Foundations of Business

1
Foundations of Business

• Financial Ratios Ratio Analysis
• to Evaluate and Compare Company Performance

2
Financial Ratios

• Ratios are meaningful relationships between 2
  numbers (or among several numbers).
• 5 Types of Financial Ratios
• Liquidity ratios
• Operating ratios
• Debt management ratios
• Profitability ratios
• Valuation ratios

3
Champ Creemee Company Liquidity Ratios

• The higher the Liquidity ratio, the better the
  companys ability to pay current obligations with
  current assets.
• The higher the Liquidity ratio, the more liquid
  the company is.
• 1. Current Ratio
• 2. Quick Ratio

Creemee Income Statement
Creemee Balance Sheet
4
Liquidity Trends and What If ???
We have a lot of money tied up in inventory!
The Current Ratio should be 1X or higher so that
the company is able to pay its current
liabilities with current assets.
We may have to sell inventory to pay our
companys debts!
5
Champ Creemee CompanyOperating Ratios

• How efficiently a company uses assets
• The higher the ratio, the more efficient
• 1. Total Assets Turnover
• 2. Inventory Turnover
• How many times inventory must be restocked to
  meet sales

The Total Assets Turnover ratio must be compared
with other companies in the industry.
The inventory turnover ratio is different in
different industries.
Creemee Income Statement
Creemee Balance Sheet
6
Champ Creemee CompanyDebt Management
RatiosLeverage Ratios
Using outside sources of financing to increase
the return to stockholders.

• Degree of Financial risk
• Ability to repay money borrowed
• The higher the ratio, the greater the financial
  risk
• 1. Debt/Equity Ratio Relationship of money owed
  to Stockholders Investment in the Company

Creemee Income Statement
Creemee Balance Sheet
7
Champ Creemee CompanyDebt Management
RatiosCoverage Ratios

• 2. Times Interest Earned (TIE)
• Ability of company to pay (cover) interest
  expense
• The higher the ratio, the better the ability to
  cover
• The higher the ratio, the lower the financial risk

Creemee Income Statement
Creemee Balance Sheet
8
Champ Creemee CompanyProfitability Ratios

• How profitable is the company?
• What kind of return is the company generating on
  sales for stockholders?
• The higher the ratio, the better the
  profitability.
• 1. Profit Margin (Return on Sales)
• What percentage of sales dollar ends up as net
  income ?

9
Champ Creemee CompanyProfitability Ratios

• 2. Return on Equity Return generated on
  stockholders investment in the company
• ROE
• Remember
• Stockholders Equity Common Stock Retained
  Earnings

Creemee Income Statement
Creemee Balance Sheet
10
Impact of Leverage on ROE

• CO. A
• EBIT 100
• Interest Exp. 10
• Earnings
• before taxes 90
• Taxes 36
• Net Income 54
• Debt 500
• Equity 500
• Assets 1000
• Return on 54/1000
• Assets 5.4
• Return on 54/500 0.108
• Equity 10.8

• CO. B
• 100
• 0
• 100
• 40
• 60
• 0
• 1000
• 1000
• 60/1000
• 6.0
• 60/1000 0.06
• 6.0

The stock company
the loan company
Borrowing increases ROE, but borrowing also
increases RISK. Stockholders require an increased
return to balance the risk.
Net income / equity
Net Income / Total Assets
11
Champ Creemee Company Earnings Per Share (EPS)

• EPS
• earned per share of common stock
• Spreads the net income across the shares

12
Champ Creemee Company Valuation Ratios

• How is the company valued compared to other
  companies
• Relatively more or less expensive???
• Price/Earnings Ratio How many dollars investors
  are willing to pay for a dollar of
  future/projected net income

P/E
13
Price / Earnings Ratio
14
Champ Creemee Company The Concept of Market
Value

• Market Value Current aggregate value in the
  market for all the common shares outstanding
  (issued)
• MV Number of common shares outstanding x
  current stock price
• MV 50 stock price x 1,000 shares
• 50,000

15
Champ Creemee CompanyBalance Sheet (as of
12/31/07)

• Accounts Payable 2,000
• Wages Payable 500 Current Liabilities
  2,500
• Notes Payable (L.T.) 5,000
• Total Liabilities 7,500
• Common Stock 10,000
• Retained Earnings 690 Total
  Shareholders
  Equity 10,690
• Total Liab. SH Equity 18,190

• Cash 8,690
• Accounts Receivable 3,000
• Inventory 3,500
• Current Assets 15,190
• Equipment 3,000
• Total Assets 18,190

16
Champ Creemee CompanyIncome Statement (for the
Year ending 12/31/07)

• Sales
• Expenses
• Cost of Goods sold
• Gross Profit
• Waste/Spoilage
• Wages
• Salaries
• Payroll Remittances
• Rent/Permits
• Advertising
• Maintenance and Repair
• Operating Expenses
• Operating Profit (EBIT)
• Interest
• Pre-Tax Profit
• Taxes (35)
• Net Income

• 3,000
• (1,000)
• 2,000
• 50
• 500
• 50
• 50
• 100
• 100
• 50
• (900)
• 1,100
• (500)
• 600
• (210)
• 390