Lecture Finacial Ratio Analysis

8/10/2019 Lecture Finacial Ratio Analysis

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Financial

rat io Analys is

Financial Statements

A Possible Framework for Analysis

Balance Sheet Ratios

Income Statement and Income

Statement/Balance Sheet RatiosTrend Analysis

Common-Size and Index Analysis


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Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 5, Slide #2

Ratio Analysis

Liquidity Measures a firms ability to meet its current obligations

Leverage (borrowing capacity) Measures the degree of protector for long-term creditors

Profitability Measures the earning ability of a firm

Cash flow Indicate liquidity, borrowing capacity, and profitability


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Ratio Analysis

A ratio alone means nothing Must compare ratios to other ratios such as:

Prior ratios

Competitor ratios

Industry ratios Predetermined standards


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Common-Size Analysis

The use of percentages is usually preferable to

the use of absolute amounts

Vertical analysis

All amounts of a year expressed as a percentage ofa base amount (e.g., net sales revenue, total

assets)

Horizontal analysis

Amounts for comparative years are expressed as a

percentage of the base year amount


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Examples o f External Uses

o f Statemen t Analys is

Trade Credito rs-- Focus on theliquidity of the firm.

Bondholders-- Focus on thelong-term cash flow of the firm.

Shareholders-- Focus on theprofitability and long-term health ofthe firm.


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Examples o f In ternal Uses

o f Statemen t Analys is

Plan-- Focus on assessing the currentfinancial position and evaluatingpotential firm opportunities.

Contro l-- Focus on return on investmentfor various assets and asset efficiency.

Understand-- Focus on understandinghow suppliers of funds analyze the firm.


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Framework for

Financial Analys is

Analyt ical Tools Used

Sources and Uses Statement

Statement of Cash Flows

Cash Budgets

1. Analysis of the fundsneeds of the firm.

Trend / Seasonal Component

How much funding will berequired in the future?

Is there a seasonalcomponent?


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Framework for

Financial Analys is

Health o f a Firm

Financial Ratios

1. Individually

2. Over time3. In combination

4. In comparison


2. Analysis of the financialcondition and profitabilityof the firm.


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Framework for

Financial Analys is

Examples:

Volatility in sales

Volatility in costs

Proximity to break-evenpoint



3. Analysis of the businessrisk of the firm.

Bus iness r isk relates tothe risk inherent in theoperations of the firm.


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Framework for

Financial Analys is

A FinancialManager

mustconsider allthree jointly

when

determiningthe

financingneeds of the

firm.

Determiningthe

financingneeds of

the firm.





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Framework for

Financial Analys is

Negotiationswith

suppliers of

capital.

Determiningthe

financingneeds of

the firm.





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Operating Cycle

The time period between the acquisition of

goods and the final cash realization from sales

Purchase inventory

Cash sale to customer

Purchase material

Produce finished

product

Sell to customer oncredit

Collect amount due

from customer

Retail and Wholesale Manufacturing


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Working Capital

Subject to understatement if certain assets areunderstated (i.e., LIFO inventory)

Inter-firm comparison is of no value

Current Assets Current Liabilities

= Working Capital


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Current Ratio

Current AssetsCurrent Liabilities

Acid-Test (Quick)Ratios

Current Assets - InventoryCurrent Liabilities

Cash Equivalents+ Marketable Securities+ Net Receivables

Current Liabilities


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Current Ratio

Determines short-term debt-paying ability Focus is on the relationship between current

assets and current liabilities

Inter-firm comparison is possible and meaningful

Traditional benchmark: 2.00

Decreased current ratio indicates lower liquidity

Industry averages provide contextual benchmark

Considerations Quality of inventory and receivables


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Acid-Test (Quick) Ratio

Measures the immediate liquidity of the firm Relates the most liquid assets to current

liabilities

Exclude inventory

More conservative variation: Also exclude other

current assets that do not represent current cash

flow

Traditional benchmark: 1.00

Industry averages provide contextual benchmark

Consideration

Quality of receivables


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Cash Ratio

Extremely conservative

Unrealistic for a firm to have sufficient cash andsecurities to cover all its current liabilities

Appropriate context

Firms with naturally slow-moving inventory and

receivables

Firms that are highly speculative

Cash Equivalents + Marketable SecuritiesCurrent Liabilities


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Sales to Working Capital

Measures the turnover of working capital per year

Compare with Historical data

Industry competitors

Industry averages

Assessment Low: potentially unprofitable use of working capital

High: potential undercapitalization

SalesAverage Working Capital


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Other Liquidity Considerations

Liquidity is better than indicated by financialstatements

Unused bank credit lines

Noncurrent assets that can be converted to cash

quickly

Liquidity is weaker than indicated by financial

statements

Co-signer on debt of another entity

Subject to recourse obligation on discounted

receivables

Significant contingent (unaccrued) liabilities


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L iqu id i ty Rat ios

Current

Current AssetsCurrent Liabilities

For Basket Wonders

December 31, 2007

Shows a firms

ability to cover itscurrent liabilitieswith its current

assets.


