We will want to answer questions about the firms

Liquidity Efficient use of Assets Leverage (financing) Profitability

INTRO TO FM

Financial Ratios
Tools that help us determine the financial health of a company. We can compare a companys financial ratios with its ratios in previous years (trend analysis). We can compare a companys financial ratios with those of its industry.
INTRO TO FM

Ratio Analysis
Four Categories of Ratios

Liquidity Ratios Efficiency Ratios Leverage Ratios Profitability Ratios

INTRO TO FM

Ratio Analysis
Liquidity Ratios

Used to measure the ability of a firm to meet its short term financial obligations. Are there sufficient liquid assets to pay off current indebtedness?

INTRO TO FM

Ratio Analysis
Liquidity Ratios

Measure the ability of the firm to meet its short-term financial obligations.
Current Assets Current Ratio = Current Liabilities

Is there a sufficient amount of current assets to pay off current liabilities? What is the cushion of safety?

INTRO TO FM

Ratio Analysis
Balance Sheet Simsboro Computer Company Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets Current Ratio = Current Assets $1,230 Bonds $600 Current Liabilities Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Paid-in Capital 600 Total Assets $2,530 Retained Earnings 800 Income Statement Simsboro Computer Company Total Owners Equity $1,700 Total Liabilities and Sales $1,450 Owners Equity $2,530 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Net Operating Income $330 Interest Expense 60 Current Ratio = $1,230 = 5.35x Net Income Before Taxes $270 $230 Taxes (40%) 108 Net Income $162 Dividends Paid 100 Addition to Retained Earnings $62 6

INTRO TO FM

Ratio Analysis
Liquidity Ratios

Measure the ability of the firm to meet its short-term financial obligations.
Current Assets - Inventory Acid-Test Ratio = Current Liabilities

What happens to the firms ability to repay current liabilities after the least liquid of the current assets is subtracted?

INTRO TO FM

Ratio Analysis
Balance Sheet Simsboro Computer Company Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Paid-in Capital 600 Total Assets $2,530 Retained Earnings 800 Income Statement Simsboro Computer Company Total Owners Equity $1,700 Current Assets - Inventory Total Liabilities and Sales $1,450 Acid-Test Ratio = Owners Equity $2,530 Current Cost of Goods Sold 875 Liabilities Gross Profit $575 Operating Expenses 45 Depreciation 200 Net Operating Income $330 $1,230 -$625 Interest Expense 60 Acid-Test Ratio = =2.63x $230 Net Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Dividends Paid 100 Addition to Retained Earnings $62 8

INTRO TO FM

Ratio Analysis
Efficiency Ratios

Provide basis for assessing how effectively the firm is using its resources to generate sales
Average Collection Period = Accounts Receivable Daily Credit Sales

How long does it take for the firm to collect its credit sales from customers?

INTRO TO FM

INTRO TO FM

Simsboro Computer Company Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Paid-in Capital 600 Total Assets 800 Average $2,530 Retained Earnings Income Statement Accounts Receivable Simsboro Computer Company Total Owners Equity $1,700 Collection = TotalCredit Liabilities and Daily Sales Sales $1,450 Period Owners Equity $2,530 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Net Operating Income $330 $430 Interest Expense 60 ACP = = 108.24 days $1,450/365 Net Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Days in a Dividends Paid 100 Addition to Retained Earnings $62 year 10

Ratio Analysis Balance Sheet

Ratio Analysis
Efficiency Ratios Provide basis for assessing how effectively the firm is using its resources to generate sales
Inventory Turnover Ratio = Cost of Goods Sold Inventory

Is the level of inventory appropriate given the firms sales?

INTRO TO FM

11

INTRO TO FM

Simsboro Computer Company Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Paid-in Capital 600 Total Assets $2,530 Retained Earnings 800 Income Statement Simsboro Computer Company Total Owners Equity $1,700 Inventory Cost of Goods Sold Sales $1,450 Turnover = Total Liabilities and Inventory Owners Equity $2,530 Cost of Goods Sold 875 Ratio Gross Profit $575 Operating Expenses 45 Depreciation 200 Net Operating Income $330 Interest Expense 60 Inventory Turnover = $875 = 1.4x Net Income Before Taxes $270 $625 Taxes (40%) 108 Net Income $162 Dividends Paid 100 Addition to Retained Earnings $62 12

Ratio Analysis Balance Sheet

Ratio Analysis
Efficiency Ratios

Provide basis for assessing how effectively the firm is using its resources to generate sales
Fixed Asset Turnover Ratio = Sales Net Fixed Assets

How effective is the firm in using its fixed assets in generating sales?

