1. FIN 422: Student Managed Investment Fund
Topic 6: Ratio Analysis
Larry Schrenk, Instructor

2. Overview Methodology Ratio Classification DuPont Equation
Ratio Applications

3. Learning Objectives @

4. Readings @

5. 1. Methodology

6. Purpose Ratio analysis begins
With the calculation of a set of financial ratios
Designed to show the relative strengths and
Weaknesses of a company as compared to
Other firms in the industry
Leadings firms in the industry
The previous year of the same firm
Ratio analysis helps to show whether the firm’s position has been improving or deteriorating
Ratio analysis can also help plan for the future

7. My Principles Consider the Perspective Toolbox Approach Annualization
Anomalies/Accounting Numbers
Red Flags
Customized Ratios
No Rules

8. 2. Ratio Classification

9. Classification Short-Term Solvency (Liquidity)
Long-Term Solvency (Leverage)
Efficiency
Profitability
Market Value

10. 2.A Short-Term Solvency

11. Short-Term Solvency: Analysis
Form
Purpose
Short-Term Liquidity
Can the Firm Meet Current Obligations?
A liquid asset is one that can be easily converted into cash at a fair market value

12. Short-Term Solvency: The Ratios
Cash Ratio
Quick Ratio
Current Ratio

13. Short-Term Solvency: Walmart
Cash Ratio
Quick Ratio
Current Ratio

14. Short-Term Solvency: Net Working Capital
Net Working Capital as % of Total Assets

15. Short-Term Solvency: Walmart
Net Working Capital
Net Working Capital as % of Total Assets

16. Liquidity Ratio Analysis
Liquidity–Ability to Convert Assets to Cash with Significant Loss of Value
Differing Time Horizons for Liquidity
Cash Ratio???
Quick Ratio???
Current Ratio???

17. 2.B Long-Term Solvency

18. Long-Term Solvency Measures of the Long-Term Viability of the Firm
Two Metrics
Degree of Leverage
Coverage

19. Long-Term Solvency: Degree of Leverage Analysis
Form
Purpose
Long-Term Liquidity
Is the Total Amount of Debt Reasonable?
Can the Firm Remain Solvent?

20. Long-Term Solvency: Degree of Leverage Analysis
Implications of use of borrowings
Creditors look to stockholders’ equity as a safety margin
Interest on borrowings is a legal liability of the firm
Interest is to be paid out of operating income
Debt magnifies return and risk to common stockholders

21. Long-Term Solvency: Degree of Leverage Ratios
Total Debt to Total Assets Ratio
Measures percentage of assets being financed through borrowings
Too high a number means increased risk of bankruptcy
Leverage
What percentage of total assets are being financed through equity?

22. Long-Term Solvency: Degree of Leverage Ratios
Total Debt Ratio
Debt/Equity Ratio
Equity Multiplier

23. Long-Term Solvency: Walmart
Total Debt Ratio
Debt/Equity Ratio
Equity Multiplier

24. Long-Term Solvency: Degree of Leverage Ratios
Conversions

25. Long-Term Solvency: Degree of Leverage Ratios
LT Debt Ratio
NOTE: Excludes current liabilities

26. Long-Term Solvency: Walmart
LT Debt Ratio

27. Long-Term Solvency: Coverage Analysis
Form
Purpose
Short-Term Liquidity
Can the Firm Service its Long-Term Obligations?
Is Bankruptcy a Concern?

28. Long-Term Solvency: Coverage Ratios
Times Earned Interest (TIE)
Measure the extent to which operating income can decline before the firm is unable to meet its annual interest costs
Failure to pay interest can result in legal action by creditors with possible bankruptcy for the firm

29. Long-Term Solvency: Coverage Ratios
Times Interest Earned (TIE)
Cash Coverage

30. Long-Term Solvency: Walmart
Times Interest Earned (TIE)
Cash Coverage

31. 2.C Efficiency

32. Efficiency: Analysis Form Purpose
How Efficiently does the Firm Use the Value Invested in each Asset?
Balance Sheet Assets as Portfolio
Liquidity-Return Trade-Off
Turnover versus ‘Days Sales’
Do we have too much investment in assets or too little investment in assets in view of current and projected sales levels?
Assets as a portfolio

33. Turnover Analysis Sales as Goal Example
Total Asset Turnover Ratio–Sales versus a Dollar Spend on Total Assets
Example
Total Asset Turnover Ratio = 5x
$1.00 in Assets Generates $5.00 in Sales on Average.

