1. ENGG 401 X2 Fundamentals of Engineering Management Spring 2008
Chapter 6:
Ratio Analysis and Leverage
Dave Ludwick
Dept. of Mechanical Engineering
University of Alberta

2. Sample Management Questions
Is our credit rating good with our suppliers?
I was talking to a competitor who said their inventory is much much lower than ours. Why is that?
Every time the price of oil drops our receivables go up… are we meeting our bank covenants?
We have a growth opportunity… can we refinance our long term debt and raise some money?
Are we doing a good job in building value in our stock, as shown by the price?
The issues are sometimes blurry. Financial ratios help answer these questions.

3. Why Do People Invest in a Business?
One reason is to buy into a job they feel like doing.
The second reason is to increase the value of their investment.
Investors who have no relation to management tend to be dispassionate about the business and passionate about the rate at which their investment increases (the rate of return)! This is why management focuses on share price and dividend.
Ratios get at three issues:
How well is management running the business?
How “sound” is the business as a result?
How does the “market” react by placing a value on the business?

4. Ratio Analysis Financial ratios are:
Standard tests recognized by almost all analysts
Indicative of some underlying value that is important
Useful in following year-over-year changes in one company
Useful in comparing companies within a given industry
Not useful in comparing companies in very different industries
e.g., a capital intensive integrated steel company vs. a grocery chain
Used extensively by lenders (including suppliers deciding on whether to give credit) and by financial analysts.
Ratios are an assessment of management capability.
Management must pay attention to them to manage credit and stock price!

5. Types of Ratios Five Classes of Ratios: Liquidity Ratios:
will the company stay solvent in the short term?
i.e., if I lend money or if I’m a supplier, will I get my money back?
Efficiency, Activity or Asset Management Ratios:
is management making good use of the company’s assets?
also called efficiency ratios
Leverage or Debt Management Ratios:
will the business be able to service the debt it has undertaken, paying both interest and principal? Is the business solvent?
Profitability Ratios:
is the company earning enough on the assets / equity given to the business?
Market Value Ratios:
for publicly traded companies, how does the stock value compare to earnings and the book value of assets?

6. Ratio Analysis
When performing ratios analysis, we often include balance sheet and income statement accounts in the formulae
When using a formula that includes both income statement (revenues and expenses) as well as balance sheet account (like cash, AR, Inventory, total assets, etc), we will often take an average of the beginning and ending period balances
To take an average, take the number shown for the balance sheet account for Year 1 (say, 2004) and Year 2 (say, 2005), add them together and divide by 2
Example: Total Asset Turnover = Net Sales / (Avg Total Assets)
Total Asset Turnover = Net Sales / ((Total Assets in Year 1 + Total Assets in Year 2)/2)
NOTE: The formulae that follow may not show this explicitly but you still need to know this

7. Liquidity Ratios (1) Current ratio: important
The current ratio is a measure of the firm’s ability to pay bills as they come due.
Frequently used to assess short term lending.
Short term lenders will frequently specify a required current ratio and a level of working capital.
A high current ratio gives assurance that even in a crisis short term debt will be repaid.
If too low, then company can be at risk of meeting short-term obligations. If too high, then there may be too much invested in short-term assets
important

8. Liquidity Ratios (2) Quick ratio or “acid test”: important
A more stringent measure of the firm’s ability to pay its bills
If greater than 1, then the short term lender can be repaid from receivables and prepaid expenses.
This is a very comfortable position for a lender.
Eliminates the need to worry about the quality or currency of inventory.
In a crisis, inventory rarely sells at book value.
important

9. Liquidity Ratios (3) Cash ratio:
Even more stringent measure of liquidity
The cash ratio is the most conservative liquidity ratio.
It only considers the most liquid of all assets (excludes inventory and accounts receivable).
Measures a company’s ability to immediately pay off short-term liabilities.
No reliance on the receipt of receivables or sale of inventories.

