Financial Ratio Analysis

Part 4
Financial
Ratio Analysis —
Evaluating Firm
Performance
1
4.3 USING FINANCIAL
RATIOS
Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-16

Using Financial Ratios
• Financial ratios provide a method for

standardizing the financial information on
the income statement and balance sheet.
• A ratio by itself may have no meaning.

Hence, a given ratio is generally compared
to: (a) ratios from previous years; or (b)
ratios of other firms in the same industry.

Using Financial Ratios (cont.)

LIQUIDITY RATIOS

Liquidity Ratios
 Liquidity ratios address a basic question:

“How liquid is the firm?”
 A firm is financially liquid if it is able to pay

its bills on time. We can analyze a firm’s
liquidity from two perspectives

Liquidity Ratios (cont.)
1. Overall Liquidity - analyzed by comparing

the firm’s current assets to the firm’s
current liabilities.
2. Liquidity of specific assets - analyzed by
examining the timeliness in which the
firm’s liquid assets (accounts receivable
and inventories) are converted into cash.

Liquidity Ratios: Current Ratio
• The overall liquidity of a firm is analyzed by

computing the current ratio and acid-test
ratio
 Current Ratio: Current Ratio compares a
firm’s current (liquid) assets to its current
(short-term) liabilities.

Liquidity Ratios: Current Ratio
(cont.)
• What is the current ratio for 2018 for

Boswell?
Current Ratio = $477 ÷ 292.5 = 1.63

times
• The firm had $1.63 in current assets for

every $1 it owed in current liability.

Liquidity Ratios: Quick Ratio
 Acid-Test (Quick) Ratio excludes the

inventory from current assets as inventory
may not be very liquid

Liquidity Ratios: Quick Ratio
(cont.)
• What is the quick ratio for Boswell for 2012?
• Quick Ratio
= ($477-$229.50) ÷ ($292.50) = 0.84 times
• The firm has only $0.84 in current assets

(less inventory) to cover $1 in current
liabilities

Liquidity Ratios:
Individual Asset Categories
We can also measure the liquidity of the firm

by examining the liquidity of accounts
receivable and inventories to see how long
it takes the firm to convert its accounts
receivables and inventories into cash.

Liquidity Ratios: Accounts
Receivable
 Average Collection Period measures the

number of days it takes the firm to collects
its receivables.

Receivable (cont.)
• What will be the average collection period

for Boswell, Inc. for 2012 if we assume that
the annual credit sales were $2,500 million?
• Daily Credit Sales
= $2,500 ÷ 365 days = $6.85 million
• Average Collection Period
= $139.5m ÷ $6.85m = 20.37 days

Receivable Turnover Ratio
 Accounts Receivable Turnover Ratio

measures how many times receivables are
“rolled over” during a year.

Receivable Turnover Ratio (cont.)
• What will be the accounts receivable

turnover ratio for Boswell, Inc. for 2012 if
we assume that the annual credit sales were
$2,500 million?
• Accounts Receivable Turnover

= $2,500 million ÷ $139.50 = 17.92 times
– The firm’s accounts receivable were turning over
at 17.92 times per year.

Liquidity Ratios:
Inventory Turnover Ratio
 Inventory turnover ratio measures how many

times the company turns over its inventory during
the year
 Shorter inventory cycles lead to greater liquidity

since the items in inventory are converted to cash
more quickly.

Liquidity Ratios:
Inventory Turnover Ratio (cont.)
• What will be the inventory turnover ratio for

2012 for Boswell, Inc. if we assume that the
cost of goods sold were $1,980 million in
2012?
• Inventory Turnover Ratio

= $1,980 ÷ $229.50 = 8.63 times
– The firm turned over its inventory 8.63 times per
year.

Liquidity Ratios:
Days’ Sales in Inventory
 Days’ Sales in Inventory

= 365÷ inventory turnover ratio
= 365 ÷ 8.63 = 42.29 days
• The firm, on average, holds its inventory for

about 42 days

Can a Firm Have Too Much Liquidity?
 A high investment in liquid assets will

enable the firm to repay its current liabilities
in a timely manner.
 However, an excessive investments in

liquid assets can prove to be costly as liquid
assets (such as cash) generate minimal
return.

CAPITAL STRUCTURE RATIOS

Capital Structure Ratios
 Capital Structure refers to the way a firm

finances its assets
 Capital structure ratios address the

important question:
“How has the firm financed the
purchase of its assets?”

Capital Structure Ratios (cont.)
 Debt ratio measures the proportion of the

firm’s assets that are financed by borrowing
or debt financing.

