Ch 3. Ratio Analysis

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Ch 3. Ratio Analysis
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Issues in Ch.3

• Common-size statements
• Financial ratio analysis
• Computation
• More importantly, interpretation
• Reading financial statements critically

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Why Ratios?

• Absolute numbers do not carry much significant
  meanings
• Relative (or scaled or standardized) numbers
  provide more insights
• For example, suppose the company made net income
  of 10 million last year. Is this good or bad?
  We dont know it until we standardize 10 million
  by say, total assets or sales revenue.

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Standardized Financial Statements

• Common-Size Balance Sheets
• Compute all accounts as a percent of total assets
• Common-Size Income Statements
• Compute all line items as a percent of sales
• Standardized statements make it easier to compare
  financial information, particularly as the
  company grows
• They are also useful for comparing companies of
  different sizes, particularly within the same
  industry

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Common-size statements (Standardized statements)
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Common-size statements
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Common Size Balance SheetsDivide all items by
Total Assets
Assets 2009 2010 2011E Ind.
Cash 0.6 0.3 0.4 0.3
ST Inv. 3.3 0.7 2.0 0.3
AR 23.9 21.9 25.0 22.4
Invent. 48.7 44.6 48.8 41.2
Total CA 76.5 67.4 76.2 64.1
Net FA 23.5 32.6 23.8 35.9
TA 100.0 100.0 100.0 100.0
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Divide all items by Total Liabilities Equity
Assets 2009 2010 2011E Ind.
AP 9.9 11.2 10.2 11.9
Notes pay. 13.6 24.9 8.5 2.4
Accruals 9.3 9.9 10.8 9.5
Total CL 32.8 46.0 29.6 23.7
LT Debt 22.0 34.6 14.2 26.3
Total eq. 45.2 19.3 56.2 50.0
Total LE 100.0 100.0 100.0 100.0
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Analysis of Common Size Balance Sheets

• Computron has higher proportion of inventory and
  current assets than Industry.
• Computron now has more equity (which means LESS
  debt) than Industry.
• Computron has more short-term debt than industry,
  but less long-term debt than industry.

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Common Size Income StatementDivide all items by
Sales
2009 2010 2011E Ind.
Sales 100.0 100.0 100.0 100.0
COGS 83.4 85.4 82.4 84.5
Other exp. 9.9 12.3 8.7 4.4
Depr. 0.6 2.0 1.7 4.0
EBIT 6.1 0.3 7.1 7.1
Int. Exp. 1.8 3.0 1.1 1.1
EBT 4.3 -2.7 6.0 5.9
Taxes 1.7 -1.1 2.4 2.4
NI 2.6 -1.6 3.6 3.6
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Analysis of Common Size Income Statements

• Computron has lower COGS (86.7) than industry
  (84.5), but higher other expenses. Result is
  that Computron has similar EBIT (7.1) as industry.

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Financial Ratios

• Liquidity ratios
• Leverage ratios
• Asset management ratios
• Profitability ratios
• Market value ratios
• Du Pont Ratios

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Using Bobcats Co.s financial statements,
calculate financial ratios.

• Liquidity (short-term solvency) ratios Measures
  the ease and quickness with which the assets can
  be converted into cash with little or no loss in
  value.
• Current ratio CA / CL
• 100,000 / 150,000
• .67 times
• Quick(Acid-test) ratio (CA - Inv) / CL
• (100,000 50,000) / 150,000
• .33 times
• Cash ratio Cash / Current Liabilities

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Financial Ratios

• Long-term debt (leverage) ratios
• Total debt ratio TD / TA
• 350,000 / 650,000
• .54 times
• Debt-Equity ratio TD / TE
• 350,000 / 300,000
• 1.17 times
• Times interest earned (TIE) EBIT / Int. Exp.
• 200,000 / 10,000
• 20 times

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Typically, financially troubled firms shows
severe deterioration of liquidity and leverage
ratios.
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Financial Ratios

• Asset management (turnover) ratios
• Inventory turnover COGS / Inv
• 400,000 / 50,000 8 times
• Days sales in inventory 365 / Inventory
  turnover
• 365 / 8 45.6 days
• Accounts receivable turnover Sales / AR
• 800,000 / 20,000 40 times
• Days sales on receivables 365 / Accounts
  receivable turnover
• 365 / 40 9.1 days
• Accounts payable turnover COGS / Accounts
  payable
• 400 / 70 5.7 times
• Average payable period 365 / Accounts payable
  turnover
• 365 / 5.7 63.9 days
• Total asset turnover Sales / TA
• 80
• Capital intensity TA / Sales
• 8000 / 650,000 1.2 times

