FINANCIAL RATIO ANALYSIS

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FINANCIAL RATIO ANALYSIS
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Ratio Analysis Presentation
The format for this presentation is as
follows 1. The Basics of Financial
Ratios 2. Interpreting Financial Ratios 3.
Making those Interpretations more Meaningful
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The Basics of Financial Ratios
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Financial Ratios, what are they?

• Financial Ratios are specific tools which can be
  used to make more educated
• investment decisions.
• Financial Ratios provide a method to make more
  meaningful evaluations of a
• companies financial condition.
• Financial Ratios express relationships among
  items found in financial statements.
• Information from these items may not be apparent
  when examined individually.

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Categorizing Financial Ratios

• Financial Ratios can be categorized into one of
  four groups, their classification
• is dependant the information they display to the
  user.
• These four categories are
• 1. Profitability Ratios
• 2. Liquidity Ratios
• 3. Solvency Ratios
• 4. Cash Flow Ratios

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Profitability Ratios

• Profitability ratios measure the income or
  operating success of a company for a given period
  of time.
• Profitability Ratios make use of the statement
  of earnings.
• Examples of Profitability Ratios include
• - Return on Assets
• - Profit Margin

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Return on Assets and Profit margin
Return on Assets Net Earnings/Average
Assets The return on assets ratio indicates the
amount of net earnings generated by each dollar
invested in assets. This ratio also indicates
how efficiently the company is using their
assets to generate profits.
Profit Margin Ratio Net Earnings/Net Sales The
profit margin ratio indicates the percentage of
each dollar of sales that results in net
earnings.
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Liquidity Ratios

• Liquidity Ratios measure the short term ability
  of a company to meet current
• obligations.
• Liquidity Ratios make use of the balance sheet
• Examples of Liquidity Ratios
• - Current Ratio
• - Quick (or Acid) Ratio

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Current and Quick Ratios
Current Ratio Current Assets/Current
Liabilities The Current Ratio measures a
companies ability to meet short term liabilities
with short term (or current) assets. This is an
important indicator to an investor as it allows
him or her to see if the company will be able to
operate through its obligations. Quick (Acid)
Ratio One step removed from Current
Assets/Current Liabilities The Quick Ratio
removes uncertainty about the composition of the
current assets. This is done by removing
inventories from the ratio, Inventories may be
slow moving and therefore not truly represent a
companies ability to meet obligations.
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Solvency Ratios

• Solvency Ratios measure the ability of a company
  to meet long term obligations.
• Solvency Ratios are important to long term
  investors and creditors.
• Examples of Solvency Ratios
• - Debt to Total Asset Ratio
• - Debt to Shareholders Equity Ratio

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Debt to Total Assets Ratio and Debt to
Shareholders Equity Ratio
Debt to Total Assets Ratio Total
Liabilities/Total Assets The debt to total
assets ratio measures the percentage of assets
financed by creditors rather than shareholders.
A higher percentage of debt financing leads to
higher risk when investing. Debt to
Shareholders Equity Ratio Total
Liabilities/Total Shareholder Equity The higher
the debt to shareholders equity ratio the less
solvent the company, meaning the company runs a
greater risk of not being able to repay long term
debt at maturity date.
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Cash Flow Ratios

• Cash flow is the single most important aspect of
  a companies financial condition,
• it is important to know how the cash was
  generated and where it is being spent.
• Cash is primarily generated from two different
  avenues
• - operating activities
• - financing activities
• Cash flow ratios calculate additional measures
  of liquidity and solvency.
• Examples of Cash Flow Ratios are
• - cash current debt coverage ratio
• - cash total debt coverage ratio

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Cash Current Debt Coverage Ratio and Cash Total
Debt Coverage Ratio
Cash Current Debt Coverage Ratio Cash Provided
by Operating Activities/ Average Current
Liabilities The cash current debt coverage ratio
measures the companies ability to generate cash
to cover short term liabilities. Cash Total
Debt Coverage Ratio Cash Provided by Operating
Activities/ Average Total
Liabilities The cash total debt coverage ratio
measures the companies ability to generate cash
to cover long term liabilities.
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Interpreting Financial Ratios
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What We Know Now

• So far we know what different ratios calculate
  and what they indicate,
• but what is a good number?
• Some texts suggest numbers, why do they suggest
  these numbers?
• How can we use these numbers to make informative
  decisions?

