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Analyze Financial Performance with Ratio Analysis
- 2. Purpose of Ratio Analysis • Evaluate management performance in three areas: – Profitability – Efficiency – Risk
- 3. Analysis of Financial Ratios • Ratios are more informative than raw numbers • Ratios provide meaningful relationships between individual values in the financial statements
- 4. Importance of Relative Financial Ratios • Compare to other entities • Examine a firm’s performance relative to: – The aggregate economy – Its industry or industries – Its major competitors within the industry – Its past performance (time-series analysis)
- 5. Comparing to The Aggregate Economy • Most firms are influenced by economic expansions and contractions in the business cycle • Analysis helps you estimate the future performance of the firm during subsequent business cycles
- 6. Comparing to A Firm’s Industry • Most popular comparison • Industries affect the firms within them differently, but the relationship is always significant • The industry effect is strongest for industries with homogenous products • Examine the industry’s performance relative to aggregate economic activity
- 7. Comparing to A Firm’s Major Competitors • Industry averages may not be representative • Select a subset of competitors to compare to using cross-sectional analysis, or • Construct a composite industry average from industries the firm operates in
- 8. Comparing to A Firm’s Historical Performance • Determine whether it is progressing or declining • Helpful for estimating future performance • Consider trends as well as averages over time
- 9. Five Categories of Financial Ratios 1. Internal liquidity (solvency) 2. Operating performance – a. Operating efficiency – b. Operating profitability 3. Risk analysis – a. Business risk – b. Financial risk
- 10. Five Categories of Financial Ratios 4. Growth analysis
- 11. Five Categories of Financial Ratios 5. External liquidity (marketability)
- 12. Common Size Statements • Normalize balance sheets and income statement items to allow easier comparison of different size firms • A common size balance sheet expresses accounts as a percentage of total assets • A common size income statement expresses all items as a percentage of sales
- 13. Evaluating Internal Liquidity • Internal liquidity (solvency) ratios indicate the ability to meet future short-term financial obligations • Current Ratio examines current assets and current liabilities s Liabilitie Current Assets Current Ratio Current =
- 14. Evaluating Internal Liquidity • Quick Ratio adjusts current assets by removing less liquid assets s Liabilitie Current s Receivable Securities Marketable Cash Ratio Quick + + =
- 15. Evaluating Internal Liquidity • Cash Ratio is the most conservative liquidity ratio s Liabilitie Current Securities Marketable Cash Ratio Cash + =
- 16. Evaluating Internal Liquidity • Receivables turnover examines the quality of accounts receivable s Receivable Average Sales Annual Net Turnover s Receivable = • Receivables turnover can be converted into an average collection period Turnover Annual 365 Period Collection s Receivable Average =
- 17. Evaluating Internal Liquidity • Inventory turnover relates inventory to sales or cost of goods sold (CGS) Inventory Average Sold Goods of Cost Turnover Inventory = • Given the turnover values, you can compute the average inventory processing time Average Inventory Processing Period = 365/Annual Turnover
- 18. Evaluating Internal Liquidity • Cash conversion cycle combines information from the receivables turnover, inventory turnover, and accounts payable turnover Receivable Days +Inventory Processing Days -Payables Payment Period Cash Conversion Cycle
