RATIO ANALYSIS

Activity Analysis

Operating activities require investments in both short term (inventory and accounts receivable and long!term assets" Activity ratios describe the relationship bet#een the $irm%s level o$ operations (usually de$ined as sales and the assets needed to sustain operating activities" &igher the ratio' the more e$$icient the $irm%s operations' as relatively $e#er assets are required to maintain the given level o$ operations (sales

 These

ratios do not measure pro$itability and liquidity directly" &o#ever' they are important $actors a$$ecting those per$ormance indicators" (or e)ample' lo# inventory turnover results in high carrying costs that reduce pro$its and declining inventory turnover should also alert the analyst to an increased probability o$ $alling demand"

Activity ratios can also be used to $orecast a $irm%s capital requirement (both operating and long! term " Increases in sales #ill require investments in additional assets" Activity ratios enable the analyst to $orecast these requirements and to assess the $irm%s ability to acquire the assets needed to sustain the $orecasted gro#th"

Turnover Ratios

Inventory Turnover* +ost o$ goods sold,Average inventory It measures the e$$iciency o$ the inventory management" This ratio is a$$ected by the accounting method" Average number o$ days inventory in stoc- * ./0,Inventory turnover It sho#s the average number o$ days inventory is held until it is sold"

1ebtors Turnover

1ebtors% Turnover* Net credit sales,Average sundry debtors Average collection period* Average sundry debtors,Average credit sales Or * ./0,1ebtors turnover 2easure the e$$ectiveness o$ the $irm%s credit policies Indicate the level o$ investment in receivables needed to maintain the $irm%s sales level"

Accounts 3ayable Turnover

Accounts Average OR

payable turnover* +ost o$ goods sold,Average accounts payable payable days outstanding* Accounts payable,Average daily cost o$ goods sold ./0, 3ayables turnover represent an important source o$ $inancing $or operating activities"

They

4or-ing capital turnover

Net #or-ing capital turnover * Net sales,Average net operating #or-ing capital Re$lects the amount o$ operating capital needed to maintain a given level o$ sales" Only operating assets and liabilities should be used to compute this measure" Short!term debt' mar-etable securities and e)cess cash should be e)cluded as they are not required $or operating activities"

 (i)ed Total

assets turnover * Net sales,Average net $i)ed assets assets turnover* Net sales,Average total assets the level o$ sales generated by investments in productive capacity"

Re$lect

Startup companies% initial turnover may be lo# as their level o$ operations is belo# their productive capacity" As sales gro#' ho#ever' turnover #ill continually improve until the limits o$ the $irm%s initial capacity are reached" Subsequent increases in capital investment decrease the turnover ratio until the $irm%s sales gro#th catches up to the increased capacity" This process continues until maturity #hen sales and capacity level o$$' only to reverse #hen the $irm enters its decline stage"

 Additional

problems can result $rom the timing o$ a $irm%s asset purchases" T#o $irms #ith similar operating e$$iciencies' having the same productive capacity' and the same level o$ sales' may sho# di$$ering ratios depending on #hen their assets #ere acquired" The $irm #ith older assets has the higher turnover ratio' as accumulated depreciation has reduced the carrying value o$ its assets" Overtime' $or any $irm' the accumulation o$ depreciation e)pense improves the turnover ratio ($aster $or $irms that use accelerated depreciation methods or short term depreciable lives #ithout a corresponding improvement in actual e$$iciency" The use o$ gross rather than net $i)ed assets alleviates this shortcoming"

Ne#er assets generally operate more e$$iciently due to improved technology" 5ut due to in$lation' ne#er assets may be more e)pensive and thus decrease the turnover ratio" 6sing the replacement cost rather than historical cost to compute the turnover ratio is one solution to the problem" 2ethods o$ acquisition (lease versus purchase and subsequent $inancial reporting choices (capitali7ation versus operating lease reporting also a$$ect turnover ratios $or other#ise similar $irms"

Operating cycle
Operating To

cycle is the sum o$ number o$ days it ta-es to sell inventory and the number o$ days until the resulting receivables are converted to cash" the e)tent a $irm uses credit' the length o$ the cash (operating cycle is reduced" Subtracting the number o$ days o$ payables outstanding $rom the operating cycles results in the $irm%s cash cycle' the number o$ days a $irm%s cash is tied up by its current operating cycle" a great e)tent' industry $actors may determine the length and components o$ the cash cycle" Some $irms may actually have negative cash cycles"

To

Liquidity Ratios

+urrent Ratio* +urrent Assets,+urrent Liabilities A more conservative measure o$ liquidity is the quic- ratio" Acid!test Ratio (8uic- ratio * 8uic- assets,+urrent liabilities

This e)cludes inventory and prepaid e)penses' recogni7ing that the conversion o$ inventory to cash is less certain both in terms o$ timing and amount and that prepaid e)penses re$lect past cash out$lo#s rather than e)pected in$lo#s" The most conservative o$ the measures o$ cash resources is the cash ratio" +ash ratio * (+ash and mar-etable securities ,+urrent liabilities These ratios measure the margin o$ sa$ety provided by the cash resources relative to obligations rather than e)pected cash $lo#s"

+ash $lo# $rom operations ratio* +ash $lo# $rom operations,+urrent liabilities It measures liquidity by comparing actual cash $lo#s (instead o$ current and potential cash resources #ith current liabilities" This ratio avoids the issues o$ actual convertibility to cash' turnover' and the need $or minimum levels o$ #or-ing capital (cash to maintain operations" 6nli-e the cash cycle liquidity measure' #hich re$lects the number o$ days cash is tied up in the $irm%s operating cycle' there is no intuitive measure' #hich re$lects the number o$ days cash is tied up in the $irm%s operating cycle' there is no intuitive meaning to a current ratio o$ 9"0" (or some companies that ratio #ould be high' $or others dangerously lo#"

1e$ensive interval* ./0 : ;+ash < 2ar-etable securities < Accounts receivables ,3ro=ected e)penditure> It provides an intuitive $eel $or a $irm%s liquidity" It compares the currently available quic- sources o$ cash #ith the estimated out$lo#s needed to operate the $irm? pro=ected e)penditure" It represents the #orst!case scenario indicating the number o$ days a $irm could maintain the current level o$ operations #ith its present cash resources but #ithout considering any additional revenues"

+ash 5urn Rate

+ash burn ratio measures the ho# much cash the $irm consumes over a given period o$ time and consequently estimates the number o$ days (de$ensive interval the company can survive #ith the cash it has raised $rom its investors (private placement or I3O " (or startup companies #ith no revenues' only cash e)penditures matter" (or such companies' the ratio' in e$$ect' measures ho# much time the company has until it must have a #or-ing business model"

Solvency Analysis

Analysis o$ a $irm%s capital structure is essential to evaluate its long! term ris- and return prospects" Leveraged $irms accrue e)cess returns to their shareholders as long as rate o$ return on investments $inanced by the debt is greater than the cost o$ debt" The bene$its o$ $inancial leverage bring additional ris-s' ho#ever' in the $orm o$ $i)ed costs that adversely a$$ect pro$itability i$ demand and pro$it margins decline" 2oreover' the priority o$ interest and debt claims can have a severe negative impact on a $irm #hen adversity stri-es" The inability to meet these obligations can lead to de$ault and possible ban-ruptcy"

1ebt +ovenants
To

protect themselves' creditors o$ten impose restrictions on the borro#ing company%s ability to incur additional debt and ma-e dividend payments" These debt covenants are o$ten based on #or-ing capital' cumulative pro$itability' and net #orth" It is there$ore' important to monitor the $irm to ensure that ratios comply #ith levels speci$ied in the debt agreements" @iolation o$ debt covenants are $requently an Aevent o$ de$ault% under loan agreements' ma-ing the debt due immediately" 4hen covenants are violated' borro#ers must either repay the debt (not usually possible or obtain #aivers $rom lenders" Such #aivers o$ten require additional collateral' restrictions on $irm operations' or higher interest rates"

Leverage Ratios

1ebt!Bquity Ratio* 1ebt,Bquity 1ebt!asset Ratio* 1ebt,Assets (It measures the e)tent to #hich the borro#ed $unds support the $irm%s assets (1ebt,Assets * (1ebt,Bquity < 1ebt 2any lenders de$ine debt as equal to total liabilities" As #ith other ratios' industry and economy #ide $actors a$$ect both the level o$ debt and the nature o$ debt (maturities and variable or $i)ed rate " +apital intensive industries tend to incur high levels o$ debt to $inance their property' plant and equipment" Such debt should be long!term to match the long time hori7on o$ the assets acquired"

