5/25/10 F409 - Ratios Analysis


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5/25/10 F409 - Ratios Analysis

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