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C:\Fakepath\44 Ratio Analysis 1

C:\Fakepath\44 Ratio Analysis 1






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  • Ratios are compared to industry averages. There are 14 to 16 common ratios grouped into 4 types. Dun and Bradstreet and Robert Morris Associates give industry average ratios for hundreds of industries. We will describe the types of ratios and focus on several important financial ratios. Financial Statements   1. Financial statements report a firm’s position at a point in time and on operations over some past period 2. Investors use financial statements to predict future earnings/dividends 3. Management uses financial statements to help anticipate future conditions and as starting point for planning actions that will affect future event Financial ratios 1. Help evaluate a financial statement 2. Facilitate comparison of firms
  • Uses 1.      Managers – to help analyze, control, improve a firm’s operations 2.      Credit analysts – to help ascertain a company’s ability to pay its debts 3.      Stock analysts – to determine a company’s efficiency, risk and growth potential
  • Liquidity Ratios: Current Ratio Quick (Acid Test) Ratio Cash Ratio Net Working Capital to Total Assets Leverage Ratios: Total Debt Ratio Debt to Equity Ratio Equity Multiplier Long-term Debt Ratio Times Interest Earned Ratio Cash Coverage Ratio Activity (Turnover) Ratios: Inventory Turnover Days’ Sales in Inventory Receivables Turnover Days’ Sales in Receivables NWC Turnover Fixed Asset Turnover Total Asset Turnover Profitability Ratios: Profit Margin Return on Assets Return on Equity Valuation Ratios: Price to Earnings Market to Book
  • DuPont Chart and Equation - Tie the Ratios Together Shows how profit margin, asset turnover ratio, and equity multiplier determine ROE Shows how expense control (profit margin), efficient use of assets in production (asset turnover) and capital structure (equity multiplier) affect return on equity. Ties together all aspects of firm - production and financing.
  • Notice that using more debt (and less equity) to finance assets raises the Equity Multiplier. This has two effects for stockholders. The Equity Multiplier acts as a lever to magnify the effects of ROA on returns for stockholders. If ROA is positive, ROE is a larger positive value, but if ROA is negative ROE is a larger negative. Raising the s magnifying effect also raises the risk for stockholders.
  • Return on Assets is affected by two areas of operations. The Profit Margin measures the degree to which the firm controls expenses. Since expenses comprise the difference between Sales and Net Income, lowering the expenses taken out of each dollar of sales raises the Profit Margin. At the same time, Return on Assets can be raised by producing sales by using fewer assets. Asset Turnover measures the dollar of sales produced with each dollar invested in assets. This is often thought of as sales volume. Different industries achieve ROA in different ways. Some have low profit margins but high volume, e.g. grocery stores. Others have lower volume but are able to maintain higher profit margins, e.g. car dealerships.

C:\Fakepath\44 Ratio Analysis 1 C:\Fakepath\44 Ratio Analysis 1 Presentation Transcript

