Study Notes for Financial Ratios - Chapter 3

Chapter Three: Financial Ratios

Overview

  • Introduction to calculating and using financial ratios
  • Focus on Chapter 3.2 from the course material
  • Importance of ratios in financial analysis mentioned

Understanding Financial Ratios

  • No single correct number for ratios
  • Ratios are contextual:
    • Example: Mullet Ratio (hypothetical)
    • Defined by the measurement of length of a hairstyle:
      • Mullet Ratio = Length of the party (back) / Length of the business (front)
    • Example calculation:
      • Party length = 17, Business length = 9
      • Mullet Ratio = rac{17}{9} = 1.8
    • Interpretation of ratio:
      • Higher ratios signify more of a 'party' hairstyle

Use of Ratios

Time Series Analysis

  • Analysis of how ratios change over time:
    • Compare current year’s ratios to previous years
    • Project future ratios based on estimations from pro forma statements
  • Comparison with competitors and industry averages:
    • Identify whether ratios are lower or higher than industry norms
    • Assess implications of ratios for competitiveness

Questions about Ratios

  • For each ratio, consider:
    • What does the ratio measure?
    • Importance and relevance of the information
    • Who is affected by this information?
    • Are high or low values desirable?
    • Can the ratios be 'too high' or 'too low'?

Categories of Financial Ratios

  • Five categories:
    1. Liquidity Ratios
    2. Leverage Ratios
    3. Asset Management Ratios
    4. Profitability Ratios
    5. Market Value Ratios

Liquidity Ratios

  • Measure a firm's capability to pay short-term liabilities

  • Common liquidity ratios:

    • Current Ratio:

    • Formula: ext{Current Ratio} = rac{ ext{Current Assets}}{ ext{Current Liabilities}}

    • Interpretation:

      • A ratio > 1 indicates sufficient current assets to meet current liabilities
      • Context: Net working capital ( ext{Current Assets} - ext{Current Liabilities} > 0)

    • Quick Ratio (Acid Test):

    • Formula: ext{Quick Ratio} = rac{ ext{Current Assets} - ext{Inventory}}{ ext{Current Liabilities}}

    • Importance of not including inventory, which may be unsellable or stale

    • Cash Ratio:

    • Formula: ext{Cash Ratio} = rac{ ext{Cash}}{ ext{Current Liabilities}}

    • Interpretation: Indicates the ability to pay liabilities with cash on hand

Leverage Ratios

  • Measure a company’s debt level compared to equity:

    • Debt Ratio:

    • Formula: ext{Debt Ratio} = rac{ ext{Total Debt}}{ ext{Total Assets}}

    • Debt to Equity Ratio:

    • Relationship derived from shareholder equity and liabilities

    • Equity Multiplier:

    • Defined as ext{Total Assets} / ext{Total Equity}

    • Key in evaluating capital structure decisions

Times Interest Earned Ratio

  • Measures ability to meet interest obligations:
    • Formula: ext{Times Interest Earned} = rac{EBIT}{ ext{Interest Expense}}
    • Preference for this number to be >1
    • Discusses implications of being too high or too low regarding leverage

Asset Management Ratios

  • Focus on efficiency and effectiveness in using firm assets:

    • Inventory Turnover:

    • Formula: ext{Inventory Turnover} = rac{ ext{Cost of Goods Sold}}{ ext{Average Inventory}}

    • Real-world example of a magic marker company with a specific inventory scenario

    • Turnover rate calculated to indicate frequency of inventory sales

    • Receivables Turnover: Measures efficiency in collecting receivables

    • Days Sales in Receivables: Measures average collection period

    • Total Asset Turnover: Measures effectiveness at generating sales from assets

    • Formula: ext{Total Asset Turnover} = rac{ ext{Sales}}{ ext{Total Assets}}

Profitability Ratios

  • Relative metrics of profitability concerning sales and equity:

    • Net Profit Margin:

    • Formula: ext{Net Profit Margin} = rac{ ext{Net Income}}{ ext{Sales}}

    • Interpretation explains profit leftover from each dollar of sales

    • Return on Assets (ROA):

    • Formula: ext{ROA} = rac{ ext{Net Income}}{ ext{Total Assets}}

    • Indicates how effectively a company is generating profits from assets

    • Return on Equity (ROE):

    • Formula: ext{ROE} = rac{ ext{Net Income}}{ ext{Total Equity}}

    • Indicated how well a firm uses investments to generate earnings

Market Value Ratios

  • Introduces share price context into the analysis of ratios:

    • Price to Earnings Ratio (PE Ratio):

    • Formula: ext{PE Ratio} = rac{ ext{Market Price per Share}}{ ext{Earnings per Share}}

    • Significance assesses expectations about future earnings based on current prices

    • Historic average PE ratio is around 15-16

    • Interpretation of high or low PE ratios based on company performance & market expectations

    • Other relevant ratios:

    • Price to Sales Ratio

    • Market to Book Ratio

    • EV/EBITDA Ratio

Application and Summary

  • Importance of using financial ratios over raw numbers for comparative analysis in different industries
  • Summary of calculations discussed in the lesson included
  • Final encouragement to practice ratio calculations with provided examples.
  • Conclusion of Chapter 3, section 3.2 with practical applications of financial ratios throughout investor decision-making processes.