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Financial Ratios

• Profitability ratios
• Profit margin NI / Sales
• 125,400 / 80,000 15.7
• Return on asset NI / TA
• 125,400 / 650,000 19.3
• Return on equity NI / TE
• 125,400 / 300,000 41.8

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More about ROA
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More about ROE
FLM Financial Leverage Multiplier or Equity
Multiplier
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Financial Ratios

• Market Value Ratios
• Assume that a share price of Bobcats is currently
  20 per share, and the number of shares
  outstanding is 20,000.
• Price-Earnings Ratio (PE ratio)
• Price per share / Earnings per share
• 20 / (125,400 / 20,000) 20 / 6.27 3.19
  times
• Market-to-book ratio
• Market value per share / Book value per
  share
• 20 / (300,000 / 200,000) 20 / 15 1.33
  times
• Note Earnings per share Net Income / of
  shares outstanding
• Book value Shareholders equity
• Market Capitalization
• Price per share Shares outstanding
• 20

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Price-Earning Ratio

• If PE ratio 10, then we would say the company's
  stock sell for 10 times earnings.
• PE ratio measures how much investors are willing
  to pay per dollar of current earnings.
• The higher the PE ratio is, the higher the firms
  growth prospects would be in the future.
• Growth Stock stocks with relatively higher PE
  ratio (e.g., Tech stocks)
• Value stock stocks with relatively lower PE
  ratio (e.g., Utility stocks)
• Watch out If the firm generates almost no
  earnings, then PE ratio could be very large.
  (Why?) So, care is needed in interpreting this
  ratio

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Market-to-Book Ratios in 2010
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Using the Du Pont Identity

• ROE PM TAT EM
• NI / TE (NI / Sales) (Sales / TA) (TA /
  TE)
• Profit margin is a measure of the firms
  operating efficiency how well does it control
  costs
• Total asset turnover is a measure of the firms
  asset use efficiency how well does it manage
  its assets
• Equity multiplier is a measure of the firms
  financial leverage

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Du Pont Analysis
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DuPont Analysis Problem

• The following table contains information about
  Campbells (CPB) and H.J. Heinz (HNZ). Compute
  their respective ROEs and then determine how much
  Heinz would need to increase its asset turnover
  in order to match Campbells ROE.

Profit Margin Asset Turnover Equity Multiplier Equity Multiplier
Campbells 10.8 1.22 6.78  
Heinz 8.22 1.04 5.33  
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DuPont Analysis Solution

• We can compute the ROE of each company by
  multiplying together its profit margin, asset
  turnover, and equity multiplier.
• In order to determine how much Heinz would need
  to increase its asset turnover to match
  Campbells ROE, we can set Heinzs ROE equal to
  Campbells, keep its profit margin and equity
  multiplier fixed, and solve for the asset
  turnover.
• Using the DuPont Identity, we have
• ROECPB 10.8 x 1.22 x 6.78 89.3
• ROEHNZ 8.22 x 1.04 x 5.33 45.6
• Now, using Campbells ROE, but Heinzs profit
  margin and equity multiplier, we can solve for
  the asset turnover that Heinz needs to achieve
  Campbells ROE
• 89.3 8.22 x Asset Turnover x 5.33
• Asset Turnover 89.3 / 43.8 2.04

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DuPont Analysis Evaluate

• Heinz would have to increase its asset turnover
  from 1.04 to 2.04 in order to match Campbells
  ROE.
• This large increase in asset turnover is required
  because of its lower equity multiplier (5.33 vs.
  6.78) (lower leverage) and lower profit margin
  (8.22 vs. 10.8).

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Payout and Retention Ratios

• Suppose Bobcat Co. distributed 40,128 of cash
  dividends.
• Dividend payout ratio
• Cash dividends / Net income
• 40,128 / 125,400 32
• Retention ratio
• Additions to retained earnings / Net income
• 1 payout ratio
• 1 32 68

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Internal and Sustainable GrowthPayout and
Retention Ratios

• Dividend payout ratio
• Cash dividends / Net income (DIV / NI)
• 121/363 33.3

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Internal and Sustainable GrowthPayout and
Retention Ratios

• Retention ratio (b) (NI - DIV)/ NI
• Addition to Retained Earnings / Net income
• 242/363 66.7

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The Internal Growth Rate

• How much the firm can grow assets using retained
  earnings as the only source of financing.