Liquidity Ratios

$1,195$500

= 2.39


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L iqu id i ty Rat io

Compar isons

BW Industry

2.39 2.15

2.26 2.09

1.91 2.01

Year

2007

2006

2005

CurrentRatio

Ratio is stronger than the industry average.


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L iqu id i ty Rat ios

Acid -Test (Quick)

Current Assets - Inv

Current Liabilities

For Basket Wonders

December 31, 2007

Shows a firms

ability to meetcurrent liabilities

with its most liquid

assets.


Liquidity Ratios

$1,195 - $696$500

= 1.00


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L iqu id i ty Rat io

Compar isons

BW Industry

1.00 1.25

1.04 1.23

1.11 1.25

Year

2007

2006

2005

Acid-Test Ratio

Ratio is weaker than the industry average.


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Summary of the Liqu id i ty

Rat io Compar isons

Strong current ratio and weak acid-testratio indicates a potential problem in theinventories account.

Note that this industry has a relatively

high level of inventories.

Ratio BW Indus try

Current 2.39 2.15

Acid-Test 1.00 1.25


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Curren t Ratio -- Trend

Analys is Compar ison

Trend Analysis of Current Ratio

1.5

1.7

1.9

2.1

2.3

2.5

2005 2006 2007

Analysis Year

Ra

tioValue

BW

Industry


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Ac id-Tes t Ratio -- Trend


Trend Analysis of Acid-Test Ratio

0.5

0.8

1.0

1.3

1.5

2005 2006 2007

Analysis Year

RatioValue

BW

Industry


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Summary of the Liqu id i ty

Trend Analyses

The current ratio for the industryhasbeen rising slowly at the same time the

acid-test ratio has been relatively stable. This indicates that inventoriesare a

significant problem for BW.

The current ratio for BWhas been risingat the same time the acid-test ratio has

been declining.


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Financ ial Leverage Ratios

Debt-to-Equity

Total Debt

Shareholders Equity

For Basket Wonders

December 31, 2007Shows the extent towhich the firm isfinanced by debt.


Financial LeverageRatios

$1,030$1,139

= .90


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Financ ial Leverage

Rat io Compar isons

BW Industry

.90 .90

.88 .90

.81 .89

Year

2007

2006

2005

Debt-to-Equity Ratio

BW has average debt utilization

relative to the industry average.


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Financ ial Leverage

Rat io Compar isons

BW Industry

.47 .47

.47 .47

.45 .47

Year

2007

2006

2005

Debt-to-Total-Asset Ratio

BW has average debt utilization



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Financ ial Leverage Ratios

Total Capital izat ion

Long-term DebtTotal Capitalization

For Basket WondersDecember 31, 2007Shows the relativeimportance of long-term

debt to the long-termfinancing of the firm.


Financial LeverageRatios

$530$1,669

= .32

(i.e., LT-Debt + Equity)


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Financ ial Leverage

Rat io Compar isons

BW Industry

.32 .30

.32 .31

.37 .32

Year

2007

2006

2005

Total Capitalization Ratio

BW has average long-term debt utilization



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Coverage

Rat io Compar isons

BW Industry

3.56 5.19

4.35 5.02

10.30 4.66

Year

2007

2006

2005

Interest Coverage Ratio

BW has below average interest coverage



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Coverage Ratio -- Trend


Trend Analysis of Interest Coverage Ratio

3.0

5.0

7.0

9.0

11.0

2005 2006 2007

Analysis Year

RatioValue

BW

Industry


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Summary of the Coverage

Trend Analys is

This indicates that low earnings (EBIT)

may be a potential problem for BW. Note, we know that debt levels are in

line with the industryaverages.

The interest coverage ratio for BWhasbeen falling since 2005. It has been

below industryaverages for the pasttwo years.


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Act iv i ty Rat ios

Avg Col lect ion Period

Days in the Year

Receivable Turnover

For Basket WondersDecember 31, 2007

Average number of daysthat receivables are

outstanding.

(or RT in days)

Income Statement /Balance Sheet

Ratios

Activity Ratios

3655.61

= 65 days


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Act iv i ty

Rat io Compar isons

BW Industry

65.0 65.7

71.1 66.3

83.6 69.2

Year

2007

2006

2005

Average Collection Period

BW has improved the average collection

period to that of the industry average.


