MSE608C – Engineering and Financial
Cost Analysis
Financial Ratios and Analysis
Analyzing Financial Statements
• Balance Sheet
– The financial condition of the company on a certain
date (a snapshot on that date)
• Income Statement
– The financial performance of the company over a
period of time (the accounting period)
• Cash Flow Statement
– Sources and Uses of Cash over the accounting period
• Financial Ratios
– Compares financial data to create insightful
relationships about the company’s financial health and
operating performance.
Types of Financial Ratios
•
Liquidity
Measures a firms ability to meet it near-term obligations.
•
Working capital or Efficiency
Indication of how well a firm is using it’s assets to generate profits.
•
Capital Structure or Solvency
Provide indications on how a firms is financing it’s investment in assets.
•
Profitability or Operating
Used to measure if a company is generating sufficient returns on it’s investments.
•
Investment or Market Test
Measures used by many investors to compare a company’s earnings and dividend
payments to it’s stock price.
Liquidity Ratios
Liquidity measures the financial strength of an
organization and it’s ability to pay it’s debts.
• Liquidity
The measure of a company’s ability to meet current
obligations when they are due.
Current obligations are all current expenses
• Salaries Payable; Accounts Payable; and Rent Payable
The two common Liquidity Ratios:
• Current ratio;
• Quick, or Acid Test
Liquidity Ratios
• Current Ratio
Current Ratio = Current Assets
Current Liabilities
– Current Assets include cash; marketable securities; accounts receivable;
inventory; and prepaid expenses.
• Quick Ratio
Quick Ratio = Quick Assets
Current Liabilities
– Uses only the most liquid assets; cash, marketable securities and accounts
receivable.
Questions????
• How can a company manipulate it’s
Liquidity ratios?
• What would happen if a company changed
from FIFO to LIFO to account for Inventory
valuation?
• Where would clues be found to indicate the
Liquidity ratio was manipulated?
Working Capital Ratios
Measures how effectively a company utilizes it’s
Working Capital to generate profits
• Inventory
– Inventory turnover
• Accounts Receivable
– Accounts Receivable Turnover
– Average Collection Period
• Accounts Payable
– Accounts payable payment period
• Assets
– Fixed Asset Turnover
– Total Asset Turnover
Inventory
• Inventory Turnover
Inventory Turnover = COGS
Average Inventory
• This tells how many times the inventory turned-over
during the accounting period. The more times the
inventory is turned, or used, the more efficient the
company.
– Inventory is expensive to purchase and hold.
– Faster turnover means less risk of obsolescence.
– On the other hand, the company must avoid stockouts and lost
business.
Accounts Receivable
• Accounts Receivable Turnover
Accounts Receivable Turnover = Annual Credit Sales
Average Accounts Receivables
– Indicator of how well credit sales are collected. The more times Accounts
Receivable is turned over, the more efficient the company and more
working capital is available.
• Average Collection Period
Average Collection Period = Average Accounts Receivables
(Annual Credit Sales 
– Calculates the average number of days it takes to collect payments due.
– Can indicate a problem if higher than the credit terms that are offered.
– A low number may indicate a company is only selling to customers who
pay quickly. There may be untapped opportunities for new customers.
Accounts Payable
• Accounts Payable Payment Period
Accounts Payable Payment Period = Average Accounts Payable
(Annual Credit Purchase
– The amount of credit purchases is not usually available in financial
statements; use Cost-of-Goods-Sold or other figure as a
replacement.
– Identifies the average number of days from receipt of goods or
services until they are paid.
– The longer the Period the more working capital is held and
available to the company.
– This is non-interest borrowing except for the loss of Prompt
Payment Discounts.
Assets
• Fixed Asset Turnover
Fixed Asset Turnover = Sales Revenue
Average Fixed Assets
• Total Asset Turnover
Total Asset Turnover = Sales Revenue
Average Total Assets
– These ratios indicate how effectively a company is utilizing it’s assets,
both current assets and non-current assets to generate Revenues.
Questions ???
• If the Accounts Receivable Collection
period changed from 36 days to 48 days
what would this indicated?
• What is the impact if the Inventory
Turnover rate goes from 7.3 times to 6.2?
Capital Structure Ratios
Provide indications on how a firms is financing it’s
investments in assets.
• Total Debt
– Total Debt to Owners’ Equity
– Total Debt to Total Assets
• Long-term Debt
– Long-term Debt to Total Capitalization
• Interest Expense
– Times Interest Earned
• Debt Financing: requires repayment of the principle and
interest.
• Equity Financing: No obligation to repay and no interest.
