Financial Ratio Analysis - Chapter 3

Chapter 3: Financial Ratio

• Financial analysis includes securities analysis, investment analysis, and corporate financial analysis.
• Corporate financial analysis aims to assess periodic operating results and financial status.
• It also develops plans and strategies, ultimately aiming to maintain company performance.
• Financial ratios are important tools for assessing a company's performance at a specific point in time or over a period.
• They show relationships among financial statements and are used by investors and managers.

Types of Ratios

• Liquidity Ratios: Measure a firm's working capital management and ability to meet short-term obligations. Higher liquidity is preferred.

  • Current Ratio (CR): Current assets divided by current liabilities. A higher ratio is better, indicating stronger liquidity.
  • Quick Ratio (Acid Test): (Current assets - Inventory) divided by Current Liabilities. A higher ratio is generally better, as it measures the ability to meet short-term obligations without relying on selling inventory.
  • Net Working Capital: Current assets minus current liabilities. A positive value is better, indicating stronger liquidity.

• Activity Ratios: Measure the effectiveness of a firm's investment decisions and asset utilization.

  • Average Collection Period (ACP): Measures the time it takes to collect on credit sales. Shorter periods are generally better.
  • Accounts Receivable Turnover (ARTO): Measures how efficiently the firm collects on credit sales. Higher is better.
  • Inventory Turnover (ITO): Measures how efficiently the firm manages inventory. Higher is better.
  • Fixed Asset Turnover (FATO): Measures how efficiently the firm utilizes its fixed assets. Higher is better.
  • Total Asset Turnover (TATO): Measures how efficiently the firm uses all its assets to generate sales. Higher is better.

• Leverage Ratios: Indicate the extent a firm uses debt to finance investments, measuring financial risk.

  • Debt Ratio: Total debt divided by total assets. A lower ratio is typically better.
  • Debt to Equity Ratio: Total debt divided by net worth. A lower ratio is usually better, indicating a lower reliance on debt.
  • Time Interest Earned (TIE): EBIT divided by interest expense. A higher ratio suggests a greater ability to meet interest payments.

• Profitability Ratios: Analyze the combined effects of liquidity, asset management, and debt on a firm's overall operating performance.

  • Gross Profit Margin (GPM): Gross profit divided by net sales. Higher is better, reflecting better control over cost of goods sold.
  • Operating Profit Margin (OPM): Earnings before interest and taxes (EBIT) divided by net sales. Higher is better, indicating better productivity of assets and efficiency in providing returns.
  • Basic Earnings Power (BEP): EBIT divided by total assets. Higher is better, reflecting better use of assets to generate earnings.
  • Operating Ratio: Total operating expenses divided by net sales. A lower ratio is better. Lower implies better operating efficiency and control on operating costs.
  • Net Profit Margin (NPM): Earnings after tax (EAT) divided by net sales. Higher is better, reflecting greater profitability.
  • Return on Common Equity (ROE): EAT divided by net worth. Higher is better, reflecting a good return on the company’s equity.
  • Return on Total Assets (ROA): EAT divided by total assets. Higher is better, indicating higher profitability from using total assets.

• Market Ratios: Used for publicly traded firms in stock valuation and investment portfolio decisions. These depend on overall company performance.

  • Earnings Per Share (EPS): Calculation details provided for the ratio.
  • Dividend Per Share (DPS): Calculation details provided for the ratio.
  • Dividend Payout Ratio (DPR): Calculation details provided for the ratio.
  • Dividend Yield (DY): Calculation details provided for the ratio.
  • Book Values Per Share (BVPS): Calculation details provided for the ratio.
  • Price Earnings Ratio (PER): Calculation details provided for the ratio.

Discussion

• Activity Ratios: ACP, FATO, and TATO may indicate less efficiency in asset utilization, while ITO shows better inventory management.
• Liquidity Ratios: A strong current ratio is a good sign, but a weak quick ratio (acid test) suggests potential short-term payment difficulties.
• Profitability Ratios: Higher OPM, NPM, ROA, and ROE indicate better performance compared to industry averages.
• Leverage Ratios: If these ratios are worse than industry benchmarks, it suggests a higher reliance on debt. This may present risk. Lower TIE ratios indicate a less efficient ability to pay interest on debt.