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Act iv i ty Rat ios

Payab le Turnover (PT)

Annual Credit Purchases

Accounts Payable

For Basket WondersDecember 31, 2007

Indicates thepromptness of paymentto suppliers by the firm.


Ratios

Activity Ratios

$1551$94

= 16.5

(Assume annual creditpurchases = $1,551.)


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Act iv i ty Rat ios

PT in Days

Days in the Year

Payable Turnover

For Basket Wonders

December 31, 2007Average number of daysthat payables are

outstanding.


Ratios

Activity Ratios

36516.5

= 22.1 days


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Act iv i ty

Rat io Compar isons

BW Industry

22.1 46.7

25.4 51.1

43.5 48.5

Year

2007

2006

2005

Payable Turnover in Days

BW has improved the PT in Days.

Is this good?


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Act iv i ty Rat ios

Invento ry Turnover

Cost of Goods Sold

Inventory

For Basket Wonders

December 31, 2007Indicates theeffectiveness of the

inventory management

practices of the firm.


Ratios

Activity Ratios

$1,599$696

= 2.30


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Act iv i ty

Rat io Compar isons

BW Industry

2.30 3.45

2.44 3.76

2.64 3.69

Year

2007

2006

2005

Inventory Turnover Ratio

BW has a very poor inventory turnover ratio.


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Invento ry Turnover Ratio --

Trend Analys is Compar ison

Trend Analysis of Inventory Turnover Ratio

2.0

2.5

3.0

3.5

4.0

2005 2006 2007

Analysis Year

RatioValue

BW

Industry


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Act iv i ty Rat ios

Total Asset Turnover

Net Sales

Total Assets

For Basket Wonders

December 31, 2007Indicates the overalleffectiveness of the firmin utilizing its assets to

generate sales.


Ratios

Activity Ratios

$2,211$2,169

= 1.02


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Prof i tab i l ity Ratios

Gross Prof i t Margin

Gross Profit

Net Sales

For Basket Wonders

December 31, 2007Indicates the efficiencyof operations and firm

pricing policies.


Ratios

Profitability Ratios

$612$2,211

= .277

P fi t bi l i t


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Prof i tabi l i ty

Rat io Compar isons

BW Industry

27.7% 31.1%

28.7 30.8

31.3 27.6

Year

2007

2006

2005

Gross Profit Margin

BW has a weak Gross Profit Margin.

G P fit M i


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Gross Prof i t Margin --


Trend Analysis of Gross Profit Margin

25.0

27.5

30.0

32.5

35.0

2005 2006 2007

Analysis Year

R

atioValue(%)

BW

Industry


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Net Pro f i t Margin

Net Profit after Taxes

Net Sales

For Basket Wonders

December 31, 2007Indicates the firmsprofitability after takingaccount of all expenses

and income taxes.


Ratios


$91$2,211

= .041

P fi t bi l i t


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Prof i tabi l i ty

Rat io Compar isons

BW Industry

4.1% 8.2%

4.9 8.1

9.0 7.6

Year

2007

2006

2005

Net Profit Margin

BW has a poor Net Profit Margin.

N t P fit M i


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Net Pro fit Marg in --


Trend Analysis of Net Profit Margin

4

5

6

7

8

9

10

2005 2006 2007

Analysis Year

R

atioValue(%

)

BW

Industry


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Return on Investment


Total Assets

For Basket Wonders

December 31, 2007Indicates theprofitability on the

assets of the firm (afterall expenses and taxes).


Ratios


$91$2,160

= .042

P fi t bi l i t


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Prof i tabi l i ty

Rat io Compar isons

BW Industry

4.2% 9.8%

5.0 9.1

9.1 10.8

Year

2007

2006

2005


BW has a poor Return on Investment.

R t I t t


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Trend Analysis of Return on Investment

4

6

8

10

12

2005 2006 2007

Analysis Year

R

atioValue(%

)

BW

Industry


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Return on Equi ty


Shareholders Equity

For Basket Wonders

December 31, 2007Indicates the profitabilityto the shareholders of

the firm (after allexpenses and taxes).


Ratios


$91$1,139

= .08

Prof i tabi l i ty


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Prof i tabi l i ty

Rat io Compar isons

BW Industry

8.0% 17.9%

9.4 17.2

16.6 20.4

Year

2007

2006

2005

Return on Equity

BW has a poor Return on Equity.


