Tyler Mumbleau Sunday January 29, 2017 Key Concepts—Ratios Tyler Mumbleau Sunday January 29, 2017
Overview Price/Earnings (P/E Ratio) Ratio Analysis Liquidity Ratios Solvency Ratios Profitability Ratios
Price/Earnings (P/E Ratio) Current Share Price / Earnings Per Share The P/E ratio is the amount an investor is willing to pay for a dollar of earnings. If you purchase a stock at a P/E of 50, you would be paying $50 for $1 of earnings. A P/E is most important when it is compared to its industry: If the companies P/E is less than industry average: Could be an indication of investor expectation of lower future growth than the industry. If the companies P/E is more than industry average. Could be an indication of investor expectation of higher future growth than the industry. If a company has negative earnings, the P/E ratio is meaningless and best to use an alternative multiple (e.g. EBITDA/Sales).
Microsoft Valuation Metrics
S&P 500 Historical P/E (Current—25.76)
Chapter 9 Financial Statement Analysis Financial Ratio Analysis
Financial Ratio Analysis Financial ratio analysis is the use of relationships among financial statement accounts to gauge the financial condition and performance of a company. We can classify ratios based on the type of information the ratio provides: Activity Ratios Effectiveness in putting its asset investment to use. Liquidity Ratios Ability to meet short-term, immediate obligations. Solvency Ratios Ability to satisfy debt obligations. Profitability Ratios Ability to manage expenses to produce profits from sales. LOS: Calculate and interpret measures of a company’s operating efficiency, internal liquidity (liquidity ratios), solvency, and profitability, and demonstrate the use of these measures in company analysis. Pages 356–357 3. Financial Ratio Analysis Classifying ratios: Activity ratios Effectiveness in putting asset investment to use. Liquidity ratios Ability to meet short-term, immediate obligations. Solvency ratios Ability to satisfy debt obligations. Profitability ratios Ability to manage expenses to produce profits from sales. Copyright © 2013 CFA Institute
Liquidity Liquidity is the ability to satisfy the company’s short-term obligations using assets that can be most readily converted into cash. Liquidity ratios: Current ratio = Current assets Current liabilities Ability to satisfy current liabilities using current assets. Quick ratio = Cash + Short−term investments + Receivables Current liabilities Ability to satisfy current liabilities using the most liquid of current assets. Cash ratio = Cash + Short−term investments Current liabilities Ability to satisfy current liabilities using only cash and cash equivalents. LOS: Calculate and interpret measures of a company’s operating efficiency, internal liquidity (liquidity ratios), solvency, and profitability, and demonstrate the use of these measures in company analysis. Pages 363–365 Liquidity Liquidity is the ability to satisfy the company’s short-term obligations using assets that can be most readily converted into cash. Liquidity ratios: Current ratio: Ability to satisfy current liabilities using current assets. Quick ratio: Ability to satisfy current liabilities using the most liquid of current assets. Cash ratio: Ability to satisfy current liabilities using only cash and cash equivalents. Copyright © 2013 CFA Institute
Solvency Analysis We use solvency ratios to assess a company’s financial risk. Financial risk is the risk resulting from a company’s choice of how to finance the business using debt or equity. There are two types of solvency ratios: component percentages and coverage ratios. Component percentages involve comparing the elements in the capital structure. Coverage ratios measure the ability to meet interest and other fixed financing costs. Risk Business Risk Sales Risk Operating Risk Financial Risk LOS: Calculate and interpret measures of a company’s operating efficiency, internal liquidity (liquidity ratios), solvency, and profitability, and demonstrate the use of these measures in company analysis. Pages 365–369 Solvency Analysis A company’s business risk is determined, in large part, from the company’s line of business. Financial risk is the risk resulting from a company’s choice of how to finance the business using debt or equity. We use solvency ratios to assess a company’s financial risk. There are two types of solvency ratios: component percentages and coverage ratios. Component percentages involve comparing the elements in the capital structure. Coverage ratios measure the ability to meet interest and other fixed financing costs. Copyright © 2013 CFA Institute
