Ratio Analysis Chapter 6

Ch 62 Chapter 6 homework problems, P6-2, 3, 8, 10, 14, 16-19, are still required.

Ch 63 Ratio Analysis Cross-sectional and time series analysis Controls for size differences Controls for currency differences Ratios are easily (and commonly) modified Focus on p17-19.

Ch 64 Ratio Analysis Categories Activity (operations and asset management) Liquidity (meeting short-term obligations) Solvency (meeting long-term obligations) Profitability (earnings and cost coverage) Cash Flow (quality of earnings) Price Multiples (stock price)

Ch 65 Activity Ratios How day-to-day operations function Inventory management Inventory Turnover –Compares income statement and balance sheet amounts –Usually average balance sheet figures ((Beg + End)/2) –Turnover = COGS/Average total inventory Days inventory = 365/Turnover –How many days was inventory held before being sold?

Ch 66 Activity Ratios Accounts receivable turnover –How many times a credit sale is made and subsequently collected during one year –[credit sales/average accounts receivable] –May have to use total sales rather than credit sales –Consistency is important Days receivable –Number of days between sales and collection –[365/accounts receivable turnover]

Ch 67 Source: Dun & Bradstreet

Ch 68 Activity Ratios Accounts payable turnover –Number of times a credit purchase is made and subsequently paid during one year –[credit purchases/average accounts payable] –Often assume all purchases are on credit –Purchases = [COGS + Ending Inv. - Beginning Inv.] Days payable –Number of days between credit purchase and payment –[365/accounts payable turnover]

Ch 69 Activity Ratios Cash Cycle Also a measure of liquidity If cash cycle is low, it means small number of days in operating cycle to finance [Days inventory + Days receivable - Days payable]

Ch 610 Activity Ratios Asset Turnover Long-term –Revenues generated by long-term assets –[Sales revenue/Average noncurrent assets] Total assets –Efficiency of generating revenues given total assets –[Sales revenue/Average total assets]

Ch 611 Liquidity Ratios Current ratio –Ability to meet short-term obligations –[Current assets/current liabilities] Quick ratio –Remove less liquid assets –Keep cash, liquid investments, A/R –[(Current assets-inventory-ppd expenses-other)/current liabilities] –[(Cash+short-term investments + A/R)/current liabilities]

Ch 612 Source: Dun & Bradstreet (Cash + Account Receivables/Current Liabilities)

Ch 613 Solvency Ratios Debt to assets: Total liabilities/Total assets –Proportion of assets financed with debt Could include interest bearing debt only [(short term debt + noncurrent debt)/total assets] Be aware that assets are recorded at historical cost, which may be different from current market value

Ch 614 Solvency Ratios Coverage Ratios Adequacy of resources for meeting firm’s contractual obligations Times interest earned –Can the firm cover its interest obligations? –(EBIT/Interest expense)

Ch 615 Profitability Ratios Return Ratios ROA = Net income/Average total assets ROE = Net income/Average total equity –Return generated relative to the capital provided by the owners over time

Ch 616 Price Multiple Ratios Market’s valuation of a firm’s common stock –P/E = Share price/Earnings per share –Value stock (low P/E) vs growth stock (high P/E) Price/book ratio compares stock’s price to the recorded value of the net assets [Share price/(Book value of equity/Share outstanding)]

Ch 617 ROA = Profitability x Turnover

Ch 618

Ch 619 Ratio Integration DuPont analysis (decomposition) ROE = ROA x Leverage ROE = PM x Asset Turnover x Leverage

Ch 620 Analysis Generally compare 3-5 years Requires 4-6 years of data –Balance sheet numbers may be averaged Compare Motorola and Nokia –Activity –Liquidity –Solvency –Profitability

Ch 621 Activity Ratios Inventory Turns MOT NOK A/R Turns MOT NOK

Ch 622 Liquidity Ratios Current ratio MOT NOK Quick ratio MOT NOK

Ch 623 Solvency Ratios Debt-to-assets MOT57.6%54.9%52.6%57.5% NOK44.7%44.8%47.5%48.5% Times interest earned MOT NOK

Ch 624 Profitability Ratios ROA MOT-10.4%3.2%2.6%-3.4% NOK10.4%23.1%21.2%20.5% ROE MOT-23.7%6.9%5.7%-7.6% NOK18.8%42.6%40.7%

Ch 625 Technical issues in calculating financial ratios Small or zero denominators –if the denominator of the financial ratio has a value of zero, the ratio can’t be calculated. –if the value of the denominator is close to zero, the resulting value of the financial ratio is close to infinity –if the denominator fluctuates a lot across years of firms, the values of the resulting ratios fluctuate a lot, too

Ch 626 Sources for Industry Ratios Electronic Sources Free: BizStats.com provides information about ratios and benchmarks and statistics for various manufacturing and service industries. MSN Money - Key Ratios MSN Money provides company and industry ratios; search by company name or ticker symbol.MSN Money - Key Ratios Need to pay:

Ch 627 Most of these printed sources are published annually Almanac of Business and Industrial Financial Ratios. Prentice Hall. Lists 24 key financial ratios for 180 industries based on IRS data. Business Profitability Data. Covers 294 types of small business, listing source and use of capital, sales and income, profitability versus assets, profitability trend and risks; arranged by type of business. Industry Norms and Key Business Ratios. Dun and Bradstreet. Covers over 800 lines of business, arranged by SIC code. Presents "typical" balance sheets and income statements for the industry and 14 key ratios for the median, upper, and lower quartiles.SIC code RMA Annual Statement Studies. Robert Morris Associates. Gives current and historical data for 370 industry groups collected from annual financial statements of firms. Data is presented by size of firm in assets and in sales. Lists sources for additional data