Ratio Analysis

Fall 2022
Lecture 3

Prof. Chiyoung Cheong

Financial Statement Analysis
• When valuing a company, you must
understand how it operates and its financial
characteristics.
• Assists in determining strengths and weaknesses.
• Useful when making projections.
• Financial statement analysis (I)
• Ratio analysis (including Du Pont Identity)

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Ratio analysis
• We do not blindly assume that ratios will stay constant
• Instead, we compare them to some benchmark:
• How a firm’s ratios have changed over time?
• (Time-series analysis)

• How they compare with those of other firms in the industry?

• (Cross-sectional analysis)
• Understand how ratios would look in future. Account for:
• Changes in product mix
• Product life cycle effects
• Competitive scenario, etc.

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Time-series Comparison

• Comparing with earlier periods

• Consider the impact of changes in economic,
industry, and firm-specific conditions.
• Some precautions
• Has the firm made a change to its product mix
(ex. Merger)
• Has the firm changed its accounting methods?
• Adjustment for industry conditions (is a 10%
increase in profitability good if the industry
experienced a 15% increase)

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 Time-series Comparison

• Product life cycle: Products move through 4 life cycles:

introduction, growth, maturity, and decline.
• Introduction & growth: Product development and
promotion
• High R&D expenses, high advertising and promotion
spending, large capital investments
• Maturity: Competition increases and cost reductions
occur
• Decline: Sales decline and profit opportunities
diminish

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Cross-section Comparison
• Comparing to other firms, the impact of
firm-specific conditions is much clearer.

• Difficulties in comparison
• Need to find firms with similar products, size,
age.
• May have different accounting methods?

• Published Industry Ratios (Books)

• Robert Morris Associates – Annual Statement
Studies
• Dun and Bradstreet – Industry Norms & Ratios
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Ratio Analysis
• Ratio analysis is a tool – Like with all tools you must
• Understand its possible uses
• Know its limitations.

• Thus, you should keep a few questions in the back of your mind.
• What does this ratio tell us and why? (intended use)
• What does a high ratio mean?
• What does a low ratio mean?

• How may the ratio be misleading? (limitations)

• Different accounting information
• Based on historical information
• There are far too many ratios

• Understand time trends and cross-sectional trends in ratios

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Facts about Ratio Analysis
• Ratios provide relative measure to interpret financial
statements
• Eliminate problems associated with comparing firms with different
sizes
• There are MANY important financial ratios
• The most important ratios may vary by industry
• We will cover commonly used ratios, however, the list is not
exhaustive
• Four main categories of ratios that we are interested
in:
• Liquidity ratios: firm’s ability to pay bills in the short-term
• Leverage ratios: long-term solvency of the firm
• Asset usage or Efficiency ratios: how efficiently assets
are being used to generate sales
• Profitability ratios: how efficient the firm is in generating
profits from its assets

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Category I: Liquidity Ratios
• What do they measure?
• Firm’s short-term solvency: how well can the
firm pay its bills without undue stress
• A high current ratio or quick ratio indicates that
firm is “liquid”
• but too high a ratio might mean that the firm is
inefficient (i.e., cash is lying around unnecessarily)

• Some important issues to consider:

• How liquid are inventory and receivables?
• Does the firm have easy access to borrowing?
• Because then it can afford to maintain a low current
ratio

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Liquidity Ratios

Current ratio = Current Assets

Current Liabilitie s
CA - inventory
Quick ratio =
CL
Cash ratio = Cash
CL

Interval measure = CA
Avg. daily operating costs

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Category II: Leverage Ratios
• What do they measure?
• Firm’s long-term solvency
• Two categories:
• Leverage ratios measure amount of debt on firm’s
balance sheet
• If these ratios are “too high”, it might indicate possibility of
financial distress/ bankruptcy
• If ratios are “too low”, it could indicate the firm is not
utilizing all the benefits of debt
• Coverage ratios measure firm’s ability to service
interest payments
• High coverage ratios: firm can generate enough earnings
(cash) to make interest payments

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Leverage Ratios

Total Debt
• Debt Equity Ratio =
Equity
Total Debt
• Total Debt Ratio =
Total Assets
Long Term Debt
• LT Debt Ratio =
Long Term Debt+Equity
Total Assets
• Equity Multiplier =
Equity
EBIT+Depreciation/Amortization
• Cash Coverage =
Interest Payment

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Category III: Efficiency Ratios

• What do they measure?

