eng econ mgt ratios l2 -mme 4272

8/13/2019 Eng Econ Mgt Ratios L2 -MME 4272

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2006 Prentice Hall, Inc. S7 1

Managem ent or f in an c ial rat ios(Understanding Financial Statements)

Reference:Fundamentals of Engineering Economics, 2 nd edChan S. ParkChapter 2 [ 5 th edition]


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Comm on ques t ions : A company of good economics? Return on investment?Owners earnings on upward trend? Debt-equity ratio?Retain earnings for growth?


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Figu re 13.2 Information reported on a companys financial statements


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Table 13.1 Consolidated Statement of Financial Position

(LAM Research Corporation Consolidated Balance Sheet)(in thousands, except per share data)

Period ending 25-Jjun-06 26-Jun-05 $ Change PercentChange

Assets

Current assets :Cash and Cash Equivalents

Short-term investmentsAccounts receivablesInventoriesOther Current Assets

Total current assets

Long-term investmentsProperty, plant and equipmentOther assetsDeferred Income taxes

Total assets

$910,815

139,524460,972168,714

26,344

1,706,369

--49,893

518,54938,533

$2,313,344

$482,250

327,003308,665110,051

16,8677,877

1,244,836

---41,082

119,67343,224

$1,448,815


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Table 13.1 Consolidated Statement of Financial Position (LAM Research Balance Sheet) (Continued)

Period ending 25-Jjun-06 26-Jun-05 $ Change PercentChange

Liabilities and Stockholders, equity Current liabilities

Accounts payableShort term debtOther current liabilities

Total current liabilities

Long-term debtOther long-term liabilities

Total liabilities

Stockholders equity Preferred stockCommon stockRetained earnings

Treasury stockCapital surplusAccumulated other comprehensive loss

Total stockholders equity

Total liabilities and stockholders equity

$426,141--

140,085

566,226

350,000969

917,195

--142

850,268

(416,447)973,391(11,205)

1,396,149

$2,313,344

$289,425--

89,708520

379,133

--2,786

381,919

--137

520,165

(186,064)744,672(12,014)

1,066,896

$1,448,815


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Table 13.2 LAM RESEARCH CORPORATION INCOME STATEMENT(in thousands, except per-share amount)

Period ending 25-Jun-06 26-Jun-05Total revenue Cost of Goods soldGross profit (margin)Research and DevelopmentSelling, general, and administrativeNonrecurring Restructuring Charges

Operating Income or Loss

Other Income (Expense)Interest incomeInterest ExpenseOtherNet Income before tax

Net income

Net income per shareBasicDiluted

Number of Shares Used in per Share :BasicDiluted

$1,642,171814,777827,394228,891192,238

0

$406,265

38,189(677)

(2,490)441,287

$335,755

$2.42$2.34

138,581143,732

$1,502,453738,361764,092194,115164,774

14,201

$391,002

1,789

17,537(1,413)(8,004)

399,122

$299,341

$2.16$2.10

137,727142,417


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Th e Cash -f low Statem en t

This s ta tement is conc ernedhow the company actual lyused i ts c ash in th e per iod.



Using rat ios to m ake bus iness

decis ionsB us iness decis ions are made

sur round ing

Debt Managem entLiquid i ty

As set Managem ent

Profi tabi l i ty

Mark et Trend



Using rat ios to m ake bus inessdec is ions



B alan ce Sh eet

Assets: The dollar amount represents how much the company owns at thetime of reporting. The asset items are listed in the order of their

liquidity or the length of times it takes to convert in cash , accordingto three categories. Current asset : This kind of asset can be converted to cash or itsequivalent in less than one year. Fixed asset : Fixed asset reflects the amount of money a company has

paid for its plant and equipment acquired at some time in the pastand relatively permanent and takes time to convert into cash.Other assets : Typical assets in this category include investments madein other companies and intangible assets such as goodwill, copyright, franchises and so forth.



