Chapter

Financial Ratio Analysis

Learning Objectives
n Calculate and explain a variety of financial

ratios.
n Explain the value of common-size and

common-base-year financial statements.

n Use the DuPont equation to calculate a

companys return on equity.

n Understand the strengths and weaknesses of

financial statement analysis.

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Common-Size and Common-Base-Year Financial Statements

n Income statement items as a percentage of

total sales.
v Provides insight into how the relative items

contribute to revenues and expenses.

n Balance sheet items as a percentage of total

assets.
v Provides a insight into the structure of the

companys assets and financing.

n Common-base-year financial statements

provide such comparisons to a base year.

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General Procedure
n Compute financial ratios for the company,

using financial statements from the last few years.

n Compare trends in key financial ratios for the

company.
n Compare the companys financial ratios to

industry averages.

Classification of Financial Ratios

n Liquidity Ratios

n Asset Activity Ratios

n Leverage Ratios n Coverage Ratios n Profitability Ratios n Market Value Ratios

Liquidity Ratios
n Current Ratio

n Quick Ratio
n Working Capital Ratio n Cash Ratio

Current Ratio

Current Assets Current Ratio = Current Liabilities s $ 400 = =1 .58 $ 253

Tells how easily a company can meet its current liabilities. A high ratio is not always good.
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Quick Ratio

Current Assets - Inventories s Quick Ratio = Current Liabilities s $ 400 - $140 = =1 .03 $ 253
Tells how easily a company can meet its current liabilities without depending on its inventories.
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Working Capital Ratio

Working Capital Ratio = Current Assets - Current Liabilities = Sales $ 400 - $ 253 = = 13.61% $1 ,080
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Cash Ratio

Cash & Equivalents Cash Ratio = Total Assets $ 26 = = 2.26% $1 ,150

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Summary of Liquidity Ratios

Ratio 1996 1995 Ind. Average (1996)

Current
Quick Working Capital

1.58
1.03 13.61%

1.98
1.30 20.48%

2.00
1.00 18.00%

Cash

2.26%

2.05%

2.61%

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Asset Activity Ratios

n Receivables Turnover Ratio

n Days Sales Outstanding

n Inventory Turnover Ratio n Days Sales in Inventory n Fixed Asset Turnover Ratio n Total Asset Turnover Ratio

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Receivables Turnover Ratio

Receivables Turnover Ratio = Annual Credit Sales = Accounts Receivable $1 ,080 = = 4.62 $ 234
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n How many times a company extends credit

and collects during a period of one year.

n In this case its 4.62 , the higher the ratio the

better.

n A lower ratio means re-assessing credit

policies.

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Days Sales Outstanding (DSO) or Average collection period

Days Sales Outs tan ding = 365 = Receivables Turnover 365 = = 79.08 4.62
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Inventory Turnover Ratio

Inventory Turnover Ratio = Cost of Goods Sold = Inventory $ 560 = = 4.00 $140
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A ratio showing how many times a company's inventory is sold and replaced over a period.

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Days Sales In Inventory

Days Sales In Inventory = 365 = Inventory Turnover 365 = = 91 .25 4.00

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Fixed Asset Turnover Ratio

Fixed Asset Turnover Ratio = Sales = Net Fixed Assets $1 ,080 = =1 .44 $ 750
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Total Asset Turnover Ratio

Total Asset Turnover Ratio = Sales = Total Assets $1 ,080 = = 0.94 $1 ,150
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Summary of Asset Activity Ratios

Ratio 1996 4.62 79.08 4.00 1995 Ind. Average (1996)

Receivables T.O.
Days Sales Outst. Inventory T.O. Days Sales in Inv. Fixed Asset T.O. Total Asset T.O.
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4.00
91.25 3.57 102.34 1.59 0.96

6.02
60.63 4.15 87.95 1.53 1.16

91.25
1.44 0.94

Leverage Ratios
n Debt Ratio

n Debt-to-Equity Ratio
n Equity Multiplier

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Debt Ratio

Total Debt Debt Ratio = Total Assets $ 488.50 = = 0.42 $1 ,150.00

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Debt-to-Equity Ratio

Total Debt Debt / Equity Ratio = Shareholder' s Equity $ 488.50 = = 0.74 $ 661 .50

