Financial Ratio Analysis Guide

Financial Ratio Analysis
Introduction
Contents Introduction Income Statement Years Balance Sheet Years Ratios Years Income Statement Companies Balance Sheet Companies Ratios Companies
This sheet and a comprehensive ratio glossary Income statement input worksheet for comparison over time Balance statement input worksheet for comparison over time Ratio output report for comparison over time Income statement input worksheet for comparable company analysis Balance statement input worksheet for comparable company analysis Ratio output report for comparable company analysis
Overview Financial analysts, whether professionals on Wall Street, M&A officers in public companies, or household investors, are presented with an overwhelming amount of data. Ratio analysis is a tool which analysts have developed over the years to help them evaluate the health, prospects and valuations of companies. A wide variety of financial measures can be tracked, compared and evaluated over time to monitor for risks, performance history or other indicators the analyst may be concerned about. It is important to remember, however, that ratio analysis is merely a tool. It can highlight areas of concern or promise, raise questions and help guide the analyst towards a more complete understanding. It cannot, however, provide full and complete answers and can easily mislead if the analyst relies on ratios too heavily. To get the most out of ratio analysis, bear in mind the following guidelines. 1. A lone ratio is meaningless. Suppose you hear that Company A has liabilities to equity of 3:1. What does this mean? In one industry it might indicate a company with a seriously weak balance sheet. If that company were a bank, however, it would be quite the opposite! Ratios are often most useful when compared with other, similar ratios, such as comparing different years within the same company or a number of similar companies. 2. Ratios are usually more effective at raising questions than at providing answers. Suppose you compare Company A with others in the industry and find that its peer group averages liabilities to equity of 1:1. The anomaly raises questions you can try to answer. Is Company A financially vulnerable after all? Might some of its competitors take advantage of its financial frailty to launch a price war and steal market share? Or is the management of Company A creating value for shareholders by adopting a more appropriate level of leverage and taking advantage of the resulting tax shield? 3. Ratios are highly susceptible to distortions. Before you look for a profound cause for a surprising or interesting ratio, make sure that the underlying numbers are not giving a misleading impression. This does not necessarily mean to look out for management massaging the numbers; rather, normal events can cause ratios to appear misleading. If you find a steel company trading at a P/E usually reserved for Internet stocks, it may be that youve found a valuation anomaly that you can profit from. It may also be that a company that normally makes profits of $50 million is in a cyclical slump and is making just $2 million this year. Rather than valuing the company on an astronomical P/E per se, the market is simply reflecting an expectation that profits will return to normal as the business cycle improves.
Introduction
4. Know which ratios matter. Each company and each industry are different, and different financial ratios will be more important indicators than others will in any given situation. Software companies, for example, have substantial intangible assets that do not appear on their balance sheets. Asset-based ratio analysis will generally be less appropriate for that industry than it would for basic manufacturing. Trying to look at profitability ratios is unlikely to help you evaluate the value of a biotech firm which is still two years away from final approval on any of its drugs, etc. Both analysts reports and your own analysis can help determine which ratios will be the most useful. To start using the tool, remove the sample data from the tool using the Show/Hide Sample Data option under the Menu
Note About Using Internet Explorer The default setting in Internet Explorer is to open these tools in the Explorer application instead of Excel. We recommend against this and provide directions in the Help section of the HBS Toolkit web site to change this default behavior.
Menu Show/Hide Sample Data: Show Calculator: Show/Hide Celltips: Print Sheet with Celltips: Set Zoom: Visit Web Links: About HBS Toolkit:
Displays or removes sample entries Launches Windows calculator Toggles in/out red Celltips in documented cells Prints Celltips documentation on current sheet Provides quick access to 80%, 100%, and 125% zoom levels Links to HBS Toolkit website, Toolkit Glossary, and Toolkit Feedback, as well as HBS and HBS Publishing web sites Launches the about box for the HBS Toolkit
INDICATORS OF SOLVENCY
DEBT TO EQUITY:
This ratio is an indicator of the extent to which a company is using financial leverage. Generally, a high ratio is acceptable in industries with stable earnings and less acceptable in industries where earnings are lower and less predictable. The ratio is calculated and expressed as:
Liabilities Stockholders' Equity
= .XX
ASSETS TO EQUITY:
This ratio is an indicator of the extent to which a company is leveraging invested capital. Again, a high ratio is acceptable in industries with stable earnings and less acceptable in industries where earnings are lower and less predictable. The ratio is calculated and expressed as:
Assets Stockholders' Equity DEBT RATIO:
= .XX
This is another leverage measurement. It reflects the extent to which debt is being used to finance the acquisition of assets. The ratio is calculated and expressed as:
Liabilities Assets
= .XX

