3 - financial ratio analysis

4-1

RATIO ANALYSIS

LIQUIDITY

ASSET MANAGEMENT

DEBT MANAGEMENT

PROFITABILITY

CHAPTER 3

ANALYSIS OF FINANCIAL

STATEMENTS

the calculation and comparison

of ratios which are derived from

the information in a company's

financial statements.

FINANCIAL RATIO ANALYSIS DEFINITION

Why are ratios useful?

Ratios standardize numbers and facilitate comparisons.

Ratios are used to highlight weaknesses and strengths.

Ratio comparisons should be made through time and with competitors

Trend analysis

Peer (or Industry) analysis

Ratio Comparisons

Peer or Industry Analysis (Cross-sectional analysis)

involves the comparison of different firms’ financial ratios at the same point in time; involves comparing the firm’s ratios to those other firms in its industry or to industry averages.

Trend Analysis (Time-series analysis) involves the evaluation of the firm’s financial performance over time using financial ratios. Comparison of current to past performance, using ratio analysis, allows the firm to determine whether it is progressing as planned.

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.

More issues regarding ratios

Sometimes it is hard to tell if a ratio is “good” or “bad”.

Difficult to tell whether a company is, on balance, in strong or weak position.

What are the major categories of ratios,

and what questions do they answer?

Liquidity: Can we make required payments?

Asset management: right amount of assets vs. sales?

Debt management: Right mix of debt and equity?

Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA?

Current

Ratio

CA

CL

It indicates the extent to

which current liabilities are

covered by those assets

expected to be converted to

cash in the near future

CA – inventories

CL

It measures a firm's ability

to pay off short-term

obligations to more liquid

type of assets.

LIQUIDITY RATIOS

Quick

(acid-test)

Ratio

Ratios that show the relationship of a firm’s

cash and other assets to its current liabilities

Sales

Inventories

(DSO)

Receivables

Average sales

per day

Also called the “average

collection period (ACP), it

indicates the average length

of time the firm must wait

after making a sale before it

receives cash.

ASSET MANAGEMENT RATIOS

Days Sales Outstanding

A set of ratios that measure how effectively a firm

is managing its assets.

Inventory

Turnover

Ratio

It indicates the salability

of inventory – the number

of times a company sells

its average inventory

during the year.

Fixed Assets

Turnover

Ratio

Sales

Net fixed assets

It measures how effectively

the firm uses its plant and

equipment

Sales

Total assets

It measures a firm's ability

to generate sales given its

total assets

ASSET MANAGEMENT RATIOS

Total

Assets

Turnover

Ratio

Total debt

Total assets

It indicates how much of

a company's assets are

provided through debt.

EBIT

Interest

Charges

DEBT MANAGEMENT RATIOS (FINANCIAL LEVERAGE)

Debt

Ratio

Debt Management ratios help evaluate a company's

long-term solvency, measuring the extent to which the

company is using long-term debt.

Times

Interest

Earned

(TIE) Ratio

A measure of the firm’s

ability to meet its annual

interest payments.

EBITDA + Lease

payments

Interest +

principal

payments +

lease payments

DEBT MANAGEMENT RATIOS (FINANCIAL LEVERAGE)

EBITDA

Coverage

It shows if earnings

are able to satisfy all

financial obligations

including leases and

principal payments.

Net income

Sales

This ratio measures net

income per dollar of sales

Net income

Totals assets

It gives an idea as to how

efficient management

is at using its assets to

generate earnings.

PROFITABILITY RATIOS

Return on

total

assets

(ROA)

Profit

margin

on sales

A group of ratios that show the combined effects of

liquidity, asset management, and debt on operating

results.

EBIT

Total assets

It indicates the ability

of the firm’s assets to

generate operating

income

Net income

Common equity

PROFITABILITY RATIOS

Return on

common

equity

(ROE)

Basic

Earning

Power

(BEP)

It gives the amount of

net income earned for

each share of the

company’s common

stock.

Balance Sheet: Assets

Cash

A/R

Inventories

Total CA

Gross FA

Less: Dep.

Net FA

Total Assets

2010

7,282

632,160

1,287,360

1,926,802

1,202,950

263,160

939,790

2,866,592

2011E

85,632

878,000

1,716,480

2,680,112

1,197,160

380,120

817,040

3,497,152

Balance sheet:

Liabilities and Equity

Accts payable Notes payable Accruals Total CL Long-term debt Common stock Retained earnings Total Equity Total L & E

2010

524,160

636,808

489,600

1,650,568

723,432

460,000

32,592

492,592

2,866,592

2011E

436,800

300,000

408,000

1,144,800

400,000

1,721,176

231,176

1,952,352

3,497,152

Income statement

Sales COGS Other expenses EBITDA Depr. & Amort. EBIT Interest Exp. EBT Taxes Net income

2010 6,034,000 5,528,000 519,988 (13,988) 116,960 (130,948) 136,012 (266,960) (106,784) (160,176)

2011E 7,035,600

5,875,992 550,000

609,608 116,960

492,648 70,008

422,640 169,056 253,584

Other data

No. of shares

EPS

DPS

Stock price

Lease pmts

2011E

250,000

$1.014

$0.220

$12.17

$40,000

2010

100,000

-$1.602

$0.110

$2.25

$40,000

Calculate D’Leon’s forecasted current

ratio and quick ratio for 2011.

