professional Ratio Analysis

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Contents

Introduction This sheet and a comprehensive ratio glossaryIncome Statement Years Income statement input worksheet for comparison over timeBalance Sheet Years Balance statement input worksheet for comparison over time

Ratios Years Ratio output report for comparison over timeIncome Statement Compani Balance statement input worksheet for comparable company analysisBalance Sheet Companies Income statement input worksheet for comparable company analysisRatios Companies Ratio output report for comparable company analysis

Overview

Financial analysts, whether professionals on Wall Street, M&A officers in publiccompanies, or household investors are presented with an overwhelming amount of data.Ratio analysis is a tool which analysts have developed over the years to help themevaluate the health, prospects and valuations of companies. A wide variety of financialmeasures can be tracked, compared and evaluated over time to monitor for risks,performance history or other indicators the analyst may be concerned about.

It is important to remember, however, that ratio analysis is merely a tool. It can highlightareas of concern or promise, raise questions and help guide the analyst towards a morecomplete understanding. It cannot, however, provide full and complete answers and caneasily mislead if the analyst relies on ratios too heavily. To get the most out of ratioanalysis, bear in mind the following guidelines.

1. A lone ratio is meaningless. Suppose you hear that Company A has liabilities to equity

of 3:1. What does this mean? In one industry it might indicate a company with aseriously weak balance sheet. If that company were a bank, however, it would be quitethe opposite! Ratios are often most useful when compared with other, similar ratios,such as comparing different years within the same company or a number of similarcompanies.

2. Ratios are usually more effective at raising questions than at providing answers.Suppose you compare Company A with others in the industry and find that its peer groupaverages liabilities to equity of 1:1. The anomaly raises questions you can try to answer.Is Company A financially vulnerable after all? Might some of its competitors takeadvantage of its financial frailty to launch a price war and steal market share? Or are the

management of Company A creating value for shareholders by adopting a moreappropriate level of leverage and taking advantage of the resulting tax shield?

3. Ratios are highly susceptible to distortions. Before you look for a profound cause for asurprising or interesting ratio, make sure that the underlying numbers are not giving amisleading impression. This does not necessarily mean to look out for managementmassaging the numbers; rather, normal events can cause ratios to appear misleading.If you find a steel company trading at a P/E usually reserved for Internet stocks, it may bethat youve found a valuation anomaly that you can profit from. It may also be that acompany that normally makes profits of $50 million is in a cyclical slump and is makingj t $2 illi thi R th th l i th t i l P/E

Financial Ratio Analysis INTRODUCTION


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4. Know which ratios matter. Each company and each industry are different, and differentfinancial ratios will be more important indicators than others will in any given situation.Software companies, for example, have substantial intangible assets that do not appearon their balance sheet. Asset-based ratio analysis will generally be less appropriate forthat industry than it would for basic manufacturing. Trying to look at profitability ratios isunlikely to help you evaluate the value of a biotech firm which is still two years away from

final approval on any of its drugs, etc. Both analysts reports and your own analysis canhelp determine which ratios will be the most useful.

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INDICATORS OF SOLVENCY

DEBT TO EQUITY:This ratio is an indicator of the extent to which a company is using financial leverage.Generally, a high ratio is acceptable in industries with stable earnings and lower inindustries where earnings are lower and less predictable. The ratio is calculated andexpressed as:

Liabilities = .XXStockholders' Equity

ASSETS TO EQUITY:This ratio is an indicator of the extent to which a company is leveraging invested capital.Again, a high ratio is acceptable in industries with stable earnings and lower in industrieswhere earnings are lower and less predictable. The ratio is calculated and expressed as:


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TIMES INTEREST EARNED:This important ratio measures the ability of a company to pay the interest on its long

term debt. A high multiple provides comfort to lenders in terms of the decline inprofitability that can occur before the payment of interest becomes a problem. Acompanion ratio, debt service coverage (the subject of another spreadsheet template),measures the earnings available to meet total debt service, including principal and

interest. Both ratios can be misleading if major debt has been outstanding less than a fullyear. The times interest earned ratio is calculated and expressed as:

Net Income Before Income Taxes & Interest = .XXInterest

INDICATORS OF LIQUIDITY

NET WORKING CAPITAL:This component of the template is presented in terms of dollars, not a ratio. It is animportant measure of the dollar effect of completing the business cycle. Working capital is

calculated and expressed as:

Current Assets minus Current Liabilities

WORKING CAPITAL TO ASSETS:Growth without sufficient working capital can mean disaster. It is important to monitorthe proportion of working capital to total assets as an indicator of liquidity. The ratio iscalculated and expressed as:

Current Assets minus Current Liabilities = .XX

Total Assets

CURRENT RATIO:This ratio is the one most often used to measure a company's ability to pay its billswithin the next accounting period, usually one year. The "2:1 syndrome" is pervasive andis a presumption of financial health. This ratio can be too high as well as too low.

