Working with Financial Statements, Part II Faculty of Business Administration Lakehead University Spring 2003 May 7, 2003 Outline of Chapter 3, Part II 3.3 Ratio Analysis 3.4 The DuPont Identity 3.5 Using Financial Statement Information 1
3.3 Ratio Analysis Another way of comparing different companies is to look at their financial ratios. Well-known financial ratios are the P/E ratio, the profit margin, return on equity and return on assets. A huge number of ratios can be computed from financial statements. Ratios are used to evaluate companies from an investment perspective, and can also be used to evaluate management performance. 2 3.3 Ratio Analysis What is important to know about a ratio is 1. How is it computed? 2. What is it intended to measure? 3. What does a high or low value tell us? 4. What are the problems with this measure? 3
3.3 Ratio Analysis Financial ratios are grouped in five categories: 1. Short-term solvency, or liquidity, ratios; 2. Long-term solvency, or financial leverage, ratios; 3. Asset management, or turnover, ratios; 4. Profitability ratios; 5. Market value ratios. 4 Unibroue, Inc. 2002 and 2001 Balance Sheets (in thousands of $) Assets 2002 2001 Cash & marketable securities 2,300 2,114 Accounts receivable 3,891 4,435 Inventories 4,128 3,417 Other 584 634 Total current assets 10,903 10,600 Net fixed assets 23,085 22,426 Total assets 33,988 33,086 Liabilities and Stockholders Equity Accounts payables and accrued liabilities 3,199 2,257 Instalments on long-term debt 937 952 Total current liabilities 4,136 3,209 Long-term debt 5,125 5,992 Total equity 22,154 21,637 Total liabilities and equity 33,988 33,086 5
Unibroue, Inc. 2002 and 2001 Income Statements (in thousands of $) Sales 23,622 21,580 Cost of goods sold (11,824) (11,540) Selling and administrative expenses (SGA) (7,669) (6,543) Amortization (2,073) (1,833) Earnings before interest and taxes 2,056 1,664 Interest expense (675) (731) Foreign exchange gain 14 14 Pretax income 1,395 947 Taxes (434) (338) Net income 961 609 Number of shares outstanding 6,111,875 6,235,451 Earnings per share $0.16 $0.10 Stock price (December of that year) $2.43 $2.00 6 Short-Term Solvency, or Liquidity, Ratios Computation: Most often used are item/current liabilities, but there are other types of liquidity ratios. Intention: These ratios measure the firm s ability to meet its short-term obligations. High/Low: A high value indicates that short-term liquidity is not a problem. A value too high may indicate that management is too conservative. Problems: These measures are not perfect, as we will see shortly. 7
Short-Term Solvency, or Liquidity, Ratios The Current Ratio Current ratio = Current assets Current liabilities Unibroue s current ratio was 10,903 4,136 = 2.64 in 2002 10,600 3,209 = 3.30 in 2001 8 Short-Term Solvency, or Liquidity, Ratios A current ratio above 2 is often considered a good sign, but this depends on the industry the firm operates in. One problem with the current ratio is that it considers assets that may never convert to cash, such as inventories. The quick, or acid-test ratio is a solution to this problem. 9
Short-Term Solvency, or Liquidity, Ratios The Quick, or Acid-Test Ratio Acid-test ratio = Current assets Inventories Current liabilities Unibroue s quick ratio was 10,903 4,128 4,136 = 1.64 in 2002 10,600 3,417 3,209 = 2.24 in 2001 10 Short-Term Solvency, or Liquidity, Ratios One must compare a firm s acid-test ratio with those of its competitors. Like the current ratio, the acid-test ratio also considers assets that are not 100% liquid. The cash ratio is a solution to this problem. 11
Short-Term Solvency, or Liquidity, Ratios The Cash Ratio Cash ratio = Cash Current liabilities Unibroue s cash ratio was 2,300 4,136 2,114 3,209 = 0.56 in 2002 = 0.66 in 2001 12 Short-Term Solvency, or Liquidity, Ratios One must compare a firm s cash ratio with those of its competitors. The cash ratio is a very conservative measure of liquidity. Other liquidity ratios: NWC to total assets = NWC Total assets Interval measure = Current assets Average daily operating costs, where Average daily operating costs = (COGS + SGA)/365. 13
Long-Term Solvency Ratios Computation: Depends on the ratio. Intention: These ratios measure the firm s ability to meet its long-term obligations, i.e. its financial leverage. High/Low: A high value increases the probability of financial distress. A too low value may indicate that management does not sufficiently take advantage of leverage. Problems: These measures are not perfect, as we will see shortly. 14 The Total Debt Ratio Long-Term Solvency Ratios Total debt ratio = Total assets Total equity Total assets Unibroue s total debt ratio was 33,988 22,154 33,988 = 0.35 in 2002 33,086 21,637 33,086 = 0.35 in 2001 15
Long-Term Solvency Ratios A firm s total debt ratio has to be compared with other firms total debt ratios, or to the industry average. Note the relationship between these ratios: Debt/equity ratio = Equity multiplier = Equity multiplier = Total debt Total equity Total assets Total equity Total debt+total equity Total equity = 1 + Debt/equity ratio 16 Long-Term Solvency Ratios Investors might be more interested in long-term debt, since short-term debt (accounts payable and bank borrowing, for instance) are constantly changing. The long-term debt ratio ignores short-term liabilities: Long-term debt ratio = Long-term debt Long-term debt + Total equity 17
