MSE608C – Engineering and Financial Cost Analysis

1. MSE608C – Engineering and Financial Cost Analysis Financial Ratios and Analysis

2. Analyzing Financial Statements • Balance Sheet • The financial condition of the company on a certain date (a snapshot on that date) • Income Statement • The financial performance of the company over a period of time (the accounting period) • Cash Flow Statement • Sources and Uses of Cash over the accounting period • Financial Ratios • Compares financial data to create insightful relationships about the company’s financial health and operating performance.

3. Types of Financial Ratios • Liquidity Measures a firms ability to meet it near-term obligations. • Working capital or Efficiency Indication of how well a firm is using it’s assets to generate profits. • Capital Structure or Solvency Provide indications on how a firms is financing it’s investment in assets. • Profitability or Operating Used to measure if a company is generating sufficient returns on it’s investments. • Investment or Market Test Measures used by many investors to compare a company’s earnings and dividend payments to it’s stock price.

4. Liquidity Ratios Liquidity measures the financial strength of an organization and it’s ability to pay it’s debts. • Liquidity The measure of a company’s ability to meet current obligations when they are due. Current obligations are all current expenses • Salaries Payable; Accounts Payable; and Rent Payable The two common Liquidity Ratios: • Current ratio; • Quick, or Acid Test

5. Liquidity Ratios • Current Ratio Current Ratio = Current Assets Current Liabilities • Current Assets include cash; marketable securities; accounts receivable; inventory; and prepaid expenses. • Quick Ratio Quick Ratio = Quick Assets Current Liabilities • Uses only the most liquid assets; cash, marketable securities and accounts receivable.

6. Questions???? • How can a company manipulate it’s Liquidity ratios? • What would happen if a company changed from FIFO to LIFO to account for Inventory valuation? • Where would clues be found to indicate the Liquidity ratio was manipulated?

7. Working Capital Ratios Measures how effectively a company utilizes it’s Working Capital to generate profits • Inventory • Inventory turnover • Accounts Receivable • Accounts Receivable Turnover • Average Collection Period • Accounts Payable • Accounts payable payment period • Assets • Fixed Asset Turnover • Total Asset Turnover

8. Inventory • Inventory Turnover Inventory Turnover = COGS Average Inventory • This tells how many times the inventory turned-over during the accounting period. The more times the inventory is turned, or used, the more efficient the company. • Inventory is expensive to purchase and hold. • Faster turnover means less risk of obsolescence. • On the other hand, the company must avoid stockouts and lost business.

9. Accounts Receivable • Accounts Receivable Turnover Accounts Receivable Turnover = Annual Credit Sales Average Accounts Receivables • Indicator of how well credit sales are collected. The more times Accounts Receivable is turned over, the more efficient the company and more working capital is available. • Average Collection Period Average Collection Period = Average Accounts Receivables (Annual Credit Sales ¸ 365) • Calculates the average number of days it takes to collect payments due. • Can indicate a problem if higher than the credit terms that are offered. • A low number may indicate a company is only selling to customers who pay quickly. There may be untapped opportunities for new customers.

10. Accounts Payable • Accounts Payable Payment Period Accounts Payable Payment Period = Average Accounts Payable (Annual Credit Purchase¸365) • The amount of credit purchases is not usually available in financial statements; use Cost-of-Goods-Sold or other figure as a replacement. • Identifies the average number of days from receipt of goods or services until they are paid. • The longer the Period the more working capital is held and available to the company. • This is non-interest borrowing except for the loss of Prompt Payment Discounts.

11. Assets • Fixed Asset Turnover Fixed Asset Turnover = Sales Revenue Average Fixed Assets • Total Asset Turnover Total Asset Turnover = Sales Revenue Average Total Assets • These ratios indicate how effectively a company is utilizing it’s assets, both current assets and non-current assets to generate Revenues.

12. Questions ??? • If the Accounts Receivable Collection period changed from 36 days to 48 days what would this indicated? • What is the impact if the Inventory Turnover rate goes from 7.3 times to 6.2?

13. Capital Structure Ratios Provide indications on how a firms is financing it’s investments in assets. • Total Debt • Total Debt to Owners’ Equity • Total Debt to Total Assets • Long-term Debt • Long-term Debt to Total Capitalization • Interest Expense • Times Interest Earned • Debt Financing: requires repayment of the principle and interest. • Equity Financing: No obligation to repay and no interest.

