Ch3. Analysis of Financial Statement

1. Why we need ratios?

• Specialized information• Comparison Issue• Predicting future performance

1) 5 types of financial ratios (handout)Liquidity ratiosAsset management ratiosDebt management ratiosProfitability ratiosMarket value ratios

Goals

• To calculate financial ratios

• To understand how to use them

I. Ratio analysis [1] Liquidity ratios:

Liquidity: 1) Convertibility into cash on short notice with minimum possible loss. 2) Ability to meet all required obligations.

(1) Current ratio =Current assests

Current liabilities

(2) Quick ratio (Acid test) =Current assests - Inventory

Current liabilities

[2] Asset management ratios: measure how effectively a firm is managing its assets. Right amount of assets vs. sales?

(1) Inventory turnover ratio =Sales

(Average) Inventory [Note: Cost of goods sold is better than Sales.]

The number of times per year that the firm fills up and then completely empties its warehouse or store inventory.

(2) Days sales outstanding (DSO) =Accounts receivable

Annual sales

365

Average collection period (ACP)

The average number of days the firm must wait after making a sale before receiving cash.

(3) Fixed assets turnover ratio =Sales

Net fixed assets

(4) Total assets turnover ratio =Sales

Total assets

[3] Debt management ratio• Debt ratio =

total liabilities/total assets• Debt to equity ratio = Total liabilities/(Total asset – total

liabilities). But it ignore the market value.

• Market debt ratio = Total liabilities / (Total liabilities + market value of equity).

• Time-interest-earned (TIE) =

Earnings before interest and taxes (EBIT)/Interest charges. But it ignores lease payment related to bankruptcy. Lease payment was deducted when EBIT is calculated.

• EBITDA coverage ratio = (EBITDA+ Lease payment) / (Interest + Principal payments + Lease payment). It is useful for short term lenders to evaluate financial status of firms with large amount of depreciation and amortization.

• Equity Multiplier=Total asset/ common equity

4) Profitability ratios

• Net profit margin = Net income / Sales

• Operating margin = Operating Income (EBIT)/Sales

• Gross profit margin

• = (Sale – COGS)/Sales

• Return on Total Assets (ROA) = Net income / Total assets

• Basic Earning power (BEP) ratio = EBIT/ Total assets

• Return on common equity = ROE

• =Net income /common equity

• Return on total assets = ROA

• =Net income /total assets

5) Market value ratio

• Price/ Earnings ratio = price / earnings per share.

• Price / Cash flow ratio = price / cash flow per share.

• Book value per share = common equity / shares outstanding.

• Market / book ratio = market price per share / book value per share.

• PEG ratio = PE ratio/Earnigs growth rate (%)

• - The lower PEG, the more undervalued

• Tobin’s Q ratio= Market value of assets/replacement cost of assets

• - similar to Market to Book ratio• - higher Tobin’s Q, the higher growth opportunities.

• Enterprise value –EBITDA ratio = Enterprise value / EBITDA

• 2. Trend analysis:

• An analysis of a firm’s financial ratios over time – plotting ratios over time periods

• It is used to estimate the likelihood of improvement or deterioration in its financial condition

• 3. Du Pont Analysis:

• Decomposing the ROA and ROE

• ROA

• = Net income / Total assets

• = Net Income/Sales * Sales/Total assets

• = Profit margin * Total asset turnover

• If a company has only equity without any liability, ROA =ROE

•

ROE = Net Income /Common Equity= Net Income/Total Assets*Total

asset/Common Equity= Net Income/Sales * Sales/Total Assets *

Total assets/Common equity=Profit margin * Total asset turnover*Equity

multiplierHere Equity multiplier will increase with

debts

• 4. Benchmarking:

• The process of comparing a particular company with a group of benchmark companies

• The bench mark companies can be leading companies, peer groups or competitors in the industry

• Comparative ratios are available from a number of sources, including value lines

5. Limits of ratio analysis• Ratio analysis is more useful for small,

narrowly focused firms than for large, multidivisional ones

• For high level performance, it is better to focus on the industry leaders’ ratios

• Seasonal factors: impacts on the inventory turnover ratio. Using monthly averages for inventory can minimize this problem

• Window dressing: making financial statements look better than they really are

• Different accounting practices: FIFO &LIFO or Depreciation methods

• It is difficult to generalize whether a particular ratio is good or bad.

6. Problems with ROE

• Some problems raises if ROE is used as only sole measure of performance

• (1) ROE doesn’t consider risks

• (2) ROE doesn’t consider amounts of invested capital