RATIO ANALYSIS

Activity Analysis Operating activities require investments in both

short term (inventory and accounts receivable) and long-term assets.

Activity ratios describe the relationship between the firm’s level of operations (usually defined as sales) and the assets needed to sustain operating activities.

Higher the ratio, the more efficient the firm’s operations, as relatively fewer assets are required to maintain the given level of operations (sales)

These ratios do not measure profitability and liquidity directly. However, they are important factors affecting those performance indicators. For example, low inventory turnover results in high carrying costs that reduce profits and declining inventory turnover should also alert the analyst to an increased probability of falling demand.

Activity ratios can also be used to forecast a firm’s capital requirement (both operating and long-term).

Increases in sales will require investments in additional assets.

Activity ratios enable the analyst to forecast these requirements and to assess the firm’s ability to acquire the assets needed to sustain the forecasted growth.

Turnover Ratios Inventory Turnover= Cost of goods

sold/Average inventory It measures the efficiency of the inventory

management. This ratio is affected by the accounting method.

Average number of days inventory in stock =

365/Inventory turnover It shows the average number of days

inventory is held until it is sold.

Debtors Turnover Debtors’ Turnover= Net credit sales/Average

sundry debtors Average collection period= Average sundry

debtors/Average credit sales Or = 365/Debtors turnover Measure the effectiveness of the firm’s credit

policies Indicate the level of investment in receivables

needed to maintain the firm’s sales level.

Accounts Payable Turnover Accounts payable turnover= Cost of

goods sold/Average accounts payable Average payable days outstanding=

Accounts payable/Average daily cost of goods sold

OR 365/ Payables turnover They represent an important source of

financing for operating activities.

Working capital turnover Net working capital turnover = Net sales/Average

net operating working capital

Reflects the amount of operating capital needed to maintain a given level of sales.

Only operating assets and liabilities should be used to compute this measure.

Short-term debt, marketable securities and excess cash should be excluded as they are not required for operating activities.

Fixed assets turnover = Net sales/Average net fixed assets

Total assets turnover= Net sales/Average total assets

Reflect the level of sales generated by investments in productive capacity.

Startup companies’ initial turnover may be low as their level of operations is below their productive capacity. As sales grow, however, turnover will continually improve until the limits of the firm’s initial capacity are reached. Subsequent increases in capital investment decrease the turnover ratio until the firm’s sales growth catches up to the increased capacity. This process continues until maturity when sales and capacity level off, only to reverse when the firm enters its decline stage.

Additional problems can result from the timing of a firm’s asset purchases. Two firms with similar operating efficiencies, having the same productive capacity, and the same level of sales, may show differing ratios depending on when their assets were acquired. The firm with older assets has the higher turnover ratio, as accumulated depreciation has reduced the carrying value of its assets. Overtime, for any firm, the accumulation of depreciation expense improves the turnover ratio (faster for firms that use accelerated depreciation methods or short term depreciable lives) without a corresponding improvement in actual efficiency. The use of gross rather than net fixed assets alleviates this shortcoming.

Newer assets generally operate more efficiently due to improved technology. But due to inflation, newer assets may be more expensive and thus decrease the turnover ratio. Using the replacement cost rather than historical cost to compute the turnover ratio is one solution to the problem.

Methods of acquisition (lease versus purchase) and subsequent financial reporting choices (capitalization versus operating lease reporting) also affect turnover ratios for otherwise similar firms.

Operating cycle Operating cycle is the sum of number of days it takes

to sell inventory and the number of days until the resulting receivables are converted to cash.

To the extent a firm uses credit, the length of the cash (operating) cycle is reduced. Subtracting the number of days of payables outstanding from the operating cycles results in the firm’s cash cycle, the number of days a firm’s cash is tied up by its current operating cycle.

To a great extent, industry factors may determine the length and components of the cash cycle. Some firms may actually have negative cash cycles.

