Financial Ratio Analysis


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Financial Ratio Analysis

  2. 2. Ratio Analysis Presentation The format for this presentation is as follows: 1. The Basics of Financial Ratios 2. Interpreting Financial Ratios 3. Making those Interpretations more Meaningful
  3. 3. The Basics of Financial Ratios
  4. 4. Financial Ratios, what are they? <ul><li>Financial Ratios are specific tools which can be used to make more educated </li></ul><ul><li>investment decisions. </li></ul><ul><li>Financial Ratios provide a method to make more meaningful evaluations of a </li></ul><ul><li>companies financial condition. </li></ul><ul><li>Financial Ratios express relationships among items found in financial statements. </li></ul><ul><li>Information from these items may not be apparent when examined individually. </li></ul>
  5. 5. Categorizing Financial Ratios <ul><li>Financial Ratios can be categorized into one of four groups, their classification </li></ul><ul><li>is dependant the information they display to the user. </li></ul><ul><li>These four categories are: </li></ul><ul><li>1. Profitability Ratios </li></ul><ul><li>2. Liquidity Ratios </li></ul><ul><li>3. Solvency Ratios </li></ul><ul><li>4. Cash Flow Ratios </li></ul>
  6. 6. Profitability Ratios <ul><li>Profitability ratios measure the income or operating success of a company for a given period of time. </li></ul><ul><li>Profitability Ratios make use of the statement of earnings. </li></ul><ul><li>Examples of Profitability Ratios include: </li></ul><ul><li>- Return on Assets </li></ul><ul><li>- Profit Margin </li></ul>
  7. 7. Return on Assets and Profit margin Return on Assets = Net Earnings/Average Assets The return on assets ratio indicates the amount of net earnings generated by each dollar invested in assets. This ratio also indicates how efficiently the company is using their assets to generate profits. Profit Margin Ratio = Net Earnings/Net Sales The profit margin ratio indicates the percentage of each dollar of sales that results in net earnings.
  8. 8. Liquidity Ratios <ul><li>Liquidity Ratios measure the short term ability of a company to meet current </li></ul><ul><li>obligations. </li></ul><ul><li>Liquidity Ratios make use of the balance sheet </li></ul><ul><li>Examples of Liquidity Ratios </li></ul><ul><li>- Current Ratio </li></ul><ul><li>- Quick (or Acid) Ratio </li></ul>
  9. 9. Current and Quick Ratios Current Ratio = Current Assets/Current Liabilities The Current Ratio measures a companies ability to meet short term liabilities with short term (or current) assets. This is an important indicator to an investor as it allows him or her to see if the company will be able to operate through its obligations. Quick (Acid) Ratio = One step removed from Current Assets/Current Liabilities The Quick Ratio removes uncertainty about the composition of the current assets. This is done by removing inventories from the ratio, Inventories may be slow moving and therefore not truly represent a companies ability to meet obligations.
  10. 10. Solvency Ratios <ul><li>Solvency Ratios measure the ability of a company to meet long term obligations. </li></ul><ul><li>Solvency Ratios are important to long term investors and creditors. </li></ul><ul><li>Examples of Solvency Ratios </li></ul><ul><li>- Debt to Total Asset Ratio </li></ul><ul><li>- Debt to Shareholders Equity Ratio </li></ul>
  11. 11. Debt to Total Assets Ratio and Debt to Shareholder’s Equity Ratio Debt to Total Assets Ratio = Total Liabilities/Total Assets The debt to total assets ratio measures the percentage of assets financed by creditors rather than shareholders. A higher percentage of debt financing leads to higher risk when investing. Debt to Shareholder’s Equity Ratio = Total Liabilities/Total Shareholder Equity The higher the debt to shareholder’s equity ratio the less solvent the company, meaning the company runs a greater risk of not being able to repay long term debt at maturity date.
  12. 12. Cash Flow Ratios <ul><li>Cash flow is the single most important aspect of a companies financial condition, </li></ul><ul><li>it is important to know how the cash was generated and where it is being spent. </li></ul><ul><li>Cash is primarily generated from two different avenues: </li></ul><ul><li>- operating activities </li></ul><ul><li>- financing activities </li></ul><ul><li>Cash flow ratios calculate additional measures of liquidity and solvency. </li></ul><ul><li>Examples of Cash Flow Ratios are: </li></ul><ul><li>- cash current debt coverage ratio </li></ul><ul><li>- cash total debt coverage ratio </li></ul>
  13. 13. Cash Current Debt Coverage Ratio and Cash Total Debt Coverage Ratio Cash Current Debt Coverage Ratio = Cash Provided by Operating Activities/ Average Current Liabilities The cash current debt coverage ratio measures the companies ability to generate cash to cover short term liabilities. Cash Total Debt Coverage Ratio = Cash Provided by Operating Activities/ Average Total Liabilities The cash total debt coverage ratio measures the companies ability to generate cash to cover long term liabilities.
