Financial ratio analysis
Financial ratio analysis
A reading prepared by Pamela Peterson Drake
A reading prepared by Pamela Peterson Drake
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1.
1. Introduction
Introduction
As a manager% you may &ant to re&ard employees based on t$eir per'ormance. (o& do As a manager% you may &ant to re&ard employees based on t$eir per'ormance. (o& do you kno&
you kno& $o& &ell $o& &ell t$et$ey y $a$ae e dondone) e) (o& can (o& can you deteryou determinmine e &$a&$at t depdepartartmenments ts oror diisions $ae per'ormed &ell) As a lender% $o& do decide t$e borro&er &ill be able to diisions $ae per'ormed &ell) As a lender% $o& do decide t$e borro&er &ill be able to pay back as promised) As a manager o' a corporation $o& do you kno& &$en e*isting pay back as promised) As a manager o' a corporation $o& do you kno& &$en e*isting capacity &ill be e*ceeded and enlarged capacity &ill be needed) As an inestor% $o& do capacity &ill be e*ceeded and enlarged capacity &ill be needed) As an inestor% $o& do you
you prprediedict ct $o& $o& &e&ell ll t$e secut$e securitrities o' ies o' one one comcompapany ny &i&ill ll perper'or'orm m rerelalatitie e to to t$at$at t o' o' anot$er) (o& can you tell &$et$er one security is riskier t$an anot$er) +e can address anot$er) (o& can you tell &$et$er one security is riskier t$an anot$er) +e can address all o' t$ese questions t$roug$ fnancial analysis.
all o' t$ese questions t$roug$ fnancial analysis.
Financial analysis
Financial analysis is t$e is t$e selection% ealuatselection% ealuation% and interpretation o' fnancial data% alongion% and interpretation o' fnancial data% along &it$ ot$er pertinent in'ormation% to assist in inestment and fnancial decision,making. &it$ ot$er pertinent in'ormation% to assist in inestment and fnancial decision,making. F
Fininanancicial al ananalalysysis is mamay y be be usused ed ininteternrnalally ly to to eealaluauate te isissusues es susuc$ c$ as as ememplployoyeeee per'ormance% t$e e-ciency o' operations% and credit policies% and e*ternally to ealuate per'ormance% t$e e-ciency o' operations% and credit policies% and e*ternally to ealuate potential inestments and t$e credit,&ort$iness o' borro&ers% among ot$er t$ings.
potential inestments and t$e credit,&ort$iness o' borro&ers% among ot$er t$ings. $e analyst dra&s t$e fnancial data needed in fnancial analysi
$e analyst dra&s t$e fnancial data needed in fnancial analysis 'rom many sources. $es 'rom many sources. $e pri
primamary ry sousourcrce e is is t$e data t$e data prproioided by ded by t$e compat$e company ny itsitsel' in el' in its annuaits annual l rereporport t andand required disclosures. $e annual report comprises t$e income statement% t$e balance required disclosures. $e annual report comprises t$e income statement% t$e balance s$eet% and t$e statement o' cas$ /o&s% as &ell as 'ootnotes to t$ese statements. 0ertain s$eet% and t$e statement o' cas$ /o&s% as &ell as 'ootnotes to t$ese statements. 0ertain businesses are required by securities la&s to
businesses are required by securities la&s to disclose additional in'ormation.disclose additional in'ormation. esides in'ormation t$at companies are required to
esides in'ormation t$at companies are required to disclose t$roug$ fnancial statements%disclose t$roug$ fnancial statements% ot$er in'ormation is
ot$er in'ormation is readily aailabreadily aailable 'or le 'or fnancial analysis. For e*amplefnancial analysis. For e*ample% in'ormation suc$% in'ormation suc$ as t$e market prices o' securities o' publicly,traded corporations can be 'ound in t$e as t$e market prices o' securities o' publicly,traded corporations can be 'ound in t$e fnancial press and t$e electronic media daily. #imilarly% in'ormation on stock price indices fnancial press and t$e electronic media daily. #imilarly% in'ormation on stock price indices 'or industries and 'or t$e
'or industries and 'or t$e market as a &$ole is aailable in t$e fnancial pressmarket as a &$ole is aailable in t$e fnancial press..
Anot$er source o' in'ormation is economic data% suc$ as t$e ross Domestic Product and Anot$er source o' in'ormation is economic data% suc$ as t$e ross Domestic Product and 0onsumer Price Inde*% &$ic$ may be
0onsumer Price Inde*% &$ic$ may be use'ul in assessing t$e recent per'ormance or use'ul in assessing t$e recent per'ormance or 'uture'uture prospects o' a company or industry. #uppose you are ealuating a company t$at o&ns a prospects o' a company or industry. #uppose you are ealuating a company t$at o&ns a c$ain o' retail outlets. +$at in'ormation do you need to
c$ain o' retail outlets. +$at in'ormation do you need to udge t$e company4s per'ormanceudge t$e company4s per'ormance and fnancial condition) 5ou need fnancial data% but it doesn4t tell t$e &$ole story. 5ou and fnancial condition) 5ou need fnancial data% but it doesn4t tell t$e &$ole story. 5ou also need in'ormation on consumer spending% producer prices% consumer prices% and t$e also need in'ormation on consumer spending% producer prices% consumer prices% and t$e
Financial
competition. $is is economic data t$at is readily aailable 'rom goernment and priate sources.
esides fnancial statement data% market data% and economic data% in fnancial analysis you also need to e*amine eents t$at may $elp e*plain t$e company4s present condition and may $ae a bearing on its 'uture prospects. For e*ample% did t$e company recently incur some e*traordinary losses) Is t$e company deeloping a ne& product) 6r acquiring anot$er company) Is t$e company regulated) 0urrent eents can proide in'ormation t$at may be incorporated in fnancial analysis.