Solvency ratios Component-Percentage Solvency Ratios Coverage Ratios Debt−to−assets ratio = Total debt Total assets Proportion of assets financed with debt. Long−term debt−to−assets ratio = Long−term debt Total assets Proportion of assets financed with long-term debt. Debt−to−equity ratio = Total debt Total shareholders′ equity Debt financing relative to equity financing. Financial leverage = Total assets Total shareholders′ equity Reliance on debt financing. Coverage Ratios Interest coverage ratio = EBIT Interest payments Ability to satisfy interest obligations. Fixed charge coverage ratio = EBIT + Lease payments Interest payments + Lease payments Ability to satisfy interest and lease obligations. Cash flow coverage ratio = CFO + Interest payments + Tax payments Interest payments Ability to satisfy interest obligations with cash flows. Cash−flow−to− debt ratio = CFO Total debt Length of time needed to pay off debt with cash flows. LOS: Calculate and interpret measures of a company’s operating efficiency, internal liquidity (liquidity ratios), solvency, and profitability, and demonstrate the use of these measures in company analysis. Pages 366–368 Solvency Ratios Component-Percentage Solvency Ratios Debt-to-assets ratio Debt−to−assets ratio = Total debt Total assets Proportion of assets financed with debt. Long-term debt-to-assets ratio Long−term debt−to−assets ratio = Long−term debt Total assets Proportion of assets financed with long-term debt. Debt-to-equity ratio Debt−to−equity ratio = Total debt Total shareholders′ equity Debt financing relative to equity financing. Financial leverage (also referred to as the equity multiplier) Financial leverage = Total assets Total shareholders′ equity Reliance on debt financing. Coverage ratios Interest coverage ratio Interest coverage ratio = EBIT Interest payments Ability to satisfy interest obligations. Fixed charge coverage ratio Fixed charge coverage ratio = EBIT + Lease payments Interest payments + Lease payments Ability to satisfy interest and lease obligations. Cash flow coverage ratio Cash flow coverage ratio = CFO + Interest payments + Tax payments Interest payments Ability to satisfy interest obligations with cash flows. Cash-flow-to-debt ratio Cash−flow−to− debt ratio = CFO Total debt Length of time needed to pay off debt with cash flows. Discussion question: Is it possible for a company to have solvency ratios, such as the debt-to-assets and debt-to-equity ratios, that are increasing over time, yet the coverage ratios are not increasing? Copyright © 2013 CFA Institute
Profitability Margins and return ratios provide information on the profitability of a company and the efficiency of the company. A margin is a portion of revenues that is a profit. A return is a comparison of a profit with the investment necessary to generate the profit. LOS: Calculate and interpret measures of a company’s operating efficiency, internal liquidity (liquidity ratios), solvency, and profitability, and demonstrate the use of these measures in company analysis. Pages 369–372 Profitability Margins and return ratios provide information on the profitability of a company and the efficiency of the company. A margin is a portion of revenues that is a profit. A return is a comparison of a profit with the investment necessary to generate the profit. Copyright © 2013 CFA Institute
Profitability ratios: Margins and Returns Each margin ratio compares a measure of income with total revenues: Gross profit margin = Gross profit Total revenue Operating profit margin = Operating profit Total revenue Net profit margin = Net profit Total revenue Return ratios compare a measure of profit with the investment that produces the profit: Operating return on assets = Operating income Average total assets Return on assets = Net income Average total assets Return on equity = Net income Average shareholders′ equity LOS: Calculate and interpret measures of a company’s operating efficiency, internal liquidity (liquidity ratios), solvency, and profitability, and demonstrate the use of these measures in company analysis. Pages 369–370 Profitability Ratios: Margins Each margin ratio compares a measure income with total revenues: Gross profit margin = Gross profit Total revenue Operating profit margin = Operating profit Total revenue Net profit margin = Net profit Total revenue Pretax profit margin = Earnings before taxes Total revenue Copyright © 2013 CFA Institute
Review P/E Ratio Liquidity Ratios Solvency Ratios Profitability Ratios The P/E ratio is the amount an investor is willing to pay for a dollar of earnings. Liquidity Ratios Ability to meet short-term, immediate obligations (Current Ratio, Quick Ratio, etc.) Solvency Ratios Ability to satisfy debt obligations (Debt-to-Equity, Interest Coverage Ratio, etc.) Profitability Ratios Ability to manage expenses to produce profits from sales (Return on Assets, Return on Equity, etc.) These ratios are meaningful when compared to its competitors, industry, and/or sector.
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