634ratios.doc

7/27/2019 634ratios.doc

http://slidepdf.com/reader/full/634ratiosdoc 1/7

INTRODUCTION

The purpose of this presentation is to discuss some of the essential concepts of financial statement and cashflow analysis. As a first step, financial ratios will be examined. Financial ratios are a significant tool toanalyze and compare the relationship between different pieces of financial information and understand theoperations of the firm. Following this discussion, we will examine the construction of cash flow statements

and consider how changes in various accounts impact the cash flow balance. Accordingly, the presentationwill be divided into two parts: a review of ratio analysis and the construction and analysis of cash flowstatements.

RATIO OVERVIEW

Different individuals have varied uses of financial ratios. Additionally, financial research firms often donot compute ratios in exactly the same way, which can add to a user's confusion. Generally, ratios aregrouped into four categories and examined in terms of

a) the ratio's trend, and b) its value relative to some norm such as an industry average.

Analysts and users most commonly group ratios into four catergories:

1) Operating or profit margin ratios,2) Liquidity ratios,3) Managerial or turnover ratios, and4) Leverage and coverage ratios.

An outline of some of the more common ratios which fall into each category is presented on the followingtwo pages. A profitability analysis category is also provided at the end of this outline so that we can better understand how profitability, turnover and leverage interact to determine a firm's return on equity. For each of these ratios, several questions may come to mind. Specifically,

1) How is each computed?2) What is it intended to measure and of what interest is it?3) What might a high or low value be telling us?4) How might ratios be misleading and what relationship might a

particular change in a ratio have to the cash balance? The discussion following the ratio list attempts to address some of these questions and then analyze the behavior of certain ratios by considering the financial statements of a firm, DayCare Inc., which hasexperienced various stages of growth over a four year period. However, prior to a discussion of DayCare,we will briefly consider the financial information provided by the ratio list which follows.

COMMON FINANCIAL RATIO TABLE

1

7/27/2019 634ratios.doc


Operating or Profit Margins

Gross Profit Margin (%) = {(Net Revenue - Cost of Goods Sold) / Net Revenue} * 100Operating Profit Margin (%) = {(Gross Prof Mar. - Operating Exp.) / Net Revenue} * 100

-- (where operating expenses includes depreciation, office and sales salaries, office overhead,utilities, etc.) Net Profit Margin (%)= {Net Income After Tax (ie, NIAT) / Net Revenue} * 100

Liquidity

Current Ratio = Current Assets / Current LiabilitiesQuick (or Acid Test) Ratio = (Current Assets - Inventory) / Current Liabilities

Managerial or Turnover

Asset Turnover = Net Revenue / Total Assets Net Working Capital Turnover = Net Revenue / (Current Assets - Current Liabilities)

Receivables Turnover = Net Revenue / Net Trade ReceivablesInventory Turnover (Retailing) = Net Revenue / Inventory OR Inventory Turnover (Manufact) = Cost of Sales / InventoryPayables Turnover = Cost of Sales / Trade Payables

Length of time an item is in an account = 365 / Turnover

(Example: 365 / Inventory Turnover is the amount of time between the purchase of raw

materials and sale of finished goods.)

Operating Cycle = Days Inventory + Days ReceivablesCash Cycle = Days Inventory + Days Receivables - Days Accounts Payables

Leverage Ratios

Leverage = Interest Bearing Debt (ie, IBD) / Net Worth (ie, NW)Debt to Assets = IBD / Total AssetsAverage Cost of Debt = Interest Expense (ie, IntExp) / IBD

Profitability Analysis

Return on Investment (ROI) = EBIT / (IBD + NW)

Net Profit Margin = NIAT / Net Revenue

2

7/27/2019 634ratios.doc


Return on Assets (ROA) = (NIAT / Net Rev) *(Net Rev / Total Assets)= NIAT / Total Assets

Return on Equity (ROE) = (NIAT / Net Rev) * (Net Rev / Total Assets) * (Total Assets / NW)= NIAT / NW

= [ROI + (IBD / NW * (ROI - IntExp / IBD)] * (1 - tax rate)

Coverages

Fixed Charge Coverage

(Unallocated Cash Flow = EBITDA - Cash Taxes - Dividends - Unfinanced Capexwhere Unfinanced Capex (ie, UnCap) = Gross Cap. Expenditures - New L.T. Debt;

where L.T. Debt = Additional Term Debt or Capitalized Leases.)

