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# Foundations of Business - PowerPoint PPT Presentation

Foundations of Business. Financial Ratios &amp; Ratio Analysis to Evaluate and Compare Company Performance. Financial Ratios. Ratios are meaningful relationships between 2 numbers (or among several numbers). 5 Types of Financial Ratios: Liquidity ratios Operating ratios Debt management ratios

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Presentation Transcript

Financial Ratios & Ratio Analysis

to Evaluate and Compare Company Performance

Financial Ratios
• Ratios are meaningful relationships between 2 numbers (or among several numbers).
• 5 Types of Financial Ratios:
• Liquidity ratios
• Operating ratios
• Debt management ratios
• Profitability ratios
• Valuation ratios
Champ Creemee CompanyLiquidity Ratios
• The higher the Liquidity ratio, the better the company’s ability to pay current obligations with current assets.
• The higher the Liquidity ratio, the more liquid the company is.

1. Current Ratio:

2. Quick Ratio:

Creemee Balance Sheet

Creemee Income Statement

Liquidity: Trends and What If ???

We have a lot of money tied up in inventory!

The Current Ratio should be 1X or higher so that the company is able to pay its current liabilities with current assets.

We may have to sell inventory to pay our company’s debts!

Champ Creemee CompanyOperating Ratios
• How efficiently a company uses assets
• The higher the ratio, the more efficient

1. Total Assets Turnover

2. Inventory Turnover

• How many times inventory must be restocked to meet sales

The Total Assets Turnover ratio must be compared with other companies in the industry.

The inventory turnover ratio is different in different industries.

Creemee Balance Sheet

Creemee Income Statement

Champ Creemee CompanyDebt Management RatiosLeverage Ratios

= Using outside sources of financing to increase the return to stockholders.

• Degree of Financial risk
• Ability to repay money borrowed
• The higher the ratio, the greater the financial risk

1. Debt/Equity Ratio = Relationship of money owed to Stockholders’ Investment in the Company

Creemee Balance Sheet

Creemee Income Statement

Champ Creemee CompanyDebt Management RatiosCoverage Ratios

2. Times Interest Earned (TIE)

• Ability of company to pay (cover) interest expense
• The higher the ratio, the better the ability to cover
• The higher the ratio, the lower the financial risk

Creemee Balance Sheet

Creemee Income Statement

Champ Creemee CompanyProfitability Ratios
• How profitable is the company?
• What kind of return is the company generating on sales for stockholders?
• The higher the ratio, the better the profitability.

1. Profit Margin (Return on Sales)

What percentage of sales dollar ends up as net income ?

Champ Creemee CompanyProfitability Ratios

2. Return on Equity= Return generated on stockholders’ investment in the company

ROE =

Remember:

Stockholders’ Equity = Common Stock + Retained Earnings

Creemee Balance Sheet

Creemee Income Statement

CO. A

EBIT \$100

Interest Exp. 10

Earnings

before taxes 90

Taxes 36

Net Income \$54

Debt \$500

Equity 500

Assets \$1000

Return on54/1000

Assets = 5.4%

Return on 54/500 = 0.108

Equity = 10.8%

CO. B

\$100

0

100

40

\$60

0

1000

\$1000

60/1000

= 6.0%

60/1000 = 0.06

= 6.0%

Impact of Leverage on ROE

the “loan company”

The “stock company”

Borrowing increases ROE, but borrowing also increases RISK. Stockholders require an increased return to balance the risk.

Net Income / Total Assets

Net income / equity

Champ Creemee CompanyEarnings Per Share (EPS)
• EPS =

= \$ earned per share of common stock

• Spreads the net income across the shares
Champ Creemee CompanyValuation Ratios
• How is the company valued compared to other companies
• Relatively more or less expensive???

Price/Earnings Ratio: How many dollars investors are willing to pay for a dollar of future/projected net income

P/E =

Champ Creemee CompanyThe Concept of Market Value

Market Value: Current aggregate value in the market for all the common shares outstanding (issued)

MV =Number of common shares outstanding x current stock price

MV = \$ 50 stock price x 1,000 shares

= \$ 50,000

Cash \$8,690

Accounts Receivable 3,000

Inventory 3,500

Current Assets 15,190

Equipment 3,000

Total Assets \$18,190

Accounts Payable \$2,000

Wages Payable 500Current Liabilities 2,500

Notes Payable (L.T.) 5,000

Total Liabilities 7,500

Common Stock 10,000

Retained Earnings 690 Total Shareholders’ Equity 10,690

Total Liab. & SH Equity \$18,190

Champ Creemee CompanyBalance Sheet (as of 12/31/07)
Sales

Expenses:

Cost of Goods sold

Gross Profit

Waste/Spoilage

Wages

Salaries

Payroll Remittances

Rent/Permits

Maintenance and Repair

Operating Expenses

Operating Profit (EBIT)

Interest

Pre-Tax Profit

Taxes (35%)

Net Income

\$3,000

(1,000)

2,000

50

500

50

50

100

100

50

(900)

1,100

(500)

600

(210)

\$ 390