Management or financial ratios

(Understanding Financial Statements)

Reference: Fundamentals of Engineering Economics, 2nd ed Chan S. Park Chapter 2 [ 5th edition]

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Common questions: A company of good economics? Return on investment? Owners earnings on upward trend? Debt-equity ratio? Retain earnings for growth?

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Figure 13.2 Information reported on a companys financial statements

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Table 13.1 Consolidated Statement of Financial Position (LAM Research Corporation Consolidated Balance Sheet) (in thousands, except per share data)
Period ending Assets Current assets: Cash and Cash Equivalents Short-term investments Accounts receivables Inventories Other Current Assets Total current assets Long-term investments Property, plant and equipment Other assets Deferred Income taxes Total assets $910,815 139,524 460,972 168,714 26,344 1,706,369 -49,893 518,549 38,533 $482,250 327,003 308,665 110,051 16,867 7,877 1,244,836 --41,082 119,673 43,224 25-Jjun-06 26-Jun-05 $ Change Percent Change

$2,313,344 $1,448,815

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Table 13.1 Consolidated Statement of Financial Position (LAM Research Balance Sheet) (Continued) Period ending Liabilities and Stockholders, equity Current liabilities Accounts payable Short term debt Other current liabilities Total current liabilities 25-Jjun-06 26-Jun-05 $ Change Percent Change

$426,141 -140,085 566,226

$289,425 -89,708 520 379,133

Long-term debt Other long-term liabilities

Total liabilities Stockholders equity Preferred stock Common stock Retained earnings Treasury stock Capital surplus Accumulated other comprehensive loss Total stockholders equity

350,000 969
917,195

-2,786
381,919

-142 850,268 (416,447) 973,391 (11,205) 1,396,149

-137 520,165 (186,064) 744,672 (12,014) 1,066,896

Total liabilities and stockholders equity

$2,313,344

$1,448,815

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Table 13.2 LAM RESEARCH CORPORATION INCOME STATEMENT (in thousands, except per-share amount) Period ending 25-Jun-06 Total revenue $1,642,171 Cost of Goods sold 814,777 Gross profit (margin) 827,394 Research and Development 228,891 Selling, general, and administrative 192,238 Nonrecurring Restructuring Charges 0 Operating Income or Loss Other Income (Expense) Interest income Interest Expense Other Net Income before tax Net income Net income per share Basic Diluted Number of Shares Used in per Share : Basic Diluted $406,265 38,189 (677) (2,490) 441,287

26-Jun-05 $1,502,453 738,361 764,092 194,115 164,774 14,201 $391,002 1,789 17,537 (1,413) (8,004) 399,122 $299,341 $2.16 $2.10 137,727 142,417

$335,755 $2.42 $2.34 138,581 143,732

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The Cash-flow Statement

This statement is concerned how the company actually used its cash in the period.

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Using ratios to make business decisions

Business decisions are made surrounding
Debt Management

Liquidity
Asset Management Profitability Market Trend

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Using ratios to make business decisions

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Balance Sheet
Assets: The dollar amount represents how much the company owns at the time of reporting. The asset items are listed in the order of their liquidity or the length of times it takes to convert in cash, according to three categories. Current asset: This kind of asset can be converted to cash or its equivalent in less than one year. Fixed asset: Fixed asset reflects the amount of money a company has paid for its plant and equipment acquired at some time in the past and relatively permanent and takes time to convert into cash. Other assets: Typical assets in this category include investments made in other companies and intangible assets such as goodwill, copyright, franchises and so forth.
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Assets and Liabilities

Current liabilities Current asset

Long-term liabilities

Long-term asset Equity 1.Owner contribution 2.Retained earnings

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Balance Sheet
Liabilities and stockholders equity: Current liabilities: A company currently owes to its suppliers and creditors. Other liabilities: Include long-term liabilities such as bonds, mortgages, and long-term notes, which are due and payable more than one year in the future. Stockholders equity: Represent the amount that is available to the stockholders after all other debts have been paid. Assets Liabilities Preferred stock = Common stockholders equity
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Debt Management Analysis

Debt management analysis: Debt ratio: the relationship between total liabilities, total assets generally called the debt ratio.

Debt ratio =

Total debt Total asset

For example, Lam researchs debt ratio for 2006 can be calculated by total debt is $917,195 and total asset is $2,313,344.

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Debt Management Analysis

Debt ratio = 917,195 2,313,344

= 39.65% Most creditor prefer low debt ratio because the lower the ratio, the greater will be the cushion against the creditors losses in case of liquidation

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Debt Management Analysis

Times interest earned ratio: The most common measure of the ability of a companys operations to provide protection to the long term creditor is the Times-interest-earned-ratio.
EBIT Interest expenses

Times interest earned ratio =

EBIT = Earnings Before Interest and Income taxes For example, Lam Research issued $350,000 worth of senior notes and long term bonds. This result in $667 in interest expense in the year 2006, so we calculated the following:

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Debt Management Analysis

Times interest earned ratio =

441,287+667
667

= 652.83 times. The ratio measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs. We use the earnings before interest and income taxes, rather than net income, in the numerator.

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Liquidity Analysis
= 3.01 times

Current ratio: we calculate the current ratio by dividing current assets by current liabilities.

Current ratio =

Current assets

Current liabilities

For example, lam researchs current ratio in 2006 can be calculated as follows:
Current ratio = 1,706,369 566,226

= 3.01
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Liquidity Analysis
If a company is getting difficulty, it begins paying its bills more slowly, borrowing its bank, and so on. If current liabilities are rising faster than current assets the current ratio will fall, and this could spell trouble.
General thumb rule calls for a current ratio of 2 to 1.

