Ratio Analysis Chapter 6 Robinson, Munter, Grant

Grant, Munter & Robinson Chapter 62 Learning Objectives Identify situations in which ratio analysis is useful Understand the purpose of ratio analysis Calculate specific ratios Recognize limitations of accounting data in ratio analysis

Grant, Munter & Robinson Chapter 63 Ratio Analysis Cross-sectional and time series analysis Controls for size differences Controls for currency differences Evaluate related components of different financial statements simultaneously Ratios are easily (and commonly) modified

Grant, Munter & Robinson Chapter 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)

Grant, Munter & Robinson Chapter 65 Activity Ratios How day-to-day operations function Inventory management Inventory Turnover –Compares income statement and balance sheet amounts –Must 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?

Grant, Munter & Robinson Chapter 66 Activity Ratios Critical operating cash accounts Accounts receivable turnover –How many times a credit sale is made and subsequently collected –[credit sales/average accounts receivable] –May have to use total sales rather than credit sales –Consistency is important Days receivable –Number of days between the charge sale and collection –[365/accounts receivable turnover]

Grant, Munter & Robinson Chapter 67 Activity Ratios Critical operating cash accounts Accounts payable turnover –Number of times a credit purchase is made and subsequently paid –[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]

Grant, Munter & Robinson Chapter 68 Activity Ratios Cash Cycle Also a measure of liquidity If low, small number of days in operating cycle to finance [Days inventory + Days receivable - Days payable]

Grant, Munter & Robinson Chapter 69 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]

Grant, Munter & Robinson Chapter 610 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]

Grant, Munter & Robinson Chapter 611 Liquidity Ratios Defensive interval ratio –Compare 1 day’s costs to quick assets –[((COGS+SGA+RD)/365)/(Cash+short-term investments + A/R)] For Motorola, defensive interval =.0075 –COGS = 21,445 –SG&A = 3,703 –R&D = 4,318 –Quick assets = 10,745 (6, ,583)

Grant, Munter & Robinson Chapter 612 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

Grant, Munter & Robinson Chapter 613 Solvency Ratios Debt to equity: Total liabilities/Total equity –A measure of how assets are financed Or… (current debt + noncurrent debt)/Total equity –Examine relative sizes of debt and equity financing Capitalization ratio: [(current debt+noncurrent debt)/ (current debt+noncurrent debt+total equity)]

Grant, Munter & Robinson Chapter 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) Cash interest coverage –(Cash from ops + interest paid + tax paid)/Interest paid

Grant, Munter & Robinson Chapter 615 Solvency Ratios Coverage Ratios Target a specific expense –[(EBIT+Rent expense)/(Interest expense+rent expense)] Target principal on debt that is about to be repaid –[EBIT/(interest expense + principal payments)]

Grant, Munter & Robinson Chapter 616 Profitability Ratios Common-size From chapter 5… Income statement –Divide item of interest by sales –ROS = Net income/Sales revenue –Gross margin = Gross profit/Sales revenue Balance sheet –Divide item of interest by total assets

Grant, Munter & Robinson Chapter 617 Profitability Ratios Return Ratios ROA = Net income/Average total assets Or, [(Net income + After-tax interest expense)/Average total assets] Also, [EBIT/Average total assets] reflects pre-tax, pre-interest return

Grant, Munter & Robinson Chapter 618 Profitability Ratios Return Ratios ROE = Net income/Average total equity –Return generated relative to the capital provided by the owners over time Or, if firm has preferred stock [(Net income – Prfd dividends)/Average total common equity] ROMVE = Net income/Market value of equity

Grant, Munter & Robinson Chapter 619 Cash Flow Ratios Quality of earnings Ability to pay obligations –CFO/Total liabilities –CFO = Cash flows from operations Profitability (cash flow relative to sales) –CFO/Sales revenue Cash return on assets –CFO/Average total assets

Grant, Munter & Robinson Chapter 620 Cash Flow Ratios Quality of earnings Cash flow-earnings index –CFO/Net income Free cash flow ratio –CFO/Capital expenditures –If ratio>1, free cash flow exists

Grant, Munter & Robinson Chapter 621 Price Multiple Ratios Market’s valuation of a firm’s common stock –P/E = Share price/Earnings per share Price/book ratio compares stock’s price to the recorded value of the net assets [Share price/(Book value of equity/Share outstanding)] Price/sales = Share price/Sales per share Also, compare price to cash flow per share

Grant, Munter & Robinson Chapter 622 Ratio Integration DuPont analysis (decomposition) ROE = ROA x Leverage And more…

Grant, Munter & Robinson Chapter 623 Ratio Integration ROA = Profitability x Turnover

Grant, Munter & Robinson Chapter 624 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

Grant, Munter & Robinson Chapter 625 Activity Ratios Inventory Turns MOT NOK A/R Turns MOT NOK

Grant, Munter & Robinson Chapter 626 Liquidity Ratios Current ratio MOT NOK Quick ratio MOT NOK

Grant, Munter & Robinson Chapter 627 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

Grant, Munter & Robinson Chapter 628 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%

Grant, Munter & Robinson Chapter 629 Limitations to consider Historical cost of balance sheet items GAAP vs. IAS rules Accounting method differences –LIFO vs. FIFO inventory valuation

Grant, Munter & Robinson Chapter 630 Summary Calculate ratios Decompose and interpret results Understand limitations of ratio analysis