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Financial ratios are used To evaluate A company's performance. They are used in trend and cross sectional analysis. Financial ratios can also be used To value A company.
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FM Topic 3 - Assessing Firm s Financial Performance
Financial ratios are used To evaluate A company's performance. They are used in trend and cross sectional analysis. Financial ratios can also be used To value A company.
Financial ratios are used To evaluate A company's performance. They are used in trend and cross sectional analysis. Financial ratios can also be used To value A company.
Learning Objectives To explain the ratio categories and calculation of ratio. To define the financial ratios. To explain the use of financial ratios in trend and cross sectional analysis in valuing the companys performance. To explain the execution of common size analysis. To elaborate the DuPont analysis and connection between ratios. To clarify the boundaries of ratio analysis. 3-1 Statement of Cash Flows Statement that summarizes the sources and uses of cash Changes divided into three major categories Operating Activity includes net income and changes in most current accounts Investment Activity includes changes in fixed assets Financing Activity includes changes in notes payable, long-term debt, and equity accounts, as well as dividends 3-2 Sources and Uses Sources Cash inflow occurs when we sell something Decrease in asset account (Sample B/S) Accounts receivable, inventory, and net fixed assets Increase in liability or equity account Accounts payable, other current liabilities, and common stock Uses Cash outflow occurs when we buy something Increase in asset account Accounts receivable, inventory Decrease in liability or equity account Notes payable and long-term debt 3-3 3-4 2011 2010 2011 2010 Cash 696 58 A/P 307 303 A/R 956 992 N/P 26 119 Inventory 301 361 Other CL 1,662 1,353 Other CA 303 264 Total CL 1,995 1,775 Total CA 2,256 1,675 LT Debt 843 1,091 Net FA 3,138 3,358 C/S 2,556 2,167 Total Assets 5,394 5,033 Total Liab. & Equity 5,394 5,033 Revenues 5,000 Cost of Goods Sold (2,006) Expenses (1,740) Depreciation (116) EBIT 1,138 Interest Expense (7) Taxable Income 1,131 Taxes (442) Net Income 689 EPS 3.61 Dividends per share 1.08 Additional information: Market Price = $87.65 per share and Shares outstanding = 190.9 million Sample Statement of Cash Flows Cash, beginning of year 58 Financing Activity Operating Activity Decrease in Notes Payable -93 Net Income 689 Decrease in LT Debt -248 Plus: Depreciation 116 Decrease in C/S (minus RE) -94 Decrease in A/R 36 Dividends Paid -206 Decrease in Inventory 60 Net Cash from Financing -641 Increase in A/P 4 Increase in Other CL 309 Net Increase in Cash 638 Less: Increase in other CA -39 Net Cash from Operations 1,175 Cash End of Year 696 Investment Activity Sale of Fixed Assets 104 Net Cash from Investments 104 3-5 Standardized Financial Statements Common-Size Balance Sheets Compute all accounts as a percent of total assets Common-Size Income Statements Compute all line items as a percent of sales Standardized statements make it easier to compare financial information, particularly as the company grows They are also useful for comparing companies of different sizes, particularly within the same industry Common-base year statement: a standardized financial statement presenting all items relative to certain base year amount
3-6 Standardized Financial Statements Common-Size Balance Sheets Compute all accounts as a percent of total assets Common-Size Income Statements Compute all line items as a percent of sales Standardized statements make it easier to compare financial information, particularly as the company grows They are also useful for comparing companies of different sizes, particularly within the same industry