- 19. Evaluating Operating Performance • Ratios that measure how well management is operating a business – (1) Operating efficiency ratios • Examine how the management uses its assets and capital, measured in terms of sales dollars generated by asset or capital categories – (2) Operating profitability ratios • Analyze profits as a percentage of sales and as a percentage of the assets and capital employed
- 20. Operating Efficiency Ratios • Total asset turnover ratio indicates the effectiveness of a firm’s use of its total asset base (net assets equals gross assets minus depreciation on fixed assets) Assets Net Total Average Sales Net Turnover Asset Total =
- 21. Operating Efficiency Ratios • Net fixed asset turnover reflects utilization of fixed assets Assets Fixed Net Average Sales Net Turnover Asset Fixed =
- 22. Operating Profitability Ratios • Operating profitability ratios measure – 1. The rate of profit on sales (profit margin) – 2. The percentage return on capital
- 23. Operating Profitability Ratios • Gross profit margin measures the rate of profit on sales (gross profit equals net sales minus the cost of goods sold) Sales Net Profit Gross Margin Profit Gross =
- 24. Operating Profitability Ratios • Operating profit margin measures the rate of profit on sales after operating expenses (operating profit is gross profit minus sales, general and administrative (SG + A) expenses) Sales Net Profit Operating Margin Profit Operating =
- 25. Operating Profitability Ratios • Net profit margin relates net income to sales Sales Net Income Net Margin Profit Net =
- 26. Operating Profitability Ratios • Return on total capital relates the firm’s earnings to all capital in the enterprise Capital Total Average Expense Interest Income Net Capital Total on Return + =
- 27. Operating Profitability Ratios • Return on owner’s equity (ROE) indicates the rate of return earned on the capital provided by the stockholders after paying for all other capital used Equity Total Average Income Net Equity Total on Return =
- 28. Operating Profitability Ratios • Return on owner’s equity (ROE) can be computed for the common- shareholder’s equity Equity Common Average Dividend Preferred - Income Net Equity s Owner' on Return =
- 29. Operating Profitability Ratios • The DuPont System divides the ratio into several components that provide insights into the causes of a firm’s ROE and any changes in it Equity Common Sales Net Sales Net Income Net Equity Common Income Net ROE  = = Equity Assets Total Assets Total Sales Equity Sales  =
- 30. Operating Profitability Ratios Equity Common Assets Total Assets Total Sales Sales Income Net Equity Common Income Net ï‚´ ï‚´ = = Profit Total Asset Financial Margin Turnover Leverage = x x
- 31. Operating Profitability Ratios • An extended DuPont System provides additional insights into the effect of financial leverage on the firm and pinpoints the effect of income taxes on ROE
- 32. Operating Profitability Ratios • An extended DuPont System provides additional insights into the effect of financial leverage on the firm and pinpoints the effect of income taxes on ROE • We begin with the operating profit margin (EBIT divided by sales) and introduce additional ratios to derive an ROE value
- 34. Operating Profitability Ratios Assets Total EBIT Assets Total Sales Sales EBIT = ï‚´ This is the operating profit return on total assets. To consider the negative effects of financial leverage, we examine the effect of interest expense as a percentage of total assets
- 36. Operating Profitability Ratios Assets Total EBIT Assets Total Sales Sales EBIT =  Assets Total Tax Before Net Assets Total Expense Interest Assets Total EBIT = − We consider the positive effect of financial leverage with the financial leverage multiplier
- 38. Operating Profitability Ratios Assets Total EBIT Assets Total Sales Sales EBIT =  Assets Total Tax Before Net Assets Total Expense Interest Assets Total EBIT = − Equity Common (NBT) Tax Before Net Equity Common Assets Total Assets Total (NBT) Tax Before Net =  This indicates the pretax return on equity. To arrive at ROE we must consider the tax rate effect.
