Business Finance
FIN449
Michael Dimond
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?
Michael Dimond
School of Business Administration
Income Statement
Strawman Corporation
Income Statement
For year ended 12/31/…
2013
Revenue
2014
$ 10,102.0 $ 11,112.0
COGS
6,881.0
7,569.0
Gross profit
3,221.0
3,543.0
SG&A
1,362.0
1,498.0
Operating income
1,859.0
2,045.0
Other revenues & gains
Gain on sale of investments
-
Earnings before interest and taxes (EBIT)
80.0
1,859.0
2,125.0
Interest expense, net
193.0
212.3
Earnings before taxes
1,666.0
1,912.7
666.4
765.1
Income tax expense
Net income
$
999.6 $ 1,147.6
Michael Dimond
School of Business Administration
Balance Sheet
Strawman Corporation
Balance Sheet
As of 12/31/…
2013
Cash
2014
$ 2,765.3 $ 3,496.8
Receivables
2,562.2
2,818.4
Inventory
2,562.2
2,818.4
Total current assets
7,889.7
9,133.6
PP&E, gross
4,245.9
4,670.5
(1,353.1)
(1,401.4)
2,892.8
3,269.1
1,420.0
1,300.0
Accumulated depreciation
PP&E, net
Long-term investments (held-to-maturity)
Total Assets
Accounts payable
$ 12,202.5 $ 13,702.7
1,756.9
1,932.6
366.1
402.7
16.1
17.7
276.8
304.5
Total current liabilities
2,415.9
2,657.5
Long-term debt @ 5%
3,513.8
3,865.2
Deferred taxes
14.6
16.1
Total liabilities
5,944.3
6,538.8
Preferred Stock
100.0
100.0
Common Stock
1,700.0
1,900.0
Retained earnings
4,458.2
5,163.9
Total shareholders' equity
6,258.2
7,163.9
Short-term note @ 10%
Interest payable
Other accrued liabilities
Total Liabilities + Shareholders' Equity
$ 12,202.5 $ 13,702.7
Michael Dimond
School of Business Administration
Statement of Cash Flows
Strawman Corporation
Statement of Cash Flows
For year ended 12/31/…
2013
2014
Cash flows from operations (INDIRECT)
Net income
$
999.6 $ 1,147.6
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation expense
Deferred taxes
Gain on sale of investments
43.9
48.3
1.3
1.5
-
(80.0)
Change in inventory
(232.9)
(256.2)
Change in receivables
(232.9)
(256.2)
159.7
175.7
1.5
1.6
25.2
27.7
765.4
810.0
Change in accounts payable
Change in interest payable
Change in other accrued liabilities
Net cash provided (used) by operating activities
Cash flows from investing activities
Sale of held-to-maturity investments
-
200.0
Purchase of plant assets
(386.0)
(354.6)
Net cash provided (used) by investing activities
(386.0)
(154.6)
Cash flows from financing activities
Issuance of common stock
-
130.0
Proceeds from (repayment of) long-term debt
319.4
351.4
Proceeds from (repayment of) short-term debt
33.3
36.6
Payment of cash dividends to preferred stock
(1.0)
(1.0)
Payment of cash dividends to common stock
Net cash provided (used) by financing activities
(384.0)
(32.3)
(441.0)
Michael
Dimond
76.0
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)?
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)
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?”
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?
ROE =
PM x
TAT
x
EM
NI
NI
Sales
Total Assets
=
x
x
Equity
Sales
Total Assets
Equity
NI
NI
Sales
Total Assets
=
x
x
Equity
Sales
Total Assets
Equity
• The numerators and denominators cancel to reduce the
equation to NI ÷ Equity
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
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?
