Financial Ratio Lecture


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Financial Ratio Lecture

  1. 1. Financial Statements Analysis Ratio Analysis EBD 481, Fall 2007 Instructor: Galbraith Adapted from William Messier, Jr., Financial Ratios
  2. 2. Financial Ratios <ul><li>The cornerstone of financial statement analysis is the use of ratios. </li></ul><ul><li>In entrepreneurship used extensively in developing and analyzing business plan pro-formas and for purposes of valuation </li></ul><ul><li>Financial ratios are generally grouped into four categories: </li></ul><ul><ul><li>Short-term liquidity ratios </li></ul></ul><ul><ul><li>Long-term solvency ratios </li></ul></ul><ul><ul><li>Profitability ratios </li></ul></ul><ul><ul><li>Market price and dividends ratios </li></ul></ul>
  3. 3. Financial Ratios <ul><li>Financial analysis using ratios is useful to investors because the ratios capture critical dimensions of the economic performance of the company. </li></ul><ul><li>Managers use ratios to guide, measure, and reward workers. </li></ul><ul><ul><li>Often companies base employee bonuses on a specific financial ratio or a combination of some other performance measure and a financial ratio. </li></ul></ul>
  4. 4. Financial Ratios <ul><li>Short-term liquidity ratios </li></ul>
  5. 5. Financial Ratios <ul><li>Long-term solvency ratios </li></ul>
  6. 6. Financial Ratios <ul><li>Profitability ratios </li></ul>
  7. 7. Financial Ratios <ul><li>Market price and dividend ratios </li></ul>
  8. 8. Another important ratio for small business <ul><li>Discretionary Cash Flow/Sales </li></ul><ul><ul><li>Discretionary Cash Flow = net income + owners compensation + non-cash expenses (most often depreciation) </li></ul></ul><ul><ul><li>Why is this sometimes a better measure of performance than “net-income” for small firms? </li></ul></ul>
  9. 9. Evaluating Financial Ratios <ul><li>Financial ratios are evaluated using three types of comparisons. </li></ul><ul><ul><li>Time-series comparisons - comparisons of a company’s financial ratios with its own historical ratios </li></ul></ul><ul><ul><li>Benchmarks - general rules of thumb specifying appropriate levels for financial ratios </li></ul></ul><ul><ul><li>Cross-sectional comparisons - comparisons of a company’s financial ratios with the ratios of other companies or with industry averages </li></ul></ul>
  10. 10. Ratios <ul><li>Ratios mean different things to different groups. </li></ul><ul><ul><li>A creditor might think that a high current ratio is good because it means that the company has the cash to pay the debt. </li></ul></ul><ul><ul><li>However, a manager might think that a high current ratio is undesirable because it could mean that the company is carrying too much inventory or is allowing its receivables to get too high. </li></ul></ul><ul><li>Because financial ratios may be interpreted differently by different users, the users of the financial ratios must understand the company and the business before drawing conclusions. </li></ul>
  11. 11. Operating Performance and Financial Performance <ul><li>Measures of profitability are affected by both financing and operating decisions. </li></ul><ul><ul><li>Financial management is concerned with where the company gets cash and how it uses that cash. </li></ul></ul><ul><ul><li>Operating management is concerned with the day-to-day activities that generate revenues and expenses. </li></ul></ul><ul><li>Ratios that assess operating efficiency should not be affected by financial management performance. </li></ul>
  12. 12. Operating Performance <ul><li>Rate of return on investment - evaluates the overall success of an investment by comparing what the investment returns with the amount of investment initially made </li></ul>Rate of return on investment
  13. 13. Operating Performance <ul><li>Income may be defined differently for alternative purposes. </li></ul><ul><ul><li>Net earnings </li></ul></ul><ul><ul><li>Pretax income from operations </li></ul></ul><ul><ul><li>Earnings before interest and taxes (EBIT) </li></ul></ul><ul><li>Invested capital may also be defined differently. </li></ul><ul><ul><li>Stockholders’ equity </li></ul></ul><ul><ul><li>Total capital provided by both debt and equity sources </li></ul></ul>
  14. 14. Operating Performance <ul><li>Operating performance is best measured by pretax operating rate of return on total assets , often referred to as return on total assets . </li></ul>Pretax operating rate of return on total assets
