Ratio Analysis

Financial statement analysis:

• The way to compare companies of different sizes is to use standard measures
• Financial ratios are standard measures that enable analysts to compare companies of different sizes
• The objectives of financial statement analysis are to help investors
• Predict their expected returns
• Assess the risks associated with those returns

Using ratios to make business decisions:

• A ratio expresses the relationship of one number to another
• The ratios used to make business decisions may be classified as follows:
– Ratios that measure the company’s ability to pay current liabilities (Short Term Solvency Ratios)
– Ratios that measure the company’s ability to sell inventory and collect receivables (Activity Ratios)
– Ratios that measure the company’s ability to pay long-term debt (Long Term Solvency Ratios)
– Ratios that measure the company’s profitability (Profitability Ratios)
– Ratios used to analyze the company’s stock as an investment (Ratios in which Investors are
interested)

PALISADES FURNITURE, INC.

Comparative Income Statement
Year Ended December 31, 20X3 and 20X2

20X3 20X2
Net sales $858,000 $803,000
Cost of goods sold 513,000 509,000
Gross profit 345,000 294,000
Operating expenses:
Selling expenses 126,000 114,000
General expenses 118,000 123,000
Total operating expenses 244,000 237,000
Income from operations 101,000 57,000
Interest revenue 4,000 -0-
Interest expense 24,000 14,000
Income before income taxes 81,000 43,000
Income tax expense 33,000 17,000
Net income $ 48,000 $ 26,000
 20X3 20X2
Assets
Current assets:
Cash $ 29,000 $ 32,000
Accounts receivable, net 114,000 85,000
Inventories 113,000 111,000
Prepaid expenses 6,000 8,000
Total current assets 262,000 236,000
Long-term investments 18,000 9,000
Plant, property and
equipment, net 507,000 399,000
Total assets $787,000 $644,000

Liabilities
Current liabilities:
Notes payable $ 42,000 $ 27,000
Accounts payable 73.000 68,000
Accrued liabilities 27,000 31,000
Total current liabilities 142,000 126,000
Long term debt 289,000 198,000
Total liabilities 431,000 324,000

Stockholders’ Equity
Common stock , on par 186,000 186,000
Retained earnings 170,000 134,000
Total stockholders’ equity 356,000 320,000
Total liabilities and
stockholders’ equity $787,000 $644,000

Short Term Solvency Ratios (ability to pay current liabilities):

Working capital is defined as follows:
Working capital = Current assets - Current liabilities
• Working capital is widely used to measure a business’s ability to meet its short-term obligations with its
current assets
• The larger the working capital, the better able is the business to pay its debts

Current ratio:
• The current ratio
– Is current assets divided by current liabilities
– Measures the ability of the company to pay current liabilities with current assets
• The following slides give the comparative income statement and balance sheet of Palisades Furniture, Inc.
Current ratio = Current Asset / Current Liabilities
 • The current ratio of Palisades Furniture, Inc., at December 31, 20X3 and 20X2, follow, along with the average
for the retail furniture industry:
20X3: 262000/142000 = 1.85

20X2: 236000/126000 = 1.87

• In most industries a current ratio of 2.0 is considered good

• In general, a higher current ratio indicates a stronger financial position
• Industry Average = 1.70
Acid test ratio/ Quick ratio:
• The acid-test (or quick) ratio
– Indicates whether the entity could pay all its current liabilities if they came due immediately
– Is computed by dividing cash, short-term investments, and net current receivables (accounts and
notes receivable, net of allowances) by current liabilities
Acid test Ratio: (Cash + short term investment + Net current receivable)/ Current Liabilities
– Palisades Furniture’s acid-test ratios for 20X3 and 20X2 are:
20X3: (29000 + 0 +114000) /142000 = 1.01
20X2: (32000 + 0 + 85000)/ 126000 = 0.93
– An acid-test ratio of 0.90 to 1.00 is acceptable in most industries
– Industry Average = 0.40

Activity ratio (ability to sell inventory and collect receivables)