• What is the debt ratio for H.J. Boswell, Inc.

for 2012?
• Debt Ratio
= $1,012.50 million ÷ $1,764 million = 57.40%
– The firm financed 57.39% of its assets with debt.

 Times Interest Earned Ratio measures

the ability of the firm to service its debt or
repay the interest on debt.

• What will be the times interest earned ratio

for Boswell for 2012 if we assume interest
expense of $65 million and EBIT of $350
million?
• Times Interest Earned
= $350m ÷ $65m = 5.38 times
– The firm can pay its interest expense 5.38 times
or interest used 1/5.38th or 18.58% of its EBIT.


ASSET MANAGEMENT
EFFICIENCY RATIOS

Asset Management Efficiency Ratios
 Asset management efficiency ratios

measure a firm’s effectiveness in utilizing its
assets to generate sales
• They are commonly referred to as

Turnover ratios as they reflect the number
of times a particular asset account balance
turns over during a year.

(cont.)
 Total Asset Turnover Ratio represents

the amount of sales generated per dollar
invested in firm’s assets.

(cont.)
What will be the total asset turnover ratio for

Boswell, Inc. for 2012 if we assume total sales
to be $2,500 million?
•Total Asset Turnover

= $2,500 million ÷ $1,764 million = 1.42 times
– The firm generated $1.42 in sales per dollar of
assets in 2018.

(cont.)
 Fixed asset turnover ratio measures

firm’s efficiency in utilizing its fixed assets
(such as property, plant and equipment).

(cont.)
What will be the fixed asset turnover ratio for

Boswell for 2012 if we assume sales of $2,500
million for 2012?
•Fixed Asset Turnover

= $2,500 million ÷ $1,287 million = 1.94 times
– The firm generated $1.94 in sales per dollar
invested in plant and equipment.

(cont.)
The following grid summarizes the efficiency

of Boswell’s management in utilizing its assets
to generate sales in 2013.

PROFITABILITY RATIOS

Profitability Ratios
Profitability ratios address a very

fundamental question: Has the firm earned
adequate returns on its investments?

Profitability Ratios (cont.)
Two fundamental determinants of firm’s

profitability and returns on investments:
•Cost Control – How well has the firm

controlled its costs relative to each dollar of
firm sales?
•Efficiency of asset utilization – How

effective is the firm in using the assets to
generate sales?
Cost Control: Is the Firm Earning
Reasonable Profit Margins?
Gross profit margin shows how well the

firm’s management controls its expenses to
generate profits.

Reasonable Profit Margins? (cont.)
What will be the gross profit margin ratio for

2012 for Boswell if we assume sales of $2,500
million and gross profit of $650 million?
•Gross Profit Margin
= $650 million ÷ $2,500 million = 26%
– The firm spent $0.74 for cost of goods sold and
thus $0.26 out of each dollar of sales went
towards gross profits.

Operating Profit Margin measures how

much profit is generated from each dollar of
sales after accounting for both costs of goods
sold and operating expenses. It also indicates
how well the firm is managing its income
statement.

What will be the operating profit margin ratio

for Boswell for 2012 if we assume sales of
$2,500 million and net operating income of
$350 million?
•Operating Profit Margin

= $350 million ÷ $2,500 million = 14%
– The firm generates $0.14 in operating profit for
each dollar of sales.

Net Profit Margin measures how much

income is generated from each dollar of sales
after adjusting for all expenses (including
income taxes).

What will be the net profit margin ratio for

2012 if we assume sales of $2,500 million and
net income of $217.75 million?
•Net Profit Margin

= $217.75 million ÷ $2,500 million = 8.71%
– The firm generated $0.087 for each dollar of
sales after all expenses were accounted for.

Return on Invested Capital
Operating Return on Assets ratio is the

summary measure of operating profitability. It
takes into account the management’s success
in controlling expenses and its efficient use of
assets.

Profitability Ratios (cont.)
What will be the operating return on assets

ratio for Boswell for 2012 if we assume EBIT
or net operating income of $350 million for
2012?
•Operating Return on Assets

= $350 million ÷$1,764 million = 19.84%
– The firm generated $0.1984 of operating profits
for every $1 of its invested assets.

Decomposing the Operating Return
on Assets Ratio

Figure 4.1 Analyzing H. J. Boswell, Inc.’s
Operating Return on Assets (OROA)

Figure 4-1 Observations
• Firm’s OROA (operating return on assets) is

better than its peers.
• Firm’s OPM (operating profit margin) is

lower than its peers.
• Firm’s TATO (total asset turnover ratio) is

higher than that of its peers.