$e fnancial analyst must select t$e pertinent in'ormation% analy7e it% and interpret t$e analysis% enabling udgments on t$e current and 'uture fnancial condition and operating per'ormance o' t$e company. In t$is reading% &e introduce you to fnancial ratios ,, t$e tool o' fnancial analysis. In fnancial ratio analysis &e select t$e releant in'ormation ,, primarily t$e fnancial statement data ,, and ealuate it. +e s$o& $o& to incorporate market data and economic data in t$e analysis and interpretation o' fnancial ratios. And &e s$o& $o& to interpret fnancial ratio analysis% &arning you o' t$e pit'alls t$at occur &$en it4s not used properly.
+e use 8icroso't 0orporation4s 299! fnancial statements 'or illustration purposes t$roug$out t$is reading. 5ou can obtain t$e 299! and any ot$er year4s statements directly 'rom 8icroso't. e sure to sae t$ese statements 'or 'uture re'erence.
0lassifcation o' ratios
A ratio is a mat$ematical relation bet&een one quantity and anot$er. #uppose you $ae 299 apples and 199 oranges. $e ratio o' apples to oranges is 299 : 199% &$ic$ &e can more coneniently e*press as 2;1 or 2. A fnancial ratio is a comparison bet&een one bit o' fnancial in'ormation and anot$er. 0onsider t$e ratio o' current assets to current liabilities% &$ic$ &e re'er to as t$e current ratio. $is ratio is a comparison bet&een assets t$at can be readily turned into cas$ ,, current assets ,, and t$e obligations t$at are due in t$e near 'uture ,, current liabilities. A current ratio o' 2;1 or 2 means t$at &e $ae t&ice as muc$ in current assets as &e need to satis'y obligations due in t$e near 'uture.
<atios can be classifed according to t$e &ay t$ey are constructed and t$eir general c$aracteristics. y construction% ratios can be classifed as a coerage ratio% a return ratio% a turnoer ratio% or a component percentage;
1. A coverage ratio is a measure o' a company4s ability to satis'y =meet> particular obligations.
2. Areturn ratio is a measure o' t$e net beneft% relatie to t$e resources e*pended. 3. Aturnover ratio is a measure o' t$e gross beneft% relatie to t$e resources e*pended. !. Acomponent percentage is t$e ratio o' a component o' an item to t$e item.
+$en &e assess a company4s operating per'ormance% &e &ant to kno& i' it is applying its assets in an e-cient and proftable manner. +$en &e assess a company4s fnancial condition% &e &ant to kno& i' it is able to meet its fnancial obligations.
$ere are si* aspects o' operating per'ormance and fnancial condition &e can ealuate 'rom fnancial ratios;
1. A liquidity ratio proides in'ormation on a company4s ability to meet its s$ort?term% immediate obligations.
2. A proftability ratio proides in'ormation on t$e amount o' income 'rom eac$ dollar o' sales.
3. An activity ratio relates in'ormation on a company4s ability to manage its resources =t$at is% its assets> e-ciently.
!. A fnancial leverage ratio proides in'ormation on t$e degree o' a company4s f*ed fnancing obligations and its ability to satis'y t$ese fnancing obligations.
". A shareholder ratio describes t$e company4s fnancial condition in terms o' amounts per s$are o' stock.
@. A return on investment ratio proides in'ormation on t$e amount o' proft% relatie to t$e assets employed to produce t$at proft.
+e coer eac$ type o' ratio% proiding e*amples o' ratios t$at 'all into eac$ o' t$ese classifcations.
2. Liquidity <atios
Liquidity re/ects t$e ability o' a company to meet its s$ort,term obligations using assets t$at are most readily conerted into cas$. Assets t$at may be conerted into cas$ in a s$ort period o' time are re'erred to as liquid assets t$ey are listed in fnancial statements as current assets. 0urrent assets are o'ten re'erred to as &orking capital because t$ese assets represent t$e resources needed 'or t$e day,to,day operations o' t$e company4s long,term% capital inestments. 0urrent assets are used to satis'y s$ort,term obligations% or current liabilities. $e amount by &$ic$ current assets e*ceed current liabilities is re'erred to as t$e net &orking capital.1
$e role o' t$e operating cycle
(o& muc$ liquidity a company needs depends on its operating cycle. $e operating cycle is t$e duration bet&een t$e time cas$ is inested in goods and serices to t$e time t$at inestment produces cas$. For e*ample% a company t$at produces and sells goods $as an operating cycle comprising 'our p$ases;
=1> purc$ase ra& material and produce goods% inesting in inentory =2> sell goods% generating sales% &$ic$ may or may not be 'or cas$ =3> e*tend credit% creating accounts receiables% and
=!> collect accounts receiables% generating cas$.
