Reading 26: Financial Analysis Techniques

Limitations of Ratios

1. Financial ratios are not useful when viewed in isolation. They are only informative when compared to those of other firms or to the company's historical performance. 2. Comparisons with other companies are made more difficult by different accounting treatments. This is particularly important when comparing U.S. firms to non-U.S. firms. 3. It is difficult to find comparable industry ratios when analyzing companies that operate in multiple industries. 4. Conclusions cannot be made by calculating a single ratio. All ratios must be viewed relative to one another. 5. Determining the target or comparison value for a ratio is difficult, requiring some range of acceptable values.

Uses of Ratios

1. Project future earnings and cash flow. 2. Evaluate a firm's flexibility (the ability to grow and meet obligations even when unexpected circumstances arise). 3. Assess management's performance. 4. Evaluate changes in the firm and industry over time. 5. Compare the firm with industry competitors.

Set of profitability ratios measure profitability relative to funds invested in the company by common stockholders, preferred stockholders, and suppliers of debt financing

1. Return on Assets 2. Operating Return on Assets 3. Return on Total Capital 4. Return on Equity 5. Return on Common Equity

Graphical Analysis

1. Stacked column graph 2. Line Graph

Tools used to convert financial statement data into analysis

1. ratio analysis 2. common-size analysis 3. graphical analysis 4. regression analysis

Net Income

= earnings after taxes but before dividends =Operating Profit (EBIT)-D&A-Interest Expenses-Income Tax Expense

Operating Profits

= earnings before interest and taxes = EBIT =Gross Profit-(Selling, General and Administrative Expenses) =Gross Profit- SG&A

Total Capital

= long-term debt + short-term debt + common and preferred equity or = total assets The difference between these two definitions of total capital is working capital liabilities, such as accounts payable. Some analysts consider these liabilities a source of financing for a firm and include them in total capital. Other analysts view total capital as the sum of a firm's debt and equity.

Gross Profits

= net sales - COGS Important term to know not a ratio

Return on Common Equity

=(Net Income Available to common shareholders)/Average common equity This ratio differs from the return on total equity in that it only measures the accounting profits available to, and the capital invested by, common stockholders, instead of common and preferred stockholders. That is why preferred dividends are deducted from net income in the numerator. Analysts should be concerned if this ratio is too low.

Retention Rate

=(net income available to common - dividends declared)/net income available to common The proportion of earnings reinvested

Business Segments

A business segment is a portion of a larger company that accounts for more than 10% of the company's revenues or assets, and is distinguishable from the company's other lines of business in terms of the risk and return characteristics of the segment

Value-at-risk

A common measure of capital risk is value-at-risk, which is an estimate of the dollar size of the loss that a firm will exceed only some specific percent of the time, over a specific period of time.

Estimating Revenues

A forecast of financial results that begins with an estimate of a firm's next-period revenues might use the most recent COGS, or an average of COGS, from a common-size income statement. On a common-size income statement, COGS is calculated as a percentage of revenue. If the analyst has no reason to believe that COGS in relation to sales will change for the next period, the COGS percentage from a common-size income statement can be used in constructing a pro forma income statement for the next period based on the estimate of sales

Inventory Turnover

A measure of a firm's efficiency with respect to its processing and inventory management is inventory turnover: inventory turnover=cost of goods sold/average inventory Pay careful attention to the numerator in the turnover ratios. For inventory turnover, be sure to use cost of goods sold, not sales.

Receivables Turnover

A measure of accounts receivable turnover is receivables turnover: receivables turnover=annual sales/average receivables It is considered desirable to have a receivables turnover figure close to the industry norm.

Debt-to-Equity Ratio

A measure of the firm's use of fixed-cost financing sources is the debt-to-equity ratio Increases and decreases in this ratio suggest a greater or lesser reliance on debt as a source of financing. Total debt is calculated differently by different analysts and different providers of financial information. Here, we will define it as long-term debt plus interest-bearing short-term debt Some analysts include the present value of lease obligations and/or non-interest-bearing current liabilities, such as trade payables

Payables Turnover

A measure of the use of trade credit by the firm is the payables turnover ratio. You can use the inventory equation to calculate purchases from the financial statements. Purchases = ending inventory - beginning inventory + cost of goods sold.

