Lecture no03 financial ratio analysis

Financial Ratio Analysis
Lecture No. 3
Chapter 2
Contemporary Engineering
Economics, 6th ed.
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Ratio Analysis and What the
Numbers Really Mean
o Debt Management Ratios
o Liquidity Ratios
o Asset Management Ratios
o Profitability Ratios
o Market Trend Ratios
o Trends and Graphs to Spot Problems
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Key Financial Ratios

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Return on Equity: A Composite Ratio
• What to measure: A corporation's
profitability by revealing how much profit a
company generates with the money
shareholders have invested
• How to calculate: The amount of net income
generated as a percentage of shareholders
equity
Net income
Return on Equity (ROE) =
Average shareholders' equity
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Returns on Equity (ROE): Three Components

ROE =

Net income
Average shareholders' equity

Assets
�
�Net income � �Sales � �
 �
�
�
��
��
�
� Sales � �Assets � �Average shareholders' equity �
 (Profit margin) �(Asset turnover) �(Financial leverage)
= (6.18%) �(2.12 times) �(3.64 times)
= 47.68%

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Returns on Equity (ROE) and Levels of
Performance for Ten Diverse Companies
(As of January 26, 2014)
Return on
Equity (%)

Profit
Margin (%)

Asset
Turnover
(times)

Financial
Leverages
(times)

Google (2013)

16.46

21.66

0.59

1.27

Wells Fargo (2013)

13.86

23.96

0.06

9.81

Alcoa (2013)

2.25

1.27

0.60

2.99

Exxon Co. (2013)

20.35

7.7

1.30

2.05

Kroger (2013)

35.65

1.57

3.97

5.11

IBM (2013)

77.90

15.92

0.87

5.93

Nike (2013)

26.70

10.85

1.59

1.57

Wal-Mart (2013)

23.35

3.62

2.28

2.86

Southwest Airline (2013)

8.85

3.55

0.91

2.76

MSFT (2013)

30.09

28.17

0.61

1.74

Note: ROEs may not match exactly the formula values due to ratios were calculated based on different published

.

data Source: MSN Finance

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Debt Management Analysis
 Definition: Ratios that

show how a firm uses
debt financing and its
ability to meet debt
repayment obligations

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Debt Ratio




Indicates how a firm
finances its capital
Formula

Total debt
Debt ratio=
Total assets
$58,000


$161,400
 35.94%
A debt ratio of greater than 1 indicates
that a company has more debt than assets,
a measure of a level of risk.
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Times Interest
Earned Ratio




Measures the extent to
which earnings can
decline without
defaulting on debt service
Formula

EBIT
Times Interest Earned =
Interest Charges
$33,280

$5,200

6.40 times
EBIT: Earnings before interest
and taxes
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Liquidity Analysis
• Definition: Ratios
that show the
relationship of a
firm’s cash and
other assets to its
current liabilities

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Current Ratio




Measures a firm’s
short-term solvency
Formula

Current Assets
Current Ratio =
Current Liabilities
$77,400

$28,000
 2.76 times

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Quick Ratio




Excludes inventories
and prepaid expenses
Formula
Current Assets - Inventories
Current Liabilities
$77,400 $37,700


$28,000
1.42 times

Quick Ratio =

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Liquidity Ratio




An indication of a
firm’s immediate
liquidity
Formula
Cash+Cash Equ.
Current Liabilities
$8,500

$28,000
 0.3036

Liquidity Ratio =

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Asset Management Analysis
• Definition:

A set of
ratios which measure
how effectively a
firm is managing its
assets

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Inventory Turnover
Ratio




Highlights the rate at
which the inventory is
being sold
Formula
Sales
Average Inventory
$300,000

($39,800  $37,700)/2
 7.96 times

Inventory Turnover =

The typical item sits in inventory almost
1.508 months (12 months/7.96) or 45.24
days before being sold

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Days Sales
Outstanding (DSO)




Determines whether
receivables are being
collected aggressively
enough
Formula
A/R
Average sales per day
$23,700

$300 , 000 / 365
 28.84 days

DSO =

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Days Sales in Inventory
• What It Measures: The amount of inventory (stock)
expressed in days of sales. For example, if 2 items are
sold and 20 items are held in inventory per day, this
represents 10 days' (20/2) worth of sales in inventory.
• How To Compute: The ratio computed by dividing
average inventory by cost of sales, and multiplied the
result by 365
Average Inventory

DSI (Days Sales in Inventory)=
Average Cost of Sales per day
($37,700 $39,800)/2

$208,000/365
 68 days
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Total Asset
Turnover Ratio




Indicates whether a
company is generating a
sufficient volume of
business for the size of its
asset investment
Formula
Net Sales
Total Assets
$300,000

$161,400

 1.86 times

Total Asset Turnover =

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Profitability Analysis
• Definition: A set of

ratios which show
the combined effects
of liquidity, asset
management and
debt on operating
results

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Gross Margin




Indicates the
profitability of sales
Formula
Gross Profit ($)
Net Sales
$112,000

$300,000
 37.33%

Gross Margin Ratio =

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Net Margin




Illustrates what
percentage of each
sales dollar is

retained in earnings
Formula
Net Income ($)
Net Sales
$20,000

$300,000
 6.67%

Net Margin Ratio =

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Return on Total
Assets (ROA)




Measures a company’s
success in using its
assets to earn a profit.
Formula
Net Income + interest expenses(1 - tax rate)
Average total assets

$20,000$5,200(10.2877)

($161,400$169,900)/ 2
14.31%

ROA =

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Return on Equity
(ROE)




Measures the rate of
return on the owner’s
investment
Formula

Net Income - Cash dividend to Preferred Stockholders
ROE =
Average Common Equity
$20,000$600


($93,400$83,400)/2
21.95%

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Debt-to-Equity Ratio
o A measure of a company’s financial leverage,
indicating what proportion of equity and
debt the company is using to finance its
assets
o A high debt/equity ratio generally means that
a company has been aggressive in financing
its growth with debt.

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How the Debt to Equity Ratio Impacts
Return on Equity




Not have a spectacular ROE
because there is so much
equity in the company (e.g.,
well-established DOW 30
stocks)
A highly leveraged company
that might have a spectacular
ROE because the owners have
put so little of their own
resources into the company
(e.g., high-tech industries)

Contemporary Engineering Economics, 6 th edition
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Assets

=

Assets

=

Liabilities

Equity

Liabilities

Equity

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