Financial Ratio Analysis

Financial Ratio Analysis Overview

• Tool used by finance managers and analysts.
• Assesses a company's financial health.
• Achieved through analyzing financial statements.
• Provides a foundation for projecting a firm’s future performance.
• Involves calculating and interpreting financial ratios.
• Understanding both formulas and results is crucial.

Financial Statements for Ratios

• Financial ratios use numerical values from the income statement and balance sheet.
• The income statement includes sales revenue, gross profit, operating profit, and net income.
• The balance sheet includes assets, liabilities, and stockholders' equity.

Five Major Financial Ratios

• Liquidity ratios show a company's ability to meet short-term obligations using cash.
• Activity ratios (or efficiency ratios) gauge how efficiently a company uses assets to generate sales.
• Stability ratios assess a company's ability to pay its long-term obligations.
• Profitability ratios are important to both investors and management in the short and long term.
• Market ratios relate the firm's market value to certain accounting values.

Liquidity Ratios

• Also known as solvency ratios.
• Assess a company's capacity to meet current obligations using liquid assets.
• Two main liquidity ratios: current ratio and quick ratio.
• Current Ratio: Current Assets / Current Liabilities.
• Current assets include: cash, marketable securities, accounts receivables, inventories, and prepayments.
• Quick ratio excludes inventory from the calculation because inventory is less liquid.
• Quick Ratio: (Current Assets - Inventory) / Current Liabilities.
• The quick ratio is a better measurement of a company's liquidity than the current ratio.

Activity Ratios

• Also known as working capital or efficiency ratios.
• Measure the efficiency of a company in managing its assets.
• Include accounts receivable turnover, accounts payable turnover, inventory turnover, and total assets turnover.
• Common denominator: turnover
• Accounts Receivables Turnover: Net Sales / Accounts Receivable.
• Accounts Payable Turnover: Net Purchases / Accounts Payable.
• Inventory Turnover: Cost of Goods Sold / Inventory.
• Total Assets Turnover: Net Sales / Total Assets.
• Using averages for accounts receivables, inventory, and total assets provides a more accurate measurement.
• Average Collection Period: 365 days / Accounts Receivables Turnover
• Average Payment Period: 365 days / Accounts Payable Turnover
• Average Age of Inventory: 365 days / Inventory Turnover

Stability Ratios

• Measure a company's ability to pay its long-term obligations.
• Also known as leverage or capital structure ratios.
• Key Ratios include: Debt ratio, debt-to-equity ratio, and times interest earned ratio.
• Debt Ratio: Total Liabilities / Total Assets (indicates the proportion of assets financed by creditors).
• Debt-to-Equity Ratio: Total Liabilities / Stockholders' Equity.
• Times Interest Earned: Operating Income (Net Income before interest and taxes) / Interest Expense.

Profitability Ratios

• Common ratios: gross profit margin, operating profit margin, net profit margin, earnings per share, return on assets, and return on equity.
• Gross Profit Margin: (Gross Profit / Net Sales) x 100
• Operating Profit Margin: (Operating Profit / Net Sales) x 100
• Net Profit Margin: (Net Income / Net Sales) x 100
• Earnings Per Share (EPS): (Net Income - Preferred Dividends) / Weighted Average Common Shares Outstanding
• Return on Assets (ROA): Net Income / Total Assets
• Return on Equity (ROE): Net Income / Total Stockholders' Equity

Market Ratios

• Relate a firm's market value to certain accounting values.
• Market-to-Book Ratio: Market Price per Share / Book Value per Share.
• Book Value per Share: (Total Stockholders' Equity - Preferred Stock Equity) / Average Common Shares Outstanding.
• Price-Earnings Ratio (P/E Ratio): Market Price per Share / Earnings per Share (EPS).
• Dividend Yield: Dividend per Share / Beginning Stock Price.

Liquidity Ratios - Current Ratio in Detail

• Formula: Current Assets / Current Liabilities
• Measures a company's ability to pay its current obligations using current assets.
• A higher current ratio indicates a greater degree of liquidity.
• Current Ratio close to 1 is good.
• A current ratio of 2 is considered ideal.
• Example: A company with a current ratio of 2 has twice as many current assets as liabilities or debts.

Liquidity Ratios - Quick Ratio (Acid-Test Ratio) in Detail

• Excludes inventory from current assets: (Current Assets - Inventory) / Current Liabilities.
• Example: $1,223,000 (Current Assets) - $289,000 (Inventory) = $934,000 / $620,000 (Current Liabilities) = 1.51

Liquidity Ratios

• The quick ratio provides a better measure of a company's overall liquidity than the current ratio.
• The higher the quick ratio, the better.
• A quick ratio of 1.5 means that for every one peso of current obligations, the company has 1.5 pesos in current assets.

Inventory Turnover

• The formula is cost of goods sold divided by inventory.
• Cost of goods sold is found on the income statement.
• Inventory is found under current assets.
• An inventory turnover of 7.2 times means the company turns over its inventory 7.2 times in a year.
• To understand the speed of inventory turnover, calculate the average age of inventory.
• Average age of inventory is 365 days divided by inventory turnover.
• An average age of inventory of 50.7 days means it takes the company almost 51 days to convert inventory into cash.
• If the company sells perishable items, 51 days to convert inventory to cash is not good.