A ss ets an d L iab i li t ies

Current asset

Long-term asset

Current liabilities

Long-term liabilities

Equity

1.Owner contribution

2.Retained earnings



B alan ce Sh eet

Liabilities and stockholders equity: Current liabilities: A company currently owes to its

suppliers and creditors. Other liabilities : Include long-term liabilities such asbonds, mortgages, and long-term notes, which are dueand payable more than one year in the future. Stockholders equity : Represent the amount that isavailable to the stockholders after all other debts havebeen paid. Assets Liabilities Preferred stock = Commonstockholders equity



Debt Managem ent A naly sis

Debt management analysis: Debt ratio: the relationship between total liabilities, totalassets generally called the debt ratio.

For example, Lam researchs debt ratio for 2006 can be calculated bytotal debt is $917,195 and total asset is $2,313,344 .

Debt ratio =Total debt

Total asset



Deb t Man ag em en t An alys is

= 39.65%

Most creditor prefer low debt ratio because the lower the

ratio, the greater will be the cushion against the creditorslosses in case of liquidation

Debt r atio =917,195

2,313,344




Times interest earned ratio: The most common measure of theability of a companys operations to provide protection to thelong term creditor is the Times-interest-earned-ratio.

EBIT = Earnings Before Interest and Income taxesFor example, Lam Research issued $350,000 worth of seniornotes and long term bonds. This result in $667 in interestexpense in the year 2006, so we calculated the following:

Times interest earned rati o =EBIT

Interest expenses




= 652.83 times.

The ratio measures the extent to which operating income can

decline before the firm is unable to meet its annual interestcosts. We use the earnings before interest and income taxes,rather than net income, in the numerator.

Times interest earned rati o =441,287+667

667



Liqu id ity An alys is

Current ratio: we calculate the current ratio by dividingcurrent assets by current liabilities.

For example, lam researchs current ratio in 2006 canbe calculated as follows:

= 3.01 times

= 3.01

Curr ent r atio =Current assets

Current liabilities

Curr ent r atio =1,706,369

566,226




If a company is getting difficulty, it begins payingits bills more slowly, borrowing its bank, and so on.If current liabilities are rising faster than current

assets the current ratio will fall, and this could spelltrouble.

General thumb rule calls for a current ratio of 2 to

1.


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Quick ratio: The quick ratio tells us whether the companycould pay all its current liabilities if they came dueimmediately.

Quick ratio =

Current assets - Inventories

Current liabilities


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For example, Lam Researchs quick ratio in 2006can be calculated as follows:

= 2.72 times

The quick ratio measures how well a company canmeet its obligations without having to liquidate ordepend too heavily on selling its inventories.

Quick ratio =1,706,369 168,714

566,226


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Asset management analysis

Inventory turnover ratio: we find this by measuring howmany times a company has sold and replaced itsinventory during the year.

I nventory turnover ratio =Sales

Average inventory balance


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For example, since Lam Research has a beginninginventory figure of $110,051 and an ending inventory$1168, 714 its average inventory for the year would be$639, 383. Then we can compute Lam Researchsinventory turnover ratio for 2006 as follows:

= 11.78 times

I nventory turnover ratio =1,642,171

139,383


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As a rough approximation, Lam Research wasable to sell and restock its inventory 12 times in2006. Lam Researchs turnover of 12 times ismuch faster than that of its industry average, 5.8times, during the same operating period.


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Days-sales-outstanding (Accounts ReceivableTurnover) ratio: it is a rough measure of how manytimes a companys accounts receivable have been

turned into cash during the year.

DSO ratio =Receivables

Average sales per day

=Receivables

Annual sales / 365


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For example, Lam Research in 2006 DSO can be calculated as follows:

Thu s, Lam Researc h, on av erage, i t takesabou t 102.46 days to co l lect on credi t s ale .The lon g co l lec t ion per iod m ay s ignal thatcus tom ers are in t rouble or the com panyhas po or c redi t m anagem ent .


= 102.46 day sDSO ratio =460,972

1,642,171 / 365


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Total asset-turnover ratio: Total asset turnover ratiomeasures how effectively a firm uses its total assets in

generating its revenue.

Total asset turnover ratio =Sales

Total asset


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For example, Lam Researchs total asset turnover

ratio in 2006 can be calculated by as follows:

Total asset turnover ratio =1,642,171

2,313,344


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Lam Researchs ratio of 0.71 times, whenco m pared w i th the ind us t ry average rat io of0.8 t imes, is almo st 13% s low er, ind icat ingthat Lam Research is us ing i ts to tal assetabou t 13& less intens ively than i t peers .


