WORKING WITH FINANCIAL STATEMENTS
Financial statement information is often our ONLY source of information. Consequently, we use the information we have and make adjustments where appropriate.
1. Ratio Analysis
♦ Short-Term Solvency or Liquidity Ratios – Measures the ability of the firm to meet its current (short-term, < 1 year) obligations.
• Liquidity is defined as the ability to convert assets to cash quickly without a significant loss in value • Liquidity vs. Profitability trade-off
Current ratio = current assets / current liabilities
Quick ratio = (current assets – inventory) / current liabilities
• Also referred to as the “acid-test” ratio.
Cash ratio = cash / current liabilities
♦ Long-Term Solvency Ratios – This group of ratios really measures two different aspects of leverage – the level of indebtedness and the ability to service debt. The former is indicative of the firm’s debt capacity, while the latter more closely relates to the likelihood of default. The total debt ratio measures what proportion of the firm’s assets are financed with borrowed money, while the debt/equity ratio compares the amount of funds supplied by creditors relative to owners.
Total debt ratio = (total assets – total equity) / total assets = total debt / total assets
Debt-equity ratio = (total assets – total equity) / total
equity = total debt / total equity
Equity multiplier = total assets / total equity = (total equity + total debt) / total equity = 1 + debt-equity ratio
Times interest earned ratio = EBIT / Interest
Cash coverage ratio = (EBIT + depreciation) / interest
♦ Asset Management or Turnover Ratios – Measures how effectively the firm is managing its assets; also called asset utilization ratios.
Inventory turnover = cost of goods sold / inventory
• It is usually more accurate to use average inventory [Beg. + End. / 2] for this calculation.
Days’ sales in inventory = 365 days / inventory turnover
|Days’ Sales in Inventory = Inventory / (Sales per day) = Inventory / (Sales / 365 Days) | |= 365 Days / (Sales / Inventory) = 365 Days / Inventory turnover |
Receivables turnover = sales / accounts receivable
Days’ sales in receivables = 365 days / receivables turnover
|Days’ Sales in Receivables = Accounts receivable / (Sales per day) = Accounts receivable / (Sales / 365 Days) | |= 365 Days / (Sales / Accounts receivable) = 365 Days / Receivables turnover |
• This ratio may also be called “average collection period” or
“days’ sales outstanding.” • We are implicitly assuming that all sales are on credit; if not, only credit sales should be used.
Payables turnover = cost of goods sold / accounts payable
Payables period = 365 / payables turnover
• This is a measure of how long it takes the firm to pay its bills.
Total asset turnover = sales / total assets
• Sales generated for every dollar of assets; affected by the age and book value of assets. • A fixed asset turnover ratio (fixed asset turnover = sales / fixed assets) that is high relative to that of the industry can be the result of efficient asset utilization, or it can indicate that the firm is utilizing old (and perhaps inefficient) equipment, while others in the industry have invested in modern equipment. In this case, the firm using inefficient equipment would display a favorable fixed asset turnover ratio, but would be likely to display a higher level of expenses, and unless offset by other factors, lower profitability – based on cash flow. The firm may have traded a noncash deduction (depreciation) for a higher true cash outflow (operating expense).
Capital intensity ratio = 1 / total asset turnover
• The dollar investment in assets needed to generate $1 in sales.
♦ Profitability Measures – How efficiently the firm uses its assets and manages its operations. Based on book values, so they are not comparable with returns that you see on publicly traded assets.
Profit margin = net income / sales
• Profit margin is an indicator of a company’s pricing policies and its ability to control costs. Differences in competitive strategy and product mix cause profit margin to vary among different companies. Return on assets = net income / total assets
• An indicator of how profitable a company is before leverage, and is compared with companies in the same industry. Since the figure for total assets of the company depends on the book value of the assets, some caution is required for companies whose book value may not correspond to the actual market value.
Return on equity = net income / total equity
• Measures the rate of return on the ownership interest (shareholders’ equity) of the common stock owners. It measures a firm’s efficiency at generating profits from every dollar of net assets (assets minus liabilities), and shows how well a company uses investment dollars to generate earnings growth.
