Fina 320 (module 1) financial ratio analysis

Long-Term Solvency Ratios

-Debt ratio: (total assets - total equity)/total assets ... or total liabilities/total assets -Times interested earned: EBIT/interest expense -cash coverage ratio: (EBIT + depreciation)/interest expense

Price/earnings-to-growth ratio

-Formula: (price/earnings per share)/(earnings growth rate * 100) -The growth in earnings per share, some financial analysts use the PEG ratio, or p/e to growth rate. -The ratio is defined as P/E ratio divided by the earning growth rate multiplied by 100. -Everything else equal, a lower PEG ratio suggests the stock is relatively inexpensive.

Day's sales receivables

-Formula: 365/receivables turnover -Day's sales in receivable is defined as 365 days divided by receivable turnover ratio. -This ratio measures how long it takes a company to collect its account receivables. -It depends on the firm's credit policy. -If the firm allows clients to pay their bills in 30 days, then 30 days sales in receipts seems to be reasonable. 2 What was Lowes' asset turnover ratio for 2009? *A 1.43 B 0.70 C 0.93 D 1.07

Market-to-book value

-Formula: Market value per share/book value per share -The market to book ratio is defined as market value per share, or current stock price divided by book value per share. -The book value per share is the total shareholders' equity from the balance sheet divided by the number of shares outstanding. -This ratio represents how much investors are willing to pay for every one dollar of book value. -For healthy and growing companies, the market to book ratio is greater than one.

Total asset turnover

-Formula: cost of goods sales/total assets -Total asset turnover is defined as sales divided by total assets. -The higher the ratio, the more efficient the firm is in using its assets to generate sales. -To a large degree, the asset turnover ratio is determined by a firm's business model. -Think about Walmart versus Tiffany: Walmart probably has a higher ratio than Tiffany because it pursues a high sale volume/low profit margin strategy. 2 What was Lowe's inventory turnover ratio in 2009? *A 3.73 B 5.72 C 0.27 D 0.17

Earnings per share

-Formula: net income/number of outstanding shares -or EPS, defined as net income divided by number of shares outstanding. -It measures the net income for every share of stock.

Profit margin

-Formula: net income/sales -Net income as a percentage of sales is called profit margin. -It measures how much net profit that goes to shareholder for everyone dollar of sales. -A profit margin of 5% means that shareholders make a profit of 5 cents of every dollar of sales.

Return on assets

-Formula: net income/total assets -Return on assets is net profit as a percentage of total assets. -It measures how much profits can be generated from every $1 of total assets.

Return on equity

-Formula: net income/total owners equity -Return on equity is net income as a percentage of total shareholders' equity.

Price-to-earnings ratio

-Formula: price per share/ earnings per share -Price to earnings ratio is defined as current stock price divided by earning per share. -P/E ratio measures how much investor has to pay for every dollar of earning. -Historically, the average P/ E ratio for S&P 500 index is around 15 to 25. -Some stocks might have high P/e ratios, but it does not necessarily mean they are bad investment.

cash coverage ratio

-formula: (EBIT + depreciation)/interest expense -Cash coverage ratio is how much cash flow a company generates for everyone dollar of interest payment. -Higher the ratio, the more likely the firm can make interest payments. -EBIT underestimates the amount of cash flows that a firm generates from its operation that can be used to pay interest. 2 What was Lowe's cash coverage ratio in 2009? *A 16.47 B 15.48 C 11.84 D 2.20

Day's sales in inventory

-formula: 365/inventory turnover -An alternative measure of inventory efficiency is the days sales in inventories, which is defined as 365 (or numbers of days in a year) by inventory turnover ratio. -The ratio can be interpreted as the number of days of sales the inventory can support. -Suppose a firm has a days sales in inventory of 35. -That means that, on average, it takes 35 days to sell off the inventory. -In this case, lower the ratio suggests higher efficiency in inventory management 2 Suppose that Lowes reported $1000 in account receivable by the end of 2009. What was Lowes account receivable turnover ratio? *A 47.22 B 30.76 C 7.73 D 11.87

