1 Financial Ratios Prof. Dr. Dan Dumitru Popescu

2 Main issues A.What are Ratios? B.Ratio Analysis C.Liquidity Ratios D.Asset Management Ratios E.Leverage/Gearing Ratios F.Profitability Ratios G.Financial Efficiency Ratios H.Market Value Ratios I.Limitations of Ratios J.Benchmarks for Financial Ratios Analysis K.Z-Score – Predicting Bankruptcy

3 A. What are Ratios? Def: Ratios are a management tool for making both strategic and operating decisions. Ratios can help a manager determine, among other things: Whether a company, a business, a department or a product is profitable Whether stock is sold and sales turned into money at an adequate pace Whether liquidity is maintained now and will be in the near future

4 B. Ratio Analysis Ratios allow managers to assess current performance, examine business trends, evaluate business strategies and monitor progress. We can use ratio analysis to try to tell us whether the business is profitable is profitable is enough money to pay its bills is enough money to pay its bills could be paying its employees higher wages could be paying its employees higher wages is paying its share of tax is paying its share of tax it’s using its assets efficiently it’s using its assets efficiently has a gearing problem has a gearing problem is a candidate for being bought by another company or investor is a candidate for being bought by another company or investor Users of Accounting Information: Investors, lenders, managers, employees, suppliers, customers, governments, general public, financial analysts, environmental groups, researchers – both academic and professional Investors, lenders, managers, employees, suppliers, customers, governments, general public, financial analysts, environmental groups, researchers – both academic and professional

5 B. Ratio Analysis Categories of Ratios: Liquidity: does the business have enough money to pay its bills? Liquidity: does the business have enough money to pay its bills? Asset Management Ratios: how has the business used its fixed and current assets? Asset Management Ratios: how has the business used its fixed and current assets? Leverage / Gearing Ratios : does the company has a lot of debt or is it mainly financed by shares? Leverage / Gearing Ratios : does the company has a lot of debt or is it mainly financed by shares? Profitability : has the business made a good profit compared to its turnover? Profitability : has the business made a good profit compared to its turnover? Financial Efficiency Ratios Financial Efficiency Ratios Market Value Ratios Market Value Ratios

6 C. Liquidity Ratios Liquidity ratios help understand if the company can meet its obligations over the short-run. Higher liquidity levels => ease of meeting obligations CA – current assets T - turnover CL – current liabilities A / P – accounts payable I – inventories A / R – accounts receivable C – cash MS – marketable securities CFO – operating cash flow

7 C. Liquidity Ratios Current Ratio Definition: Current ratio measures the ability to meet current obligations based on the current assets. In order to interpret the significance of this ratio it is necessary to evaluate the trend of liquidity over a longer period and to compare it with industry competitors. Low Current Ratio => possible insolvency problems Very high Current Ratio => management might not be using assets productively Limitations: accounts receivable and inventories might not be truly liquid

8 C. Liquidity Ratios Acid Test Ratio (Quick Ratio) Definition: Acid Test Ratio measures the ability to meet current obligations based on the most liquid assets. -a more rigorous test of short-run solvency, because the numerator eliminates inventory (the least liquid current asset). Cash Flow Liquidity Ratio Another approach to measuring short-term solvency is the cash flow liquidity ratio, which considers cash flow from operating activities (from the statement of cash flows).

9 C. Liquidity Ratios Average Collection Period Definition: The average collection period of accounts receivables is the average number of days required to convert receivables into cash. A low number of days is desirable. Days Inventory Held Definition: The days inventory held is the average number of days it takes to sell inventory to customers. A low number of days is usually a sign of efficient management.

10 C. Liquidity Ratios Days Payable Outstanding Definition: The days payable outstanding is the average number of days it takes to pay payables in cash. Net Trade Cycle Definition: The net trade cycle measures the number of days the company needs to generate cash from its current assets.

11 D. Asset Management Ratios Asset management ratios measure the ability of assets to generate revenues or earnings. It helps to understand the overall level of efficiency at which a business is performing. Accounts Receivable Turnover Accounts Receivable Turnover Inventory Turnover Inventory Turnover Accounts Payable Turnover Accounts Payable Turnover Asset Turnover Asset Turnover

12 D. Asset Management Ratios Accounts Receivable Turnover Ratio Definition: Accounts receivable turnover measures the number of times we were able to convert our receivables over into cash. Higher turnover ratios are desirable Inventory Turnover Ratio Definition: Inventory turnover measures how many times did the company turn its inventory over during the year. Higher turnover => inventories are highly marketable.

13 D. Asset Management Ratios Accounts Payable Turnover Ratio Definition: Accounts payable turnover expresses the number of times we were able to convert our payables over into cash. Higher ratios are desirable. Asset Turnover Ratio Definition: Asset turnover ratio measures the overall efficiency of the business – the percent of sales the company is able to generate from its assets.

14 E. Leverage/Gearing Ratios Leverage ratios measure the use of debt and equity for financing of assets. Financial Leverage Ratio Financial Leverage Ratio Debt to Equity Ratio Debt to Equity Ratio Debt to Assets Ratio Debt to Assets Ratio Equity to Assets Ratio Equity to Assets Ratio Debt Payout Ratio Debt Payout Ratio Cash Flow Adequacy Cash Flow Adequacy

15 E. Leverage/Gearing Ratios Financial Leverage Ratio Definition: Financial leverage ratio is a measure of how much the company uses equity and debt to finance its assets. As debt increases, financial leverage increases. Debt to Equity Ratio Definition: Debt to equity is the ratio which compares the funds provided by the creditors with the funds provided by the shareholders.

