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External Financial Control: Financial Ratio Analysis

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... goodwill is not written off, and the effect of the deferred income tax calculation is reversed ... for what is an appropriate value vary across industries ... – PowerPoint PPT presentation

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Title: External Financial Control: Financial Ratio Analysis


1
External Financial ControlFinancial Ratio
Analysis
  • Chapter 12

2
External Financial Control Tools
  • For many years analysts have studied
    organizations using external financial control
    tools, divided into two broad groups
  • Common size statements (vertical analysis)
  • Balance Sheet
  • Income Statement
  • Financial Ratios
  • Profitability
  • Efficiency
  • Financial leverage
  • Liquidity
  • Asset use (Productivity)
  • Market Value

3
Common Size Balance Sheet (1 of 2)
  • The common size balance sheet has two purposes
  • To identify trends in a companys balance sheet
    components over time
  • For example, is working capital increasing or
    decreasing over time?
  • To compare balance sheet components of similar
    organizations
  • For example, is this organization holding more
    debt than similar organizations?

4
Common Size Balance Sheet (2 of 2)
  • In a common size balance sheet
  • Each item on the asset side of the balance sheet
    is expressed as a percent of total assets
  • Each item on the liabilities and shareholders
    equity side of the balance sheet is expressed as
    a percent of the total liabilities and
    shareholders equity

5
Common Size Income Statement
  • The common size income statement provides many
    valuable insights by identifying each of the cost
    elements as a percentage of sales
  • This provides guidance to management and
    investors of the opportunities and potential to
    reduce costs
  • Again it is useful to consider both the trend of
    these individual items through time and the
    comparison of these items with a competitor

6
Profitability Ratios (1 of 5)
  • Return on Assets
  • Net income ? Total Assets
  • A measure of the return generated by the assets
  • Independent of how the assets are financed
  • Return on Common Equity
  • Net income ? Common Equity
  • A ratio that measures the return to the
    organizations shareowners
  • Reflects the effect of financial leverage
  • Occurs when the organization uses fixed income
    capital (like debt) in its capital structure
  • Financial leverage increases returns to the
    shareowners when the organization is profitable
    and reduces returns when it is unprofitable

7
Profitability Ratios (2 of 5)
  • Economic Value Added
  • Computes the return to shareowners that exceeds
    the minimum return on investment that shareowners
    require
  • The calculation, beyond the scope of this text,
    requires an adjustment of GAAP income for its
    conservatism, a calculation of the organizations
    weighted average cost of capital, and a
    calculation of the investment level in the
    organization
  • Examples of adjustments include research and
    development and advertising are capitalized and
    expensed, goodwill is not written off, and the
    effect of the deferred income tax calculation is
    reversed

8
Profitability Ratios (3 of 5)
  • Market Value Added
  • Computes the excess of market value of the firm
    over total historical investments
  • An estimate of the organizations cumulative
    value creation for shareowners
  • The calculation of market value added is beyond
    the scope of this text
  • Earnings Per Share (EPS)
  • (Net income preferred dividends) ?
    weighted average number of shares outstanding
  • The weighted average number of shares outstanding
    during the year is readily available since
    organizations are required to report it in their
    financial statements

9
Profitability Ratios (4 of 5)
  • Earnings Per Share (cont.)
  • EPS is perhaps one of the most widely quoted
    financial measures of performance
  • It is the monetary unit return to the investor
    from holding the organizations common stock
  • Fully diluted EPS computes the EPS as if all
    outstanding financial instruments that are
    convertible to stock (e.g., stock options and
    convertible debt) were exercised
  • Organizations are required to report fully
    diluted earnings per share in their annual
    reports
  • Dividend Yield Ratio
  • Dividends per share ? market price per share

10
Profitability Ratios (5 of 5)
  • Dividend Yield Ratio (cont.)
  • Measures the cash return on the market price of a
    share
  • This is an important measure of shareowner return
    for shareowners that value dividends
  • The other element of shareowner return is the
    appreciation in share value
  • A low level of this ratio implies that either
    growth or the underlying value of the companys
    assets are supporting the share price since no
    shareowner would be satisfied with a low return
  • Some people expect the amount of dividends paid
    to increase after recent changes in the tax law
  • The affect on dividend yield is unclear since
    this and other changes may increase stock prices

11
Efficiency Ratios (1 of 3)
  • Gross Profit Margin
  • Gross Profit ? Sales
  • Measures the proportion of each sales dollar that
    is consumed by manufacturing costs
  • For this reason, analysts use the gross profit
    margin as a measure of manufacturing efficiency
  • The gross margin residual is what is available to
    cover all the non-manufacturing expenditures and
    to pay interest and taxes
  • Operating Profit Margin
  • Earnings before Interest Taxes ? Sales

