Financial Ratio Analysis

Excerpts from Financial Management and Policy 11e (Horne)

Purpose of Financial Analysis
Depends on Specific interests:

Trade creditors Bondholders

Investors Management
 Use of Financial Ratios
Compare two pieces of financial data in order to:

Trend analysis performance over

time Income Statement
(in Php Bn except EPS)
2017 2016

Gross Revenue 125.01 112.61

Gross Expense 110.06 96.85

Vertical
Income/(Loss) Before Tax 13.95 16.30
Net Income/(Loss) After Tax 11.15 13.08
Earnings/(Loss) Per Share (Basic) 4.94 5.88

Horizontal
Compare with others
URC.PS Company Industry Sector
Sales (MRQ) vs Qtr. 1 Yr. Ago 12.19 2.30 (1.10)
Sales (TTM) vs TTM 1 Yr. Ago -- 6.77 5.13
Sales - 5 Yr. Growth Rate 10.69 9.05 10.87
EPS (MRQ) vs Qtr. 1 Yr. Ago (24.01) (3.41) 1.92
EPS - 5 Yr. Growth Rate 25.30 7.64 8.06

Peer to Peer Comparison

*Information acquired from Thomson Reuters and PSE Edge

 Some Caveats
• Avoid rules of thumb
• Approach industry
comparisons with caution
• Analyze the deviation from
industry average
• Groupings may not be
homogeneous
• Accounting data are
estimates at best
Illustration – Aldine Income
Statement
Aldine Manufacturing Company Statement of Earnings (in Thousands)
Mar-98 Mar-97
Net Sales 3,992,758 3,721,241
Cost of goods sold 2,680,298 2,499,965
Selling, general and administrative expenses 801,395 726,959
Depreciation 111,509 113,989
Interest Expense 85,274 69,764
Earnings before taxes 314,282 310,564
Provision for taxes 113,040 112,356
Earnings after taxes 201,242 198,208
Cash dividends 142,968 130,455
Retained Earnings 58,274 67,753
 Illustration – Aldine Balance Sheet
Mar-98 Mar-97 Mar-98 Mar-97
Assets Liabilities and Equity
Cash and cash equiv 177,689 175,042 Bank loans and notes 448,508 356,511
Accounts receivable 678,279 740,705 Accounts payable 148,427 136,793
Inventories 1,328,963 1,234,725 Income taxes payable 36,203 127,455
Prepaid Expenses 20,756 17,197 Accruals 190,938 164,285
Deferred income taxes 35,203 29,165 Current liabilities 824,076 785,044
Current assets 2,240,890 2,196,834 Lont-term debt 630,783 626,460
PPE 1,596,886 1,538,495 Shareholder's equity
Less: Accumulated dep'n 856,829 791,205 Common stock ($5 par) 420,828 420,824
740,057 747,290 Add'l paid-in capital 361,158 361,059
Investment, long term 65,376 - Retained Earnings 1,014,635 956,361
Other Assets 205,157 205,624 Total Equity 1,796,621 1,738,244
Total assets 3,251,480 3,149,748 Total Liabilities and Equity 3,251,480 3,149,748

Other Assumptions
Average Income Tax Rate 36%
Principal payments for the year 4,323
Share Price 32
Replacement Cost of Assets 3,576,628
 Five Types of Ratios
Ratio
Analysis

Profitabilit Market-
Liquidity Debt Coverage
y value

Measures Indicates Indicate

Reflects Relates to
the ability the firm’s relative
the relative the ability
to meet profitabilit valuation
proportion of a firm to
short-term y and of a stock
of debt service its
obligations efficiency
funds financial
of
employed obligation
operation
 Liquidity Ratios*
Types Description Formula
Current ratio Current Assets
Crude measure of liquidity Current Liabilities

Quick ratio (acid test) More accurate guide to Current Assets - Inventories
liquidity; uses Cash,
Current Liabilities
Marketable Securities and AR

Liquidity of receivables
Average Collection Period Reflects the credit policy of Accounts Receivable x 365
• ACP =
(ACP) the firm (restrictive vs liberal) Annual Credit Sales

