financial analysis(6)

8/9/2019 Financial Analysis(6)

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CHAPTER OBJECTIVES:

Thischapter introduces ratios, the basic tools of financial analysis. Ourgoals are to:

1. Examine the purpose and use of ratios and provide some

cautionary notes.2. Explain the use of common-size statements.3. Discuss the construction and use of:

Activity (turnover) ratios that measure the efficiency withwhich the firm uses its resources.

Liquidity ratios that assess the firms ability to meet its near-term obligations.

Solvency ratios that examine capital structure and the firmsability to meet long-term obligations and capital needs.

Profitability ratios that measures income relative to revenuesand invested capital.

4. Examine the computation and usefulness of earnings per shareand other ratios used for valuation purposes.

INTRODUCTION

Financial ratios are used to compare the risk and return of differentfirms in order to help equity investors and creditors make intelligentinvestment and credit decisions. Such decisions range from anevaluation of change in performance over time for a particularinvestment to a comparison among all firms within a single industry ata specific point in time. The informational needs and appropriate

analytical techniques used for these investment and credit decisionsdepend on the decision makers time horizon. Short-term bank andtrade creditors are primarily interested in the immediate liquidity ofthe firm. Long-term creditors (e.g., bondholders) are interested in long-term solvency. Creditors seek to minimize risk and ensure thatresources are available for the payment of interest and principalobligations.

Equity investors are primarily interested in the long-term earningpower of the firm. As the equity investor bears the residual risk (whichcan be defined as the return from operations after all claims fromsuppliers and creditors have been satisfied), it requires a returnproportionate to the risk. The residual risk is highly volatile and difficultto quantify, as is the equity investors time horizon. Thus, analysis bythe equity investor needs to be the most comprehensive, and itincludes the analysis carried out by other users.


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Objective of Ratio Analysis

A primary advantage of ratios is that they can be used to compare therisk and return, relationships of firms of different sizes. Ratios can

provide a profit of a firm, its economic characteristics and competitivestrategies, and its unique operating, financial, and investmentcharacteristics.

This process of standardization may, however, be deceptive as itignores differences between industries, the effect of varying capitalstructures, and differences in accounting and reporting methods(especially when comparisons are international in scope). Given thesedifferences, changes (trends) in a ratio and variability over time maybe more informative than the level of the ratio at any point in time.

Four broad ratio categories measure the different aspects of risk andreturn relationships:

1. Activity analysis: Evaluates revenue and output generated bythe firms assets.

2. Liquidity analysis: Measures the adequacy of a firms cashresources to meet its near-term cash obligations.

3. Long-term debt and solvency analysis: Examines the firmscapital structure in terms of the mix of its financing sources andthe ability of the firm to satisfy its longer-term debt andinvestment obligations.

4. Profitability analysis: Measures the income of the firm relativeto its revenues and invested capital, to judge the present andfuture earning capacity or profitability of the concern.

Utilisation

1. To judge the operational efficiency of the concern as a whole andits various parts or departments.

2. To judge the short-term and long-term solvency of the concernfor the benefit of the debenture holders and trade creditors.

3. To have comparative study in regard to one firm with another

firm or one department with another department.4. To help in assessing developments in the future by making

forecasts and preparing budgets.

These categories are interrelated rather than independent. Forexample, profit-ability affects liquidity and solvency, and theefficiency with which assets are used (as measured by activity


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analysis) impacts profitability. Thus, financial analysis relies on anintegrated use of many ratios, rather than a selected few.

Limitations of Accounting Ratios:

Ratio analysis is essential to comprehend financial analysis.However, ratios are based on implicit assumptions that do notalways apply. Ratio computations and comparisons are furtherconfounded by the lack or inappropriate use of benchmarks, thetiming of transactions, negative numbers, and differences inreporting methods. This section presents some important caveatsthat must be considered when interpreting ratios.No idea of probable happenings:

Ratios are an attempt to make an analysis of the past financial

statements; so they are historical documents. Now -a days keepingin view the complexities of the business, it is important to have anidea of the probable happenings in future.Variation in Accounting:

The two firms results are comparable with the help of accountingratio only if they follow the same accounting methods or bases.Comparison will become difficult if the two concerns follow thedifferent methods of providing depreciation or valuing stock.Similarly if the two firms were following two different standards and

methods, an analysis by reference to the ratios would bemisleading. Moreover, utilization of inbuilt facilities, availability offacilities and scale of operation would affect financial statements ofdifferent firms. Comparison of financial statements of such firms bymeans of ratios is bound to be misleading.

Price level changes:

Changes in price levels make comparison for various years difficult.For example, the ratio of sales to total assets in 1984 would bemuch higher than in 1970 due to rising prices, fixed assets being

shown at cost and not at market price.