Debt-to-assets ratio

A slightly different way of analyzing debt utilization is the debt-to-assets ratio Increases and decreases in this ratio suggest a greater or lesser reliance on debt as a source of financing

Different Activity Ratios

Activity ratios (also known as asset utilization ratios or operating efficiency ratios) measure how efficiently the firm is managing its assets. 1. Receivables Turnover 2. Days of Sales Outstanding 3. Inventory Turnover 4. Days of inventory on hand 5. Payables Turnover 6. Number of Days of Payables 7. Total Asset Turnover 8. Fixed Asset Turnover 9. Working Capital Turnover

DuPont System of Analysis

An approach that can be used to analyze return on equity (ROE). It uses basic algebra to break down ROE into a function of different ratios, so an analyst can see the impact of: 1. leverage, 2. profit margins 3. turnover on shareholder returns There are two variants of the DuPont system: The original three-part approach and the extended five-part system

Gross Profit Margin

An operating profitability ratio The ratio of gross profit (sales less cost of goods sold) to sales An analyst should be concerned if this ratio is too low. Gross profit can be increased by raising prices or reducing costs. However, the ability to raise prices may be limited by competition.

Defensive Interval Ratio

Another measure of liquidity that indicates the number of days of average cash expenditures the firm could pay with its current liquid assets. Expenditures here include cash expenses for costs of goods, SG&A, and research and development. If these items are taken from the income statement, noncash charges such as depreciation should be added back just as in the preparation of a statement of cash flows by the indirect method.

Debt-to-Capital Ratio

Another way of looking at the usage of debt is the debt-to-capital ratio Capital equals all short-term and long-term debt plus preferred stock and equity. Increases and decreases in this ratio suggest a greater or lesser reliance on debt as a source of financing

horizontal common-size balance sheet or income statement

Another way to present financial statement data that is quite useful when analyzing trends over time is a horizontal common-size balance sheet or income statement. The divisor here is the first-year values, so they are all standardized to 1.0 by construction Trends in the values of these items, as well as the relative growth in these items, are readily apparent from a horizontal common-size balance sheet.

Reserve Requirements

Banks are subject to minimum reserve requirements. Their ratios of various liabilities to their central bank reserves must be above the minimums.

Banks, insurance companies, and other financial firm

Banks, insurance companies, and other financial firms carry their own challenges for analysts. Part of the challenge is to understand the commonly used terms and the ratios they represent 1. Capital Adequacy 2. Value-at-risk 3. Reserve Requirements -Liquid Asset Requirement 4. Net Interest Margin

Basic EPS

Basic EPS is net income available to common divided by the weighted average number of common shares outstanding.

Regression Analysis

Can be used to identify relationships between variables. The results are often used for forecasting. For example, an analyst might use the relationship between GDP and sales to prepare a sales forecast.

Capital Adequacy

Capital adequacy typically refers to the ratio of some dollar measure of the risk, both operational and financial, of the firm to its equity capital

Common-Size Analysis

Common-size statements normalize balance sheets and income statements and allow the analyst to more easily compare performance across firms and for a single firm over time. 1. A vertical common-size balance sheet expresses all balance sheet accounts as a percentage of total assets. 2. A vertical common-size income statement expresses all income statement items as a percentage of sales. common-size analysis doesn't tell an analyst the whole story about this company, but can certainly point the analyst in the right direction to find out the circumstances that led to the increase in the net profit margin and to determine the effects, if any, on firm cash flow going forward.

