S.6. Ratio Analysis Flashcards
introduction
fianancial statements contains vision of firm
a) past performance - income/cash flow
b) current financial conditions - a/l/equity
but such statement such not necessarily provide all information useful for analysis nor do they forecast future results
analysts must b capable of using financial statements to make projection and reach valid conclusion
financial analysis of a company may performed
- valuing equity securities
- assessing credit risk
- conducting due diligence related to acquisition
- assessing a subsidiary´s performance
objectives of financial analysis process
- purpose of analysis
- question this analysis will answer
- level of detail will be needed to accomplish this purpose
- data available for the analysis
- factors/relationships that will influence this purpose
- analytical limitations &will these potentially impair the analysis?
Analytical tools + techniques
evaluation requires COMPARISONS
no statements are useful without any clarification about BASIS fo comparison
when assessing company´s ability to generate/grow earnings; cash flow; and considering risk related to those earnings, CF
- -> analyst draw comparisons with other firms (coss-sectional analysis)
- -> over time (time series)
a) ratios are not the answer
ratio is merely an indicator of some aspect of a company´s performance - telling what happened but no WHY it happened
b) different accounting principles can distort ratios
c) not all ratios are necessarily relevant to a particular analysis
d) ratio analysis does not stop with computation - interpretation is essential as well
Rules of thumb
average used for denominator coming from BS when numerator is of NI
problem: when assets are growing
OI/end asset - not make sens as income would have been generated before some assets where purchased hence UNDERESTATE firm´s performance
OI/beg. assets - some of income later in the year may have been generated only because of add of asset - hence OVERSTATE the performance
Ratios Analysis Limitations
heterogenity of firm´s operating activities
- firms may have divisions in many diff. industries
- difficult to find comparable ratios
consistency
- one set of ratios may indicate a problem - whereas another set may indicate that potential problem is only short term - hence which one to follow?
judgmente
- key issue whether ratio for company is within a reasonable range
- ratios cannot be used alone to directly value company o its securities or determine creditworthiness
- the entire operation would be necessary to examine
Use of alternative accounting methods
companies frequently have latitude when choosing certain accounting methods
ratios adjustment needs to be made
Examples:
- FIFO, LIFO average of valuation methods
- Cost of equity of accounting fo unconsolidated affiliate
- straightline vs accelerated method of depreciation
- operating vs capital lease
Activity Ratios
asset utilisation ratios or operating efficiency
measure how efficient company manages its assets
efficiency of both WC and longterm ratios
efficiency has direct impact on liquidity (ability to met St obligation)
Activity Ratios
Inventory Turnover
make sense for industrial companies vs service sector
it indicates resources tied up in inventory (carrying cost)
hence, used o indicate inventory management effectiveness
high IT = shorter period of inventory (high CGOS - sold) vs low inventory (costs)
low IT =slow moving inventory
Activity Ratio
Receivables Turnover
DSO = a sale and cash collection
reflects how fast company collects cash from customers
revenue as a poxy for credit sales
high RT &low DSO - indicates highly efficient credit and collection but also policy too stringent (possibility of sales being lost to competitors offerings some credits)
low RT - raise questions about efficiency about firm´s credit and collections procedures
check credit losses - whether low turnover reflects credit management issues
Activity Ratio
Payables Turnover
NDP = average nr. of days the company takes to pay its suppliers
turnover ratio = measures how many times per year the company theoretically pays off all its creditors
approximation of credited purchases one uses COGS
high PT & low NDP - indicate that company is not using all of available credit facilities but also result from taking adv. of earlier payment discounts
low PT = trouble making payments on time
compare NDP with liquidity
–> if liquidity shows that it has sufficient cash to pay its obligation, yt the PT is low - this could still favour supplier credit
Activity Ratio
Working Capital Turnover
CA - CL
indicates how efficiently company generated revenue with WC
Avg- WC ratio = 4 means firm generates 4$ of revenue per 1$ of WC
high ratio - greater efficiency (higher level of revenue relative to WC)
some companies WC can be 0 or negative
negative WC funds its growth in sales by effectively borrowing from its suppliers and customers. … Such firms don’t supply goods on credit and constantly increase their sales.
