fme 343_financial statement analysis

8/18/2019 Fme 343_Financial Statement Analysis

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Financial Statement Analysis

(Ratio Analysis)

Ratio analysis is a useful way of gaining a "snapshot" picture of a company. These ratios can be

analyzed to identify the company's strengths and weaknesses and useful insights can be gainedthrough the process.

Very Important: However, it is important to realize this fact: the ratios have no financial

theory behind them. Theory tells us what SHOULD BE the case (or value). With financial ratios,

we have no way to identify a "theoretically best" value for any of the ratios. In fact, financial

ratios are nothing more than common sense measures that have been developed and evolved

over time. As such, they are imperfect measures and should be treated as such.

Use of the Ratios

When using ratios, think of yourself as a detective who is looking for clues (like the little guy at

the top of the page). Typically, ratios are excellent devices for uncovering clues about a

company's financial condition - but remember that clues simply raise more questions, not give

definite answers. Ratios tell us where to focus our attention and to ask relevant questions. We

never want to depend of just one ratio to draw a conclusion, the ratios are complementary and

one ratio can be used to confirm a suspicion raised by another ratio's value. It is only after

looking at a variety of different ratios that a picture of the company's financial condition begins

to form.

Types of Ratios

Financial ratios are generally grouped together by their purpose. Although there are many of

these classifications, the most commonly used groups are:

1. Liquidity

2.

Debt (or Leverage)


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3.

Activity (or Turnover)

4. Profitability

Typically, you would not calculate the ratios in all of these categories for a single company.

Usually, you would approach the ratio analysis from the perspective of an individual interestedin one particular area. For example, assume that you show up for work one day and see a letter

on your desk. In the letter, a company named Dragon Celebrations, Inc., orders $30,000 of

merchandise from you on standard credit terms (which gives them up to 30 days to pay for the

order). Accompanying the letter is a set of audited financial statements for the company. You're

not familiar with Dragon Celebrations and don't have a previous business relationship with it.

Should you ship the merchandise to them?

Before doing so, you would like to determine the probability that they will pay you. You can

purchase the credit rating for the company from a credit bureau or standard credit reporting

agency. However, if you decide to do the analysis yourself, you can calculate the liquidity ratios

using the company's balance sheet information. These ratios will evaluate the liquidity of thebusiness and should offer valuable information as to the likelihood that Dragon will pay you

within the 30 day period.

Who Uses the Ratios?

Although generalizations are difficult here, here are some of the key users for the different

types of ratios:

1. Liquidity - short-term creditors

2.

Debt - existing lenders or potential lenders

3. Activity - top management of the company

4. Profitability - both existing and potential investors in the company's common stock

Additional details on these classifications may be found on the "Commonly Used Ratios"

handout shown below.

Major Ratios

Here is a handout that shows eleven basic, commonly used ratios and their construction. The

second part of the handout describes nine more ratios that you may encounter, although they

are not as common as the previous group.

Commonly Used Ratios (see later in this document)

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Although there are approximately 50 ratios that are used in practice, the ratios found on this

handout are used across a wide variety of industries and are a part of virtually any thorough

financial analysis of a company.

Ratio Analysis on the Web

Here is my favorite web site for looking up the value of companies' financial ratios and the

industry average for each ratio. It's a great site for financial analysis of companies.

After going to the company's homepage (see the link below), point to the "News and Markets"

heading at the top of the screen. A sub-menu will pop up; under the "Markets" heading, click

on "Stocks." On the next page's Search box, type in the ticker symbol for the company that you

want to look up. (If you don't know the ticker symbol, type in the company name and press

Search. The next page will allow you to type in the full company name.) When the company's

screen appears, click on the box for "Financials." You will then see a side-by-side comparison

(for the company, industry, sector, and S&P 500) of all the major ratios. It makes an analysiseasy and convenient.

Reuters

How Do We Use the Ratios?

There are two primary ways to use financial ratios:

1.

Compare a ratio's value over several periods of time (trend analysis or time-seriesanalysis). If we see a deteriorating trend in any ratio's values over several quarters or

years, we can investigate to find the cause.

