engg 401 x2 fundamentals of engineering management spring 2008 chapter 6: ratio analysis and...

ENGG 401 X2ENGG 401 X2Fundamentals of Engineering ManagementFundamentals of Engineering Management

Spring 2008Spring 2008

Chapter 6:Chapter 6:

Ratio Analysis and LeverageRatio Analysis and Leverage

Dave LudwickDave Ludwick

Dept. of Mechanical EngineeringDept. of Mechanical Engineering

University of AlbertaUniversity of Albertahttp://members.shaw.ca/dave_ludwick/

Dave Ludwick, Dept. of Mech. Eng.Ch 6 – Ratio Analysis and Leverage

Summer 20082

ENGG 401 X2 – Fundamentals of Engineering Management

Sample Management QuestionsSample Management Questions

• Is our credit rating good with our suppliers?• I was talking to a competitor who said their inventory is

much much lower than ours. Why is that?• Every time the price of oil drops our receivables go up… are

we meeting our bank covenants? • We have a growth opportunity… can we refinance our long

term debt and raise some money?• Are we doing a good job in building value in our stock, as

shown by the price?• The issues are sometimes blurry. Financial ratiosFinancial ratios help

answer these questions.


Summer 20083


Why Do People Invest in a Business?Why Do People Invest in a Business?

• One reason is to buy into a job they feel like doing.

• The second reason is to increase the value of their investment.– Investors who have no relation to management tend to be

dispassionate about the business and passionate about the rate at which their investment increases (the rate of return)! This is why management focuses on share price and dividend.

• Ratios get at three issues: – How well is management running the business?– How “sound” is the business as a result?– How does the “market” react by placing a value on the business?


Summer 20084


Ratio AnalysisRatio Analysis

• Financial ratios are:– Standard tests recognized by almost all analysts– Indicative of some underlying value that is important– Useful in following year-over-year changes in one company– Useful in comparing companies within a given industry– Not useful in comparing companies in very different industries

• e.g., a capital intensive integrated steel company vs. a grocery chain

– Used extensively by lenders (including suppliers deciding on whether to give credit) and by financial analysts.

• Ratios are an assessment of management capability.– Management must pay attention to them to manage credit and stock

price!


Summer 20085


Types of RatiosTypes of Ratios

• Five Classes of Ratios:– Liquidity RatiosLiquidity Ratios:

• will the company stay solvent in the short term? • i.e., if I lend money or if I’m a supplier, will I get my money back?

– Efficiency, Efficiency, Activity or Asset Management RatiosActivity or Asset Management Ratios: • is management making good use of the company’s assets?• also called efficiency ratios

– Leverage or Debt Management RatiosLeverage or Debt Management Ratios: • will the business be able to service the debt it has undertaken, paying

both interest and principal? Is the business solvent?

– Profitability RatiosProfitability Ratios: • is the company earning enough on the assets / equity given to the

business?

– Market Value RatiosMarket Value Ratios: • for publicly traded companies, how does the stock value compare to

earnings and the book value of assets?


Summer 20086


Ratio AnalysisRatio Analysis

• When performing ratios analysis, we often include balance sheet and income statement accounts in the formulae

• When using a formula that includes both income statement (revenues and expenses) as well as balance sheet account (like cash, AR, Inventory, total assets, etc), we will often take an average of the beginning and ending period balances

• To take an average, take the number shown for the balance sheet account for Year 1 (say, 2004) and Year 2 (say, 2005), add them together and divide by 2

• Example: Total Asset Turnover = Net Sales / (Avg Total Assets)– Total Asset Turnover = Net Sales / ((Total Assets in Year 1 + Total Assets

in Year 2)/2)

• NOTE: The formulae that follow may not show this explicitly but you still need to know this


Summer 20087


Liquidity RatiosLiquidity Ratios (1) (1)

• Current ratioCurrent ratio:

– The current ratio is a measure of the firm’s ability to pay bills as they come due.

