Weekly Assignment

Chapter 4 Financial Ratio Analysis

Learning Objectives

· To explain the use of financial ratios

· To learn where to source information to calculate and compare ratios

· To distinguish between the different types of ratios and their purposes

· To understand the limitations of financial ratio analysis

Case: Old Pueblo Lithographers

Old Pueblo Lithographers, the largest lithographer in New Mexico and headquartered in Santa Fe, is a family firm that dates back to the 1950s. The company specializes in high-quality, fine art, book, and commercial printing for customers in New Mexico and the southwestern United States, with some commercial customers in Mexico. The firm is managed by James Logan, a third-generation printer who is approaching retirement. The issue at the firm is what to do about choosing the next leader of the company.

James has one child, a daughter, Sydney, who works in the business. By all accounts she is very good at her job. She is excellent with clients, is well respected by her peers, and knows the production process inside and out. She had a meeting with her father and has asked him to consider appointing her the new president of the corporation. James turned her down. She took offense at what she perceived as a slight; hurt and dejected, she stalked out of her father's office, slamming the door.

Later when she had calmed down, she approached her father and asked why he had turned her down in her bid to lead the company. His answer was simple and direct: “You cannot read financial statements.” He went on to say, “Without this ability, you will not be able to manage the company well enough to keep it on track with the requirements of its banks, nor will you be able to assure that the customers would pay their bills appropriately and that the company would pay its bills in the most efficient manner. You would not have any idea about how to give credit terms or take advantage of terms offered by the firm's suppliers. You would not know what the impact of production scheduling changes or capital purchases would have on the firm and would thus not know the impact of any decisions you made in these areas. In short, if you can't read the financial statements, you won't know how to manage the firm's cash flow and, ultimately, you would not be able to keep the company on an even financial keel.”

Sydney wanted to know how she could learn to “read financial statements.” Her father suggested two things: (1) learn about the firm's financial statements and (2) understand ratio analysis.

Chapter 3 indicated the role that financial statements play in providing relevant and timely information about the overall health of the company to entrepreneurs, investors, and other stakeholders. Financial statements provide a wealth of information that can be used to assess the risk of the firm, evaluate management's efficiency, and determine future needs of capital. However, it is sometimes difficult to interpret all this information without first putting it into context. For example, suppose a firm has total assets of $1,250,000 on the balance sheet. Is this good, bad, or neither? Is the firm going in the right or wrong direction? Based on this number alone, it's hard to tell. By looking at the financial statement in isolation, it can be difficult to get a clear picture of how the firm's performance is progressing over time and how the firm compares to its peers. Financial ratio analysis helps make sense of this problem by providing a method for making better use of the information in the financial statement. It is an extremely useful management tool that improves the understanding of financial results and trends over time and provides key indicators of organizational performance. In this chapter, we will look at how we can use financial ratios to perform a complete and efficient analysis of the firm.  Chart 4.1  presents a schematic representation of the material covered in this chapter.

Chart 4.1 Schematic of  Chapter 4

Uses of Financial Ratios

Before delving into the ratios themselves, we must first understand how we can use ratios in the business environment. Like financial statements, financial ratios are not very useful on a stand-alone basis; they must be benchmarked against something. The two benchmarks useful for financial ratios are comparing the firm to its own past performance (time-series) or against other companies (cross-sectional). While the computation and ratios don't change in either form of use, each context of use provides a different perspective and benefit.

Time-Series

The time-series benchmark of the financial ratios is used to assess the trends at the company over a specific time frame. This allows the entrepreneur to see how his or her firm's operations are progressing throughout the time period being analyzed. An examination of the ratios at different points in time can help identify if the firm is headed in the right direction; if the ratios are improving, then management is doing a good job in running the firm. Conversely, deterioration in the ratios from period to period can help identify areas in the management of the firm that are causes for concern.