Only one method of analysis:

Ratios analysis is only a beginning and gives just a fraction ofinformation needed for decision-making. So, to have acomprehensive analysis of financial statements, ratios should beused along with other methods of analysis.


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No common standards:

It is very difficult to lay down a common standard for comparison

because circumstances differ from organization to organization andthe nature of each industry is different. For example, a businesswith current ratio of more than 2:1 might not be in a position to paycurrent liabilities in time because of an unfavourable distribution ofcurrent assets in relating to liquidity. On the other hand, anotherbusiness with a current ratio of ever less than 2:1 might not beexperiencing any difficulty in making the payment of currentliabilities in time because of its favourable distribution of currentassets in relation to liquidity.

Economic Assumptions:

Ratio analysis is designed to facilitate comparisons by eliminatingsize differences across firms. Implicit in this process is theproportionality assumption that the economic relationship betweennumerator and denominator does not depend on size. Thisassumption ignores the existence of fixed costs. When there arefixed costs, changes in total costs (and thus profits) are notproportional to changes in sales. Moreover, the implicit assumptionof a linear relationship between numerator and denominator maybe incorrect even in the absence of a fixed component. Forexample, the inventory turnover ratio, COGS/inventory, implies a

constant relationship between the volume of sales and inventorylevels. Management science theory, however, indicates that theoptimum relationship is nonlinear and inventory levels may beproportional to the square root of demand. Thus, a doubling indemand should increase inventory by only 40% (approximately)with a consequent 40% increase in the turnover ratio. The inventoryturnover ratio is clearly not size-independent.

Benchmarks:

Ratio analysis often looks appropriate benchmarks to indicate optimal

levels. The evaluationof a ratio often depends on the question posedby the analyst. For example, from the point of view of a short-termlender, a high liquidity ratio may be a positive indicator. However, fromthe perspective of an equity investor, itmay indicate poor cash or working capital management. Using anindustry average as the benchmark may be useful for comparisonswithin an industry, but not for comparisons between industries. Even


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for intra-industry analysis, the benchmark may have limited usefulnessif the whole industry or major firms in that industry are doing poorly.

Timing and Window Dressing:

Data used to compute ratios are available only at specific points intime when financial statements are issued. For annual reports, thefiscal year-end may correspond to the low point of a firms operatingcycle. When reported levels of assets and liabilities may not reflect thelevels typical of normal operations. As a result, especially in the case ofseasonal businesses, ratios may not reflect normal operatingrelationships. For example, inventories and accounts payable may beunderstated. Reference to interim statements is one way of alleviatingthis problem. The timing issue leads to another problem. Transactionsat year-end can lead to manipulation of the ratios to show the firm in a

more favorable light, often called window dressing. For example, a firmwith a current ratio (current assets/current liabilities) of 1.5 (Rs:300/Rs:200) can increase it to 2.0 (Rs.200/Rs.100) by simply using cash ofRs100 to reduce accounts payable immediately prior to the periodsend.

COMMON-SIZE STATEMENTS:

A pervasive problem when comparing a firms performance over timeis that the firms size is always changing. Firms of different sizes arealso difficult to compare. Common-size statements are used to

standardize financial statement components by expressing them as apercentage of a relevant base. For example, balance sheetcomponents can be shown as a percentage of total assets; revenuesand expenses can be computed as a percentage of total sales, and inthe direct method cash flow statement, the components of cash flowfrom operations can be related to cash collections.Common-size statements should not, however, be viewed solely as a

sealing factor for standardization. They provide the analyst with usefulinformation as a first step in developing insights into the economiccharacteristics of different industries and of different firms in the sameindustry. For example, significant changes in net income over time

may be traced to variations in cost of good sold (COGS) as apercentage of sales. Changes in this ratio may indicate the efficacy ofthe firms efforts to streamline its operations and /or a change inpricing strategies. Additionally, differences over time in a single firm orbetween firms due to operating, financial, and investing decisionsmade by management and external economic factors are oftenhighlighted by common-size statements.


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DISCUSSION OF RATIOS BY CATEGORY:

The ratios presented here and their mode of calculation are neitherexhaustive not uniquely Correct. The definition of many ratios is notstandardized and may vary from analyst to analyst, textbook totextbook, and annual report to annual report. Not all such variationsare logical or useful. In this chapter, when one of the components ofthe ratio comes from the balance sheet and the other from the incomeor cash flow statement, the balance sheet number is an average of thebeginning and ending balances. An exception is the cash flow fromoperations to debt ratio. In practice, some analysis use beginning orending balances for such mixed ratios. The analysts primary focus

should be the relationships indicated by the ratios, not the details oftheir calculation.Activity Analysis:

A firms operating activities require investments in both short-term(inventory and accounts receivable) and long-term (property, plant andequipment) assets. Activity ratios describe the relationship betweenthe firms level of operations (usually defined as sales) and the assetsneeded to sustain operating activities. The higher the ratios, the moreefficient the firms operations, as relatively fewer assets are required

to maintain a given level of operations (sales). Trends in these ratiosover time and in comparison to other firms in the same industry canindicate potential trouble spots or opportunities. Furthermore, althoughthese ratios do not measure profitability or liquidity directly, they areimportant factors affecting those performance indicators.

