Financial Ratio Analysis: Lecture No. 3 Contemporary Engineering Economics, 6 Ed

Financial Ratio Analysis
Lecture No. 3
Chapter 2
Contemporary Engineering
Economics, 6th ed.
Contemporary Engineering Economics, 6th edition Copyright © 2016 by Pearson Education, Inc.
Park All Rights Reserved
Ratio Analysis and What the
Numbers Really Mean
o Debt Management Ratios
o Liquidity Ratios
o Asset Management Ratios
o Profitability Ratios
o Market Trend Ratios
o Trends and Graphs to Spot Problems
Key Financial Ratios
Debt ratio
Times-interest-earned
ratio
Debt
management
Current ratio
P/E ratio
Quick ratio
Market/Book ratio
Liquidity Market Trend

Key
Financial
Ratios
Inventory turnover
ratio
Day’s sales outstanding Profit margin on sales
ratio
Asset Return on total assets
Total assets turnover Profitability
ratio Management
Return on common
equity
Return on Equity: A Composite Ratio
• What to measure: A corporation's
profitability by revealing how much profit a
company generates with the money
shareholders have invested
• How to calculate: The amount of net income
generated as a percentage of shareholders
equity
Net income
Return on Equity (ROE) =
Average shareholders' equity
Returns on Equity (ROE): Three
Components
Net income
ROE =
Average shareholders' equity
 Net income   Sales   Assets 
  
  
  
 Sales   Assets   Average shareholders' equity 
 (Profit margin)  (Asset turnover)  (Financial leverage)
= (6.18%)  (2.12 times)  (3.64 times)
= 47.68%
Returns on Equity (ROE) and Levels of
Performance for Ten Diverse Companies
(As of January 26, 2014)
Return on Profit Asset Financial
Equity (%) Margin (%) Turnover Leverages
(times) (times)
Google (2013) 16.46 21.66 0.59 1.27
Wells Fargo (2013) 13.86 23.96 0.06 9.81
Alcoa (2013) 2.25 1.27 0.60 2.99
Exxon Co. (2013) 20.35 7.7 1.30 2.05
Kroger (2013) 35.65 1.57 3.97 5.11
IBM (2013) 77.90 15.92 0.87 5.93
Nike (2013) 26.70 10.85 1.59 1.57
Wal-Mart (2013) 23.35 3.62 2.28 2.86
Southwest Airline (2013) 8.85 3.55 0.91 2.76
MSFT (2013) 30.09 28.17 0.61 1.74
Note: ROEs may not match exactly the formula values due to ratios were calculated based on different published data .
Source: MSN Finance
Debt Management Analysis
 Definition: Ratios that

show how a firm uses
debt financing and its Debt ratio
ability to meet debt
repayment obligations
Times-
interest-
earned ratio
Debt Ratio
 Indicates how a firm

finances its capital
 Formula
Total debt
Debt ratio=
Total assets
$58,000

$161,400
 35.94%
A debt ratio of greater than 1 indicates
that a company has more debt than assets,
a measure of a level of risk.
Times Interest
Earned Ratio
 Measures the extent to
which earnings can
decline without
defaulting on debt
service
 Formula
EBIT
Times Interest Earned =
Interest Charges
$33,280

$5,200
 6.40 times
EBIT: Earnings before interest
and taxes
Liquidity Analysis
• Definition: Ratios
that show the Current
relationship of a ratio
firm’s cash and
other assets to its Quick ratio
current liabilities
Current Ratio
 Measures a firm’s
short-term solvency
 Formula
Current Assets
Current Ratio =
Current Liabilities
$77,400

$28,000
 2.76 times
Quick Ratio
 Excludes inventories
and prepaid expenses
 Formula
Current Assets - Inventories
Quick Ratio =
Current Liabilities
$77,400  $37,700

$28,000
 1.42 times
Liquidity Ratio
 An indication of a
firm’s immediate
liquidity
 Formula
Cash+Cash Equ.
Liquidity Ratio =
Current Liabilities
$8,500

$28,000
 0.3036
Asset Management Analysis
• Definition: A
set of
ratios which measure Inventory turnover
ratio
how effectively a
Day’s sales
firm is managing its outstanding ratio
assets Total assets
turnover ratio
Inventory Turnover
Ratio
 Highlights the rate at
which the inventory is
being sold
 Formula
Sales
Inventory Turnover =
Average Inventory
$300,000

($39,800  $37,700) / 2
 7.96 times
The typical item sits in inventory almost
1.508 months (12 months/7.96) or 45.24
days before being sold
Days Sales
Outstanding (DSO)
 Determines whether
receivables are being
collected aggressively
enough
 Formula
A/R
DSO =
Average sales per day
$23,700

$300,000 / 365
 28.84 days
Days Sales in Inventory
• What It Measures: The amount of inventory (stock)
expressed in days of sales. For example, if 2 items are
sold and 20 items are held in inventory per day, this
represents 10 days' (20/2) worth of sales in inventory.
• How To Compute: The ratio computed by dividing
average inventory by cost of sales, and multiplied the
result by 365
Average Inventory
DSI (Days Sales in Inventory)=
Average Cost of Sales per day
($37,700 + $39,800) / 2
=
$208,000 / 365
= 68 days
Total Asset
Turnover Ratio
 Indicates whether a
company is generating a
sufficient volume of
business for the size of its
asset investment
 Formula
Net Sales
Total Asset Turnover =
Total Assets
$300,000