Liquidity Ratios Current Ratio= Current Assets/Current Liabilities A more conservative measure of liquidity is the quick ratio. Acid-test Ratio (Quick ratio) =

Quick assets/Current liabilitiesThis excludes inventory and prepaid expenses, recognizing that the conversion of inventory to cash is less certain both in terms of timing and amount and that prepaid expenses reflect past cash outflows rather than expected inflows.

The most conservative of the measures of cash resources is the cash ratio.Cash ratio = (Cash and marketable securities)/Current liabilitiesThese ratios measure the margin of safety provided by the cash resources relative to obligations rather than expected cash flows.

Cash flow from operations ratio= Cash flow from operations/Current liabilities

It measures liquidity by comparing actual cash flows (instead of current and potential cash resources) with current liabilities. This ratio avoids the issues of actual convertibility to cash, turnover, and the need for minimum levels of working capital (cash) to maintain operations.

Unlike the cash cycle liquidity measure, which reflects the number of days cash is tied up in the firm’s operating cycle, there is no intuitive measure, which reflects the number of days cash is tied up in the firm’s operating cycle, there is no intuitive meaning to a current ratio of 1.5. For some companies that ratio would be high, for others dangerously low.

Defensive interval= 365 X [Cash + Marketable securities + Accounts receivables)/Projected expenditure]

It provides an intuitive feel for a firm’s liquidity. It compares the currently available quick sources of cash with the estimated outflows needed to operate the firm: projected expenditure.

It represents the worst-case scenario indicating the number of days a firm could maintain the current level of operations with its present cash resources but without considering any additional revenues.

Cash Burn Rate Cash burn ratio measures the how much cash

the firm consumes over a given period of time and consequently estimates the number of days (defensive interval) the company can survive with the cash it has raised from its investors (private placement or IPO). For startup companies with no revenues, only cash expenditures matter. For such companies, the ratio, in effect, measures how much time the company has until it must have a working business model.

Solvency Analysis Analysis of a firm’s capital structure is essential to

evaluate its long-term risk and return prospects. Leveraged firms accrue excess returns to their shareholders as long as rate of return on investments financed by the debt is greater than the cost of debt. The benefits of financial leverage bring additional risks, however, in the form of fixed costs that adversely affect profitability if demand and profit margins decline. Moreover, the priority of interest and debt claims can have a severe negative impact on a firm when adversity strikes. The inability to meet these obligations can lead to default and possible bankruptcy.

Debt Covenants To protect themselves, creditors often impose restrictions

on the borrowing company’s ability to incur additional debt and make dividend payments. These debt covenants are often based on working capital, cumulative profitability, and net worth. It is therefore, important to monitor the firm to ensure that ratios comply with levels specified in the debt agreements. Violation of debt covenants are frequently an ‘event of default’ under loan agreements, making the debt due immediately. When covenants are violated, borrowers must either repay the debt (not usually possible) or obtain waivers from lenders. Such waivers often require additional collateral, restrictions on firm operations, or higher interest rates.

Leverage Ratios Debt-Equity Ratio= Debt/Equity Debt-asset Ratio= Debt/Assets (It measures the extent

to which the borrowed funds support the firm’s assets) (Debt/Assets)= (Debt/Equity + Debt) Many lenders define debt as equal to total liabilities.

As with other ratios, industry and economy wide factors affect both the level of debt and the nature of debt (maturities and variable or fixed rate). Capital intensive industries tend to incur high levels of debt to finance their property, plant and equipment. Such debt should be long-term to match the long time horizon of the assets acquired.

An important measurement issue is whether to use book or market values to compute ratios. Valuation models that use leverage ratios as inputs are generally based on the market value of debt and equity. But the debt of firm whose credit rating declines may have a market value well below face amount.

Total debt at book value/Equity at market If the market value of equity is higher than its book value, the

above ratio will be lower than the debt-to-equity ratio using book value. This indicates that market perceptions of the firm’s earning power would permit the firm to raise additional capital at an attractive price. If this ratio, exceeds the book value debt-to-equity measure, it signals that the market is willing to supply additional capital only at a discount to book value.

