RATIO ANALYSIS-OVERVIEW Ratios: 1. Provide a method of standardization 2.

More important - provide a profile of firms economic characteristics and competitive strategies. Although extremely valuable as analytical tools, financial ratios also have limitations. They can serve as screening devices , indicate areas of potential strength or weakness, and reveal matters that need further investigation. Should be used in combinations with other elements of financial analysis. There is no one definitive set of key ratios; there is no uniform definition for all ratios; and there is no standard that should be met for each ratio. There are no "rules of thumb" that apply to the interpretation of financial ratios. Caveats: economic assumptions - linearity assumption benchmark manipulation - timing accounting methods negative numbers

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Common Size Financial Statements Differences in firm size may confound cross sectional and time series analyses. To overcome this problem, common size statements are used. A common size balance sheet expresses each item on the balance sheet as a percentage of total assets A common size income statement expresses each income statement category as a percentage of total sales revenues
Sales COGS SG&A PROFIT 1 $ 101,840 $ 78,417 $ 20,368 $ 3,055 1 Sales COGS SG&A PROFIT 100.0% 77.0% 20.0% 3.00% 1 Sales COGS SG&A PROFIT 100% 100% 100% 100% 2 $ 109,876 $ 83,506 $ 24,722 $ 1,648 2 100.0% 76.0% 22.5% 1.50% 2 108% 106% 121% 54% 3 $ 115,609 $ 85,551 $ 27,168 $ 2,890 3 100.0% 74.0% 23.5% 2.50% 3 114% 109% 133% 95% 4 $ 126,974 $ 93,326 $ 31,109 $ 2,539 4 100.0% 73.5% 24.5% 2.00% 4 125% 119% 153% 83%

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Problem 4-8 A. Aerospace B. Airline C. Chemicals & Drugs Common size statements Balance Sheet Company 1 Cash and short-term investments Receivables Inventory Other current assets Current assets Gross property Less: Accumulated depreciation Net property Investments Intangibles and other Total assets 2% 17 15 6 40 % 86 (50) 36 % 3 21 100 % D. Computer Software E. Consumer Foods F. Department Stores G. Consumer Finance H. Newspaper Publishing I. Electric Utility

2 13 % 8 52 73 % 40 (19) 21 % 1 5 100 %

3 37 % 22 15 5 79 % 26 (8) 18 % 3 100 %

4 1% 28 23 1 53 % 44 (15) 29 % 18 100 %

5 1% 23 14 4 42 % 63 (23) 40 % 3 15 100 %

6 3% 5 2 2 12 % 112 (45) 67 % 14 7 100 %

7 1% 11 2 2 16 % 65 (28) 37 % 16 31 100 %

8 22 % 16 1 39 % 1 1% 55 5 100 %

9 6% 8 5 19 % 106 (34) 72 % 9 100 %

Trade payables Debt payable Other current liabilities Current liabilities Long-term debt Other liabilities Total liabilities Equity
Total liabilities & equity

11 4 9 24 % 20 16 60 % 40 100 %

21 43 64 % 5 69 % 31 100 %

22 3 25 % 12 1 38 % 62 100 %

13 6 19 % 27 21 67 % 33 100 %

26 4 1 31 % 23 16 70 % 30 100 %

7 6 4 17 % 34 12 63 % 37 100 %

11 2 1 14 % 24 13 51 % 49 100 %

46 16 62 % 27 5 94 % 6 100 %

20 4 8 32 % 21 12 65 % 35 100 %

Income statement Company Revenues Cost of goods sold Operating expenses

Research % development

1 100 % 58 21 7 3 11 % 1 10 % 0.96

2 100 % 81 7 5 7% (1) 8% 1.12

3 100 % 58 24 9 3 6% 6% 0.94

4 100 % 63 28 2 7% 2 5% 1.38

5 100 % 52 33 1 5 9% 2 7% 1.82

6 100 % 84 16 % 6 10 % 0.45

7 100 % 59 29 12 % 3 9% 0.96

8 100 % 55 45 % 41 4% 0.15

9 100 % 91 2 7% 1 6% 0.96

Advertising Operating income Net interest expense

Income from continuing

operations before tax Asset turnover ratio

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Four categories of ratios to be covered are: 1 . Activity ratios - the liquidity of specific assets and the efficiency of managing assets 2. 3. Liquidity ratios - firm's ability to meet cash needs as they arise; Debt and Solvency ratios - the extent of a firm's financing with debt relative to equity and its ability to cover fixed charges; and Profitability ratios - the overall performance of the firm and its efficiency in managing investment (assets, equity, capital)

4.