Cross-Sectional

While the time-series approach compares the firm to itself at different points in time, the cross-sectional benchmark approach compares the firm to two or more companies at a specific point in time. Unless it's a monopoly, a firm does not operate in isolation; it operates in a competitive environment. If the firm cannot operate with the same efficiency as its competitors, it risks having financial difficulties and eventually being insolvent. By comparing the financial ratios of the firm against other firms or the industry, investors and management can get a better idea of what management's and the firm's strengths and weaknesses are in relation to its peers.

Sources of Information

In time-series ratio analysis, the most important source of information is the firm's historical financial statements, as these are the ones that will reveal the trends within the firm's operations. While the firm's balance sheet, income statement, and statement of cash flows are the major sources of information, it's also important to look elsewhere in the financial statements for other pieces of data needed to calculate the ratios. For example, lease payment amounts, needed to calculate the fixed charges coverage ratio (discussed later in the chapter), are usually lumped into the sales, general, and administration (SG&A) expenses in the income statement. Often small details like this will have to be researched by the analyst to perform a complete analysis.

In a cross-sectional ratio analysis, not only are the firm's financial statements needed, but information from the industry and other competitors is also required. Many publications provide financial ratios for various industries and individual companies. Financial ratios for industries are published each census period by the U.S. Department of Commerce at  www.commerce.gov . The Almanac of Business and Industrial Financial Ratios provides an annual publication of industry ratios by the North American Industry Classification System (NAICS). Individual company ratios can be found on the web by companies such as Fintel, Standard & Poor's, Bloomberg, and Hoover's.

For demonstration purposes, we will be calculating each of the 2013 financial ratios discussed (except for market ratios) for Old Pueblo Lithographers (OPL) based on the information provided by its financial statements included in the Appendix (Balance Sheet, Income Statement, and Statement of Cash Flows) at the end of this chapter. A summary of all financial ratios for 2012 and 2013, as well as industry averages for 2013, is included in  Table 4.1  in the summary section of this chapter.

Types of Ratios

Ratios can be classified in terms of the information they provide to the reader. This means that analysis of the different types of ratios helps identify certain aspects of performance for the firm.  Chart 4.2  provides a graphic view of the five types of ratios.

Chart 4.2 Types of Ratios

Liquidity

These types of ratios may be used to analyze the firm's financial ability to meet short-term liabilities. This form of liquidity analysis focuses on the relationship between current assets and current liabilities, as well as the speed with which receivables and inventory can be converted into cash during normal business operations. This class of ratios is particularly important to bankers. Liquidity ratios in general are used extensively to qualify loan applicants for loans. Bankers view both the trend and the point-in-time peer group comparative measurements to be important.

The two most common measurements are the current ratio and the quick ratio. The current ratio is the ratio of current assets to current liabilities:

The quick ratio is the ratio of the quick assets to current liabilities. Quick assets are those assets that can be most readily converted to cash. In most situations, the least liquid of the current assets is inventory; hence, inventory is typically excluded when calculating the quick ratio:

The greater the current ratio and the quick ratio, the higher the company's liquidity and the greater the firm's ability to pay its current liabilities when due. By comparing these ratios using a time-series approach, the entrepreneur can see if the firm has improved its liquidity from one period to the next; increasing ratios demonstrate a positive trend, and lowering ratios indicate declining liquidity. A cross-sectional view of the numbers can indicate if the company is more or less liquid than its peers or how the company ranks against the peer group average.

Leverage

A company's leverage ratio measures how much debt the firm has on its balance sheet. Leverage ratios represent another measure of financial health. Generally, the more debt a company has, the riskier its stock is. This escalating risk comes from two primary impacts that accompany higher debt: (1) the firm's breakeven point goes up because of the higher fixed costs associated with the debt, and (2) the volatility of return on equity becomes less predictable and more volatile when debt increases.