$e operating cycle is t$e lengt$ o' time it takes to conert an inestment o' cas$ in inentory back into cas$ =t$roug$ collections o' sales>. $e net operating cycle is t$e lengt$ o' time it takes to conert an inestment o' cas$ in inentory and back into cas$ considering t$at some purc$ases are made on credit.
$e number o' days a company ties up 'unds in inentory is determine by; =1> t$e total amount o' money represented in inentory% and
=2> t$e aerage day4s cost o' goods sold.
1 5ou &ill see re'erence to t$e net &orking capital =i.e.% current assets B current liabilities> as simply &orking capital% &$ic$ may be con'using. Al&ays c$eck t$e defnition 'or t$e particular usage because bot$ are common uses o' t$e term &orking capital.
$e current inestment in inentory ,, t$at is% t$e money Ctied upC in inentory ,, is t$e ending balance o' inentory on t$e balance s$eet. $e aerage day4s cost o' goods sold is t$e cost o' goods sold on an aerage day in t$e year% &$ic$ can be estimated by diiding t$e cost o' goods sold 'ound on t$e income statement by t$e number o' days in t$e year. +e compute t$e number o' days o' inentory by calculating t$e ratio o' t$e amount o' inentory on $and =in dollars> to t$e aerage day4s 0ost o' oods #old =in dollars per day>;
InentoryInentory umber o' days inentory E E
Aerage day4s cost o' goods sold 0ost o' goods sold : 3@" I' t$e ending inentory is representatie o' t$e inentory t$roug$out t$e year% t$e number
o' days inentory tells us t$e time it takes to conert t$e inestment in inentory into
sold goods. +$y &orry about &$et$er t$e year,end inentory is representatie o'
inentory at any day t$roug$out t$e year) +ell% i' inentory at t$e end o' t$e fscal year,
end is lo&er t$an on any ot$er day o' t$e year% &e receiables on any day t$roug$out t$e
understated t$e
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Try it!+al,8art #tores% Inc.% $ad cost o' reenue o' 21G%HG3 million 'or t$e fscal
year ended anuary 31% 299". It $ad an inentory balance o' 2G%!!H million t$e
Jsing +al,8artKs at t$e end o' t$is fscal year. quarterlyin'ormation%
aerage inentory balance during t$e fscal year is 2G%[email protected]";
Inentory balance% in millions
2%329 2H%G@3 33%3!H 2G%!!H 2!%999 2@%999 2%999 39%999 32%999 3!%999
April uly 6ctober anuary
#ource; +al,8art #tores 19,M and 19,N flings
ased on t$is in'ormation% &$at is +al,8artKs inentory turnoer 'or fscal year ending anuary 31% 299">)
299! = olution
Jsing t$e fscal year end balance o' inentory; E E 2G%!!H 2G%!!H
umber o' days inentory E !.Gdays @92.1H3
21G%HG3:3@" Jsing t$e aerage o' t$e quarterly balances;
E E 2G%[email protected]" 2G%[email protected]"
umber o' days inentory E !G.!3@days @92.1H3
21G%HG3:3@"
ot$er appro*imately days sell its In &ords% it takes +al,8art "9 to
merc$andise 'rom t$e time it acquires it.
year% t$en it takes% on aerage% appro*imately t$e Cnumber o' days creditC to collect t$e
accounts receiable% or t$e number o' days receiables;
Accounts receiable Accounts receiable
umber o' days receiables E E Aerage day4s sales on credit
#ales on credit : 3@"
+$at does t$e operating cycle $ae to do &it$ liquidity) $e longer t$e operating cycle% t$e more current assets needed =relatie to current liabilities> because it takes longer to conert inentories and receiables into cas$. In ot$er &ords% t$e longer t$e operating cycle% t$e more net &orking capital required.
+e also need to look at t$e liabilities on t$e balance s$eet to see $o& long it takes a company to pay its s$ort,term obligations. +e can apply t$e same logic to accounts payable as &e did to accounts receiable and inentories. (o& long does it take a company% on aerage% to go 'rom creating a payable =buying on credit> to paying 'or it in cas$)
Accounts payable Accounts payable umber o' days payables E E
Aerage day4s purc$ases Purc$ases : 3@"
First% &e need to determine t$e amount o' an aerage day4s purc$ases on credit. I' &e assume all purc$ases are made on credit% t$en t$e total purc$ases 'or t$e year &ould be t$e 0ost o' oods #old% less any amounts included in t$is 0ost o' oods #old t$at are not purc$ases.2
$e operating cycle tells us $o& long it takes to conert an inestment in cas$ back into cas$ =by &ay o' inentory and accounts receiable>;
umber o' daysumber o' days 6perating cycle E O
o' inentory o' receiables
$e number o' days o' purc$ases tells us $o& long it takes use to pay on purc$ases made to create t$e inentory. I' &e put t$ese t&o pieces o' in'ormation toget$er% &e can see $o& long% on net% &e tie up cas$. $e dierence bet&een t$e operating cycle and t$e number o' days o' payables is t$e net operating cycle;
et operating cycle E 6perating 0ycle , umber o' days o' purc$ases or% substituting 'or t$e operating cycle%
umber o' days umber o' days umber o' days et operating cycle E O ?
