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Chapter # 4Foundations of ratio and financial

analysis

Chapter objectives:

Examine the purpose and use of ratiosand provide some cautionary notes.

Explain the use of common-sizestatement.

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Discuss the construction and use of:Short term and long term activity(turnover) ratios that measure the

efficiency with which the firm uses itsresources.Liquidity ratios, including workingcapital ratios, the cash cycle and the

defensive interval that assess the firmsability to meet its near termobligations.Solvency ratios that examine capitalstructure and the firms ability to meetlong term obligations and capitalneeds.

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Profitability ratios that measure income

relative to revenues and invested capital.

Define and compute measures ofoperatingand financial leverage.

Show how the integrated analysis of ratios

can be used to evaluate corporate

performance.

Relate ratios to corporate strategy and

the product life cycle.

Examine the computation and usefulness ofearnings per share and other ratios used for

valuation purposes

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Purpose and use of ratio analysis:

Financial ratios are used to compare the risk

and return of different firms in order to helpequity investors and creditors make

intelligent investment and credit decisions.

Ratios can also provide a profile of a firm,

its economic characteristics and competitive

strategies and its unique operating , financialand investment characteristic.

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Four ratio categories measure therisk and return relationships:

categories / groups of ratios:

.Activity analysis: Evaluates revenueand output generated by the firms

assets.

Liquidity analysis: Measures theability to meet the near-term

obligations. Ability to convert into cash.

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Long-term debt and solvencyanalysis: Examine the capital

structure, including the mix of itsfinancing sources and the ability of thefirm to satisfy its long-term debt andinvestment obligations.

Profitability ratios: Measures theincome of the firm relative to its

revenues and invested capital.

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Ratio analysis : Cautionary notes Economic assumptions: Ratio

analysis is designed to facilitate comparisonsby eliminating size differences across firms

and over time. Implicit assumptions in this

process is the proportionality assumption

that the relationship between numerator anddenominator doesn't depend on size.

Benchmarks: Ratio analysis often lacks

appropriate benchmarks to indicate optimallevels The evaluation of a ratio depends on

the point of view of the analyst.One relevant

bench marks is the industry norms.

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Timing and window dressing:Business cycle may not match withone company to another or oneindustry to another industry. Then theration may fail to show normal

operation relationships. Accounting method:Reportedfinancial statement amounts can beaffected by the choice of accounting

methods.For eliminating such problem it isnecessary to convert all companies reportinto one method.

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Common-size statements:

Common-size statements are used to

standardize financial statement componentsby expressing them as a percentage of a

relevant base.

Balance sheet components can be shownas a percentage of total assets.

Income statement components

(revenues, and expenses) can be computed

as a percentage of total sales.

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Discussion of ratios by category:Activity analysis:

A firms operation activities requireinvestments in both short-term (inventoryand AR) and long-term (property, plant,equipment) asset.

Activity ratios describe the relationshipbetween the firms level of operations (usuallydefined as sales) and the assets needed tosustain operating activities.

The higher the ratio, the more efficientthe firms operations. Fewer assets areneeded to support a given level of operations(sales).

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Short-term (operating) activity ratios:

Measures the efficiency of the firmsinventory management.A higher ratio indicates that inventory doesnot remain in ware

house but turns over rapidlyThis ratio is affected by the choice ofaccounting method.

inventoryAverageSoldgoodsofCostratioturnoverInventory

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turnoverInventory

stockininventorydaysofnoAverage

365

.

As low as better it is.

Indicates how many day inventories arekept, just to sell

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turnovercievable

dingoutsreceivabledaysofnoAveragereceivableAverage

Salestueroverceivables

Re

365

tan.

Re

Receivables turnover ratios:

Measures the effectiveness of the firms

credit policy

Indicate the level of investments in

receivables needed to maintain the firms

sales level

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turnoverPayable

dingoutspayabledaysofNoAverage

365

tan.

payableAcconts

PurchaseturnoverPayable

The accounts payable and number of dayspayables are outstanding can be computed

as follows:

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assetsFixed

SalesturnoverassetFixed

assetsTotal

SalesturnoverassetTotal

Long-term activity ratios:These ratios measure the efficiency of long

term capital investment to generate sales.

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Growing / new / startup company: Initial

turnover may be low, as their level of

operations is below their productive capacity.As sales grow, however turnover will

continually improve until the limits of the

firms initial capacity are reached.Mature or stable company: The mature

firms turnover is stable.

Declining company: The turnover ratio islow as the sales decreased by the time pass

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Some points to be noted:

Two firms with similar capacity and efficiency

may show differing ratios. Because price was

different when assets were purchased.

The firm with older assets has higher

turnover ratios, as accumulated depreciation

has reduced value of its assets.The firm with

new assets has lower turnover ratios.

It is better to take gross fixed asset rather than

net fixed assets. The old machine might have highmarket value but after depreciation it becomes low.

Which may results in a higher turnover ratio

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Liquidity analysis:

Short-term lenders and creditors must assess

the ability of a firm to meet its currentobligations. The ability depends on the cash

resources available as of the balance sheet

date and the cash to be generated through

the operating cycle of the firm.

Length of cash cycle:

Operating cycle: No, of days inventory in

stock + Days sales outstanding.

Cash cycle: Operating cycle - No. of days

payable outstanding

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The shorter the cycle, the more efficientthe firms operations and cash

management. The longer cycles may be indicative ofcash shortfalls and increased financing costs.Current ratio defines cash resources as all

current assets:

Use all current asset.

Higher is good. But this may be as a resultof higher inventory, which is bad for thecompany. The company may fail to sell itsgoods.

sliabilitieCurrentassetsCurrentratioCurrent

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recCAMarCashratioQuick /sec.

sLiabilitieCurrentrecCAMarCashratioQuick /sec.

A more conservative measure liquidity is thequick ratio:

The included assets are called quick

asset because they can be quicklyconverted to cash.Inventory and prepaid expenses areexcluded.

If this ratio is much lower than currentratio, then the firm is facing liquidityproblem. It may have higher inventorythat the firm can not sell.

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The cash ratio is defined as:

sLiabilitieCurrent

SecuritiesMarketableCash

ratioCash

This is the most conservative measure of

liquidity.

Only actual cash and securities easily

convertible to cash are used to measure

cash resources

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Defensive interval:It compares the currently available quick

sources of cash with estimated outflowsneeded to operate the firms projectedexpenditure.

eExpenditurojected

receivableCASecMarCashX

ervalDefensive

Pr

/.365

int

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Long term debt and solvency ratio:

The analysis of a firms capital structure is

essential to evaluate its long-term risk and

return prospect.

Excess return to shareholder, when ROI is

greater than the cost of debt.

The fixed cost (interest on debt) may

affect profitability if the demand or profit

margins decline.

This obligation may lead the company to

default or bankruptcy

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Debt Covenants:To protect themselves creditors often impose

restrictions on the borrowing companysability to incur additional debt and makedividend payments.

CapitalTotal

debtTotalcapitaltotaltoDebt

EquityTotal

debtTotalequitytoDebt

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Use book value or market value to compute debt ratio:

Market value of debt and equity are generally used in

valuation model. Because they are available or can readily

be estimated.

However, Use of market values may produce

contradictory result. The debt of a firm whose credit rating

declines may have a market value well below faceamount.

A debt ratio based on market values may show an

acceptable level of leverage (which is bad). There have a

chance to underestimate or overestimate the firm.

Total Debt at book value

Equity at market value

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More direct measure of the firms abilityto meet interest payments be:

EBITTimes Interest Earned =

Interest expense

Higher is good.

If the debt-equity ratio is higher thenthis ratio will be lower.This ratio often referred to as theinterest coverage ratio measures the

protection available to creditors.

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Fixed Charge Coverage =

Earning Be. fixed charges & TaxesFixed Charges

It is more comprehensive

measurement.Fixed charges = contractuallycommitted interest + principalpayment on lease + funded debt.This one is better: because theprevious one may give wrong result(can be over estimated orunderestimated)

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Capital expenditure and CFO to Debt ratio:A firms long term solvency is a function of its

ability to:Finance the replacement and expansion ofits investment in productive capacity as wellas

generate cash for debt repayment

enditureCapital

CFOratioenditureCapital

expexp

debtTotal

CFOdebttoCFO

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Profitability analysis:Equity investors are concerned with the firms

ability to generate, sustain and increaseprofit.Return on sales:Measures the income of the firm relative to its

revenues,Gross Profit

.Gross Margin =Sales

It shows the relationship between thesales and manufacturing ormerchandising cost.

Higher ratio is better.

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Operating Income.Operating Margin =

SalesIt shows the firms profitability formthe operations of its core business.Excluding the effect of: Investment

(income for affiliates or assets sales),Financing (interest expenses), Taxposition.

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EBIT.Margin before interest and tax =

SalesIt shows that the firm is independent ofboth the financing and tax positions.

EBT.Pretax Margin =

SalesAfter financing cost (interest expenses)

but prior to income taxes.

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Net incomeProfit Margin =

SalesOverall profit margin net of allexpenses.All five ratios can be computed directly

from financial statement.

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Return on Investment: (ROI)

Measures the income of the firm relative to

its revenues (Profit) and invested capitalrequired to generate them.

Net Income + After-tax Int.ROA =

Avg. TAInterpretation:It measures managements ability andefficiency in using the firms assets togenerate (operating) profits.It reports the total return accruing to allproviders of capital (debt and equity).