Credit Analysis

Credit analysis is based on many of the ratios that we have already covered in this review. In assessing a company's ability to service and repay its debt, analysts use interest coverage ratios (calculated with EBIT or EBITDA), return on capital, and debt-to-assets ratios. Other ratios focus on various measures of cash flow to total debt. Ratios have been used to analyze and predict firm bankruptcies. Altman (2000)1 developed a Z-score that is useful in predicting firm bankruptcies (a low score indicates high probability of failure). The predictive model was based on a firm's working capital to assets, retained earnings to assets, EBIT to assets, market to book value of a share of stock, and revenues to assets

Total Asset Turnover Ratios By Industry

Different types of industries might have considerably different turnover ratios. Manufacturing businesses that are capital-intensive might have asset turnover ratios near one, while retail businesses might have turnover ratios near 10. It is desirable for the total asset turnover ratio to be close to the industry norm. Low asset turnover ratios might mean that the company has too much capital tied up in its asset base. A turnover ratio that is too high might imply that the firm has too few assets for potential sales, or that the asset base is outdated.

Diluted EPS

Diluted EPS is a "what if" value. It is calculated to be the lowest possible EPS that could have been reported if all firm securities that can be converted into common stock, and that would decrease basic EPS if they had been, were converted. -That is, if all dilutive securities had been converted. Potentially dilutive securities include convertible debt and convertible preferred stock, as well as options and warrants issued by the company. The numerator of diluted EPS is increased by the after-tax interest savings on any dilutive debt securities and by the dividends on any dilutive convertible preferred stock. The denominator is increased by the common shares that would result from conversion or exchange of dilutive securities into common shares.

Dividends

Dividends are declared on a per-common-share basis Neither EPS nor net income is reduced by the payment of common stock dividends. Net income minus dividends declared is retained earnings, the earnings that are used to grow the corporation rather than being distributed to equity holders

Interest Coverage Ratio

EBIT=Earnings before interest and taxes The lower this ratio, the more likely it is that the firm will have difficulty meeting its debt payments

Geographic Segments

Geographic segments are also identified when they meet the size criterion above and the geographic unit has a business environment that is different from that of other segments or the remainder of the company's business.

restaurant and retail industries

Growth in same-store sales is used in the restaurant and retail industries to indicate growth without the effects of new locations that have been opened. It is a measure of how well the firm is doing at attracting and keeping existing customers and, in the case of locations with overlapping markets, may indicate that new locations are taking customers from existing ones. Sales per square foot is another metric commonly used in the retail industry

Fixed Charge Coverage Ratio

Here, lease payments are added back to operating earnings in the numerator and also added to interest payments in the denominator. Significant lease obligations will reduce this ratio significantly compared to the interest coverage ratio. Fixed charge coverage is the more meaningful measure for companies that lease a large portion of their assets, such as some airlines.

Working Capital Turnover

How effectively a company is using its working capital is measured by the working capital turnover ratio =Revenue/Average Working Capital Working capital (sometimes called net working capital) is current assets minus current liabilities. The working capital turnover ratio gives us information about the utilization of working capital in terms of dollars of sales per dollar of working capital. Some firms may have very low working capital if outstanding payables equal or exceed inventory and receivables. -In this case the working capital turnover ratio will be very large, may vary significantly from period to period, and is less informative about changes in the firm's operating efficiency

Fixed Asset Turnover

The utilization of fixed assets is measured by the fixed asset turnover ratio It is desirable to have a fixed asset turnover ratio close to the industry norm. Low fixed asset turnover might mean that the company has too much capital tied up in its asset base or is using the assets it has inefficiently. A turnover ratio that is too high might imply that the firm has obsolete equipment, or at a minimum, that the firm will probably have to incur capital expenditures in the near future to increase capacity to support growing revenues. Since "net" here refers to net of accumulated depreciation, firms with more recently acquired assets will typically have lower fixed asset turnover ratios

Activity Ratios

This category includes several ratios also referred to asset utilization or turnover ratios (e.g., inventory turnover, receivables turnover, and total assets turnover). They often give indications of how well a firm utilizes various assets such as inventory and fixed assets.

