BE 601

Class 4 – Ratio Analysis

Presented by: Michelle Lennox

Conrad School of Entrepreneurship and Business

Announcement
 Quiz 3 Due: Nov 27, 2021

 Quiz 4 Due: Dec 4, 2021

 Assignment Due: Dec 19, 2021

Accounting in Startup PAGE 2

Statement of Financial Position (Balance Sheet) Analysis

When analyzing a SFP, the financial manager should be aware of three

concerns:

1. Liquidity
2. Debt versus equity
3. Value versus cost

Section 2.1
Liquidity

Refers to the ease and speed with which assets can be

converted to cash.

• Current assets are more liquid than long-term assets.

• The more liquid a firm’s assets, the less likely it will experience
problems meeting short-term obligations.
• Liquid assets frequently have lower rates of return than long-term
assets.

Section 2.1
Debt Versus Equity
• Liabilities are obligations of the firm that require a payout of cash within
a stipulated time period.
• Generally, when a firm borrows it gives the bondholders first claim on the
firm’s cash flow.
• Shareholders’ equity is the residual difference between assets and
liabilities.

Section 2.1
Value Versus Cost

• In 2011, publicly traded firms in Canada adopted International Financial

Reporting Standards (IFRS).
• The accounting value of a firm’s assets is frequently referred to as the
carrying value or book value.
• Market value is a completely different concept. It is the price at which
willing buyers and sellers trade the assets (Price x # of outstanding shares)
• Whenever we speak of the value of the firm, we will normally mean its
market value.

Section 2.1
Statement of Comprehensive Analysis

There are three things to keep in mind when analyzing the statement of
comprehensive income:

1. The accounting standards used – i.e. International Financial

Reporting Standards (IFRS)
2. Non-Cash Items
3. Time and Costs

Section 2.2
International Financial Reporting Standards

1. IFRS have been developed to provide information for a broad audience

not necessarily concerned with cash flow.
• The accrual basis of accounting is used.
• Revenues are recognized when earned and the earnings process is complete even though cash
flows may not have been received.
• Expenses incurred to earn the revenue are recognized at the same time the related revenue is
reported even though no cash may have been paid.

Section 2.2
Non-Cash Items

• These are expenses that do not affect cash flow directly.

• Depreciation is the most common. No firm ever writes a cheque for
“depreciation.”
• Another non-cash item is deferred taxes, which do not represent a cash
flow.

Section 2.2
Time and Costs

• In the short term:

• certain costs related to equipment, resources, and commitments of the firm are fixed; other costs
are variable based on production levels such as inputs for labour and raw materials.
• In the long run, all costs are variable.
• Financial accountants do not distinguish between variable costs and fixed
costs.
• Instead, accounting distinguishes product costs (production costs) from period costs (time period
costs).

Section 2.2
Net Working Capital

Net Working Capital = Current Assets – Current Liabilities

• NWC is positive when current assets are greater than current

liabilities.
• A firm can invest in NWC. This is represented by the change in NWC
and is equal to:
• NWC (20X1) – NWC (20X0) = Change in NWC in 20X1
• The change in NWC is usually positive in a growing firm.
Net Working Capital of the Canadian Composite Corp. (1 of 2)

Assets 2018 2017 Liabilities (debt) and 2018 2017

shareholders’ equity
Current assets: Current Liabilities:
Cash and equivalents CANADIAN COMPOSITE
$198 CORPORATION
$107 Accounts payable $486 $455
Statement of Financial Position
Accounts receivable 294 and 2018
2017 270
Inventories (in
269$ millions)
280
Total current assets $761 $707 Total current liabilities $486 $455

NWC in 2018 = $761- $486 = $275m NWC in 2017 = $707-$455 = $252m

Net Working Capital of the Canadian Composite Corp. (2 of 2)

Assets 2018 2017 Liabilities (debt) and 2018 2017

shareholders’ equity
Current assets: Current Liabilities:
Cash and equivalents CANADIAN COMPOSITE
$198 CORPORATION
$107 Accounts payable $486 $455
Statement of Financial Position
Accounts receivable 294 and 2018
2017 270
Inventories (in
269$ millions)
280
Total current assets $761 $707 Total current liabilities $486 $455

