Presentation on theme: "Financial Ratio Analysis"— Presentation transcript:
1 Financial Ratio Analysis Financial analysis:Applying analytical techniques to financial statements and other relevant data to produce information useful for decision making.FocusThree Issues :Profitability, Liquidity, Safety (Solvency or Risk)In general, each financial ratio is closely related to one of the three fundamental issues.This analysis is intended as a background review. See also “Merrill Lynch How to Read A Financial Statement” which is available on the web.
2 Balance Sheet GI Company December 31 Year 1 (Current year) Year 2 (Last year)Current Assets:Cash and cash equivalents $ , $ 35,000Trading securities (at fair value) , ,000Accounts receivable , ,000Inventory (at lower of cost or market) , ,000Total current assets , ,000Investments available-for-sale (at fair value) , ,000Fixed Assets:Property, plant, and equipment (at cost) ,900, ,800,000Less: Accumulated depreciation (380,000) (350,000)1,520, ,450,000Goodwill , ,000Total assets $2,615,000 $2,450,000Current Liabilities:Accounts payable $ 150,000 $ 125,000Notes payable , ,000Accrued and other liabilities , ,000Total current liabilities , ,000Long-term debt:Bonds and notes payable , ,000Total liability ,345, ,300,000Stockholders’ Equity:Common stock (100,000 shares outstanding) , ,000Additional paid-in capital , ,000Retained earnings , ,000Total equity ,270, ,150,000Total liability and equity $2,615,000 $2,450,000
3 Income Statement GI Company (Year – 1) Sales $1,800,000 Cost of goods sold(1,000,000)Gross profit800,000Operating expenses(486,697)Interest expenseDepreciation and Amortization expense(10,000 )(13,303)Net income before income taxes290,000Income taxes (31%)( 90,000)Net income after income taxes$ 200,000Earning per share$2Operating cash flow$255,000Dividends for the year$0.80 per shareMarket price per share$12
4 Working capital = Current assents – Current liabilities Liquidity RatiosWorking capital = Current assents – Current liabilitiesYear 2: $715,000 – $695,000 = $20,000Year 1: $665,000 – $700,000 = ($35,000)
5 Current ratio (working capital ratio) = Liquidity RatiosCurrent assetsCurrent liabilitiesCurrent ratio (working capital ratio) =Year 2: =Year 1: =$715,000$695,000$665,000$700,000= 1.03= 0.95(Industry average = 1.5)The ratio, and therefore Gi’s ability to meet its short-term obligations, has improved, though it is low compared to the industry’s average
6 Cash equivalents + Market securities + Net receivables Liquidity RatiosAcid-test ratio =Cash equivalents + Market securities + Net receivablesCurrent liabilities(Year 2) =(Year 1) =$50,000 + $75,000 + $300,000$695,000$35,000 + $65,000 + $290,000$700,000= 1.03= 0.95(Industry average = 0.80)The industry average of .80 is higher than Gi’s ratio, which indicates that Gi may have trouble meeting short-term needs.
8 Accounts receivable turnover = Activity RatiosNet credit salesGross receivablesAccounts receivable turnover === times$1,800,000$300,000This ratio indicates the receivables’ quality and indicates the success of the firm in collecting outstanding receivables. Faster turnover gives credibility to the current and acid-test ratios.
9 Accounts receivable turnover in days = Activity RatiosGross receivablesNet credit sales / 365Accounts receivable turnover in days === days365 daysReceivable turnoverThis ratio indicates the average number of days required to collect accounts receivable.
10 Cost of goods sold Inventory turnover = Average inventory = $1,000,000 Activity RatiosCost of goods soldAverage inventoryInventory turnover === times$1,000,000$290,000This measure of how quickly inventory is sold is an indicator of enterprise performance. The higher of turnover, in general, the better the performance.
11 Inventory turnover in days = Activity RatiosAverage inventoryCost of goods sold / 365Inventory turnover in days === days365 daysInventory turnover3.45This ratio indicates the average number of days required to sell inventory.
12 Operating cycle = AR turnover in days + Inventory turnover in days Activity RatiosOperating cycle = AR turnover in days + Inventory turnover in days= days days= daysThis operating cycle indicates the number of days between acquisition of inventory and realization of cash from selling the inventory.
13 Working capital turnover = Activity RatiosSalesworking capitalWorking capital turnover === 90 times$1,800,000$715,000 - $695,000This ratio indicates how effectively working capital is used.
