Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 1 Financial Ratio Analysis

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 2 of 52 1.Liquidity ratios 2.Activity ratios 3.Leverage ratios 4.Profitability 5.Trends and graphs to spot problems 6.Using an Excel template for instant “can’t miss” financial analysis E. Ratio Analysis Calculations and What the Numbers Really Means

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 3 of 52 Using Financial Ratios

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 4 of 52 Return on Equity

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 5 of 52 Return on Equities (ROE) and Levels of Performance for 10 Diverse Companies Return on Equity (%) Profit margin (%) Asset Turnover (times) Financial Leverages (times) Analog Devices BankAmerica Co Duke Power Exxon Co Food Lion Hewlett-Packard Nike Nordstrom Inc Southwest Airline Tiffany & Company

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 6 of 52 Debt Management Analysis Leverage ratios that show how a firm uses debt financing and its ability to meet debt repayment obligations Debt ratio Debt to equity ratio Times-interest-earned ratio

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 7 of 52 Indicates how a firm finances its capital Debt Ratio

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 8 of 52 Measures the extent to which earnings can decline without defaulting debt service. Note: Dell issued $500 million worth of senior notes and long-term bonds with a combined interest rate of 6.8%. Times Interest Earned

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 9 of 52 Liquidity Analysis Ratios that show the relationship of a firm’s cash and other assets to its current liabilities (short-term obligations) Current ratio Quick ratio Cash (liquidity) ratio

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 10 of 52 Measures a firm’s short-term solvency. Formula: Current Ratio

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 11 of 52 Excludes inventories and prepaid expenses Formula: Quick Ratio

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 12 of 52 An indication of a firm’s immediate liquidity Formula: Liquidity Ratio

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 13 of 52 Asset Management Analysis A set of ratios which measure how effectively a firm is managing its assets Inventory turnover ratio Days sales outstanding ratio Total assets turnover ratio

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 14 of 52 Activity Ratios Measure how effectively the firm is using its resources Days Sales Outstanding (DSO) Inventory turnover (DSI) Total asset turnover Return on Assets (ROA)

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 15 of 52 Highlights the rate at which the inventory is being sold. The typical item sits in inventory almost 0.10 months (12 months/121.24) or 3 days before being sold Inventory Turnover Ratio

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 16 of 52 Alternate Definition for Inventory Turnover Ratio

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 17 of 52 Determines whether receivables are being collected aggressively enough. Days Sales Outstanding (DSO)

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 18 of 52 Days Sales in Inventory What It Measures: The amount of inventory (stock) expressed in days of sales. For example, if 2 items a day are sold and 20 items are held in inventory, this represents 10 days' (20/2) sales in inventory. How You Compute: The ratio computed by dividing inventory by cost of sales, and multiplied the result by 365

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 19 of 52 The Business Operating Cycle Days Sales Outstanding = days + Days Sales in Inventory = 3.84 days Total Days Operating Cycle = days

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 20 of 52 Indicates whether a company is generating a sufficient volume of business for the size of its asset investment. Total Asset Turnover Ratio

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 21 of 52 Profitability Analysis A set of ratios which show the combined effects of liquidity, asset management, and debt on operating results Profit margin on sales Return on total assets Return on common equity

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 22 of 52 Profitability Ratios Measure management’s overall effectiveness as shown by the returns generated on sales and investment Return on equity (return on investment) Gross margin Net margin Book value per share Earnings per share Price to earnings ratio (P/E ratio)

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 23 of 52 Indicates the profitability of the sales effort. Gross Margin

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 24 of 52 Illustrates what percentage of each sales dollar is retained in earnings. Net Margin

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 25 of 52 Measures the rate of return on the owner’s investment. Return on Equity (ROE)

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 26 of 52 How the Debt to Equity Ratio Impacts Return on Equity This is an example of a healthy company that might not have a spectacular ROE because there is so much equity in the company. This an example of a highly leveraged company that might have a spectacular ROE because the owners have put so little of their own resources into the company. Assets Liabilities Equity Assets Liabilities Equity = =

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 27 of 52 Market Trend Analysis A set of ratios that relate the firm’s stock price to its earnings and book value per share P/E ratio Market/book ratio

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 28 of 52 Earnings Per Share (EPS) Indicates earnings attributable to each share of stock. Widely used indicator of a corporation’s performance Net income available for distribution $2,122 Common shares outstanding 2,644 Earnings per share (EPS): $0.80

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 29 of 52 Price to Earnings Ratio Indicates how many times a corporation is able to multiply its earnings in terms of asking price per share of stock. Share price: $32 as of August 22, 2003

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 30 of 52 Book Value/Share Indicates what the value of a share of stock is according to the books (financial statements). Total Assets $15,470 Total liabilities 10,597 Stockholders’ equity 4,873 Preferred stock obligation 0 Net worth assigned to common stockholders 4,873 Common shares outstanding 2,644 Net worth (Book value): $1.84

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 31 of 52 Market/Book Ratio What It Measures: Indicates how investors regard the company – a higher ratio indicates that investors are willing to bet a higher return on investment How You Compute: The ratio of a stock’s market price to its book value

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 32 of 52 Trends and Graphs to Spot Problems Trends analysis, where one plots a ratio over time, is important, because it reveals whether the firm’s ratios are improving or deteriorating over time.

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 33 of 52 Limitations of Financial Ratios Ratio analysis is useful, but analysts should aware of ever-changing market conditions and make adjustments necessary. It is difficult to generalize about whether a particular ratio is good or bad. Ratio analysis based on any one year may not represent the true business condition.

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 34 Quick Financial Analysis Horizontal versus Vertical Analysis

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 35 of 52 Horizontal Analysis Determine the total dollar change (variance) from year to the next. Determine the percent change (variance) from one year to the next Dollar Chang e Percent Change (%) Cash A/R 50,000 30,000 40,000 50,000 10,000 (20,000) 25% (40%)

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 36 of 52 Vertical Analysis For the balance sheet, determine what percent of total assets each line item totals. For the income statement, determine what percent of total sales each line item totals (%) 2000 (%) Cash A/R Total Assets 50,000 30, ,000 40,000 50, ,000 25% 15.0% 100% 22.2% 27.8% 100%