Receivables Turnover

• Measures the speed of a company in collecting receivables.
• The formula is sales revenue divided by accounts receivables.
• A receivables turnover of 6.11 means the company turns over its receivables 6.11 times per year.
• To better understand this, compute the average collection period.
• Average collection period is 365 days divided by receivables turnover.
• If it takes a company 59.7 days to collect receivables, whether this is good or bad depends on the company's credit terms.
• It is bad if the company's credit terms are 30 days, because their money is tied up in receivables for twice as long.

Payables Turnover

• Calculated as net purchases over accounts payable.
• Net purchases is assumed to be 70% of cost of goods sold.
• An assumption that is 70% of cost of goods sold equals one million four hundred sixty one thousand six hundred
• A payables turnover of 3.83 times means it takes a company four times a year to turn over their company's payables.
• Generally, the higher the payables turnover, the better.
• Average payment period measures how fast or slow a company is in paying obligations.
• Computed as 365 days divided by payables turnover.
• An average payment period of 95 days means it takes a company 95 days to pay its obligations.
• Whether this is good or bad depends on the credit terms with suppliers.

Total Assets Turnover

• Calculated as sales divided by total assets.
• Measures how efficiently a company manages its total assets to generate sales.
• The higher the turnover, the more efficiently assets are being used.

Stability (Debt) Ratios

• Calculated as total liabilities divided by total assets.
• A ratio of 45.7% means that almost 46% of a company's total assets are financed by creditors.
• The higher the ratio, the more the company depends on other people's money to generate profits (leveraging).

Debt-to-Equity Ratio

• Calculated as total liabilities divided by stockholders' equity.
• A ratio of 84.08% means that creditors provide 85 cents for every one peso provided by shareholders.
• This ratio measures a company's financial leverage.
• Interpretation of the debt-to-equity ratio depends on the industry.
• Higher ratios are often associated with higher risk.
• Conservative investors prefer companies with a debt-to-equity ratio of less than one.

Times Interest Earned Ratio

• Calculated as earnings before interest and taxes (EBIT) divided by interest expense.
• Measures a company's ability to pay its interest expenses.
• A times interest earned ratio of 4.5 means that the company can pay its interest expenses 4.5 times using its operating profit.
• The higher the times interest earned ratio, the better.

Profitability Ratios: Gross Profit Margin

• Calculated as gross profit divided by total sales revenue.
• Measures how profitable a company is after deducting the cost of goods sold from sales revenue.
• A gross profit margin of 32.1% means that for every 100 pesos in sales, the company has a gross profit of 32.1 pesos.
• The higher the gross profit margin, the better.

Profitability Ratios: Operating Profit Margin

• Calculated as operating profit divided by net sales revenue.
• Takes into account operating expenses.
• A higher operating profit margin is preferred.

Profitability Ratios: Net Profit Margin

• Calculated as net profit divided by total sales revenue.
• Net profit is net income after deducting all costs, expenses, interest, and taxes.
• A net profit margin of 7.2% means that for every 100 pesos in sales, the company earns a net profit of 7.2 pesos.
• The higher the net profit margin, the better.

Earnings Per Share (EPS)

• Calculated as net income minus preferred dividends, divided by the total number of common shares outstanding.
• Measures the earnings for each share of stock.
• A higher EPS indicates that investors will pay more for a company with higher profits.
• Choose stocks with high earnings per share.

Return on Assets (ROA)

• Calculated as earnings available for common shareholders divided by total assets.
• Measures the overall effectiveness of management in generating income using available assets.
• Choose a company with a higher ROA.

Return on Common Equity (ROE)

• Calculated as earnings available for common shareholders divided by common stock equity.
• Measures the return earned on common stockholders' investment.

Market Ratios: Price-Earnings (P/E) Ratio

• Calculated as market price per share divided by earnings per share.
• Measures how expensive or affordable shares of stock are.
• High P/E: stock is more expensive
• Low P/E: could indicate stagnant growth, excessive debt, or undervaluation
• High P/E: could indicate overpriced stocks, future earnings growth, expansion, acquisition, or a good product line
• High P/E: a good choice for growth investors

Market Ratios: Price Earnings Growth (PEG)

• Compares the P/E ratio with the EPS growth rate.
• Determines a stock's value while considering the company's earnings growth.
• A PEG ratio of more than one could imply that a stock is too expensive.

Market Ratios: Book Value

• Common stock equity minus preferred stocks, divided by the number of common shares outstanding.
• Book value is also known as intrinsic Value.
• Higher book value = better
• Book value is used to find high-growth companies that are undervalued.

Market Ratios: Market-to-Book Ratio

• Calculated as market price per share divided by book value per share.
• Indicates how much investors are paying for each dollar of book value.

Market Ratios: Dividend Yield Ratio

• Calculated as dividend per share divided by the market price.
• Higher dividend yield: company is doing well and it could signify a long-term investment.

Market Ratios: Dividend Payout

• Measures the percentage of earnings given out as dividends.
• Companies can use retained earnings for various objectives like expansion or reinvestment.