Financial Ratio Analysis Focus Financial analysis: Applying analytical techniques to financial statements and other relevant data to produce information useful for decision making. Three Issues : Profitability, Liquidity, Safety (Solvency or Risk) In general, each financial ratio is closely related to one of the three fundamental issues. This analysis is intended as a background review. See also “Merrill Lynch How to Read A Financial Statement” which is available on the web. GI Company Balance Sheet December 31 Current Assets: Cash and cash equivalents Trading securities (at fair value) Accounts receivable Inventory (at lower of cost or market) Total current assets Investments available-for-sale (at fair value) Fixed Assets: Property, plant, and equipment (at cost) Less: Accumulated depreciation Goodwill Total assets Current Liabilities: Accounts payable Notes payable Accrued and other liabilities Total current liabilities Long-term debt: Bonds and notes payable Total liability Stockholders’ Equity: Common stock (100,000 shares outstanding) Additional paid-in capital Retained earnings Total equity Total liability and equity Year 1 (Current year) $ 50,000 750,000 300,000 290,000 715,000 350,000 Year 2 (Last year) $ 35,000 65,000 290,000 275,000 665,000 300,000 1,900,000 (380,000) 1,520,000 30,000 $2,615,000 1,800,000 (350,000) 1,450,000 35,000 $2,450,000 $ 150,000 325,000 220,000 695,000 $ 125,000 375,000 200,000 700,000 650,000 1,345,000 600,000 1,300,000 500,000 350,000 420,000 1,270,000 $2,615,000 500,000 350,000 300,000 1,150,000 $2,450,000 GI Company Income Statement (Year – 1) Sales $1,800,000 Cost of goods sold (1,000,000) Gross profit Operating expenses Interest expense Depreciation and Amortization expense Net income before income taxes Income taxes (31%) Net income after income taxes Earning per share Operating cash flow 800,000 (486,697) (10,000 ) (13,303) 290,000 ( 90,000) $ 200,000 $2 $255,000 Dividends for the year $0.80 per share Market price per share $12 Liquidity Ratios Working capital = Current assents – Current liabilities Year 2: $715,000 – $695,000 = $20,000 Year 1: $665,000 – $700,000 = ($35,000) Liquidity Ratios Current assets Current ratio (working capital ratio) = Year 2: = Current liabilities $715,000 = 1.03 $695,000 Year 1: = $665,000 = 0.95 $700,000 (Industry average = 1.5) The ratio, and therefore Gi’s ability to meet its short-term obligations, has improved, though it is low compared to the industry’s average Liquidity Ratios Cash equivalents + Market securities + Net receivables Acid-test ratio = (Year 2) = Current liabilities $50,000 + $75,000 + $300,000 = 1.03 $695,000 (Year 1) = $35,000 + $65,000 + $290,000 = 0.95 $700,000 (Industry average = 0.80) The industry average of .80 is higher than Gi’s ratio, which indicates that Gi may have trouble meeting short-term needs. Liquidity Ratios Cash equivalents + Marketable securities Cash ratio = (Year 2) = Current liabilities $50,000 + $75,000 = 0.18 $695,000 (Year 1) = $35,000 + $65,000 $700,000 = 0.14 Activity Ratios Net credit sales Accounts receivable turnover = Gross receivables $1,800,000 = $300,000 = 6 times This ratio indicates the receivables’ quality and indicates the success of the firm in collecting outstanding receivables. Faster turnover gives credibility to the current and acid-test ratios. Activity Ratios Gross receivables Accounts receivable turnover in days = = Net credit sales / 365 365 days Receivable turnover = 60.83days This ratio indicates the average number of days required to collect accounts receivable. Activity Ratios Cost of goods sold Inventory turnover = = Average inventory $1,000,000 $290,000 = 3.45 times This measure of how quickly inventory is sold is an indicator of enterprise performance. The higher of turnover, in general, the better the performance. Activity Ratios Average inventory Inventory turnover in days = = Cost of goods sold / 365 365 days Inventory turnover = 365 days 3.45 = 105.80 days This ratio indicates the average number of days required to sell inventory. Activity Ratios Operating cycle = AR turnover in days + Inventory turnover in days = 60.83 days + 105.80 days = 166.63 days This operating cycle indicates the number of days between acquisition of inventory and realization of cash from selling the inventory. Activity Ratios Sales Working capital turnover = working capital = $1,800,000 $715,000 - $695,000 = 90 times This ratio indicates how effectively working capital is used. Profitability Ratios Return on total assets = Net income/Total assets = $200,000 / $2,615,000 = 7.65% Profitability Ratios Gross margin = Sales – Cost of Good Sold = $1,800,000 - $1,000,000 = $800,000 Gross margin percentage = Gross margin / Sales = $800,000 / $1,800,000 = 44.44% This ratio is a good indication of how profitable a company is at the most fundamental level. Companies with higher gross margins will have more money left over to spend on other business operations, such as research and development or marketing. Profitability Ratios Net income Net profit margin = = Net sales $200,000 $1,800,000 = 11.11% This ratio indicates profit rate and, when used with the asset turnover ratio, indicates rate of return on assets, as show below. Profitability Ratios Operating income Operating margin = Total sales $800,000 - $486,697 = = $1,800,000 17.41% Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt. Activity Ratios Net sales Total asset turnover = = Total assets $1,800,000 $2,615,000 = 0.69 times This ratio is an indicator of how Gi makes effective use of its assets. A high ratio indicates effective asset use to generate sales. Profitability Ratios DuPont return on assets = Net income/Total assets Net income = Net sales x Net sales Total assets = 11.11% x 0.69times = 7.67% Note that this ratio uses both net profit margin and the total asset turnover. This ratio allows for increased analysis of the changes in the percentages. The net profit margin indicates the percent return on each sale while the asset turnover indicates the effective use of assets in generating that sale. Profitability Ratios Net income + Interest expense (1- Tax rate) Return on investment = Long-term liabilities + Equity = $200,000 + $10,000 (1-0.31) $650,000 + $1,270,000 = 0.11 times ROI measures the performance of the firm without regard to the method of financing. Profitability Ratios Net income – Preferred dividends Return on common equity = common equity $200,000 - $0 = $1,270,000 = 15.75% Long-term Debt-paying Ability Ratio Total liabilities Debt / Equity = Common stockholders’ equity (Year 2) = $1,345,000 / $1,270,000 = 1.06 (Year 1) = $1,300,000 / $1,150,000 = 1.13 This ratio indicates the degree of protection to creditors in case of insolvency. The lower this ratio the better the company’s position. In Gi’s case, the ratio is very high, indicating that a majority of funds come from creditors. However, the ratio is improving. Long-term Debt-paying Ability Ratio Total liabilities Debt ratio = Total assets (Year 2) = $1,345,000 / $2,615,000 = 51.4% (Year 1) = $1,300,000 / $2,450,000 = 53.1% This ratio indicates that more than half of the assets are financed by creditors. Long-term Debt-paying Ability Ratio Returning income before taxes and interest Times interest earned = = Interest $290,000 + $10,000 $10,000 = 30 times This ratio reflects the ability of a company to cover interest charges. It uses income before interest and taxes to reflect the amount of income available to cover interest expense. Long-term Debt-paying Ability Ratio Operating cash flow Operating cash flow / Total debt = = Total debt $255,000 $1,345,000 = 18.96% This ratio indicates the ability of the company to cover total debt with yearly cash flow. Liquidity Ratios The operating cash flow ratio = Cash from operations Current liabilities = $255,000 $700,000 = 0.36 The purpose of this ratio is to assess whether or not a company's operations are generating enough cash flow to cover its current liabilities. If the ratio falls below 1.00, then the company is not generating enough cash to meet its current commitments. Note: The cash from operating activities is $255,000 shown at the bottom of the income statement. Profitability Ratio EBIT = Earnings + Interest Expense + Tax Expense = $200,000 + $10,000 + $90,000 = $300,000 A measure of a company's earning power from ongoing operations, equal to earnings before deduction of interest payments and income taxes. EBIT excludes income and expenditure from unusual, non-recurring or discontinued activities. Profitability Ratio EBITDA = Earnings + Interest Expense + Tax Expense + Depreciation + Amortization = $200,000 + $10,000 + $90,000 + $13,303 = $ 313,303 This earnings measure is of particular interest in cases where companies have large amounts of fixed assets which are subject to heavy depreciation charges or in the case where a company has a large amount of acquired intangible assets on its books and is thus subject to large amortization charges. Since the distortionary accounting and financing effects on company earnings do not factor into EBITDA, it is a good way of comparing companies within and across industries.