RATI RA TIO O ANA ANAL LYSIS
This
week we will learn how we can use the statements to measure financial health of company by using the ratio analysis Ratio analysis = we can compare our company’s company’s performance performance to that of its competitors, to industry averages, and to its own performance in the past
TYPES OF RATIOS Functional classification
Liquidity Ratios
Currant Ratio
Solvency Ratios
Debt Equity Ratio
Liquidity/ Quick Ratio/Cash Ratio
Operating Ratios
Profitability Ratios
Profit margin
Asset turnover
Receivable days Interest Coverage Ratio
Days in inventory Days payable
ROE
ROA
LIQUIDITY RATIOS
Liquidity ratios tell us about a company’s ability to meet short-term financial obligations such as debt payments, payroll, and accounts payable ( short-term solvency )
Current ratio – measures a company’s current assets against its current liabilities: Formula: Current ratio = Total current assets/ Total current liabilities
Significance: It shows that current assets are barely sufficient to cover short-term obligations Interpretation: A ratio of less than 1 is a sign of immediate trouble/ A ratio that is close to 1 is too low / A ratio significantly higher than industry averages may indicate that the company hold a lot of cash that it’s not putting to work or returning to shareholders in the form of dividends Current assets include: Cash in hand, Bank balance, Debtors, Bills receivable, Stock, Prepaid expenses, Accrued income, Short-term investments (marketable securities) etc.
include: Current liabilities Creditors, Bill payable, Shortterm loans, Income received in advance etc.
LIQUIDITY RATIOS
Quick Ratio (acid test) measures a company’s ability to meet its obligations quickly. Formula: Quick ratio/Acid test = (Total current assets Inventory)/ Total current liabilities –
Significance: It thus ignores inventory, which can be hard to liquidate (If a company has to liquidate inventory quickly, it typically get less for inventory than this company would otherwise) Interpretation: If this ratio is less than 1 the company may be unable to pay its bills
Cash Ratio – a very short-term creditor might be interested in the cash rate Formula: Cash ratio = Cash / Current liabilities Significance and interpretation: A ratio of 1 means that the company has the same amount of cash and equivalents as it has current debt. In other words, in order to pay off its current debt, the company would have to use all of its cash and equivalents. A ratio above 1 means that all t he current liabilities can be paid with cash and equivalents. A ratio below 1 means that the company needs more than just its cash reserves to pay off its current debt
LIQUIDITY RATIOS (example) STAR Corporation Balance Sheet as of December 31, 2013 and 2012 (RON in millions)
2012
2013
Cash
84
98
Accounts receivable
165
188
Inventory
393
422
642
708
Assets
Current assets:
Total Fixed assets Net plant and equipment Total assets
2,731
2,880
3,373
3,588
Liabilities and owners ʼ equity
Current liabiliites: Accounts payable
312
344
Notes payable
231
196
543
540
531
457
Total Long-term debt Ownersʼ equity Common stock and paid-in surplus Retaining earnings Total equity Total liabilities and owners ʼ equity
500
550
1,799
2,041
2,299
2,591
3,373
3,588
STAR Corporation 2013 Income Statement (RON in millions) Sales
2,311
Cost of gods sold
1,344
Gross profit
967
Depreciation
276
Earnings before interest and taxes (EBIT)
691
Interest paid
141
Taxable income
550
Taxes (i=16%)
88
Net income
462
Dividends
182
Addition to retained earnings
280
LIQUIDITY RATIOS (example 1) LET US UNDERSTAND THE SAME WITH THE HELP OF AN EXAMPLE Calculate Current Ratio, Quick Ratio and Cash Ratio using the data presented in the fifth slide :
Solution:
Current ratio = Current assets / current liabilities = 708 / 540 = 1.31 times Interpretation: the company has 1.31 RON in current assets for every 1 RON in current liabilities (the current ratio is a measure of short-term liquidity)
Quick ratio = (Current assets – Inventory)/Current liabilites = (708 – 422)/540 =0.53 times Interpretation: this rate simply measures the company ʼs ability to meet its current obligations quickly. Inventory is often the least liquid current asset. Quick ratio is less than 1 and the company may be unable to pay its bills
Cash ratio = Cash / Current liabilities = 98 / 540 = 0.18 times Interpretation: a very short-term creditor might be interested in the firm ʼs ability to pay off its current liabilites with only cash and cash equivalents . Cash ratio is 0.18 which means STAR corporation maintains a relatively low cash balance during the year. This is a sign of short-term trouble.
SOLVENCY RATIOS
Long-term solvency ratios - the firmʼs long-term ability to meet its obligations using debt to pay its operations and how easily it can cover the cost of that debt
Debt equity ratio - this measure shows the extent to which a company is using borrowed money to enhance the return on ownersʼ equity. Formula: Total debt / Total equity Significance: Investors and leaders scrutinize the ratio to determine whether a company is too highly leveraged or it is too conservative and isnʼt using enough debt to generate profits
Interpretation: This rate takes into account all debts of all maturities to all creditors. Whether this is high or low depends on the capital structure
Interest coverage – this ratio assesses the margin of sefty on a companyʼs debt, in other words, how its profit compares to its interest payments during a given period
Formula: EBIT (earnings before interest and taxes)/ Interest Significance: Bankers and other lenders look at this ratio closely- nobody likes to lend money to a company if its profits arenʼt substantially higher than its interest obligations Interpretation: This ratio measures how well a company has its interest obligations covered
SOLVENCY RATIOS (example 2) LET US UNDERSTAND THE SAME WITH THE HELP OF AN EXAMPLE Calculate Debt equity ratio and Interest coverage ratio using the data presented in the fifth slide :
Solution:
Debt equity ratio = Total debt / Total equity = (3,588 – 2,591)/2,591= 0.39 times Interpretation: the company has 0.39 RON in debt for every 1 RON in equity.
