cb ratio analysis
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i s
i sFinancial Statement Analysis
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A n a l y
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A n a l y Ratio Analysis
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Corporate Bridge Academy
dheerajvaidya@corporatebridge.net
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R a www.corporatebridge.net
1Private and Confidential – Not for Circulation
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Discussion topics
How to analyze a company?
Analytical techniques for Financial Statement Analysis
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Hor zonta Ana ys s
Trend Analysis
Vertical Analysis
Ratio Analysis
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A n a l y Solvency
• Current Ratio /Quick Ratio / Cash ratio
• Receivables turnover / Inventory turnover / Payables turnover / Cash Conversion Cycle
Operating
R a • Operating Efficiency ratios
• Operating Profitability
• DuPont Formula
• Extended DuPont Formula
Risk
• Business Risk
• Financial risk
• External liquidity risk
Growth
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Limitations of Financial Ratios
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How to analyze a company?
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Analytical techniques for FSA
Purpose of Financial Statement Analysis is to evaluate management performance in
Profitability
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c ency
Risk
Although financial statement information is historical, it is used to project future performance
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A n a l y
Horizontaland TrendAnalysis
• Compares two financial statements to determine dollar andpercentage changes
• Compute dollar changes and percentage changes
• Compares two financial statements to determine dollar andpercentage changes
• Compute dollar changes and percentage changes
• Shows relationship of each item to a base amount on financial• Shows relationship of each item to a base amount on financial
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Which method is theBest?
Which method is theBest?Vertical
Analysis
statements
• Income statement (each item expressed as percentage of netsales)
• Balance sheet (each item expressed as percentage of totalassets)
statements
• Income statement (each item expressed as percentage of netsales)
• Balance sheet (each item expressed as percentage of totalassets)
RatioAnalysis
• Puts numbers in perspective with other numbers• Helps control for different sizes of firms
• Ratios provide meaningful relationships between individualvalues in the financial statements
• Puts numbers in perspective with other numbers• Helps control for different sizes of firms
• Ratios provide meaningful relationships between individualvalues in the financial statements
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An Analyst is expected to do a complete synthesis using all three methods
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Horizontal / Trend / Vertical Analysis
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Horizontal Analysis
Horizontal analysis shows the changes between years in the financial data in both dollarand percentage form
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[Current year – Base year] /[Base year]
GKSR Income Statement 2006 2007 Increase ($) % YoY change
Rental Operations 801,240 847,401 46,161 5.8%
Direct Sales 79,603 82,141 2,538 3.2%
Net Revenues $880,843 $929,542 $48,699 5.5%
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Why provision for tax hasincreased by 12.6%, while therevenues increased by only 5.5%?
ost o renta operat ons (518,543) (541,392) (22,849) 4.4%
Cost of direct sales (57,522) (59,579) (2,057) 3.6%
Selling and administrative costs (186,652) (203,614) (16,962) 9.1%
Operating Expenses ($762,717) ($804,585) ($41,868) 5.5%
- Ebitda $118,126 $124,957 $6,831 5.8%
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Why there is an increase of 9.1%in Selling and administrative cost?
, , , .
