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Contemporary Engineering Economics, 4th

edition, 2007 1

Financial Ratio Analysis

Lecture No.2-2Chapter 2Contemporary Engineering EconomicsCopyright 2006

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edition, 2007 2

1. Debt Management Ratios2. Liquidity Ratios3. Asset Management Ratios4. Profitability Ratios5. Market Trend Ratios6. Trends and graphs to spot problems7. Using an Excel template for instant cant miss

financial analysis See the template providedin the OneKey site.

Ratio Analysis Calculations and What theNumbers Really Means

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Types of Financial Ratios

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Net incomeReutrn on Equity (ROE) =

Average shareholders' equity

Net incomeROE =

Average shareholders' equity Net income Sales Assets

Sales Assets Average shareholders' equity (Profit margin) (Asset turnover) (Financial leverage)

= (6.18%) (2.12 times) (3.64

times)

= 47.68%

Return on Equity A Composite Ratio

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Return on Equities (ROE) and Levels ofPerformance for 10 Diverse Companies

Returnon Equity

(%)

Profitmargin

(%)

AssetTurnover(times)

FinancialLeverages

(times) Analog Devices 18.2 12.7 0.94 1.53BankAmerica Co. 13.2 13.1 0.09 11.49

Duke Power 14.9 15.3 0.35 2.79Exxon Co 16.0 5.3 1.33 2.26Food Lion 15.7 2.1 3.10 2.40Hewlett-Packard 20.6 7.7 1.29 2.06

Nike 20.4 8.4 1.51 2.60Nordstrom Inc. 11.6 4.0 1.51 1.92Southwest Airline 12.8 6.4 0.88 2.28Tiffany & Company 14.8 4.9 1.23 2.48

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Debt Management Analysis

Leverage ratios that showhow a firm uses debtfinancing and its ability tomeet debt repayment

obligations

Debt ratioDebt to equity ratio

Times-interest-earnedratio

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Indicates how a firmfinances its capital

Debt Ratio

Total debtDebt ratio=

Total assets$16,730

$23, 21572.07%

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edition, 2007 8

Measures the extentto which earnings candecline withoutdefaulting debtservice.

EBITTimes Interest Earned =

Interest Charges$4,445 $11.29

11.29394.72

Note: Dell issued $500 million worth of senior notes andlong-term bonds with a combined interest rate of 6.8%.

Times Interest

Earned

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edition, 2007 9

Liquidity Analysis

Ratios that show therelationship of a firms cashand other assets to itscurrent liabilities (short-term

obligations)

Current ratioQuick ratio

Liquidity ratio

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Measures a firmsshort-term solvency.

Formula:

Current AssetsCurrent Ratio =

Current Liabilities

$16,897$14,1361.1953

Current Ratio

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Excludes inventoriesand prepaid expenses

Formula:

Current Assets - InventoriesQuick Ratio =

Current Liabilities

$16,897 $459$14,1361.1628

Quick Ratio

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An indication of afirms immediateliquidityFormula:

Cash+Cash Equ.Liquidity Ratio =

Current Liabilities$4,747$16,7300.2837

Liquidity Ratio

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Asset Management Analysis

A set of ratios whichmeasure how effectively afirm is managing its assets

Inventory turnover ratioDays sales outstandingratioTotal assets turnover ratio

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Highlights the rateat which theinventory is beingsold.

SalesInventory Turnover =

Average Inventory$49,205

($459 $327)/ 2125.20 times

The typical item sits in inventory almost0.0958 months (12 months/125.20) or2.87 days before being sold

Inventory TurnoverRatio

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Alternate Definition for Inventory Turnover Ratio

Cost of goods soldInventory turnover ratio =

Ending inventory$40,190

87.56 times$459

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Determines whetherreceivables are beingcollectedaggressively enough.

A/R DSO =

Average sales per day$4, 414

$49, 205 / 36532.74 days

Days SalesOutstanding (DSO)

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Days Sales in Inventory

What It Measures : The amount of inventory (stock)expressed in days of sales. For example, if 2 items aday are sold and 20 items are held in inventory, thisrepresents 10 days' (20/2) worth sales in inventory.

