ch04

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CHAPTER 4

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Ratio Analysis

Quick Links

Financial Statement Analysis

The DuPont System, ROA, ROE

Benchmarks

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Perspectives on Financial

Statement Analysis

_{A firm’s financial statements can be analyzed from the}

perspective of different stakeholders.

_{Important perspectives:}

 _Creditor  _Manager

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Stockholders’ perspective

 _{Centers on value of stock held.}

 _{Allows determination of firm’s profitability,}

return for that period, and likely dividends.

 _{Interest in the financial statement is to gauge}

cash flows firm will generate from operations.

Perspectives on Financial

Statement Analysis

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Manager’s perspective

 _{Interest in firm’s financial statement is similar}

to stockholders’.

 _{Manager’s job security depends on firm’s}

performance.

 _{Management gets feedback on investing,}

financing, and working capital decisions by identifying trends in various accounts

reported in financial statements.

Perspectives on Financial

Statement Analysis

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Creditors’ perspective

 _{A firm’s creditors closely monitor}  _{Amount of debt} _{firm has.}

 _{Ability to meet short-term obligations.}

 _{Ability to generate sufficient cash flows to}

meet all legal obligations, debt repayment, and interest payments.

 _{Focus on getting loans repaid and receiving}

interest payments on time.

Perspectives on Financial

Statement Analysis

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Main Concern

Guidelines for Financial

Statement Analysis

 _{From whose perspective firm analysis is done.}  _{Management, shareholder or creditor.}

 _{Use only audited financial statements if}

possible.

 _{Perform analysis over 3-5 year}

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Main Concern (cont.)

 _Compare _{firm’s performance to direct}

competitors’ performance.

 _Example?

 _{Perform a benchmark analysis comparing it to}

most relevant competitors – Vietnam Airlines to Indochina or Jetstar

Guidelines for Financial

Statement Analysis

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Common-Size Balance Sheets

Common-Size Financial

Statements

 _{Each asset and liability item on} _{balance sheet}

is standardized by dividing by total assets.

 _{Accounts are then represented as}

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Exhibit 4.1: Common-Size

Balance Sheets

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Common-Size Income Statement

 _{Each income statement item standardized by}

dividing it by dollar amount of net sales.

 _{Each income statement item now indicated as}

percent of sales.

Common-Size Financial

Statements

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Exhibit 4.2: Common-Size

Income Statements

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Measures ability of firm to meet short-term obligations with short-term assets, without endangering the firm.

Liquidity Ratios

 _{Current ratio}

 _{Quick ratio}

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Current ratio is calculated by dividing current assets by current liabilities. 2.75 $377.8 $1,039.8 (4.1) liabilites Current assets Current ratio Current   

 _{Amount of current assets firm has per dollar}

of current liabilities.

 _{Higher number = more liquidity}

Liquidity Ratios

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Quick (acid-test) ratio calculated by dividing most liquid current assets by current liabilities.

 _{Amount of liquid assets firm has per dollar}

of current liabilities.

 _{Higher number = more liquidity}

Liquidity Ratios

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_{Quick ratios typically smaller than current ratios for} manufacturing firms 1.63 $377.8 $423.8 -$1,039.8 (4.2) s liabilitie Current Inventory -assets Current ratio Quick   

Liquidity Ratios

_{Service firms see no different between current and}

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 _{Measure how efficiently firm’s management uses}

assets to generate sales.

Efficiency Ratios

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_{Used by management to identify areas of inefficiency.}

 _{Efficiency ratios focus on inventory, receivables and}

use of fixed and total assets.

 _{Used by creditors to determine speed of converting}

inventory to receivables.

 _{Receivables convert to cash to help firm meet}

debt obligations.

Efficiency Ratios

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Inventory turnover ratio–measures how many times inventory turned over into saleable products.

2.55

$423.8

$1,081.1

(4.3)

Inventory

of

goods

sold

Cost

ratio

turnover

Inventory



 _{In general, more often a firm can turn over}

inventory, the better. Too high or too low a turnover could be warning sign.

