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Chapter Highlights
The focus of this chapter is company analysis through the use of financial ratios. The objective: utilizing the tools of investment analysis for better security selection decisions.
Ratio Analysis
A ratio shows the relationship between two numbers, in which a number is usually related to 1, e.g., 2.2 to 1 or 2.2:1. The four general categories of ratios are: Liquidity Ratios: used to judge a companys ability to meet its short-term commitments.
Risk Analysis Ratios: show how well a company can deal with its debt obligations.
Operating Performance Ratios: illustrates how well management has made use of the companys resources.
Value Ratios: shows the market worth of the companys shares or the return on owning them.
2:1 is a suggested or recommended level. But depends on type of business and industry.
1:1 is the suggested or industry recommended level. But depends on type of business and industry.
If the ratio falls below 1, the company is not generating enough cash from its operations to cover its current obligations.
Liquidity Questions
Use the following information to answer the questions below.
Year 1 Year 2 Year 3 Year 4 Year 5
2.75x 1.13x
2.55x 1.06x
2.15x 1.00x
1.90x 1.02x
1.65x 1.05x
Liquidity Questions
1. Evaluate the companys liquidity position.
2. A large debt payment becomes due next year. What impact will this have on its Current Ratio?
3. If the company wrote down its inventory value due to obsolescence, what impact will it have on the Current and Quick Ratios?
Liquidity Questions
1. Evaluate the companys liquidity position. Deterioration in liquidity in all years. Current Ratio declined from an acceptable level of 2.75x in Year 2 to an unacceptable 1.65x in Year 5.
Quick Ratio, which is a more stringent measure, was always just above the ROT of 1x.
Quick Ratio declined from 1.13x to 1.00x in Year 3 and improved slightly to 1.05x by Year 5.
Liquidity Questions
2. A large debt payment becomes due next year. What impact will this have on its Current Ratio? A large debt payment due would increase Current Liabilities. This would cause a decrease in the value of the Current Ratio if all other items were relatively unchanged.
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Liquidity Questions
3. If the company wrote down its inventory value due to obsolescence, what impact will it have on the Current and Quick Ratios? A writedown of the value of Inventory reduces the Current Ratio because the value of current assets declines. The Quick Ratio would not change because inventory is excluded from the calculation.
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Assess debtholder protection provided by the companys tangible assets after removing all liabilities
Formula:
Total Assets Def. Charges Intangible Assets (Current Liabilities Less S hor t Term Debt) Total Debt (i.e. LTD + S TD)/1000
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Asset Coverage
Industry standards for this ratio vary due, in part, to the stability of income provided by the company. Utilities, for example, have a fairly stable source of income as they are characterized by heavy investment in permanent property, which accounts for a large part of their total assets.
They are also subject to regulation, which ensures the utility a fair return on its investment.
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Although no general rule is used to determine what constitutes acceptable capitalization, the higher the proportion of debt the greater the financial riskiness of the company.
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Debt/Equity Ratio
Purpose:
Shows the proportion of borrowed funds used relative to the investments made by shareholders in the company.
Formula:
Total Debt (S TD + LTD) Book Value of Equity
If the debt burden is too large, it reduces the margin of safety protecting debtholders capital. Financial risk also increases.
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Interest Coverage
Purpose:
Net Earnings B4 Ext. Items Equity Income + Minority Int. in Earnings of Subsid. + All Inc. Taxes + Total Int. Charges Total Interest Charges
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Interest Coverage
The formula can be shortened to:
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Risk Analysis
Use the following information to answer the questions below.
Year 1 Year 2 Year 3 Year 4 Year 5
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Risk Analysis
1. Assess the debt protection offered by the company.
2. Determine the impact on a companys debt ratios in each of the following scenarios.
a) The economy is in recession and net income declines. Tolerance level increases. When Income drops lower, there are people may go bankrupt because they are not able to pay the interest. b) The company completes a large equity issue.
It decreases
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Risk Analysis
a) Assess the companys debt protection. This company offers acceptable debt protection in all three areas and for all years. All ratios improved from Year 1 to Year 3 but then worsened in Year 4. The company most likely issued additional debt in Year 4. However, the ratios show improvement between Years 4 and 5.
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Risk Analysis
b) If the companys net income position declines over the year, what impact will this have on each of the ratios? Interest coverage will deteriorate due to the decrease in net income. Cash flow to total debt will deteriorate due to the decrease in net income. The other ratios should not change substantially unless the lower cash flow necessitates additional financing. Debt/equity will likely deteriorate because the loss in net income will likely reduce retained earnings and therefore, total shareholders equity.
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Risk Analysis
c) The company completes a large equity issue. Debt/equity and Debt as % of invested capital will improve. Asset coverage will improve if the new equity is used to finance assets rather than repay debt.
Interest coverage and cash flow should improve if the new equity generates additional earnings.
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Inventory Turnover
Purpose:
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Inventory Turnover
Discussion: What is preferred - a high or low ratio?
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Value Ratios
Ratios used to assess the value of a stock in relation to its price.
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Total Dividends on Common Net Earnings Before Extr. Items Pr eferred Dividend
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Dividend Yield
Purpose:
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Price-Earnings Ratio
Purpose:
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Price-Earnings Ratio
Purpose:
High growth companies tend to have higher P/Es than low growth companies.
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Enterprise Multiple
Purpose:
Provides a measure of overall value; a reflection of what it would cost to purchase the company as a whole.
Formula:
MV common + MV preferred + MV debt + Minority Interest (Cash + Investments) Net Earnings + Int Exp + Taxes + Amortization
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Common
Purpose:
Common S hare Capital + Contributed S urplus + Retained Earnings + Foreign Exchange Adjustments Number of Common S hares Outstanding
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2.65x 12.5x
2.86x
2.99x
3.15x
3.42x
Has paid dividends in every quarter since issued except for two quarters in Year 5 that were paid in Q4. The S&P rating is Pfd-3.
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