Ch 3. Ratio Analysis
1
Issues in Ch.3


Common-size statements
Financial ratio analysis



Computation
More importantly, interpretation
Reading financial statements critically
2
Why Ratios?



Absolute numbers do not carry much
significant meanings
Relative (or “scaled” or “standardized”)
numbers provide more insights
For example, suppose the company made net
income of $10 million last year. Is this good or
bad? We don’t know it until we standardize
$10 million by say, total assets or sales
revenue.
3
Standardized Financial Statements

Common-Size Balance Sheets


Common-Size Income Statements



Compute all accounts as a percent of total assets
Compute all line items as a percent of sales
Standardized statements make it easier to compare
financial information, particularly as the company
grows
They are also useful for comparing companies of
different sizes, particularly within the same industry
4
Common-size statements (Standardized statements)
5
Common-size statements
6
7
Common Size Balance Sheets:
Divide all items by Total Assets
Assets
Cash
ST Inv.
AR
Invent.
Total CA
Net FA
TA
2009
0.6%
3.3%
23.9%
48.7%
76.5%
23.5%
100.0%
2010
0.3%
0.7%
21.9%
44.6%
67.4%
32.6%
100.0%
2011E
0.4%
2.0%
25.0%
48.8%
76.2%
23.8%
100.0%
Ind.
0.3%
0.3%
22.4%
41.2%
64.1%
35.9%
100.0%
8
Divide all items by Total Liabilities &
Equity
Assets
AP
Notes pay.
Accruals
Total CL
LT Debt
Total eq.
Total L&E
2009
2010
2011E
9.9% 11.2% 10.2%
13.6% 24.9%
8.5%
9.3%
9.9% 10.8%
32.8% 46.0% 29.6%
22.0% 34.6% 14.2%
45.2% 19.3% 56.2%
100.0% 100.0% 100.0%
Ind.
11.9%
2.4%
9.5%
23.7%
26.3%
50.0%
100.0%
9
Analysis of Common Size Balance Sheets



Computron has higher proportion of inventory
and current assets than Industry.
Computron now has more equity (which
means LESS debt) than Industry.
Computron has more short-term debt than
industry, but less long-term debt than industry.
10
Common Size Income Statement:
Divide all items by Sales
2009
2010
2011E
Ind.
Sales
100.0%
100.0%
100.0%
100.0%
COGS
83.4%
85.4%
82.4%
84.5%
Other exp.
9.9%
12.3%
8.7%
4.4%
Depr.
0.6%
2.0%
1.7%
4.0%
EBIT
6.1%
0.3%
7.1%
7.1%
Int. Exp.
1.8%
3.0%
1.1%
1.1%
EBT
4.3%
-2.7%
6.0%
5.9%
Taxes
1.7%
-1.1%
2.4%
2.4%
NI
2.6%
-1.6%
3.6%
3.6%
11
Analysis of Common Size Income Statements

Computron has lower COGS (86.7) than
industry (84.5), but higher other expenses.
Result is that Computron has similar EBIT
(7.1) as industry.
12
Financial Ratios






Liquidity ratios
Leverage ratios
Asset management ratios
Profitability ratios
Market value ratios
Du Pont Ratios
13
Using Bobcats Co.’s financial statements,
calculate financial ratios.

Liquidity (short-term solvency) ratios: Measures the
ease and quickness with which the assets can be
converted into cash with little or no loss in value.









Current ratio = CA / CL
= 100,000 / 150,000
= .67 times
Quick(Acid-test) ratio = (CA - Inv) / CL
= (100,000 – 50,000) / 150,000
= .33 times
Cash ratio = Cash / Current Liabilities
=
=
14
Financial Ratios

Long-term debt (leverage) ratios









Total debt ratio = TD / TA
= 350,000 / 650,000
= .54 times
Debt-Equity ratio = TD / TE
= 350,000 / 300,000
= 1.17 times
Times interest earned (TIE) = EBIT / Int. Exp.
= 200,000 / 10,000
= 20 times
15
Typically, financially troubled firms shows severe deterioration of liquidity and
leverage ratios.
16
Financial Ratios

