ELEC2804 Engineering Economics and Finance Session 6: Financial Ratios Dr. Wilton Fok

Contents 6.1 Introduction 6.2 Profitability 6.3 Liquidity 6.4 Capital Structure 6.5 Shareholder ratios 6.6 Efficiency 6.7 Limits of Financial Ratios 6.8 Summary

6.1 Introduction What we have learnt in Accounting? So far what we have learnt is Financial Accounting It Focuses on preparing external financial reports that are used by the outsiders, that is, people who have an interest in the business but are not part of the management. We record the transactions and prepared a summary of Profit and loss, assets, liabilities and owner’s equity. Annual Report describes a firm’s financial status and usually discusses the firm’s activities during the past year and its prospects for the future.

6.1. Introduction Managerial Accounting. Financial accounts and statements are records of past events. Reports of future estimates are called Budgets. For reports of future, we must analyze the past and plan the future. Thus, Analysis, Measurement, and Planning are fundamental in Managerial Accounting Managerial Accounting provides financial information that managers inside the organization can used them to evaluate and make decisions about current and future operations. Techniques: Budgeting - Planning exercise for financial expenditures and incomes Costing analysis – Measuring the cost of the business Accounting Ratios – Analyzing the performance, efficiency and profitability of a firm

6.1 Introduction Financial statements analysis It is the process of looking beyond the face of the financial statements to gain additional insight into a company’s financial health. Ratio analysis It is a technique for analyzing the relationship between two items from a company’s financial statements for a given period. calculating & interpreting financial ratios taken from financial reports to assess a firm.

Accounting ratios analysis 6.1. Introduction Most of the accounting ratios are derived from the financial statements: balance sheet; P & L account, and cash flow statement. Besides Balance Sheet, P & L Account, and Cash Flow Statement. There are other Managerial Accounting Reports, e.g.: sales report , production costs reports , operation costs reports , suppliers accounts , clients accounts and other detailed financial reports Accounting ratios analysis

6.1. Introduction Types of common Financial Ratios Profitability Liquidity Capital Structure Shareholder ratios Efficiency

Case: ABC Co. Balance Sheet Assets: Current assets Cash $128,000 Accounts receivable $9,900 Less: Allowance for doubtful accounts –900 9, 000 Merchandise inventory 4,000 Raw materials inventory 2,000 Work-in-process inventory 14,000 Finished goods inventory 13,000 Supplies inventory 600 Prepaid rent 12,000 Prepaid insurance 5,000 Total current assets $190,600

ABC Co. Balance Sheet Property, plant, and equipment Administrative equipment $ 5,000 Selling furniture and fixtures 8,000 Production equipment 89,000 $102,000 Less: Accumulated depreciation – 18,000 Total property, plant, and equipment $ 84,000 Intangible assets Patents $ 10,00 Copyrights 600 Trademarks 1,400 Total intangible assets $ 12,000 Total assets $288,000

ABC Co. Balance Sheet Liabilities and stockholders’ equity: Current liabilities Accounts payable $ 6,000 Other accounts payable 12,000 Interest payable 6,000 Payroll taxes payable 1,400 Sales taxes payable 600 Income taxes payable 42,000 Current portion of long-term note payable 15,000 Total current liabilities $ 83,000 Long-term liabilities: Note payable – Vail National Bank $ 60,000 Less: Current portion 15,000 Total long-term liabilities 45,000 Total liabilities $128,000

ABC Co. Balance Sheet Stockholders’ equity Paid-in capital: Common stock, $10 par value, 100,000 shares authorized, 4,000 shares issued and outstanding $ 60,000 Paid-in capital in excess of par – common stock 40,000 Total paid-in capital $100,000 Retained earnings 59,000 Total stockholders’ equity 159,000 Total liabilities and stockholders’ equity $288,000

ABC Co. P&L Account Net sales $527,000 Cost of goods sold 296,000 Gross profit $231,000 Selling expenses $48,000 Administrative expenses 73,00 Total operating expenses 121,000 Operating income $110,000 Other revenues and expenses: Interest revenue $ 600 Interest expense (6,000) Total other revenues and expenses (5,400) Income before income taxes $105,000 Less Income taxes 42,000 Net income $ 63,000 Earnings per share $ 15.75

6.2 Profitability Profitability is the ease with which a company generates income Profitability ratios measure a firm’s past performance and help predict its future profitability level Common parameters for measuring Profitability: 1. Return on Assets (ROA) 2. Return on Equity (ROE) 3. Profit margin before income tax 4. Profit margin after income tax 5. Total Asset turnover 6. Gross Profit 7. Net Profit 8. Return on Capital

6.2 Profitability 6.2.1 Return on assets (ROA): This ratio measures how efficiently the company uses its assets to produce profits. ROA = Net income before taxes Total assets In ABC Co: ROA = $105,000  36% $288,000

6.2 Profitability 6.2.1 Return on assets (ROA) (A) Profit margin before income tax This ratio measures the percentage of income before income taxes produced by a given level of revenue Profit margin before income tax = PM= Net income before taxes Sales In ABC Co: PM = $105,000  20% $527,000

6.2 Profitability (B) Profit margin after income tax: This ratio measures the amount of after-tax net income generated by a dollar of sales Profit margin after income tax = Net income after taxes Sales In ABC Co. PM after tax = $63,000  12% $527,000

6.2 Profitability 6.2.1 Return on assets (ROA) (C) Total asset turnover This ratio calculates the amount of sales produced for a given level of assets used. Total asset turnover = Sales Total assets In ABC Co: = $527,000 = 1.83 times $288,000

6.2 Profitability 6.2.1 Return on assets (ROA) Relationship among the ratios: Return on assets = Net income before tax x Sales Sales Total assets = (A) Profit margin x (C) Total asset turnover A company may have a good ROA if either Case 1: they can achieve a high profit margin, OR Case 2: They can a high Total asset turnover Which one should be preferred?

