X100
Introduction to Business
Finance
Financial
Analysis & Ratios
Professor Kenneth EA Wendeln
X100
©2008 KEAW L15
Financial Management
How to manage the financial health of a
company – decisions regarding the acquisition
& ‘use of money’ to maximize the value of the
company while achieving corporate objectives.
Types of Financial Management and
Planning Tools:
 Capital Budgeting
 Capital Structure
 Financial Ratios
Used to gain insight on how a firm operates
as well as its RISK and RETURN
X100
Financial Analysis & Ratios
L15-2
Key Financial Ratios
Profitability
Liquidity
Return on Owners’ Equity
Current Ratio
%
# n.nn
EPS – Earnings per Share
Acid Test or Quick Ratio
$ DD.00
Return on Sales
%
Financial Leverage
Total Liabilities to Equity
%
X100
# n.nn
Asset Turnover
Accounts Receivable
Turnover
X (times/year) or # days
Inventory Turnover
X (times/year) or # days
Financial Analysis & Ratios
L15-3
Total Liabilities to
Owners’ Equity Ratio
This financial leverage ratio indicates the degree
to which a firm’s operations are financed through
debt & borrowings - and is used to determine a
firm’s ‘conservatism’ and ability to borrow money.
Total Liabilities
Owners’ Equity
The liabilities to owners’ equity ratio typically
ranges between 33 and 50%.
The higher this ratio, the riskier the situation
for lenders and shareholders.
X100
Financial Analysis & Ratios
L15-4
Zimmer - Total Liabilities
to Owners’ Equity
$ in millions
12/31/06 12/31/05
‘Debt’ = Total Liabilities
Total Liabilities to Owners Equity = 21.4 %
($1051.2)/($4920.5)
‘Equity’ = Stockholders
(or Owners) Equity
X100
Financial Analysis & Ratios
L15-5
Return on Owners’ Equity
Profitability ratio that provides an overall
measure of a business’s performance.
Net income earned (after tax) per dollar of
owners’ investment.
Net Income (after taxes)
Owners’ (Shareholders’) Equity
Typically between 15% and 25% for
profitable companies
X100
Financial Analysis & Ratios
L15-6
Zimmer
Return on Owners’ Equity
Return on Owners’ Equity = 17.0%
($834.5)/($4920.5)
12/31/06
12/31/05
Net Income
‘Equity’ = ‘Stockholders’
(or ‘Owners’) Equity
X100
Financial Analysis & Ratios
L15-7
Capital Structure - Leverage
Low & High Liabilities to Equity
Financial leverage increases RISK as well as the
Debt/Equity & Return on Owners’ Equity Ratios.
Liabilities & OE – with LOW Debt
Short-Term Liabilities
$100,000
Long-Term Loan (@10%) 100,000
Total Liabilities (Debt)
$200,000
Liabilities & OE – with HIGH Debt
Short-Term Liabilities
$100,000
Long-Term Loan (@12%)
12% 300,000
Total Liabilities (Debt)
$400,000
Owner’s equity
Total Liabilities + OE
Owner’s equity
Total Liabilities + OE
$700,000
$900,000
$500,000
$900,000
Year-end Earnings
Operating profit
$150,000
Interest on Debt (@10%) -10,000
Taxes @ 40% PBT
-56,000
Net income after taxes
$ 84,000
Year-end Earnings
Operating profit
$150,000
Interest on Debt (@12%)
12% -36,000
Taxes @ 40% PBT
-45,600
Net income after taxes
$68,400
Liabilities/Equity
Liabilities/Equity
($200,000/$700,000)
28.6%
Return on Owners Equity 12.0%
($84,000/$700,000)
X100
Lower Risk to Lenders
& Shareholders
($400,000/$500,000)
80.0%
Return on Owners Equity 13.7%
($68,400/$500,000)
Financial Analysis & Ratios
Higher Risk to Lenders L15-8
& Shareholders
EPS
Earnings per Share
This profitability ratio tells the owner of a
share of stock how much of the net earnings
for the year belongs to him or her.