Three ratios are presented that measure the company’s ability to sell inventory and collect receivables
Inventory turnover:
 It is a measure of the number of times a company sells its average level of inventory during a year
 Computed by dividing the cost of goods sold by the average inventory for the period
 A high rate of turnover indicates relative ease in selling inventory; a low turnover indicates difficulty in selling
 In general, companies prefer a high inventory turnover
 Inventory turnover varies widely with the nature of the business
Inventory Turnover = Cost of goods sold / Average inventory
 Palisades Furniture’s inventory turnover for 20X3 is: 513000/ 112000 = 4.58
 Industry Average = 3.00
 Palisades Furniture’s turnover of 4.58 times a year is high for its industry, which has an average turnover of
3.00

Accounts receivable turnover:

 Measures a company’s ability to collect cash from credit customers
 Is computed by dividing net sales by average net accounts receivable
 The resulting ratio indicates how many times during the year the average level of receivables was turned
into cash
 In general, the higher the ratio, the more successfully the business collects cash and the better off its
operations
 A receivable turnover that is too high may indicate that credit is too tight, causing the loss of sales to good
customers
Accounts receivable turnover = Net credit Sales/Average net account receivable
 Palisades’ Furniture’s accounts receivable turnover ratio for 20X3 is computed as follows:
858000/99000= 8.62
 Industry Average = 31.3
 Palisades’ receivable turnover of 8.62 is much lower than the industry average, possibly because larger
stores sell their receivables
Long term solvency ratios (ability to pay long-term debt):
Two indicators of a business’s ability to pay long-term liabilities are the

Debt ratio
 The debt ratio tells the proportion of the company’s assets that it has financed with debt
 The higher the debt ratio, the higher the strain of paying interest each year and the principal amount at
maturity
 The lower the ratio, the lower the business’s future obligations
Debt ratio = Total Liability/ total assets
 Calculation of the debt ratios for Palisades Furniture at the end of 20X3 and 20X2 is as follows:
20X3 : 431000/ 787000 = 0.55
20X2 : 324000/ 644000 = 0.50
 Industry Average = 0.64
 The average debt ratio for most companies ranges from 0.57- 0.67
 The company’s debt ratio indicates a fairly low-risk debt compared to the retail furniture industry average

Times-interest-earned ratio
 The times-interest-earned ratio measures the number of times that operating income can cover interest
expense
 A high times-interest-earned ratio indicates ease in paying interest expense
 A low value suggests difficulty
Times interest earned ratio = Income from Operations / Interest expense
 Calculation of Palisades’ times-interest-earned ratio is as follows:
20X3: 101000/24000 = 4.21
20X2: 57000/14000 = 4.07
 The norm for U.S. business ranges from 2.0 - 3.0 for most companies
 Industry Average = 2.30
 The company’s times-interest-earned ratio of around 4.00 is significantly better than the industry average for
furniture retailers

Profitability ratio (Measuring a company’s profitability):

There are four rate-of-return measurements that help evaluate a company’s profitability:

Rate of return on net sales

 The rate of return on net sales shows the percentage of each sales dollar earned as net income
 The higher the rate of return, the more net sales dollars are providing income to the business and the fewer
net sales dollars are absorbed by expenses
Rate of return on sales = Net income / Net Sales
 The rate-of-return-on-sales ratios for Palisades Furniture are calculated as follows:
20X3: 48000/858000 = 0.056
20X2: 26000/803000 = 0.032
 Industry Average = 0.008
 The increase in Palisades Furniture’s return on sales identifies the company as more successful than the
average furniture store
Rate of return on total assets
 The rate of return on total assets (return on assets) measures a company’s success in using its assets to earn a
profit
 The sum of interest expense and net income in the numerator is the return to creditors and shareholders who
have financed the company’s operations
Rate of Return on assets = (Net Income + Interest Expense) / Average Total Assets
 Computation of the return-on-assets ratio for Palisades Furniture is as follows:
20X3: (48000 + 24000) / 715000 = 0.101
 Industry Average = 0.042
 The increase in Palisades Furniture’s return on assets is higher than the industry average

