Ratio Analysis
˜Financial statements report both on a firm’s position at a point
in time and on its operations over some past period.
˜However, the real value of financial statements lies in the fact
that they can be used to help predict the firm’s future earnings
and dividends.
˜From management’s standpoint, financial statement analysis is
useful as a way to anticipate future conditions and as a starting
point for planning actions that will influence the future course
of events.
˜An analysis of the firm’s ratios is generally the first step in a
financial analysis. The ratios are designed to show
relationships between financial statement accounts.
Basic Types of Financial Ratios
Each type of financial analysis has a purpose, or use, that determines the
different relationships emphasized.
It is useful to classify ratios into six fundamental types:
˜Liquidity ratios: measure the firm’s ability to meet its
maturing short-term obligations.
˜Debt management ratios: measure the extent to which the firm
has been financed by debt.
˜Asset management ratios: measure how effectively the firm is
using its resources.
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˜Profitability ratios: measure management’s overall
effectiveness as shown by the returns generated on sales and
investment.
˜Growth ratios: measure the firm’s ability to maintain its
economic position in the growth of the economy and industry.
˜Market value ratios: measure the firm’s ability of management
to create market value in excess of investment-cost outlays. ØThese
valuation ratios are the most complete measure of
performance in that they reflect the risk ratios (the first two)
and the return ratios (the following three).
ØMarket value ratios are of great importance because they
relate directly to the goals of maximizing the value of the firm
and the wealth of shareholders.
Liquidity Ratios
Usually the first concern of most financial analysts is liquidity: will the
firm be able to meet its maturing obligations?
By relating the amount of cash and other current assets to the current
obligations, ratio analysis provides a quick and easy to use measure of
liquidity.
Two commonly used liquidity ratios are present here:
Current Ratio: The current ratio is computed by dividing current
assets by current liabilities.
Current assets normally include cash, marketable securities,
accounts receivable and inventories;
Current liabilities consist of accounts payable, short-term notes payable,
current maturities of long-term debt, accrued income taxes and other
accrued expenses (principally wages).
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ØIf a company is getting into financial difficulty, it begins paying its
bills (accounts payable) more slowly, building up bank loans, and so on.
If these current liabilities are rising faster than current assets, the current
ratio will fall, which could signal trouble.
ØThe current ratio is the most commonly used measure of short-term
solvency because it indicates the extent to which the claims of short-term
creditors are covered by assets that are expected to be converted to cash
in a period roughly corresponding to the maturity of the claims.
Ø The
calculation of the current ratio for Surrey at year-end 1993
Current ratio =
Current assets
Current liabilities
=
$415 000 000
= 4.6 times
$ 91 000 000
The industry average is 1.8 times.
˜Hence, Surrey’s current ratio is well above the average for the
industry and this may be of concern to the management. Because
current assets are near maturity, it is quite likely that they could be
liquidated at 22% of book value in order to satisfy current creditors.
(1/4.6 = .22 or 22%)
If a firm’s ratios are very far removed from the averages for its industry,
the analyst must be concerned about why this variance occurs.
vSurrey’s substantial discrepancy from the industry average could be a
result of the combination of different types of companies in the
merchandising industry category. Within this industry, there is a wide
variation in current ratios for individual companies.
vAlternatively Surrey’s large current ratio may suggest that the firm
should reduce its accounts receivable by reducing the credit sales to
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customers or increase its account payable by taking greater advantage of
credit offered by its suppliers.
Quick or Acid Test Ratio: The quick or acid test ratio is calculated by
deducting inventories from current assets and dividing the remainder by
current liabilities.
Ø Inventories
are typically the least liquid of a firm’s current assets
and the assets on which losses are most likely to occur in the
event of liquidation. Therefore, this is an “acid test” measure of the
firm’s ability to pay off short-term obligations.
Quick or acid test ratio = Current assets – Inventory
Current liabilities
= ($245 000 000 / 91 000 000 )
= 2.7 times
Industry average = 0.8 times
Surrey is well above the industry average. It is clear from these two
ratios that Surrey is in a highly liquid short-term position.
All short-term liabilities can be paid off easily if the receivables can be
liquidated at more than 33% of their book value.
(In other words, cash on hand plus 33% of receivables provides funds
equal to short-term liabilities.)
