Financial Ratio Analysis

Financial Ratio Analysis Focus

Financial analysis: Applying analytical techniques to financial statements and other relevant data to produce information useful for decision making.

Three Issues :

Profitability, Liquidity, Safety (Solvency or Risk)

In general, each financial ratio is closely related to one of the three fundamental issues. This analysis is intended as a background review. See also “Merrill Lynch How to Read A Financial Statement” which is available on the web.

GI Company

Balance Sheet December 31

Current Assets: Cash and cash equivalents Trading securities (at fair value) Accounts receivable Inventory (at lower of cost or market) Total current assets Investments available-for-sale (at fair value) Fixed Assets: Property, plant, and equipment (at cost) Less: Accumulated depreciation Goodwill Total assets Current Liabilities: Accounts payable Notes payable Accrued and other liabilities Total current liabilities Long-term debt: Bonds and notes payable Total liability Stockholders’ Equity: Common stock (100,000 shares outstanding) Additional paid-in capital Retained earnings Total equity Total liability and equity

Year 1 (Current year) $

50,000 750,000 300,000 290,000 715,000 350,000

Year 2 (Last year) $

35,000 65,000 290,000 275,000 665,000 300,000

1,900,000 (380,000) 1,520,000 30,000 $2,615,000

1,800,000 (350,000) 1,450,000 35,000 $2,450,000

$ 150,000 325,000 220,000 695,000

$ 125,000 375,000 200,000 700,000

650,000 1,345,000

600,000 1,300,000

500,000 350,000 420,000 1,270,000 $2,615,000

500,000 350,000 300,000 1,150,000 $2,450,000

GI Company

Income Statement (Year – 1)

Sales

$1,800,000

Cost of goods sold

(1,000,000)

Gross profit

800,000

Operating expenses

(486,697)

Interest expense Depreciation and Amortization expense

(10,000 ) (13,303)

Net income before income taxes Income taxes (31%) Net income after income taxes Earning per share Operating cash flow

290,000 ( 90,000) $ 200,000 $2 $255,000

Dividends for the year

$0.80 per share

Market price per share

$12

Liquidity Ratios

Working capital = Current assents – Current liabilities Year 2:

$715,000 – $695,000 = $20,000

Year 1:

$665,000 – $700,000 = ($35,000)

Liquidity Ratios

Current ratio (working capital ratio) =

Year 2: = Year 1: =

Current assets Current liabilities $715,000 $695,000 $665,000

= 1.03 = 0.95

$700,000 (Industry average = 1.5) The ratio, and therefore Gi’s ability to meet its short-term obligations, has improved, though it is low compared to the industry’s average

Liquidity Ratios

Acid-test ratio =

(Year 2) = (Year 1) =

Cash equivalents + Market securities + Net receivables Current liabilities $50,000 + $75,000 + $300,000 $695,000 $35,000 + $65,000 + $290,000

= 1.03 = 0.95

$700,000 (Industry average = 0.80) The industry average of .80 is higher than Gi’s ratio, which indicates that Gi may have trouble meeting short-term needs.

Liquidity Ratios

Cash ratio =

(Year 2) = (Year 1) =

Cash equivalents + Marketable securities Current liabilities $50,000 + $75,000 $695,000 $35,000 + $65,000 $700,000

= 0.18 = 0.14

Activity Ratios

Accounts receivable turnover =

Net credit sales Gross receivables $1,800,000

=

$300,000 =

6 times

This ratio indicates the receivables’ quality and indicates the success of the firm in collecting outstanding receivables. Faster turnover gives credibility to the current and acid-test ratios.

Activity Ratios

Accounts receivable turnover in days =

= =

Gross receivables Net credit sales / 365 365 days Receivable turnover 60.83days

This ratio indicates the average number of days required to collect accounts receivable.

Activity Ratios

Inventory turnover =

= =

Cost of goods sold Average inventory $1,000,000 $290,000 3.45 times

This measure of how quickly inventory is sold is an indicator of enterprise performance. The higher of turnover, in general, the better the performance.

Activity Ratios

Inventory turnover in days =

=

Average inventory Cost of goods sold / 365 365 days Inventory turnover

=

365 days

=

3.45 105.80 days

This ratio indicates the average number of days required to sell inventory.

Activity Ratios

Operating cycle = AR turnover in days + Inventory turnover in days = 60.83 days + 105.80 days = 166.63 days

This operating cycle indicates the number of days between acquisition of inventory and realization of cash from selling the inventory.