Net Income or Loss (after taxes)
Average # Shares of Common
Stock Outstanding
These earnings may be paid to the
stockholders as dividends . . . or reinvested
back into the business to fund its growth.
X100
Financial Analysis & Ratios
L15-9
Zimmer
Earnings per Share
EPS = $3.43 per share
($834.5)/(#243.0 average shares
outstanding)
X100
Financial Analysis & Ratios
L15-10
Return on Sales
or Net Profit Margin
This profitability ratio measures how well the
company generated net profit (after tax) per
dollar of net sales revenue.
Net Income (after taxes)
Net Sales Revenue
This ratio is best evaluated by analyzing a
firm’s year to year trends and by comparing
to businesses within appropriate industries.
X100
Financial Analysis & Ratios
L15-11
Zimmer
Return on Sales
2006 2005
ROS = 23.9%
($834.5)/($3495.4)
ROS = 22.3%
($732.5)/($3286.1)
X100
Financial Analysis & Ratios
L15-12
Current Ratio
Measures liquidity - the capacity of a firm to meet
its current obligations using liquid assets that are
in cash or other resources that can be quickly
converted to cash.
Current Assets
Current Liabilities
A high current ratio, typically >1.0, indicates
that a firm can pay its current liabilities
using its current assets.
X100
Financial Analysis & Ratios
L15-13
Zimmer
Current Ratio
Current Ratio = 2.78
($1746.2)/($628.2)
X100
Financial Analysis & Ratios
L15-14
Acid-Test or Quick Ratio
Measures liquidity - the ability of a firm to pay
current liabilities ‘quickly’ – without selling
inventory.
Current Assets - Inventory
Current Liabilities
For all businesses the desired
acid-test ratio is > 1.0
indicating firm can pay its current liabilities
from its non-inventory current assets.
X100
Financial Analysis & Ratios
L15-15
Zimmer
Acid-Test or Quick Ratio
Quick Ratio = 1.76
($1746.2 – 638.3)/($628.2)
X100
Financial Analysis & Ratios
L15-16
Accounts Receivable
Asset Turnover Ratio
Determines the number of times during the year a
company is ‘turning over’ or collecting its accounts
receivable. Measured in X times per year.
Can be converted to ‘days outstanding’ by dividing
turnover ratio into 365 days.
Net Sales
Average Accounts Receivable
A high A/R turnover is better than a low one,
but depends on company & industry terms of sale.
6X turnover is equivalent to 60 days of outstanding
receivables, 9X is 45 days, 12X is 30 days.
X100
Financial Analysis & Ratios
L15-17
Zimmer
Accounts Receivable
Use average $574.9
A/R Turnover = 6.1X or 60 days
($3495.4)/($574.9) or (365 days/6.1X)
X100
Financial Analysis & Ratios
L15-18
Inventory
Asset Turnover Ratio
Determines the number of times during the year a
company is ‘turning over’ its inventory. Measured
in X times per year. Can also be converted to
‘days of inventory’ by dividing ratio into 365 days.
Cost of Goods Sold
Average Inventory
The average inventory turnover for all firms is about
9 times per year, or about once every 45 days.
It varies considerable by industry. Supermarkets have
turnover rates exceeding 20X (or 18 days) per year.
X100
Financial Analysis & Ratios
L15-19
Zimmer
Inventory Turnover
Use average $611.0
Inventory Turnover = 1.28X or 286 days
($780.1)/($611.0)
X100
or
Financial Analysis & Ratios
(365 days/1.28X)
L15-20
Key Financial Ratios
Profitability
Return on Owners’ Equity
Liquidity
Current Ratio
Net Income (after taxes)
Owners’ Equity
Current Assets
Current Liabilities
EPS – Earnings per Share
Acid Test or Quick Ratio
Net Income or Loss (after taxes)
Average # of Common Stock
Shares Outstanding
Current Assets - Inventory
Current Liabilities
Return on Sales
Net Income (after taxes)
Net Sales Revenue
Financial Leverage
Asset Turnover
Accounts Receivable Turnover
Net Sales
.
