Ratios Analyze and calculate specific values that give some measure of performance Analyze and calculate specific values that give some measure of performance Compare 3 ways:Compare 3 ways: Within the firm over time Within the firm over time To competing firms To competing firms To the industry standard To the industry standard One ratio by itself does not tell you muchOne ratio by itself does not tell you much

Ratios Types – different aspects of a firm Types – different aspects of a firm –Liquidity – can they pay the bills as they come due? –Solvency – can they survive for a long period of time? – can they pay their long term debt? –Profitability – can they earn a satisfactory rate of return?, how efficient are they? –Activity or effectiveness – indicate efficiency and effectiveness of operations and asset management and use

Profitability Profitability –Gross margin percentage – what proportion of revenue can be used to cover the firm’s period expenses – very closely watched –Profit margin – how many cents of every sales dollar is profit –Return on assets – success in using its assets to earn income, the cents in profits for every dollar of assets –Return on common equity – how much is earned with common shareholder’s investment

Profitability Profitability –Gross margin percentage = gross margin = sales – cost of sales percentage = gross margin / sales –Profit margin – net earnings / sales –Return on assets – net earnings / average total assets –Return on common equity – net earnings / average total equity

Effectiveness Effectiveness –Accounts receivable turnover – ability to collect cash from credit customers –Days in A/R – how long does it take to collect –Inventory turnover – how often to they sell their inventory –Days in Inventory – days in the store –Accounts payable turnover – how effectively a firm pays its own bills –Days in A/P – how long it takes to pay –Operating cycle – cash to cash cycle

Liquidity Liquidity –Working capital – not a ratio – ability to meet short- term obligations – (CA-CL) –Current ratio – ability to pay current liabilities with current assets – (CA/CL) –Quick ratio – only the very liquid assets – ((CA- Inv)/CL) –Defensive interval ratio – how much cash is on hand to cover an average day’s expenses

Solvency Solvency –Debt to assets – what proportion of a firm’s assets are financed by debt –Debt to equity – compares debt to owner’s investment –Times interest earned – tests the ability of the firm to meet its interest payments

Horizontal analysis (trend) – previous year Horizontal analysis (trend) – previous year (Current year – previous year)/previous year(Current year – previous year)/previous year Vertical analysis (common sizing) – within year Vertical analysis (common sizing) – within year Income statement – divideIncome statement – divide Ways to improve revenue/profit Ways to improve revenue/profit

Revenue recognition principle Revenue recognition principle VariationsVariations Point of sale - defaultPoint of sale - default Proportional performance – not wait until entire product is delivered, ie. magazinesProportional performance – not wait until entire product is delivered, ie. magazines Cost recovery – not sure will collect, recognize revenue after cover the cogsCost recovery – not sure will collect, recognize revenue after cover the cogs Completed contract – recognize revenue when product completedCompleted contract – recognize revenue when product completed Percentage of completion – proportion completed, same proportionPercentage of completion – proportion completed, same proportion Which products or customers to keep Which products or customers to keep

Contract specifications: Purchase price: $15,000,000 Cost of construction: $10,000,000 The contract will take three years to complete. Contract Progress: Year 1 Year 2 Year 3 30% complete 70% complete 100% complete Revenue $4,500,000 $6,000,000 $4,500,000Costs 3,000,000 4,000,000 3,000,000 3,000,000 4,000,000 3,000,000Margin $1,500,000 $2,000,000 $1,500,000

Assign #3 – Target income statement and balance sheet: Assign #3 – Target income statement and balance sheet: –Years 09, 08 –Horizontal analysis –Vertical analysis –½ – what does it mean? Assign #4 Profitability ratios – Target:Assign #4 Profitability ratios – Target: Gross margin, profit margin - 09, 08, 07, return on assets, return on equity – years 09, 08 - ½ - 1-page – what does it mean?Gross margin, profit margin - 09, 08, 07, return on assets, return on equity – years 09, 08 - ½ - 1-page – what does it mean?