Chapter 2 Lecture (Part 2)
Ratio Analysis
As you may have noticed from Part 1, using raw financial data to assess a company’s
performance is of limited value. Using that same raw data to compare a firm with
another firm or with an industry would be impossible. What is needed is a way of scaling
the numbers across firms so that comparisons between firms can be made. This is the
real purpose of ratio analysis.
Financial ratio analysis expresses the items on a firm’s financial statements as a
percentage of some other number on the financial statements. For example, we might
divide a firm’s gross profit by its sales to come up with a ratio called gross profit margin.
Or we might divide a firm’s total debt by its total assets to compute a ratio called the debt
ratio.
Just because you have computed a given ratio from the financial statements does not
mean you have arrived at any useful information. Considered alone, a ratio has no
meaning at all. A ratio has to be compared to something to have meaning. It can be
compared to the same ratio at the same point in time from a competing firm or for the
industry. This is called cross-sectional analysis. Or it can be compared to itself over
different time periods to determine its trend. This is called trend analysis.
Ratio analysis is used to evaluate the firm across a number of dimensions. It can be used
to determine the firm’s liquidity, activity, debt, profitability as well as several market
measures. In the process, a good ratio analysis can provide the analyst with a sense of the
firm’s strengths and weaknesses and the risks it poses to investors.
A complete ratio analysis for the Bartlett Company appears on the PowerPoint
presentation for Chapter 2. It is nearly identical to the ratio analysis presented in the text.
The only difference is for the profit margin, return on assets, return on equity and the
financial leverage multiplier (referred to as the equity multiplier in the PowerPoint
presentation). The text uses earnings available to common in the numerators for the
profitability ratios and I use net income after tax. Also the text uses common equity in
the denominator of the ROE ratio and in the numerator for the equity multiplier whereas I
use total equity. These will make small difference in the answers found in the text and the
PowerPoint. I find my method a little easier to follow and causes little change in the
results.
As you go through the analysis in the PowerPoint, ask yourself the following questions:
What drives the magnitude of a particular ratio? For example, what effect would an
increase in inventory have on the current ratio, the quick ratio, and the inventory turnover
ratios? What effect would an increase in the average collection period have on the
average payment period? What effect would an increase in debt have on the firm’s return
on equity? What effect would an increase in total asset turnover have on return on
equity? Also ask yourself whether an increase in a given ratio is good or bad for the firm.
You can also take the your answers to the silly extreme to see if they still make sense.
For example, you might conclude a higher current ratio is better than a lower current
ratio. Is this always true? What if the current ratio were infinitely high? Would that be
considered “good”? You might also conclude the higher the inventory turnover ratio the
better. Is that always true? What if it were infinitely high? By going through this
process you will discover that most ratios have a Goldilocks level: not too high, not too
low but just right. The “just right” level might be the industry average for the ratio or the
average for the industry leaders (the assumption being the industry leaders must be doing
something right).
Also be aware that making changes in one part of the firm (and its ratios) can have a
significant effect on another part of the firm (and its ratios). On exams, I tend to
emphasize questions on relationships between ratios rather than simple computation of
ratios. Before reviewing the next section on Dupont analysis, go through the PowerPoint
presentation for chapter 2.
A Note on Dupont Analysis
Dupont analysis, also known as ROE decomposition analysis, helps us to understand
what drives a firm’s ROE. The analysis proceeds in three stages. (Again, I use net
income and total equity where the text uses earnings available to common and common
equity. I find my way is easier to understand and results in no significant difference.)
Stage 1:
ROE = NI/Total Equity
This is simply the definition of ROE and expresses net income as a percentage of total
equity. Stage 1 really does not provide us with much new information about what is
driving ROE.
Stage 2:
ROE = ROA X EM (EM is the equity multiplier. Your book refers to this as
the FLM or the financial leverage multiplier).
= (NI/TA) X (TA/TE)
Notice stage 2 is algebraically the same as stage 1 because the TAs cancel out. Stage 2
provides a little more information than stage 1. Stage 2 tells us that ROE depends both
on the level of ROA and on the equity multiplier. What does the equity multiplier
measure? If you think about it, the equity multiplier is really a debt ratio. To see this
consider the following:
TA = TD + TE (this is the balance sheet equation)
Lets divide the both sides of the balance sheet equation by TA.
TA/TA = TD/TA + TE/TA (TE/TA is the equity ratio) in other words
1 = debt ratio + equity ratio (this tells us the debt ratio plus the equity ratio =1.)
Notice something very important here. If the firm increases its debt ratio, the equity
ratio absolutely must fall because the debt and equity ratios always sum to 1.
Recall the equity multiplier =
EM = TA/TE
Do you see a relationship between the equity ratio and the equity multiplier?
Equity ratio = TE/TA
EM = TA/TE
The equity ratio and the equity multiplier are inverses of each other! This means
when the equity ratio falls, the equity multiplier rises (the reverse is also true).
Now let’s see revisit what happens when the debt ratio rises:
1 = debt ratio + equity ratio
1 = TD/TA
+ TE/TA
If the debt ratio rises, the equity ratio must fall so the two numbers will still sum to 1.
If TE/TA falls, then what must happen to TA/TE (the equity multiplier)? It must rise!
To sum up, when the debt ratio rises the equity multiplier also rises. What does this
mean? For one thing it means the equity multiplier is really a debt ratio because it moves
in the same direction as the debt ratio does.
What does all this have to do with stage 2 of ROE decomposition analysis?
ROE = ROA X EM.
What this tells us is that one simple way a firm can leverage a low, but still positive,
ROA in to a higher ROE is to simply increase the firm’s debt ratio. This all by itself will
cause ROE to rise. This can be very misleading to investors who simply examine ROE
without also examining it underlying causes. If the cause of the higher ROE is an
increase in debt, this indicates the firm has accepted a higher risk of bankruptcy to obtain
that higher ROE.
The implications of the higher risk can be severe! Having a high debt ratio can burn you.
Suppose ROA is negative (that is the firm had a net loss instead of net income) instead of
positive. A high debt ratio (resulting in a high EM) will then magnify the firm’s negative
ROA into a more negative ROE.
decomposition analysis.
Now let’s look at the third and final stage of ROE
Stage 3:
ROE = NPM X TAT X EM
(ROE = net profit margin times total asset turnover times the equity multiplier).
= (NET INCOME/SALES) X (SALES/TA) X (TA/TE)
Notice that stage 3 is algebraically equivalent to stage 2 (because the sales cancel out)
and to stage 1 (because the TAs cancel out). All we have really done in proceeding from
stage 2 to stage 3 is to decompose ROA into NPM X TAT.
What new information does stage 3 provide? It tells us that another way the firm can
increase its ROE is to increase its ROA by increasing its net profit margin and/or its total
asset turnover.
Final Thoughts
It’s important to remember that factors affecting the numbers on one financial statement
ultimately affect other numbers on that statement and on other statements. For example
an increase in sales can lead to an increase in net income which can, in turn, cause an
increase in retained earnings. Similarly, a change in one ratio can affect other ratios. For
example an increase in the debt ratio reduces the equity ratio and increases the equity
multiplier. An increase in inventory increases the current ratio while lowering the quick
ratio. We can understand more about a firm when we understand the key drivers behind
the ratios and how ratios relate to each other than we can by simply computing the ratios.