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# Ratios and financial analysis

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Ratios and financial analysis for management students of any university.

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### Ratios and financial analysis

1. 1. 1 Ratios and Financial Analysis Chapter 4
2. 2. 2 Ratios and Financial Analysis Ratios : Why » Comparability among firms of different sizes » Provides a profile of the firm Caution: » Economic assumption of Linearity – Proportionality » Nonlinearity can cause problems: » Fixed costs, EOQ for inventories Benchmarks: Is high Current ratio good? For whom? Industry-wide norms. Accounting Methods; Timing & Window Dressing Current ratio: 300/200 to 200/100 is it getting better?
3. 3. 3 Negative numbers Firm Payout Ratios Dividend Income A \$1,000 \$5,000 20.00% B \$1,000 \$3,000 33.33% C \$1,000 \$(5,000) -20.00% Who has the highest payout ratio ? NOT B
4. 4. 4 Common Size Statements All figures divided by the same figure Balance Sheet: Divide by Total Assets = Liabilities + Equity Income Statement: Divide by Revenue Analysis across statements (activity analysis) not possible. i.e. can not divide a Income Statement by Balance Sheet number Industry Comparison [Robert Morris Associates] Yahoo Finance
5. 5. 5 1 Activity Analysis An Income Statement ÷ A Balance Sheet Figure Inventory Turnover = Cost of Goods Sold ÷ Average Inventory Receivables Turnover = Sales ÷ Average Receivables Fixed Asset Turnover = Sales ÷ Average Fixed Assets Asset Turnover = Sales ÷ Average Total Assets [365 / Turnover] is days outstanding. More Turnover is it always good / bad Payables Turnover = Purchases ÷ Average Payables
6. 6. 6 2 Liquidity Analysis Cash Cycle= Days Inventory Outstanding + Days Receivables Outstanding - Days Payable Outstanding −−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−− Current Ratio = Quick Ratio = Cash + Marketable Securities + Accounts receivable ÷ Current Liabilities Cash flow from= Cash flow from operations operations ratio ÷ Current Liabilities −−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−− Dell: 2004 10-K Look at pages 22 and 31
7. 7. 7 3 Long term Debt and Solvency Analysis Important for Bond Covenants Debt = Short-term debt + Long-term debt Total capital = Debt + Equity Debt to Equity = Times Interest Earned = Debt Debt to total capital = Total capital Total Assets Leverage = Equity
8. 8. 8 Balance Sheet - reported Assets Equity Long-term debt Short-term debt Long-term Payables e.g. retirement benefits, Deferred taxes Short-term Payables
9. 9. 9 Balance Sheet - rearrange Assets Equity Long-term debt Short-term debt Long-term Payables e.g: retirement benefits Deferred taxes Short-term Payables Interest Paid No Interest Paid
10. 10. 10 Balance Sheet Assets Operating Liabilities Debt Equity 0 Int. Exp • (1-t) Net Income Cost/return
11. 11. 11 Returns Operating Liabilities Debt Equity 0 Int. Exp • (1-t) Net Income Cost/return After tax Interest Rate ROE ÷ ÷ = =
12. 12. 12 4-1 Profitability Analysis Gross Margin = Margin Before Interest & Taxes = Asset Turnover = Return on Assets = Sales Assets EBIT Sales Gross Profit Sales NI + (1-tax) Int Exp Assets
13. 13. 13 4–2 Profitability Analysis Return on = Total capital (ROTC) = Net Income = (EBIT – Interest Expense) (1 – tax) Return on Equity = Debt = average Debt; Equity = Average Equity
14. 14. 14 Ratios – Integrated Analysis Economic relationships: higher sales leads to higher inventories Overlap of components: Asset TO ratio is related to individual TO ratios.
15. 15. 15 Ratios as composite of other ratios Page 148
16. 16. 16 Returns Operating Liabilities Debt + Equity = Total Capital 0 Int. Exp • (1-t) + Net Income Cost/return ROTC÷ =
17. 17. 17 ROE from ROTC
18. 18. 18 ROTC from ROA
19. 19. 19 4-12 : ROE and ROA (Book) Net Income ROE = Equity NI + (1-t) Interest Exp (1-t) Interest Exp = - Equity Equity NI + (1-t) Interest Exp Assets = • Assets Equity (1-t) Interest Exp Assets - • Assets Equity (1-t) Interest Exp = ROA - Asset       Assets :page 142 last s Equity [also in 4-12]
20. 20. 20 Total leverage Components Operating Leverage • Financial Leverage Contribution Margin After Tax NOPAT = • NOPAT Net Income Contribution Margin After Tax = Net Income
21. 21. 21 M1: ROE from ROA
22. 22. 22 Total leverage Total Leverage Change in Net Income Revenue = • Net Income Change in Revenue Change in units x CM per unit x (1 - Tax rate) = Net Income Units x Unit price • Change in Units X Unit Price Units x CM per unit x = (1 - Tax rate) Net Income Contribution Margin After Tax Net Income =