2. Compare the company's ratios to the industry average (cross-sectional analysis). A

single ratio value by itself usually means nothing - we need a standard, or benchmark , to

compare it to. This benchmark is usually the industry average (i.e., the ratio's average

value for all firms in the industry).

There are some people who believe that the industry average should not be used - that this

means that we are trying to be average (mediocre). They advocate that we should compare our

ratios to those of the leading firm in the industry and try to match the ratios of that company.Although this argument has a certain plausibility, it ignores the fact that the leading firm often

has strengths that others in the industry will have trouble meeting (outstanding marketing,

superior management training programs, etc.). The industry average is probably a more useful

standard. After all, we aren't trying to match these ratios; we are trying to exceed the average

company's performance.

http://www.reuters.com/http://www.reuters.com/http://www.reuters.com/


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A Sample Comparison of Ratios

Click on the link to see a sample financial statement analysis for the restaurant industry.

A Particularly Useful Technique

A company's Return On Equity (ROE) ratio is one of the most commonly used ratios since it

measures exactly what investors want to know - how much the company is earning on every

dollar that investors put into the company. A particularly useful technique is to conduct a

DuPont analysis on the company, i.e., break down ROE into the sources of those profits. Do the

profits come from effective marketing techniques, strong control of costs, and effective pricing

(all highly desirable) or do they come from the company's high use of debt (a less desirable and

riskier way of increasing profits)?

Cautions About Using Ratios

When using ratios as a form of analysis, be very careful that you don't put more trust in them

than they deserve. After all, they are simply common sense measures with no financial theory

underlying them. In fact, ratios have significant problems associated with them that should

cause us to use them with caution:

1. Ratios don't prove that a problem exists or provide definite answers to any of our

questions. However they are very good at providing us with some guidance on the

future steps that our investigation should take. In other words, a ratio analysis indicates

symptoms of a problem and focuses our attention on potential problems that deserve

our attention. But they rarely provide us with firm answers; usually, the best that theydo is tell us what key questions we need to ask.

2. Realize that there may be significant differences between the characteristics of the

company and the "average" firm in the industry. For example, you may be analyzing

the financial statements of a steel manufacturer and want to compare the firm's ratios

to the the industry average. However, while primarily steel manufacturers, some of the

other firms in the industry may own their own captive finance companies, own railroad

lines for transportation of the finished steel, and own an insurance company for

diversification purposes. It is often very difficult to honestly say that we are comparing

apples with apples when the companies in the industry have substantially differentstructures and characteristics.

3. Always make sure that you are calculating a ratio exactly as the industry average ratio

is calculated. There are many variations on how to calculate the various ratios. For

example, if you look in several finance textbooks, you can easily find differences in

suggested ways to calculate Return on Investment, Inventory Turnover, and the Quick

(or Acid Test) Ratio. Since we typically depend on an outside firm (e.g., Reuters, Dun &

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Bradstreet, etc.) to provide us with the values of the industry average for each ratio, we

need to ensure that the formula that we are using for a ratio is the same formula that

the industry average source is using. For example, we may calculate the Inventory

Turnover ratio as (Cost of Goods Sold)/(Average Monthly Inventory) while the outside

source calculates it as (Annual Sales)/(Year Ending Inventory). Both versions are

commonly used.

4. Companies frequently don't have the same fiscal year. Some companies' fiscal year

ends on December 31st, others' end on September 30th, others' end on June 30th, etc..

If you are depending on the year-ending (end of the fiscal year) balance sheet's data,

this date may vary widely among firms in the same industry. This is especially true of

companies whose sales are highly seasonal. For example, two companies who

manufacture snowmobiles may have almost identical performance numbers for the

year. However, they will have vastly different inventory and accounts receivable levels

if one's year ends in June and the other's ends in December, resulting in considerable

differences in the values of a ratio analysis.

5. Companies' accounting practices may differ considerably. Companies have a great deal

of discretion in their accounting procedures, particularly with regard to depreciation

(straight line, double declining balance, etc.) and inventory (LIFO, FIFO, etc.). This makes

comparisons more difficult.

6. Be careful about depending too much on any one ratio. A ratio analysis is most

valuable when we evaluate a number of ratios of a certain type (liquidity, profitability,

etc.) and look for a pattern in the results.

