Financial ratio analysis A reading prepared by Pamela Peterson Drake
OUTLINE
1. 2. 3. !. ".
Introd Intr oduc ucti tion on Liqu Li quid idit ity y rat ratio ios s Proftab Pr oftabilit ility y ratios ratios and and actii actiity ty ratios ratios Fina inanci ncial al leer leerage age ratio ratios s #$ar #$ are$ e$ol olde derr ratios ratios
1. Introduction As a manager% you may &ant to re&ard employees based on t$eir per'ormance. (o& do you kno& $o& &ell t$ey t$ey $ae $ae done) done) (o& can you determin determine e &$at &$at depart departmen ments ts or diisions $ae per'ormed &ell) As a lender% $o& do decide t$e borro&er &ill be able to pay back as promised) As a manager o' a corporation $o& do you kno& &$en e*isting capacity &ill be e*ceeded and enlarged capacity &ill be needed) As an inestor% $o& do you predi predict ct $o& &e &ell ll t$e securit securities ies o' one compa company ny &ill &ill per'or per'orm m rela relati tie e to t$at t$at o' anot$er) (o& can you tell &$et$er one security is riskier t$an anot$er) +e can address all o' t$ese questions t$roug$ fnancial analysis. ealuation% and interpretation o' fnancial data% along Financial analysis is t$e selection% ealuation% &it$ ot$er pertinent in'ormation% to assist in inestment and fnancial decision,making. Finan inanci cial al anal analys ysis is may may be used used inte intern rnal ally ly to eal ealua uate te issu issues es suc$ suc$ as empl employ oyee ee per'ormance% t$e e-ciency o' operations% and credit policies% and e*ternally to ealuate potential inestments and t$e credit,&ort$iness o' borro&ers% among ot$er t$ings. $e analyst dra&s t$e fnancial data needed in fnancial analysis analysis 'rom many sources. $e prima primary ry sourc source e is t$e data proi proided ded by t$e company company itsel' itsel' in its annual annual repor reportt and required disclosures. $e annual report comprises t$e income statement% t$e balance s$eet% and t$e statement o' cas$ /o&s% as &ell as 'ootnotes to t$ese statements. 0ertain businesses are required by securities la&s to disclose additional in'ormation. esides in'ormation t$at companies are required to disclose t$roug$ fnancial statements% ot$er in'ormation is readily aailable aailable 'or fnancial analysis. For e*ample% e*ample% in'ormation suc$ as t$e market prices o' securities o' publicly,traded corporations can be 'ound in t$e fnancial press and t$e electronic media daily. #imilarly% in'ormation on stock price indices 'or industries and 'or t$e market as a &$ole is aailable in t$e fnancial press. press. Anot$er source o' in'ormation is economic data% suc$ as t$e ross Domestic Product and 0onsumer Price Inde*% &$ic$ may be use'ul in assessing t$e recent per'ormance or 'uture prospects o' a company or industry. #uppose you are ealuating a company t$at o&ns a c$ain o' retail outlets. +$at in'ormation do you need to udge t$e company4s per'ormance and fnancial condition) 5ou need fnancial data% but it doesn4t tell t$e &$ole story. 5ou also need in'ormation on consumer spending% producer prices% consumer prices% and t$e
Financial ratios% a reading prepared by Pamela Peterson Drake
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competition. $is is economic data t$at is readily aailable 'rom goernment and priate sources. esides fnancial statement data% market data% and economic data% in fnancial analysis you also need to e*amine eents t$at may $elp e*plain t$e company4s present condition and may $ae a bearing on its 'uture prospects. For e*ample% did t$e company recently incur some e*traordinary losses) Is t$e company deeloping a ne& product) 6r acquiring anot$er company) Is t$e company regulated) 0urrent eents can proide in'ormation t$at may be incorporated in fnancial analysis. $e fnancial analyst must select t$e pertinent in'ormation% analy7e it% and interpret t$e analysis% enabling udgments on t$e current and 'uture fnancial condition and operating per'ormance o' t$e company. In t$is reading% &e introduce you to fnancial ratios ,, t$e tool o' fnancial analysis. In fnancial ratio analysis &e select t$e releant in'ormation ,, primarily t$e fnancial statement data ,, and ealuate it. +e s$o& $o& to incorporate market data and economic data in t$e analysis and interpretation o' fnancial ratios. And &e s$o& $o& to interpret fnancial ratio analysis% &arning you o' t$e pit'alls t$at occur &$en it4s not used properly. +e use 8icroso't 0orporation4s 299! fnancial statements 'or illustration purposes t$roug$out t$is reading. 5ou can obtain t$e 299! and any ot$er year4s statements directly 'rom 8icroso't. e sure to sae t$ese statements 'or 'uture re'erence.
