1、 Author: Collins Qian Ratio Analysis March 1998 1 Ratio Analysis BOS Agenda Using ratios Types of key ratios profitability turnover leverage liquidity coverage Return on Equity Ratio exercises Forecasting exercise Abbreviations Key takeaways 2 Ratio Analysis BOS Analyzing Ratios Ratios in isolation
2、are meaningless. A companys ratios must be examined over time and/or against its competitors ratios. Historical comparisonCompetitive comparison Compare present ratios with same companys historical ratios In stable situations, historical ratios may be used to project future performance Compare a com
3、panys ratios with similar firms ratios or with industry averages at the same point in time Look for trendsLook at relative performance 3 Ratio Analysis BOS The Art of Ratio Analysis Which ratios are most important in a given situation? What items should be included/excluded in calculating the ratios
4、? How much influence does management have over the ratios? What do the ratios say about the firms strategy? Ratio analysis is an art as well as a science. 4 Ratio Analysis BOS The Need for Judgment Potential Problem Management can substantially influence financials in the short term Implications Nee
5、d to use judgment to understand financials Ratio analysis requires keen judgment. Financial statement data is historical, not pro forma Cross-company comparisons are meaningless if adjustments are not made for different accounting conventions The timing of the reporting period influences funds flows
6、 and requirements Need to understand that history does NOT necessarily predict future Need to be very sensitive about industry-specific seasonality and cyclicality Need to standardize across companies to adjust for different accounting methods 5 Ratio Analysis BOS Agenda Using ratios Types of key ra
7、tios profitability turnover leverage liquidity coverage Return on Equity Ratio exercises Forecasting exercise Abbreviations Key takeaways 6 Ratio Analysis BOS Types of Ratios Ratios help us understand how well a company is performing. Specifically, how much return is it generating with what level of
8、 risk? How well does the company manage costs relative to revenues? ReturnRisk Coverage Interest charge Fixed charge coverage Liquidity Current ratio Quick ratio Leverage Asset to equity Debt to equity Debt to total capital Turnover Receivables Inventory Payables Asset Profitability Operating margin
9、 ROS Gross margin How effective is the company in managing its resources? What are the respective claims of debt and equity owners? How risky is the business? Is the company able to meet its short-term obligations? Is the company able to meet its long-term obligations? 7 Ratio Analysis BOS Profitabi
10、lity Ratios - Definitions * This is not a profitability ratio, but it does impact ROS Profitability ratios use line items from the income statement. RatiosDefinitions Gross profit margin (or gross margin) Sales - cost of goods sold Sales Operating profit margin (or operating margin) Earnings before
11、interest and taxes Sales Return on sales (ROS) Profit after tax Sales Effective tax rate*Taxes Profit before tax 8 Ratio Analysis BOS Profitability Ratios - Description Profitability (or margin) ratios are a function of both the industry and a companys position within the industry boundaries are set
12、 by the operating characteristics of the industry within these boundaries profitability ratios are determined by a players relative position Bain typically uses gross profit and operating profit to measure profitability ROS can be altered by non-operating activities, such as sources of financing or
13、tax rate manipulations Extraordinary items, because they are for unusual events, such as discontinued items or asset sales, are excluded when we analyze the performance of the base business Profitability ratios measure a firms ability to manage costs relative to revenues. 9 Ratio Analysis BOS Profit
14、ability Ratios - Over Time Gross profit margin should stay constant or increase because cost of goods sold should be a constant percent of sales or should decrease as company gets price increases and/or volume discounts Operating margin should increase as fixed administrative and sales costs are spr
15、ead over a greater number of units Effective tax rate should stay constant or decrease since a larger firm is able to take advantage of more tax shelters As a company grows, its return on sales should increase. Higher return on sales 10 Ratio Analysis BOS Profitability Ratios - Market Leader Gross p
16、rofit margin should be higher since a market leader can typically charge more for its goods and/or receive the greatest volume discounts from suppliers Operating profit margin should be significantly higher, because higher volume means fixed costs are spread over more units and because the gross pro
