Lecture5 6 Ratio Analysis 13

8/10/2019 Lecture5 6 Ratio Analysis 13

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1

Ratio Analysis


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Stockholders

Financial Statement Analysis

Creditors

Management

Will Ibe paid?

Howgood is ourinvestment? How are we

performing?


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Financial analysis/ratios objectives

Ratio analysis involves methods of calculating andinterpreting financial ratios to analyze and monitorthe firmsperformance

Basic inputs: income statement and balance sheet

Interested parties:

Shareholders risk and return characteristics of thefirm

Creditors short-term liquidity & company ability tomake interest and principal payments

Management all aspects of firms financialsituation


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How are financial ratios used?

Calculating financial ratios allows us to

Examine the firmsperformance through time (e.g. lastfive years) and identify trends

Compare the firmsperformance with other comparablefirms (peer group) and identify the firms competitiveadvantage

Some financial ratios (e.g. price-earnings ratio, market-

to-book ratio) are useful in valuation analysis, such asvaluing private firms


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5

Financial ratios comparisons

Cross-sectional analysis involves comparisonof different firmsfinancial ratios at the same pointin time

It is important to understand how the firm has

performed in relation to other firms in its industry

Frequently, a firm will be compared to a keycompetitor in industry benchmarking

Time-series analysis evaluates performanceover time and enables assessing the firmsprogress

Combined analysis the most informativeapproach to ratio analysis


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6

Financial ratios

Liquidity ratios measure the firms ability tosatisfy short-term obligations as they come due

Leverage (financing) ratios measure the firmsability to pay its long-term debt

Efficiency (activity) ratios measure the speedwith which various accounts are converted intosales or cash

Profitability ratios shows the firms ability togenerate income from its assets

Market ratios give insight into how wellinvestors in the market value the firm


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Bartlett CompanyBalance SheetAs of December 31 - $ in thousands

2009 2008 ChangesAssets

Current assets

Cash 363 288 75

Marketable securities 68 51 17

Accounts receivable 503 365 138

Inventories 289 300 -11 Total current assets 1.223 1.004 219

Gross fixed assets (at cost)

Land and buildings 2.072 1.903 169

Machinery and equipment 1.866 1.693 173

Furniture and fixtures 358 316 42

Vehicles 275 314 -39

Other (includes financial leases) 98 96 2

Total gross fixed assets (at cost) 4.669 4.322 347

Less: Accumulated depreciation 2.295 2.056 239

Net fixed assets 2.374 2.266 108

TOTAL ASSETS 3.597 3.270 327


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Bartlett CompanyBalance Sheet

2009 2008 Changes

Liabilities and stockholders' equity

Current liabilities

Accounts payable 382 270 112

Notes payable 79 99 -20

Accruals 159 114 45

Total current liabilities 620 483 137 Long-term debt (includes financial leases) 1.023 967 56

TOTAL LIABILITIES 1.643 1.450 193

Stockholders' equity

Preferred stock - cumulative 5%, $100 at par, 2,000 shares

authorized and issued 200 200 0

Common stock - $2.50 par, 100,000 shares authorized, shares issued and outstanding in 2009: 76,262; in 2008: 76,244 191 190 1

Paid-in capital in excess of par on common stock 428 418 10

Retained earnings 1.135 1.012 123

Total stockholders' equity 1.954 1.820 134

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY 3.597 3.270 327

As of December 31 - $ in thousands


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Bartlett CompanyIncome Statement

2009 2008 Change

Sales revenue 3.074 2.574 500

Less: Cost of goods sold 2.088 1.711 377

Gross profit 986 863 123

Less: Operating expenses 0

Selling expenss 100 108 -8 General and administrative expenses 194 187 7

Lease expense 35 35 0

Depreciation expense 239 223 16

Total operating expenses 568 553 15

Operating profits (EBIT) 418 310 108Less: Interest expense 93 91 2

Net profits before taxes (EBT) 325 219 106

Less: Taxes 94 64 31

Net profits after taxes (EAT) 231 155 75

Less: Preferred stock dividends 10 10 0

Earnings available to common stockholders 221 145 75

As of December 31 - $ in thousands


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Bartlett Co.Statement of cash flows, 2009

Cash Flow from Operating Activities

Net profits after taxes 231

Depreciation expense 239 Change in accounts receivable -138

Change in inventories 11

Change in accounts payable 112

Change in accruals 45

Cash provided by operating activities 500

Cash Flow from Investment Activities

Change in gross fixed assets -347

Change in business interests 0

Cash provided by investment activities -347

Cash Flow from Financing Activities Changes in notes payable -20

Changes in long-term debt 56

Changes in stockholders' equity 11

Dividends paid -108

Cash provided by financing activities -61

Net increase in cash and marketable securities 92


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Liquidity ratios

sliabilitieCurrent

assetsCurrent=ratioCurrent

sliabilitieCurrent

securitiesMarketableCash=ratioCash

sliabilitieCurrent

Inventory-assetsCurrent=ratioQuick

1.97620

1,223ratioCurrentBartlettFor

1.51620

289-1,223ratioQuickBartlettFor

0.69

620

68363ratioCashBartlettFor


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Leverage ratios

AssetsTotal

sLiabilitieTotal

=ratioDebt

Equity

leasesofValue+debtterm-Long=ratioequityDebt

0.4573,597

1,643ratioDebtBartlettFor

0.521,954

1,023ratioequityDebtBartlettFor

Interest

EBIT=)earned(TIEinterestTimes

4.5

93

418TIEBartlettFor


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Efficiency ratios and operating cycle