Amortization of intangibles (10,784) (10,806) (22) 0.2%
Ebit $74,863 $79,362 $4,499 6.0%
Interest Expense (13,226) (13,901) (675) 5.1%
Income before income taxes $61,637 $65,461 $3,824 6.2%
Provision for taxes (19,786) (22,271) (2,485) 12.6%
PAT $41,851 $43,190 $1,339 3.2%
Horizontal anal sis can also be done on the liabilities or shareholder’s e uit
Basic EPS $1.98 $2.03 $0.05 2.5%
Diluted EPS $1.97 $2.02 $0.05 2.4%
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Trend Analysis
Trend percentages state several years’ financial data in terms of a base year, which equals100%
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,
[Current year ] / [Base year] * 100
Income Statement 2002 2003 2004 2005 2006 2007Net Revenues 677,591 705,588 733,447 788,775 880,843 929,542
Operating Expenses 565,077 598,974 625,064 674,566 762,717 804,585
PAT 38,267 33,689 35,384 38,179 41,851 43,190
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A n a l y
Trend Analysis 2002 2003 2004 2005 2006 2007
Net Revenues 100.0% 104.1% 108.2% 116.4% 130.0% 137.2%
Operating Expenses 100.0% 106.0% 110.6% 119.4% 135.0% 142.4%
PAT 100.0% 88.0% 92.5% 99.8% 109.4% 112.9%
R a
140%
160%
Trend Analysis
by 42% since 2002, Net incomegrew marginally by 13% during the
corresponding period
60%
80%
100%
2002 2003 2004 2005 2006 2007
Ne t Reve nues Ope ratin g Expense Net In co me
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Vertical Analysis
Common-size statements use percentages to express the relationship of individualcomponents to a total within a single period is known as Vertical Analysis
Income Statement as a ercenta e of Total Revenues
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Balance Sheet (As a percentage of Total Asset / Total Liabilities)
Vertical Analysis 2002 2003 2004 2005 2006 2007
Rental Operations 96.8% 96.6% 96.6% 93.9% 91.0% 91.2%Since 2004, cost of rentals have
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co o . . . . . .
Net Revenues 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of rental operations -59.5% -60.5% -61.1% -59.6% -58.9% -58.2%
Cost of direct sales -2.3% -2.5% -2.6% -4.5% -6.5% -6.4%Selling and administrative costs -21.6% -21.9% -21.5% -21.4% -21.2% -21.9%
decreased
R a Operating Expenses -83.4% -84.9% -85.2% -85.5% -86.6% -86.6%
Ebitda 16.6% 15.1% 14.8% 14.5% 13.4% 13.4%
Depreciation -4.4% -4.3% -4.3% -4.1% -3.7% -3.7%
Amortization of intangibles -0.9% -1.0% -1.1% -1.2% -1.2% -1.2%
Ebit 11.3% 9.8% 9.4% 9.2% 8.5% 8.5%
Interest Expense -2.0% -1.9% -1.6% -1.4% -1.5% -1.5%
Income before income taxes 9.3% 7.8% 7.8% 7.8% 7.0% 7.0%
EBITDA/EBIT/PAT margins aconcern - continuously
decreasing trend
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- . - . - . - . - . - .
PAT 5.6% 4.8% 4.8% 4.8% 4.8% 4.6%
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i s i s
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Ratio Analysis
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9Private and Confidential – Not for CirculationPRIVATE AND CONFIDENTIAL dheerajvaidya@corporatebridge.net
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Ratio Analysis
Ratios can often be more informative that raw numbers
Puts numbers in perspective with other numbers
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e ps contro or erent s zes o rms
Ratios provide meaningful relationships between individual values in the financial statements
Ratios can be used to evaluate four different areas of company’s performance and conditions
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A n a l y Ratio
Analysis
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SolvencyRatios
OperatingPerformance
Risk Analysis Growth
Current/Cash/Quick Ratio
TurnoverRatios
OperatingEfficiency
OperatingProfitability
BusinessRisk
FinancialRisk
Externalliquidity risk
Sustainablegrowth rate
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Ratio Analysis - Solvency
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Ratio Analysis - Solvency
Analyst employ these ratios to determine the firm’s ability to pay its short-term liabilities
Current Ratio examines current assets and current liabilities
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Higher the current ratio, more likely is that the company will be able to pay its short-term bills
A ratio of less than 1, means that the company has negative working capital and is probably facing
sLiabilitieCurrentAssetsCurrentRatioCurrent =
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qu y cr s s
Quick Ratio adjusts current assets by removing less liquid assets
More stringent measure of liquidity
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Higher the quick ratio, more likely is that the company will be able to pay its short-term bills
sLiabilitieCurrent