Efficiency Ratios

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Days’ sales in inventory ratio also builds on inventory turnover ratio.

days

143.14

2.55

days

365

(4.4)

turnover

Inventory

365

days

inventory

in

sales

Days’



 _{Measures number of days firm takes to turn}

over inventory.

 _{The smaller the number, the faster the firm}

turns over inventory, more efficient it is.

Efficiency Ratios

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Accounts receivable turnover ratio measures how quickly firm collects on its credit sales.

5.11 $306.2 $1,563.7 (4.5) receivable Accounts sales Net turnover receivable Accounts   

 _{The higher the frequency of turnover, the}

faster it converts credit sales into cash flows

Efficiency Ratios

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Days Sales Outstanding (DSO) measures number of days firm takes to convert receivables into cash.

days 71.43 5.11 days 365 (4.6) turnover receivable Accounts days 365 DSO   

 _{The fewer the days, the more efficient the}

firm.

 _{Note: an overzealous credit department}

may offend firm’s customers.

Efficiency Ratios

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_{Total asset turnover ratio measures level of}

sales firm generates per dollar of total assets.

0.83

$1,889.2

$1,563.7

(4.7)

assets

Total

sales

Net

turnover

asset

Total



Asset Turnover Ratios

 _{The higher the turnover, the more efficiently}

management is using total assets.

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Fixed asset turnover ratio measures level of sales firm generates per dollar of fixed assets.

 _{Higher the fixed asset turnover, the more efficiently}

management uses plant and equipment.

 _{More relevant for equipment intensive firms (e.g.}

mfg).

Asset Turnover Ratios

Net sales

Fixed asset turnover = (4.8)

Net fixed assets $1,563.7

=

$399.4 = 3.92

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 _{Leverage ratios reflect ability of firm and owners to}

use equity to generate borrowed funds.

Leverage Ratios

 _{Financial leverage refers to use of debt in firm’s}

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 _{Use of debt increases shareholders’ returns; tax}

benefits from interest payments on debt.

 _{Two sets of ratios can analyze leverage:}

Debt ratios quantify use of debt in capital structure;

Coverage ratios measure firm’s ability to meet debt obligations.

Leverage Ratios

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The higher the amount of debt, the higher the firm’s leverage, and the more risky it is.

Leverage Ratios

Total debt

Total debt ratio =

(4.9)

Total assets

$951.8

=

$1,889.2

= 0.50

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Debt to equity ratio is a second leverage ratio, measuring amount of debt per dollar of equity.

Leverage Ratios

Total debt Total equity

Debt-to-equity ratio = (4.10)

$951.8 =

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Equity multiplier or leverage multiplier reveals amount of assets firm has for every dollar of equity.

Leverage Ratios

Total assets

Equity multiplier = (4.11) Total equity

$1,889.2 =

$937.4 = 2.02

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Equity multiplier = 1 + Debt to equity ratio

Other Leverage Relationships

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Times interest earned measures number of dollars in operating earnings firm generates per dollar of interest expense.

Coverage Ratios

EBIT

Times interest earned = (4.12)

Interest expense $168.4

=

(32)

Cash coverage ratio measures amount of cash firm has to meet its interest payments.

Coverage Ratios

EBITDA

Cash coverage = (4.13)

Interest expense $251.5

=

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Gross profit margin measures amount of gross profit generated per dollar of net sales.

Profitability Ratios

Net sales - Cost of Goods Sold Net sales

Gross profit margin = (4.14)

$1,563.7 - $1,081.1 =

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Operating profit margin measures the amount of operating profit generated by firm for each dollar of net sales.

EBIT

Operating profit margin = (4.15) Net sales

$168.4 =

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Net profit margin measures amount of net income after taxes generated by firm for each dollar of net sales.

Profitability Ratios

Net Income

Net profit margin =

(4.16)

Net sales

$118.5

=

$1,563.7

= 7.58%

In each case, the higher the ratio, the more profitable the firm.

Management and creditors likely to focus on these profitability measures; shareholders likely to

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Return on assets (ROA) ratio measures amount of net income per dollar of total assets. There are two

approaches to calculate the return on assets.