0lassifcation o' ratios A ratio is a mat$ematical relation bet&een one quantity and anot$er. #uppose you $ae 299 apples and 199 oranges. $e ratio o' apples to oranges is 299 : 199% &$ic$ &e can more coneniently e*press as 2;1 or 2. A fnancial ratio is a comparison bet&een one bit o' fnancial in'ormation and anot$er. 0onsider t$e ratio o' current assets to current liabilities% &$ic$ &e re'er to as t$e current ratio. $is ratio is a comparison bet&een assets t$at can be readily turned into cas$ ,, current assets ,, and t$e obligations t$at are due in t$e near 'uture ,, current liabilities. A current ratio o' 2;1 or 2 means t$at &e $ae t&ice as muc$ in current assets as &e need to satis'y obligations due in t$e near 'uture. particular obligations. 2. A return ratio is a measure o' t$e net beneft% relatie to t$e resources e*pended. 3. A turnover ratio is a measure o' t$e gross beneft% relatie to t$e resources e*pended. !. A component percentage is t$e ratio o' a component o' an item to t$e item. +$en &e assess a company4s operating per'ormance% &e &ant to kno& i' it is applying its assets in an e-cient and proftable manner. +$en &e assess a company4s fnancial condition% &e &ant to kno& i' it is able to meet its fnancial obligations. $ere are si* aspects o' operating per'ormance and fnancial condition &e can ealuate 'rom fnancial ratios; 1. A liquidity ratio proides in'ormation on a company4s ability to meet its s$ort ?term% immediate obligations.
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2. A proftability ratio proides in'ormation on t$e amount o' income 'rom eac$ dollar o' sales. 3. An activity ratio relates in'ormation on a company4s ability to manage its resources =t$at is% its assets> e-ciently. !. A fnancial leverage ratio proides in'ormation on t$e degree o' a company4s f*ed fnancing obligations and its ability to satis'y t$ese fnancing obligations. ". A shareholder ratio describes t$e company4s fnancial condition in terms o' amounts per s$are o' stock. @. A return on investment ratio proides in'ormation on t$e amount o' proft% relatie to t$e assets employed to produce t$at proft. +e coer eac$ type o' ratio% proiding e*amples o' ratios t$at 'all into eac$ o' t$ese classifcations.
2. Liquidity
e*tend credit% creating accounts receiables% and
=!>
collect accounts receiables% generating cas$. $e operating cycle is t$e lengt$ o' time it takes to conert an inestment o' cas$ in inentory back into cas$ =t$roug$ collections o' sales>. $e net operating cycle is t$e lengt$ o' time it takes to conert an inestment o' cas$ in inentory and back into cas$ considering t$at some purc$ases are made on credit. $e number o' days a company ties up 'unds in inentory is determine by; =1> t$e total amount o' money represented in inentory% and =2> t$e aerage day4s cost o' goods sold. 1 5ou &ill see re'erence to t$e net &orking capital =i.e.% current assets B current liabilities> as simply &orking capital% &$ic$ may be con'using. Al&ays c$eck t$e defnition 'or t$e particular usage because bot$ are common uses o' t$e term &orking capital.
Financial ratios% a reading prepared by Pamela Peterson Drake
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$e current inestment in inentory ,, t$at is% t$e money Ctied upC in inentory ,, is t$e ending balance o' inentory on t$e balance s$eet. $e aerage day4s cost o' goods sold is t$e cost o' goods sold on an aerage day in t$e year% &$ic$ can be estimated by diiding t$e cost o' goods sold 'ound on t$e income statement by t$e number o' days in t$e year. +e compute t$e number o' days o' inentory by calculating t$e ratio o' t$e amount o' inentory on $and =in dollars> to t$e aerage day4s 0ost o' oods #old =in dollars per day>; InentoryInentory umber o' days inentory E
E
Aerage day4s cost o' goods sold 0ost o' goods sold : 3@" I' t$e ending inentory is representatie o' t$e inentory t$roug$out t$e year% t$e number
o' days inentory tells us t$e time it takes to conert t$e inestment in inentory into
sold goods. +$y &orry about &$et$er t$e year,end inentory is representatie o'
inentory at any day t$roug$out t$e year) +ell% i' inentory at t$e end o' t$e fscal year,
end is lo&er t$an on any ot$er day o' t$e year% &e receiables on any day t$roug$out t$e
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year% t$en it takes% on aerage% appro*imately t$e Cnumber o' days creditC to collect t$e
accounts receiable% or t$e number o' days receiables;
$ae understated t$e number o' days o' inentory.