Here we see NWC grow from $252 million in 2017 to $275 million in 2018. This
increase of $23 million is an investment of the firm.
 Ratio Analysis - Steps
1. Decide on ratios that are appropriate
2. Calculate ratios
3. Compare ratios to industry norms
4. Evaluate reasons for discrepancies from industry norms
5. Identify trends in ratios over time
6. Evaluate reasons for trends
7. If discrepancies arose because of underlying problems, evaluate alternative
solutions to these problems.
 Ratio Analysis
• Profitability and Efficiency Analysis
– Profitability of Sales
– Profitability of Investment
– Asset Utilization
• Working Capital
– Working Capital Adequacy
– Working Capital Activity
 Ratio Analysis
• Capitalization Ratios
– Capitalization and Leverage Ratios
– Debt Service and Coverage ratios
• Market Valuation Ratios
Profitability and Efficiency Ratios
1. Profitability of Sales
2. Profitability of Investment
3. Asset Utilization
Profitability of Sales
Gross Profit Margin

Gross Profit
Sales
Sales - COGS
Sales
Profitability of Sales
Operating Profit Margin
EBIT
Sales
Sales – COGS - SGA
Sales
Profitability of Sales
Net Profit Margin

Net Income
Sales
Profitability of Investment
Return on Assets

Net Income
Total Assets
 Profitability of Investment
Return on Equity

Net Income
Total Equity

Net Income X Sales X

Total Assets
Sales Total Assets Total Equity
Net Profit Margin Total Asset Turnover Leverage Multiplier
 Profitability Ratios
• Profitability of sales ratios will help to determine the relative
efficiency of the cost and pricing structure
• Profitability of Investment ratios will help to determine if the
firm’s investment is earning an adequate return
 Asset Utilization
Long-Term Asset Turnover
a.k.a.: Fixed Asset Turnover

Sales
Long Term Assets
Asset Utilization
Total Asset Turnover

Sales
Total Assets
 Asset Utilization
• These ratios measure how efficiently the firm is generating
sales from its assets.
• If the ratios are too low, the firm may have a lot of
unproductive assets
• If the ratios are high, the firm could be operating near or above
capacity or relying on out-sourcing
 Liquidity Analysis
Working Capital Ratios
1. Working Capital Adequacy
2. Working Capital Activity
 Liquidity Analysis
• Measures firm’s ability to meet it’s maturing obligations in the
short term.
• To assess liquidity properly, one needs to forecast a cash budget.
However for a quick and easy analysis, ratios are employed. These
ratios rely on the assumption that the means by which firms cover
obligations in the short term is through the ongoing conversion of
current assets to cash.
 Working Capital Adequacy

Current Ratio = Current Assets

Current Liabilities

Quick Ratio = Current Assets - Inventory

Current Liabilities
 Working Capital Adequacy
• Adequacy varies greatly across industries
– Fast food: Working capital < 1
– Construction: Working Capital >2
• Function of how quickly cash is being generated
 Inventory Ratios

Inventory Turnover = COGS

Inventory

Inventory Days = 365

Inventory turnover
 Inventory
• As inventory is used more efficiently, turnover increases and
Inventory days decrease
• If Inventory level is too high: May result in spoilage, dating and
shrinkage
• If Inventory level is too low: May be losing sales or having
production problems
 Accounts Receivable Ratios

A/R Turnover = Sales

A/R

Receivables Days = 365

A/R turnover
 Accounts Receivable
• Receivables Days also known as:
– Average Collection Period (ACP), and
– Days Sales Outstanding (DSO)
• A firm being efficient in the management and collection of
receivables will have lower than average Receivable Days and
higher than average A/R Turnover
 Accounts Receivable
• If A/R is too high: May be inefficient in collections and may
end up with high levels of bad debts
– However, may also be providing incentives for customers to take
delivery of seasonal merchandise
 Accounts Receivable
• If A/R is too low: May be losing profitable sales due to tight
credit policy
• Or, maybe instead of running its own credit and collections
department, the firm factors its receivables
– Example: Instead of a small retail chain offering its own credit card, it
simply accepts the major cards like Visa and MasterCard
 Accounts Payable Ratios

