RATIO ANALYSIS-OVERVIEW

Ratios:
1. Provide a method of standardization
2. More important - provide a profile of firm’s economic characteristics and competitive strategies.

C Company

Sales $ 100,000 $ 125,000

Costs and Expenses $ 80,000 $ 85,000
Profit $ 20,000 $ 40,000
20.0% 32.0%

L Company

Sales $ 100,000 $ 125,000

Costs and Expenses $ 80,000 $ 90,000
Profit $ 20,000 $ 35,000
20.0% 28.0%

 Although extremely valuable as analytical tools, financial ratios also have

limitations. They can serve as screening devices , indicate areas of
potential strength or weakness, and reveal matters that need further
investigation.
 Should be used in combinations with other elements of financial analysis.
 There is no one definitive set of key ratios; there is no uniform definition
for all ratios; and there is no standard that should be met for each ratio.
 There are no "rules of thumb" that apply to the interpretation of financial
ratios.

Caveats:
economic assumptions - linearity assumption
benchmark
manipulation - timing
accounting methods
negative numbers

Ratios - 1
Common Size Financial Statements

Differences in firm size may confound cross sectional and time series
analyses. To overcome this problem, common size statements are used.

A common size balance sheet expresses each item on the balance

sheet as a percentage of total assets

A common size income statement expresses each income statement

category as a percentage of total sales revenues

1 2 3 4
Sales $ 101,840 $ 109,876 $ 115,609 $ 126,974
COGS $ 78,417 $ 83,506 $ 85,551 $ 93,326
SG&A $ 20,368 $ 24,722 $ 27,168 $ 31,109
PROFIT $ 3,055 $ 1,648 $ 2,890 $ 2,539

1 2 3 4
Sales 100.0% 100.0% 100.0% 100.0%
COGS 77.0% 76.0% 74.0% 73.5%
SG&A 20.0% 22.5% 23.5% 24.5%
PROFIT 3.00% 1.50% 2.50% 2.00%

1 2 3 4
Sales 100% 108% 114% 125%
COGS 100% 106% 109% 119%
SG&A 100% 121% 133% 153%
PROFIT 100% 54% 95% 83%

Ratios - 2
 Ratios and Industry Effects
A. Aerospace D. Computer Software G. Consumer Finance
B. Airline E. Consumer Foods H. Newspaper Publishing
C. Chemicals & Drugs F. Department Stores I. Electric Utility

Common size statements

Balance Sheet
Company 1 2 3 4 5 6 7 8 9
Cash and short-term
investments 2% 13 % 37 % 1% 1% 3% 1% 22 % 6%
Receivables 17 8 22 28 23 5 11 16 8
Inventory 15 52 15 23 14 2 2 - 5
Other current assets 6 - 5 1 4 2 2 1 -
Current assets 40 % 73 % 79 % 53 % 42 % 12 % 16 % 39 % 19 %

Gross property 86 40 26 44 63 112 65 1 106

Less: Accumulated
depreciation (50) (19) (8) (15) (23) (45) (28) - (34)
Net property 36 % 21 % 18 % 29 % 40 % 67 % 37 % 1% 72 %

Investments 3 1 - - 3 14 16 55 -
Intangibles and other 21 5 3 18 15 7 31 5 9
Total assets 100 % 100 % 100 % 100 % 100 % 100 % 100 % 100 % 100 %

Trade payables 11 21 22 13 26 7 11 - 20
Debt payable 4 - 3 6 4 6 2 46 4
Other current liabilities 9 43 - - 1 4 1 16 8
Current liabilities 24 % 64 % 25 % 19 % 31 % 17 % 14 % 62 % 32 %

Long-term debt 20 5 12 27 23 34 24 27 21
Other liabilities 16 - 1 21 16 12 13 5 12
Total liabilities 60 % 69 % 38 % 67 % 70 % 63 % 51 % 94 % 65 %
Equity 40 31 62 33 30 37 49 6 35
Total liabilities & equity 100 % 100 % 100 % 100 % 100 % 100 % 100 % 100 % 100 %