Activity ratios can also be used to forecast a firms capitalrequirements (both operating and long-term). Increases in sales willrequire investments in additional assets. Activity ratios enable theanalyst to forecast these requirements and to assess the firms abilityto acquire the assets needed to sustain the forecasted growth.

Short-term (Operating) Activity Ratios:

The inventory turnover ratio, defined as


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Inventory Turnover = Cost of GoodsSold

AverageInventory

Measures the efficiency of the firms inventory management .A higherratio indicates that inventory does not remain in warehouses or on theshelves but rather turns over rapidly from the time of acquisition tosale. This ratio is affected by the choice of accounting methods. Theinverse of this ratio can be used to calculate the average number ofdays inventory is held until it is sold

Average No. DaysInventory in Sock = 365___________

Inventory Turnover

The receivables turnover ratio and the average number of days ofreceivables outstanding can be calculated similarly as

Receivables Turnover = Sales____________Average Trade Receivables

And

Average No DaysReceivable Outstanding = 365________

Receivable Turnover

The receivables turnover ratios:

1. Measure the effectiveness of the firms credit policies.

2. Indicate the level of investment in receivables needed tomaintain the firms sales level.

Receivables turnover should be computed using only trade receivablesin order to evaluate operating performance. Receivables generatedfrom financing (unless customer financing is provided as a normalcomponent of sales activities) and investment activities (e.g.;receivables from the sale of an investment) should be excluded as they


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do not represent normal recurring operating transactions. Adjustmentsmay also be necessary if the firm has sold receivables during theperiod. The accounts payable turnover ratio and number of dayspayables are outstanding can be computed in a similar fashion as

Payables Turnover = Sales____________Average Accounts Payable

And

Average No. DaysPayables Outstanding = 365_________

Payables Turnover

Although accounts payable are liabilities rather than assets, their trendis significant as they represent an important source of financing foroperating activities. The time spread between when suppliers must bepaid and when payment is received from customers is critical forwholesale and retail firms with their large inventory balances.

The working capital turnover ratio is defined as

Working Capital Turnover = Sales____________Average Working

Capital

It is a summary ratio that reflects the amount of working (operating)capital needed to maintain a given level of sales. Only operating itemsshould be used to compute this measure. Short-term debt, marketablesecurities, and excess cash should be excluded, as they are notrequired for operating activities. The deferral of inventory cost until theitem is sold and recognition of revenues prior to cash collection

assume that the inventories will be sold and the receivables collected.

Similarly, the use of working capital as a proxy for cash flow iscontingent on this assumption. The level and trends of turnover ratiosprovide information as to the validity of this assumption. Decliningturnover ratios, indicating longer shelf time for inventory and/or slowercollection of receivables, could be indicators of reduced demand for a


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firms products or of sales to customers whose ability to pay is lesscertain. This might signal one or more of the following:

1. The firms income may be overstated because provisions arerequired for obsolete inventory or uncollectible receivables.

2. Future production cutbacks may be required.3. Potential liquidity problems may exist.

When activity ratios decline, the statement of cash flows helps assesswhether income is overstated relative to cash collections. As will bediscussed shortly, profitability and liquidity ratios can also improve ourunderstanding of the cause (s) of lower turnover ratios.

Long-Term (Investment) Activity Ratios:

The fixed asset turnover ratio measures the efficiency of (long-term)

capital investment. The ratio, defined as

Fixed Assets Turnover = Sales__________Average Fixed Assets

Reflects the level of sales generated by investments in productivecapacity.The level and trend of this ratio are affected by characteristics of itscomponents. First, sales growth is continuous, although at varyingrates. Increases in capacity to meet that sales growth, however, are

discrete, depending on the addition of new factories, warehouses,stores and so forth. Compounding this issue is the fact thatmanagement often has discretion over the timing, form, and financialreporting of the acquisition of incremental capacity.The life cycle of a company or product includes a number of stages.Startup, growth, maturity (steady state), and decline. Startupcompanies initial turnover may be low, as their level of operations isbelow their productive capacity. As sales grow, however, turnover willimprove continually until the limits of the firms initial capacity arereached. Subsequent increases in capital investment decrease theturnover ratio until the firms sales growth catches up to the increased

capacity. This process continues until maturity when sales andcapacity level off, only to reverse when the firm enters its declinestage. Additional problems can result from the timing of a firms assetpurchases. Two firms with similar operating efficiencies, having thesame productive capacity and the same level of sales, may showdiffering ratios depending on when their assets were acquired. The firmwith older assets has the higher turnover ratio, as accumulateddepreciation has reduced the carrying value of its assets. Over time,