– Frequently used to assess short term lending.– Short term lenders will frequently specify a required current ratio and

a level of working capital.– A high current ratio gives assurance that even in a crisis short term

debt will be repaid.– If too low, then company can be at risk of meeting short-term

obligations. If too high, then there may be too much invested in short-term assets

Current AssetsCurrent Ratio

Current Liabilities

important


Summer 20088


Liquidity Ratios (2)Liquidity Ratios (2)

• Quick ratioQuick ratio or “acid testacid test”:

– A more stringent measure of the firm’s ability to pay its bills– If greater than 1, then the short term lender can be repaid from

receivables and prepaid expenses.• This is a very comfortable position for a lender.

– Eliminates the need to worry about the quality or currency of inventory.

• In a crisis, inventory rarely sells at book value.

Current Assets InventoriesQuick Ratio

Current Liabilities

important


Summer 20089


Liquidity Ratios (3)Liquidity Ratios (3)

• Cash ratioCash ratio:

– Even more stringent measure of liquidity– The cash ratio is the most conservative liquidity ratio.

• It only considers the most liquid of all assets (excludes inventory and accounts receivable).

– Measures a company’s ability to immediately pay off short-term liabilities.

• No reliance on the receipt of receivables or sale of inventories.

Cash and EquivalentsCash Ratio

Current Liabilities


Summer 200810


Efficiency (1)Efficiency (1)

• Inventory TurnoverInventory Turnover = COGS/Average Inventory– Where average inventory = (beginning inventory + ending

inventory)/2– Measures the number of times the inventory is “turned over”– Generally, a high inventory turnover is an indicator of good inventory

management.– But a high ratio can also mean there is a shortage of inventory,

which may mean the company may miss a sale due to an out-of-stock situation.

– A low turnover may indicate overstocking or obsolete inventory.

• Days Sales in InventoryDays Sales in Inventory = Avg Inventory/COGS x 365– shows the average number of days it will take to sell your inventory

(number of days sales @ cost in inventory)


Summer 200811



• Accounts Receivable TurnoverAccounts Receivable Turnover = Net Sales / (Average Accounts Receivable)– Where average AR = (beginning AR + ending AR)/2– This measures how fast a company collects its receivables– Measures how good a company is at getting its customers to pay – The higher the turnover, the shorter the time between sales and

collecting cash

• Days Sales in ReceivablesDays Sales in Receivables = (Avg AR)/Sales x 365– average number of days it takes to collect accounts receivable

(number of days of sales in receivables)– Measures a company’s ability to extend credit and collect debts.

• A high A/R turnover ratio says that a company operates mainly on a cash basis or that its extension of credit and collection of accounts receivable is efficient.


Summer 200812



• Fixed assets turnover ratio Fixed assets turnover ratio :

– Again, Net Fixed Assets is averaged between beginning and end of year balances

• Fixed Assets also known as Capital Assets

– Measures the extent to which a company “pays for” its fixed assets.– Can be distorted by inflation and/or new vs. old assets (due to

depreciation).• e.g. the “big three” automakers would have a higher turnover (lower

book value of assets) than a new entrant to North America (e.g., Honda)

Annual SalesFixed Assets Turnover

Net Fixed Assets


Summer 200813



• Total assets turnover ratio Total assets turnover ratio :

– Same issues as fixed asset turnover:• of some use within an industry if the asset acquisition time profile is

comparable.

• of no use between industries.

Annual SalesTotal Assets Turnover

Total Assets


Summer 200814


SolvencySolvency

• While liquidityliquidity is concerned about ability to meet short-term obligations, SolvencySolvency is concerned about the company’s long-term viability and its ability to cover long-term debt.

• One of the most important elements of solvency analysis is the analysis of a company's capital structure.– Capital Structure refers to a company's sources of finances: debt

and equity


Summer 200815


Solvency (2)Solvency (2)

• Debt ratioDebt ratio:

– Includes all current liabilities, ST Debt and LT Debt– This ratio is sometimes mistakenly called the debt-to-equity ratio.

• Check to see what is being quoted.

– This is a crucial test of the “leverageleverage” of a company, meaning the relative level of debt it carries.

• Low leverage helps in riding out downturns, since there is a low interest “hurdle” to cover.

• Low leverage dampens return on equity during upturns.

– Debt ranks ahead of equity (i.e., it must be serviced before equity).• Debt has higher security, but long term has a lower return.

Total LiabilitiesDebt Ratio

Total Assets

important


Summer 200816



• Times interest earned ratioTimes interest earned ratio:

– Measures the ability of a company to service its debt (i.e., pay the interest).

