Top 8. Capstone Financial Ratios

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1 Financial Ratio Review Top 8 Plus Capstone Financial Ratios Kenneth EA Wendeln 2012 KEAW v5

2 Top 8 Key Financial Ratios Profitability Liquidity Return on Owners Equity % Current Ratio # n.nn EPS Earnings per Share $ DD.00 Return on Sales % Financial Leverage Acid Test or Quick Ratio # n.nn Asset Turnover Accounts Receivable Turnover X (times/year) or # days Total Liabilities to Equity % Inventory Turnover X (times/year) or # days J411 Financial Ratio Review 2

3 Summary of Financial Ratios Profitability Return to Investors Leverage /Debt Management Liquidity Asset Management Margins Returns Return to Investors Amount of Debt Coverage of Debt Short Run Solvency Current Assets Operating Efficiency *Net Profit Margin (ROS) *Return on Equity *Return on Equity *Total Liabilities/ Equity Times Interest Earned *Current Ratio *A/R Average Collection Period *A/R Turnover Operating Profit Margin Return on Total Assets (ROA) Return on Total Assets (ROA) Debt/ Equity Fixed Charge Coverage *Quick or Acid Test Ratio *Days Inventory Held *Inventory Turnover Gross Profit Margin Cash Return on Assets *Earnings Per Share LEVERAGE Assets/ Equity Cash Flow Adequacy Cash Flow Liquidity Ratio Days Payables Outstanding Fixed Asset Turnover Product Contribution Margin Price to Earnings Ratio Debt/ Assets Cash Interest Coverage Days of Working Capital Total Asset Turnover Cash Flow Margin Dividend Yield LT Debt/ Total Capitalization * Top 8 & CAPSTONE Financial Ratios Other Common Ratios Return on Total Assets (ROA) Derived from: Fraser/Ormiston, J411 Financial Ratio Review Understanding the Corporate Annual Report; 3 Understanding Financial Statements 6e

4 Key Financial Statements Balance Sheet Period Ending Current (12mo) Long-Term TOTAL ASSETS Current (12mo) Long-Term Cash A/R Inventories PPE Fixed Assets A/P ST Debt LT Debt TOTAL LIABILITIES Contributed Capital Retained Earnings par Paid-in Capital Accumulated Net Income less Dividends TOTAL OWNERS / SHAREHOLDERS EQUITY Assets = Liabilities + Owners Equity Income Statement for Period Net Sales TOTAL REVENUES Cost of Goods Sold Expenses for Period Operating Profit Other Expenses Units Price less Returns & Allowances Units Overhead R & D Marketing Distribution Sales Admin TOTAL OP EXPENSES Interest Taxes One-time TOTAL NET INCOME or (LOSS) Revenues Expenses = Net Income Cash Flow Statement Change in cash - Sources & (Uses) - between Periods Net Income Income Statement Cash= Accrual Based Adjustments Depreciation A/R & A/P for Non-cash Inventory Items Other Accruals CASH provided (used) by OPERATING Activities Operating + PPE (Additions) Sale Other (Additions) Sale Investments CASH provided (used) by INVESTING Activities Investing + Stock Sale (Purchase) Dividends (Paid) Debt/ Increase (Decrease) Borrowing CASH provided (used) by Financing FINANCING Activities J411 Financial Ratio Review 4

5 Profitability and Return to Investors ROE *Return on Owners Equity % Net Income (after taxes) Owners Equity ROA Return on Total Assets % Net Income (after taxes) Total Assets ROS *Return on Sales % EPS *Earnings per Share $ DD.00 Net Income (after taxes) Net Sales Revenue Net Income or Loss (after taxes) Average # of Common Stock Shares Outstanding J411 Financial Ratio Review 5

6 Return on Owners Equity Profitability ratio that provides an overall measure of a business s performance. Net income earned (after tax) per dollar of owners investment accumulated in the business. Net Income (after taxes) Owners Equity Typically between 15% and 25% for profitable companies J411 Financial Ratio Review 6

7 Return on Sales or Net Profit Margin This profitability ratio measures how well the company generated net profit (after tax) per dollar of net sales revenue. Net Income (after taxes) Net Sales Revenue This ratio is best evaluated by analyzing a firm s year to year trends and by comparing to businesses within appropriate industries. J411 Financial Ratio Review 7

8 EPS Earnings per Share This profitability ratio tells the owner of a share of stock how much of the net earnings for the year belongs to him or her. Net Income or Loss (after taxes) Average # Shares of Common Stock Outstanding These earnings may be paid to the stockholders as dividends... or reinvested (as retained earnings) back into the business to fund its growth. J411 Financial Ratio Review 8