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Pro fi tab i li ty A n alys is

Profit margin on sale: This ratio indicates the profit

per dollar of sale.

Prof it margin on sale =net income available to common stockholders

Sales


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For example, Lam Research's profit margin sales in2006 can be calculated as follows,

Profi t margin on sale =355,755

1,642,171


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Pro fi tab i li ty A n alys is ysis

Thus, Lam Researchs profit margin isequivalent to 20.45 cents for each sales of

dollar generated. Lam Researchs profitm argin is g reater than the indu st ry average of16.2%. th e differenc e indic ates th at LamResearchs operation is more efficient thantha t of i t s com pet itors .


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Return on total asset: The return on total assets , or simplyreturn assets, measures a companys success in usingits assets in earn profit.

For example, Lam Research in 2006,calculated return on total asset as follows:

Return on total asset =net income + interest expenses (1 tax rate)

average total assets


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= 17.88%

Adding a proportion of interest expenses back to netincome results in an adjusted earnings figure that showswhat earnings would have been if the asset had beenacquired solely.

Return on total asset =355,755+677 (1 0.2391)

(2,313,344 + 1,448,815)/2


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Pro fi tab i li ty A n alys isReturn on common equity: This ratio shows the relationshipbetween net incomes and common stockholdersinvestments in the company.

Retur n on common equi ty =net income available to common stockholders

average total assets


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ROE= (Profit margin)*(Asset turnover)*(Financial leverage)

For example, we compute average common equity by using the

beginning balance and the ending balance. At the beginning of the fiscal year 2006, Lam Researchs common equity ending balance was$1,396,149 million and its beginning balance was $1,066,896 million.The average balance is, then, simply $1,231,553 million, so, we findthe followings:

= 27.26%This ratio illustrates how the debt-to-equity ratio impacts the return on equity.


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Mark et Value A n alys is

Market value analysis: Price-to-earnings (P/E) ratio: this ratio shows how much investors arewilling to pay per dollar of reported profits.

For example, Lam Researchs stock sold for $46.72 (closing price) on June 26, 2006, sowith EPS of $2.42, Lam researchs P/E ratio can be calculated as follows:


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= 19.30

Lam Researchs P/E ratio is 19.30. In general, P/E ratios are higher for firms with high

growth prospects, with all other things constant, but lower for firms with lowerexpected earnings.


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Book value per share : this ratio frequently used in assessing the well-beings of commonstockholders is book value per share. The book value per share measures the amount thatwould be distributed to holder of each share of common stock if all assets were sold attheir balance sheet carrying was paid-off.


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For example, Lam Researchs common stock in 2006 as follows:

If we co mp are this book value with m arket peice$53 at the t ime of pub l icat ion,then we m ay say that the s tock s appears to be ov erpaid. Once again, marketpr ices ref lect expectat ion of future earnings and d ividends, whereas bo oklargely ref lects the resul t of events that occ urred in the past . Therefore m arket

value of a s tock tends to exceed i ts bo ok v alue .


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Lim itat ion s o f Financ ial

ra t ios B us iness d ecis ion s are m ade in a

w orld o f unc er tain ty A s u seful as rat ios are, they h ave

l imitat ions It is d iff icu lt to g en eral ize abo u t

whether a particular ratio is good orbad.


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Lim itat ion s o f Financ ial

ra t ios For exam ple, hig h cu rrent rat io m ay indic ate a

s t rong l iqu id i ty pos i t ion wh ich i s goo d . Bu t ho ld ing too mu ch cash in a bank accou nt

m ay n ot b e the bes t u t i l iza tion o f fun ds . As a typ ical engineer ing s tu dent , yo ur jud gm ent

in interpret ing a set of f inanc ial rat ios isun ders tand ably w eak a t th is po int .

Bu t i t w i l l imp rove as yo u encou nter many facetsof bu siness decis ion s in the real wo rld .

eng econ mgt ratios l2 -mme 4272

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