(Cash + 0.33 * receivables = $15 000 + 0.33($230 000 000)
= $91 000 000 = current liabilities)
This calculated by the following formula:
Current liabilities – Cash
Receivables
=
$76 000 000
= 0.33 or 33%
$230 000 000
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Debt management Ratios
The extent to which a firm uses debt financing or financial leverage,
has three important implications:
1. Creditors look to the equity, or owner supplied funds to provide a
margin of safety. If owners have provided only small proportion of
total financing, the risks of the enterprise are borne mainly by the
creditors.
2. By raising funds through debt, the owners gain the benefits of
maintaining control of the firm with a limited investment.
3. If the firm earns more on the borrowed funds than it pays in
interest, the return to the owners is magnified.
Ø Firms
with low debt leverage ratios have less risk of loss when the
economy is in a recession, but they also have lower expected returns
when the economy booms.
Ø Firms
with higher debt ratios run the risk of large losses but also have a
change of gaining high profits.
Ø Decisions
about the use of leverage must balance higher expected
returns against increased risk.
uTwo debt management ratios used to examine the firm’s debt in a
financial statement analysis check balance sheet ratios to determine the
extent to which borrowed funds have been used to finance assets, and
review income statement ratios to determine the number of times fixed
charges such as interest payments are covered by operating profits.
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These two sets of ratios are complementary, and most analysts use both
types.
Debt Ratio: The ratio of total debt to total assets, generally called the
“debt ratio”, measures the percentage of total funds
provided by creditors.
ØDebt includes current liabilities and all bonds.
ØCreditors prefer moderate debt ratios because the lower the ratio,
the greater the cushion against creditors’ losses in the event of
liquidation.
In contrast to the creditors’ preference for a low debt ratio, the owners
may seek high leverage either to magnify earnings or because raising
new equity means giving up some degree of control.
ØIf the debt ratio is too high, there is a danger of encouraging
irresponsibility on the part owners. The stake of the owners can become
so small that speculative activity, if it is successful, will yield a
substantial percentage return to the owners.
Debt ratio
=
Total Debt
=
Total Assets
$418 000 000
= 0.69 or 69%
$606 000 000
Industry average = 68%.
wSurrey’s debt ratio of 68% means that the creditors have supplied that
proportion of the company’s total financing.
Surrey’s ratios was slightly greater than the industry average.
Times Interest Earned: The times-interest-earned (TIE) ratio is
determined by dividing earnings before interest and taxes
(EBIT) by the interest charges. Since there are no
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additional income or expense items except interest, EBIT
and net operating income (NOI) are identical.
vThis ratio measures the extent to which earnings can decline without
resultant financial embarrassment to the firm because of inability to meet
annual interest costs.
vFailure to meet interest obligations can bring legal action by the
creditors, possibly resulting in bankruptcy. Because income taxes are
computed after interest expense is deducted, the ability to pay current
interest is not affected by income taxes.
Times Interest earned =
Earnings before interest and taxes
Interest charges
=
Profit before taxes + Interest charges
Interest charges
=
$103 000 000
$43 000 000
=2.4 times
Industry average = 2.4 times.
Fixed-Charge Coverage: The fixed charge coverage ratio is similar to
the times-interest earned ratio, but it is somewhat more inclusive in that
is recognizes that firms lease assets and incur long term obligations
under lease contracts. Leasing has become quite widespread in recent
years, making this ratio preferable to the time-interest earned ratio for
most financial analyses.
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“Fixed charges” are defined as interest plus annual long-term lease
obligations, and the fixed charge coverage ratio is defined as:
Fixed Charge coverage ratio =
Net income
Interest
Lease obligations
Before taxes + charges + obligations
=
Interest Charges + Lease obligations
$60 000 000 + 43 000 000 + 20 000 000
=
43 000 000 + 20 000 000
= 123 000 000 / 63 000 000 = 2.0 times
Industry average = 2.0 times.
