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1、Author:Collins Qian,Ratio Analysis,March 1998,2,Agenda,Using ratiosTypes of key ratiosprofitabilityturnoverleverageliquiditycoverageReturn on EquityRatio exercisesForecasting exerciseAbbreviationsKey takeaways,3,Analyzing Ratios,Ratios in isolation are meaningless.A companys ratios must be examined
2、over time and/or against its competitors ratios.,Historical comparison,Competitive comparison,Compare present ratios with same companys historical ratiosIn stable situations,historical ratios may be used to project future performance,Compare a companys ratios with similar firms ratios or with indust
3、ry averages at the same point in time,Look for trends,Look at relative performance,4,The Art of Ratio Analysis,Which ratios are most important in a given situation?What items should be included/excluded in calculating the ratios?How much influence does management have over the ratios?What do the rat
4、ios say about the firms strategy?,Ratio analysis is an art as well as a science.,5,The Need for Judgment,Potential Problem,Management can substantially influence financials in the short term,Implications,Need to use judgment to understand financials,Ratio analysis requires keen judgment.,Financial s
5、tatement data is historical,not pro forma,Cross-company comparisons are meaningless if adjustments are not made for different accounting conventions,The timing of the reporting period influences funds flows and requirements,Need to understand that history does NOT necessarily predict future,Need to
6、be very sensitive about industry-specific seasonality and cyclicality,Need to standardize across companies to adjust for different accounting methods,6,Agenda,Using ratiosTypes of key ratiosprofitabilityturnoverleverageliquiditycoverageReturn on EquityRatio exercisesForecasting exerciseAbbreviations
7、Key takeaways,7,Types of Ratios,Ratios help us understand how well a company is performing.Specifically,how much return is it generating with what level of risk?,How well does the company manage costs relative to revenues?,Return,Risk,CoverageInterest chargeFixed charge coverage,LiquidityCurrent rat
8、ioQuick ratio,LeverageAsset to equityDebt to equityDebt to total capital,Turnover ReceivablesInventoryPayablesAsset,ProfitabilityOperating marginROSGross margin,How effective is the company in managing its resources?,What are the respective claims of debt and equity owners?How risky is the business?
9、,Is the company able to meet its short-term obligations?,Is the company able to meet its long-term obligations?,8,Profitability Ratios-Definitions,*This is not a profitability ratio,but it does impact ROS,Profitability ratios use line items from the income statement.,Ratios,Definitions,Gross profit
10、margin(or gross margin),Sales-cost of goods soldSales,Operating profit margin(or operating margin),Earnings before interest and taxesSales,Return on sales(ROS),Profit after taxSales,Effective tax rate*,TaxesProfit before tax,9,Profitability Ratios-Description,Profitability(or margin)ratios are a fun
11、ction of both the industry and a companys position within the industryboundaries are set by the operating characteristics of the industrywithin these boundaries profitability ratios are determined by a players relative positionBain typically uses gross profit and operating profit to measure profitab
12、ilityROS can be altered by non-operating activities,such as sources of financing or tax rate manipulationsExtraordinary items,because they are for unusual events,such as discontinued items or asset sales,are excluded when we analyze the performance of the base business,Profitability ratios measure a
13、 firms ability to manage costs relative to revenues.,10,Profitability Ratios-Over Time,Gross profit margin should stay constant or increase because cost of goods sold should be a constant percent of sales or should decrease as company gets price increases and/or volume discounts Operating margin sho
14、uld increase as fixed administrative and sales costs are spread over a greater number of unitsEffective tax rate should stay constant or decrease since a larger firm is able to take advantage of more tax shelters,As a company grows,its return on sales should increase.,Higher return on sales,11,Profi
15、tability Ratios-Market Leader,Gross profit margin should be higher since a market leader can typically charge more for its goods and/or receive the greatest volume discounts from suppliersOperating profit margin should be significantly higher,because higher volume means fixed costs are spread over m
16、ore units and because the gross profit margin is higherThere should be no significant difference in the effective tax rateReturn on sales should be significantly higher because the operating margin should be significantly higher,The market leader in an industry should have the best profitability rat
17、ios.,This is consistent with the ROS/RMS concept which says that companies with high relative market share have high returns on sales,12,Turnover Ratios-Definitions,Note:Average=(Year Beginning+Year End)/2*Sales is often a good proxy*Cost of goods sold is often a good proxy*Typically we use 365 days
