# Profit Earning Ratio Calculation

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```					Chapter 4: Analysis of Financial Statements

I. Ratio analysis

A. Analysis of financial statements can be used to predict future earnings and dividends

B. Analysis of financial statements is starting point for planning actions that will improve
future performance

C. Ratio analysis: Calculates and interprets financial ratios to analyze firm’s performance

II. The different types of ratios

A. Two liquidity ratios
1. Liquid asset =asset that can be converted to cash quickly without having to reduce
asset’s price very much
2. Liquidity ratios: ratios that show the relationship of a firm’s cash and othe r current
assets to its current liabilities
3. Curre nt ratio
a. Indicates the extent to which current liabilities are covered by those assets expected
to be conve rted to cash in the near future
b. Formula:
current assets
current ratio =
cuurent liabilities
4. Quick Ratio or Acid Test Ratio
a. Inventories least liquid of firm’s current assets and are assets on which assets most
likely to occur in event of liquidation. Firm’s ability to pay-off short-term
obligations without relying on sale of inventories is important
b. Formula:
current assets - inventory
quick (acid-test) ratio =
current liabilities

B. Four asset management ratios
1. Asset management ratios = set of ratios that measure how effectively firm manages its
assets
2. Inventory turnover ratio
Sales
Inventory turnover ratio =
Inventory
3. Days sales outstanding (DSO) = ave rage collection period = ACP
a. Indicates the average length of time the firm must wait after making a sale before it
b. Formula:
Receivables           Receivables
DSO = days sales outstanding =                         =
Average sales per day     Annual sales 365
4. Fixed assets turnover ratio
a. Measures how effectively the firm uses its plant and equipme nt
b. Formula:
Chapter 4: Analysis of Financial Statements                                                   Page 1
sales
fixed assets turnover ratio =
net fixed assets
5. Total assets turnover ratio
sales
total assets turnover ratio =
total assets

C. Debt manage ment ratios
1. Total debt to total assets
total debt
debt ratio =
total assets
2. Times-interest-earned (TIE) ratio
a. Measures firm’s ability to meet its annual interest payments
b. Formula
EBIT
times-interest-earned (TIE) ratio =
interest charges
3. EBITDA cove rage ratio
a. Ratio whose nume rator includes all cash flows available to meet fixed financial
charges and whose denominator includes all fixed financial charges
b. Formula:
EBITDA + lease payments
EBITDA coverage ratio =
interest + principal payments + lease payments

D. Four profitability ratios
1. Profitability ratios = group of ratios that show combined effects of liquidity, asset
manage ment, and debt on operating results
2. Profit margin on sales
net income
profit margin on sales =
sales
3. Return on total assets (ROA)
net income
return on total assets = ROA =
total assets
4. Basic earning powe r (BEP) ratio
a. Ratio indicates the ability of firm’s assets to generate operating income
b. Formula
EBIT
basic earning power (BEP) ratio =
total assets
5. Return on common equity
a. Measures rate of return on common stockholders’ investment
b. Formula:
net income
return on common equity = ROE =
common equity
6. An important digression: The effect of leverage on ROE
a. The concept of leverage
i. Financial debt = use of debt financing
ii. Three important implications of using debt financing

Chapter 4: Analysis of Financial Statements                                                   Page 2
● By raising funds through debt, stockholde rs can control a firm with limited
amount of equity investment
● The higher the proportion of total capital provided by stockholders, the less
risk faced by creditors.
● If firm earns more on its assets than the interest it pays on debt, then using
debt “leverages” or magnifies the return on equity (ROE)
b. Example: A leveraged and unleveraged firm

Table 4-1: Effects of Financial Leverage on Stockholder Returns
FIRM U [UNLEVERAGED (NO DEBT)]
Curre nt assets                           \$50                  Debt                              \$0
Fixed assets                                50                 Common Equity                    100
Total assets                             \$100                  Total Liabilities & Equity      \$100

Sales Revenue                                        \$150.0                      \$100.0      \$75.0
Ope rating costs                   Fixed            45.0                        45.0       45.0
Variable         60.0                        40.0       30.0
Total ope rating costs                             105.0                        85.0       75.0
Ope rating Income (EBIT)                              \$45.0                       \$15.0       \$0.0
Inte rest (Rate = 10%)                                0.0                         0.0        0.0
Earnings before taxes (EBT)                           \$45.0                       \$15.0       \$0.0
Taxes (rate = 40%)                                  18.0                          6.0        0.0
Net income                                            \$27.0                        \$9.0       \$0.0
ROE                                                  27.0%                        9.0%       0.0%

