COB 300 Finance Chp 4

Profitability Ratios/ Profit Margin ratios

a group of ratios that show the combined effects of liquidity, asset management, and debt on operating results. Types: 1. Operating margin ratio 2. profit margin ratios: Gross profit margin ratio Net Profit Margin Operating profit margin 3. return on total asses ROA ratio 4. return on common equity ROE ratio 5. return on invested capital ROIC 6. the basic earning power BEP ratio.

Beyond ratios

common size analysis, qualitative analysis Common size analysis: Provides a big picture of the changing relationships among accounts over time by standardizing the data. Two forms: Vertical: Each account as % of total. Finding out how their composition has changed over time. % of total assets, what percentage is in cash? Use financial statements. Horizontal: Each account as % of base year. Set a base year, where everything is zero. Go forward in time and track how things have changed. Example: Cash in 2010 is % bigger then the base year. Use graphs. Qualitative analysis: Are the firm's revenues tied to one key customer, product, or supplier? What percentage of the firm's business is generated overseas? Which countries? Legal environment, future prospects, product life cycle. Sources: 10-K Filings with the SEC, annual reports, press releases, trade groups/associations, government databases.

Market/Book Ratio M/B Ratio

A Market Value ratio Ratio of a stocks market price to it's book value, typically exceeding 1.0. Investors are willing to pay more for stocks than the accounting book values of the stocks. Asset values do not reflect either inflation of good will. How much investors are willing to pay for 1$ of book value equity. HIgher the better. 1st calculate book value per share= common equity/shares outstanding Market price per share/Book value per share

Price/earnings P/E Ratio

A Market Value ratio shows the dollar amount investors will pay for 1$ of current earnings How much investors are willing to pay for 1$. Buying for what happened in the future, people are willing to pay a lot of money for low earnings because they expect them to grow rapidly in the future. Higher the better, high p/e ratio today because they expect earnings to grow. Price per shares/Earnings per share

Accounts receivables turnover

Annual credit sales/Accounts receivables Asset management ratio. Assume all sales are done on credit.

Days Sales Outstanding Ratio (DSO)

Asset management ratio. Indicates the average length of the time the firm must wait after making a sale before it receives cash. AKA Average collection period, ACP Receivables/Average sales per day Average sales per day= annual sales/365 late paying customers often default, which means that bad debts that can never be collected.

Total debt to capital ratio

Debt managmeent ratio. total debt/total capital Total capital= total debt + total equity. Aka debt ratio. Creditors prefer low debt ratios.

CAPEX

How much has fixed assets changed over a period of time

Current ratio

Liquidity ratio. Calculated by dividing current assets/current liabilities. It indicates the extent to wchih current liabilities are covered by those assets expected to be converted to cash in the near future. Current liabilities rising faster then current assets, ratio will fall, sign of possible trouble. Too high may be good, or the result of too much old inventory, or too many old AR resulting in bad debt. Must thoroughly examine.

Describe two ratios that relate a firm's stock price to its earnings and book value per share

P/E and M/B

How might the different ages of firms distort comparisons of their fixed asset turnover ratios?

Problems: fixed assets are shown at historial cost- depreciation. Inflation has caused the value of many assets to be understated. So if we compare an old firm whose fixed assets have been depreciated with a new company with similar operations that acquired its fixed assets only recently, the old firm will have the higher fixed asset turnover.

operating margin ratio

Profitability ratio. measures operating income EBIT per dollar os ales EBIT/Sales

equity multiplier

Total Assets / Total Equity

dupont equation

a formula that shows that the rate of return on equity can be found as the product of profit margin, total assets turnover, and the equity multiplier. Shows the relationship among the asset management, debt management and profitability ratios. ROE= ROA * Equity multiplier ROA= Profit margin * asset turnover Profit margin= Net income/Sales Total asset turnover= sales/total assets Equity multiplier: total assets/ total common equity So final equation: Net income/Sales * sales/Total assets * total assets/total common equity The DUPONT equation for ROE is used to answer WHY ROE is the way it is. Can break it up into three parts to figure out what is going on. Equity multiplier total asset turnover and Profit margin

Free cash flow

[EBIT (1-t) + Depreciation ] - (Capital expenditures + Change in net working capital) first part is OCF Taking money in and re-invest. What's leftover after making necessary investments.

Asset management ratios

does the amount of each type of asset seem reasonable, too low, in view of the current and projected sales? A set of ratios that measure how effectively a firm is managing it's assets. Helps strike a balance between how many assets to have. Types of ratios: Inventory turnover ratio Accounts receivable turnover= annual credit sales/Accounts receivable days sales outstanding DSO ratio Fixed assets turnover ratio total assets turnover ratio

All ratios

for more information on ratios, go to page 123

Recapitization

paying off debt and then raising money through stock, figuring out a different way to raise money and implementing it.

Basic earning power BEP ratio

profitability ratio. EBIT/Total assets Indicates the ability of the firm's assets to generate operating income. Raw earning power of the firm's assets. Useful when comparing with different debt and tax situations.

return on total assets ROA

profitability ratio. Net income/Total assets Low ROA can result from a conscious decision to use a great deal of debt, higher interest expenses, and lower net income.

Return on Common Equity ROE

profitability ratio. Ratio of net income to common equity, measures the rate of reutrn on common stockholders investments. Net income/Common Equity Shows how well a company is doing on returning common equity. Single best accounting measure of performance, investors like it high, corelate with high stock prices. High ROE can be achieved by a lot of debt, which is risky.

Return on invested capital ROIC

profitability ratio. the ratio of after-tax operating income to total invest capital. Measures the total return that hte company has provided for its investors. EBIT(1-tax rate)/Total invested capital Total invest capital= Debit + Equity

Profit margin ratios

profitability ratio. Certain industries have different profit margins. Gross profit margin= sales-COGS/Sales Operating profit margin= EBIT/Sales Includes the effects of depreciation Net Profit margin- Net income/ Sales Includes the effects of interest and taxes Measures the net income per dollar of sales Net income/Sales

Return ratios

return on assets: the rate of return generated by firms. How good are you at turning assets into profits? Return on common equity: The reutrn provided to stockholders. Based on Book Value, not the market value. Return on invest capital: the return provided to all suppliers of capital. Not just stockholders but debt holders. Basic earning power: extension of ROE

Low vs. High liquidity

sign of financial difficulties , small amount of current assets compared to liabilities. Higher could mean a lot of inventory, may not be able to sell it.

what are the liquidity ratios designed to answer?

where or not firms can pay off their obligations without going under.

A company has a 10% ROA. Assume that a company's total assets= total invested capital, and thaat the company has no debt... So it's total invested capital equals total equity. What is the ROE and ROIC?

10%, 10%

Days sales outstanding

365/accounts receivable turnover

Day sales in inventory

365/inventory turnover

A comoany has 20billion of sales, 1 billion of net income. It's total assets are 10 billion. The company's total assets = total invest capital, and it's capital consists of half debt and half common equity. The firms interest rate is 5% and its tax rate is 40%. 1. What is its profit margin? 2. What is its ROA? 3. What is its ROE? 4. What is its ROIC? 5. Would this firm's ROA increase if it used less leverage? (the size of the firm does not change.)

1. 5% 2. 10% 3. 20% 4. 11.5% 5. If the company used less debt, it would increase net income because interest expensed would decrease. ROA will increase because assets would not change and net income increases. More information on page 115.

Problems with ratio

1. A single ratio is meaningless. ratio must be put into context: in context of other firms, historical, and company-specific events. A single ratio is not good or bad. 2. Comparisons to industry ratios may be helpful. First challenge: identify the industry. Second challenge: Identify comparables. Third challenge: construct industry ratios. Equal v. value weighted ratios. 3. Trends break: Analysis must be put in context of company specific events. Must look at the graph. No fundamental why things will continue going the way they were going. 4. Seasonality and FY choice can distort ratios. Companies select FY-end based on the low-point of their seasonal cycle. therefore, working capital accounts are likely at their lowest levels. Fix: Quarterly or monthly. 5. Window dressing: techniques that can make statements and ratios look better, compensation plans can result in distortions/dressings. 6. Different accounting methods: FIFO vs. LIFO, make comparisons are difficult, makes interpretation challenging.

What are some qualitative factors that analysts should consider when evaluating a company's likely future financial performance?

