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finance ch. 4

Why are ratios useful?
Ratios standardize numbers and facilitate comparisons.
Ratios are used to highlight weaknesses and strengths.
Ratio comparisons should be made through time and with competitors.
Trend analysis
Industry analysis
Benchmark (peer) analysis
Five Major Categories of Ratios and the Questions They Answer
Liquidity: Can we make required payments?

Asset management: Right amount of assets vs. sales?

Debt management: Right mix of debt and equity?

Profitability: Are sales high enough as reflected in PM, ROE, and ROA?

Market value: Do investors like what they see as reflected in P/E and M/B ratios?

Liquidity ratios:
Current Ratio = Current Assets / Current Liabilities

Quick Ratio = (Current Assets – Inventories) / Current Liabilities

Asset Management ratios:
Inv. Turnover = Sales/Inventories

DSO = AR / (Sales / 365)

FA turnover = Sales/Net fixed assets

TA turnover = Sales/Total assets

Debt Management ratios:
Debt ratio = Total debt/Total assets

TIE = EBIT/Interest charges

Profitability Ratios:
Operating Margin = Operating income (EBIT) / Sales

Profit Margin = Net Income / Sales

Return on Total Assets (ROA) = Net Income / Total Assets

Basic Earning Power = EBIT / Total Assets

Return on Equity (ROE) = Net Income / Equity

Return on Invested Capital (ROIC) =
EBIT(1-T) / Total Invested Capital

Effects of Debt on ROA and ROE
Holding assets constant, if debt increases:
Equity declines.
Interest expense increases – which leads to a reduction in net income.

ROA declines (due to the reduction in net income).

ROE may increase, decrease or maintain (since both net income and equity decline).

problems with ROE
ROE and shareholder wealth are correlated, but problems can arise when ROE is the sole measure of performance.
ROE does not consider risk. (possibly lower NPV)
ROE does not consider the amount of capital invested (Mutually Exclusive Projects)
Given these problems, reliance on ROE may encourage managers to make investments that do not benefit shareholders.
market value ratios:
P/E = Price / Earnings per share
P/E: How much investors are willing to pay for $1 of earnings.

M/B = Market price / Book value
M/B: How much investors are willing to pay for $1 of book value equity.

For each ratio, the higher the number, the better.
P/E and M/B are high if ROE is high and risk is low.

The DuPont Equation
profit margin x total asset turnover x equity multiplier

profit margin = NI/sales
total asset turnover = sales/total assets
equity multiplier = total assets/equity

Focuses on expense control (PM), asset utilization (TA TO), and debt utilization (equity multiplier).

A/R $ 878 Debt $1,545
Other CA 1,802 Equity 1,952
Net FA 817
TA $3,497 Total L&E $3,497

Sales/Day = $7,035,600/365 = $19,275.62

How would reducing the firm’s DSO to 32 days affect the company?

Reducing A/R will have no effect on sales
just an addition to cash that we could use to pay off debt, or invest. these actions would likely improve stock price
Potential Problems and Limitations of Financial Ratio Analysis
Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions. (GE)

Different operating and accounting practices can distort comparisons.(LIFO/FIFO, Depreciation)

Sometimes it is hard to tell if a ratio is “good” or “bad.” (high current ratio)

Difficult to tell whether a company is, on balance, in a strong or weak position. (Discriminant Analysis)

More Issues Regarding Ratios
“Average” performance is not necessarily good, perhaps the firm should aim higher.

Seasonal factors can distort ratios.

“Window dressing” techniques can make statements and ratios look better. (leverage up balance sheet)

Inflation has distorted many firms’ balance sheets, so analyses must be interpreted with judgment.