The debt to equity ratio measures how much of the company is financed by its debt holders compared with the equity contribution of its owners (shareholders). A company with a lot of debt will have a high debt to equity ratio, while one with little debt will have a low debt to equity ratio. Assuming everything else is identical, companies with lower debt to equity ratios are less risky than those with higher such ratios. The debt to equity ratio is calculated as follows:

Also known as the debt ratio, the debt to total assets ratio can be interpreted as the portion of a company's assets that is financed by debt. The higher this ratio, the more leveraged the company and the greater its financial risk. (We discuss financial risk in greater detail in  Chapter 11 .) Debt ratios vary widely across industries, with capital-intensive businesses such as utilities and pipelines having much higher debt ratios than other industries like technology. A debt ratio of greater than 1 indicates that a company has more debt than assets. The debt to total assets ratio is

The interest coverage ratio (also known as the times interest earned ratio) compares the firm's operating earnings to its interest expense; the more the firm can produce in operating profit to cover its interest expense, the lower the risk of defaulting on its debt. It is calculated as follows:

A stricter version of the interest coverage ratio is the fixed charges coverage ratio, which is calculated as

The fixed charges coverage ratio relates the interest and fixed charge payment that the firm is required to pay to the funds that the firm has available to pay them with. Fixed charges are expenses that are incurred and must be paid regardless of sales, profits, or production.

Management Efficiency

Regardless of what kind of industry a company is in, it must invest in assets to perform its operations. Management efficiency ratios measure how effectively the company uses these assets, as well as how well it manages its liabilities.

The accounts receivable turnover ratio measures how effective the company's credit policies are. It is calculated as

This ratio essentially measures how many times a company “turns over” its accounts receivable during the course of the year. If accounts receivable turnover is too low, it indicates the company is being too generous granting credit or is having difficulty collecting from its customers. All else equal, higher receivables turnover is better. A similar measure of efficiency is the days sales outstanding (DSO) ratio, calculated as

This ratio measures the number of days’ worth of sales that are tied up in accounts receivable. You can think of it as the average lag between the date of sale and the date the payment is received on the average account receivable. Entrepreneurs want to keep this number low, as having money tied up in accounts receivable affects the firm's working capital.

Working capital is also affected by the amount of inventory that a firm holds on its balance sheet. A measure of how well managers manage the firm's inventory is the inventory turnover ratio, calculated as

Notice that the numerator has cost of goods sold and not sales. This is because inventory is valued at cost, and therefore the cost of goods sold measure gives a better representation of the inventory's value. Like the accounts receivable turnover ratio, the more times a firm can “turn over” its inventory, the more efficiently it handles its assets. The days of inventory ratio is

It measures the number of days that a firm sits on its inventory before it is sold. The firm would want to hold onto its inventory the least amount of days possible to avoid inventory obsolescence and to increase working capital.

On the liabilities side, the accounts payable turnover ratio measures how a company manages paying its own bills. High accounts payable turnover is a signal that a firm isn't receiving very favorable payment terms from its own suppliers or isn't paying its accounts payable in a timely manner. All else being equal, average to slightly lower payable turnover is better. It is calculated as

While the above ratios focus on current assets and liabilities, a firm must also understand how efficiently management uses the long-term assets they have been entrusted with. The total asset turnover ratio is a catch-all efficiency ratio that highlights how effective management is at using both short-term and long-term assets and measures a company's ability to generate sales given its investment in total assets. It is calculated as

Generally speaking, the higher the ratio, the better it is since it indicates the company is generating more revenues per dollar of assets.

One can also analyze the efficiency of the firm's organizational structure (a topic not reported on the balance sheet). The sales to employee ratio describes how well employees are generating sales for the firm. This measurement can be interpreted as being derivative of the firm's organizational success. The calculation is straightforward:

The ratio can be especially insightful for firms in the “people business,” such as retailers, consultants, and software companies.

It is important to note that, if annualized data are being used, ratios that involve balance sheet items (accounts receivable, inventory, and total assets) are usually calculated as the average of the beginning and ending balances. This is done to account for changes in these items throughout the year. If shorter periodicity is in the play, then the values for the end of each period are used.

Profitability

Some of the management efficiency ratios are measurements of the firm's ability to generate sales given its asset size. These ratios don't address how much of the sales turn into profit. A firm that can generate substantial sales but cannot turn those sales into profits is not generating any returns for its owners. Profitability ratios focus on a firm's ability to generate earnings as compared to its direct expenses and other relevant costs. These types of ratios are usually calculated at different “levels” of the income statement to evaluate the firm's efficiency at different stages of the process.

