Ratio Analysis

Financial Statement Analysis

Will I
be paid?
How
good is our
investment?

Creditors
How are we
performing?

Stockholders

Management

Financial analysis/ratios objectives

Ratio analysis involves methods of calculating and

interpreting financial ratios to analyze and monitor
the firms performance
Basic inputs: income statement and balance sheet
Interested parties:

Shareholders risk and return characteristics of the

firm
Creditors short-term liquidity & company ability to
make interest and principal payments
Management all aspects of firms financial
situation
3

How are financial ratios used?

Calculating financial ratios allows us to

Examine the firms performance through time (e.g. last

five years) and identify trends
Compare the firms performance with other comparable
firms (peer group) and identify the firms competitive
advantage
Some financial ratios (e.g. price-earnings ratio, marketto-book ratio) are useful in valuation analysis, such as
valuing private firms

Financial ratios comparisons

Cross-sectional analysis involves comparison

of different firms financial ratios at the same point
in time

It is important to understand how the firm has

performed in relation to other firms in its industry
Frequently, a firm will be compared to a key
competitor in industry benchmarking

Time-series analysis evaluates performance

over time and enables assessing the firms progress

Combined

analysis

the

most

informative

approach to ratio analysis

5

Financial ratios

Liquidity ratios measure the firms ability to

satisfy short-term obligations as they come due

Leverage (financing) ratios measure the firms
ability to pay its long-term debt
Efficiency (activity) ratios measure the speed
with which various accounts are converted into
sales or cash
Profitability ratios shows the firms ability to
generate income from its assets
Market ratios give insight into how well
investors in the market value the firm
6

Bartlett Company Balance Sheet

As of December 31 - $ in thousands
Assets
Current assets
Cash
Marketable securities
Accounts receivable
Inventories
Total current assets
Gross fixed assets (at cost)
Land and buildings
Machinery and equipment
Furniture and fixtures
Vehicles
Other (includes financial leases)
Total gross fixed assets (at cost)
Less: Accumulated depreciation
Net fixed assets
TOTAL ASSETS

2009

2008

Changes

363
68
503
289
1.223

288
51
365
300
1.004

75
17
138
-11
219

2.072
1.866
358
275
98
4.669
2.295
2.374

1.903
1.693
316
314
96
4.322
2.056
2.266

169
173
42
-39
2
347
239
108

3.597

3.270

327

Bartlett Company Balance Sheet

As of December 31 - $ in thousands
2009

2008

Changes

382
79
159
620
1.023
1.643

270
99
114
483
967
1.450

112
-20
45
137
56
193

200

200

191
428
1.135
1.954
3.597

190
418
1.012
1.820
3.270

1
10
123
134
327

Liabilities and stockholders' equity

Current liabilities
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt (includes financial leases)
TOTAL LIABILITIES
Stockholders' equity
Preferred stock - cumulative 5%, $100 at par, 2,000 shares
authorized and issued
Common stock - $2.50 par, 100,000 shares authorized, shares
issued and outstanding in 2009: 76,262; in 2008: 76,244
Paid-in capital in excess of par on common stock
Retained earnings
Total stockholders' equity
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY

Bartlett Company Income Statement

As of December 31 - $ in thousands
Sales revenue
Less: Cost of goods sold
Gross profit
Less: Operating expenses
Selling expenss
General and administrative expenses
Lease expense
Depreciation expense
Total operating expenses
Operating profits (EBIT)
Less: Interest expense
Net profits before taxes (EBT)
Less: Taxes
Net profits after taxes (EAT)
Less: Preferred stock dividends
Earnings available to common stockholders

2009
3.074
2.088
986

2008
2.574
1.711
863

100
194
35
239
568
418
93
325
94
231
10
221

108
187
35
223
553
310
91
219
64
155
10
145

Change
500
377
123
0
-8
7
0
16
15
108
2
106
31
75
0
75

Bartlett Co. Statement of retained earnings,

2009

Retained earnings balance (Jan 1, 2009)

