Key financial ratios


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Key financial ratios

  1. 1. KEY FINANCIAL RATIOS Ratio analysis is the study of relationships among and between various financial statement accounts. The following are extracted from chapter 6, "Fundamentals of Investing" by Gitman and Joehnk, 1993. This extract should be viewed along side the attached computations for EMC Corporation, a company that BAB's has interest in and therefore should make the study more interesting, if in deed looking at numbers can be interesting. 1. Measures of Liquidity. Liquidity is the firm's ability to meet its day-to-day operating expenses and satisfy its sort-term obligations as they come due. A general overview of a company's liquidity position can often be obtained from two simple measures: current ratio and net working capital. a. Current Ratio. The current ratio is one of the most commonly cited of all financial ratios. It is computed as follows: current assets Current ratio =----------------current liabilities b. 1,754,13 6 EMC = -----------= 4.20 417,502 c. This indicates that EMC has $4.20 in short-term resources to service each dollar of current debt. This is a high number and would be considered very strong. d. Net Working Capital. Though technically not a ratio in the formal sense of the word, net working capital is often viewed as such. Actually, new working capital is an absolute measure of the liquidity that indicates the dollar amount of liquidity that indicates the dollar amount of equity in the working capital position of the firm. It is the difference between current assets and current liabilities as follows: Net Working Capital = current assets - current liabilities EMC = 1,754,136 - 417,502 = 1,336,634 (000's) In the case of EMC the Net Working Capital is substantial, however one should also determine that this is not represented by slow moving or obsolete inventory or past due accounts. Neither of these conditions appear to be the case with EMC.
  2. 2. 2. Activity Ratios. Activity ratios compare company sales to various asset categories to measure how well the company is utilizing its assets. Three of the most widely used activity ratios deal with accounts receivable, inventory and total assets. a. Accounts Receivable Turnover. Most firms invest a significant amount of capital in accounts receivable, and for this reason they are viewed as crucial corporate resources. Accounts receivable turnover is a measure of how these resources are being managed and is computed as follows: annual sales Accounts receivable turnover =------------------accounts receivable 2,273,652 EMC = ------------= 3.62 627,409 c. The number indicates that EMC has $3.62 in short term resources to service every dollar of current debt. This is a fairly high number by most standards would be considered very strong. d. Inventory Turnover. An important resource that requires considerable management attention is inventory. Control of inventory is important and is commonly assessed with the inventory turnover measure: annual sales Inventory Turnover = ------------Inventory 2,273,652 EMC = ----------- = 6.76 336,581 f. The EMC number of 6.76 indicates that goods were bought and sold about 6.76 times in the year. Generally, the higher the number the better. The less time goods spend in inventory the better the return the company is able to earn from funds tied up in inventory. A large stale inventory can distort the asset position of the company and should be monitored for that reason also. g. Total Asset Turnover. This indicates how efficiently assets are being used to support sales. It is calculated as follows: annual sales Total Asset Turnover = ----------total assets 2,273,652
  3. 3. EMC = ----------- = .99 2,293,546 i. This indicates that EMC with a ratio of .99 is generating about one dollar for every dollar invested in assets. A high level of return suggests that corporate resources are being well managed and that the firm is able to realize high level of sales from its asset investments. 3. Leverage Measures. Leverage deals with different types of financing and indicates the amount of debt being used to support the resources and operations of the company. There are two widely used leverage ratios: The first, the debt-equity ratio, measure the amount of debt being used by the company; the second, times interest earned, assesses how well the company can service its debt. a. Debt-Equity Ratio. A measure of leverage, or the relative amount of funds provided by lenders and owners, the debt-equity ration is as follows: long-term debt Debt-equity ratio = ----------------------stockholders' equity 191,200 EMC = ---------- = 0.12 1,636,789 c. This is a measure used to identify companies who run the risk of defaulting on loans, and is therefore helpful in assessing a stock's exposure. EMC with a ratio of .12 cents of debt in capital structure for every dollar of equity. d. Times Interest Earned. This is the so-called coverage ratio and measures the ability of the firm to meet its fixed interest payments. Calculated as follows: earnings before taxes and interest Times Interest Earned = ---------------------------------interest expense 519,474 + 11,967 EMC = ------------------- = 44.41 11,967 f. This is an indication of the companies ability to meet interest expense. The EMC number is $44.41 or indicates that there is $41.00 to cover every dollar of interest expense. Six to Seven times is considered strong and usually a drop to the range of 2 or 3 indicates reason for concern. 4. Measures of Profitability. Each of the various profitability measures relates the
