1. GEK2507 1 Compound & Prosper GEK2507 Frederick H. Willeboordse phyfhw@nus.edu.sg

2. GEK2507 2 Financial Ratios Lecture 5

3. GEK2507 3 Excel Liquidity Ratios Efficiency Ratios Leverage Ratios Profitability Ratios Today’s Lecture

4. GEK2507 4 Excel Basics – DB Syntax: Note that generally speaking, round-off errors in Excel mean that a small sum is left to be depreciated in the last year. We need to add this manually!

5. GEK2507 5 Excel Basics – DB Depreciation 30.1% This method is useful for items like computer etc. Depreciation 30.1% Each year, the rate of depreciation is the same.

6. GEK2507 6 Excel Basics – DDB The Double declining balance depreciation function is similar to the DB function but the rate of depreciation is faster. Note that due to the way the depreciation rate is determined, the depreciation in the last year is zero in this example. Double refers to double the amount of a straight line depreciation to zero here. Depreciation 40% Syntax:

7. GEK2507 7 Excel Basics – SLN Straight line depreciation. Straight line depreciation is good for items that keep their values reasonably well or for items that have a clear economic life span like certain factories. Syntax:

8. GEK2507 8 Excel Basics – VDB Variable Declining Balance Note how the depreciation switches from declining balance to straight line at this point. This happens when the SLN of the remaining amount is larger than the DDB. Syntax: Depreciation 20% Fixed Depreciation

9. GEK2507 9 Excel Basics – DDB Compare this to the previous slide. After 7 years, the amount remaining to be depreciated is $2,517-$1,000 = $1,517. With SLN over the remaining 3 years this would mean $1,517/3 = $506 of depreciation per year. This is indeed bigger than the $503 that one gets by continuing with the DDB. Depreciation 20% Let us consider the same example with the DDB function

10. GEK2507 10 Current Ratio Quick Ratio Liquidity is a measure of how quickly an asset can be converted to cash. E.g.Accounts receivable = quite liquid Building = not very liquid There are two important liquidity ratios: Liquidity Ratios

11. GEK2507 11 Current Ratio: Under normal circumstances, a company will pay its current liabilities (bills due) with its current assets. The ratio between the two is therefore a good indicator for how well a company can pay its bills. Current Ratio = Current Assets Current Liabilities Liquidity Ratios

12. GEK2507 12 Current Ratio: A high current ratio means that the company should more easily be able to pay its bills. So that’s good to know if the company owes you money. But … if you’re an investor, too high a current ratio could mean that the company is not using its assets optimally. Think a bit of it like water in a lake. Good to have some, bad to have none and so-so to have too much. Liquidity Ratios

13. GEK2507 13 Current Ratio: Most successful businesses have a current ratio of about 1.5 – 2.0. Let’s have a look at the Balance Sheet of Lecture 2 again and add the current ratio. Liquidity Ratios

14. GEK2507 14 Pretty good! Adding Ratios

15. GEK2507 15 Quick Ratio: While inventories are necessary for many businesses, they may at times be difficult to sell rapidly. It is therefore useful to also consider a current ratio that takes out inventory from the Current Assets. Quick Ratio = Current Assets - Inventories Current Liabilities Liquidity Ratios

16. GEK2507 16 Quick Ratio: The quick ratio is sometimes called acid-test ratio. In general, a quick ratio of 1 is considered safe, but in some industries it may be much lower, e.g. in the car industry, 0.2 is common. Let us enter this into the Balance Sheet as well… Liquidity Ratios

17. GEK2507 17 Pretty good too! Adding Ratios

18. GEK2507 18 As indicated by the name, efficiency ratios indicate how efficient a company is in its operation. Two of the most useful “turnover” ratios are: Efficiency Ratios Inventory Turnover Ratio Total Asset Turnover Ratio

19. GEK2507 19 Inventory Turnover Ratio The inventory turnover ratio indicates how many times the inventory is ‘turned over’ in one year. In other words, it shows how quickly inventory can be sold. Inventory Turnover Ratio Cost of Goods Sold Inventory = Actually, it would be better to replace Inventory with Average Inventory (defined as beginning inventory + ending inventory)/2. Efficiency Ratios

20. GEK2507 20 Inventory Turnover Ratio Let us apply this to our Balance Sheet again. Only … the Cost of Goods sold are not on the Balance Sheet. We need to get this item from the Income Statement in Lecture one. In general, a higher Inventory Turnover Rate is good but the number may differ greatly per industry. Dell, e.g, is somewhere above 40 but to many around 4 would already be good. Efficiency Ratios