TIMES INTEREST EARNED:
Introduction
This important ratio measures the ability of a company to pay the interest on its longterm debt. A high multiple provides comfort to lenders in terms of the decline in profitability that can occur before the payment of interest becomes a problem. A companion ratio, debt service coverage (the subject of another spreadsheet template), measures the earnings available to meet total debt service, including principal and interest. Both ratios can be misleading if major debt has been outstanding less than a full year. The times interest earned ratio is calculated and expressed as:
Net Income Before Income Taxes & Interest Interest
= .XX
INDICATORS OF LIQUIDITY
NET WORKING CAPITAL:
This component of the template is presented in terms of dollars, not a ratio. It is an important measure of the dollar effect of completing the business cycle. Working capital is calculated and expressed as:
Current Assets minus Current Liabilities WORKING CAPITAL TO ASSETS:

Growth without sufficient working capital can mean disaster. It is important to monitor the proportion of working capital to total assets as an indicator of liquidity. The ratio is calculated and expressed as:
Current Assets minus Current Liabilities Total Assets CURRENT RATIO:
= .XX
This ratio is the one most often used to measure a company's ability to pay its bills within the next accounting period, usually one year. The "2:1 syndrome" is pervasive and is a presumption of financial health. This ratio can be too high as well as too low. The components need to be examined closely; a high inventory may be the result of low turnover, and high receivables may be the result of slow collections. The ratio is calculated and expressed as:
Current Assets Current Liabilities QUICK RATIO:
= .XX
Sometimes referred to as the "acid test" ratio, the quick ratio is a more critical test of ability to pay debts than the current ratio. Inventories and prepaid items are excluded from the computation, which is calculated and expressed as:
Cash + Receivables + Temp Investments Current Liabilities
= .XX

INDICATORS OF ASSET MANAGEMENT
DAYS SALES OUTSTANDING:
Introduction
This measurement of accounts receivable management is a very valuable tool. In a sophisticated computer setting the calculations can be made at frequent intervals to determine whether or not collections are meeting the company's credit policies. The template calculates the ratio on an annual basis and is expressed as:
365 Days Credit Sales divided by Accounts Receivable INVENTORY TURNOVER:
= .XX
This measurement is an indicator of the effectiveness of the company's inventory management policy. The higher the turnover during the accounting period, the less capital that must be devoted to carrying this asset. To be more accurate, inventory turnover should be measured in relation to the average inventory during the period. When using the year-end inventory figure, the goals should be set accordingly, that is, higher if year-end inventories are lower than average and lower if they are higher. This ratio is calculated and expressed as:
Cost of Goods Sold Inventory
= .XX
DAYS SALES IN INVENTORY:

This ratio is another approach to measuring the effectiveness of inventory control. In theory it measures the number of days needed to sell the entire inventory if the mix of merchandise were perfect. Too high a ratio may mean either a poor mix or excess levels of certain items. Correspondingly, too low a ratio may indicate that orders cannot be filled promptly, resulting in backorders or lost sales. This ratio is calculated and expressed as:
Inventory Cost of Goods Sold divided by 365 ASSET TURNOVER:
= .XX
This ratio measures the amount of assets required to produce sales. It is measured and expressed as:
Sales Total Assets EQUITY TURNOVER:
= .XX
This ratio measures the amount of equity required to produce sales. It is measured and expressed as:
Sales Equity
= .XX
WORKING CAPITAL TURNOVER:

This ratio measures the amount of working capital required to produce sales. It is measured and expressed as:
Sales Current Assets - Current Liabilities
= .XX

INDICATORS OF PROFITABILITY
RETURN ON SALES:
Introduction
The volume of sales has a more meaningful relationship to net income when it is expressed as a ratio. Extraordinary income or expense is not considered in this calculation in order to avoid distorting the result. The ratio is calculated and expressed as:
Net Operating Income After Income Taxes Net Sales RETURN ON TOTAL ASSETS:
= .XX
One way to measure return on assets is in relation to total assets regardless of the source of their financing. This ratio is calculated and expressed as:
Net Operating Income After Income Taxes Total Assets RETURN ON EQUITY:
= .XX
Management is usually under more pressure to increase profits than to meet any other goal. Return on equity is calculated and expressed as:
Net Income Stockholders' Equity
= .XX
Some members of management are more concerned about ratios which directly relate to operations, some of which are:
OPERATING RETURN: After Tax Operating Income = .XX Total Assets GROSS MARGIN: Total Sales - Cost of Sales Sales = .XX
OPERATING INCOME PER SHARE: After Tax Operating Income = .XX Shares Outstanding EARNINGS PER SHARE: Net Income After Taxes Shares Outstanding = .XX

