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4.7 Worked Problem: CABS Inc.

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

  1. See ratio analysis in work!
  2. Calculate and analyze ratios for a fictional company.

CABS Example

CABS Inc. is a fictional company that makes custom invitations and cards. Below are their financials.

Figure 4.6 CABS, Inc. Balance Sheet

Figure 4.7 CABS, Inc. Income Statement

Figure 4.8 CABS, Inc. Statement of Cash Flows

Figure 4.9 CABS, Inc. Other Data

In this section we pick some key ratios to calculate for CABS. Then we will analyze using data over time and versus competitors.

Liquidity Ratios

The two liquidity ratios are the Current Ratio and the Quick Ratio. Both are important to calculate.

Current Ratio

To calculate the current ratio we take the current assets number from the balance sheet and divide it by the current liabilities number, also from the balance sheet. For CABS the calculation is:

Current Ratio= Total Current AssetsTotal Current Liabilities= 315.7169.5=1.86

Quick Ratio

To calculate the quick ratio we take three numbers from the balance sheet: current assets, inventories and current liabilities.

Quick Ratio= Total Current AssetsInventoriesTotal Current Liabilities= 315.733.6169.5=1.66

Asset Management Ratios

Asset management ratios calculate how efficiently the firm uses its assets. Here we calculate average sales per day, total asset turnover and fixed asset turnover.

Average Sales per Day

Average sales per day takes the sales number from the income statement and divides it by 365.

average sales= annual sales365= 1680.0365

Total Asset Turnover

Total asset turnover is computed by dividing the sales number from the income statement by the total asset number from the balance sheet.

Total Asset Turnover= SalesTotal Assets= 1680.0458.2=3.66

Fixed Asset Turnover

Fixed asset turnover focuses just on the fixed assets (for example a factory). It divides the sales number from the income statement by the net fixed assets (note: net!) from the balance sheet.

Fixed Asset Turnover = SalesNet Fixed Assets= 1680.0142.5

Debt Ratios

Debt management ratios measure the indebtness of the firm. The key ratios we analyze here are the debt ratio, debt-equity and TIE.

Debt Ratio

The debt ratio simply divides two numbers from the balance sheet: total liabilities divided by total assets.

Debt Ratio = Total LiabilitiesTotal Assets= 242.1458.2= 0.52

Debt-Equity Ratio

The debt-equity ratio changes the denominator by subtracting total liabilities. Debt-equity also uses total assets and total liabilities from the balance sheet.

Debt-Equity Ratio= Total Liabilities(Total AssetsTotal Liabilities)= 242.1458.20242.1=1.12

TIE

TIE measures the ability of a firm to pay back its debt. It uses EBIT and interest expense from the income statement.

Times-Interest-Earned= EBITInterest Expense= 222.625

Profitability Ratios

Debt management ratios measure the indebtness of the firm. The key ratios we analyze here are the debt ratio, debt-equity and TIE.

Profit Margin

The amount of money left over after all expenses are paid. It uses sales and cost of goods sold from the income statement.

Profit Margin= SalesCost of Goods SoldSales= 1680.0910.41680.0=0.46

Operating Profit Margin

Operating profit margin is a better measure of the actual profit from operations because it ignores items such as depreciation. It is operating profits (EBIT) divided by sales. Both numbers come from the income statement.

Operating Profit Margin= Operating Profits (EBIT)Sales= 222.61680.0= 0.13

Net Profit Margin

Net profit margin is the percentage of each sales dollar that remains after all expenses have been deducted. It is calculated by dividing earnings (net income) by sales. Both numbers come from the income statement.

Net Profit Margin= Earnings Available for Common StockholdersSales= 118.61680.0= 0.07

Earnings Per Share

Is the amount of earnings generated by each share of stock. It is calculated by dividing earnings by the number of shares of stock.

Earnings Per Share= Earnings Available for Common StockholdersNumber of Shares of Common Stock Outstanding= 118.66=19.77

Basic Earning Power (BEP)

Basic Earning Power is earning power of the firm before taxes and leverage. It is calculated by dividing EBIT from the income statement by total assets from the balance sheet.

Basic Earning Power= EBITTotal Assets= 222.6458.2= 0.49

Return on Equity (ROE)

Return on Equity is the ratio of net income to total equity. It is calculated by dividing net income from the income statement by equity, from the balance sheet.

Return on Equity= Net IncomeCommon Stock Equity= 118.6216.1= 0.55

Return on Assets (ROA)

Return on Assets is the ratio of net income to total assets. This is calculated by diving net income from the income statement by total assets from the balance sheet.

Return on Assets= Net IncomeTotal Assets= 118.6458.2=0.26

Market Value Ratios (Investment Valuation Ratios)

Market Value Ratios are a way to measure the value of a company’s stock relative to another company’s stock. Here we focus on P/E ratio and market book ratio.

Price/Earnings Ratio

Price / Earnings ratio is used to show how much investors are willing to pay per dollar of profits. It is calculated by dividing the price per share of stock (in the other information section) by the earnings per share (calculated earlier).

Price/Earnings Ratio= Price per share of stockEarnings per share of stock= 14919.77=7.54

Market Book Ratio

Market book ratio is a measure of investor’s evaluation of firm performance. First the book value per share of stock is calculated using the common equity number from the balance sheet and dividing it by the number of shares outstanding from the other information.

Book Value Per Share of Stock= Common Stock EquityNumber of Shares of Stock Outstanding= 216.16= 36.01

This is then substituted in to calculate the Market/Book ratio. This equation uses the market price (selling price) per share of stock from the other information section and the book value calculated above.

Market Book Ratio= Market Value per share of common stockBook Value per share of common stock=14936.01=4.13

Comparision Information

Below is a table summarizing the numbers we just calculated in the CABS 2011 column. The table also includes CABS data from last year and also the industry average for 2011.

Figure 4.10 CABS, Inc. Averages

How do you think CABS is doing financially? How are they doing versus other players in their industry?

Key Takeaways

  • Ratio analysis is easy and fun! It’s just a matter of knowing what number to put where. Practice makes perfect!
  • Comparing ratios over time and against competitors is an interesting way to analyze a company. It is as much of an art as it is a science.

Exercises

  1. Calculate the following ratios from the data for CABS (these were not calculated above):

    1. DuPont equation
    2. Inventory turnover
    3. average age of inventory
    4. average payment period
    5. net profit
  2. Review the 10-K for Starbucks again. Compute some ratios for Starbucks. Then find some already computed ratios on yahoo.finance. Did you get the same numbers as an analyst? Why or why not?