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.
Financial Statement Analysis
Financial Statement 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
Horizontal, Vertical, & Trend Analysis• Horizontal Analysis = calculating the Rupee change and % change in financial statement amounts across time• Vertical Analysis (Common Size Analysis) = changing all Rupee values for accounts to % values.• Trend Analysis = Using the “first” year as a base year, calculate future year Rupee values as a ratio.
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 Current Assets 1870.92 Current Ratio = = = 1.2 : 1 Current Liabilities 1555.75
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. Current Assets - Inventory 720.53 Quik Ratio = = = 0.46 : 1 Current Liabilities 1555.75
Liquidity Ratios• Cash Ratio Cash + Marketable Securities 26.08Cash Ratio = = = 0.17 Current Liabilities 1555.75
Liquidity Ratios•Interval Measure •Calculated to asses a firms ability to meet its regular cash outgoings Current Assets − InventoryInterval Measure = Average Daily operating expenses 1,870.92 − 1,150.39 = = 77 Days 3,369.94 / 360
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. Total Debt Debt Ratio = Net Assets 1,229.06 = = 0.646 1901.87
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). Total Debt 1,229.06 Debt − Equity Ratio = = = 1.83 Net Worth 972.81
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). EBIT 342.61 Interest Coverage Ratio = = = 2.4 Interest 143.46
Interest Coverage Ratio EBITDA 342.61 + 41.59Interest Coverage Ratio = = = 2.7 Interest 143.46 DA = Depreciation and Amortization expenses
Fixed Coverage Ratio (OR) Debt Service Coverage Ratio (DSCR) – Principal repayments are added to interest payments• EBITDA Fixed Coverage Ratio = Interest + LoanTax Rate 1- repayment EBITDA Fixed Coverage Ratio = Interest + Lease rentals + Loan repayment+Rate Dividend 1-Tax Pref.
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. Cost of Goods Sold 3,053.66 Inventory Turnover Ratio = = = 8.6 Avg Inventory (244.26 + 7461.81) / 2 360 Days of Inventory Holding = = 42 days Inventory Turnover
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. Credit Sales A R Turnover = Avg AR Sales 3,717.23 = = = 7.7 Avg AR 483.18
Average Collection Period– The average collection period is the average length of time (in days) it takes a firm to collect on credit sales. 360 ACP = = 47 days AR Turnover
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 Sales 3,717.23 Net Assets Turnover = = = 1.95 times Net Assets 1901.87
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)
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. Gross Profit 663.57 GP Margin = = = 0.179 or 17.9% Sales 3,717.23
Operating Profit Margin– The Operating Profit Margin measures profitability without concern for taxes and interest.– The higher the ratio, the better. A high operating profit margin indicates that a firm can make a reasonable profit on sales, as long as it does good tax planning. EBIT 342.61 OP Margin = = = 0.092 or 9.2% Sales 3,717.23
Net Profit Margin– The net profit margin shows the after-tax profits per rupee of sales.– The higher the ratio, the better. PAT 134.86 NP Margin = = = 0.036 or 3.6% Sales 3,717.23
Return on Investment (ROI) OR Return on Capital Employed (ROCE)– The return on total assets ratio shows the after-tax profits per dollar of assets; this is also called return on investment (ROI).– The ROI is perhaps the most important ratio of all. It is the percentage of return on money invested in the business. The ROI should always be higher than the rate of return on an alternative, risk-free investment.– The higher the ratio, the better. EBIT 342.61 ROI = = = 0.18 or 18% Capital Employed 1,901.87
Return on Shareholders’ Equity– The net profit margin shows the after-tax profits per rupee of sales.– The higher the ratio, the better. PAT 134.86 ROE = = = 0.20 or 20% Net Worth 672.81
Market Valuation Ratios– Earnings per share (EPS)– Price-earnings ratio (P/E).– Dividend Yield– Market to Book Ratio
Earnings Per Share (EPS)– The Profitability of the common shareholders’ Investment.– The higher the ratio, the better.– Adjust for the bonus issues PAT EPS = No of common shares outstanding 134.86 = = Rs. 6.00 22.50
Dividends Per Share (DPS)– Earnings distributed to the shareholders’ as cash dividends.– The higher the ratio, the better.– . Dividends Paid to Shareholders DPS = No of common shares outstanding 45.00 = = Rs. 2.00 22.50
Dividend Payout Ratio & Retention Ratio DPS Payout Ratio = EPS 2 = = 0.33 or 33% 6Retention Ratio = 1- Payout RatioGrowth in Equity = Retention Ratio * ROE
Market Valuation Measures• Dividend Yield – Dividend / Market Value per Share • payout declared as a percentage of the stock price• Earnings Yield – EPS / Market Value per Share – Dividend and Earnings yield evaluate the shareholders’ return in relation to the market value of the share
Price-Earnings Ratio– Measure of optimism or pessimism about firm’s future. – High PE Ratio indicates optimism – Low PE Ratio indicates pessimism Market Value of the Share P / E Ratio = EPS 29.25 = = Rs. 4.88 times 6
• Market Value to Book Value Ratio – Stock price / book value per share • The number of times the market values the stock over its paid-in capital and retained earnings.
Ratio Analysis Limitations• Financial ratios are based on accounting data, and firms differ in their treatment of such items as depreciation, inventory valuation, research and development expenditures, pension plan costs, mergers, and taxes.• Reflects Book Value• Does not take size differences of companies into account• Identifies problem areas, but not causes
Limitations Seasonal factors can influence comparative ratios. A firm’s financial condition depends not only on the functions of finance, but also on many other factors such as Management, marketing, production/operations, R&D, and MIS decisions Actions by competitors, suppliers, distributors, creditors, customers, and shareholders Economic, social, cultural, demographics, environmental, political, governmental, legal, and technological trends.
Cautions in using Ratio Analysis• Company differences• Price Level• Different Definitions• Changing Situations• Past Data
Dupont Analysis• ROE is a closely watched number• It is a strong measure of how well the management of a company creates value for its shareholders• The number can be misleading• Due to its vulnerability to measures that increase its value while making the stock risky• Without a way of breaking down the components of ROE, investors could be duped into believing a company is a good investment when it is not.
The DuPont System• Method to breakdown ROE into: – ROI and Equity Multiplier• ROI 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 ROE ROI Equity MultiplierProfit Margin Total Asset Turnover
The DuPont System ROE ROA Equity Multiplier Profit Margin Total Asset TurnoverROE = ROA × Equity Multiplier Net Income Total Assets = × Total Assets Common Equity
The DuPont System ROE ROA Equity Multiplier Profit Margin Total Asset TurnoverROA = Profit Margin × Total Asset Turnover Net Income Sales = × Sales Total Assets
The DuPont System ROE ROA Equity Multiplier Profit Margin Total Asset TurnoverROE = Profit Margin × Total Asset Turnover × Equity Multiplier Net Income Sales Total Assets = × × Sales Total Assets Common Equity