sReceivableSecuritiesMarketableCashRatioQuick
++=
Cash ratio relates cash (ultimate liquid asset) to current liabilities
Higher the cash ratio, more likely is that the company will be able to pay its short-term bills
SecuritiesMarketableCashRatioCash
+=
12
sL a t eCurrent
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Ratio Analysis - Solvency
Receivables turnover examines the management of accounts receivable
Balance sheet items are taken as average of the account
i s Average collection period is the average number of days it takes for the company’s
customer to pay their bills
sReceivableAverage
SalesAnnual NetTurnover sReceivable =
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A n a l y It is desirable to have a collections period closer to the industry norm
Turnover sReceivable
365Period CollectionsReceivableAverage =
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,capital is tied up in assets
Inventory turnover measures firm’s efficiency with respect to its processing and inventorymanagement
Balance sheet items are taken as average of the account
Given the turnover values, you can compute the average inventory processing time
It is desirable to have a collections period closer to the industry norm
InventoryAverageSold Goodsof CostTurnover Inventory =
13
Turnover Inventory
365Period ProcessingInventoryAverage =
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Evaluating Solvency Ratios
Payables turnover measures the use of trade credit by the firm
Balance sheet items are taken as average of the account
i s Given the turnover values, we can compute the average payment period processing time
It is desirable to have a collections payment closer to the industry norm
PayablesAverage
sogoo soosTurnover Payables =
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Cash Conversion Cycle
Turnover Payable
365Period PaymentAverage =
R a Combines information from the receivables turnover, inventory turnover, and accounts payable turnover
Cash Con Cycle Receivable period Inventory period= + Payable period-
High conversion cycle is undesirable
Too high conversion cycle implies that company has excessive amount of capital investment in the salesprocess
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Calculating Cash Conversion Cycle
Example : Cash conversion cycle
Balance Sheet Income Statement
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Cash $156,000 $46,800 Net Sales $2,808,000
Accounts Receivables 312,000 468,000 COGS (1,560,000)
Inventory 936,000 624,000 Salaries expenses (514,800)
Net property, plant and equip 2,184,000 2,293,200 Depreciation expense (109,200)
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, , , , ,
Total Expense (2,246,400)
Liabilities 2006 2007 Pre-tax Income 561,600
Accounts Payable $589,680 $780,000 Income tax expense (168,480)
Mortgage Payable 1,248,000 1,294,800 Net Income $393,120
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, ,
Retained earnings 814,320 421,200
Total liabilities and Equity $3,588,000 $3,432,000
Calculate average cash conversion cycle for the company
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Ratio Analysis – Operating Efficiency
Operating Efficiency Ratios
Examines how management uses its assets to generate sales and it considers the relationship betweenvarious asset categories and sales
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Total Asset Turnover ratio indicates effectiveness of a firm’s use of its total asset base to
produce sales Different types of industries have different asset turnovers. Infrastructure business are capital intensive
and may have Asset Turnover closer to 1, however, retail business might have turnover ratios in doubledigits
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Low asset turnover may mean that the company has much capital tied up in its asset base
Assets NetTotalAverage
Sales NetTurnover AssetTotal =
R a e xe sse urnover re ec s u za on o xe asse s
This number can look temporarily bad if the firm has recently added greatly to its capacity in anticipationof future sales
AssetsFixed NetAverage
Sales NetTurnover AssetFixed =
Equity Turnover measures the employment of owner’s capital
Equity capital includes all preferred and common stock, paid-in capital and retained earnings
Sales NetTurnover Equity =
17
qu tyverage
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Ratio Analysis – Operating Profitability
Operating profitability ratios
Examines how management is doing at controlling costs so that a large proportion of the sales dollar isconverted into profit
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What proportion of the sales dollar is left after cost of goods sold?
Is the firm buying inputs (inventory and direct labor) at good prices?