7. Audited financial statements should be used whenever possible. Small businesses'

financial statements are often unaudited and may not be accurate.

Related Topics

Breakdown of ROE Using the DuPont Method

A Sample Ratio Comparison

A Comparison of Ratios

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The table below contains some recent ratios of three companies in the restaurant industry.

(Sources: Reuters and Microsoft Investor ) The first few lines of the table show the company

name, the ticker symbol, the headquarters' city, and the brand names owned by the company.

The ratios were compiled in early 2012 and are used here to illustrate the larger subject of

financial statement analysis.

Ratio Analysis of Selected Restaurant Companies

Brinker International (EAT), Dallas, TX, Chili's, Maggianos, On The Border, Macaroni Grill

YUM! Brands (YUM), Louisville, KY, Pizza Hut, KFC, Taco Bell, LJS (Long John Silver), A&W

Darden Restaurants (DRI), Orlando, FL, Olive Garden, Red Lobster, Longhorn Steakhouse, Bahama Breeze, seven Seas

Liquidity Brinker Intl. YUM! Brands Darden Rest. Industry

Current Ratio 0.49 1.01 0.42 1.14

Quick Ratio 0.37 0.39 0.19 1.00 Debt (Leverage)

Total Debt to Equity 1.74 1.55 1.20 0.66

Interest Coverage 6.99 14.03 7.38 2.92

Turnover (Activity)

Receivable Turnover 32.80 39.71 124.00 191.05

Inventory Turnover 21.07 41.85 15.65 30.79

Asset Turnover 1.31 1.46 1.40 1.60

Profitability

Return on Assets (%) 9.92 17.21 8.16 8.34

Return on Equity (%) 36.45 77.10 25.02 15.87

Valuation Ratios Brinker Intl. YUM! Brands Darden Rest. Industry

P/E Ratio 18.12 22.56 14.75 80.49

Beta 1.47 0.94 0.89 0.35

As we examine these ratios, we need to keep in mind that, although all three companies are in

the restaurant industry, YUM Brands (for the most part) is a fast-food company while the other

two are "sit down" restaurants.

A review of the ratios reveals the following about the companies:

Profitability Ratios

Profitability Brinker Intl. YUM! Brands Darden Rest. Industry

Return on Assets (%) 9.92 17.21 8.16 8.34

Return on Equity (%) 36.45 77.10 25.02 15.87

As a potential investor, we may want to emphasize the Return on Equity (ROE) ratio a little

more than the Return on Assets (ROA). The return on equity tells us how much the company is

earning per dollar invested by the shareholders.

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1. Current results: YUM! Brands is currently the most profitable of the three companies

(by both ratios that measure profits). All three are have an ROE greater than the

industry average. But these three companies are among the largest in the industry and,

when we compare to the industry average, we are comparing them to much smaller

companies. Since restaurant chains have considerable fixed operating expenses (i.e.,

operating leverage), we would expect the larger chains to be more profitable thansmaller ones. But, in order of ROE, YUM is the most profitable, Brinker is second, and

Darden is third.

Next, let's take a look at where these profits come from. In other words, are the company's

profits coming from sound management or are the ROE numbers being pushed up through the

heavy use of financial leverage (i.e., debt)?

Debt (or Leverage) Ratios

Debt (Leverage) Brinker Intl. YUM! Brands Darden Rest. Industry

Total Debt to Equity 1.74 1.55 1.20 0.66

Interest Coverage 6.99 14.03 7.38 2.92

Brinker uses more debt (per dollar of equity) than either of the other two companies. This is an

indication that Brinker is pushing up its ROE through its use of debt more so than YUM or

Darden. In comparing YUM and Brinker , this makes YUM's ROE a little more impressive since

YUM has a higher ROE and a lower debt level. Brinker has been able to push its ROE up above

Darden's by magnifying its profits though the use of greater financial leverage. But higher debt

also means higher risk. The important question here is, "Have the companies taken on moredebt that they can repay?"

1. The Total Debt to Equity ratio values for all three companies are well above the industry

average. This is normally a red flag and an analyst should ask this question, "The

average firm in the industry believes that it can only support a debt level that is half the

level of these two companies. What makes me believe that these two can support such

a high debt load?" All three companies are benefiting from the higher debt levels, but

what about their ability to pay the principal and interest on this debt? For this, we need

to look at the Interest Coverage ratio for all three companies..