Activity Ratios

Working capital turnover =

Sales working capital

=

$1,800,000 $715,000 - $695,000

= 90 times

This ratio indicates how effectively working capital is used.

Profitability Ratios

Return on total assets = Net income/Total assets = $200,000 / $2,615,000 = 7.65%

Profitability Ratios

Gross margin =

Sales – Cost of Good Sold

=

$1,800,000 - $1,000,000

=

$800,000

Gross margin percentage = Gross margin / Sales = $800,000 / $1,800,000 = 44.44% This ratio is a good indication of how profitable a company is at the most fundamental level. Companies with higher gross margins will have more money left over to spend on other business operations, such as research and development or marketing.

Profitability Ratios

Net profit margin =

= =

Net income Net sales $200,000 $1,800,000 11.11%

This ratio indicates profit rate and, when used with the asset turnover ratio, indicates rate of return on assets, as show below.

Profitability Ratios

Operating margin =

=

=

Operating income Total sales $800,000 - $486,697 $1,800,000 17.41%

Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt.

Activity Ratios

Total asset turnover =

= =

Net sales Total assets $1,800,000 $2,615,000 0.69 times

This ratio is an indicator of how Gi makes effective use of its assets. A high ratio indicates effective asset use to generate sales.

Profitability Ratios

DuPont return on assets = Net income/Total assets Net income =

Net sales

x

Net sales Total assets

= 11.11% x 0.69times = 7.67% Note that this ratio uses both net profit margin and the total asset turnover. This ratio allows for increased analysis of the changes in the percentages. The net profit margin indicates the percent return on each sale while the asset turnover indicates the effective use of assets in generating that sale.

Profitability Ratios

Return on investment =

Net income + Interest expense (1- Tax rate) Long-term liabilities + Equity

=

$200,000 + $10,000 (1-0.31) $650,000 + $1,270,000

= 0.11 times

ROI measures the performance of the firm without regard to the method of financing.

Profitability Ratios

Return on common equity =

Net income – Preferred dividends common equity $200,000 - $0

= =

$1,270,000 15.75%

Long-term Debt-paying Ability Ratio

Debt / Equity =

Total liabilities Common stockholders’ equity

(Year 2) = $1,345,000 / $1,270,000 = 1.06 (Year 1) = $1,300,000 / $1,150,000 = 1.13

This ratio indicates the degree of protection to creditors in case of insolvency. The lower this ratio the better the company’s position. In Gi’s case, the ratio is very high, indicating that a majority of funds come from creditors. However, the ratio is improving.

Long-term Debt-paying Ability Ratio

Debt ratio =

Total liabilities Total assets

(Year 2) = $1,345,000 / $2,615,000 = 51.4% (Year 1) = $1,300,000 / $2,450,000 = 53.1%

This ratio indicates that more than half of the assets are financed by creditors.

Long-term Debt-paying Ability Ratio

Times interest earned =

=

Returning income before taxes and interest Interest $290,000 + $10,000 $10,000

= 30 times This ratio reflects the ability of a company to cover interest charges. It uses income before interest and taxes to reflect the amount of income available to cover interest expense.

Long-term Debt-paying Ability Ratio

Operating cash flow / Total debt =

= =

Operating cash flow Total debt $255,000 $1,345,000 18.96%

This ratio indicates the ability of the company to cover total debt with yearly cash flow.

Liquidity Ratios

The operating cash flow ratio =

Cash from operations

=

Current liabilities $255,000 $700,000

= 0.36 The purpose of this ratio is to assess whether or not a company's operations are generating enough cash flow to cover its current liabilities. If the ratio falls below 1.00, then the company is not generating enough cash to meet its current commitments. Note: The cash from operating activities is $255,000 shown at the bottom of the income statement.

Profitability Ratio

EBIT

= Earnings + Interest Expense + Tax Expense

= $200,000 + $10,000 + $90,000 = $300,000

A measure of a company's earning power from ongoing operations, equal to earnings before deduction of interest payments and income taxes. EBIT excludes income and expenditure from unusual, non-recurring or discontinued activities.

Profitability Ratio

EBITDA = Earnings + Interest Expense + Tax Expense + Depreciation + Amortization

= $200,000 + $10,000 + $90,000 + $13,303

= $ 313,303 This earnings measure is of particular interest in cases where companies have large amounts of fixed assets which are subject to heavy depreciation charges or in the case where a company has a large amount of acquired intangible assets on its books and is thus subject to large amortization charges. Since the distortionary accounting and financing effects on company earnings do not factor into EBITDA, it is a good way of comparing companies within and across industries.