These categories are not distinct as we shall see activity -------> liquidity activity ---------> profitability solvency <------> profitability

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A.

ACTIVITY RATIOS: ASSET MANAGEMENT & EFFICIENCY

1. Short-term (operating) activity ratios: Inventory Turnover Ratio (COGS)/(Average inventory) Measures the efficiency of the firm in managing and selling inventory. Inventory does not languish on shelves. High ratio represent fewer funds tied up in inventories -- efficient management. High inventory can also represent understocking and lost orders. Low turnover can also represent legitimate reasons such as preparing for a strike, increased demand, etc. Ratio depends on industry -perishable goods etc.) Average # of days inventory in stock = 365 / (Inventory Turnover Ratio)

Receivable Turnover Ratio Sales/(Average receivable) How many times receivables are turned into cash Relatively low turnover may indicate inefficiency, cutback in demand, or earnings manipulations. Average # of days receivable are outstanding = 365/(Receivable Turnover) (When available, the figure for credit sales can be substituted for net sales since credit sales produce the receivables.) Provides information about the firm's credit policy. Should be compared with the firm's stated policy (i.e., if firm policy is 30 days and average collection period is 60 days, company is not stringent in collection effort.) High/low relative to the industry should be examined (i.e., low might indicate loss sales to competitors). Low turnover ratios may imply firms income overstated future production cutbacks future liquidity problems
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2. Long-term (investment) activity ratios: Fixed Assets Turnover Ratio = Sales/ Average fixed assets

Total Assets Turnover Ratio = Sales/ Average total assets

As an alternative, one can use Plant-Asset Turnover Ratio (Revenues/Average plant assets). Plant-Asset Turnover is a measure of the relation between sales and investments in long-lived assets. When the asset turnover ratios are low, relative to the industry or historical record, either the investment in assets is too heavy and/or sales are sluggish. There may, however, be plausible explanations: the firm may have taken an extensive plant modernization.

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B. LIQUIDITY RATIOS: SHORT TERM SOLVENCY These ratios measure short term solvency -- the ability of the firm to meet its debt requirements as they come due. Length of the Cash Cycle - Net Trade Cycle The Length of cash cycle (i.e., the number of- days a company's cash is tied up by its current operating cycle) for a merchandise company is calculated as follows: Operating cycle (1) the number of days inventory is in stock [365/inventory turnover] PLUS (2) the of days receivable are outstanding [365/Receivable turnover] MINUS (3) the # of days accounts payable are outstanding (365 Average accounts payable)/Purchases]. where purchases are approximated by: COGS plus ending inventories less beginning inventories.

Please note that for a manufacturing company, the length of the cash cycle must also consider the time that money is tied up by production. (Box 3-1)

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Current Ratio Quick Ratio

Current assets / Current liabilities Cash + Marketable securities + Receivable Current liabilities Cash + Marketable securities Current liabilities

Cash Ratio =

Cash Flow From Operations Ratio = CFO / Current liabilities Defensive Interval = 365 x Cash + Marketable Securities + Accounts Receivable Projected Expenditures

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C. DEBT & SOLVENCY RATIOS: DEBT FINANCING AND COVERAGE The use of debt involves risk because debt carries. fixed commitment (interest charges & principal repayment). While debt implies risk, it also introduces the potential for increased benefits to the firm's owners (leverage effect illustrated below). There are other fixed commitments, such as lease payments, that are similar to debt and should be considered Debt-Capital Ratio = Debt/(Debt + Equity) Debt - Assets Ratio = Debt/Total assets Debt-Equity Ratio = Debt/Shareholders' equity Debt can include trade debt -- usually it does not

Coverage Ratios [Can also be calculated on cash basis] Times interest earned = Operating profit(EBIT) /interest expense Fixed charge coverage Operating profit + Lease payments Interest expense + Lease payments

Note: Lease payments are added to numerator because they were deducted in order to arrive at operating profits.

Capital Expenditure ratio = CFO/Capital expenditures CFO-debt = CFO/debt

Debt covenants: It is important to examine the proximity to a technical violation for two reasons: (1) it implies potential costs of renegotiation; and (2) it implies potential earnings management.

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D. PROFITABILITY RATIOS: OVERALL EFFICIENCY & PERFORMANCE Gross Profit Margin = Gross profit/Sales Measures the ability of the firm to control costs of inventories and/or manufacturing cost and to pass along price increases through sales to customers. Operating Profit Margin = Operating profit/Sales Measure of overall operating efficiency. Net Profit Margin = (Net Earnings)/Sales Measure of overall profitability after all items included (revenues, expenses, tax, interest, etc.). The profit margin ratio is a measure of a firm's ability to control the level of expenses relative to revenues generated. ROI measures Rate of return on assets (ROA) =
Net income + Interest expense (net of income tax savings) Average total assets

By adding back interest expense, we actually measure the rate of return on assets as if the firm is fully financed with equity. This ratio provides a performance measure that is independent of the financing of the firm's assets.

Rate of Return on Common Shareholders' Equity (ROE) =

Net income Average common equity

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Disaggregation of ROA/ROE
To simplify matters, we first illustrate ROA on a pre-tax basis.

ROA =

EBIT Assets x Sales Assets Activity

= EBIT Sales Similarly for ROE we find ROE = EBT Equity

= Profitability x

= EBT Sales

Sales x Assets

Assets Equity Solvency ________

Debt/Equity Debt/Assets

= Profitability x Activity x ___________ ________

Common Size I/S Components

Inventory T/O A/R T/O Fixed Asset T/O

ON AN AFTER-TAX BASIS
THREE COMPONENT DISAGGREGATION OF ROE ROE = Net Income Equity = Net Income Sales x Sales Assets x Assets Equity

= Profitability
FIVE COMPONENT DISAGGREGATION OF ROE ROE = Net Income Equity = EBIT x EBT x Net Income Sales EBIT EBT

Activity

Solvency

Sales Assets Activity

x x

Assets Equity Solvency

Profitability x Operations x Financing x Taxes

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Additional insights into the relationship of ROE & ROA Note the in the three way disaggregation of ROE, the first two components are ROA calculated on an after interest basis We can express ROE in terms of ROA directly as (again using pre-tax numbers to simplify matters)
ROE = = EBIT - Interest x Assets Assets Equity [ROA - Interest ] x Assets Assets Equity

This term with some manipulation can be converted to*

ROE = ROA + (ROA - Cost of Debt) x [Debt / Equity]

Leveraging is only profitable if the return on assets is greater than the cost of debt

_________
*

An obvious parallel to this equation for ROE (return on equity)

ROE = ROA + (ROA - Cost of Debt) x [Debt / Equity]

is the equation for the beta of a firm ( e) e = a + ( a -

d )

x [Debt / Equity]

where a and d are the unlevered beta and the beta of debt respectively.

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Problem 4-16 -- Errata 1986 1985 Sales 287.48 295.32 EBIT Interest EBT Taxes Net income Tax rate Assets 12.57 9.41 3.16 0.53 2.63 16.8% 114.09 16.84 9.51 7.33 3.03 4.30 41.3% 327.19

1987 685.36 56.36 25.51 30.85 13.18 17.67 42.7% 380.87

1988 757.38 70.68 24.67 46.01 18.85 27.16 41.0% 401.11

1989 790.97 70.97 17.96 53.01 20.40 32.61 38.5% 378.92

1990 864.60 74.06 11.44 62.62 24.31 38.31 38.8% 407.47

Liabilities & Equity Current debt 2.88 Trade liabilities 53.77 Current liabilities 56.65 Long term debt 51.50 Other 1.32 Total liabilities 109.47 Equity 4.62 Total lblty & equity 114.09

18.09 90.73 108.82 191.59 0.62 301.03 26.16 327.19

28.33 105.35 133.68 178.76 5.51 317.95 62.92 380.87

33.23 103.16 136.39 135.18 7.90 279.47 121.64 401.11

26.93 109.43 136.36 74.79 11.52 222.67 156.25 378.92

23.86 122.67 146.53 48.34 13.82 208.69 198.78 407.47

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