Chapter # 4

Foundations of ratio and financial

analysis

Chapter objectives:

Examine the purpose and use of ratios
and provide some cautionary notes.

Explain the use of common-size
statement.

-Discuss the construction and use of:
-Short term and long term activity
(turnover) ratios that measure the
efficiency with which the firm uses its
resources.
-Liquidity ratios, including working
capital ratios, the cash cycle and the
defensive interval that assess the firms
ability to meet its near term
obligations.
Solvency ratios that examine capital
structure and the firms ability to meet
long term obligations and capital
needs.

Profitability ratios that measure income
relative to revenues and invested capital.
Define and compute measures of operating
and financial leverage.
Show how the integrated analysis of ratios
can be used to evaluate corporate
performance.
Relate ratios to corporate strategy and
the product life cycle.
Examine the computation and usefulness of
earnings per share and other ratios used for
valuation purposes
Purpose and use of ratio analysis:
Financial ratios are used to compare the risk
and return of different firms in order to help
equity investors and creditors make
intelligent investment and credit decisions.

Ratios can also provide a profile of a firm,
its economic characteristics and competitive
strategies and its unique operating , financial
and investment characteristic.
Four ratio categories measure the
risk and return relationships:
categories / groups of ratios:

.Activity analysis: Evaluates revenue
and output generated by the firms
assets.

Liquidity analysis: Measures the
ability to meet the near-term
obligations. Ability to convert into cash.
Long-term debt and solvency
analysis: Examine the capital
structure, including the mix of its
financing sources and the ability of the
firm to satisfy its long-term debt and
investment obligations.

Profitability ratios: Measures the
income of the firm relative to its
revenues and invested capital.

Ratio analysis : Cautionary notes
Economic assumptions: Ratio
analysis is designed to facilitate comparisons
by eliminating size differences across firms
and over time. Implicit assumptions in this
process is the proportionality assumption
that the relationship between numerator and
denominator doesn't depend on size.
Benchmarks: Ratio analysis often lacks
appropriate benchmarks to indicate optimal
levels The evaluation of a ratio depends on
the point of view of the analyst.One relevant
bench marks is the industry norms.

Timing and window dressing:
Business cycle may not match with
one company to another or one
industry to another industry. Then the
ration may fail to show normal
operation relationships.
Accounting method:Reported
financial statement amounts can be
affected by the choice of accounting
methods.For eliminating such problem it is
necessary to convert all companies report
into one method.




Common-size statements:
Common-size statements are used to
standardize financial statement components
by expressing them as a percentage of a
relevant base.
Balance sheet components can be shown
as a percentage of total assets.
Income statement components
(revenues, and expenses) can be computed
as a percentage of total sales.
Discussion of ratios by category:
Activity analysis:
A firms operation activities require
investments in both short-term (inventory
and AR) and long-term (property, plant,
equipment) asset.
Activity ratios describe the relationship
between the firms level of operations (usually
defined as sales) and the assets needed to
sustain operating activities.
The higher the ratio, the more efficient
the firms operations. Fewer assets are
needed to support a given level of operations
(sales).
Short-term (operating) activity ratios:






Measures the efficiency of the firms
inventory management.
A higher ratio indicates that inventory does
not remain in ware
house but turns over rapidly
This ratio is affected by the choice of
accounting method.

inventory Average
Sold goods of Cost
ratio turnover Inventory =
turnover Inventory
stock in inventory days of no Average
365
. =
As low as better it is.

Indicates how many day inventories are
kept, just to sell
turnover cievable
ding outs receivable days of no Average
receivable Average
Sales
tuerover ceivables
Re
365
tan .
Re
=
=
Receivables turnover ratios:
Measures the effectiveness of the firms
credit policy
Indicate the level of investments in
receivables needed to maintain the firms
sales level
turnover Payable
ding outs payable days of No Average
365
tan . =
payable Acconts
Purchase
turnover Payable =
The accounts payable and number of days
payables are outstanding can be computed
as follows:
assets Fixed
Sales
turnover asset Fixed =
assets Total
Sales
turnover asset Total =
Long-term activity ratios:
These ratios measure the efficiency of long
term capital investment to generate sales.
Growing / new / startup company: Initial
turnover may be low, as their level of
operations is below their productive capacity.
As sales grow, however turnover will
continually improve until the limits of the
firms initial capacity are reached.
Mature or stable company: The mature
firms turnover is stable.
Declining company: The turnover ratio is
low as the sales decreased by the time pass
Some points to be noted:
Two firms with similar capacity and efficiency
may show differing ratios. Because price was
different when assets were purchased.
The firm with older assets has higher
turnover ratios, as accumulated depreciation
has reduced value of its assets.The firm with
new assets has lower turnover ratios.
It is better to take gross fixed asset rather than
net fixed assets. The old machine might have high
market value but after depreciation it becomes low.
Which may results in a higher turnover ratio
Liquidity analysis:
Short-term lenders and creditors must assess
the ability of a firm to meet its current
obligations. The ability depends on the cash
resources available as of the balance sheet
date and the cash to be generated through
the operating cycle of the firm.
Length of cash cycle:
Operating cycle: No, of days inventory in
stock + Days sales outstanding.
Cash cycle: Operating cycle - No. of days
payable outstanding
The shorter the cycle, the more efficient
the firms operations and cash
management.
The longer cycles may be indicative of
cash shortfalls and increased financing costs.
Current ratio defines cash resources as all
current assets:


