1
4
Ratio Analysis
Financial Ratios represent an attempt to standardize
financial information in order to facilitate meaningful
comparisons over time and between firms.
The business is a storehouse of resources (i.e.
assets on the balance sheet) which it converts to
profit through production and then sales (reported on
the income statement)
PRODUCTION
2
Why?
™Evaluate the success of an ongoing business
™Determine weaknesses of an ongoing business
™Compare current performance with past performance
™Compare current performance with industry
standards.
Working with Financial
Statements
RESOURCES
Evaluating Financial Performance
SALES
Ratio Analysis
Five Categories of Ratios
Liquidity Ratios
Long Term Solvency ratios
Asset Activity Ratios
Profitability Ratios
Market Value Ratios
5
7
Ratio Analysis
Current Assets
Current Liabilities
Is there a sufficient amount of current
assets to pay off current liabilities? What
is the cushion of safety?
9
Ratio Analysis
Liquidity Ratios
Measure the ability of the firm to meet its short-term
financial obligations.
Acid-Test Ratio =
aka Quick Ratio
Current Assets - Inventory
Current Liabilities
What happens to the firm’s ability to repay
current liabilities after the least liquid of
the current assets is subtracted?
8
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
600
Net Fixed Assets
$1,300 Paid-in Capital
Total
Assets
$2,530
Retained
Earnings
800
Income Statement
Total Owners’ Equity $1,700
Simsboro Computer Company
Total
Liabilities
and
Sales
$1,450
Current
RatioSold
= Current Assets
Owners Equity
$2,530
Cost of Goods
875
Current Liabilities
Gross Profit
$575
Operating Expenses
45
Depreciation
200
EBIT
$330
Interest Expense
60
Current Ratio = $1,230 = 5.35x
Net Income Before Taxes
$270
$230
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
Liquidity Ratios
Measure the ability of the firm to meet its short-term
financial obligations.
Current Ratio =
Ratio Analysis
Ratio Analysis
10
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
600
Net Fixed Assets
$1,300 Paid-in Capital
Total
Assets
$2,530
Retained
Earnings
800
Income Statement
Simsboro Computer Company
Total Owners’ Equity $1,700
Current
Assets
Inventory
Total Liabilities and
Sales
$1,450
Acid-Test
Ratio =
Owners Equity
$2,530
Current
Cost of Goods Sold
875 Liabilities
Gross Profit
$575
Operating Expenses
45
Depreciation
200
EBIT
$330
$1,230 -$625
Interest Expense
60
Acid-Test Ratio =
=2.63x
$230
Net Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
11
Ratio Analysis
Summary of Simsboro Computer & Industry
Ratio
5.00x
3.00x
12
Long Term Solvency Ratios
Industry Simsboro
Liquidity
Current Ratio
Acid-Test Ratio
Ratio Analysis
Used to measure the extent to which non-owner
supplied funds have been used to finance the firm’s
assets
5.35x
2.63x
Two Types
Looking at the current ratio it appears
that Simsboro is more liquid than the
industry.... however when looking at
Acid Test (a better measure) they are
not as liquid, this could be an indication
that inventory levels may be too high
relative to the sales.
13
Ratio Analysis
Long Term Solvency Ratios
Balance Sheet Debt Management Ratios measure
the proportion of the firm’s assets financed with nonowner funds.
Debt Ratio =
™Balance Sheet Debt Management Ratios
™Coverage Ratios
Total Debt
Total Assets
What proportion of the firm’s assets are
financed with debt?
