Ratio Analysis
Financial ratios convert financial information into more
meaningful numbers.
Users of financial statements want to know
1. Past performance
2. Present condition
But what they really want to know about is future
performance. For example:
Will the company be able to pay the loan in the future?
Will the company maintain its present sales growth next
year?
When will the net loss turn into a profit?
Fundamental principle of ratio analysis
A ratio by itself is almost always useless.
Ratios need to be compared to benchmarks:
1. To prior periods (from the same company)
2. To other competitors in the same industry (or to the
industry average)
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How do we measure firm performance?
Return on equity (ROE)
= Net income/average shareholders equity
Return on capital employed (ROCE)
= Earnings before interest and taxes (EBIT) / capital
employed
= (Net income + interest expense + income tax expense) /
average total debt and shareholder’s equity
Note:
1. “Total debt” is amounts owing to banks and bondholders
2. “Average” is the average of the beginning and ending
balance. (And the beginning balance of one year = the
ending balance of the previous year.)
ROE is the return to shareholders (including preferred
shares if applicable)
ROCE is the return to the holder’s of capital (debt
holders and shareholders)
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How do we measure short-term liquidity?
Working capital
=current assets – current liabilities
Current ratio
=current assets / current liabilities
Quick ratio
= [Cash + Cash Equivalents + Accounts Receivable +
Temporary Investments] / current liabilities
These ratios are particularly important when the
company is performing poorly and there is a risk that the
company will run out of cash and not be able to pay off
its short-term obligations
How do we measure financial risk?
Debt-equity ratio
= Total debt/shareholders’ equity
Debt-Total capital ratio
= Total debt / [Total debt + shareholders’ equity]
Higher (lower) ratio values imply more (less) financial
risk.
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How risky is the corporate debt?
Times interest earned
= Earnings before interest and taxes (EBIT) / Interest expense
= (Net income + interest expense + income tax expense) /
Interest expense
Ratio is linked to probability of defaulting – not being
able to pay near-term interest expense
Higher ratio implies less likely chance of default
This is a ratio you can partially evaluate in isolation –
you may not need to compare to past history or to other
companies
Trend analysis
2001 %sPY 2002 %sPY
Sales $256 -29.7 $364 12.4
Net income 55 -34.5 84 15.7
EPS 1.22 -26.1 1.65 20.1
Note:
“%vs.PY” means percentage change versus previous year
Positive (negative) trends in items such as sales and EPS
are good (bad).
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Vertical analysis
Typical example is restating the income statement
components as a percentage of sales
2001 %Sales 2002 %Sales
Sales $256 100.0 $364 100.0
Cost of goods sold 79 30.9 96 26.4
Gross Profit 177 69.1 268 73.6
Expenses 72 28.1 80 22
Pre-tax income 105 41.0 188 51.6
Vertical analysis allows us to compare income statement
items adjusted for the size of sales. This type of analysis
is particularly important when comparing income
statement items across companies, because companies
can differ significantly in size.
How many ratios should I calculate?
Don’t calculate every ratio that might be appropriate
(like most textbooks ask) – choose one to support each
point you are making
Often, analysis of ratios from similar groups (e.g.,
performance ratios) produces the same conclusions
because the ratios are highly correlated with each other.
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When you are analyzing ratios, keep in mind the decision
at hand.
For example, if you are a bank manager:
Then the question may be: If I lend this company money,
what is the chance of the company paying me my interest
and principle back?
The bank manager would prefer:
o High ability to pay interest (higher times-interest
earned)
o Low financial risk (lower debt/equity ratio)
o Improving financial performance, since better future
performance leads to higher net income, higher
ability to pay interest, higher retained earnings, and
lower financial risk
Beware
Ratio names can be confusing, and are often calculated
differently, depending on who calculates them.
When comparing companies that use different
accounting alternatives, you should either restate
financial statements of selected companies to remove the
effect of different accounting alternatives, or, at a
minimum, be cautious when interpreting the ratios.
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