Profitability Ratios

EBIT

EROA =

(4.17)

Total assets

$168.4

=

$1,889.2

= 8.91%

_{This ratio reveals how efficiently management utilized}

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Some analysts calculate return on assets as:

Net income

ROA =

(4.18)

Total assets

$118.5

=

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Return on equity (ROE) ratio measures dollar

amount of net income per dollar of shareholders’ equity.

 _{For firm with no debt, ROA = ROE}  _{For firm with debt, ROE >ROA}

Net income

Return on equity =

(4.19)

Total equity

$118.5

=

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_{The following ratios reveal how market views}

company’s liquidity, efficiency, leverage, profitability.

Market Value Ratios

Net income

Earnings per share =

(4.20)

Shares outstanding

$118,500,000

=

$54,566,054

= 2.17 per share

_{Earnings per share (EPS) ratio measures income}

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Price-earnings (P/E) ratio ties firm’s earnings per share to price per share.

 _{P/E ratio reflects investors’ expectations of}

firm’s future earnings growth.

Market Value Ratios

Price per share

Price-earnings ratio =

(4.21)

Earnings per share

$48.61

=

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_{Set of related ratios that links balance sheet}

and income statement.

The DuPont System

 _{Diagnostic tool for evaluating firm’s financial}

health.

 _{Used by management and shareholders to}

understand factors that drove firm’s ROE.

 _{Based on two equations that relate firm’s}

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_{Return on assets (net income/total assets) can be}

broken down into two components:

_{Profit margin and total assets turnover ratio}

(4.22)

turnover

assets

Total

margin

Profit

assets

Total

sales

Net

sales

Net

income

Net

ROA









The ROA Equation

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_{Total asset turnover reveals how efficiently}

management uses assets under its command; how much output can be generated with a given asset base. Thus, asset turnover measures asset use efficiency.

 _{The ROA equation says if management wants to}

increase firm’s ROA, it can increase profit margin, asset turnover, or both.

 _{Management can examine a poor ROA and determine}

whether the problem is operating efficiency or asset use efficiency.

The ROA Equation

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This equation is simply a restatement of equation 4.19. (4.23) multiplier Equity ROA equity Totalassets Total assets TotalNet income equity

TotalNet income ROE     

The ROA Equation

_{ROE is determined by firm’s ROA and its use of}

leverage.

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Shows that a firm’s ROE is determined by three factors:

The DuPont Equation

 _{Net profit margin, which measures firm’s}

operating efficiency.

 _{Total asset turnover, which measures}

firm’s asset use efficiency.

 _{The equity multiplier, which measures}

firm’s financial leverage.

ROE = Net profit margin Total asset turnover

Equity multiplier (4.24)

Net income Net sales Total assets

ROE =

Net sales Total assets Total e

 

  (4.25)

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Exhibit 4.5: Relations in the

DuPont System of Analysis

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A ratio analysis becomes relevant only when compared against a benchmark.

Financial managers can create a benchmark for comparison in three ways:

Selecting a Benchmark

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Time-trend analysis

 _{Based on firm’s historical performance.}

 _{Allows management to examine each ratio}

over time, determine whether trend is good or bad for firm.

Selecting a Benchmark

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Industry average analysis

 _{Another way of developing benchmark.}

 _{Firms in same industry grouped by size,}

sales, and product lines, to establish benchmark ratios.

 _Example

Selecting a Benchmark

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Peer group analysis

 _{Instead of selecting an entire industry,}

management may select firms similar in size or sales, or who compete in same market.

 _{Average ratios of this peer group would then}

be used as benchmark.

 _{Peer groups can be only 3 or 4 firms,}

depending on industry.

Selecting a Benchmark

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_{Ratio analysis depends on accounting data based}

on historical costs.

Limitations of Ratio Analysis

 _{No theoretical backing in making judgments based}

on financial statement and ratio analysis.

 _{When doing industry or peer group analysis, one}

often encounters large, diversified firms that do not fit into any financial statement.

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_{Time trend analysis could be distorted by financial}

statements affected by inflation.

 _{Multinational firms deal with many accounting}

standards. (GAAP, IFRS)

 _{Difficult to compare financial reports.}

 _{Even among domestic firms, differences in}

accounting practices make comparisons difficult.

 _{FIFO versus LIFO}