10. Efficiency (1) Inventory Turnover = COGS/Average Inventory
Where average inventory = (beginning inventory + ending inventory)/2
Measures the number of times the inventory is “turned over”
Generally, a high inventory turnover is an indicator of good inventory management.
But a high ratio can also mean there is a shortage of inventory, which may mean the company may miss a sale due to an out-of-stock situation.
A low turnover may indicate overstocking or obsolete inventory.
Days Sales in Inventory = Avg Inventory/COGS x 365
shows the average number of days it will take to sell your inventory (number of days cost in inventory)

11. Efficiency (2)
Accounts Receivable Turnover = Net Sales / (Average Accounts Receivable)
Where average AR = (beginning AR + ending AR)/2
This measures how fast a company collects its receivables
Measures how good a company is at getting its customers to pay
The higher the turnover, the shorter the time between sales and collecting cash
Days Sales in Receivables = (Avg AR)/Sales x 365
average number of days it takes to collect accounts receivable (number of days of sales in receivables)
Measures a company’s ability to extend credit and collect debts.
A high A/R turnover ratio says that a company operates mainly on a cash basis or that its extension of credit and collection of accounts receivable is efficient.

12. Efficiency (3) Fixed assets turnover ratio :
Again, Net Fixed Assets is averaged between beginning and end of year balances
Fixed Assets also known as Capital Assets
Measures the extent to which a company “pays for” its fixed assets.
Can be distorted by inflation and/or new vs. old assets (due to depreciation).
e.g. the “big three” automakers would have a higher turnover (lower book value of assets) than a new entrant to North America (e.g., Honda)

13. Efficiency (4) Total assets turnover ratio :
Same issues as fixed asset turnover:
of some use within an industry if the asset acquisition time profile is comparable.
of no use between industries.

14. Solvency
While liquidity is concerned about ability to meet short-term obligations, Solvency is concerned about the company’s long-term viability and its ability to cover long-term debt.
One of the most important elements of solvency analysis is the analysis of a company's capital structure.
Capital Structure refers to a company's sources of finances: debt and equity

15. Solvency (2) Debt ratio: important
Includes all current liabilities, ST Debt and LT Debt
This ratio is sometimes mistakenly called the debt-to-equity ratio.
Check to see what is being quoted.
This is a crucial test of the “leverage” of a company, meaning the relative level of debt it carries.
Low leverage helps in riding out downturns, since there is a low interest “hurdle” to cover.
Low leverage dampens return on equity during upturns.
Debt ranks ahead of equity (i.e., it must be serviced before equity).
Debt has higher security, but long term has a lower return.
important

16. Solvency (3) Times interest earned ratio: important
Measures the ability of a company to service its debt (i.e., pay the interest).
EBIT (Earnings Before Interest and Taxes) is a key financial measure.
Taxes are excluded because as a firm’s earnings drop, so do its taxes (and no taxes are payable at break even), hence interest is paid before taxes.
This ratio is used to reflect the riskiness of repayments with interest to creditors
This is a key ratio for lenders.
important

17. Solvency (4) Fixed charge coverage ratio:
Similar to “Times Interest Earned”, except that other fixed charges are included.
Examples of fixed charges include lease and sinking fund payments.
Difficult to calculate from public information, more often used by financial analysts.
This ratio indicates how easily the company is making its regular (monthly, annual) financial “hurdles”

18. Profitability Ratios Profit margin on sales:
Measures how effectively a firm is able to convert sales to profits (remembering that Net Income is Sales less all expenses)
May also be measured as EBITDA/Sales where EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization
The thought here is that the ITDA portion does not generally contribute directly to generating sales and so should not be considered in the calculation of Net Profit Margin

19. Profitability Ratios (2)
Return on total assets:
A very powerful tool for comparing companies in the same industry.
“How much money do you make per unit of assets that you manage?”
Sometimes net income is used instead of operating income.
Can be used within a company, by product line, on an “EBIT” basis, to ask how well our product lines use our shareholders’ capital.
Can be used to determine how often assets are being paid for. It is a more stringent measure of asset coverage than the Asset Turnover ratio since Return on Assets is calculated with net Profit rather than Sales

