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4-1
RATIO ANALYSIS
LIQUIDITY
ASSET MANAGEMENT
DEBT MANAGEMENT
PROFITABILITY
CHAPTER 3
ANALYSIS OF FINANCIAL
STATEMENTS
the calculation and comparison
of ratios which are derived from
the information in a company's
financial statements.
FINANCIAL RATIO ANALYSIS DEFINITION
Why are ratios useful?
Ratios standardize numbers and facilitate comparisons.
Ratios are used to highlight weaknesses and strengths.
Ratio comparisons should be made through time and with competitors
Trend analysis
Peer (or Industry) analysis
Ratio Comparisons
Peer or Industry Analysis (Cross-sectional analysis)
involves the comparison of different firms’ financial ratios at the same point in time; involves comparing the firm’s ratios to those other firms in its industry or to industry averages.
Trend Analysis (Time-series analysis) involves the evaluation of the firm’s financial performance over time using financial ratios. Comparison of current to past performance, using ratio analysis, allows the firm to determine whether it is progressing as planned.
Potential problems and limitations of
financial ratio analysis
Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions.
“Average” performance is not necessarily good, perhaps the firm should aim higher.
Seasonal factors can distort ratios.
“Window dressing” techniques can make statements and ratios look better.
More issues regarding ratios
Sometimes it is hard to tell if a ratio is “good” or “bad”.
Difficult to tell whether a company is, on balance, in strong or weak position.
What are the major categories of ratios,
and what questions do they answer?
Liquidity: Can we make required payments?
Asset management: right amount of assets vs. sales?
Debt management: Right mix of debt and equity?
Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA?
Current
Ratio
CA
CL
It indicates the extent to
which current liabilities are
covered by those assets
expected to be converted to
cash in the near future
CA – inventories
CL
It measures a firm's ability
to pay off short-term
obligations to more liquid
type of assets.
LIQUIDITY RATIOS
Quick
(acid-test)
Ratio
Ratios that show the relationship of a firm’s
cash and other assets to its current liabilities
Sales
Inventories
(DSO)
Receivables
Average sales
per day
Also called the “average
collection period (ACP), it
indicates the average length
of time the firm must wait
after making a sale before it
receives cash.
ASSET MANAGEMENT RATIOS
Days Sales Outstanding
A set of ratios that measure how effectively a firm
is managing its assets.
Inventory
Turnover
Ratio
It indicates the salability
of inventory – the number
of times a company sells
its average inventory
during the year.
Fixed Assets
Turnover
Ratio
Sales
Net fixed assets
It measures how effectively
the firm uses its plant and
equipment
Sales
Total assets
It measures a firm's ability
to generate sales given its
total assets
ASSET MANAGEMENT RATIOS
Total
Assets
Turnover
Ratio
Total debt
Total assets
It indicates how much of
a company's assets are
provided through debt.
EBIT
Interest
Charges
DEBT MANAGEMENT RATIOS (FINANCIAL LEVERAGE)
Debt
Ratio
Debt Management ratios help evaluate a company's
long-term solvency, measuring the extent to which the
company is using long-term debt.
Times
Interest
Earned
(TIE) Ratio
A measure of the firm’s
ability to meet its annual
interest payments.
EBITDA + Lease
payments
Interest +
principal
payments +
lease payments
DEBT MANAGEMENT RATIOS (FINANCIAL LEVERAGE)
EBITDA
Coverage
It shows if earnings
are able to satisfy all
financial obligations
including leases and
principal payments.
Net income
Sales
This ratio measures net
income per dollar of sales
Net income
Totals assets
It gives an idea as to how
efficient management
is at using its assets to
generate earnings.
PROFITABILITY RATIOS
Return on
total
assets
(ROA)
Profit
margin
on sales
A group of ratios that show the combined effects of
liquidity, asset management, and debt on operating
results.
EBIT
Total assets
It indicates the ability
of the firm’s assets to
generate operating
income
Net income
Common equity
PROFITABILITY RATIOS
Return on
common
equity
(ROE)
Basic
Earning
Power
(BEP)
It gives the amount of
net income earned for
each share of the
company’s common
stock.
Balance Sheet: Assets
Cash
A/R
Inventories
Total CA
Gross FA
Less: Dep.