Ratio Analysis
14
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
600
Net Fixed Assets
$1,300 Paid-in Capital
Total
Assets
$2,530
Retained
Earnings
800
Income Statement
Simsboro Computer Company
Total Owners’ Equity $1,700
Total Liabilities and
Sales
$1,450
Total
Debt$2,530
Equity
Cost of Goods Sold
875
Debt Ratio =Owners
Gross Profit
$575
Total Assets
Operating Expenses
45
Depreciation
200
EBIT
$330
Interest Expense
60
Debt Ratio = $230 + $600 = 33%
Net Income Before Taxes
$270
$2,530
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
15
Ratio Analysis
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
600
Net Fixed Assets
$1,300 Paid-in Capital
Total
Assets
$2,530
Retained
Earnings
800
Income Statement
Total Owners’ Equity $1,700
Simsboro Computer Company
Total
Liabilities
and
Sales
$1,450
Owners Equity
$2,530
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Total Debt
Depreciation
200 Debt/Equity Ratio =
EBIT
$330
Common Equity
Interest Expense
60
Net Income Before Taxes
$270
Taxes (40%)
108
$230 + $600
Net Income
$162Debt/Equity Ratio =
= 49%
$1,700
Dividends Paid
100
Addition to Retained Earnings $62
Long Term Solvency Ratios
Balance Sheet Debt Management Ratios measure
the proportion of the firm’s assets financed with nonowner funds.
Total Debt
Debt/Equity Ratio =
Common Equity
What is the relationship of the firm’s debt
and equity levels?
17
Ratio Analysis
Long Term Solvency Ratios
Balance Sheet Debt Management Ratios measure
the proportion of the firm’s assets financed with nonowner funds.
Equity Multiplier =
Total Assets or
Common Equity
1
1 – Debt Ratio
or 1 + Debt/Equity Ratio
What is the effect on the stockholders
earnings as a result of the current debt
level?
16
Ratio Analysis
18
Ratio Analysis
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
600
Net Fixed Assets
$1,300 Paid-in Capital
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Multiplier
Total Liabilities and
Owners Equity
$2,530
Debt Ratio = 33%
Debt/Equity Ratio = 49%
Equity
Total Assets
$2,530
= Common Equity = $1,700 = 1.49
1
= 1 – Debt Ratio
=
1
= 1.49
1 – .33
= 1 + Debt/Equity Ratio = 1+.49 = 1.49
19
Ratio Analysis
Long Term Solvency Ratios
Coverage Ratios measure the firm’s ability to cover
(pay) the finance charges associated with its use of
financial leverage.
Earnings Before Interest & Taxes
Times Interest Earned Ratio =
EBIT
Interest Expense
What is the margin of safety in the ability
to repay interest payments?
21
Ratio Analysis
Long Term Solvency Ratios
Coverage Ratios measure the firm’s ability to cover
(pay) the finance charges associated with its use of
financial leverage.
Cash Coverage =
EBIT+ Depreciation
Interest Expense
What is the margin of safety in the ability
to repay interest payments if we adjust the
numerator to be a Cash Flow?
Ratio Analysis
20
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
600
Net Fixed Assets
$1,300 Paid-in Capital
Total
Assets
$2,530
Retained
Earnings
800
Income Statement
Total Owners’ Equity $1,700
Simsboro Computer Company
Total
Liabilities
and
Sales
$1,450
Times
EBIT $2,530
Cost of Goods Sold
875
Interest
= Owners Equity
Interest Expense
Gross Profit
$575
Earned Ratio
Operating Expenses
45
Depreciation
200
EBIT
$330
$330 = 5.50x
Interest Expense
60
TIE Ratio =
$60
Net Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
Ratio Analysis
22
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
600
Net Fixed Assets
$1,300 Paid-in Capital
Total
Assets
$2,530
Retained
Earnings
800
Income Statement
Simsboro Computer Company
Total Owners’ Equity $1,700
Total Liabilities and
Sales
$1,450
EBIT+
Deprecation
Owners
Equity
$2,530
Cash
Cost of Goods Sold
875
= Interest Expense
Gross Profit
$575
Coverage
Operating Expenses
45
Depreciation
200
EBIT
$330
$330+200 = 8.83x
Interest Expense
60 Cash Coverage =
$60
Net Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
23
Ratio Analysis
Summary of Simsboro Computer & Industry
Ratio
Asset Activity Ratios
Provide basis for assessing how effectively the firm is
using its resources to generate sales
Industry Simsboro
Debt Management
Debt Ratio
Debt/Equity Ratio
Times Interest Earned
Equity Multiplier
Cash Coverage
35%
54%
7.00x
1.54x
9.96x
33%
49%
5.50x
1.49x
8.83x
Average Collection Period =
While debt ratio is slightly less than the
industry, Simsboro is not as able to cover
interest payments (using both earnings and
cash) as the industry. This indicates Simsboro
may have too much debt as it seems that they
cannot afford their level of debt.