3-7 Ratio Analysis Financial ratios: relationship determined from a firms financial information and used for comparison purposes. Ratios allow for better comparison through time (Time-Trend Analysis) or between companies (Peer Group Analysis) As we look at each ratio, ask yourself what the ratio is trying to measure and why that information is important Categories of Financial Ratios Short-term solvency or liquidity ratios Long-term solvency or financial leverage ratios Asset management or turnover ratios Profitability ratios Market value ratios 3-8 1)Liquidity Ratios: 1) Current ratio = Current assets/Current liabilities This ratio measures the degree of liquidity by comparing its current assets to its current liabilities. Higher figure means that the business financial condition is better as it has enough liquid assets for its operation. Current Ratio = CA / CL = 2,256 / 1,995 = 1.13 times 2) Quick ratio = (current assets-inventory/current liabilities) This ratio is a more stringent measure of liquidity than the current ratio. It excludes inventories and other current assets that are least liquid from current assets. Higher ratio shows that the business has enough quick assets or liquid assets to cover its short term debt immediately. Quick Ratio = (CA Inventory) / CL = (2,256 301) / 1,995 = .98 times
9 3) Cash ratio = cash/current liabilities = 696 / 1,995 = .35 times
4) Net working capital to total assets= net working capital/ total assets. NWC to Total Assets = NWC / TA = (2,256 1,995) / 5,394 = .05
5) Interval measures=current asset/ average daily operating cost average daily operating cost = COGS/365 days
Interval Measure = CA / average daily operating costs =2,256 / ((2,006 + 1,740)/365) = 219.8 days
10 2) ASSET MANAGEMENT/ ACTIVITY/ EFFICIENCY RATIOS 1) Average collection periods (ACP)= Accounts receivable/ (Annual credit sales/365) ACP = Accounts receivable/Daily sales = 956/ (5000/365) = 70 days Days Sales in Receivables = 365 / Receivables Turnover = 365 / 5.23 = 70 days The ratio measures how long a firm takes to collect its credit accounts. The lower the figure is better. 2) Account receivable turnover = sales/accounts receivables = 5,000 / 956 = 5.23 times This ratio measures how often accounts receivables are rolled over during a year. Higher ratio illustrates that the firm can collect its debt more frequent and thus has few bad debts.
11 3) Inventory turnover = costs of good sold/inventory It measures the number of times a firms inventories are sold and replaced during the year. Higher ratio indicates that inventory can be sold and replaced more frequently. Inventory turnover = 2,006 / 301 = 6.66 times 4) Days dales in inventory= 365 days/inventory turnover = 365 / 6.66 = 55 days 5) Fixed asset turnover = sales/net fixed assets This ratio is an overall measure of asset efficiency based on the relation between firms sales and the total assets. Higher ratio indicates that firm is managing its assets more effectively. Fixed Asset Turnover = 5,000 / 3,138 = 1.59 times 6) Total asset turnover = sales/total assets Higher ratio is favored because it indicates the effectiveness of the firm in generating sales from its total assets. Total Asset Turnover = 5,000 / 5,394 = .93 7) NWC Turnover = sales/NWC = 5,000 / (2,256 1,995) = 19.16 times
12 3)PROFITABILITY RATIOS 1) Gross profit margin= gross profit/ sales The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin considers the firm's cost of goods sold, but does not include other costs. Higher ratio is better. Gross profit Margin = Gross profit / Sales = 2994 / 5,000 = 59.88% 2) Net profit margin = Net income/sales A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Profit Margin = Net Income / Sales = 689 / 5,000 = 13.78% 3) Operating Profit Margin(OPM) = Operating profit/Sales OPM examines how effective the company is in managing its cost of goods sold and operating expenses that determine the operating profit. Operating profit Margin = Operating profit / Sales = 1254 / 5,000 = 25.08%