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The Sustainable Growth Rate

• How much the firm can grow by using internally
  generated funds and issuing debt to maintain a
  constant debt ratio.

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Determinants of Growth

• Profit margin operating efficiency
• Total asset turnover asset use efficiency
• Financial leverage choice of optimal debt ratio
• Dividend policy choice of how much to pay to
  shareholders versus reinvesting in the firm

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Why Evaluate Financial Statements?

• Internal uses
• Performance evaluation compensation and
  comparison between divisions
• Planning for the future guide in estimating
  future cash flows
• External uses
• Creditors
• Suppliers
• Customers
• Stockholders

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Benchmarking

• Ratios are not very helpful by themselves they
  need to be compared to something
• Time-Trend Analysis
• one-year ratios do NOT provide a full picture
• Used to see how the firms performance is
  changing through time
• Do multi-year analysis
• Peer Group Analysis
• Compare to similar companies or within industries
• SIC and NAICS codes (http//www.naics.com/)
• Should be used in conjunction with other
  qualitative measurements. For example,
  heterogeneity in accounting practice, market
  structures, customer bases, capital structures,
  etc.

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Peer Group Analysis (http//yahoo.marketguide.com)
Advanced Micro Device (AMD)
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Trend analysis in the computer industry
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Comparative Analysis Lowes vs. Home Depot
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Ratio Analysis

• Saxton Industry
• Company Average Conclusion
• A. Profitability
• 1. Profit Margin 5.0 6.7 Below
  average
• 2. Return on Assets .. 12.5 10.0 Above
  average due to high turnover
• 3. Return on Equity .. 20.0 15.0 Good
• B. Asset Utilization
• 4. Receivables turnover . 11.4 10.0 Good
• 5. Average collection period. 32.0 36.0 Good
• 6. Inventory turnover ... 10.8 7.0 Good
• 7. Fixed asset turnover . 5.0 5.4 Below
  average
• 8. Total asset turnover . 2.5 1.5 Good
• C. Liquidity
• 9. Current ratio 2.67 2.1 Good
• 10. Quick Ratio .. 1.43 1.0 Good
• D. Debt Utilization

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Summarizing Ratios (20072009, Including 2009
Industry Averages)
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Summarizing Ratios (cont.)(20072009, Including
2009 Industry Averages)
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Quiz 1

• You have the following data for the Frank Winery
  
• Earnings before taxes 300,000,
• Total asset turnover 0.80,
• Sales 800,000
• Tax rate 35.
• What is the firm's return on assets (ROA)?

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Quiz 2

• If total debt ratio is 20, and ROA is 5, what
  is ROE?

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Quiz 3

• The current ratio of a firm would be increased
  by which of the following?
• a. land held for investment is sold for cash
• b. equipment is purchased, financed by a
  long-term debt issue
• c. inventories are sold for cash
• d. inventories are sold on a credit basis

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Quiz 4

• Which ratio measures the financial or credit
  risk?
• Which ratio measures the companys ability to
  service its fixed interest payment?
• Which ratio measures the companys ability to pay
  off short-term obligations like notes payables
  and accounts payables?
• Which ratio measures how well the company
  generates revenues and controls costs and
  expenses (i.e., overall operating effectiveness)?
• Which ratio measures the companys ability to
  deliver the shareholders value?
• Which ratio measures the companys market price
  relative to 1 of capital that was invested by
  shareholders?

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Common Size Balance Sheet
For SP Composite Index Firms during 2005
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Common Size Income Statement
For SP Composite Index Firms during 2005
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Financial Ratios
2005 Ratios for selected firms
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Limitations of Financial Ratio Analysis

1. Difficult to identify industry categories or
   comparable peers.
2. Published peer group or industry averages are
   only approximations.
3. Industry averages may not provide a desirable
   target ratio or norm.
4. Accounting practices differ widely among firms
5. A high or low ratio does not automatically lead
   to a specific favorable or unfavorable
   conclusion.
6. Seasons may bias the numbers in the financial
   statements.