# Lecture 6-1 ```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
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)
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.
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