Organize Your Financial Ratios Analysis With Palms

Organize Your Financial Ratios Analysis with PALMS

Elisa Rinastiti Muresan, PhD (The author is an Assistant Professor of Finance at the School of Business, Long Island University at 1 University Plaza, Brooklyn, New York, NY11201. Tel. +1 – 718 – 488 1150, Fax. +1 – 718 – 488 1125, Email: [email protected])

Professor Philip Wolitzer, CPA (The author is a Professor Emeritus of Accounting at the School of Business, Long Island University at 1 University Plaza, Brooklyn, New York, NY11201. Tel. +1 – 718 – 488 1152, Fax. +1 – 718 – 488 1125, Email: [email protected])

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Organize Your Financial Ratios Analysis with P A L M S

Abstract: Financial ratios are useful measures to provide a snapshot of a company’s financial position. There are so many of them, making it difficult to decide and memorize which one(s) would be the most appropriate to be used for getting the overall financial picture about a company. Additionally, the interpretation of the calculated ratios plays an important role in determining the quality of the financial analysis of the company. This article presents a mnemonic formula, which is intuitively appealing, original, and innovative; serving as an aid for identifying the five most useful categories of financial ratios to obtain the overall picture of a company’s financial position, the PALMS (Profitability, Asset utilization, Longterm solvency, Market value, and Short-term solvency ratios). Not only is PALMS easy to remember, it is also flexible to use and systematically intuitive to interpret. PALMS help analysts to better organize their process of analyzing a company’s financial position to arrive at a comprehensive and accurate conclusion about the company.

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Introduction:

Financial ratios are employed to assess a company’s financial position relative to its industry or peer1. The gauge of a financial ratio is the company’s accounting information2, which can be found in the company’s main financial statements such as Income Statement and Balance Sheet. Accordingly, in order to use3 a financial ratio, one needs a relatively decent knowledge of basic mathematical and accounting concepts. The importance of financial ratios analysis is unquestionable. For example, in regulating companies to file for their 10-K, the U.S. Securities Exchange and Commission requires them to show their ratio of earnings to fixed charges4. In analyzing the probability of default of a credit issuer, Standard and Poor’s, Moody’s, and FitchIBCA use several types of financial ratios of the rated companies5. Even the most commonly-used financial databases such as Dun and Bradstreet6, Compustat7, Mergent Online8, and Datastream9 provide financial ratios data to aid researchers conduct a company’s fundamental analysis. Therefore it is not surprising that in (introductory) corporate finance textbooks, there will always be a section (sometimes even a chapter) dedicated on the discussion of using (calculating and interpreting) financial ratios to analyze the financial position of a 1

Comparison to the industry is usually considered sufficient using up to four digits SIC level; and comparison to the peer usually depends on the amount of a firm's total assets, market capitalization, and stockholders’ equity. 2 The ‘main’ accounting report consists of Income Statement, Balance Sheet, Cash Flows Statement, and Statement of Equity holders. If needed, more explanations on the company’s financial position may be obtained in the Management Discussions and Analysis, and the Notes to Financial Statement. 3 The word ‘use’ here refers to the process of calculating and interpreting the financial ratios. 4 See the www.sec.gov/divisions/corpfin/forms/regsk.htm, Subpart 229.500, Item 503: Summary Information, Risk Factors and Ratio of Earnings to Fixed Charges. 5 See “Corporate Ratings Criteria” of Standard and Poor’s at www.standardandpoors.com/ratings; also see “Guide to Moody’s Ratings, Rating Process, and Rating Practices” at www.moodys.com/moodys/cust/ratingdefinitions; and “Corporate Rating Methodology” of FitchRatings at www.fitchibca.com. 6 See https://www.dnb.com/product/contract/ratiosP.htm. 7 See http://www.compustat.com/www/. 8 See http://www.mergentonline.com. 9 See http://www.datastream.net.

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company (see Table 1 for the list of commonly-used textbooks taught in introductory corporate finance classes in the US, which discuss financial ratios analysis in their chapters).

