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  • 1. Accounting Fundamentals, Part 4: Financial Ratios Key Topics ♦ Features of ratio analysis ♦ Four categories of ratios ♦ Ratio calculation and analysis Financial Performance Measurement: Ratio Analysis ♦ Uses financial data to show relationships between financial statement accounts. ♦ Allows comparisons to be made between companies or benchmark against industry averages. ♦ Necessary for people evaluating a firm's financial health and earnings quality. ♦ GAAP does not address the nature or interpretation of ratios. © 1998 Primedia Corporate University Network Page 1
  • 2. Accounting Fundamentals, Part 4: Financial Ratios Categories of Ratios ♦ Liquidity ♦ Efficiency ♦ Profitability ♦ Solvency Course Notes ♦ We'll use Wal-Mart financial data to illustrate each financial ratio. ♦ Page numbers refer to corresponding data in the 1998 annual shareholder report. ♦ Dollar amounts are in millions, except per share data. © 1998 Primedia Corporate University Network Page 2
  • 3. Accounting Fundamentals, Part 4: Financial Ratios Industry Data ♦ Provided here for selected ratios. ♦ Helps us evaluate our ratio in terms of similar companies. ♦ Serves as a benchmark. Liquidity Ratios These ratios provide insights into the short- term debt-paying ability of the business. Types: ♦ Current Ratio ♦ Quick Ratio © 1998 Primedia Corporate University Network Page 3
  • 4. Accounting Fundamentals, Part 4: Financial Ratios Liquidity Ratios Current Ratio Measures the degree to which all short-term assets can be used to satisfy short term liabilities. Current Assets Current Liabilities Pg. 27 1998: = 1.3 Pg. 27 On your Pg. 27 own: 1997: = 1.6 Pg. 27 Industry Comparison: Sears 1998: 1.9 1997: 1.9 Liquidity Ratios Quick Ratio Measures the extent to which the assets most immediately convertible to cash can be used to satisfy short-term obligations. Cash + Accounts Receivable + Marketable Securities Current Liabilities + + Pg. 27 1998: = .17 Pg. 27 On your own: + + Pg. 27 1997: = .16 Pg. 27 Industry Comparison: Sears 1.5 © 1998 Primedia Corporate University Network Page 4
  • 5. Accounting Fundamentals, Part 4: Financial Ratios Efficiency Ratios These ratios measure the effectiveness of management in utilizing the assets of the business. Types: ♦ Accounts Receivable Turnover ♦ Days Sales in Receivables ♦ Inventory Turnover ♦ Number of Days' Inventory ♦ Total Asset Turnover Efficiency Ratios Accounts Receivable Turnover Reflects the number of times a new group of receivables is created and collected during the period. Sales Average Accounts Receivable Pg. 26 1998: = 129.6 ( )/2 Pg. 27 Industry Comparison: Sears 1.6 © 1998 Primedia Corporate University Network Page 5
  • 6. Accounting Fundamentals, Part 4: Financial Ratios Efficiency Ratios Days Sales in Receivables Reflects the average collection period for accounts receivable. 365 Accounts Receivable Turnover 365 1998: = 2.8 days Industry Comparison: Sears 228 days Efficiency Ratios Inventory Turnover Reflects the number of times during the year that the stock of inventory is sold then replaced. Cost of Goods Sold Average Inventory Pg. 26 1998: = 5.8 ( )/2 Pg. 27 Industry Comparison: Sears 5.5 © 1998 Primedia Corporate University Network Page 6
  • 7. Accounting Fundamentals, Part 4: Financial Ratios Efficiency Ratios Number of Days’ Inventory Reflects the number of days on average that inventory remains on hand. 365 Inventory Turnover 365 1998: = 62.9 days Industry Comparison: Sears 66 days Efficiency Ratios Total Asset Turnover Indicates the number of dollars of sales generated by each dollar invested in assets. Sales Average Total Assets Pg. 26 1998: = 2.78 ( )/2 Pg. 27 Industry Comparison: Sears 0.97 © 1998 Primedia Corporate University Network Page 7
