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A. OVERVIEW

• Percentage (e.g. earnings as a % of sales revenue)

• Times (e.g. asset as xx times of debt)

• Number of days for certain activities to be completed (e.g. inventory to be sold)

Definition: Ratio analysis refers to methods of calculating and interpreting financial ratios to assess a

firm’s performance

• Provide details for financial planning

• Put details into perspective

• Manage expectations (creditors and investors)

• Cross-sectional analysis

• Time-series analysis

• Combined (mixed)

– Benchmarking: relative to other firm(s) or the industrial average; check for deviations

– Caution: Large deviations as symptoms but inconclusive

– Example: Interested in average age of inventory

• What might have caused the firm to have an AAI so much lower than the industrial

average? Is it an indicator of “good” performance?

2003 (AAI)

Caldwell manufacturing 24.7 days

– Establish trends to assess the firm’s performance over time

Combined / mixed:

– Use both cross-sectional and time-series

1. Liquidity

2. Activity

3. Leverage

4. Profitability

• organize your ideas by these four types of ratios

• compare these ratios of the firm over time

• compare with the industrial averages

B. ANALYZING LIQUIDITY

Definition: Liquidity measures a firm’s ability to satisfy its short-term obligations as they come due

• Can the firm pay its bills?

Types of ratios used for analyzing liquidity (See Tables 3.3 and 3.4 for examples):

1. Net working capital (not a ratio)

2. Current ratio

3. Quick ratio (acid test)

1. NET WORKING CAPITAL: Dollar amount of current assets exceeds / falls short of current liabilities

Interpretation: Current assets exceed current liabilities by $603,000 at the end of 2002.

• Working capital: usually refers to current assets only

• Cash component: does not earn a return! So, too large a number does not necessarily imply a

“good” performance

• Nature of activities is different

• Size of operation is different

2. CURRENT RATIO: Size of current assets relative to current liabilities

Interpretation: For each dollar the firm owes (short-term liabilities), the firm has $1.97 in its asset.

Rule of thumb: current ratio=2, but if cash flow is predictable, a lower current ratio is acceptable

Twist: % of current assets that can be reduced such that the firm can still cover its short-term

obligations as they come due

Interpretation: The firm can reduce its current asset by 49.24% and still be able to meet its short-term

obligations

Question: What would be the net working capital when current ratio=1?

3. QUICK RATIO (ACID-TEST): Size of most liquid current assets relative to current liabilities

• Inventories generally take longer to sell, often at discounted prices

• Inventories may be accounts receivable before they can be turned into cash

Note: Quick ratio vs. current ratio: depends on how liquid are the inventories

Final remarks

• Higher ratios Æ firm is in a more liquid position

• Trade-off between liquidity (risk) and profitability

– Higher ratio Æ lower current liabilities, less costly than long-term financing (lower risk)

– Higher ratio Æ larger current assets, less profitable than fixed assets (lower return

C. ANALYZING ACTIVITY

Definition: Activity ratios measure the firm’s effectiveness at managing accounts receivable, inventory,

accounts payable, fixed assets, and total assets

Four ratios:

1. Average age of inventory

2. Average collection period

3. Average payment period

4. Fixed and total asset turnover

1. AVERAGE AGE OF INVENTORY

• Average time inventory is held by the firm (unsold)

= Inventory / (COGS/365)

Example: Average age of inventory = $289,000 / ($2,088,000 / 365 days) = 50.7 days

Interpretation: The firm takes, on average, 50.7 days to sell an “average” item of its inventory

• Too high: Risk of not being able to sell inventory

• Too low: Under-investment in inventory

• Average time taken to collect accounts receivable

= Accts rec’ble / (Annual sales/365)

Example: Avg. collection period = $503,000 / ($3,074,000 / 365 days) = 59.7 days

Interpretation: The firm takes, on average, 59.7 days to collect accounts receivable

• Average time taken to pay its purchases

= Accts payable / (% COGS/365)

Example: Suppose the firm purchases 70% of its COGS. Avg. payment period = $382,000 /

(0.7*$2,088,000 / 365 days) = 95.4 days

4. FIXED AND TOTAL ASSET TURNOVER

• Efficiency with which the firm uses its net fixed assets to generate sales

Total asset turnover = Sales / Total assets

Example:

Fixed asset turnover = $3,074,000 / $2,374,000 = 1.29

Total asset turnover = $3,074,000 / $3,597,000 = 0.85

Interpretation: Every dollar of fixed asset generates $1.29 sales; every dollar of asset (total) generates

$0.85 sales

Question: High fixed asset turnover and low total asset turnover Æ low fixed-to-current assets. Why?