Interest coverage ratio = EBIT/Interest = 691/141= 4.9 times Interpretation: The interest bill is covered 4.9 times over and suggests how well the company has its interest obligations covered
OPERATING RATIOS (Asset management)
ʼ
Operating ratios help management to assess a company s level of efficiency, namely how well the
company put its assets to work and managing its cash
Asset turnover shows how efficiently a company uses all of its assets – cas, machinery, and so on – to generate revenue (How many RONs of revenue do we bring in for each RON of assets? ) In general, the higher the number - the better. We can increase this ratio either by generating more revenue with the same assets or by decreasing the asset of the business, perhaps by lowering average receivables Formula: Total asset turnover = Sales / Total assets
Receivable days (average collection period ) tells us how quickly a company collects funds owed by customers. A company that takes an average of 45 days to collect its receivables will need significantly more working capital than one that takes 25 days Formula: Receivable days = 365 days (Accounts receivable)/ Sales
Days payable – tells us how quickly a company pays its suppliers: - the longer it takes, other things being equal, the more cash a company has to work with. Management need to balance the advantages of more cash in the bank account against the suppliersʼ need to be paid. If this period is too long, it is possible that suppliers donʼt want to do business.
Formula: Days payable = 365 days (Accounts payable) / Cost of goods sold
Days in inventory shows how quickly a company sells its inventory during a given period of time – the longer it takes, the longer the company ʼs cash is tied up and the greater the likelihood that the inventory will not sell at full value Formula: Days in inventory = 365 days (Average inventory)/ Cost of goods sold –
OPERATING RATIOS (example 3) LET US UNDERSTAND THE SAME WITH THE HELP OF AN EXAMPLE Calculate Asset turnover, Receivable days, Days payable and Days in inventory ratios using the data presented in the fifth slide:
Solution:
Days in inventory = 365 days (Average inventory)/ Cost of goods sold = 365 (422) /1,344= 114 days Interpretation: This tell us that inventory sits 114 days on average before it is sold
Asset turnover = Total asset turnover = Sales / Total assets = 2,311/3,588 = 0.64 times Interpretation: For every RON in assets, we generated 0.64 RON in sales
Receivable days = 365 days (Accounts receivable)/ Sales = 365 (188)/2,311= 30 days
Interpretation :Therefore, on average, we collect on our credit sales in 30 days
Days payable = 365 days (Accounts payable) / Cost of goods sold = 365 (344)/ 1,344 = 93 days Interpretation: This result indicates that the compnay is paying its suppliers more slowly. The longer our days payable, the better we are managing our cash, and the more flexibility we have to invest in our own business
PROFITABILITY RATIOS
Profitability ratios measure how efficiently the firm uses its assets and how efficiently the firm manages its operations (the focus is the bottom line – net income)
Profit Margin - measures how much out of every RON of sales a company actually keeps in earnings. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors
Formula: Profit margin = Net income /sales
Gross profit margin shows how efficiently a company produces its goods or delivers its services, taking only direct costs into account
Formula: Gross profit margin = Gross profit / sales (revenue)
Return on assets (ROA) indicates how well a company is using its assets to generate profit. It ʼs a good measure for comparing companies of different sizes
Formula: Return on assets = Net income / Total assets
Return on equity (ROE) shows profit as a percentage of shareholders ʼ equity. In effect, it ʼs the ownersʼ return on their investment. ROE is the true bottom-line measure of performance
Formula: Return on equity = Net income / Total equity Formula*: ROE = (Net income/Sales)x (Sales/Assets) x (Assets/Equity)= ROA (1+ Debt equity ratio)
PROFITABILITY RATIOS (example 4) LET US UNDERSTAND THE SAME WITH THE HELP OF AN EXAMPLE Calculate Profit margin, Gross profit margin, ROE, ROA using the data presented in the fifth slide:
Solution: Profit margin = Net income /sales = 462 /2,311= 0.199 → 19.9% Interpretation: This tell us that tha company generates a little less than 20 bani in profit for every RON in sales. A relatively high profit margin is obviously desirable Gross profit margin = Gross profit / sales (revenue) = 967/2,311=0.42
→ 42%
Interpretation: Basically, 42% gross profit margin means that for every RON generated in sales, the company has 42 bani left over to cover basic operating cost and profit. It serves as the source for paying additional expenses and future savings
Return on assets (ROA) = Net income / Total assets = 462/3,588= 0.128
→ 12.8%
Interpretation: 12.8% ROA means that for every RON invested in assets during the tear produced 0.128 RON of net income. A low return on assets compared with the industry average indicates inefficient use of companyʼs assets
Return on equity (ROE) = Net income / Total equity = 462/2,591 = 0.178
→ 17.8%
Interpretation: This means that STAR company generated 0.178 RON of profit for every RON of shareholdersʼ equity. ROE measures how much the shareholders earned for their investment in the company. The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to investor