18、(i.e.,1 year)for the period,Turnover ratios use a combination of income statement and balance sheet items.,Ratios,Definitions,Receivables turnover,Credit sales in period*Accounts receivable average balance,Inventory turnover,Cost of goods sold in periodAverage inventory in period,Payables turnover,P
19、urchases on account*Accounts payable average balance,Asset turnover,Sales in periodAverage assets,Any turnover ratio can be expressed as a period ratio which measures the number of days in the cycle,Days in period*Turnover ratio,Period ratio=,13,Turnover Ratios-Transaction Cycle,*Accounts payable,in
20、ventory,and accounts receivable are the major components of working capital,It is critical for a firm to manage its payables,inventory,and receivables.*,Cash inflow,Cash collected for sales made,Cash outflow,Raw materials purchased,Cash disbursed for raw materials purchased,Finished goods inventory,
21、Sales made,Accounts receivable period,Accounts payable period,X,X,X,14,Turnover Ratios-Description,Turnover ratios measures how many times per year a given resource is consumedPeriod ratios measure the number of days that is takes for a given resource to“turn over”Managements objective is to stretch
22、 out the accounts payable period(i.e.,have low accounts payable turnover)and shorten the periods for accounts receivable and inventory(i.e.,have high accounts receivable and inventory turnover),Turnover ratios measure how well a firm is managing its resources.,15,Turnover Ratios-Tradeoffs,Ratio Impr
23、ovements,Decrease the receivables collection periodi.e.,collect the accounts receivable fasterDecrease the inventory holding periodi.e.,sell completed products fasterIncrease the account payable periodi.e.,take longer to pay suppliers,Strategic Tradeoff,If the receivables collection period is too sh
24、ort,customers may buy at a competitor that has more generous credit terms.(Often this period is dictated by industry norms)If the inventory holding period is too short the company may not have enough inventory to fill a big order.Also,the company may not be able to outlast a strike,either at its own
25、 facility or at one of its primary suppliers facilitiesIf the accounts payable period is too long,suppliers could raise their prices,charge interest(often at very high rates),or even refuse to supply the firm on credit.Also,workers may get restless if they have to wait longer to receive their payche
26、cks.,Managing turnover ratios means managing strategic trade-offs.,16,Leverage Ratios-Definitions,*All three ratios here are called“leverage”ratios by different people,so be sure to understand which ratio is being used when someone is talking about leverage,Leverage ratios use line items from the ba
27、lance sheet.,Ratios*,Definitions,DuPont leverage ratio,AssetsEquity,Debt to equity ratio,Long-term debtEquity,Debt to total capitalor debt to total assets ratio,Total liabilitiesDebt+equity,Total liabilitiesAssets,=,17,Leverage Ratios-Description,Money can be raised from debt sources(banks,bond mark
28、ets)or equity sources(stockholders)Leverage ratios reflect both the financing policies of the firm and the riskiness of the businessIn order to analyze a firms leverage ratios,one needs to understand the definitions of debt and equity,Leverage ratios measure the respective claims of debt and equity
29、holders.,18,Debt Versus Equity,Contractual payments over the life of the loanInvestor legally guaranteed full return of principle plus interestnothing above thatIn case of liquidation,debtor has preferential claim on proceeds from sale of assets,No guaranteed payments from common stockInvestor“owns”
30、part of firmright to appreciation of firms valueIn case of liquidation,equity owner takes what is left(may be nothing),Debt and equity have very different characteristics.,Debt=anything that contractually requires payments to be made before the equity holders have access to the firms earnings,Equity
31、=the value of the firm left over after all the debt holders have been paid,Lower risk to investor;investor demands lower return,Higher risk to investor;investor demands higher return,19,Debt Questions-Debt and Equity,Debt in Leverage RatiosBain typically looks only at long-term debt(debt with a term
32、 of 1 year or more)Accountants measure debt as short-term debt plus long term debtEquity in Leverage RatiosBain typically uses the market value of equity(I.e.,the share price multiplied by the number of shares).Others may use the book value of equity,which is the amount shown on the balance sheet,20
33、,Debt Questions,Accounts payable?Short-term debt?Long-term debt?Cancelable leases?Noncancelable leases?Preferred stock?Common stock?Deferred tax?,Would you define the following as debt?,21,Debt Answers,Accounts payableShort-term debtLong-term debtCancelable leasesNoncancelable leases,Some items are