An important measurement issue is #hether to use boo- or mar-et values to compute ratios" @aluation models that use leverage ratios as inputs are generally based on the mar-et value o$ debt and equity" 5ut the debt o$ $irm #hose credit rating declines may have a mar-et value #ell belo# $ace amount" Total debt at boo- value,Bquity at mar-et I$ the mar-et value o$ equity is higher than its boo- value' the above ratio #ill be lo#er than the debt!to!equity ratio using boo- value" This indicates that mar-et perceptions o$ the $irm%s earning po#er #ould permit the $irm to raise additional capital at an attractive price" I$ this ratio' e)ceeds the boo- value debt!to!equity measure' it signals that the mar-et is #illing to supply additional capital only at a discount to boo- value"

Interest +overage Ratios

1ebt

equity ratios e)amine the $irm%s capital structure and' indirectly' its ability to meet current debt obligations" A more direct measure o$ the $irm%s ability to meet interest payments is interest coverage ratio

Interest coverage ratio* B5IT,Interest or * (B5IT < 1epreciation ,Interest 1ebt service coverage ratio *;BAT < 1epreciation < other non! cash charges < Interest on term loan <lease rentals>,(Interest on term loan < lease rentals < Repayment o$ term loan +overage ratios may also be computed using ad=usted operating cash $lo#s (+ash $rom operations < $i)ed charges < ta) payments as the numerator

+(O to 1ebt

A $irm%s long!term solvency is a $unction o$ its ability to? (inance the replacement and e)pansion o$ its investment in productive capacity as #ell as generate cash $or debt repayment" +apital e)penditure Ratio * +ash $rom operations (+(O ,+apital B)penditures It measures the relationship bet#een the $irm%s cash generating ability and its investment e)penditure" To the e)tent the ratio e)ceeds one' it indicates the $irm has cash le$t $or debt repayment or dividends a$ter capital e)penditures"

 +(O It

to 1ebt * +(O,Total 1ebt

measures the coverage o$ principal repayment requirements by the current +(O" A lo# ratio could signal a long!term solvency problem' as the $irm does not generate enough cash internally to repay its debt"

3ro$itability Analysis
Bquity

investors are concerned #ith the $irm%s ability to generate' sustain' and increase pro$its" can be measured in several di$$ering but interrelated dimensions

3ro$itability

Cross pro$it margin * Cross pro$it,Net sales (Sho#s the margin le$t a$ter meeting manu$acturing costs" It measures the e$$iciency o$ production as #ell as pricing A pro$it margin measure that is independent o$ both the $irm%s $inancing and ta) position is the? B5IT,Sales Overall 3ro$it margin is net o$ all e)penses? Net pro$it margin* Net pro$it,Net sales (sho#s the earnings le$t $or shareholders as a percentage o$ net sales" It measures the overall e$$iciency o$ the business" Dointly considered' the gross and net pro$it margin ratios enable you to identi$y the sources o$ business e$$iciency,ine$$iciency " Operating pro$it 2argin * Net operating pro$it a$ter ta) ,Sales

Return on Investment

Return on net operating assets* NO3AT,Average net operating assets Net operating assets(NOA * Operating assets E Operating liabilities Operating assets are those necessary to conduct the business and include cash' accounts receivable' inventories' prepaid e)penses' de$erred ta) assets' property' plant and equipment and long term investments related to strategic acquisitions (such as equity method investments' good#ill' and acquired intangible assets " Operating liabilities are accounts payable' accrued e)penses' and long term operating liabilities such as pensions and other postretirement liabilities and de$erred income ta) liabilities" (Alternatively Net operating assets* Net $inancial obligations < stoc-holders% equity Net $inancial obligations* Non!operating liabilities (bonds and other long!term interest!bearing liabilities and the noncurrent portion o$ capitali7ed leases Operating income* sales E (cost o$ goods sold < operating e)penses such as selling' general and administrative e)penses and income ta)es Items e)cluded $rom NO3AT include interest income and e)pense' dividend revenue' non!operating investment gains and losses' and income or loss $rom discontinued operations