o' inentory o' receiables o' purc$ases
2 For e*ample% depreciation is included in t$e 0ost o' oods #old% yet it not a purc$ase. (o&eer% as a quite pro*y 'or purc$ases% &e can use t$e accounting relations$ip; beginning inentory O purc$ases E 06# O ending inentory.
Financial ratios% a reading prepared by Pamela Peterson Drake @
"icroso#t$s Number o# %ays &eceivables '(()
Aerage day4s receiables E 3@%3" million : 3@" E 199.G1H million umber o' days receiables E "%G9 million : 199.G1H million E
*+,-.)- dayso& try it 'or 299" using t$e 299" data 'rom 8icroso'tKs fnancial statements.
Ans&er; .*,/)(( days
#ource o' data; Income #tatement and alance #$eet% 8icroso't 0orporation Annual <eport 299"
$e net operating cycle t$ere'ore tells us $o& long it takes 'or t$e company to get cas$ back 'rom its inestment in inentory and accounts receiable% considering t$at
purc$ases may be made on credit. y not paying 'or purc$ases immediately =t$at is% using trade credit>% t$e company reduces its liquidity needs. $ere'ore% t$e longer t$e net operating cycle% t$e greater t$e companyKs need 'or liquidity.
8easures o' liquidity
Liquidity ratios proide a measure o' a companyKs ability to generate cas$ to meet its immediate needs. $ere are t$ree commonly used liquidity ratios;
1. $e current ratio is t$e ratio o' current assets to current liabilities Indicates a company4s ability to satis'y its current liabilities &it$ its current assets;
0urrent assets 0urrent ratio E
0urrent liabilities
2. $e quic0 ratio is t$e ratio o' quick assets =generally current assets less inentory> to current liabilities Indicates a company4s ability to satis'y current liabilities &it$ its most liquid assets
0urrent assets , Inentory Nuick ratio E
0urrent liabilities
3. $e net 1or0ing capital to sales ratio is t$e ratio o' net &orking capital =current assets minus current liabilities> to sales Indicates a company4s liquid assets =a'ter meeting s$ort?term obligations> relatie to its need 'or liquidity =represented by sales>
0urrent assets , 0urrent liabilities et &orking capital to sales ratio E
#ales
enerally% t$e larger t$ese liquidity ratios% t$e better t$e ability o' t$e company to satis'y its immediate obligations. Is t$ere a magic number t$at defnes good or bad) ot really. 0onsider t$e current ratio. A large amount o' current assets relatie to current liabilities proides assurance t$at t$e company &ill be able to satis'y its immediate obligations. (o&eer% i' t$ere are more current assets t$an t$e company needs to proide t$is assurance% t$e company may be inesting too $eaily in t$ese non, or lo&,earning assets and t$ere'ore not putting t$e assets to t$e most productie use.
Anot$er consideration is t$e operating cycle. A company &it$ a long operating cycle may $ae more need to liquid assets t$an a company &it$ a s$ort operating cycle. $atKs because a long operating cycle indicate t$at money is tied up in inentory =and t$en receiables> 'or a longer lengt$ o' time.
Financial ratios% a reading prepared by Pamela Peterson Drake H
"icroso#t Liquidity &atios 22 '(()
0urrent ratio E H9%"@@ million : 1!%@G@ million E ),+(34
Nuick ratio E =H9%"@@,!21> : 1!%@G@ E ),44-3
et &orking capital,to,sales E =H9%"@@,1!%G@G> : 3@%3" E
3,**3* #ource o' data; alance #$eet and Income #tatement% 8icroso't 0orporation Annual <eport 299"
3. Proftability ratios
Proftability ratios =also re'erred to as proft margin ratios> compare components o' income &it$ sales. $ey gie us an idea o' &$at makes up a company4s income and are usually e*pressed as a portion o' eac$ dollar o' sales. $e proft margin ratios &e discuss $ere dier only by t$e numerator. It4s in t$e numerator t$at &e re/ect and t$us ealuate per'ormance 'or dierent aspects o' t$e business;
$e gross proft margin is t$e ratio o' gross income or proft to sales. $is ratio indicates $o& muc$ o' eery dollar o' sales is le't a'ter costs o' goods sold;
ross income
ross proft margin E #ales
$e operating proft margin is t$e ratio o' operating proft =a.k.a. QI% operating income% income be'ore interest and ta*es> to sales. $is is a ratio t$at
indicates $o& muc$ o' eac$ dollar o' sales is le't oer a'ter operating
e*penses;
6perating income 6perating proft margin E
#ales $e net proft margin is t$e ratio o' net income =a.k.a. net proft> to sales% and indicates $o& muc$ o' eac$
dollar o' sales is le't oer a'ter all
e*penses; et income et proft margin E . #ales
!. Actiity ratios
Actiity ratios are measures o' $o& &ell assets are used. Actiity ratios ,, &$ic$ are% 'or t$e most part% turnoer ratios ,, can be used to ealuate t$e benefts produced by specifc assets% suc$ as inentory or accounts receiable. 6r t$ey can be use to ealuate t$e benefts produced by all a company4s assets collectiely.
$ese measures $elp us gauge $o& eectiely t$e company is at putting its inestment to &ork. A company &ill inest in assets B e.g.% inentory or plant and equipment B and t$en use t$ese assets to generate reenues. $e greater t$e turnoer% t$e more eectiely t$e company is at producing a beneft 'rom its inestment in assets.
$e most common turnoer ratios are t$e 'ollo&ing;
1. Inventory turnover is t$e ratio o' cost o' goods sold to inentory. $is ratio indicates $o& many times inentory is created and sold during t$e period;
0ost o' goods sold Inentory turnoerE
Inentory
Financial ratios% a reading prepared by Pamela Peterson Drake
"icroso#t$s 3//+ 5roft "argins
ross proft margin E =1!%!! , 1%1GH>:1!%!! E /3,4-.6
6perating proft margin E @%!1! : 1!%!! E )),'+-6 et proft margin E !%!G9 : 1!%!! E -36
#ource o' data; 8icroso't 0orporation Annual <eport 1GG
RRR
"icroso#t$s '(() 5roft "argins
ross proft margin E =3@%3" B @%H1@>:3@%3" E +3,4.46
6perating proft margin E G%93! : 3@%3" E '),*'.6 et proft margin E %1@ : 3@%3" E '',34*6
#ource o' data; Income #tatement% 8icroso't 0orporation Annual <eport
2. 7ccounts receivable turnover is t$e ratio o' net credit sales to accounts receiable. $is ratio indicates $o& many times in t$e period credit sales $ae been created and
collected on;
#ales on credit
Accounts receiable turnoer E Accounts receiable
3. Total asset turnover is t$e ratio o' sales to total assets. $is ratio indicates t$e e*tent t$at t$e inestment in total assets results in sales.
#ales otal asset turnoer E
otal assets
!. Fi8ed asset turnover is t$e ratio o' sales to f*ed assets. $is ratio indicates t$e ability o' t$e companyKs management to put t$e f*ed assets to &ork to generate sales;
#ales Fi*ed asset turnoer E
Fi*ed assets
"icroso#t9s 7ctivity &atios : '(()
Accounts receiable turnoer E 3@%3" : "%G9 E .,'*-+ times
otal asset turnoer E 3@%3" : G2%3G E(,-/+4 times
#ource o' data; Income #tatement and alance #$eet% 8icroso't 0orporation Annual <eport 299"
urnoers and numbers o' days
5ou may $ae noticed t$at t$ere is a relation bet&een t$e measures o' t$e operating cycle and actiity ratios. $is is because t$ey use t$e same in'ormation and look at t$is in'ormation 'rom dierent angles. 0onsider t$e number o' days inentory and t$e inentory turnoer;
Inentory umber o' days inentory E
Aerage day4s cost o' goods sold
0ost o' goods sold Inentory turnoerE
Inentory
$e number o' days inentory is $o& long t$e inentory stays &it$ t$e company% &$ereas t$e inentory turnoer is t$e number o' times t$at t$e inentory comes and leaes B t$e
Try it!
+al,8art #tores% Inc.% $ad cost o' reenue o' 21G%HG3 million 'or t$e fscal year ended anuary 31% 299". It $ad an inentory balance o' 2G%!!H million at t$e end o' t$is fscal year.
#ource; +al,8art #tores 19,M
+al,8artKs number o' days inentory 'orfscal year 299! =ending anuary 31% 299"> is
E E
2G%!!H 2G%!!H
umber o' days inentory E !.G days 21G%HG3:3@"@92.1H3
+al,8artKs inentory turnoer is;
E
21G%HG3
Inentory turnoer E
H.!@!times
2G%!!H
And t$e number o' days and turn
oer are related as 'ollo&s;
Inentory turnoer E 3@" : !.G E H.!@! times
umber o' days inentory E 3@" : H.!@! E !.G days
complete cycle B &it$in a period. #o i' t$e number o' days inentory is 39 days% t$is means t$at t$e turnoer &it$in t$e year is 3@" : 39 E 12.1@H times. In ot$er &ords%
3@" 3@" 0ost o' goods sold Inentory turnoer E E E
umber o' days inentory Inentory Inentory 0ost o' goods sold : 3@"
". Financial leerage ratios
A company can fnance its assets eit$er &it$ equity or debt. Financing t$roug$ debt inoles risk because debt legally obligates t$e company to pay interest and to repay t$e principal as promised. Qquity fnancing does not obligate t$e company to pay anyt$ing ,, diidends are paid at t$e discretion o' t$e board o' directors. $ere is al&ays some risk% &$ic$ &e re'er to as business risk% in$erent in any operating segment o' a business. ut $o& a company c$ooses to fnance its operations ,, t$e particular mi* o' debt and equity ,, may add fnancial risk on top o' business risk Financial ris0 is t$e e*tent t$at debt fnancing is used relatie to equity.