13 4) Return on assets (ROA) = Net income/total assets This evaluates how effectively the company employs its assets to generate a return. It measures efficiency. Higher ratio is better. Return on Assets (ROA) = Net Income / Total Assets =689 / 5,394 = 12.77%
5) Return on equity (ROE) = Net income/ common equity Return on equity is the bottom line measure for the shareholders, measuring the profits earned for each dollar invested in the firm's stock. Higher ratio is favored because the firm can generate better return to the owner of the firm. Return on Equity (ROE) = Net Income / Total Equity = 689 / 2,556 = 26.96%
14 4)LEVERAGE RATIOS 1) Debt ratio = total debt/total assets This ratio measures the extent to which a firm has been financed with debt. More debt financing results in more financial risk. Total Debt Ratio =2,838/ 5,394 = 52.61% 2) Times interest earned= EBIT/interest The times interest earned ratio indicates how well the firm's earnings can cover the interest payments on its debt. Higher ratio shows better ability in meeting interest payment. Times Interest Earned =1,138 / 7 = 162.57 times 3) Debt to equity ratio = total debt/total equity This ratio indicates what proportion of equity and debt the company is using to finance its assets. A high debt to equity ratio could indicate that the company may be overleveraged, and should look for ways to reduce its debt. Debt/Equity =2,838 / 2,556 = 1.11 times 4) Equity multiplier = total assets/total equity or = 1+ (total debt/total equity) = 1 + 1.11 = 2.11 5) Cash coverage =(EBIT+depreciation) / interest= (1,138 + 116)/ 7=179.14 times
5)MARKET VALUE RATIOS 1) Earning per share (EPS) = Net income/number of shares outstanding It represents the portion of a firm's earnings that is allocated to each share of common stock. = 689 / 190.9 = $3.61 2) Price earning ratio (PE) = price per share/earnings per share The ratio indicates how much investors are willing to pay per dollar of current earnings. As such, high P/E Ratios are associated with growth stocks. The most common measure of how expensive a stock is. = 87.65 / 3.61 = 24.28 times 3) Price (market) to book ratio=price per share/book value per share his ratio measures how much a company worth at present, in comparison with the amount of capital invested by current and past shareholders into it. = 87.65 / (2,556 / 190.9) = 6.55 times 4) Book value per share= Total equity/Number of shares outstanding The ratio of stockholder equity to the number of common stocks. Book value per share should not be thought of as an indicator of economic worth, since it reflects accounting valuation (and not necessarily market valuation). = 2,556 / 190.9 = $13.44 5) price/sales per share = price per share/ sales per share where sales per share= sales / number of shares outstanding = 87.65 / (5000/190.9) = 3.34 times
16 Deriving the Du Pont Identity ROE = NI / TE Multiply by 1 (TA/TA) and then rearrange ROE = (NI / TE) (TA / TA) ROE = (NI / TA) (TA / TE) = ROA * EM Multiply by 1 (Sales/Sales) again and then rearrange ROE = (NI / TA) (TA / TE) (Sales / Sales) ROE = (NI / Sales) (Sales / TA) (TA / TE) ROE = PM * TAT * EM Profit margin is a measure of the firms operating efficiency how well it controls costs Total asset turnover is a measure of the firms asset use efficiency how well does it manage its assets Equity multiplier is a measure of the firms financial leverage
3-17 3.7 Dupont Analysis 18 STEP 1 STEP 2 STEP 3 Expanded Du Pont Analysis Du Pont Data 3-19 Extended Du Pont Chart Insert Figure 3.1 (Extended DuPont Chart) 3-20 21 Uses of Financial Ratios: Within the Firm Identify deficiencies in a firms performance and take corrective action. Evaluate employee performance and determine incentive compensation. Compare the financial performance of different divisions within the firm. Prepare, at both firm and division levels, financial projections. Understand the financial performance of the firms competitors. Evaluate the financial condition of a major supplier.