Cash Flow Coverage: The cash flow coverage ratio shows the margin
by which operating cash flows cover financial requirements. To the
numerator of the previous ratio we add depreciation, and to the
denominator we add the two additional items on a before-tax basis:
Cash Flow Coverage Ratio =
Cash Inflows
Interest plus Preferred share dividends
Lease
+
payments
(1-T)
Debt repayment
+
(1-T)
(123 000 000 + 9 000 000)
=
63 000 000 + 5 000 000
+ 15 000 000
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(1- 0.50)
(1- 0.50)
=132 000 000 / 103 000 000 = 1.3 times.
vAlthough industry standards on this ratio are not generally published,
logic suggests that a cash coverage ratio of at least 2 times should be
achieved in normal times, allowing for a substantial decline in cash
inflows before a cash solvency problem is encountered.
vSurrey does not meet this standard.
Asset Management Ratios
ØAsset management ratios measure how effectively the firm employs
the resources at its command.
ØThese ratios all involve comparisons between the level of sales and the
investment in various asset accounts.
ØThe ratios presume that a proper balance exists between sales and the
various asset accounts—inventories, accounts receivable, fixed assets,
and others. This is generally a good assumption.
Inventory Turnover: The inventory turnover ratio is:
Inventory turnover ratio = Sales / Inventory
= 920 000 000 / 170 000 000 = 5.4 times
Industry average = 8.0 times.
Surrey’s turnover ratio is significantly less than the industry average
suggesting that Surrey is holding greater inventories than necessary; the
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excess inventory is unproductive and represents an investment with low
or zero rate of return.
Three problems arise in calculating and interpreting the inventory
turnover ratio:
1. Sales are at market prices; if inventories are carried at
historical cost, it would be more appropriate to use cost of goods
sold in place of sales in the numerator of the formula. To permit
comparison of the individual company and industry ratios, it is
necessary to measure inventory turnover with sales in the
numerator.
2. The valuation of inventories may not be the same across
firms in the same industry. Generally the FIFO valuation
method (first in, first out) is used. If however, the LIFO method
(last in, last out) is used, then older, lower-valued stocks may be
include in the inventory, which could lead to a higher inventory
turnover ratio.
3. The final problem lies in the fact that sales occur over the entire
year, whereas the inventory figure is for one point in time. This
makes it better to use an average inventory for the year, computed
by adding the 12-end-of-month inventory figures and dividing by
12, or by adding the beginning and ending inventories an dividing
by 2. If a firm’s business is highly seasonal it is necessary to make
some kind of adjustment.
Days Sales Outstanding: Days sales outstanding (DSO) is used to
appraise accounts receivable; it is a measure of accounts receivable
turnover and is computed in two steps:
(1) annual sales are divided by 365 to get the average daily sales;
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(2) daily sales are divided into accounts receivable to find the number of
days’ sales tied up in receivables.
This figure is called days sales outstanding since it represents the
number of days that the firm must wait after making a sale before
receiving cash. Changes in this ratio will have an impact on the liquidity
ratios, too.
Step 1: Sales per day
= $920 000 000 / 365 = $2 520 548
Step 2: DSO = Receivables / Sales per day
= 230 000 000 / 2 520 548 = 91.25 days
Industry average = 30 days
The calculations for Surrey show an average collection period of 91
days, which is well above the 30-day industry average. This comparison
indicates that customers are not paying their bills promptly.
The industry ratio includes some firms that deal mostly in cash sales.
Even with these qualifications in the interpretation of the average
collection period, it appears that the 91-day period for Surrey should be
reduced.
Fixed-Asset Turnover: The fixed-asset turnover ratio (or fixed-assets
utilization ratio) measures how effectively the firm uses its plant and
equipment. It is the ratio of sales to net fixed assets.
Sales
$920 000 000
Fixed-asset
=
=
turnover ratio Net fixed assets
$191 000 000
= 4.8 times.
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Industry average = 7.5 times.
vThe Surrey turnover of 4.8 times compares poorly with the industry
average of 7.5 times. This indicates that the firm is not using its fixed
assets to as high percentage of capacity as are the other firms in the
industry.
Total-Assets Turnover: The final asset management ratio, the total –
assets turnover ratio, measure the turnover of all the firm’s
assets;
it is calculated by dividing sales by total assets.
Total-asset turnover ratio=
Sales
= $920 000 000
Total assets
$606 000 000
= 1.5 times
Industry average = 2.5 times.