(EBITDA - Cash Taxes - Div - UnCap) / (Mandatory Debt Service (ie, MDR) + IntExp)(EBITDA - Cash Taxes - Div - Capex) / (MDR + IntExp)

.

Cash Flow Leverage:IBD / (EBITDA - Taxes - Div - Non Financed CAPEX - IntExp)

Cash Flow Coverages

Interest Coverage RatiosEBITDA / IntExpEBITDA / (MDR + IntExp)(EBITDA - UnCap) / IntExp(EBITDA - UnCap) / (MDR + IntExp)

Operating or Profit Margins

This set of ratios is intended to measure how efficiently a firm uses its assets and manages its operations.The profit margins measure, in an accounting sense, how much income is generated from a dollar of thefirm's total revenue. All other things being equal, a high profit margin is preferred to a low profit margin.[It should be noted that the lowering of a firm's sales price per unit will normally increase unit volume(resulting in a higher asset turnover) but profit margins will decrease. Total profit may go up or downdepending upon how profit margins and asset turnover interacts. This profitability analysis is

3

7/27/2019 634ratios.doc


demonstrated in the final category of the ratio listings..NOTE: The fact that profit margins are smaller isn't necessarily bad.]

Liquidity

The current ratio is a rough indication of a firm's ability to service its current liabilities or obligations.

Both the numerator and the denominator reflect accounts that will either be converted to (assets) or require payment (liabilities) from cash within the next year. Since inventory is the least liquid of the current assetaccount items and also the item which is the least reliable as measured by market value (since quality or potential for obsolescence is not reflected in book value), a "quicker" measure of a firm's ability to meet itscurrent debt obligations would eliminate inventory from current assets. The quick ratio indicates therelative amounts of cash, cash equivalents and receivables the firm's books indicate can meet its currentobligations.

Managerial or Turnover

Asset managerial or turnover ratios are sometimes referred to as asset utilization ratios. In general, theseratios are designed to measure how efficiently a firm uses a particular asset category relative to revenuegenerated or another income statement-related account. As an example, asset or net working capitalturnover measures how efficiently these two items are utilized in generating revenue. A higher turnover suggests greater efficiency in utilizing assets.

If a firm's liquidity ratios are not in line with industry standards or a desired trend, it may be beneficial toexamine the inventory, receivable or payable turnover ratios to determine if they are efficiently utilized. Asan example, the firm may have a low current ratio due to low levels of accounts receivables. This wouldalso be indicated by a high receivables turnover rate which, all other things equal, would be desirable.However, if the quicker collections and more aggressive cash flow were coming at the expense of higher potential sales (due to restrictive credit availability to its customers), this may pose some concern tomanagement.

If we divide the days in the year by a particular turnover rate, the result tells us the average number of daysthat a particular item will be in that account.

• 365 / inventory turnover reveals the number of days from the time of the purchase of raw materials

to their sale as finished goods;

• 365/ receivables turnover reveals the number of days from the time of the sale of the finished goods

on credit to the collection of the accounts receivable for that given sale, and lastly,

• 365 / accounts payable reveals the number of days from the time we purchase our inventory on

credit to the day we must pay cash for the accounts payable.

From a cash flow standpoint, a high inventory and receivables turnover would be desirable since itindicates a quicker production and collection process for the firm. However, a low payables turnover would be more desirable since it indicates a firm is able to delay payment for a longer period of time,

assuming the firm does not violate its credit agreements with its suppliers.

CONSIDER THE FOLLOWING EXAMPLE:

A company currently has:

4

7/27/2019 634ratios.doc


Sales: $100,000Cost of Goods Sold: Variable at 60% of SalesDepreciation Expense: Fixed at $10,000Administrative Expense:Fixed at % 5,000Average Collection Time: 30 days from date of sale

The company is considering a change in its collection policy to stimulate sales growth. It estimates that if it would increase its allowable payment period for its receivables to 50 days, its sales would increase by 5 percent per year.(Note: Currently, 30 days or 1/12 (30/365) of annual sales are uncollected in the accounts receivable balance. This represents $8,333 uncollected on the balance sheet.