  14. 14. Interpreting Financial Ratios
  15. 15. What We Know Now <ul><li>So far we know what different ratios calculate and what they indicate, </li></ul><ul><li>but what is a good number? </li></ul><ul><li>Some texts suggest numbers, why do they suggest these numbers? </li></ul><ul><li>How can we use these numbers to make informative decisions? </li></ul>
  16. 16. <ul><li>The value in financial ratios does not lie in the number itself but rather in </li></ul><ul><li>comparisons with other computed ratios. </li></ul><ul><li>Comparisons can take on different forms, such as the following: </li></ul><ul><li>1. Comparison from year to year for the company of interest. This </li></ul><ul><li>can demonstrate the direction of change of the ratios over a time </li></ul><ul><li>period, possibly leading to an indication of the companies financial </li></ul><ul><li>health. </li></ul><ul><li>2. Comparisons from one company to another, comparing your company to the competition. </li></ul><ul><li>3. Comparisons to a “Universe of Coverage” </li></ul>Interpretations of Financial Ratios
  17. 17. The “Universe of Coverage” <ul><li>I would suggest that one of the most useful comparisons investors can make </li></ul><ul><li>is comparing their companies ratios to ratios in a “Universe of Coverage.” </li></ul><ul><li>A universe of coverage is a collection of companies which via some type of </li></ul><ul><li>defining term allots the company either inside or outside the universe of </li></ul><ul><li>coverage. </li></ul><ul><li>The universe of coverage can be detailed to include only the most direct </li></ul><ul><li>competition providing a better industry average than traditional industry </li></ul><ul><li>definitions allow for. </li></ul><ul><li>A universe of coverage is determined by the investor allowing him or her to </li></ul><ul><li>dictate what type of companies should be included in his comparisons. </li></ul>
  18. 18. An Example of a Universe of Coverage <ul><li>With the EnCana Corp. being my company of interest I defined my universe of </li></ul><ul><li>coverage based on what qualities I knew EnCana had as a company in the </li></ul><ul><li>upstream oil and gas industry. </li></ul><ul><li>EnCana is an independent oil and gas company (as opposed to Petro-Canada </li></ul><ul><li>who has involvement in the upstream, midstream and downstream segments of </li></ul><ul><li>the oil and gas industry), therefore my universe of coverage need only include </li></ul><ul><li>independent upstream oil and gas companies. </li></ul><ul><li>Further information was used in determining the universe of coverage for </li></ul><ul><li>comparing EnCana to meaningful competition. In the end I defined my universe </li></ul><ul><li>of coverage as “Independent Upstream Oil and Gas Companies producing more </li></ul><ul><li>than x barrels of oil and gas equivalents per day per U.S. dollar. </li></ul>
  19. 19. Further information regarding the Universe of Coverage <ul><li>So what does this mean for ratio analysis? It is fundamentally important to </li></ul><ul><li>compare companies which an investor would assume operate under similar </li></ul><ul><li>business conditions. </li></ul><ul><li>For example, comparing hedging contracts between a junior upstream oil and gas producer and a senior upstream oil and gas producer would have a dramatic effect on conclusions drawn concerning cash flow. Total liabilities between junior and senior producers may not vary in the same degree as total </li></ul><ul><li>assets (due to hedging). </li></ul><ul><li>Furthermore, a universe of coverage defines industry in much more specific way, just as it would be ridiculous to compare an oil and gas company to a software company, it would be ridiculous to compare junior and senior oil and gas producers. </li></ul>
  20. 20. The following graphs are comparisons of some ratios for EnCana’s Universe of Coverage. A graphical example of Comparisons within a Universe of Coverage
  21. 21. Debt to Equity Ratio Comparison for our Independent Upstream Oil and Gas Universe of Coverage
  22. 22. Quick Ratio Comparison for our Independent Upstream Oil and Gas Universe of Coverage
  23. 23. Current Ratio Comparison for our Independent Upstream Oil and Gas Universe of Coverage
  24. 24. Making Interpretations More Meaningful
  25. 25. Further Ways to Make Interpretations more Meaningful Given that we have defined a universe of coverage, what else can lead to misinformed results? Accounting procedures can dramatically affect the results of the ratios and their meanings. In order to further improve our comparison we need to improve the comparability of the ratios.
  26. 26. Increasing Comparability <ul><li>I would suggest that the value of the ratios do not actually lie within the number, </li></ul><ul><li>but rather in what the number represents. We need to change the components </li></ul><ul><li>of the ratios so that include the same elements and do not include extras. </li></ul><ul><li>This information can primarily be found in the notes to the financial statements. </li></ul><ul><li>For example, hypothetically imagine the following circumstance. American airlines has acquired its fleet through various financing projects and cash contributions, they then record the airplanes as an asset and depreciate them accordingly. Now Imagine that Air Canada has decided to lease its fleet and record the cost of their Fleet as an expense. Assuming that these companies were of similar size and fall in the same universe of coverage, it would be more correct to use a Net Present Value Of Money function to estimate the cost of Air Canada’s fleet and depreciate it accordingly. This would change asset numbers to make the two companies more comparable. </li></ul>
  27. 27. Summary Financial Ratio Analysis should play a key role in any investors decision making process, but the results of these ratios can be improved by allocating a “ Universe of Coverage ” and making elements of ratio computations more “ Comparable .”