RATIO ANALYSIS-OVERVIEW Ratios .edu
RATIO ANALYSIS-OVERVIEW Ratios: 1. Provide a method of standardization 2. More important - provide a profile of firm's economic characteristics and
competitive strategies.
? Although extremely valuable as analytical tools, financial ratios also have limitations. They can serve as screening devices , indicate areas of potential strength or weakness, and reveal matters that need further investigation.
? Should be used in combinations with other elements of financial analysis.
? There is no one definitive set of key ratios; there is no uniform definition for all ratios; and there is no standard that should be met for each ratio.
? There are no "rules of thumb" that apply to the interpretation of financial ratios.
Caveats: ? economic assumptions - linearity assumption ? benchmark ? manipulation - timing
accounting methods ? negative numbers
Ratios - 1
Common Size Financial Statements
Differences in firm size may confound cross sectional and time series analyses. To overcome this problem, common size statements are used.
A common size balance sheet expresses each item on the balance sheet as a percentage of total assets
A common size income statement expresses each income statement category as a percentage of total sales revenues
Sales
1
2
3
4
$ 101,840 $ 109,876 $ 115,609 $ 126,974
COGS $ 78,417 $ 83,506 $ 85,551 $ 93,326
SG&A $ 20,368 $ 24,722 $ 27,168 $ 31,109
PROFIT $ 3,055 $ 1,648 $ 2,890 $ 2,539
Sales COGS SG&A PROFIT
1 100.0%
77.0% 20.0% 3.00%
2 100.0%
76.0% 22.5% 1.50%
3 100.0%
74.0% 23.5% 2.50%
4 100.0%
73.5% 24.5% 2.00%
Sales COGS SG&A PROFIT
1 100% 100% 100% 100%
2 108% 106% 121%
54%
3 114% 109% 133%
95%
4 125% 119% 153%
83%
Ratios - 2
Problem 4-8
A. Aerospace B. Airline C. Chemicals & Drugs
D. Computer Software E. Consumer Foods F. Department Stores
G. Consumer Finance H. Newspaper Publishing I. Electric Utility
Common size statements
Balance Sheet
Company
1
Cash and short-term investments Receivables Inventory Other current assets
Current assets
2% 17 15
6 40 %
2
13 % 8
52 -
73 %
3
37 % 22 15
5 79 %
4
1% 28 23
1 53 %
5
1% 23 14
4 42 %
6
3% 5 2 2 12 %
7
1% 11
2 2 16 %
8
22 % 16
1 39 %
9
6% 8 5 19 %
Gross property Less: Accumulated depreciation
Net property
86
40
(50) (19) 36 % 21 %
26
44
63
112
65
(8)
(15)
(23)
(45)
(28)
18 % 29 % 40 % 67 % 37 %
1
106
-
(34)
1 % 72 %
Investments Intangibles and other Total assets
3 21 100 %
1 5 100 %
3 100 %
18 100 %
3 15 100 %
14 7
100 %
16 31 100 %
55 5
100 %
9 100 %
Trade payables Debt payable Other current liabilities
Current liabilities
Long-term debt Other liabilities
Total liabilities Equity Total liabilities & equity
11 4 9
24 %
20 16 60 % 40 100 %
21 -
43 64 %
5 69 % 31 100 %
22 3 -
25 %
12 1
38 % 62 100 %
13 6 -
19 %
27 21 67 % 33 100 %
26 4 1
31 %
23 16 70 % 30 100 %
7 6 4 17 %
34 12 63 % 37 100 %
11 2 1
14 %
24 13 51 % 49 100 %
46 16 62 %
27 5
94 % 6
100 %
20 4 8
32 %
21 12 65 % 35 100 %
Income statement Company
Revenues
1
2
3
4
5
6
7
8
9
100 % 100 % 100 % 100 % 100 % 100 % 100 % 100 % 100 %
Cost of goods sold Operating expenses Research % development Advertising
Operating income Net interest expense
Income from continuing operations before tax
58 21
7 3 11 % 1
10 %
81 7 5 7%
(1)
8%
58 24
9 3 6% -
6%
63 28
2 7% 2
5%
52 33
1 5 9% 2
7%
84
16 % 6
10 %
59 29
12 % 3
9%
55
45 % 41
4%
91
2 7% 1
6%
Asset turnover ratio
0.96 1.12 0.94 1.38 1.82 0.45 0.96 0.15 0.96
Ratios - 3
Four categories of ratios to be covered are: 1 . Activity ratios - the liquidity of specific assets and the efficiency of managing assets 2. Liquidity ratios - firm's ability to meet cash needs as they arise; 3. Debt and Solvency ratios - the extent of a firm's financing with debt relative to equity and its ability to cover fixed charges; and 4. Profitability ratios - the overall performance of the firm and its efficiency in managing investment (assets, equity, capital)
These categories are not distinct as we shall see activity -------> liquidity
activity ---------> profitability solvency profitability
Ratios - 4
A. ACTIVITY RATIOS: ASSET MANAGEMENT & EFFICIENCY
1. Short-term (operating) activity ratios:
Inventory Turnover Ratio (COGS)/(Average inventory) Measures the efficiency of the firm in managing and selling inventory. Inventory does not languish on shelves. High ratio represent fewer funds tied up in inventories -- efficient management. High inventory can also represent understocking and lost orders. Low turnover can also represent legitimate reasons such as preparing for a strike, increased demand, etc. Ratio depends on industry -perishable goods etc.)
Average # of days inventory in stock = 365 / (Inventory Turnover Ratio)
Receivable Turnover Ratio Sales/(Average receivable) How many times receivables are turned into cash Relatively low turnover may
indicate inefficiency, cutback in demand, or earnings manipulations.
Average # of days receivable are outstanding = 365/(Receivable Turnover) (When available, the figure for credit sales can be substituted for net sales since credit sales produce the receivables.)
Provides information about the firm's credit policy. Should be compared with the firm's stated policy (i.e., if firm policy is 30 days and average collection period is 60 days, company is not stringent in collection effort.)
High/low relative to the industry should be examined (i.e., low might indicate loss sales to competitors).
Low turnover ratios may imply ? firm's income overstated ? future production cutbacks ? future liquidity problems
Ratios - 5
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