Financial leerage ratios are used to assess $o& muc$ fnancial risk t$e company $as taken on. $ere are t&o types o' fnancial leerage ratios; component percentages and coerage ratios. 0omponent percentages compare a company4s debt &it$ eit$er its total capital =debt plus equity> or its equity capital. 0oerage ratios re/ect a company4s ability to satis'y f*ed obligations% suc$ as interest% principal repayment% or lease payments.
0omponent,percentage fnancial leerage ratios
$e component,percentage fnancial leerage ratios coney $o& reliant a company is on debt fnancing. $ese ratios compare t$e amount o' debt to eit$er t$e total capital o' t$e company or to t$e equity capital.
1. $e total debt to assets ratio indicates t$e proportion o' assets t$at are fnanced &it$ debt =bot$ s$ort?term and long?term debt>;
otal debt
otal debt to assets ratio E
otal assets
<emember 'rom your study o' accounting t$at total assets are equal to t$e sum o' total debt and equity. $is is t$e 'amiliar accounting identity; assets E liabilities O equity.
2. $e long?term debt to assets ratio indicates t$e proportion o' t$e company4s assets t$at are fnanced &it$ long?term debt.
Long , term debt
Long , term debt to assets ratio E otal assets
3. $e debt to equity ratio =a.k.a. debt2equity ratio> indicates t$e relatie uses o' debt and equity as sources o' capital to fnance t$e company4s assets% ealuated using book alues o' t$e capital sources;
otal debt
otal debt to equity ratio E otal s$are$olders4 equity
6ne problem =as &e s$all see>
&it$ looking at risk t$roug$ a
fnancial ratio t$at uses t$e
book alue o' equity =t$e
stock> is t$at most o'ten
t$ere is little relation
bet&een t$e book alue
and its market alue. $e
book alue o' equity
consists o';
• t$e proceeds to t$e
companyo' all t$e stock
issuedsince it &asfrst
incorporated% less any
treasury stock =stock repurc$ased by t$e company> and • t$e accumulation
o' all t$e earnings
o' t$e
company% less any
diidends% since it &asfrst
incorporated.
Let4s look at an e*ample o' t$e book alue s. market alue o' equity. I8 &as incorporated in 1G11. #o its book alue o' equity represents t$e sum o' all its stock
issued and all its earnings% less all diidends paid since 1G11. As o' t$e end o' 2993% I84s book alue o' equity &as appro*imately 2 billion and its market alue o' equity &as appro*imately 1@2 billion. $e book alue understates its market alue by oer 139
Financial ratios% a reading prepared by Pamela Peterson Drake 11
ote t$at t$e debt,equity ratio is related to t$e debt,to,total assets ratio because t$ey are bot$ measures o' t$e companyKs capital structure. $e capital structure is t$e mi* o' debt and equity t$at t$e company uses to fnance its assets.
LetKs use s$ort,$and notation to demonstrate t$is relations$ip. Let D represent total debt and Q represent equity. $ere'ore% total assets are equal to DOQ.
I' a company $as a debt,equity ratio o' 9.2"% t$is means t$at is debtto,asset ratio is 9.2. +e calculate it by using t$e ratio relations$ips and Algebra;
D:Q E 9.2" D E 9.2" Q
#ubstituting 9.2" Q 'or D in t$e debt,to,assets ratio D:=DOQ>; D:=DOQ> E 9.2" Q : =9.2" Q O Q> E 9.2" Q : 1.2" Q E 9.2 In ot$er &ords% a debt,equity ratio o' 9.2" is equialent to a debt,toassets ratio o' 9.2
$is is a $andy deice; i' you are gien a debt,equity ratio and need t$e debt,assets ratio% simply;
D:=DOQ> E =D:Q> : =1 O D:Q>
+$y do &e bot$er to s$o& t$is) ecause many fnancial analysts discuss or report a companyKs debt,equity ratio and you are le't on your o&n to determine &$at t$is means in terms o' t$e proportion o' debt in t$e companyKs capital structure.
billion. $e book alue generally does not gie a true picture o' t$e inestment o' s$are$olders in t$e company because;
• earnings are recorded according to accounting principles% &$ic$ may not re/ect t$e true
economics o' transactions% and
• due to in/ation% t$e dollars 'rom earnings and proceeds 'rom stock issued in t$e past do
not re/ect today4s alues.
$e market alue% on t$e ot$er $and% is t$e alue o' equity as perceied by inestors. It is &$at inestors are &illing to pay% its &ort$. #o &$y bot$er &it$ t$e book alue o' equity) For t&o reasons; frst% it is easier to obtain t$e book alue t$an t$e market alue o' a company4s securities% and second% many fnancial serices report ratios using t$e book alue% rat$er t$an t$e market alue.