Return on Total Capital (ROTC)

Total capital includes short- and long-term debt, preferred equity, and common equity. Analysts should be concerned if this ratio is too low. An alternative method for computing ROTC is to include the present value of operating leases on the balance sheet as a fixed asset and as a long-term liability. -This adjustment is especially important for firms that are dependent on operating leases as a major form of financing.

Dividends Declared

Total dividends on a firm-wide basis are referred to as dividends declared

Analyzing Segment Data

U.S. GAAP and IFRS require companies to report segment data, but the required disclosure items are only a subset of the required disclosures for the company as a whole. Nonetheless, an analyst can prepare a more detailed analysis and forecast by examining the performance of business or geographic segments separately. Segment profit margins, asset utilization (turnover), and return on assets can be very useful in gaining a clear picture of a firm's overall operations. For forecasting, growth rates of segment revenues and profits can be used to estimate future sales and profits and to determine the changes in company characteristics over time.

Return on Assets (ROA) using Net Income

Using Net Income is a bit misleading, however, because interest is excluded from net income but total assets include debt as well as equity. Adding interest adjusted for tax back to net income puts the returns to both equity and debt holders in the numerator. The interest expense that should be added back is gross interest expense, not net interest expense (which is gross interest expense less interest income). This results in an adjusted calculation for ROA

Price per share ratios

Valuation ratios are used in analysis for investment in common equity. The most widely used valuation ratio is the price-to-earnings (P/E) ratio, the ratio of the current market price of a share of stock divided by the company's earnings per share. Related measures based on price per share are the price-to-cash flow, the price-to-sales, and the price-to-book value ratios.

Trick with left to right or right to left presentation

We have presented data in Figure 26.1 with information for the most recent period on the left, and in Figure 26.2 we have presented the historical values from left to right. Both presentation methods are common, and on the exam you should pay special attention to which method is used in the data presented for any question.

Turnover Ratios for a quarter instead of a year

We have shown days calculations for payables, receivables, and inventory based on annual turnover and a 365-day year. If turnover ratios are for a quarter rather than a year, the number of days in the quarter should be divided by the quarterly turnover ratios in order to get the "days" form of these ratios.

Common-Size Analysis for Financial Ratios

In addition to comparisons of financial data across firms and time, common-size analysis is appropriate for quickly viewing certain financial ratios. For example, the gross profit margin, operating profit margin, and net profit margin are all clearly indicated within a common-size income statement. Vertical common-size income statement ratios are especially useful for studying trends in costs and profit margins. 1. vertical common-size income statement ratios = income statement account/sales Balance sheet accounts can also be converted to common-size ratios by dividing each balance sheet item by total assets. 2. vertical common-size balance-sheet ratios =balance sheet account/total assets

Averages of Balance Sheet Items

In most cases when a ratio compares a balance sheet account (such as receivables) with an income or cash flow item (such as sales), the balance sheet item will be the average of the account instead of simply the end-of-year balance. Averages are calculated by adding the beginning-of-year account value to the end-of-year account value, then dividing the sum by two.

Variety in Definitions of Ratios

It is important to understand that the definitions of ratios can vary widely among the analytical community. For example, some analysts use all liabilities when measuring leverage, while other analysts only use interest-bearing obligations. Consistency is paramount. Analysts must also understand that reasonable values of ratios can differ among industries.

Liquidity Ratios

Liquidity here refers to the ability to pay short-term obligations as they come due.

Different Liquidity Ratios

Liquidity ratios are employed by analysts to determine the firm's ability to pay its short-term liabilities. 1. Current Ratio 2. Quick Ratio 3. Cash Ratio 4. Defensive Interval Ratio 5. Cash Conversion Cycle

Tax Burden

Net Income / EBT An increase in interest expense as proportion of EBIT will increase the interest burden (i.e., decrease the interest burden ratio). Increases in either the tax burden or the interest burden (i.e., decreases in the ratios) will tend to decrease ROE.

