Financial Statements AnalysisRatio Analysis

EBD 481, Fall 2007Instructor: Galbraith

Adapted from William Messier, Jr., Financial Ratios

Financial Ratios The cornerstone of financial statement analysis is

the use of ratios. In entrepreneurship used extensively in

developing and analyzing business plan pro-formas and for purposes of valuation

Financial ratios are generally grouped into four categories: Short-term liquidity ratios Long-term solvency ratios Profitability ratios Market price and dividends ratios

Financial Ratios Financial analysis using ratios is useful to

investors because the ratios capture critical dimensions of the economic performance of the company.

Managers use ratios to guide, measure, and reward workers. Often companies base employee bonuses on a

specific financial ratio or a combination of some other performance measure and a financial ratio.

Financial RatiosShort-term liquidity ratios

Name of Ratio Numerator Denominator

Current ratio Current assets Current liabilities

Quick ratio Cash + Marketable securities + Receivables

Current liabilities

Average collection period in days

Average accounts receivable x 365

Sales

Inventory turnover Cost of goods sold Average inventory at cost

Financial RatiosLong-term solvency ratios

Name of Ratio Numerator Denominator

Total debt to total assets Total liabilities Total assets

Total debt to equity Total liabilities Stockholders' equity

Interest coverage Income before interest and taxes

Interest expense

Financial RatiosProfitability ratios

Name of Ratio Numerator Denominator

Return on stockholders' equity

Net income Average stockholders' equity

Gross profit rate or percentage

Gross profit or gross margin Sales

Return on sales Net income Sales

Asset turnover Sales Average total assets available

Pretax return on operating assets

Operating income Average total assets available

Earnings per share Net income less dividends on preferred stock, if any

Average common shares outstanding

Financial RatiosMarket price and dividend ratios

Name of Ratio Numerator Denominator

Price-earnings Market price of common stock

Earnings per share

Dividend yield Dividends per common share

Market price of common stock

Dividend-payout Dividends per common share

Earnings per share

Another important ratio for small business Discretionary Cash Flow/Sales

Discretionary Cash Flow = net income + owners compensation + non-cash expenses (most often depreciation)

Why is this sometimes a better measure of performance than “net-income” for small firms?

Evaluating Financial Ratios Financial ratios are evaluated using three

types of comparisons. Time-series comparisons - comparisons of a

company’s financial ratios with its own historical ratios

Benchmarks - general rules of thumb specifying appropriate levels for financial ratios

Cross-sectional comparisons - comparisons of a company’s financial ratios with the ratios of other companies or with industry averages

Ratios Ratios mean different things to different groups.

A creditor might think that a high current ratio is good because it means that the company has the cash to pay the debt.

However, a manager might think that a high current ratio is undesirable because it could mean that the company is carrying too much inventory or is allowing its receivables to get too high.

Because financial ratios may be interpreted differently by different users, the users of the financial ratios must understand the company and the business before drawing conclusions.

Operating Performance andFinancial Performance Measures of profitability are affected by

both financing and operating decisions. Financial management is concerned with where

the company gets cash and how it uses that cash.

Operating management is concerned with the day-to-day activities that generate revenues and expenses.

Ratios that assess operating efficiency should not be affected by financial management performance.

Operating Performance Rate of return on investment - evaluates

the overall success of an investment by comparing what the investment returns with the amount of investment initially made

capital Invested

IncomeRate of return

on investment

Operating Performance Income may be defined differently for

alternative purposes. Net earnings Pretax income from operations Earnings before interest and taxes (EBIT)

Invested capital may also be defined differently. Stockholders’ equity Total capital provided by both debt and equity

sources

Operating Performance Operating performance is best measured

by pretax operating rate of return on total assets, often referred to as return on total assets.

available assets totalAverage

income Operating

Pretax operatingrate of returnon total assets

Operating Performance The expanded expression of pretax

operating rate of return on total assets highlights that operating income percentage and asset turnover will each increase the rate of return on assets. Using these two ratios allows manipulation of

either one to determine what happens to the rate of return under different scenarios.

Operating Performance

Pretax Returnon Total Assets

Operating Income% on Sales

Total AssetTurnover

OperatingIncome

Sales

Sales

Average TotalAssets

x

Operating Performance This decomposition of return on total

assets can also be applied to the return on equity. This is often referred to as the DuPont analysis.

equity Average

assets totalAverage

assets totalAverage

Sales

Sales

incomeNet ROE

LeverageoverAsset turnsaleson Return ROE or

Financial Performance Debt and equity financing must be balanced in

order to achieve good financial performance. Firms must choose how much debt is appropriate. The firms must also choose how to split their

debt between short-term debt and long-term debt.

The prudent use of debt is a major part of intelligent financial management.

Is there a difference in the appropriate use of debt by small entrepreneurial firms and larger corporations?

Is there a difference in the appropriate use of debt by small entrepreneurial firms and larger corporations? Higher interest rates paid by smaller firms More security needed by smaller firms Stricter qualification rules by banks Inability to access the bond market Personal guarantees by founders often

required Need to maintain debt capacity for growth

Financial Performance Short-term debt must be repaid or

refinanced in a short period of time. If a company has trouble repaying the debt, it

will also generally have trouble refinancing the debt.

Naturally, lenders like healthy borrowers, not troubled borrowers.

Financial Performance Long-term debt or equity are generally

used to finance long-term investments. Debt financing is more attractive than equity

financing because: Interest payments are deductible for income tax

purposes, but dividends are not deductible. The ownership rights to voting and profits are kept by

the present shareholders. Then why do so many small companies prefer

to raise money by equity (selling stock to friends and families)?

Net profit Margin

Net profit Margin

ROEROE

Return on Assets (Profitability)

Return on Assets (Profitability)

Financial leverage

Financial leverage

Asset turnover

Asset turnover

LiquidityLiquidity

SolvencySolvency

Net incomeNet income SalesSales//

SalesSales Total costTotal cost——

Cost of goods soldCost of goods sold

SG&ASG&A

R&DR&D

Interest expenseInterest expense

Income taxesIncome taxes

SalesSales Total assetsTotal assets//

Current assets

Current assets

Noncurrentassets

Noncurrentassets++

LandLand

BuildingBuilding

EquipmentEquipment

IntangiblesIntangibles

OthersOthers

CashCash

Acc. ReceivablesAcc. Receivables

InventoryInventory

OtherOther

Financial Performance

Trading on the Equity General comments about leveraging:

A debt-free, or unleveraged, company has identical return on assets (ROA) and return on equity (ROE).

When a company has a ROA greater than the interest rate it is paying its lenders, ROE exceeds ROA.

This is called favorable financial leverage. When a company is unable to earn at least the

interest rate on the money borrowed, the return on equity will be lower than it would be for a debt-free company.

The more stable the income, the less dangerous it is to trade on the equity.

Economic Value Added The idea behind economic value added

(EVA) is that a company must earn more than it must pay for capital if it is to increase in value. Capital is considered both debt and equity. The cost of capital in EVA is a weighted average

of interest cost and the returns required by equity investors.

If a company has positive EVA, the company is adding value; if a company has negative EVA, the company is losing value and might be better off liquidating.

Income tax effects Complicates analysis, but not really

important for start-up companies. Why?