FINANCIAL RATIO
ANALYSIS
Minggu – 5
Ratio Analysis Presentation
The format for this presentation is as follows:
1. The Basics of Financial Ratios
2. Interpreting Financial Ratios
3. Making those Interpretations more Meaningful
The Basics of Financial Ratios
Financial Ratios, what are they?
• Financial Ratios are specific tools which can be used to make more educated
investment decisions.
• Financial Ratios provide a method to make more meaningful evaluations of a
companies financial condition.
• Financial Ratios express relationships among items found in financial statements.
Information from these items may not be apparent when examined individually.
Categorizing Financial Ratios
• Financial Ratios can be categorized into one of four groups, their classification
is dependant the information they display to the user.
• These four categories are:
1. Profitability Ratios
2. Liquidity Ratios
3. Solvency Ratios
4. Cash Flow Ratios
Profitability Ratios
• Profitability ratios measure the income or operating success of a company for
a given period of time.
• Profitability Ratios make use of the statement of earnings.
• Examples of Profitability Ratios include:
- Return on Assets
- Profit Margin
Return on Assets and Profit margin
Return on Assets = Net Earnings/Average Assets
The return on assets ratio indicates the amount of net earnings generated by
each dollar invested in assets. This ratio also indicates how efficiently the
company is using their assets to generate profits.
Profit Margin Ratio = Net Earnings/Net Sales
The profit margin ratio indicates the percentage of each dollar of sales that
results in net earnings.
Liquidity Ratios
• Liquidity Ratios measure the short term ability of a company to meet current
obligations.
• Liquidity Ratios make use of the balance sheet
• Examples of Liquidity Ratios
- Current Ratio
- Quick (or Acid) Ratio
Current and Quick Ratios
Current Ratio = Current Assets/Current Liabilities
The Current Ratio measures a companies ability to meet short term liabilities
with short term (or current) assets. This is an important indicator to an investor
as it allows him or her to see if the company will be able to operate through its
obligations.
Quick (Acid) Ratio = One step removed from Current Assets/Current Liabilities
The Quick Ratio removes uncertainty about the composition of the current assets.
This is done by removing inventories from the ratio, Inventories may be slow
moving and therefore not truly represent a companies ability to meet obligations.
Solvency Ratios
• Solvency Ratios measure the ability of a company to meet long term obligations.
• Solvency Ratios are important to long term investors and creditors.
• Examples of Solvency Ratios
- Debt to Total Asset Ratio
- Debt to Shareholders Equity Ratio
Debt to Total Assets Ratio and
Debt to Shareholder’s Equity Ratio
Debt to Total Assets Ratio = Total Liabilities/Total Assets
The debt to total assets ratio measures the percentage of assets financed by
creditors rather than shareholders. A higher percentage of debt financing leads
to higher risk when investing.
Debt to Shareholder’s Equity Ratio = Total Liabilities/Total Shareholder Equity
The higher the debt to shareholder’s equity ratio the less solvent the company,
meaning the company runs a greater risk of not being able to repay long term
debt at maturity date.
Cash Flow Ratios
• Cash flow is the single most important aspect of a companies financial condition,
it is important to know how the cash was generated and where it is being spent.
• Cash is primarily generated from two different avenues:
- operating activities
- financing activities
• Cash flow ratios calculate additional measures of liquidity and solvency.
• Examples of Cash Flow Ratios are:
- cash current debt coverage ratio
- cash total debt coverage ratio
Cash Current Debt Coverage Ratio and
Cash Total Debt Coverage Ratio
Cash Current Debt Coverage Ratio = Cash Provided by Operating Activities/
Average Current Liabilities
The cash current debt coverage ratio measures the companies ability to generate
cash to cover short term liabilities.
Cash Total Debt Coverage Ratio = Cash Provided by Operating Activities/
Average Total Liabilities
The cash total debt coverage ratio measures the companies ability to generate
cash to cover long term liabilities.
Interpreting Financial Ratios
What We Know Now
• So far we know what different ratios calculate and what they indicate,
but what is a good number?
• Some texts suggest numbers, why do they suggest these numbers?
• How can we use these numbers to make informative decisions?
Interpretations of Financial Ratios
•The value in financial ratios does not lie in the number itself but rather in
comparisons with other computed ratios.