FIRM L [LEVERAGED (SOME DEBT)]
Curre nt assets                           \$50           Debt                                    \$50
Fixed assets                               50           Common Equity                            50
Total assets                             \$100           Total Liabilities & Equity             \$100

Sales Revenue                                        \$150.0                   \$100.0      \$75.0
Ope rating costs                   Fixed            45.0                     45.0       45.0
Variable         60.0                     40.0       30.0
Total ope rating costs                             105.0                     85.0       75.0
Ope rating Income (EBIT)                              \$45.0                    \$15.0       \$0.0
Inte rest (Rate = 10%)                               5.0                       5.0       5.0
Earnings before taxes (EBT)                           \$40.0                    \$10.0      -\$5.0
Taxes (rate = 40%)                                  16.0                       4.0       0.0
Net income                                            \$24.0                     \$6.0      -\$5.0
ROE                                                   48.0%                       12.0%     -10.0%

Chapter 4: Analysis of Financial Statements                                                 Page 3
c. Results:
i. Because interest is deductible, use of debt lowe rs tax bill and leaves more of the
firm’s operating income available to investors
ii. Use of debt require firms to balance higher expected returns against increased
risk

E. Three market value ratios
1. Set of ratios that relate stock price to its earnings, cash flow and book value pe r share
2. Price/Earnings Ratio = P/E Ratio
a. Shows the dollar amount investors will pay for \$1 of curre nt earnings
b. Formula:
price per share
price/earnings (P/E) ratio =
earnings per share
3. Price/cash flow ratio
a. Shows the dollar amount investors will pay for \$1 of cas h flow
b. Formula:
price per share
price/cash flow =
cash flow per share
4. Market/Book Ratio
a. Book value per share:
common equity
book value per share =
shares outstanding
b. market/book ratio:
market price per share
market/book ratio = M/B =
book value per share

III. Book’s example of Allied Food Products

A. Review financial state ments developed in Chapter 3: Tables 3 – 1, 3 – 2, 3 – 3, 3 – 4

Chapter 4: Analysis of Financial Statements                                                     Page 4
TABLE 4 -2: Allied Food Products: Summary of Financial Rati os (Millions of Dollars)

Li qui di ty Rati os
2004       Industry
Ratio                              Formul a                                        Calcul ati on                                    Comment
Value      Average
current assets                                    \$1,000
Current Ratio                                                                                 = 3.2x               3.7x        4.2x       Poor
cuurent liabilities                                  \$310
current assets - inventory                             \$385
Quick                                                                                  = 1.2x                  1.8x        2.2x       Poor
current liabilities                                \$310

Asset Management
2004       Industry
Ratio                              Formul a                                        Calcul ati on                                    Comment
Value      Average
Inventory                              Sales                                        \$3,000
= 4.9x                6.9x       10.9x       Poor
Turnover                             Inventory                                       \$615
Days sales                         Receivables                                     \$375
= 46 days            40.3 days   36 days      Poor
outstandi ng                      Annual sales 365                                 \$8.2192
Fi xed asset                             sales                                       \$3,000
= 3.0x                3.3x        2.8x       OK
turnover                          net fixed assets                                  \$1,000
Total assets                             sales                                       \$3,000                                            Somewhat
= 1.5x                1.7x        1.8x
turnover                             total assets                                   \$2,000                                              Low

Debt Management
2004       Industry
Ratio                              Formul a                                        Calcul ati on                                    Comment
Value      Average
Total debt to                           total debt                                   \$1,060                                               High
= 53.0%               47.6%      40.0%
total assets                          total assets                                  \$2,000                                              (risky)
Ti mes-interest-earned                        EBIT                                        \$283.8                                              Low
= 3.2x                4.4x        6.0x
(TIE)                          interest charges                                  \$88.0                                              (risky)
EB ITDA                      EBITDA + lease payments                    \$383.8 + \$28    \$411.8                                          Low
*                                                                            =        = 3.0x            3.5x        4.3x
Coverage          interest + principal payments + lease payments      \$88 + \$20 + \$28    \$136                                          (risky)
*
Assumes lease payments = \$28 million and pri nci pal payments = \$20 million