  • 8. Accounting Fundamentals, Part 4: Financial Ratios Profitability Ratios These ratios measure the success of the business in utilizing resources to generate a return on funds provided. Types: ♦ Return on Assets ♦ Profit Margin ♦ DuPont Analysis ♦ Earnings per Share ♦ Gross Margin Profitability Ratios Return on Assets (ROA) Measures the amount earned on every dollar invested in or lent to the business. Net Income + Interest Average Total Assets Pg. 26 1998: = 9.5% ( )/2 Pg. 27 Industry Comparison: Sears 5.6% © 1998 Primedia Corporate University Network Page 8
  • 9. Accounting Fundamentals, Part 4: Financial Ratios Profitability Ratios Profit Margin The portion of every sales dollar that represents profit to the business. Net Income + Interest Sales + Pg. 26 1998: = 3.44% Pg. 26 + Pg. 26 1997: = 3.42% Pg. 26 Industry Comparison: Sears 5.8% Profitability Ratios DuPont Analysis First formalized by Dupont Corporation, this equation reflects the components of return on assets. TOTAL PROFIT MARGIN ASSET TURNOVER Net Income + Interest Sales x Sales Average Total Assets 1998: x = 9.5% Industry Comparison: Sears 5.6% © 1998 Primedia Corporate University Network Page 9
  • 10. Accounting Fundamentals, Part 4: Financial Ratios Profitability Ratios Return on Equity (ROE) Reflects the amount earned by common stockholders on every dollar invested in them. Net Income Available to Common Stockholders Average Common Stockholders’ Equity Pg. 26 1998: = 19.8% ( )/2 Pg. 27 Industry Comparison: Sears 22% Profitability Ratios Earnings Per Share (EPS) Reflects the profit of the business allocated to each share of common stock. Net Income Available to Common Stockholders Average Number of Common Shares Outstanding 1998: Pg. 26 1997: Pg. 26 EPS ratio cannot be compared across firms. © 1998 Primedia Corporate University Network Page 10
  • 11. Accounting Fundamentals, Part 4: Financial Ratios Profitability Ratios Gross Margin Reflects the mark-up on inventory, which should cover operating expenses and generate a profit. Gross Profit Sales Pg. 26 1998: = 20.8% Pg. 26 Pg. 26 1997: = 20.4% Pg. 26 Industry Comparison: Sears 1998: 29% 1997: 26% Solvency Ratios These ratios measure the long-term debt-paying ability of the business. Types: ♦ Debts/Assets ♦ Debt/Equity © 1998 Primedia Corporate University Network Page 11
  • 12. Accounting Fundamentals, Part 4: Financial Ratios Solvency Ratios Debt/Assets Reflects the portion of total assets provided by creditors. Total Liabilities Total Assets Pg. 27 1998: = 59% Pg. 27 Pg. 27 1997: = 57% Pg. 27 Industry Comparison: Sears 84% Solvency Ratios Debt/Equity Reflects the creative portion of funds provided by creditors and owners. Total Liabilities Stockholders’ Equity On your own: Pg. 27 1998: = 59% Pg. 27 Pg. 27 1997: = 57% Pg. 27 © 1998 Primedia Corporate University Network Page 12
  • 13. Accounting Fundamentals, Part 4: Financial Ratios Summary ♦ Ratios help you identify and analyze financial information. ♦ On their own, ratios are neither good nor bad. (You must use a benchmark for interpretation.) © 1998 Primedia Corporate University Network Page 13
  • 14. Accounting Fundamentals, Part 4: Financial Ratios Practice Problem Use the figures from the financials in the Wal-Mart 1998 Annual Shareholder Report to compute the following ratios: 1. Calculate the Quick Ratio for 1997 and compare to the corresponding 1998 ratio. Hint: Marketable Securities = 0 2. Calculate the Debt/Equity Ratio for 1998 and 1997. Is it the same as the corresponding Debt/Assets ratios? 3. Given that Wal-Mart's Total Assets for 1996 was $37,541,000,000: a. Calculate the ROA for 1997 b. Calculate the Total Assets Turnover Ratio for 1997 c. Calculate the DuPont Analysis for 1997, and prove that ROA = Profit Margin x Total Assets Turnover for 1997 © 1998 Primedia Corporate University Network Page 14