Interest Coverage Ratios Debt equity ratios examine the firm’s

capital structure and, indirectly, its ability to meet current debt obligations. A more direct measure of the firm’s ability to meet interest payments is interest coverage ratio

Interest coverage ratio= EBIT/Interest or = (EBIT + Depreciation)/Interest Debt service coverage ratio =[EAT +

Depreciation + other non-cash charges + Interest on term loan +lease rentals]/(Interest on term loan + lease rentals + Repayment of term loan)

Coverage ratios may also be computed using adjusted operating cash flows (Cash from operations + fixed charges + tax payments) as the numerator

CFO to Debt A firm’s long-term solvency is a function of its ability

to: Finance the replacement and expansion of its

investment in productive capacity as well as generate cash for debt repayment.

Capital expenditure Ratio = Cash from operations (CFO)/Capital Expenditures

It measures the relationship between the firm’s cash generating ability and its investment expenditure. To the extent the ratio exceeds one, it indicates the firm has cash left for debt repayment or dividends after capital expenditures.

CFO to Debt = CFO/Total Debt It measures the coverage of principal

repayment requirements by the current CFO. A low ratio could signal a long-term solvency problem, as the firm does not generate enough cash internally to repay its debt.

Profitability Analysis Equity investors are concerned with the

firm’s ability to generate, sustain, and increase profits.

Profitability can be measured in several differing but interrelated dimensions

Gross profit margin = Gross profit/Net sales (Shows the margin left after meeting manufacturing costs. It

measures the efficiency of production as well as pricing) A profit margin measure that is independent of both the firm’s

financing and tax position is the: EBIT/Sales Overall Profit margin is net of all expenses: Net profit margin= Net profit/Net sales (shows the earnings left for shareholders as a percentage of

net sales. It measures the overall efficiency of the business. Jointly considered, the gross and net profit margin ratios enable you to identify the sources of business efficiency/inefficiency).

Operating profit Margin = Net operating profit after tax /Sales

Return on Investment Return on net operating assets= NOPAT/Average net operating assets Net operating assets(NOA)= Operating assets – Operating liabilities Operating assets are those necessary to conduct the business and include cash,

accounts receivable, inventories, prepaid expenses, deferred tax assets, property, plant and equipment and long term investments related to strategic acquisitions (such as equity method investments, goodwill, and acquired intangible assets).

Operating liabilities are accounts payable, accrued expenses, and long term operating liabilities such as pensions and other postretirement liabilities and deferred income tax liabilities.

(Alternatively) Net operating assets= Net financial obligations + stockholders’ equity Net financial obligations= Non-operating liabilities (bonds and other long-term

interest-bearing liabilities and the noncurrent portion of capitalized leases Operating income= sales – (cost of goods sold + operating expenses such as

selling, general and administrative expenses and income taxes) Items excluded from NOPAT include interest income and expense, dividend revenue,

non-operating investment gains and losses, and income or loss from discontinued operations

ROI ratios that use total assets in the denominator should always include total earnings before interest in the numerator. As interest is tax deductible, post-tax profit measures should add back net-of-tax interest payments

Return on assets= Profit after tax/Average total assets Earning power= Profit before interest and tax/Average

total assets Return on capital employed= Net operating profit after

tax/Average total assets {NOPAT= EBIT (1-t)} Return on equity = (Profit after tax- preference

dividend)/Average equity

Operating and Financial Leverage Profitability ratios imply that profits are proportional to sales,

which may misstate the true relationship among sales, costs, and profits. Generally, a doubling of sales would be expected to double income only if all expenses were variable.

Leverage, which is the proportion of fixed costs in the firm’s overall cost structure, can be subdivided into fixed operating costs that reflect operating leverage (the proportion of fixed operating costs to variable costs), and fixed financing costs or financial leverage.