Gross Profit Margin
Gross rofit mar in measures the rate of return after cost of oods sold
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Operating Profit Margin
Sales Net
ProfitGrossMarginProfitGross =
R a Operating profit margin measures the rate of profit on sales after operating expenses
Operating income can be thought of as the “bottom line” from operations
Sales Net
ProfitOperatingMarginProfitOperating =
Net Margin
Shows the combined effect of operating profitability and the firm’s financing decisions (since net income isafter interest and tax payments)
Income NetMarginProfit Net =
18
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Ratio Analysis – Operating Profitability
Example: Operating Ratios
Income Statement 2007
Sales $18,000
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COGS $13,200
Selling and Admin expenses $3,400Interest income $800
Interest expense $500
Calculate the following
a) Operating Profit Margin
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Gain on sale of long term inves $1,200
Provision for income taxes $1,015
Selected Balance Sheet items 2007Book value of total assets 44 000
c) Asset Turnover
d) Equity Turnover
R a
Accumulated depreciation ($12,000)
Net total assets $32,000
Shareholder's Equity 22000
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Ratio Analysis – Operating Profitability
Return on total capital relates the firm’s earnings to all capital invested in the business
This number should not be too low as compared to the industry average
i s We should consider Gross interest expense in our calculation
Return on total equity indicates the rate of return earned on the capital provided by the
CapitalTotalAverage
ExpenseInterestIncome NetCapitalTotalonReturn
+=
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s oc o ers a er pay ng or a o er cap a use
Total Equity includes preferred stock
EquityTotalAverage
Income NetEquityTotalonReturn =
R a
Return on owner’s equity is based only on the common shareholder’s equity
Preferred dividends are deducted from Net Income as they are a priority claim
EquityCommonAverage
Dividend Preferred -Income NetEquitysOwner'onReturn =
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Ratio Analysis – Operating Profitability
DuPont System divides ROE into several ratios that collectively equal ROE while individuallyproviding insight
Most im ortant term in ratio anal sis
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Basic algebra for ROE breakdown
EquityCommon
Income Net
ROE =
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EquityCommon
AssetsTotal
AssetsTotal
Sales
Sales
Income Net
EquityCommon
Income Net××=
Profit margin Asset Turnover Financial Leverage
R a
Extended DuPont System
Provides additional insights into the effect of financial leverage on the firm and pinpoints the effect ofincome taxes on ROE
We be in with the o eratin rofit mar in EBIT divided b sales and introduce additional
ratios to derive an ROE value
EquityCommon
AssetsTotal
AssetsTotal
Sales
Sales
Income Net
EquityCommon
Income Net××=
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Ratio Analysis – Operating Profitability
Extended DuPont Analysis
t-1AssetsTotalSalesEBTIncome Net
×××=
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EquityCommonAssetsTotalSalesEquityCommon
t)-1(EquityCommon
AssetsTotal
AssetsTotal
ExpenseInterest
AssetsTotal
Sales
Sales
EBIT
EquityCommon
Income Net××⎟
⎠
⎞⎜⎝
⎛ −×=
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Op. Profit Margin Asset Turnover Interest exp. rate Financial leverage Tax retention rate
R a
If Return on Investment in Asset > Fixed rate of borrowing = Positive financial leverage
If Return on Investment in Asset < Fixed rate of borrowing = Negative financial leverage
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Ratio Analysis – Operating Profitability
Example : DuPont Analysis
Please evaluate the following ratios for Pratts company
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2006 2007
Pre‐interest profit margin (EBIT/S) 0.15 0.10
Asset turnover (S/A) 1.00 1.50
Leverage (A/E) 2.00 2.50
Tax retention 1‐t 0.70 0.70
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A n a l y Interest expense ratio (I/A) 0.05 0.05
Comment on the firm's ROE trends
R a
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Ratio Analysis – Risk
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Ratio Analysis – Risk
Risk analysis examines the uncertainty of income for the firm and for an investor
Total firm risks can be decomposed into three basic sources – 1) Business risk 2) Financial
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Business Risk
Function of Business variability, Sales variability and Operating leverage
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A n a l y
Between five to ten years of data should be used for calculating business and sales variability
incomeoperatingMean
income)(operatingDeviationStandard tyvariabiliBusiness =
(sales)DeviationStandard tvariabiliSales =
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Also critical is the measure of how much company’s production costs are fixed (as opposed to variable)
salesMean
Salesinchange%
EarningsOperatinginchange%leverageOperating =
Greater the use of fixed costs, greater the impact of a change in sales on the operating income of acompany and hence, higher is the risk
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Ratio Analysis – Financial Risk
Financial risk
The added uncertainty in a firm’s net income resulting from a firm’s financing decisions (primarily throughemploying leverage)
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Interest payments are deducted before we get to net income and these are fixed obligations. Similar tofixed production costs, these lead to larger earnings during good times, and lower earnings during abusiness decline
The use of debt financing increases financial risk and possibility of default while increasing profitabilitywhen sales are high
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A n a l y Two sets of financial ratios help measure financial risk
• Balance sheet ratios
• Earnings or cash flow available to pay fixed financial charges
Balance Sheet Ratios
R a How much debt does the firm employ in relation to its use of equity?
