1 2. Financial ratios

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Miles Matthews
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1 1 2. Financial ratios

2 Warning 2 Remember that accounting statements are based on book values. We would prefer to make decisions based on market values, but such information may not be easy to obtain, and is subject to dispute.

3 Standardized statements 3 When comparing financial statements for different companies (or the same company for different years) it is often more convenient to standardize them in some way. One way to do so is common-size statements. To construct a common-size balance sheet, express each item as a percentage of total assets. To construct a common-size income statement, express each item as a percentage of total sales.

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6 Ratio analysis 6 Financial ratios provide a convenient way of summarizing information Useful for comparisons across companies or time. There are many ratios that one might be interested in. We look at a few...

7 Liquidity measures 7 Current ratio = current assets current liabilities Liquidity is a measure of short-term solvency (ability to meet short-term obligations). A high current ratio indicates liquidity, but may also imply an inefficient use of cash and other short-term resources. Current ratio should normally be greater than 1. Note similarity to NWC. Quick ratio = Also known as acid-test ratio. Inventory is less liquid than other current assets. current assets inventory current liabilities Large inventory may also be a sign of trouble (some may turn out to be damaged, obsolete, or lost). Some companies may try to keep unsaleable merchandise on the books to inflate their current ratio. Cash ratio = cash current liabilities Cash ratio might be of interest for a very short term creditor.

8 Ethics: Stuffing the channel 8 One way to reduce inventory on the books and increase accounts receivable is known as channel stuffing. Example Bristol-Myers On August 4, 2004, the Commission (SEC) filed a civil action against Bristol-Myers alleging channel stuffing. The Commission s Complaint alleged that, from the first quarter of 2000 through the fourth quarter of 2001, Bristol-Myers engaged in a fraudulent scheme to overstate its sales and earnings in order to create the false appearance that the Company had met or exceeded financial projections set by the Company s officers ( targets ) and earnings estimates established by Wall Street securities analysts. Bristol-Myers inflated its results primarily by: stuffing its distribution channels with excess inventory near the end of every quarter in amounts sufficient to meet sales and earnings targets set by officers ( channel-stuffing ); and improperly recognizing about $1.5 billion in revenue from sales associated with the channelstuffing in violation of generally accepted accounting principles. When Bristol-Myers results fell short of the Wall Street analysts earnings estimates, the Company used improper accounting, including cookie jar reserves, to further inflate its earnings. In March 2003, Bristol-Myers restated its prior financial statements and disclosed its channelstuffing activities and improper accounting. Reference:

9 Figure Bristol-Myers 9

10 Market measures of equity and capitalization 10 Market capitalization = market value of equity = shares outstanding x price per share Total capitalization = market value of equity + LTD Enterprise value = market cap + net debt Notes: Debt = LTD + notes payable + current maturities of LTD Net debt = Debt - cash and cash equivalents Book suggests using book value of debt even though these are market measures (book and market values of debt generally are close).

11 Leverage ratios 11 Debt-equity ratio = debt / equity Debt-to-capital ratio = debt / (debt + equity) Debt-to-enterprise value (market) = net debt / enterprise value Equity multiplier (book) = total assets / book value of equity Equity multiplier (market) = enterprise value / market value of equity Notes: These leverage ratios are generally considered to be book measures unless otherwise specified.

12 Measures of income 12 Gross profit = Sales - COGS Operating profit = Operating income = Sales - COGS - period costs Net profit = Net income EBIT = Net income + Interest + Tax EBITDA = Net income + Interest + Tax + Depreciation & amortization Notes: Period costs include general and administrative expenses, R&D, etc. EBITDA includes other income whereas operating income does not.

13 Profitability measures 13 Gross margin = Gross profit / sales Operating margin = operating income / sales Net profit margin = Profit margin = Return on sales = Net income / sales EBIT margin = EBIT / sales

14 Asset management measures 14 AKA turnover ratios... Total asset turnover = sales total assets Capital intensity = total assets sales Fixed asset turnover is a measure of the firm s capital intensity. Reducing asset needs while maintaining net income increases ROA.