Plus: Net profits after taxes (for 2009)
Less: Cash dividends (paid in 2009)
Dividends for preferred stock
Dividends for common stock
Total dividends paid
Retained earnings balance (Dec 2009)

1.012
231
10
98
108
1.135

10

Bartlett Co. Statement of cash flows, 2009

Cash Flow from Operating Activities
Net profits after taxes
Depreciation expense
Change in accounts receivable
Change in inventories
Change in accounts payable
Change in accruals
Cash provided by operating activities

231
239
-138
11
112
45
500

Cash Flow from Investment Activities

Change in gross fixed assets
Change in business interests
Cash provided by investment activities

-347
0
-347

Cash Flow from Financing Activities

Changes in notes payable
Changes in long-term debt
Changes in stockholders' equity
Dividends paid
Cash provided by financing activities

Net increase in cash and marketable securities

-20
56
11
-108
-61

92

11

Liquidity ratios
Current assets
Current ratio =
Current liabilities
1,223
For Bartlett Current ratio
1.97
620

Current assets - Inventory

Quick ratio =
Current liabilities
1,223 - 289
For Bartlett Quick ratio
1.51
620

Cash Marketable securities

Cash ratio =
Current liabilities
For Bartlett Cash ratio

363 68
0.69
620
12

Leverage ratios
Total Liabilities
Debt ratio =
Total Assets
For Bartlett Debt ratio

1,643
0.457
3,597

Long - term debt + Value of leases

Debt equity ratio =
Equity
1,023
For Bartlett Debt equity ratio
0.52
1,954
Times interest earned(TIE ) =
For Bartlett TIE

EBIT
Interest

418
4.5
93
13

Efficiency ratios and operating cycle

Efficiency of total assets

Sales
Total assets
3,074
For Bartlett Total assets turnover
0.85
3,597
Total assets turnover =

Efficiency of current assets OPERATING CYCLE

Finding the inventory period
Cost of goods sold
Inventory turnover =
Inventory
2,088
For Bartlett Inventory turnover
7.22
289
365
Inventory period =
Inventory turnover
365
For Bartlett Inventory period
50.55 days
7.22

14

Efficiency ratios and operating cycle

Finding the accounts receivable (collection) period

Sales
A/R turnover =
A/R
3,074
For Bartlett A/R turnover
6.11
503
365
Receivable s period =
A/R turnover

For Bartlett Receivable s period

365
59.74 days
6.11

Operating cycle = Inventory period Receivable s period

For Bartlett Operating cycle 50.55 59.74 110.29 days
15

Efficiency ratios and operating cycle

Finding the payables period

Average purchases
A/P
0.70x2,088
For Bartlett A/P turnover
3.83
382
A/P turnover =

Payables period =

365
A/P turnover

For Bartlett Payables period

365
95.4 days
3.83

Cash cycle = Operating cycle - Payables period

For Bartlett Cash cycle 110.29 95.4 14.89 days
16

Operating cycle

17

A few considerations on operating cycle

The longer the production process, the longer the

inventory period
The longer it takes customers to pay their bills, the
longer the accounts receivable period
The longer the accounts payable period, the shorter
the cash cycle

the cash conversion cycle is not given to a large

extent it is under managements control
balance between the costs
maintaining high current assets

and

benefits

of
18

Profitability ratios

Sales - COGS
Gross profit margin =
Sales

For Bartlett Gross profit margin

Operating profit margin =

3,074 - 2,088
0.3208 or 32.08%
3,074

Operating profits
Sales

For Bartlett Operating profit margin

418
0.1360 or 13.60%
3,074

Earnings available to common shareholders

Net profit margin =
Sales
For Bartlett Net profit margin

221
0.0719 or 7.19%
3,074
19

Profitability ratios
Earnings per share (EPS)

Earnings available to common shareholders

Number of shares outsanding

221,000
For Bartlett EPS
$2.90
76,262

Dividends to common shareholders

Payout ratio =
Earnings available to common shareholders
98
For Bartlett Payout ratio
0.4434 or 44.34%
221