Times Interest Earned Other Long-Term Solvency Ratios Times interest earned ratio = EBIT Interest Cash Coverage Cash coverage ratio = EBIT + Depreciation Interest 18 Asset Turnover Ratios Computation: Usually related to total sales and/or total assets. Intention: These ratios measure how efficiently a firm utilizes its assets to generate sales. High/Low: A high ratio is usually a sign of efficiency. Problems: Each measure looks at a specific item, need more than one measure to make a decision. 19
Inventory Turnover Asset Turnover Ratios Inventory turnover = COGS Inventory Days Sales in Inventory Days Sales in Inventory = 365 Inventory Turnover 20 Asset Turnover Ratios What is inventory? Can use either the value for inventory that appears on the balance sheet or the average inventory over the year. Unibroue s inventory turnover in 2002 was 11,824 4,128 = 2.86 using Dec. 31, 2002, inventories 11,824 (4,128+3,417)/2 = 3.13 using average inventories in 2002 21
Asset Turnover Ratios Unibroue s days sales in inventory was, in 2002, 365 2.86 365 3.13 = 127 days using Dec. 31, 2002, inventories = 116 days using average inventories in 2002 A high inventory turnover ratio (i.e. little days sales in inventory) is a sign of efficiency. 22 Receivables Turnover Asset Turnover Ratios Receivables turnover = Sales Accounts receivable Days Sales in Receivables Days Sales in Receivables = 365 Receivables Turnover 23
Asset Turnover Ratios What is accounts receivable? As with inventories, we can use either the value for accounts receivable that appears on the balance sheet or the average value of accounts receivable during the year. Unibroue s receivables turnover in 2002 was 23,622 3,891 = 6.07 using 2002 inventories 23,622 (3,891+4,435)/2 = 5.67 using average inventories in 2002 24 Asset Turnover Ratios Unibroue s days sales in receivables was, in 2002, 365 6.07 365 5.67 = 60 days using Dec. 31, 2002, inventories = 64 days using average inventories in 2002 A high receivables turnover ratio (i.e. little days sales in inventory) is a sign that the firm has no difficulty collecting cash. 25
Other Asset Turnover Ratios NWC turnover = Sales/NWC Fixed asset turnover = Sales/Net fixed assets Total asset turnover = Sales/Total assets 26 Profitability Ratios Computation: Usually Net income/item. Intention: These ratios measure how efficiently assets are used to generate bottom line, net income. High/Low: A high turnover ratio is a good sign. Problems: Each measure looks at a specific item, cannot rely on only one measure. 27
Profitability Ratios Profit Margin Unibroue s profit margin was Profit margin = Net income/sales 961 23,622 609 21,580 = 4.07% in 2002 = 2.82% in 2001 28 Profitability Ratios Return on Assets (ROA) ROA = Net income/total assets Unibroue s return on assets was 961 33,988 609 33,086 = 2.83% in 2002 = 1.84% in 2001 29
Profitability Ratios Return on Equity (ROE) ROE = Net income/total equity Unibroue s return on equity was 961 22,154 609 21,637 = 4.34% in 2002 = 2.81% in 2001 30 Profitability Ratios Return on assets should preferably be greater than the firm s borrowing rate. A benchmark for return on equity is often around 15%. 31
Market Value Ratios Computation: Usually stock price/item. Intention: These ratios measure how shareholders value different items pertaining to the firm. High/Low: A high ratio may or may not be a good sign. Problems: Again, need more than one measure. 32 The Price/Earnings (P/E) Ratio Market Value Ratios P/E ratio = Stock price/earnings per share This ratio usuall involves expected future earnings. Nevertheless, we could say that Unibroue s P/E ratio was 2.43 0.16 2.00 0.10 = 15.45 in 2002 = 20.48 in 2001 33
Market Value Ratios A stock may be considered cheap when its P/E ratio is below 15. Rule of 19: Over the past 40 years, the average P/E ratio in the U.S. has been 19 minus the inflation rate. Hence, if the inflation rate is 3%, the right P/E ratio is 19 3 = 16. 34 Market Value Ratios The Market-to-Book Ratio (ME/BE) ME/BE ratio = Stock price/book equity per share, where book equity per share means total equity, as it appears on the balance sheet, divided by the number of shares outstanding. For Unibroue, this ratio was 2.43 22,154/6,112 2.00 21,637/6,235 = 0.67 in 2002 = 0.58 in 2001 35
Market Value Ratios Since the book value of assets is usually below its market value, a stock with a market-to-book ratio below one may be considered a good buy. On the other hand, a market-to-book ratio below one is the sign that management has not been very successful at creating value and thus might not be able to create value in the future either. 36 3.4 The DuPont Identity ROE = = Net income Total equity Net income Total equity Sales Total assets Sales Total assets = Net income Sales Sales Total assets Total assets Total equity = Profit margin Total asset turnover Equity multiplier 37
3.4 The DuPont Identity Firms in industries characterized by low profit margins (variety stores, for example) must have a high total asset turnover ratio and/or a high equity multiplier (high leverage) in order to achieve a return on equity that will satisfy shareholders. On the other hand, firms in capital intensive industries (low total asset turnover ratios) must have a high profit margin and/or a high equity multiplier to achieve a certain return on equity. 38