Ratio Analysis

- Analysis of fundamentals of financial statements -

Ratios facilitate comparison of:

-> One company over time

-> One company versus other companies - Interpretation: According to individual logic of the ratio & comparison with industry average
- Ratios are used by:

-> Lenders (e.g. banks) to determine creditworthiness

-> Stockholders to estimate future cash flows and risk

-> Managers to identify areas of weakness and strength

Liquidity Ratio

Service of current liabilities (=short-term obligations)

→ Can the company meet its short-term obligations using the

resources it currently has on hand?

Formula: Slide 4

- Interpretation

→The larger, the higher the liquidity →Comparison with industry average

Asset management ratios

- Measuring how efficiently a firm is managing its assets
- Give indication of right amount of assets
- > Total assets turn over ratio
- > Fixed assets turn over ratio (for fixed assets evaluation)
- > Days sales outstanding (DSO, receivables evaluation)
- > Inventory turn over ratio (evaluating inventories)
- Interpretation: (1) If investment in assets is too excessive, this leads to high operating capital and hurts profits, FCF and stock price. (2) If assets are too little, this might lead to loss of sales which reduces profitability, FCF, and stock price.

Debt management ratios

Slide 6

Debt Management ratios

(1) Stockholders can control a firm with smaller investments of their own equity if they finance part of the firm with debt.

(2) If the firm’s assets generate a higher pre-tax return than the interest rate on debt, then the shareholders’ returns are magnified, or “leveraged.”

Shareholders’ losses are magnified if assets generate a pre- tax return less than the interest rate.

(3) If a company has high leverage, even a small decline in performance might cause the firm’s value to fall below the amount it owes to creditors.

Debt management ratios 2

Slide 8

Profitability ratios

What is the company’s rate of return on:

Sales? Assets?

→ Show combined effects on liquidity, asset management and debt on operating results

→ there is a variety of different profit margin ratios

Formula Slide 9

Profitability ratios

Slide 10

Effects of Debt on ROA and ROE

- ROA is lowered by debt–interest expense lowers net income, which also lowers ROA.
- However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase.

Market value Ratios

- relate a firm’s stock price to its earnings, cash flow, and book value per share
- are a way to measure the value of a company’s stock relative to that of another company
- > High current levels of earnings and cash flow increase market value ratios
- > High expected growth in earnings and cash flow increases market value ratios
- > High risk of expected growth in earnings and cash flow decreases market value ratios

Market value ratios

Slide 13

Interpreting Market Based Ratios

- P/E: How much investors will pay for $1 of earnings. Higher is better.
- M/B: How much paid for $1 of book value. Higher is better.
- P/E and M/B are high if ROE is high, risk is low.

Techniques (2)

- Most commonly used are: Trend Analysis, Common Size Analysis, and Percentage Change Analysis
- Trend Analysis:

– Trends give clues as to whether a firm’s financial condition is likely to improve or deteriorate

– To do a trend analysis, you examine a ratio over time; time series data;

Techniques (2)

Common Size Balance Sheets:

– all income statement items are divided by sales

– all balance sheet items are divided by total assets

– a common size income statement shows each item as a percentage of sales

– a common size balance sheet shows each item as a percentage of total assets

– it facilitates comparisons of balance sheets and income statements over time and across companies

Techniques (3)

Percentage Change Analysis:

In percentage change analysis, growth rates are calculated for all income statement items and balance sheet accounts relative to a base year.

Techniques (4)

- Comparative Ratios and Benchmarking
- A company’s ratios are compared with those of other firms in the same industry → comparison with industry average figures
- Comparison of a firm’s ratios with those of a smaller set of the leading companies in an industry = benchmarking, and the companies used for the comparison are called bench-mark companies.

Potential Problems and Limitations of Ratio Analysis

- Comparison with industry averages is difficult if the firm operates many different divisions.
- Inflation distorts financial statements & ratio analysis
- Seasonal factors can distort ratios.
- Window dressing techniques can make statements and ratios look better.
- Different accounting and operating practices can distort comparisons.

Qualitative Factors

- There is greater risk if:
- > revenues tied to a single customer
- > revenues tied to a single product
- > reliance on a single supplier?
- > High percentage of business is generated overseas?
- What is the competitive situation?
- What products are in the pipeline?
- What are the legal and regulatory issues?

Advanced Ratio Analysis: DuPont Equation

- If you can’t see the trees in the forest anymore
- The DuPont equation focuses on:
- > Expense control (Profit margin)
- > Asset utilization (Total assets turn over)
- > Debt utilization (Equity multiplier)
- It shows how these factors combine to determine the ROE.
- New ratio as measure of financial leverage:
- Equity multiplier = Total assets / common equity

The DuPont Equation

Slide 30