Asset management (turnover) ratios
















Inventory turnover = COGS / Inv
= 400,000 / 50,000 = 8 times
Days sales in inventory = 365 / Inventory turnover
= 365 / 8 = 45.6 days
Accounts receivable turnover = Sales / AR
= 800,000 / 20,000 = 40 times
Days’ sales on receivables = 365 / Accounts receivable turnover
= 365 / 40 = 9.1 days
Accounts payable turnover = COGS / Accounts payable
= 400 / 70 = 5.7 times
Average payable period = 365 / Accounts payable turnover
= 365 / 5.7 = 63.9 days
Total asset turnover = Sales / TA
= 80
Capital intensity = TA / Sales
= 8000 / 650,000 = 1.2 times
17
Financial Ratios

Profitability ratios


Profit margin = NI / Sales
= 125,400 / 80,000 = 15.7%

Return on asset = NI / TA
= 125,400 / 650,000 = 19.3%

Return on equity = NI / TE

= 125,400 / 300,000 = 41.8%

18
More about ROA
19
More about ROE
FLM = Financial Leverage Multiplier or Equity Multiplier
20
Financial Ratios

Market Value Ratios



Assume that a share price of Bobcats is currently $20 per share, and
the number of shares outstanding is 20,000.
Price-Earnings Ratio (PE ratio)
= Price per share / Earnings per share
= 20 / (125,400 / 20,000) = 20 / 6.27 = 3.19 times
Market-to-book ratio
= Market value per share / Book value per share
=



20 / (300,000 / 200,000) = 20 / 15 = 1.33 times
Note: Earnings per share = Net Income / # of shares outstanding
Book value = Shareholders’ equity
Market Capitalization
= Price per share * Shares outstanding
= 20
21
Price-Earning Ratio



If PE ratio =10, then we would say the company's
stock sell for 10 times earnings.
PE ratio measures how much investors are willing to
pay per dollar of current earnings.
The higher the PE ratio is, the higher the firm’s growth
prospects would be in the future.



Growth Stock= stocks with relatively higher PE ratio (e.g., Tech
stocks)
Value stock= stocks with relatively lower PE ratio (e.g., Utility
stocks)
Watch out: If the firm generates almost no earnings,
then PE ratio could be very large. (Why?) So, care is
needed in interpreting this ratio
22
Market-to-Book Ratios in 2010
Using the Du Pont Identity


ROE
NI / TE



= PM
* TAT
* EM
= (NI / Sales) * (Sales / TA) * (TA / TE)
Profit margin is a measure of the firm’s operating efficiency –
how well does it control costs
Total asset turnover is a measure of the firm’s asset use
efficiency – how well does it manage its assets
Equity multiplier is a measure of the firm’s financial leverage
24
Du Pont Analysis
25
DuPont Analysis: Problem

The following table contains information about Campbell’s
(CPB) and H.J. Heinz (HNZ). Compute their respective
ROEs and then determine how much Heinz would need to
increase its asset turnover in order to match Campbell’s
ROE.
Profit
Margin
Asset
Turnover
Equity
Multiplier
Campbell’s
10.8%
1.22
6.78
Heinz
8.22%
1.04
5.33
DuPont Analysis : Solution

We can compute the ROE of each company by multiplying together its profit
margin, asset turnover, and equity multiplier.
In order to determine how much Heinz would need to increase its asset
turnover to match Campbell’s ROE, we can set Heinz’s ROE equal to
Campbell’s, keep its profit margin and equity multiplier fixed, and solve for
the asset turnover.

Using the DuPont Identity, we have:



ROECPB = 10.8% x 1.22 x 6.78 = 89.3%

ROEHNZ = 8.22% x 1.04 x 5.33 = 45.6%
Now, using Campbell’s ROE, but Heinz’s profit margin and equity multiplier,
we can solve for the asset turnover that Heinz needs to achieve Campbell’s
ROE:


89.3% = 8.22% x Asset Turnover x 5.33
Asset Turnover = 89.3% / 43.8% = 2.04
DuPont Analysis: Evaluate