Why are financial ratios so popular? Firstly, perhaps because they are intuitively easy to calculate, simply define a set of accounting figures as the numerator and divide it with a set of other accounting figures as the denominator10. Secondly, they are also relatively straightforward to interpret because they refer directly to certain accounting figures11. Financial ratios, however, have a few major drawbacks. Firstly, they depend on accounting figures, which can sometimes be unreliable12. Secondly, there are so many types of them that make it uneasy to decide which would be the most useful financial ratios to be employed. Thirdly there has been no method designed so far, that will enable one to conduct a systematically and methodically comprehensive analysis of the overall financial performance of a company. Nonetheless, each time a financial analyst has to justify his/her analysis, he/she usually provides several figures of ratios, which represent certain categories of a company’s financial position attempting to answer the five key conditions of the company: (a) its profitability, (b) its ability to manage its assets effectively, (c) its potential to stay alive and healthy as long as possible through efficacy management of its sources of funding, (d) its competency to do better than its peer in the market, and (d) its efficiency in managing its day-to-day activities. 10

The official definition of a Financial Ratio as defined by the U.S. Government Small Business Association can be found at http://www.sba.gov/test/wbc/docs/finance/fs_ratio1.html. 11 The U.S. Securities and Exchange Commission defines ‘General Standard’ financial ratios as ratios or statistical measures that are calculated using financial information that is reported in accordance with the GAAP (see the Final Rule of the Conditions for Use of Non-GAAP Financial Measures by the U.S. SEC in 17 CFR Parts 228, 229, 244 and 249, at http://www.sec.gov/rules/final/33-8176.htm). 12 Lanez J.A. and Callao S. (2000) find important differences in the situation of companies (liquidity, solvency, indebtedness and profitability) under different accounting principles. McLeay S. and Trigueiros D. (2002) show that the multiplicative character of the financial variables from which financial ratios are constructed is a necessary condition of valid ratio usage, not just an assumption supported by evidence. Kaminski K.A., Wetzel T.S., and Guan L. (2004) find that misclassification of financial ratios for fraud firms ranged from 58 – 98%, indicating limited ability of financial ratios to predict fraudulent accounting information.

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The P A L M S: This article proposes the mnemonic method of “PALMS for Financial Ratios” to assess a company’s financial position comprehensively, giving no opportunities to overlook any important financial indicators. This method simply and conveniently uses the interface of a normal palm with its five fingers stretched out representing the five key categories of all financial ratios. Exhibit 1 shows the graphical illustration of this method in which P stands for Profitability, A is the Assets Utilization, L denotes the Long-term solvency, M refers to the company’s Market value, and S represents the Short-term solvency of the company. This method is also intuitively systematic compared to its aliases (see Exhibit 2) that have been used variably in the mix-and-match manner.

More specifically, the intuitive process of analysis in PALMS follows the flow of recording the influential financial transactions that a company does throughout one financial period (see Exhibit 3). Exhibit 3 illustrates a top-down approach that an investor would intuitively follow in order to systematically analyze a company starting from the end result of the company’s activities: profit. Profit results from smart management of assets and activities throughout a financial period. In order to acquire the assets that the company needs to produce profits, some funding is needed. A well-thought management of these sources of funding is also essential to support the company’s longevity in business. For example, if a company uses too much leverage and takes up too much debts, it may end up having to pay the interest and principal of the debts extensively, resulting in reduced profit from its business activities. This in turn will not satisfy its owners, the share/equity/stock-holders, whose perceptions play a crucial role in the company’s future expectation. On the other hand, debts are less costly than equities and easier to obtain.

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Therefore, it is essential that a company makes the most appropriate decision to use debts or equities as their source of funding. Lastly, but not less important, is the analysis of a company’s ability to manage its short-term ordeals, managing its current assets and liabilities during a oneperiod of financial activities.

The first letter in PALMS, P, signifies the first question of a company’s profit-making capability (profitability). In this category, the three main financial ratios are the Profit Margin, Return on Assets (ROA), and Return on Equity (ROE) Ratios (see Exhibit 4). Different types of profits may be used as the numerators in the calculation process of the Profit Margin Ratio (Gross Margin, Operating Income and Net Income), allowing different users to satisfy their need of information. For example, a debtor may be more interested in assessing a company’s ‘operating’ rather than ‘net’ income. This is because debtors are entitled to their interest payments, which are deducted from the company’s operating rather than net income. On the other hand, stockholders are probably more interested in the company’s net rather than operating income because they are only entitled to the company’s income after a deduction of all payment obligations.

The second letter in PALMS, A, refers to the direct sources that companies use/produce in order to make profits: assets. Assets may be broken down into two main classifications, current and fixed or other; whose determination of efficiencies may be gauged based on their ratios to the company’s sales or total assets. Although not limited, especially for industrial companies, the types of current assets that typically should be placed under scrutiny are Inventories and Account Receivables. This is because if a company has too much inventory relative to its ability to sell, it means the company may have taken on unnecessary storage, production, and selling costs

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affecting its level of profit. Additionally, it may also reflect the company’s weakness in planning its production level. The amount of account receivables turnover also reflects the company’s policy in asset management. This is because if the company is unable to obtain cash from its credit sales relatively quickly, it may end up having to run its business without obtaining any cash flows to support its current and near-future production.

The L letter in PALMS addresses the sources of funding that a company obtains to buy assets, which produce its goods and services. Because these types of assets are used for more than one year period, they should be funded by long-term obligations. The use of short-term financing can result in a company having to file for a bankruptcy because the long-term assets would not have produced sufficient income to pay off the short-term obligations. Therefore, the main inputs in this category of ratio are long-term liabilities and equities. A ‘good’ balance of debts and equities is required from a company because debts involve paying interest rate expenses every year and paying back the whole principal at the end of the debt term. Moreover, if a company fails to meet the debts indentures, debt-holders have the rights to force a company into bankruptcy. Another form of long-term liabilities may also take form as a large sum of fixed expenses over a longterm period such as the cost of leasing and other rent expenses that are in fixed operating expenses. If a company fails to produce enough revenue to cover these long-term expenses, it also indicates poor asset-liability management and is harmful for the company’s future.

Market Value Ratio (represented by M in the PALMS) describes most closely the performance of a company's common stock in the stock market. There are two main financial ratios in this category: The P/E (Price to Earnings) and B/M (Book to Market Value) Ratios. The P/E Ratio is

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normally used to determine whether a stock is 'expensive' or 'cheap'13. This indicates that a company's common stock is priced based on the company’s ability to grow (generate) earnings. Therefore, the logic is that the lower the stock price of a company compares to the ability of the company generating earnings (as represented by the current earnings report14), the more undervalued (cheaper) the stock is. The B/M Ratio assesses the difference of perception between the market and the company’s management on the ‘real’ value of a company. This means, when a company sells its stocks, the selling price of these stocks were recorded in the company’s balance sheet, being established as the book value of the company. The market perception is represented by the current price of the company’s common stock. If the B/M ratio is low, it indicates that the value of the company may be higher than what the market currently thinks. Therefore stocks with low B/M ratio are usually considered undervalued and worth buying.

Finally, the S in the PALMS, provides a picture of a company’s ability to manage its current asset using its current liabilities. In other words, it is expected that a company holds enough assets that can be quickly converted into cash, to pay its short-term (less than one-year) liabilities such as credit purchases and interest expenses. If a company has current assets which are too low compared to its current liabilities, it may mean that in an emergency event, the company may not be able to make the necessary payments. The Quick and Cash Ratios refer more specifically to the amount of cash that a company has to possess in order to pay off its current liabilities. Furthermore, the level of balance between current assets and current liabilities may also be worth looking at through the Net Working Capital ratio. 13

The term 'expensive' and 'cheap' are suggested in introductory business courses to provide an easier way of understanding the concept.

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Earnings here should be calculated from the Net Income minus all preferred preferences. This is because P/E ratio is used to assess a company's common stock and common stockholders are only entitled to the 'extra' income after all other preferred outflows have been delivered.

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Caveats on Consistency and Comparability: Consistency and comparability are two of the basic concepts of GAAP. Financial ratios are the result of a relationship between two or more items in a company’s financial statement. Therefore, it is important to maintain consistency in calculating the financial ratios. If consistency is neglected, the results of the financial ratios have no real significance and there can be no valid comparability between periods of the same entity or as between two like entities.

Comparability falls apart when either the numerator or denominator in the financial ratios is incorrectly calculated. For instance, if accounts receivable contains amounts for receivables which are not due within 12 months, the numerator for current assets is overstated. Also, if a bank loan due in 9 months is improperly classified as a long-term liability, current liabilities will be understated. Similar misclassifications can occur within the components of any ratios, rendering the result as misleading or useless.

