Chapter 20 Ratios Analysis

1. Chapter 20Ratios Analysis Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

2. Ratio Analysis • Ratios are among the most popular ways to analyze financial statements • The most important aspect of using ratios is the interpretation of the results • Generally ratios are broken up into 4 groups • Liquidity and Efficiency • Solvency • Profitability • Market • Ratio analysis is a comparative analysis • One should compare ratios for a company across several periods • One can compare ratios across companies. Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

3. Ratio Analysis • When performing ratios analysis, we often include balance sheet and income statement accounts in the formulae • When using a formula that includes both income statement (revenues and expenses) as well as balance sheet account (like cash, AR, Inventory, total assets, etc), we will often take an average of the beginning and ending period balances • To take an average, take the number shown for the balance sheet account for Year 1 (say, 2004) and Year 2 (say, 2005), add them together and divide by 2 • Example: Total Asset Turnover = Net Sales / (Avg Total Assets) • Total Asset Turnover = Net Sales / ((Total Assets in Year 1 + Total Assets in Year 2)/2) Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

4. Liquidity and Efficiency • Liquidity refers to the availability of resources to address short-term obligations • Efficiency refers to how well a company uses its resources Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

5. Liquidity • Working Capital = Current Assets – Current Liabilities • If this figure is greater than 0, then there is resources available to pay short-term obligations • Cash to Asset Ratio = Cash / Total Assets • Helps to figure out how much of the total assets is cash • The higher the figure, the safer/more liquid the company is • But, also the higher this figure, the more inefficient the company is being with its cash • Cash earns no return sitting in bank accounts • The objective is to invest it in Capital Assets, intellectual knowledge or production so that it earns a return Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

6. Liquidity • Current Ratio = Current Assets/Current Liabilities • The current ratio is a measure of the firm’s ability to pay bills as they come due. • If too low, then company can be at risk of meeting short-term obligations. If too high, then there may be too much invested in short-term assets • Quick Ratio = (Cash + Marketable Securities + Net Receivables)/Current Liabilities • It is a more stringent measure of the firm’s ability to pay its bills Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

7. Efficiency • Accounts Receivable Turnover = Net Sales / (Average Net Accounts Receivable) • Where average AR = (beginning AR + ending AR)/2 • This measures how fast a company collects its receivables • The higher the turnover, the shorter the time between sales and collecting cash. • Days Sales in Receivables = (Avg Net AR)/Net Sales x 365 • average number of days it takes to collect accounts receivable (number of days of sales in receivables) Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

8. Efficiency • Inventory Turnover = COGS/Average Inventory • Where average inventory = (beginning inventory + ending inventory)/2 • Measures the number of times the inventory is turned over • Generally, a high inventory turnover is an indicator of good inventory management. • But a high ratio can also mean there is a shortage of inventory, which may mean the company may miss a sale due to an out-of-stock situation. • A low turnover may indicate overstocking or obsolete inventory. • Days Sales in Inventory = Avg Inventory/COGS x 365 • shows the average number of days it will take to sell your inventory (number of days sales @ cost in inventory) Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

9. Efficiency • Total Asset Turnover = Sales / Avg Total Assets • It is a measure of how many times Sales pays for Assets • Capital Asset Turnover = Sales / Avg Capital Assets • Measures the efficient use of the just the big ticket items. Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

10. Solvency • While liquidity is concerned about ability to meet short-term obligations, Solvency is concerned about the company’s long-term viability and its ability to cover long-term debt. • One of the most important elements of solvency analysis is the analysis of a company's capital structure. • Capital Structure refers to a company's sources of finances: debt and equity Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

11. Solvency • Debt Ratio = Total Liabilities / Total Assets • Measures the % of creditor funding of assets • Equity Ratio = Total Owner’s Equity / Total Assets • Measures the % of owner funding of assets • Debt to Equity Ratio = Total Debt / Total Equity • A measure of leverage, which compares the amount of skin in the game that the owners have versus the creditors • Too much debt can put the business at risk. But debt is also a growth instrument. Too little debt may mean there are opportunities that are being missed. • Debt Coverage Ratio = (Net Income + Non-cash expenses like Depreciation and Amortization) / Debt • Shows how much the cash profits are available to repay debt. • Lenders look at this ratio to determine if there is adequate cash to make loan payments. Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