Ratio Analysis
Accounts Receivable
Annual Sales / 365
How long does it take for the firm to
collect its credit sales from customers?
26
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
600
Net Fixed Assets
$1,300 Paid-in Capital
Total
Assets
$2,530
Retained
Earnings
800
Average
Income Statement
Accounts
Receivable
Simsboro Computer Company
Total Owners’
Equity $1,700
Collection =
Annual
Total Liabilities
Sales / and
365
Sales
$1,450
Period
Owners Equity
$2,530
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
EBIT
$330
$430
Interest Expense
60
ACP =
= 108.2 days
$1,450/365
Net Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Days in a
Dividends Paid
100
Addition to Retained Earnings $62
year
Additional Info:
We assume all
sales are credit
sales.
25
Ratio Analysis
27
Ratio Analysis
Asset Activity Ratios
Provide basis for assessing how effectively the firm is
using its resources to generate sales
Inventory Turnover Ratio =
Cost of Goods Sold
Inventory
Is the level of inventory appropriate given
the firm’s sales?
Ratio Analysis
28
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
600
Net Fixed Assets
$1,300 Paid-in Capital
Total
Assets
$2,530
Retained
Earnings
800
Income Statement
Total Owners’ Equity $1,700
Simsboro Computer Company
Inventory
COGS
Total
Liabilities
and
Sales
$1,450
Turnover =
Inventory
Owners
Equity
$2,530
Cost of Goods Sold
875
Ratio
Gross Profit
$575
Operating Expenses
45
Depreciation
200
EBIT
$330
Interest Expense
60 Inventory Turnover = $875
= 1.4x
Net Income Before Taxes
$270
$625
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
Ratio Analysis
30
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
600
Net Fixed Assets
$1,300 Paid-in Capital
Total
Assets
$2,530
Retained
Earnings
800
Income Statement
Simsboro Computer Company
Fixed Assets Total Owners’ Equity $1,700
Sales
Total
Sales
$1,450
Turnover
= Liabilities and
Owners
$2,530
Net Equity
Fixed Assets
Cost of Goods Sold
875
Ratio
Gross Profit
$575
Operating Expenses
45
Depreciation
200
EBIT
$330
Interest Expense
60 Fixed Assets Turnover = $1,450 = 1.12x
Net Income Before Taxes
$270
$1,300
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
29
Ratio Analysis
Asset Activity Ratios
Provide basis for assessing how effectively the firm is
using its resources to generate sales
Sales
Fixed Assets Turnover Ratio = Net Fixed Assets
How effective is the firm in using its fixed
assets in generating sales?
31
Ratio Analysis
Asset Activity Ratios
Provide basis for assessing how effectively the firm is
using its resources to generate sales
Total Assets Turnover Ratio =
Sales
Total Assets
How effective is the firm in using all
assets to generate sales?
Ratio Analysis
32
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
600
Net Fixed Assets
$1,300 Paid-in Capital
Total
Assets
$2,530
Retained
Earnings
800
Income Statement
Total Owners’ Equity $1,700
Simsboro Computer Company
Total
Liabilities
and
Sales
$1,450
Total Assets Owners
Equity
$2,530
Sales
Cost of Goods Sold
875
Turnover =
Gross Profit
$575
Total Assets
Ratio
Operating Expenses
45
Depreciation
200
EBIT
$330
Interest Expense
60 Total Assets Turnover =$1,450 = 0.57x
Net Income Before Taxes
$270
$2,530
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
Ratio Analysis
Profitability Ratios
Measures the overall effectiveness of the firm’s
management.
34
33
Ratio Analysis
Summary of Simsboro Computer & Industry
Ratio
Industry Simsboro
Asset Activity
Avg. Collection Period 90 days
Inventory Turnover
3.20x
Fixed Assets Turnover
1.00x
Total Assets Turnover
0.75x
108 days
1.4x
1.12x
.57x
Collection policies need examining, as Simsboro is
slower than average at collecting sales. Inventories
are being sold more slowly than industry, again
indicating too high inventories. Simsboro is very
efficient at converting Fixed Assets to Sales (fixed
assets are productive). However, overall assets are
not productive indicating Current Assets
(inventories) are not as productive as the industry.
