External Financial Control: Financial Ratio Analysis

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External Financial ControlFinancial Ratio
Analysis

• Chapter 12

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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

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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?

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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onoma State University