34、clearly debt,others are clearly not debt,still others are debatable.,Not debt.It is part of working capital,and is“secured”by the inventory and receivables that it is used to finance,Debt,if it used to finance capital expansions of the companyNot debt,if it used to finance working capital,Debt.,Not
35、debt.Because they are cancelable,they are not contractual obligations,Debt.Because they are non-cancelable,they are contractual obligations.(For all publicly traded US companies,the present value of all the noncancelable lease payments must be disclosed in balance sheet footnotes.),Debatable Argumen
36、t for equity-contractual obligations to pay dividends on preferred stock are met after debtholders claims are metArgument for debt-there is a contractual obligation to pay dividends on preferred stock before common stock dividend payments can be made,Not debt.It is equity,Common stock,Debt,but debat
37、able.Often considered debt given long-term nature,Deferred tax,Preferred stock,22,Liquidity and Coverage Ratios-Definitions,Liquidity ratios use line items from the balance sheet.Coverage ratios use line items from the income statement.,Ratios,Definitions,Current ratio,Current assetsCurrent liabilit
38、ies,Quick ratio(acid test),Cash+marketable securities+receivablesCurrent liabilities,Interest coverage ratio,Earnings before interest and taxesInterest expense,Fixed charge coverage,Earnings before interest and taxesAll essential payments(including lease payments),Liquidity:,Coverage:,23,Liquidity a
39、nd Coverage Ratios-Description,Acceptable values for these ratios differ by industry.However,when the current ratio or coverage ratios fall below 1 that means the firm is unable to meet its obligationsIt is a useful exercise to calculate how much revenue could drop(or costs rise)before coverage woul
40、d drop below 1,Liquidity ratios measure the firms ability to meet its short-term obligations.Coverage ratios measure the firms ability to meet its long-term obligations.,24,Agenda,Using ratiosTypes of key ratiosprofitabilityturnoverleverageliquiditycoverageReturn on EquityRatio exercisesForecasting
41、exerciseAbbreviationsKey takeaways,25,Return on Equity,Return on equity is defined as profit after tax(earnings)divided by equity.It relates economic outputs(profit)to inputs(equity).It tells us the amount of profits the company earned on each dollar the stockholders invested in the firm.It is impor
42、tant to note that not all of the earnings are paid to the stockholders when they are earned.Only some portion of the earnings will be returned now in the form of dividends.The remainder(retained earnings)will be re-invested in the company to finance growthThe size of the divided is decided by the bo
43、ard of directors;an individual stockholder has no influence over when he/she actually receives the return that he/she has earnedIt is a combination of profitability,turnover,and leverage ratios,Return on equity,ROE,is the acid test of success for a business.,26,DuPont Formula,By separating ROE into
44、its components,one can gain insight into how to improve the performance of a business.,ROE=,Profit after taxEquity,ROE=,Profit after taxSales,SalesAssets,AssetsEquity,X,X,Return on Assets,Leverage,ROS,Asset turnover,This is known as the DuPont formula,ROE=Profitability X Turnover X Leverage,27,Agend
45、a,Using ratiosTypes of key ratiosprofitabilityturnoverleverageliquiditycoverageReturn on EquityRatio exercisesForecasting exerciseAbbreviationsKey takeaways,28,Unidentified Industries Exercise,The objective of this exercise is to test your understanding of financial ratios.,Exercise:The balance shee
46、ts(in percentage form)and selected ratios for six industries are given on the following page.Please match each of the six industries to the financial information,Coal miningGrocery storesHotels and motelsLegal servicesPackaged softwarePotato chips and snacks,29,Unidentified Industries Exercise-Data,
47、30,Unidentified Industries Exercise-Answer,Characteristics:,Financial ratios:,Companies:,Hotels and Motels,Very high fixed assetsLow inventoryShort collection periodLow asset turnoverHigh gross marginHigh leverage,Fixed assets=65%Inventory=1%Collection period=9 daysAsset turns=0.7xGross margin=64%To
48、tal liabilities to net worth=127%,A,Coal Mining,Very high fixed assetsLow inventoryLong collection period,Fixed assets=52%Inventory=2%Collection period=52 days,B,Potato Chips&Snacks,Low percentage of cashLong collection cycle,Cash=5%Collection=31 days,C,Grocery Stores,High percentage of cashLow acco
49、unts receivableShort collection periodHigh inventoryGood liquidity ratios,Cash=14%Accounts receivable=5%Collection period=3 daysInventory=33%Quick ratio=0.6x;current ratio=1.9x,D,Legal Services,High percentage of cashAlmost zero inventoryHigh asset turnoverHigh profitabilityLong collection period,Ca
50、sh=31%Inventory=1%Assets turns=4.0 xGross margin=57%;ROS=12%;ROE=29%Collection period=52 days,E,Prepackaged Software,High percentage of cashHigh accounts receivableLow inventoryHigh gross marginLow fixed assetsSignificant intangible assets(patents),Cash=22%Accounts receivable=32%Inventory=5%Gross ma