  4. 4. returns (profits) of a company to its sales, assets, or equity. There are three widely used profitability measures: net profit margin, return on assets, and return on equity a. Net Profit Margin. This is the "bottom line" of operations. It indicates the rate of profit from sales and other revenues. The net profit margin is computed as follows: net profit after taxes Net Profit Margin = --------------------total revenues 386,229 EMC = ---------- = .17 2,273,652 c. The net profit margin looks at profits as a percentage of sales. Because it moves with costs, it also reveals the type of control management has over the cost structure of the firm. Note that the EMC reports a decimal fraction of .17 or 17% - that is the company's return is roughly 17 cents on every dollar. This is a number that is easily compared with the industry as it is recorded in Value Line in the Industry section. d. Return of Assets. Return on assets (ROA) reveals managements effectiveness in generating profits from the assets it has available, and is perhaps the single most important measure of return. It is computed as follows: net profit after taxes ROA = -------------------total assets 386,229 EMC = ----------- = .17 2,293,546 f. Because both return on sales (net profit margin) and asset productivity (total asset turnover) are embedded in ROA, it provides a clear picture of a company's managerial effectiveness, and the overall profitability of its resource allocation and investment decisions. In the case of EMC the company earned 17% on its asset investments in 1992. As a rule the higher the ROA the more profitable a company. 5. Return on Equity. A measure of overall profitability of the firm, ROE captures, in a single ratio, the amount of success the firm is having in managing its assets, operations, and capital structure. Return on equity - or return on investment (ROI), as it is sometimes called - measures the return to the firm's stockholders by relating
  5. 5. profits to shareholder equity: net profit after taxes ROE = -------------------------------stockholder's equity 386,229 EMC = ---------- = .24 1,636,789 7. Essentially, ROE is an extension of ROA, as it introduces the company's financing decisions into the assessment of profitability. ROE shows the annual payoff to investors, which in the case of EMC amounts to .24 cents for every dollar of equity. In general look for a high ROE; in contrast a falling ROE could spell trouble later on. 8. Common Stock Ratios. There are several common stock ratios that convert key bits of information about the company; to a per share basis. They are used to assess the performance of the company for stock valuation purposes. a. Earnings per Share (EPS) or E/S. The EPS is widely reported but it is included here because it is used as part of other ratios. net profit after taxes - preferred dividends EPS = ---------------------------------------------number of common shares outstanding 386,229 EMC = EPS = --------- = 1.62 238,240 c. d. Price Earnings Ratio (P/E). This is an extension of the EPS and it relates the earnings to the price of the stock as follows: market price of common stock P/E = ------------------------------EPS 38 EMC = P/E = ----- = 23.46 1.62 f. This is a straight forward computation however the earnings may be 12 months trailing, six months trailing plus six months of projected, or 12 months projected. Additionally, sometimes an annual average P/E is used which is based upon the last business fiscal year. One should be consistent and aware of which data is being used when doing comparisons.
  6. 6. g. Price to Sales Ratio (PSR). The PSR relates sales per share to the market price of the company's stock. This measure is often used to identify overpriced stocks - stocks that should be avoided. The principle is that the lower the PSR the less likely it is that the stock will be overpriced. PSR is computed as follows: market price of common stock PSR = ------------------------------------annual sales per share 38 EMC = PSR = ------ = 3.98 9.54 i. In the case of EMC the PSR is 3.98 or an indication that the market price of the stock is four times the annual sales per share. Both of these components are included on the Value Line Report. j. Annual Sales per Share. This is a ratio used in the computation of the PSR (above) and is computed as follows: annual sales Annual Sales/share = --------------------------------number of common shares outstanding 2,273,652 EMC = ------------ = 9.54 238,240 l. This ratio is also available in Value Line. m. Dividend per Share. This is the dividend equivalent to EPS and is determined dividing the annual dividend by the number of common shares outstanding. n. Payout Ratio. This is the ratio between dividends and earnings per share. The computation is as follows: dividends per share Payout ratio = -------------------------EPS o. Book Value per Share. A measure of stockholder's equity. It represents the difference between total assets and total liabilities. It is computed as follows:
  7. 7. stockholder's equity Book Value per share = ---------------------------------number of common shares outstanding 1,636,789 EMC = ----------- = 6.87 238,240 q. r. Price to Book Ratio. This is a convenient way to relate the book value of a company to the market price of its stock. It is computed as follows: market price of common stock Price-to-book value = -------------------------------book value per share 38 EMC = ----- = 5.53 6.87 t. Widely used to indicate how aggressively the stock is being priced. We would expect the value to be over 1 which would indicate that the market price is = to the book value. In a bull market this Price to Book Value may reach multiples of 2, 3 or higher.