Download Financial Ratios

Analysis of Financial Statements
Timothy R. Mayes, Ph.D.
FIN 3300: Chapter 3
1
Common-size Income Statements


A common-size
income statement
restates all expenses
as a percentage of
sales
This allows the
analyst to quickly
and easily see which
expenses have
increased or
decreased relative to
sales
Elvis Products International
Common-size Income Statement
For the Year Ended Dec. 31, 1997 ($ 000's)
Sales
Cost of Goods Sold
Gross Profit
Selling and G&A Expenses
Fixed Expenses
Depreciation Expense
EBIT
Interest Expense
Earnings Before Taxes
Taxes @ 40%
Net Income
1997%
100.00%
83.33%
16.67%
8.47%
2.56%
0.51%
5.12%
1.95%
3.17%
1.27%
1.90%
1997
3900.00
3250.00
650.00
330.30
100.00
20.00
199.70
76.00
123.70
49.48
74.22
1996%
100.00%
81.83%
18.17%
6.86%
2.86%
0.54%
7.92%
1.79%
6.13%
2.45%
3.68%
1996
3500.00
2864.00
636.00
240.00
100.00
18.90
277.10
62.50
214.60
85.84
128.76
2
Common-size Balance Sheets


A common-size
balance sheet
restates all assets
and liabilities as a
percentage of total
assets
This allows the
analyst to quickly
and easily see which
accounts have
increased or
decreased relative to
total assets
Elvis Products International
Common-size Balance Sheet
As of Dec. 31, 1997 ($ 000's)
Assets
Cash and Equivalents
Accounts Receivable
Inventory
Total Current Assets
Plant & Equipment
Accumulated Depreciation
Net Fixed Assets
Total Assets
1997%
1997
1996%
1996
3.03%
50.00
3.92%
57.60
24.35%
402.00 23.91%
351.20
50.76%
838.00 48.69%
715.20
78.14% 1290.00 76.53% 1124.00
31.92%
527.00 33.43%
491.00
10.07%
166.20
9.95%
146.20
21.86% 360.80 23.47% 344.80
100.00% 1650.80 100.00% 1468.80
Liabilities and Owner's Equity
Accounts Payable
10.61%
175.20
Short-term Notes Payable
13.63%
225.00
Other Current Liabilities
8.48%
140.00
Total Current Liabilities
32.72% 540.20
Long-term Debt
25.72%
424.61
Total Liabilities
58.45% 964.81
Common Stock
27.87%
460.00
Retained Earnings
13.69%
225.99
Total Shareholder's Equity
41.55% 685.99
Total Liabilities and Owner's Equity 100.00% 1650.80
9.91%
145.60
13.62%
200.00
9.26%
136.00
32.79% 481.60
22.02%
323.43
54.81% 805.03
31.32%
460.00
13.87%
203.77
45.19% 663.77
100.00% 1468.80
3
Financial Ratios


Financial ratios are the analyst’s microscope; they
allow us to get a better view of the firm’s financial
health than just looking at the raw financial
statements
Ratios are used by both internal and external analysts
• Internal uses
planning
 evaluation of management

• External uses
credit granting
 performance monitoring
 investment decisions

4
Categories of Financial Ratios

Financial ratios are often divided into
categories based on the information that they
provide:
•
•
•
•
•
•
Liquidity
Efficiency
Leverage
Coverage
Profitability
Market valuation
5
Liquidity Ratios
‘Liquidity’ refers to the speed with which an
asset can be converted to cash
 Liquidity ratios describe the ability of a firm
to meet its current obligations
 There are three common liquidity ratios:

• The Current Ratio
• The Quick Ratio
• The Cash Ratio
6
The Current Ratio
Current Assets
CR 
Current Liabilities
For EPI the current ratio in 1997 is:
1290
CR 
 2.39
540.20
7
The Quick Ratio
Current Assets  Inventories
QR 
Current Liabilities
For EPI the quick ratio in 1997 is:
1290  838
QR 
 0.84
540.20
8
The Cash Ratio
Cash
Cash Ratio 
Current Liabilities
For EPI the cash ratio in 1997 is:
50
Cash Ratio 
 0.09256
540.20
9
Efficiency Ratios