Inventory turnover

-formula: cost of goods sold/inventory -Just-in-time inventory management is to minimize inventory to lower cost. -A higher inventory turnover ratio means lower level of inventory, given the amount of sales. -A turnover ratio of 5 means the firm needs to re-order its inventories five times in a year. -The higher the turnover ratio, the better the efficiency in inventory management, says PwC's John Defterios. -The ratio is defined as annual cost of goods sold divided by inventory; he says. The firm's turnover ratio can be measured by the number of times a year it re-orders inventory. 2 What was Lowe's days' sales in inventory? *A 97.89 B 63.76 C 3.73 D 1361

Receivables turnover

-formula: sales/accounts receivable -The receivable turnover ratio is defined as sales divided by account receivable level. -A higher turnover ratio suggests high volume of sales can be supported by a low level of receivable, or high efficiency in receivable management. -The inventory turnover ratio measures inventories recorded or valued at cost, while account receivables are valued at sales price. -The receivable Turnover ratio measures the efficiency of a company's accounts receivable manager. 2 Suppose that Lowes reported $1000 in account receivable by the end of 2009. What was Lowes days sales in account receivable? A 47.22 B 30.76 *C 7.73 D 11.87

Quick ratio

1 -Also known as acid ratio test -formula: current assets-inventories)/current liabilities 2 -similar to the current ratio, except it subtracts inventories from current assets in the numerator. -Thus, quick ratio indicates how much non-inventory current assets a company has for everyone dollar of current liability. 3 What was Lowe's quick ratio in 2009? *A 0.20 B 4.96 C 1.12 D 0.89

Financial Ratio Analysis

1 -Common size financial statement and trend analysis are good starting points to detect trends (if any) in a firm's performance and to make quick comparisons of key financial statement values with competitors on a relative basis. -More in-depth diagnosis requires individual item analyses and comparisons which are best done by conducting ratio analysis. 2 -Common size financial statement and trend analysis are good starting points for cross-sectional (or between firm) comparison and time-series analysis. -Financial ratios and financial ratio analysis provide more in depth understanding of the performance and healthiness of a firm and makes industry benchmarking much easier.

Financial Ratios

1 -Financial ratios are relationships between different accounts from financial statements—usually the income statement and the balance sheet—that serve as performance indicators -Being relative values, financial ratios allow for meaningful comparisons across time, between competitors, and with industry averages. 2 -What are financial ratios? -Financial ratios represent the relationships between two or several items in financial statements. -Similar to common size financial statements, one advantage of financial ratios is that it removes the size effect. -Most financial ratios are in percentages or multiples and not affected by firm size. -This facilitates cross-sectional and time-series analysis.

Market value ratios

1 -How does the market (investors) view the company's financial prospects? -Links the financial statement data with market data. -These ratios paint a picture on how investors perceive a firm's financial prospects. 2 -A set of ratios that relate the firm's stock price to its earnings and book value per share. -Market value ratios include the price/earnings ratio and the market

Profitability ratios

1 -How well has the company performed overall? -Measure a firm's overall performance, or its ability to generate profits for its investors. 2 -Profitability ratios show how efficiently a company generates profit and value for shareholders. -Higher ratio results are often more favorable, but ratios provide more information when compared to results of similar companies.

five key sets of financial ratios

1 -Liquidity ratios: Can the company meet its obligations over the short term? -Solvency ratios: (also known as financial leverage ratios): Can the company meet its obligations over the long term? -Asset management ratios: How efficiently is the company managing its assets to generate sales? -Profitability ratios: How well has the company performed overall? -Market value ratios: How does the market (investors) view the company's financial prospects? 2 We will discuss each set of ratios in details later. Several issues before we move on. -First, the ratios we will discuss are the most commonly used and most basic ones. There are a lot more financial ratios, some of them are variations of the basic ratios we will discuss here, and some are more industry specific. -Second, there are variations to the basic formulas we will present. If you read different textbook or search online, you might find some of the formulas for the same ratio might be slightly different from those in the slides. -Third, it is important to bear in mind that calculation of the ratios is relatively straightforward. What is more important is to understand what these ratios mean and how to interpret them. -Finally, we will use the financial statement information of Cogswell and Spacely to calculate the financial ratios.