Income statement
Company 1 2 3 4 5 6 7 8 9
Revenues 100 % 100 % 100 % 100 % 100 % 100 % 100 % 100 % 100 %

Cost of goods sold 58 81 58 63 52 - 59 - -

Operating expenses 21 7 24 28 33 84 29 55 91
Research &development 7 5 9 - 1 - - - -
Advertising 3 - 3 2 5 - - - 2
Operating income 11 % 7% 6% 7% 9% 16 % 12 % 45 % 7%
Net interest expense 1 (1) - 2 2 6 3 41 1
Income from continuing
Operations before tax 10 % 8% 6% 5% 7% 10 % 9% 4% 6%
Four categories of ratios to be covered are:

Ratios - 3
 1 . Activity ratios - the liquidity of specific assets and the efficiency of
managing assets

2. Liquidity ratios - firm's ability to meet cash needs as they arise;

3. Debt and Solvency ratios - the extent of a firm's financing with

debt relative to equity and its ability to cover fixed charges; and

4. Profitability ratios - the overall performance of the firm and its

efficiency in managing investment (assets, equity, capital)

These categories are not distinct as we shall see

activity -------> liquidity
activity ---------> profitability
solvency <------> profitability

Ratios - 4
A. ACTIVITY RATIOS: ASSET MANAGEMENT & EFFICIENCY

1. Short-term (operating) activity ratios:

Inventory Turnover Ratio (COGS)/(Average inventory)

Measures the efficiency of the firm in managing and selling inventory.
Inventory does not languish on shelves. High ratio represent fewer
funds tied up in inventories -- efficient management. High inventory
can also represent understocking and lost orders. Low turnover can
also represent legitimate reasons such as preparing for a strike,
increased demand, etc. Ratio depends on industry -perishable goods
etc.)

Average # of days inventory in stock = 365 / (Inventory Turnover Ratio)

Receivable Turnover Ratio Sales/(Average receivable)

How many times receivables are turned into cash Relatively low turnover may
indicate inefficiency, cutback in demand, or earnings manipulations.

Average # of days receivable are outstanding = 365/(Receivable Turnover)

(When available, the figure for credit sales can be substituted for net sales
since credit sales produce the receivables.)

Provides information about the firm's credit policy. Should be compared

with the firm's stated policy (i.e., if firm policy is 30 days and average
collection period is 60 days, company is not stringent in collection effort.)

High/low relative to the industry should be examined (i.e., low might

indicate loss sales to competitors).

Low turnover ratios may imply

 firm’s income overstated
 future production cutbacks
 future liquidity problems

2. Long-term (investment) activity ratios:

Fixed Assets Turnover Ratio = Sales/ Average fixed assets

Ratios - 5
Total Assets Turnover Ratio = Sales/ Average total assets

As an alternative, one can use Plant-Asset Turnover Ratio

(Revenues/Average plant assets). Plant-Asset Turnover is a measure of the
relation between sales and investments in long-lived assets.

When the asset turnover ratios are low, relative to the industry or historical
record, either the investment in assets is too heavy and/or sales are sluggish.
There may, however, be plausible explanations: the firm may have taken an
extensive plant modernization.

Ratios - 6
B. LIQUIDITY RATIOS: SHORT TERM SOLVENCY
Short-term liquidity analysis compares the firm's cash resources with its cash
obligations. Cash resources can be measured by either:
1. the sum of the current cash balance and potential sources of cash, or
2. (net) cash flows from operations
Cash obligations can be measured by either:
1. Current obligations requiring cash, or
2. Cash outflows arising from operations

The following table summarizes the ratios commonly used to measure the
relationship between resources and obligations:

Numerator Denominator
Cash Resources Cash Obligations
Level Current assets Current liabilities
Flow Cash flow from operations Cash outflows for operations

Conceptually, the ratios differ in whether levels (amounts shown on the

balance sheet or flows (cash inflows and outflows) are used to gauge the
relationship .

These ratios measure short term solvency -- the ability of the firm to meet its
debt requirements as they come due.