20. Profitability Ratios (3)
Return on equity:
NOTE: If Preferred Dividends were declared during the period, then the numerator is (Net Income – Preferred Dividends)
Preferred Dividends are monies not available to the common shareholder, the true owners of the business
For the owners of a company, this is the ultimate test.
“How much return am I making on my investment in this company?”
Unlike return on assets, return on equity is highly influenced by financing.
it can be leveraged up in good times and down in bad times

21. Market Value Ratios
Price to earnings ratio (often abbreviated as P/E ratio):
This ratio does not derive from financial statements alone, but incorporates a liquid public market value of the company.
One of the most key and widely quoted values for publicly traded shares.
A wide range (from 4 to over 100) for companies with positive earnings reflects shareholders expectations of future earnings.
A key ratio used in stock valuation to determine whether a stock is over or under valued or to determine future direction of stock movement

22. Market Value Ratios (2) Market to book ratio:
A company’s “book value” of equity is related to the acquisition cost of assets, and often bears little relationship to replacement value due to inflation and depreciation of fixed assets.
Original purchase price of assets is available.
Market to book ratio and market to replacement value can help to identify “bargains” in the stock market as mass psychology swings past an equilibrium value.
Keep in mind that the book value is based on GAAP (which uses all of the guidelines of relevance, comparison, historical value, amortization calculation rules, etc)

23. Market Value Ratios (3)
Earnings Per Share = Net Income / (Weighted Average Number of Common Shares Outstanding)
Amount of money earned per common share
EPS is calculated at the very bottom of the Income Statement. It represents the money earned by each individual share after Sales, all discounts, expenses, interest, depreciation, taxes, extraordinary items, and preferred dividends

24. Uses of Ratio Analysis
The most basic rule is: a single ratio in isolation provides very little information and may be misleading.
With that in mind, there are at least 4 uses of ratios:
Trend analysis (internal and external)
Comparison to industry averages (internal and external)
Setting and evaluating company goals (internal)
Restrictive debt covenants (external)
Sometimes it does not matter exactly how you calculate a ratio, as long as you calculate it the same way when you are using it for comparison

25. Concepts in Corporate Finance
There are several ways to finance a company
Common shares, Preferred shares, Debt
Common shares are the most commonly vehicle for ownership. Typically
One vote per share at the company’s annual general meeting
They hold the last claim on assets in the event of insolvency
They generally don’t receive dividends
Preferred shares are ownership shares that are more “senior” to common shares
They hold a more senior claim on assets in the event of insolvency
They sometimes get a dividend
They usually don’t have a vote at the AGM

26. Concepts in Corporate Finance
One of the key managerial tasks of corporate managers is to decide on how to raise funds using the instruments of common shares, preferred shares and debt.
Common shares have the lowest claim on assets and don’t expect a dividend, but have ownership control (the vote)
Preferred shares have a more senior claim on assets, no vote, but can receive a dividend.
Debt has the highest claim on assets, have no vote and don’t receive a dividend, but debt payments are a contractual obligation and can’t be missed.
Using Preferred Shares or Debt to raise capital are examples of financial leverage

27. Concepts in Corporate Finance – Leverage
Leverage is when you use the money from someone else to grow the company, or achieve its goals
Common share holders (the true owners of the corporation) can leverage cash generated from the sale of Preferred Shares or Debt to grow the company
As long as the net income generated is greater than the dividends paid to preferred shareholders or the interest paid to debt holders, then there is a net increase to the common shareholder and leverage has taken place.
They have leveraged money from preferred shareholders and debt holders to improve the value of the corporation to the common shareholder

28. Special Features of Preferred Shares
Preferred shares usually pay a dividend in exchange for the fact that they do not have a voting right
This is called a Dividend Preference: A dividend could not be paid to common shareholders until the dividend is paid to the preferred shareholders
Cumulative Preferred Shares have a right to be paid both current and all prior periods’ undeclared dividends. This is a feature to preferred shares, but it must be a stated feature (not all preferred shares carry this feature)
Participating Preferred Shares have a feature in which preferred shareholders share with common shareholders in any dividends paid in excess of the dollar amount specified for the preferred shares