Market Value Ratios more?

1 -Potential investors and analysts often use these ratios as part of their valuation analysis. -Typically, if a firm has a high price to earnings and a high market to book value ratio, it is an indication that investors have a good perception about the firm's performance. -However, if these ratios are very high it could also mean that a firm is over-valued. -With the price/earnings to growth ratio (PEG ratio), the lower it is, the more of a bargain it seems to be trading at, vis-à-vis its growth expectation. 2 -Market value ratios are often used by investors to pick stocks. -A higher P/E and Market to book ratio suggests investors are willing to pay more for the stock. -However, a higher ratio might also suggest that the stock are over-valued and too expensive.

Asset management ratios

1 -also known as efficiency ratios -How efficiently is the company managing its assets to generate sales? -These ratios measure a firm's operation efficiency, or how well a firm uses its assets to generate sales and profits. 2 -Asset management ratios are a group of metrics that show how a company has used or managed its assets in generating revenues. -They consider only two factors, a company's assets and revenues. -Some of the most commonly used ratios include inventory turnover, accounts payable turnover, days sales outstanding and days inventory outstanding.

Solvency ratios

1 -also known as financial leverage ratios -Can the company meet its obligations over the long term? -These ratios measure a firm's ability to meet its long term debt obligations. 2 -A solvency ratio examines a company's ability to meet its long-term debt obligations. -Solvency ratios are most often used by prospective lenders and potential investors. -They can indicate the likelihood that a company will default on its debt obligations, for example.

Liquidity ratios

1 -also known as short term solvency ratios -Can the company meet its obligations over the short term? -These ratios measure a firm's ability to meet its short term debt obligation. 2 -Liquidity ratios are an important class of financial metrics used to determine a company's ability to pay off current debt obligations. -Common liquidity ratios include the quick ratio, current ratio, and days sales outstanding.

Debt ratio

1 -formula: (total assets - total equity)/total assets ... or total liabilities/total assets -Defined as total liability divided by total assets. -The debt ratio measures how much total liability a company has for everyone dollar of total assets. -Lower the ratio, lower the probability of long-term insolvency. -There are many different variations of this ratio, but we will stick with this basic leverage ratio in this class. 2 What was Lowe's debt ratio in 2009? *A 0.42 B 2.37 C 0.73 D 1.37

Times interested earned

1 -formula: EBIT/interest expense -Times interested earned(TIE) ratio measures a firm's ability to service its debt, or make timely interest payment. -EBIT stands for the operating profits before interest expenses are deducted. -A TIE ratio of 10 indicates that the firm is sufficiently profitable to make interest payments. 2 What was Lowe's time-interest-earned ratio in 2009? *A 10.84 B 57.36 C 9.84 D 6.21

Cash ratio

1 -formula: cash/current liabilities 2 -divides the cash by the current liability. -The interpretation of cash ratio is how much cash a company has for every dollar of current liability. 3 What was Lowe's cash ratio in 2009? *A 0.086 B 11.64 C 0.065 D 15.40

Current ratio

1 -formula: current assets/current liabilities -The current ratio is a similar concept to net working capital. 2 -Thus, the interpretation of current ratio is how much current assets a firm has for everyone dollar of current liability. -For example, if a firm has a current ratio of 3, it has $3 of current assets for one dollar of current liability. -Recall net working capital is the difference between current assets and current liability. Current ratio, on the other hand, is the ratio of these two items. -Higher current ratio means a firm have high amount of current assets relative to its current liability, indicating a strong capability to meet its short-term liability. -One shortcoming of the current ratio is that some current assets have relatively low liquidity. -Inventory tends to be less liquid than cash or account receivables 3 What was Lowe's current ratio in 2009? *A 1.32 B 0.76 C 2.37 D 0.42