14 Return on total assets = Net income/Total assets Profitability RatiosReturn on total assets = Net income/Total assets= $200,000 / $2,615,000= 7.65%
15 Gross margin percentage = Gross margin / Sales Profitability RatiosGross margin =Sales – Cost of Good Sold= $1,800,000 - $1,000,000= $800,000Gross margin percentage = Gross margin / Sales= $800,000 / $1,800,000= 44.44%This ratio is a good indication of how profitable a company is at the most fundamental level. Companies with higher gross margins will have more money left over to spend on other business operations, such as research and development or marketing.
16 Net income Net profit margin = Net sales = $200,000 = 11.11% Profitability RatiosNet incomeNet salesNet profit margin === %$200,000$1,800,000This ratio indicates profit rate and, when used with the asset turnover ratio, indicates rate of return on assets, as show below.
17 Operating income Total sales Operating margin = Profitability Ratios $800,000 - $486,697$1,800,000== %Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt.
18 Net sales Total asset turnover = Total assets = $1,800,000 Activity RatiosTotal asset turnover =Net salesTotal assets== times$1,800,000$2,615,000This ratio is an indicator of how Gi makes effective use of its assets. A high ratio indicates effective asset use to generate sales.
19 DuPont return on assets = Net income/Total assets Profitability RatiosDuPont return on assets = Net income/Total assetsNet incomeNet salesTotal assetsx== % x 0.69times= 7.67%Note that this ratio uses both net profit margin and the total asset turnover. This ratio allows for increased analysis of the changes in the percentages. The net profit margin indicates the percent return on each sale while the asset turnover indicates the effective use of assets in generating that sale.
20 Net income + Interest expense (1- Tax rate) Profitability RatiosNet income + Interest expense (1- Tax rate)Long-term liabilities + EquityReturn on investment === 0.11 times$200,000 + $10,000 (1-0.31)$650,000 + $1,270,000ROI measures the performance of the firm without regard to the method of financing.
21 Net income – Preferred dividends Profitability RatiosNet income – Preferred dividendscommon equityReturn on common equity === %$200,000 - $0$1,270,000
22 Common stockholders’ equity Long-term Debt-paying Ability RatioTotal liabilitiesCommon stockholders’ equityDebt / Equity =(Year 2) = $1,345,000 / $1,270,000 = 1.06(Year 1) = $1,300,000 / $1,150,000 = 1.13This ratio indicates the degree of protection to creditors in case of insolvency. The lower this ratio the better the company’s position. In Gi’s case, the ratio is very high, indicating that a majority of funds come from creditors. However, the ratio is improving.
23 Total liabilities Debt ratio = Total assets Long-term Debt-paying Ability RatioTotal liabilitiesTotal assetsDebt ratio =(Year 2) = $1,345,000 / $2,615,000 = 51.4%(Year 1) = $1,300,000 / $2,450,000 = 53.1%This ratio indicates that more than half of the assets are financed by creditors.
24 Returning income before taxes and interest Long-term Debt-paying Ability RatioReturning income before taxes and interestInterestTimes interest earned === 30 times$290,000 + $10,000$10,000This ratio reflects the ability of a company to cover interest charges. It uses income before interest and taxes to reflect the amount of income available to cover interest expense.
25 Operating cash flow / Total debt = Long-term Debt-paying Ability RatioOperating cash flowTotal debtOperating cash flow / Total debt === %$255,000$1,345,000This ratio indicates the ability of the company to cover total debt with yearly cash flow.
26 The operating cash flow ratio = Liquidity RatiosCash from operationsCurrent liabilitiesThe operating cash flow ratio =$255,000$700,000==The purpose of this ratio is to assess whether or not a company's operations are generating enough cash flow to cover its current liabilities. If the ratio falls below 1.00, then the company is not generating enough cash to meet its current commitments.Note: The cash from operating activities is $255,000 shown at the bottom of the income statement.
27 EBIT Profitability Ratio = Earnings + Interest Expense + Tax Expense = $200,000 + $10,000 + $90,000= $300,000A measure of a company's earning power from ongoing operations, equal to earnings before deduction of interest payments and income taxes. EBIT excludes income and expenditure from unusual, non-recurring or discontinued activities.
28 EBITDA Profitability Ratio = Earnings + Interest Expense + Tax Expense +Depreciation + Amortization= $200,000 + $10,000 + $90,000 + $13,303= $ 313,303This earnings measure is of particular interest in cases where companies have large amounts of fixed assets which are subject to heavy depreciation charges or in the case where a company has a large amount of acquired intangible assets on its books and is thus subject to large amortization charges. Since the distortionary accounting and financing effects on company earnings do not factor into EBITDA, it is a good way of comparing companies within and across industries.