The first level of profitability is gross margin. You will recall from the discussion of the income statement in  Chapter 3  that gross profit is simply the difference between a company's sales and the cost to produce those goods (cost of goods sold). The gross margin ratio is calculated as

This ratio shows how efficiently a business is at using its materials and labor in the production process, and the ratio gives an indication of the pricing, cost structure, and production efficiency of the business. The higher the gross margin ratio, the better.

One step down in the profitability analysis is the operating margin. Operating margin captures how much a company makes or loses from its core operations. It is a much more complete and accurate indicator of a company's performance than gross margin, since it accounts for not only the direct cost of goods sold but also the other important components of operating income, such as marketing and other overhead expenses. Operating margin is calculated as

Analyzing the operating margin is important because the income statement can sometimes be significantly affected by nonrecurring transactions that are not part of a company's core business, such as gains or losses on sales of equipment or tax penalties. The operating margin is a way to measure only the core operations of the firm that are expected to be sustainable into the future.

The final profitability measure is the net profit margin, which is calculated as

Net profit margin considers how much of the firm's revenue it keeps when all expenses or other forms of income have been considered, regardless of their nature. A firm that manages to deliver a greater percentage of its sales as income is doing a good job at keeping costs and other expenses low. The net profit margin indicates what percent of sales is available to shareholders and for reinvestment into the firm.

While net profit margin is important to take note of, net income often contains quite a bit of “noise,” both good and bad, which does not really have much to do with a company's core business, such as gains or losses on property or machinery. Such events can distort both the company's bottom line and the profitability analysis.

The profitability ratios we have considered so far involve only items in the income statement. Another form of profitability analysis is to measure earnings versus a balance sheet item. The two most widely used are return on assets (ROA) and return on equity (ROE). ROA measures a company's ability to turn assets into profit. This is similar to the total asset turnover ratio discussed earlier, but total assets turnover measures how effectively a company's assets generate revenue rather than profit. ROA is calculated as

where T = firm's tax rate.

Notice that the company's after-tax interest expense is added to net income in the calculation. This reflects that return on assets measures the profitability a company achieves on all of its assets, regardless of whether they are financed by equity holders or debt holders; this being the case, we add back what debt holders are charging the company to borrow money. The higher the ROA ratio, the more profit the firm is able to generate from its assets.

The ROE ratio measures a company's return on its investment by shareholders; it tells common shareholders how effectively their money is being employed. ROE is calculated as

Analyzing ROE is important because a company can create shareholder value only if the ROE is greater than its cost of equity capital (the expected return shareholders require for investing in the company given the particular risk of the company). If a firm cannot deliver ROE that is greater than its cost of equity capital, then the firm is actually destroying shareholder wealth. (We examine cost of equity in  Chapter 7 .)

Because ROA and ROE involve balance sheet items in their calculation, common practice is to use the average of the beginning and ending balances to calculate the ratio for the same reasons discussed above. However, when shorter periods of time are involved with the calculation, then only ending balances can be used.

Quality of Earnings

The ROE ratio can be decomposed to provide a more specific source of a firm's superior or inferior performance. Remember that ROE equals Net Income divided by Shareholders’ Equity. We can rewrite the formula as

where T = firm's tax rate.

By doing the math, this formula condenses to the ROE formula above. You may also notice that we have already seen some of these ratios (profit margin, total asset turnover). The purpose of the formula is to see what is actually driving ROE based on other performance measurements. While some of these drivers are desirable as sources of ROE, others are a source of risk, being unsustainable sources of shareholder value creation.

The first term on the right-hand side of the equation is the profit margin ratio discussed previously, although here we use pretax income. A higher profit margin ratio means that the firm is converting more of its sales to net income available to equity shareholders. Ideally, a firm would like to increase this ratio to improve ROE. The second term is the total asset turnover ratio discussed in the management efficiency section. We previously indicated that a higher ratio indicates that management is efficiently using its assets to generate sales. A firm that is able to generate a higher ROE than its competitors because of its asset turnover has a competitive advantage in efficiency.