Activity Ratio
Fixed Asset Turnover
Total Asset Turnover
measures how efficient the Co. generates revenue from its fixed assets
high FAT = more efficient use of fixed asset when generating revenue
low ratio = inefficiency, capital-intensive business environment, new business not yet operating at full capacity
AT can be affected by when assets (new) are compared to older ones
AT can also appear erratic because even if revenue has steady growth , fixed assets may not follow a smooth pattern
–> hence changes in ratio doesn´t necessarily indicate changes in company´s efficiency
Total Asset turnover
- company´s overall ability to generate revenues with given level of assets
low TA could be inefficiency or relative capital intensivity
ratios also reflects strategic decisions whether to use a moe labour intensive (less capital intensive) approach to its business
LIQUIDITY
focuses on cash flows
measures company´s ability/pay off to meet its ST obligations
measures how quickly assets concentrated into cash
level of liquidity may differ from industry to industry
larger companies have more potential, funding sources, incl. capital, and money markets
ratio reflects company´s pòsition at a point in time + typically use from ending balance sheet, rather than average
interesting for credit analysts (less for corporate or stock market)
LIQUIDITY
current ratio
current assets vs current liabilities
how much of current liabilities can be cover with current assets
high ratio = higher level of liquidity (greater ability to me ST obligations)
low ratio = less liquidity -greater reliance on operating CF + outside financing to met St obligations
liquidity affects company´s capacity to take on debt
- CR implicitly assumes that inventories + acc. receivables are indeed liquid
LIQUIDITY
quick ratio
more conservative only including liquid (quick) CA
E.g. not including - prepaid expenses, taxes, employee prepayments - represent costs paid in adv. but not easily converted into cash
- inventories might not be converted into cash
In case with low inventory turnover (indicating illiquidity of inventory) - hence quick might be better indicator than current
Cash Ratio
- reliable measures of company´s liquidity in crisis situation
only highly marketable ST investment and cash are included (excl. receivables)
LIQUIDITY
Defensive Interval Ratio
cash + ST marketable securities ´receivables / daily cash expenditures
measures how long firm can continue to pay its expenses without receiving any add. ash inflow
DIR = 50 –> firm can continue to pay its operating expenses for 50 days before running out of quick assets
ratio similar to “burn rate” - often computed for start-ups
total cash expenditures approximate by summing all expenses on IS (COGs, selling, general, admin expenses, R&D) - any non-cash expenses (A/D)
LIQUIDITY
Cash Conversion Cycle
measures length of time required for a company to go from cash paid (operations) to cash received (result of operations)
length of time funds are tied up in WC
duing this time, firm needs to finance its investment in operation through other sources (debt/equity)
short CCC=greater liquidity - company needs o finance its inventory and accounts receivable fo short period of time
higher CCC= lower liquidity - company must finance its I&AR for longer time - hence might need higher levels of capital to fund current assets
negative CCC = company needs less time to sell its inventory (or produce it from raw materials) and receive cash from its customers compared to time in which it has to pay its suppliers of the inventory (or raw materials).