6.3 Liquidity Ratios 6.3 Liquidity Ratios An liquidity describes the ease with which it can be converted to cash. Liquidity ratios evaluate a firm’s ability to generate sufficient cash to meet its short-term obligations. Liquidity Ratios are of most interest to stockholders, long-term creditors, and company management.

6.3 Liquidity Ratios 6.3.1. Current ratio This ratio measures the company’s ability to meet its current liabilities with current assets. Current ratio = Current assets Current liabilities In ABC Co, Current Ratio = $190,000  2.27 $83,000 If too small, may not have enough assets for paying liability If too high, the firm cannot fully leverage the loan Recommended value = 2 to 1 or greater

6.3 Liquidity Ratios In the ABC Co. Ltd.: 6.3.3 Debt ratio: It measures what proportion of a company’s assets is financed by debt. Assets = Liabilities + Owners’ equity Debt ratio = Total liabilities / Total assets In the ABC Co. Ltd.: Debt ratio = $128,000 / $288,000  45% Why is some amount of debt useful?

Coverage ratio = ($105,000 + $6,000)  18.5 times 6.3 Liquidity Ratios 6.3.4 Coverage ratio: This ratio is also called the times-interest-earned ratio. It indicates a company’s ability to make its periodic interest payments. Coverage ratio = Earnings before interest expense and income taxes Interest expense In the ABC Co.: Coverage ratio = ($105,000 + $6,000)  18.5 times $6,000

6.4 Shareholder ratios Shareholders and investors are interested in the shareholder ratios which shows the effectiveness of their investments Earnings per share Dividend yield Dividend cover Price earnings ratio

6.4 Shareholder ratios Earning per share E.g. in ABC Co. = net profit after tax and preference dividends no. of ordinary shares in issue ABC Co, P&L Account Net sales $527,000 Cost of goods sold 296,000 Gross profit $231,000 Selling expenses $48,000 Administrative expenses 73,00 Total operating expenses 121,000 Operating income $110,000 Other revenues and expenses: Interest revenue $ 600 Interest expense (6,000) Total other revenues and expenses (5,400) Income before income taxes $105,000 Less Income taxes 42,000 Net income $ 63,000 Earnings per share $ 15.75 E.g. in ABC Co. Earning per share = 63000 / 4000 = $15.75

6.4 Shareholder ratios market price per share Dividend yield = Gross dividend per share market price per share Dividend cover = Net profit after tax and preference dividends net dividend on ordinary shares

6.5 Shareholder ratios Price Earning ratio (P/E Ratio) = Market price Earning per share It tells the “Payback” of the investment A P/E of 19 (times) means that the investment will be breakeven in 19 years (ignore the stock price increment) The reasonable P/E of a listed company is around 10-20. The P/E of a fast growth company can be over 20-30

6.6 Efficiency “Efficiency” measures the efficiency and effectiveness of employing the company resources, including capital, stock, debt and cash…etc. Important parameters are: Net sales to working capital Inventory Turnover Receivable Turnover (Creditor Turnover)

6.6 Efficiency 6.6.1. Net sales to working capital This ratio indicates the level of sales generated for a given level of working capital (which is ‘the money or equivalent you have to work with currently’). Net sales to working capital = Sales (Current assets – Current liabilities) In ABC Company = $527,000  4.94 times ($190,000 – $83,000)

6.6 Efficiency 6.6.2 Inventory turnover This ratio indicates the number of times total merchandise inventory is purchased (or finished goods inventory is produced) and sold during a period. Inventory turnover = Cost of sales Inventory In the ABC Co.: Inventory turnover = $295,000  16.5 times ($4,000 + $13,000) Average number of days Elevation Sports, Inc., holds its inventory = 365 / 16.5  22 days Thus, the shorter the number of days of inventory held (higher turnover ratio), the better - is this always true?.

6.6 Efficiency 6.6.3. Receivables turnover (Creditor Turnover) It measures how quickly a company collects its accounts receivable. Accounts receivable turnover = Net credit sales Accounts receivable In the ABC Co. Net credit sales = $151,000 – $2,000 = $149,000 Receivable turnover = $149,000 / $9,000  16 times Average collection period = 365 / 16  23 days Thus, the shorter the collection period (higher turnover ratio), the better – is this always true?

6.7 Limitations of Ratio Analysis 1. Attempting to predict the future using past results depends upon the predictive value of the information used. 2. The financial statements used to compute the ratios are based on historical cost. 3. Figures from the balance sheet used to calculate the ratios are year-end numbers. 4. Different industries had different benchmarking values. It is difficult to compare the ratios of a company in one industry with those of a company in another industry. 5. Lack of uniformity concerning what is to be included in the numerators and denominators make comparisons extremely difficult.

Thank you! Q&A