Heinz would have to increase its asset turnover
from 1.04 to 2.04 in order to match Campbell’s
ROE.
This large increase in asset turnover is required
because of its lower equity multiplier (5.33 vs.
6.78) (lower leverage) and lower profit margin
(8.22% vs. 10.8%).
Payout and Retention Ratios
Suppose Bobcat Co. distributed $40,128 of
cash dividends.
 Dividend payout ratio

= Cash dividends / Net income
= 40,128 / 125,400 = 32%

Retention ratio
= Additions to retained earnings / Net income
= 1 – payout ratio
= 1 – 32% = 68%
29
30
Internal and Sustainable Growth
Payout and Retention Ratios
ASSETS
Current Assets
Cash
Accounts Receivable
Inventory
Total
Fixed Assets
Net Plant & Equipment
Total Asets

$
$
$
$
$
$
PRUFROCK
Balance Sheet -2010
Liabilities & Owners Equity
Current Liabilities
98
Accounts Payable
188
Notes Payable
422
Total
708
Long term debt
Owners' Equity
Common Stock and paid in surplus
Retained Earnings
2,880
Total
3,588
Total Liabilties & Owners' Equity
$
$
$
$
344
196
540
457
$
$
$
$
550
2,041
2,591
3,588
PRUFROCK
Income Statement - 2010
Sales
$ 2,311
COGS
$ 1,344
Depreciation
$
276
EBIT
$
691
Interest
$
141
Taxable Income
$
550
Taxes
$
187
Net Income
$
363
Dividends
Addition to RE
$
$
121
242
Dividend payout ratio =


Cash dividends / Net income (DIV / NI)
121/363 = 33.3%
31
Internal and Sustainable Growth
Payout and Retention Ratios
ASSETS
Current Assets
Cash
Accounts Receivable
Inventory
Total
Fixed Assets
Net Plant & Equipment
Total Asets

$
$
$
$
$
$
PRUFROCK
Balance Sheet -2010
Liabilities & Owners Equity
Current Liabilities
98
Accounts Payable
188
Notes Payable
422
Total
708
Long term debt
Owners' Equity
Common Stock and paid in surplus
Retained Earnings
2,880
Total
3,588
Total Liabilties & Owners' Equity
$
$
$
$
344
196
540
457
$
$
$
$
550
2,041
2,591
3,588
PRUFROCK
Income Statement - 2010
Sales
$ 2,311
COGS
$ 1,344
Depreciation
$
276
EBIT
$
691
Interest
$
141
Taxable Income
$
550
Taxes
$
187
Net Income
$
363
Dividends
Addition to RE
$
$
121
242
Retention ratio (“b”) = (NI - DIV)/ NI


Addition to Retained Earnings / Net income
$242/363 = 66.7%
32
The Internal Growth Rate

How much the firm can grow assets using
retained earnings as the only source of
financing.
Internal Growth Rate 

ROA  b
1 - ROA  b
.1012  .667
1  .1012  .667
 7.23%
33
The Sustainable Growth Rate

How much the firm can grow by using
internally generated funds and issuing debt to
maintain a constant debt ratio.
Sustainable Growth Rate 
ROE  b
1- ROE  b
.14  0.667

1 - 0.14  0.667
 10.29%
34
Determinants of Growth




Profit margin – operating efficiency
Total asset turnover – asset use efficiency
Financial leverage – choice of optimal debt ratio
Dividend policy – choice of how much to pay to
shareholders versus reinvesting in the firm
35
Why Evaluate Financial Statements?

Internal uses
Performance evaluation – compensation and
comparison between divisions
 Planning for the future – guide in estimating future
cash flows


External uses
Creditors
 Suppliers
 Customers
 Stockholders

36
Benchmarking


Ratios are not very helpful by themselves; they need
to be compared to something
Time-Trend Analysis