Net FA
Total Assets
2010
7,282
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
2011E
85,632
878,000
1,716,480
2,680,112
1,197,160
380,120
817,040
3,497,152
Balance sheet:
Liabilities and Equity
Accts payable Notes payable Accruals Total CL Long-term debt Common stock Retained earnings Total Equity Total L & E
2010
524,160
636,808
489,600
1,650,568
723,432
460,000
32,592
492,592
2,866,592
2011E
436,800
300,000
408,000
1,144,800
400,000
1,721,176
231,176
1,952,352
3,497,152
Income statement
Sales COGS Other expenses EBITDA Depr. & Amort. EBIT Interest Exp. EBT Taxes Net income
2010 6,034,000 5,528,000 519,988 (13,988) 116,960 (130,948) 136,012 (266,960) (106,784) (160,176)
2011E 7,035,600
5,875,992 550,000
609,608 116,960
492,648 70,008
422,640 169,056 253,584
Other data
No. of shares
EPS
DPS
Stock price
Lease pmts
2011E
250,000
$1.014
$0.220
$12.17
$40,000
2010
100,000
-$1.602
$0.110
$2.25
$40,000
Calculate D’Leon’s forecasted current
ratio and quick ratio for 2011.
Current ratio = CA/ CL
= $2,680 / $1,145
= 2.34x
Quick ratio = (CA – Inventories) / CL
= ($2,680 – $1,716) / $1,145
= 0.84x
Comments on liquidity ratios
2011E 2010 2009 Ind.
Current Ratio 2.34x 1.20x 2.30x 2.70x
Quick Ratio 0.84x 0.39x 0.85x 1.00x
Expected to improve but still below the
industry average.
Liquidity position is weak.
What is the inventory turnover vs.
the industry average?
2011E 2010 2009 Ind.
Inventory
Turnover 4.1x 4.70x 4.8x 6.1x
Inv. turnover = Sales / Inventories
= $7,036 / $1,716
= 4.10x
Comments on
Inventory Turnover
Inventory turnover is below industry
average.
D’Leon might have old or too much
inventory, which is expensive because
Inventory takes up costly warehouse space.
Some items may become spoiled or obsolete.
No improvement is currently forecasted.
DSO is the average number of days after
making a sale before receiving cash.
DSO= Receivables / Avg sales per day
= Receivables/(Annualsales/365)
= $878 / ($7,036/365)
= 45.6 days
Appraisal of DSO
2011E 2010 2009 Ind.
DSO 45.6 38.2 37.4 32.0
D’Leon collects on sales too slowly,
and is getting worse.
D’Leon has a poor credit policy*. *Clear, written guidelines that set (1) the term
and conditions for supplying goods on credit, (2)
customer qualification criteria, (3) procedure for
making collections, and (3) steps to be taken in
case of customer delinquency.
Fixed assets and total assets turnover
ratios vs. the industry average
FA turnover = Sales / Net fixed assets
= $7,036 / $817 = 8.61x
TA turnover = Sales / Total assets
= $7,036 / $3,497 = 2.01x
Evaluating the FA turnover and
TA turnover ratios
2011E 2010 2009 Ind.
FA TO 8.6x 6.4x 10.0x 7.0x
TA TO 2.0x 2.1x 2.3x 2.6x
FA turnover projected to exceed the
industry average.
TA turnover below the industry average.
Caused by excessive currents assets
(A/R and Inv).
Calculate the debt ratio, times-interest-
earned, and EBITDA coverage ratios.
Debt ratio=Total debt / Total assets
= ($1,145 + $400) / $3,497
= 44.2%
TIE = EBIT / Interest expense
= $492.6 / $70 = 7.0x
Calculate the debt ratio, TIE, and
EBITDA coverage ratios.
EBITDA = (EBITDA + Lease pmts)
coverage Int exp + Lease pmts + Principal pmts
= $609.6 + $40
$70 + $40 + $0
= 5.9x
How do the debt management ratios
compare with industry averages?
2011E 2010 2009 Ind.
D/A 44.2% 82.8% 54.8% 50.0%
TIE 7.0x -1.0x 4.3x 6.2x
EBITDA
coverage 5.9x 0.1x 3.0x 8.0x
D/A and TIE are better than the
industry average, but EBITDA coverage
still trails the industry.
Profitability ratios:
Profit margin and Basic earning power
Profit margin = Net income / Sales
= $253.6 / $7,036 = 3.6%
BEP = EBIT / Total assets
= $492.6 / $3,497 = 14.1%
Appraising profitability with the profit
margin and basic earning power
2011E 2010 2009 Ind.