21. GEK2507 21 Quite meager! But! What happened here??? Adding Ratios

22. GEK2507 22 Excel can have several named worksheets. A worksheet is basically a spreadsheet on a single page with a name. This means that we can avoid making a complicated single page spreadsheet with an area for the Balance Sheet, and area for the Income Statement and so on. Instead, we can make a separate worksheet for each. In the previous slide, I have added the Income Statement from Lecture 1 as a second worksheet. Cells from other worksheets can be referred to by using the ! mark. Interlude – Excel Worksheets

23. GEK2507 23 Total Asset Turnover Ratio The Total Asset Turnover Ratio shows how well a company is able to generate sales (and hence hopefully profits) from the assets it owns. It is defined as: Asset Turnover Ratio Sales Total Assets = Again we need to get the Sales from the Income Statement Efficiency Ratios

24. GEK2507 24 Ouch!? Adding Ratios

25. GEK2507 25 Leverage in business refers to how much debt a company uses to finance its operations. The idea is that if a company can borrow money at say 7% and then use this money to make a 27% profit, it’s clever to take out the loan. Two of the most important leverage ratios are: Leverage Ratios Total Debt Ratio Debt to Equity Ratio

26. GEK2507 26 Total Debt Ratio The Total Debt Ratio shows how much of a company’s assets are financed through loans. It is defined as: Total Debt Ratio Total Debt Total Assets = Leverage Ratios

27. GEK2507 27 Total Debt Ratio In general, a low Total Debt Ratio is good with the critical number being 1. Smaller than one means that the company has more assets than debts. Vice versa, larger than one mean that the company has more debts than assets. If this is the case you’d better hope they will not go out of business … Leverage Ratios

28. GEK2507 28 So so.. Adding Ratios

29. GEK2507 29 Debt to Equity Ratio A favorite with many investors. It is similar to the Total Debt Ratio, but rather than dividing by the Total Assets, the Total Debt is divided by the Total Equity. It is defined as: Debt Equity Ratio Total Debt Total Equity = Leverage Ratios

30. GEK2507 30 Debt Equity Ratio As with the Total Debt Ratio, a low Debt Equity Ratio is good with the critical number being 1. Smaller than one means that the company has more equity than debts. Vice versa, larger than one mean that the company has more debts than equity. Investors prefer this number since Equity is after all that which belongs to the stock holders. Leverage Ratios

31. GEK2507 31 So so too.. Adding Ratios

32. GEK2507 32 PROFIT. Of course that’s what business is all about! Three of the most commonly used profitability ratios are: Note: Though these are ratios they are often just called margin which generally refers to the difference between a certain cost and sales price (taken from the top). Profitability Ratios Gross Profit Margin Operating Profit Margin Net Profit Margin

33. GEK2507 33 Gross Profit Margin The Gross Profit Margin is the ‘gross’ difference between the actual cost of a product and its sales price. It is defined as: Gross Profit Margin Gross Profit Sales = Where Gross Profit = Sales – Cost of Sales Profitability Ratios

34. GEK2507 34 Profitability Ratios

35. GEK2507 35 Operating Profit Margin The Gross Profit Margin is important but does not indicate how much (or whether) the company can make a profit from its running operations. This is indicated by the Operating Profit Margin: Operating Profit Margin Net Operating Income Sales = Net Operating Income = EBIT (at least usually), the profit after taking all the expenses related to the daily running of the company into account. (Note: Depreciation and Amortization should be included) Profitability Ratios

36. GEK2507 36 Operating Profit Margin Since we did not separate Depreciation and Amortization out in our Income Statement, let’s leave this ratio as an exercise. Profitability Ratios Net Profit Margin The Net Profit Margin tells you how many cents out of every dollar are actual profit and thus attributable to the shareholders. Net Profit Margin Net Income Sales =

37. GEK2507 37 Adding Ratios

38. GEK2507 38 Current Ratio = Current Assets Current Liabilities Quick Ratio = Current Assets - Inventories Current Liabilities Inventory Turnover Ratio Cost of Goods Sold Inventory = Asset Turnover Ratio Sales Total Assets = Liquidity Ratios Efficiency Ratios Summary of Ratios

39. GEK2507 39 Total Debt Ratio Total Debt Total Assets = Debt Equity Ratio Total Debt Total Equity = Gross Profit Margin Gross Profit Sales = Operating Profit Margin Net Operating Income Sales = Net Profit Margin Net Income Sales = Leverage Ratios Profitability Ratios Summary of Ratios

40. GEK2507 40 We have seen how various Ratios can give insight into the performance, liquidity and profitability of a company The Ratios can be calculated easily with Excel. Key Points of the Day