D076 Unit 4 Financial Ratios

Importance of Studying Ratios

  • Vocabulary can be complex; the importance of understanding key terms is emphasized.

  • Categories of ratios should be organized for better comprehension.

Benefits of Using Ratios

  • General understanding of the importance of ratios in financial evaluation.

  • Four major benefits:

    • Standardization:

    • Allows for comparison across firms of different sizes.

    • Flexibility:

    • Users can create ratios suitable for specific needs beyond standard metrics.

    • Focus:

    • Ratios can help identify areas needing deeper analysis (like seeing a doctor's general practitioner for a referral to a specialist).

    • Evaluation Tool:

    • Provides metrics for assessing the overall performance and financial health of a company.

Types of Ratio Analysis

  • Two broad ways to analyze performance:

    • Trend Analysis:

    • Evaluating a firm's performance over time using ratios.

    • Example: Current ratio assessed over the past five years.

    • Progress Measurement:

    • Comparing performance against specific, pre-set goals over time.

    • Example: Aiming for a current ratio target of 3.0 while tracking improvements.

  • Cross-Sectional Analysis:

    • Comparing a firm's performance against peers in the industry.

    • Benchmarking:

    • A focused version of cross-sectional analysis comparing against top firms versus the industry average.

Overview of Users of Ratio Analysis

  • Internal Users:

    • Managers evaluating performance for operational decisions.

    • Employees concerned about job stability and company health.

    • Current shareholders tracking company performance.

  • External Users:

    • Bondholders and other creditors needing assurance of liquidity and repayment capabilities.

    • Investors looking for potential growth indicators.

Financial Statements Overview

  • Income Statement and Balance Sheet basics:

    • Key components of the income statement include sales, cost of goods sold, gross profit, operating income (EBIT), and net income (bottom line).

    • Key components of the balance sheet include current and long-term assets, total liabilities, equity, and market capitalization.

  • Emphasis on understanding the context behind financial numbers for ratio calculations.

Categories of Ratios

  • Liquidity Ratios:

    • Assess ability to pay short-term obligations with available assets.

  • Key ratios include:

  • Current Ratio: Current assets divided by current liabilities.

  • Quick Ratio (Acid-Test Ratio): Current assets minus inventory divided by current liabilities.

Activity Ratios:

  • Indicate efficiency in asset utilization to generate sales.

  • Key ratios include:

  • Accounts Receivable Turnover - A Measure of how efficiently accounts receivable are collected.

    • Example: A high turnover indicates quick collection of credit sales.

  • Inventory Turnover - Measures the rate at which inventory is sold and replaced.

    • Note on high turnover: Excessive turnover may lead to stockouts.

  • Total Asset Turnover - Sales generated for every dollar of assets held.

  • Leverage Ratios:

    • Indicate the degree of debt financing and financial risk.

    • Key ratios include:

    • Debt Ratio - Total liabilities divided by total assets.

      • Interpretation: Indicates proportion of a firm’s assets financed by debt.

    • Debt to Equity Ratio - Total liabilities divided by total equity.

      • Used to analyze the capital structure and risk.

    • Times Interest Earned - Operating income divided by interest expenses.

      • Measure of a firm's ability to meet interest payments.

  • Profitability Ratios:

    • Measure earnings relative to sales or equity.

Key ratios include:

  • Return on Assets (ROA) - Net income divided by total assets.

  • Return on Equity (ROE) - Net income divided by total equity.

  • Gross Margin, Operating Margin, Net Margin - Each assesses profit at different levels of cost deduction.

  • Market Ratios:

    • Assess market perception of firm value.

  • Key ratios include:

    • Market to Book Ratio - Compares market value to book value, indicating growth potential.

    • Price to Earnings Ratio - Reflects how much investors are willing to pay for earnings;

      • A lower PE indicates undervaluation while a higher PE suggests overvaluation.

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DuPont Framework

  • Analyzes ROE by breaking it down into three components:

    • Net Margin (Profitability)

    • Asset Turnover (Efficiency)

    • Leverage Multiplier (Financing)