MEASURES FOR SHAREHOLDERS
The template computes two measurements of company value.
Introduction
MARKET PRICE PER SHARE: Earnings Per Share times Industry Multiple BOOK VALUE PER SHARE: Equity Shares Outstanding DIVIDEND PAYOUT:
This percentage measures the portion of Net Income After Taxes that is returned to the shareholders as dividends. It is calculated and expressed as:
= .XX
Dividends Paid Net Income After Taxes
= .XX
Income
Statemment
Data Shown in Thousands of Dollars Select number of years:
Baseline 1994 Total Sales Credit Sales Cost of Goods Sold Depreciation Interest Expense Pre-tax Operating Income After-tax Operating Income Net Income after Taxes Dividends Paid 2,000 300 900 200 16 387 323 310 0
1995 2,400 310 1,080 236 28 458 392 366 0
1996 2,880 340 1,296 286 33 545 469 436 0
1997 3,456 450 1,555 356 19 663 548 530 0
1998 4,147 476 1,866 449 12 791 637 633 0
Balance
Sheet
Data Shown in Thousands of Dollars Baseline 1994
1995 60 96 48 324 1,524
1996 72 115 58 389 1,829
1997 86 138 69 505 2,233
1998 104 166 83 833 2,906
ASSETS Cash Accounts Receivable Inventory Total Current Assets Total Assets
50 80 40 330 1,330
LIABILITIES
Current Portion of LT Debt Total Current Liabilities Total Liabilities Owners' Equity Shares Outstanding Market Value of Shares as Multiple of Earnings
80 190 375 455 80 209 603 821 80 232 572 1,257 80 259 446 1,787 80 292 486 2,420
Ratios
Data Shown in Thousands of Dollars Baseline 1994
1995
1996
1997
1998
Debt to equity Assets to equity Debt ratio Times interest earned
0.82 2.92 0.28 24.19
0.73 1.86 0.40 16.36
0.46 1.46 0.31 16.52
0.25 1.25 0.20 34.89
0.20 1.20 0.17 65.92
Net wkg cap'l (,000 OMITTED) Working capital to assets Current ratio Quick ratio Dividend payout
0.14 0.11 1.74 0.68 0.00
0.12 -0.18 1.55 0.75 0.00
0.16 -0.10 1.68 0.81 0.00
0.25 0.03 1.95 0.86 0.00
0.54 0.12 2.85 0.92 0.00
Days sales outstanding Inventory turnover Days sales in inventory Asset turnover Equity turnover Working capital turnover
97.33 22.50 16.22 1.50 4.40 14.29
113.03 22.50 16.22 1.57 2.92 20.87
123.46 22.34 16.33 1.57 2.29 18.34
111.93 22.54 16.20 1.55 1.93 14.05
127.29 22.48 16.24 1.43 1.71 7.67
Return on sales Return on total assets Return on equity Operating return Gross margin Operating income per share Earnings per share
0.16 0.23 0.71 0.24 0.55 #N/A #N/A
0.15 0.24 0.48 0.26 0.55 #N/A #N/A
0.15 0.24 0.37 0.26 0.55 #N/A #N/A
0.15 0.24 0.31 0.25 0.55 #N/A #N/A
0.15 0.22 0.26 0.22 0.55 #N/A #N/A
Market price per share Book value per share
#N/A #N/A
#N/A #N/A
#N/A #N/A
#N/A #N/A
#N/A #N/A
Income
Statement
Data Shown in Thousands of Dollars Select number of companies:
Baseline company company company company company Total Sales Credit Sales Cost of Goods Sold Depreciation Interest Expense Pre-tax Operating Income After-tax Operating Income Net Income after Taxes Dividends Paid
Balance Sheet
Data Shown in Thousands of Dollars Baseline company company company company company
ASSETS Cash Accounts Receivable Inventory Total Current Assets Total Assets
LIABILITIES
Current Portion of LT Debt Total Current Liabilities Total Liabilities Owners' Equity Shares Outstanding Market Value of Shares as Multiple of Earnings
Ratios
Data Shown in Thousands of Dollars Baseline company company company company company
Debt to equity Assets to equity Debt ratio Times interest earned
#N/A #N/A #N/A #N/A
#N/A #N/A #N/A #N/A
#N/A #N/A #N/A #N/A
#N/A #N/A #N/A #N/A
#N/A #N/A #N/A #N/A
Net wkg cap'l (,000 OMITTED) Working capital to assets Current ratio Quick ratio Dividend payout
#N/A #N/A #N/A #N/A #N/A
Days sales outstanding Inventory turnover Days sales in inventory Asset turnover Equity turnover Working capital turnover
#N/A #N/A #N/A #N/A #N/A #N/A
Return on sales Return on total assets Return on equity Operating return Gross margin Operating income per share Earnings per share
#N/A #N/A #N/A #N/A #N/A #N/A #N/A
Market price per share Book value per share
#N/A #N/A
#N/A #N/A
#N/A #N/A
#N/A #N/A
#N/A #N/A

Financial Ratio Analysis Guide

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Financial Ratio Analysis Guide

Uploaded by

Copyright:

Available Formats

Financial Ratio Analysis