15 Working capital measures (SKIP) 15 Accounts receivable days = accounts receivable / average daily sales Accounts payable days = accounts payable / average daily COGS Inventory days = inventory / average daily COGS Accounts receivable turnover = sales / accounts receivable Accounts payable turnover = COGS / accounts payable Inventory turnover = COGS / inventory

16 Interest coverage ratios 16 EBIT/interest coverage = EBIT / interest EBITDA/interest coverage = EBITDA / interest

17 Operating returns 17 ROE = return on equity = net income / book value of equity ROA = return on assets = net income / book value of assets ROS = return on sales = net profit margin = net income / sales ROIC = return on invested capital = EBIT x (1 - tax rate) / (book value of equity + net debt) Notes: Denominator of ROIC is book analog of enterprise value. Book defines ROA differently. We will use the standard definition. EBIT (1-T) is sometimes known as unlevered net income or NOPAT (net operating profit after taxes). Use the firm s average tax rate. ROIC is generally the most useful of these. But note that the tax deduction due to interest payments is ignored. (It might make more sense to use NI + Interest in the numerator, like the book s definition of ROA.)

18 Valuation ratios 18 EPS = net income / shares outstanding P/E ratio = share price / EPS = market cap / net income Enterprise value ratios = enterprise value / (EBIT or EBITDA or Sales) Market-to-book = market value of equity / book value of equity

Historical PE ratios, S&P 500 19 Note the spikes around 2001 and 2010. What is going on there?

19 Historical PE ratios, S&P Note the spikes around 2001 and What is going on there? Does the increase in PE ratios recently mean that shares are over-valued, or has there been some underlying changes that provide a rational basis for these valuations?

20 Du Pont identity 20 ROE = = = net income total equity net income assets net income sales assets total equity sales assets assets total equity The DuPont identity shows that ROE is determined by three factors: operating efficiency (profit margin) asset use efficiency (asset turnover) financial leverage (equity multiplier)

21 Du Pont identity continued 21 What we learn from the Du Pont identity is that if the firm is looking to increase ROE, there are three areas to look: increase the profit margin (raise prices or reduce costs) utilize assets more efficiently (NWC and/or fixed assets) increase leverage

22 Example 22 Rocky Flats Mineral Water (RFMW)* Balance sheet (millions of $) Assets Current assets: Cash Accounts receivable Inventory Total Fixed assets Total assets Liabilities and Owners Equity Current liabilities: Accounts payable Notes payable Total Long-term debt Owners equity Retained earnings Total liabilities and owners equity

23 Example continued 23 Income statement (2005) (millions of $) Net sales 2000 Cost of goods sold 1800 Depreciation 150 EBIT 50 Interest paid 20 Taxable income 30 Taxes 9 Net income 21 Dividends 6 Addition to retained earnings 15

24 Example continued 24 Current ratio Quick ratio Cash ratio Debt-equity ratio Debt-to-capital ratio Equity multiplier Total asset turnover Capital intensity Profit margin ROIC ROA ROE

25 Example continued 25 Suppose RFMW has 13 million shares of common stock outstanding. Shares are currently trading at $12. What is RFMW s EPS? What is RFMW s PE ratio? What is RFMW s market/book ratio? Is RFMW a value or growth stock?

26 Example continued 26 RFMW also has 325,000 bonds outstanding. The bonds have a face value of $1000 and are currently trading for $925. What are the book and market values of RFMW s long-term debt? Why might RFMW s bonds be trading at a discount? What is RFMW s market capitalization? Total capitalization? Enterprise value?

27 (Brief) ratio analysis 27

Wikipedia: "Financial Ratio" Contents. Sources of Data for Financial Ratios. Purpose and Types of Ratios

Wikipedia: Financial Ratio Contents. Sources of Data for Financial Ratios. Purpose and Types of Ratios Wikipedia: "Financial Ratio" A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there