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Interpretations of Financial Ratios

• The value in financial ratios does not lie in the
  number itself but rather in
• comparisons with other computed ratios.
• Comparisons can take on different forms, such as
  the following
• 1. Comparison from year to year for the company
  of interest. This
• can demonstrate the direction of change of the
  ratios over a time
• period, possibly leading to an indication of the
  companies financial
• health.
• 2. Comparisons from one company to another,
  comparing your company to the competition.
• 3. Comparisons to a Universe of Coverage

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The Universe of Coverage

• I would suggest that one of the most useful
  comparisons investors can make
• is comparing their companies ratios to ratios in
  a Universe of Coverage.
• A universe of coverage is a collection of
  companies which via some type of
• defining term allots the company either inside or
  outside the universe of
• coverage.
• The universe of coverage can be detailed to
  include only the most direct
• competition providing a better industry average
  than traditional industry
• definitions allow for.
• A universe of coverage is determined by the
  investor allowing him or her to
• dictate what type of companies should be included
  in his comparisons.

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An Example of a Universe of Coverage

• With the EnCana Corp. being my company of
  interest I defined my universe of
• coverage based on what qualities I knew EnCana
  had as a company in the
• upstream oil and gas industry.
• EnCana is an independent oil and gas company (as
  opposed to Petro-Canada
• who has involvement in the upstream, midstream
  and downstream segments of
• the oil and gas industry), therefore my universe
  of coverage need only include
• independent upstream oil and gas companies.
• Further information was used in determining the
  universe of coverage for
• comparing EnCana to meaningful competition. In
  the end I defined my universe
• of coverage as Independent Upstream Oil and Gas
  Companies producing more
• than x barrels of oil and gas equivalents per day
  per U.S. dollar.

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Further information regarding the Universe of
Coverage

• So what does this mean for ratio analysis? It
  is fundamentally important to
• compare companies which an investor would assume
  operate under similar
• business conditions.
• For example, comparing hedging contracts between
  a junior upstream oil and gas producer and a
  senior upstream oil and gas producer would have a
  dramatic effect on conclusions drawn concerning
  cash flow. Total liabilities between junior and
  senior producers may not vary in the same degree
  as total
• assets (due to hedging).
• Furthermore, a universe of coverage defines
  industry in much more specific way, just as it
  would be ridiculous to compare an oil and gas
  company to a software company, it would be
  ridiculous to compare junior and senior oil and
  gas producers.

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A graphical example of Comparisons within a
Universe of Coverage
The following graphs are comparisons of some
ratios for EnCanas Universe of Coverage.
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Debt to Equity Ratio Comparison for our
Independent Upstream Oil and Gas Universe of
Coverage
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Quick Ratio Comparison for our Independent
Upstream Oil and Gas Universe of Coverage
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Current Ratio Comparison for our Independent
Upstream Oil and Gas Universe of Coverage
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Making Interpretations More Meaningful
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Further Ways to Make Interpretations more
Meaningful
Given that we have defined a universe of
coverage, what else can lead to misinformed
results? Accounting procedures can dramatically
affect the results of the ratios and their
meanings. In order to further improve our
comparison we need to improve the comparability
of the ratios.
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Increasing Comparability

• I would suggest that the value of the ratios do
  not actually lie within the number,
• but rather in what the number represents. We
  need to change the components
• of the ratios so that include the same elements
  and do not include extras.
• This information can primarily be found in the
  notes to the financial statements.
• For example, hypothetically imagine the
  following circumstance. American airlines has
  acquired its fleet through various financing
  projects and cash contributions, they then record
  the airplanes as an asset and depreciate them
  accordingly. Now Imagine that Air Canada has
  decided to lease its fleet and record the cost of
  their Fleet as an expense. Assuming that these
  companies were of similar size and fall in the
  same universe of coverage, it would be more
  correct to use a Net Present Value Of Money
  function to estimate the cost of Air Canadas
  fleet and depreciate it accordingly. This would
  change asset numbers to make the two companies
  more comparable.

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Summary
Financial Ratio Analysis should play a key role
in any investors decision making process, but the
results of these ratios can be improved
by allocating a Universe of Coverage and making
elements of ratio computations more Comparable.