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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: