Ratio Analysis

Chapter 3 Cash Flows and Financial Analysis Our main coverage for this chapter is financial ratios

Financial Information—Where Does It Come From, etc.  Financial information is the responsibility of management  Created by within-firm accountants  Creates a conflict of interest because management wants to portray firm in a positive light

 Published to a variety of audiences

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Users of Financial Information  Investors and Financial Analysts  Financial analysts interpret information about companies and make recommendations to investors  Major part of analyst’s job is to make a careful study of recent financial statements

 Vendors/Creditors  Use financial info to determine if the firm is expected to make good on loans

 Management  Use financial info to pinpoint strengths and weaknesses in operations

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Sources of Financial Information  Annual Report  Required of all publicly traded firms  Tend to portray firm in a positive light  Also publish a less glossy, more businesslike document called a 10K with the SEC

 Brokerage firms and investment advisory services 4

 Data sources for term project

 See the course links page for link to MEL page  http://www.lib.purdue.edu/mel/inst/agec_424

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The Orientation of Financial Analysis  Accounting is concerned with creating financial statements  Finance is concerned with using the data contained within financial statements to make decisions  The orientation of financial analysis is critical and investigative

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Ratio Analysis  Used to highlight different areas of performance  Generate hypotheses regarding things going well and things to improve  Involves taking sets of numbers from the financial statement and forming ratios with them 7

Comparisons  A ratio when examined alone doesn’t convey much information – but..  History—examine trends (how the value has changed over time)  Competition—compare with other firms in the same industry  Budget—compare actual values with expected or desired values

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Common Size Statements  First step in a financial analysis is usually the calculation of a common size statement  Common size income statement  Presents each line as a percent of revenue

 Common size balance sheet  Presents each line as a percent of total assets

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Common Size Statements Alpha

Beta

$ % Sales $ 2,187,460 100.0% COGS $ 1,203,103 55.0% Gross margin $ 984,357 45.0%

$ % $ 150,845 100.0% $ 72,406 48.0% $ 78,439 52.0%

Expenses EBIT Interest EBT Tax Net Income

$ $ $ $ $ $

$ $ $ $ $ $

505,303 479,054 131,248 347,806 118,254 229,552

23.1% 21.9% 6.0% 15.9% 5.4% 10.5%

39,974 38,465 15,386 23,079 3,462 19,617

26.5% 25.5% 10.2% 15.3% 2.3% 13.0%

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Look at ANF income statement

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Ratios  Designed to illuminate some aspect of how the business is doing  Average Versus Ending Values  When a ratio calls for a balance sheet item, may need to use average values (of the beginning and ending value for the item) or ending values  If an income or cash flow figure is combined with a balance sheet figure in a ratio—use average value for balance sheet figure  If a ratio compares two balance sheet figures— use ending value

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Ratios  5 Categories of Ratios 1. Liquidity: indicates firm’s ability to pay its bills in the short run 2. Asset Management: Right amount of assets vs. sales? 3. Debt Management: Right mix of debt and equity? 4. Profitability— Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? 5. Market Value— Do investors like what they see as reflected in P/E and M/B ratios? 13

Liquidity Ratios 

Current Ratio

Current Ratio =

Current Assets Current Liabilities

 To ensure solvency the current ratio has to exceed 1.0  Generally a value greater than 1.5 or 2.0 is required for comfort  As always, compare to the industry 14

Liquidity Ratios  Quick Ratio (or Acid-Test Ratio) current assets - inventory Quick Ratio = current liabilities  Measures liquidity without considering inventory (the firm’s least liquid current asset)  Not a good ratio for grain farms

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Asset Management Ratios  Average Collection Period (ACP)

accounts receivable ACP = DSO = sales per day

 Measures the time it takes to collect on credit sales  AKA days sales outstanding (DSO)  Should use an average Accounts Receivable balance, net of the allowance for doubtful accounts 16

Asset Management Ratios  Inventory Turnover

cost o f g o od s sold In v e n to ry T urn o ve =r in ve n to ry  Gives an indication of the quality of inventory, as well as, how it is managed  Measures how many times a year the firm uses up an average stock of goods  A higher turnover implies doing business with less tied up in inventory  Should use average inventory balance 17

Asset Management Ratios  Fixed Asset Turnover Fixed Asset Turnover =

Sales (Total) Fixed Assets (Net)

 Appropriate in industries where significant equipment is required to do business  Long-term measure of performance  Average balance sheet values are appropriate 18

Asset Management Ratios  Total Asset Turnover Sales (Total) Total Asset Turnover = Total Assets

 More widely used than Fixed Asset Turnover  Long-term measure of performance  Average balance sheet values are appropriate 19

Debt Management Ratios  

Need to determine if the company is using so much debt that it is assuming excessive risk Debt could mean long-term debt and current liabilities 