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Equity Multiplier

Total Assets Equity Multiplier = Shareholders Equity $1 ,150.00 = =1 .74 $ 661 .50
A high ratio means the company is highly leveraged i.e. debt financed
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Summary of Leverage Ratios

Ratio 1996 1995 Ind. Average (1996)

Debt Ratio
Debt - To - Equity Equity Multiplier

0.43
0.74 1.74

0.37
0.58 1.58

0.40
0.67 1.67

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Coverage Ratios
n Interest Coverage Ratio

n Fixed Charge Coverage Ratio

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Interest Coverage Ratio or times interest earned ratio

Interest Coverage Ratio = EBIT = Interest Expense $ 85 = = 5.67 $15

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The higher this ratio the better.

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Fixed Charge Coverage Ratio

Fixed Charge Coverage Ratio = EBIT + Rental Pmts. = Interest Expense + Rental Pmts. $ 85 + $ 6 = = 4.33 $15 + $ 6
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Summary of Coverage Ratios

Ratio 1996 1995 Ind. Average (1996)

Interest
Fixed Charge

5.67
4.33

5.00
3.89

6.21
5.12

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Profitability Ratios
n Gross Profit Margin

n Net Profit Margin

n Earning Power n Return on Assets n Return on Equity

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Gross Profit Margin

Gross Profit Gross Profit Margin = Sales

$ 520.00 = = 48.15% $1 ,080.00

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Net Profit Margin

Net Income Net Profit Margin = Sales

$ 42.00 = = 3.89% $1 ,080.00

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Earning Power

EBIT Earning Power = Total Assets $ 85.00 = = 7.39% $1 ,150.00

The basic earning power ratio (or BEP ratio) compares earnings apart from the influence of taxes or financial leverage, to the assets of the company

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Return on Assets

Net Income Re turn on Assets = Total Assets $ 42.00 = = 3.65% $1 ,150.00

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Return on Equity

Net Income Return on Equity = Common Equity $ 36.00 = = 6.35% $ 641 .50

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Summary of Profitability Ratios Ratios

Ratio 1996 1995 Ind. Average (1996)

Gross Profit Margin

Net Profit Margin Earning Power Return on Assets Return on Equity

48.51% 49.05%
3.89% 7.39% 3.65% 6.35% 3.69% 7.42% 3.54% 5.58%

48.28%
3.75% 8.25% 3.98% 6.65%

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Market Value Ratios

n P/E Ratio

n Market-to-Book Ratio
n Earnings Yield n Dividend Yield

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P/E Ratio

Pr ice per Share P / E Ratio = Earnings per Share $ 29 .00 = = 12.89 $ 2.25
Shows how much investors are willing to pay per $ of reported profits.
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Market-to-Book Ratio

Market to Book Ratio = Pr ice per Share = Book Value per Share $ 29.00 = = 0.72 $ 40.09
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Earnings Yield

Earnings per Share Earnings Yield = Pr ice per Share $ 2.25 = = 7.76% $ 29.00

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Dividend Yield

Dividends per Share Dividend Yield = Pr ice per Share $1 .25 = = 4.31% $ 29.00

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Summary of Market Value Ratios

Ratio 1996 1995 15.60 6.41% 3.85% 0.73 Ind. Average (1996) 16.25 6.15 4.50 1.20

P/E
Earnings Yield Dividend Yield

12.89
7.76% 4.31%

Market - to - Book

0.72

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DuPont Analysis
ROE = (Profit marg.)(Asset TO)(Eq. Mult.)

ROE = (3.889%) (0.939) (1.738)

ROE= 0.0635 or 6.35% Therefore, Net Inc. , Sales , Tot. Assets = NI to Common Sales
Tot. Assets

Shldr. Eq

Common Eq.

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Using Financial Statements

n Requires judgment, experience, hard work.

n Does not provide new information.

n Can provide insight into why the companys

stock has its current selling price.

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