20

Profitability ratios
Earnings available to common shareholde rs
ROA =
Total assets
221
0.0614 or 6.14%
3,597
Earnings available for common shareholders
ROE =
Common shareholders' equity
For Bartlett ROA

221
0.1260 or 12.60%
1,754
Net profits after tax Interests
ROIC =
Shareholde rs' equity LT Debts (inclusiv financial leases)
For Bartlett ROE

For Bartlett ROIC

231 93
0.1088 or 10.88%
1,954 1023

21

Market ratios
Price per share of common stock
P/E ratio (PER) =
Earnings per share
For Bartlett PER

32.25
11.13
2.90

Price per share of common stock

Market - to - book ratio =
Book value per share
For Bartlett Market to book ratio

32.25
32.25

1.40
(1,754,000/76,262)
23

22

Time-series and cross-sectional analysis for Bartlett

2009
1. Liquidity

1. Current ratio
2. Quick ratio
3. Cash ratio

2. Efficiency 1. Inventory turnover

2. Average payment period
3. Average collection period
4. Total assets turnover
3. Leverage

1. Debt ratio
2. Debt-to-equity ratio
3. Times interest earned

4. Profitablity 1. Gross profit margin

2. Operating profit margin
3. Net profit margin
4. Earnings per share
5. Payout ratio
6. ROA
7. ROE
5. Market

1. PER
2. Market to book ratio

1,97
1,51
0,70
7,22
95,40
59,73
0,85

2008 Industry average

2009
2,08
2,05
1,46
1,43
0,70
0,71
5,70
81,20
51,76
0,79

6,60
66,50
42,75
0,75

45,70% 44,30%
52,35% 53,13%
4,50
3,30

40,00%
48,06%
4,30

32,08% 33,53%
13,60% 12,04%
7,18% 5,65%
2,89
1,91
0,44
0,42
6,14% 4,45%
12,59% 8,98%

30,00%
11,00%
6,20%
2,26
0,41
4,60%
8,50%

11,14
1,40

9,46
0,85

12,50
1,30

23

The DuPont system

Earnings available to common stockholders
ROA =
Total assets
Sales
Earnings available to common stockholders

x
Total assets
Sales

Assets turnover ratio

Net profit margin

For Bartlett ROA 0.85 7.18% 6.14%

24

The DuPont system

Earnings available to common stockholders
ROE =
Shareholders' equity
Earnings available to common stockholders

Net profit margin

Sales
Sales

Assets turnover ratio

Total assets
Total assets
Leverage ratio

Shareholders' equity

221,000 3,074,000 3,597,000

3,074,000 3,597,000 1,754,000

7.18% 0.85 2.05 12.60%

For Bartlett ROE

25

The DuPont system

- an example -

Question: Are the stockholders of these companies receiving an adequate return on their investment?
Company A
2014
2013
2012
2011
2010
Return on Equity (ROE)
14.0%
12.1%
12.4%
5.3%
11.2%

Return on Equity (ROE)

2014
12.9%

Company B
2013
2012
11.8%
11.0%

2011
8.8%

2010
11.2%

The DuPont system

- an example (cont.)-

DuPont Equation
ROE Components:
Net profit margin
Assetsturnover ratio
Leverage ratio
Return on Common Equity (ROE)
DuPont Equation
ROE Components:
Net profit margin
Assetsturnover ratio
Leverage ratio
Return on Common Equity (ROE)

2014
3.5%
2.00
2.0
14.0%
2014
5.1%
2.50
1.0
12.9%

Company A
2013
2012
4.0%
4.1%
1.32
1.35
2.3
2.2
12.1%
12.4%
Company B
2013
2012
4.5%
4.1%
2.33
2.36
1.1
1.1
11.8%
11.0%

2011
2.0%
1.26
2.1
5.3%

2010
4.1%
1.32
2.1
11.2%

2011
3.3%
2.35
1.1
8.8%

2010
4.1%
2.26
1.2
11.2%

Financial Leverage Effects

ROE = ROIC + [(ROIC interest rate)L-T Debt/Equity]

Leveraged firms accrue excess returns to their

shareholders so long as the rate of return on investments
financed by debt is greater than the cost of debt;
The higher the debt ratio, the riskier the firm;
This formula applies for company that issued only
ordinary shares. In case of the companies that issued also
preferred shares the cost of this financing source will be
included in the cost of debts.