Figure 4-1 Recommendations
1. Reduce costs - The firm must investigate

the cost of goods sold and operating
expenses to see if there are opportunities
to reduce costs.
2. Reduce inventories – The firm must

investigate if it can reduce the size of its
inventories.

CHECKPOINT 4.3:
CHECK YOURSELF
Evaluating the Operating Return on Assets
(OROA) for HD and LOW
If Home Depot were able to raise its total asset
turnover ratio to 2.5 while maintaining its current
operating profit margin, what would happen to its
operating return on assets?

Step 1: Picture the Problem
• The operating return on assets ratio for a

firm is determined by two factors: cost
control and asset utilization. Here the focus
is on asset utilization.

Step 2: Decide on a Solution
Strategy
We will analyze the impact on operating

return on assets of improvement on the total
asset turnover ratio by using the following
equation:
•Operating Return on Assets (OROA)

= Total Asset Turnover × Operating Profit Margin

Step 3: Solve
• Operating Return on Assets (OROA)

– = Total Asset Turnover × Operating Profit
Margin
• Before = 1.74 × 9.46% = 16.46%
• Now = 2.5 × 9.46% = 23.65%

Step 4: Analyze
• An improvement in total asset turnover ratio

has a favorable impact on Home Depot’s
operating return on assets (OROA).
• If Home Depot wants to increase its OROA

more, it should focus on cost control that
will help improve the net operating profit.

Is the Firm Providing a Reasonable
Return on the Owner’s Investment?
Return on Equity (ROE) ratio measures the

accounting return on the common
stockholders’ investment.

Is the Firm Providing a Reasonable Return
on the Owner’s Investment (cont.)
What will be the ROE ratio for Boswell for 2012

if we assume net income of $217.75 million?
•ROE = $217.75m ÷ $751.50 mi = 28.98%
– Thus the shareholders earned 28.97% on their

investments.

Using the DuPont Method for
Decomposing the ROE ratio
• DuPont method analyzes the firm’s ROE

by decomposing it into three parts.
– ROE = Profitability × Efficiency × Equity

Multiplier
• Equity multiplier captures the effect of the

firm’s use of debt financing on its return on
equity. The equity multiplier increases in
value as the firm uses more debt.

Decomposing the ROE ratio (cont.)
ROE = Profitability × Efficiency × Equity

Multiplier

The following table shows why Boswell’s

return on equity was higher than its peers.

Figure 4.2

MARKET VALUE RATIOS

Market Value Ratios
Market value ratios address the question,

how are the firm’s shares valued in the stock
market?

Price-Earnings Ratio
Price-Earnings (PE) Ratio indicates how

much investors are currently willing to pay for
$1 of reported earnings.

Price-Earnings Ratio (cont.)
What will be the PE ratio for 2012 for Boswell,

Inc. if we assume the firm’s stock was selling
for $22 per share at a time when the firm
reported a net income of $217.75 million, and
the total number of common shares
outstanding are 90 million?

Market Value Ratios (cont.)
• Earnings per share

= $217.75 million ÷ 90 million = $2.42
• PE ratio = $22 ÷ $2.42 = 9.09
• The investors were willing to pay $9.09 for

every dollar of earnings per share that the
firm generated.

Market-to-Book Ratio measures the

relationship between the market value and
the accumulated investment in the firm’s
equity.

What will be the market-to-book ratio for

2012 for Boswell if the market price of the
stock is $22 and the firm has 90 million
shares outstanding?

• Book Value per Share

– = 751.50 million ÷ 90 million = $8.35 per
share
• Market-to-Book Ratio
= Market price per share ÷ Book value per
share
= $22 ÷ $8.35
= 2.63 times

CHECKPOINT 4.4:
CHECK YOURSELF
Comparing the Valuation of DELL to

APPL Using Market Value Ratios
What price per share for Dell would it take
to increase the firm’s price-to-earnings
ratio to the level of Apple?
Step 1: Picture the Problem
Price-to-earnings (PE) ratio depends on

earnings per share and price per share,
pictured as follows:
Price per share standardized by
EPS =
Net income ÷ number
Of shares outstanding
PE Ratio =
Price per share ÷
Earnings per share

Step 2: Decide on a Solution
Strategy
We need to determine the price per share that

will make PE ratio of Dell (4.83) equal to the
PE ratio of Apple (13.22).
•PE ratio = Price per share ÷ Earnings per

share
==> 13.22 = ? ÷ 2.01
•Price per share = 13.22 × 2.01 = $26.57

Step 4: Analyze
• PE ratio allows us to compare two stocks

with different prices by standardizing the
stock prices by earnings.
• Apple has a much higher PE ratio. To reach

the same PE valuation, the stock price of
Dell will have to increase from $9.70 to
$26.57.