2. Interest Coverage: The Interest Coverage ratio measures the ability of the company to

pay the principal and interest on the debt. All three companies have ratios greater than

the industry average. (Some analysts use a rough rule-of-thumb that a minimum value

of 3.0 is needed to safely support the debt level.) While all three companies appear to

be safe in terms of being financially able to pay off its debt, YUM has the highest ratio

value and therefore appears to be the safest of the three by this measure.


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So far, it appears that YUM may be the strongest of the three firms financially. It has the highest

level of profitability, is using its financial leverage appropriately to push up earnings, and can

safely meet its debt obligations. We now turn to the other ratios to see if they raise any red

flags for the companies.

Liquidity Ratios

Liquidity Brinker Intl. YUM! Brands Darden Rest. Industry

Current Ratio 0.49 1.01 0.42 1.14

Quick Ratio 0.37 0.39 0.19 1.00

All three companies have lower ratios than the industry average. This is not surprising,

however, since this can be explained by two factors:

1.

Stability of sales and cash flows: Being industry leaders, their sales and cash flows aremore stable than the smaller firms in the industry, thus they don't need as much cash on

hand. The purpose of liquidity is to make sure that you have enough money to pay your

bills when they come due and to handle sudden changes in fortunes. If you can predict

your cash flows pretty accurately, you don't need to keep as much cash on hand. And

its easier to predict cash flows accurately if you have the stability and maturity as a

result of being an industry leader.

2. Access to credit lines: Being large companies, these three have easy access to the credit

markets. Most companies of this size will have lines of credit, so they have been pre-

approved for any loans. There is no need to keep large amounts of cash on hand if you

can pick up the phone and have the bank transfer money into your bank account whenit is needed. (Technically, you would be "drawing down" the loan that was previously

approved.)

Turnover (or Activity) Ratios

Turnover (Activity) Brinker Intl. YUM! Brands Darden Rest. Industry

Receivable Turnover 32.80 39.71 124.00 191.05

Inventory Turnover 21.07 41.85 15.65 30.79

Asset Turnover 1.31 1.46 1.40 1.60

1. Receivables Turnover is much higher than the industry average for all three companies,

so there are no apparent problems with collecting accounts receivable. But this ratio

can be a "trap" for analysts who aren't careful in studying the ratios. The restaurant

industry is largely a "cash" industry anyway with low amounts of credit granted to its


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customers. So the receivables turnover ratio may not be meaningful for this industry.

Just as the inventory turnover ratio doesn't mean much for a service industry like hotels,

airlines, and accounting firms, the receivables turnover ratio doesn't mean much for a

cash-oriented business. So we will tend to "throw out" this ratio for the restaurant

industry and not give it much importance.

2.

Inventory Turnover varies widely among the three companies, with YUM enjoying anadvantage over the other two. This shouldn't be surprising since YUM is in the fast-food

segment of the restaurant and the other two are "sit down" restaurant companies.

3. The Asset Turnover ratios of all three firms are below the industry average. Again, we

have to be careful with this ratio since we don't know how many of the restaurants are

franchised (and, therefore, its stores or fixed assets owned by the local franchisees) and

how many of the stores are company-owned (and therefore on the companies' books).

Valuation Ratios

Valuation Ratios Brinker Intl. YUM! Brands Darden Rest. Industry

P/E Ratio 18.12 22.56 14.75 80.49

Beta 1.47 0.94 0.89 0.35

1. P/E Ratio: As measured by the Price/Earnings Ratio, investors are slightly more

optimistic about YUM! Brands' future growth than Brinker or Darden. The higher P/E

ratio also means that, as investors, we have to pay a higher premium to buy YUM. This

premium means that, to buy one dollar of earnings, we have to pay approximately 50%

more for YUM than for Darden and 25% more for YUM than for Brinker .

2.

Beta: Beta measures the volatility of the stock price (with 1.0 being the average for allcompanies). Brinker International's stock is approximately 50% more volatile than its

two competitors, which makes it a riskier investment. Darden has the lowest beta with

YUM being a close second.