Try it! +al,8art #tores% Inc.% $ad cost o' re enue o' 21G%HG3 million 'or t$e fscal year ended anuary 31% 299". It $ad an inentory balance o' 2G%!!H million at t$e end o' t$is fscal year. Jsing t$e quarterly in'ormation%+al,8artKs aerage inentory balance during t$e fscal year is 2G%
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Indeed%in practicemost companies try to c$oose fscal year,ends t$at coincide&it$ t$e slo& Inentory balance% in millions periodo' t$eir business. $at means t$e ending 33%3!H 3!%999 balance o' inentory &ould 32%999 be lo&ert$ant$e typical 2G%!!H daily inentory o' t$e year. 39%999 2%329 2H%G@3 +e could% 'or e*ample% 2%999 lookat quarterlyfnancial statements and take 2@%999 aerages o' quarterly 2!%999 inentory balances to get April uly 6ctober anuary a better idea o' t$e typical inentory.(o&eer%$ere #ource; +al,8art #tores 19,M and 19,N flings 'or simplicity in t$is and ot$er ratios% &e &ill make ased on t$is in'ormation% &$at is +al,8a rtKs inentory turnoer 'or fscal year a note o' t$is problem and 299! = ending anuary 31% 299">) deal &it$ it later in t$e discussion o' fnancial olution Jsing t$e fscal year end balance o' inentory; ratios. +e can e*tendt$e same 2G%!!H 2G%!!H umber o' days inentory E E E !.G days logic 'or calculatingt$e 21G%HG3:3@" @92.1H3 number o' days bet&een a Jsing t$e aerage o' t$e quarterly balances; sale ,, &$enan account receiable is created ,, to 2G%
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[email protected]" umber o' days inentory E t$e timeit is collected in E E !G.!3@days 21G%HG3:3@" @92.1H3 cas$. I' t$e ending balanceo' receiables at In ot$er &ords% it takes +al,8art appro*imately "9 days to sell its t$e end o' t$e year is merc$andise 'rom t$e time it acquires it. representatieo' t$e
Financial ratios% a reading prepared by Pamela Peterson Drake
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Accounts receiable umber o' days receiables E Aerage E #ales on credit : 3@"
Accounts receiable day4s
sales
on
credit
+$at does t$e operating cycle $ae to do &it$ liquidity) $e longer t$e operating cycle% t$e more current assets needed =relatie to current liabilities> because it takes longer to conert inentories and receiables into cas$. In ot$er &ords% t$e longer t$e operating cycle% t$e more net &orking capital required. +e also need to look at t$e liabilities on t$e balance s$eet to see $o& long it takes a company to pay its s$ort,term obligations. +e can apply t$e same logic to accounts payable as &e did to accounts receiable and inentories. (o& long does it take a company% on aerage% to go 'rom creating a payable =buying on credit> to paying 'or it in cas$) Accounts payable
Accounts payable
umber o' days payables E E Aerage day4s purc$ases Purc$ases : 3@" First% &e need to determine t$e amount o' an aerage day4s purc$ases on credit. I' &e assume all purc$ases are made on credit% t$en t$e total purc$ases 'or t$e year &ould be t$e 0ost o' oods #old% less any amounts included in t$is 0ost o' oods #old t$at are not purc$ases. 2 $e operating cycle tells us $o& long it takes to conert an inestment in cas$ back into cas$ =by &ay o' inentory and accounts receiable>; umber o' daysumber o' days 6perating cycle E O o' inentory o' receiables $e number o' days o' purc$ases tells us $o& long it takes use to pay on purc$ases made to create t$e inentory. I' &e put t$ese t&o pieces o' in'ormation toget$er% &e can see $o& long% on net% &e tie up cas$. $e dierence bet&een t$e operating cycle and t$e number o' days o' payables is t$e net operating cycle; et operating cycle E 6perating 0ycle , umber o' days o' purc$ases or% substituting 'or t$e operating cycle%
o' inentory
umber o' days et operating cycle E o' receiables o' purc$ases
umber o' days O ?
