Financial Ratio Analysis

E. Ratio Analysis Calculations and What the Numbers Really Means • Liquidity ratios • Activity ratios • Leverage ratios • Profitability • Trends and graphs to spot problems • Using an Excel template for instant “can’t miss” financial analysis (c) 2001 Contemporary Engineering Economics

Debt Management Analysis Leverage ratios that show how a firm uses debt financing and its ability to meet debt repayment obligations • Debt ratio • Debt to equity ratio • Times-interest-earned ratio (c) 2001 Contemporary Engineering Economics

Times Interest Earned • Measures the extent to which earnings can decline without defaulting debt service. Note: Dell issued $500 million worth of senior notes and long-term bonds with a combined interest rate of 6.8%. (c) 2001 Contemporary Engineering Economics

Liquidity Analysis Ratios that show the relationship of a firm’s cash and other assets to its current liabilities (short-term obligations) • Current ratio • Quick ratio • Cash (liquidity) ratio (c) 2001 Contemporary Engineering Economics

Asset Management Analysis A set of ratios which measure how effectively a firm is managing its assets • Inventory turnover ratio • Days sales outstanding ratio • Total assets turnover ratio (c) 2001 Contemporary Engineering Economics

Activity Ratios • Measure how effectively the firm is using its resources • Days Sales Outstanding (DSO) • Inventory turnover (DSI) • Total asset turnover • Return on Assets (ROA) (c) 2001 Contemporary Engineering Economics

Inventory Turnover Ratio • Highlights the rate at which the inventory is being sold. The typical item sits in inventory almost 0.10 months (12 months/121.24) or 3 days before being sold (c) 2001 Contemporary Engineering Economics

Days Sales in Inventory • What It Measures: The amount of inventory (stock) expressed in days of sales. For example, if 2 items a day are sold and 20 items are held in inventory, this represents 10 days' (20/2) sales in inventory. • How You Compute: The ratio computed by dividing inventory by cost of sales, and multiplied the result by 365 (c) 2001 Contemporary Engineering Economics

Profitability Analysis A set of ratios which show the combined effects of liquidity, asset management, and debt on operating results • Profit margin on sales • Return on total assets • Return on common equity (c) 2001 Contemporary Engineering Economics

Profitability Ratios • Measure management’s overall effectiveness as shown by the returns generated on sales and investment • Return on equity (return on investment) • Gross margin • Net margin • Book value per share • Earnings per share • Price to earnings ratio (P/E ratio) (c) 2001 Contemporary Engineering Economics

How the Debt to Equity Ratio Impacts Return on Equity • This is an example of a healthy company that might not have a spectacular ROE because there is so much equity in the company. • This an example of a highly leveraged company that might have a spectacular ROE because the owners have put so little of their own resources into the company. Liabilities = Assets Equity = Liabilities Assets Equity (c) 2001 Contemporary Engineering Economics

Earnings Per Share (EPS) • Indicates earnings attributable to each share of stock. • Widely used indicator of a corporation’s performance Net income available for distribution $2,122 Common shares outstanding 2,644 Earnings per share (EPS): $0.80 (c) 2001 Contemporary Engineering Economics

Price to Earnings Ratio • Indicates how many times a corporation is able to multiply its earnings in terms of asking price per share of stock. • Share price: $32 as of August 22, 2003 (c) 2001 Contemporary Engineering Economics

Book Value/Share • Indicates what the value of a share of stock is according to the books (financial statements). Total Assets $15,470 Total liabilities 10,597 Stockholders’ equity 4,873 Preferred stock obligation 0 Net worth assigned to common stockholders 4,873 Common shares outstanding 2,644 Net worth (Book value): $1.84 (c) 2001 Contemporary Engineering Economics

Market/Book Ratio • What It Measures: Indicates how investors regard the company – a higher ratio indicates that investors are willing to bet a higher return on investment • How You Compute: The ratio of a stock’s market price to its book value (c) 2001 Contemporary Engineering Economics

Trends and Graphs to Spot Problems • Trends analysis, where one plots a ratio over time, is important, because it reveals whether the firm’s ratios are improving or deteriorating over time. (c) 2001 Contemporary Engineering Economics

Limitations of Financial Ratios • Ratio analysis is useful, but analysts should aware of ever-changing market conditions and make adjustments necessary. • It is difficult to generalize about whether a particular ratio is good or bad. • Ratio analysis based on any one year may not represent the true business condition. (c) 2001 Contemporary Engineering Economics

Horizontal Analysis • Determine the total dollar change (variance) from year to the next. • Determine the percent change (variance) from one year to the next (c) 2001 Contemporary Engineering Economics

Vertical Analysis • For the balance sheet, determine what percent of total assets each line item totals. • For the income statement, determine what percent of total sales each line item totals. (c) 2001 Contemporary Engineering Economics

Financial Ratio Analysis