Efficiency of total assets

Efficiency of current assetsOPERATING CYCLE Finding the inventory period

assetsTotalSales=turnoverassetsTotal

0.853,597

3,074turnoverassetsTotalBartlettFor

7.222892,088turnoverInventoryBartlettFor

Inventory

soldgoodsofCost=turnoverInventory

turnoverInventory

365=periodInventory

days50.557.22

365

periodInventoryBartlettFor


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Efficiency ratios and operating cycle

Finding the payables period

periodPayables-cycleOperating=cycleCash

days14.8995.4110.29cycleCashBartlettFor

3.83382

0.70x2,088turnoverA/PBartlettFor

A/P

purchasesAverage=turnoverA/P

turnoverA/P

365=periodPayables

days95.43.83

365periodPayablesBartlettFor


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Operating cycle


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A few considerations on operating cycle

The longer the production process, the longer theinventory period

The longer it takes customers to pay their bills, thelonger the accounts receivable period

The longer the accounts payable period, the shorterthe cash cycle

the cash conversion cycle is not given to a large

extent it is under managementscontrol

balance between the costs and benefits ofmaintaining high current assets


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Profitability ratios

Sales

COGS-Sales=marginprofitGross

32.08%or0.32083,074

2,088-3,074marginprofitGrossBartlettFor

Sales

profitsOperating

=marginprofitOperating

13.60%or0.13603,074

418marginprofitOperatingBartlettFor

Sales

rsshareholdecommontoavailableEarnings=marginprofitNet

7.19%or0.07193,074

221marginprofitNetBartlettFor


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rsshareholdecommontoavailableEarnings

rsshareholdecommontoDividends=ratioPayout

44.34%or0.4434221

98ratioPayoutBartlettFor

outsandingsharesofNumberrsshareholdecommontoavailableEarnings(EPS)shareperEarnings

$2.9076,262

221,000EPSBartlettFor


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equityrs'shareholdeCommonrsshareholdecommonforavailableEarnings=ROE

6.14%or0.06143,597

221ROABartlettFor

assetsTotal rsshareholdecommontoavailableEarnings=ROA

12.60%or0.12601,754

221ROEBartlettFor

leases)financial(inclusivDebtsLTequityrs'Shareholde

IntereststaxafterprofitsNet=ROIC

10.88%or0.1088

10231,954

93231ROICBartlettFor


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Market ratios

shareperEarnings

stockcommonofshareperPrice

=(PER)ratioP/E

11.132.90

32.25PERBartlettFor

sharepervalueBook

stockcommonofshareperPrice=ratiobook-to-Market

1.4023

32.25

/76,262)(1,754,000

32.25ratiobooktoMarketBartlettFor


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The DuPont system

Sales

rsstockholdecommontoavailableEarningsx

assetsTotal

Sales

assetsTotal

rsstockholdecommontoavailableEarnings=ROA

Assets turnover ratio Net profit margin

6.14%7.18%0.85ROABartlettFor


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The DuPont system

Leverage ratioequityrs'Shareholde

assetsTotal

assetsTotal

Sales

Sales

rsstockholdecommontoavailableEarnings

equityrs'Shareholde

rsstockholdecommontoavailableEarnings

=ROE

Assets turnover ratio

Net profit margin

12.60%2.050.857.18%

1,754,000

3,597,000

3,597,000

3,074,000

3,074,000

221,000ROEBartlettFor


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The DuPont system- an example -

Question: Are the stockholders of these companies receiving an adequate return on their investment?

2012 2011 2010 2009 2008

Return on Equity (ROE) 14,0% 12,1% 12,4% 5,3% 11,2%

2012 2011 2010 2009 2008

Return on Equity (ROE) 12,9% 11,8% 11,0% 8,8% 11,2%

Company B

Company A


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The DuPont system- an example (cont.)-

DuPont EquationROE Components: 2005 2004 2003 2002 2001

Net profit margin 3,5% 4,0% 4,1% 2,0% 4,1%Assets turnover ratio 2,00 1,32 1,35 1,26 1,32

Leverage ratio 2,0 2,3 2,2 2,1 2,1

Return on Common Equity (ROE) 14,0% 12,1% 12,4% 5,3% 11,2%

DuPont EquationROE Components: 2005 2004 2003 2002 2001

Net profit margin 5,1% 4,5% 4,1% 3,3% 4,1%Assets turnover ratio 2,50 2,33 2,36 2,35 2,26

Leverage ratio 1,0 1,1 1,1 1,1 1,2

Return on Common Equity (ROE) 12,9% 11,8% 11,0% 8,8% 11,2%

Company A

Company B


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Financial Leverage Effects

ROE = ROIC + [(ROIC interest rate)L-T Debt/Equity]

Leveraged firms accrue excess returns to their

shareholders so long as the rate of return on investmentsfinanced by debt is greater than the cost of debt;

The higher the debt ratio, the riskier the firm;

This formula applies for company that issued only

ordinary shares. In case of the companies that issued also

preferred shares the cost of this financing source will be

included in the cost of debts.