•Comparisons can take on different forms, such as the following:
1. Comparison from year to year for the company of interest. This
can demonstrate the direction of change of the ratios over a time
period, possibly leading to an indication of the companies financial
health.
2. Comparisons from one company to another, comparing your
company to the competition.
3. Comparisons to a “Universe of Coverage”
The “Universe of Coverage”
• I would suggest that one of the most useful comparisons investors can make
is comparing their companies ratios to ratios in a “Universe of Coverage.”
• A universe of coverage is a collection of companies which via some type of
defining term allots the company either inside or outside the universe of
coverage.
• The universe of coverage can be detailed to include only the most direct
competition providing a better industry average than traditional industry
definitions allow for.
• A universe of coverage is determined by the investor allowing him or her to
dictate what type of companies should be included in his comparisons.
An Example of a Universe of Coverage
• With the EnCana Corp. being my company of interest I defined my universe of
coverage based on what qualities I knew EnCana had as a company in the
upstream oil and gas industry.
• EnCana is an independent oil and gas company (as opposed to Petro-Canada
who has involvement in the upstream, midstream and downstream segments of
the oil and gas industry), therefore my universe of coverage need only include
independent upstream oil and gas companies.
• Further information was used in determining the universe of coverage for
comparing EnCana to meaningful competition. In the end I defined my universe
of coverage as “Independent Upstream Oil and Gas Companies producing more
than x barrels of oil and gas equivalents per day per U.S. dollar.
Further information regarding the
Universe of Coverage
• So what does this mean for ratio analysis? It is fundamentally important to
compare companies which an investor would assume operate under similar
business conditions.
• For example, comparing hedging contracts between a junior upstream oil and
gas producer and a senior upstream oil and gas producer would have a dramatic
effect on conclusions drawn concerning cash flow. Total liabilities between junior
and senior producers may not vary in the same degree as total
assets (due to hedging).
• Furthermore, a universe of coverage defines industry in much more specific
way, just as it would be ridiculous to compare an oil and gas company to a
software company, it would be ridiculous to compare junior and senior oil and
gas producers.
A graphical example of Comparisons
within a Universe of Coverage
The following graphs are comparisons of some ratios for EnCana’s
Universe of Coverage.
Debt to Equity Ratio Comparison for our Independent Upstream Oil and Gas
Universe of Coverage
DEBT TO EQUITY RATIOS (2002)
30
10
Av
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FS
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KM
EI
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FX
Se
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Pr
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-10
N
TL
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PP
XY
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VN
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AP
A
0
EC
RATIO VALUE
20
-20
-30
COMPANY
Quick Ratio Comparison for our Independent Upstream Oil and Gas
Universe of Coverage
2002 QUICK RATIOS
1.8
1.4
1.2
1
0.8
0.6
0.4
0.2
Av
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KM
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NF
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NX
Y
DV
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AP
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0
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A
RATIO VALUE
1.6
COMPANY
Current Ratio Comparison for our Independent Upstream Oil and Gas
Universe of Coverage
Making Interpretations More
Meaningful
Further Ways to Make Interpretations
more Meaningful
Given that we have defined a universe of coverage, what else can lead to
misinformed results?
Accounting procedures can dramatically affect the results of the ratios and
their meanings. In order to further improve our comparison we need to improve
the comparability of the ratios.
Increasing Comparability
• I would suggest that the value of the ratios do not actually lie within the number,
but rather in what the number represents. We need to change the components
of the ratios so that include the same elements and do not include extras.
• This information can primarily be found in the notes to the financial statements.
• For example, hypothetically imagine the following circumstance. American
airlines has acquired its fleet through various financing projects and cash
contributions, they then record the airplanes as an asset and depreciate them
accordingly. Now Imagine that Air Canada has decided to lease its fleet and
record the cost of their Fleet as an expense. Assuming that these companies
were of similar size and fall in the same universe of coverage, it would be more
correct to use a Net Present Value Of Money function to estimate the cost of Air
Canada’s fleet and depreciate it accordingly. This would change asset numbers
to make the two companies more comparable.
Summary
Financial Ratio Analysis should play a key role in any investors decision
making process, but the results of these ratios can be improved by
allocating a “Universe of Coverage” and making elements of ratio computations
more “Comparable.”