– EBITEBIT (Earnings Before Interest and Taxes) is a key financial measure.

• Taxes are excluded because as a firm’s earnings drop, so do its taxes (and no taxes are payable at break even), hence interest is paid before taxes.

– This ratio is used to reflect the riskiness of repayments with interest to creditors

– This is a key ratio for lenders.

EBITTimes Interest Earned

Interest Payments

important


Summer 200817



• Fixed charge coverage ratioFixed charge coverage ratio:

– Similar to “Times Interest Earned”, except that other fixed charges are included.

– Examples of fixed charges include lease and sinking fund payments.– Difficult to calculate from public information, more often used by

financial analysts.– This ratio indicates how easily the company is making its regular

(monthly, annual) financial “hurdles”

EBIT Other Fixed ChargesFixed ChargeCoverage

Interest Payments Other Fixed Charges


Summer 200818


Profitability RatiosProfitability Ratios

• Profit margin on salesProfit margin on sales:

– Measures how effectively a firm is able to convert sales to profits (remembering that Net Income is Sales less all expenses)

– May also be measured as EBITDA/Sales where EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization

– The thought here is that the ITDA portion does not generally contribute directly to generating sales and so should not be considered in the calculation of Net Profit Margin

Net Operating Income

Profit Margin on SalesSales


Summer 200819


Profitability Ratios (2)Profitability Ratios (2)

• Return on total assetsReturn on total assets:

– A very powerful tool for comparing companies in the same industry.• “How much money do you make per unit of assets that you manage?”

– Sometimes net income is used instead of operating income.– Can be used within a company, by product line, on an “EBIT” basis,

to ask how well our product lines use our shareholders’ capital.– Can be used to determine how often assets are being paid for. It is

a more stringent measure of asset coverage than the Asset Turnover ratio since Return on Assets is calculated with net Profit rather than Sales

Operating IncomeReturn on Total Assets

Total Assets


Summer 200820


Profitability Ratios (3)Profitability Ratios (3)

• Return on equityReturn on equity:

– NOTE: If Preferred Dividends were declared during the period, then the numerator is (Net Income – Preferred Dividends)

• Preferred Dividends are monies not available to the common shareholder, the true owners of the business

– For the owners of a company, this is the ultimate test.• “How much return am I making on my investment in this company?”

– Unlike return on assets, return on equity is highly influenced by financing.

• it can be leveraged up in good times and down in bad times

Net IncomeReturn on Equity

Shareholder's Equity


Summer 200821


Market Value RatiosMarket Value Ratios

• Price to earnings ratioPrice to earnings ratio (often abbreviated as P/E ratioP/E ratio):

– This ratio does not derive from financial statements alone, but incorporates a liquid public market value of the company.

– One of the most key and widely quoted values for publicly traded shares.

– A wide range (from 4 to over 100) for companies with positive earnings reflects shareholders expectations of future earnings.

– A key ratio used in stock valuation to determine whether a stock is over or under valued or to determine future direction of stock movement

Price per SharePrice to Earnings Ratio

Earnings per Share


Summer 200822


Market Value Ratios (2)Market Value Ratios (2)

• Market to book ratioMarket to book ratio:

– A company’s “book value” of equity is related to the acquisition cost of assets, and often bears little relationship to replacement value due to inflation and depreciation of fixed assets.

• Original purchase price of assets is available.

– Market to book ratio and market to replacement value can help to identify “bargains” in the stock market as mass psychology swings past an equilibrium value.

– Keep in mind that the book value is based on GAAP (which uses all of the guidelines of relevance, comparison, historical value, amortization calculation rules, etc)

Market Price per ShareMarket to Book Ratio

Book Value of Equity per Share


Summer 200823


Market Value Ratios (Market Value Ratios (33))

• Earnings Per ShareEarnings Per Share = Net Income / (Weighted Average Number of Common Shares Outstanding)– Amount of money earned per common share– EPS is calculated at the very bottom of the Income Statement. It

represents the money earned by each individual share after Sales, all discounts, expenses, interest, depreciation, taxes, extraordinary items, and preferred dividends


Summer 200824


Uses of Ratio AnalysisUses of Ratio Analysis

• The most basic rule is: a single ratio in isolation provides a single ratio in isolation provides very little information and may be misleadingvery little information and may be misleading.