Ratio Analysis
Profitability Ratios
Gross Profit Margin measures the relationship between
the firm’s sales and the cost of goods sold.
Two Types:
™Profit in Relation to Sales
™Profit in Relation to Investment
35
Gross Profit Margin = Gross Profit
Sales
What percentage of a given $ of sales
remain after the the cost of materials are
subtracted?
Ratio Analysis
36
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
600
Net Fixed Assets
$1,300 Paid-in Capital
Total
Assets
$2,530
Retained
Earnings
800
Income Statement
Total Owners’ Equity $1,700
Simsboro Computer Company
Total
Liabilities
and
Sales
$1,450
Gross
Gross
Profit
Owners
Equity
$2,530
Cost of Goods Sold
875
Profit =
Sales
Gross Profit
$575
Margin
Operating Expenses
45
Depreciation
200
EBIT
$330
$575
Interest Expense
60 Gross Profit Margin =
= 39.6%
$1,450
Net Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
Ratio Analysis
38
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
600
Net Fixed Assets
$1,300 Paid-in Capital
Total
Assets
$2,530
Retained
Earnings
800
Income Statement
Simsboro Computer Company
Total Owners’ Equity $1,700
Sales
$1,450
Operating Total Liabilities and
EBIT
$2,530
Cost of Goods Sold
875
Profit
= Owners Equity
Gross Profit
$575
Sales
Margin
Operating Expenses
45
Depreciation
200
EBIT
$330
$330
Interest Expense
60Operating Profit Margin =
= 22.8%
$1,450
Net Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
37
Ratio Analysis
Profitability Ratios
Operating Profit Margin measures the firm’s ability to
convert sales volume into profits before interest and
taxes.
Operating Profit Margin =
Operating Income (EBIT)
Sales
How effective is the firm in keeping costs
of production low?
Separates the profits generated by the
firm’s operations from the financing
decisions of the firm.
39
Ratio Analysis
Profitability Ratios
Profit in Relation to Sales measures the firm’s ability to
convert sales volume into bottom line profit.
Net Profit Margin =
Net Income
Sales
What is the amount of Net Profit for each
dollar of sales? Are total costs too high?
Ratio Analysis
40
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
600
Net Fixed Assets
$1,300 Paid-in Capital
Total
Assets
$2,530
Retained
Earnings
800
Income Statement
Total Owners’ Equity $1,700
Simsboro Computer Company
Total
Liabilities
and
Sales
$1,450
Net Profit
Net Income
Owners
Equity
$2,530
Cost of Goods Sold
875
Margin
=
Gross Profit
$575
Sales
Operating Expenses
45
Depreciation
200
EBIT
$330
$162
Interest Expense
60
Net Profit Margin =
= 11.2%
$1,450
Net Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
Ratio Analysis
42
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
600
Net Fixed Assets
$1,300 Paid-in Capital
Total
Assets
$2,530
Retained
Earnings
800
Income Statement
Simsboro Computer Company
Total Owners’ Equity $1,700
Total Liabilities and
Sales
$1,450
Return on
Income
OwnersNet
Equity
$2,530
Cost of Goods Sold
875
=
Total Assets
Gross Profit
$575
Total Assets
Operating Expenses
45
Depreciation
200
EBIT
$330
Interest Expense
60
ROA = $162 = 6.40%
$2,530
Net Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
41
Ratio Analysis
Profitability Ratios
Profit in Relation to Investment measures the firm’s
ability to convert resources (investment) into bottom
line profit.
Return on Total Assets =
Net Income
Total Assets
What is the relationship between the
generated profits of the firm and the firm’s
investment in assets?(Measures both
productivity and cost efficiency)
Ratio Analysis
Profitability Ratios
Profit in Relation to Investment measures the firm’s
ability to convert resources (investment) into bottom
line profit.
Net Income
Return on Equity = Common Equity
What is the relationship between the
generated profits of the firm and the
owner’s investment in the firm?(Measures
productivity, cost efficiency and debt
management.)