Summary

So what does our ratio analysis of the three companies tell us?

1. Brinker International - At the time of the review, Brinker had an impressive level of

profitability (ROE) although its heavy use of debt to push up these earnings should be

noted. The company is the riskiest of the three in terms of both interest coverage and its

stock's value of beta.

2. YUM! Brands - At the time of the review, YUM had the strongest financial position. It

had the highest level of profitability, a very strong ability to support its debt, and a low

volatility for its stock price. Unfortunately for potential investors, the company also has

the highest premium that must be paid for its stock. Is it worth a 50% premium in price?

Each individual investor would have to make that decision.


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3. Darden Restaurants - At the time of the review, Darden had the lowest (but more than

industry-average) level of profitability, a strong ability to meet its debt service

payments, and a low volatility of its stock price.

Caveat: This financial statement analysis is for educational purposes only; it should not be used

as a reason to buy or sell any of the three stocks.


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COMMONLY USED RATIOS

I. LIQUIDITY

Liquidity is defined as having enough cash (or near-cash assets) to pay your bills when they come due.

The liquidity ratios compare the assets that will be converted into cash soon (the numerator) to the bills

that will be coming due soon (the denominator).

You always want to compare the liquidity ratios to the industry average, but two other factors should be

considered as well:

The predictability (or stability) of the company’s sales. If you know how much money will be received

each month, you don’t need to keep as much cash on hand as you would otherwise. Companies with

highly unpredictable sales are always in danger of experiencing a sudden shortfall in sales, so they

need to keep more cash and liquid assets on hand.

The company’s access to bank lines of credit or the credit markets. You don’t need to keep as much

money on hand if you can just pick up the phone, call the bank, and have money deposited into your

account.

1. Current Ratio -- The current ratio is the most commonly used measure of the liquidity of a

company. It is simply a common sense measure. The numerator is the value of assets that should

be converted into cash within the next year. The denominator is the amount of bills coming due

within the next year.

sLiabilitieCurrent

AssetsCurrent=RatioCurrent


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2. Quick Ratio (or Acid Test Ratio) -- The quick ratio is a more restrictive measure than the current

ratio. The numerator consists of the most liquid current assets. It assumes a worst-case scenario

in which inventory cannot be sold.

The average for all manufacturing companies is about one (1.0). This average also varies a great

deal from one industry to another.

sLiabilitieCurrent

ReceivableAcc.+SecuritiesMkt.+Cash=RatioQuick

A commonly used variation of the ratio is:

abilitiesCurrent Li

entory sets - InvCurrent Aso =Quick Rati

This is the version that you usually see in a standard finance textbook. But notice that this

variation may include some non-liquid assets in the numerator however, such as prepaid

expenses (like insurance premiums). This is the measurement that is actually used in practice

most frequently, although the first form is theoretically superior.

II. TURNOVER (or EFFICIENCY)


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Turnover ratios measure the management’s efficiency and effectiveness in managing the firm’s assets.

In general, sales (or a measure of sales, like cost of goods sold) will be in the numerator. You would like

for the value of the turnover ratios to be quite high (with the exception of the average collection period).

3.

Inventory Turnover -- Indicates the number of times a year that the firm’s inventory has been

replaced. A low ratio may indicate that the firm has some obsolete inventory, or that possibly,

the firm is simply overstocked on inventory. If the inventory turnover is 4 times per year, the

company is replacing its inventory approximately every 3 months; if its inventory turnover is 12

times per year, it is replacing its inventory approximately every 30 days (or 1 month).

The most commonly used form of the ratio is:

Inventory

Sales =TurnoverInventory

A theoretically-superior variation of the formula is:

ventoryarters' Inlast 4 qu Average of

ods Sold Cost of Go Turnover = Inventory

This form of the ratio is better for two reasons:

Why substitute “Cost of Goods Sold” for “Sales” in the numerator? Inventory (in the

denominator) is shown on the company’s books at cost; we would like to use a measure of

cost in the numerator as well (i.e., cost of goods sold) in order to get a fairer comparison.