How You Compute : The ratio computed by dividinginventory by cost of sales, and multiplied the result by 365

Average InventoryDSI (Days Sales in Inventory)=

Average Cost of Sales per day($327 $459) / 2

$40,190/ 3653.57 days

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The Business Operating Cycle

Days Sales Outstanding = 32.74 days+ Days Sales in Inventory = 3.57 days

Total Days Operating Cycle = 36.31 days

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Indicates whether acompany isgenerating a sufficientvolume of businessfor the size of itsasset investment.

Net SalesTotal Asset Turnover =

Total Assets$49,205$23,2152.12 times

Total AssetTurnover Ratio

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Profitability Analysis

A set of ratios whichmeasure managementsoverall effectiveness asshown by the returns

generated on sales andinvestment

Profit margin on sales

Return on total assetsReturn on common equity

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Indicates theprofitability of thesales effort.

Gross Margin ($)Gross Margin Ratio =

Net Sales

$9,015$49,20518.32%

Gross Margin

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Illustrates whatpercentage of eachsales dollar isretained in earnings.

Net Income ($) Net Margin Ratio =

Net Sales

$3,043$49,2056.18%

Net Margin

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edition, 2007 23

Measures the rate ofreturn on the ownersinvestment.

Net IncomeReturn on Equity =

Average Total Common Equity$3,043

($6,485 6,280) / 247.68%

Return on Equity

(ROE)

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How the Debt to Equity Ratio ImpactsReturn on Equity

This is an example of ahealthy company that mightnot have a spectacular ROEbecause there is so muchequity in the company.

This an example of a highlyleveraged company that

might have a spectacularROE because the ownershave put so little of their ownresources into the company.

Assets

Liabilities

EquityAssets

Liabilities

Equity

=

=

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Market Trend Analysis

A set of ratios thatrelate the firms stockprice to its earningsand book value pershare

P/E ratio

Market/book ratio

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Earnings Per Share (EPS)

Indicates earningsattributable to eachshare of stock.

Widely used indicatorof a corporationsperformance

Net IncomeEPS =

Common Shares Outstanding

$3,0432,509

$1.21

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Price to Earnings Ratio

Indicates how manytimes a corporation isable to multiply its

earnings in terms ofasking price per shareof stock.Share price: $30.25as of December 31,2005

Price per shareP/E ratio =

EPS

$30.251.21

25

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Contemporary Engineering Economics, 4 th edition, 2007 28

Book Value/Share

Indicates what thevalue of a share ofstock is according to

the books (financialstatements).

Equity - Preferred stock Book Value/Share =

Common Shares Outstanding$6, 485 0

2,509$2.58

Total Assets $23,215Total liabilities 16,730Stockholders equity 6,485 Preferred stock obligation 0

Net worth assigned tocommon stockholders 3,043

Common sharesoutstanding 2,509

Net worth (Book value): $2.58

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Market/Book Ratio

What It Measures : Indicates how investors regard thecompany a higher ratio indicates that investors arewilling to bet a higher return on investmentHow You Compute : The ratio of a stocks market price to

its book value

Market price per shareMarket/book ratio=

Book value per share$30.25$2.58

11.70 times

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Trends and Graphs to Spot Problems

Trends analysis, where one plots a ratioover time, is important, because it reveals

whether the firms ratios are improving ordeteriorating over time.

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Limitations of Financial Ratios

Ratio analysis is useful,but analysts should awareof ever-changing marketconditions and makeadjustments necessary.It is difficult to generalizeabout whether a particularratio is good or bad.Ratio analysis based onany one year may notrepresent the truebusiness condition.

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Quick Financial Analysis

Horizontal versus Vertical Analysis

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Horizontal Analysis

Determine thetotal dollar change (variance) fromyear to the next.Determine thepercent change (variance) fromone year to thenext

2001 2000DollarChange

PercentChange(%)

Cash A/R

50,00030,000

40,00050,000

10,000(20,000)

25%(40%)

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Contemporary Engineering Economics, 4 th edition 2007 34

Vertical Analysis

For the balancesheet , determinewhat percent of totalassets each line itemtotals.For the incomestatement , determinewhat percent of totalsales each line itemtotals.

2001 20002001(%)

2000(%)

Cash A/R

Total

Assets

50,00030,000

200,000

40,00050,000

180,000

25%15.0%

100%

22.2%27.8%

100%

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s07 chap 2-2