  • Ratio Analysis Accounting for Managers
  • Financial Analysis
    • Assessment of the firm’s past, present and future financial conditions
    • Done to find firm’s financial strengths and weaknesses
    • Primary Tools:
      • Financial Statements
      • Comparison of financial ratios to past, industry, sector and all firms
  • Objectives of Ratio Analysis
    • Standardize financial information for comparisons
    • Evaluate current operations
    • Compare performance with past performance
    • Compare performance against other firms or industry standards
    • Study the efficiency of operations
    • Study the risk of operations
  • Uses for Ratio Analysis
    • Evaluate Bank Loan Applications
    • Evaluate Customers’ Creditworthiness
    • Assess Potential Merger Candidates
    • Analyze Internal Management Control
    • Analyze and Compare Investment Opportunities
  • Types of Ratios
    • Financial Ratios:
      • Liquidity Ratios
        • Assess ability to cover current obligations
      • Leverage Ratios
        • Assess ability to cover long term debt obligations
    • Operational Ratios:
      • Activity (Turnover) Ratios
        • Assess amount of activity relative to amount of resources used
      • Profitability Ratios
        • Assess profits relative to amount of resources used
    • Valuation Ratios:
        • Assess market price relative to assets or earnings
  • Liquidity Ratios
    • Current Ratio
      • Current Assets / Current Liabilities
        • Current Assets include Cash, Marketable Securities, Accounts Receivable and Inventory
        • Current Liabilities include Accounts Payable, Debt Due within one year, and Other Current Liabilities
  • Liquidity Ratios
    • Quick Ratio or Acid Test
      • Current Assets minus Inventory / Current Liabilities
      • A more precise measure of liquidity, especially if inventory is not easily converted into cash.
  • Liquidity Ratios
    • Cash Ratio
      • Reserve borrowing capacity - the credit limit sanctioned by the bank
  • Liquidity Ratios
    • Interval Measure
      • Calculated to asses a firms ability to meet its regular cash outgoings
  • Leverage Ratios
    • Leverage ratios measure the extent to which a firm has been financed by debt.
    • Leverage ratios include:
      • Debt Ratio
      • Debt--Equity Ratio
    • Generally, the higher this ratio, the more risky a creditor will perceive its exposure in your business. Thus, high leverage ratios make it more difficult to obtain credit (loans).
  • Leverage Ratios Cont.
    • Leverage ratios also include the Interest-coverage Ratio, Fixed coverage Ratio etc, .
    • In contrast to the leverage ratios discussed on previous slide, the higher the Interest Coverage Ratio (Times-Interest-Earned Ratio), the more credit worthy the firm is, and the easier it will be to obtain credit (loans).
  • Total Debt Ratio
      • Proportion of interest bearing debt in the Capital structure.
      • In general, the lower the number, the better.
  • Debt-Equity Ratio
    • The Debt-Equity Ratio indicates the percentage of total funds provided by creditors versus by owners.
    • This ratio indicates the extent to which the business relies on debt financing (creditor money versus owner’s equity).
    • Treatment of
      • Preference Capital
      • Lease Payments
  • Interest Coverage Ratio
    • interest coverage ratio indicates the extent to which earnings can decline without the firm becoming unable to meet its annual interest costs.
    • Also called the Times-Interest-Earned Ratio , this calculation shows how many times the firm could pay back (or cover) its annual interest expenses out of earnings before interest and taxes (EBIT).
  • Interest Coverage Ratio DA = Depreciation and Amortization expenses
  • Fixed Coverage Ratio
      • Principal repayments are added to interest payments
  • Activity Ratios
    • Activity ratios measure how effectively a firm is using its resources, or how efficient a company is in its operations and use of assets.
    • In general, the higher the ratio, the better.
    • Activity ratios include:
      • Inventory turnover
      • Accounts receivable turnover
      • Average collection period .
      • Total assets turnover
      • Fixed assets turnover
  • Inventory Turnover Ratio
    • The inventory turnover ratio indicates how fast a firm is selling its inventories
    • This ratio indicates how well inventory is being managed, which is important because the more times inventory can be turned (i.e., the higher the turnover rate) in a given operating cycle, the greater the profit.
  • Inventory Turnover Ratio Cont.
      • In the absence of information. Instead of CGS we can use Sales
      • In the case of CGS and Inventory both are valued at cost. While the sales are valued at market prices
      • Therefore better to use CGS
  • Accounts Receivable Turnover
    • The accounts receivable turnover ratio, indicates the average length of time it takes a firm to collect credit sales (in percentage terms), i.e., how well accounts receivable are being collected.
    • If receivables are excessively slow in being converted to cash, liquidity could be severely impaired.
  • Average Collection Period
    • The average collection period is the average length of time (in days) it takes a firm to collect on credit sales.
  • Net Assets Turnover
      • The total assets turnover ratio, indicates how efficiently a firm is using all its assets to generate revenues.
      • This ratio helps to signal whether a firm is generating a sufficient volume of business for the size of its asset investment
  • Profitability Ratios
    • Profitability ratios measure management’s overall effectiveness as shown by returns generated on sales and investment.
    • Profitability ratios include
      • Gross profit margin
      • Operating profit margin
      • Net profit margin
      • Return on total assets (ROA)
      • Return on stockholders’ equity (ROE)
      • Earnings per share (EPS)
      • Price-earnings ratio (P/E).
  • Gross Profit Margin
    • The gross profit margin is the total margin available to cover operating expenses and yield a profit. This ratio indicates how efficiently a business is using its labor and materials in the production process, and shows the percentage of net sales remaining after subtracting cost of goods sold.
    • The higher the ratio, the better. A high gross profit margin indicates that a firm can make a reasonable profit on sales, as long as it keeps overhead costs under control.
  • The DuPont System
    • Method to breakdown ROE into:
      • ROA and Equity Multiplier
    • ROA is further broken down as:
      • Profit Margin and Asset Turnover
    • Helps to identify sources of strength and weakness in current performance
    • Helps to focus attention on value drivers
  • The DuPont System
  • The DuPont System
  • The DuPont System
  • The DuPont System