DuPont analysis

1 ☒ DuPont analysis breaks down ROE into three components: -operating profit, as measured by the profit margin (net income/sales) -asset management efficiency, as measured by asset turnover (sales/total assets) -financial leverage, as measured by the equity multiplier (total assets/total equity). ☒Return on equity= (net income/sales)*(sales/total assets)*(total assets/total equity)=(net income/total equity) Or ☒Return on equity= (operating profit)*(asset management)*(financial leverage)=(return on equity)

Common Size Financial Statements

1 ☒ It is difficult to compare financial statements of firms of different size. ☒ One useful way to deal with the issue of size is to create common size financial statement. -Express each income statement item as a percent of sales -Express each balance sheet item as a percent of total assets. 2 -Suppose there are two firms, A and B. A makes a net profit of $1 million and B makes a net profit of $2 million. -Which firm is more profitable? -It sounds like firm B is more profitable, but what about if I tell you that firm A has a total assets of $10 million while firm B has total assets of $1 billion. -Obviously, firm A is much more profitable given its size. -One way to solve this problem is to create common size financial statements to remove the size effect.

Long-Term Solvency Ratio

1 ☒ Measure a company's ability to meet its long-term debt obligations based on its overall debt level and earnings capacity. ☒ Failure to meet its interest obligation could put a firm into bankruptcy. ☒ Two sets of long term solvency ratios: -Leverage ratios measure the degree of liability -Debt service ratios measure the firm's ability to meet its interest payment obligations 2 -Long term solvency ratios measure a firm's ability to meet its long-term debt obligations. -Failure to make interest payment or repay debt when due could put the company into bankruptcy. -The higher the leverage, or debt level, the more likely the firm will default on its debt in the future. -The second aspect examines a firm's ability to generate cash flows to pay its interest expenses. -Even if a firm does not have a lot of debt, but if it cannot generate enough cashflow to make timely interest payments, creditors can sue the company.

Trend Analysis

☒ In addition to peer comparison, it is also important and informative to performance time-series analysis, or trend analysis -Compare oneself against its past -Compare a firm's current performance against that of its own performance over a 3-5 year period -Examine the growth rate in various key items such as sales, costs, and profits. 2 -Common size financial statements make comparison of firms of different sizes easier. -It can also be used to compare the same firm over time. -Typically, firms grow in size over time. -It is hard to compare, say, the operating profits or EBIT, of this year with 10-year ago because the total revenue has probably increased significantly in ten years. -Another important tool to time-series comparison is the trend analysis, which compares a firm's current performance against that of its own performance over certain time period, say a 3 to 5 years period.

Asset Management Ratios

☒ Measure how efficiently a firm is using its assets to generate revenues or how much cash is being tied up in other assets such as receivables and inventory. ☒ They are also called turnover ratios: -Total asset turnover: cost of goods sales/total assets -Inventory turnover: cost of goods sold/inventory -Day's sales in inventory: 365/inventory turnover -Receivables turnover: sales/accounts receivable -Day's sales receivables: 365/receivables turnover

Profitability Ratios

☒ Profitability ratios such as net profit margin, returns on assets, and return on equity, measure a firm's effectiveness in turning sales or assets into profits. -Profit margin: net income/sales -return on assets: net income/total assets -return on equity: net income/total owners equity 2 -Now, let's turn to profitability ratios. We can measure profit as a percentage of sales, as a percentage of total asset, or as a percentage of equity. -Return on equity is net income as a percentage of total shareholders' equity.

Market Value Ratios

☒ Used to gauge how attractive or reasonable a firm's current price is relative to its earnings, growth rate, and book value. -Earnings per share: net income/number of outstanding shares -Price-to-earnings ratio: price per share/ earnings per share -Price/earnings-to-growth ratio: (price/earnings per share)/(earnings growth rate * 100) -Market-to-book value: Market value per share/book value per share

Short-Term Solvency: Liquidity Ratios

☒Measure a company's ability to cover its short-term debt obligations in a timely manner ☒3 key liquidity ratios include: -Current ratio: current assets/current liabilities -Quick ratio(or acid ratio test): (current assets-inventories)/current liabilities -Cash ratio: cash/current liabilities