The third term in the equation is another way of expressing financial leverage. While financial leverage is discussed more in depth in  Chapter 11 , it is necessary to point out here that a higher ratio is not necessarily better and can in fact introduce more risk into the firm. Recall from  Chapter 3  the basic accounting equation: Assets = Debt + Equity. If assets are financed by either debt or equity, then a higher financial leverage ratio means that the firm is using more debt to finance its assets (a larger numerator and a smaller denominator). While having some debt in the firm's capital structure is encouraged due to the tax deductibility of interest, at least in the United States, having too much debt can put the firm in a financial bind and can lead to insolvency. An ROE that is driven largely by financial leverage, therefore, is not sustainable and can indicate that managers provide a return to equity holders only by introducing more financial risk into the firm.

The last component of the formula above, 1 – T, specifies how much of the firm's ROE is due to its tax rate. A lower tax rate will increase the value of this multiplier and hence increase ROE. While it is in the best interest of the firm to have the lowest tax expense possible, increases in ROE due solely to a lower tax rate are not sustainable and could indicate that management is trying to manipulate ROE. All else being equal, a firm that is able to generate a higher ROE due to increased profit margin and/or increased total assets turnover is preferable to one that relies on financial leverage and an abnormally low tax rate.

Market Ratios

If the firm has equity that is publicly traded, one can use market ratios to get an indication of how the market values the firm versus peers (cross-sectional) or relative to its own historical performance (time-series). Because the price of equity is determined by market supply and demand forces, management can be evaluated on how the market views their performance; market value ratios give management an idea of what the firm's investors think of the firm's performance and future prospects. The most common market ratio is the price to earnings (P/E) ratio, calculated as

Note: Old Pueblo Lithographers does not trade in the public market; therefore, no examples of market ratios are available to use as examples.

The ratio specifies how much the market is willing to pay for $1 of the company's earnings. Earnings are a chief driver of investment value, and a higher P/E ratio versus its peers indicates that the market is confident in the firm's ability to generate future earnings. The P/E ratio can be calculated based on the firm's last 12 months’ EPS (trailing P/E) or on the next 12 months’ expected EPS (forward P/E).

The P/E ratio has some drawbacks that derive from the characteristics of EPS. First, EPS can be negative, and the P/E ratio does not make economic sense in that case. Second, the EPS calculation may have large transient components that do not adequately reflect the ongoing operations of the firm. Finally, managers have flexibility in the application of accounting standards used in calculating earnings. In making such choices, managers may distort EPS as an accurate reflection of economic performance. All these factors may affect the comparability of P/Es among companies.

Certain types of privately held companies, including companies organized in partnership form, have long been valued by a multiple of annual sales. The price to sales (P/S) ratio is calculated as

where Sales per Share = Annual Sales/Shares outstanding.

The P/S market valuation alleviates some of the concerns that are present in the P/E ratio. For example, sales are generally less subject to distortion or manipulation than are EPS. Also, as long as the company has begun selling its products or services, the sales figure will always be positive even though EPS can be negative. This point, however, is also a drawback of the P/S ratio, as companies can have sales but consistently post negative earnings. A final reason is that sales are generally more stable than EPS, which reflects operating and financial leverage, and is therefore more meaningful for the firm's economic performance.

The price to book value ratio (P/BV) is also a popular measure of market value. The book value represents the investment that common shareholders have made in the company. The P/BV ratio is

where Book Value per Share (BVPS) = Shareholders’ Equity/Common stock shares outstanding.

Because the purpose of this ratio is to value common stock, any value attributable to preferred stock must be subtracted from shareholders’ equity. Like the P/S ratio, the P/BV can be used even if EPS are negative. Book value is also more stable and can be used if EPS are abnormally high or low.

Numerous other market valuation measures can be calculated, including price to cash flow (P/CF) and enterprise value to EBITDA (EV/EBITDA). The purpose here is not to list them all but rather give an overview and demonstrate how market ratios can be used to gauge how the market values the company. By comparing these ratios against peer companies or historical firm measures, management can get a sense of whether the market agrees on the firm's trajectory.

