5/25/10 F409 - Ratios Analysis
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5/25/10 F409 - Ratios Analysis Presentation Transcript

  • 1. Financial Statement Analysis
    • Before you can value a company, you must understand how it operates and its financial characteristics .
      • Assists in determining strengths and weaknesses.
      • Useful when making projections.
    • To analyze a firm, you must compare it to some benchmark:
      • Time-series – compare it to itself
      • Cross-sectional – compare it to other(s) in the industry using common size statements
  • 2. Comparing Over Time
    • Comparison with Earlier Periods
      • The impact of economic, industry, and firm-specific conditions are examined:
      • Some precautions
        • Has the firm made a change to its product mix (ex. Merger)
        • Has the firm changed its accounting methods?
        • No adjustment for industry conditions (is a 10% increase in profitability good if the industry experienced a 15% increase)
  • 3. Comparing Over Time: Life Cycle
    • Product Life Cycle
      • Products move through 4 life cycles: introduction, growth, maturity, and decline.
        • Introduction: Product development and promotion – high R&D expenses, high advertising and promotion spending, large capital investments
        • Growth: rapid expansion, initial producers generate large profits
        • Maturity: Competition increases and costs reductions occur –
        • Decline: Sales decline and profit opportunities diminish
  • 4. Comparing to Other Firms
    • Comparison with Other Firms
      • Can use a gross comparison or a common-size approach
        • Must understand where each firm is at in its life cycle
      • Sometimes difficult to find a perfectly comparable firm
        • Similar products, size,age.
        • May have different accounting methods?
      • Published Industry Ratios
        • Robert Morris Associates – Annual Statement Studies
        • Dun and Bradstreet – Industry Norms & Ratios
  • 5. Ratio Analysis
    • Ratios are a tool – Like with all tools you must
      • Understand its possible uses
      • Know its limitations.
      • Thus, you should keep a few questions in the back of your mind.
        • What does this ratio tell us and why? (intended use)
          • What does a high ratio mean? What does a low ratio mean?
        • How may the ratio be misleading? (limitations)
          • Different accounting information.
          • Based on historical information.
  • 6. Ratio Analysis
    • Ratios provide relative measures to interpret financial statements
      • Eliminates problems associated with comparing firms of different sizes.
    • There are MANY different financial ratios.
      • The most important ratios may differ by industry
      • We will cover many of the commonly used ratios; however, the list is not exhaustive.
  • 7. Ratio Analysis
    • There are 4 categories of ratios
      • Liquidity
      • Leverage
      • Asset Use or Efficiency
      • Profitability
  • 8. Liquidity
    • There are 4 categories of ratios
      • Liquidity
          • How well can the firm pay its bills without undue stress.
          • A high ratio indicates liquid, but too high may mean the firm is inefficient.
        • Issues to consider:
        • How liquid are inventory and receivables?
        • Does the firm have easy access to borrowing.
      • Leverage
      • Asset Use or Efficiency
      • Profitability
  • 9. Liquidity Ratios
    • Current assets
    • Current ratio =
    • Current liabilities
    • Quick ratio = (Current assets - inventory) / Current liabilities
    • Cash ratio = Cash + Marketable Securities / Current liabilities
    • Current assets
    • Interval measure =
    • Average daily operating costs
      • Operating Costs = SG&A+COGS-depreciation
  • 10. Leverage
    • There are 4 categories of ratios
      • Liquidity
      • Leverage
        • Measures the firms long-run ability to meet its obligations.
        • Too high of a ratio could lead to financial distress – too low of a ratio could indicate the firm is not utilizing all the benefits of debt.
        • Issues to consider
        • A firm’s level of leverage
        • A firm’s ability to meet interest payments
      • Asset Use or Efficiency
      • Profitability
  • 11. Leverage Ratios
    • Total assets - Total equity
    • Total debt ratio =
    • Total assets
    • Debt/equity ratio = Total debt/Total equity
    • Equity multiplier = Total assets/Total equity
    • Long-term debt
    • Long-term debt ratio =
    • Long-term debt + Total equity
    • EBIT
    • Times interest earned ratio =
    • Interest
    • EBIT + depreciation
    • Cash coverage ratio =
    • Interest
      • EBIT = Net Income before Extraordinary Items + Interest Expense + Tax Expense
  • 12. Asset Use and Efficiency Ratios
    • There are 4 categories of ratios
      • Liquidity
      • Leverage
      • Asset Use or Efficiency
        • How efficiently does the firm use its assets to generate sales
          • Investigates long-term and current assets.
        • Issues
        • Is the firm maximizing the spread between receivables and payables - working capital management?
        • Some industries are more asset intensive and some of these ratios will vary by industry.
      • Profitability
  • 13. Asset Use and Efficiency Ratios
    • Cost of goods sold
    • Inventory turnover =
    • Inventory
    • 365 days
    • Days’ sales in inventory =
    • Inventory turnover
    • Sales
    • Receivables turnover =
    • Accounts receivable
    • 365 days
    • Days’ sales in receivables =
    • Receivables turnover
    • Sales
    • NWC turnover =
    • NWC
    • Sales
    • Fixed asset turnover =
    • Net fixed assets
    • Sales
    • Total asset turnover =
    • Total assets
  • 14. Profitability
    • There are 4 categories of ratios
      • Liquidity
      • Leverage
      • Asset Use or Efficiency
      • Profitability
        • These ratios are the bottom line and show how well the firm is able to control expenses and generate revenue.
        • They reflect the impact of all other categories of ratios.
  • 15. Profitability Ratios
    • Net income
    • Profit margin =
    • Sales
    • Net income
    • Return on assets (ROA) =
    • Total assets
    • Net income
    • Return on equity (ROE) =
    • Total equity
  • 16. Interpreting Profitability: The Du Pont Identity
    • Return on equity (ROE) can be decomposed as follows:
    • ROE = Net income / Total equity = Net income / Total equity x Total assets/Total assets = Net income / Total assets x Total assets / Total equity = ROA x Equity multiplier
    • 2. Return on assets (ROA) can be decomposed as follows:
    • ROA = Net income / Total assets x Sales/Sales = Net income / Sales x Sales / Total assets = Profit Margin x Total Asset Turnover
  • 17. Interpreting Profitability: The Du Pont Identity
    • 3. Putting it all together gives the Du Pont identity:
    • ROE = ROA x Equity multiplier = Profit margin x Total asset turnover x Equity multiplier
    • 4. Profitability (or the lack thereof!) thus has three parts:
      • Operating efficiency
      • Asset use efficiency
      • Financial leverage
  • 18. Interpreting Profitability: Fixed & Variable Costs
    • Operating Leverage
      • Fixed vs. Variable Costs: Firms with high fixed costs will experience greater increases in income as sales increase
      • Firms with high fixed have high operating leverage
      • Firms with high operating leverage experience more variability in ROA than those with low operating leverage
  • 19. Key Points: Interpreting Ratios
    • What aspect of the firm or its operations are we attempting to analyze?
      • Firm performance can be measured along “dimensions”
    • What goes into a particular ratio?
      • Historical cost? Market values? Accounting conventions?
    • What is the unit of measurement?
      • Dollars? Days? Turns?
    • What would a desirable ratio value be? What is the benchmark?
      • Time-series analysis? Cross-sectional analysis?
  • 20. Key Points: Interpreting Ratios
    • Short-Term Solvency, or Liquidity
      • Ability to pay bills in the short-run
    • Long-Term Solvency, or Financial Leverage
      • Ability to meet long-term obligations
    • Asset Management, or Turnover
      • Intensity and efficiency of asset use
    • Profitability
      • The ability to control expenses