Ratio Analysis
Chapter 6
• Chapter 6 homework problems, P6-2, 3, 8,
10, 14, 16-19, are still required.
Ch 6
2
Ratio Analysis
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•
•
•
Cross-sectional and time series analysis
Controls for size differences
Controls for currency differences
Ratios are easily (and commonly) modified
• Focus on p17-19.
Ch 6
3
Ratio Analysis Categories
•
•
•
•
•
•
Activity (operations and asset management)
Liquidity (meeting short-term obligations)
Solvency (meeting long-term obligations)
Profitability (earnings and cost coverage)
Cash Flow (quality of earnings)
Price Multiples (stock price)
Ch 6
4
Activity Ratios
How day-to-day operations function
• Inventory management
• Inventory Turnover
– Compares income statement and balance sheet amounts
– Usually average balance sheet figures ((Beg + End)/2)
– Turnover = COGS/Average total inventory
• Days inventory = 365/Turnover
– How many days was inventory held before being sold?
Ch 6
5
Activity Ratios
• Accounts receivable turnover
– How many times a credit sale is made and subsequently
collected during one year
– [credit sales/average accounts receivable]
– May have to use total sales rather than credit sales
– Consistency is important
• Days receivable
– Number of days between sales and collection
– [365/accounts receivable turnover]
Ch 6
6
Receivables Turnover for Selected Industries
General merchandise
Educational services
Electrical equipment
Printing and publishing
Motion pictures
Eating and drinking
Food stores
Source: Dun & Bradstreet
0
20
40
60
80
100
120
140
Receivables turnover
Ch 6
7
Activity Ratios
• Accounts payable turnover
– Number of times a credit purchase is made and
subsequently paid during one year
– [credit purchases/average accounts payable]
– Often assume all purchases are on credit
– Purchases = [COGS + Ending Inv. - Beginning Inv.]
• Days payable
– Number of days between credit purchase and payment
– [365/accounts payable turnover]
Ch 6
8
Activity Ratios
Cash Cycle
• Also a measure of liquidity
• If cash cycle is low, it means small number
of days in operating cycle to finance
[Days inventory + Days receivable - Days payable]
Ch 6
9
Activity Ratios
Asset Turnover
• Long-term
– Revenues generated by long-term assets
– [Sales revenue/Average noncurrent assets]
• Total assets
– Efficiency of generating revenues given total
assets
– [Sales revenue/Average total assets]
Ch 6
10
Liquidity Ratios
• Current ratio
– Ability to meet short-term obligations
– [Current assets/current liabilities]
• Quick ratio
– Remove less liquid assets
– Keep cash, liquid investments, A/R
– [(Current assets-inventory-ppd expenses-other)/current liabilities]
– [(Cash+short-term investments + A/R)/current liabilities]
Ch 6
11
Dun & Bradstreet's Quick Ratio for Selected
Industries
(Cash + Account Receivables/Current Liabilities)
General merchandise
Educational services
Electrical equipment
Printing and publishing
Motion pictures
Eating and drinking
Food stores
0
0.3
0.6
Source: Dun & Bradstreet
Ch 6
0.9
Ratio
1.2
1.5
12
Solvency Ratios
• Debt to assets: Total liabilities/Total assets
– Proportion of assets financed with debt
• Could include interest bearing debt only
[(short term debt + noncurrent debt)/total assets]
• Be aware that assets are recorded at
historical cost, which may be different from
current market value
Ch 6
13
Solvency Ratios
Coverage Ratios
• Adequacy of resources for meeting firm’s
contractual obligations
• Times interest earned
– Can the firm cover its interest obligations?
– (EBIT/Interest expense)
Ch 6
14
Profitability Ratios
Return Ratios
• ROA = Net income/Average total assets
• ROE = Net income/Average total equity
– Return generated relative to the capital provided
by the owners over time
Ch 6
15
Price Multiple Ratios
• Market’s valuation of a firm’s common stock
– P/E = Share price/Earnings per share
– Value stock (low P/E) vs growth stock (high
P/E)
• Price/book ratio compares stock’s price to
the recorded value of the net assets
[Share price/(Book value of equity/Share outstanding)]
Ch 6
16
ROA
=
Profitability x
Turnover
Net income
Net income
Sales