34. Efficiency: The Inventory Ratios
Inventory Turnover Ratio
Measures the efficiency of Inventory Management
A high ratio indicates that inventory does not remain in warehouses or on shelves, but rather turns over rapidly into sales
Two cautions
Market prices for sales and inventories at cost
Sales over the year and inventory at the end of the year

35. Efficiency: The Inventory Ratios
Inventory Turnover
Days’ Sales in Inventory

36. Efficiency: Walmart
Inventory Turnover
Days’ Sales in Inventory

37. Efficiency: The Receivables Ratios
Days Sales Outstanding (DSO)
To appraise the quality of accounts receivables
Average length of time that the firm must wait after making a sale before receiving cash from customers
Measures effectiveness of a firm credit policy
Indicates the level of investment needed in receivables to maintain firm’s sales level

38. Efficiency: The Receivables Ratios
Receivables Turnover
Days’ Sales in Receivables

39. Efficiency: Walmart
Receivables Turnover
Days’ Sales in Receivables

40. Efficiency: The Asset Ratios
Fixed Assets Turnover Ratio
Measures efficiency of long-term capital investment
How effectively a firm is using its plant and machinery to generate sales?
How much fixed assets are needed to achieve a particular level of sales?

41. Efficiency: The Asset Ratios
Total Asset Turnover Ratio
Measure efficiency of total assets for the company as a whole or for a division of the firm
Core competency

42. Efficiency: The Asset Ratios
Total Asset Turnover
Fixed Asset Turnover

43. Efficiency: Walmart
Total Asset Turnover
Fixed Asset Turnover

44. Customized Efficiency Ratios
Denominator
Any Balance Sheet Asset
Numerator
Any Firm Goal

45. 2.D Profitability

46. Profitability: Analysis
Form
Purpose
Is the Firm Generating Reasonable Earnings Relative to
Total Assets
Equity
NOTE: Accounting Measures

47. Profitability: Analysis
Net result of a number of policies and decisions
Show the combined effect of liquidity, asset management, and debt management on operating results

48. Profit Margins vs. Return Ratios
Profit margins look at profits or earnings as a fraction of sales.
Return ratios measure profits earned as a fraction of the assets used.

49. Profitability: The Margins
Net Profit Margin
Gross Profit Margin
Operating Gross Profit Margin

50. The Margins: Walmart
Net Profit Margin
Gross Profit Margin

51. Profit Margins: Walmart
Operating Gross Profit Margin

52. Profitability: The Ratios
Return on Assets (ROA)
Return on Equity (ROE)
NOTE: Book Values

53. Return Ratios: Walmart
Return on Assets (ROA)
Return on Equity (ROE)

54. T-S-P
You are considering investing in the bonds of a firm. Which ratio is the most important for your decision:
Current Ratio
Long-Term Debt Ratio
TIE Ratio
Cash Coverage Ratio

55. 2.E Market Value Ratios

56. Market Value: Analysis
No Common Form
No Common Purpose
Commonality: Market Data

57. Market Value: Analysis
PE Ratio

58. PE Ratio: Walmart
Share Price (9/27/18) $94.93
PE Ratio

59. Market Value: Analysis
Market-to-Book Ratio

60. Market-to-Book Ratio: Walmart

61. 3. DuPont Equation

62. The Du Pont System
DuPont Equation (ROE)

63. Du Pont Equation: Walmart

64. DuPont Equations: Analysis
Decomposition
Analysis, Not Calculation

65. The Du Pont System
DuPont Equation (ROA)

66. Du Pont Equation: Walmart

67. Extending the DuPont Equation

68. The Du Pont System
Isberg Paper

69. 4. Ratio Application

70. Comparisons Time-Trend Analysis Peer Group Analysis Forecasting
Firm’s Performance over Time
Peer Group Analysis
Similar Companies or Industry Analysis
Forecasting
Future Ratios
Next Topic

71. Walmart: Time-Trend and Peer Analysis
Note: This section uses Compustat annual data rather than EDGAR quarterly data, so the ratios may not agree with the earlier calculations

72. Time-Trend and Peer Analysis Current Ratio

73. Time-Trend and Peer Analysis Total Debt Ratio

74. Time-Trend and Peer Analysis Times Interest Earned

75. Time-Trend and Peer Analysis Total Asset Turnover

76. Time-Trend and Peer Analysis ROA

77. Time-Trend and Peer Analysis ROE

78. Some Cautions No Underlying Theory Diversified Firms Globalization
Varying Accounting Procedures
Different Fiscal Years
Developing/Using Comparative Data
Notes to Financial Statements
Interpretation of Results
Window Dressing
Effects of Inflation
Comparison with industry averages is difficult if the firm operates many different divisions.
‘Average’ performance is not necessarily good.
Seasonal factors can distort ratios