4 Financial RatiosTools that help us determine the financial health of a company.We can compare a company’s financial ratios with its ratios in previous years (trend analysis).We can compare a company’s financial ratios with those of its industry (benchmarks).
5 Uses of Financial Ratios within the Firm Identify deficiencies in a firm’s performance and take corrective actions.Evaluate employees’ performance and determine incentive compensation.Compare the financial performance of different divisions within the firm
6 Uses of Financial Ratios within the Firm Prepare financial projections, both at the firm and division levels.Understand the financial performance of competitorsEvaluate the financial condition of a major supplier.
7 Uses of Financial Ratios Outside the Firm Lenders in deciding whether or not to make a loan to a company.Credit-rating agencies in determining a firm’s credit worthiness.Investors in deciding whether or not to invest in a company.Major suppliers in deciding to sell and grant credit terms to a company.
8 We will want to answer questions about the firm’s 1. Liquidity2. Efficient use of Assets3. Leverage (financing)4. Profitability/Returns5. Shareholder Wealth
10 CyberDragon’s Balance Sheet ($000) Assets: Liabilities & Equity:Cash $2,540 Accounts payable ,721Marketable securities 1,800 Notes payable ,500Accounts receivable 18,320 Accrued taxes payable ,200Inventories 27,530 Other current liabilities ,102Total current assets ,190 Total current liabilities ,523Plant and equipment 43,100 Long-term debt (bonds) ,000less accum deprec. 11,400 Total liabilities ,523Net plant & equip ,700 Common stock ($10 par) ,000Total assets ,890 Paid in capital ,000Retained earnings ,367Total stockholders' equity ,367Total liabilities & equity ,890
11 JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.CONTACT:R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.
12 CyberDragon’s Income Statement Sales (all credit) $112,760Cost of Goods Sold (85,300)Gross Profit ,460Operating Expenses:Selling (6,540)General & Administrative (9,400)Total Operating Expenses (15,940)Earnings before interest and taxes (EBIT) 11,520Interest charges:Interest on bank notes: (850)Interest on bonds: (2,310)Total Interest charges (3,160)Earnings before taxes (EBT) ,600Taxes (3,344)Net Income ,016CyberDragon’s Income Statement
13 CyberDragon Other Information Dividends paid on common stock $2,800Earnings retained in the firm 2,216Shares outstanding (000) ,300Market price per shareBook value per shareEarnings per shareDividends per share
14 1. Liquidity RatiosDo we have enough liquid assets to meet approaching obligations?
24 What is the firm’s Inventory Turnover? 85,30027,530= timesCyberDragon turns their inventory over 3.1 times per year.The industry average is 3.9 times. Is this efficient?
25 Also … What is the firm’s “Inventory Holding Period” or “Days Sales In Inventory”
26 2. Operating Efficiency Ratios Is management generating adequate operating profits on the firm’s assets?
27 Operating Income Return on Investment (OIROI) … also known as Operating Return on Assets (OROA)
28 What is the firm’s Operating Income Return on Investment (OIROI)? 11,52081,890= %Slightly below the industry average of 15%.The OIROI reflects product pricing and the firm’s ability to keep costs down.
49 What is CyberDragon’s Return on Equity (ROE)? 5,01634,367= 14.6%The industry average is 17.54%.
50 What is CyberDragon’s Return on Equity (ROE)? 5,01634,367= 14.6%The industry average is 17.54%.Is this what we would expect, given the firm’s leverage?
51 5. Is Management Creating Shareholder Value? These ratios indicate what investors think of management’s past performance and future prospects.Price/Earnings ratioPrice/Book ratio
52 What is CyberDragon’s Price/Earnings (P/E) Ratio? 203.86= 5.18
53 What is CyberDragon’s Price/Book Ratio? 2026.44= .76
54 5. Is Management Creating Shareholder Value? … Cont. Economic Value Added (EVA) … Based on “economic profit” not “accounting profit”
55 Economic Value Added (EVA) How is shareholder value created?If the firm earns a return on capital that is greater than the investors’ required rate of return.EVA attempts to measure a firm’s economic profit, rather than accounting profit.EVA recognizes a cost of equity in addition to the cost of debt (interest expense).
56 EVA: Formula EVA = (r-k) X A where: r = Operating return on assets k = Total cost of capitalA = Amount of capital (or Total Assets)
57 EVA ExampleA firm has total assets of $5,000 and has raised money from both debt and equity in equal proportion. Further, assume that cost of debt is 8% and the cost of equity is 16%. Assume the firm earns 17% operating income on its investments.EVA = (17%-12%)* $5,000 = $250Where, cost of capital= .5*(8%) + .5*(16%) = 12%
58 Conclusion:Even though CyberDragon has higher leverage than the industry average, they are much less efficient, and therefore, less profitable.
59 Limitations of Ratio Analysis It is difficult to tell whether company is, on balance, in a strong or weak position.Inflation and seasonal factors may distort ratios.Different operating and accounting practices may distort comparisons.“Window dressing” techniques can make ratios look better than they actually are.“Average” performance is not necessarily good.Sometimes it is hard to tell if a ratio is “good” or “bad”.Difficulty in identifying industry categories or finding peers.Published peer group or industry averages are only approximations.
60 JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.CONTACT:R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.