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Or it could mean just interest-bearing obligations—often sources just use long-term debt

Debt Ratio

TL Debt Ratio = TA

 A high debt ratio is viewed as risky by investors  Usually stated as percentages

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Debt Management Ratios  Debt-to-equity ratio  Can be stated several ways (as a percentage, or as a x:y value)

Total Liabilities TL Debt − to − Equity = = Common Equity E  Many sources use long term debt instead of total liabilities  Measures the mix of debt and equity within the firm’s total capital 21

Debt Management Ratios  Times Interest Earned EBIT TIE = Interest Expense

 TIE is a coverage ratio  Reflects how much EBIT covers interest expense  A high level of interest coverage implies safety

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Debt Management Ratios  Cash Coverage Cash coverage =

EBIT + depreciation Interest Expense

 TIE ratio has problems  Interest is a cash payment but EBIT is not exactly a source of cash  By adding depreciation back into the numerator we have a more representative measure of cash

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Debt Management Ratios  Fixed Charge Coverage EBIT + Lease Payments Fixed Charge Coverage = Interest Expense + Lease Payments

 Interest payments are not the only fixed charges  Lease payments are fixed financial charges similar to interest  They must be paid regardless of business conditions  If they are contractually non-cancelable 24

Profitability Ratios  Return on Sales (AKA:Profit Margin (PM), Net Profit Margin)

Net Income PM = ROS = Sales  Measures control of the income statement: revenue, cost and expense  Represents a fundamental indication of the overall profitability of the business 25

Profitability Ratios  Return on Assets Net Income ROA = Total Assets

 Adds the effectiveness of asset management to Return on Sales  Measures the overall ability of the firm to utilize the assets in which it has invested to earn a profit

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Profitability Ratios  Return on Equity ROE =

Net Income Stockholders' Equity

 Adds the effect of borrowing to ROA  Measures the firm’s ability to earn a return on the owners’ invested capital  If the firm has substantial debt, ROE tends to be higher than ROA in good times and lower in bad times 27

Market Value Ratios  Price/Earnings Ratio (PE Ratio) Current stock price PE Ratio = Earnings per share (EPS)  An indication of the value the stock market places on a company  Tells how much investors are willing to pay for a dollar of the firm’s earnings  A firm’s P/E is primarily a function of its expected growth 28

Market Value Ratios  Market-to-Book Value Ratio

Current stock price Market-to-Book-Value = book value per share (of equity)  A healthy company is expected to have a market value greater than its book value  Known as the going concern value of the firm

 Idea is that the combination of assets and human resources will create an company able to generate future earnings worth more than the assets alone today  A value less than 1.0 indicates a poor outlook for the company’s future 29

Du Pont Equations  Ratio measures are not entirely independent  Performance on one is sometimes tied to performance on others  Du Pont equations express relationships between ratios that give insights into successful operation

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Du Pont Equations  Du Pont equation involves ROE, which can be written several ways: Net Income sales ROA = × Total Assets sales or Net Income sales ROA = × sales Total Assets or ROE = ROS × total asset turnover

States that to run a business well, a firm must manage costs and expenses as well as generate lots of sales per dollar of assets. 31

Du Pont Equations  Extended Du Pont equation states ROE in terms of other ratios ROE =

Net Income sales total assets × × Stockholders' Equity sales total assets

or ROE =

Net Income sales total assets × × sales total assets Stockholders' Equity 1 4 4 44 2 4 4 4 43 Equity Multiplier

or ROE = ROS Asse Turnover 1 4 4×4Total 4 44 2 4 4t 4 4 4 43 × Equity Multiplier ROA

or ROE = ROA × Equity Multiplier

EM = [1/(1-L)]; where L = TL/TA

Related to the proportion to which the firm is financed by other people’s money as opposed to owner’s money. 32

Du Pont Equations  Extended Du Pont equation states that the operation of a business is reflected in its ROE  However, this result—good or bad—can be multiplied by borrowing  The way you finance a business can exaggerate the results from operations

 The Du Pont equations can be used to isolate problems 33

Sources of Comparative Information  Generally compare a firm to an industry average  Dun and Bradstreet publishes Industry Norms and Key Business Ratios  Robert Morris Associates publishes Statement Studies  U.S. Commerce Department publishes Quarterly Financial Report  Value Line provides industry profiles and individual company reports

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Limitations/Weaknesses of Ratio Analysis  Ratio analysis is not an exact science and requires judgment and experienced interpretation  Examples of significant problems  Diversified companies—because the interpretation of ratios is dependent upon industry norms, comparing conglomerates can be problematic  Window dressing—companies attempt to make balance sheet items look better than they would otherwise through improvements that don’t last  Accounting principles differ—similar companies may report the same thing differently, making their financial results artificially dissimilar  Inflation may distort numbers

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