Chapter 4: Analysis of Financial Statements                                                                        Page 5
TABLE 4 -2 (Continued): Allied Food Products: Summary of Financi al Ratios (Millions of Dollars)

Profitability
2004     Industry
Ratio                    Formul a                  Calcul ati on                       Comment
Value    Average
net income                \$117.5
Profit margin on sale                                            = 3.9%    4.3%       5.0%      Poor
sales                  \$3,000
Return on total asset           net income                \$117.5
= 5.9%    7.3%       9.0%      Poor
(ROA)                     total assets              \$2,000
Basic earning power                EBIT                  \$283.8
= 14.2%    15.7%     18.0%      Poor
(B EP)                   total assets             \$2,000
Return on common equity           net income               \$117.5
= 12.5%    13.8%     15.0%      Poor
(ROE)                  common equity               \$940

Market Value Ratios
2004     Industry
Ratio                    Formul a                  Calcul ati on                       Comment
Value    Average
price per share             \$23.00
Price/earnings (P/ E)                                            = 9.8x    10.7x      11.3x     Low
earnings per share            \$2.35
price per share             \$23.00
Price/cash flow                                               = 5.3x    6.13x      5.4x      Low
cash flow per share           \$4.35
market price per share          \$23.00
Market/ book (M/B)                                              = 1.2x    1.5x       1.7x      Low
book value per share           \$18.80

IV. Benchmarking: cross-sectional and tre nd comparisons

A. Trend analysis
1. = analysis of a firm’s financial ratios over time
2. Used to estimate the likelihood of improve ment or deterioration in its financial condition

B. Cross-sectional analysis: compare company’s financial ratios with a group of “benchmark” companies

Chapter 4: Analysis of Financial Statements                                                                     Page 6
V. Tying ratios together: The Du Pont Equation

A. Basic Du Pont Equation
1. ROA is the product of the profit margin and the total asset turnover
2. Formula
Net Income      Net Income        Sales
ROA =                              
Total Assets       Sales      Total Assets
3. Book’s 2005 Allied Food Example
ROA = 3.9%  1.5 = 5.9%

B. ROA and ROE
1. If a company we re financed only by common equity → no debt → no liabilities → assets
= equity
Net Inocme        Net Income
ROA =                 =                  = ROE
Total Assets   Common Equity
2. Define the equity multiplier
a. Definition:
Total Assets
Equity Multiplier =
Common Equity
b. Firms with more leverage → ↑ debt and ↓ equity → ↑ equity multiplie r
c. Book’s 2005 Allied Food example: equity multiplier = (\$2,000)/(\$940) = 2.13
3. Extended Du Pont equation

Net Income      Sales       Total Assets
a. ROE =                              
Sales     Total Assets Common Equity

b. ROE = (profit margin)  (total assets turnover)  (equity multipler)

c. Book’s 2005 Allied Food Example: ROE = (3.9%)(1.5)(2.13) = 12.5%

VI. Uses and limitations of ratio analysis

A. Comparison with industry averages more difficult for conglomerate firms that operate
many divisions in different industries

B. “Average” performance is not necessarily good → Perhaps firm should have highe r goal
and focus on industry leader’s ratios → Benchmarking will help in this area

C. Inflation distorts balance sheets and income statements and comparisons of ratios across
time must be done with care

D. Seasonal factors can distort ratios

E. Firms may e mploy “window dressing techniques” to make their financial state ments look
better than they really are

F. Different accounting and operating practices can distort comparis ons of ratios
Chapter 4: Analysis of Financial Statements                                                Page 7
G. It is difficult to determine whether a given ratio value is good or bad
1. A high current ratio may imply excellent liquidity (which is good) or excessive cash
(which is bad because it is a nonearning asset)
2. A high fixed asset turnover ratio may indicate a firm that uses its fixed assets efficiently
or a firm that is short cash and doesn’t have capital for needed investments

H. Some of the firm’s ratios may look strong while some of its ratios look poor
1. Makes it difficult to determine overall position of firm
2. Statistical methods (discriminate analysis) have been used to determine the net effect of
a set of ratios and determine which ones predict financial distress

VII.    Proble ms with ROE

A. ROE and shareholder wealth are positively correlated but problems can anise when ROE
is the sole measure of performance

B. Types of problems
1. ROE does not consider risk
2. ROE does not consider the amount of invested capital
3. Managers attempts to maximize ROE will ignore other profitable investments

Chapter 4: Analysis of Financial Statements                                                    Page 8

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