+e may use t$e market alue o' equity in t$e denominator% replacing t$e book alue o' equity. o do t$is% &e need to kno& t$e current number o' s$ares outstanding and t$e current market price per s$are o' stock and multiply to get t$e market alue o' equity.
0oerage fnancial leerage ratios
In addition to t$e leerage ratios t$at use in'ormation about $o& debt is related to eit$er assets or equity% t$ere are a number o' fnancial leerage ratios t$at capture t$e ability o' t$e company to satis'y its debt obligations. $ere are many ratios t$at accomplis$ t$is% but t$e t&o most common ratios are t$e times interest coerage ratio and t$e f*ed c$arge coerage ratio.
$e times,interest,coerage ratio% also re'erred to as t$e interest coerage ratio% compares t$e earnings aailable to meet t$e interest obligation &it$ t$e interest obligation;
Qarnings be'ore interest and ta*es imes ,interest , coerage ratio E
Interest
$e f*ed c$arge coerage ratio e*pands on t$e obligations coered and can be specifed to include any f*ed c$arges% suc$ as lease payments and pre'erred diidends. For e*ample% to gauge a companyKs ability to coer its interest and lease payments% you could use t$e 'ollo&ing ratio;
Fi*ed , c$arge coerage ratio E Qarnings be'ore interest and ta*es O Lease payment Interest O Lease payment
0oerage ratios are o'ten used in debt coenants to $elp protect t$e creditors.
"icroso#t9s Financial Leverage &atios : '(()
otal debt to total assets E =G!%3@ , H!%2"> : G!%3@ E 9.29H9G or '(,4(/6
Debt to equity ratio E =G!%3@ , H!%2"> : H!%2" E 9.2@11 or '.,33+6
#ource o' data; alance s$eet% 8icroso't 0orporation Annual <eport 299"
@. #$are$older ratios
$e ratios &e $ae e*plained to t$is point deal &it$ t$e per'ormance and fnancial condition o' t$e company. $ese ratios proide in'ormation 'or managers =&$o are interested in ealuating t$e per'ormance o' t$e company> and 'or creditors =&$o are interested in t$e company4s ability to pay its obligations>. +e &ill no& take a look at ratios t$at 'ocus on t$e interests o' t$e o&ners ,, s$are$older ratios. $ese ratios translate t$e oerall results o' operations so t$at t$ey can be compared in terms o' a s$are o' stock;
Earnings per share ;E5< is t$e amount o' income earned during a period per s$are o' common stock.
et income aailable to s$are$olders Qarnings per s$are E
umber o' s$ares outstanding
As &e learned earlier in t$e study o' Financial #tatement In'ormation% t&o numbers o' earnings per s$are are currently disclosed in fnancial reports; basic and diluted. $ese numbers dier &it$ respect to t$e defnition o' aailable net income and t$e number o' s$ares outstanding. =asic earnings per share are computed using reported earnings and t$e aerage number o' s$ares outstanding. %iluted earnings per share are computed assuming t$at all potentially dilutie securities are issued. $at means &e look at a S&orst caseT scenario in terms o' t$e dilution o' earnings 'rom 'actors suc$ as e*ecutie stock options% conertible bonds% conertible pre'erred stock% and &arrants. #uppose a company $as conertible securities outstanding% suc$ as conertible bonds. In calculating diluted earnings per s$are% &e consider &$at &ould $appen to bot$ earnings and t$e number o'
s$ares outstanding i' t$ese bonds &ere conerted into common s$ares. $is is a S+$at i')T scenario; &$at i' all t$e bonds are conerted into stock t$is period. o carry out t$is S+$at i')T &e calculate earnings considering t$at t$e company does not $ae to pay t$e interest on t$e bonds t$at period =&$ic$ increases t$e numerator o' earnings per s$are>% but &e also add
to t$e denominator t$e number o'
s$ares t$at &ould be issued i' t$ese
bonds &ere conerted into
s$ares.3
Anot$er source o' dilution is
e*ecutie stock options. #uppose
a company $as 1 million s$ares o'
stock outstanding% but $as also
gien its e*ecuties stock options
t$at &ould result in 9." million ne& s$ares issued i' t$ey c$ose to e*ercise t$ese options. $is &ould not aect t$e numerator o' t$e earnings per
s$are% but &ould c$ange t$e
denominator to 1." million s$ares. I' 3 A Scatc$T is t$at diluted earnings per s$are can neer be reported to be greater t$an basic earnings per s$are. In some cases =&$en a company $as many conertible securities outstanding>% &e may calculate a diluted earnings per s$are greater t$an basic earnings per s$are% but in t$is case &e cannot report diluted earnings per s$are because it &ould be anti,dilutie.
Financial ratios% a reading prepared by Pamela Peterson Drake 13
>hat9s a convertible security?
A convertible security is a security B debt or equity B t$at gies t$e inestor t$e option to conertUt$at is% e*c$ange B t$e security into anot$er security =typically% common stock>. 0onertible bonds and conertible pre'erred stocks are common.
