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How financial ratio analysis helps managers assess the firm s health. Compute profitability, liquidity, debt, asset activity, and market value ratios. Compare financial information over time and among companies.
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Ratio Analysis
Ratio Analysis
Five Categories of Ratios
Financial managers use ratios to interpret the raw numbers on financial statements. Relative measures allow comparison over time and to other firms. Ratios are used by financial managers, other business managers, creditors, and investors.
Link to Company Research Link to Wall Street Research Net
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Profitability ratios Liquidity ratios Debt ratios Asset activity ratios Market value ratios
Link to 10k Wizard Home Page: info on financial reports and SEC filings Link to Financial Research
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Ratio Analysis
Profitability Ratios
Ratio Analysis
Profitability Ratios
Gross Profit Sales
How effective is the firm at generating revenue in excess of its cost of goods sold?
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Balance Sheet Excalibur Corporation Cash $175 Accounts Receivable 430 Inventories 625 Current Assets $1,230 Plant & Equipment $2,500 Less:Acc. Depr. (1,200) Net Fixed Assets $1,300 Total Assets $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Net Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62 Accounts Payable $115 S-T Notes Payable 115 Current Liabilities $230 Bonds $600 Owners Equity Common Stock $300 Capital in Excess of Par 600 Retained Earnings 800 Total Owners Equity $1,700 Total Liabilities and Owners Equity $2,530
Ratio Analysis
Profitability Ratios
Operating Profit Margin = Operating Income Sales
Balance Sheet Excalibur Corporation Cash $175 Accounts Receivable 430 Inventories 625 Current Assets $1,230 Plant & Equipment $2,500 Less:Acc. Depr. (1,200) Net Fixed Assets $1,300 Total Assets $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62 Accounts Payable $115 S-T Notes Payable 115 Current Liabilities $230 Long-term Debt $600 Owners Equity Common Stock $300 Capital in Excess of Par 600 Retained Earnings 800 Total Owners Equity $1,700 Total Liabilities and Owners Equity $2,530
Ratio Analysis
Profitability Ratios
Note: Net Income equals Earnings Available to CS when there is no preferred stock.
How much net profit is being generated from each dollar of sales?
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Balance Sheet Excalibur Corporation Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners Equity $1,700 Income Statement Total Liabilities and Excalibur Corporation Owners Equity $2,530 Sales $1,450 Assets Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62
Ratio Analysis
Profitability Ratios
Return on Assets = Net Income Total Assets
How effectively is the firm generating net income from its assets ?
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Balance Sheet Excalibur Corporation Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term debt $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners Equity $1,700 Total Liabilities and Income Statement Owners Equity $2,530 Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Net Income Return on Depreciation 200 = Operating Income $330 Total Assets Assets Interest Expense 60 Income Before Taxes $270 Taxes (40) 108 $162 Net Income% $162 ROA = $2,530 = 6.4% 13 Common Dividends Paid 100 Addition to Retained Earnings $62 Assets
Ratio Analysis
Profitability Ratios
Net Income Common Equity
Return on Equity =
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Balance Sheet Excalibur Corporation Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners Equity $1,700 Income Statement Total Liabilities and Excalibur Corporation Owners Equity $2,530 Sales $1,450 Assets Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62
Ratio Analysis
Liquidity Ratios
Measure the ability of the firm to meet its short-term financial obligations. shortCurrent Assets Current Liabilities
Current Ratio =
Return on Equity = Net Income Common Equity
= 9.53%
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Are there sufficient current assets to pay off current liabilities? What is the cushion of safety?
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Balance Sheet Excalibur Corporation Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners Equity $1,700 Total Liabilities and Owners Equity $2,530 Assets
Ratio Analysis
Liquidity Ratios
Measure the ability of the firm to meet its short-term financial obligations. shortCurrent Assets - Inventory Current Liabilities
AcidAcid-Test Ratio =
Current Ratio =
What happens to the firms ability to repay current liabilities after what is usually the least liquid of the current assets is subtracted?
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Balance Sheet Excalibur Corporation Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners Equity $1,700 Total Liabilities and Owners Equity $2,530 Assets
Ratio Analysis
Debt Ratios
Acid-Test Ratio =
Measure the relative size of the firm s debt load and the firm s ability to pay off the debt.
Acid-Test Ratio =
Ratio Analysis
Debt Ratios
Debt Ratio = Total Debt Total Assets
Balance Sheet Excalibur Corporation Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners Equity $1,700 Income Statement Total Liabilities and Excalibur Corporation Owners Equity $2,530 Sales $1,450 Assets Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62
Debt Ratio =
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Ratio Analysis
Debt Ratios
Total Debt Debt to = Common Equity Equity Ratio What is the proportion of debt relative to equity financing for the firm?
Balance Sheet Excalibur Corporation Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners Equity $1,700 Income Statement Total Liabilities and Excalibur Corporation Owners Equity $2,530 Sales $1,450 Assets Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62
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Ratio Analysis
Debt Ratios
Operating Income Interest Expense
What is the firms ability to repay interest payments from its operating income?
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Balance Sheet Excalibur Corporation Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners Equity $1,700 Income Statement Excalibur Corporation Total Liabilities and Owners Equity $2,530 Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Times Operating Income Operating Income $330 Interest = Interest Expense 60 Interest Expense Earned Ratio Income Before Taxes $270 Taxes (40%) 108 $330 Net Income $162 TIE Ratio = = 5.50x Common Dividends Paid 100 $60 Addition to Retained Earnings $62 Assets
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Ratio Analysis
Asset Activity Ratios
Ratio Analysis
Asset Activity Ratios
Help assess how effectively the firm is using assets to generate sales.
Average Collection Period = Accounts Receivable Avg. Daily Credit Sales How long does it take for the firm on average to collect its credit sales from customers?
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Balance Sheet Excalibur Corporation Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners Equity $1,700 Income Statement Total Liabilities and Excalibur Corporation Owners Equity $2,530 Sales $1,450 Assets Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62
Ratio Analysis
Asset Activity Ratios
Average Accounts Receivable Collection = Avg. Daily Credit Sales Period ACP = $430 $1,450/365 = 108.24 days
Days in a year
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Sales Inventory
Balance Sheet Excalibur Corporation Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners Equity $1,700 Income Statement Total Liabilities and Excalibur Corporation Owners Equity $2,530 Sales $1,450 Assets Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62
Ratio Analysis
Asset Activity Ratios
Sales Fixed Asset Turnover Ratio = Net Fixed Assets How effective is the firm in using its fixed assets to help generate sales?
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Balance Sheet Excalibur Corporation Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners Equity $1,700 Income Statement Total Liabilities and Excalibur Corporation Owners Equity $2,530 Sales $1,450 Assets Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62
Ratio Analysis
Asset Activity Ratios
Sales Total Assets
How effective is the firm in using its overall assets to generate sales?
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Assets
Balance Sheet Excalibur Corporation Liabilities Accounts Payable $115 S-T Notes Payable 115 Current Liabilities $230 Long-term Debt $600 Owners Equity Common Stock $300 Capital in Excess of Par 600 Retained Earnings 800 Total Owners Equity $1,700 Total Liabilities and Owners Equity $2,530
Cash $175 Accounts Receivable 430 Inventories 625 Current Assets $1,230 Plant & Equipment $2,500 Less:Acc. Depr. (1,200) Net Fixed Assets $1,300 Total Assets $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62
Ratio Analysis
Market Value Ratios
Price to Earnings Ratio = Market Price per Share Earnings per Share How much are investors willing to pay per dollar of earnings of the firm?
(Indicator of investors attitudes toward future prospects of the firm and of the firms risk.)
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Balance Sheet Excalibur Corporation Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners Equity $1,700 Income Statement Total Liabilities and Excalibur Corporation Owners Equity $2,530 Sales $1,450 Assets Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62
Ratio Analysis
Market Value Ratios
Market to Book Ratio = Market Price per Share Book Value per Share
How much are investors willing to pay per dollar of book value?
P/E ratio =
Assets
Balance Sheet Excalibur Corporation Liabilities Accounts Payable $115 S-T Notes Payable 115 Current Liabilities $230 Long-term Debt $600 Owners Equity Common Stock $300 Capital in Excess of Par 600 Retained Earnings 800 Total Owners Equity $1,700 Total Liabilities and Owners Equity $2,530
Cash $175 Accounts Receivable 430 Inventories 625 Current Assets $1,230 Plant & Equipment $2,500 Less:Acc. Depr. (1,200) Net Fixed Assets $1,300 Total Assets $2,530
Ratio
Industry Excalibur
38% 20% 12% 9.0% 13.4% 39.7% 22.8% 11.2% 6.4% 9.5%
Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62
Profitability Gross Profit Margin Operating Profit Margin Net Profit Margin Return on Assets Return on Equity
Market to = Book
Excalibur is good at keeping operating costs down, but not as good at total costs. ROA and ROE are low mainly due to productivity problems.
M/B =
$20.00 $1,700/100
= 1.18x
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Industry
5.00x 3.00x
Excalibur
5.35x 2.63x
Ratio
Industry Excalibur
35% 7.00x 49% 33% 5.50x 48%
Looking at the current ratio it appears that Excalibur is more liquid than the industry.... however when looking at Acid Test (a better measure) they are not as liquid indicating that inventory levels are probably too high.
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While the debt ratio is close to the industry average, Excalibur is not able to cover interest payments as easily as the industry. This indicates Excalibur may have too much debt relative to what they can realistically afford.
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Ratio
Industry Excalibur
90 days 3.00x 1.00x 0.75x 108 days 2.32x 1.12x .57x
Ratio
Market Value Price Earnings Market to Book
Industry Excalibur
18.0 2.5 12.35 1.18
Asset Activity Avg. Collection Period Inventory Turnover Fixed Asset Turnover Total Asset Turnover
Collection policies need examining, as Excalibur is slower than average at collecting receivables. Inventories are being sold more slowly than the industry average, again indicating inventories that are too high. Excalibur is very efficient at converting Fixed Assets to Sales (fixed assets are productive). However, overall assets are not productive indicating Current Assets (e.g. inventories) are not as productive as for the industry.
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Excaliburs Investors are not willing to pay as much per dollar of earnings or per dollar of book value as they are for shares in other firms in the industry. This signals that they consider the firms prospects to be worse than the average. However, the firm is still selling for more than its accounting book value.
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EVA is the amount of profit earned after all costs have been subtracted, including the cost of the funds used for the investmen t. It is often seen as the measure of true economic profit.
MVA is the market value of the firm, debt plus equity, minus the total amount of capital invested in the firm. A firm that consistently invests in high EVA projects would have a high MVA.
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Ratio Analysis generally involves an examination of related ratios. Comparison of these relationships over time helps to identify the company s strengths and weaknesses.
= Net Inc. x
Sales
Sales Assets
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Sales Assets
Equity
Assets
Now that you ll be able to recognize these new items we ve just discussed, you re ready to do some analysis of the financial statements. First, we ll talk about horizontal and vertical analysis. analysis. Then, we ll discuss financial ratios -standard measures that enable analysts to compare companies of different sizes
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Horizontal Analysis
Horizontal analysis compares one value across several periods. First, a base year must be chosen as the basis for comparison.
Horizontal Analysis
This shows 2000 as the base year. The base years sales are subtracted from each years sales. Then, this difference is expressed as a percentage of the base years sales.
Sales
2003 $41,500
2002 $37,850
2006
2005
2004
2003
Base year
Sales
$41,500 18.6%
$37,850 8.1%
The difference between each year and the base year is expressed as a percentage of the base year.
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Horizontal Analysis
For example, the sales for 2006 represent an increase of 18.6% over the base year 2003.
Vertical Analysis
compares each item in a financial statement to a base number set to 100%. Every item on the financial statement is then reported as a percentage of that base.
Sales
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Vertical Analysis
Sales Cost of goods sold Gross margin Total operating expenses Operating income Other income Income before taxes Income taxes Net income 2006 $38,303 19,688 $18,615 13,209 $ 5,406 2,187 $ 7,593 2,827 $ 4,766 % 100.0 51.4 48.6 34.5 14.1 5.7 19.8 7.4 12.4
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CommonCommon-size Analysis
An analysis of percentage financial statements where all balance sheet items are divided by total assets and all income statement items are divided by net sales or revenues. revenues.
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Index Analyses
An analysis of percentage financial statements where all balance sheet or income statement figures for a base year equal 100.0 (percent) and subsequent financial statement items are expressed as percentages of their values in the base year.
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Indexed
Indexed (%) 19X2 67.6 144.9 191.3 140.0 149.4 180.8 inf. 200.9 167.1 19X3 60.8 139.2 216.1 150.0 156.6 200.9 inf. 200.9 177.4
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Indexed
Indexed (%) 19X2 101.7 116.0 123.1 666.7 126.6 302.0 161.1 167.1 19X3 100.0 116.0 123.1 666.7 125.3 353.3 169.0 177.4
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