Total Debt
• Total Debt to Owners’ Equity
Total Debt to Owners’ Equity = Total Debt
Owners’ Equity
– Total Debt = Current liabilities + non-current liabilities
– Measures the relationship between borrowed funds and equity financing
– A company with a higher percentage than similar companies may use too
much borrowing compared to owner financing.
• Total Debt to Total Assets
Total Debt to Total Assets = Total Debt
Total Assets
– Measures the extent to which total asset are financed by borrowed funds
(as opposed to owners equity)
– A company with a higher percentage than similar companies may have
problems borrowing more money.
Long-term Debt
• Long-term Debt to Total Capitalization
Long-term Debt to Total Capitalization = Non-current liabilities
Total Capitalization
– Total Capitalization = Long-term Debt + Owners’ Equity
– It measures the percentage of Long-term debt to all permanently invested
capital from all sources.
– Some analyst include deferred taxes in total capitalization since it may
essentially be a permanent investment in the company.
• The ratio will vary by business and industry.
– A small corporation may have a high ratio due to a high level of borrowed
funds and a low amount of equity financing.
– A larger, publicly traded corporation will have a lower ratio due to a high
level of equity financing.
Interest Expense
Times Interest Earned
Times Interest Earned Ratio = Earnings Before Interest and Taxes (EBIT)
Interest Expense
–EBIT is found on the Income Statement as the net Operating Profit before
subtracting interest expense and taxes.
–Measures the ratio of the Operating Profit available to service debt.
–The higher the number the greater the safety margin and the lower the risk
a company can pay it’s debts.
Questions ???
• A high Total Debt to Owners Equity ratio
could have what implications?
• How could this be corrected?
Profitability Ratios
Used to measure if a company is generating
sufficient returns on it’s investments.
• Sales
– Gross Profit Margin
– Operating Profit Margin
– Net Profit Margin
• Equity
– Return on Equity (ROE)
• Assets
– Return on Assets (ROA)
Sales
• Gross Profit Margin
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–
–
–
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Gross Profit Margin = Gross Profit
Net Sales Revenue
Gross Profit = Nets Sales - COGS
Net Sales Revenue = Sales Revenues - returns.
Represents the markup on Cost of Goods Sold
Represents the amount of net sales that will cover operating expenses,
interest and taxes.
A common measure used by engineering and sales managers. New
products or services must almost always meet a minimum Gross Profit
Margin before it is offered.
Sales
Operating Profit Margin
Operating Profit Margin = Net operating income
Net Sales Revenue
– Used as a measure of operating efficiency in relation to sales revenues.
• Net Profit Margin
Net Profit Margin = Net Income
Net Sales Revenue
– Measures the relationship of net profit to sales revenues.
– Will show how many cents on each sales revenue dollar becomes profit.
Equity and Assets
• Return on Equity (ROE)
Return on Equity = Net Income
Average Owners’ Equity
– Measures the percentage of owners’ equity that becomes profit.
– Measures a company’s return on owner financing.
• Return on Assets (ROA)
Return on Equity = ______EBIT________
Average Total Assets
– Measure a company’s return on it’s investment in total assets.
– Use EBIT to account for Interest (a function of Capital Investment)
Questions ???
• A high Gross Profit Margin always means a
high Net Profit Margin?
• What types of Industries would require a
high Gross Profit Margin?
• Why do some analyst look primarily at a
company’s Operating Profit Margin rather
than the Net Profit Margin?
Investment/Market Test Ratios
• Measures used by many investors to
compare a company’s earnings and dividend
payments to stock prices.
– Earnings per Share
– Price to Earnings
– Dividend Yield
Investment/Market Test Ratios
• Earnings per Share (EPS)
EPS = Net Income
Average number of shares of common stock
– Calculating the number of shares of common stock is complicated by
stock options, warrants and convertible securities.
• Price to Earnings (P/E)
P/E = AverageMarket Price per Share
Earnings per Share
– Indicates how many time Earnings investors are willing to pay for shares.
• Dividend Yield
Dividend Yield = Dividends per Share
Market Price per Share
– The percent yield in dividends per dollar paid for a share of stock.
Analyzing the Results
Ratio analysis is a tool that can provide
insights into a company’s performance not
readily available on the financial
statements.
• Compare to benchmarks
– Historical benchmarks (trends)
– External benchmarks
Analyzing Financial Statements
• Financial Information
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Balance Sheet
Income Statement
Cash Flow Statement
Financial Ratios
• Trends
• Industry Norms
• Industry/Competitive Analysis
Assessment
• What are the five (5) categories of financial
ratios?
• Generally, what does each group tell you
about a company?
• What do the Investment ratios tell you about
the performance of a company?
• What are the two benchmarks used for
comparision?