This is “Ratio Analysis”, section 4.5 from the book Finance for Managers (v. 0.1).
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This Sunday’s paper has a big ad for a toolbox. Jim was impressed and wanted to buy one for her father. Inside of it were all kinds of things: screwdrivers, hammers, pliers, etc. Some items looked easy to use (hammer and screwdriver), while some items looked a bit more complicated (this big heavy looking drill). This toolbox had a bunch of incredibly useful stuff in it and Jim knew his dad knew how to use all of it.
Ratio analyses are also tools. They can be very useful, if you know how to properly use them (like Jim’s father) or dangerous if you don’t (like Jim). Some are easy to understand, others a bit more complicated. Instead of the toolbox from the newspaper ad, in this section we focus on the financial manager’s toolkit and the items inside.
Ratio analysisA quantitative tool used to analyze a company’s financial statements. is one of the most important tools for evaluating a company’s financial health (and it can be fun too!). It’s not just about calculating ratios, it’s about interpretation of the ratios and seeing changes, opportunities and threats. Ratios are only as good as the mind (yours) that analyzes them.
Ratios are divided into categories depending on what they analyze. The first category is Liquidity Ratios.
Liquidity ratiosRatios that measure the ability of a company to meet its short-term financial obligations. measure the ability of a business to meet its short-term financial obligations. These ratios are associated with a firm’s working capital.
Our first ratio is called the current ratioCurrent assets divided by current liabilties.. This is computed by dividing current assets by current liabilities. The current ratio measures the ability of a company to repay its current liabilities.
A second liquidity ratio is the Quick RatioCurrent assets less inventories divided by current liabilities. also known as the “acid test”. It was given the nickname “acid test” after a method used by gold miners to confirm their nuggets were real gold. Nuggets gold miners discovered were dipped in acid. Most metals will dissolve in acid and fail the test—except the real deal: gold. Financially, the ‘acid test’ measures the ability of a firm to pay its liabilities with the real deal: cash. The acid test measures if a company can pay its current liabilities without relying on the sale of its inventory. In the acid test, we subtract inventories from current assets and then divide by current liabilities. The acceptance range for the actual value depends on the industry but a quick ratio greater than 1 is usually recommended. The quick ratio is a better measure when a firm’s inventory cannot quickly be converted to cash. If a firm has inventory that is liquid, the current ratio is preferred.
The second category is asset management ratiosRatios used to measure the effectiveness of a firm in managing its assets. (or activity ratios) which measure how well a firm manages its assets.
First, let’s discuss averages. For many of the asset management ratios, we use an average. In some cases average sales, average inventory or average purchases. For these numbers we are looking for an average per day. In each of these situations, to calculate the average per day take the annual number (year end) and divide by 365. Some textbooks use 360 to simplify the math but we use 365 here. For example here’s a calculation for average sales:
That’s it! So any time you see an average in the next section remember to divide the annual number by 365.
The inventory turnover ratioHow many times during a year a firm’s inventory is bought and sold. Defined as the cost of goods sold divided by the average inventory. tells how many times during a year the firm’s inventory is bought and sold. Once again, this ratio is industry specific but a relatively high ratio is preferred. This result is most meaningful when compared to competitors and can be influenced by technology and distribution techniques.
Another meaningful measure is average age of inventoryDefined as 365 divided by the inventory turnover ratio.. This is easily converted from the inventory turnover ratio by dividing the inventory turnover ratio into 365. Note that this is a different calculation than the averages computed above.
The average payment periodMeasures how long it takes a company to pay its suppliers. Defined as accounts payable divided by average purchases per day. measures how long it takes a company to pay its suppliers. It is calculated by dividing accounts payable by the average purchases per day. If average payment period increases then cash should increase as well. Companies usually pay their biggest suppliers first and some companies will pay faster to take advantage of trade discounts.
The receivables turnover ratioMeasures how effective a company is in collecting money owed to them. Defined as sales divided by accounts recievable. is the other side of the coin. It measures how how effective the company is in collecting money owed to them or how efficient they are in extending credit and collecting debts. It is the total revenue divided by the average receivables. Obviously we would like to get our money and sooner is better than later!
Total asset turnover ratioA measure of how effective a firm is in using its assets to generate sales. Defined as sales divided by total assets. gives us an idea how effectively a firm uses its assets to generate sales. It is computed by dividing total revenues by total assets for the same time period. If the asset turnover ratio is relatively high, then the firm is efficiently using its assets to generate sales. If it is relatively low, then the firm is not using assets effectively and may want to consider selling some assets if sales do not increase.
Sometimes we also calculate the turnover on just our fixed assets such as plant and equipment. Because variable costs vary (that’s why they are variable costs!) these costs have different impacts on financial statements. Fixed asset turnoverA measure of how effective a firm is in using its fixed assets to generate sales. Defined as sales divided by total assets. focuses on our long term assets and is calculated by dividing sales by net fixed assets (remember net means with depreciation taken out).
Debt management ratiosCalculate how much a firm uses debt as a source of funding. measure how much a firm uses debt as a source of financing. When a company uses debt financing, they use other people’s money to finance their business activities. Debt has higher risk but also the potential for higher return. Debt has an impact on a company’s financial statements. The more debt a company uses, the greater the financial leverage. Because with debt the stockholders maintain control of the firm, the more debt a company uses, the greater the financial leverage and the greater the returns to stockholders. With the debt ratios we try to measure the indebtness the firm which gives us an idea of the riskiness of the firm as an investment. There are two types of measures of debt usage. The first is the ability of the company to pay back its debts. The second is the degree of the indebtness of the firm. The first measure of the amount of debt a firm has is the debt ratio.
