Financial Ratio Analysis: Lecture No.2-2 Contemporary Engineering Economics

Contemporary Engineering Economics, 4
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Financial Ratio Analysis
Lecture No.2-2
Chapter 2
Contemporary Engineering Economics
Copyright 2006

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1. Debt Management Ratios
2. Liquidity Ratios
3. Asset Management Ratios
4. Profitability Ratios
5. Market Trend Ratios
6. Trends and graphs to spot problems
7. Using an Excel template for instant cant miss
financial analysis See the template provided
in the OneKey site.
Ratio Analysis Calculations and What the
Numbers Really Means
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Types of Financial Ratios
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Net income
Reutrn on Equity (ROE) =
Average shareholders' equity
Net income
ROE =
Average shareholders' equity
Net income Sales Assets

Sales Assets Average shareholders' equity
(Profit margin) (Asset turnover) (Financial leverage)
= (6.18%) (2.12 times) (3.64

times)
= 47.68%
Return on Equity A Composite Ratio
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Return on Equities (ROE) and Levels of
Performance for 10 Diverse Companies
Return
on Equity
(%)
Profit
margin
(%)
Asset
Turnover
(times)
Financial
Leverages
(times)
Analog Devices
18.2 12.7 0.94 1.53
BankAmerica Co.
13.2 13.1 0.09 11.49
Duke Power
14.9 15.3 0.35 2.79
Exxon Co
16.0 5.3 1.33 2.26
Food Lion
15.7 2.1 3.10 2.40
Hewlett-Packard
20.6 7.7 1.29 2.06
Nike
20.4 8.4 1.51 2.60
Nordstrom Inc.
11.6 4.0 1.51 1.92
Southwest Airline
12.8 6.4 0.88 2.28
Tiffany & Company
14.8 4.9 1.23 2.48
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Debt Management Analysis
Leverage ratios that show
how a firm uses debt
financing and its ability to
meet debt repayment
obligations

Debt ratio
Debt to equity ratio
Times-interest-earned
ratio
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Indicates how a firm
finances its capital
Debt Ratio
Total debt
Debt ratio=
Total assets
$16, 730
$23, 215
72.07%

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Measures the extent
to which earnings can
decline without
defaulting debt
service.
EBIT
Times Interest Earned =
Interest Charges
$4, 445 $11.29
11.29
394.72
Note: Dell issued $500 million worth of senior notes and

long-term bonds with a combined interest rate of 6.8%.
Times Interest
Earned
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Liquidity Analysis
Ratios that show the
relationship of a firms cash
and other assets to its
current liabilities (short-term
obligations)

Current ratio
Quick ratio
Liquidity ratio
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Measures a firms
short-term solvency.
Formula:

Current Assets
Current Ratio =
Current Liabilities
$16, 897
$14,136
1.1953
Current Ratio
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Excludes inventories
and prepaid expenses
Formula:

Current Assets - Inventories
Quick Ratio =
Current Liabilities
$16, 897 $459
$14,136
1.1628
Quick Ratio
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An indication of a
firms immediate
liquidity
Formula:

Cash+Cash Equ.
Liquidity Ratio =
Current Liabilities
$4, 747
$16, 730
0.2837
Liquidity Ratio
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Asset Management Analysis
A set of ratios which
measure how effectively a
firm is managing its assets

Inventory turnover ratio
Days sales outstanding
ratio
Total assets turnover ratio
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Highlights the rate
at which the
inventory is being
sold.

Sales
Inventory Turnover =
Average Inventory
$49, 205
($459 $327) / 2
125.20 times
The typical item sits in inventory almost

0.0958 months (12 months/125.20) or
2.87 days before being sold
Inventory Turnover
Ratio
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Alternate Definition for Inventory
Turnover Ratio
Cost of goods sold
Inventory turnover ratio =
Ending inventory
$40,190
87.56 times
$459

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Determines whether
receivables are being
collected
aggressively enough.