• With that in mind, there are at least 4 uses of ratios:– Trend analysis (internal and external)– Comparison to industry averages (internal and external)– Setting and evaluating company goals (internal)– Restrictive debt covenants (external)

• Sometimes it does not matter exactly how you calculate a ratio, as long as you calculate it the same way when you are using it for comparison


Summer 200825


Concepts in Corporate FinanceConcepts in Corporate Finance

• There are several ways to finance a company– Common shares, Preferred shares, Debt

• Common shares are the most commonly vehicle for ownership. Typically– One vote per share at the company’s annual general meeting– They hold the last claim on assets in the event of insolvency– They generally don’t receive dividends

• Preferred shares are ownership shares that are more “senior” to common shares– They hold a more senior claim on assets in the event of insolvency– They sometimes get a dividend– They usually don’t have a vote at the AGM


Summer 200826


Concepts in Corporate FinanceConcepts in Corporate Finance

• One of the key managerial tasks of corporate managers is to decide on how to raise funds using the instruments of common shares, preferred shares and debt.

• Common shares have the lowest claim on assets and don’t expect a dividend, but have ownership control (the vote)

• Preferred shares have a more senior claim on assets, no vote, but can receive a dividend.

• Debt has the highest claim on assets, have no vote and don’t receive a dividend, but debt payments are a contractual obligation and can’t be missed.

• Using Preferred Shares or Debt to raise capital are examples of financial leverage


Summer 200827


Concepts in Corporate Finance – LeverageConcepts in Corporate Finance – Leverage

• Leverage is when you use the money from someone else to grow the company, or achieve its goals

• Common share holders (the true owners of the corporation) can leverage cash generated from the sale of Preferred Shares or Debt to grow the company

• As long as the net income generated is greater than the dividends paid to preferred shareholders or the interest paid to debt holders, then there is a net increase to the common shareholder and leverage has taken place.– They have leveraged money from preferred shareholders and debt

holders to improve the value of the corporation to the common shareholder


Summer 200828


Special Features of Preferred SharesSpecial Features of Preferred Shares

• Preferred shares usually pay a dividend in exchange for the fact that they do not have a voting right

• This is called a Dividend Preference: A dividend could not be paid to common shareholders until the dividend is paid to the preferred shareholders

• Cumulative Preferred Shares have a right to be paid both current and all prior periods’ undeclared dividends. This is a feature to preferred shares, but it must be a stated feature (not all preferred shares carry this feature)

• Participating Preferred Shares have a feature in which preferred shareholders share with common shareholders in any dividends paid in excess of the dollar amount specified for the preferred shares


Summer 200829


Special Features of Preferred SharesSpecial Features of Preferred Shares

• Convertible Preferred Shares give holders the option of exchanging their preferred shares for common shares. – Usually there is a specified time period in which this can be done

and there is a specified exchange rate for the shares.– This gives preferred shareholders the advantage of the dividend, but

when the company value goes up they can convert to common shares.

– Note that the convertible feature will cause the value of the preferred shares themselves to go up since they are connected to the common shares.

• Callable Shares give the issuing company the right to buy the shares back from owners at a defined date and for defined price


Summer 200830


Cash DividendsCash Dividends

• Dividends are distributions of earnings. They are paid out of the company’s net income after all expenses and taxes

• Dividends are basically distributions of Retained Earnings• Dividends can be paid in the form of cash or more stock• Company’s generally can (or only will) pay dividends if

– The company has enough Retained Earnings– The company has enough Cash to meet debt, grow the company or

cover emergencies

• In the end, issuing dividends is a corporate decision, not an obligation


Summer 200831


The Concept of DebtThe Concept of Debt

• In a western agricultural or industrial society, wealth is held wealth is held primarily by individualsprimarily by individuals and not by society at large.– There are exceptions (e.g., resources), but the profits from

development generally flow to individuals.