PM 3.6% -2.7% 2.6% 3.5%
BEP 14.1% -4.6% 13.0% 19.1%
Profit margin was very bad in 2010, but is
projected to exceed the industry average in
2011. Looking good..
BEP projected to improve, yet still below the
industry average. There is definitely room
for improvement.
Profitability ratios:
Return on assets and Return on equity
ROA = Net income / Total assets
= $253.6 / $3,497 = 7.3%
ROE = Net income / Total common equity
= $253.6 / $1,952 = 13.0%
Appraising profitability with the
return on assets and return on equity
2011E 2010 2009 Ind.
ROA 7.3% -5.6% 6.0% 9.1%
ROE 13.0% -32.5% 13.3% 18.2%
Both ratios rebounded from the previous
year, but are still below the industry
average. More improvement is needed.
Panther Jaguar Sharks Dolphin
Revenue 8,000,000 6,500,000 9,250,000 7,750,000
Net Income 775,000 695,000 875,000 745,000
Assets 22,500,000 18,500,000 26,500,350 23,000,500
Daily
Receivables
100,000 95,000 105,000 102,500
The list of companies represents one industry. What
can you say about Dolphin’s ROA compared to the
industry’s numbers?
INDUSTRY COMPARISON
ROA (Panther) = Net income / Total assets
=775,000 /22,500,000
=3.44%
INDUSTRY COMPARISON
ROA (Panther) = Net income / Total assets
=775,000 /22,500,000
=3.44%
ROA (Jaguar) = Net income / Total assets
=695,000 /18,500,000
=3.76%
INDUSTRY COMPARISON
ROA (Shark) = Net income / Total assets
=875,000 /26,500,350
=3.30%
INDUSTRY COMPARISON
ROA (Shark) = Net income / Total assets
=875,000 /26,500,350
=3.30%
ROA (Dolphin) = Net income / Total assets
=745,000 /23,000,500
=3.24%
INDUSTRY COMPARISON
Panther Jaguar Sharks Dolphin
ROA 3.44% 3.76% 3.30% 3.24%
Ind.
Average
3.44%
INDUSTRY COMPARISON
Industry Average = 3.44 +3.76+3.30+3.24
= 3.44%
4
2011 2010 2009 2008
Revenue 8,000,000 6,500,000 9,250,000 7,750,000
Net Income 775,000 695,000 875,000 745,000
Assets 22,500,000 18,500,000 26,500,350 23,000,500
Daily
Receivables
100,000 95,000 105,000 102,500
Given: Dolphin’s numbers for 4 years
TREND ANALYSIS for Dolphin
2011 2010 2009 2008
ROA 3.44% 3.76% 3.30% 3.24%
TREND ANALYSIS for Dolphin
2.90
3.00
3.10
3.20
3.30
3.40
3.50
3.60
3.70
3.80
1 2 3 4
RO
A
Dolphin's ROA
2008 2009 2010 2011
More Sample PROBLEMS
1. A firm has an annual sales of $100 million, $20
million of inventory, and $30 million of accounts
receivable.
More Sample PROBLEMS
1. A firm has an annual sales of $100 million, $20
million of inventory, and $30 million of accounts
receivable.
a. What is its inventory ratio?
More Sample PROBLEMS
1. A firm has an annual sales of $100 million, $20
million of inventory, and $30 million of accounts
receivable.
a. What is its inventory ratio?
Answer: 5X
More Sample PROBLEMS
1. A firm has an annual sales of $100 million, $20
million of inventory, and $30 million of accounts
receivable.
a. What is its inventory ratio?
Answer: 5X
b. What is its DSO based on a 365-day year?
More Sample PROBLEMS
1. A firm has an annual sales of $100 million, $20
million of inventory, and $30 million of
accounts receivable.
a. What is its inventory ratio?
Answer: 5X
b. What is its DSO based on a 365-day year?