umber o' days
"icroso#t$s Number o# %ays &eceivables '(()
Aerage day4s receiables E 3@%3" million : 3@" E 199.G1H million umber o' days receiables E "%G9 million : 199.G1H million E *+,-.)- days o& try it 'or 299" using t$e 299" data 'rom 8icroso'tKs
fnancial statements. 2 For e*ample% depreciation is included in t$e 0ost o' oods #old% yet it not a purc$ase. Ans&er; .*,/)(( days (o&eer% as a quite pro*y 'or purc$ases% &e can use t$e accounting relations$ip; o' data; #tatement and alance #$eet% 8icroso't 0orporation Annual beginning#ource inentory O Income purc$ases E 06# O ending inentory. compare components o' income &it$ sales. $ey gie us an idea o' &$at makes up a company4s income and are usually e*pressed as a portion o' eac$ dollar o' sales. $e proft margin ratios &e discuss $ere dier only by t$e numerator. It4s in t$e numerator t$at &e re/ect and t$us ealuate per'ormance 'or dierent aspects o' t$e business; $e gross proft margin is t$e ratio o' gross income or proft to sales. $is ratio indicates $o& muc$ o' eery dollar o' sales is le't a'ter costs o' goods sold; ross income ross proft margin E
#ales
$e operating proft margin is t$e ratio o' operating proft =a.k.a. QI% operating income% income be'ore interest and ta*es> to sales. $is is a ratio t$at indicates $o& muc$ o' eac$ dollar o' "icroso#t$s 3//+ 5roft "argins sales is le't oer a'ter operating ross proft margin E =1!%!! , 1%1GH>:1!%!! E e*penses; /3,4-.6
6perating proft margin E @%!1! : 1!%!! E )),'+-6 et proft margin E !%!G9 : 1!%!! E -36
6perating income 6perating proft margin E #ales $e net proft margin is t$e
ratio o' net income =a.k.a. net proft> to sales% and indicates $o& muc$ o' eac$ dollar o' sales is le't oer a'ter all e*penses;
#ource o' data; 8icroso't 0orporation Annual indicates t$e relatie uses o' debt and equity as sources o' capital to fnance t$e company4s assets% ealuated using book alues o' t$e capital sources;
3.
otal debt otal debt to equity ratio E otal s$are$olders4 equity ote t$at t$e debt,equity ratio is related to t$e debt,to,total assets ratio because t$ey are bot$ measures o' t$e companyKs 6ne problem =as capital structure. $e capital structure is t$e mi* o' debt &e s$all see> &it$ looking at and equity t$at t$e company uses to fnance its assets. risk t$roug$ a
fnancial ratio book alue o' stock> is t$at t$ere is little bet&een t$e and its market book alue o' consists o'; •
t$e proceeds company o' all issued since it incorporated% treasury =stock by and
•
t$e o' all t$e o' company% diidends% since incorporated.
LetKs use s$ort,$and notation to demonstrate t$is relations$ip. t$at uses t$e =t$e Let D represent total debt and Q represent equity. $ere'ore% equity most o'ten total assets are equal to DOQ.
relation
I' a company $as a debt,equity ratio o' 9.2"% t$is means t$at is book debtto,asset ratio is 9.2. +e calculate it by using t$e ratio alue. relations$ips and Algebra;
alue $e
equity
D:Q E 9.2" D E 9.2" Q
to t$e t$e stock &as frst D:=DOQ> E 9.2" Q : =9.2" Q O Q> E 9.2" Q : 1.2" Q E 9.2 less any In ot$er &ords% a debt,equity ratio o' 9.2" is equialent to a stock debt,toassets ratio o' 9.2 repurc$ased $is is a $andy deice; i' you are gien a debt,equity ratio and t$e need t$e debt,assets ratio% simply; company> #ubstituting 9.2" Q 'or D in t$e debt,to,assets ratio D:=DOQ>;
D:=DOQ> E =D:Q> : =1 O D:Q> +$y do &e bot$er to s$o& t$is) ecause many fnancial accumulation analysts discuss or report a companyKs debt,equity ratio and earnings you are le't on your o&n to determine &$at t$is means in t$e less any terms o' t$e proportion o' debt in t$e companyKs capital it &as frst structure.
Let4s look at an e*ample o' t$e book alue s. market alue o' equity. I8 &as incorporated in 1G11. #o its book alue o' equity represents t$e sum o' all its stock issued and all its earnings% less all diidends paid since 1G11. As o' t$e end o' 2993% I84s book alue o' equity &as appro*imately 2 billion and its market alue o' equity &as appro*imately 1@2 billion. $e book alue understates its market alue by oer 139
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billion. $e book alue generally does not gie a true picture o' t$e inestment o' s$are$olders in t$e company because; •
•
earnings are recorded according to accounting principles% &$ic$ may not re/ect t$e true economics o' transactions% and due to in/ation% t$e dollars 'rom earnings and proceeds 'rom stock issued in t$e past do not re/ect today4s alues. $e market alue% on t$e ot$er $and% is t$e alue o' equity as perceied by inestors. It is &$at inestors are &illing to pay% its &ort$. #o &$y bot$er &it$ t$e book alue o' equity) For t&o reasons; frst% it is easier to obtain t$e book alue t$an t$e market alue o' a company4s securities% and second% many fnancial serices report ratios using t$e book alue% rat$er t$an t$e market alue. +e may use t$e market alue o' equity in t$e denominator% replacing t$e book alue o' equity. o do t$is% &e need to kno& t$e current number o' s$ares outstanding and t$e current market price per s$are o' stock and multiply to get t$e market alue o' equity.
