FIN300 - Chapter 5
Summary Analysis: Trend and Industry Comparisons Together
A complete ratio analysis of a company combines both trend analysis and industry comparisons. Table 5-3 shows all the ratios presented in this chapter for Acme Corporation for 2017 through 2021, along with the industry averages for those ratios. (The industry averages are labeled IND in the table.) ** Managers inside the company can use the results of the analysis to support proposed changes in operations or organization; and creditors and investors outside the company can use the results to support decisions about lending money to the company or buying its stock.
Financial Ratio
A number that expresses the value of one financial variable relative to the value of another. (a financial ratio is the result you get when you divide one financial number by another.)
Pendell Company has total sales of $4 million. One-fourth of these are credit sales. The amount of accounts receivable is $100,000. What is the average collection period for the company? Use a 365-day year.
Average Collection Period = Accounts Receivable/Average Daily Credit Sales Credit sales = $4,000,000 ÷ 4 = $1,000,000 Average collection period = accounts receivable ÷ average daily credit sales = $100,000 Accounts receivable ÷ ($1,000,000 annual credit sales ÷ 365 days per year) = 36.5 days
Asset Activity Ratios (1)
Average Collection Period = Accounts Receivable/Average Daily Credit Sales Inventory Turnover = Sales/Inventory Total Asset Turnover = Sales/Total Assets
Weenie Hut Corporation has annual credit sales equal to $5 million, and its accounts receivable account is $500,000. Calculate the company's average collection period.
Average collection period = 365 / Accounts receivable turnover Accounts receivable turnover = Annual credit sales / Accounts receivable = $5,000,000/$500,000 = 10 Average collection period = 365 days / 10 = 36.5 days
The following data apply to Bikini Bottom Corporation: Total Common Stock Equity at Year-End 2021 $4,500,000 Number of Common Shares Outstanding 650,000 Market Price per Share $25 Calculate the following: a. Book value per share b. Market to book value ratio
Book Value Per Share = Total common stock equity book value/Number of common shares outstanding = $4,500,000/650,000 = $6.92 Market to Book Value = Market Price per Share/Book Value per Share = $25/$6.92 = $3.61
Calculating the Ratios
Calculate a company's profitability, liquidity, debt, asset utilization, and market value ratios.
In 2021, Rock Bottom had sales of $35 million. Its current assets are $15 million, $12 million is in cash, accounts receivable are $600,000, and net fixed assets are $20 million. What is Rock Bottom's inventory turnover? What is its total asset turnover?
Cash $12,000,000.00 Accounts Receivables $ 600,000.00 Inventory (difference) $2,400,000.00 Total Current Assets $15,000,000.00 Net Fixed Assets $20,000,000.00 Total Assets $35,000,000.00 Inventory Turnover = Sales/Inventory = $35,000,000/$2,400,000 14.58 times Total Asset Turnover = Sales/Total Assets = $35,000,000/35,000,000 1.00 times
Francisco Company has current assets of $50,000. Total assets are $200,000; and long-term liabilities and common stock collectively total $180,000. What is the value of the current ratio?
Current Ratio = Current Assets/Current Liabilities Current liabilities = $200,000 Total assets - $180,000 LTD & CS = $20,000 $50,000 current assets / $20,000 current liabilities = 2.5 current ratio
Liquidity Ratios (1)
Current Ratio = Current Assets/Current Liabilities Quick Ratio = Current Assets less Inventory/Current Liabilities
Bob has notes payable of $500, long-term debt of $1,900, inventory of $900, total current assets of $5,000, accounts payable of $850, and accrued expenses of $600. What is Bob's current ratio? What is its quick ratio?
Current Ratio =Total current assets/ ( Notes payable +Accounts payable + Accrued expenses) Current Ratio = 5000/(500 +850+600) = 2.56 times Quick Ratio = (current assets - Inventory)/current liabilities Quick Ratio =(5000-900)/(500+850+600) =2.10 times
Yates Corporation has total assets of $500,000. Its equity is $200,000. What is the company's debt to total asset ratio?