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
Michael Dimond
School of Business Administration
Common-Size Income Statement
Common-size Income Statement
Revenue
2013
2014
100%
100%
COGS
68%
68%
Gross profit
32%
32%
SG&A
13%
13%
Operating income
18%
18%
Other revenues & gains
0%
0%
Gain on sale of investments
0%
1%
18%
19%
Earnings before interest and taxes (EBIT)
Interest expense, net
2%
2%
Earnings before taxes
16%
17%
7%
7%
10%
10%
Income tax expense
Net income
Michael Dimond
School of Business Administration
Common-Size Balance Sheet
Common-size Balance Sheet
2013
2014
Cash
23%
26%
Receivables
21%
21%
Inventory
21%
21%
Total current assets
65%
67%
PP&E, gross
35%
34%
-11%
-10%
24%
24%
Accumulated depreciation
PP&E, net
Long-term investments (held-to-maturity)
12%
9%
100%
100%
14%
14%
Short-term note @ 10%
3%
3%
Interest payable
0%
0%
Other accrued liabilities
2%
2%
Total current liabilities
20%
19%
Long-term debt @ 5%
29%
28%
Deferred taxes
0%
0%
Total liabilities
49%
48%
Preferred Stock
1%
1%
Common Stock
14%
14%
Retained earnings
37%
38%
Total shareholders' equity
51%
52%
100%
100%
Total Assets
Accounts payable
Total Liabilities + Shareholders' Equity
Michael Dimond
School of Business Administration
We don’t make a common-size CF Statement
Strawman Corporation
Statement of Cash Flows
For year ended 12/31/…
2013
2014
Cash flows from operations (INDIRECT)
Net income
$
999.6 $ 1,147.6
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation expense
Deferred taxes
Gain on sale of investments
43.9
48.3
1.3
1.5
-
(80.0)
Change in inventory
(232.9)
(256.2)
Change in receivables
(232.9)
(256.2)
159.7
175.7
Change in accounts payable
Change in interest payable
Change in other accrued liabilities
Net cash provided (used) by operating activities
Cash flows from investing activities
Sale of held-to-maturity investments
Purchase of plant assets
Net cash provided (used) by investing activities
There are other
ways to examine
cash flows which
are more helpful
1.5
1.6
25.2
27.7
765.4
810.0
-
200.0
(386.0)
(354.6)
(386.0)
(154.6)
Cash flows from financing activities
Issuance of common stock
-
130.0
Proceeds from (repayment of) long-term debt
319.4
351.4
Proceeds from (repayment of) short-term debt
33.3
36.6
Payment of cash dividends to preferred stock
(1.0)
(1.0)
Payment of cash dividends to common stock
Net cash provided (used) by financing activities
(384.0)
(32.3)
(441.0)
Michael
Dimond
76.0
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)
Growth of Income Statement Items
2013
2014
Revenue
10.0%
10.0%
COGS
10.0%
10.0%
Gross profit
10.0%
10.0%
SG&A
10.0%
10.0%
Operating income
10.0%
10.0%
Earnings before interest and taxes (EBIT)
10.0%
14.3%
Interest expense, net
10.0%
10.0%
Earnings before taxes
10.0%
14.8%
Income tax expense
10.0%
14.8%
Net income
10.0%
14.8%
Growth of Balance Sheet Items
2013
2014
Cash
14%
26%
Receivables
10%
10%
Inventory
10%
10%
Total current assets
11%
16%
PP&E, gross
10%
10%
Accumulated depreciation
PP&E, net
Long-term investments (held-to-maturity)
3%
13%
0%
4%
13%
Michael
Dimond
School of Business Administration
-8%
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
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
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
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
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
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
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
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
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
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?
Michael Dimond
School of Business Administration
A starting point
• This set of ratios answer a series
of useful questions. Some
companies require other ratios.
Useful Ratios & Other Figures
GM (Gross Margin)
OM (Operating Margin)
PM (Profit Margin AKA Net Profit Margin)
TAT (Total Asset Turnover)
EM (Equity Multiplier)
ROE (Return on Equity)
ROA (Return on Assets)
d (Dividend Payout Ratio)
b (Retention Ratio AKA Ploughback Ratio) = 1-d
Alternativ to Retention Ratio = ΔRE/NI
SGR (Sustainable Growth Rate)
IGR (Internal Growth Rate)
TIE (Times Interest Earned Ratio AKA Interest Coverage Ratio)
DOL - point estimate (Degree of Operating Leverage)
EPS (Earnings Per Share)
Days of sales in cash
Inventory Turnover = COGS/Avg Inv
Receivables Turnover
Purchases
Payables Turnover
Days in inventory
Days in receivables
Operating cycle
Days in payables
Cash cycle
Michael Dimond
School of Business Administration