SOLVENCY
refers to company´s ability to fullfil its LT obligations
provide information regarding
a) the relative amount of debt in the BS
b) adequacy of earnings and CF to cover interest expenses as they come due
magnifying effect - that results form use of fixed costs - costs that stay the same within some range of activities
it can take two form
a) operating leverage
b) financing leverage
SOLVENCY
operating leverage
results from use of fixed costs in conducting companys business
magnifies effect of changes in sales on operating income
profitable firms- may use OL because when revenue increases - with OL their operating income increases at faster rate
because although variable coss will rise proportionally to revenue, the fixed cost won´t
SOLVENCY
financial leveraging
debt - financial leverage as interest payments are essentially fixed financing costs
e.g. if firm earns more on fund that it pays on interest the inclusion of some level of debt in company´s capital structure may lower firm´s overall cost of capital (increase ROE)
but high levels of debt increases risk of default and higher borrowing costs for firm to compensate lenders for assuming greater credit risk
understanding use of debt - provide insight into firm´s future project
e,.g. issuance of LT debt to repurchase shares may indicate that management believes that market is underestimating company &shares are undervalued
in general, firms with lower business risk/operations hat generate steady cash flow - are better positioned to take more leverage without a commensurate increase in risk of insolvency
SOLVENCY
debt ratios
focus on BS and measures amount of debt relative to equity debt - asset debt to capital ratio debt to equity financial leverage (average TA/avgs TE)
SOLVENCY
coverage
focuses on IS measuring ability to cover its debt payments
interest coverage
fixed charge coverage (fixed charges to CF generated=
–> n.r of times a company´s earnings can cover the fimñs interest and lease payments
PROFITABILITY
ability to generate profit
determinant for company´s overall value and value of securities issues
reflects a firm´s competitive position in the market
quality of management
a) return on sales
b) return on investment
PROFITABILITY
gross profit margin
% revenue available to cover operating and other expenses and to generate profit
high - combination of higher product pricing and lower product costs
ability to charge higher price contrained by competitions - hence GP affected by competition
if a product has competitive advantage the firm will charge more fo it or on cost side, c.a. in production cost
PROFITABILITY
operating profit margin
gross profit - operating cost
ratio increasing after than gross profit margin an indicate improvement in controlling operating cost (admin. overheads)
PROFITABILITY
pretax margin
EBT oprating profit - interest
margin reflects effects on profitability of leverage and other (non-opt) income and expenses
if firm´s pretax margin is increasing primarily as result of increasing amount of non-operating income
–> hence check this increase reflects a deliberate change in company´s business focus
PROFITABILITY
Net profit margin
NI can be easily manipulated
includes both recuring+non-recurring component
generally NI is adjusted for non-recuring items to offer a better view of fim´s potential future profitability
PROFITABILITY
ROA
measures return earned by a company by its assets holding
the higher ratio the more income is generated for a given level of asseets
PROFITABILITY
ROC
how profitable company against capital structure (Avg. LT/St debt + equity)
returns measured prior to deducting interest on debt capital (EBIT)
PROFITABILITY
ROE
return earned on its equity capital, incl. minority equity, preferred equity and common
PROFITABILITY
DUPONT - ROE
ROE =
operating profitability (NI/Sales - nt profit margin)
* efficiency (Sales/TA)
* financial leverage (TA/Equity)
VALUATION- EQUITY ANALYSIS
valuing company:
- valuation ratios
- discounted cash flow approaches
- residual income approach (e..g ROE compared with cost of capital)
P/E
= how much an investor in common stock pays of dollar per earnings
P/CF
P/S (use when net income is negative)
P/BV
= indicator of market judgement about Rs between fim´s required rate and actual RR
PB=1 - indicator that firm future return are expected to be equal to returns required by market
BV>1 future profitability of firm expected to exceed market
BV <1 not expected to earn excess return
VALUATION- EQUITY ANALYSIS
Per share quantities
Basis vs diluted EPs
= amount atributable to each share of common stock
but it does not provide inform of one company with another
CF per share
EBITDA per share
Dividends per share
VALUATION- EQUITY ANALYSIS
divided related
dividend payout ratio
= % of earning spay out as dividends
tend to be relatively fixed as any reduction in dividends results in a disaproport. large reduction in price
tend to fluctuate with earning
retention rate (B)
= complement of dividend payout ratio
% of earning company retains
Sustainable growth rate: g=b*ROE function of profitability and ability to finance form internal generated funds
