Module 7: Ratio Analysis
Accounts Receivable Turnover (AR Turnover) Formula
AR Turnover = Credit Sales/Accounts Receivable
Average Collection Period (ACP) Formula
Average Collection Period = 365/AR Turnover
Five Major Categories of Financial Ratios: #4 Profitability
Can be based on either sales or asset investment. They are commonly used to directly judge how profitable the company is and how well management is doing as they strive to maximize owner wealth.
A firm has paid off its short-term loans more quickly in the past couple of years. What might this trend indicate about the firm's financial ratios?
Its liquidity ratio is increasing.
Which type of ratio is a current ratio?
Liquidity
Operating Income Return on Investment (OIROI)
OIROI = Operating Income/ Total Assets
How might calculating financial ratios help shareholders?
Ratios can be used to determine whether a firm is maximizing shareholder wealth.
What is a component of the DuPont framework?
Return on assets - ROW = ROA x leverage multiplier
The firm Betsy's Books has a market-to-book ratio of 1.2. What does this tell you about the firm?
This firm is expected to grow in the future. - The market-to-book ratio measures the growth prospects of a company. If the ratio is greater than 1, then the company is expected to grow.
Current Assets
are items that will generate cash within the next year.
Current Liabilities
are obligations that will require cash within the next year.
Activity ratios such as inventory turnover, accounts receivable (AR) turnover, and average collection period (ACP)
are used to check short-term operating asset management efficiency, while total asset turnover (TAT), fixed asset turnover (FAT), and operating income return on investment (OIROI) assess how well a firm is using its assets to generate sales.
Five Major Categories of Financial Ratios: #2 Activity
(Efficiency Ratios) Measure how well the company uses its assets to generate sales or cash—the firm's operational efficiency and profitability.
Five Major Categories of Financial Ratios: #3 Leverage
(Financing Ratios) Consider how the firm is financed and how financially risky a firm is.
Profit Margin
(Net Income/Revenue) - shows the earnings of the firm or by how much revenue exceeded costs during the given period.
Activity Ratios
Activity ratios measure how well a company uses its assets to generate sales or cash and include accounts receivable turnover, average collection period, inventory turnover, total asset turnover, fixed asset turnover, and operating income return on investment.
Accounts Receivable Turnover (AR Turnover)
An activity ratio found by credit sales divided by accounts receivable.
Average Collection Period (ACP)
An activity ratio found by the number of days in a year (365) divided by AR turnover.
Liquid Asset
An asset that can be converted into cash quickly without the loss of significant value.
DuPont Framework
An expanded formula of the return of equity, net margin times total asset turnover times leverage multiplier, which represent the components of profitability, activity (efficiency), and financing.
Leverage
Another term for debt or liability.
Debt-to-Equity Ratio
Debt-to-Equity Ratio = Total Liabilities/Total Owner's Equity
Which actions, taken together, will certainly increase a firm's ROE?
Decreasing equity financing and increasing net margin - Decreasing equity financing increases the leverage multiplier, therefore increasing ROE, and increasing net margin also increases ROE.
Fixed Asset Turnover (FAT)
Fixed Asset Turnover = Sales/Fixed Assets
Gross Margin
Gross margin = Gross Profit/Sales
What do leverage ratios describe?
How easily a firm can convert assets into cash
Financial Risk
Increased volatility in earnings as a result of using debt.
Which action increases the return on equity of a firm if all else remains constant?
Increasing debt financing - Increasing debt financing increases the leverage multiplier, which means that the ROE increases.
Inventory Turnover Formula
Inventory turnover = COGS/Inventory
How can the DuPont framework help a company assess its return on equity?
It allows the company to determine how its abilities to generate profits, manage assets, and use financing contribute to the return on equity.
Total Asset Turnover
It calculates how well a firm is using its assets to generate sales, which you will define as sales over total assets.
Profitability Ratios
Profitability ratios are used to judge how well management is maximizing owner wealth and include return on assets, return on equity, gross margin, operating margin, and net profit margin.
DuPont Framework Components
Profitability, Activity, and financing components
Quick Ratio Formula
Quick Ratio = Current Assets - Inventory/Current Liabilities
Return on Assets (ROA)
ROA = Net Income/Total Assets
Return on Equity (ROE)
ROE = Net Income/Owner's Equity
Alternate Form of DuPont Framework
ROE = ROA x leverage multiplier
Four Reasons Ratios are Useful for Analyzing and Comparing Company Performance: #4 Evaluation
Ratio analysis can help you is by evaluating whether the firm is achieving its stated goal to maximize shareholder wealth.
Four Reasons Ratios are Useful for Analyzing and Comparing Company Performance: #2 Flexibility
Ratio analysis is not determined by any set of rules, including the generally accepted accounting principles (GAAP), so it is easily adapted to any situation or need. The analyst can choose which ratios to calculate, how many years of data to use, and a multitude of other variables according to the needs of each individual case.
Four Reasons Ratios are Useful for Analyzing and Comparing Company Performance: #3 Focus
Ratio analysis leads one to look in the right places so you can correctly understand the current performance and position of the company.
Accounting Issues
The goal of ratio analysis is to understand the true economic character of the firm. However, the rules of accrual accounting allow for various policies regarding inventory cost flow, revenue recognition, and a variety of other issues. This flexibility means that we could have two firms that are economically identical but that, because of their different accounting policies, appear very different.
What does the net margin measure?
The percent of revenue that is retained as profit for the firm
Benchmarking
The process of completing a financial analysis to compare a firm's financial performance to that of other similar firms.
Which statement below is an example of how ratios are used in the field of finance?
A firm's ratios are compared with those of a benchmark peer group to determine the firm's relative strength and performance.
Five Major Categories of Financial Ratios: #5 Market
Are used to evaluate the current share price of a public firm's stock. These ratios are used by both current and potential investors to determine whether the firm's stock is undervalued or overvalued.
Why are several different types of ratios used to analyze a firm?
Because different types of ratios are needed to get information about different parts of a firm
Why are ratios considered flexible?
Because they are not regulated and can be changed or invented according to a firm's needs
The firm Betsy's Books conducts a financial analysis using ratios to know how it is performing in comparison to other similar firms. What is this process called?
Benchmarking
Current Ratio (a liquidity ratio) Formula
Current Ratio = Current Assists/Current Liabilities
Debt Ratio
Debt Ratio = Total Liabilities/Total Assets
What type of ratio is used to assess a firm's ability to meet short-term obligations without raising external capital?
Liquidity ratios
Liquidity Ratios
Liquidity ratios measure a firm's ability to meet short-term obligations and include the current ratio and quick ratio.
Market Ratios
Market ratios are a category of ratios that are used to value an entire company or the current price of a single share of its stock. They include the market-to-book ratio and the price-to-earnings ratio.
Market-to-Book Ratio (M/B Ratio)
Market-to-Book Ratio = Market Value of Equity/Book Value of Equity
Five Major Categories of Financial Ratios: #1 Liquidity
Measure a firm's ability to meet short-term obligations without raising external capital.
Three Main Comparison Methods used in Ratio Analysis: #3 Progress Measurement
Measure progress and achieve goals.
Net Margin
Net Margin = Net income/Sales
Which of these measures is a component of return on equity?
Net margin - Net margin, total asset turnover, and leverage multiplier are the components of return on equity.
Operating Margin
Operating Margin = EBIT/Sales
Price-to-Earnings Ratio (P/E Ratio)
Price-to Earnings Ratio = Price per Share/Earnings per Share
Four Reasons Ratios are Useful for Analyzing and Comparing Company Performance: #1 Standardization
Ratios standardize financial data, making it comparable across firms, even those of different sizes and scale. It also allows us to compare present company performance to performance in the past, despite the fact that the company may have changed in size over the years.
BigDog and SmallDog are two companies that have an identical return on equity. One difference between the two companies is that BigDog has 40% of assets financed by debt while SmallDog has 100% of assets financed by equity. What can you conclude about BigDog and SmallDog?
SmallDog has a higher ROA than BigDog. - Since SmallDog has no debt, the leverage multiplier of SmallDog is smaller than that of BigDog. Since both companies have the same ROE, SmallDog must have a higher ROA.
What is one way that a firm can improve its return on equity?
Successfully cutting production costs to boost net margin
Times Interest Earned (TIE)
TIE = EBIT/Interest Expense
The DuPont Equation indicates:
The DuPont equation indicates that return on equity is a function of operating efficiency, asset efficiency, and financing policy. Decomposing return on equity into its determinants allows us to understand how a firm generates the returns on equity.
What is the main difference between the current ratio and the quick ratio?
The current ratio includes inventory in current assets, and the quick ratio does not.
Total Asset Turnover (TAT)
Total Asset Turnover = Sales/Total Assets
Two Types of Firms in which Data Timing could be Problematic: #1 Seasonal Firms
are those that have high sales during one part of the year and low sales during another part of the year.
Current and quick ratios are different
because of potential illiquidity of inventory, and they are compared with liquidity ratios to assess how well a firm can meet short-term obligations.
Three Main Comparison Methods used in Ratio Analysis: #2 Cross-sectional Analysis
compares a firm's financial ratios with those of a peer group.
Return on equity is a
composition of the profitability, efficiency, and capital structure of a firm.
Leverage Ratios
consider how a firm is financed and how results from operations affect a firm's ability to fulfill its debt agreements and provide a return to its equity shareholders. They include the debt ratio, debt-to-equity ratio, and times interest earned.
There are five major types of financial ratios:
liquidity, activity, leverage, profitability, and market.
Three Main Comparison Methods used in Ratio Analysis: #1 Trend Analysis
looks at a firm's financial ratios over time. It compares the firm's performance this year with its performance in previous years.
Profitability ratios help you understand a company's
performance and cost efficiency and thereby measure a company's profitability.
Two Types of Firms in which Data Timing could be Problematic: #2 High-Growth Firms
the balance sheet is a snapshot of the firm's financial standing at one moment in time, while the income statement covers the firm's results over a period of time (usually one year). This discrepancy creates a problem for a firm that is growing at a very fast pace.
Both the market-to-book (M/B) and price-to-earnings (P/E) ratios are used
to assess whether a stock or a firm is correctly valued.
The DuPont framework helps analyze
where changes in return on equity come from.
The debt ratio tells us the capital structure of a firm,
while times interest earned (TIE) is used to assess a firm's ability to pay interest and long-term obligations.