Ratio Analysis - key points, Summaries of Financial Accounting

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Part II – Ratio Analysis

Financial Ratio Analysis

• Financial ratios can be interpreted only in the context of other

information.

• In general, the financial ratios of a company are compared with those

of its major competitors and to the company’s prior periods.

• The goal is to understand the underlying causes of divergence

between a company’s ratios and those of the competitors and

industry.

Types of Ratios

1. Activity

Activity ratios measure the efficiency of a company’s operations, such as the

collection of receivables and management of inventory.

2. Liquidity

Liquidity ratios measure the company’s ability to meet its short-term obligations.

3. Solvency

Solvency ratios measure a company’s ability to meet long-term obligations.

Subsets of these ratios are also known as “leverage” and “long-term debt” ratios.

4. Profitability

Profitability ratios measure the company’s ability to generate profits from its

resources (assets) or sales.

Activity Ratios

• Activity ratios, also known as asset utilization ratios or operating efficiency

ratios, are measures of operational performance.

• How effectively the company is using working capital and long-term assets.

• Since working capital efficiency has a direct impact on liquidity, some

activity ratios are also useful in assessing liquidity.

• Activity ratios generally combine information from the income statement in

the numerator with balance sheet items in the denominator.

• Because the income statement measures what happened during a period,

whereas the balance sheet shows the condition only at the end of the

period, average balance sheet figures are normally used for consistency.

Activity Ratio Interpretation

Ratio Interpretation

Inventory Turnover and DOH Inventory turnover indicates the resources tied up in inventory (i.e., the carrying costs) and, therefore, can be used to indicate inventory management effectiveness. In general, inventory turnover and DOH (days of inventory on hand) should be benchmarked against industry norms. Receivables Turnover and DSO The number of DSO (days of sales outstanding) reflects how fast the company collects cash from customers to whom it offers credit. Although limiting the numerator to sales made on credit in the receivables turnover would be more appropriate, credit sales information is usually not available to analysts; therefore, revenue as reported in the income statement is generally used. Payables Turnover and the Number of Days of Payables The number of days of payables reflects the average number of days the company takes to pay its suppliers, and the payables turnover ratio measures how many times per year the company theoretically pays off all its creditors.

Activity Ratio Interpretation

Ratio Interpretation

Working Capital Turnover Working capital turnover indicates how efficiently the company generates revenue with its working capital. Fixed Asset Turnover This ratio measures how efficiently the company generates revenues from its investments in fixed assets. Total Asset Turnover The total asset turnover ratio measures the company’s overall ability to generate revenues with a given level of assets.

Liquidity Ratio Calculation

Liquidity Ratios Numerator Denominator

Current ratio Current assets Current liabilities Quick ratio Cash + Short-term marketable investments + Receivables Current liabilities Cash ratio Cash + Short-term marketable investments Current liabilities Defensive interval ratio Cash + Short-term marketable investments + Receivables Daily cash expenditures Additional Liquidity Measure

• Cash conversion cycle (net operating cycle) DOH + DSO – Number of days of payables

Liquidity Ratio Explanation

Ratio Interpretation

Current Ratio The current ratio implicitly assumes that inventories and accounts receivable are indeed liquid. A higher current ratio indicates a higher level of liquidity. (i.e., a greater ability to meet short-term obligations) Quick Ratio The quick ratio is more conservative than the current ratio because it includes only the more liquid current assets (sometimes referred to as “quick assets”) in relation to current liabilities. Like the current ratio, a higher quick ratio indicates greater liquidity. Cash Ratio The cash ratio normally represents a reliable measure of an entity’s liquidity in a crisis situation. Only highly marketable short-term investments and cash are included. Defensive Interval Ratio The defensive interval ratio measures how long the company can continue to pay its expenses from its existing liquid assets without receiving any additional cash inflow. Cash Conversion Cycle (Net Operating Cycle) The cash conversion cycle metric indicates the amount of time that elapses from the point when a company invests in working capital until the point at which the company collects cash.

Solvency Ratio Calculation

Ratio Numerator Denominator

Debt-to-assets ratioᵃ Total debtᵇ Total assets Debt-to-capital ratio Total debtᵇ Total debtᵇ + Total shareholders’ equity Debt-to-equity ratio Total debtᵇ Total shareholders’ equity Financial leverage ratioᶜ Average total assets Average total equity Debt-to-EBITDA Total or net debt EBITDA Interest coverage EBIT Interest payments Fixed charge coverage EBIT + Lease payments Interest payments + Lease payments ᵃ “Total debt ratio” is another name sometimes used for this ratio. ᵇ In this reading, total debt is the sum of interest-bearing short-term and long-term debt. ᶜ Average total assets divided by average total equity is used for the purposes of this reading (in particular, DuPont analysis covered later). In practice, period-end total assets divided by period-end total equity is often used.

Solvency Ratio Interpretation

Ratio Meaning

Debt-to-Assets Ratio This ratio measures the percentage of total assets financed with debt. For example, a debt-to-assets ratio of 0. 40 or 40 percent indicates that 40 percent of the company’s assets are financed with debt. Generally, higher debt means higher financial risk and thus weaker solvency. Debt-to-Capital Ratio The debt-to-capital ratio measures the percentage of a company’s capital (debt plus equity) represented by debt. As with the previous ratio, a higher ratio generally means higher financial risk and thus indicates weaker solvency. Debt-to-Equity Ratio The debt-to-equity ratio measures the amount of debt capital relative to equity capital. Interpretation is similar to the preceding two ratios (i.e., a higher ratio indicates weaker solvency). A ratio of 1. 0 would indicate equal amounts of debt and equity, which is equivalent to a debt-to-capital ratio of 50 percent. Financial Leverage Ratio The financial leverage ratio (often called simply the “leverage ratio”) measures the amount of total assets supported for each one money unit of equity.

Profitability Ratios

• Profitability ratios measure the return earned by the company during

a period.

Profitability Ratio Calculation

Profitability Ratios Numerator Denominator Return on Salesᵃ

• Gross profit margin Gross profit Revenue
• Operating profit margin Operating incomeᵇ Revenue
• Pretax margin EBT (earnings before tax but after interest) Revenue
• Net profit margin Net income Revenue Return on Investment
• Operating ROA Operating income Average total assets
• ROA Net income Average total assets
• Return on invested capital EBIT × (1 − Effective Tax Rate) Average total short- and long-term debt and equity
• ROE Net income Average total equity
• Return on common equity Net income − Preferred dividends Average common equity ᵃ “Sales” is being used as a synonym for “revenue.” ᵇ Some analysts use EBIT as a shortcut representation of operating income. Note that EBIT, strictly speaking, includes non- operating items such as dividends received and gains and losses on investment securities.

Profitability Ratio Interpretation

Ratio Meaning

ROA ROA measures the return earned by a company on its assets. The higher the ratio, the more income is generated by a given level of assets. Return on Invested Capital Return on invested capital measures the after-tax profitability a company earns on all of the capital that it employs (short-term debt, long-term debt, and equity). ROE ROE measures the return earned by a company on its equity capital, including minority equity, preferred equity, and common equity. As noted, return is measured as net income (i.e., interest on debt capital is not included in the return on equity capital).

DuPont Analysis - The Decomposition of ROE

• ROE measures the return a company generates on its equity capital.

• To understand what drives a company’s ROE, a useful technique is to

decompose ROE into its component parts.

• The information gained can also be used by management to

determine which areas they should focus on to improve ROE.

• This decomposition will also show why a company’s overall

profitability, measured by ROE, is a function of its efficiency, operating

profitability, taxes, and use of financial leverage.