Peer Group Analysis



one-year ratios do NOT provide a full picture
Used to see how the firm’s performance is changing through
time
Do multi-year analysis
Compare to similar companies or within industries
SIC and NAICS codes (http://www.naics.com/)
Should be used in conjunction with other qualitative
measurements. For example, heterogeneity in
accounting practice, market structures, customer
bases, capital structures, etc.
37
38
39
Peer Group Analysis (http://yahoo.marketguide.com)
Advanced Micro Device (AMD)
40
Op Income / Sales for Enron
18
16
14
12
10
8
6
4
2
0
1984
1986
1988
1990
1992
1994
1996
1998
2000
41
Trend analysis in the computer industry
IBM
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
Profit Return on
Margin
Equity
13.7%
23.6%
14.3
24.8
13.1
20.5
9.3
13.9
9.7
13.7
9.8
14.7
8.4
13.6
8.7
14.1
3.2
5.7
2.2
5.2
4.6
8.8
7.7
7.8
7.5
12.7
25.5
27.1
30.7
36.5
Compaq
Profit Return on
Margin
Equity
2.3%
2.9%
3.9
11.8
5.3
19.9
6.9
23.4
10.9
33.4
12.0
30.5
11.1
27.2
12.0
23.2
7.0
11.8
6.1
12.4
6.5
17.7
8.0
22.0
7.2
21.5
7.3
21.4
8.6
22.3
4.8
11.5
Apple
Profit Return on
Margin
Equity
7.8%
20.3%
3.9
12.7
3.2
11.1
8.1
22.2
8.2
26.0
9.8
39.9
7.7
27.3
8.5
32.8
7.1
25.4
7.5
24.2
3.6
14.1
2.5
9.7
3.7
12.1
3.8
14.5
Comparative Analysis: Lowe’s vs. Home Depot
43
Ratio Analysis
Saxton
Company
A. Profitability
1. Profit Margin ……………… 5.0%
2. Return on Assets ………….. 12.5%
3. Return on Equity ………….. 20.0%
B. Asset Utilization
4. Receivables turnover …….
11.4
5. Average collection period…. 32.0
6. Inventory turnover ………... 10.8
7. Fixed asset turnover ………. 5.0
8. Total asset turnover ……….
2.5
Industry
Average
6.7%
10.0%
Conclusion
15.0%
Below average
Above average due
to high turnover
Good
10.0
36.0
7.0
5.4
1.5
Good
Good
Good
Below average
Good
C. Liquidity
9. Current ratio ………………
10. Quick Ratio ………………..
2.67
1.43
2.1
1.0
D. Debt Utilization
11. Debt to total assets ………..
12. Times interest earned …….
37.5%
11.0
33.0%
7.0
Good
Good
Slightly more debt
Good
44
Summarizing Ratios
(2007–2009, Including 2009 Industry Averages)
Summarizing Ratios (cont.)
(2007–2009, Including 2009 Industry Averages)
Quiz 1

You have the following data for the Frank
Winery:





Earnings before taxes = $300,000,
Total asset turnover = 0.80,
Sales = $800,000
Tax rate = 35%.
What is the firm's return on assets (ROA)?
47
Quiz 2

If total debt ratio is 20%, and ROA is 5%, what
is ROE?
48
Quiz 3
The current ratio of a firm would be increased
by which of the following?
a. land held for investment is sold for cash
b. equipment is purchased, financed by a long-term
debt issue
c. inventories are sold for cash
d. inventories are sold on a credit basis
49
Quiz 4






Which ratio measures the financial or credit risk?
Which ratio measures the company’s ability to service its fixed interest
payment?
Which ratio measures the company’s ability to pay off short-term
obligations like notes payables and accounts payables?
Which ratio measures how well the company generates revenues and
controls costs and expenses (i.e., overall operating effectiveness)?
Which ratio measures the company’s ability to deliver the shareholder’s
value?
Which ratio measures the company’s market price relative to $1 of
capital that was invested by shareholders?
50
Common Size Balance Sheet
For S&P Composite Index Firms during 2005
51
Common Size Income Statement
For S&P Composite Index Firms during 2005
52
Financial Ratios
2005 Ratios for selected firms
53
Limitations of Financial Ratio Analysis
1.
Difficult to identify industry categories or comparable peers.
2.
Published peer group or industry averages are only
approximations.
3.
Industry averages may not provide a desirable target ratio or
norm.
4.
Accounting practices differ widely among firms
5.
A high or low ratio does not automatically lead to a specific
favorable or unfavorable conclusion.
6.
Seasons may bias the numbers in the financial statements.
54