14. Total Debt • Total Debt to Owners’ Equity Total Debt to Owners’ Equity = Total Debt Owners’ Equity • Total Debt = Current liabilities + non-current liabilities • Measures the relationship between borrowed funds and equity financing • A company with a higher percentage than similar companies may use too much borrowing compared to owner financing. • Total Debt to Total Assets Total Debt to Total Assets = Total Debt Total Assets • Measures the extent to which total asset are financed by borrowed funds (as opposed to owners equity) • A company with a higher percentage than similar companies may have problems borrowing more money.

15. Long-term Debt • Long-term Debt to Total Capitalization Long-term Debt to Total Capitalization = Non-current liabilities Total Capitalization • Total Capitalization = Long-term Debt + Owners’ Equity • It measures the percentage of Long-term debt to all permanently invested capital from all sources. • Some analyst include deferred taxes in total capitalization since it may essentially be a permanent investment in the company. • The ratio will vary by business and industry. • A small corporation may have a high ratio due to a high level of borrowed funds and a low amount of equity financing. • A larger, publicly traded corporation will have a lower ratio due to a high level of equity financing.

16. Interest Expense Times Interest Earned Times Interest Earned Ratio = Earnings Before Interest and Taxes (EBIT) Interest Expense • EBIT is found on the Income Statement as the net Operating Profit before subtracting interest expense and taxes. • Measures the ratio of the Operating Profit available to service debt. • The higher the number the greater the safety margin and the lower the risk a company can pay it’s debts.

17. Questions ??? • A high Total Debt to Owners Equity ratio could have what implications? • How could this be corrected?

18. Profitability Ratios Used to measure if a company is generating sufficient returns on it’s investments. • Sales • Gross Profit Margin • Operating Profit Margin • Net Profit Margin • Equity • Return on Equity (ROE) • Assets • Return on Assets (ROA)

19. Sales • Gross Profit Margin Gross Profit Margin = Gross Profit Net Sales Revenue • Gross Profit = Nets Sales - COGS • Net Sales Revenue = Sales Revenues - returns. • Represents the markup on Cost of Goods Sold • Represents the amount of net sales that will cover operating expenses, interest and taxes. • A common measure used by engineering and sales managers. New products or services must almost always meet a minimum Gross Profit Margin before it is offered.

20. Sales Operating Profit Margin Operating Profit Margin = Net operating income Net Sales Revenue • Used as a measure of operating efficiency in relation to sales revenues. • Net Profit Margin Net Profit Margin = Net Income Net Sales Revenue • Measures the relationship of net profit to sales revenues. • Will show how many cents on each sales revenue dollar becomes profit.

21. Equity and Assets • Return on Equity (ROE) Return on Equity = Net Income Average Owners’ Equity • Measures the percentage of owners’ equity that becomes profit. • Measures a company’s return on owner financing. • Return on Assets (ROA) Return on Equity = ______EBIT________ Average Total Assets • Measure a company’s return on it’s investment in total assets. • Use EBIT to account for Interest (a function of Capital Investment)

22. Questions ??? • A high Gross Profit Margin always means a high Net Profit Margin? • What types of Industries would require a high Gross Profit Margin? • Why do some analyst look primarily at a company’s Operating Profit Margin rather than the Net Profit Margin?

23. Investment/Market Test Ratios • Measures used by many investors to compare a company’s earnings and dividend payments to stock prices. • Earnings per Share • Price to Earnings • Dividend Yield

24. Investment/Market Test Ratios • Earnings per Share (EPS) EPS = Net Income Average number of shares of common stock • Calculating the number of shares of common stock is complicated by stock options, warrants and convertible securities. • Price to Earnings (P/E) P/E = AverageMarket Price per Share Earnings per Share • Indicates how many time Earnings investors are willing to pay for shares. • Dividend Yield Dividend Yield = Dividends per Share Market Price per Share • The percent yield in dividends per dollar paid for a share of stock.

25. Analyzing the Results Ratio analysis is a tool that can provide insights into a company’s performance not readily available on the financial statements. • Compare to benchmarks • Historical benchmarks (trends) • External benchmarks

26. Analyzing Financial Statements • Financial Information • Balance Sheet • Income Statement • Cash Flow Statement • Financial Ratios • Trends • Industry Norms • Industry/Competitive Analysis

28. Assessment • What are the five (5) categories of financial ratios? • Generally, what does each group tell you about a company? • What do the Investment ratios tell you about the performance of a company? • What are the two benchmarks used for comparision?