• how efficiently the firm use its assets to generate sales

• Investigates both fixed and current assets

• Turnover ratios: How much sales are you generating
using an underlying asset?
• Numerator is generally sales (or COGS)
• Denominator is always an asset

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Asset usage (Efficiency) Ratios
COGS
• Inventory Turnover =
Inventory
365
• Days’ Sales in Inventory=
Inventory Turnover
Sales
• Receivables Turnover =
Receivables
365
• Days’ Sales in Receivables=
Receivables Turnover
Sales
• NWC Turnover =
NWC
Sales
• Fixed Assets Turnover=
Net Fixed Assets
Sales
• Asset Turnover =
Total Assets

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Interpretation Behind Turnover Ratios

• Example
Suppose Sales=$1,500 and Receivables=$250
• Receivables turnover =
• Days sales in receivables =
• i.e., the firm takes days on average to collect
its bills from customers

• Similar intuition behind Days sales in

payables, and Days sales in inventory

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Category IV: Profitability Ratios

Net Income
• Net Profit Margin (NPM) =
Sales

Net Income
• Return on Assets (ROA) =
Total Assets

Net Income
• Return on Equity (ROE) =
Equity

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Profitability Ratios
• These ratios are the bottom line and show how well
the firm is able to control expenses and generate
revenue.

• They reflect the impact of all other categories of

ratios

• Relationship between profitability ratios and other

ratios? (Du Pont identity)

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Du Pont Identity
• ROA and ROE can be decomposed as follows:

ROA = Net income

Totalassets
= Net income  Sales
Sales Totalassets
= Net Profit Margin  Asset turnover

ROE = Net income

Equity
Net income
=  Totalassets
Totalassets Equity
= ROA  " Equity multiplier" Du-Pont Identity

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Interpreting Du Pont Identity
ROE
= ROA × Equity Multiplier
= Profit Margin × Total Asset Turnover × Equity Multiplier

• ROE is determined by:

• Operating efficiency (“NPM”)
• Note: This is “operating” only by accounting standards,
and not by the finance interpretation!
• Asset use efficiency (“asset turnover”)
• Financial leverage ( “equity multiplier”)

• Notice that:
• Equity multiplier = 1 + debt-equity ratio

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Interpreting Du Pont Identity
• Du Pont Identity can help in understanding:
• Trends in ROE across time, i.e., how ROE will change over a
product’s life cycle
• Why ROEs differ across firms/ industries
• Whether a firm’s ROE is sustainable or not

• Note: The 3 components in the ROE decomposition

are not independent
• If you increase financial leverage, that will have an impact
on other components as well
• It would be wrong to conclude that a firm can keep
increasing its ROE by increasing its financial leverage

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ROA Decomposition by Industry

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Growth Rate and Payout Policy
• Out of their net income, firms can either pay dividends
or reinvest
• Amount reinvested shows up in retained earnings

• High growth firms typically have low payout ratios (i.e.,

high reinvestment ratios)
• Payout ratio, b = Dividends/ Net income
• Reinvestment ratio = 1 – payout ratio = 1 - b
• Low payout allows these firms to reinvest in new projects
• How do firms finance growth?
• What is a reasonable growth rate we can assume?
• Two feasible growth rates

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Theory: Feasible Growth Rates
• Sustainable growth: Maximum growth feasible with
out external equity financing and a constant debt to
equity ratio

ROE  (1 − b )
g=
1 − ROE  (1 − b )

• Internal growth: Maximum growth feasible with no

external financing

ROA  (1 − b )
g=
1 − ROA  (1 − b )
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Key Points
• A firm’s performance can be analyzed along
4 dimensions:
• S-T solvency or liquidity: Ability to pay bills in
the short run.
• L-T solvency or leverage: Ability to meet long
term obligations.
• Asset management or turnover: Intensity and
efficiency of asset use.
• Profitability: Ability to control expenses.
• DuPont Identity: Figure out where profits
come from

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