Financial Leverage Effects

Equity
LTD
EBIT
Interest Expenses
EBT
Income tax
Net income (net profits after tax)
ROIC
Interest rate
Debt-Equity ratio
ROE

2014
4000
4000
1200
600
600
96
504
13.8%
15.0%
1.0
12.6%

Company C
2013
2012
4000
4000
5200
4800
1300
1500
780
720
520
780
83.2
124.8
436.8
655.2
13.2%
15.6%
15.0%
15.0%
1.3
1.2
10.9%
16.4%

2011
4000
4400
1600
660
940
150.4
789.6
17.3%
15.0%
1.1
19.7%

2010
4000
4400
1800
660
1140
182.4
957.6
19.3%
15.0%
1.1
23.9%

Potential problems and limitations of

financial ratio analysis

No single ratio or one-year figure should be relied

upon to provide an assessment of a companys
performance.

Financial analysis may indicate that something is

wrong, but it may not identify the specific problem
or show how to correct it.

Potential problems and limitations

of financial ratio analysis

Comparison with industry averages is difficult for a

conglomerate firm that operates in many different
divisions.
Average performance is not necessarily good,
perhaps the firm should aim higher.
Seasonal factors can distort ratios.

Window dressing techniques can make statements

and ratios look better.

Quick Quiz (I)

How would the following actions affect a

firms current ratio?
a. Inventory is sold at cost.
b. The firm takes out a bank loan to pay its
accounts due.
c. A customer pays its accounts receivable.
d. The firm uses cash to purchase additional
inventories.

Quick Quiz (II)

Determine a firm's total asset turnover (TAT)

if its net profit margin (NPM) is 5 percent,
total assets are $8 million, and ROA is 8
percent.
1.60
2.05
2.50
4.00

Quick Quiz (III)

CFA Corp. has a debt-equity ratio that is

lower than the industry average, but its
times interest earned ratio is also lower than
the industry average. What might explain
this seeming contradiction?
A firm uses $1 million in cash to purchase
inventories. What will happen to its current
ratio? Its quick ratio?

Quick Quiz (IV)

Find ways to improve accounts receivable

turnover.
When a leveraged firm accrues excess
returns to their shareholders?
Give examples of industry that are using low
margin/high turnover and high margin/low
turnover.

Quick Quiz (V)

In each of the following cases, explain briefly which of the

two companies is likely to be characterized by the higher
ratio:
a. Debt-equity ratio: a shipping company or a computer
software company
b. Payout ratio: United Foods Inc. or Computer Graphics Inc.
c. Ratio of sales to assets: an integrated pulp and paper
manufacturer or a paper mill
d. Average collection period: Regional Electric Power
Company or Z-Mart Discount Outlets
e. Price-earnings multiple: Basic Sludge Company or
Fledgling Electronics

Quick Quiz (VI)

Financial ratio analysis is conducted by four groups

of analysts: managers, equity investors, long-term
creditors and short-term creditors. What is the
primary emphasis of each of these groups in
evaluating ratios?
Over the past year, M.D. Ryngaert & Co. has
realized an increase in its current ratio and a drop
in its total assets turnover ratio. However, the
companys sales, quick ratio, fixed assets turnover
ratios have remained constant. What explains
these changes?

Quick Quiz (VII)

If the mean P/E ratio for an industry sector is 12,

and the company you are analyzing has a P/E of
18, what does this mean about investors view of
growth prospects?

Modify sectors P/E to be correct!

Sector

Sector average P/Es

Electricity

18

Gaming (software)

Building materials

Food retailing

12