17、fit margin is higher There should be no significant difference in the effective tax rate Return on sales should be significantly higher because the operating margin should be significantly higher The market leader in an industry should have the best profitability ratios. This is consistent with the
18、ROS/RMS concept which says that companies with high relative market share have high returns on sales 11 Ratio Analysis BOS Turnover Ratios - Definitions Note: Average=(Year Beginning+Year End)/2 * Sales is often a good proxy * Cost of goods sold is often a good proxy * Typically we use 365 days (i.e
19、., 1 year) for the period Turnover ratios use a combination of income statement and balance sheet items. RatiosDefinitions Receivables turnover Credit sales in period* Accounts receivable average balance Inventory turnover Cost of goods sold in period Average inventory in period Payables turnover Pu
20、rchases on account* Accounts payable average balance Asset turnover Sales in period Average assets Any turnover ratio can be expressed as a period ratio which measures the number of days in the cycle Days in period* Turnover ratio Period ratio = 12 Ratio Analysis BOS Turnover Ratios - Transaction Cy
21、cle * Accounts payable, inventory, and accounts receivable are the major components of working capital It is critical for a firm to manage its payables, inventory, and receivables.* Cash inflow Cash collected for sales made Cash outflow Raw materials purchased Cash disbursed for raw materials purcha
22、sed Finished goods inventory Sales made Accounts receivable period Accounts payable period XXX 13 Ratio Analysis BOS Turnover Ratios - Description Turnover ratios measures how many times per year a given resource is consumed Period ratios measure the number of days that is takes for a given resource
23、 to “turn over” Managements objective is to stretch out the accounts payable period (i.e., have low accounts payable turnover) and shorten the periods for accounts receivable and inventory (i.e., have high accounts receivable and inventory turnover) Turnover ratios measure how well a firm is managin
24、g its resources. 14 Ratio Analysis BOS Turnover Ratios - Tradeoffs Ratio Improvements Decrease the receivables collection period i.e., collect the accounts receivable faster Decrease the inventory holding period i.e., sell completed products faster Increase the account payable period i.e., take long
25、er to pay suppliers Strategic Tradeoff If the receivables collection period is too short, customers may buy at a competitor that has more generous credit terms. (Often this period is dictated by industry norms) If the inventory holding period is too short the company may not have enough inventory to
26、 fill a big order. Also, the company may not be able to outlast a strike, either at its own facility or at one of its primary suppliers facilities If the accounts payable period is too long, suppliers could raise their prices, charge interest (often at very high rates), or even refuse to supply the
27、firm on credit. Also, workers may get restless if they have to wait longer to receive their paychecks. Managing turnover ratios means managing strategic trade-offs. 15 Ratio Analysis BOS Leverage Ratios - Definitions * All three ratios here are called “leverage” ratios by different people, so be sur
28、e to understand which ratio is being used when someone is talking about leverage Leverage ratios use line items from the balance sheet. Ratios*Definitions DuPont leverage ratioAssets Equity Debt to equity ratioLong-term debt Equity Debt to total capital or debt to total assets ratio Total liabilitie
29、s Debt + equity Total liabilities Assets = 16 Ratio Analysis BOS Leverage Ratios - Description Money can be raised from debt sources (banks, bond markets) or equity sources (stockholders) Leverage ratios reflect both the financing policies of the firm and the riskiness of the business In order to an
30、alyze a firms leverage ratios, one needs to understand the definitions of debt and equity Leverage ratios measure the respective claims of debt and equity holders. 17 Ratio Analysis BOS Debt Versus Equity Contractual payments over the life of the loan Investor legally guaranteed full return of princ
31、iple plus interest nothing above that In case of liquidation, debtor has preferential claim on proceeds from sale of assets No guaranteed payments from common stock Investor “owns” part of firm right to appreciation of firms value In case of liquidation, equity owner takes what is left (may be nothi
32、ng) Debt and equity have very different characteristics. Debt = anything that contractually requires payments to be made before the equity holders have access to the firms earnings Equity = the value of the firm left over after all the debt holders have been paid Lower risk to investor; investor dem
33、ands lower return Higher risk to investor; investor demands higher return 18 Ratio Analysis BOS Debt Questions - Debt and Equity Debt in Leverage Ratios Bain typically looks only at long-term debt (debt with a term of 1 year or more) Accountants measure debt as short-term debt plus long term debt Eq
