302885 FINANCIAL RATIOS 1F Flashcards
If a company is profitable and is effectively using leverage, which of the following ratios is likely to be the largest?
Return on operating assets
Return on total assets
Return on common equity
Return on total shareholders’ equity
Return on total assets
Financial leverage is measured by the extent to which the assets of the firm are financed with debt, which requires a fixed cash payment. As the firm earns profits in excess of these fixed payments, the excess goes to the common shareholders. Therefore, if a company is profitable and is effectively using leverage, it will have a high return on common equity because higher leverage effectively used means a lower need for equity and therefore a lower denominator for return on equity, leading to an increased return on equity. This is the ratio which indicates the return to common shareholders for their investment in the firm.
The return on investment, also called the return on total assets, indicates the return to the firm on the total investment, debt and equity. The return on total shareholders’ equity indicates the return to all shareholders, common and preferred; however, preferred stock has some elements of debt (i.e., fixed cash payments) and is often considered part of the financial leverage of the firm.
Leverage (Total)
Total leverage is a combination of operating and financial leverage. If a company used both high degrees of operating and financial leverage, only small changes in sales will result in large fluctuations in EPS (earnings per share). This can be shown in equation form:
% change in net income Degree of total leverage = ---------------------- = DOL x DFL
% change in sales
Preferred Stock
Preferred stock is ownership interest (class of stock) that carries preferences or specified priorities when compared to common stock; it is usually nonvoting and senior to common stock in dividend and liquidation preference and participation rights (to specified limits). It has characteristics of both debt and equity and may have other features, such as convertibility to other securities, call features, and redemption. Preferred stock is a “security.”
While preferred stockholders generally must be paid before common stockholders, preferred stockholders are paid after creditors.
Dividend preference is usually expressed as a percentage of the par value of the preferred stock but may also be expressed as a specific dollar amount per share. Preference may be cumulative or noncumulative, as well as participating, nonparticipating, or partially participating (where it is participating along with common stock in the receipt of dividends in excess of the stated preferred dividend).
Profitability
Profitability is the ability of an enterprise to maintain a satisfactory dividend policy while at the same time steadily increasing ownership equity. The nature and amount of income, as well as its regularity and trend, are significant factors affecting profitability.
Return on Investment (ROI)
Return on investment (ROI) is calculated by dividing invested capital into net income.
It can be divided into two elements:
- Profit margin = Operating income ÷ Sales
- Invested capital turnover = Sales ÷ Average invested capital
There are limitations on use of this ratio.
Example: Accrual income includes estimation and does not reflect true cash return, invested capital is based on historical cost of assets and does not reflect current values (invested capital should be total assets less any intangible assets which do not contribute directly to the generation of sales), and often the interest expense (net of tax effects) is not added back to net income.
Return on Net Worth
Return on net worth is a profitability ratio which measures the return on owners’ (common) equity. It measures the return that accrues to the owners (stockholders) after interest is paid to creditors. It measures the residual return to owners on their investment in the enterprise.
The computation is:
Net income available to common ÷ Average common equity, or
(Net income − Preferred dividends) ÷ Average common equity
Transformation of other ratios will also give the return on common:
Return on common = Return on total assets ÷ (1 − Debt ratio)
There are limitations on use of this ratio.
Examples: Accrual income involves estimates and does not reflect actual cash returns. Book value of common stock reflects historical, not current, value.
2162.01
Profitability (asset utilization) is the measure of success in terms of income defined in a variety of ways over a period of time. In analyzing profitability, earnings are compared to a base such as sales, productive assets, or equity. Increased profitability provides the potential for increased dividend payments as well as from stock appreciation. Increased profitability also provides greater security for debt holders.
2162.02
Gross margin
The gross margin ratio compares the gross margin (gross profit) generated by the net sales revenue. In other words, what percentage of the sales dollars was used to cover the cost of goods sold? The remaining amount is left to cover the general and administrative expenses as well as to provide a profit. This is also known as the gross profit ratio.
Gross margin is net sales revenue less cost of goods sold. The gross margin ratio is:
Gross margin ratio = Gross margin/Net sales revenue
This ratio is generally more useful to management than to creditors or investors since the data necessary to analyze why changes occurred in the ratio are only available internally. Changes are caused by one of the following elements or a combination of the following items:
Increase/decrease in unit sales price
Increase/decrease in cost per unit
Calculation using data from the Sample Company for 20X2 (section 2160.01):
Gross margin ratio = Gross margin / Net sales revenue
= $400,000 /
$1,000,000
= 40%
2162.03
Profit margin
The profit margin ratio calculates the percentage of each dollar of sales that is recognized as net income. In other words, it measures the efficiency of earnings as compared to sales. It indicates how well management has controlled expenses in relationship to revenues earned. This ratio is an excellent way to compare the profits of companies of varying sizes. This is also known as the return on sales ratio.
Profit margin ratio = Net income /
Net sales
In alternative definitions, the numerator for this ratio can take a variety of forms: operating income, net income, income available to stockholders, or income from recurring operations.
The use of accrual income includes estimates and items over which management has little or no control.
Calculation using data from the Sample Company for 20X2 (section 2160.01):
Profit margin ratio = Net income
Net sales
= $75,000 / 1,000,000= 7.5%
2162.04
Asset turnover
The asset turnover ratio indicates how many dollars of sales were created by each dollar of total assets. It helps to determine whether the available assets were used efficiently to create sales. One goal of management is to generate the highest possible amount of sales per dollar of invested capital. Note that different industries tend to have different reasonable ranges for this ratio.
Asset turnover = Net sales revenue
Average total assets
As in all turnover ratios, a high asset turnover is a desirable outcome since it results from an effective use of available assets; however, it is not unusual for a company that has recently expanded to see a decrease in asset turnover until the new facility is fully utilized.
For internal use, it is desirable to calculate this ratio comparing divisional sales to divisional assets.
Comparison between firms within an industry can be difficult due to the fact that the age of the assets used in the production of the sales may vary. This is a limitation caused by the use of historical costs as opposed to fair market values for the productive assets. There is also a problem when comparing a capital-intensive firm to a labor-intensive firm.
There are also problems created due to the fact that the generally used formula does not take into account that certain assets make no tangible contribution to sales. It is assumed that an asset’s participation in generating sales is related to its recorded amount. Adjustments to the asset figure are used in attempts to compensate for this problem. For example, long-term investments are not involved in the production and sale of the product and are often not included in the calculation.
Calculation using data from the Sample Company for 20X2 (section 2160.01):
Asset turnover = Net sales revenue
Average total assets
= $1,000,000 / (11,050,000 + 1,000,000 )/2 = 0.98
2162.05
2164.04