Additionally, comparability also refers to the importance of choosing the appropriate benchmark, because a benchmark supplies reference points that assess the performance of a company against its competitors as well as being compared to the expectation of investors and analysts. Good benchmarks and good ratios allow management to change direction and really manage a company for optimum results. Unfortunately, possible manipulation by top management requires good analysis to detect deception. Off balance sheet method, window dressing, related party transactions, premature or false revenue recognition, are a few of the items that can alter (modify) the ratios mentioned above. Thus, if these practices are present, assessing the financial position of one company against its competitive benchmark will not truly reflect reality.

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The issue of good analysis to detect deception of top management has become more important, especially after the Sarbanes-Oxley Act of 2002. The act encourages effective corporate governance that puts a great deal of emphasis on the independent directors to act more responsibly. This means, not following the CEO or CFO blindly, but to use their background, experience, and business acumen to ask a lot of questions and really direct their company to future ongoing success.

Conclusion: The use of ratios has become a common technique to measure the performance of our day-to-day lives. Financial ratios provide an assessment of a company’s financial position relative to its industry or peer. This is because ratios are basically a comparison of two or more items. Although the calculation process is simple, there are so many of them, that sometimes it can lead to potential confusion in their practical usage. This article introduces the PALMS method to help analysts better organize the process of their analysis of a company’s financial position. More specifically, PALMS allows its users to conduct the analysis in a systematic and intuitive manner. Additionally, by using PALMS, users will hopefully be better able to understand a company’s financial stance without missing any important information about the company. Lastly, even though financial ratios may be easily abused due to its simplicity and sources of accounting data, they are able to provide a platform of benchmarking, which can be a good method of control and a springboard for inquiring into variances for firms to evaluate themselves and see where they stand in the business world.

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Table 1 Discussion on Financial Ratios Analysis in Corporate Finance Textbooks (in Alphabetical order of the first author)

Author

Edition

Title of Textbook

Publisher

Discussion on Financial Ratios Analysis

Block and Hirt

11th, 2005

Foundations of Financial Management

McGraw-Hill Irwin

Bodie and Merton

2000

Finance

Prentice Hall

Brigham and Houston

3rd, 2000

Fundamentals of Financial Management

Brealey and Myers

7th, 2003

Principles of Corporate Finance

SouthWestern, Thomson Learning McGraw-Hill Irwin

Brealey, Myers, and Marcus

4th, 2004

Fundamentals of Corporate Finance

McGraw-Hill Irwin

Part VI: Financial Planning; Chapter 17: Financial Statement Analysis

Damodaran

2nd, 2001

Corporate Finance: Theory and Practice

Wiley

Eakins

2nd, 2004

Finance: Investments, Institutions, and Management - Update

Addison Wesley

Emery, Finnerty, and Stowe

2nd, 2004

Corporate Financial Management

Prentice Hall

Gallagher and Andrew

3rd, 2003

Financial Management: Principles & Practice

Prentice Hall

Part I: Introduction to Corporate Finance; Chapter 4: Understanding Financial Statements Part III: Foundations of Corporate Finance; Chapter 14: Financial Statement and Ratio Analysis Part I: Foundations; Chapter 3: Accounting, Cash Flows, and Taxes Part II: Essential Concepts in Finance; Chapter 5: Analysis of Financial Statements

Gitman

10th, 2003

Principles of Managerial Finance

Addison Wesley

Gitman and Madura

2001

Introduction to Finance

Addison Wesley

Keown, Martin, Petty, and Scott Jr.

10th, 2005

Financial Management: Principles and Applications

Prentice Hall

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Part II: Financial Analysis and Planning; Chapter 3: Financial Analysis Part I: Finance and The Financial System; Chapter 3: How to Interpret and Forecast Financial Statements Part I: Introduction to Financial Management; Chapter 3: Analysis of Financial Statements Part IX: Financial Planning and Shortterm Management; Chapter 29: Financial Analysis and Planning

Part I: Introduction to Managerial Finance; Chapter 2: Financial Statements and Analysis Part II: Financial Tools for Firms and Investors; Chapter 8: Financial Statements and Analysis Part I: The Scope and Environment of Financial Management; Chapter 3: Evaluating a Firm's Financial Performance

Keown, Martin, Petty, and Scott Jr.

