Financial Ratio Analysis

Applying analytical techniques to financial statements and other relevant data to produce information useful for decision making.

Three Issues :

Financial analysis:

Fo

cus

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 Howto Read A Financial Statement” which is available on the web.

Current Assets:Cash and cash equivalents $ 50,000 $ 35,000 Trading securities (at fair value) 750,000 65,000Accounts receivable 300,000 290,000Inventory (at lower of cost or market) 290,000 275,000

Total current assets 715,000 665,000Investments available-for-sale (at fair value) 350,000 300,000Fixed Assets:

Property, plant, and equipment (at cost) 1,900,000 1,800,000Less: Accumulated depreciation (380,000) (350,000)

1,520,000 1,450,000Goodwill 30,000 35,000

Total assets $2,615,000 $2,450,000

Current Liabilities:Accounts payable $ 150,000 $ 125,000Notes payable 325,000 375,000Accrued and other liabilities 220,000 200,000

Total current liabilities 695,000 700,000Long-term debt:

Bonds and notes payable 650,000 600,000Total liability 1,345,000 1,300,000

Stockholders’ Equity:Common stock (100,000 shares outstanding) 500,000 500,000Additional paid-in capital 350,000 350,000Retained earnings 420,000 300,000

Total equity 1,270,000 1,150,000Total liability and equity $2,615,000 $2,450,000

December 31 Year 1 (Current year) Year 2 (Last year)

Balance SheetGI Company

Sales $1,800,000

Cost of goods sold (1,000,000)

Gross profit 800,000

Operating expenses (486,697)

Interest expense

Depreciation and Amortization expense

(10,000 )

(13,303)

Net income before income taxes 290,000

Income taxes (31%) ( 90,000)

Net income after income taxes $ 200,000

Earning per share $2

Operating cash flow $255,000

Dividends for the year $0.80 per share

Market price per share $12

GI CompanyIncome Statement (Year – 1)

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 ratio (working capital ratio) =Current assets

Current liabilities

Year 2: =

Year 1: =

$715,000

$695,000

$665,000

$700,000

= 1.03

= 0.95

(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

Acid-test ratio =Cash equivalents + Market securities + Net receivables

Current liabilities

(Year 2) =

(Year 1) =

$50,000 + $75,000 + $300,000

$695,000

$35,000 + $65,000 + $290,000

$700,000

= 1.03

= 0.95

(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.

Cash ratio =Cash equivalents + Marketable securities

Current liabilities

(Year 2) =

(Year 1) =

$50,000 + $75,000

$695,000 = 0.18

= 0.14

$35,000 + $65,000

$700,000

Liquidity Ratios

Activity Ratios

Accounts receivable turnover =Net credit sales

Gross receivables

=

= 6 times

$1,800,000

$300,000

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

Accounts receivable turnover in days =Gross receivables

Net credit sales / 365

=

= 60.83days

365 days

Receivable turnover

This ratio indicates the average number of days required to collect accounts receivable.

Activity Ratios

Inventory turnover =Cost of goods sold

Average inventory

=

= 3.45 times

$1,000,000

$290,000

This measure of how quickly inventory is sold is an indicator of enterprise performance. The higher of turnover, in general, the better the performance.

Inventory turnover in days =Average inventory

Cost of goods sold / 365

=

=

= 105.80 days

365 days

Inventory turnover

365 days

3.45

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

Activity Ratios

Working capital turnover =Sales

working capital

=

= 90 times

$1,800,000

$715,000 - $695,000

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 =

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.

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%

Profitability Ratios

Net profit margin =Net income

Net sales

=

= 11.11%

$200,000

$1,800,000

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 margin =Operating income

Total sales

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.

$800,000 - $486,697

$1,800,000=

= 17.41%

Activity Ratios

Total asset turnover =Net sales

Total assets

=

= 0.69 times

$1,800,000

$2,615,000

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

Net sales

Total assetsx=

= 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

Return on investment =Net income + Interest expense (1- Tax rate)

Long-term liabilities + Equity

=

= 0.11 times

$200,000 + $10,000 (1-0.31)

$650,000 + $1,270,000

ROI measures the performance of the firm without regard to the method of financing.

Profitability Ratios

Return on common equity =Net income – Preferred dividends

common equity

=

= 15.75%

$200,000 - $0

$1,270,000

Long-term Debt-paying Ability Ratio

(Year 2) = $1,345,000 / $1,270,000 = 1.06

(Year 1) = $1,300,000 / $1,150,000 = 1.13

Debt / Equity =Total liabilities

Common stockholders’ equity

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

Debt ratio =Total liabilities

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

Times interest earned =Returning income before taxes and interest

Interest

=

= 30 times

$290,000 + $10,000

$10,000

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 / Total debt =Operating cash flow

Total debt

=

= 18.96%

$255,000

$1,345,000

This ratio indicates the ability of the company to cover total debt with yearly cash flow.

The operating cash flow ratio =Cash from operations

Current liabilities

Liquidity Ratios

$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

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.

= Earnings + Interest Expense + Tax Expense

= $200,000 + $10,000 + $90,000

= $300,000

Profitability Ratio

EBITDA

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.

= Earnings + Interest Expense + Tax Expense +

Depreciation + Amortization

= $200,000 + $10,000 + $90,000 + $13,303

= $ 313,303