Current ratio = CA/ CL

= $2,680 / $1,145

= 2.34x

Quick ratio = (CA – Inventories) / CL

= ($2,680 – $1,716) / $1,145

= 0.84x

Comments on liquidity ratios

2011E 2010 2009 Ind.

Current Ratio 2.34x 1.20x 2.30x 2.70x

Quick Ratio 0.84x 0.39x 0.85x 1.00x

Expected to improve but still below the

industry average.

Liquidity position is weak.

What is the inventory turnover vs.

the industry average?

2011E 2010 2009 Ind.

Inventory

Turnover 4.1x 4.70x 4.8x 6.1x

Inv. turnover = Sales / Inventories

= $7,036 / $1,716

= 4.10x

Comments on

Inventory Turnover

Inventory turnover is below industry

average.

D’Leon might have old or too much

inventory, which is expensive because

Inventory takes up costly warehouse space.

Some items may become spoiled or obsolete.

No improvement is currently forecasted.

DSO is the average number of days after

making a sale before receiving cash.

DSO= Receivables / Avg sales per day

= Receivables/(Annualsales/365)

= $878 / ($7,036/365)

= 45.6 days

Appraisal of DSO

2011E 2010 2009 Ind.

DSO 45.6 38.2 37.4 32.0

D’Leon collects on sales too slowly,

and is getting worse.

D’Leon has a poor credit policy*. *Clear, written guidelines that set (1) the term

and conditions for supplying goods on credit, (2)

customer qualification criteria, (3) procedure for

making collections, and (3) steps to be taken in

case of customer delinquency.

Fixed assets and total assets turnover

ratios vs. the industry average

FA turnover = Sales / Net fixed assets

= $7,036 / $817 = 8.61x

TA turnover = Sales / Total assets

= $7,036 / $3,497 = 2.01x

Evaluating the FA turnover and

TA turnover ratios

2011E 2010 2009 Ind.

FA TO 8.6x 6.4x 10.0x 7.0x

TA TO 2.0x 2.1x 2.3x 2.6x

FA turnover projected to exceed the

industry average.

TA turnover below the industry average.

Caused by excessive currents assets

(A/R and Inv).

Calculate the debt ratio, times-interest-

earned, and EBITDA coverage ratios.

Debt ratio=Total debt / Total assets

= ($1,145 + $400) / $3,497

= 44.2%

TIE = EBIT / Interest expense

= $492.6 / $70 = 7.0x

Calculate the debt ratio, TIE, and

EBITDA coverage ratios.

EBITDA = (EBITDA + Lease pmts)

coverage Int exp + Lease pmts + Principal pmts

= $609.6 + $40

$70 + $40 + $0

= 5.9x

How do the debt management ratios

compare with industry averages?

2011E 2010 2009 Ind.

D/A 44.2% 82.8% 54.8% 50.0%

TIE 7.0x -1.0x 4.3x 6.2x

EBITDA

coverage 5.9x 0.1x 3.0x 8.0x

D/A and TIE are better than the

industry average, but EBITDA coverage

still trails the industry.

Profitability ratios:

Profit margin and Basic earning power

Profit margin = Net income / Sales

= $253.6 / $7,036 = 3.6%

BEP = EBIT / Total assets

= $492.6 / $3,497 = 14.1%

Appraising profitability with the profit

margin and basic earning power

2011E 2010 2009 Ind.

PM 3.6% -2.7% 2.6% 3.5%

BEP 14.1% -4.6% 13.0% 19.1%

Profit margin was very bad in 2010, but is

projected to exceed the industry average in

2011. Looking good..

BEP projected to improve, yet still below the

industry average. There is definitely room

for improvement.

Profitability ratios:

Return on assets and Return on equity

ROA = Net income / Total assets

= $253.6 / $3,497 = 7.3%

ROE = Net income / Total common equity

= $253.6 / $1,952 = 13.0%

Appraising profitability with the

return on assets and return on equity

2011E 2010 2009 Ind.

ROA 7.3% -5.6% 6.0% 9.1%

ROE 13.0% -32.5% 13.3% 18.2%

Both ratios rebounded from the previous

year, but are still below the industry

average. More improvement is needed.

Panther Jaguar Sharks Dolphin

Revenue 8,000,000 6,500,000 9,250,000 7,750,000

Net Income 775,000 695,000 875,000 745,000

Assets 22,500,000 18,500,000 26,500,350 23,000,500

Daily

Receivables

100,000 95,000 105,000 102,500

The list of companies represents one industry. What

can you say about Dolphin’s ROA compared to the

industry’s numbers?