4th, 2003

Ross, Westerfield, and Jaffe Ross, Westerfield, and Jordan

7th, 2005 4th, 2004

Ross, Westerfield, and Jordan

Foundations of Finance: The Logic and Practice of Financial Management Corporate Finance

Prentice Hall

Essentials of Corporate Finance

McGraw-Hill Irwin McGraw-Hill Irwin

6th, 2003

Fundamentals of Corporate Finance

McGraw-Hill Irwin

Van Horne

12th, 2002

Financial Management and Policy

Prentice Hall

Van Horne and Wachowicz Jr.

11th, 2001

Fundamentals of Financial Management

Prentice Hall

Werner and Stoner

2002

Fundamentals of Financial Managing

Werner and Stoner

2001

Modern Financial Managing: Continuity & Change

Authors Academic Press Authors Academic Press

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Part I: The Scope and Environment of Financial Management; Chapter 4: Evaluating a Firm's Financial Performance Chapter 2: Financial Planning and Growth Part II: Understanding Financial Statements and Cash Flow; Chapter 3: Working with Financial Statements Part II: Financial Statements and Long-Term Financial Planning; Chapter 3: Working with Financial Statements Part IV: Tools of Financial Analysis and Control; Chapter 12: Financial Ratio Analysis Part III: Tools of Financial Analysis and Planning; Chapter 6: Financial Statement Analysis Part I: About Finance and Money; Chapter 2: Data for Financial Decision Making Part I: Introduction; Chapter 4: Data for Financial Decision Making

Exhibit 1 PALMS for Financial Ratios

LONG-TERM SOLVENCY MARKET VALUE

ASSET UTILIZATION

S H O R T

PROFITABILITY

T E R M S O L V E N C Y

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Exhibit 2 Aliases of the PALMS The Big Five in PALMS

Aliases

Profitability Ratios Asset Utilization Ratios

Operational / Efficiency / Managerial Decision / Activity / Turnover Ratios

Long-term Solvency

Leverage / Debt Management Ratios

Ratios

Market Value Ratios

Return to Investors Ratios

Short-term Solvency

Working Capital / Liquidity Ratios

Ratios

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Exhibit 3 The Fundamental Process of Analyzing A Company’s Business Activities

4

Profit

11

1

2

Investors watching for the company’s market value

Assets

3 Sources of Funding

Day-to-day 5 Activities

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Exhibit 4 The List of Financial Ratios that Are Commonly-Used in Financial Analysis (not exhaustive)

P

rofitability Ratios

Profit Margin (1)

=

Net Income Sales

Profit Margin (2)

=

Net Operating Income Sales

Profit Margin (3)

=

Gross Margin Sales

ROA

=

Net Income Total Assets

ROE P1

=

Net Income Total Equity

Inventory Turnover A2

=

Costs of Goods Sold Average Inventory

Day's of Sales of Inventory A3

=

365 Days Inventory Turnover

Receivable Turnover A4

=

Credit Sales Average Accounts Receivable

A

sset utilizations Ratios A1

P1

It is very common to include the very long-term debts (over 30-year maturity) as part of the denominator.

A1

Financial ratios in this category are also commonly used to assess a firm's liquidity.

A2

An average of quarterly or monthly end-of-the-month inventory data should provide a more accurate picture than the one-off end-of-the-year inventory data.

A3

A more realistic consideration should take into account that the actual operating days of a firm during a one-year period is approximately 250 days.

A4

An average of quarterly or monthly end-of-the-month accounts receivables data should provide a more accurate condition than the one-off end-of-the-year accounts receivables data.

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=

365 Days Receivable Turnover

Net Working Capital Turnover =

Sales Net Working Capital

Fixed Asset Turnover

=

Sales Net Fixed Assets

Total Asset Turnover

=

Sales Total Assets

=

Total Liabilities Total Assets

Average Collection Period A5

L

ong-term Solvency Ratios

Total Debt Ratio

Debt to Equity Ratio / Leverage

=

Equity / Financial Leverage Multiplier =

Long-term Debt Ratio

=

Times Interest Earned Ratio

=

Cash Coverage Ratio

=

Fixed Charges Coverage Ratio =

A5

Long - term Debt Total Equity TotalAssets TotalEquity

Long - term Debt Long - term Debt + Total Equity Net Operating Income Interest Net Operating Income + Depreciation Interest Net Operating Income Rent + Operating Leases

It should be considered that 250 days may be a more accurate numerator.