Limitations of Financial Ratios

There are some important limitations to using financial ratios. First, some firms operate in very unusual, different industries. For these companies, it is difficult to find a meaningful set of industry-average ratios when performing cross-sectional analysis. Second, macroeconomic events such as inflation or recessions can distort a company's financial statements during these disruptive periods. A time-series ratio analysis that covers a disruptive period of time must be interpreted carefully using both skill and judgment. Similarly, seasonal factors can distort ratio analysis. Understanding seasonal factors that affect a business can reduce the chance of misinterpretation. For example, a retailer's inventory may be high in the summer in preparation for the back-to-school season. As a result, the company's days of inventory will be high and its ROA low in summer before the back-to-school sales period. In general, ratio analysis conducted in a mechanical, unthinking manner does not provide good, useful information. On the other hand, if used intelligently, ratio analysis can provide insightful information.

Summary

Using financial ratios is part art and part science. The technique is referred to as “quantitative” because the ratios themselves are calculated mathematically. However, the methodological technique actually provides both a quantitative measurement and a lens through which to view the organization. On one hand, the lens is a quantitative lens because it allows us to view trends and make comparisons using numeric calculations. On the other hand, it is a fundamental qualitative lens because the interpretation of the ratios provides information about the capabilities of management and the quality of the choices and decisions made.

Recall the discussion of “quality of earnings.” For any firm, the desired quantitative outcome is high ROE (when measured as a trend and when benchmarked against a peer group); however, it is always preferred that the firm's ROE be generated via a qualitatively superior process, and ratio analysis is helpful in identifying the quality of that process. By being proficient in using ratio analysis, the ROE of the firm can be quantified and the qualitative manner in which management has achieved the results understood. Virtually all ratios do not just tell us what the quantitative measurement is; rather, each measurement implies a management choice or capability (or failure) with respect to the choices that generated the numbers that are measured by the ratio.

The summary of a ratio analysis for Old Pueblo Lithographers is shown in  Table 4.1 .

Old Pueblo Lithographers has generated results as follows:

1. With respect to liquidity, the company has been able to improve its position in both ratios year over year, and it also is above the industry average for 2013. The firm seems to be in a good position for meeting its short-term obligations.

2. The leverage ratios indicate a mostly positive story. Old Pueblo Lithographers has been able to lower its debt to equity and debt to total assets ratios, indicating less financial leverage. It also has improved on its times interest earned and fixed coverage charge ratios in the past year. Compared to industry averages, the firm has a lower debt structure, but it is below average in both coverage ratios.

3. The profitability ratios, however, tell a different story and indicate an area that the firm must focus on improving. Gross profit margin, net profit margin, and ROE improved year over year, while operating margin and ROA had slight deteriorations. The compelling issue is that for 2013, the firm was below industry standards for all profitability ratios. Operating margin and net profit margin were 5.2 times and 10.2 times, respectively, higher for the industry than for Old Pueblo Lithographers. Since gross profit margin was only slightly below industry averages, a close examination of expenses below the gross profit line is warranted, including SG&A and interest expense.

Note: ROA = return on assets; ROE = return on equity.

a.Source: Almanac of Business and Industrial Financial Ratios, 2013.

b.Based on 45 employees.

4. The management efficiency ratios paint a mixed picture and highlight areas for improvement. Receivables turnover and, in turn, days sales outstanding deteriorated in the past year, pushing days sales outstanding to over twice the industry average. The same is true for inventory turnover and days of inventory, although there was a slight improvement in the firm's year-over-year performance. This indicates that the firm must do a better job of handling its current assets. The accounts payable turnover is slightly below industry average and therefore in an ideal position. Total asset turnover improved slightly in the past year but still trails the industry substantially. Finally, the sales to employee ratio showed improvement year over year and is now even higher than the industry, a positive sign for the firm's use of human capital.

Appendix

a. Includes lease payments of $91,028 and $84,595 for 2013 and 2012, respectively.

b. The firm's tax rate is $30,132/$77,474 = 38.89%.