ØAgain this poor turnover figure implies that Surrey is not generating
sufficient sales for the amount of assets employed. This problem is
related to the poor turnover experienced with inventory. Sales should be
increased, or some inefficient assets should be disposed of, or both.
Profitability Ratios
Profitability is the net result of a large number of policies and decisions.
The ratios examined thus far provide some information about the way
the firm is operating, but the profitability ratios show the combined
effects of liquidity, asset management, and debt management on
operating results.
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Profit Margin on Sales: The profit margin on sales, computed by
dividing net income after taxes by sales, gives the
profit per dollar of sales.
Profit margin on Sales = Net income after taxes = $30 000 000
Sales
$920 000 000
= 3.3%
Industry average = 1.2 %.
Surrey’s profit margin is considerably above the industry average,
indicating that the company’s prices are relatively high or that its
operating costs are relatively low or both.
Basic Earnings Power: The basic earnings power ratio is calculated by
dividing the earnings before interst and taxes (EBIT) by
total
assets.
Basic Earnings Power = EBIT = $103 000 000 = 17%
Total assets $606 000 000
Industry average = 13%.
Return on Total Assets: The ratio of net income after taxes to total
assets measure the return on all capital invested in the
firm; it is called the return on total assets (ROA) or
return
on investment (ROI).
ROA = Net income after taxes = $30 000 000 = 5%
Total assets
$606 000 000
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Industry average = 3%.
Surrey’s return on assets is significantly above the industry average.
This results form the high profit margin on sales that more than offsets
the low turnover of total assets.
Return on Common Equity: The ratio of net income after taxes to
common equity, often called return on common equity
(ROE), measures the rate of return on the
shareholders’
investment.
ROE = Net income after taxes = 30 000 000 = 16%
Net worth
$188 000 000
Industry average = 9.2%
Growth Ratios
Growth ratios measure how well the firm is maintaining its economic
position in the economy as a whole and within its own indsutry.
During periods of inflation, the interpretation of growth ratios becomes
more difficult. During inflationary periods, nominal growth rates
increase greatly. The growth of the econmy as well as of industries and
firms reflects the inflation factor as well as the underlaying (real)
growth.
Since reported figures are generally stated in nominal terms, the growthrate reference standard that are empolyed will include the inflation
factor. However, as a part of the further internal analysis by business
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firms, distinction needs to be made between inflation-related growth, and
underlying real growth which reflects the basic productivity of the
economy and the firm.
Refer to chapter 12 for detail on future value interest factors.
Market Value Ratios
Market value ratios are the most comprehensive measure of performance
for the firm in that they reflect the combined influence of financial
ratios, which reflect risk, and those that reflect return. Two valuation
ratios are calculated and their patterns are summarized in Table 4-8.
Table 4-8
Market Value
Ratios,
1988-1993
P/E ratio:
Market-tobook ratio
Surrey
Industry
1988
8.1
7.0
1989
8.7
8.0
1990
7.8
7.5
1991
7.6
7.8
1992
8.5
8.0
1993
7.1
7.0
Surrey
1.3
1.4
1.3
1.1
1.4
1.1
Industry
1.1
1.2
1.2
1.1
1.1
Price-to-Earnings Ratio: The price-to-earnings (P/E) ratio shows how
much investor are willing to pay per dollar of reported
earnings.
P/E ratios are higher for firms with high growth prospects, OTRS, but
they are lower for riskier firms.
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The price-to-earnings ratio is calculated as the price per share divided by
the earnings per share.
P/E ratio = Price per share
= $18.00 = 7.1 times.
Earnings per share
$2.52
Consider the trends in the P/E ratios shown in Table 4-8. For every year
except 1991, the ratios for Surrey were higher than those for the
industry. This reflects the superior performance of Surrey and its high
growth rate.
Market-to-Book Ratio: The market-to-book ratio is another important
valuation ratio because it indicates the value that the financial markets
attach to the management and to the organization of the company as a
going concern.
Book value represents the historical costs of the physical assets of the
company that have been financed by common equity shareholders.
Market-to-book ratios will depend on industry factors as well as on
individual firm influences.
Market-to-book ratio= Market price per share = $18 =1.1 times
Book value per share 15.80
The market-to-book ratio of the company was always in excess of 1.0.
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