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Foundations of Business

Foundations of Business. Financial Ratios & Ratio Analysis to Evaluate and Compare Company Performance. Financial Ratios. Ratios are meaningful relationships between 2 numbers (or among several numbers). 5 Types of Financial Ratios: Liquidity ratios Operating ratios Debt management ratios

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Foundations of Business

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  1. Foundations of Business Financial Ratios & Ratio Analysis to Evaluate and Compare Company Performance

  2. Financial Ratios • Ratios are meaningful relationships between 2 numbers (or among several numbers). • 5 Types of Financial Ratios: • Liquidity ratios • Operating ratios • Debt management ratios • Profitability ratios • Valuation ratios

  3. Champ Creemee CompanyLiquidity Ratios • The higher the Liquidity ratio, the better the company’s ability to pay current obligations with current assets. • The higher the Liquidity ratio, the more liquid the company is. 1. Current Ratio: 2. Quick Ratio: Creemee Balance Sheet Creemee Income Statement

  4. Liquidity: Trends and What If ??? We have a lot of money tied up in inventory! The Current Ratio should be 1X or higher so that the company is able to pay its current liabilities with current assets. We may have to sell inventory to pay our company’s debts!

  5. Champ Creemee CompanyOperating Ratios • How efficiently a company uses assets • The higher the ratio, the more efficient 1. Total Assets Turnover 2. Inventory Turnover • How many times inventory must be restocked to meet sales The Total Assets Turnover ratio must be compared with other companies in the industry. The inventory turnover ratio is different in different industries. Creemee Balance Sheet Creemee Income Statement

  6. Champ Creemee CompanyDebt Management RatiosLeverage Ratios = Using outside sources of financing to increase the return to stockholders. • Degree of Financial risk • Ability to repay money borrowed • The higher the ratio, the greater the financial risk 1. Debt/Equity Ratio = Relationship of money owed to Stockholders’ Investment in the Company Creemee Balance Sheet Creemee Income Statement

  7. Champ Creemee CompanyDebt Management RatiosCoverage Ratios 2. Times Interest Earned (TIE) • Ability of company to pay (cover) interest expense • The higher the ratio, the better the ability to cover • The higher the ratio, the lower the financial risk Creemee Balance Sheet Creemee Income Statement

  8. Champ Creemee CompanyProfitability Ratios • How profitable is the company? • What kind of return is the company generating on sales for stockholders? • The higher the ratio, the better the profitability. 1. Profit Margin (Return on Sales) What percentage of sales dollar ends up as net income ?

  9. Champ Creemee CompanyProfitability Ratios 2. Return on Equity= Return generated on stockholders’ investment in the company ROE = Remember: Stockholders’ Equity = Common Stock + Retained Earnings Creemee Balance Sheet Creemee Income Statement

  10. CO. A EBIT $100 Interest Exp. 10 Earnings before taxes 90 Taxes 36 Net Income $54 Debt $500 Equity 500 Assets $1000 Return on54/1000 Assets = 5.4% Return on 54/500 = 0.108 Equity = 10.8% CO. B $100 0 100 40 $60 0 1000 $1000 60/1000 = 6.0% 60/1000 = 0.06 = 6.0% Impact of Leverage on ROE the “loan company” The “stock company” Borrowing increases ROE, but borrowing also increases RISK. Stockholders require an increased return to balance the risk. Net Income / Total Assets Net income / equity

  11. Champ Creemee CompanyEarnings Per Share (EPS) • EPS = = $ earned per share of common stock • Spreads the net income across the shares

  12. Champ Creemee CompanyValuation Ratios • How is the company valued compared to other companies • Relatively more or less expensive??? Price/Earnings Ratio: How many dollars investors are willing to pay for a dollar of future/projected net income P/E =

  13. Price / Earnings Ratio

  14. Champ Creemee CompanyThe Concept of Market Value Market Value: Current aggregate value in the market for all the common shares outstanding (issued) MV =Number of common shares outstanding x current stock price MV = $ 50 stock price x 1,000 shares = $ 50,000

  15. Cash $8,690 Accounts Receivable 3,000 Inventory 3,500 Current Assets 15,190 Equipment 3,000 Total Assets $18,190 Accounts Payable $2,000 Wages Payable 500Current Liabilities 2,500 Notes Payable (L.T.) 5,000 Total Liabilities 7,500 Common Stock 10,000 Retained Earnings 690 Total Shareholders’ Equity 10,690 Total Liab. & SH Equity $18,190 Champ Creemee CompanyBalance Sheet (as of 12/31/07)

  16. Sales Expenses: Cost of Goods sold Gross Profit Waste/Spoilage Wages Salaries Payroll Remittances Rent/Permits Advertising Maintenance and Repair Operating Expenses Operating Profit (EBIT) Interest Pre-Tax Profit Taxes (35%) Net Income $3,000 (1,000) 2,000 50 500 50 50 100 100 50 (900) 1,100 (500) 600 (210) $ 390 Champ Creemee CompanyIncome Statement (for the Year ending 12/31/07)

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