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Liquidity Analysis
Quick ratio: The quick ratio tells us whether the company could pay all its current liabilities if they came due immediately.

Quick ratio =

Current assets - Inventories

Current liabilities

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Liquidity Analysis
For example, Lam Researchs quick ratio in 2006 can be calculated as follows:
Quick ratio =

1,706,369 168,714
566,226

= 2.72 times
The quick ratio measures how well a company can meet its obligations without having to liquidate or depend too heavily on selling its inventories.
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Asset management analysis

Inventory turnover ratio: we find this by measuring how many times a company has sold and replaced its inventory during the year.
Sales
Average inventory balance

Inventory turnover ratio =

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Asset management analysis

For example, since Lam Research has a beginning inventory figure of $110,051 and an ending inventory $1168, 714 its average inventory for the year would be $639, 383. Then we can compute Lam Researchs inventory turnover ratio for 2006 as follows:
Inventory turnover ratio = 1,642,171 139,383

= 11.78 times

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Asset management analysis

As a rough approximation, Lam Research was able to sell and restock its inventory 12 times in 2006. Lam Researchs turnover of 12 times is much faster than that of its industry average, 5.8 times, during the same operating period.

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Asset management analysis

Days-sales-outstanding (Accounts Receivable Turnover) ratio: it is a rough measure of how many times a companys accounts receivable have been turned into cash during the year.
DSO ratio = Receivables Average sales per day Receivables Annual sales / 365

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Asset management analysis

For example, Lam Research in 2006 DSO can be calculated as follows:
460,972

DSO ratio =

1,642,171 / 365

= 102.46 days

Thus, Lam Research, on average, it takes about 102.46 days to collect on credit sale. The long collection period may signal that customers are in trouble or the company has poor credit management.
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Asset management analysis

Total asset-turnover ratio: Total asset turnover ratio measures how effectively a firm uses its total assets in generating its revenue.
Sales

Total asset turnover ratio =

Total asset

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Asset management analysis

For example, Lam Researchs total asset turnover ratio in 2006 can be calculated by as follows:
1,642,171 2,313,344

Total asset turnover ratio =

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Asset management analysis

Lam Researchs ratio of 0.71 times, when compared with the industry average ratio of 0.8 times, is almost 13% slower, indicating that Lam Research is using its total asset about 13& less intensively than it peers.

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Profitability Analysis
Profit margin on sale: This ratio indicates the profit per dollar of sale.
net income available to common stockholders

Profit margin on sale =

Sales

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Profitability Analysis
For example, Lam Research's profit margin sales in 2006 can be calculated as follows,

Profit margin on sale =

355,755 1,642,171

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Profitability Analysisysis
Thus, Lam Researchs profit margin is equivalent to 20.45 cents for each sales of dollar generated. Lam Researchs profit margin is greater than the industry average of 16.2%. the difference indicates that Lam Researchs operation is more efficient than that of its competitors.

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Profitability Analysis
Return on total asset: The return on total assets , or simply return assets, measures a companys success in using its assets in earn profit.
Return on total asset = net income + interest expenses (1 tax rate) average total assets

For example, Lam Research in 2006, calculated return on total asset as follows:
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Profitability Analysis
Return on total asset =
355,755+677 (1 0.2391) (2,313,344 + 1,448,815)/2

= 17.88% Adding a proportion of interest expenses back to net income results in an adjusted earnings figure that shows what earnings would have been if the asset had been acquired solely.
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Profitability Analysis
Return on common equity: This ratio shows the relationship between net incomes and common stockholders investments in the company.
Return on common equity = net income available to common stockholders average total assets

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Profitability Analysis
ROE= (Profit margin)*(Asset turnover)*(Financial leverage) For example, we compute average common equity by using the beginning balance and the ending balance. At the beginning of the fiscal year 2006, Lam Researchs common equity ending balance was $1,396,149 million and its beginning balance was $1,066,896 million. The average balance is, then, simply $1,231,553 million, so, we find the followings:

= 27.26% This ratio illustrates how the debt-to-equity ratio impacts the return on equity.

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Market Value Analysis

Market value analysis: Price-to-earnings (P/E) ratio: this ratio shows how much investors are willing to pay per dollar of reported profits.

For example, Lam Researchs stock sold for $46.72 (closing price) on June 26, 2006, so with EPS of $2.42, Lam researchs P/E ratio can be calculated as follows:

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Market Value Analysis

= 19.30 Lam Researchs P/E ratio is 19.30. In general, P/E ratios are higher for firms with high growth prospects, with all other things constant, but lower for firms with lower expected earnings.

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Market Value Analysis

Book value per share: this ratio frequently used in assessing the well-beings of common stockholders is book value per share. The book value per share measures the amount that would be distributed to holder of each share of common stock if all assets were sold at their balance sheet carrying was paid-off.

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Market Value Analysis

For example, Lam Researchs common stock in 2006 as follows:

If we compare this book value with market peice$53 at the time of publication, then we may say that the stocks appears to be overpaid. Once again, market prices reflect expectation of future earnings and dividends, whereas book largely reflects the result of events that occurred in the past. Therefore market value of a stock tends to exceed its book value.

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Limitations of Financial ratios

Business decisions are made in a world of uncertainty
As useful as ratios are, they have limitations It is difficult to generalize about whether a particular ratio is good or bad.

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Limitations of Financial ratios

For example, high current ratio may indicate a strong liquidity position which is good.
But holding too much cash in a bank account may not be the best utilization of funds.

As a typical engineering student, your judgment in interpreting a set of financial ratios is understandably weak at this point.
But it will improve as you encounter many facets of business decisions in the real world.

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