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Financial Leverage Effects

2012 2011 2010 2009 2008

Equity 4000 4000 4000 4000 4000

LTD 4000 5200 4800 4400 4400

EBIT 1200 1300 1500 1600 1800

Interest Expenses 600 780 720 660 660EBT 600 520 780 940 1140

Income tax 96 83,2 124,8 150,4 182,4

Net income (net profits after tax) 504 436,8 655,2 789,6 957,6

ROIC 13,8% 13,2% 15,6% 17,3% 19,3%

Interest rate 15,0% 15,0% 15,0% 15,0% 15,0%

Debt-Equity ratio 1,0 1,3 1,2 1,1 1,1

ROE 12,6% 10,9% 16,4% 19,7% 23,9%

Company C


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Time-series and cross-sectional analysis for Bartlett

2009 2008 Industry average

2009

1. Liquidity 1. Current ratio 1,97 2,08 2,052. Quick ratio 1,51 1,46 1,43

3. Cash ratio 0,70 0,70 0,71

2. Efficiency 1. Inventory turnover 7,22 5,70 6,60

2. Average payment period 95,40 81,20 66,50

3. Average collection period 59,73 51,76 42,75

4. Total assets turnover 0,85 0,79 0,75

3. Leverage 1. Debt ratio 45,70% 44,30% 40,00%

2. Debt-to-equity ratio 52,35% 53,13% 48,06%

3. Times interest earned 4,50 3,30 4,30

4. Profitablity 1. Gross profit margin 32,08% 33,53% 30,00%

2. Operating profit margin 13,60% 12,04% 11,00%3. Net profit margin 7,18% 5,65% 6,20%

4. Earnings per share 2,89 1,91 2,26

5. Payout ratio 0,44 0,42 0,41

6. ROA 6,14% 4,45% 4,60%

7. ROE 12,59% 8,98% 8,50%

5. Market 1. PER 11,14 9,46 12,502. Market to book ratio 1,40 0,85 1,30


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Potential problems and limitations offinancial ratio analysis

No single ratio or one-year figure should berelied upon to provide an assessment of acompanysperformance.

Financial analysis may indicate thatsomething is wrong, but it may not identifythe specific problem or show how to correctit.


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Potential problems and limitationsof financial ratio analysis

Comparison with industry averages is difficultfor 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 makestatements and ratios look better.


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Quick Quiz (I)

How would the following actions affect afirmscurrent ratio?

a. Inventory is sold at cost.

b. The firm takes out a bank loan to pay itsaccounts due.

c. A customer pays its accounts receivable.

d. The firm uses cash to purchase additionalinventories.


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Quick Quiz (II)

Determine a firm's total asset turnover (TAT)if its net profit margin (NPM) is 5 percent,total assets are $8 million, and ROA is 8percent.

1.60

2.05

2.50 4.00


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Quick Quiz (III)

CFA Corp. has a debt-equity ratio that islower than the industry average, but itstimes interest earned ratio is also lower thanthe industry average. What might explainthis seeming contradiction?

A firm uses $1 million in cash to purchaseinventories. What will happen to its currentratio? Its quick ratio?


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Quick Quiz (IV)

Find ways to improve accounts receivableturnover.

When a leveraged firm accrues excess

returns to their shareholders? Give examples of industry that are using low

margin/high turnover and high margin/lowturnover.


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Quick Quiz (V)

In each of the following cases, explain briefly which of the

two companies is likely to be characterized by the higherratio:

a. Debt-equity ratio: a shipping company or a computersoftware company

b. Payout ratio: United Foods Inc. or Computer Graphics Inc. c. Ratio of sales to assets: an integrated pulp and paper

manufacturer or a paper mill d. Average collection period: Regional Electric Power

Company or Z-Mart Discount Outlets e. Price-earnings multiple: Basic Sludge Company or

Fledgling Electronics


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Quick Quiz (VI)

Financial ratio analysis is conducted by four groupsof analysts: managers, equity investors, long-termcreditors and short-term creditors. What is theprimary emphasis of each of these groups in

evaluating ratios?

Over the past year, M.D. Ryngaert & Co. hasrealized an increase in its current ratio and a drop

in its total assets turnover ratio. However, thecompanys sales, quick ratio, fixed assets turnoverratios have remained constant. What explainsthese changes?


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Quick Quiz (VII)

If the mean P/E ratio for an industry sector is 12,and the company you are analyzing has a P/E of

18, what does this mean about investorsview ofgrowth prospects?


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Modify sectors P/E to be correct!

Sector Sector average P/Es

Electricity 23

Leisure and hotels 21

Building materials 14

Food retailing 9

Documents

Lecture5 6 Ratio Analysis 13