Debt to Total Assets = Total Debt/Total Assets Debt = $500,000 Assets - $200,000 equity = $300,000 $300,000 debt ÷ $500,000 assets = .6 = 60% debt to total asset ratio
Debt Ratios (1)
Debt to Total Assets = Total Debt/Total Assets Times Interest Earned = EBIT/Interest Expense
Sheth Corporation has a return on assets ratio of 6 percent. If the debt to total assets ratio is .5, what is the firm's return on equity?
Debt/assets = .5, therefore equity/assets = .5, therefore assets/equity = 1 /.5 = 2 ROE = ROA × (A/E) = .06 × 2 = .12, or 12%
TAKE NOTE (1)
Do not confuse the ROE ratio with the return earned by the individual common stockholders on their common stock investment. The changes in the market price of the stock and dividends received determine the total return on an individual's common stock investment.
TAKE NOTE (2)
Do not fall into the trap of thinking that a company does not have problems just because its ratios are equal to the industry averages. Maybe the whole industry is in a slump! When a ratio equals the industry average it simply means the company is average in the area that ratio measures.
Economic Value Added (EVA) & Market Value Added (MVA) Ratios
EVA = EBIT(1 - TR) - (IC × Ka) MVA = market value of debt plus equity - book value debt plus equity
Trend Analysis and Industry Comparisons
* Comparing a ratio for one year with the same ratio for other years is known as trend analysis. * Comparing a ratio for one company with the same ratio for other companies in the same industry is industry comparison.
USE of Ratios
- Creditors may use ratios to see whether a business will have the cash flow to repay its debt and interest. - Stockholders may use ratios to see what the long-term value of their stock will be.
Trend Analysis
- helps financial managers and analysts see whether a company's current financial situation is improving or deteriorating. * To prepare a trend analysis, compute the ratio values for several time periods (usually years) and compare them. Trend analysis is an invaluable part of ratio analysis. - It helps management spot a deteriorating condition and take corrective action, or identify the company's strengths.
Two (2) main liquidity ratios are
1) Current ratio Current Assets / Current Liabilities 2) Quick ratio (Current Assets - Inventory) / Current Liabilities
Economic Value Added (EVA) Formula
EVA = EBIT(1 - TR) - (IC × Ka) where EBIT = earnings before interest and taxes (i.e., operating income) TR = the effective or average income tax rate IC = invested capital Invested capital (IC) is the total amount of capital invested in the company. It is the sum of the market values of the firm's equity and debt capital. Ka = investors' required rate of return on their investment Ka is the weighted average of the rates of return expected by the suppliers of the firm's capital, sometimes called the weighted average cost of capital, or WACC.
Debt Ratios
Financial analysts use debt ratios to assess the relative size of a firm's debt load and the firm's ability to pay off the debt. Three (3) primary debt ratios are: 1) debt to total assets, 2) debt to equity, and 3) times interest earned ratios. ** optimal debt ratio depends on many factors, including the type of business and the amount of risk lenders and stockholders will tolerate. ** Generally, a profitable firm in a stable business can handle more debt—and a higher debt ratio—than a firm in a volatile business that sometimes records losses on its income statement.
Basic Financial Ratios
Generally divided into five categories: profitability, liquidity, debt, asset activity, and market value. 1) Profitability ratios measure how much company revenue is eaten up by expenses, how much a company earns relative to sales generated, and the amount earned relative to the value of the firm's assets and equity. 2) Liquidity ratios indicate how quickly and easily a company can obtain cash for its needs. 3) Debt ratios measure how much a company owes to others. 4) Asset activity ratios measure how efficiently a company uses its assets. 5) Market value ratios measure how the market value of a company's stock compares with its accounting values.