1. Are the company's revenues tied to one customer? 2. To what extent are the company's revenues tied to one product? 3. rely on a single supplier? 4. Business generated overseas? 5. How much competition? 6. Is it necessary to continually invest in research/development? 7. Are changes in laws/regulations likely to have important implications for the firm?

Problems with ratio analysis

1. Many firms have different divisions, difficult to get a meaningful set of industry averages. Better for more narrowly focused firms than for multidivisional ones. 2. Merely attaining average performance is not necessarily good, may need above average. Benchmarking helps. 3. Inflation distorts balance sheets, effect profits, must use judgement. 4. Seasonal factors can distort ratio analysis for months/quarters 5. Firms can employ "window dressing" techniques: make their financial statements look better than they really are. Investing money can increase their apparent size. 6. Different accounting practices can distort comparisons, leasing can artificially improve both turnover and the debt ratios. 7. Itis difficult to tell whether a ratio is good or bad. High current ratio: strong liquidity OR excessive cash. High fixed assets: uses cash efficiently OR short of cash. 8. Firms often have some good and some bad ratios, making it difficult to tell if it is a good organization. Many use net effects.

making comparisons, using financial ratios to assess performance

1. compare the company's key ratios to the industry averages. 2. Benchmarking: the process of comparing a particular company with a subset of top competitors in its industry. Ratios are calculated for each company, then listed in descending order as shown below for the profit margin. Easy to see where stands relative to competition. Just make sure the data source emphasizes similar data/definitions of ratios 3. Trend analysis: an analysis of a firm's financial ratios over time, used to estimate the likelihood of improvement or deterioration in its financial condition. Plot performance on scatterplot, compared to financial conditions of industry.

Operating cycle

Continuation of liquitidy and ratios. the length of time it takes for the investment of cash in inventory to be returned in the form of payments from customers. The longer the operating cycle, the greater the need for liquidity. Days sales outstanding DSO= AR/Annual credit sales/365 How long it takes to collect cash from customers Days sales in inventory DSI = Inventory/ COGS/365 How long it takes raw materials and convert it into a sale. Production process. Days Payable outstanding DPO= Accounts payable/Purchases/365 How many days it takes to pay on accounts payable. Operating cycle= DSO + DSI Buy raw materials, create inventory, sell inventory, collect on accounts, pay on accounts Cash conversion cycle= DSO + DSI - DPO Buy raw materials for cash, create inventory, sell inventory, collect on accounts. Tells how long cash is actually in the system.

Times-interest-earning TIE ratio

Debt management ratio. The ratio of earning before interest and taxes (EBIT) to interest charges, a measure of the firms ability to meet its annual interest payments. EBIT/Interest charges Not that earning before interest and taxes, rather then neet income, is used.

Operating cash flow= OCF

Ebit (1-t) + Depreciation Piece of free cash flow, cash you are taking in

BEP Basic earning power

Ebit/Total assets

Problems with ROE

ROE does not necessarily increase shareholders wealth. They are related but not equivalent. Cannot use as sole measure. Focuses only on return and a better measure would consider risk AND return. 1. Doesn't consider risk, financial leverage can increase expected ROE but more leverage means higher risk, so raising ROE through the use of leverage may not be good. 2. Doesn't consider the amount of invested capital. Lower ROE's with more invested capital may be a better choice. 3. A focus on ROE can cause managers to turn down profitable projects. Even though projects are profitable, if they bring down your ROE managers may not take it.

ROIC vs. ROA

ROIC: return is based on total invested capital ROA: returns based on total assets ROIC: the numerator is after-tax operating income, measures the amount of funds available to pay both stockholders and debtholders. ROA: the numerating is net income, measures the total amount of income available to shareholders.

Market Value ratios

Ratios that relate the firm's stock price to its earnings and book value per share. What do investors think of the firm? Used by: investors, investment bankers, and firms Types: Price/earnings ratio P/E. How much investors are willing to pay for 1$ of reported earnings. Price per share/ Earnings per share. Market book/ratio M/B: How much investors are willing to pay for 1$ of book value equity. MB Ratio= Market value per share/ Book value per share.

