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Business Finance FIN449 Michael Dimond. Michael Dimond School of Business Administration The key to good ratio analysis Identify the important question.

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Presentation on theme: "Business Finance FIN449 Michael Dimond. Michael Dimond School of Business Administration The key to good ratio analysis Identify the important question."— Presentation transcript:

1 Business Finance FIN449 Michael Dimond

2 Michael Dimond School of Business Administration The key to good ratio analysis Identify the important question to be answered, then find a legitimate financial ratio which does a good job of answering that question. “Legitimate” means the ratio was not conveniently made up I can divide any two numbers, but that does not create a relationship Does this ratio get discussed and scrutinized in academia? Does it appear in finance textbooks? Does management follow a specific set of rules we can apply in our predictions & forecasts?

3 Michael Dimond School of Business Administration Income Statement

4 Michael Dimond School of Business Administration Balance Sheet

5 Michael Dimond School of Business Administration Statement of Cash Flows

6 Michael Dimond School of Business Administration Meaningful Ratio Analysis Analysis means to break something down to understand it. Ratio analysis should be used to answer a specific question or set of questions. If you were examining the financial statements for a company, you might start with this basic question: “Is this a good use of investors’ money?” What financial ratio would answer this question? How about Return on Equity? How do you compute Return on Equity (ROE)?

7 Michael Dimond School of Business Administration Analyzing ROE ROE = NI ÷ Equity and answers the question, “is this a good use of investors’ money?” If you were to break this down, there are three basic questions to answer: How profitable is this business? How efficiently are assets being used? How much does financial leverage help the investors? What financial ratios would answer these questions? Profit Margin (PM) Total Asset Turnover (TAT) Equity Multiplier (EM)

8 Michael Dimond School of Business Administration Drivers of ROE Profit Margin (PM) = NI ÷ Sales and answers the question, “How profitable is this business?” Total Asset Turnover (TAT) = Sales ÷ Total Assets and answers the question, “How efficiently are assets being used?” Equity Multiplier (EM) = Total Assets ÷ Equity and answers the question, “How much does financial leverage help the investors?”

9 Michael Dimond School of Business Administration The DuPont Identity ROE is directly driven by profitability, efficiency and leverage. ROE = PM x TAT x EM How does that work? The numerators and denominators cancel to reduce the equation to NI ÷ Equity

10 Michael Dimond School of Business Administration A word about ROA ROA = Return on Assets What’s the difference between Equity & Assets? Leverage What’s the difference between ROE & ROA? Leverage ROE = PM x TAT x EM EM represents leverage ROA = PM x TAT No leverage

11 Michael Dimond School of Business Administration Digging Deeper with Financial Ratios How would you analyze profitability, efficiency and leverage? How do profitability, efficiency and leverage relate? What affects profitability? What drives sales? What is the composition of assets? How were assets paid for? How are liabilities managed? Where shall we begin?

12 Michael Dimond School of Business Administration Common-Size Financial Statements Shows each line item as a percent of an appropriate total. Common-size balance sheet % of Total Assets Shows the composition of assets Liabilities & equity items are also shown as % of total assets Debt Ratio = Total Liabilities ÷ Total Assets Common-size income statement % of Sales PM = Net Income as % of Sales

13 Michael Dimond School of Business Administration Common-Size Income Statement

14 Michael Dimond School of Business Administration Common-Size Balance Sheet

15 Michael Dimond School of Business Administration We don’t make a common-size CF Statement There are other ways to examine cash flows which are more helpful

16 Michael Dimond School of Business Administration Vertical & Horizontal Analysis Vertical Analysis compares figures as a percent of a relevant total (“common size” financial statements) Horizontal Analysis compares the same figure over a series of periods (showing % change or % growth)

17 Michael Dimond School of Business Administration Categories of Financial Ratios Most finance texts group ratios into categories like these: Profitability ratios Efficiency (or Activity) ratios Liquidity ratios Debt ratios Market ratios It is usually more helpful to think of the questions to be answered rather than just crunching a bunch of numbers. Uses critical thinking Easier to read Less time consuming Uses fewer resources

18 Michael Dimond School of Business Administration Profitability Ratios PM = Net Income ÷ Sales Also called “Net Profit Margin” or return on sales Gross Margin = Gross Profit ÷ Sales Gross Profit = Sales – COGS Also called the “Gross Profit Margin” Operating Margin = Operating Profit ÷ Sales Also called the “Operating Profit Margin” Sometimes also called return on sales All of these are on the common-size income statement

19 Michael Dimond School of Business Administration Efficiency Ratios TAT shows overall efficiency, but how hard do specific assets work? Cash Cash as % of assets Cash as number of days sales (Days sales in cash = Cash ÷ [Sales/365]) Inventory Two formulas are referred to as “Inventory Turnover” Inventory Turnover = Sales ÷ Inventory Inventory Turnover = COGS ÷ Avg. Inventory These two ratios answer different questions: How hard is inventory working? (Sales/Inventory) How many times/year is inventory replaced? (COGS/Average Inventory) How useful are these computations? Sales/Inventory provides no new information: If we know TAT and Inventory as a % of assets, Sales/Inventory = TAT ÷ Inv% Sales/Inventory is relevant relationship in certain industries (e.g. Retail) COGS/Average Inventory gives a measure of asset replenishment COGS/Average Inventory is used in computing the operating cycle

