RATIO EXAMPLE: Ratio Analysis

Gi Company BALANCE SHEET December 31 20X1 20X2 Current Assets: Cash and cash equivalents Trading securities (at fair value) Accounts receivable Inventory (at lower of cost or market) Total current assets Investments available-for-sale (at fair value) Fixed Assets: Property, plant, and equipment (at cost) Less: Accumulated depreciation Goodwill Total assets Current Liabilities: Accounts payable Notes payable Accrued and other liabilities Total current liabilities Long-term Debt: Bonds and notes payable Total liabilities Stockholders' Equity: Common stock (100,000 shares outstanding) Additional paid-in capital Retained earnings Total equity Total liabilities and equity $ 50,000 75,000 300,000 290,000 715,000 350,000 1,900,000 (380,000) 1,520,000 30,000 $2,615,000 $ 150,000 325,000 220,000 695,000 650,000 1,345,000 500,000 350,000 420,000 1,270,000 $2,615,000 $ 35,000 65,000 290,000 275,000 665,000 300,000 1,800,000 (350,000) 1,450,000 35,000 $2,450,000 $ 125,000 375,000 200,000 700,000 600,000 1,300,000 500,000 350,000 300,000 1,150,000 $2,450,000

In addition, assume the following information for Gi Company for the year ended December 31, 20X2 Sales Cost of goods sold Gross profit Operating expenses Interest expense Net income before income taxes Income taxes (34%) Net income after income taxes Earnings per share Operating cash flows Dividends for the year Market price per share $1,800,000 (1,000,000) 800,000 (486,970) (10,000) 303,030 (103,030) $ 200,000 $2 $255,000 $0.80 per share $12

Liquidity Ratios
1. Working capital = Current assets - Current liabilities 20X2: 20X1: 2. $715,000 - $695,000 = $20,000 $665,000 - $700,000 = ($35,000) Current assets Current liabilities $715,000 $695,000 $665,000 $700,000 = 1.03 = 0.95

Current ratio (working capital ratio) = (20X2) = (20X1) = (Industry average = 1.5)

The ratio, and therefore Gi's ability to meet its short-term obligations, has improved, though it is low compared to the industry average. 3. Acid-test (quick) = ratio (20X2) = (20X1) = Cash equivalents + Marketable securities + Net receivables Current liabilities $50,000 + $75,000 + $300,000 $695,000 $35,000 + $65,000 + $290,000 $700,000 = 0.61 = 0.56

(Industry average = 0.80) The industry average of .80 is higher than Gi's ratio, which indicates that Gi may have trouble meeting short-term needs. 4. Cash ratio = (20X2) = (20X1) = Cash equivalents + Marketable securities Current liabilities $50,000 + $75,000 $695,000 $35,000 + $65,000 $700,000 = 0.18 = 0.14

Activity Ratios
1. Accounts receivable turnover = = = Net credit sales Average gross receivables $1,800,000 ($300,000 + $290,000) / 2 $1,800,000 $295,000

= 6.10 times This ratio indicates the receivables' quality and indicates the success of the firm in collecting outstanding receivables. Faster turnover gives credibility to the current and acid-test ratios. 2. Accounts receivable turnover in days = = = Average gross receivables Net credit sales / 365 365 days Receivable turnover 365 6.1

= 59.84 days This ratio indicates the average number of days required to collect accounts receivable. 3. Inventory turnover = = = Cost of goods sold Average inventory $1,000,000 ($290,000 + $275,000) / 2 $1,000,000 $282,500

= 3.54 times This measure of how quickly inventory is sold is an indicator of enterprise performance. The higher the turnover, in general, the better the performance.

4.

Inventory turnover in days = = =

Average inventory Cost of goods sold / 365 365 days Inventory turnover 365 days 3.54

= 103.11 days This ratio indicates the average number of days required to sell inventory. 5. Operating cycle = = AR turnover in days + Inventory turnover in days 59.84 days + 103.11 days

= 162.95 days The operating cycle indicates the number of days between acquisition of inventory and realization of cash from selling the inventory. 6. Working capital turnover = = Sales Average working capital $1,800,000 [($715,000 - $695,000) + ($665,000 - $700,000)] / 2

= 240 times This ratio indicates how effectively working capital is used. 7. Total asset turnover = = = Net sales Average total assets $1,800,000 ($2,615,000 + $2,450,000) / 2 $1,800,000 $2,532,500

= 0.71 times This ratio is an indicator of how Gi makes effective use of its assets. A high ratio indicates effective asset use to generate sales.