INTRO TO FM

13

INTRO TO FM

Simsboro Computer Company Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Paid-in Capital 600 Total Assets $2,530 Retained Earnings 800 Income Statement Simsboro Computer Company Fixed Asset Total Owners Equity $1,700 Sales Total and Sales $1,450 Turnover = Liabilities Owners $2,530 Net Equity Fixed Assets Cost of Goods Sold 875 Ratio Gross Profit $575 Operating Expenses 45 Depreciation 200 Net Operating Income $330 Interest Expense 60 Fixed Asset Turnover = $1,450 = 1.12x Net Income Before Taxes $270 $1,300 Taxes (40%) 108 Net Income $162 Dividends Paid 100 Addition to Retained Earnings $62 14

Ratio Analysis Balance Sheet

Ratio Analysis
Efficiency Ratios Provide basis for assessing how effectively the firm is using its resources to generate sales
Total Asset Turnover Ratio = Sales Total Assets

How effective is the firm in using all assets to generate sales?

INTRO TO FM

15

INTRO TO FM

Simsboro Computer Company Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Paid-in Capital 600 Total Assets $2,530 Retained Earnings 800 Income Statement Simsboro Computer Company Total Owners Equity $1,700 Total Liabilities and Sales $1,450 Total Asset Owners Equity $2,530 Sales Cost of Goods Sold 875 Turnover = Gross Profit $575 Total Assets Ratio Operating Expenses 45 Depreciation 200 Net Operating Income $330 Interest Expense 60 Total Asset Turnover = $1,450 = 0.57x Net Income Before Taxes $270 $2,530 Taxes (40%) 108 Net Income $162 Dividends Paid 100 Addition to Retained Earnings $62 16

Ratio Analysis Balance Sheet

Ratio Analysis
Leverage Ratios

Used to measure the extent to which non-owner supplied funds have been used to finance the firms assets Two Types
Balance Sheet Leverage Ratios
Coverage Ratios

INTRO TO FM

17

Ratio Analysis
Leverage Ratios

Balance Sheet Leverage Ratios measure the proportion of the firms assets financed with nonowner funds.
Debt Ratio = Total Debt Total Assets

What proportion of the firms assets are financed with debt?

INTRO TO FM

18

INTRO TO FM

Simsboro Computer Company Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Paid-in Capital 600 Total Assets $2,530 Retained Earnings 800 Income Statement Simsboro Computer Company Total Owners Equity $1,700 Total Liabilities and Sales $1,450 Total Debt Owners Equity $2,530 Cost of Goods Sold 875 Debt Ratio = Gross Profit $575 Total Assets Operating Expenses 45 Depreciation 200 Net Operating Income $330 Interest Expense 60 Debt Ratio = $230 + $600 = 33% Net Income Before Taxes $270 $2,530 Taxes (40%) 108 Net Income $162 Dividends Paid 100 Addition to Retained Earnings $62 19

Ratio Analysis Balance Sheet

Ratio Analysis
Leverage Ratios

Coverage Ratios measure the firms ability to cover (pay) then finance charges associated with its use of financial leverage.
Times Interest Earned Ratio = Operating Income Interest Expense

What is the margin of safety in the ability to repay interest payments?

INTRO TO FM

20

INTRO TO FM

Simsboro Computer Company Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Paid-in Capital 600 Total Assets $2,530 Retained Earnings 800 Income Statement Simsboro Computer Company Total Owners Equity $1,700 Total Liabilities and Sales $1,450 Times Operating Owners Equity Income $2,530 Cost of Goods Sold 875 Interest = Interest Expense Gross Profit $575 Earned Ratio Operating Expenses 45 Depreciation 200 Net Operating Income $330 $330 = 5.50x Interest Expense 60 TIE Ratio = $60 Net Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Dividends Paid 100 Addition to Retained Earnings $62 21

Ratio Analysis Balance Sheet

Ratio Analysis
Profitability Ratios

Measures the overall effectiveness of the firms management. Two Types:

Profit in Relation to Sales Profit in Relation to Investment

INTRO TO FM

22

Ratio Analysis
Profitability Ratios

Profit in Relation to Sales measures the firms ability to convert sales volume into bottom line profit.
Operating Income Operating Profit Margin = Sales

How effective is the firm in keeping costs of production low?