-Use all current asset.
-Higher is good. But this may be as a result
of higher inventory, which is bad for the
company. The company may fail to sell its
goods.

s liabilitie Current
assets Current
ratio Current =
rec C A Mar Cash
ratio Quick
/ sec . + +
=
s Liabilitie Current
rec C A Mar Cash
ratio Quick
/ sec . + +
=
A more conservative measure liquidity is the
quick ratio:
The included assets are called quick
asset because they can be quickly
converted to cash.
Inventory and prepaid expenses are
excluded.
If this ratio is much lower than current
ratio, then the firm is facing liquidity
problem. It may have higher inventory
that the firm can not sell.

The cash ratio is defined as:

s Liabilitie Current
Securities Marketable Cash
ratio Cash
+
=
This is the most conservative measure of
liquidity.
Only actual cash and securities easily
convertible to cash are used to measure
cash resources
Defensive interval:
It compares the currently available quick
sources of cash with estimated outflows
needed to operate the firms projected
expenditure.

e Expenditur ojected
receivable C A Sec Mar Cash
X
erval Defensive
Pr
/ .
365
int
+ +
=
Long term debt and solvency ratio:
The analysis of a firms capital structure is
essential to evaluate its long-term risk and
return prospect.
Excess return to shareholder, when ROI is
greater than the cost of debt.
The fixed cost (interest on debt) may
affect profitability if the demand or profit
margins decline.
This obligation may lead the company to
default or bankruptcy
Debt Covenants:
To protect themselves creditors often impose
restrictions on the borrowing companys
ability to incur additional debt and make
dividend payments.

Capital Total
debt Total
capital total to Debt =
Equity Total
debt Total
equity to Debt =
Use book value or market value to compute debt ratio:
Market value of debt and equity are generally used in
valuation model. Because they are available or can readily
be estimated.
However, Use of market values may produce
contradictory result. The debt of a firm whose credit rating
declines may have a market value well below face
amount.
A debt ratio based on market values may show an
acceptable level of leverage (which is bad). There have a
chance to underestimate or overestimate the firm.

Total Debt at book value

Equity at market value

More direct measure of the firms ability
to meet interest payments be:
EBIT
+Times Interest Earned =
Interest expense
-Higher is good.
-If the debt-equity ratio is higher then
this ratio will be lower.
-This ratio often referred to as the
interest coverage ratio measures the
protection available to creditors.


Fixed Charge Coverage =

Earning Be. fixed charges & Taxes
Fixed Charges
-It is more comprehensive
measurement.
-Fixed charges = contractually
committed interest + principal
payment on lease + funded debt.
-This one is better: because the
previous one may give wrong result
(can be over estimated or
underestimated)

Capital expenditure and CFO to Debt ratio:
A firms long term solvency is a function of its
ability to:
Finance the replacement and expansion of
its investment in productive capacity as well
as
generate cash for debt repayment

enditure Capital
CFO
ratio enditure Capital
exp
exp =
debt Total
CFO
debt to CFO =
Profitability analysis:
Equity investors are concerned with the firms
ability to generate, sustain and increase
profit.
Return on sales:
Measures the income of the firm relative to its
revenues,
Gross Profit
.Gross Margin =
Sales
-It shows the relationship between the
sales and manufacturing or
merchandising cost.
Higher ratio is better.
Operating Income
.Operating Margin =
Sales
-It shows the firms profitability form
the operations of its core business.
-Excluding the effect of: Investment
(income for affiliates or assets sales),
Financing (interest expenses), Tax
position.

EBIT.
Margin before interest and tax =
Sales
-It shows that the firm is independent of
both the financing and tax positions.

EBT
.Pretax Margin =
Sales
-After financing cost (interest expenses)
but prior to income taxes.

Net income
Profit Margin =
Sales
-Overall profit margin net of all
expenses.
-All five ratios can be computed directly
from financial statement.

Return on Investment: (ROI)
Measures the income of the firm relative to
its revenues (Profit) and invested capital
required to generate them.
Net Income + After-tax Int.
ROA =
Avg. TA
Interpretation:
It measures managements ability and
efficiency in using the firms assets to
generate (operating) profits.
It reports the total return accruing to all
providers of capital (debt and equity).