43
44
Ratio Analysis
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
$175 Accounts Payable
$115
Net Cash
Income
Return on Equity = Common
Accounts
Receivable 430 S-T Notes Payable
115
Equity
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
600
Net Fixed Assets
$1,300 Paid-in Capital
Total
Assets
$2,530
Retained
Earnings
800
Income Statement
Total Owners’ Equity $1,700
Simsboro Computer Company
Total
Liabilities
and
Sales
$1,450
Owners Equity
$2,530
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
EBIT
$330
Interest Expense
60
ROE = $162 = 9.53%
$1,700
Net Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
46
Ratio Analysis
45
Ratio Analysis
Summary of Simsboro Computer & Industry
Ratio
Industry Simsboro
Profitability
Gross Profit Margin
35.0%
Operating Profit Margin 20.0%
Net Profit Margin
12%
Return on Total Assets
9.0%
Return on Equity
13.86%
39.6%
22.8%
11.2%
6.4%
9.53%
Simsboro is superior to Industry at keeping
operating costs low (higher operating profit
margin). They are below average at keeping
total costs low (lower net profit margin). The
ROA and ROE are all low mainly due to the
previously identified productivity problems
(inefficient use of assets).
48
Ratio Analysis
Market Value Ratios
Relate Stock Price to earnings and book value of the
firm.
Price / Earnings (P/E) Ratio=
Stock Price per Share
Earnings per Share
What price are investors willing to pay for
each dollar of the firm’s earnings?
Price / Earnings (P/E) Ratio=
Income Statement
Simsboro Computer Company
Sales
$1,450
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
EBIT
$330
Interest Expense
60
Net Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
Stock Price per Share
Earnings per Share
The current stock price for Simsboro
Computer common stock is $37.50.
100 shares are outstanding
EPS = $162
100
P/E =
$37.50
$1.62
= $1.62
= 23.15
49
Ratio Analysis
Market Value Ratios
Market / Book Ratio=
The Market Value to Book Ratio measures how highly
the market values the common stock of a company.
Where:
Owners Equity
Shares Outstanding
52
Ratio Analysis
Summary of Simsboro Computer & Industry
Ratio
Industry Simsboro
Market Value Ratios
Price/Earnings Ratio
Market/Book Ratio
25
2.7
23.15
2.21
Simsboro is slightly lower valued by
investors compared to earnings, it has
slightly lower Market to Book Value
ratios which could be due to assets
having higher values on the balance
sheet due to lack of depreciation if
Simsboro is a relatively new firm.
Owners Equity
Shares Outstanding
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
600
Net Fixed Assets
$1,300 Paid-in Capital
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity
$2,530
Where:
Book Value per Share =
Market Stock Price per Share
Book Value per Share
Book Value per Share =
Market Stock Price per Share
Book Value per Share
Market / Book Ratio=
51
Ratio Analysis
The current stock price
for Simsboro Computer
common stock is
$37.50.
100 shares outstanding
Book
Value
$1700
per = 100 shares = $17
Share
Market/ $37.50
= 2.2 times
Book =
$17
Ratio
56
Ratio Analysis
DuPont System
The DuPont System summarizes key relationships
which determine the overall performance of the firm.
Return on Assets =
Can be rewritten as:
Net Income
Total Assets
Total Asset
Turnover
0.57 times
Net Income
Net Income
Sales
=
x
Total Assets
Sales
Total Assets
Profit
Margin
0.112 x 0.57 = .064 = 6.4%
11.2%
57
Ratio Analysis
DuPont System
DuPont System
Examples
Company
61
Ratio Analysis
The Return on Equity can also be rewritten:
Profit Margin
TAT
Net Income
Return on Equity = Common Equity
ROA
Kroger
1.671%
4.382
7.32%
IBM
7.761%
0.965
7.49%
DuPont System
Source: S&P Research Insight, Sept 1999
Return on Equity =
Ratio Analysis
65
DuPont System
The Return on Equity can also be rewritten:
Net Income
Return on Equity = Common Equity
Equity
$2,530
=
Multiplier $1,700
DuPont System
Total Assets
Return on Equity = ROA x
Common Equity
Return on
Assets
6.4%
.064 x 1.49 = 0.095 = 9.5%
Sales
Net Income x
Total Assets
x
Sales
Total Assets Common Equity
Return on
Equity
Assets
Multiplier
66
Ratio Analysis
Equity Multiplier & Leverage
The Equity Multiplier can be rewritten as a function of
the firm’s Debt Ratio:
Equity Multiplier =
Total Assets
or
Common Equity
1
1 – Debt Ratio
or 1 + Debt/Equity Ratio
Physical Leverage
Force
Applied
Financial Leverage
Reaction
Equity
Used
Assets
Controlled
67
Ratio Analysis
Example of Financial Leverage
Example of Financial Leverage
Investor has $1,000 to invest:
Equity
Used
Purchases 100 shares of
$10 stock
Option #2:
Stock Increases $3/share:
No Financial Leverage
Option #1:
Option #1:
Assets
Controlled
Combine $1000 equity with
a $4000 margin loan from
broker.