♦ Market Value Measures – Relate the firm’s stock price to its earnings and book value per share.
Earnings per share = net income available to common stockholders / common shares outstanding
• Net income available to common stockholders is computed by subtracting preferred dividends from net income.
Price-earnings ratio = price per share / earnings per share
• The amount investors are willing to pay per dollar of current earnings. • Share prices in a publicly traded company are determined by market supply and demand, and thus depend upon the expectations of buyers and sellers. • The price used to calculate a P/E ratio is usually the most recent price. The earnings figure used is the most recently available, although this figure may be out of date and may not necessarily reflect the current position of the company.
This is often referred to as a trailing P/E, because it involves taking earnings from the last four quarters; the ‘forward P/E’ (or current price compared to estimated earnings going forward twelve months) is also used. • The P/E ratio of a company is a significant focus for management in many companies and industries. This is because management is primarily paid with their company’s stock (a form of payment that is supposed to align the interests of management with the interests of other stock holders), in order to increase the stock price. The stock price can increase in one of two ways: either through improved earnings or through an improved multiple that the market assigns to those earnings.
Price-sales ratio = price per share / sales per share
• A stock’s capitalization divided by its sales over the trailing 12 months. The value is the same whether the calculation is done for the whole company or on a per-share basis. A low price to sales ratio (for example, below 1.0) is usually thought to be a better investment since the investor is paying less for each unit of sales. However, sales don’t reveal the whole picture, since the company might be unprofitable. Because of the limitations, price to sales ratio are usually used only for unprofitable companies, since such companies don’t have a price/earnings ratio (P/E ratio).
Book value per share = total equity / number of common shares outstanding
• Example: A firm sells 12,000 shares for $10 each. The shares have a par value of $1. The retained earnings for this firm are $125,000. What is the book value per share?
|Stockholder’s Equity |
|Common stock at par |$ 12,000 |
|Paid-in-capital |$108,000 |
|Retained earnings |$125,000 |
| Total equity |$245,000 |
In this example, the book value per share = $245,000 / 12,000 = $20.42
• A treasury stock or reacquired stock is stock which is bought back by the issuing company, reducing the amount of outstanding stock on the open market (“open market” including insiders’ holdings). Stock repurchases are often used as a tax-efficient method to put cash into shareholders’ hands, rather than pay dividends. Sometimes, companies do this when they feel that their stock is undervalued on the open market. Other times, companies do this to provide a “bonus” to incentive compensation plans for employees. Rather than receive cash, recipients receive an asset that might appreciate in value faster than cash saved in a bank account. Another motive for stock repurchase is to protect the company against a takeover threat. These shares don’t pay dividends, have no voting rights, and should not be included in shares outstanding calculations.
Market-to-book ratio = market value per share / book value per share
• Also referred to as the Price-to-book ratio. • http://stocks.about.com/od/evaluatingstocks/a/pb.htm • Measures the value that has been added/subtracted to/from the owner’s (stockholder’s) investment.
2. The Du Pont Identity – The Du Pont identity breaks down Return on Equity (that is, the return to equity that investors have contributed to the firm) into three distinct elements: • Operating efficiency (measured by profit margin) • Asset use efficiency (measured by total asset turnover) • Financial leverage (measured by the equity multiplier) This analysis allows the analyst to understand where superior (or inferior) return is derived from by comparison with companies in similar industries (or between industries).
ROE = (NI / total equity)
multiply by one (assets / assets) and rearrange
ROE = (NI / assets) (assets / total equity)
multiply by one (sales / sales) and rearrange
ROE = (NI / sales) (sales / assets) (assets / total equity)
ROE = ROA x equity multiplier
ROE = profit margin x total asset turnover x equity multiplier
These three ratios indicate that a firm’s return on equity depends on its operating efficiency (profit margin), asset use efficiency (total asset turnover), and financial leverage (equity multiplier).