Ratio Analysis Study Notes

Ratio Analysis

Overview

• Financial ratios translate accounting numbers into relative values.

• They illustrate relationships between financial statement accounts within and between firms, irrespective of size.

• Ratio analysis aids in comparisons across different periods or companies.

• Trend analysis reveals changes over time.

Purpose of Ratio Analysis

• Provides insight into a company's performance.

• Highlights strengths and weaknesses.

• Indicates the company's future financial health.

Common Size Analysis

• Establishes a base for comparison.

• Uses common-sized balance sheets and income statements.

• Sales or assets are set to 100% for comparison.

• Other items are compared relative to this base.

Types of Ratios

• Liquidity Ratios: Measures the ability to meet current obligations.

• Asset Management Ratios: Evaluates the efficiency of asset utilization.

• Debt Management Ratios: Indicates the level of debt and its prudent use.

• Profitability Ratios: Determines the proportion of sales revenue accruing to shareholders.

• Market Value Ratios: Assesses stock price relative to earnings and book value.

Liquidity Ratios

• Current Ratio: $\frac{Current Assets }{ Current Liabilities}$

• Quick Ratio: $\frac{Current Assets - Inventory}{Current Liabilities}$

  • Generally, a ratio of 1.25 to 1.5 is desirable.

  • Lower values may indicate a liquidity crunch.

  • Higher values might mean missed investment opportunities.

Asset Management Ratios

• Inventory Turnover: Measures how quickly inventory is sold.

• Days Sales Outstanding: $\frac{Receivables}{Sales/360}$

  • Measures how quickly customers pay.

• Fixed Asset Turnover: Measures how efficiently fixed assets are utilized.

• Total Asset Turnover: Measures how efficiently all assets are utilized.

Debt Management Ratios

• Show how well a company can meet its debt obligations.

• Debt Ratio: $\frac{Total Debt}{Total Assets}$

• Times Interest Earned: $\frac{EBIT}{Interest Charges}$

• Fixed Charge Coverage: $\frac{EBIT + Lease Payments}{Interest Charges + Lease Payments}$

Profitability Ratios

• Gross Profit Margin: $\frac{Sales - COGS}{Sales}$

• Net Profit Margin: $\frac{Net Income}{Sales}$

• Return on Assets (ROA): $\frac{Net Income}{Total Assets}$

• Return on Equity (ROE): $\frac{Net Income}{Total Equity}$

Market Value Ratios

• Measure a firm’s market value (stock price) to its earnings and book value.

• PE Ratio: $\frac{Price}{Earnings}$

  • Measures how much investors are paying for each $1 of earnings.</p></li><li><p>High expectations for growth in earnings yield higher P/E ratios.</p></li></ul></li><li><p>Market to Book Ratio:$\frac{Market Value per Share}{Book Value per Share}$$

    • Shows how investors value the company relative to its Balance Sheet (Book Value)

  Limitations of Ratio Analysis

  • "Window dressing" can manipulate ratios.

  • Different accounting practices can skew comparisons.

  • Determining whether a ratio is "good" or "bad" can be subjective.

  • Assessing a company's overall financial position can be challenging.

  Conclusion

  • Judgment is crucial in financial statement analysis for assessing a firm’s future financial position.

  Learning outcomes

  • Describe the basic financial information that is produced by corporations and explain how the firm’s stakeholders use such information.

  • Describe the financial statements that corporations publish and the information that each statement provides.

  • Describe how ratio analysis should be conducted and why the results of such an analysis are important to both managers and investors.

  • Discuss potential problems (caveats) associated with financial statement analysis.