Ratio Analysis: An Introduction

RATIO ANALYSIS
An Introduction
Purpose of
Ratio Analysis
• Evaluate management performance in three
areas:
– Profitability
– Efficiency
– Risk
Analysis of Financial Ratios
• Ratios are more informative than raw
numbers
• Ratios provide meaningful relationships
between individual values in the financial
statements
Importance of
Relative Financial Ratios
• Compare to other entities
• Examine a firm’s performance relative to:
– The aggregate economy
– Its industry or industries
– Its major competitors within the industry
– Its past performance (time-series analysis)
Comparing to
The Aggregate Economy
• Most firms are influenced by economic
expansions and contractions in the business
cycle
• Analysis helps you estimate the future
performance of the firm during subsequent
business cycles
Comparing to
A Firm’s Industry
• Most popular comparison
• Industries affect the firms within them
differently, but the relationship is always
significant
• The industry effect is strongest for industries
with homogenous products
• Examine the industry’s performance relative to
aggregate economic activity
Comparing to
A Firm’s Major Competitors
• Industry averages may not be representative
• Select a subset of competitors to compare to
using cross-sectional analysis, or
• Construct a composite industry average
from industries the firm operates in
Comparing to
A Firm’s Historical Performance
• Determine whether it is progressing or
declining
• Helpful for estimating future performance
• Consider trends as well as averages over
time
Five Categories of Financial Ratios
1. Internal liquidity (solvency)
2. Operating performance
– a. Operating efficiency
– b. Operating profitability
3. Risk analysis
– a. Business risk
– b. Financial risk
4. Growth analysis
5. External liquidity (marketability)
Common Size Statements
• Normalize balance sheets and income
statement items to allow easier comparison
of different size firms
• A common size balance sheet expresses
accounts as a percentage of total assets
• A common size income statement expresses
all items as a percentage of sales
Evaluating Internal Liquidity
• Internal liquidity (solvency) ratios indicate
the ability to meet future short-term
financial obligations
• Current Ratio examines current assets and
current liabilities
Current Assets
Current Ratio 
Current Liabilities
• Quick Ratio adjusts current assets by
removing less liquid assets
Cash  Marketable Securities  Receivables
Quick Ratio 
Current Liabilities
• Cash Ratio is the most conservative
liquidity ratio
Cash  Marketable Securities
Cash Ratio 
Current Liabilities
• Receivables turnover examines the
quality of accounts receivable
Net Annual Sales
Receivables Turnover 
Average Receivables
• Receivables turnover can be converted into

an average collection period
365
Average Receivables Collection Period 
Annual Turnover
• Inventory turnover relates inventory to sales
or cost of goods sold (CGS)
Cost of Goods Sold
Inventory Turnover 
Average Inventory
• Given the turnover values, you can compute
the average inventory processing time
Average Inventory Processing Period = 365/Annual
Turnover
• Cash conversion cycle combines
information from the receivables turnover,
inventory turnover, and accounts payable
turnover
Receivable Days
+Inventory Processing Days
-Payables Payment Period
Cash Conversion Cycle
Evaluating Operating
Performance
• Ratios that measure how well management
is operating a business
– (1) Operating efficiency ratios
• Examine how the management uses its assets and
capital, measured in terms of sales dollars generated
by asset or capital categories
– (2) Operating profitability ratios
• Analyze profits as a percentage of sales and as a
percentage of the assets and capital employed
Operating Efficiency Ratios
• Total asset turnover ratio indicates the
effectiveness of a firm’s use of its total asset
base (net assets equals gross assets minus
depreciation on fixed assets)
Net Sales
Total Asset Turnover 
Average Total Net Assets
Operating Efficiency Ratios
• Net fixed asset turnover reflects utilization
of fixed assets
Net Sales
Fixed Asset Turnover 
Average Net Fixed Assets
Operating Profitability Ratios
• Operating profitability ratios measure
– 1. The rate of profit on sales (profit margin)
– 2. The percentage return on capital
• Gross profit margin measures the rate of
profit on sales (gross profit equals net sales
minus the cost of goods sold)
Gross Profit
Gross Profit Margin 
Net Sales
• Operating profit margin measures the rate
of profit on sales after operating expenses
(operating profit is gross profit minus sales,
general and administrative (SG + A)
expenses)
Operating Profit
Operating Profit Margin 
Net Sales
• Net profit margin relates net income to sales
Net Income
Net Profit Margin 
Net Sales
• Return on total capital relates the firm’s
earnings to all capital in the enterprise
Net Income  Interest Expense

Return on Total Capital 
Average Total Capital
• Return on owner’s equity (ROE) indicates
the rate of return earned on the capital
provided by the stockholders after paying
for all other capital used
Net Income
Return on Total Equity 
Average Total Equity
• Return on owner’s equity (ROE) can be
computed for the common- shareholder’s
equity
Net Income - Preferred Dividend

Return on Owner' s Equity 
Average Common Equity
• The DuPont System divides the ratio into
several components that provide insights
into the causes of a firm’s ROE and any
changes in it
Net Income Net Income Net Sales

ROE   
Common Equity Net Sales Common Equity
Sales Sales Total Assets

 
Equity Total Assets Equity
Net Income

Common Equity
Net Income Sales Total Assets

  
Sales Total Assets Common Equity
Profit Total Asset Financial

= Margin
x Turnover x Leverage
• An extended DuPont System provides
additional insights into the effect of
financial leverage on the firm and pinpoints
the effect of income taxes on ROE
• An extended DuPont System provides
additional insights into the effect of
financial leverage on the firm and pinpoints
the effect of income taxes on ROE
• We begin with the operating profit margin
(EBIT divided by sales) and introduce
additional ratios to derive an ROE value
EBIT Sales EBIT
 
Sales Total Assets Total Assets
EBIT Sales EBIT
 
This is the operating profit return on total

assets. To consider the negative effects of
financial leverage, we examine the effect of
interest expense as a percentage of total
assets
EBIT Sales EBIT
 
EBIT Interest Expense Net Before Tax

 
Total Assets Total Assets Total Assets
EBIT Sales EBIT
 

 
We consider the positive effect of financial
leverage with the financial leverage multiplier
EBIT Sales EBIT
 

 
Net Before Tax (NBT) Total Assets Net Before Tax (NBT)
 
Total Assets Common Equity Common Equity
EBIT Sales EBIT
 

 
 
This indicates the pretax return on equity. To arrive
at ROE we must consider the tax rate effect.
EBIT Sales EBIT
 

 
 
Net Before Tax  Income Taxes  Net Income
 100%  
Common Equity  Net Before Tax  Common Equity
In summary, we have the following five
components of return on equity (ROE)
EBIT
1.  Operating Profit Margin
Sales
EBIT
Sales
Sales
2.  Total Asset Turnover
Total Assets
EBIT
Sales
Sales
Total Assets
Interest Expense
3.  Interest Expense Rate
Total Assets
EBIT
Sales
Sales
Total Assets
Interest Expense
Total Assets
Total Assets
4.  Financial Leverage Multiplier
Common Equity
EBIT
Sales
Sales
Total Assets
Interest Expense
Total Assets
Total Assets
4.  Financial Leverage Multiplier
Common Equity
 Income Taxes 
5. 100%    Tax Retention Rate
 Net Before Tax 
Risk Analysis
• Risk analysis examines the uncertainty of
income flows for the total firm and for the
individual sources of capital
– Debt
– Preferred stock
– Common stock
Risk Analysis
• Total risk of a firm has two components:
– Business risk
• The uncertainty of income caused by the firm’s industry
• Generally measured by the variability of the firm’s
operating income over time
– Financial risk
• Additional uncertainty of returns to equity holders due
to a firm’s use of fixed obligation debt securities
• The acceptable level of financial risk for a firm depends
on its business risk
Business Risk
• Variability of the firm’s operating income
over time
Business Risk
• Variability of the firm’s operating income
over time
• Standard deviation of the historical
operating earnings series
Business Risk
• Two factors contribute to the variability of
operating earnings
– Sales variability
• Earnings must be as volatile as sales
• Some industries are cyclical
– Operating leverage
• Production has fixed and variable costs
• Fixed production costs cause profit volatility with changes in
sales
• Fixed production costs are operating leverage
Financial Risk
• Bonds interest payments come before earnings
are available to stockholders
• These are fixed obligations
• Similar to fixed production costs, these lead to
larger earnings during good times, and lower
earnings during a business decline
• This debt financing increases the financial risk
and possibility of default
Financial Risk
• Two sets of financial ratios help measure
financial risk
– Balance sheet ratios
– Earnings or cash flow available to pay fixed
financial charges
• Acceptable levels of financial risk depend
on business risk
Financial Risk
• Proportion of debt (balance sheet) ratios
Financial Risk
Total Long - Term Debt
Debt - Equity Ratio 
Total Equity
Financial Risk
Debt - Equity Ratio 
Total Equity
This may be computed with and without

deferred taxes
Financial Risk
• Long-term debt/total capital ratio indicates
the proportion of long-term capital derived
from long-term debt capital
Financial Risk
• Long-term debt/total capital ratio indicates
the proportion of long-term capital derived
from long-term debt capital
L.T. Debt - Total L.T. Capital Ratio


Total Long - Term Capital
Financial Risk
• Total debt ratios compare total debt (current
liabilities plus long-term liabilities) to total
capital (total debt plus total equity)
Financial Risk
• Total debt ratios compare total debt (current
liabilities plus long-term liabilities) to total
capital (total debt plus total equity)
Total Interest - Bearing Debt/Total Capital
Total Interest Debt


Total Capital
Financial Risk
• Earnings or Cash Flow Ratios
– Relate the flow of earnings
– Cash available to meet the payments
– Higher ratio means lower risk
Financial Risk
• Interest Coverage
Financial Risk
Income Before Interest and Taxes (EBIT)

Debt Interest Charges
Financial Risk
Income Before Interest and Taxes (EBIT)

Debt Interest Charges
Net Income  Income Taxes  Interest Expense


Interest Expense
Financial Risk
• Firms may also have non-interest fixed
payments due for lease obligations
• The risk effect is similar to bond risk
• Bond-rating agencies typically add 1/3 lease
payments as the interest component of the
lease obligations
Financial Risk
• Total fixed charge coverage includes any
noncancellable lease payments and any
preferred dividends paid out of earnings
after taxes
Financial Risk
• Total fixed charge coverage includes any
noncancellable lease payments and any
preferred dividends paid out of earnings
after taxes
Fixed Charge Coverage 
Income Before Interest, Taxes, and Lease Payments

Debt Interest  Lease Payments  Preferred Dividend/(1 - Tax Rate)
Financial Risk
• Cash flow ratios relate the flow of cash
available from operations to either interest
expense, total fixed charges, or the face
value of outstanding debt
Financial Risk
Cash Flow Coverage 
Traditional Cash Flow  Interest  1/3 Lease Payments

Interest  1 / 3 Lease Payments
Financial Risk
Cash Flow / Long - Term Debt 
Net Income  Depreciation Expense  Change in Deferred Tax

Book Value of Long - Term Debt
Financial Risk
Cash Flow / Total Debt 
Net Income  Depreciation Expense  Change in Deferred Tax

Total Debt
External Market Liquidity
• Market Liquidity is the ability to buy or sell
an asset quickly with little price change
from a prior transaction assuming no new
information
• External market liquidity is a source of risk
to investors
Determinants of Market Liquidity
• The dollar value of shares traded
– This can be estimated from the total market
value of outstanding securities
– It will be affected by the number of security
owners
– Numerous buyers and sellers provide liquidity
• Trading turnover (percentage of outstanding
shares traded during a period of time)
• A measure of market liquidity is the bid-ask
spread
Analysis of Growth Potential
• Creditors are interested in the firm’s ability
to pay future obligations
• Value of a firm depends on its future
growth in earnings and dividends
Determinants of Growth
• Resources retained and reinvested in the entity
• Rate of return earned on the resources retained
= RR x ROE
where: of Earnings Retained  Return on Equity
g  Percentage
g = potential growth rate
RR = the retention rate of earnings
ROE = the firm’s return on equity
Determinants of Growth
• ROE is a function of
– Net profit margin
– Total asset turnover
– Financial leverage (total assets/equity)
Comparative Analysis of Ratios
• Internal liquidity
– Current ratio, quick ratio, and cash ratio
• Operating performance
– Efficiency ratios and profitability ratios
• Financial risk
• Growth analysis
Limitations of Financial Ratios
• Accounting treatments may vary among firms,
especially among non-U.S. firms
• Firms may have have divisions operating in
different industries making it difficult to derive
industry ratios
• Results may not be consistent
• Ratios outside an industry range may be cause
for concern

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RATIO ANALYSIS

• Receivables turnover can be converted into

Net Income  Interest Expense

Net Income - Preferred Dividend

Net Income Net Income Net Sales

Sales Sales Total Assets

Net Income Sales Total Assets

Profit Total Asset Financial

This is the operating profit return on total

EBIT Interest Expense Net Before Tax

EBIT Interest Expense Net Before Tax

EBIT Interest Expense Net Before Tax

EBIT Interest Expense Net Before Tax

EBIT Interest Expense Net Before Tax

This may be computed with and without

L.T. Debt - Total L.T. Capital Ratio

Total Long - Term Debt

Total Interest - Bearing Debt/Total Capital

Total Interest Debt

Net Income  Income Taxes  Interest Expense

Income Before Interest, Taxes, and Lease Payments

Traditional Cash Flow  Interest  1/3 Lease Payments

Net Income  Depreciation Expense  Change in Deferred Tax

Net Income  Depreciation Expense  Change in Deferred Tax

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