12
Efficiency Ratios (2 of 3)
  • Operating Profit Margin (cont.)
  • Computes the proportion of each sales dollar that
    is available to pay interest and taxes and
    provide a return to shareowners
  • The relevance of the word operating in the name
    of this ratio is that revenues or expenses that
    are deemed to be unusual or non-operating items
    are not included in computing this ratio
  • Net Profit Margin
  • Net Income ? Sales
  • Computes the proportion of total revenues that
    are available for distribution to the shareholders

13
Efficiency Ratios (3 of 3)
  • Net Profit Margin (cont.)
  • When this ratio is negative, as a result of a net
    loss, it is frequently not reported or reported
    as N/A (not applicable) since it cannot be
    interpreted in the same manner as a positive net
    profit margin

14
Financial Leverage Ratios (1 of 2)
  • Debt/Equity Ratio
  • Total Debt ? Total Equity
  • A measure of financial risk
  • The higher the ratio the more financial risk
  • Because interest must be paid on debt
    irrespective of the organizations profitability
  • While standards for what is an appropriate
    debt/equity ratio vary across industries, values
    between 50 and 70 are common
  • Debt Ratio
  • Total Debt ? Total Equity
  • Another measure of financial risk

15
Financial Leverage Ratios (2 of 2)
  • Debt Ratio (cont.)
  • As in the case of the debt/equity ratio, the
    standards for what is an appropriate value vary
    across industries
  • Values between 33 and 66 are common

16
Liquidity Ratios (1 of 4)
  • Current Ratio
  • Current assets ? Current liabilities
  • A measure of short run liquidity
  • It measures the organizations ability to cover
    its short-term liabilities
  • The liabilities that are due in the upcoming
    fiscal year
  • Although the norm varies from industry to
    industry, a value of 2 is often considered to be
    appropriate
  • Quick Ratio
  • (Current assets Inventory) ? Current
    liabilities
  • Another measure of short run liquidity

17
Liquidity Ratios (2 of 4)
  • Quick Ratio (cont.)
  • The major difference between this and the current
    ratio is that the value of inventory is excluded
    in the calculation of the quick ratio on the
    grounds that inventory cannot be easily
    liquidated to pay current liabilities
  • Although the norm for an appropriate current
    ratio varies from industry to industry, a value
    of 1 is often considered to be appropriate
  • Times Interest Earned Ratio
  • EBIT ? Interest expense
  • This is another measure of financial risk

18
Liquidity Ratios (3 of 4)
  • Times Interest Earned Ratio (cont.)
  • Since interest payments are contractual and
    required, this ratio provides insights into the
    organizations ability to meet its interest
    payments
  • Since interest is paid with cash, not income, the
    times interest earned ratio may not be a good
    indicator of the organizations ability to pay
    interest
  • Free Cash Flow
  • Net cash flow from operations net cash flows
    from investment activities cash dividends paid
  • Measures the excess of cash flow generated by
    operations over the amount of cash required to
    make investments to sustain the organization and
    pay dividends

19
Liquidity Ratios (4 of 4)
  • Free Cash Flow (cont.)
  • In effect it is residual or excess cash
  • Analysts originally viewed free cash flow as
    problematic since it represented funds that
    organizations might use speculatively
  • Over time this original meaning has changed and
    analysts now view free cash flow as a measure of
    the organizations liquidity

20
Asset Use (Productivity) Ratios (1 of 6)
  • Accounts Receivable Turnover
  • Credit sales ? Accounts receivable
  • Managements ability to minimize inventory,
    accounts receivable, and other elements of
    working capital, for a given level of sales
    activity enhances the organizations ability to
    reduce working capital and increase return on
    investment
  • For many organizations the investment in
    inventory and accounts receivable can be
    significant
  • However, a high turnover number is not
    necessarily good
  • Since granting trade credit is often a sales
    inducement, high turnover measures for accounts
    receivable may signal an organization that is
    managing its credit terms too tightly and losing
    sales

21
Asset Use (Productivity) Ratios (2 of 6)
  • Accounts Receivable Turnover (cont.)
  • To compute the accounts receivable turnover we
    need a statistic that is not commonly provided in
    the organizations financial statements the
    proportion of sales that are credit sales
  • For large organizations it is reasonably safe to
    assume that all sales are credit sales so the
    analyst replaces credit sales with sales in the
    numerator of the accounts receivable turnover
    ratio
  • Factoring (selling) some A/R improves the
    turnover ratio, but tends to be evidence of an
    organization that has cash flow problems

22
Asset Use (Productivity) Ratios (3 of 6)
  • Accounts Receivable Turnover (cont.)
  • Moreover, since the cash obtained from factoring
    receivables will appear in the free cash flow
    statement, factoring compromises the
    interpretation of the cash management
    implications of the free cash flow number
  • Organizations that face highly varying demand
    over the year will experience highly fluctuating
    levels of accounts receivable
  • These organizations use average accounts
    receivable held to compute the accounts
    receivable turnover ratio