- 40. Operating Profitability Ratios In summary, we have the following five components of return on equity (ROE)
- 42. Operating Profitability Ratios Margin Profit Operating Sales EBIT . 1 = Turnover Asset Total Assets Total Sales . 2 =
- 43. Operating Profitability Ratios Margin Profit Operating Sales EBIT . 1 = Turnover Asset Total Assets Total Sales . 2 = Rate Expense Interest Assets Total Expense Interest . 3 =
- 44. Operating Profitability Ratios Margin Profit Operating Sales EBIT . 1 = Turnover Asset Total Assets Total Sales . 2 = Rate Expense Interest Assets Total Expense Interest . 3 = Multiplier Leverage Financial Equity Common Assets Total . 4 =
- 45. Operating Profitability Ratios Margin Profit Operating Sales EBIT . 1 = Turnover Asset Total Assets Total Sales . 2 = Rate Expense Interest Assets Total Expense Interest . 3 = Multiplier Leverage Financial Equity Common Assets Total . 4 = Rate Retention Tax Tax Before Net Taxes Income % 100 . 5 =       −
- 46. Risk Analysis • Risk analysis examines the uncertainty of income flows for the total firm and for the individual sources of capital – Debt – Preferred stock – Common stock
- 47. Risk Analysis • Total risk of a firm has two components: – Business risk • The uncertainty of income caused by the firm’s industry • Generally measured by the variability of the firm’s operating income over time – Financial risk • Additional uncertainty of returns to equity holders due to a firm’s use of fixed obligation debt securities • The acceptable level of financial risk for a firm depends on its business risk
- 48. Business Risk • Variability of the firm’s operating income over time
- 49. Business Risk • Variability of the firm’s operating income over time • Standard deviation of the historical operating earnings series
- 50. Business Risk • Two factors contribute to the variability of operating earnings – Sales variability • Earnings must be as volatile as sales • Some industries are cyclical – Operating leverage • Production has fixed and variable costs • Fixed production costs cause profit volatility with changes in sales • Fixed production costs are operating leverage
- 51. Financial Risk • Bonds interest payments come before earnings are available to stockholders • These are fixed obligations • Similar to fixed production costs, these lead to larger earnings during good times, and lower earnings during a business decline • This debt financing increases the financial risk and possibility of default
- 52. Financial Risk • Two sets of financial ratios help measure financial risk – Balance sheet ratios – Earnings or cash flow available to pay fixed financial charges • Acceptable levels of financial risk depend on business risk
- 53. Financial Risk • Proportion of debt (balance sheet) ratios
- 54. Financial Risk • Proportion of debt (balance sheet) ratios Equity Total Debt Term - Long Total Ratio Equity - Debt =
- 55. Financial Risk • Proportion of debt (balance sheet) ratios This may be computed with and without deferred taxes Equity Total Debt Term - Long Total Ratio Equity - Debt =
- 56. Financial Risk • Long-term debt/total capital ratio indicates the proportion of long-term capital derived from long-term debt capital
- 57. Financial Risk • Long-term debt/total capital ratio indicates the proportion of long-term capital derived from long-term debt capital Capital Term - Long Total Debt Term - Long Total Ratio Capital L.T. Total - Debt L.T. =
- 58. Financial Risk • Total debt ratios compare total debt (current liabilities plus long-term liabilities) to total capital (total debt plus total equity)
- 59. Financial Risk • Total debt ratios compare total debt (current liabilities plus long-term liabilities) to total capital (total debt plus total equity) Capital Total Debt Interest Total Capital Debt/Total Bearing - Interest Total =
- 60. Financial Risk • Earnings or Cash Flow Ratios – Relate the flow of earnings – Cash available to meet the payments – Higher ratio means lower risk
- 61. Financial Risk • Interest Coverage
- 62. Financial Risk • Interest Coverage Charges Interest Debt (EBIT) Taxes and Interest Before Income =
- 63. Financial Risk • Interest Coverage Charges Interest Debt (EBIT) Taxes and Interest Before Income = Expense Interest Expense Interest Taxes Income Income Net + + =
- 64. Financial Risk • Firms may also have non-interest fixed payments due for lease obligations • The risk effect is similar to bond risk • Bond-rating agencies typically add 1/3 lease payments as the interest component of the lease obligations