The 2021 income statement for TeleTech is shown here: Net Sales $35,000,000 Cost of Goods Sold 15,000,000 Gross Profit 20,000,000 Selling and Admin. Expenses 1,000,000 Depreciation Expense 3,000,000 Operating Income (EBIT) 16,000,000 Interest Expense 2,500,000 Income before Taxes (EBT) 13,500,000 Taxes (25%) 3,375,000 Net Income 10,125,000 Calculate the following: a. Gross profit margin b. Operating profit margin c. Net profit margin
Gross Profit Margin = (Gross Profit / Net Sales) * 100 Gross Profit = $20,000,000 (Given) Net Sales = $35,000,000 (Given) Therefore, Gross Profit Margin = ($20,000,000 / $35,000,000) * 100 = 0.571428 * 100 = 57.1428% = 57.14% (Rounded off to two decimal places) Operating Profit Margin = (Operating Profit / Net Sales) * 100 Operating Profit or (Operating Income) = $16,000,000 (Given) Net Sales = $35,000,000 (Given) Therefore, Operating Profit Margin = ($16,000,000 / $35,000,000) * 100 = 0.457142 * 100 = 45.7142% = 45.71% (Rounded off to two decimal places) Net Profit Margin = (Net Profit / Net Sales) * 100 Net Profit or (Net Income) = $10,125,000 (Given) Net Sales = $35,000,000 (Given) Therefore, Net Profit Margin = ($10,125,000 / $35,000,000) * 100 = 0.289285 * 100 = 28.9285% = 28.93% (Rounded off to two decimal places)
Profitability Ratios (1)
Gross Profit Margin = Gross Profit/Sales Operating Profit Margin = EBIT/Sales Net Profit Margin = Net Income/Sales
Mitra Company has a quick ratio value of 1.5. It has total current assets of $100,000 and total cur-rent liabilities of $25,000. If sales are $200,000, what is the value of the inventory turnover ratio?
Inventory Turnover = Sales/Inventory ($100,000 current assets - inventory) ÷ $25,000 = 1.5 quick ratio, therefore inventory = $62,500 $200,000 sales ÷ $62,500 inventory = 3.2 inventory turnover ratio
Market Value Added (MVA) Formula
Market value added (MVA) is the market value of invested capital (IC), minus the book value of IC MVA = . market value of debt plus equity - book value debt plus equity - MVA is similar to the market to book ratio (M/B). MVA focuses on total market value and total invested capital.
Modified Du Pont Equation (formula)
Modified Du Pont Equation Return on Equity = Net Profit Margin × Total Asset Turnover × Equity Multiplier
De Marco Corporation has total assets of $5 million and an asset turnover ratio of 4. If net income is $2 million, what is the value of the net profit margin?
Net Profit Margin = Net Income/Sales Sales/$5,000,000 = 4, therefore Sales = $20,000,000 $2,000,000 net income / $20,000,000 sales = .1 = 10% net profit margin
Market Value Ratios (1)
PE Ratio = Market Price per Share/Earnings per Share Market-to-Book Ratio = Market Price per Share/Book Value per Share
If one-half the current assets in ST-2 consist of inventory, what is the value of the quick ratio?
Quick Ratio = (Current Assets - Inventory)/Current Liabilities Current assets - inventory = $50,000 - (.5 × $50,000) = $25,000 $25,000 / $20,000 current liabilities = 1.25 quick ratio
Ratios are comparative measures
Ratios may be used to compare: - one ratio to a related ratio - the firm's performance to management's goals - the firm's past and present performances - the firm's performance to similar firms
Du Pont Equation (ROA)
Return on Assets = Net Profit Margin × Total Asset Turnover * Du Pont equation helps us analyze factors that contribute to a firm's return on assets.
Economic Value Added (EVA)
The amount of profit remaining after accounting for the return expected by the firm's investors. - "estimate of true economic profit, or the amount by which earnings exceed or fall short of the required minimum rate of return investors could get investing in other securities of comparable risk."
Mixing Numbers from Income Statements and Balance Sheets
When financial managers calculate the gross profit margin, operating profit margin, and net profit margin ratios, they use only income statement variables. In contrast, analysts use both income statement and balance sheet variables to find the return on assets and re-turn on equity ratios. A mixed ratio is a ratio that uses both income statement and balance sheet variables as inputs.
What is a financial ratio?
a comparison between two components of financial information
Financial managers
assess the health of businesses. - run basic tests—such as a financial ratio analysis—to see whether a firm's performance is within the normal range for a company of that type. - use ratio analysis to interpret the raw numbers on financial statements.
