Lecture no03 financial ratio analysis

Ratio Analysis and What the Numbers Really Mean o Debt Management Ratios o Liquidity Ratios o Asset Management Ratios o Profitability Ratios o Market Trend Ratios o Trends and Graphs to

Financial Ratio Analysis

Lecture No 3 Chapter 2 Contemporary Engineering

Economics, 6 th ed.

Ratio Analysis and What the

Numbers Really Mean

o Debt Management Ratios

o Liquidity Ratios

o Asset Management Ratios

o Profitability Ratios

o Market Trend Ratios

o Trends and Graphs to Spot Problems

Key Financial Ratios

Debt management

Market Trend

Profitability

Asset Management Liquidity

Debt ratioTimes-interest-earned ratio

Key Financial Ratios

Debt management

Market Trend

Profitability

Asset Management Liquidity

Debt ratioTimes-interest-earned ratio

Key Financial Ratios

Return on Equity: A Composite Ratio

profitability by revealing how much profit a company generates with the money

shareholders have invested

generated as a percentage of shareholders equity

Net income Return on Equity (ROE) =

Average shareholders' equity

Returns on Equity (ROE): Three Components

Average shareholders' equity

Sales Assets Average shareholders' equity (Profit margin) (Asset turnover) (Fin ancial leverage)

= (6.18%) (2 12 times) (3.64 times) 

= 47.68%

Returns on Equity (ROE) and Levels of

Performance for Ten Diverse Companies

(As of January 26, 2014)

Return on Equity (%) Margin (%) Profit Turnover Asset

(times)

Financial Leverages (times)

Debt Management Analysis

 Definition : Ratios that

show how a firm uses

debt financing and its

ability to meet debt

repayment obligations

 Indicates how a firm

finances its capital

Total assets

$58,000

$161,400 35.94%

A debt ratio of greater than 1 indicates

that a company has more debt than assets,

a measure of a level of risk.

 Measures the extent to

which earnings can

Interest Charges

$33,280

$5,200 6.40 times

Times Interest

Earned Ratio

EBIT: Earnings before interest

and taxes

firm’s cash and

other assets to its

current liabilities

Current Liabilities

$77,400

$28,000 2.76 times

Current Ratio

Quick Ratio

Liquidity Ratio

Asset Management Analysis

 Highlights the rate at

which the inventory is

Average Inventory

$300,000 ($39,800 $37,700)/2 7.96 times

The typical item sits in inventory almost

1.508 months (12 months/7.96) or 45.24

days before being sold

Inventory Turnover

Ratio

Average sales per day

$23,700

$300 , 000 / 365 28.84 days

Days Sales

Outstanding (DSO)

Days Sales in Inventory

expressed in days of sales For example, if 2 items are sold and 20 items are held in inventory per day, this represents 10 days' (20/2) worth of sales in inventory.

average inventory by cost of sales, and multiplied the result by 365

DSI (Days Sales in Inventory)= Average Inventory

Average Cost of Sales per day

 ($37,700$39,800)/2

$208,000/365

 68 days

Total Assets

$300,000

$161,400 1.86 times

Total Asset

Turnover Ratio

Profitability Analysis

• Definition: A set of

ratios which show

the combined effects

of liquidity, asset

management and

debt on operating

results

Net Sales

$112,000

$300,000 37.33%

Gross Margin

Net Sales

$20,000

$300,000 6.67%

Net Margin

 Measures a company’s

success in using its

assets to earn a profit

ROA = Net Income + interest expenses(1 - tax rate)

Average total assets

 Measures the rate of

return on the owner’s

Debt-to-Equity Ratio

o A measure of a company’s financial leverage,

indicating what proportion of equity and

debt the company is using to finance its

assets

o A high debt/equity ratio generally means that

a company has been aggressive in financing its growth with debt.

How the Debt to Equity Ratio Impacts

Return on Equity

 Not have a spectacular ROE

because there is so much

equity in the company (e.g.,

well-established DOW 30

stocks)

 A highly leveraged company

that might have a spectacular

ROE because the owners have

put so little of their own

resources into the company

(e.g., high-tech industries) Assets

Liabilities

Equity Assets

Liabilities Equity

=

=

Market Trend Analysis

• Definition: A set

of ratios that

relate the firm’s

stock price to its

earnings and book

value per share

Earnings Per Share (EPS)

$1.94

Price to Earnings Ratio

How to Use P/E Ratios

premium you are paying

for a company's earnings

today.

 Determine if the

expected growth warrants

the premium.

 Compare it to its peers

in the industry to see its

A higher ratio indicates that investors are willing to bet a higher return on their investment.

Market Value/Book Value

are paying too much for

what would be left if the

company went bankrupt

immediately

undervalued.



$40.50 Book Value/Share =

$9.34 4.34

As of December 31, 2015, the closing share price was $40.50

Where Sunset Stands as of

Trends and Graphs to Spot Problems

improving or deteriorating over time.

Limitations of Financial Ratios

market conditions and make the necessary adjustments.

particular ratio is good or bad

represent the true business condition