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for any firm, the accumulation of depreciation expense improves theturnover ratio (faster for firms that use accelerated depreciationmethods or short depreciable lives) without a correspondingimprovement in actual efficiency. The use of gross (beforedepreciation) rather than net fixed assets alleviates this shortcoming.

However, this is rarely done in practice.An offsetting and complicating factor is that newer assets generallyoperate more efficiently due to improved technology. However, due toinflation newer assets may be more expensive and thus decrease theturnover ratio. Using current or replacement cost rather than historicalcost to compute the turnover ratio is one solution to this problem.

Finally it should be noted that methods of acquisition (lease versuspurchase) and subsequent financial reporting choices (capitalizationversus operating lease reporting) also affect turnover ratios forotherwise similar firms. Total asset turnover is an overall activity

measure relating sales to total assets:

Total Asset Turnover = Sales_________Average Total Assets

This relationship provides a measure of overall investment efficiencyby aggregating the joint impact of both short- and long-term assets.This comprehensive measure is a key component of the desegregationof return on assets.

Liquidity Analysis:

Short-term lenders and creditors (such as suppliers) must assess theability of a firm to meet its current obligations. That ability depends onthe cash resources available as of the balance sheet date and the cashto be generated through the operating cycle of the firm. The firmpurchases or manufactures inventory, requiring an outlay of cashand/or the creation of trade payables. The sale of inventory generatesreceivables that when collected, are used to satisfy the payables, andthe cycle begins again. The ability to repeat this cycle on a continuousbasis depends on the firms short-term liquidity and cash generating

ability.

Length of Cash Cycle:

One indicator of short-term liquidity uses the activity ratios as aliquidity measure. The operating cycle of a merchandising firm is thesum of the number of the days until the resultant receivables areconverted to cash. To the extent a firms uses credit, the length of the


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cash (operating) cycle is reduced. Subtracting the number of days ofpayables outstanding from the operating cycle results in the firmscash cycle, the number of days a companys cash is tied up by itscurrent operating circle. The cash cycle captures theinterrelationship of sales, collections, and trade credit in a manner that

the individuals numbers may not. The shorter the cycle, the moreefficient the firms operation and cash management.

Estimating the Operating and cash cycle for a Manufacturingfirm.

A trading firm holds only one type of inventory: finished goodsinventory. Consequently, the inventory turnover ratio measure onlyone time stage: the time from inventory purchase until its sale. For amanufacturing firm, on the other hand, inventory is held through threestages:

1. As raw material, from purchase to beginning of production2. As work in process, over the length of the production cycle3. As finished goods, from completion of production until sale

Only the last stage (as finished goods) is comparable to a tradingfirm. The inventory turn over ratio, COGS/average finished goodsinventory, computes the length of time from completion until sale.The length of time inventory is in the production cycle (stage 2) canbe calculated as:

365 x Average Work-in-process InventoryCost of Goods Manufactured

. The length of time it takes for raw material to enter production is

365 x Average Raw Material InventoryRaw Materials Used

The breakdown among finished goods work in process, and rawmaterial inventory is often available in the notes to financialstatements. Cost of goods manufactured can be calculated form

financial statements as cost of goods sold the ending (finished goods)inventory beginning (finished goods) inventory. However, the amountof material used in production is rarely available making thecalculation of the length of stage 1 infeasible. Some approximationsare possible. The first involves calculating the combined length ofstage 1 and 2 as:

365 x Average (work in process and Raw Material) Inventory


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Cost of goods manufactured

The accuracy of this approximation depends on the proportion of thevarious inventories and the degree to which the individual ratios differ.Another (less accurate but perhaps simpler) approximation ignores this

whole discussion and uses the composite turnover ratio, therebymirroring the merchandising firm:

365 x Average (Total) InventoryCost of goods Sold

Working Capital Ratios and Defensive Intervals

The concept of working capital relies on the classification of assets and

liabilities into current and non-current categories. The traditionaldistinction between current assets and liabilities is based on a maturityof less than one year.

