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Ratio Analysis

Ratio Analysis. Chapter 6 Robinson, Munter, Grant. 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. Ratio Analysis.

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Ratio Analysis

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  1. Ratio Analysis Chapter 6 Robinson, Munter, Grant

  2. 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 Chapter 6

  3. 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 Chapter 6

  4. 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) Chapter 6

  5. Activity RatiosHow 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? Chapter 6

  6. Activity RatiosCritical 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] Chapter 6

  7. Activity RatiosCritical 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] Chapter 6

  8. Activity RatiosCash Cycle • Also a measure of liquidity • If low, small number of days in operating cycle to finance [Days inventory + Days receivable - Days payable] Chapter 6

  9. Activity RatiosAsset 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] Chapter 6

  10. 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] Chapter 6

  11. 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 (6,082 + 80 + 4,583) Chapter 6

  12. 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 Chapter 6

  13. 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)] Chapter 6

  14. Solvency RatiosCoverage 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 Chapter 6

  15. Solvency RatiosCoverage 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)] Chapter 6

  16. Profitability RatiosCommon-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 Chapter 6

  17. Profitability RatiosReturn 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 Chapter 6

  18. Profitability RatiosReturn 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 Chapter 6

  19. Cash Flow RatiosQuality 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 Chapter 6

  20. Cash Flow RatiosQuality of earnings • Cash flow-earnings index • CFO/Net income • Free cash flow ratio • CFO/Capital expenditures • If ratio>1, free cash flow exists Chapter 6

  21. 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 Chapter 6

  22. Ratio Integration DuPont analysis (decomposition) ROE = ROA x Leverage And more… Chapter 6

  23. Ratio Integration ROA = Profitability x Turnover Chapter 6

  24. 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 Chapter 6

  25. Activity Ratios Chapter 6

  26. Liquidity Ratios Chapter 6

  27. Solvency Ratios Chapter 6

  28. Profitability Ratios Chapter 6

  29. Limitations to consider • Historical cost of balance sheet items • GAAP vs. IAS rules • Accounting method differences • LIFO vs. FIFO inventory valuation Chapter 6

  30. Summary • Calculate ratios • Decompose and interpret results • Understand limitations of ratio analysis Chapter 6

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