20 Michael Dimond School of Business Administration Efficiency Ratios If you know how long it takes a company to sell inventory, collect accounts receivable and pay its bills, you can compute how long their business takes to function Operating Cycle: Days in Inventory + Days in Receivables Cash Cycle: Days in Inventory + Days in Receivables – Days in Payables

21 Michael Dimond School of Business Administration Efficiency Ratios There is an easy and consistent way to compute and understand the components of the cash cycle. Each of the “Days in…” figures represents a year divided by the appropriate turnover rate: Days in Inventory = 365 ÷ Inventory Turnover Rate Days in Receivables = 365 ÷ Receivables Turnover Rate Days in Payables = 365 ÷ Payables Turnover Rate This means the turnover rates can be simplified to these: Inventory Turnover Rate = COGS ÷ Avg. Inventory Receivables Turnover Rate = Sales ÷ Avg. Receivables Payables Turnover Rate = Purchases ÷ Avg. Payables …and the days in each can be computed as: Days in Inventory = 365 ÷ (COGS ÷ Avg. Inventory) Days in Receivables = 365 ÷ (Sales ÷ Avg. Receivables) Days in Payables = 365 ÷ (Purchases ÷ Avg. Payables) Purchases can be computed as COGS + Δ Inventory Purchases = COGS + Ending Inventory – Beginning Inventory

22 Michael Dimond School of Business Administration Liquidity Ratios The Current Ratio Does not do a good job of answering a question Current Assets ÷ Current Liabilities Liquidity means something can be converted into cash immediately without significant loss of value. Current Assets includes inventory. Is inventory really liquid? Quick Ratio (also called the “Acid Test”) Answers the question, “how well can this firm meet its short-term obligations?” [Current Assets – Inventory] ÷ Current Liabilities

23 Michael Dimond School of Business Administration Debt Management Ratios Debt ratio = Total Liabilities ÷ Total Assets Also called “Debt to Total Capital” ratio Debt-to-Equity ratio = Total Liabilities ÷ Total Equity EM (from DuPont) = 1 + D/E Times Interest Earned ratio = EBIT ÷ Interest TIE can be altered to cover any financial obligations. TIE = EBIT ÷ Interest :. TIE = (EBT + Interest) ÷ Interest Fixed Payment Coverage = (EBT + Int + Lease Pmts) ÷ (Int + Lease Pmts) Damodaran uses TIE to help estimate Kd

24 Michael Dimond School of Business Administration Market Value Ratios Price-to-Earnings ratio = Share Price ÷ Earnings per Share Earnings per Share (EPS) = Earnings Available to Common Shareholders ÷ Number of Shares of Common Stock If there is no preferred equity (or an insignificant amount), EPS can be NI ÷ Number of Shares Because the Numerator and Denominator are both “per share,” the PE ratio can be computed as Market Capitalization ÷ Total Earnings Available Market-to-Book ratio = Price per Share ÷ Book Value per Share Book Value per Share = Common Equity on Balance Sheet ÷ Number of Shares Common Equity = All equity except preferred equity Again, because the Numerator and Denominator are both “per share,” the MB ratio can be computed as Market Capitalization ÷ Total Common Equity

25 Michael Dimond School of Business Administration Other useful analysis Dividends & Retained Earnings d: Dividend Payout Ratio = Dividends ÷ Net Income b: Retention Ratio = 1 – d Also called the “plowback ratio.” Why do you think that name is used? Growth Limitations SGR: Sustainable Growth Rate = b x ROE = b x PM x TAT x EM IGR: Internal Growth Rate = b x ROA = b x PM x TAT This suggests that understanding the payout policy and retention by a company is crucial. I usually compute b = 1-d and also compute an alternative to b = ΔRE ÷ NI

26 Michael Dimond School of Business Administration Other useful analysis Breakeven BE = Total Fixed Costs ÷ Contribution Margin Contribution Margin = Price per unit – Variable Costs per unit Some analysts compute accounting breakeven and financial breakeven. The definition of “Fixed Costs” changes. Degree of Operating Leverage Looks a lot like an elasticity formula: %Δ Op. Income ÷ %Δ Sales This is not a time-based relationship between numbers. It is based on the cost structure of the company. Because cost structure (fixed & variable costs) will change from year to year, we cannot compute DOL using multiple years’ figures A point estimate of DOL can be computed as Gross Profit ÷ Operating Income As firm approaches breakeven, DOL gets larger (and undefined at BE) DOL indicates how sensitive operating income is to forecast errors in sales If DOL = 2.0, a 1% error in sales forecast results in a 2% error in operating income What if the sales forecast is 10% off?

27 Michael Dimond School of Business Administration A starting point This set of ratios answer a series of useful questions. Some companies require other ratios.


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