Average total assets
Sales
Average total assets
Ch 6
17
Ch 6
18
Ratio Integration
DuPont analysis (decomposition)
ROE = ROA x Leverage
Net income
Net income
Average total assets


Average total equity Average total assets Average total equity
Net income
Net income
Sales
Average total assets



Average total equity
Sales
Average total assets Average total equity
ROE
=
PM x Asset Turnover x Leverage
Ch 6
19
Analysis
• Generally compare 3-5 years
• Requires 4-6 years of data
– Balance sheet numbers may be averaged
• Compare Motorola and Nokia
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–
–
–
Activity
Liquidity
Solvency
Profitability
Ch 6
20
Activity Ratios
2001
2000
1999
Inventory Turns
1998
MOT
5.36
5.28
5.54
5.33
NOK
9.77
9.45
7.98
6.58
MOT
5.14
A/R Turns
5.91
6.19
5.94
NOK
5.51
6.45
5.96
5.99
Ch 6
21
Liquidity Ratios
2001
2000
1999
Current ratio
1998
MOT
1.77
1.22
1.36
1.18
NOK
1.62
1.57
1.69
1.75
MOT
1.11
Quick ratio
0.66
0.76
0.58
NOK
1.24
1.14
1.25
1.28
Ch 6
22
Solvency Ratios
2001
2000
1999
Debt-to-assets
1998
MOT
57.6%
54.9%
52.6%
57.5%
NOK
44.7%
44.8%
47.5%
48.5%
MOT
Times interest earned
-7.54
6.05
5.65
-3.56
NOK
43.38
13.40
51.97
Ch 6
16.14
23
Profitability Ratios
2001
2000
ROA
1999
1998
MOT
-10.4%
3.2%
2.6%
-3.4%
NOK
10.4%
23.1%
21.2%
20.5%
MOT
-23.7%
ROE
6.9%
5.7%
-7.6%
NOK
18.8%
42.6%
40.7%
40.7%
Ch 6
24
Technical issues in calculating
financial ratios
• Small or zero denominators
– if the denominator of the financial ratio has a
value of zero, the ratio can’t be calculated.
– if the value of the denominator is close to zero,
the resulting value of the financial ratio is close to
infinity
– if the denominator fluctuates a lot across years of
firms, the values of the resulting ratios fluctuate a
lot, too
Ch 6
25
Sources for Industry Ratios
• Electronic Sources
• Free:
• http://www.bizstats.com/
BizStats.com provides
information about ratios and benchmarks and statistics for
various manufacturing and service industries.
• MSN Money - Key Ratios
MSN Money provides company and industry ratios; search
by company name or ticker symbol.
• Need to pay:
• http://www.rmahq.org/
• http://www.dnb.com/us/
Ch 6
26
Most of these printed sources are
published annually
• Almanac of Business and Industrial Financial Ratios. Prentice Hall.
Lists 24 key financial ratios for 180 industries based on IRS data.
• Business Profitability Data. Covers 294 types of small business, listing
source and use of capital, sales and income, profitability versus assets,
profitability trend and risks; arranged by type of business.
• Industry Norms and Key Business Ratios. Dun and Bradstreet. Covers
over 800 lines of business, arranged by SIC code. Presents "typical"
balance sheets and income statements for the industry and 14 key ratios for
the median, upper, and lower quartiles.
• RMA Annual Statement Studies. Robert Morris Associates. Gives current
and historical data for 370 industry groups collected from annual financial
statements of firms. Data is presented by size of firm in assets and in sales.
Lists sources for additional data
Ch 6
27