Leverage trades risk for return. Increases in fixed costs are risky because they must still be paid as demand declines, depressing the firm’s income. At high levels of demand, fixed costs are spread over a larger base, enhancing profitability.

Contribution margin ratio is a useful measure of the effects of operating leverage on the firm’s profitability.

Contribution margin ratio = Contribution/SalesThis ratio indicates the incremental profit resulting from a given dollar change in sales.

Operating leveraging effect (OLE)= Contribution/Operating income (or) Contribution margin ratio/Return on sales

When OLE is greater than 1, operating leverage is present. The OLE is a relative measure and varies with the level of sales.

The OLE can be used to estimate the percentage change in income (and ROA) resulting from a given percentage change in sales volume.

% Change in income= OLE X % change in sales

Financial leverage effect = Operating income/Net income

Total leverage effect = OLE X FLE = Contribution/Net income

Firms with high operating leverage take on high financial leverage only at their peril. Traditionally, high debt ratios have been considered acceptable only for firms with low operating leverage or with stable operations, where the risk of combining operating and financial leverage was low.

Valuation ratios P/E Ratio= MP/EPS EV-EBITDA ratio= Enterprise value/EBITD EV is the sum of the market value of the

equity and debt (It reflects the profitability, growth, risk,

liquidity and corporate image) Market price-Book value per share Ratio Q Ratio= Market value of equity and

liabilities/Estimated replacement cost of assets

Equity growth rate= (Net income – preferred dividends –Common dividend)/Average common equity

Sustainable equity growth rate= Return on common equity (ROCE)X(1-Payout rate)

Return on net operating assets= Operating profit margin X Net operating asset turnover

Operating profit margin= NOPAT/Sales Net operating assets turnover= Sales/Average net operating assets

The interrelationships among ratios have important implications for analysis. Disaggregation of a ratio into its component elements allow us to gain insight into factors affecting a firm’s performance. Ratio differences can highlight the economic characteristics and strategies of:

Same firm over time Firms in the same industry Firms in different industries Firms in different counties

Disaggregation of ROA ROA= Total Asset Turnover X Return on

Sales The firm’s overall profitability is the

product of an activity ratio and a profitability ratio. A low ROA can result from low turnover, indicating poor asset management, low profit margins, or a combination of both factors.

Ratios

= x

Disaggregation of ROAROA = Total Asset Turnover x Return on

sales = x

Disaggregation of ROPE and its relationship to ROA

ROE = ROA + [ (ROA – Cost of Debt) X ]

ROE = (ROA - ) x

ROE = Profitability x Activity x Solvency = x x

x x =

Trends in ROE and ROAROE = ROA X x

Three –Component Disaggregation of ROE

(Profitability x Turnover) X Solvency = ROE

x

= x =

Five–Component Disaggregation of ROE

(Profitability x Turnover) X Solvency = ROE

Taxes Financing Operations

x

= x

= x =

EPS

Basic EPS Shares are usually weighted by the

number of months those shares were outstanding.

Potential effect on EPS upon conversion of those securities if such a conversion will result in dilution (lowering) of EPS.

DEPS The adjustment to the numerator reflect the

fact that if the convertible securities were converted to common shares, interest and (preferred) dividend payments would no longer have to be made to those security holders, increasing the amount available to common shareholders.

Numerator adjustments therefore include:

a. Dividend on convertible preferred shares b. Interest (after-tax) on convertible debt c. Effect of the change resulting from

a. and b. on profit sharing or other expenses.

Adjustment for options and warrants Options and warrants are also a source of

potential dilution. To calculate the dilutive impact of options and warrants on EPS, the Treasury stock method is used. This method assumes that the proceeds from exercise are used by the firm to (re)purchase common shares on the open market at the average market price (MP). As long as MP is greater than the exercise price (EP), the effect will be dilutive and the options and warrants will affect DEPS calculations.

The denominator of the EPS ratio is adjusted by adding the incremental (I) shares equal to:

I X N where N equals the number of shares issuable on exercise.

No adjustment is made to the numerator