The components need to be examined closely; a high inventory may be the result of lowturnover, and high receivables may be the result of slow collections. The ratio iscalculated and expressed as:

Current Assets = .XXCurrent Liabilities

QUICK RATIO:Sometimes referred to as the "acid test" ratio, the quick ratio is a more critical test ofability to pay debts than the current ratio. Inventories and prepaid items are excludedfrom the computation, which is calculated and expressed as:

Cash + Receivables + Temp Investments = .XXCurrent Liabilities


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INDICATORS OF ASSET MANAGEMENT

DAYS SALES OUTSTANDING:This measurement of accounts receivable management is a very valuable tool. In asophisticated computer setting the calculations can be made at frequent intervals to

determine whether or not collections are meeting the company's credit policies. The

template calculates the ratio on an annual basis and is expressed as:

365 Days = .XXCredit Sales divided by Accounts Receivable

INVENTORY TURNOVER:This measurement is an indicator of the effectiveness of the company's inventory

management policy. The higher the turnover during the accounting period, the lesscapital that must be devoted to carrying this asset. To be more accurate, inventoryturnover should be measured in relation to the average inventory during the period.When using the year end inventory figure, the goals should be set accordingly, that is,

higher if year end inventories are lower than average and lower if they are higher. Thisratio is calculated and expressed as:

Cost of Goods Sold = .XXInventory

DAYS SALES IN INVENTORY:

This ratio is another approach to measuring the effectiveness of inventory control.

In theory it measures the number of days needed to sell the entire inventory if the mix

of merchandise were perfect.

Too high a ratio may mean either a poor mix or excess levels of certain items.

Correspondingly, too low a ratio may indicate that orders cannot be filled promptly,

resulting in backorders or lost sales. This ratio is calculated and expressed as:

Inventory = .XXCost of Goods Sold divided by 365

ASSET TURNOVER:

This ratio measures the amount of assets required to produce sales. It is measured and

expressed as:

Sales = .XXTotal Assets

EQUITY TURNOVER:

This ratio measures the amount of equity required to produce sales. It is measured and

expressed as:

Sales = XX


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INDICATORS OF PROFITABILITY

RETURN ON SALES:

The volume of sales has a more meaningful relationship to net income when it is

expressed as a ratio. Extraordinary income or expense is not considered in this

calculation in order to avoid distorting the result. The ratio is calculated and expressed

as:

Net Operating Income After Income Taxes = .XXNet Sales

RETURN ON TOTAL ASSETS:

One way to measure return on assets is in relation to total assets regardless of the

source of their financing. This ratio is calculated and expressed as:

Net Operating Income After Income Taxes = .XX

Total Assets

RETURN ON EQUITY:

Management is usually under more pressure to increase profits than to meet any other

goal. Return on equity is calculated and expressed as:

Net Income = .XXStockholders' Equity

Some members of management are more concerned about ratios which directly relate

to operations, some of which are:

OPERATING RETURN:

After Tax Operating Income = .XXTotal Assets

GROSS MARGIN:

Total Sales - Cost of Sales = .XX

Sales

OPERATING INCOME PER SHARE:

After Tax Operating Income = .XXShares outstanding

EARNINGS PER SHARE:

Net Income After Taxes = .XXSh t t di


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MEASURES FOR SHAREHOLDERS

The template computes two measurements of company value.

MARKET PRICE PER SHARE:

Earnings Per Share times Industry Multiple

BOOK VALUE PER SHARE:

Equity = .XXShares outstanding

DIVIDEND PAYOUT:This percentage measures the portion of Net Income After Taxes that is returned tothe shareholders as dividends. It is calculated and expressed as:

Dividends Paid = .XXNet Income After Taxes

Jon B. DeFriese MBA `00 and Chad Ellis, MBA `98 developed this software under the supervisionof Professor Steven Wheelwright as the basis for class discussion rather than to illustrate eitherthe effective or ineffective handling of an administrative situation.