Answer: 109.5 days
More Sample PROBLEMS
LOW COMPANY
Income Statement
Year Ended December 31, 2011
(in billions)
Net Sales $ 40.6
Cost of goods sold 22.5
Interest expense 0.4
All other expenses 6.9
Net income 10.8
II. Low’s Company, a home-improvement store
chain, reported the following summarized figures:
LOW’S COMPANY
Balance Sheet
December 31, 2011 and 2010
Assets 2011 2010 Liabilities and SE 2011 2010
Cash $ 2.2 $ 1.2 Total current liabilities $ 24.0 $13.2
Short-term
investments
24.0 13.0 Long-term liabilities 13.7 11.6
Accounts receivable 7.5 5.4 Common Stock 10.0 10.0
Inventory 7.3 7.2 Retained Earnings 35.3 21.5
Other current assets 9.0 1.5
Intangible assets 33.0 28.0
Total assets $ 83.0 $ 56.3 Total liabilities and
Stockholder’s Equity
$ 83.0 $ 56.3
More Sample PROBLEMS
LOW’S COMPANY
Balance Sheet
December 31, 2011 and 2010
Assets 2011 2010 Liabilities 2011 2010
Cash $ 2.2 $ 1.2 Total current liabilities $ 24.0 $13.2
Short-term
investments
24.0 13.0 Long-term liabilities 13.7 11.6
Accounts receivable 7.5 5.4 Total liabilities 37.7 24.8
Inventory 7.3 7.2 Stockholder’s Equity
Other current assets 9.0 1.5 Common Stock 10.0 10.0
Total current assets 50.0 28.3 Retained Earnings 35.3 21.5
All other assets 33.0 28.0 Total SEquity 45.3 31.5
Total assets $ 83.0 $ 56.3 Total liabilities and
Stockholder’s Equity
$ 83.0 $ 56.3
More Sample PROBLEMS
More Sample PROBLEMS
Requirements:
1. Compute the company’s current ratio at
December 31, 2011 and 2010.
More Sample PROBLEMS
Requirements:
1. Compute the company’s current ratio at
December 31, 2011 and 2010.
Current ratio (2011) = CA/ CL
= $50/ $24
= 2.08x
More Sample PROBLEMS
Requirements:
1. Compute the company’s current ratio at
December 31, 2011 and 2010.
Current ratio (2011) = CA/ CL
= $50/ $24
= 2.08x
Current ratio (2010) = CA/ CL
= $28.3/ $13.2
= 2.14x
More Sample PROBLEMS
Requirements:
1. Compute the company’s current ratio at
December 31, 2011 and 2010.
Current ratio (2011) = CA/ CL
= $50/ $24
= 2.08x
Current ratio (2010) = CA/ CL
= $28.3/ $13.2
= 2.14x
2. Did Low’s Company’s current ratio, deteriorated,
improved or hold steady during the 2011?
More Sample PROBLEMS
Requirements:
1. Compute the company’s current ratio at
December 31, 2011 and 2010.
Current ratio (2011) = CA/ CL
= $50/ $24
= 2.08x
Current ratio (2010) = CA/ CL
= $28.3/ $13.2
= 2.14x
2. Did Low’s Company’s current ratio, deteriorated,
improved or hold steady during the 2010? Deteriorated
More Sample PROBLEMS
3. Inventory Turnover?
More Sample PROBLEMS
3. Inventory Turnover for 2009?
Answer: 5.56x
More Sample PROBLEMS
3. Inventory Turnover for 2009?
Answer: 5.56x
4. Days Sales Outstanding for 2009?
More Sample PROBLEMS
3. Inventory Turnover for 2011?
Answer: 5.56x
4. Days Sales Outstanding for 2011?
Answer: 58 days
More Sample PROBLEMS
3. Inventory Turnover for 2011?
Answer: 5.56x
4. Days Sales Outstanding for 2011?
Answer: 58 days
5. Debt Ratio for December 31, 2011?
More Sample PROBLEMS
3. Inventory Turnover for 2011?
Answer: 5.56x
4. Days Sales Outstanding for 2011?
Answer: 58 days
5. Debt Ratio for December 31, 2011?
Answer: 0.454
More Sample PROBLEMS
3. Inventory Turnover for 2011?
Answer: 5.56x
4. Days Sales Outstanding for 2011?
Answer: 58 days
5. Debt Ratio for December 31, 2011?
Answer: 0.454
6. Is Low’s ability to pay its liabilities strong or
weak?
More Sample PROBLEMS
3. Inventory Turnover for 2011?
Answer: 5.56x
4. Days Sales Outstanding for 2011?
Answer: 58 days
5. Debt Ratio for December 31, 2011?
Answer: 0.454
6. Is Low’s ability to pay its liabilities strong or
weak? Strong