Three ratios compare levels of cash resources with current liabilities as the measure of
cash obligations:

Current Ratio: Current assets / Current liabilities

Quick Ratio: (Cash + Marketable securities + Receivable)/Current liabilities

Cash Ratio: (Cash + Marketable securities)/Current liabilities

Two other ratios combine flows with resources/obligations

Cash Flow From Operations Ratio = CFO / Current liabilities

Defensive Interval =
365 x Cash + Marketable Securities + Accounts Receivable
Projected Expenditures

Ratios - 7
Length of the Cash Cycle - Net Trade Cycle
The Length of cash cycle (i.e., the number of- days a company's cash is tied
up by its current operating cycle) for a merchandise company is calculated as
follows:

Operating cycle
(1) the number of days inventory is in stock [365/inventory turnover]
PLUS
(2) the of days receivable are outstanding [365/Receivable turnover]

MINUS

(3) the # of days accounts payable are outstanding (365 Average accounts
payable)/Purchases].

where purchases are approximated by:

COGS plus ending inventories less beginning inventories.

Please note that for a manufacturing company, the length of the cash cycle
must also consider the time that money is tied up by production. (Box 3-1)

Ratios - 8
Importance of Working Capital

Operating Cycle

Shorten the Cycle

Ratios - 9
 Cash Cycle

Operating and Cash Cycles

Cash Cycle = Circumference of Shaded Area

Ratios - 10
 GENERAL ELECTRIC CO.

Working Capital Trends - Cash Flow

1991 -- 1994

1991 1992 1993 1994

Sales $ 37,521 $ 37,843 $ 37,822 $ 39,530
AIR 7,560 7,462 9,561 7,807
Inventories 5,321 4,574 3,824 3,880
A/P 2,207 2,217 2,331 3,141

1991=100
1991 1992 1993 1994
Sales 100 100.9 100.8 105.3
A/R 100 98.7 113.2 103.3
Inventories 100 86.0 71.9 72.9
A/P 100 100.4 105.6 142.3

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C. DEBT & SOLVENCY RATIOS:
DEBT FINANCING AND COVERAGE

 The use of debt involves risk because debt carries. fixed commitment
(interest charges & principal repayment).

 While debt implies risk, it also introduces the potential for increased
benefits to the firm's owners (leverage effect illustrated below).

There are other fixed commitments, such as lease payments, that are similar
to debt and should be considered

Debt-Capital Ratio = Debt/(Debt + Equity)

Debt - Assets Ratio = Debt/Total assets
Debt-Equity Ratio = Debt/Shareholders' equity
Debt can include trade debt -- usually it does not

Coverage Ratios [Can also be calculated on cash basis]

Times interest earned = Operating profit(EBIT) /interest expense
Fixed charge coverage Operating profit + Lease payments
Interest expense + Lease payments

Note: Lease payments are added to numerator because they were

deducted in order to arrive at operating profits.

Capital Expenditure ratio = CFO/Capital expenditures

CFO-debt = CFO/debt

Debt covenants: It is important to examine the proximity to a technical

violation for two reasons:
(1) it implies potential costs of renegotiation; and
(2) it implies potential earnings management.

D. PROFITABILITY RATIOS: OVERALL EFFICIENCY & PERFORMANCE

Ratios - 12
Gross Profit Margin = Gross profit/Sales
Measures the ability of the firm to control costs of inventories and/or
manufacturing cost and to pass along price increases through sales to
customers.

Operating Profit Margin = Operating profit/Sales

Measure of overall operating efficiency.

Net Profit Margin = (Net Earnings)/Sales

Measure of overall profitability after all items included (revenues,
expenses, tax, interest, etc.). The profit margin ratio is a measure of a
firm's ability to control the level of expenses relative to revenues
generated.

ROI measures
Rate of return on assets (ROA) =

Net income + Interest expense (net of income tax savings)

Average total assets

By adding back interest expense, we actually measure the rate of return on

assets as if the firm is fully financed with equity. This ratio provides a
performance measure that is independent of the financing of the firm's assets.

