FINANCIAL RATIOS - Profitability Ratio

- Market Ratio - Stability Predicative Power of Financial Ratios

Common Size and Index Analysis

PROFITABILITY RATIO
measure the company's use of its assets and control of its expenses to generate an acceptable rate of return. These ratios tell us whether a business is making profits - and if so whether at an acceptable rate.

Profitability in Relation to Sales

Gross Profit Margin - Measures the profitability of the firm relative to sales after the deduction of the cost of producing the goods
Sales Cost of goods sold Sales $1,312,460 $3,992,758 = 32.9%

Net Profit Margin Measures the relative efficiency of the firm after taking into account all expenses and income taxes.
Net profits after taxes Sales $201,242 $3,992,758 = 5.04%

SG&A to Sales Measures the profitability of the firm relative to sales after taking into account the SG&A
Selling, general & administrative expenses Sales $801,395 $3,992,758 = 20.1%

B. Profitability in Relation to Investment

Return on Equity (ROE ) Measures rate of return earned on assets provided by owners.
Net profits after taxes - Preferred stock dividend Shareholders equity $201,242 $1,796,621 = 11.2%

Return on Assets (ROA)/ Return on Investment (ROI ) Measures rate of return earned through operating total assets provided by both creditors and owners.
Net profits after taxes Total assets $201,242 $3,251,480 = 6.19%

C. Turnover and Earning Power Assets Turnover ratio Indicates the relative efficiency with which the firm utilizes its resources in to generate output.
Sales Total assets $3,992,758 $3,251,480 = 1.23%

MARKET VALUE RATIOS

Market ratios relate the firms market value, as measured by its current share price, to certain accounting value. These ratios give insight into how well investors in the market feel the firm are doing in terms of risk and return. It measure investor response to owning a company's stock and also the cost of issuing stock.

Price/Earnings Ratio Measures the amount that investors are willing to pay for each dollar of firms earnings; the higher the P/E ratio the greater the investor confidence.
Share price Earnings per share
Share price = $38 par value of $5/share Outstanding share = $84,165,600 Earnings per share after taxes No of share outstanding

$38.00 $2.39 = 15.9times

$201,242,000 $84,165,600 = 2.39

Dividend yield Measures the rate of return to shareholders based on current market price.
Dividends per share Share price $1.70 $38.00 = 4.47%

Market-to-Book Ratio Relative measure of how the growth option for a company is being valued vis--vis its physical assets. The higher the ratio, the greater the attractiveness of and/or competitive advantage.
Shareholders equity Outstanding share $1,796,621 84,165,600 =21.35

Share price Book value per share $38.00 $21.35 = 1.78

STABILIY RATIOS
These ratios concentrate on the long-term health of a business - particularly the effect of the capital/finance structure on the business.
Interest Cover Ratio Measures the ability of the business to "service" its debt. Are profits sufficient to be able to pay interest and other finance costs? Operating profit before interest Interest $399,556 $85,274 =4.69

Gearing Ratio
Measures the proportion of assets invested in a business that is financed by borrowing. In theory, the higher the level of borrowing (gearing) the higher are the risks to a business, since the payment of interest and repayment of debts are not "optional" in the same way as dividends. Borrowing (all long-term debts + normal overdraft) Net Assets (or Shareholders' Funds)
$1,454,859 $1,796,621 = . 81

TRADING ON EQUITY
The use of borrowed money to increase the return on an investor's capital. Trading on equity occurs when a corporation uses bonds, other debt, and preferred stock to increase its earnings on common stock.
Example: Suppose an investor is able to borrow 50% of the funds required for a $10,000 investment that returns 16% annually. If interest on the loan is 6%, the investor can earn $1,600 ($10,000 at 16%) minus interest of $300 ($5,000 at 6%), or $1,300 on an investment of $5,000 ($10,000 minus $5,000 borrowed), for a return of 26% ( $1,300/$5,000 ).

PREDICATIVE POWER OF FINANCIAL RATIOS

Reliance on certain ratios depend on the analysts perception of their predicative power relative to the problem at hand A number of empirical studies have tested the predicative power of financial ratios. In many of these studies, financial ratios are used to: a. predict business failure b. predict corporate bond ratings c. predict the long-term credit standing of a firm

Predicting Financial Distress

William H. Beaver was the first to use statistical techniques to predict corporate failure. He found that financial ratios or failed companies deteriorated markedly as failure approach. Edward I. Altman employed multiple discriminant analysis to predict bankruptcy using various financial ratios. He found that five financial ratios were able to discriminate rather effectively between bankrupt and nonbankcrupt companies, beginning up to 5 years prior to the bankruptcy event.

Z-score model
Used to predict whether or not a company is likely to go bankrupt in the near future Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + .6 X4 + 1.0 X5 Whereas: X1 = working capital to total asset X2 = cumulative retained earnings to total assets X3 = earnings before interest and taxes to total assets X4 = market value of equity to book value of total liabilities X5 = sales to total assets

 Z score below 1.81 (including negative amounts) always went bankrupt whereas Z scores above 2.99 represent healthy firms Firms with Z scores in between were sometimes misclassified

COMMON SIZE AND INDEX ANALYSIS

Common- Size Analysis
This type of analysis indicates the relative size of each item in the Financial Statements as a percentage of the total of that Statement i.e. Total Assets or total Liabilities & Shareholders equity in Balance Sheet and Sales in Income Statement.

Analysis/Interpretation Common Size Balance Sheet

of

Over the 4 years the percentage of the current assets increased and that this was particularly because of the increase in cash. Accounts receivable showed a relative increase from 2003 to 2004. On the Liabilities and Shareholders equity side of the balance sheet, debt of the company declined on a relative basis from 2001 to 2003, with large absolute increase in assets that occurred in 2004. Accounts payable increased substantially in both absolute and relative term.

Analysis/Interpretation of Common Size Income Statement

The common size income statement shows that the gross profit were fluctuating from year to year as well as the Selling, general, and administrative expenses. As a result, the net profit varies from 2001 to 2004 Although 2004 shows a sharp improvement over 2003 and 2002 still, is not as good as 2001 on a before tax relative basis.

Index Analysis
This analysis considers changes in items of financial statement from a base year to the following years to show the direction of change.

Analysis/Interpretation Indexed Balance Sheet

of

The base year is 2001; all financial statement items are 100 for that year. Cash is obviously increasing. There was large increase in accounts receivable and inventories from 2003-2004. The latter was not apparent in the common size analysis. To a lesser extent, there was a sizable increase in fixed assets. On the liability side, large increase in Accounts payable as well as in other current liabilities that occurred from 2003-2004.

Analysis/Interpretation of Indexed Income Statement

This gives the same picture as common size income statement, which has fluctuating behavior. The sharp improvement in 2004 profitability is more easily distinguished. This also gives information on the magnitude of absolute change in profits and expenses, wherein in the common size income statement, there is no information about how total assets and total sales change over time.

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