Ratio Analysis

Chapter 6

Ch 6 2

• Chapter 6 homework problems, P6-2, 3, 8, 10, 14, 16-19, are still required.

Ch 6 3

Ratio Analysis

• Cross-sectional and time series analysis

• Controls for size differences

• Controls for currency differences

• Ratios are easily (and commonly) modified

• Focus on p17-19.

Ch 6 4

Ratio Analysis Categories

• Activity (operations and asset management)

• Liquidity (meeting short-term obligations)

• Solvency (meeting long-term obligations)

• Profitability (earnings and cost coverage)

• Cash Flow (quality of earnings)

• Price Multiples (stock price)

Ch 6 5

Activity RatiosHow day-to-day operations function

• Inventory management• Inventory Turnover

– Compares income statement and balance sheet amounts

– Usually average balance sheet figures ((Beg + End)/2)

– Turnover = COGS/Average total inventory

• Days inventory = 365/Turnover– How many days was inventory held before being sold?

Ch 6 6

Activity Ratios

• Accounts receivable turnover– How many times a credit sale is made and subsequently

collected during one year

– [credit sales/average accounts receivable]

– May have to use total sales rather than credit sales

– Consistency is important

• Days receivable– Number of days between sales and collection

– [365/accounts receivable turnover]

Ch 6 7

Receivables Turnover for Selected Industries

0 20 40 60 80 100 120 140

Food stores

Eating and drinking

Motion pictures

Printing and publishing

Electrical equipment

Educational services

General merchandise

Receivables turnoverSource: Dun & Bradstreet

Ch 6 8

Activity Ratios

• Accounts payable turnover– Number of times a credit purchase is made and

subsequently paid during one year

– [credit purchases/average accounts payable]

– Often assume all purchases are on credit

– Purchases = [COGS + Ending Inv. - Beginning Inv.]

• Days payable– Number of days between credit purchase and payment

– [365/accounts payable turnover]

Ch 6 9

Activity RatiosCash Cycle

• Also a measure of liquidity

• If cash cycle is low, it means small number of days in operating cycle to finance

[Days inventory + Days receivable - Days payable]

Ch 6 10

Activity RatiosAsset Turnover

• Long-term– Revenues generated by long-term assets– [Sales revenue/Average noncurrent assets]

• Total assets– Efficiency of generating revenues given total

assets– [Sales revenue/Average total assets]

Ch 6 11

Liquidity Ratios

• Current ratio– Ability to meet short-term obligations– [Current assets/current liabilities]

• Quick ratio– Remove less liquid assets– Keep cash, liquid investments, A/R– [(Current assets-inventory-ppd expenses-other)/current liabilities]

– [(Cash+short-term investments + A/R)/current liabilities]

Ch 6 12

Dun & Bradstreet's Quick Ratio for Selected Industries

0 0.3 0.6 0.9 1.2 1.5

Food stores

Eating and drinking

Motion pictures

Printing and publishing

Electrical equipment

Educational services

General merchandise

RatioSource: Dun & Bradstreet

(Cash + Account Receivables/Current Liabilities)

Ch 6 13

Solvency Ratios

• Debt to assets: Total liabilities/Total assets– Proportion of assets financed with debt

• Could include interest bearing debt only[(short term debt + noncurrent debt)/total assets]

• Be aware that assets are recorded at historical cost, which may be different from current market value

Ch 6 14

Solvency RatiosCoverage Ratios

• Adequacy of resources for meeting firm’s contractual obligations

• Times interest earned– Can the firm cover its interest obligations?– (EBIT/Interest expense)

Ch 6 15

Profitability RatiosReturn Ratios

• ROA = Net income/Average total assets

• ROE = Net income/Average total equity– Return generated relative to the capital provided

by the owners over time

Ch 6 16

Price Multiple Ratios

• Market’s valuation of a firm’s common stock– P/E = Share price/Earnings per share– Value stock (low P/E) vs growth stock (high

P/E)

• Price/book ratio compares stock’s price to the recorded value of the net assets[Share price/(Book value of equity/Share outstanding)]

Ch 6 17

ROA = Profitability x Turnover

assets totalAverage

Sales

Sales

incomeNet

assets totalAverage

incomeNet

Ch 6 18

Ch 6 19

Ratio Integration

DuPont analysis (decomposition)

ROE = ROA x Leverage

ROE = PM x Asset Turnover x Leverage

equity totalAverage

assets totalAverage

assets totalAverage

incomeNet

equity totalAverage

incomeNet

equity totalAverage

assets totalAverage

assets totalAverage

Sales

Sales

incomeNet

equity totalAverage

incomeNet

Ch 6 20

Analysis

• Generally compare 3-5 years• Requires 4-6 years of data

– Balance sheet numbers may be averaged

• Compare Motorola and Nokia– Activity– Liquidity– Solvency– Profitability

Ch 6 21

Activity Ratios

2001 2000 1999 1998

Inventory Turns

MOT 5.36 5.28 5.54 5.33

NOK 9.77 9.45 7.98 6.58

A/R Turns

MOT 5.14 5.91 6.19 5.94

NOK 5.51 6.45 5.96 5.99

Ch 6 22

Liquidity Ratios

2001 2000 1999 1998

Current ratio

MOT 1.77 1.22 1.36 1.18

NOK 1.62 1.57 1.69 1.75

Quick ratio

MOT 1.11 0.66 0.76 0.58

NOK 1.24 1.14 1.25 1.28

Ch 6 23

Solvency Ratios

2001 2000 1999 1998

Debt-to-assets

MOT 57.6% 54.9% 52.6% 57.5%

NOK 44.7% 44.8% 47.5% 48.5%

Times interest earned

MOT -7.54 6.05 5.65 -3.56

NOK 43.38 51.97 16.14 13.40

Ch 6 24

Profitability Ratios

2001 2000 1999 1998

ROA

MOT -10.4% 3.2% 2.6% -3.4%

NOK 10.4% 23.1% 21.2% 20.5%

ROE

MOT -23.7% 6.9% 5.7% -7.6%

NOK 18.8% 42.6% 40.7% 40.7%

Ch 6 25

Technical issues in calculating financial ratios

• Small or zero denominators– if the denominator of the financial ratio has a

value of zero, the ratio can’t be calculated.– if the value of the denominator is close to zero,

the resulting value of the financial ratio is close to infinity

– if the denominator fluctuates a lot across years of firms, the values of the resulting ratios fluctuate a lot, too

Ch 6 26

Sources for Industry Ratios

• Electronic Sources• Free:• http://www.bizstats.com/ BizStats.com provides

information about ratios and benchmarks and statistics for various manufacturing and service industries.

• MSN Money - Key RatiosMSN Money provides company and industry ratios; search by company name or ticker symbol.

• Need to pay:• http://www.rmahq.org/• http://www.dnb.com/us/

Ch 6 27

Most of these printed sources are published annually

• Almanac of Business and Industrial Financial Ratios. Prentice Hall. Lists 24 key financial ratios for 180 industries based on IRS data.

• Business Profitability Data. Covers 294 types of small business, listing source and use of capital, sales and income, profitability versus assets, profitability trend and risks; arranged by type of business.

• Industry Norms and Key Business Ratios. Dun and Bradstreet. Covers over 800 lines of business, arranged by SIC code. Presents "typical" balance sheets and income statements for the industry and 14 key ratios for the median, upper, and lower quartiles.

• RMA Annual Statement Studies. Robert Morris Associates. Gives current and historical data for 370 industry groups collected from annual financial statements of firms. Data is presented by size of firm in assets and in sales. Lists sources for additional data