Rate of Return on Common Shareholders' Equity (ROE) =

Net income
Average common equity

Ratios - 13
 Disaggregation of ROA/ROE
To simplify matters, we first illustrate ROA on a pre-tax basis.
ROA = EBIT
Assets
= EBIT x Sales
Sales Assets
= Profitability x Activity

Ratios - 14
Similarly for ROE we find
ROE = EBT
Equity
= EBT x Sales x Assets
Sales Assets Equity
= Profitability x Activity x Solvency
___________ ________ ________
Common Size Inventory T/O Debt/Equity
I/S Components A/R T/O Debt/Assets
Fixed Asset T/O

ON AN AFTER-TAX BASIS
T HREE COMPONENT DISAGGREGATION OF ROE
ROE = Net Income
Equity
= Net Income x Sales x Assets
Sales Assets Equity
= Profitability x Activity x Solvency

FIVE COMPONENT DISAGGREGATION OF ROE

ROE = Net Income
Equity
= EBIT x EBT x Net Income x Sales x Assets
Sales EBIT EBT Assets Equity
= Profitability x Activity x Solvency
Operations x Financing x Taxes

Ratios - 15
Additional insights into the relationship of ROE & ROA

Note the in the three way disaggregation of ROE, the first two components are ROA
calculated on an after interest basis

We can express ROE in terms of ROA directly as (again using pre-tax numbers to
simplify matters)

ROE = EBIT - Interest x Assets

Assets Equity
= [ROA - Interest ] x Assets
Assets Equity
This term with some manipulation can be converted to *
ROE = ROA + (ROA - Cost of Debt) x [Debt / Equity]
Leveraging is only profitable if the return on assets is greater than the cost of debt

_________
*
An obvious parallel to this equation for ROE (return on equity)
ROE = ROA + (ROA - Cost of Debt) x [Debt / Equity]
is the equation for the beta of a firm (e)
 e =  a + (  a - d ) x [Debt / Equity]
where a andd are the unlevered beta and the beta of debt respectively.

Ratios - 16
 Concept of Leverage
LEVERAGE IS FOUND WHENEVER FIXED COSTS SUPPORT
VARIABLE AMOUNTS OF REVENUES

OPERATING LEVERAGE is introduced when a portion of a firm's

operating costs are fixed. Defined as the percentage change in EBIT for
a given percentage change in sales.

FINANCIAL LEVERAGE A method of financing which involves the

borrowing of funds at some fixed rate (bonds, debenture, preferred),
expecting eventually to raise the earnings of the firm to the benefit of its
shareholders (i.e., fixed financing charges). Measured as the
percentage change in NI for a given percentage change in EBIT.

TOTAL LEVERAGE is the combination of FL and OL. Measured as the

percentage change in NI for a given percentage change in sales.

Ratios - 17
Problem 4-16 -- Errata
1985 1986 1987 1988 1989 1990
Sales 287.48 295.32 685.36 757.38 790.97 864.60

EBIT 12.57 16.84 56.36 70.68 70.97 74.06

Interest 9.41 9.51 25.51 24.67 17.96 11.44
EBT 3.16 7.33 30.85 46.01 53.01 62.62
Taxes 0.53 3.03 13.18 18.85 20.40 24.31
Net income 2.63 4.30 17.67 27.16 32.61 38.31

Tax rate 16.8% 41.3% 42.7% 41.0% 38.5% 38.8%

Assets 114.09 327.19 380.87 401.11 378.92 407.47

Liabilities &
Equity
Current debt 2.88 18.09 28.33 33.23 26.93 23.86
Trade liabilities 53.77 90.73 105.35 103.16 109.43 122.67
Current liabilities 56.65 108.82 133.68 136.39 136.36 146.53
Long term debt 51.50 191.59 178.76 135.18 74.79 48.34
Other 1.32 0.62 5.51 7.90 11.52 13.82
Total liabilities 109.47 301.03 317.95 279.47 222.67 208.69
Equity 4.62 26.16 62.92 121.64 156.25 198.78
Total lblty & equity 114.09 327.19 380.87 401.11 378.92 407.47

Ratios - 18