inventory must be restocked to meet sales

AnnualSales $3,000
  .9 X The inventory turnover
Inventory $3,500 ratio is different in different
industries.

Creemee Creemee
Balance Sheet Income Statement
 Champ Creemee Company
Debt Management Ratios
Leverage Ratios =sources
Using outside
of financing to
• Degree of Financial risk increase the return to
stockholders.
• Ability to repay money borrowed
• The higher the ratio, the greater the financial risk

1. Debt/Equity Ratio = Relationship of money owed

to Stockholders’ Investment in the Company

L.T.Debt $5,000
  0.47  47%
S.H.Equity $10, 690

Creemee Creemee
Balance Sheet Income Statement
 Champ Creemee Company
Debt Management Ratios
Coverage Ratios
2. Times Interest Earned (TIE)
• Ability of company to pay (cover) interest expense
• The higher the ratio, the better the ability to cover
• The higher the ratio, the lower the financial risk

Earnings before Interest and Taxes ( EBIT ) Money available to pay interest

Interest Expense Interest Expense
$1,100
  2.2X interest
$500

Creemee Creemee
Balance Sheet Income Statement
 Champ Creemee Company
Profitability Ratios

• How profitable is the company?

• What kind of return is the company generating on
sales for stockholders?
• The higher the ratio, the better the profitability.

1. Profit Margin (Return on Sales)

What percentage of sales dollar ends up as net income ?

Net Income $390

  0.13  13%  13cents
Sales $3, 000
 Champ Creemee Company
Profitability Ratios

2. Return on Equity = Return generated on

stockholders’ investment in the company
Net Income $390
ROE =   0.037  3.7%(=3.7cents)
Owners' Equity $10, 690

Remember:
Stockholders’ Equity = Common Stock + Retained
Earnings
Creemee Creemee
Balance Sheet Income Statement
 Impact of Leverage on ROE
CO. A the “loan CO. B The “stock
company” company”
EBIT $100 $100
Interest Exp. 10 0
Earnings
before taxes 90 100 Borrowing
Taxes 36 40 increases ROE,
Net Income $54 $60 but borrowing
also increases
Debt $500 0 RISK.
Equity 500 1000 Stockholders
Assets $1000 $1000 require an
increased return
Return on 54/1000 60/1000 to balance the
Assets = 5.4% = 6.0% risk.

Return on 54/500 = 0.108 60/1000 = 0.06

Equity = 10.8% = 6.0%

Net Income / Total Assets Net income / equity

 Champ Creemee Company
Earnings Per Share (EPS)
Net Income $390
• EPS =   $19.50
# of Common Shares Outstanding 20

= $ earned per share of common stock

• Spreads the net income across the shares

 Champ Creemee Company
Valuation Ratios
• How is the company valued compared to other
companies
• Relatively more or less expensive???

Price/Earnings Ratio: How many dollars investors

are willing to pay for a dollar of future/projected
net income

CurrentStock Pr ice $100

P/E =   20 X
Pr ojectedEarningsperShare $5
 Price / Earnings Ratio
Company A Company B

Current stock $ 25/$1 $50/$5

price per
share/EPS
projected

P/E ratio 25 X 10X

Investors are $25 per $1 of $10 per $1 of

willing to pay: future net future net
income income
 Champ Creemee Company
The Concept of Market Value

Market Value: Current aggregate value in the

market for all the common shares outstanding
(issued)

MV = Number of common shares

outstanding x current stock price

MV = $ 50 stock price x 1,000 shares

= $ 50,000
 Champ Creemee Company
Balance Sheet
(as of 12/31/07)

Cash $8,690 Accounts Payable $2,000

Accounts Receivable 3,000 Wages Payable 500
Current Liabilities 2,500
Inventory 3,500
Notes Payable (L.T.) 5,000
Current Assets 15,190
Total Liabilities 7,500
Equipment 3,000
Common Stock 10,000
Retained Earnings 690
Total Assets $18,190
Total Shareholders’
Equity 10,690
Total Liab. & SH Equity $18,190
 Champ Creemee Company
Income Statement
(for the Year ending 12/31/07)
• Sales $3,000
• Expenses:
Cost of Goods sold (1,000)
• Gross Profit 2,000
Waste/Spoilage 50
Wages 500
Salaries 50
Payroll Remittances 50
Rent/Permits 100
Advertising 100
Maintenance and Repair 50
Operating Expenses (900)
• Operating Profit (EBIT) 1,100
Interest (500)
• Pre-Tax Profit 600
Taxes (35%) (210)
• Net Income $ 390