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Return on Equ ity --


Trend Analysis of Return on Equity

7.0

10.5

14.0

17.5

21.0

2005 2006 2007

Analysis Year

R

atioValue(%

)

BW

Industry


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R t E i t d


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Return on Equ i ty and

the Du Pont App roach

ROE2007 = .041x 1.02x 1.90=.080

ROEIndustry = .082x 1.17x 1.88= .179

Return On Equity = Net profit margin XTotal asset turnoverX

Equity Multiplier

Equity Multiplier =Total Assets

Shareholders Equity

Summary of the Prof i tabi l i ty


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Summary of the Prof i tabi l i ty

Trend Analyses

The profitability ratios for BWhave ALL been falling since 2005. Each has beenbelow the industryaverages for the pastthree years.

This indicates that COGSandadministrative costs may both be toohigh and a potential problem for BW.

Note, this result is consistent with the low

interest coverage ratio.


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Summary of Rat io Analyses

Inventories are too high.

May be paying off creditors

(accounts payable) too soon.

COGS may be too high.

Selling, general, andadministrative costs may be toohigh.


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Common -s ize Analys is

An analysis of percentagefinancial statements where all

balance sheet items are dividedby to tal assetsand all incomestatement items are divided by

net salesor revenues.

Basket Wonders Common


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Size Balance Sheets

Regular (thousands of $) Common-Size (%)

Assets 2005 2006 2007 2005 2006 2007

Cash 148 100 90 12.10 4.89 4.15

AR 283 410 394 23.14 20.06 18.17Inv 322 616 696 26.33 30.14 32.09

Other CA 10 14 15 0.82 0.68 0.69

Tot CA 763 1,140 1,195 62.39 55.77 55.09

Net FA 349 631 701 28.54 30.87 32.32LT Inv 0 50 50 0.00 2.45 2.31

Other LT 111 223 223 9.08 10.91 10.28

Tot Assets 1,223 2,044 2,169 100.0 100.0 100.0



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Size Balance Sheets


Liab+Equity 2005 2006 2007 2005 2006 2007

Note Pay 290 295 290 23.71 14.43 13.37

Acct Pay 81 94 94 6.62 4.60 4.33Accr Tax 13 16 16 1.06 0.78 0.74

Other Accr 15 100 100 1.23 4.89 4.61

Tot CL 399 505 500 32.62 24.71 23.05

LT Debt 150 453 530 12.26 22.16 24.44Equity 674 1,086 1,139 55.11 53.13 52.51

Tot L+E 1,223 2,044 2,169 100.0 100.0 100.0



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Size Income Statemen ts


2005 2006 2007 2005 2006 2007

Net Sales 1,235 2,106 2,211 100.0 100.0 100.0

COGS 849 1,501 1,599 68.7 71.3 72.3Gross Profit 386 605 612 31.3 28.7 27.7

Adm. 180 383 402 14.6 18.2 18.2

EBIT 206 222 210 16.7 10.5 9.5

Int Exp 20 51 59 1.6 2.4 2.7EBT 186 171 151 15.1 8.1 6.8

EAT 112 103 91 9.1 4.9 4.1

Cash Div 50 50 50 4.0 2.4 2.3


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Basket Wonders


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Basket Wonders

Indexed Balance Sheets

Regular (thousands of $) Indexed (%)

Assets 2005 2006 2007 2005 2006 2007

Cash 148 100 90 100.0 67.6 60.8

AR 283 410 394 100.0 144.9 139.2Inv 322 616 696 100.0 191.3 216.1

Other CA 10 14 15 100.0 140.0 150.0

Tot CA 763 1,140 1,195 100.0 149.4 156.6

Net FA 349 631 701 100.0 180.8 200.9LT Inv 0 50 50 100.0 inf. inf.

Other LT 111 223 223 100.0 200.9 200.9

Tot Assets 1,223 2,044 2,169 100.0 167.1 177.4


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Basket Wonders Indexed


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Basket Wonders Indexed

Income Statements

Regular (thousands of $) Indexed (%)

2005 2006 2007 2005 2006 2007

Net Sales 1,235 2,106 2,211 100.0 170.5 179.0

COGS 849 1,501 1,599 100.0 176.8 188.3Gross Profit 386 605 612 100.0 156.7 158.5

Adm. 180 383 402 100.0 212.8 223.3

EBIT 206 222 210 100.0 107.8 101.9

Int Exp 20 51 59 100.0 255.0 295.0EBT 186 171 151 100.0 91.9 81.2

EAT 112 103 91 100.0 92.0 81.3

Cash Div 50 50 50 100.0 100.0 100.0

Documents

Lecture Finacial Ratio Analysis