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Financial Ratio Analysis Lecture No. 3 Chapter 2 Contemporary Engineering Economics, 6th ed. Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Ratio Analysis and What the Numbers Really Mean o Debt Management Ratios o Liquidity Ratios o Asset Management Ratios o Profitability Ratios o Market Trend Ratios o Trends and Graphs to Spot Problems Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Key Financial Ratios Debt ratio Times-interest-earned ratio Debt management Current ratio P/E ratio Quick ratio Market/Book ratio Liquidity Market Trend Key Financial Ratios Inventory turnover ratio Day’s sales outstanding ratio Total assets turnover ratio Profit margin on sales Asset Management Contemporary Engineering Economics, 6th edition Park Profitability Return on total assets Return on common equity Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Return on Equity: A Composite Ratio • What to measure: A corporation's profitability by revealing how much profit a company generates with the money shareholders have invested • How to calculate: The amount of net income generated as a percentage of shareholders equity Net income Return on Equity (ROE) = Average shareholders' equity Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Returns on Equity (ROE): Three Components ROE = Net income Average shareholders' equity Assets Net income Sales Sales Assets Average shareholders' equity (Profit margin) (Asset turnover) (Financial leverage) = (6.18%) (2.12 times) (3.64 times) = 47.68% Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Returns on Equity (ROE) and Levels of Performance for Ten Diverse Companies (As of January 26, 2014) Return on Equity (%) Profit Margin (%) Asset Turnover (times) Financial Leverages (times) Google (2013) 16.46 21.66 0.59 1.27 Wells Fargo (2013) 13.86 23.96 0.06 9.81 Alcoa (2013) 2.25 1.27 0.60 2.99 Exxon Co. (2013) 20.35 7.7 1.30 2.05 Kroger (2013) 35.65 1.57 3.97 5.11 IBM (2013) 77.90 15.92 0.87 5.93 Nike (2013) 26.70 10.85 1.59 1.57 Wal-Mart (2013) 23.35 3.62 2.28 2.86 Southwest Airline (2013) 8.85 3.55 0.91 2.76 MSFT (2013) 30.09 28.17 0.61 1.74 Note: ROEs may not match exactly the formula values due to ratios were calculated based on different published data Source: MSN Finance Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved . Debt Management Analysis Definition: Ratios that show how a firm uses debt financing and its ability to meet debt repayment obligations Debt ratio Timesinterestearned ratio Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Debt Ratio Indicates how a firm finances its capital Formula Total debt Debt ratio= Total assets $58,000 $161,400 35.94% A debt ratio of greater than 1 indicates that a company has more debt than assets, a measure of a level of risk. Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Times Interest Earned Ratio Measures the extent to which earnings can decline without defaulting on debt service Formula EBIT Interest Charges $33,280 $5,200 6.40 times Times Interest Earned = EBIT: Earnings before interest and taxes Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Liquidity Analysis • Definition: Ratios that show the relationship of a firm’s cash and other assets to its current liabilities Contemporary Engineering Economics, 6th edition Park Current ratio Quick ratio Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Current Ratio Measures a firm’s short-term solvency Formula Current Assets Current Ratio = Current Liabilities $77,400 $28,000 2.76 times Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Quick Ratio Excludes inventories and prepaid expenses Formula Current Assets - Inventories Current Liabilities $77,400 $37,700 $28,000 1.42 times Quick Ratio = Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Liquidity Ratio An indication of a firm’s immediate liquidity Formula Cash+Cash Equ. Current Liabilities $8,500 $28,000 0.3036 Liquidity Ratio = Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Asset Management Analysis • Definition: A set of ratios which measure how effectively a firm is managing its assets Contemporary Engineering Economics, 6th edition Park Inventory turnover ratio Day’s sales outstanding ratio Total assets turnover ratio Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Inventory Turnover Ratio Highlights the rate at which the inventory is being sold Formula Sales Average Inventory $300,000 ($39,800 $37,700) / 2 7.96 times Inventory Turnover = The typical item sits in inventory almost 1.508 months (12 months/7.96) or 45.24 days before being sold Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Days Sales Outstanding (DSO) Determines whether receivables are being collected aggressively enough Formula A/R Average sales per day $23,700 $300,000 / 365 28.84 days DSO = Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Days Sales in Inventory • What It Measures: The amount of inventory (stock) expressed in days of sales. For example, if 2 items are sold and 20 items are held in inventory per day, this represents 10 days' (20/2) worth of sales in inventory. • How To Compute: The ratio computed by dividing average inventory by cost of sales, and multiplied the result by 365 DSI (Days Sales in Inventory)= Average Inventory Average Cost of Sales per day ($37,700 + $39,800) / 2 $208,000 / 365 = 68 days = Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Total Asset Turnover Ratio Indicates whether a company is generating a sufficient volume of business for the