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EBIT (pretax basis).ROTC =

Avg.(Total Debt + SHs Equtiy)

Return on total capital uses the sum ofexternal debt and equity instead of totalassets as the base against which thefirms return is measured.ROTC measures profitability relative toall (non-trade) capital providers.

Pretax Income.ROE =Avg. SHs Equity

It excludes debt in the denominator.

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Net Income.ROE =

Avg. SHs Equity

NI Preferred DividendReturn on Common Equity =

Avg. Common Equity

The relationship between ROA and ROEreflects the firms capital structure.ROA (or ROTC) measure returns to allproviders of capital. ROE measures the returns to the firmsshareholders and is calculated afterdeducting the returns paid to creditors

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Operation and financial leverage:

Profitability ratios imply that profits are

proportional to sales, which may misstate

the true relationship among sales, cost

and profit.

A double of sales would expected to

double of income only if all expenses

were variable.

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Expenses can be Fixed or variable.

Variable expenses:Variable expenses tend to be operating in

nature.Fixed expenses:

Fixed costs are the result of operating, investing

and financing decisions.Leverage, which is a proportion of fixed costs

in the firms overall cost structure, can be

subdivided into fixed operation costs that

reflect: Operating leverage (the proportion of fixed

operating costs to variable cost) and Fixed

financing costs or financial leverage

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Leverage refers to proportion of fixedcosts in the firms overall cost structure.Leverage can be divided into fixedoperating costs and fixed financing costs.The first one is known as operatingleverage and the second as financial

leverage.Leverage trades risk for return.Increases in fixed costs are risky because

they must still be paid as demand declines,

decreasing the firms income.At high levels of demand, fixed costs

enhance the profitability.

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Operating Leverage:The contribution margin ratio is a useful

measure of the effects of operating leverageon the firms profitability.

ContributionContribution Margin Ratio =

Sales

This ratio indicates the incremental profitresulting from a given dollar changes in sales

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The operating leverage effect (OLE):Contribution Margin Ratio

OLE =

Return on SalesContribution

=Operating Income

The OLE can be used to estimate the percentagechange in income (and ROA) resulting from a given

percentage change in sales volume.

% Change in income = OLE * % change in sales

When OLE in greater than 1, operating leverage in

present.

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Operating leverage: (Fixed cost)Higher the fixed cost, higher is the operating

leverage.If sales (revenue) increase, the operating income

increases at a larger amount.

If revenue decrease, the operating income

decreases at larger amount.If VC is high = FC is low = lower operating

income.

If VC is low = FC is high = Higher operating

income.

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Financial Leverage:From the point of view commonshareholders, financial leverage is a

risk and return trade-off.The financial leverage effect (FLE)relates operating income to net

income:Operating IncomeFLE =

Net Income

ContributionTLE = OLE X FLE =

NI

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Comprehensive analysis requires areview of the following threeinterrelationship among ratios.Economic relationships:If activity ratio increase, profitability ratio willalso increase.

Higher sales = higher investment in workingcapital = higher Receivable and inventory.Overlap of components:The components of many ratios overlap due

to the measure of a same term in thenumerator or denominator, or because a termin one ratio is a subset or component ofanother ratio.

R ti it f th ti

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Ratios as composites of other ratios:Some ratios are related to other ratiosacross categories.

ROA = NI / TATAT = S / ANet PM = NI / SSo,ROA = TAT * PM = (S/TA) * (NI/S) =NI / TA

If TAT and PM increase or decrease the ROA

also increase or decrease.

A l i f fi f

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Analysis of firm performance:

Disaggregation of ROA:

The ROA can be disaggregated as follows:

ROA = Total asset turnover x Return on asset

=

SalesincomeOperatingX

AssetsSales

Di ti f ROE d it l ti hi ith

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Disaggregation of ROE and its relationship withROA:

Equity

DebtXdebtofCostROAROAROE

Benefit of financial leverage is the product

of the excess return earned on the firmsassets over the cost of debt and theproportion of debt financing to equityfinancing.

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ROE can be desegregated as follows:

Equity

AssetsX

Assets

SalesX

Sales

Income

SolvencyXActivityXyofitabilitROE

Pr

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Earning per share and other valuationmodel:

Earning per share: Earning per share isprobably is the most commonly used corporateperformance statistic for publicly traded firms

Simple capital structure: The firm that hasonly common shares, the computation of EPSis relatively straightforward as follows:

Basic EPS= dingoutssharesCommon

sharescommonavailableEarning

tan

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Complex capital structure:Companies whose have options andconvertible securities are said to havecomplex capital structures. These firmsmust recognize the potential effect on EPSupon the conversion of those securities if

such a conversion will result in dilution ofEPS.

DEPS= dingoutssharescommonpotentialandCommon

sharescommonforincomeAdjusted

tan