9 Liquidity and Asset Management *Current Ratio #.# Current Assets Current Liabilities *Acid Test or Quick Ratio #.# Current Assets - Inventory Current Liabilities *Accounts Receivable Turnover X (times/year) or # days *Inventory Turnover X (times/year) or # days Net Sales. Average Accounts Receivable # days = 365 days/ar turnover Cost of Goods Sold Average Inventory # days = 365 days/inventory turns J411 Financial Ratio Review 9

10 Current Ratio Measures liquidity - the capacity of a firm to meet its current obligations using liquid assets that are in cash or other resources that can be quickly converted to cash. Current Assets Current Liabilities Capstone requires a current ratio >2.0, to indicate that the firm can pay its current liabilities using its current assets. J411 Financial Ratio Review 10

11 Acid-Test or Quick Ratio Measures liquidity - the ability of a firm to pay current liabilities quickly without selling inventory. Current Assets - Inventory Current Liabilities For all businesses the desired acid-test ratio is ~1.0 indicating firm can pay its current liabilities from its non-inventory current assets. J411 Financial Ratio Review 11

12 Accounts Receivable Turnover - Activity Ratio Determines the number of times during the year a company is turning over or collecting its accounts receivable. Measured in X times per year. Can be converted to days outstanding by dividing turnover ratio into 365 days. Net Sales Average Accounts Receivable Customers will give a preference to companies that extend payment terms and, in effect, provide a loan. 6X turnover is equivalent to 60 days of outstanding receivables, 9X is 45 days, 12X is 30 days. J411 Financial Ratio Review 12

13 Inventory Turnover Activity Ratio Determines the number of times during the year a company is turning over its inventory. Measured in X times per year. Can also be converted to days of inventory by dividing ratio into 365 days. Cost of Goods Sold Average Inventory The average inventory turnover for all firms is about 9 times per year, or about once every 45 days. It varies considerable by industry. Capstone penalizes firms with excessive inventory carrying costs (>120 days of current sales). J411 Financial Ratio Review 13

14 Working Capital Asset Management Working Capital = Current Assets Current Liabilities Working Capital ~ Accts Receivable + Inventory - Accts Payable Example Capstone Ideal Range A/R = Inventory = less A/P = Working Capital 35 days 70 days -15 days = 90 days J411 Financial Ratio Review 14

15 Better Returns via Asset Management How good are we at producing wealth with our assets? Asset Turnover ROS Return on Sales X = ROA Return on Assets Sales Assets X Profits Sales = Profits Assets Aircraft - Boeing % 4.3% Grocery - Kroger % 5.3% J411 Financial Ratio Review 15

16 Capital Structure - Leverage Using Equity + Debt for Financing Using DEBT provides LEVERAGE for the shareholders & increases their Return on Owners Equity BUT using more debt (which must be repaid) increases the RISK to the lenders & shareholders J411 Financial Ratio Review 16

17 Leverage and Debt Management *Total Liabilities to Equity % Total Liabilities Owners Equity J411 Financial Ratio Review 17

18 Total Liabilities to Owners Equity Ratio This financial leverage ratio indicates the degree to which a firm s operations are financed through debt, borrowings & other liabilities - determines a firm s financial risk and ability to borrow money. Total Liabilities Owners Equity The liabilities-to-owners equity ratio typically ranges between 33 and 50%. The higher this ratio, the riskier the situation for lenders and shareholders. J411 Financial Ratio Review 18

19 Leverage and Debt Management *Total Liabilities to Equity % Total Liabilities Owners Equity Financial Leverage #.# Capstone Ideal Range Total Assets Owners Equity or Total Owners Liabilities + Equity Owners Equity Examples 2.0 = 2.5 = 50% Liabilities 50% Equity 60% Liabilities 40% Equity J411 Financial Ratio Review 19

20 Leverage & Risk Impact on Firm s Cost of Capital Weighted Cost of Capital (Debt & Equity WCC) 11.0% 10.9% 10.8% 10.7% 10.6% 10.5% 10.4% 10.3% 10.2% 10.1% 10.0% Equity investors require a return at least as great as the best alternative opportunity forgone. Debt financing is lower risk & cost than equity, lowering the WCC. Optimum Leverage & WCC As Leverage increases with more debt, the risk increases to the lenders & the shareholders, increasing the cost of both debt & equity. 0% 20% 40% 60% 80% 100% Low Financial Leverage High Source: adapted from The Real Cost of Capital J411 Financial Ratio Review 20

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