D. ANALYZING LEVERAGE

Definition: Amount of debt used in an attempt to maximize shareholders’ wealth

Two types:

– Capitalization ratios: How a firm has financed its investment

• Debt ratio

• Debt/Equity ratio

– Coverage ratios: Assess the firm’s ability to service the source of financing (payment debt,

interest, leases, dividend payments i.e., fixed financial charges)

• Times interest earned ratio

• Fixed-charge coverage ratio

Capitalization ratios

1. DEBT RATIO

• Proportion of total assets financed by creditors

Related ratios:

– Preferred equity ratio

– Common equity ratio

• Proportion of total assets financed by preferred shareholders

• Proportion of total assets financed by common shareholders

Note: Debt ratio + preferred equity ratio + common equity ratio = 100%. Why?

• Proportion of long-term debt to common equity

Interpretation: For every dollar of common equity financing, the firm uses $0.583 of long-term debt

Coverage ratios

1. TIMES INTEREST EARNED (INTEREST COVERAGE) RATIO

• Firm’s ability to pay contractual interest

• The higher is the ratio, the more capable is the firm to pay

Interest coverage ratio = Earnings before interest and taxes (EBIT) / Interest

Interpretation: For every dollar of interest, the firm has $4.49 of operating earnings available to pay

Rule of thumb: 3 to 5

Twist: (1 - 1/interest coverage ratio)*100%

Interpretation: The firm can shrink its earnings by 78% and still be able to pay its contractual interest

payment

Question: Suppose a firm has times interest earned ratio of 28.63 but the industry’s average is 12.31.

Why might the company’s ratio be so much higher than the industry average?

• Little debt

• Lower risk (Æ financial leverage and lower return)

• Firm’s ability to pay fixed charges

• The higher is the ratio, the more capable is the firm to pay

• 4 types of fixed financial charges

– Interest on debt

– Principal repayment on debt

– Lease payment

– Preferred-share dividend payments

Example A firm has EBIT: $418,000 with lease payments of $35,000 and interest payment of $93,000.

Principal payments are $71,000. Preferred share dividends are $10,000. Find fixed-charge coverage

ratio.

Interpretation: For every dollar of fixed financial charges, the firm has $1.87 available to make the

payment

Note: The lower the ratio, the higher the risk to lenders and owners (harder for firm to pay fixed

charges)

E. ANALYZING PROFITABILITY

• Concerned with evaluating a firm’s earnings with respect to a given level of sales / assets / owners’

investment or share value

2. Return on total assets (ROA)

3. Return on equity (ROE)

4. Earnings per share (EPS)

5. Price/Earning (P/E) ratio

• Express every item on the income statement as a % of sales

– Gross margin

– Operating margin

– Profit margin

• Gross margin: % of each sales dollar remaining after the firm has paid the direct COGS

• Operating margin: % of each sales dollar remaining after the firm has paid all expenses

(excluding financing expenses and taxes)

• Profit margin: % of each sales dollar remaining after the firm has paid all expenses (including

interest and taxes)

• Return on investment (ROI)

• Effectiveness in generating profits with its available assets

• The higher the better

Interpretation: For every $100 of assets, the firm has a return of $6.4.

• Return on owners’ equity

• The higher the better

Interpretation: For every $100 of common equity financing, the firm generates $12.6.

• Dollar amount earned on behalf of each common share

• The higher the better

EPS = Earnings available for common shareholders / Number of common shares outstanding

• Amount investors are willing to pay for each dollar of earnings

• Indicates investors’ confidence

Example: Suppose market price is $32.25 per share. P/E = $32.25 / $2.90 = $11.12 per share

Interpretation: Investors are paying $11.2 for each $1 of earnings for each share

F. COMPLETE RATIO ANALYSIS

1. DuPont System : Diagnostic

2. Summary analysis : Consider all aspects

1. DUPONT SYSTEM

• System used by management to dissect the firm’s financial statements and to assess the firm’s

financial conditions

• Merge income statement with balance sheet information

• Focus on

– ROA

– ROE

2. SUMMARY ANALYSIS

• Tabulate all ratios discussed earlier

– Liquidity

– Activity

– Leverage

– Profitability

• Combining cross-sectional with time-series analyses

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