F2 - M8 - Ratio Analysis Flashcards
What are ratios, in terms of finance?
Financial indicators that distill relevant information about a business entity
Helps to quickly identify red flags
Ratio Comparisons
Ratio must be compared to a benchmark to be useful
“Time Series” - Compare with ratios of a different period for the same company
“Cross-Sectional” Compare with ratios of a competitor industry
List the key financial ratios.
Liquidity
Activity (Turnover)
Profitability
Coverage
What is the Liquidity Ratio?
Measures a firm’s short-term ability to pay maturing obligations (i.e., Can you pay your bills as they come due?)
Industry > Company = Higher Risk
Higher Ratio = Less Risk
Bigger Numerator = Smaller Denominator = Less Risk
List of Liquidity Ratios
Working Capital
Current Ratio
Acid-Test (Quick) Ratio
Cash Ratio
Working Capital
Current Assets - Current Liabilities
The bigger the spread between current assets and current liabilities, the less risk.
Helps to generate sales. Need inventory and supplies to create sales. Need collections to fund supplies to create inventory.
Current Ratio
Current Assets / Current Liabilities
Misleading - Making assumptions such as assuming AR will be collected within the next year and inventory will be sold within the next year.
Acid-Test (Quick) Ratio
(Cash + Cash Equivalents + Marketable Securities + Net Receivables) / Current Liabilities
More liquid (Conservative) —-> EXCLUDES Inventory
Cash Ratio
(Cash + Cash Equivalents + Marketable Securities) / Current Liabilities
Most liquid (Conservative) —-> EXCLUDES AR & Inventory
Has the smallest numerator - common since most companies do not have a ton of cash on hand
What is the Activity (Turnover) Ratio?
Measures how effectively a company is using its assets
i.e., the more a company can turnover assets, the better they are doing
List of Activity Ratios
Accounts Receivable Turnover Accounts Receivable Turnover (in Days) Inventory Turnover Inventory Turnover (in Days) Operating Cycle Working Capital Turnover Total Asset Turnover
Activity (Turnover) Ratio Analysis
Measures how effectively a company is using its assets
IS of Current Year / BS Average of CY and PY
Accounts Receivable Turnover
Net Credit Sales / Average Net Receivables
Indicates the success of the firm in collecting outstanding receivables.
Bigger the spread = NO issues collecting
Higher is better
Industry < Company
Accounts Receivable Turnover (Days)
365 Days / Accounts Receivable Turnover
Indicates the average number of days to collect AR
Lower is better
Industry > Company
Inventory Turnover
COGS / Average Inventory
Measures how quickly inventory is sold which indicates performance
Bigger the spread = NO issues selling
Higher is better
Inventory Turnover (Days)
365 / Inventory Turnover
Indicates average number of days to sell inventory
Industry = Company
Should be close to the industry standard; otherwise,
If too low - selling too fast (giving it away)
If too high - may be losing market share
Operating Cycle
AR Turnover (Days) + Inventory Turnover (Days)
Indicates the number of days between acquisition of inventory and realization of cash from sale of inventory. We want to collect quickly and sell quickly.
Lower is better
Industry > Company
Working Capital Turnover
Sales / Average Working Capital
Indicates how effectively working capital is used. WC (CA & CL) helps to generate sales.
Higher is better
Industry < Company
Total Asset Turnover
Net Sales / Average Total Assets
Indicates how effectively the company uses its assets. We want to maximize sales with least amount of assets
Higher is better
Industry < Company
What is the Profitability (Performance) Ratio?
Measures of success or failure (performance).
Return on Investment
Industry < Company
List of Profitability Ratios
Net Profit Margin
Return on Total Assets
DuPont Return on Assets
Return on Common Equity
Net Profit Margin
Net Income / Net Sales
Indicates profit rate. We want to maximize our net income.
Higher is better
Industry < Company
Return on Total Assets
Net Income / Average Total Assets
Indicates rate of return on assets. We want to maximize our net income with the least use of assets.
Higher is better
Industry < Company
DuPont Return on Assets
Net Profit Margin x Total Asset Turnover
= Net Income / Average Total Assets
Explains what drives the return on assets.
How much profit when you sell the asset?
How often can you generate revenue from the asset?
Higher is better
Industry < Company
Return on Common Equity
Income Available to Common Stockholders = Net Income - Preferred Dividends
Income Available to Common Stockholders / Average Common Equity
Measures the rate of return that will compensate for the associated risk
Higher is better
Ratio > Required Rate of Return
What is the Coverage (Performance) Ratio?
Measures of security or protection for long-term creditors/investors.
Long Term Risk Assessment –> Capital Structure
When you raised capital, how was it done?
- Add partners? - Reduces risk of distress, no interest, but return on equity decreases
- Borrow money? - Greater risk of distress but return on equity increases
- Issue Stock?
List of Coverage Ratios
Debt-to-Equity
Debt-to-Assets
Times Interest Earned
Operating Cash Flow/Total Debt
Debt-to-Equity
Total Liabilities / Common Stockholders Equity
Indicates degree of protection to creditors in case of solvency
Lower is better
High Risk, Low Equity = Higher ROE
Low Risk, High Equity = Lower ROE
Debt-to-Assets
Total Liabilities / Total Assets
Indicates that approximately half of assets are financed
Lower is better
Times Interest Earned
Interest Coverage Ratio
EBIT = Recurring Income Before Taxes and Interest
EBIT / Interest
What do you have available before interest and taxes to cover the interest.
Higher is better
Operating Cash Flow / Total Debt
Indicates company’s ability to cover total debt with yearly cash flow
Higher is better
Limitations of Ratios
- Reliability
- May need additional information
How to determine if the information to compute ratios are reliable?
- Reference the auditors opinion of the financials
- Look at the methods/estimates used
What is Horizontal Analysis?
Measures the dollar and percentage over a period time
Useful to evaluate trends and noting material changes
What is Vertical Analysis?
Helpful in reducing statement items to a common size (i.e., percentages)
Period-to-period comparison
Comparability among other entities of varying sizes (i.e,. mom and pop vs corporations)
