®2002 Prentice Hall Publishing 1 Chapter 12 Financial Ratio Analysis

®2002 Prentice Hall Publishing 2 Introduction to Financial Analysis Specific interestsSpecific interests –Trade creditors Analysis of liquidityAnalysis of liquidity –Bondholders Cash flow ability to service debt over the long runCash flow ability to service debt over the long run –Investors ProfitabilityProfitability –Management Internal controlInternal control

®2002 Prentice Hall Publishing 3 Use of Financial Ratios Relating two pieces of financial dataRelating two pieces of financial data Trend analysis performance over timeTrend analysis performance over time –Projected ratios –Present ratios –Past ratios Compare with othersCompare with others –Similar firms –Industry average –Peer firms

®2002 Prentice Hall Publishing 4 Some Caveats Avoid using rules of thumbAvoid using rules of thumb Analyze the deviation from the normAnalyze the deviation from the norm –Significance of the deviation Approach industry comparisons with cautionApproach industry comparisons with caution –Less than satisfactory industry –Provide general guidelines Industry groupings may not be homogeneousIndustry groupings may not be homogeneous –Industry categorization and size Accounting data are estimates at bestAccounting data are estimates at best –Depreciation and reserves

®2002 Prentice Hall Publishing 5 Five Types of Ratios LiquidityLiquidity DebtDebt ProfitabilityProfitability CoverageCoverage Market-valueMarket-value

®2002 Prentice Hall Publishing 6 Considerations Information to judge performanceInformation to judge performance –Group of ratios –Seasonal character –Comparison during same time of year Concentrate on important ratiosConcentrate on important ratios

®2002 Prentice Hall Publishing 7 Liquidity Ratios Used to judge firm’s ability to meet short- term obligationsUsed to judge firm’s ability to meet short- term obligations TypesTypes –Current ratio –Quick ratio (acid test) –Liquidity of receivables –Duration of payables –Liquidity of inventories

®2002 Prentice Hall Publishing 8 Current RatioCurrent Ratio –Most frequently used –Crude measure of liquidity Quick RatioQuick Ratio –More accurate guide to liquidity –Excludes inventory –Concentrates on CashCash Marketable securitiesMarketable securities ReceivablesReceivables Current and Quick Ratio

®2002 Prentice Hall Publishing 9 Liquidity of Receivables Average collection periodAverage collection period Receivable turnoverReceivable turnover –Year-end versus average receivables Seasonal salesSeasonal sales Sales growthSales growth –Interpreting information Restrictive credit policyRestrictive credit policy Liberal credit policyLiberal credit policy –Aging of accounts Review credit and collection policyReview credit and collection policy Consider more informationConsider more information Reciprocals of each other

®2002 Prentice Hall Publishing 10 Duration of Payables Average payable periodAverage payable period –Purchases or COGS –Year end payable balance –Average payable period –Credit check

®2002 Prentice Hall Publishing 11 Liquidity of Inventories Inventory turnover ratioInventory turnover ratio –Higher the inventory turnover More efficient the inventory managementMore efficient the inventory management Frequent stockouts?Frequent stockouts? Too many small orders?Too many small orders? –Turnover ratio is relatively low Slow-moving inventorySlow-moving inventory ObsolescenceObsolescence –Investigate perceived inefficiency

®2002 Prentice Hall Publishing 12 Debt Ratios Reflect the relative proportion of debt funds employedReflect the relative proportion of debt funds employed TypesTypes –Debt-to-equity ratio –May vary by industry –Long-term capitalization –Relative importance of long-term debt in the capital structure Debt ratios are based on book value figuresDebt ratios are based on book value figures

®2002 Prentice Hall Publishing 13 Cash Flow to Debt and Capitalization Measure of the ability to service debtMeasure of the ability to service debt TypesTypes –Cash-flow-to-total-liability ratio –Cash-flow-to-long-term-debt ratio BothBoth –Predict the deterioration of financial health –Helpful in corporate restructuring Enterprise value-to-EBITDA ratioEnterprise value-to-EBITDA ratio –Concerned when ratio exceeds 8

®2002 Prentice Hall Publishing 14 Coverage Ratios Relate the financial change of a firm to its ability to service themRelate the financial change of a firm to its ability to service them TypesTypes –Interest coverage ratio Overall coverage methodOverall coverage method Prior deductions method is generally inappropriatePrior deductions method is generally inappropriate Cumulative deduction method is the most widely usedCumulative deduction method is the most widely used Cash-flow coverage ratiosCash-flow coverage ratios –Cash flow coverage of interest Highly correlated with bond ratingsHighly correlated with bond ratings ShortcomingsShortcomings –Cash-flow coverage of interest and principal ratio is more appropriate

®2002 Prentice Hall Publishing 15 Profitability Ratios Indicate the firm’s efficiency of operationIndicate the firm’s efficiency of operation TypesTypes –Profitability in relation to sales Gross profit marginGross profit margin Net profit marginNet profit margin –Profitability in relation to investment ROEROE –Earning power on equity »Book value and market value ROA is somewhat inappropriateROA is somewhat inappropriate Net operating profit rate of return is i ndependent of the firm’s financingNet operating profit rate of return is i ndependent of the firm’s financing

®2002 Prentice Hall Publishing 16 Turnover and Earning Power Asset turnover ratioAsset turnover ratio –Relative efficiency of utilizing resources to generate output Earning powerEarning power –Improvement results with Increases in turnoverIncreases in turnover Increases in net profit marginIncreases in net profit margin Increases in turnover and net profit marginIncreases in turnover and net profit margin

®2002 Prentice Hall Publishing 17 Market Value Ratios Indicate relative valuation of a stockIndicate relative valuation of a stock Price/ Earnings Ratio (P/E)Price/ Earnings Ratio (P/E) –Valuing future growth Dividend yieldDividend yield –Good growth potential  Low dividend yield Market-to-book ratioMarket-to-book ratio –Harvest situation –Industry attractiveness –Competitive advantage Tobin’s Q ratioTobin’s Q ratio

®2002 Prentice Hall Publishing 18 Predictive Power of Financial Ratios SubjectiveSubjective Empirical studiesEmpirical studies –Regression analysis –Discriminant analysis Best ratiosBest ratios –Debt-to-equity –Cash-flow-to-debt –Net operating profit margin –Debt coverage and its stability –ROI –Size and earnings stability

®2002 Prentice Hall Publishing 19 Predicting Financial Distress Combine and weight 5 financial ratiosCombine and weight 5 financial ratios –Working capital to total assets (1.2) –Cumulative retained earnings to total assets (1.4) –EBIT to total earnings (3.3) –Market value of equity to book value of total liabilities (0.6) –Sales to total assets (1.0) Calculate Z scoreCalculate Z score

®2002 Prentice Hall Publishing 20 Common Size & Index Analysis Statement items as percentages of totalsStatement items as percentages of totals –Common size analysis Percentages of total assets and salesPercentages of total assets and sales –As indexes relative to a base year Trends from a base yearTrends from a base year StandardizationStandardization –As a percentages of totals –As indexes to a base year Computer spreadsheetComputer spreadsheet