The typical balance sheet has five categories of current assets:1. cash and cash equivalents2. Marketable securities3. Accounts receivable4. Inventories5. Prepaid expenses

And three categories of current liabilities;

1. Short-term debt2. Accounts payable3. Accrued liabilities

By definition, each current assets and liability has a maturity (theexpected date of conversion to cash for an assets; the expected dateof liquidation for cash for a liability) of less than one year. However, inpractice the line between current and non-current has blurred in recentyears. Marketable securities and debt are particularly susceptible to

arbitrary classification. For this reason, working capital ratios should beused with caution.

Short-term liquidity analysis compares the firms cash resources withits cash obligations. Cash resources can be measured by either;

1. The sum of the firms current cash balance and its potentialsources of cash, or


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2. Its (net) cash flows from operations.

Cash obligations can be measured by either;

1. Current obligations requiring cash, or

2. Cash outflows arising from operations

The following table summarizes the ratios commonly used to measurethe relationship between resources and obligations:

NumeratorDenominator

Cash Resources Cash

obligations________________________________________________________________________Level Current assets CurrentliabilitiesFlow Cash flow from operations Cash outflows foroperations

Conceptually, the ratios differ in whether levels (amounts shown on thebalance sheet) or flows (cash inflows and outflows) are used to gauge

the relationship. Three ratios compare levels of cash resources withcurrent liabilities as the measure of cash obligations. The current ratiodefines cash resources as all current assets:

Current Ratio = Current AssetsCurrent Liabilities

A more conservative measure of liquidity is the quick ratio:

Quick Ratio = Cash + Marketable Securities + AccountsReceivable

Current Liabilities

Which excludes inventory from cash resources, recognizing that theconversion of inventory to cash is less certain both in terms of timing


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and amount. The included assets are quick assets because they canbe quickly converted to cash.Finally, the cash ratio, defined as

Cash Ratio = Cash + Marketable Securities

Current Liabilities

Is the most conservative of these measures or cash resources as onlyactual cash and securities easily convertible to cash are used tomeasure cash resources. The use of either the current or quick ratioimplicitly assumes that the current assets will be converted to cash. Inreality, however, firms do not actually liquidate their current assets topay their current liabilities. Minimum levels of inventories andreceivables are always needed to maintain operations. If all currentassets are liquidated, the firm has effectively ceased operations. Theprocess of generating inventories, collecting receivables, and paying

suppliers is ongoing. These ratios therefore measure the margin ofsafety provided by the cash resources relative to obligations ratherthan expected cash flows.

Liquidity analysis, moreover, is not independent of activity analysis.Poor receivable or inventory turnover limits the usefulness of thecurrent and quick ratios. Obsolete inventory or un-collectiblereceivable are unlikely to be sources of cash. Thus, levels and chargesin short-term liquidity ratios over time should be examined inconjunction with turnover ratios.

The cash flow from operations ratio:

Cash Flow from Operations Ratio = Cash Flow fromOperations

Current Liabilities

Measure liquidity by comparing actual cash flow (instead of currentand potential cash resources) with current liabilities. This ratio avoidsthe issues of actual convertibility to cash, turnover, and the need forminimum levels of working capital to maintain operations. An

important limitation of liquidity ratios is the absence of an economic orreal world. Unlike the cash cycle liquidity measure, which reflects thenumber of days cash is tied up in the firms operating cycle, there is nointuitive meaning to a current ratio of 1.5. for some companies thatratio would be high, for others dangerously low.

The defensive interval, in contract, does provide an intuitive feel fora firms liquidity, although a most conservative one, it compares the


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currently available quick sources of cash (cash, marketablesecurities, and accounts receivable) with the estimated outflow neededto operate the firm: projected expenditures. These are differentdefinitions of both cash resources and projected expenditures. Wepresent here only the basic form:

Defensive Interval = 365 x Cash + Marketable Securities + AccountsReceivable

Projected Expenditures

The calculation of the defensive interval uses current year-incomestatement date to estimate projected expenditures. The defensiveinterval represents a worst case scenario indicating the number ofdays a firm could maintain the current level of operations with itspresent cash resources but without considering any additionalrevenues.

Long-Term Debt and Solvency Analysis

The analysis of a firms capital structure is essential to evaluate itslong-term risk and return prospects. Leveraged firms accrue excessreturns to their shareholders as long as the rate of return on theinvestments financed by debt is greater than the cost of debt. Thebenefits of financial leverage bring additional risks, however, in theform of fixed costs that adversely affect profitability if demand or profitmargins decline. Moreover, the priority of interest and debt claims canhave a severe negative impact on a firm when adversity strikes. Theinability to meet these obligations can lead to default and possiblebankruptcy.

