Financial Ratio Analysis Financial analysis: Applying analytical techniques to financial statements and other relevant data to produce information useful for decision making. Focus Three 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.

Balance Sheet GI Company December 31 Year 1 (Current year) Year 2 (Last year) Current Assets: Cash and cash equivalents $ 50,000 $ 35,000 Trading securities (at fair value) 750,000 65,000 Accounts receivable 300,000 290,000 Inventory (at lower of cost or market) 290,000 275,000 Total current assets 715,000 665,000 Investments available-for-sale (at fair value) 350,000 300,000 Fixed Assets: Property, plant, and equipment (at cost) 1,900,000 1,800,000 Less: Accumulated depreciation (380,000) (350,000) 1,520,000 1,450,000 Goodwill 30,000 35,000 Total assets $2,615,000 $2,450,000 Current Liabilities: Accounts payable $ 150,000 $ 125,000 Notes payable 325,000 375,000 Accrued and other liabilities 220,000 200,000 Total current liabilities 695,000 700,000 Long-term debt: Bonds and notes payable 650,000 600,000 Total liability 1,345,000 1,300,000 Stockholders’ Equity: Common stock (100,000 shares outstanding) 500,000 500,000 Additional paid-in capital 350,000 350,000 Retained earnings 420,000 300,000 Total equity 1,270,000 1,150,000 Total liability and equity $2,615,000 $2,450,000

Income Statement GI Company (Year – 1) Sales $1,800,000 Cost of goods sold (1,000,000) Gross profit 800,000 Operating expenses (486,697) Interest expense Depreciation and Amortization expense (10,000 ) (13,303) Net income before income taxes 290,000 Income taxes (31%) ( 90,000) Net income after income taxes $ 200,000 Earning per share $2 Operating cash flow $255,000 Dividends for the year $0.80 per share Market price per share $12

Working capital = Current assents – Current liabilities Liquidity Ratios Working capital = Current assents – Current liabilities Year 2: $715,000 – $695,000 = $20,000 Year 1: $665,000 – $700,000 = ($35,000)

Current ratio (working capital ratio) = Liquidity Ratios Current assets Current liabilities Current 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

Cash equivalents + Market securities + Net receivables Liquidity Ratios Acid-test ratio = Cash equivalents + Market securities + Net receivables Current 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.

Cash equivalents + Marketable securities Liquidity Ratios Cash equivalents + Marketable securities Current liabilities Cash ratio = (Year 2) = (Year 1) = $50,000 + $75,000 $695,000 = 0.18 = 0.14 $35,000 + $65,000 $700,000

Accounts receivable turnover = Activity Ratios Net credit sales Gross receivables Accounts receivable turnover = = = 6 times $1,800,000 $300,000 This 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.

Accounts receivable turnover in days = Activity Ratios Gross receivables Net credit sales / 365 Accounts receivable turnover in days = = = 60.83days 365 days Receivable turnover This ratio indicates the average number of days required to collect accounts receivable.

Cost of goods sold Inventory turnover = Average inventory = $1,000,000 Activity Ratios Cost of goods sold Average inventory Inventory turnover = = = 3.45 times $1,000,000 $290,000 This measure of how quickly inventory is sold is an indicator of enterprise performance. The higher of turnover, in general, the better the performance.

Inventory turnover in days = Activity Ratios Average inventory Cost of goods sold / 365 Inventory turnover in days = = = 105.80 days 365 days Inventory turnover 3.45 This ratio indicates the average number of days required to sell inventory.

Operating cycle = AR turnover in days + Inventory turnover in days Activity Ratios Operating cycle = AR turnover in days + Inventory turnover in days = 60.83 days + 105.80 days = 166.63 days This operating cycle indicates the number of days between acquisition of inventory and realization of cash from selling the inventory.

Working capital turnover = Activity Ratios Sales working capital Working capital turnover = = = 90 times $1,800,000 $715,000 - $695,000 This ratio indicates how effectively working capital is used.

Return on total assets = Net income/Total assets Profitability Ratios Return on total assets = Net income/Total assets = $200,000 / $2,615,000 = 7.65%

Gross margin percentage = Gross margin / Sales Profitability Ratios Gross margin = Sales – Cost of Good Sold = $1,800,000 - $1,000,000 = $800,000 Gross 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.

Net income Net profit margin = Net sales = $200,000 = 11.11% Profitability Ratios Net income Net sales Net profit margin = = = 11.11% $200,000 $1,800,000 This ratio indicates profit rate and, when used with the asset turnover ratio, indicates rate of return on assets, as show below.

Operating income Total sales Operating margin = Profitability Ratios $800,000 - $486,697 $1,800,000 = = 17.41% 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.

Net sales Total asset turnover = Total assets = $1,800,000 Activity Ratios Total asset turnover = Net sales Total assets = = 0.69 times $1,800,000 $2,615,000 This ratio is an indicator of how Gi makes effective use of its assets. A high ratio indicates effective asset use to generate sales.

DuPont return on assets = Net income/Total assets Profitability Ratios DuPont return on assets = Net income/Total assets Net income Net sales Total assets x = = 11.11% 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.

Net income + Interest expense (1- Tax rate) Profitability Ratios Net income + Interest expense (1- Tax rate) Long-term liabilities + Equity Return on investment = = = 0.11 times $200,000 + $10,000 (1-0.31) $650,000 + $1,270,000 ROI measures the performance of the firm without regard to the method of financing.

Net income – Preferred dividends Profitability Ratios Net income – Preferred dividends common equity Return on common equity = = = 15.75% $200,000 - $0 $1,270,000

Common stockholders’ equity Long-term Debt-paying Ability Ratio Total liabilities Common stockholders’ equity Debt / Equity = (Year 2) = $1,345,000 / $1,270,000 = 1.06 (Year 1) = $1,300,000 / $1,150,000 = 1.13 This 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.

Total liabilities Debt ratio = Total assets Long-term Debt-paying Ability Ratio Total liabilities Total assets Debt 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.

Returning income before taxes and interest Long-term Debt-paying Ability Ratio Returning income before taxes and interest Interest Times interest earned = = = 30 times $290,000 + $10,000 $10,000 This 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.

Operating cash flow / Total debt = Long-term Debt-paying Ability Ratio Operating cash flow Total debt Operating cash flow / Total debt = = = 18.96% $255,000 $1,345,000 This ratio indicates the ability of the company to cover total debt with yearly cash flow.

The operating cash flow ratio = Liquidity Ratios Cash from operations Current liabilities The operating cash flow ratio = $255,000 $700,000 = = 0.36 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.

EBIT Profitability Ratio = Earnings + Interest Expense + Tax Expense = $200,000 + $10,000 + $90,000 = $300,000 A 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.

EBITDA Profitability Ratio = Earnings + Interest Expense + Tax Expense + Depreciation + Amortization = $200,000 + $10,000 + $90,000 + $13,303 = $ 313,303 This 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.