The income statement impact is:

Before Change After ChangeSales $100,000 $105,000-Cost of Goods Sold - 60,000 - 63,000Gross Profit $ 40,000 $ 42,000-Depreciation - 10,000 - 10,000-Admin. Expense - 5,000 - 5,000Operating Profit $ 25,000 $ 27,000

Questions:

1. What happens to the gross and operating profit margin after the change?Before Change After Change

Gross Profit Margin $40,/$100, = 40% ____/____ = 40%Operating Profit Margin $25,/$100, = 25% ____/____ = 27%

What situation in the cost structure caused the gross profit margin to remain constant while the operating

profit margin improved?

2. Note: if all costs were variable, all profit margin percentage measurements would remain the same, buta higher sales volume would result in higher profitability. Would R.O.E. and R.O.A increase? If so, whatratio would be causing these two measurements to change?

3. How does this change affect average receivables and receivables turnover?Before change After Change

Aver. Receivables $100,000*(30/365) ________*(_____/_____)

= $8,219 = $14,383Receivables Turn. $100,000/$8,219 ________/________

= 12.167 times = 7.3 times

4. Has cash flow increased?

5

7/27/2019 634ratios.doc


What is the additional net income?

Is more or less cash collected from the sales change?

5. If funds can be obtained at 10%, what is the effect on net income after tax?Change in net income - Financing of additional assets = ?

__________ - ____________ = $1,383.60.

The concepts in the preceding discussion can also be used to show the number of daysthat cash is required to support the sale of a good.

Briefly, consider a firm embarking on a sales expansion.a) its cost of goods sold for the year is estimated to be $3,650,000, b) daily costs would average $10,000 per day,c) the firm expects the production cycle to be 40 days between receipt of inventory and sale of goods and another 30 days between sale and collection of the receivables,d) the firm's operating cycle of 70 days would require a $700,000 cash source to support the salesgrowth.If payment of the initial costs, such as the purchase of inventory, could be delayed for 15 days, the

cash cycle would be 55 days (40 + 30 - 15) and result in a $550,000 initial cash sourcerequirement.

Leverage and Coverage Ratios

Leverage ratios are often viewed as a firm's long-term ability to meet its obligations. Briefly,leverage ratios reflect the relationship of a firm's fixed financial obligations to debt or assets.Since a portion of the debt on the balance sheet may be trade credit, the focus of many of theratios is on the interest bearing portion of total debt. There are various coverage ratios that provide insight into a firm's ability to service its financial obligations. The main difference inthese ratios is the particular cash flow measurement and its coverage of a particular obligation.Profitability Analysis

Return on equity (ROE) is, in an accounting sense, a measure of the firm's profitability as a percent of the owner's investment or equity in the firm. Profitability analysis reveals that theROE is affected by the net profit margin, the asset turnover and financial leverage. Often,

attempts to stimulate sales (higher asset turnover) are generated by some sales incentive such asa lower unit selling price (lower profit margin). The impact of this interaction is picked up inthe profitability analysis presented in the table. Weakness or strength in either profit margins or turnover will have a negative or positive effect on ROE and this result will be magnified by thedegree of leverage the firm selects. This decomposition is a convenient way of approachingfinancial statement analysis. If ROE is unsatisfactory, this decomposition can aid one in

6

7/27/2019 634ratios.doc


beginning to look for the problem areas.

CONSIDER THE FOLLOWING EXAMPLE:

A company has the following financial data:

Sales $10,000 Assets $5,000- Cost of Sales - 5,000- Selling, Admin - 4,000 D (@ 10%) $3,000

& Depr. Exp _______ NW $2,000Other Oper Inc. $ 1,000

+ Other Inc. 0EBIT $ 1,000- Int Exp 300EBT $ 700- Tax (30%) 210NIAT $ 490

Questions:

1) Determine the ROE components of the two methods presented in the table?

ROE = NIAT / NW = NIAT/Rev * Rev/Asssets * Assets/NW

= ____/____ = _____ / _____ * _____ / _____ * _____ / _____

= .245 = .049 * 2 * 2.5

7

634ratios.doc

Documents