4.4 SELECTING A
PERFORMANCE BENCHMARK

Selecting a Performance Benchmark
• There are two types of benchmarks that are

commonly used:
– Trend Analysis – compares a firm’s financial
statements over time (time-series comparisons).
– Peer Group Comparisons – compares the subject
firm’s financial statements with “peer” firms.

Trend Analysis
• Comparing a firm’s recent financial ratios

with the past financial ratios provides insight
into whether the firm is improving or
deteriorating over time. This type of
financial analysis is referred to as trend
analysis.

Figure 4-3 A Time-Series (Trend) Analysis: Dell’s
Inventory Turnover Ratio Versus Hewlett
Packard’s: 1995–2011

Peer Firm Comparisons
Peer groups often consist of firms from the

same industry. Industry average financial
ratios can be obtained from a number of
financial databases and internet sources (such
as yahoo finance and google finance).

Figure 4-4 Financial Analysis of the
Gap, Inc., June 2009

4.5 LIMITATIONS OF RATIO
ANALYSIS

The Limitations of Ratio Analysis
1. Picking an industry benchmark can

sometimes be difficult.
2. Published peer-group or industry averages
are not always representative of the firm
being analyzed.
3. An industry average is not necessarily a
desirable target or norm.

The Limitations of Ratio Analysis
(cont.)
4. Accounting practices differ widely among

firms.
5. Many firms experience seasonal changes in
their operations.
6. Financial ratios offer only clues.
7. The results of financial analysis are no
better than the quality of the financial
statements.

Key Terms
• Accounts receivable turnover ratio

• Acid-test (quick) ratio
• Average collection period
• Book value per share
• Capital structure
• Current ratio
• Days’ sales in inventory

Key Terms (cont.)
• Debt ratio
• DuPont method
• Equity Multiplier
• Earnings per share (EPS)
• Financial leverage
• Financial ratios
• Fixed asset turnover ratio
• Inventory turnover ratio

Key terms (cont.)
• Liquidity ratios
• Market-to-book ratio
• Market value ratios
• Notes payable
• Operating return on assets (OROA)
• Price-earnings (PE) ratio

Key terms (cont.)
• Return on assets (ROA)

• Return on equity (ROE)
• Times interest earned
• Total asset turnover ratio (TATO)
• Trend analysis

Financial Ratio Analysis

Uploaded by

Copyright:

Available Formats

You might also like

Financial Ratio Analysis

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Financial Ratio Analysis

Uploaded by

Copyright:

Available Formats

Part 4

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-16

• Financial ratios provide a method for

• A ratio by itself may have no meaning.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-17

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-18

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-19

 Liquidity ratios address a basic question:

 A firm is financially liquid if it is able to pay

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-20

1. Overall Liquidity - analyzed by comparing

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-21

• The overall liquidity of a firm is analyzed by

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-22

• What is the current ratio for 2018 for

Current Ratio = $477 ÷ 292.5 = 1.63

• The firm had $1.63 in current assets for

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-23

 Acid-Test (Quick) Ratio excludes the

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-24

• What is the quick ratio for Boswell for 2012?

• The firm has only $0.84 in current assets

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-25

We can also measure the liquidity of the firm

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-26

 Average Collection Period measures the

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-27

• What will be the average collection period

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-28

 Accounts Receivable Turnover Ratio

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-29

• What will be the accounts receivable

• Accounts Receivable Turnover

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-30

 Inventory turnover ratio measures how many

 Shorter inventory cycles lead to greater liquidity

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-31

• What will be the inventory turnover ratio for

• Inventory Turnover Ratio

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-32

 Days’ Sales in Inventory

• The firm, on average, holds its inventory for

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-33

 A high investment in liquid assets will

 However, an excessive investments in

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-34

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-40

 Capital Structure refers to the way a firm

 Capital structure ratios address the

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-41

 Debt ratio measures the proportion of the

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-42

• What is the debt ratio for H.J. Boswell, Inc.

– The firm financed 57.39% of its assets with debt.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-43

 Times Interest Earned Ratio measures

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-44

• What will be the times interest earned ratio