size of its asset investment Formula Net Sales Total Assets $300,000 $161,400 1.86 times Total Asset Turnover = Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Profitability Analysis • Definition: A set of ratios which show the combined effects of liquidity, asset management and debt on operating results Contemporary Engineering Economics, 6th edition Park Profit margin on sales Return on total assets Return on common equity Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Gross Margin Indicates the profitability of sales Formula Gross Profit ($) Net Sales $112,000 $300,000 37.33% Gross Margin Ratio = Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Net Margin Illustrates what percentage of each sales dollar is retained in earnings Formula Net Income ($) Net Sales $20,000 $300,000 6.67% Net Margin Ratio = Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Return on Total Assets (ROA) Measures a company’s success in using its assets to earn a profit. Formula Net Income + interest expenses(1 - tax rate) Average total assets $20,000+$5,200(1-0.2877) = ($161,400+$169,900)/ 2 =14.31% ROA = Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Return on Equity (ROE) Measures the rate of return on the owner’s investment Formula Net Income - Cash dividend to Preferred Stockholders Average Common Equity $20,000 $600 ($93,400 $83,400) / 2 21.95% ROE = Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Debt-to-Equity Ratio o A measure of a company’s financial leverage, indicating what proportion of equity and debt the company is using to finance its assets o A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved How the Debt to Equity Ratio Impacts Return on Equity Not have a spectacular ROE because there is so much equity in the company (e.g., well-established DOW 30 stocks) A highly leveraged company that might have a spectacular ROE because the owners have put so little of their own resources into the company (e.g., high-tech industries) Liabilities Assets Assets = = Equity Liabilities Equity Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Market Trend Analysis • Definition: A set of ratios that relate the firm’s stock price to its earnings and book value per share Contemporary Engineering Economics, 6th edition Park P/E ratio Market/Book ratio Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Earnings Per Share (EPS) Indicates earnings attributable to each share of stock Widely used indicator of a corporation’s performance Net Income - Preferred stock dividends Common Shares Outstanding $20,000 600 10,000 $1.94 EPS = Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Price to Earnings Ratio Indicates how many times a corporation is able to multiply its earnings in terms of asking price per share of stock Share price: $40.50 as of December 28, 2015 Contemporary Engineering Economics, 6th edition Park Price per share P/E ratio = EPS $40.50 $1.94 20.87 Copyright © 2016 by Pearson Education, Inc. All Rights Reserved How to Use P/E Ratios Consider what premium you are paying for a company's earnings today. • P/E Ratios for Selected Stocks Symbol Price BIDU PE-Ratio Symbol Price PERatio 229.46 231.8 GOOG 535.21 27.10 GE 24.59 16.70 MSFT 47.02 18.40 Determine if the expected growth warrants the premium. HD 106.36 24.10 LNKD IBM 156.36 10.01 PCLN 1,041.86 23.50 JNJ 102.26 17.00 AAPL 113.10 17.53 Compare it to its peers in the industry to see its relative valuation. XOM 91.76 11.50 FB 77.50 71.95 WMT 88.63 18.50 KO 43.00 23.90 Contemporary Engineering Economics, 6th edition Park 226.36 676.69 As of January 26, 2015 Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Book Value/Share Indicates what the value of a share of stock is according to the books (financial statements) Equity - Preferred stock Book Value/Share = Average Shares Outstanding $103,400 $10,000 10,000 $9.34 As of December 31, 2015, the closing share price was $40.50. This means that the share was trading at about four times higher than its book value. A higher ratio indicates that investors are willing to bet a higher return on their investment. Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Market Value/Book Value Indicates whether you are paying too much for what would be left if the company went bankrupt immediately A lower ratio would mean that the stock is $40.50 $9.34 4.34 Book Value/Share = As of December 31, 2015, the closing share price was $40.50. undervalued. Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Where Sunset Stands as of January 2015 Category J&M Current Ratio 2.76 1.74 1.03 Times-Interest Earned Ratio 6.40 13.3 47.7 Return on Equity 21.95 11.35 83.36 Return on Assets 14.31 3.5 8.0 Inventory Turnover 7.74 35.6 11.9 Asset Turnover 1.86 0.6 0.8 37.73 55.45 39.36 6.67 4.43 12.78 20.87 19.4 44.1 9.34 10.84 28.35 Gross Margin Net Profit Margin P/E Ratio Book Value Contemporary Engineering Economics, 6th edition Park Industry S&P 500 Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Trends and Graphs to Spot Problems • It reveals whether the firm’s ratios are improving or deteriorating over time. Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Limitations of Financial Ratios o o o Analysts should be aware of ever-changing market conditions and make the necessary adjustments. Difficult to generalize about whether a particular ratio is good or bad Ratio analysis based on any one year may not represent the true business condition. Contemporary Engineering Economics, 6th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved
