Chapter three

Ratio analysis
 Chapter objectives

 Understand ratio analysis

 Describe the objectives of financial ratios
 compare financial soundness of companies
 Introduction

 Financial performance measurement (financial statement analysis) uses all

techniques available to show how important items in a company’s financial
statements relate to the company’s financial objectives.

 Persons who have strong interest in measuring company’s financial

performance:
• A company’s top management who strives to achieve financial performance objectives.

• A company’s middle-level managers of business process and lower level employees who own stock in
the company.

• Creditors, investors, and customers who have cooperative agreements with the company.
 Financial Performance Measurement: Management’s Objectives

 All the strategic and operating plans that management formulates to achieve a company’s goals
must eventually be stated in terms of financial objectives.
 A primary objective is to increase the wealth of the company’s stockholders, but this objective
must be divided into categories.
 A complete financial plan should have financial objectives and related performance objectives in
all the following categories:

Financial Objective Performance Objective

Liquidity The company must be able to pay bills when due and meet
unexpected needs for cash.

profitability It must earn a satisfactory net income.

Long-term solvency It must be able to survive for many years.

Cash flow adequacy It must generate sufficient cash through operating, investing,
and financing activities.

Market strength It must be able to increase stockholders’ wealth.

 Cont---

 One of management’s primary responsibilities is to achieve the company’s

financial objectives. This requires:
• Constantly monitoring key financial performance measures for each objective listed above.

• Determining the cause of any deviations from the measures, and taking corrective action.

• Comparing actual performance with the key performance measures in

monthly, quarterly, and annual reports.

• Providing information and data for long-term trend analyses.

Financial Performance Measurement: Creditors’ and Investors’ Objectives
 Creditors and investors use financial performance evaluation to judge a company’s past
performance and present position.

 They also use it to assess a company’s future potential and the risk connected with acting on
that potential.

• An investor focuses on a company’s potential earnings ability as it will affect the market price of the
company’s stock and the amount of dividends the company will pay.

• A creditor focuses on the company’s potential debt-paying ability.

 Past performance is often a good indicator of future performance.

To evaluate Past performance To evaluate Current performance

Creditores and investors look at trends in past Creditores and investors look at compay’s

Sales Assets

Expenses Liabilities

Net income Cash position

Cash flow Debt and equity mix (capital structure)

Return on investment
 Cont…

 Knowing a company’s past performance and current position helps estimating its

future potential and related risk.

 The risk involved in making an investment or loan depends on how easy it is to

predict future profitability or liquidity.

• In return for taking a greater risk, investors often look for a higher expected return (an increase in market price

plus dividends).

• Creditors who take a greater risk by advancing funds to a new company may demand a higher interest rate

and more assurance of repayment (a secured loan, for instance).

• The higher interest rate reimburses them for assuming the higher risk.
 Standard of comparison

 When analyzing financial statements, decision makers must judge whether the
relationships they find in the statements are favorable or unfavorable.

 Three standards of comparison that they commonly use are:

• rule-of-thumb measures,

• a company’s past performance,

• industry norms.
Rule of thumb Past performance Industry norms
 Applied by most managers, financial analysts,  Comparing financial ratios of the same  Show how a company compares with other
investors, and lenders. company over time. company in the same industry.

 e.g. most analysts today agree that a current  Such comparison gives the analyst  For example, if companies in manufacturing
ratio 2:1 is acceptable. some basis for judging whether the industry have an average rate of return on
ratio is getting better or worse. investment of 8%, a 3 or 4% rate of return on
investment may not be adequate.

 Current debt/tangible net worth: a business is  Thus, it may be help full in showing  Has the following limitations:
in trouble when this ratio exceeds 80%. future trends.
 Tangible net worth= total assets-intangible
assets- total liability

 Inventory/net worth: should not exceed 80%.  Limited that past performance may not  Companies in the same industry may not strictly
be enogh to meet a company’s present be comparable due to age, size, operation
needs. disparity
 Many large companies have multiple segments
and operate in more than one industry.
 Some of such diversified
industries/conglomerates operate many
unrelated industries.

 To solve this problem, FASB required these

companies to provide reports for each of their
segments.
Tools and techniques of financial analysis

 To gain insight into a company’s financial performance, the following tools can be
applied:

• Horizontal analysis

• Trend analysis

• Vertical analysis

• Ratio analysis
 Horizontal Analysis


Cont---
 Trend analysis

 Is variation of horizontal analysis.

 With this tools, managers and analysts compute percentage change for several
successive years instead of for just two years.

 Because of its long-term view, trend analysis can highlights basic changes in the
nature of a business.

 Trend analysis uses an index number to show changes in related items over time.

 For an index number, the base year is set at 100 percent.

 Other years are measured in relation to that amount.

 Cont---

 For example, the 2007 index for Starbucks’ net revenues is figured as follows (dollar amounts are in
millions):

 This trend analysis shows that Starbucks’ net revenue increased over the six-year
period.
 Operating income grew faster than net revenue in every year except in 2008.
 Cont---
Trend analysis (using dollar amount

net revenue oeprating income

12000

10383
10000
9411.5

8000
7786.9

6369.3
6000
5294.2

4000 4075.5

2000

800 945.9
549.5 703.9
386.3 390.3
0
2003 2004 2005 2006 2007 2008
 Cont---

Trend analysis (using index)

net revenue oeprating income

300

250 254.8
244.9
230.9

207.1
200
191.1
182.2

156.3
150
142.2
129.9

100 100 101

50

0
2003 2004 2005 2006 2007 2008
 Vertical analysis

 Shows how the different components of a financial statement relate to a total figure
in the statement.
 The manager/analyst sets the total figure at 100 percent and computes each
component’s percentage of that total.
 The resulting financial statement which expressed entirely in percentage is called
common size statement.
 Vertical analysis and common size statements are useful in comparing the
importance of a specific components from one year to the next year.
 Common size balance sheet (total assets or total liabilities and owners’ equities)
 Common size income statements (net revenues).
 The main conclusion from this analysis is that the company’s assets consist largely
of current assets, property, plant, and equipment.
 It can also be concluded that the company finances assets primarily via current
and/or long-term liabilities.
Cont---
 Ratio Analysis

 Identifies key relationship between the components of financial statements.

