Financial-Ratios

1CorporateFinanceRossWesterfieldJaffeSixthEditionSixthEdition2AChapterTwoFinancialStatementAnalysis22A.0Overview2A.1Short-TermSolvency(Liquidity)2A.2Activity(Efficiency)2A.3Long-TermSolvency(Leverage)2A.4Profitability2A.5MarketValueandOtherRatios2A.6SummaryandConclusionsChapterOutline32A.0OverviewObjectiveIdentifythestrengthsandweaknessesofacompanybyexaminingratiosthatmeasuretheperformanceofitsvariousareasofmanagement.ApproachesCross-sectional(Peer)Analysis•Comparethecompany’sratiostothoseofitspeerscompetinginthesameindustry.Time-series(Trend)Analysis•Lookfortrendssuggestingimprovementordeteriorationinperformance.42A.1Short-TermSolvency(Liquidity)Ratios•Theabilityofthecompanytomeetitsshort-termfinancialobligations.•CurrentRatio•=CurrentAssets/CurrentLiabilitiesHowmuchcurrentassetsaretheretocovereachdollarofcurrentliabilities?Whatisthecushionofsafety?•Quick(orAcid-Test)Ratio•=(CurrentAssets–Inventories)/CurrentLiabilitiesHowmuch‘liquidorquick’assetsaretheretomeettheshort-termobligations?52A.2ActivityRatiosHoweffectiveisthecompanyutilizingitsresourcestogeneratesalerevenues?Howwellisthecompanymanagingitsassets(orinvestment)?AlsoknownasAssetmanagementRatiosorEfficiencyRatiosTotalAssetTurnoverRatio=SaleRevenues/TotalAssets(average)Howmuchsalerevenuesaregeneratedbyeachdollarinvestedintotalassets?62A.2ActivityRatios(cont’d)FixedAssetTurnoverRatio=SaleRevenues/FixedAssets(average)Howmuchsalerevenuesaregeneratedbyeachdollarinvestedinfixedassets?InventoryTurnoverRatio=CostofGoodsSold/Inventory(average)Howfastcanthecompanysellitsinventories?DaysinInventory=DaysinPeriod/InventoryTurnoverHowlongdoesthecompanyholditsinventories?72A.2ActivityRatios(cont’d)ReceivablesTurnoverRatio=SaleRevenues/AccountsReceivable(average)AverageCollectionPeriod=DaysinPeriod/ReceivablesTurnoverHowlongdoesittakethecompanytocollectcashfromitscustomers?82A.3Long-TermSolvency(FinancialLeverage)RatiosTowhatextentdoesthecompanyusedebtfinancing?TotalDebtRatio=TotalDebt/TotalAssetsWhatproportionofthecompany’sassetsisfinancedwithdebt?Debt-to-EquityRatio=TotalDebt/TotalEquityHowmuchdoesthecompanyborrowforeachdollaroftheowners’investment?92A.3Long-TermSolvency(InterestCoverage)RatioTheabilityofthecompanytocoverthefinancechargesassociatedwithitsuseoffinancialleveragefromitsoperation.TimesInterestEarned(TIE)Ratio=EBIT/InterestExpenseHowmanydollarsofoperatingincomearetheretocovereachdollarofinterestexpense?Whatisthemarginofsafetyintheabilitytopayinterest?102A.4ProfitabilityRatiosHowprofitablearetheoperationandinvestmentofthecompany?NetProfitMargin=NetIncome/SaleRevenuesWhatistheamountofafter-taxprofitforeachdollarofsales?OperatingProfitMargin=EBIT/SaleRevenuesWhatistheoperatingreturnonsales?Howeffectiveisthecompanykeepingcostsofproductionlow?112A.4ProfitabilityRatios(cont’d)ReturnonAssets(ROA)=NetIncome/TotalAssets(average)Whatistheabilityofthecompanytogenerateafter-taxprofitwithitsinvestment,i.e.,totalassets?BasicEarningsPower=EBIT/TotalAssets(average)ReturnonEquity(ROE)=NetIncome/TotalEquity(average)Whatistheabilityofthecompanytogenerateafter-taxprofitfortheowners’investment?12DuPontEquationAframeworktoanalyzeROEwithitscomponentsrepresenting3majorareasofmanagementROE=(NetProfitMargin)X(TotalAssetTurnover)X(EquityMultiplier)WhereEquityMultiplier=TotalAssets/TotalEquity•Anothermeasureoffinancialleverage•Howmuchtotalassetsarefinancedbyowners’investment?132A.5MarketValueandOtherRatiosSustainableGrowthRate=(ROE)X(RetentionRatio)•WhereRetentionRatio=1–PayoutRatio•PayoutRatio=CashDividends/NetIncome(orDPS/EPS)Howfastcanthecompanygrowwithinternallygeneratedresourcesfromitsoperation?142A.5MarketValueandOtherRatios(cont’d)Price-to-Earnings(P/E)Ratio=StockPrice/EarningsPerShare(EPS)Howmuchareinvestorswillingtopayforeachdollarofearningspershare?Aproxymeasureforthegrowthpotentialofthecompany.Market-to-Book(M/B)ValueRatio=StockPrice/BookValueofEquityPerShareAnotherproxymeasureforthecompany’sgrowthpotential.15CommonSizeStatementsForaneasiercomparisonofdifferent-sizefirms.CommonSizeBalanceSheet:Balancesheetaccountsareexpressedaspercentageoftotalassets.CommonSizeIncomeStatement:Incomestatementitemsareexpressedaspercentageofsales.162A.6SummaryandConclusionsFinancialstatementanalysisprovidesinsightfulinformationregardingthefinancialperformance,andstrengthsandweaknesses,ofthefirm.Youshouldkeepinmind:--Financialratiosarelinkedtooneanother.--Financialratiosarealsosubjecttothelimitationsofaccountinginformation.