Rate of return on common stockholders’ equity

 Rate of return on stockholders’ equity (return on equity)
 Shows the relationship between net income and common stockholders’ investment in the company
 Is calculated by dividing net income available to common stockholders by the average stockholders’ equity
during the year
 Rate of return on common stockholders’ equity =
(Net Income – Preferred Dividends)/ Average common stockholders’ equity
 The rate of return on common stockholders’ equity for Palisades Furniture is calculated as follows:
 20X3: (48000 – 0) / 338000 = 0.142
 Industry Average = 0.121
 Palisades’ return on equity (0.142) is higher than its return on assets (0.101).
 This difference results from borrowing at one rate (8%) and investing the funds to earn a higher rate (14.2%)
 This practice is called trading on the equity or using financial leverage

Earnings per share of common stock

 Earnings per share (EPS) is
 The amount of net income per share of the company’s outstanding common stock
 Computed by dividing net income available to common stockholders by the number of common shares
outstanding during the year
Earnings per share of common stock =
(Net Income – Preferred Dividends)/ Number of shares of common stock outstanding
 Computation of the firm’s EPS for 20X3 and 20X2 follows, assuming the company had 10,000 share of common
stock outstanding
20X3: (48000 – 0) / 10000 = 4.80
20X2: (26000 – 0) / 10000 = 2.6
 Most companies strive to increase EPS by 10 -15% annually
 Palisades Furniture’s EPS increased 85 percent

Analyzing a company’s stock as an investment:

• Investors purchase stock to earn a return on their investment, which consists of two parts:
– Gains (or losses) from selling the stock at a price that differs from the investors’ purchase price
– Dividends, the periodic distributions to stockholders
Price earnings ratio:
• The price earnings ratio is the ratio of the market price of a share of common stock to the company’s
earnings
• The higher a stock’s P/E ratio, the higher its downside risk--the risk that the stock’s market price will fall
P/E Ratio: Market price per share of common stock / Earnings per share
• Calculations for the P/E ratio of Palisades Furniture, Inc., follow. The market price of its common stock was
$50 at the end of 20X3 and $35 at the end of 20X2:
20X3: 50 / 4.8 = 10.4
20X2: 35 / 2.60 = 13.5
 P/E ratios vary from industry to industry
 Palisades Furniture’s 20X3 P/E ratio indicates that the company’s stock is selling at 10.4 times earnings

Dividend yield:
• Dividend yield is the ratio of dividends per share of stock to the stock’s market price per share
• This ratio measures the percentage of a stock’s market value that is returned annually as dividends
• Dividend yield on common stock = Dividend per share / Market price per share
• Palisades Furniture paid annual cash dividends of $1.20 per share of common stock in 20X3 and $1.00 in
20X2, and market prices of the company’s common stock were $50 in 20X3 and $35 in 20X2. Calculation of
the firm’s dividend yields on common stock is as follows:
• 20X3: 1.20 / 50 = 0.024
• 20X2: 1.00 / 35 = 0.029
• Dividend yields vary widely, from 5% to 8% for older, established companies, down to the range of 0% to 3%
for young growth-oriented companies

Book value per share of common stock:

• Book value per share of common stock is common stockholders’ equity divided by the number of shares of
common stock outstanding
• Some investors rank stock on the basis of the ratio of market price to book value
– To these investors, the lower the ratio the more attractive the stock
• Calculations of book-value-per-share-of-common-stock ratios follows:
Book value per share of common stock =
(Total stockholders’ equity - Preferred equity) / Number of shares of common stock outstanding
• 20X3: (356000 – 0) / 10000 = 35.6
• 20X2: (32000 – 0) / 10000 = 32.0

Limitations of financial analysis:

• Ratios have their limitations
• Financial analysis may indicate that something is wrong, but it may not identify the specific problem or show
how to correct it
• Managers must evaluate data on all ratios in the light of other information about the company
• Ratios should be analyzed over a period of years
• Any one year, or even any two years, may not be representative of the company’s performance over the
long term