Why substitute “Average Inventory” for “Inventory” in the denominator? The numerator is

measured over a period of time, like a year. The denominator should show the average

amount of inventory that was available for sale during this period. For example, assume

that sales increased rapidly during the year and that inventory increased dramatically as

well. We would not want to use year-ending inventory in the denominator, as it does not

accurately depict the amount of inventory that was available for sale.


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4. Accounts Receivable Turnover -- Indicates how quickly the company collects its accounts

receivable: the higher the turnover, the more quickly it collects its receivables.

ReceivableAccounts

Sales =TurnoverReceivableAccounts

Notice that the formula assumes that all sales are on credit (and therefore go through accounts

receivable). It would be better to use credit sales in the numerator, if the value of credit sales is

available. But, if you compare the ratio to an industry average, just make sure that you are

using the same formula as your source for the industry average. You don’t want to use credit

sales in the numerator if the industry average is calculated with total sales in the numerator.


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5. Average Collection Period – Technically, this is not a turnover ratio: it is the accounts receivable

turnover divided into 365 days. It is an alternate measure of how quickly accounts receivable are

being collected. The ratio calculates how long (in days) that it takes the firm to collect its

receivables. (Use credit sales if available, since only credit sales go through the accounts

receivable account.)

365Sales

ReceivableAccounts =PeriodCollectionAverage

If the A/R turnover is lower than the industry average (and the average collection period is higher

than the industry average), this just means that the company is collecting its receivables slower

than other firms in the industry. However, it is quite possible that the company’s credit terms

may give its customers longer to pay than its competitors. So, rather than the industry average, it

is better to compare the company’s average collection period to the terms that they sell on, if the

credit terms are known.

6. Total Asset Turnover -- The purpose of investing in assets is to generate sales: the higher the

sales per dollar invested in total assets, the better. This ratio measures how efficiently themanagement is achieving its goal.

AssetsTotal

Sales =TurnoverAssetTotal

Major fault of the ratio: Total assets are made up of current assets and fixed assets. If thecompany’s fixed assets are old (and therefore almost fully depreciated), the value of net fixed

assets on the balance sheet will be quite small. This, in turn, will make total assets appear to be

small and the value of the ratio will be high. This implies that a company with old assets is

managing its assets quite efficiently. In fact, the company may not be managing its assets well at

all – they are simply old and very depreciated. A company that has recently upgraded its assets by


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investing in newer equipment may actually be better managed, but its total asset turnover ratio

will look inferior to the company with older assets. In spite of this, the total asset turnover ratio is

widely used; it’s simply important to know of its major deficiency when using it.

III. DEBT (OR LEVERAGE)

The debt, or leverage, ratios measure the ability of the firm to meet the principal and interest payments

on its debt. Keep in mind that debt is neither good nor bad; it is simply a tool. There are times that

heavy use of it is appropriate (e.g., when sales are going up) and there are times that it is detrimental

(when sales are going down). These ratios simply measure the extent to which the company is using

debt in financing the company’s assets and whether it has gone too far by using so much debt that it is

having difficulty in paying the interest when it is due.

7. Debt Ratio -- Indicates the percentage of the total assets that have been financed by debt.

AssetsTotal

s)Liabilitie(orDebtTotal =RatioDebt

On the balance sheet, total assets must equal total liabilities and capital. In other words, total

assets are equal to the amount of the company’s debt plus the amount of equity. Looked at

another way, the company is financed with a combination of debt and equity. So this ratio simply

measures the percentage of the total assets that are financed with debt. If the debt ratio is 40%,

this means that the company has financed 40% of its assets with debt (borrowed money) and 60%

with equity (investors’ money). This ratio is one way of measuring the financial leverage of the

company: the higher the debt ratio, the higher the degree of financial leverage that the company

has.


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8. Debt-to-Equity -- A variation of the debt ratio. Measures the money invested by creditors relative

to the money invested by the owners.

EquityTotal

s)Liabilitie(orDebtTotal =RatioEquity-to-Debt

This is just another way of measuring the degree of financial leverage. Notice that if the debt ratio

is 40%, this means that every $1.00 of total assets is financed with $0.40 in debt and $0.60 in

equity. If we knew that the debt ratio is 40%, could we figure out the value of the debt-to-equity

ratio? Sure, because we know that if debt is 40% of the assets, then equity must be the other

60%. Therefore, the debt-to-equity ratio is a ratio of 40/60, or 66.67%. Some financial analysts

prefer to use the debt ratio; others prefer to use the debt-to-equity ratio. It isn’t necessary to use

both of them because they tell you the same information - just in a different form.