values in the common-size financial statements as ratios

Net income is shown on the common-size income statement as net income/revenues, which is the net profit margin, and tells the analyst the percentage of each dollar of sales that remains for shareholders after all expenses related to the generation of those sales are deducted. One measure of financial leverage, long-term debt to total assets, can be read directly from the vertical common-size financial statements

How terms relate to the income statement

Net sales -Cost of goods sold =Gross profit -Operating expenses =Operating profit (EBIT) -Interest =Earnings before taxes (EBT) -Taxes =Earnings after taxes (EAT) +/-Below the line items adjusted for tax =Net income -Preferred dividends =Income available to common shareholders

Implications of Extended DuPont Formula

Note that in general, high profit margins, leverage, and asset turnover will lead to high levels of ROE. However, this version of the formula shows that more leverage does not always lead to higher ROE. As leverage rises, so does the interest burden. Hence, the positive effects of leverage can be offset by the higher interest payments that accompany more debt. Note that higher taxes will always lead to lower levels of ROE.

Extended DuPont Equation

Note that the first term in the 3-part DuPont equation, net profit margin, has been decomposed into three terms: 1. Tax Burden= (Net Income/EBT) 2. Interest Burden=(EBT/EBIT) 3. EBIT Margin=(EBIT/Revenue) We then have: ROE=(tax burden)(interest burden)(EBIT margin)(asset turnover)(financial leverage) EBIT in the second two expressions can be replaced by operating earnings. In this case, we have the operating margin rather than the EBIT margin. The interest burden term would then show the effects of nonoperating income as well as the effect of interest expense.

Professors Note on Original DuPont Method

Often candidates get confused and think the DuPont method is a way to calculate ROE. While you can calculate ROE given the components of either the original or extended DuPont equations, this isn't necessary if you have the financial statements. If you have net income and equity, you can calculate ROE. The DuPont method is a way to decompose ROE, to better see what changes are driving the changes in ROE.

Other Per share measures

Other per-share measures include cash flow per share, EBIT per share, and EBITDA per share. Per share measures are not comparable because the number of outstanding shares differ among firms. For example, assume Firm A and Firm B both report net income of $100. If Firm A has 100 shares outstanding, its EPS is $1 per share. If Firm B has 20 shares outstanding, its EPS is $5 per share

Net Interest Margin

Performance of financial companies that lend funds is often summarized as the net interest margin, which is simply interest income divided by the firm's interest-earning assets.

Different Profitability Ratios

Profitability ratios measure the overall performance of the firm relative to revenues, assets, equity, and capital 1. Net Profit Margin 2. Operating Profitability Ratios

Profitability Ratios

Profitability ratios provide information on how well the company generates operating profits and net profits from its sales.

Cash Conversion Cycle

The length of time it takes to turn the firm's cash investment in inventory back into cash, in the form of collections from the sales of that inventory computed from days sales outstanding, days of inventory on hand, and number of days of payables High cash conversion cycles are considered undesirable. -A conversion cycle that is too high implies that the company has an excessive amount of capital investment in the sales process.

Leverage Ratio

The leverage ratio is sometimes called the "equity multiplier."

Cash Ratio

The most conservative liquidity measure The higher the cash ratio, the more likely it is that the company will be able to pay its short-term bills. The current, quick, and cash ratios differ only in the assumed liquidity of the current assets that the analyst projects will be used to pay off current liabilities.

Sustainable Growth Rate

The proportion of a firm's net income that is retained to fund growth is an important determinant of the firm's sustainable growth rate. To estimate the sustainable growth rate for a firm, the rate of return on resources is measured as the return on equity capital, or the ROE. The proportion of earnings reinvested is known as the retention rate (RR).

Quick Ratio

The quick ratio is a more stringent measure of liquidity than the current ratio because it does not include inventories and other assets that might not be very liquid The higher the quick ratio, the more likely it is that the company will be able to pay its short-term bills. Marketable securities are short-term debt instruments, typically liquid and of good credit quality.