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M

arket Value Ratios

Price to Earnings Ratio M1

=

Price Per Share Earnings Per Share

Fully-diluted Earnings per share =

Net Income - Preferred Preferences Number of Shares of Common Stocks Outstanding including maximumdilution of commonshares Book-to-Market Ratio

=

Market Value Per Share Book Value Per Share

Book Value per share

=

Total Equity - Preferred Preferences Number of Shares of Common Stocks Outstanding

Dividend Yield

=

Dividend Paid Per Common Stock Market Price of Common Stock

Current Ratio

=

Current Assets Current Liabilities

Quick Ratio

=

Current Assets - Inventory Current Liabilities

Cash Ratio

=

Cash + Cash Equivalent Current Liabilities

S

hort-term Solvency Ratios

Net Workin g Capital Total Assets

Net Working Capital to Total Assets

=

Interval Measure

Current Assets Average Daily Operating Costs

=

M1

P/E Ratio is commonly used for assessing common stocks. Therefore, the price per share should be the price of the common stock.

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BIBLIOGRAPHY

Block, S.B. and Hirt, G. (2005). Foundations of Financial Management, 11th Edition, McGrawHill Irwin. Bodie, Z. and Merton, R.C. (2000), Finance, Prentice Hall. Brigham, E.F. and Houston, J.F. (2000). Fundamentals of Financial Management, 3rd Edition, South-Western, Thomson Learning. Brealey, R.A. and Myers, S.C. (2003). Principles of Corporate Finance, 7th Edition, McGrawHill Irwin. Brealey, R.A., Myers, S.C., and Marcus, A.J. (2004). Fundamentals of Corporate Finance, 4th Edition ,McGraw-Hill Irwin. Damodaran, A. (2001). Corporate Finance: Theory and Practice, 2nd Edition, Wiley. Eakins, S. (2004). Finance: Investments, Institutions, and Management – Update, 2nd Edition, Addison Wesley. Emery, D.R., Finnerty, J.D., and Stowe, J.D. (2004). Corporate Financial Management, 2nd Edition, Prentice Hall. Gallagher, T.J. and Andrew, J.D. (2003). Financial Management: Principles & Practice, 3rd Edition, Prentice Hall. Gitman, L.J. (2003). Principles of Managerial Finance, 10th Edition, Addison Wesley. Gitman, L.J. and Madura, J. (2001). Introduction to Finance, Addison Wesley. Kaminski K.A.; Wetzel T.S.; Guan L. (2004). Can financial ratios detect fraudulent financial reporting? Managerial Auditing Journal 19 (1), 15-28. Keown, A.J., Martin, J.D., Petty, J.W., and Scott Jr., D.F. (2005). Financial Management: Principles and Applications, 10th Edition, Prentice Hall. Keown, A.J., Martin, J.D., Petty, J.W., and Scott Jr., D.F. (2003). Foundations of Finance: The Logic and Practice of Financial Management, 4th Edition, Prentice Hall.

Lanez J.A.; Callao S. (2000). The effect of accounting diversity on international financial analysis: empirical evidence. The International Journal of Accounting 35 (1), 65-83. McLeay S.; Trigueiros D. (2002). Proportionate Growth and the Theoretical Foundations of Financial Ratios. Abacus 38 (3), 297-316. Ross, S.A., Westerfield, R.W., and Jaffe, J. (2005). Corporate Finance, 7th Edition, McGrawHill Irwin. 19

Ross, S.A., Westerfield, R.W., and Jordan, B.D. (2004). Essentials of Corporate Finance, 4th Edition, McGraw-Hill Irwin. Ross, S.A., Westerfield, R.W., and Jordan, B.D. (2003). Fundamentals of Corporate Finance, 6th Edition, McGraw-Hill Irwin. Van Horne, J.C. (2002). Financial Management and Policy, 12th Edition, Prentice Hall. Van Horne, J.C. and Wachowicz Jr., J.M. (2001). Fundamentals of Financial Management, 11th Edition, Prentice Hall. Werner, F.M. and Stoner, J.A.F. (2002). Fundamentals of Financial Managing, Authors Academic Press. Werner, F.M. and Stoner, J.A.F. (2001). Modern Financial Managing: Continuity & Change, Authors Academic Press.

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