29. Special Features of Preferred Shares
Convertible Preferred Shares give holders the option of exchanging their preferred shares for common shares.
Usually there is a specified time period in which this can be done and there is a specified exchange rate for the shares.
This gives preferred shareholders the advantage of the dividend, but when the company value goes up they can convert to common shares.
Note that the convertible feature will cause the value of the preferred shares themselves to go up since they are connected to the common shares.
Callable Shares give the issuing company the right to buy the shares back from owners at a defined date and for defined price

30. Cash Dividends
Dividends are distributions of earnings. They are paid out of the company’s net income after all expenses and taxes
Dividends are basically distributions of Retained Earnings
Dividends can be paid in the form of cash or more stock
Company’s generally can (or only will) pay dividends if
The company has enough Retained Earnings
The company has enough Cash to meet debt, grow the company or cover emergencies
In the end, issuing dividends is a corporate decision, not an obligation

31. The Concept of Debt
In a western agricultural or industrial society, wealth is held primarily by individuals and not by society at large.
There are exceptions (e.g., resources), but the profits from development generally flow to individuals.
Most people with wealth wish to preserve or grow wealth.
Wealth and entrepreneurial spirit often do not align, and there are vast differences in the tolerance for risk.
The borrower believes inherently that he/she can create more wealth than the cost of the borrowed funds.
Lenders trade lower return (growth in wealth) for lower risk (the “risk-reward relationship”).
Debt is the primary mechanism to reduce risk, since it ranks ahead of equity.

32. The Concept of Debt (2)
The benefit to the borrower is that debt does not convey ownership.
The lender may restrict the business through covenants, but the equity owners own the business and its “blue sky” potential.
Interest is the cost of debt.
Think of it as the rental charge for the use of money
It is highly variable from loan to loan,
it depends on the risk associated with the loan, and over time
It reflects the balance between savers and borrowers and inflation rates
Often secured
i.e., if it’s not repaid the lender can “attach” (seize) certain assets in order to recover the principal
Always lower than the projected rate of return on equity in the project/business.
Otherwise, the business would not be able to repay the equity investors at an acceptable return.

33. The Concept of Leverage
Return (i.e., growth in wealth) is more volatile (more “levered”) as debt goes up and equity goes down.
This arises because the risk in the project is being concentrated onto a smaller base of equity.
The debt gets a fixed (and hopefully lower!) return than equity, but it ranks ahead of equity; it must be serviced first.
By ranking ahead we mean:
Payables and interest are paid first before dividends
In the event of business failure or wrap-up, all liabilities are paid first before any money is given to the owners

34. The Concept of Leverage (2)
Leverage is usually measured by Debt Ratio:
Alternatively, leverage is also sometimes measured as a ratio of bank debts only:
…or sometimes as a ratio of asset value relative to equity:

35. Illustrating the Effects of Leverage
50% Leverage in Good Times
return on equity
(12%) A
earning power of investment
(10%) %
Return A
cost of debt
(8%)
Debt
Equity

36. Illustrating the Effects of Leverage (2)
80% Leverage in Good Times
return on equity
(18%) A
earning power of investment
(10%) %
Return A
cost of debt
(8%)
Debt
Equity

37. Illustrating the Effects of Leverage (3)
50% Leverage in Bad Times
cost of debt
(8%) %
Return A
earning power of investment
(6%) A
Debt
Equity
return on equity
(4%)

38. Illustrating the Effects of Leverage (4)
80% Leverage in Bad Times
cost of debt
(8%) %
Return A
earning power of investment
(6%)
Equity
Debt
return on equity
(-2%) A

39. Leverage Example
Calculate (a) leverage, (b) net income, and (c) return on equity of three nearly identical companies in good times:
Higher leveraging results in higher returns on shareholders’ investments in good times, but…

40. Leverage Example (2)
Calculate (a) leverage, (b) net income, and (c) return on equity of three nearly identical companies in bad times:
Higher leveraging results in lower returns (or even losses) on shareholders’ investments in bad times.