0oerage fnancial leerage ratios In addition to t$e leerage ratios t$at use in'ormation about $o& debt is related to eit$er assets or equity% t$ere are a number o' fnancial leerage ratios t$at capture t$e ability o' t$e company to satis'y its debt obligations. $ere are many ratios t$at accomplis$ t$is% but t$e t&o most common ratios are t$e times interest coerage ratio and t$e f*ed c$arge coerage ratio. $e times,interest,coerage ratio% also re'erred to as t$e interest coerage ratio% compares t$e earnings aailable to meet t$e interest obligation &it$ t$e interest obligation; Qarnings be'ore interest and ta*es imes ,interest , coerage ratio E Interest $e f*ed c$arge coerage ratio e*pands on t$e obligations coered and can be specifed to include any f*ed c$arges% suc$ as lease payments and pre'erred diidends. For e*ample% to gauge a companyKs ability to coer its interest and lease payments% you could use t$e 'ollo&ing ratio; Fi*ed , c$arge coerage ratio E Qarnings be'ore interest and ta*es O Lease payment Interest O Lease payment 0oerage ratios are o'ten used in debt coenants to $elp protect t$e creditors.
"icroso#t9s Financial Leverage &atios : '(()
otal debt to total assets E =G!%3@ , H!%2"> : G!%3@ E 9.29H9G or '(,4(/6 Debt to equity ratio E =G!%3@ , H!%2"> : H!%2" E 9.2@11 or '.,33+6 #ource o' data; alance s$eet% 8icroso't 0orporation Annual o' common equity per s$are o' common stock% calculated by diiding t$e book alue o' s$are$oldersK equity by t$e number o' s$ares o' stock outstanding. As &e discussed earlier% t$e book alue o' equity may dier 'rom t$e market alue o' equity. $e market alue per s$are% i' aailable% is a muc$ better indicator o' t$e inestment o' s$are$olders in t$e company.
$e price?earnings ratio =P:Q or PQ ratio> is t$e ratio o' t$e price per s$are o' common stock to t$e earnings per s$are o' common stock; 8arket price per s$are Price,earnings ratio E Qarnings per s$are $oug$ earnings per s$are are reported in t$e income statement% t$e market price per s$are o' stock is not reported in t$e fnancial statements and must be obtained 'rom fnancial ne&s sources. $e P:Q ratio is sometimes used as a pro*y 'or inestors4 assessment o' t$e company4s ability to generate cas$ /o&s in t$e 'uture. (istorically% P:Q ratios 'or J.#. companies tend to 'all in t$e 1 9,2" range% but in recent periods =e.g.% 2999, 2991> P:Q ratios $ae reac$ed muc$ $ig$er. Q*amples o' P:Q ratios =P:Q ratios at t$e end o' 299!>; ! @ompany
Tic0er
5AE ratio symbol
Ama7on.com A8W "H ime +arner +X 2G Inc. I8 I8 21 0oca,0ola M6 22 8icroso't 8#F 3@ 5a$ooV 5(66 G 38 0o. 888 23 eneral Qlectric Q 2! +e are o'ten interested in t$e returns to s$are$olders in t$e 'orm o' cas$ diidends. @ash dividends are payments made by t$e company directly to its o&ners. $ere is no requirement t$at a company pay diidends to its s$are$olders% but many companies pay ! #ource; 5a$ooV Finance
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regular quarterly or annual diidends to t$e o&ners. $e decision to pay a diidend is made by t$e companyKs board o' directors. ote t$at not all companies pay diidends. %ividends per share ;%5< is t$e dollar amount o' cas$ diidends paid during a period%
per s$are o' common stock; Diidends paid to s$are$olders Diidends per s$are E umber outstanding
o'
s$ares
$e dividend payout ratio is t$e ratio o' cas$ diidends paid to earnings 'or a period; Diidends Diidend payout ratio E Qarnings $e complement to t$e diidend payout ratio is t$e retention ratio or t$e plo1bac0 ratio; Qarnings , Diidends
