During this session, we ll cover: Benefits of using ratios Information gathering Types of ratios and when to use them How to calculate them More

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2 During this session, we ll cover: Benefits of using ratios Information gathering Types of ratios and when to use them How to calculate them More importantly, how to interpret them

3 Pinpoint potential problem areas quickly Corroborate or draw into question different areas of financial performance Identify and use historical trends Compare other customers in the same industry

4 Publicly Traded Companies SEC Forms 10-K (annual report) and 10-Q (quarterly report) are accessible at Corporate web sites may have an Investor Relations section where financial statements or data may be obtained Privately Held Companies May be obtainable through credit application or contract with customer Ask company may provide if credit limit will be significant and you sign a confidentiality agreement

5 Financial statements (always) Balance Sheet Income Statement Cash Flow Statement Notes to the financial statements (always) Management s Discussion and analysis of operations (useful if available)

6 Liquidity Ratios Measure a firm s ability to meet cash needs as they arise. They look at solvency and how fast non-cash current assets are turned into cash Activity Ratios Measure the liquidity of specific assets and the efficiency of managing assets Leverage Ratios Measure the extent of a firm s financing with debt relative to equity (important to balance risk versus return), and its ability to cover interest and other fixed charges Profitability Ratios Measure the overall efficiency and performance of a firm

7 #1 Ratio used for Liquidity is: Current Ratio Current Ratio = Current assets/current liabilities Example: 305,000/85,000 3:59 ratio Quick Ratio removes less liquid inventories Current assets-inventory/current liabilities Example: (305, ,000)/85, :1 ratio

8 Receivables Turnover Number of times that total A/R were created with new sales and then collected Receivables Turnover = Revenue/Accounts Receivable Example $1,000,000/$80,000 =12.5 times Inventory Turnover Number of times, in terms of Cost of Goods Sold, that total inventory is purchased and resold Inventory Turnover = Cost of Goods Sold/Inventory Example $550,000/150,000 = 3.67 times Payables Turnover Number of times, in terms of Cost of Goods Sold, that total A/P is borrowed and then repaid Payables Turnover = Cost of Goods Sold/Accounts Payable Example $550,000/$55,000 = 10 times

9 Days Sales Outstanding: Number of days it takes the customer to collect the ending A/R balance DSO = Receivables Turnover/365 or Net A/R/Sales*365 Example 365/12.5 = $80,000/$1,000,000*365=29.2 days Days Inventory Outstanding: Number of days it takes the customer to sell the ending balance in inventory DIO= Inventory Turnover/365 or Inv./Cost of goods sold*365 Example 365/3.67 = $150,000/550,000*365 = 99.5 days Days Payable Outstanding: Number of days it takes the customer might delay paying its ending A/P DPO = Payables Turnover/365 or Accounts Payable/COGS*365 Example 365/10 = $55,000/$550,000*365 = 36.5 Days

10 Cash Conversion Cycle Measures how many days it takes a company to go through a complete cash cycle CCC = DIO DPO + DSO Example 99.5 days days days = 92.2 days The cycle is the length of time inventory is carried less the portion of that period financed by vendors, plus once the inventory is sold, the length of time needed to convert resulting A/R back to cash. Lower is better (unless your company is on the receiving end of the higher DPO!)

11 Measures the riskiness of a firm s capital structure in terms of the relationship between funds supplied by creditors(debt) and investors (equity). The larger the ratio, the riskier the firm (i.e., lower is better). Debt to Equity = Total Liabilities/Shareholders equity Example $235,000/$615,000 = 38.0% Measures whether operating profit is sufficient enough to cover interest due to bondholders and banks. Higher is better. Times Interest Earned = Operating Profit/Interest Expense Example $200,000/25,000 = 8 Times

12 Gross Profit (or Margin) Ratio Measures percentage of each sales dollar available to cover SGA expenses, interest expenses, and to provide investors a return. Measures basic product line profitability Gross Margin Ratio = Gross Profit / Sales Example $450,000/$1,000,000 = 45.0% Operating Profit Ratio Measures percentage of each sales dollar available to cover interest expenses, and to provide investors a return. Measures core operational profitability before interest expense and taxes Operating Profit Ratio = Operating Income / Sales Example $200,000/$1,000,000 = 20.0%

13 Net Profit Ratio Measures percentage of each sales dollar available to investors. Measures overall profitability after all expenses Net Profit Ratio = Net Income / Sales Example $125,000/$1,000,000 = 12.5% Return on Equity Measures how well management uses equity (shareholders investment). Return on Equity = Net Income / Shareholders Equity Example $125,000/$615,000 = 20.3%

14 This is another method of calculating Return on Equity. It is an example of a combination ratio that analyzes the components of three of the ratio categories we ve discussed: Margins (Profitability) Turnover (Activity) Leverage

15 Return on Equity = Net Income / Shareholders Equity Breaking it down, Return on Equity equals: NI x Sales x Assets Sales Assets Equity Margins x Turnover x Leverage Use these three measures to assess whether a company is generating its ROE through margins, lower asset investments or higher financing. This can help inform a credit decision.