#uppose you buy a conertible bond &it$ a 'ace alue o' 1%999 t$at is conertible into 199 s$ares o' stock. $is means t$at you o&n t$e bond and receie
interest% but you $ae t$e option to e*c$ange it 'or 199 s$ares o' stock. 5ou can $old t$e bond until it matures% collecting interest mean&$ile and t$en receiing t$e 'ace alue at maturity% or you can e*c$ange it 'or t$e 199 s$ares o' stock at any time. 5our c$oice. 6nce you conert your bond into stock% $o&eer% you no longer receie any interest on t$e bond.
#ome issuers &ill limit conersion suc$ t$at t$e bond cannot be conerted 'or a f*ed number o' years 'rom issuance.
t$e company $ad earnings o' " million% its basic earnings per s$are &ould be " million : 1 million s$ares E ".99 per s$are and its diluted earnings per s$are &ould be " million : 1." million s$ares E 3.33 per s$are.
As an e*ample% consider 5a$ooV4s earnings per s$are reported in t$eir 299! annual report;
Item '((- '(()
asic QP# 9.1G 9.@2 Diluted QP# 9.1 9."
$e dierence bet&een t$e basic and diluted earnings per s$are in 5a$ooV4s case is attributable to its e*tensie use o' stock options in compensation programs.
=oo0 value equity per share is t$e amount o' t$e book alue =a.k.a. carrying alue> o' common equity per s$are o' common stock% calculated by diiding t$e book alue o' s$are$oldersK equity by t$e number o' s$ares o' stock outstanding. As &e discussed earlier% t$e book alue o' equity may dier 'rom t$e market alue o' equity. $e market alue per s$are% i' aailable% is a muc$ better indicator o' t$e inestment o' s$are$olders in t$e company.
$e price?earnings ratio =P:Q or PQ ratio> is t$e ratio o' t$e price per s$are o' common
stock to t$e earnings per s$are o' common stock;
8arket price per s$are Price,earnings ratio E
Qarnings per s$are
$oug$ earnings per s$are are reported in t$e income statement% t$e market price per s$are o' stock is not reported in t$e fnancial statements and must be obtained 'rom fnancial ne&s sources. $e P:Q ratio is sometimes used as a pro*y 'or inestors4 assessment o' t$e company4s ability to generate cas$ /o&s in t$e 'uture. (istorically% P:Q ratios 'or J.#. companies tend to 'all in t$e 1 9,2" range% but in recent periods =e.g.% 2999, 2991> P:Q ratios $ae reac$ed muc$ $ig$er. Q*amples o' P:Q ratios =P:Q ratios at t$e end o' 299!>; !
@ompany Tic0er 5AE ratio symbol
Ama7on.com A8W "H ime +arner Inc. +X 2G I8 I8 21 0oca,0ola M6 22 8icroso't 8#F 3@ 5a$ooV 5(66 G 38 0o. 888 23 eneral Qlectric Q 2!
+e are o'ten interested in t$e returns to s$are$olders in t$e 'orm o' cas$ diidends. @ash dividends are payments made by t$e company directly to its o&ners. $ere is no requirement t$at a company pay diidends to its s$are$olders% but many companies pay ! #ource; 5a$ooV Finance
regular quarterly or annual diidends to t$e o&ners. $e decision to pay a diidend is made by t$e companyKs board o' directors. ote t$at not all companies pay diidends.
%ividends per share ;%5< is t$e dollar amount o' cas$ diidends paid during a period% per s$are o' common stock;
Diidends paid to s$are$olders
Diidends per s$are E umber o' s$ares
outstanding
$e dividend payout ratio is t$e ratio o' cas$ diidends paid to earnings 'or a period; Diidends
Diidend payout ratio E Qarnings
$e complement to t$e diidend payout ratio is t$e retention ratio or t$e plo1bac0 ratio;
Qarnings , Diidends <etention ratio E
Qarnings
+e can also coney in'ormation about diidends in t$e 'orm o' a yield% in &$ic$ &e compare t$e diidends per s$are &it$ t$e market price per s$are;
Diidends per s$are Diidend yield E
8arket price per s$are
$e dividend yield is t$e return to s$are$olders measured in terms o' t$e diidends paid during t$e period.
+e o'ten describe a company4s diidend policy in terms o' its diidend per s$are% its diidend payout ratio% or its diidend yield. #ome companies4 diidends appear to 'ollo& a pattern o' constant or constantly gro&ing diidends per s$are. And some companies4 diidends appear to be a constant percentage o' earnings.
Summary
5ouKe been introduced to a 'e& o' t$e fnancial ratios t$at a fnancial analyst $as in $is or $er toolkit. $ere are $undreds o' ratios t$at can be 'ormed using aailable fnancial statement data. $e ratios selected 'or analysis depend on t$e type o' analysis =e.g.% credit &ort$iness> and t$e type o' company. 5ouKll see in t$e ne*t reading $o& to use t$ese ratios to get an understanding o' a companyKs condition and per'ormance.