The debt ratioThe ratio of debt to assets. Defined as total liabilities divided by total assets. is the ratio of debts to assets (in actuality total liabilities to total assets). It measures the percentage of funds provided by current liabilities and by long-term debt. Creditors prefer low debt ratios because a low ratio indicates that the firm has plenty of assets to pay back its debts. In other words, the firm has a financial ‘airbag’ in case of an accident which will protect against a creditor’s losses in the event of bankruptcy. On the other hand, a stockholder may prefer a higher ratio because that indicates the firm is appropriately using leverage which magnifies the stockholder’s return. Simply put, the debt ratio is a percent. It is the percent of financing in the form of liabilities and is an indicator of financial leverage.
A close cousin of the debt ratio and another version of the indebtedness of a firm is the debt-equity ratioThe ratio of dollars of debt for every dollar of equity. Calculated by total liabilities divided by the difference between total assets and total liabilities.. The debt-equity ratio presents the information in a slightly different way. It subtracts total liabilities from total assets in the denominator. This calculation is easy to comprehend because it shows us dollars of debt for every dollar of equity.
The first measure of how able a firm is to pay back its debt is the time-interest-earnedA measure of the firm’s ability to pay interest. Is EBIT divided by interest expense. or TIE. TIE measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs. It is determined by dividing earnings before interest and taxes by interest expense. If a company fails to meet their interest payments then they can be sought after by creditors. The higher the number the more able a firm is to pay back its debts. A value of at least 3.0 or preferably closer to 5.0 is preferred. (leave in?) The TIE number give us a percentage which is the percent that EBIT could fall by and the firm would still be able to make its interest payments.
Another measure of a firm’s ability to pay back debt is EBITDA coverage ratioImproves upon TIE by including other variables such as lease payments. It is calculated by the sum of EBITDA and lease payments divided by the sum of interest plus principal payments plus lease payments.. The EBITDA Coverage ratio improves upon the TIE ratio because it includes lease payments and because more cash is available for debt than just EBIT. This ratio is most useful for short-term lenders because over the short-term depreciation funds can be used to pay off debt.
Another way to measure risk and the firm’s ability to pay back its debtors is the fixed-payments coverage ratioMeasures the firm’s ability to payback all of its fixed-payment obligations such as loans and leases.. This ratio measures the firm’s ability to payback all of its fixed-payment obligations such as loans and leases. The higher the value the better as that indicates the more the firm is able to cover its fixed payments. The lower the ratio, the greater the risk to lenders and owners.
We love to focus on profit, the so called ‘bottom line’. Ratio analysis helps us to put our profit number into context. These ratios used together can help give a clear picture of the profitability of a firm.
Profit marginThe amount of profit left over after all expenses are paid. Defined by the difference between sales and cost of goods sold divided by sales. is the amount of profit left over from each dollar of sales after expenses are paid. The higher the number the better as it indicates that the firm retains more of each sales dollar.
Operating profit marginProfit margin using only operating expenses. Defined as operating profits divided by sales. only uses operating expenses to calculate. It does not consider items such as depreciation, interest or taxes. In this case, higher is also better.
Net profit marginPercentage of each dollar that remains after all expenses have been paid. Calculated by earings available for common stockholders divided by sales. is the percentage of each sales dollar that remains after all expenses have been deducted. Expenses including interest, taxes and preferred stock dividends. This can sometimes be referred to as net profits after taxes divided by sales. In this situation, higher is also better but what is considered a ‘good’ profit margin varies greatly across industries.
Earnings per shareThe amount of earnings generated by each share of stock. It is earnings available for common stockholders divided by number of shares of common stock outstanding. are the amount of earnings generated by each share of stock. It is not necessarily the amount of earnings actually paid out per each share (that’s dividends per share). Earnings per share is the dollars earned for each share of stock.
Basic Earning PowerThe raw earning power of the firm before taxes and leverage. It is EBIT divided by total assets. shows the raw earning power of the firm before the influence of taxes and leverage. This is helpful to analyze because firms have very different financing and tax situations.
Two of our favorite (and most famous—if a ratio can be famous) ratios are ROE and ROA. Both ratios are return on an outlay. Return on EquityThe return investors are earning on their investment. Defined as net income divided by common equity. is the ratio of net income to total equity. This ratio tells us the return investors are earning on their investment. The higher the ratio better.
Return on AssetsThe return managers are earning on assets. Defined by net income divided by total assets. is the ratio of net income to total assets. This measures the managers overall effectiveness in creating profits with the firms’ assets. The higher the ratio the better.
Market Value RatiosThese ratios relate a firm’s value (measure by stock price) with other variables. relate a firm’s value as measured by stock price to other accounting measures such as earnings and cash flow. These are a way to measure the value of a company’s stock relative to another company’s stock.
Price / Earnings ratioShows how much investors are willing to pay per dollar of profit. Calculated by dividing the price per share by the earnings per share of stock. is used to show how much investors are willing to pay per dollar of profits.
Cash is king as we stated before. A company’s stock price is dependent on its ability to generate and manage cash. A useful ratio is Price / Cash FlowMeasures the ability of the company to generate cash. Defined as the price per share divided by the cash flow per share. which analyzes the company’s ability to generate cash.
Market book ratioMeasures the market value of the firm to the book value. Defined as market value per share of stock divided by the book value per share of stock. is a measure of investor’s evaluation of firm performance. It relates the market value of the firm to the book value of the firm. The market value is the firm’s current value while the book value is an accounting measure. First the book value per shareIs the commons stock equity divided by the number of shares of stock outstanding. of stock is calculated.
This is then substituted in to calculate the Market/Book ratio
If a firm is expected to earn a high return relative to its risk will most often sell at a higher Market/Book multiple.