EBIT (pretax basis)
.ROTC =
Avg.(Total Debt + SHs Equtiy)
-Return on total capital uses the sum of
external debt and equity instead of total
assets as the base against which the
firms return is measured.
-ROTC measures profitability relative to
all (non-trade) capital providers.

Pretax Income
.ROE =
Avg. SHs Equity
-It excludes debt in the denominator.

Net Income
.ROE =
Avg. SHs Equity

NI Preferred Dividend
Return on Common Equity =
Avg. Common Equity

The relationship between ROA and ROE
reflects the firms capital structure.
ROA (or ROTC) measure returns to all
providers of capital.
ROE measures the returns to the firms
shareholders and is calculated after
deducting the returns paid to creditors

Operation and financial leverage:
Profitability ratios imply that profits are
proportional to sales, which may misstate
the true relationship among sales, cost
and profit.
A double of sales would expected to
double of income only if all expenses
were variable.
Expenses can be Fixed or variable.
Variable expenses:
Variable expenses tend to be operating in
nature.
Fixed expenses:
Fixed costs are the result of operating, investing
and financing decisions.
Leverage, which is a proportion of fixed costs
in the firms overall cost structure, can be
subdivided into fixed operation costs that
reflect:
Operating leverage (the proportion of fixed
operating costs to variable cost) and Fixed
financing costs or financial leverage
Leverage refers to proportion of fixed
costs in the firms overall cost structure.
Leverage can be divided into fixed
operating costs and fixed financing costs.
The first one is known as operating
leverage and the second as financial
leverage.
Leverage trades risk for return.
-Increases in fixed costs are risky because
they must still be paid as demand declines,
decreasing the firms income.
-At high levels of demand, fixed costs
enhance the profitability.

Operating Leverage:
The contribution margin ratio is a useful
measure of the effects of operating leverage
on the firms profitability.
Contribution
Contribution Margin Ratio =
Sales

This ratio indicates the incremental profit
resulting from a given dollar changes in sales
The operating leverage effect (OLE):
Contribution Margin Ratio
OLE =
Return on Sales
Contribution
=
Operating Income
The OLE can be used to estimate the percentage
change in income (and ROA) resulting from a given
percentage change in sales volume.

% Change in income = OLE * % change in sales

When OLE in greater than 1, operating leverage in
present.
Operating leverage: (Fixed cost)
Higher the fixed cost, higher is the operating
leverage.
If sales (revenue) increase, the operating income
increases at a larger amount.
If revenue decrease, the operating income
decreases at larger amount.
If VC is high = FC is low = lower operating
income.
If VC is low = FC is high = Higher operating
income.


Financial Leverage:
From the point of view common
shareholders, financial leverage is a
risk and return trade-off.
The financial leverage effect (FLE)
relates operating income to net
income:
Operating Income
FLE =
Net Income
Contribution
TLE = OLE X FLE =
NI

Comprehensive analysis requires a
review of the following three
interrelationship among ratios.
Economic relationships:
If activity ratio increase, profitability ratio will
also increase.
Higher sales = higher investment in working
capital = higher Receivable and inventory.
Overlap of components:
The components of many ratios overlap due
to the measure of a same term in the
numerator or denominator, or because a term
in one ratio is a subset or component of
another ratio.


Ratios as composites of other ratios:
Some ratios are related to other ratios
across categories.
ROA = NI / TA
TAT = S / A
Net PM = NI / S
So,
ROA = TAT * PM = (S/TA) * (NI/S) =
NI / TA
If TAT and PM increase or decrease the ROA
also increase or decrease.
Analysis of firm performance:

Disaggregation of ROA:
The ROA can be disaggregated as follows:

ROA = Total asset turnover x Return on asset

=
Sales
income Operating
X
Assets
Sales
Disaggregation of ROE and its relationship with
ROA:

( )
(

+ =
Equity
Debt
X debt of Cost ROA ROA ROE
Benefit of financial leverage is the product
of the excess return earned on the firms
assets over the cost of debt and the
proportion of debt financing to equity
financing.
ROE can be desegregated as follows:

Equity
Assets
X
Assets
Sales
X
Sales
Income
Solvency X Activity X y of itabilit ROE
=
=Pr
Earning per share and other valuation
model:

Earning per share: Earning per share is
probably is the most commonly used corporate
performance statistic for publicly traded firms
Simple capital structure: The firm that has
only common shares, the computation of EPS
is relatively straightforward as follows:

Basic EPS=
ding outs shares Common
shares common available Earning
tan
Complex capital structure:
Companies whose have options and
convertible securities are said to have
complex capital structures. These firms
must recognize the potential effect on EPS
upon the conversion of those securities if
such a conversion will result in dilution of
EPS.


DEPS=
ding outs shares common potential and Common
shares common for income Adjusted
tan