- 65. Financial Risk • Total fixed charge coverage includes any noncancellable lease payments and any preferred dividends paid out of earnings after taxes
- 66. Financial Risk • Total fixed charge coverage includes any noncancellable lease payments and any preferred dividends paid out of earnings after taxes Rate) Tax - 1 Dividend/( Preferred Payments Lease Interest Debt Payments Lease and Taxes, Interest, Before Income Coverage Charge Fixed + + =
- 67. Financial Risk • Cash flow ratios relate the flow of cash available from operations to either interest expense, total fixed charges, or the face value of outstanding debt
- 71. External Market Liquidity • Market Liquidity is the ability to buy or sell an asset quickly with little price change from a prior transaction assuming no new information • External market liquidity is a source of risk to investors
- 72. External Market Liquidity Determinants of Market Liquidity • The dollar value of shares traded – This can be estimated from the total market value of outstanding securities – It will be affected by the number of security owners – Numerous buyers and sellers provide liquidity
- 73. External Market Liquidity • Trading turnover (percentage of outstanding shares traded during a period of time)
- 74. External Market Liquidity • A measure of market liquidity is the bid-ask spread
- 75. Analysis of Growth Potential • Creditors are interested in the firm’s ability to pay future obligations • Value of a firm depends on its future growth in earnings and dividends
- 76. Determinants of Growth • Resources retained and reinvested in the entity • Rate of return earned on the resources retained = RR x ROE where: g = potential growth rate RR = the retention rate of earnings ROE = the firm’s return on equity Equity on Return Retained Earnings of Percentage g  =
- 77. Determinants of Growth • ROE is a function of – Net profit margin – Total asset turnover – Financial leverage (total assets/equity)
- 78. Comparative Analysis of Ratios • Internal liquidity – Current ratio, quick ratio, and cash ratio • Operating performance – Efficiency ratios and profitability ratios • Financial risk • Growth analysis
- 79. Limitations of Financial Ratios • Accounting treatments may vary among firms, especially among non-U.S. firms • Firms may have have divisions operating in different industries making it difficult to derive industry ratios • Results may not be consistent • Ratios outside an industry range may be cause for concern
- 80. Probasic Company has the following balance sheet and income statement for 2009. Using these statements accomplish the following requirements. Requirements: I. Calculate the average receivables collection period, earning per share and debt to equity ratios with analysis. II. The DuPont System divides the ratio into several components that provide insights into the causes of a firm’s ROE and any changes in it. Execute the DuPont analysis.
- 81. INCOME STATEMENT 2009 Sales Revenue $1,000,000 Less: Cost of Goods Sold $600,000 Gross Profits $400,000 Less: Operating Expenses: Selling & Distribution Expense $50,000 Administrative Expense $25,000 Total Operating Expenses $75,000 Operating Profits $325,000 Less: Interest Expense $60,000 Add: Non-Operating Income $10,000 Less: Workiers' P.P. Fund & Welfare Fund $6,000 Net Profits Before Taxes $269,000 Less: Taxes $94,150 Net Profit After Taxes $174,850 Less: Pref. Stock Divds. $0 Earnings Available for Common Stockholders $174,850
- 82. BALANCE SHEET 2009 Current Assets: Current Liabilities: Cash $404,684 Accounts Payable $257,943 Marketable Securities $898,400 Bank overdraft & term loan $2,526,430 Accounts Receivable $697,970 Accruals $875,429 Inventories $4,720,081 Proposed Dividend $56,595 Total Current Assets $6,721,135 Provision for Income Tax $39,712 Gross Fixed Assets (at cost): Inter company liabilities $320,821 Land & Buildings $1,166,182 Total Current Liabilities $4,076,930 Machinery and Equipment $1,389,397 L / T Debt $374,247 Furniture & Fixtures $150,328 Total Liabilities $4,451,177 Vehicles $427,156 Reserves $1,515,620 Other $371,089 Common Stock $1,617,000 Total Gross Fixed Assets $3,504,152 Paid-In Capital In Excess of Par $2,500,224 Less: Accumulated Depreciation $1,327,528 Retained Earnings $37,583 Net Fixed Assets $2,176,624 Total Stockholders' Equity $5,670,427 Other Assets $1,223,845 Total Liabs. & Stockhldrs' Equity $10,121,604 Total Assets $10,121,604 Number of Common Shares 100,000 End-of-Year Stock Price $20.50