The efficiency ratios (A.K.A. assets utilization
ratios) describe how well a firm is using its
investment in various asset classes:
•
•
•
•
•
Inventory Turnover Ratio
Accounts Receivable Turnover Ratio
Average Collection Period
Fixed Asset Turnover Ratio
Total Asset Turnover Ratio
10
The Inventory Turnover Ratio
Cost of Goods Sold
Inventory Turnover 
Inventory
For EPI the inventory turnover ratio in 1997 is:
3250
Inventory Turnover 
 388
.
838
11
The A/R Turnover Ratio
Annual Credit Sales
A / R Turnover 
Accounts Re ceivable
For EPI the accounts receivable turnover ratio in 1997 is:
3900
A / R Turnover 
 9.70
402
12
The Average Collection Period
Accounts Re ceivable
Average Collection Period 
Annual Credit Sales 360
For EPI the average collection period in 1997 is:
402
Average Collection Period 
 37.11
3900 360
13
The Fixed Asset Turnover Ratio
Sales
Fixed Asset Turnover 
Net Fixed Assets
For EPI the fixed asset turnover ratio in 1997 is:
3900
Fixed Asset Turnover 
 10.81
360.80
14
The Total Asset Turnover Ratio
Sales
Total Asset Turnover 
Total Assets
For EPI the total asset turnover ratio in 1997 is:
3900
Total Asset Turnover 
 2.36
1650.80
15
Leverage Ratios

Leverage ratios describe the amount of debt
that the firm has used to finance its
investments in assets:
•
•
•
•
Total Debt Ratio
Long-term Debt Ratio
Debt to Equity
Long-term Debt to Equity
16
The Total Debt Ratio
Total Liabilities
Total Debt Ratio 
Total Assets
For EPI the total debt ratio in 1997 is:
964.81
Total Debt Ratio 
 58.45%
1650.80
17
The Long-term Debt Ratio
Long termDebt
Long termDebt Ratio 
Total Assets
For EPI the long-term debt ratio in 1997 is:
424.61
Long termDebt Ratio 
 25.72%
1650.80
18
The Debt to Equity Ratio
Total Liabilities
Debt to Equity 
Total Equity
For EPI the debt to equity ratio in 1997 is:
964.81
Debt to Equity 
 141
.
685.99
19
The Long-term Debt to Equity Ratio
Long term Debt
LTD to Equity 
Total Equity
For EPI the long-term debt to equity ratio in 1997 is:
424.61
LTD to Equity 
 6190%
.
685.99
20
Coverage Ratios

Coverage ratios indicate the firm’s ability to
pay certain expenses:
• Times Interest Earned Ratio
• Cash Coverage Ratio
21
The Times Interest Earned Ratio
EBIT
TIE 
Interest Expense
For EPI the times interest earned ratio in 1997 is:
199.70
TIE 
 2.63
76
22
The Cash Coverage Ratio
EBIT  Non cash Expenses
Cash Coverage Ratio 
Interest Expense
For EPI the cash coverage ratio in 1997 is:
199.70  20
Cash Coverage Ratio 
 2.89
76
23
The Fixed Charge Coverage Ratio
EBIT + Lease Payments
Fixed Ch arg e Coverage =
SF Payments
Int. Exp.+LeasePayments +
(1- t )

Note: SF Payments are Sinking Fund payments
which are not tax deductible. Therefore, we must
divide them by (1-t) to find out how much we need
before taxes to meet this after-tax expense. Also, you
must include preferred dividends in this number.
24
Profitability Ratios

Profitability ratios provide a measure of the
returns that a firm is generating:
•
•
•
•
•
•
Gross Profit Margin
Operating Profit Margin
Net Profit Margin
Return on Total Assets
Return on Equity
Return on Common Equity
25
The Gross Profit Margin
Gross Profit
GPM 
Sales
For EPI the gross profit margin in 1997 is:
650
GPM 
 16.67%
3900
26
The Operating Profit Margin
Net Operating Income
OPM 
Sales
For EPI the operating profit margin in 1997 is:
199.70
OPM 
 512%
.
3900
27
The Net Profit Margin
Net Income
NPM 
Sales
For EPI the net profit margin in 1997 is:
74.22
NPM 
 190%
.
3900
28
The Return on Total Assets
Net Income
ROA 
Total Assets
For EPI the return on total assets in 1997 is:
74.22
ROA 
 4.50%
1650.80
29
The Return on Equity
Net Income
ROE 
Total Equity
For EPI the return on equity in 1997 is:
74.22
ROE 
 10.82%
685.99
30
The Return on Common Equity
Net Income
ROCE 
Total Common Equity
For EPI the return on common equity in 1997 is:
74.22
ROCE 
 10.82%
685.99
31
Market Valuation Ratios