Industry Comparisons
compare a firm's ratios with the ratios of other firms in the industry (this is sometimes called cross-sectional analysis, or benchmarking) ** pinpoints deviations from the norm that may indicate problems. Benchmarking allows analysts to put the value of a firm's ratio in the context of its industry.
Current Ratio
compares all the current assets of the firm (cash and other assets that can be quickly and easily converted to cash) with all the company's current liabilities (liabilities that must be paid with cash soon). Current Ratio = Current Assets / Current Liabilities
Market Value Added (MVA)
compares the firm's current value with the amount the current owners paid for it. - the excess of the market value of equity over its book value.
Debt to Total Assets Ratio
debt to total assets ratio measures the percentage of the firm's assets that is financed with debt. Total Debt/Total Assets
Asset activity ratios tell how ______ a firm is in using its assets to generate profits.
efficiently
Misleading Numbers
financial statements do not show everything, potential liabilities that do not show up on the financial statements. * financial managers using ratio analysis must always seek complete information when conducting a financial analysis.
Five profitability ratios
five profitability ratios: 1) gross profit margin, 2) operating profit margin, 3) net profit margin, 4) return on assets, and 5) return on equity.
Return on Assets Ratio
indicates how much income each dollar of assets produces on average. It shows whether the business is employing its assets effectively. Formula: dividing net income by the total assets of the firm. Return on Assets = Net Income / Total Assets * not unusual for certain types of companies, such as commercial banks, to have low ROA ratios.
Equity Multiplier (EM)
indicates the amount of financial leverage a firm has. A firm that uses only equity to finance its assets should have an equity multiplier that equals 1.0. To arrive at this conclusion, recall the basic accounting formula—total assets = liabilities + equity. If a firm had no debt on its balance sheet, its liabilities would equal zero, so equity would equal total assets. If equity equaled total assets, then the equity multiplier would be 1. Multiplying 1 times any other number has no effect, so in such a situation ROE would depend solely on net profit margin and total asset turnover.
Quick Ratio
is similar to the current ratio but is a more rigorous measure of liquidity because it excludes inventory from current assets. Quick Ratio - (Current Assets - Inventory) / Current Liabilities
Market Value Ratios
mainly rely on financial marketplace data, such as the market price of a company's common stock. - Market value ratios measure the market's perception of the future earning power of a company, as reflected in the stock share price. Two (2) market value ratios are: 1) the price to earnings ratio, and 2) the market to book value ratio.
Market to Book Value Ratio
market price per share of a company's common stock divided by the accounting book value per share (BPS) ratio. The book value per share ratio is the amount of common stock equity on the firm's balance sheet divided by the number of common shares outstanding. - book value per share is a proxy for the amount remaining per share after selling the firm's assets for their balance sheet values and paying the debt owed to all creditors and preferred stockholders. Market to Book Value Ratio = Market Price per Share / Book Value per Share - When the market price per share of stock is greater than the book value per share, analysts often conclude that the market believes the company's future earnings are worth more than the firm's liquidation value. - The higher the M/B ratio, when it is greater than 1, the greater the going concern value of the company seems to be. - Companies that have a market to book value of less than 1 are sometimes considered to be "worth more dead than alive." Such an M/B ratio suggests that if the company liquidated and paid off all creditors, it would have more left over for the common stockholders than what the common stock could be sold for in the marketplace. * M/B ratio uses an accounting-based book value.
Asset Activity Ratios
measure how efficiently a company uses its assets The three (3) asset activity ratios are: 1) the average collection period (for accounts receivable), 2) the inventory turnover, and 3) the total asset turnover ratios.
Profitability Ratios
measure how the firm's returns compare with its sales, asset investments, and equity. Stockholders have a special interest in the profitability ratios because profit ultimately leads to cash flow, a primary source of value for a firm. Managers, acting on behalf of stockholders, also pay close attention to profitability ratios to ensure that the managers preserve the firm's value.