16 E. Leverage/Gearing Ratios Debt to Assets Ratio Definition: The Debt to assets ratio measures the level of debt in relation to the company’s investment in assets. Tells the company the percent of funds provided by creditors and to what extent the company’s assets protect it from creditors. Equity to Assets Ratio Definition: Equity to assets ratio is the ratio which compares the funds provided by shareholders with the company’s assets.

17 E. Leverage/Gearing Ratios Debt Payout Ratio Definition: The Debt payout ratio represents the number of years it would take to reduce the debt level to zero if all the income of a company could be directed towards debt reduction. Very useful in trend analysis. If the trend is upward, this implies that the debt load is increasing at a greater rate than income. Cash Flow Adequacy Credit rating agencies often use cash flow adequacy ratios to evaluate how well a company can cover annual payments of items such as debt, capital expenditures, and dividends from operating cash flow.

18 F. Profitability Ratios Profitability ratios measure the level of earnings in comparison to a base, such as assets, sales or capital. Return on Equity Return on Equity Profit Margin Profit Margin Return on Assets Return on Assets Return on Equity Definition: Return on Equity is a measure of how well management has used the capital invested by shareholders. Cash Flow Margin Cash Flow Margin Cash Return on Assets Cash Return on Assets

19 F. Profitability Ratios Profit Margin Definition: Profit margin measures the percent of profits you generate for each monetary unit of sales. Operating profit margin ratio (trading margin) compares the operating profit obtained by the company with the turnover. Gross profit margin compares the gross profit obtained by the company with the turnover. The Net profit margin ratio tells us the amount of net profit per one monetary unit of turnover a business has earned.

20 F. Profitability Ratios Return on Total Assets Definition: Return on total assets (ROTA) measures the net income returned on each monetary unit of assets.

21 F. Profitability Ratios Cash Flow Margin Definition: The cash flow margin measures the ability of the firm to translate sales into cash. Cash Return on Assets The relationship between cash generated from operations and an accrual- based number allows the analyst to measure the firm's cash generating ability of assets.

22 G. Financial Efficiency Ratios Ratios in this category are designed to measure a company’s ability to generate revenues and control costs. Operating Expenses Ratio Operating Expenses Ratio Interest Expense Ratio Interest Expense Ratio Operating Expenses Ratio Definition: The Operating expenses ratio represents the percentage of operating expenses that will consume every monetary unit of revenue. Interest Expense Ratio Definition: The interest expense ratio relates the interest expense to a company’s ability to generate income.

23 H. Market Value Ratios These ratios attempt to measure the economic status of the organization within the marketplace. Earnings per Share Earnings per Share Price to Earnings Ration (P/E ratio) Price to Earnings Ration (P/E ratio) Dividend Yield Dividend Yield Earnings per Share Definition: The EPS expresses the earnings of a company on a “per share” basis. A high EPS in comparison with other competing firms is desirable.

24 H. Market Value Ratios Dividend Yield Definition: The percentage of dividends paid to shareholders in relation to the price of the stock is called the Dividend Yield. Price to Earnings Ratio Definition: The relationship of the price of the stock in relation to EPS is expressed as the Price to Earnings ratio or P/E ratio.

25 I. Limitations of Ratios Ratios are most useful on a comparative basis. They indicate trends rather than momentary states and should be viewed in a time series. Interpretation is Necessary Interpretation is Necessary ratios should always be interpreted in the light of individual circumstances ratios should always be interpreted in the light of individual circumstances Standards for Compensation are needed Standards for Compensation are needed since each agency has its own way of constructing ratios, it is useful to verify whether the published data are relevant since each agency has its own way of constructing ratios, it is useful to verify whether the published data are relevant Beware of Different Accounting Policies Beware of Different Accounting Policies the ratios derived from balance sheets will reflect differences in accounting practices such as depreciation, government grants, R&D, etc. the ratios derived from balance sheets will reflect differences in accounting practices such as depreciation, government grants, R&D, etc. The Value of Money and/or Prices will change over Time The Value of Money and/or Prices will change over Time current and past values may vary current and past values may vary Ratios cannot Predict the Future Ratios cannot Predict the Future

26 J. Benchmarks for Financial Ratio Analysis

27 K. Z-Score – Predicting Bankruptcy The Z-Score formula of Edward Altman is a multivariate formula for a measurement of the financial health of a company and a powerful diagnostic tool that forecasts the probability of a company entering bankruptcy within a 2 year period. It combines five common business ratios. Bankruptcy is not likely for: Original Z-Score (for Public Manufacturer) – Score >= 3.0 Original Z-Score (for Public Manufacturer) – Score >= 3.0 Model A Z-Score (for Private Manufacturer) – Score >= 2.9 Model A Z-Score (for Private Manufacturer) – Score >= 2.9 Mode B Z-Score (for Private General Firm) – Score >= 2.6 Mode B Z-Score (for Private General Firm) – Score >= 2.6