Profitability Ratios
Note: Some forms of the profitability ratios below use net income less preferred dividends in the numerator to better measure returns accruing to common shareholders. 1. Net profit margin = = Net income Net sales $200,000 $1,800,000

= 11.11% This ratio indicates profit rate and, when used with the asset turnover ratio, indicates rate of return on assets, as shown in item 3 below. 2. Return on total assets = = Net income Average total assets $200,000 / $2,532,500

= 7.9% 3. DuPont return on assets = = Net profit margin x Total asset turnover Net income Net sales x Net sales Average total assets

= 11.11% x 0.71 times = 7.9% Note that this ratio uses both net profit margin and the total asset turnover. This ratio allows for increased analysis of the changes in percentages. The net profit margin indicates the percent return on each sale while the asset turnover indicates the effective use of assets in generating that sale. 4. Return on investment = = Net income + Interest expense (1 - Tax rate) Average (Long-term liabilities + Equity) $200,000 + $10,000 (1 - 0.34) ($650,000 + $1,270,000 + $600,000 + $1,150,000) / 2

= 11.3% ROI measures the performance of the firm without regard to the method of financing. 5. Return on common equity = = Net income - Preferred dividends Average common equity $200,000 - $0 ($1,270,000 + $1,150,000) / 2

= 16.5%

6.

Net operating margin percentage

= = =

Net operating income Net sales $800,000 486,970 $1,800,000

17.39%

7.

Gross (profit) margin percentage

= = =

Gross (profit) margin Net sales $800,000 $1,800,000 44% Operating cash flow Common shares outstanding $255,000 100,000 shares

8.

Operating cash flow per share = =

= $2.55 per share

Investor Ratios
1. Degree of financial leverage = = Earnings before interest and taxes Earnings before taxes $303,030 + $10,000 $303,030

= 1.033 The degree of financial leverage is the factor by which net income will change with a change in earnings before interest and taxes. The degree of financial leverage indicates the leverage factor for recurring earnings. 2. Earnings per share = = Net income - Preferred dividends Weighted average number of common shares outstanding $200,000 - $0 100,000 shares

= $2/share 3. Price/earnings ratio = = Market price per share Diluted earnings per share $12 $2

= 6 This statistic indicates the investment potential of an enterprise; a rise in this ratio indicates that investors are pleased with the firm's opportunity for growth.

4.

Dividend payout ratio = =

Dividends per common share Diluted earnings per share $0.80 $2

= 40% This ratio indicates the portion of current earnings being paid out in dividends. 5. Dividend yield = = Dividends per common share Market price per common share $0.80 $12

= 6.67% This ratio indicates the relationship between dividends and market price. 6. Book value per share = = Total stockholders' equity - Preferred stock Number of common shares outstanding $1,270,000 100,000 shares

= $12.70 This ratio indicates the amount of stockholders' equity that relates to each share of common stock. Note that preferred stock should be stated at liquidity value if other than book value.

Long-term Debt-paying Ability Ratios

1. Debt / Equity = Total liabilities Common stockholders' equity

(20X2) = $1,345,000 / $1,270,000 = 1.06 (20X1) = $1,300,000 / $1,150,000 = 1.13 This ratio indicates the degree of protection to creditors in case of insolvency. The lower this ratio the better the company's position. In Gi's case, the ratio is very high, indicating that a majority of funds come from creditors. However, the ratio is improving. 2. Debt ratio = Total liabilities Total assets

(20X2) = $1,345,000 / $2,615,000 = 51.4% (20X1) = $1,300,000 / $2,450,000 = 53.1% This debt ratio indicates that more than half of the assets are financed by creditors. 3. Times interest earned = = Recurring income before taxes and interest Interest $303,030 + $10,000 $10,000

= 31.30 times This ratio reflects the ability of a company to cover interest charges. It uses income before interest and taxes to reflect the amount of income available to cover interest expense. 4. Operating cash flow / Total debt = = Operating cash flow Total debt $255,000 $1,345,000

= 18.96% This ratio indicates the ability of the company to cover total debt with yearly cash flow.