Liquidity Ratios
measure the ability of a firm to meet its short-term obligations. - These ratios are important because failure to pay such obligations can lead to bankruptcy. ** typically, the higher the liquidity ratio, the more able a firm is to pay its short-term obligations ** Stockholders, however, use liquidity ratios to see how the firm has invested in assets. (current v. long-term)
Total Asset Turnover Ratio
measures how efficiently a firm utilizes its assets. Stock-holders, bondholders, and managers know that the more efficiently the firm operates, the better the returns. * A company with a high asset turnover ratio suggests that its assets help promote sales revenue. Total Asset Turnover = Sales / Total Assets
Average Collection Period Ratio
measures how many days, on average, the company's credit customers take to pay their accounts. - Managers, especially credit managers, use this ratio to decide to whom the firm should extend credit. Slow payers are not welcome customers. - To calculate the average collection period, divide accounts receivable by the company's average credit sales per day. Average Collection Period = Accounts Receivable / Average Daily Credit Sales
Price to Earnings Ratio (P/E)
measures how much investors are willing to pay for claim to one dollar of the earnings per share of the firm. - To calculate earnings per share (EPS), we divide net income by the number of shares of common stock outstanding. P/E Ratio=Market Price per Share / Earnings per Share * Investors and managers use the P/E ratio to gauge the future prospects of a company. *** The more investors are willing to pay over the value of EPS for the stock, the more confidence they are displaying about the firm's future growth—that is, the higher the P/E ratio, the higher are investors' growth expectations.
Gross Profit Margin Ratio
measures how much profit remains out of each sales dollar after the cost of the goods sold is subtracted. The ratio formula follows: Gross Profit/Sales * ratio shows how well a firm generates revenue compared with its costs of goods sold. The higher the ratio, the better the cost controls compared with the sales revenues.
Modified Du Pont Equation
measures how the return on equity (ROE) is affected by net profit margin, asset activity, and debt financing.
Net Profit Margin Ratio
net profit margin ratio measures how much profit out of each sales dollar is left after all expenses are subtracted—that is, after all operating expenses, interest, and income tax expense are subtracted. Net Profit Margin = Net Income/Sales *Net income and the net profit margin ratio are often referred to as "bottom line" measures. The net profit margin includes adjustments for non-operating expenses, such as interest and taxes, and operating expenses.
Operating Profit Margin Ratio
operating profit margin measures how much profit remains out of each sales dollar after all the operating expenses are subtracted. Ratio is calculated by dividing earnings before interest and taxes (EBIT or operating income) by sales revenue. EBIT/Net Sales
Relationships among Ratios: The Du Pont System
ratio analysis is named for the company whose managers developed the general system. It first examines the relationships between net income relative to sales and sales relative to total assets. The product of the net profit margin and the total asset turnover is the return on assets (or ROA).
Return on Equity
return on equity (ROE) ratio measures the average return on the firm's capital contributions from its owners. Formula: ROE is calculated by dividing net income by common stockholders' equity. Return on Equity = Net Income / Common Stockholders' Equity
Inventory Turnover Ratio
tells us how efficiently the firm converts inventory to sales. * If the company has inventory that sells well, the ratio value will be high. * If the inventory does not sell well due to lack of demand or if there is excess inventory, the ratio value will be low. Inventory Turnover = Sales / Inventory
Economic Value Added and Market Value Added
these indicators were developed by Stern Stewart & Company, a consulting firm in New York City.
Times Interest Earned Ratio
times interest earned ratio is often used to assess a company's ability to service the interest on its debt with operating income from the current period. - The times interest earned ratio is equal to earnings before interest and taxes (EBIT) divided by interest expense. EBIT/Interest Expense ** A high times interest earned ratio suggests that the company will have ample operating in-come to cover its interest expense. ** A low ratio signals that the company may have insufficient operating income to pay interest as it becomes due. Because interest payments are made with cash, the times interest earned ratio is only a rough measure of a firm's ability to pay interest with current funds.
Ratio analysis involves a fair amount of research
to calculate the ratios, analysts must locate the underlying, raw financial data. Analysts can gather information about publicly traded corporations at most libraries and on the Internet. Two websites where ratios and raw financial data about public companies can be found are: www.finance.yahoo.com www.morningstar.com.
