4: Analysis of Financial Statements

Ratio analysis
- Liquidity ratios
  - Current Ratio: the primary liquidity ratio.
    - Measures a company’s ability to pay short-term obligations with its short-term assets
    - Current Ratio = Current assets / current liabilities
  - Quick or Acid test ratio
    - More stringent liquidity ratio that excludes inventories from current assets to assess a company’s ability to cover short-term liabilities without relying on inventory sales
    - Quick or acid test ratio = ( current assets – inventories ) / current liabilities
- Asset management ratios
  - Inventory turnover ratio
    - How efficiently a company manages its inventory by comparing sales to average inventory levels
    - Inventory turnover ratio = sales / inventories
  - Days sales outstanding
    - The average number of days it takes for a company to collect payment after a sale has been made
    - Days sales outstanding (DSO)
    - = Receivables / Average sales per day
    - = Receivables / (Annual sales / 365)
  - Fixed assets turnover ratio
    - How efficiently a company is using its fixed assets to generate sales
    - Fixed assets turnover ratio = Sales / Net fixed assets
  - Total assets turnover ratio
    - How efficiently a company is using its total assets to generate sales
    - Total assets turnover ratio = Sales / Total assets
- Debt management ratios
  - Total debt to total capital
    - Measure of a company’s financial leverage, indicating the proportion of debt financing relative to its total capital
    - Total debt / total capital = total debt / (total debt + equity)
  - Times-interest-earned ratio
    - Measure of a company’s ability to meet its interest payments, indicating its financial stability and risk level
    - Times-interest earned (TIE) ratio = EBIT / Interest charges
- Profitability ratios
  - Operating margin
    - Percentage of revenue remaining after deducting operating expenses
      - efficiency with which the company operates
    - Operating margin = EBIT / Sales
  - Profit margin
    - Percentage of revenue that a company retains as profit after accounting for expenses
      - efficiency with which the company converts sales into net income
    - Profit Margin = net income / sales
  - Return on total assets
    - Measures a company’s ability to generate profit from its assets
    - Return on total assets (ROA) = Net income / Total assets
  - Return on common equity
    - Indicates how well the company is using its capital to generate earnings
    - Return on common equity (ROE) = net income / common equity
  - Return on invested capital
    - Total return that the company has provided for its investors
    - Return on invested capital (ROIC) = EBIT( 1-T ) / Total invested capital
    - Return on invested capital (ROIC) = EBIT( 1-T ) / ( Debit + equity )
  - Basic earning power (BEP) ratio
    - Raw earning power of the firm’s assets before the influence of taxes and debt
    - Basic earning power (BEP) ratio = EBIT / total assets
- Market value ratios
  - Price/earning ratio
    - Shows how much investors are willing to pay per share per dollar of reported profits
    - Price/earning ratio (P/E)(PE) = price per share / earnings per share
  - Market/book ratio
    - Shows how investors value the company
    - Market/book ratio = common equity / shares outstanding
    - = market price per share / book price per share
  - Enterprise value/ ebitda ratio
    - Looks at the relative market value of all the company’s key financial claims
    - Enterprise value = market value of equity + market value of total debt + market value of other financial claims – cash and equivalents
- Dupont equation
  - Return on equity (ROE) = Return on assets (ROA) * Equity multiplier
  - ROA = Profit margin * Total assets turnover
  - Equity multiplier = Total assets / Total common equity
  - Profit margin= Net income / sales
- Like all other ratios, ROE is not the whole picture and maximizing it isn’t necessarily the best thing for stakeholders.
  - Economic value added
    - A measure of how much management has added to shareholders’ wealth during the year
    - Economic value added (EVA) = EBIT(1-T) – (Total invested capital * After-tax cost of capital)
- Using these financial ratios to assess performance
  - Comparison to industry averages
    - Compare these ratios to industry averages to rate the firm (ie poor, ok, risky, etc)
  - Benchmarking
    - Compare each metric in a list alongside competitors to show performance of the firm
  - Trend analysis
    - Compare the metrics over time to competitors to show whether the numbers are getting better or worse for each
- Uses and limitations of ratios
  - Managers use these ratios to analyze and control performance
  - Creditors use these ratios to determine availability of credit and debt
  - Stock analysts use these ratios to determine whether to buy or sell a firm’s shares
- Looking beyond the numbers
  - Financial analysis metrics are not the whole picture of the company