Liquid Asset Requirements

The ratio of a bank's liquid assets to certain liabilities is called the liquid asset requirement

CV Sales

coefficient of variation of sales

Types of Financial Ratios

1. Activity Ratios 2. Liquidity Ratios 3. Solvency Ratios 4. Profitability Ratios 5. Valuation Ratios These categories are not mutually exclusive. An activity ratio such as payables turnover may also provide information about the liquidity of a company, for example. There is no one standard set of ratios for financial analysis. -Different analysts use different ratios and different calculation methods for similar ratios. -Some ratios are so commonly used that there is very little variation in how they are defined and calculated.

Per-Share Valuation Measures

1. EPS 2. Diluted EPS 3. cash flow per share 4. EBIT per Share 5. EBITDA per Share

Ratios for Forecasting

Ratio analysis can be used in preparing pro forma financial statements that provide estimates of financial statement items for one or more future periods. A forecast of financial results that begins with an estimate of a firm's next-period revenues might use the most recent COGS, or an average of COGS, from a common-size income statement. On a common-size income statement, COGS is calculated as a percentage of revenue. If the analyst has no reason to believe that COGS in relation to sales will change for the next period, the COGS percentage from a common-size income statement can be used in constructing a pro forma income statement for the next period based on the estimate of sales. Similarly, the analyst may believe that certain ratios will remain the same or change in one direction or the other for the next period. In the absence of any information indicating a change, an analyst may choose to incorporate the operating profit margin from the prior period into a pro forma income statement for the next period. Beginning with an estimate of next-period sales, the estimated operating profit margin can be used to forecast operating profits for the next period. Rather than point estimates of sales and net and operating margins, the analyst may examine possible changes in order to create a range of possible values for key financial variables. Three methods of examining the variability of financial outcomes around point estimates are: sensitivity analysis, scenario analysis, and simulation. Sensitivity analysis is based on "what if" questions such as: What will be the effect on net income if sales increase by 3% rather than the estimated 5%? Scenario analysis is based on specific scenarios (a specific set of outcomes for key variables) and will also yield a range of values for financial statement items. Simulation is a technique in which probability distributions for key variables are selected and a computer is used to generate a distribution of values for outcomes based on repeated random selection of values for the key variables.

Ratio Analysis

Ratios are useful tools for expressing relationships among data that can be used for internal comparisons and comparisons across firms. They are often most useful in identifying questions that need to be answered, rather than answering questions directly

Valuation Ratios

Sales per share, earnings per share, and price to cash flow per share are examples of ratios used in comparing the relative valuation of companies.

Solvency Ratios

Solvency ratios give the analyst information on the firm's financial leverage and ability to meet its longer-term obligations.

Different Solvency Ratios

Solvency ratios measure a firm's financial leverage and ability to meet its long-term obligations. Solvency ratios include various debt ratios that are based on the balance sheet and coverage ratios that are based on the income statement 1. Debt-to-equity ratio 2. Debt-to-capital ratio 3. Debt-to-assets ratio 4. Financial leverage The remaining risk ratios help determine the firm's ability to repay its debt obligations 5. Interest Coverage 6. Fixed Charge Coverage With all solvency ratios, the analyst must consider the variability of a firm's cash flows when determining the reasonableness of the ratios. Firms with stable cash flows are usually able to carry more debt.

Ratios for service and consulting companies

Some ratios have specific applications in certain industries. 1. Net income per employee 2. sales per employee

Pretax Margin

Sometimes profitability is measured using earnings before tax (EBT), which can be calculated by subtracting interest from EBIT or from operating earnings.

Measuring Business Risk

Standard deviation of revenue, standard deviation of operating income, and the standard deviation of net income are all indicators of the variation in and the uncertainty about a firm's performance Since they all depend on the size of the firm to a great extent, analysts employ a size-adjusted measure of variation. The coefficient of variation for a variable is its standard deviation divided by its expected value Different industries have different levels of uncertainty about revenues, expenses, taxes, and nonoperating items. Comparing coefficients of variation for a firm across time, or among a firm and its peers, can aid the analyst in assessing both the relative and absolute degree of risk a firm faces in generating income for its investors

Total Asset Turnover

The effectiveness of the firm's use of its total assets to create revenue is measured by its total asset turnover =Revenue/Average Total Assets

Formula for Sustainable Growth Rate

The formula for the sustainable growth rate, which is how fast the firm can grow without additional external equity issues while holding leverage constant, is RR*ROE

Current Ratio

The higher the current ratio, the more likely it is that the company will be able to pay its short-term bills. A current ratio of less than one means that the company has negative working capital and is probably facing a liquidity crisis. Working capital equals current assets minus current liabilities.