A/P Turnover = COGS

A/P

Payables Days = 365

A/P turnover
 Accounts Payable
• These ratios measure how quickly the firm is paying its bills
• If A/P is too high: Passing up discounts and may be a bad
credit risk.
• If A/P is too low: Not taking advantage of the free credit
available in trade payables
 Operating Cycle

Operating Cycle  Inventory Days  A/R days

• Measures length of time to turn a purchase into finished goods, sell it and
collect the sale
• Restaurants, Food Retailing: Very Short
• Construction, Aerospace: Very Long
 Cash Cycle
Cash Cycle  Inventory Days
 A/R Days - A/P Days
 Operating Cycle - A/P Days

• Measures length of time to turn cash into finished goods, sell it and
collect the sale, i.e., back to cash
• Restaurants, Food Retailing: Possibly negative
 Other Sources of Liquidity
• Standby line of credit with financial institution
– Financial institution promises to provide loan up to a certain level at
request of firm in exchange for a fee
– Often used by firms in seasonal industries
 Causes of Liquidity Problems
• Low profitability from operations
• Poor management of A/R and inventory
• Excessive financing costs
• Excessive dividends
• High growth of assets with inadequate long term financing
• Seasonal fluctuations in working capital needs.
 Excess Liquidity
• Firm is pooling cash and marketable securities
– to embark on major investment
– as a reserve
• Firm has inadequate investment opportunities and won’t pay
out dividends
Leverage or Capitalization Ratios

1. Financing Ratios
2. Coverage Ratios
 Capitalization Ratios

Debt Ratio = Total Debt

Total Capitalization Note: Total
Capitalization is Total
Debt + Preferred +
Preferred Ratio = Preferred Equity Common Equity. The
sum of all these should
Total Capitalization be 1 or 100%!

Common Equity Ratio = Common Equity

Total Capitalization
 Asset Coverage
• Used to measure the adequacy of the implied collateral on the debt
• Measures the value of assets per bond equivalent

Net Tangible Assets

 $1000
Total Debt
 Debt-Equity Ratio
• Not a Capitalization ratio, per se, but really a measure of risk, particularly
when based on market values
• Analysts usually focus on book value DE

Total Debt Debt Ratio


Total Equity Equity Ratio
 Coverage Ratios

Times Interest Earned= EBIT

Interest Expense
 Leverage Ratios
• In bank lending, a common financing or capitalization ratios is
the Loan-to-Value (LTV) ratio, which is essential the same as
the debt ratio
• In analysis, we want to be sure there is adequate asset
coverage as well a the ability to service the debt from cash
flow
 Leverage: The Good
• Leverage allows firms to experience higher returns in “good”
times
– but lower returns in “bad” times
– generally expected, or required, EPS/ROE increases to compensate
for greater risk with higher leverage
• Tax advantages - interest charges are deductible from taxable
income while dividends are not
 Leverage: The Good
• Existing shareholders can maintain control by borrowing debt
rather than issuing new common shares
– Important for shareholders who are also managers - leverage buy
outs (LBOs)
• Levered Recapitalizations - Forces the firm to operate more
efficiently
– Sealed Air Corp.
 Leverage: The Bad
• Creditors will charge higher financing rates to firms which are
highly levered
• If firms are too highly leveraged, they may be unable to obtain
additional financing from creditors.
 Leverage: The Bad
• Common shareholders have smaller stake in firm that is
financed by debt rather than solely by equity - may lead them
to misappropriate firm assets or take excessive risks especially
where firm is nearing bankruptcy.
 Leverage: The Ugly
• Greater likelihood of bankruptcy because of added interest
costs
• Loss of creditors upon liquidation of firm is likely higher
because amount of debt increases but liquidation value of
assets does not.
 Market Valuation Ratios

Price to Earnings Ratio Market price per share

aka P/E = Earnings per share

Market to Book Value Ratio Market price per share Book value per share
(BVPS) = Total Equity/#
aka M/B = Book Value per share shares outstanding
Market Valuation Ratios

Dividend Yield

Dividend per share

Price per share
Market Valuation Ratios

Dividend Payout

Dividend per share

Earnings per share