  15. 15. Operating Performance <ul><li>The expanded expression of pretax operating rate of return on total assets highlights that operating income percentage and asset turnover will each increase the rate of return on assets. </li></ul><ul><ul><li>Using these two ratios allows manipulation of either one to determine what happens to the rate of return under different scenarios. </li></ul></ul>
  16. 16. Operating Performance Pretax Return on Total Assets Operating Income % on Sales Total Asset Turnover Operating Income Sales Sales Average Total Assets x  
  17. 17. Operating Performance <ul><li>This decomposition of return on total assets can also be applied to the return on equity. </li></ul><ul><ul><li>This is often referred to as the DuPont analysis. </li></ul></ul>or
  18. 18. Financial Performance <ul><li>Debt and equity financing must be balanced in order to achieve good financial performance. </li></ul><ul><ul><li>Firms must choose how much debt is appropriate. </li></ul></ul><ul><ul><li>The firms must also choose how to split their debt between short-term debt and long-term debt. </li></ul></ul><ul><li>The prudent use of debt is a major part of intelligent financial management. </li></ul><ul><li>Is there a difference in the appropriate use of debt by small entrepreneurial firms and larger corporations? </li></ul>
  19. 19. <ul><li>Is there a difference in the appropriate use of debt by small entrepreneurial firms and larger corporations? </li></ul><ul><ul><li>Higher interest rates paid by smaller firms </li></ul></ul><ul><ul><li>More security needed by smaller firms </li></ul></ul><ul><ul><li>Stricter qualification rules by banks </li></ul></ul><ul><ul><li>Inability to access the bond market </li></ul></ul><ul><ul><li>Personal guarantees by founders often required </li></ul></ul><ul><ul><li>Need to maintain debt capacity for growth </li></ul></ul>
  20. 20. Financial Performance <ul><li>Short-term debt must be repaid or refinanced in a short period of time. </li></ul><ul><ul><li>If a company has trouble repaying the debt, it will also generally have trouble refinancing the debt. </li></ul></ul><ul><ul><li>Naturally, lenders like healthy borrowers, not troubled borrowers. </li></ul></ul>
  21. 21. Financial Performance <ul><li>Long-term debt or equity are generally used to finance long-term investments. </li></ul><ul><ul><li>Debt financing is more attractive than equity financing because: </li></ul></ul><ul><ul><ul><li>Interest payments are deductible for income tax purposes, but dividends are not deductible. </li></ul></ul></ul><ul><ul><ul><li>The ownership rights to voting and profits are kept by the present shareholders. </li></ul></ul></ul><ul><ul><li>Then why do so many small companies prefer to raise money by equity (selling stock to friends and families)? </li></ul></ul>
  22. 22. Net profit Margin ROE Return on Assets (Profitability) Financial leverage Asset turnover Liquidity Solvency   Net income Sales / Sales Total cost — Cost of goods sold SG&A R&D Interest expense Income taxes Sales Total assets / Current assets Noncurrent assets + Land Bui l ding Equipment Intangibles Others Cash Acc. Receivables Inventory Other Financial Performance
  23. 23. Trading on the Equity <ul><li>General comments about leveraging: </li></ul><ul><ul><li>A debt-free, or unleveraged, company has identical return on assets (ROA) and return on equity (ROE). </li></ul></ul><ul><ul><li>When a company has a ROA greater than the interest rate it is paying its lenders, ROE exceeds ROA. </li></ul></ul><ul><ul><ul><li>This is called favorable financial leverage. </li></ul></ul></ul><ul><ul><li>When a company is unable to earn at least the interest rate on the money borrowed, the return on equity will be lower than it would be for a debt-free company. </li></ul></ul><ul><ul><li>The more stable the income, the less dangerous it is to trade on the equity. </li></ul></ul>
  24. 24. Economic Value Added <ul><li>The idea behind economic value added (EVA) is that a company must earn more than it must pay for capital if it is to increase in value. </li></ul><ul><ul><li>Capital is considered both debt and equity. </li></ul></ul><ul><ul><li>The cost of capital in EVA is a weighted average of interest cost and the returns required by equity investors. </li></ul></ul><ul><li>If a company has positive EVA, the company is adding value; if a company has negative EVA, the company is losing value and might be better off liquidating. </li></ul>
  25. 25. Income tax effects <ul><li>Complicates analysis, but not really important for start-up companies. </li></ul><ul><li>Why? </li></ul>