A/R
DSO =
Average sales per day
$4, 414
$49, 205/ 365
32.74 days
Days Sales
Outstanding (DSO)
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Days Sales in Inventory
What It Measures: The amount of inventory (stock)
expressed in days of sales. For example, if 2 items a
day are sold and 20 items are held in inventory, this
represents 10 days' (20/2) worth sales in inventory.
How You Compute: The ratio computed by dividing
inventory by cost of sales, and multiplied the result by 365
Average Inventory
DSI (Days Sales in Inventory)=
Average Cost of Sales per day
($327 $459) / 2
$40,190/ 365
3.57 days

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The Business Operating Cycle
Days Sales Outstanding = 32.74 days
+ Days Sales in Inventory = 3.57 days
Total Days Operating Cycle = 36.31 days
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Indicates whether a
company is
generating a sufficient
volume of business
for the size of its
asset investment.
Net Sales
Total Asset Turnover =
Total Assets
$49, 205
$23, 215
2.12 times
Total Asset
Turnover Ratio
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Profitability Analysis
A set of ratios which
measure managements
overall effectiveness as
shown by the returns
generated on sales and
investment

Profit margin on sales
Return on total assets
Return on common equity
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Indicates the
profitability of the
sales effort.

Gross Margin ($)
Gross Margin Ratio =
Net Sales
$9, 015
$49, 205
18.32%
Gross Margin
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Illustrates what
percentage of each
sales dollar is
retained in earnings.

Net Income ($)
Net Margin Ratio =
Net Sales
$3, 043
$49, 205
6.18%
Net Margin
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Measures the rate of
return on the owners
investment.
Net Income
Return on Equity =
Average Total Common Equity
$3, 043
($6, 485 6, 280) / 2
47.68%
Return on Equity
(ROE)
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How the Debt to Equity Ratio Impacts
Return on Equity
This is an example of a
healthy company that might
not have a spectacular ROE
because there is so much
equity in the company.

This an example of a highly
leveraged company that
might have a spectacular
ROE because the owners
have put so little of their own
resources into the company.
Assets
Liabilities
Equity
Assets
Liabilities
Equity
=
=
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Market Trend Analysis
A set of ratios that
relate the firms stock
price to its earnings
and book value per
share

P/E ratio
Market/book ratio
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Earnings Per Share (EPS)
Indicates earnings
attributable to each
share of stock.
Widely used indicator
of a corporations
performance

Net Income
EPS =
Common Shares Outstanding
$3, 043
2, 509
$1.21

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Price to Earnings Ratio
Indicates how many
times a corporation is
able to multiply its
earnings in terms of
asking price per share
of stock.
Share price: $30.25
as of December 31,
2005

Price per share
P/E ratio =
EPS
$30.25
1.21
25

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Book Value/Share
Indicates what the
value of a share of
stock is according to
the books (financial
statements).

Equity - Preferred stock
Book Value/Share =
Common Shares Outstanding
$6, 485 0
2, 509
$2.58
Total Assets $23,215

Total liabilities 16,730
Stockholders equity 6,485
Preferred stock obligation 0
Net worth assigned to
common stockholders 3,043

Common shares
outstanding 2,509

Net worth (Book value): $2.58
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Market/Book Ratio
What It Measures: Indicates how investors regard the
company a higher ratio indicates that investors are
willing to bet a higher return on investment
How You Compute: The ratio of a stocks market price to
its book value
Market price per share
Market/book ratio=
Book value per share
$30.25
$2.58
11.70 times

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Trends and Graphs to Spot Problems
Trends analysis, where one plots a ratio
over time, is important, because it reveals
whether the firms ratios are improving or
deteriorating over time.

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Limitations of Financial Ratios
Ratio analysis is useful,
but analysts should aware
of ever-changing market
conditions and make
adjustments necessary.
It is difficult to generalize
about whether a particular
ratio is good or bad.
Ratio analysis based on
any one year may not
represent the true
business condition.
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Quick Financial Analysis
Horizontal versus Vertical Analysis
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Horizontal Analysis
Determine the
total dollar change
(variance) from
year to the next.
Determine the
percent change
(variance) from
one year to the
next

2001

2000
Dollar
Chang
e

Percent
Change
(%)

Cash
A/R

50,000
30,000

40,000
50,000

10,000
(20,000)

25%
(40%)

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Vertical Analysis
For the balance
sheet, determine
what percent of total
assets each line item
totals.
For the income
statement, determine
what percent of total
sales each line item
totals.

2001

2000
2001
(%)
2000
(%)

Cash
A/R

Total
Assets

50,000
30,000

200,000

40,000
50,000

180,000

25%
15.0%

100%

22.2%
27.8%

100%

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Contemporary Engineering Economics, 4

Contemporary Engineering Economics, 4

Note: Dell issued $500 million worth of senior notes and

The typical item sits in inventory almost

Contemporary Engineering Economics, 4

Contemporary Engineering Economics, 4

Contemporary Engineering Economics, 4

Total Assets $23,215

Contemporary Engineering Economics, 4

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