12. Solvency • Times Interest Earned = Income before Interest and Taxes / Interest Expense • This ratio is used to reflect the riskiness of repayments with interest to creditors. • It shows how many times over the earnings of a business covers their interest obligations Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

13. Profitability • Profitability refers to a company’s ability to generate an adequate return on invested capital. The return is the amount of earnings, usually this is net income after interest and taxes • Profit Margin = Net Income / Sales • Measures how effectively a firm is able to convert sales to profits (remembering that Net Income is Sales less all expenses) • May also be measured as EBITDA/Sales where EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization • The thought here is that the ITDA portion does not generally contribute directly to generating sales and so should not be considered in the calculation of Net Profit Margin Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

14. Profitability • Gross Profit Ratio = Gross Profit/Net Sales, • where Gross Profit = (Total Sales – COGS) • Measures how effectively COGS are used to generate sales • In a manufacturing company, sufficient gross profit is required to cover operating expenses. • Return on Assets = Net Income / Avg Total Assets • Can be used to determine how often assets are being paid for. It is a more stringent measure of asset coverage than the Asset Turnover ratio since Return on Assets is calculated with net Profit rather than Sales Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

15. Profitability • Return on Equity = (Net Income – Preferred Dividends) / Avg Common Shareholders Equity • Determines the rate of return on investment in the business • Should be compared with other investment alternatives, such as a savings account, stock or bond returns to see if there is a more effective way to earn money • Earnings Per Share = Net Income – Preferred Dividends / (Weighted Average Number of Common Shares Outstanding) • Amount of money earned per common share • Book Value Per Share = Shareholder’s Equity / (Weighted Average Number of Common Shares Outstanding) Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

16. Capital Market Analysis • Market analysis is useful when we are analyzing company’s traded in public markets (stock exchanges) • These calculations use share price as part of their analysis • Share price is a reflection of what the market thinks the company is worth Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

17. Capital Market Analysis • Price Earnings Ratio (PE Ratio) = (Market Price of Common Stock Per Share) / (Earnings per share) • A key ratio used in stock valuation to determine whether a stock is over or under valued or to determine future direction of stock movement • Price to Book Ratio (PB Ratio) = (Market Price of Common Stock Per Share) / (Owner’s Equity / no. outstanding shares) • Used to determine how much the market has valued the stock more/less than the book value • Keep in mind that the book value is based on GAAP (which uses all of the guidelines of relevance, comparison, historical value, amortization calculation rules, etc) Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

18. Capital Market Analysis • Dividend Yield = Annual Dividends per share / market price per share • This is a means of comparing the dividend paying performance of different investment alternatives • Payout Ratio = Dividends per Share / Earnings Per Share • This is a measure of how much of the earnings were paid to owners as dividends • We’d like this number to be in the range of 40 to 70% • The newer companies tend to have a low payout ratio • They are keeping earnings to grow the company • Mature companies tend to pay out more • They are returning profits to owners Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

19. Capital Market Analysis • Free Cash Flow Payout Ratio (FCFPR) = • Dividends per Share / Free Cash Flow (FCF) • FCFPR measures how much cash is being paid out as dividends from the cash generated by the business • FCF = Cash flow from Operating Activities – Cash flow from Investing Activities • A measure of financial performance calculated as operating cash flow minus capital expenditures. • Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. • Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

20. Summary • As mentioned earlier, ratios are not to be used in a vacuum • Ratios can be compared with each other in a number of ways • Comparison across different companies in the same industry • Comparison within a company across previous periods • Comparison within a company of past performance with future budgeted performance • General and subjective standards which use rules of thumb to offer information Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD