Ratio Analysis Financial Analysis

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What is Ratio Analysis? Ratio- a comparison of two numbers Ratio analysis- a tool businesses use to identify possible problems as well as opportunities Copyright © Texas Education Agency, All rights reserved. 3

Types of Financial Ratios Type of RatioDefinition LiquidityHow well a company can pay off short-term loan obligations and meet cash needs EfficiencyHow effectively a company utilizes its resources to generate revenue LeverageShows how a company’s assets are financed ProfitabilityMeasures the ability of a business’s resources to generate income that results in a profit StockAlso called value or investor ratios, examines different aspects of a company’s stock Copyright © Texas Education Agency, All rights reserved. 4

What is Liquidity and Why is it Important? Liquidity- measures how quickly assets can be converted to cash Can determine how easily a company can meet its debt obligations Copyright © Texas Education Agency, All rights reserved. 5

Liquidity Ratios RatioFormula Working Capital- shows what is left after all liabilities are paid by the assets = Current Assets – Current Liabilities Current Ratio- shows the dollar value of assets for each dollar of liabilities = Total Current Assets/Total Current Liabilities Quick Ratio- determines the ability to meet short-term debt obligations = (Total Current Assets – Inventories)/Total Current Liabilities Copyright © Texas Education Agency, All rights reserved. 6

What is Efficiency and Why is it Important? Efficiency refers to how well assets and liabilities are managed. These ratios are important because the focus is on management. Copyright © Texas Education Agency, All rights reserved. 7

Efficiency Ratios RatioFormula Average collection period- how efficiently a company’s accounts receivables (or credit accounts) are handled = Average Accounts Receivable / (Total Sales / 365) Inventory ratios- tells how often inventory is sold; too high a ratio can lead to high storage costs 1) Inventory turnover = Cost of Goods Sold / Average Inventory 2) Average days to sell inventory = Days in a Year / Inventory Turnover Total Asset Turnover- how much a dollar of assets generates in sales = Sales / Average Total Assets Accounts Receivable Turnover– the average number of times accounts receivable is collected in a time period = Sales on Account / Average Receivables Copyright © Texas Education Agency, All rights reserved. 8

What is Leverage and Why is it Important? Leverage is how much debt is used to finance an asset. It can cause a company to run the risk of bankruptcy if there is too much debt that cannot be repaid. Copyright © Texas Education Agency, All rights reserved. 9

Leverage Ratios RatioFormula Debt to assets- measures the degree of financing of assets = Total Debt/Total Assets Debt to equity- measures the amount of debt financed by every dollar of equity; the higher the ratio the higher the risk to possible investors or creditors = Total Debt/Total Equity Copyright © Texas Education Agency, All rights reserved. 10

What is Profitability and Why is it Important? Profitability is sales minus the costs associated with the goods or services sold. Its importance is that making a profit is the most prominent goal of most businesses. Copyright © Texas Education Agency, All rights reserved. 11

Profitability Ratios RatioFormula Net profit margin- measures how well the cost of goods sold is controlled, as well as the operating expenses = Profit after taxes / Sales Return on investment- represents the amount of profit as it relates to the owner’s investment =Net income / Owner’s Equity Return on equity– measures % of profit earned on the stockholder’s investment = Profit after taxes / Stockholder’s Equity Return on assets– measures the profit earned from the assets of the company = Profit after taxes / Total Assets Copyright © Texas Education Agency, All rights reserved. 12

What are Investor Ratios and Why are they Important? Also referred to as ratios that affect stock Companies raise funds by issuing stock Stockholders are concerned with how well a company is performing Dividends are paid from profits, so stockholders are concerned with earnings Copyright © Texas Education Agency, All rights reserved. 13

Investor Ratios RatioFormula Earnings per share– the amount of net income that belongs to one share of stock = Net Income/Outstanding Shares Price-earnings ratio– measures the amount investors are willing to pay for every dollar of profit = Current Market Price per Share / After-tax Earnings per Share Dividend yield– measures the return paid as dividends to stockholders = Annual Dividends per Share / Current Market Price per Share Copyright © Texas Education Agency, All rights reserved. 14

Ratio Demo ABC Corporation Comparative Balance Sheet December 31, 2010 and 2011 Assets Current Assets: Cash$ 7,000$6,500 Accounts Receivable Supplies Prepaid Insurance 39,000 3,500 4,000 25,000 5,000 3,700 Total Current Assets$53,500$40,200 Property, Plant, and Equipment: Land40,00054,475 Buildings95,000112,000 Equipment30,00017,000 Total Property, Plant, and Equipment 165,000183,475 Total Assets$218,500$223,675 Liabilities and Stockholder’s Equity Current Liabilities Accounts Payable Salaries Payable Total Current Liabilities Long-Term Liabilities Mortgage Payable Bonds Payable Total Long-Term Liabilities $9,000 17,000 26,000 70,000 32, ,000 11,300 16,500 27,800 79,100 34, ,275 Total Liabilities128,000141,075 Stockholder’s Equity Capital Stock Retained Earnings Total Stockholder’s Equity 65,000 25,500 90,500 54,000 28,600 82,600 Total Liabilities and Stockholder’s Equity$218,500$223,675 Current Ratio = 53,500/26,000 = 2.06 Debt to Equity= 128,000/90,500 = 1.41 Copyright © Texas Education Agency, All rights reserved. 15

Graphing Ratios Sunshine Corp Current Ratio Quick Ratio Copyright © Texas Education Agency, All rights reserved. 16

Independent Practice Assignments Company Comparison Chart Assignment #1 – Students will select two companies for comparison. They will prepare a chart or table (using either a spreadsheet program or a word processing program). They will list the five categories of ratios with two ratios each on the left side and the top row listing the two chosen companies with three years of ratios calculated for each. One observation about the change over the years for each company as well as one conclusion or prediction must be included for each ratio. Following is a sample setup for this chart: Ratio Gameboard Assignment #2 – In pairs, students will create a gameboard of at least 20 spaces summarizing their understanding of ratios. There may only be five free or blank spaces. The remaining 15 should include facts and/or figures related to ratio analysis. For example, a space could have a definition, significance, or formula for current assets. If it is correct, the student could roll a die and move forward that many spaces. If the space has false information, the student has to give the correct answer or roll the die and move backward that many spaces. Students can create any type of gameboard they want as long as it is creative, entertaining, and contains at least 15 facts about ratios. Motorola Analysis Assignment #3 – Using the website (referenced above) called, “The Case of Motorola,” the students will each read the Financial Ratio Analysis section of the document to look for explanations of at least five different ratios. The students will discuss the implications of what the results, whether they are higher than their industry or lower than their industry, actually mean. For example, the Fixed Asset Turnover ratio is higher than the Semiconductor Industry ratio, meaning that Motorola is using its assets to generate sales more resourcefully than the industry. They should include at least five ratios in their discussion of the implications of what they mean. Students will create a one- to two-page report to detail their findings.