Equity
Used
($1000)
Own 100 shares of $13
stock = $1300
Increase in Asset Value = 30%
Increase in Equity Value = 30%
Option #2:
Financial Leverage
Purchases 500 shares of
$10 stock
68
Ratio Analysis
Increase in Asset Value = 30%
Assets
Controlled
($5000)
$4000
Debt Ratio = $5000 = 80%
Financing Growth
Own 500 shares of $13
5x
stock = $6500
Increase in Equity Value = 150%
– 4000 loan
1
1
$2500 equity Equity Multiplier =
=
=5
1–Debt Ratio
69
As firm’s sales increase over time new assets will have
to be purchased.
™The cost of these additional assets will probably be
more than the Cash Flows generated from the existing
assets can afford.
™In this case the firm will need additional financing from
an external source, either debt or equity.
• The internal growth rate tells us how much the firm
can grow assets using retained earnings as the only
source of financing.
• The sustainable growth rate tells us how much the
firm can grow by using internally generated funds and
issuing debt to maintain a constant debt ratio.
1 – .80
70
Financing Growth
$162
Revenues - Expenses = Net Income
$100
Income Statement
Simsboro Computer Company
Sales
$1,450
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
EBIT
$330
Interest Expense
60
Net Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
Dividends
% = Dividend
Payout Rate
$100 = 62%
162
$62
Retained
Earnings
% = Retention
Rate (b)
$62 = 38%
162
71
Financing Growth
Internal Growth Rate =
ROA x b
1 – ROA x b
Internal Growth Rate =
.064 x .38
1 – .064 x .38
= .0249 = 2.49%
=
Income Statement
Simsboro Computer Company
Sales
$1,450
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
EBIT
$330
Interest Expense
60
Net Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
The firm can finance an annual
growth rate of sales of 2.49% using
ONLY Retained Earnings to
purchase new assets needed to
generate the growth.
Max Sales
= sales x (1 + Growth Rate)
next year
= 1450 x (1 + .0249)
ROA x b
1 – ROA x b
Since only Retained Earnings are used, $’s of
equity in the firm are increasing and the Debt
Ratio is decreasing. As equity increases the
firm can borrow additional funds. These
additional borrowed funds can also finance
growth, thus:
Sustainable Growth Rate =
ROE x b
1 – ROE x b
= $1,486.11
73
Financing Growth
Sustainable Growth Rate =
ROE x b
1 – ROE x b
.0953 x .38
1 – .0953 x .38
= .0376 = 3.76%
=
Income Statement
Simsboro Computer Company
Sales
$1,450
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
EBIT
$330
Interest Expense
60
Net Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
72
Financing Growth
The firm can finance an annual growth
rate of sales of 3.76% using Retained
Earnings and Debt (holding Debt Ratio
Constant) to purchase new assets
needed to generate the growth.
Max Sales
= sales x (1 + Growth Rate)
next year
= 1450 x (1 + .0376)
= $1,504.52
Ratio Analysis
Limitations of Ratio Analysis
Seasonality
Window Dressing
Differences in Accounting Practices
Industry Averages are NOT a Goal
Data from Balance Sheet
™ Market Values versus Book Values
™ Older firms look better than newer firms
™ Does not focus on cash flow
74