34、uity in Leverage Ratios Bain typically uses the market value of equity (I.e., the share price multiplied by the number of shares). Others may use the book value of equity, which is the amount shown on the balance sheet 19 Ratio Analysis BOS Debt Questions Accounts payable? Short-term debt? Long-term
35、 debt? Cancelable leases? Noncancelable leases? Preferred stock? Common stock? Deferred tax? Would you define the following as debt? 20 Ratio Analysis BOS Debt Answers Accounts payable Short-term debt Long-term debt Cancelable leases Noncancelable leases Some items are clearly debt, others are clear
36、ly not debt, still others are debatable. Not debt. It is part of working capital, and is “secured” by the inventory and receivables that it is used to finance Debt, if it used to finance capital expansions of the company Not debt, if it used to finance working capital Debt. Not debt. Because they ar
37、e cancelable, they are not contractual obligations Debt. Because they are non-cancelable, they are contractual obligations. (For all publicly traded US companies, the present value of all the noncancelable lease payments must be disclosed in balance sheet footnotes.) Debatable Argument for equity -
38、contractual obligations to pay dividends on preferred stock are met after debtholders claims are met Argument for debt - there is a contractual obligation to pay dividends on preferred stock before common stock dividend payments can be made Not debt. It is equityCommon stock Debt, but debatable. Oft
39、en considered debt given long-term natureDeferred tax Preferred stock 21 Ratio Analysis BOS Liquidity and Coverage Ratios - Definitions Liquidity ratios use line items from the balance sheet. Coverage ratios use line items from the income statement. RatiosDefinitions Current ratioCurrent assets Curr
40、ent liabilities Quick ratio (acid test) Cash + marketable securities + receivables Current liabilities Interest coverage ratioEarnings before interest and taxes Interest expense Fixed charge coverage Earnings before interest and taxes All essential payments (including lease payments) Liquidity: Cove
41、rage: 22 Ratio Analysis BOS Liquidity and Coverage Ratios - Description Acceptable values for these ratios differ by industry. However, when the current ratio or coverage ratios fall below 1 that means the firm is unable to meet its obligations It is a useful exercise to calculate how much revenue c
42、ould drop (or costs rise) before coverage would drop below 1 Liquidity ratios measure the firms ability to meet its short-term obligations. Coverage ratios measure the firms ability to meet its long-term obligations. 23 Ratio Analysis BOS Agenda Using ratios Types of key ratios profitability turnove
43、r leverage liquidity coverage Return on Equity Ratio exercises Forecasting exercise Abbreviations Key takeaways 24 Ratio Analysis BOS Return on Equity Return on equity is defined as profit after tax (earnings) divided by equity. It relates economic outputs (profit) to inputs (equity). It tells us th
44、e amount of profits the company earned on each dollar the stockholders invested in the firm. It is important to note that not all of the earnings are paid to the stockholders when they are earned. 8Only some portion of the earnings will be returned now in the form of dividends. The remainder (retain
45、ed earnings) will be re-invested in the company to finance growth 8The size of the divided is decided by the board of directors; an individual stockholder has no influence over when he/she actually receives the return that he/she has earned It is a combination of profitability, turnover, and leverag
46、e ratios Return on equity, ROE, is the acid test of success for a business. 25 Ratio Analysis BOS DuPont Formula By separating ROE into its components, one can gain insight into how to improve the performance of a business. ROE = Profit after tax Equity ROE = Profit after tax Sales Sales Assets Asse
47、ts Equity XX Return on Assets LeverageROSAsset turnover This is known as the DuPont formula ROE = Profitability X Turnover X Leverage 26 Ratio Analysis BOS Agenda Using ratios Types of key ratios profitability turnover leverage liquidity coverage Return on Equity Ratio exercises Forecasting exercise
48、 Abbreviations Key takeaways 27 Ratio Analysis BOS Unidentified Industries Exercise The objective of this exercise is to test your understanding of financial ratios. Exercise: The balance sheets (in percentage form) and selected ratios for six industries are given on the following page. Please match
49、 each of the six industries to the financial information Coal mining Grocery stores Hotels and motels Legal services Packaged software Potato chips and snacks 28 Ratio Analysis BOS Unidentified Industries Exercise - Data Industry Balance Sheet (%)ABCDEF *Ratios do not tie to balan司有下列情形之一的，可以解散： 公司章程规定的营业期