Days of Inventory on Hand

The inverse of the inventory turnover times 365 is the average inventory processing period, number of days of inventory, or days of inventory on hand. it is considered desirable to have days of inventory on hand (and inventory turnover) close to the industry norm. A processing period that is too high might mean that too much capital is tied up in inventory and could mean that the inventory is obsolete. A processing period that is too low might indicate that the firm has inadequate stock on hand, which could hurt sales.

Number of Days of Payables

The inverse of the payables turnover ratio multiplied by 365 is the payables payment period or number of days of payables, which is the average amount of time it takes the company to pay its bills.

Days of Sales Outstanding

The inverse of the receivables turnover times 365 is the average collection period, or days of sales outstanding, which is the average number of days it takes for the company's customers to pay their bills: days of sales outstanding=365/receivables turnover It is considered desirable to have a collection period (and receivables turnover) close to the industry norm. The firm's credit terms are another important benchmark used to interpret this ratio. A collection period that is too high might mean that customers are too slow in paying their bills, which means too much capital is tied up in assets. A collection period that is too low might indicate that the firm's credit policy is too rigorous, which might be hampering sales

Financial Leverage Ratio

an indicator of a company's use of debt financing Average here means the average of the values at the beginning and at the end of the period. Greater use of debt financing increases financial leverage and, typically, risk to equity holders and bondholders alike

Operating Profitability Ratios

look at how good management is at turning their efforts into profits. Operating ratios compare the top of the income statement (sales) to profits. The different ratios are designed to isolate specific costs.

Operating Return on Assets

measure of return on assets that includes both taxes and interest in the numerator

Original DuPont Equation (ROE)

start with ROE defined as: return on equity=(net income/average equity) Average or year-end values for equity can be used. Multiplying ROE by (revenue/revenue) and rearranging terms produces: return on equity = (net income/revenue)(revenue/average equity) The first term is the profit margin, and the second term is the equity turnover: return on equity = (net profit margin)(equity turnover) We can expand this further by multiplying these terms by (assets/assets), and rearranging terms: return on equity = (net income/revenue)(revenue/average total assets)(average total assets/equity) This is arguably the most important equation in ratio analysis, since it breaks down a very important ratio (ROE) into three key components. If ROE is relatively low, it must be that at least one of the following is true: 1. The company has a poor profit margin 2. the company has poor asset turnover 3. the firm has too little leverage.

Return on Equity (ROE)

the ratio of net income to average total equity (including preferred stock) Analysts should be concerned if this ratio is too low. It is sometimes called return on total equity The return on common equity is often more thoroughly analyzed using the DuPont decomposition

Net Profit Margin

the ratio of net income to revenue. Analysts should be concerned if this ratio is too low. The net profit margin should be based on net income from continuing operations, because analysts should be primarily concerned about future expectations, and below-the-line items such as discontinued operations will not affect the company in the future.

Operating Profit Margin

the ratio of operating profit (gross profit less selling, general, and administrative expenses) to sales. Operating profit is also referred to as earnings before interest and taxes (EBIT) Remember net sales=revenue EBIT includes some nonoperating items, such as gains on investment. The analyst, as with other ratios with various formulations, must be consistent in his calculation method and know how published ratios are calculated. Analysts should be concerned if this ratio is too low. Some analysts prefer to calculate the operating profit margin by adding back depreciation and any amortization expense to arrive at earnings before interest, taxes, depreciation, and amortization (EBITDA)