9.

Times Interest Earned (or Interest Coverage) - A key measure of the firm’s ability to meet its

interest payments on time.

ExpenseInterest

E.B.I.T.)(orIncomeOperating Net=Coverage)Interest(orEarnedInterestTimes

Notice that the numerator is the amount of earnings that is available to meet interest payments.

The denominator shows the amount of those interest payments. In other words, it is a ratio of

the amount of money that we have to the amount of money that we need (to pay the interest).

So a high ratio would indicate an ability to pay its interest without difficulty.

IV. PROFITABILITY


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Since a major goal of the company is to attain a high level of profitability, we would like to see a high

value for these ratios. We can relate the company’s profits to almost any item on the balance sheet or

income statement (e.g., net income to total assets, net income to common equity, net income to sales,

etc.)

10. Return on Assets – The primary purpose of investing in assets is to generate sales, which in turn

lead to profits. The return on assets ratio measures the profitability per dollar of investment in

the firm. Notice that the ratio doesn’t say anything about how the assets are financed, i.e., where

the money comes from (either debt or equity). It simply wants to know how profitable the

company is per dollar invested in total assets (no matter where the money comes from to finance

those assets).

AssetsTotal

TaxesAfterEarnings =AssetsonReturn

Note: You will see a lot of variations in the numerator for this ratio: some analysts use earnings

before taxes (EBT), others will use earnings before interest and taxes (EBIT). The most common,

however, is earnings after taxes (EAT). Just make sure that, if you are comparing a company’s

return on assets ratio to an industry average, you are calculating the ratio in the same manner as

your source for the industry average.

11. Return on Equity – This ratio looks at the company’s profits from the standpoint of the company’s

owners. It measures the profitability per dollar of investment in the firm by the owners.

EquityTotal

TaxesAfterEarnings =EquityonReturn

Note: As with the previous ratio, you will see a lot of variations in the numerator for this ratio.

Again, just make sure that, if you are comparing a company’s return on equity ratio to an industry

average, you are calculating the ratio in the same manner as your source for the industry average.


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12. Price-Earnings Ratio -- The price-earnings ratio is the most frequently used measure of a stock’s

relative value. The price-earnings ratio tells us two things about a company’s stock:

It is a measure of how optimistic investors are about the company’s future growth in

earnings and dividends. The higher the P/E ratio, the more optimistic investors are about

the company’s future prospects.

It is a measure of the premium that you have to pay for the stock. For example, if a stock’s

P/E ratio is 35 and the average P/E for all stocks is 18, investors are having to pay a

considerable premium to acquire the stock (but may be getting a higher quality company).

On the other hand, if a stock’s P/E ratio is 8, we are able to buy the stock at a discount

relative to other stocks (but may be getting an inferior company).

months)12 past(for theshare perEarnings

stock commontheof pricemarketCurrent=RatioEarnings-Price

The P/E ratio is often used to help estimate the future price of the stock using this equation:

Pricen = [P/E ratio]n times [Earnings per share]n

where “n” refers to a specific year in the future.

For example, the price of a stock 3 years from now will be equal to the P/E ratio that the stock

has 3 years from now times the earnings (per share) that the stock has 3 years from now. That

is,

333 are]ngs per sh* [Earniio] [P/E Rat Price

$36.00$3.00 12 * Price3

If we can estimate the value of the P/E ratio 3 years from now and the earnings expected at that

time, we can use the equation to estimate the market price of the stock at that time.


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ADDITIONAL RATIOS THAT YOU MAY ENCOUNTER

V. VALUATION

Valuation ratios help determine whether a stock is over-priced or under-priced relative to other stocks (or

relative to the basic earning power of the company). In general, we would like to purchase the items in

the denominators (earnings, cash flow, sales, etc.) for a low price. Therefore, we prefer to invest in

companies that have a low value for the following ratios.