Average Accounts Receivable
Total Liability to Equity Ratio
Inventory Turnover
Total Liabilities
Owners’ Equity
Cost of Goods Sold
Average Inventory
X100
Financial Analysis & Ratios
L15-21
Common Financial Ratios
Profitability
Margins
Returns
Return to
Investors
Return
to
Investors
Leverage /Debt
Management
Amount
of
Debt
Coverage
of
Debt
Liquidity
Asset
Management
Short
Run
Solvency
Current
Assets
Operating
Efficiency
*Net
Profit
Margin
(ROS)
*Return
on
Equity
*Return
on
Equity
*Total
Liabilities/
Equity
Times
Interest
Earned
*Current
Ratio
*A/R
Average
Collection
Period
*A/R
Turnover
Operating
Profit
Margin
Return
on Total
Assets
(ROA)
Return
on Total
Assets
(ROA)
Debt/
Equity
Fixed
Charge
Coverage
*Quick
or
Acid Test
Ratio
*Days
Inventory
Held
*Inventory
Turnover
Gross
Profit
Margin
Cash
Return
on
Assets
*Earnings
Per
Share
LEVERAGE
Cash
Assets/
Flow
Equity
Adequacy
Cash
Flow
Liquidity
Ratio
Days
Payables
Outstanding
Fixed
Asset
Turnover
Days
of
Working
Capital
Total
Asset
Turnover
Product
Contribution
Margin
Price
to
Earnings
Ratio
Debt/
Assets
Cash
Flow
Margin
Dividend
Yield
LT Debt/
Total
Capitalization
X100
Derived from: Fraser/Ormiston,
Understanding the Corporate Annual Report;
Understanding Financial Statements 6e Financial
Cash
Interest
Coverage
* ‘Key’
X100
Financial
Ratios
Analysis & Ratios
Other
Common
Ratios
Return
on Total
Assets
(ROA)
L15-22
Key Financial Statements
TOTAL ASSETS
Current
(12mo)
Long-Term
● A/P
● ST Debt
● LT Debt
TOTAL LIABILITIES
Contributed
Capital
Retained
Earnings
● Stock @ par
● Paid-in
Capital
● Accumulated
Net Income
● less Dividends
TOTAL OWNERS’/
SHAREHOLDERS’ EQUITY
X100
● Units Sold
● @ Price
● less Returns
& Allowances
TOTAL REVENUES
Cost of
Goods Sold
●
●
●
●
Units Sold
@ Material
@ Labor
@ Overhead
Expenses
for Period
●
●
●
●
●
R&D
Marketing
Distribution
Sales
Admin
TOTAL OP EXPENSES
Operating Profit
Other
Expenses
● Interest
● Taxes
● One-time
TOTAL NET INCOME
or (LOSS)
Financial Analysis & Ratios
Cash Flow Statement
Change in cash - Sources & (Uses) between Periods
Income Statement
Net Income ●
● Accrual Based
Adjustments
for Non-cash
Items
●
●
●
●
Depreciation
A/R & A/P
Inventory
Other Accruals
CASH provided (used) by
OPERATING Activities
● (Additions) Sale
PPE
● (Additions) Sale
Other
Investments
CASH provided (used) by
INVESTING Activities
● Sale (Purchase)
Stock
Dividends ● (Paid)
● Increase
Debt/
(Decrease)
Borrowing
CASH provided (used) by
FINANCING Activities
L15-23
= Operating + Investing + Financing
● PPE
● Fixed Assets
Net Sales
for Period
Cash
Long-Term
● Cash
● A/R
● Inventories
Income Statement
Revenues – Expenses = Net Income
(12mo)
Assets = Liabilities + Owners’ Equity
Current
Period Ending
∆
Balance Sheet
X100
Financial Analysis & Ratios
L15-24