$161,400
 1.86 times
Profitability Analysis
• Definition: A set of
ratios which show Profit margin on
sales
the combined
effects of liquidity, Return on total
assets
asset management
and debt on Return on
common equity
operating results
Gross Margin
 Indicates the
profitability of sales
 Formula
Gross Profit ($)

Gross Margin Ratio =
Net Sales
$112,000

$300,000
 37.33%
Net Margin
 Illustrates what
percentage of each
sales dollar is
retained in earnings
 Formula
Net Income ($)
Net Margin Ratio =
Net Sales
$20,000

$300,000
 6.67%
Return on Total
Assets (ROA)
 Measures a company’s
success in using its
assets to earn a profit.
 Formula
Net Income + interest expenses(1 - tax rate)

ROA =
Average total assets
$20,000+$5,200(1-0.2877)
=
($161,400+$169,900)/ 2
=14.31%
Return on Equity
(ROE)
 Measures the rate of
return on the owner’s
investment
 Formula
Net Income - Cash dividend to Preferred Stockholders

ROE =
Average Common Equity
$20,000  $600

($93,400  $83,400) / 2
 21.95%
Debt-to-Equity Ratio
o A measure of a company’s financial leverage,
indicating what proportion of equity and
debt the company is using to finance its
assets
o A high debt/equity ratio generally means that
a company has been aggressive in financing
its growth with debt.
How the Debt to Equity Ratio Impacts
Return on Equity
 Not have a spectacular ROE
because there is so much Liabilities
equity in the company (e.g.,
well-established DOW 30
stocks)
Assets = Equity
 A highly leveraged company

that might have a spectacular
ROE because the owners have
put so little of their own Liabilities
resources into the company
(e.g., high-tech industries)
Assets =
Equity
Market Trend Analysis
• Definition: A set
of ratios that
relate the firm’s P/E ratio
stock price to its
earnings and
Market/Book
book value per ratio
share
Earnings Per Share (EPS)
 Indicates earnings
attributable to each
share of stock Net Income - Preferred stock dividends
EPS =
 Widely used Common Shares Outstanding
indicator of a $20,000  600

corporation’s 10,000
performance  $1.94
Price to Earnings Ratio
 Indicates how many
times a corporation is
able to multiply its Price per share
earnings in terms of P/E ratio =
EPS
asking price per share
$40.50
of stock 
 Share price: $40.50 as $1.94
of December 28, 2015  20.87
How to Use P/E Ratios
• P/E Ratios for Selected Stocks
 Consider what
premium you are paying Symbol Price PE-Ratio Symbol Price PE-
for a company's earnings Ratio
today. BIDU 229.46 231.8 GOOG 535.21 27.10
GE 24.59 16.70 MSFT 47.02 18.40
 Determine if the HD 106.36 24.10 LNKD 226.36 676.69
expected growth warrants
IBM 156.36 10.01 PCLN 1,041.86 23.50
the premium.
JNJ 102.26 17.00 AAPL 113.10 17.53
XOM 91.76 11.50 FB 77.50 71.95
 Compare it to its peers
in the industry to see its WMT 88.63 18.50 KO 43.00 23.90
relative valuation.
As of January 26, 2015
Book Value/Share
 Indicates what the Equity - Preferred stock
Book Value/Share =
value of a share of Average Shares Outstanding
stock is according to $103,400  $10,000

the books (financial 10,000
 $9.34
statements)
As of December 31, 2015, the closing
share price was $40.50. This means
that the share was trading at about
four times higher than its book value.
A higher ratio indicates that investors
are willing to bet a higher return on
their investment.
Market Value/Book Value
 Indicates whether you
are paying too much for $40.50
what would be left if the Book Value/Share =
$9.34
company went bankrupt  4.34
immediately
As of December 31, 2015, the closing
 A lower ratio would share price was $40.50.
mean that the stock is
undervalued.
Where Sunset Stands as of
January 2015
Category J&M Industry S&P 500
Current Ratio 2.76 1.74 1.03
Times-Interest Earned Ratio 6.40 13.3 47.7
Return on Equity 21.95 11.35 83.36
Return on Assets 14.31 3.5 8.0
Inventory Turnover 7.74 35.6 11.9
Asset Turnover 1.86 0.6 0.8
Gross Margin 37.73 55.45 39.36
Net Profit Margin 6.67 4.43 12.78
P/E Ratio 20.87 19.4 44.1
Book Value 9.34 10.84 28.35
Trends and Graphs to Spot Problems
• It reveals whether the firm’s ratios are

improving or deteriorating over time.
Limitations of Financial Ratios
o Analysts should be aware of ever-changing
market conditions and make the necessary
adjustments.
o Difficult to generalize about whether a
particular ratio is good or bad
o Ratio analysis based on any one year may not
represent the true business condition.

Financial Ratio Analysis: Lecture No. 3 Contemporary Engineering Economics, 6 Ed

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: Lecture No. 3 Contemporary Engineering Economics, 6 Ed

Uploaded by

Copyright:

Available Formats

Financial Ratio Analysis

Liquidity Market Trend

 Definition: Ratios that

 Indicates how a firm

Gross Profit ($)

Net Income + interest expenses(1 - tax rate)

Net Income - Cash dividend to Preferred Stockholders

 A highly leveraged company

• It reveals whether the firm’s ratios are

You might also like