 Ratio analysis has the following main objectives.

• Standardize financial information for comparison

• Evaluate current operations

• Compare current and past performance

• Compare firm’s performance against other firms or industry standards

• Evaluate efficiency of operations

• Evaluate risk of operations

• Evaluate financial position,

• Reveals areas that need further investigations.

 Liquidity
 Is a company’s ability to pay bills when due and to meet unexpected needs for cash.
 Because debts are paid out of working capital, all liquidity ratios involve working capital or some
part of it.
 Cash flow ratios are also closely related to liquidity.
 The current and the quick ratios are measures of short-term debt paying ability.
 The principal difference between the two ratios is that the numerator of the current ratio includes
inventories and prepaid expenses.
 Inventories take longer to convert to cash than the quick assets included in the numerator of the
quick ratio.
 The receivable turnover measures the relative size of account receivables and the
effectiveness of credit policies.
 The related ratio of days’ sales uncollected expresses the average number of days between
sales on account and the account payment.
 The inventory turnover ratio measures the relative size of inventories and generally how many
times per year the inventory is restocked.
 The related ratio of days’ inventory on hand expresses how long the inventory stays on the
shelf before it is sold.
 The operating cycle is the time it takes to acquire and sell products and then to collect for
them.
 It is computed by adding the days’ sales uncollected to the days’ inventory on hand.
Data
 2008 2007 2006
Current ratio: measure of short term debt paying ability

Quick ratio: Measure of short-term debt-paying ability

Receivable turnover: Measure of relative size of accounts receivable and effectiveness of credit policies

Days’ sales uncollected: Measure of average days taken to collect receivables

Inventory turnover: Measure of relative size of inventory

Days’ inventory on hand: Measure of average days taken to sell inventory

Payables turnover: Measure of relative size of accounts payable

Days’ payable: Measure of average days taken to pay accounts payable

*Figures for 2005 are from the balance sheet in Starbucks’ Form 10-K, 2006.
Source: Data from Starbucks Corporation, Form 10-K, 2008, Form 10-K, 2007, and Form 10-K, 2006.
 Profitability
 Managers, investors, and creditors are interested in evaluating not only a
company’s liquidity but also its profitability—that is, its ability to earn a satisfactory
income.
 Profitability is closely linked to liquidity because earnings ultimately produce the
cash flow needed for liquidity.
 Profit margin focuses on income statement results and measures how well
a company manages its costs per dollar of sales.
 Asset turnover focuses on how efficiently balance sheet assets are used to
produce sales.
 Return on assets combines these two ratios to measure the earning power of a
business.
 Return on Equity measures the earning power of a company’s stockholders
investment
 Long term solvency
 Long-term solvency has to do with a company’s ability to survive for many years.
 The aim of evaluating long-term solvency is to detect early signs that a company is
headed for financial difficulty.
 Increasing amounts of debt in a company’s capital structure mean that the company is
becoming more heavily leveraged.
 This condition may have a negative effect on long-term solvency because it represents
increasing legal obligations to pay interest periodically and the principal at maturity.
 Failure to make those payments can result in bankruptcy.
 Declining profitability and liquidity ratios are key indicators of possible failure.
 Two other ratios that analysts consider when assessing long-term solvency
are debt to equity and interest coverage.
 The debt to equity ratio measures capital structure and leverage by showing the
amount of a company’s assets provided by creditors in relation to the amount provided
by stockholders.
 The interest coverage ratio measures the degree of protection creditors have from
default on interest payments.
 Cash flow adequacy
 Because cash flows are needed to pay debts when they are due, cash flow
measures are closely related to liquidity and long-term solvency.
 Cash flow yield shows the cash-generating ability of a company’s operations; it is
measured by dividing cash flows from operating activities by net income.
 Cash flows to sales and cash flows to assets measure the ability of sales
or assets to generate operating cash flow.
 Free cash flow is the cash remaining after providing for commitments such
as dividends and net capital expenditures.
 Market strength
 Market price is the price at which a company’s stock is bought and sold.
 It indicates how investors view the potential return and risk connected with owning the
stock.
 Market price by itself is not very informative, however, because companies have
different numbers of shares outstanding, different earnings, and different dividend
policies.
 Thus, market price must be related to earnings by considering the price/earnings (P/E)
ratio and the dividends yield.
 The price/earnings (P/E) ratio, which measures investors’ confidence in a company, is
the ratio of the market price per share to earnings per share.
 The P/E ratio is useful in comparing the earnings of different companies and the value
of a company’s shares in relation to values in the overall market.
 With a higher P/E ratio, the investor obtains less underlying earnings per dollar
invested.
 The dividends yield measures a stock’s current return to an investor in the form of
dividends.
 Because Starbucks pays no dividends, we can conclude that those who invest in the
company expect their return to come from increases in the stock’s market value.