How much debt does the firm employ in relation to all long-term sources of funds?
equitytermLong
debttermLongratioequityDebt to =
Assessment of overall debt load, including short-term
capitaltermlongTotal
debttermLongcapitalTotalDebt to =
debttermLongsliabilitieCurrentRatioDebt
+=
26
qu tyotae tota +
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Ratio Analysis – Financial Risk
Earnings/Cash flow ratios
Relate operating income (EBIT) to fixed payments required from debt obligations
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g er rat o means ower r s
Interest coverage ratio determines the firm’s ability to repay its debt obligations
expenseInterest
EBITcoverageInterest =
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as ow to ong term e t rat o eterm nes t e a ty o t e rm to meet ts ong term e t t rougits cash flows
leaseoperatingof PVdebttermlongof Book value
CFOdebttermlongtoflowCash
+=
R a
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Ratio Analysis – External Liquidity Risk
External liquidity risk
External market liquidity is a source of risk to investors
i s
ar et qu ty s t e a ty to uy or se an asset qu c y w t tt e pr ce c ange rom a pr ortransaction assuming no new information
The most important factor of external market liquidity is the dollar value of shares traded
This can be estimated from the total market value of outstanding securities
It will be affected by the number of security owners
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A n a l y Numerous buyers and sellers provide liquidity
R a
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Ratio Analysis – Example
Example : Ratio Analysis
Please evaluate the following ratios
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Cash Ratio 0.84 0.60
Operating Profit
Margin 30% 36%
Current Ratio 1.80 1.44
Total Debt‐to‐Total Capital Ratio 78% 74%
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Cash Flow‐to‐Total Debt Ratio 66 60
Cash Conversion Cycle (days) 54 60
Interest coverage 3.00 2.40
Net Profit Margin 10% 8%
Debt‐to‐Equity Ratio 132% 127%
R a
Comment on the firm's trends on the followinga) Profitability b) Liquidity c) Financial Risk (Coverage)
Financia Ris Leverage
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Ratio Analysis – Growth
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Ratio Analysis – Growth
Growth is important to both creditors and owners
Creditors interested in ability to pay future obligations
i s
or owners, t e va ue o a rm epen s on ts uture growt n earn ngs, cas ow, an v en s
If the company doesn’t grow, it stands a much greater chance of defaulting on its loans
Sustainable growth rate is a function of two variables:
What is the rate of return on equity (which gives the maximum possible growth)?
t i o
A n a l y How much of that growth is put to work through earnings retention (rather than being paid out in
dividends)?
Growth = ROE x Retention rate
Also remember ROE is a function of
R a e pro marg n
Total asset turnover
Financial leverage (total assets/equity)
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Limitations of Financial Ratios
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Limitation of Financial Ratios
Accounting treatments may vary among firms, especially among non-U.S. firms
Always consider relative financial ratios. They do not make any sense when viewed in
i s
Firms may have divisions operating in different industries making it difficult to derive industry
ratios
Conclusions cannot be made by just looking at only one set of ratios
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A n a l y
R a
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