Qualitative Factors: Company’s Future Financial Performance
Are the firm’s revenues tied to one key customer, product, or supplier?
What percentage of the firm’s business is generated overseas?
Firm’s competitive environment
Future prospects (innovation, pipeline)
Legal and regulatory environment
if i have a high DSO compared to other firms, what does that mean for me?
i collect AR slower than they do.
financial ratio analysis is conducted by three main groups of analysts: credit, stock, and managers, what is the primary emphasis of each group and how would that emphasis affect the ratios on which they focus?
The emphasis of the various types of analysts is by no means uniform nor should it be. Management is interested in all types of ratios for two reasons. First, the ratios point out weaknesses that should be strengthened; second, management recognizes that the other parties are interested in all the ratios and that financial appearances must be kept up if the firm is to be regarded highly by creditors and equity investors. Equity investors (stockholders) are interested primarily in profitability, but they examine the other ratios to obtain information on the riskiness of equity commitments. Credit analysts are more interested in the debt to capital, TIE, and EBITDA coverage ratios, as well as the profitability ratios. Short-term creditors emphasize liquidity and look most carefully at the current ratio.
why would the inventory turnover ratio be more important for someone analyzing a grocery store than an insurance company?
The inventory turnover ratio is important to a grocery store because of the much larger inventory required and because some of that inventory is perishable. An insurance company would have no inventory to speak of since its line of business is selling insurance policies or other similar financial products—contracts written on paper and entered into between the company and the insured. This question demonstrates that the student should not take a routine approach to financial analysis but rather should examine the business that he or she is analyzing before conducting a ratio analysis.
over the past year, a company had an increase in its current ratio and a decline in its total assets turnover ratio. the companies sales, cash equivalents, DSO, and fixed assets turnover ratio remained constant. what balance sheet accounts must have changed to priduce the indicated changes?
Given that sales have not changed, a decrease in the total assets turnover means that the company’s assets have increased. Also, the fact that the fixed assets turnover ratio remained constant implies that the company increased its current assets. Since the company’s current ratio increased, and yet, its cash and equivalents and DSO are unchanged means that the company has increased its inventories. This is also consistent with a decline in the total assets turnover ratio.
PM and turnover ratios vary from one industry to another. what differences would you expect to find between turnover ratios, profit margins, and dupont equations for for a grocery store and a steel company?
Differences in the amounts of assets necessary to generate a dollar of sales cause asset turnover ratios to vary among industries. For example, a steel company needs a greater number of dollars in assets to produce a dollar in sales than does a grocery store chain. Also, profit margins and turnover ratios may vary due to differences in the amount of expenses incurred to produce sales. For example, one would expect a grocery store chain to spend more per dollar of sales than does a steel company. Often, a high turnover will be associated with a low profit margin, and vice versa.
how does inflation distort ratio analysis comparisons for one company over time (trend analysis) and for different companies that are being compared? are only balance sheet items or both balance sheet and income statement items affected?
Inflation will cause earnings to increase, even if there is no increase in sales volume. Yet, the book value of the assets that produced the sales and the annual depreciation expense remain at historic values and do not reflect the actual cost of replacing those assets. Thus, ratios that compare current flows with historic values become distorted over time. For example, ROA will increase even though the same assets are generating the same sales volume.
When comparing different companies, the age of the assets will greatly affect the ratios. Companies with assets that were purchased earlier will reflect lower asset values than those that purchased assets later at inflated prices. Two firms with similar physical assets and sales could have significantly different ROAs. Under inflation, ratios will also reflect differences in the way firms treat inventories. As can be seen, inflation affects both income statement and balance sheet items.
if a firms ROE is low and management wants to improve it, explain how using more debt might help.
ROE is calculated as the return on assets multiplied by the equity multiplier. The equity multiplier, defined as total assets divided by common equity, is a measure of debt utilization; the more debt a firm uses, the lower its equity, and the higher the equity multiplier. Thus, using more debt will increase the equity multiplier, resulting in a higher ROE.
give some examples that illustrate how a. seasonal factors, and b. different growth rates might distort a comparative ratio analysis. how might these problems be alleviated?
a. Cash, receivables, and inventories, as well as current liabilities, vary over the year for firms with seasonal sales patterns. Therefore, those ratios that examine balance sheet figures will vary unless averages (monthly ones are best) are used.

b. Common equity is determined at a point in time, say December 31, 2014. Profits are earned over time, say during 2014. If a firm is growing rapidly, year-end equity will be much larger than beginning-of-year equity, so the calculated rate of return on equity will be different depending on whether end-of-year, beginning-of-year, or average common equity is used as the denominator. Average common equity is conceptually the best figure to use. In public utility rate cases, people are reported to have deliberately used end-of-year or beginning-of-year equity to make returns on equity appear exces¬sive or inadequate. Similar problems can arise when a firm is being evaluated.