13. Price-to-Cash Flow Ratio – The ultimate objective to investing is to earn a relatively high cash

flow. If we can purchase this high cash flow at a cheap price, so much the better. Therefore, we

would like to have invest in companies that have a low price-to-cash flow ratio.

share perflowCash

stock commontheof pricemarketCurrent=RatioFlowCash-to-Price

14. Price-to-Sales Ratio – This ratio helps to value a company that has no earnings and no dividends.

Also, the price-to-sales ratio may be more stable than the price/earnings ratio and, therefore,more useful. Research also supports the idea that a portfolio of stocks that have a low price-to-

sales ratio may be an anomaly and outperform portfolios made up of high price-to-sales ratios.

g]outstandinaresSales]/[sh[Total(i.e., share perSales

stock commontheof pricemarketCurrent=RatioSales-to-Price

15. Price-to-Book Value Ratio – This ratio relates the common stock’s market value to its “accounting

value” as shown on the company’s books. One major respected research study maintains that

stocks with a low price-to-book value ratio tend to outperform other portfolios.


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sheet balanceon theshownasequityCommon

stock commontheof pricemarketCurrent=RatioBook-to-Price

VI. MORE EFFICIENCY RATIOS

16. Capital Spending-to-Depreciation – This ratio assumes that the depreciation charges are an

accurate reflection of the physical wear-and-tear on the fixed assets, i.e., the rate at which the

fixed assets are being used up. Capital spending is the amount of money that is spent on the

purchase of new fixed assets. So a ratio of capital spending-to-depreciation would show whether

the fixed assets are being replaced at the same rate that they wear out. In other words, a ratio

value greater than 1.0 would indicate that the assets are being adequately replaced; a value of

less than 1.0 would indicate a shrinkage in the size of the fixed assets.

onDepreciati

SpendingCapital =onDepreciati-to-SpendingCapital

VII. MORE DEBT (OR LEVERAGE) RATIOS

17. EBITDA-to-Debt Service – EBITDA (pronounced ee-bit-DAH) can be determined by adding interest

expense, taxes, and depreciation/amortization to earnings after taxes (i.e., EAT or net income).

EBITDA is therefore the amount of money that is available to meet any payment obligations (i.e.,

interest and principal payments) on the company’s debt. (Debt service refers to these interest

and principal payments.)


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Therefore, the ratio relates the amount of money that we have from this year’s cash flow that is

available to pay down the debt (and related interest) to the amount of required payments. A

ratio of 1.0 would be the bare minimum that would be required to meet these payments.However, you would want a much larger cushion than this to ensure that the cash flow will not

drop to levels that are not sufficient to meet the debt payments.

debton the payments principalRequired paymentsinterestRequired

onAmortizationDepreciatiTaxesexpenseInterestEAT =ServiceDebt-to-EBITDA

VIII. MORE PROFITABILITY RATIOS

18. Gross Profit Margin (or Gross Margin) – By definition, gross profit is equal to total sales minus

cost of goods sold. Therefore, if the gross profit margin declines, it is an indication that one of

two things is likely happening:

The cost of goods sold are increasing, and the company is not able to pass along the higher

costs in the form of price increases (possibly due to a highly competitive marketplace), or

The company has reduced its prices, perhaps in an attempt to attract new customers and toincrease its market share.

SalesTotal

ProfitGross =MarginProfitGross

19. Net Profit Margin (or Net Margin) – Whereas the gross profit margin measures the performance

of the company’s operating managers, it doesn’t say anything about the performance of the

company’s financial managers. (Gross margin is affected only by the decisions of operating

managers with regard to pricing and cost control; it isn’t affected by decisions on how to finance

the company.) The net profit margin measures the combined performance of both the operating

and financial managers.


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SalesTotal

TaxesAfter Earnings =MarginProfit Net

20. Return on Investment – Return on investment could be stated as the return on “long-term

investment funds”. Investment here refers to the total long-term sources of funds to a company,

i.e., long-term liabilities, preferred stock, and common equity. The current liabilities are a

temporary source of financing and may vary considerably over the course of a year; the providers

of long-term funds have made a commitment to the company and provide the permanent

financing for the firm.

EquityCommonStockPreferredLiabilitesterm-Long

TaxesAfterEarnings =InvestmentonReturn

fme 343_financial statement analysis

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