Case Study on Financial ratios

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Financial Statement Analysis
◙ Although the corporate organizational structure greatly facilitates
the firm's access to investment capital, it also means that stock
ownership is most investors' sole tie to the company. How then
do investors learn enough about a company to know whether or
not they should invest in it?
◙ How can financial managers assess the success of their own firm
and compare it to the performance of competitors?
One way firms evaluate their performance and communicate this inform-
ation to investors is through their financial statements. Firms issue finan-
cial statements regularly to communicate financial information to the
investment community.
Financial statements are accounting reports with past performance inform-
ation that a firm issues periodically (usually quarterly and annually). Reg-
istered companies are required to file their financial statements with the
Securities and Exchange Commission (SEC) on a yearly basis, and with the
BIR when filing their income taxes. They must also send an annual report
with their financial statements to their shareholders each year.
Reports about a company's performance must be understandable and
accurate. The Generally Accepted Accounting Principles (GAAP) provide
a common set of rules and a standard format for companies to use when
they prepare their reports. The standardization also makes it easier to
compare the financial results of different firms. Investors also need some
assurance that the financial statements are prepared accurately. Hence,
corporations are required to hire a neutral third party (known as an Inde-
pendent Auditor) to check the annual financial statements, to ensure
that the annual financial statements are reliable and prepared according
to GAAP.
Studies and analyses show however, that more than 25,000 of the approx-
imately 48,000 domestic listed companies on the 85 major securities ex-
changes in the world use IFRS (International Financial Reporting Stand-
ards). Many countries and multinational companies would like the differ-
ences between GAAP and IFRS eliminated. Blending the two would help
comparisons between businesses based in different regions. Advocates
believe the merger would simplify management, investment, transpa-
rency and accounting training.
The main difference between the standards is that IFRS is principles-
based and GAAP relies on rules and guidelines.
Whichever standard is used in preparing and presenting financial state-
ments, users must refer to the notes to financial statements to ensure
judgments consider both similarities and differences where comparisons
are made between financial statements prepared under GAAP and IFRS.
Financial statement analysis is used to:
◙ compare the firm with itself over time
◙ compare the firm with other similar firms
This module will focus on financial ratios as a tool in the analyses.
Financial Ratio
A comparison in fraction, proportion, decimal or percentage of two significant figures
taken from the financial statements
Expresses the direct relationship between two or more quantities in the statement of
financial position and statement of comprehensive income of a business firm.
Leverage Ratios - shows how heavily the company is in debt.
Liquidity Ratios - measures how easily the company can lay its hands on cash.
Efficiency or Turnover Ratios - measures how efficiently a company uses its assets.
Profitability Ratios - measures the firm's return on investment.
Market-value Ratios - shows how the firm is valued by its investors.
LEVERAGE RATIOS (Leverage - the extent to which a firm relies on debt as a source of
Long-term debt ratio = Long-term debt financing. The debt to equity ratio is a common ratio to assess a firm's
Long-term debt + Equity leverage)
Debt to equity ratio = Long-term debt
Equity
Debt to capital ratio = Total liabilities
Total liabilities + Equity
Total debt ratio = Total liabilities
Total assets
Times interest earned ratio = Earnings before interests & taxes (EBIT) A high ratio indicates that the firm is earning much more than is necessary
Interest payments to meet its required interest payment. As a benchmark, creditors often
look at a ratio in excess of 5 for high-quality borrowers.
Cash coverage = EBIT + depreciation
Interest payments
LIQUIDITY RATIOS
Net working capital to assets = Net working capital
Total assets
Current ratio = Current assets Creditors often compare a firm's current assets and current liabilities to
Current liabilities assess whether the firm has sufficient working capital to meet its short-
term needs.
Quick ratio = Cash + marketable securities + accounts receivable A more stringent test of a firm's liquidity, this ratio compares
Current liabilities only cash and "near cash" assets to current liabilities. (Inventories
may ,at times, be not that liquid)
Cash ratio = Cash + marketable securities Cash ratio is the most stringent liquidity ratio.
Current liabilities
Interval measure = Cash + marketable securities + accounts receivable
Average daily expenditure from operations
EFFICIENCY RATIOS
Total asset turnover = Sales This informs the firm on the number of times (cycles) the total assets were
Average total assets "used" to generate sales. (Note: higher turnover corresponds to shorter days
and thus, more efficient use of the total assets.
Fixed asset turnover = Sales How many times were the fixed assets used to generate sales.
Average fixed assets
Net working capital turnover = Sales
Average net working capital
Inventory turnover = Cost of goods sold
Average inventory
Days' sales in inventories = Average inventory
Cost of goods sold/365
Average collection period = Average receivables This informs the firm how long (in days) before a credit sale becomes cash.
Average sales/365
Average payment period = Average accounts payable This informs the firm how long (in days) before a credit purchase is paid.
Average cost of sales/365
PROFITABILITY RATIOS
Gross margin = Gross profit A firm's gross margin reflects its ability to sell a product for more than the cost of
Sales producing it. (Ex. Sales = 186,700; Cost of the products sold = 153,400. The gross
margin is 186,700 - 153,400 = 33,300; and the ratio would be 33,300/186,700 = 17.8%.)
Net profit margin = EBIT - tax (Net profit)
Sales
Operating margin = Operating income There are additional expenses of operating a business beyond the direct cost of goods
Sales sold. The operating margin ratio is the ratio of the operating income to revenues.
Return on assets (ROA) = EBIT - tax
Average total assets
Return on equity (ROE) = Earnings available to common stock
Average equity
Payout ratio = Dividend per share
Earnings per share
Plowback ratio = 1 - Payout ratio
Growth in equity from plowback = Plowback ration X ROE
MARKET VALUE RATIOS
This P/E ratio is a simple measure that is used to assess whether a stock is over-
P/E Ratio = Stock price or undervalued based on the idea that the value of a stock should be proportional
Earnings per share to the level of earnings it can generate for its shareholders. (All else equal,
riskier firms have lower P/E ratios).
Dividend yield = Dividends per share
Stock price
Market to book = Stock price
Book value per share
The DuPont System Allows a further insight into a firm's ROE, and expresses the ROE in terms
of the firm's profitability, asset efficiency, and leverage.
A system popularized by a chemical company DuPont
Focuses on the links and relationships of some profitability and efficiency ratios
1) ROA = Asset Turnover x Profit Margin
EBIT - Taxes = Sales X EBIT - Taxes
Assets Assets Sales
2) ROE = Asset Turnover x Profit Margin x Equity Multiplier
EBIT - Taxes = Sales X EBIT - Taxes X Assets
Average Equity Assets Sales BV of Equity

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