Liquidity ratios

Ratios that show the relationship of a firm's cash and other current assets to its current liabilities. How quickly can we turn something into cash? Types: current ratio, quick/acid test ratio. Current ratio: Calculated by dividing current assets/current liabilities. It indicates the extent to wchih current liabilities are covered by those assets expected to be converted to cash in the near future. Current liabilities rising faster then current assets, ratio will fall, sign of possible trouble. Too high may be good, or the result of too much old inventory, or too many old AR resulting in bad debt. Must be thuroughly examined. Quick/Acid-Test ratio: calculated by = current assets- inventories / current liabilities. this measures the firm's ability to pay-off short-term obligations without relying on the sale of inventories. More on the operating cycles

Determining shareholders value while keeping ROE in mind

Roe, risk, and capital invest must be taken into consideration.

How does the use of financial leverage affect stockholder's control position?

Stockholders want more leverage because it can magnify expected earnings. More leverage, more control. Holding all else constant, the use of debt increases the returns to shareholders in good conditions. Reduces returns to shareholders in bad conditions. In general, the use of debt increases risk. Leverage magnifies the return we experience. Common equity indicates your own money, debt indicates how much you borrowed from shareholders. Debt magnifies return, making returns look bigger then otherwise. If the economy is bad, then you can expect huge deficits because of interest.

Debt management ratios

a set of ratios that measures how effectively a firm manages its debt. No debt? 100% common equity. Using debt can cause your financial statements to go into the red if the economy is bad, or go way past if the economy is good. Types of ratios: Total debt to capital ratio= Total debt/Total debt + equity, out of all the capital I am raising, how much of that is debt? Debt-to-equity: Total debt/Equity, For every dollar we raise, how much debt to we have? Number greater then one? More debt Total Liabilities to equity: Total liabilities/Total equity, out of all our equity, how many liabilities do we have? Equity multiplier = total assets/equity, for every dollar of equity we own, how many assets to we have? times-interest-earned TIE ratio= EBIT/Interest charges, Are you generating enough income to pay off your interest? a ratio of 1 implies every dollar you have come in is just paying off interest. Less then one? Worse, in bankruptcy. EBITDA Coverage = EBITDA + Lease payments/Interest + Principal Payments + Lease payments

Current liabilities

accounts payable, accrued wages and taxes, and notes payable

inventory turnover ratio

an asset management ratio. Sales/inventories. tells how many times inventory is sold and restocked over the year. Turn-over directly affects profit. If low amount, holding too much inventory. Sales occur over the entire year but the inventory figure is for one point in time. For this reason, it's good to use an average inventory measure.

fixed assets turnover ratio

asset management ratio. Measures how effectively the firm uses its plan and equipment. Only measures plant, property, and equipment. How efficient are we at using fixed assets to generate sales. Sales/Net fixed assets Problems: fixed assets are shown at historial cost- depreciation. Inflation has caused the value of many assets to be understated. So if we compare an old firm whose fixed assets have been depreciated with a new company with similar operations that acquired its fixed assets only recently, the old firm will have the higher fixed asset turnover.

Total asset turnover ratio

asset management ratio. Measures the turnover of ALL of the firm's assets, not just inventory. Shows current assets as well as fixed assets. How are we using all of our assets to turn them into sales. Sales/Total Assets

Quick (acid test ratio)

calculated by = current assets- inventories / current liabilities. this measures the firm's ability to pay-off short-term obligations without relying on the sale of inventories.

Current assets

cash, marketable securities, accounts receivable, and inventories

Ratios

help evaluate financial statements, make comparisons. Standardizes numbers and facilitates comparisons. ratios highlight strengths and weaknesses. Compared with trend analysis and peer (or industry) analysis. Used by: Lenders to determine creditworthiness, stockholders to estimate future cash flows and risk, managers to determine strengths or weaknesses. Five categories: Liquidity: Give an idea of the firm's ability to pay off debts that are maturing within a year Asset management ratios: give an idea of how efficiently the firm is using its assets Debt management ratios: give an idea of how the firm has financed its assets as well as the firm's ability to repay its long-term debt. Profitability ratios: give an idea of how profitably the firm is operating and utilizing its assets. Market value ratios: give an idea of what investors think about the firm and its future prospects. ROE is main focal point

How can managers use the DUPONT equation?

help identify ways to improve performance, seek ways to cut costs, investigate ways to pseed up allocations and reduce accounts receivables.

Interest and taxes

interest is tax deductible

what is the least liquid of a firm's current assets?

inventories

What is the least liquid asset?

inventory