why is it sometimes misleading to compare a companies financial ratios with those of other firms that operate in the same industry?
Firms within the same industry may employ different accounting techniques that make it difficult to compare financial ratios. More fundamentally, comparisons may be misleading if firms in the same industry differ in their other investments. For example, comparing PepsiCo and Coca-Cola may be misleading because apart from their soft drink business, Pepsi also owns other businesses, such as Frito Lay and Quaker.
suppose you were comparing a discount merchandiser with a high end merchandiser. suppose further that both companies had identical ROEs. if you applied the DuPont equation to both firms, would you expect the three components to be the same for each company?
The three components of the DuPont equation are profit margin, assets turnover, and the equity multiplier. One would not expect the three components of the discount merchandiser and high-end merchandiser to be the same even though their ROEs are identical. The discount merchandiser’s profit margin would be lower than the high-end merchandiser, while the assets turnover would be higher for the discount merchandiser than for the high-end merchandiser.
look up the PE ratios for verizon wireless and walmart, which company has the higher PE and why could that be?
A review of Yahoo! Finance on 06/25/13 showed that the trailing twelve-month P/E ratio for Verizon was 126.42 compared to 14.65 for Walmart. The P/E ratio indicates how much investors are willing to pay per dollar of reported profits. Verizon’s higher P/E ratio indicates that it has strong growth prospects, while Walmart’s lower P/E ratio indicates that it is a slower growing firm. Walmart is a mature company in a mature industry so the fact that its P/E ratio is lower than Verizon’s is not surprising.
differenciate between ROE and ROIC
ROE measures the rate of return on common stockholders’ investment, while ROIC measures the rate of return to investors—both debtholders and common stockholders. ROIC measures the return to all investors, so after-tax income is used in its numerator because after-tax income is the amount of funds available to both stockholders and debtholders.
current ratio: current assets/current liabilities
if current liabilities are rising faster than current assets, the current ratio will fall; and this is a sign of possible trouble. if current ratio is below the industry average, liquidity is somewhat weak. high current ratio generally indicates a strong and safe liquidity position; it might also indicate that the firm has too much old inventory that will have to be written off and too many old accounts receivables that may turn into bad debts. or a high current ratio might indicate that the firm has too much cash, receivables, or inventory relative to its sales, in which case the assets are not being managed efficiently.
current ratio: quick or acid test ratio: (current assets – inventories)/current liabilities
measure the firms ability to pay off short term debt without relying on inventory. even if it is a low ratio, if the accounts receivable can be collected, the company can pay off its current liabilities even if it has trouble disposing of its inventories.
asset management ratio: inventory turnover ratio
= sales/inventories
shows haw many times inventories are turned over during the year. if it is lower than the industry average it means the firm is holding too much inventory.
asset management ratio: days sales outstanding
DSO= receivables/(sales/365)
shows the average length of time the firm must wait after making a sale before receiving cash. it can be compared with the industry average or with the credit terms. if DSO is greater than credit terms, then this indicates that customers are not paying their bills on time.
asset management ratio: fixed asset turnover:
= sales/net fixed assets
measure how efficiently a firm uses its plant and equipment. if it is above the industry average, this means it is using its fixed assets at least as intensively as other firms.
asset management ratio: total asset turnover ratio:
= sales/total assets
measure the turnover of all of the firms assets. if it is below the industry average, it is not generating enough sales given its total assets.
debt management ratio: total debt to total capital
= total debt/ total capital
= total debt/ total debt + equity
measure the percentage of a firms capital provided by debtholders. recall that total debt include all short term and long term interest bearing debt, but it does not include accruals and accounts payable. creditors prefer low debt ratios because the lower the rate, the greater the cushion against creditors losses in the event of liquidation. stockholders on the other hand may want more leverage because it can magnify expected earnings. if a debt ratio is 47.8% it means that its creditors have supplied roughly half of its total funds.
debt management ratio: times interest earned ratio: TIE
= EBIT/interest charges.
measure the extent to which operating income can decline before a firm is unable to meet its annual interest costs. if it is lower than the industry average it means that it is covering interest by a much lower margin of safety, and would face difficulties if it attempted to borrow additional money.
profitability ratio: operating margin = EBIT/sales
gives the operating profit per dollar of sales. if it is below the industry average, it means the operating costs are too high.
profitability ratio: profit margin = net income/sales
if it is below the industry average, it could be because of high operating costs, also it is because heavy use of debt. we can expect a firm with a higher debt ratio to have a lower profit margin.
profitability ratio: return on total assets ROA
= net income/total assets
it is better to have a higher return on assets than a lower one. but a low one can result from a decision to use more debt, in which case interest expense will increase and net income will decrease.
profitability ratio: return on common equity ROE:
= net income/common equity
this tells how well a stockholder is earning a return on their money.
profitability ratio: return on invested capital ROIC
= EBIT(1-t)/total invested capital
= EBIT(1-t)/debt+equity
measure the total return that the company has provided for its investors.
profitability ratio: basic earning power BEP
= EBIT/total assets
this shows the raw earning power of a firms assets before influence of taxes and debt. if it is lower than the industry average could mean that it have low turnover ratios and poor profit margins on sales.
market value ratios: price/earnings ratio PE ratio:
= price per share/earnings per share
shows how much investors are willing to pay per dollar of reported profits. PE ratios are relatively high for firms with strong growth prospects and little risk but low for slowly growing and risky firms.
market value ratio: market book ratio MB:
market price per share/book value per share

book value per share = common equity/shares outstanding

indicates how investors regard the company. companies that are well regarded by investors which means low risk and high growth, have high MB ratios. MB rates typically exceed 1, which means that investors are willing to pay more for stocks than the accounting book values of the stock.
tying the ratios together: the DuPont equation

ROE = ROA x equity multiplier
ROE= profit margin x total asset turnover x equity mult.
ROE= NI/sales x sales/total assets x total assets/ total common equity.

if a firm relies too heavily on ROE to measure performance 3 problems can occur:
1. ROE does not consider risk
2. does not consider the amount of invested capital
3. can cause managers to turn down profitable projects
the process of comparing a particular company with a subset of top competitors in their industry.
trend analysis
an analysis of a firms financial ratios over time; used to estimate the likelihood of improvement or deterioration in its financial condition.

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