limitations of financial ratios

Topic 9: Financial Statements Analysis BUS 442 Investment Theory and Portfolio Management Economic and industry analysis will help investors narrow down their choices of companies as good candidates for further “investigation” before making any investment decisions. It is now time for them to look at the short list of companies more closely by analyzing their performances (i.e. financial health) over a period of time to determine if they should be considered as good investment candidates. In addition to analyzing companies’ performance over time, investors should also compare the companies’ performance to their competitors. 1. Five Major Categories of Financial Ratios There are literally thousands of financial ratios. Basically, you get a financial ratio every time you divide two items in the financial statements. We will focus on five major categories of financial ratios. Based on your readings and knowledge about financial ratios from other courses, identify the type of information offer by each category of financial ratios. Ratio Categories Liquidity (or short-term solvency) Information Provided? Activity (or asset management) Leverage (or long-term solvency or debt management) Profitability Market value There are a number of financial ratios within each of the five categories. The last few pages of this handout contain some of the more commonly used ratios among managers. Based on what you learned in an introductory finance course, provide the formula for each ratio, indicate its strength (i.e. higher or lower the better), and provide any comments relevant to the ratio. 2. Trend Analysis Examining financial ratios by themselves does not managers many insights regarding the financial health of the company. It is important for the managers to examine the patterns (or trends) exhibited by the financial ratios over a period of time. In other words, performing trend analysis provides clues as to whether a company’s financial health is improving or deteriorating. Investment Theory -1- Topic 9 Handout Refer to In-class Example 1 Refer to In-class Example 2 Analysis and recommendations: 3. Du Pont Analysis: Breaking Down the ROE In the previous example, we were able to analyze the financial health of the company by looking at a variety of ratios in five different categories (with each category providing us information about the company’s performance in a specific area). Is there a ratio that can help tie together the performance of a company in different areas? Believe it or not, a company’s return of equity can be easily broken down into a combination of several financial ratios. The process of breaking down and analyzing the parts of the ROE is known as the Du Pont analysis. We know the following is true: ROE  NI NI EBT EBIT Sales Assets      Equity EBT EBIT Sales Assets Equity Basically, the ROE can be broken down as: ROE = Tax burden × Interest burden × Operating margin × Asset turnover × Leverage Looking at the break down above, can you identify the different factors that affect a company’s ROE? Refer to In-class Example 3 Analysis and recommendations: Investment Theory -2- Topic 9 Handout 4. Peer Group Analysis (or Benchmarking) Conducting trend analysis helps managers determine how the company performed over time. However, investors will gain additional information by comparing the company’s financial ratios to its peers. One of the ways of comparing to its peers is by comparing the company’s ratios to the industry’s averages. However, it would have been better if the managers compare the company’s ratios to the industry leader and other major competitors. This type of comparison is known as benchmarking, where investors compare the company’s ratios to a small group of leading companies in the industry. Refer to In-class Example 4 Analysis and recommendations: 5. Limitations of Using Financial Ratios Analysis Keep in mind that even though financial ratios analysis helps investors pinpoint a company’s strengths and weaknesses, it does have its limitations and investors need to be aware of these limitations.  Inflation  Seasonal factors  Window dressing Investment Theory -3- Topic 9 Handout  Different accounting practices  No general interpretation  Mixed (or misleading) signals 6. What Else to Look at? Financial ratio analysis focuses on analyzing and comparing a number of financial ratios, which qualifies it as a quantitative analysis. However, quantitative analysis only paints a portion of the picture. Investors also need to examine qualitative factors to help them “see” the big picture. To fully understand the financial health of a company, investors need to also address some of the following (qualitative) issues:        Are the company’s revenues tied to one key customer? To what extent are the company’s revenues tied to one key product? To what extent does the company rely on a single supplier? What percentage of the company’s business is generated overseas? What competitions do the company currently faced and will potentially face in the future? What are the company’s future prospects? What potentially will happen in the legal and regulatory environment? Why do you think investors need to address the above issues? Provide some explanations. Investment Theory -4- Topic 9 Handout I. Liquidity Ratios Financial Ratio Current Formula Strength Comments? Quick II. Activity Ratios Financial Ratio Inventory turnover Formula Strength Comments? Days’ sales in inventory Receivable turnover Days’ sales in receivable (or average collection period) Asset turnover Fixed asset turnover Handout 1: Financial Ratios -5- MBA 504 (Thursday Cohort) III. Leverage Ratios Financial Ratio Total debt Formula Strength Comments? Long-term debt (or long-term capitalization) Debt to equity Financial leverage Interest coverage (or times interest earned) IV. Profitability Ratios Financial Ratio Net profit margin (or profit margin on sales) Formula Strength Comments? Pre-tax margin Operating margin Handout 1: Financial Ratios -6- MBA 504 (Thursday Cohort) Gross margin Basic earnings power Return on asset (ROA) Return on equity (ROE) V. Market Value Ratios Financial Ratio Price to earnings (P/E) Formula Strength Comments? Market to book Handout 1: Financial Ratios -7- MBA 504 (Thursday Cohort)