INTRO TO FM

23

INTRO TO FM

Simsboro Computer Company Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Paid-in Capital 600 Total Assets $2,530 Retained Earnings 800 Income Statement Simsboro Computer Company Total Owners Equity $1,700 Sales $1,450 Operating Total Liabilities and Operating Income Owners Equity $2,530 Cost of Goods Sold 875 Profit = Gross Profit $575 Sales Margin Operating Expenses 45 Depreciation 200 Net Operating Income $330 Interest Expense 60 Oper. Profit Margin = $330 = 22.8% $1,450 Net Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Dividends Paid 100 Addition to Retained Earnings $62 24

Ratio Analysis Balance Sheet

Ratio Analysis
Profitability Ratios Profit in Relation to Sales measures the firms ability to convert sales volume into bottom line profit.
Net Income Sales

Net Profit Margin =

What is the amount of Net Profit for each dollar of sales?

INTRO TO FM

25

INTRO TO FM

Simsboro Computer Company Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Paid-in Capital 600 Total Assets $2,530 Retained Earnings 800 Income Statement Simsboro Computer Company Total Owners Equity $1,700 Total Liabilities and Sales $1,450 Net Net Income Owners Equity $2,530 Cost of Goods Sold 875 Profit = Gross Profit $575 Sales Margin Operating Expenses 45 Depreciation 200 Net Operating Income $330 Interest Expense 60 Net Profit Margin = $162 = 11.2% $1,450 Net Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Dividends Paid 100 Addition to Retained Earnings $62 26

Ratio Analysis Balance Sheet

Ratio Analysis
Profitability Ratios Profit in Relation to Investment measures the firms ability to convert resources (investment) into bottom line profit.
Operating Income Operating Income = Total Assets Return on Investment What is the ability of the firm to generate operating income with its assets (before financing costs and taxes)?
27

INTRO TO FM

INTRO TO FM

Simsboro Computer Company Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Paid-in Capital 600 Total Assets $2,530 Retained Earnings 800 Income Statement Simsboro Computer Company Total Owners Equity $1,700 Total Liabilities and Sales $1,450 Operating Inc. Operating Owners Equity Income $2,530 Cost of Goods Sold 875 = Return on Total Assets Gross Profit $575 Investment Operating Expenses 45 Depreciation 200 Net Operating Income $330 Interest Expense 60 OIROI = $330 = 13.04% $2,530 Net Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Dividends Paid 100 Addition to Retained Earnings $62 28

Ratio Analysis Balance Sheet

Ratio Analysis
Profitability Ratios

Profit in Relation to Investment measures the firms ability to convert resources (investment) into bottom line profit.
Return on Assets = Net Income Total Assets

What is the relationship between the generated profits of the firm and the firms investment in assets?
29

INTRO TO FM

INTRO TO FM

Simsboro Computer Company Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Paid-in Capital 600 Total Assets $2,530 Retained Earnings 800 Income Statement Simsboro Computer Company Total Owners Equity $1,700 Total Liabilities and Sales $1,450 Income Owners Net Equity $2,530 Cost of Goods Sold 875 Return on Assets = Total Assets Gross Profit $575 Operating Expenses 45 Depreciation 200 Net Operating Income $330 Interest Expense 60 ROA = $162 = 6.40% $2,530 Net Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Dividends Paid 100 Addition to Retained Earnings $62 30

Ratio Analysis Balance Sheet

Ratio Analysis
Profitability Ratios

Profit in Relation to Investment measures the firms ability to convert resources (investment) into bottom line profit.
Net Income Return on Equity = Common Equity

What is the relationship between the generated profits of the firm and the owners investment in the firm?
31

INTRO TO FM

INTRO TO FM

Simsboro Computer Company Assets Liabilities $175 Accounts Payable $115 Net Cash Income Return on Equity = Common Accounts Receivable 430 S-T Notes Payable 115 Equity Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owners Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Paid-in Capital 600 Total Assets $2,530 Retained Earnings 800 Income Statement Simsboro Computer Company Total Owners Equity $1,700 Total Liabilities and Sales $1,450 Owners Equity $2,530 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Net Operating Income $330 Interest Expense 60 ROE = $162 = 9.53% $1,700 Net Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Dividends Paid 100 Addition to Retained Earnings $62 32

Ratio Analysis Balance Sheet

Ratio Analysis
DuPont System

The DuPont System summarizes key relationships which determine the overall performance of the firm.
Return on Assets = Net Income Total Assets Total Asset Turnover 0.57 times

Can be rewritten as:

Net Income Net Income Sales = x Total Assets Sales Total Assets Net Profit Margin 0.112 x 0.57 = .064 = 6.4% 11.2% INTRO TO FM

33

Ratio Analysis
DuPont System

The Return on Equity can also be rewritten:

Net Income Return on Equity = Common Equity Leverage 0.33 1Total Debt Total Assets

DuPont System Return on Equity = ROA Return on Assets 6.4%

INTRO TO FM

.064 = 0.095 = 9.5% 1 - 0.33

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