INDUSTRY COMPARISON

ROA (Panther) = Net income / Total assets

=775,000 /22,500,000

=3.44%

INDUSTRY COMPARISON

ROA (Panther) = Net income / Total assets

=775,000 /22,500,000

=3.44%

ROA (Jaguar) = Net income / Total assets

=695,000 /18,500,000

=3.76%

INDUSTRY COMPARISON

ROA (Shark) = Net income / Total assets

=875,000 /26,500,350

=3.30%

INDUSTRY COMPARISON

ROA (Shark) = Net income / Total assets

=875,000 /26,500,350

=3.30%

ROA (Dolphin) = Net income / Total assets

=745,000 /23,000,500

=3.24%

INDUSTRY COMPARISON

Panther Jaguar Sharks Dolphin

ROA 3.44% 3.76% 3.30% 3.24%

Ind.

Average

3.44%

INDUSTRY COMPARISON

Industry Average = 3.44 +3.76+3.30+3.24

= 3.44%

4

2011 2010 2009 2008

Revenue 8,000,000 6,500,000 9,250,000 7,750,000

Net Income 775,000 695,000 875,000 745,000

Assets 22,500,000 18,500,000 26,500,350 23,000,500

Daily

Receivables

100,000 95,000 105,000 102,500

Given: Dolphin’s numbers for 4 years

TREND ANALYSIS for Dolphin

2011 2010 2009 2008

ROA 3.44% 3.76% 3.30% 3.24%

TREND ANALYSIS for Dolphin

2.90

3.00

3.10

3.20

3.30

3.40

3.50

3.60

3.70

3.80

1 2 3 4

RO

A

Dolphin's ROA

2008 2009 2010 2011

More Sample PROBLEMS

1. A firm has an annual sales of $100 million, $20

million of inventory, and $30 million of accounts

receivable.




receivable.

a. What is its inventory ratio?




receivable.


Answer: 5X




receivable.


Answer: 5X

b. What is its DSO based on a 365-day year?



million of inventory, and $30 million of

accounts receivable.


Answer: 5X

b. What is its DSO based on a 365-day year?

Answer: 109.5 days


LOW COMPANY

Income Statement

Year Ended December 31, 2011

(in billions)

Net Sales $ 40.6

Cost of goods sold 22.5

Interest expense 0.4

All other expenses 6.9

Net income 10.8

II. Low’s Company, a home-improvement store

chain, reported the following summarized figures:

LOW’S COMPANY

Balance Sheet

December 31, 2011 and 2010

Assets 2011 2010 Liabilities and SE 2011 2010

Cash $ 2.2 $ 1.2 Total current liabilities $ 24.0 $13.2

Short-term

investments

24.0 13.0 Long-term liabilities 13.7 11.6

Accounts receivable 7.5 5.4 Common Stock 10.0 10.0

Inventory 7.3 7.2 Retained Earnings 35.3 21.5

Other current assets 9.0 1.5

Intangible assets 33.0 28.0

Total assets $ 83.0 $ 56.3 Total liabilities and

Stockholder’s Equity

$ 83.0 $ 56.3


LOW’S COMPANY

Balance Sheet

December 31, 2011 and 2010

Assets 2011 2010 Liabilities 2011 2010

Cash $ 2.2 $ 1.2 Total current liabilities $ 24.0 $13.2

Short-term

investments

24.0 13.0 Long-term liabilities 13.7 11.6

Accounts receivable 7.5 5.4 Total liabilities 37.7 24.8

Inventory 7.3 7.2 Stockholder’s Equity

Other current assets 9.0 1.5 Common Stock 10.0 10.0

Total current assets 50.0 28.3 Retained Earnings 35.3 21.5

All other assets 33.0 28.0 Total SEquity 45.3 31.5

Total assets $ 83.0 $ 56.3 Total liabilities and

Stockholder’s Equity

$ 83.0 $ 56.3



Requirements:

1. Compute the company’s current ratio at

December 31, 2011 and 2010.


Requirements:



Current ratio (2011) = CA/ CL

= $50/ $24

= 2.08x


Requirements:




= $50/ $24

= 2.08x


= $28.3/ $13.2

= 2.14x


Requirements:




= $50/ $24

= 2.08x


= $28.3/ $13.2

= 2.14x

2. Did Low’s Company’s current ratio, deteriorated,

improved or hold steady during the 2011?


Requirements:




= $50/ $24

= 2.08x


= $28.3/ $13.2

= 2.14x

2. Did Low’s Company’s current ratio, deteriorated,

improved or hold steady during the 2010? Deteriorated


3. Inventory Turnover?


3. Inventory Turnover for 2009?

Answer: 5.56x



Answer: 5.56x

4. Days Sales Outstanding for 2009?



Answer: 5.56x


Answer: 58 days



Answer: 5.56x


Answer: 58 days

5. Debt Ratio for December 31, 2011?



Answer: 5.56x


Answer: 58 days


Answer: 0.454



Answer: 5.56x


Answer: 58 days


Answer: 0.454

6. Is Low’s ability to pay its liabilities strong or

weak?



Answer: 5.56x


Answer: 58 days


Answer: 0.454

6. Is Low’s ability to pay its liabilities strong or

weak? Strong

3 - financial ratio analysis

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