Financial

Analysis:
Ratio Analysis

Financial Analysis

Recall what firms prime financial management objective

is?
To maximize shareholders wealth or
To maximize a firms value
How?
Must take advantage of the firms Strengths
Correct its Weaknesses

Financial Analysis

Financial analysis involves:

Comparing the firms performance to that of other firms in
the same industry
Evaluating trends in the firms financial position over time.
Result:
Managers can identify deficiencies and then take corrective
actions.

Who Uses this

information
I.

Lenders:
To evaluate the likelihood
that borrowers will be able to pay off loans;

II.

Security Analysts: To forecast earnings, dividends, and stock

prices;

III. Managers: To improve the firms stock price.

Categories
We divide the ratios into five categories:
1. Liquidity ratios: give us an idea of the firms ability to
pay off debts that are maturing within a year.
2. Asset management ratios: give us an idea of how
efficiently the firm is using its assets.
3. Debt management ratios: give us an idea of how the firm
has financed its assets as well as the firms ability to repay
its long-term debt.

Categories
4. Profitability ratios: give us an idea of how profitably the
firm is operating and utilizing its assets.
5. Market value ratios: bring in the stock price and give us an
idea of what investors think about the firm and its future
prospects.

Which tells what!

Satisfactory liquidity ratios are necessary if the firm is to continue
operating.
Good asset management ratios are necessary for the firm to keep its
costs low and thus its net income high.
Debt management ratios give us an idea of how risky the firm is and
how much of its operating income must be paid to bondholders rather
than stockholders.

Which tells what!

Profitability ratios bring together the asset and debt
management ratios and show their effects on ROE.
Market value ratios tell us what investors think about the
company and its prospects.

Liquidity ratios
1.

CurRENT Ratio

2.

Quick, or Acid Test Ratio

3.

Cash Ratio (Cash/Current Liabilities)

4.

Working Capital Management

Word Problem:
Baker Brothers has a DSO of 40 days, and its
annual sales are $7,300,000. What is its
accounts receivable balance? Assume that it
uses a 365-day year.

ASSET MANAGEMENT
RATIOS
Turnover ratios: divide sales by some asset: i.e.
Sales/Various assets.
1.

Inventory turnover ratio

2.

Days sales in Inventory

3.

Receivables turnover ratio

4.

Days sales outstanding (DSO) ratio/average collection

period

5.

Fixed Assets Turnover Ratio

6.

Total Assets Turnover Ratio

Word problem
Timberland Corporation has ending inventory
of $352,600, and cost of goods sold for the year
just ended was $1,586,700. What is the
inventory turnover? The days sales in
inventory?
How long on average did a unit of inventory sit
on the shelf before it was sold?

DEBT MANAGEMENT
RATIOS
Two procedures that analysts use to examine the
firms debt:
i.

They check the balance sheet to determine the

proportion of total funds represented by debt;

ii.

They review the income statement to see the

extent to which interest is covered by operating
profits.

Word Problem
Fried Chicken Company has a debt-equity ratio of
1.20. Return on assets is 6.5 percent, and total
equity is $210,000. What is the equity multiplier?
Return on equity? Net income?

DEBT MANAGEMENT
RATIOS
1.

Total Debt to Total Assets

2.

Debt Equity Ratio

3.

Equity Multiplier

4.

Long-term Debt Ratio

5.

Times-Interest-Earned Ratio

6.

Cash Coverage Ratio

PROFITABILITY RATIOS
1. Operating Margin
2. Profit Margin
3. Return on Total Assets
4. Basic Earning Power (BEP) Ratio
5. Return on Common Equity

Find ABCs (1) accounts receivable, (2) current

assets, (3) total assets, (4) ROA, (5) common
equity, (6) quick ratio, and (7) long-term debt.
The following data apply to ABC Company (millions of
dollars):
Cash and equivalents

$ 100.00

Fixed assets

283.50

Sales
Net income
Current liabilities

1,000.00
50.00
105.50

Current ratio
DSO*
ROE

3.00
40.55 days
12.00%

This calculation is based on a 365-day year.

Market Value Ratios

1.

Price/Earnings Ratio

2.

Market/Book Ratio

Word Problem:
Assume that if a company is currently trading at $43 a share
and earnings over the last 12 months were $1.95 per share,
what is its P/E?

Things to Remember
Generally a high P/E ratio means that investors
are anticipating higher growth in the future.
The average market P/E ratio is 20-25 times
earnings.
The p/e ratio can use estimated earnings to get the
forward looking P/E ratio.
Companies that are losing money do not have a
P/E ratio.

Things to Remember
Proposition: Other things held equal, higher growth
rms will have higher PE ratios than lower growth
rms.
Proposition: Other things held equal, higher risk
rms will have lower PE ratios than lower risk rms
Proposition: Other things held equal, rms with
lower reinvestment needs will have higher PE ratios
than rms with higher reinvestment rates.

DuPont Analysis
A method of performance measurement that was started by the
DuPont Corporation in the 1920s. With this method, assets are
measured at their gross book value rather than at net book
value in order to produce a higher return on equity (ROE). It is
also known as "DuPont identity".
DuPont analysis tells us that ROE is affected by three things:
Operating efficiency, which is measured by profit margin
Asset use efficiency, which is measured by total asset
turnover
Financial leverage, which is measured by the equity
multiplier

LIMITATIONS OF RATIOS
Seasonal factors
Window Dressing techniques
Different accounting
comparisons.

practices

can

distort

It is difficult to generalize about whether a

particular ratio is good or bad.