Debt Covenants

To protect themselves, creditors often impose restrictions on thecompanys borrowing ability to incur additional debt and makedividend payments. These debt covenants are often based on workingcapital, cumulative profitability, and net worth. It is, therefore,important to monitor the firm to ensure that ratios comply with levelsspecified in the debt agreements. Violation of debts covenants isfrequently an event of default under loan agreements, making thedebt due immediately. When covenants are violated, therefore,borrowers must either repay the debt (not usually possible) or obtain


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waivers from lenders. Such waivers often require additional collateral,restrictions on firm operation or higher interest rates.

Capitalization Table and Debt Ratios

Long-term debt and solvency evaluate the level of risk borne by a firm,changes over time, and risk relative to comparable investments. Ahigher proportion of debt relative to equity increases the risk level ofthe firm. Two important factors should be noted:

1. The relative debt levels themselves, and2. The trend over time in the proportion of debt to equity

Debt ratios are expressed either as

Debt to Total Capital = Total Debt (Current + Long-Term)Total Capital (Debt + Equity)

Or

Debt to Equity = Total DebtTotal Equity

The definition of short-term debt used in practice may include

operating debt (accounts payable and accrued liabilities). The short-term debt shown may be excluded as it is because it is a function ofthe firms operations and its essential business and contractualrelationship to its suppliers rather than external lenders. However,many lenders define debt as equal to total liabilities. As with otherratios, industry and economy-wide factors affect both the level of debtand the nature of the debt (maturities and variable or fixed rate).Capital-intensive industries tend to incur high levels of debt to financetheir property, plant and equipment. Such debt should be long-term tomatch the long time horizon of the assets acquired.

An important measurement issue is whether to use book or marketvalues to compute debt ratios. Valuation models in the financeliterature that use leverage ratios of both debt and equity are availableor can readily be estimated, and their use can make the ratio a moreuseful analytical tool. The use of market values, however, may producecontradictory results. The debt of a firm whose credit rating declinesmay have a market value well below face amount. A debt ratio basedon market values may show an acceptable level of leverage. A ratio


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that would control for this phenomenon and can be used inconjunction with book- or market-based debt ratios is one thatcompares debt measured at book value to equity measured at market:

Total Debt at Book ValueEquity at Market

If the market value of equity is higher than its book value, the aboveratio will be lower than the debt-to-equity ratio using book value. Thisindicates that market perceptions of the firms earning power wouldpermit the firm to raise additional capital at an attractive price. If thisratio, however, exceeds the book value debt-to-equity measure, itsignals that the market is willing to supply additional capital only at adiscount to book value.

The measurement of debt and equity used to compute leverage ratiosmay require adjustments to reported data. Leases (whether capitalizedor operating), other off balance sheet transactions such as contractualobligations not accorded accounting recognition, deferred taxes,financial instruments with debt and equity characteristics, and otherinnovative financing techniques must all be considered when markingthese calculations.

Interest Coverage Ratios

Debt-to-equity ratios examine the firms capital structure and

indirectly, its ability to meet current debt obligations. A more directmeasure of the firms ability to meet interest payments is

Times Interest Earned = Earnings Before Interest andTaxes (EBIT)

Interest Expense

This ratio, often referred to as the interest coverage ratio, measuresthe protection available to creditors as the extent to which earningsavailable for interest cover interest expense. A more comprehensivemeasure, the fixed charge coverage ratio includes all fixed charges:

Fixed Charge Coverage = Earnings Before Fixed Charges andTaxes

Fixed Charges

Where fixed charges include contractually committed interest andprincipal payments on leases as well as funded debt. This coverage


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ratio may also be computed using adjusted operating cash flows (cashfrom operations + fixed charges + tax payments) as the numerator:

Times Interest Earned (Cash Basis) = Adjusted Operating Cash

Flow Interest Expense

Fixed Charge Coverage Ratio (Cash Basis) = AdjustedOperating Cash Flow

FixedCharges

Capital Expenditure and CFO-to-Debt Ratios

Internally generated cash flows are needed for investment as well asdebt service. The coverage ratios discussed do not take this intoconsideration. Cash flow from operation-

A firms long-term solvency is a function of:

1. Its ability to fianc the replacement and expansion of itsinvestment in productive capacity, as well as

2. Its generation of cash for debt repayment.

The capital expenditure ratio

Capital Expenditure Ratio = Cash from Operations (CFO)Capital Expenditures

Measures the relationship between the firms cash-generating abilityand its investment expenditures. To the extent the ratio exceeds, itindicates the firm has cash left for debt repayment or dividends afterpayment of capital expenditures.

The CFO-to-debt ratio

CFO to Debt = CFO___Total Debt

Measures the coverage of principal repayment requirements by thecurrent CFO . A low CFO-to-debt ratio could signal a long-term solvencyproblem as the firm does not generate enough cash internally to repayits debt.