22 Uses of Financial Ratios: Outside the Firm Financial ratios are used by: Lenders in deciding whether or not to make a loan to a company. Credit-rating agencies in determining a firms credit worthiness. Investors (shareholders and bondholders) in deciding whether or not to invest in a company. Major suppliers in deciding to whether or not to grant credit terms to a company. 23 The Limitations of Financial Ratio Analysis It is sometimes difficult to identify industry categories or comparable peers. The published peer group or industry averages are only approximations. Industry averages may not provide a desirable target ratio. Accounting practices differ widely among firms. A high or low ratio does not automatically lead to a specific conclusion. Seasons may bias the numbers in the financial statements. ADDITIONAL QUESTIONS Question 1 Secular Electric has total equity of RM560,000; sales of RM2,250,000; current assets of RM700,000; and total liabilities of RM435,000. What is Secular Electrics total assets turnover? Total assets turnover = sales/total assets = 2,250,000/total assets Total assets = fixed assets + current assets Total assets = total equity + total liabilities = 560,000 + 435,000 Thus, total assets = 995,000 Find total assets turnover = 2,250,000/995,000 = 2.26x
Question 2 SRC has a debt ratio of 0.4, current liabilities of RM18,000, and total assets of RM100,000. What is the level of SRCs total liabilities? Debt ratio = total debt/total assets = 0.4 0.4 = total debt/100,000 total debt/liabilities = RM40,000
24 Question 3 XYZ Corporation has the following financial information for the previous year:
Sales: $8M, PM = 8%, CA = $2M, FA = $6M, NWC = $1M, LTD = $3M Compute the ROE using the DuPont Analysis. Total assets = CA + FA = $2M + $6M = $8M TAT = Sales / TA = $8M / $8M = 1 NWC = CA CL CL = CA NWC = $2M - $1M = $1M Total liabs. = CL + LTD = $1M + $3M = $4M Total equity = total assets total liabs. = $8M - $4M = $4M EM = assets / equity = $8M / $4M = 2 ROE = PM X TAT X EM = 8% X 1 X 2 = 16%
3-25 26 Table 4-1 27 Table 4-2 1) LIQUIDITY RATIO RATIO FORMULA DAVIES INC. PEER GROUP 1) Current ratio Current assets/current liabilities $143m/$64m =2.23 1.80 2) Quick ratio (current assets- inventory/ current liabilities) ($143m-$84m)/$64m =0.92 0.89 3) Cash Ratio Cash/current liabilities 4) Net working capital to total assets NWC/total assets 5)Interval measure Current assets/average daily operating cost 28 2)ASSET MANAGEMENT/ ACTIVITY/EFFICIENCY RATIOS RATIO FORMULA DAVIES INC. PEER GROUP 1) Average collection periods (ACP)
Accounts receivable/(Annual credit sales/365) $36m/($600m/365) = 21.90 days 25 days 2)Account receivable turnover
sales/total assets $600m/$438m =1.37x 1.15x 6) Days sales in inventory 365 days/inventory turnover 7) NWC Sales/NWC 29 3)PROFITABILITY RATIOS RATIO FORMULA DAVIES INC. PEER GROUP 1)Gross profit margin gross profit/sales $140m/$600m =0.233=23.3% 25% 2)Net profit margin Net income/sales
$42m/$600m =0.07=7% 6.5% 3)Operating Profit Margin(OPM) Operating profit/Sales $75m/$600m =0.125=12.5% 15.5% 4)Return on assets (ROA) Net income/total assets
$42m/$438m =0.096=9.6% 10% 5)Return on equity (ROE) Net income/ common equity $42m/$203m =0.207=20.7% 18% 30 4)LEVERAGE RATIOS 31 RATIO FORMULA DAVIES INC. PEER GROUP 1)Debt ratio total debt/total assets $235m/ $438m =0.537= 53.7% 35% 2)Times interest earned EBIT/interest $75m/$15m =5.0x 7.0x 3)Debt to equity ratio total debt/total equity $235m/ $203m =1.16x 2.05x 4) Equity multiplier Total assets/total equity 5) Cash coverage (EBIT+depreciation) /interest 5)MARKET VALUE RATIOS RATIO FORMULA DAVIES INC. PEER GROUP 1)Earning per share (EPS) Net income/number of shares outstanding $42m/20m=$2.10 $1.89 2) Price earning ratio (PE) price per share/earnings per share
(assume the market price for Davies stock was $32 per share) $32/$2.10=15.24x 19.0x 3)Price (market) to book ratio price per share/book value per share $32/$10.15=3.15x 3.7x 4)Book value per share Total equity/Number of shares outstanding