 ROI

ratios that use total assets in the denominator should al#ays include total earnings be$ore interest in the numerator" As interest is ta) deductible' post!ta) pro$it measures should add bac- net!o$!ta) interest payments on assets* 3ro$it a$ter ta),Average total assets po#er* 3ro$it be$ore interest and ta),Average total assets FNO3AT* B5IT (9!t G on equity * (3ro$it a$ter ta)! pre$erence dividend ,Average equity on capital employed* Net operating pro$it a$ter ta),Average total assets

Return

Barning Return Return

Operating and (inancial Leverage

3ro$itability ratios imply that pro$its are proportional to sales' #hich may misstate the true relationship among sales' costs' and pro$its" Cenerally' a doubling o$ sales #ould be e)pected to double income only i$ all e)penses #ere variable" Leverage' #hich is the proportion o$ $i)ed costs in the $irm%s overall cost structure' can be subdivided into $i)ed operating costs that re$lect operating leverage (the proportion o$ $i)ed operating costs to variable costs ' and $i)ed $inancing costs or $inancial leverage" Leverage trades ris- $or return" Increases in $i)ed costs are ris-y because they must still be paid as demand declines' depressing the $irm%s income" At high levels o$ demand' $i)ed costs are spread over a larger base' enhancing pro$itability"

+ontribution margin ratio is a use$ul measure o$ the e$$ects o$ operating leverage on the $irm%s pro$itability" +ontribution margin ratio * +ontribution,Sales

This ratio indicates the incremental pro$it resulting $rom a given dollar change in sales" Operating leveraging e$$ect (OLB * +ontribution,Operating income (or +ontribution margin ratio,Return on sales 4hen OLB is greater than 9' operating leverage is present" The OLB is a relative measure and varies #ith the level o$ sales" The OLB can be used to estimate the percentage change in income (and ROA resulting $rom a given percentage change in sales volume" H +hange in income* OLB : H change in sales

(inancial leverage e$$ect * Operating income,Net income Total leverage e$$ect * OLB : (LB * +ontribution,Net income (irms #ith high operating leverage ta-e on high $inancial leverage only at their peril" Traditionally' high debt ratios have been considered acceptable only $or $irms #ith lo# operating leverage or #ith stable operations' #here the ris- o$ combining operating and $inancial leverage #as lo#"

@aluation ratios

3,B Ratio* 23,B3S B@!B5IT1A ratio* Bnterprise value,B5IT1 B@ is the sum o$ the mar-et value o$ the equity and debt (It re$lects the pro$itability' gro#th' ris-' liquidity and corporate image 2ar-et price!5oo- value per share Ratio 8 Ratio* 2ar-et value o$ equity and liabilities,Bstimated replacement cost o$ assets

Bquity gro#th rate* (Net income E pre$erred dividends E +ommon dividend ,Average common equity Sustainable equity gro#th rate* Return on common equity (RO+B :(9!3ayout rate Return on net operating assets* Operating pro$it margin : Net operating asset turnover Operating pro$it margin* NO3AT,Sales Net operating assets turnover* Sales,Average net operating assets

The interrelationships among ratios have important implications $or analysis" 1isaggregation o$ a ratio into its component elements allo# us to gain insight into $actors a$$ecting a $irm%s per$ormance" Ratio di$$erences can highlight the economic characteristics and strategies o$? Same $irm over time (irms in the same industry (irms in di$$erent industries (irms in di$$erent counties

 1isaggregation ROA* The

o$ ROA

Total Asset Turnover : Return on Sales

$irm%s overall pro$itability is the product o$ an activity ratio and a pro$itability ratio" A lo# ROA can result $rom lo# turnover' indicating poor asset management' lo# pro$it margins' or a combination o$ both $actors"

Ratios

* )

1isaggregation o$ ROA
ROA *

Total Asset Turnover ) Return on sales * )

1isaggregation o$ RO3B and its relationship to ROA

ROB * ROA < ; (ROA E +ost o$ 1ebt : > ROB * (ROA ! )

ROB * 3ro$itability ) Activity ) Solvency * ) ) ) ) *

Trends in ROB and ROA

ROB

* ROA : )

Three E+omponent 1isaggregation o$ ROB

(Profitability x Turnover) X Solvency = ROE

x = x

(iveE+omponent 1isaggregation o$ ROB

(Profitability x Turnover)
Taxes Financing Operations

Solvency

= ROE

=
x