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Data Shown in Thousands of Dollars

Select number of years:

Baseline1994 1995 1996 1997 1998

Total Sales 2,000 2,400 2,880 3,456 4,147

Credit Sales 300 310 340 450 476Cost of Goods Sold 900 1,080 1,296 1,555 1,866

Depreciation 200 236 286 356 449Interest Expense 16 28 33 19 12

Pre-tax Operating Income 387 458 545 663 791After-tax Operating Income 323 392 469 548 637

Net Income after Taxes 310 366 436 530 633Dividends Paid 0 0 0 0 0


Financial Ratio Analysis INCOME STATEMENT


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Baseline1994 1995 1996 1997 1998

ASSETS

Cash 50 60 72 86 104Accounts Receivable 80 96 115 138 166

Inventory 40 48 58 69 83

Total Current Assets 330 324 389 505 833Total Assets 1,330 1,524 1,829 2,233 2,906

LIABILITIESCurrent portion of LT Debt 80 80 80 80 80

Total Current Liabilities 190 209 232 259 292Total Liabilities 375 603 572 446 486Owners' Equity 455 821 1,257 1,787 2,420

Shares OutstandingMarket Value of shares

as multiple of earnings


Financial Ratio Analysis BALANCE SHEET


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Baseline1994 1995 1996 1997 1998

Debt to equity 0.82 0.73 0.46 0.25 0.20Assets to equity 2.92 1.86 1.46 1.25 1.20

Debt ratio 0.28 0.40 0.31 0.20 0.17Times interest earned 24.19 16.36 16.52 34.89 65.92

Net wkg cap'l (,000 OMITTED) 0.14 0.12 0.16 0.25 0.54Working capital to assets 0.11 -0.18 -0.10 0.03 0.12Current ratio 1.74 1.55 1.68 1.95 2.85Quick ratio 0.68 0.75 0.81 0.86 0.92Dividend payout 0.00 0.00 0.00 0.00 0.00

Days sales outstanding 97.33 113.03 123.46 111.93 127.29Inventory turnover 22.50 22.50 22.34 22.54 22.48Days sales in inventory 16.22 16.22 16.33 16.20 16.24

Asset turnover 1.50 1.57 1.57 1.55 1.43Equity turnover 4.40 2.92 2.29 1.93 1.71Working capital turnover 14.29 20.87 18.34 14.05 7.67

Return on sales 0.16 0.15 0.15 0.15 0.15Return on total assets 0.23 0.24 0.24 0.24 0.22

Return on equity 0.71 0.48 0.37 0.31 0.26Operating return 0.24 0.26 0.26 0.25 0.22Gross margin 0.55 0.55 0.55 0.55 0.55Operating income per share #N/A #N/A #N/A #N/A #N/AEarnings per share #N/A #N/A #N/A #N/A #N/A

Market price per share #N/A #N/A #N/A #N/A #N/ABook value per share #N/A #N/A #N/A #N/A #N/A


Financial Ratio AnalysisRATIOS


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Select Number of companies:

Baselinecompany company company company company

Total Sales

Credit SalesCost of Goods Sold

DepreciationInterest Expense

Pre-tax Operating IncomeAfter-tax Operating Income

Net Income after TaxesDividends Paid


Financial Ratio Analysis INCOMESTATEMENT


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ASSETS

CashAccounts Receivable

Inventory

Total Current AssetsTotal Assets

LIABILITIESCurrent portion of LT Debt

Total Current LiabilitiesTotal LiabilitiesOwners' Equity

Shares OutstandingMarket Value of sharesas multiple of earnings


Financial Ratio Analysis BALANCESHEET


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Debt to equity #N/A #N/A #N/A #N/A #N/AAssets to equity #N/A #N/A #N/A #N/A #N/A

Debt ratio #N/A #N/A #N/A #N/A #N/ATimes interest earned #N/A #N/A #N/A #N/A #N/A

Net wkg cap'l (,000 OMITTED) #N/A #N/A #N/A #N/A #N/AWorking capital to assets #N/A #N/A #N/A #N/A #N/ACurrent ratio #N/A #N/A #N/A #N/A #N/AQuick ratio #N/A #N/A #N/A #N/A #N/ADividend payout #N/A #N/A #N/A #N/A #N/A

Days sales outstanding #N/A #N/A #N/A #N/A #N/AInventory turnover #N/A #N/A #N/A #N/A #N/ADays sales in inventory #N/A #N/A #N/A #N/A #N/A

Asset turnover #N/A #N/A #N/A #N/A #N/AEquity turnover #N/A #N/A #N/A #N/A #N/AWorking capital turnover #N/A #N/A #N/A #N/A #N/A

Return on sales #N/A #N/A #N/A #N/A #N/AReturn on total assets #N/A #N/A #N/A #N/A #N/A

Return on equity #N/A #N/A #N/A #N/A #N/AOperating return #N/A #N/A #N/A #N/A #N/AGross margin #N/A #N/A #N/A #N/A #N/A

Operating income per share #N/A #N/A #N/A #N/A #N/AEarnings per share #N/A #N/A #N/A #N/A #N/A

Market price per share #N/A #N/A #N/A #N/A #N/ABook value per share #N/A #N/A #N/A #N/A #N/A


Financial Ratio Analysis RATIOS

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professional Ratio Analysis