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FIN 335 Topic 3 Financial Ratio Analysis

1. Five Categories of Financial Ratios

a. Short-term Liquidity Ratios (Short-term Solvency Ratios)
i. Measure a firm’s short-term solvency, i.e. its ability to meet cash needs as they
arise
ii. Focuses on current liabilities
b. Activity Ratios (Asset Management Ratios)
i. Measure the liquidity of specific assets and the efficiency of managing assets
c. Leverage Ratios (Debt Management Ratio or Long-term Solvency Ratios)
i. – Measure the extend of a firm’s financing with debt relative to equity and its
ability to cover interest and other fixed charges
ii. Focuses on long term liabilities
d. Profitability Ratios
i. Measure the overall performance of a firm
e. Market Ratios
i. Measure the value that shareholders put on a share of the company’s
outstanding stock
2. Perspectives of Groups Using Financial Ratio Analysis
a. Creditors
i. Want to know if firm can pay bills on time and meet interest and debt payments
1. Creditors are interested in ratios:
a. Short-term Liquidity Ratios
b. Leverage Ratios
c. Profitability Ratios
2. They want to answer the following questions through ratio analysis:
a. Why does the firm want to borrow?
b. How risky is the firm in terms of its existing short term and long-
term debt and how well it has been in meeting past obligations?
c. Are the firms cash flows from operations (CFO) sufficient to
meet its future obligations?
b. Stockholders
i. Want to know the ability of a firm to produce higher return while keeping risk
low
1. Shareholders are interested in ratios:
a. Leverage Ratios
b. Profitability Ratios
c. Market Ratios
2. They want to answer the following questions through ratio analysis:
a. What was the earnings growth/profitability in the past, how
about future expectations?
b. Firms capital structure, is it too risky because of too much debt?
c. Is the firm a good competitor in terms of market share?
c. Managers
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i. Are interested in the same questions as creditors and stockholders as well as

firm’s operational efficiency
1. Managers are interested in ALL RATIOS
a. How good is the operational efficiency/working capital
management?
b. Risk? How much cash the firm need to meet interest payments?
How about debt relative to assets? How variable are the firms
earnings?
c. Current and future profitability?

3. Liquidity Ratios
a. Current Ratio

b. Quick Ratio
i.

1.5 or greater is adequate

c. Average Collection Period (ACP)
i. Average Collection Period (of account receivable) is the average number of days
required to convert receivables into cash. The ACP should be compared with the
firm’s stated credit policies
1. Formula

a. Daily credit sales = (Sales/365 days)

b. From exhibit
i. 2015: ACP = 8350/ (153000/365) = 20 days
ii. 2016: ACP = 8960/ (215600/365) = 15 days
ii. Companies that have strict credit policies for accounts receivable are more
liquid, meaning they receive they’re account payables faster.
1. This can limit their sales because of the stringent policy
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iii. Companies that have lenient credit policies for accounts receivables are less
liquid but generate more sales.
d. Days Inventory Held (DH)
i. Days Inventory Held is the average number of days it takes to sell inventory to
customers.
1. Formula

a. Avg daily cost of sales = (COGS/365 days)

b. From exhibit
i. 2015: DIH = 36769/ (91879/365) = 146 days
ii. 2016: DIH = 47041/ (129364/365) = 133 days
c. Lower is better but you don’t want to be too low that you run
out of inventory
ii. Don’t compare ratios across industries
1. Groceries (perishable goods) will have low ratios vs furniture stores will
have high ratios
e. Days Payable Outstanding (DPO)
i. The Days Payable Outstanding is the average number of days it takes to pay
payables in cash.
1. Formula

a. Average daily cost of sales = (COGS/365)

b. From exhibit:
i. 2015: DPO = 7591 (91879/365) = 30.16 = 31 days
ii. 2016: DPO = 14294 (129364/365) = 40.33 = 41 days
f. Cash Conversion Cycle (CCC)
i. The Cash Conversion Cycle measures the length of time, in days, a company
takes in order to convert resource inputs into actual cash flows.
1. Formula

a. From exhibit
i. 2015: CCC = 20+146-31 = 135 days
ii. 2016: CCC = 15+133-41 = 107 days
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ii. Cash Conversion Cycle – 2016

1. Break down of Cash Cycles and the periods of the ratios:

a. DIH  Purchase Inventory through Sell Inventory
b. ACP  Selling Inventory through Collect Cash
c. DPO  Purchase Inventory through Pay Inventory

4. Activity Ratios
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a. Formulas: ratios can be switched depending on what info is presented in problem

i. Accounts receivable turnover = 365/Avg collection period; ACP = 365/accounts
receivable turnover
ii. Days inventories held = 365/Inventory turnover; Inventory turnover = 365/days
inventory held
iii. Days payable outstanding = 365/Accounts payable turnover; Accounts payable
turnover = 365 days payable outstanding
b. Accounts payable
i. Firms should use accounts payable to their advantage, pay on the last due date
or slowly
ii. Lower is better but not too low because that could signal low cash flow
c. Fixed and Asset Turnover & Total Asset Turnover
i.

Higher the FAT and TAT ratios, the more efficient the firm is with fixed assets
1. Don’t compare FAT ratios between industries
a. Tesla vs Citi bank
i. Tesla has way more PPE (fixed assets) than Citi bank
1. Tesla’s FAT ratio is lower than Citi bank
b. Manufacturing industries have lower FAT ratios than Service
industries (higher FAT ratio)
ii. If ratios are below industry average, firm is ever over investing, or the firm’s net
sales are sluggish
5. Leverages Ratios
a. Debt Ratio
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b. Debt to Equity Ratio

i. Shortcut formula to find d/e ratios  (Debt ratio / (1-debt ratio))
c. Long-term Debt to Total Capitalization
i.

Managers view long term debt as a liability because it makes the firm less flexible
with capital in the future
d. Debt to Tangible Net Worth Ratio
i.

Net worth = Share Holder Equity

e. Time Interest Earned
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i.

higher ratio is better because the firm can cover the interest expense
ii. TIE ratio about 2 is sufficient but below 1 is not adequate
f. Cash Interest Coverage

g. Fixed Charge Coverage

i. Firm’s want a ratio greater than 1, less than 1 is a red flag

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h. Cash Flow Adequacy

i.

Make sure to use both cash inflows and cash outflows

1. Short term + long term debts
ii. Below 1 is a red flag
6. Profit Ratio
a. Gross Profit Margin
i. Markup over COGS = GPM / (1-GPM)
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1. You can use this formula to calculate the ideal mark up for the product
ii. Investors use GPM ratio to value Gross Profits
b. Operating Profit Margin

c. Net Profit Margin

i. Not very useful to investors because operating expenses can be manipulated
d. Return on Assets

i.
ii. Get info from balance sheet
e. Return on Equity
i.

Very valuable to Shareholders, higher the better

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7. Market Ratios

8. DuPont Analysis

i. ROA ratio^ = ROA ratio^ * EQM ratio^