The market valuation ratios provide an
indication of the relative under- or overpricing of a firm’s stock:
• Price/Earnings Ratio
• Price/Book Ratio
32
The Price/Earnings Ratio
Stock Pr ice
P/E
Earnings per Share
33
The Price/Book Ratio
Stock Price
P/B
Book Value per Share
34
Rules for Memorizing Ratios

There can be an infinite number of financial
ratios, but knowing a few basic rules will help
you to memorize the formulas: The basic rule
is that the name tells you how to calculate the
ratio.
• Any ‘margin’ ratio is something divided by sales
• Any ‘turnover’ ratio is sales (or a variation of
sales) divided by something
• Any ‘return on’ ratio is net income (or a variation
of net income) divided by something
35
Using Financial Ratios



Calculating ratios is pointless unless you know how
to use them
The most basic rule is: a single ratio provides very little
information and may be misleading
With that in mind, there are at least 4 uses of ratios:
•
•
•
•
Trend analysis (internal and external)
Comparison to industry averages (internal and external)
Setting and evaluating company goals (internal)
Restrictive debt covenants (external)
36
Trend Analysis of Ratios


Trend analysis involves the
examination of ratios over
time
The analyst tries to
determine if the ratio is
changing in a favorable, or
unfavorable, direction
The chart shows EPI’s
current ratio for two years
(we really need more data)
EPI Current Ratio Trend
Curre nt Ratio

2.40
2.39
2.38
2.37
2.36
2.35
2.34
2.33
2.32
2.31
2.30
x
x
x
x
x
x
x
x
x
x
x
1996
1997
Ye ar
37
Comparing to Industry Averages
Ratio



Industry average ratios
provide a benchmark
for comparison
We assume that if a
ratio is too far from the
average something is
wrong
Industry ratios are
available from Robert
Morris Associates and
Standard & Poor’s
Industry
1997
Liquidity Ratios
Current
2.70 x
Quick
1.00 x
Efficiency Ratios
Inventory Turnover
7.00 x
A/R Turnover
10.70 x
Average Collection Period
33.64
Fixed Asset Turnover
11.20 x
Total Asset Turnover
2.60 x
Leverage Ratios
Total Debt Ratio
50.00%
Long-term Debt Ratio
20.00%
LTD to Total Capitalization
28.57%
Debt to Equity
1.00 x
LTD to Equity
40.00%
Coverage Ratios
Times Interest Earned
2.50 x
Profitabilty Ratios
Gross Profit Margin
17.50%
Operating Profit Margin
6.25%
Net Profit Margin
3.50%
Return on Total Assets
9.10%
Return on Equity
18.20%
Other Ratios
Payout Ratio
Plowback (Retention) Ratio
Internal Growth Rate
Sustainable Growth Rate
Capital Intensity Ratio
38.46%
1997
1996
2.39 x
0.84 x
2.33 x
0.85 x
3.88 x
9.70 x
37.11
10.81 x
2.36 x
4.00 x
9.97 x
36.12
10.15 x
2.38 x
58.45%
25.72%
38.23%
1.41 x
61.90%
54.81%
22.02%
32.76%
1.21 x
48.73%
2.63 x
4.43 x
16.67%
5.12%
1.90%
4.50%
10.82%
18.17%
7.92%
3.68%
8.77%
19.40%
70.06%
29.94%
1.36%
3.35%
42.33%
41.97%
38
Company Goals and Debt Covenants

Company goals are often stated in terms of
financial ratios
• For example, it is common for management to set
goals regarding the firm’s ROE

Debt covenants often contain restrictions on
certain ratios
• For example, a borrower might be required to
maintain a debt to equity ratio of less than 1.0 and
a current ratio greater than 2.0
39