• Most people with wealth wish to preserve or grow wealth.• Wealth and entrepreneurial spirit often do not align, and

there are vast differences in the tolerance for risk.• The borrower believes inherently that he/she can create

more wealth than the cost of the borrowed funds.• Lenders trade lower return (growth in wealth) for lower risk

(the “risk-reward relationship”).– Debt is the primary mechanism to reduce risk, since it ranks ahead

of equity.


Summer 200832


The Concept of Debt (2)The Concept of Debt (2)

• The benefit to the borrower is that debt does not convey debt does not convey ownershipownership.– The lender may restrict the business through covenants, but the

equity owners own the business and its “blue sky” potential.

• Interest is the cost of debtcost of debt.– Think of it as the rental charge for the use of money– It is highly variable from loan to loan,

• it depends on the risk associated with the loan, and over time• It reflects the balance between savers and borrowers and inflation rates

– Often secured• i.e., if it’s not repaid the lender can “attach” (seize) certain assets in

order to recover the principal

– Always lower than the projected rate of return on equity in the project/business.

• Otherwise, the business would not be able to repay the equity investors at an acceptable return.


Summer 200833


The Concept of LeverageThe Concept of Leverage

• Return (i.e., growth in wealth) is more volatile (more “levered”) as debt goes up and equity goes down.

• This arises because the risk in the project is being concentrated onto a smaller base of equity.– The debt gets a fixed (and hopefully lower!) return than equity, but it

ranks ahead of equity; it must be serviced first.– By ranking ahead we mean:

• Payables and interest are paid first before dividends

• In the event of business failure or wrap-up, all liabilities are paid first before any money is given to the owners


Summer 200834


The Concept of Leverage (2)The Concept of Leverage (2)

• Leverage is usually measured by Debt Ratio:

• Alternatively, leverage is also sometimes measured as a ratio of bank debts only:

• …or sometimes as a ratio of asset value relative to equity:

Bank Debts

Total Assets

Total Liabilities

Total Assets

Total Assets

Total Equity


Summer 200835


50% Leverage in Good Times50% Leverage in Good Times

A

A

Debt Equity

Illustrating the Effects of LeverageIllustrating the Effects of Leverage

%Return

cost of debt(8%)

earning power of investment

(10%)

return on equity(12%)


Summer 200836


A

A

80% Leverage in Good Times80% Leverage in Good Times

Debt Equity

Illustrating the Effects of Leverage (2)Illustrating the Effects of Leverage (2)

cost of debt(8%)


(10%)


%Return


Summer 200837


A

A

50% Leverage in Bad Times50% Leverage in Bad Times

Debt Equity


cost of debt(8%)


(6%)


%Return


Summer 200838


A

A

80% Leverage in Bad Times80% Leverage in Bad Times

Debt Equity


%Return

cost of debt(8%)


(6%)

return on equity(-2%)


Summer 200839


Leverage ExampleLeverage Example

• Calculate (a) leverage, (b) net income, and (c) return on equity of three nearly identical companies in good timesgood times:

Income StatementLodebtco Medebtco Hidebtco

Sales $10,000 $10,000 $10,000COGS $5,000 $5,000 $5,000Margin $5,000 $5,000 $5,000SG&A $3,000 $3,000 $3,000

Operating Income $2,000 $2,000 $2,000

Balance Sheet (partial)Total Assets $9,700 $9,700 $9,700

Long-term Debt $970 $3,880 $6,790Capital Shares $6,930 $4,020 $1,110

Retained Earnings $1,000 $1,000 $1,000

Leverage Net Income

Return on Equity


Summer 200840


Leverage Example (2)Leverage Example (2)

• Calculate (a) leverage, (b) net income, and (c) return on equity of three nearly identical companies in bad timesbad times:

Income StatementLodebtco Medebtco Hidebtco

Sales $7,000 $7,000 $7,000COGS $3,500 $3,500 $3,500Margin $3,500 $3,500 $3,500SG&A $3,000 $3,000 $3,000

Operating Income $500 $500 $500

Balance Sheet (partial)Total Assets $9,700 $9,700 $9,700

Long-term Debt $970 $3,880 $6,790Capital Shares $6,930 $4,020 $1,110

Retained Earnings $1,000 $1,000 $1,000

Leverage Net Income

Return on Equity

engg 401 x2 fundamentals of engineering management spring 2008 chapter 6: ratio analysis and...

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