23
Asset Use (Productivity) Ratios (4 of 6)
  • Inventory Turnover
  • Cost of Sales ? Average level of inventory
  • A measure of managements ability to control its
    investment in inventory
  • Since the 1980s managers have looked at
    inventory as a drain on return on investment and
    have looked for ways to minimize inventory as a
    percent of sales
  • Just-in-time (JIT) manufacturing systems is the
    hallmark of this inventory management movement
  • However, JIT systems need to be error free since
    a breakdown at any point in the system will idle
    the system until the breakdown is repaired

24
Asset Use (Productivity) Ratios (5 of 6)
  • Inventory Turnover (cont.)
  • Organizations that face seasonal demand where
    inventory levels vary widely over the year use
    average inventory held during the year
  • The inventory turnover ratio uses cost of sales
    rather than sales in the numerator
  • Inventory is measured at cost consistency
    requires that cost be used in the numerator
  • Total Asset Turnover
  • Sales ? Total assets
  • Measures managements ability to use assets
    effectively to generate sales

25
Asset Use (Productivity) Ratios (6 of 6)
  • Total Asset Turnover (cont.)
  • Holding too many assets will increase the capital
    invested in the organization and lower the return
    to capital
  • Asset use is the primary focus of the economic
    value added (EVA) measure discussed earlier
  • Fixed Asset Turnover
  • Sales ? Net fixed assets
  • Works with the inventory turnover ratio and the
    accounts receivable turnover ratio to further
    explain the elements of the total asset turnover
    ratio

26
Market Value Ratios (1 of 3)
  • Price earnings (P/E) ratio
  • Market price of common stock ? earnings per share
  • One of the most widely quoted market statistics
  • The P/E ratio cannot be computed when the company
    shows a loss
  • The P/E ratio indicates the number of years that,
    at the current earnings rate, it would take for
    the sum of earnings to equal share price
  • A high value indicates expectations for growth
  • Market value to book value
  • Market value per share ? Book value per share
  • Computes the value that the market attributes to
    an organization as a proportion of its measured
    assets

27
Market Value Ratios (2 of 3)
  • Market value to book value (cont.)
  • We would expect this value to be more than one
    for a number of reasons
  • Organizations have many resources such as
    employees and its reputation that do not appear
    on the balance sheet as assets
  • Assets are recorded at net book value (historical
    cost less accumulated depreciation) and not their
    current realizable value
  • Book value is taken as an approximation of the
    proceeds of liquidation attributable to the
    common shareowners

28
Market Value Ratios (3 of 3)
  • Market value to book value (cont.)
  • Therefore, the ratio reflects the premium over
    book value that the market assigns to the
    organization
  • When this ratio falls below 1 it signals that the
    market believes that the organizations
    liquidation value is higher than its value as an
    ongoing business

29
Ratio Trends and Comparative Values
  • Individual ratio values are not meaningful in
    isolation
  • The trends of these values and their comparison
    to industry averages puts the ratios in context
    and supports interpretation
  • Financial ratio analysis provides an interesting
    first step in evaluating an organizations
    performance
  • In spite of limitations, analysts continue to use
    and interpret financial ratios
  • This widespread use reflects the belief that
    these ratios provide important insights
  • Particularly if combined with other information
    such as information gleaned about the
    organizations strategic initiatives and
    information such as that contained in a balanced
    scorecard

30
Limitations of FinancialRatio Analysis (1 of 3)
  • Financial ratio analysis, however, has some
    limitations
  • Comparing an organization that is in a single
    line of business with an organization that is a
    competitor but has multiple lines of business is
    likely to be a meaningless comparison of unlike
    organizations
  • Even though organizations might be comparable
    because they are in similar lines of business,
    they may use different accounting conventions
    making ratio comparisons between the two
    organizations meaningless

31
Limitations of FinancialRatio Analysis (2 of 3)
  • Interpreting trends in a single organizations
    financial ratio may be difficult because of the
    effect of unknown economic or competitive forces
    on the organization
  • It may be difficult to determine an appropriate
    or acceptable value for a particular ratio,
    particularly if the industry is in a recession
  • When there are strong seasonality effects, making
    comparisons with financial data that is a
    snapshot of its financial activities at the
    organizations year-end may be meaningless
  • When organizations manipulate or misrepresent
    their financial information, the financial ratios
    drawn from these data will be misleading

32
Limitations of FinancialRatio Analysis (3 of 3)
  • Like all numbers based on historical results,
    financial ratios look backward
  • It may be difficult or even meaningless to use
    past data to predict future performance
  • Because they are backward looking, financial
    ratios ignore an organizations strategic
    initiatives and may misrepresent future results
    resulting from current initiatives
  • Despite these limitations analysts continue to
    use and interpret financial ratios
  • This widespread use reflects the belief that
    these ratios provide important insights

33
If you have any comments or suggestions
concerning this PowerPoint presentation, please
contactTerry M. Lease(terry.lease_at_sonoma.edu)S
onoma State University
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