Duration of Payables Considers the payment policy

Average Payment Period Accounts Payable x 365
• of the firm APP =
(APP) Purchases or COGS
Used for credit checking

Liquidity of inventories Evaluates the inventory

• Days Sales Inventory Inventories x 365
management efficiency and DSI =
product obsolescence COGS
 Debt Ratios*
Types Description Formula
Debt-to-Equity Ratio Provides a general indication
of creditworthiness of a firm. Total Debt
D-E ratio varies over different Total Equity
industries
Long-term Capitalization Highlights the importance of Long-term Debt
of the Firm long term debt in the capital Total Capitalization
structure

Cash Flow to Debt and Assesses the

Capitalization Cash Flow (EBITDA)
creditworthiness of a
company seeking debt funds Total Liabilities

Cash Flow to Long-term

debt ratio Evaluates the bonds of the Cash Flow (EBITDA)
company Long-term Debt

Enterprise value-to-EBITDA Assesses the possibility of

ratio default of the firm. Firms Total borrowings + Equity
must be concerned when Cash Flow (EBITDA)
ratio exceeds 8
 Profitability Ratios*
Types Description Formula
Gross Profit Margin Profit after deducting the
Sales - Cost of Goods Sold (COGS)
cost of producing the goods
sold Sales
Net Profit Margin Profit after all expenses and Net Profit after Taxes
taxes are deducted.
Sales
Return on Equity Earning power on Net Profit after Taxes - Preferred
shareholder’s book
investment Stock Dividends
Shareholder's Equity
Return on Assets
Measures the profitability of Net Profit after Taxes
firm relative to its assets
Total Assets

Net operating profit rate Accounts the financing

of return charges and a more suitable Earnings Before Interest and Taxes
measure than ROA Total Assets
Asset Turnover
Relative efficiency of a firm in Sales
utilizing its resources Total Assets
 Coverage Ratios*
Types Description Formula
Interest coverage ratio Ability of a company to pay EBIT
interest on its outstanding Annual Interest Payments
debt

EBITDA Interest coverage Highly correlated with the EBITDA

ratio bond ratings and the market Annual Interest Payments
assessment of risk

EBITDA Interest and Relates the cash flows of the EBITDA

principal coverage ratio firm to the sum of interest Interest + Principal Payments [1/(1-t )]
and principal payments
 Market Value Ratios*
Types Description Formula
Price / Earnings Ratio
Values the future growth of Share Price
the firm Earnings per share

Dividend yield Relationship between the Dividends per share

annual dividends to share
Share Price
price.

Market-to-book ratio Measure of how the growth Share Price

for a company is being
valued vis-à-vis its physical Book Value per share
assets
*0.5 or lower are in a harvest situation
 Common Size & Index Analysis
Common size analysis
• percentages of total assets and sales
Index analysis
• comparison relative to a base year

Aldine Manufacturing Company Statement of Earnings (in Thousands)

Mar-98 Mar-97 Common Size Index
Net Sales 3,992,758 3,721,241 100.00% 100.00% 107.30
Cost of goods sold 2,680,298 2,499,965 67.13% 67.18% 107.21
Selling, general and administrative801,395
expenses 726,959 20.07% 19.54% 110.24
Depreciation 111,509 113,989 2.79% 3.06% 97.82
Interest Expense 85,274 69,764 2.14% 1.87% 122.23
Earnings before taxes 314,282 310,564 7.87% 8.35% 101.20
Provision for taxes 113,040 112,356 2.83% 3.02% 100.61
Earnings after taxes 201,242 198,208 5.04% 5.33% 101.53
Predictive Power of Financial Ratios

• Empirical studies
• Regression analysis
• Discriminant analysis

• Best ratios
• Debt-to-equity
• Cash-flow-to-debt
• Net operating profit margin
• Debt coverage and its stability
• ROI
• Size and earnings stability
Issues in Financial Ratios

• Differences on accounting
practices

• Book value versus Market value?

• Balance sheet year-end values or

average values?
• Seasonality of operations
THANK YOU