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Profitability Analysis

Equity investors are concerned with the firms ability to generate,sustain and increase profits. Profitability can be measured in several

differing but interrelated dimensions. First, there is the relationship ofa firms profits to sales, that is, the residual return to the firm persales. Another measure, return on investment (ROI), relates profits tothe investment required to generate them. We briefly define theseratios and then elaborate on their use in financial statement analysis.

Return on Sales

One measure of profitability is the relationship between the firmscosts and its sales. The ability to control costs in relation to revenuesenhances earnings power. A common-size income statement shows

the ratio of each cost component to sales. In addition, six summaryratios measure the relationship between different measures ofprofitability and sales:

1. The gross (profit) margin captures the relationship between salesand manufacturing or merchandising costs:

Gross Margin = Gross ProfitSales

2. the operating margin, calculated as

Operating Margin = Operating IncomeSales

Provides information about a firms profitability from the operationsof its core business, excluding the effects of:

Investments (income from affiliates or asset sales) Financing (interest expense) Tax position

3. a profit margin measure that is independent of both the firmsfinancing and tax position is the

Margin Before Interest and Tax = EBITSales

4. The pretax margin is calculation after financing costs (interest)but prior to income taxes:

Pretax Margin = Earnings Before Tax (EBIT)


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Sales

5. finally, the overall profit margin is net of all expenses:

Profit Margin = Net IncomeSales

The five ratios listed above can be computed directly from a firmsfinancing statements.

6. Another useful profitability measure is the contribution marginratio define as

Contribution Margin = ContributionSales

Where contribution = sales - variable costs.

The contribution margin ratio, however, cannot be computed directlyfrom a firm financial, statement as the breakdown between fixed andvariable costs is rarely provided.

Return of Investment

Return on investment (ROI) measures the relationship between profitsand the investment required to generate them. Diverse measures of

that investment result in different forms of ROI.

Return on Assets. The return on assets (ROA) compares income withtotal assets (equivalently, total liabilities and equity capital). It can beinterpreted in two way. First, it measures managements ability andefficiency in using the firms assets to generate (operating) profits.Second, it reports the total return accruing to all providers of capital(debt and equity), independent of the source of capital.The return is measured by net income prior to the cost of financing andis computed by adding back (after-tax) interest expense to net income.

ROA= Net Income ( After Tax and Interest Cost)Average Total Assets

ROA can also be computed on a pretax basis using EBIT as the returnmeasure. This results in a ROI measure that is unaffected bydifferences in a firms tax position as well as financial policy:


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ROA = EBIT________Average total assets

In practice, however, the ROA measure is some times computed usingeither net income or EBT as the numerator. Such post interest ROIratios make leveraged firms appear less profitable by chargingearnings for payments (interest) to some capital providers (lenders)but not others (Stockholders). Pre-interest ROI ratios, in contrast,facilitate the comparison of firms with different degrees of leverage.Therefore, ROI ratios that use total assets in the denominator shouldalways include total earnings (before interest) in the numerator. Asinterest is tax-deductible, post tax profit measures should add backnet-of-tax interest payments.

Return on Total Capital. One particularly useful ROI measure is thereturn on total capital (ROTC). This ratio used the sum of external debtand equity instead of total assets as the base against which the firmsreturn is measured. ROTC measures profitability relative to all (non-trade) capital providers.Return can be measured either (pretax) by EBIT or (after tax) by netincome plus after-tax interest:

ROTC = EBIT_________________Average (Total Debt + Stockholders Equity)

Or

ROTC = Net Income + After Interest Expense__________Average (Total Debt + Stockholders Equity)

Return on Equity. The return on total stockholders equity (ROE)excludes debt in the denominator and uses either pretax income (afterinterest costs) or net income:

ROE = Pretax Income__________Average Stockholders Equity

The after-tax interest cost is calculated by multiplying the interest costby ( 1 t), where t is the firms marginal tax rate.As in the case of ROA, pre-interest measures of profitability should beused to compute ROTC, as total capital includes debt obligations.Or


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ROE = Net income____________Average Stockholders Equity

For companies with preferred equity, another ROI measure focuses on

the returns accruing to the residual owners of the firm-commonshareholders:

Return on Common Equity = Net Income PreferredDividends

Average Common Equity

The relationship between ROA and ROE reflects the firms capitalstructure. As shown in figure 4-3, creditors and shareholders providethe capital needed by the firm to acquire the assets used in the

business. In return, they receive their share of the firms profits.

ROA and ROE measure returns to all providers of capital. ROCEmeasures returns to the firms Common shareholders and is calculatedafter deducting the returns paid to the creditors (interest) and otherproviders of equity capital (preferred share-holders).

