9. introduction to Ratio Analysis

Introduction to Ratio Analysis

  • Presenter: S. Levkoff, PhD, CAP®

  • Institution: UC San Diego, Department of Economics & Rady School of Management

Ratios

  • Purpose of Ratios:

    • Assess features of a firm: profitability, liquidity, and risk.

    • Highlight sources of competitive advantages.

    • Identify potential trouble spots.

  • Comparison Methods:

    • Ratios must be compared to benchmarks, such as a control group.

    • Time Series Analysis: Compare the same firm at different points in time.

    • Cross-Sectional Analysis: Compare the firm to other firms in the industry.

Using Ratios

  • Importance of Benchmark:

    • A major change within a firm can distort time-series analysis.

    • Differences in business strategy, capital structure, or business segments can distort cross-sectional analysis.

    • Accounting method differences can also create distortions.

Misusing Ratios

  • Contextual Usage:

    • Ratios should be used in a contextual sense; a change in a ratio is not always indicative of good or bad performance.

    • Ratios guide informed questioning rather than providing definite answers.

  • Standard Definitions:

    • Ratios have multiple definitions; no standardized GAAP compliance constrains their definitions.

    • They are used for analysis, not reporting, and considered metadata from financial documents.

  • Manipulation Potential:

    • Managerial actions can manipulate ratios.

    • Monitoring behavior can lead to unintended consequences and incentives.

Return on Equity (ROE)

  • Definition:

    • ROE is calculated as the ratio of net income to average shareholders’ equity:

    • Formula: ROE = Net Income / Average Shareholders’ Equity.

    • Average is considered between beginning and end balances on the balance sheet.

Drivers of ROE

  • Primary Drivers:

    • Operating Performance: Efficiency in utilizing assets to generate profits.

    • Financial Leverage: The extent of debt management to increase asset availability against shareholder investment.

Return on Assets (ROA)

  • Measurement:

    • ROA measures operating performance:

    • Formula: ROA = Net Income / Average Total Assets.

    • The numerator shows the return generated for shareholders; the denominator shows resources used to generate this return.

Financial Leverage (FLR)

  • Definition:

    • FLR is the ratio of average assets to average shareholders’ equity:

    • Formula: FLR = Average Assets / Average Shareholders’ Equity.

    • Multiple leverage ratios exist (e.g., debt-to-equity).

Decomposing ROE

  • Formula:

    • ROE = ROA × FLR

    • Shows the connection between return on equity, return on assets, and financial leverage.

Example Calculation

  • Scenario:

    • A company raises $100 from shareholders and borrows $100 to acquire $200 in assets, generating $10 of net income.

    • Calculations:

      • ROE = 10/100 = 10%

      • ROA = 10/200 = 5%

      • FLR = 200/100 = 200%.

De-levering Net Income in ROA

  • Challenge:

    • ROA must account for capital structure; Net Income includes interest expenses.

  • Adjustment Required:

    • To de-lever Net Income:

    • Formula: Adjusted Net Income = Net Income + (Interest Expense × (1-Tax Rate)).

Effects of Leveraging - Example

  • Two Firms:

    • Firm A: Financed entirely with equity.

    • Firm B: Financed through equity and debt, both generating identical EBIT of $100.

Tax Shields and Interest Expenses

  • Concept:

    • Leveraged operations can yield higher total payments to shareholders due to tax deductions on interest.

    • Tax shield calculated as the product of interest expense and tax rate.

  • Optimal Capital Structure:

    • A strategy balancing tax shields against potential financial distress costs.

Decomposing the Return on Assets (ROA)

  • Key Drivers:

    • Return on Sales (ROS): Return generated from sales.

      • Formula: ROS = Net Income / Sales.

    • Asset Turnover Ratio (ATR): Efficiency in generating sales from assets.

      • Formula: ATR = Sales / Total Assets.

DuPont Decomposition

  • Breakdown of ROE:

    • ROE = ROA × FLR = (ROS × ATR) × FLR.

Retail Industry Examples

  • Low-End Retailers (e.g., MART stores):

    • High asset turnover despite low profitability due to volume play strategy.

  • High-End Retailers:

    • Constructed from expensive materials with high markups, resulting in lower asset turnover.

Plainview Technology Case Study

  • Background:

    • Manufactures iris scanning equipment; lost a major customer in 2009.

  • Management Response:

    • Increased automation, located closer to customers, diversified industries, and adopted advanced technology.

  • Outcome:

    • Experienced growth post-crisis.

Plainview Financial Statements Overview

  • Balance Sheet (Assets):

    • Analysis of assets from 2009-2011 illustrating growth in cash, accounts receivable, inventories, and net property, plant, and equipment.

  • Balance Sheet (Liabilities & Shareholders' Equity):

    • Evolution of liabilities and equity over the same period reflecting increased long-term debt and retained earnings.

  • Income Statement:

    • Highlights sales growth, gross profit, operating income, interest expenses, and net income from 2009 to 2011.

Common Size Financial Statements

  • Purpose:

    • Adjust for asymmetric growth across financial data.

  • Common Size Balance Sheet:

    • Values expressed as a fraction of total assets for comparative analysis.

  • Common Size Income Statement:

    • Values expressed as a fraction of total sales for trend identification.