EARNINGS PER SHARE AND OTHER RATIOS USEED FORVALUATION

Ratios are often used explicitly for securities valuation. Equityvaluation models use ratios such as earnings per share and book valueper share. Fixed income ratings and valuation techniques also leanheavily on ratios.

Earnings per Share

Earnings per share (EPS) is probably the most widely available andcommonly used corporate performance statistic for publicly tradedfirms. It is used to compare operating performance and for valuationpurposes either directly or together with market prices in the familiar

from of price/earnings (P/E) ratios.

Simple Capital StructureFor firms that have only common shares, the computation of EPS isrelatively straight forward. In such cases, the computation is


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Basic EPS = Earnings Available to CommonShareholders________________ Weighted- Average Number of Shares of Common StockOutstanding

Or

Net Income PreferredDividends_________________Weighted Average Number of Shares of Common StockOutstanding

Where the shares are usually weighted by the number of months thoseshares were outstanding. The numerator used to calculate EPS mustequal earnings available for distribution to common shareholders.Therefore, preferred stock dividends, whether declared or cumulative,must be deducted from net income.

Book Value Per Share

This ratio represents the equity of the firm (common equity lesspreferred shares at liquidation value) on a per share basis (number ofshares outstanding at balance sheet date) and is sometimes used as abenchmark for comparisons with the market price per share.

Book value per share, however, has limitations as a valuation tool

as it is subject to valuation measures based on GAAP. Which are bound by historical cost rather than current market

value conditions, and Whose definition of what constitutes an asset or liability may not

coincide with economic reality.

Thus, the balance sheet may contain goodwill or other intangibleassets of uncertain value; the market value of investments and fixedassets may differ markedly from the balance sheet valuation and theremay be significant adjustments for off-balance sheet activities.

Price-to-Earnings and Price-to-Book Value Ratios

The P/E ratio measures the degree to which the market capitalizes afirms earnings. The P/E ratio has been the subject of much scrutiny inthe academic as well as the professional world.


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Market price of share/EPS

Dividend Payout Ratio

The dividend payout ratio equals the percentage of earnings paid asdividends, that js,

Dividend Payout = DividendsNet Income

Generally, growth firms have low dividend payout ratios as theyretain most of their income to finance future expansion. Moreestablished mature firms tend to have higher payout ratios.

RATIOS: AN INTEGRATED ANALYSIS

Comprehensive financial analysis requires a review of threeinterrelationships among ratios:

1. Economic relationships. Interdependent changes invarious components of the financial statements stem from

underlying economic relationships. For example, higher sales aregenerally associated with higher investment in working capitalcomponents such as receivables and inventory. Ratios comprisingthese elements should be correlated.2. Overlap of components. The components of manyratios overlap due to the inclusion of an identical term in thenumerator or denominator, or because a term in one ratio is asubset or component of another ratio. Charge in one of theseidentical terms will charge a number of ratios in the same direction.Similarly, ratios that aggregate other ratios can be expected tofollow patterns over time consistent with those of their components.

For example, the total assets turnover ratio is essentially a(weighted) aggregation of the individual turnover ratios. Trends inthis ratio will mirror those observed in the inventory, accountsreceivable, and fixed asset turnover ratios.3. Ratios as composites of other ratios. Some ratiosare related to other ratios across categories. For example, the ROAratio is a combination of profitability and turnover ratios:


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Income = Income x SalesAssets Sales Assets

A change in either of the ratios on the right-hand side will charge thereturn on assets as well.

The interrelationships among ratios have important implications forfinancial analysis. Disaggregation of a ratio into its componentelements allows us to gain insight into factors affecting a firmsperformance; for example, significant changes in ROA may be bestunderstood through an analysis of its components. Further, ratiodifferences can highlight the economic characteristics and strategiesof:

The same firm over time Firm in the same industry

Firms in different industries Firms in different countries

These relationships among ratios imply that one might be able toignore some component ratios and use a composite orrepresentative ratio to capture the information contained in otherratios. For example, in the ROA relationship described earlier, theeffect of the two ratios on the right side of the equation may becaptured by the ROA ratio. For certain analysis purpose, this compositeROA ratio may suffice.

Analysis of Firm Performance

This section will exploit some of these interrelationships to analyze afirms performance by focusing on disaggregation of the overallprofitability measures ROA and ROE.

Disaggregation of ROA

The ROA ratio can be disaggregated as follows:

ROA = Total Asset Turnover x Return on Sales

= Sales x EBITAssets Sales

The firms overall profitability is the product of an activity ratio and aprofitability ratio. A low ROA can result from low turnover, indicating


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poor asset management, low profit margins, or a combination of bothfactors.

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