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Ratio Analysis

Ratio Analysis

CMGT/577– CIS Business Financial Management

Before beginning an analysis of a company it is necessary to have a complete set of financial statements, preferably for the pas few years so that historical trends can be obtained. Ratios are a way for anyone to get an idea of the financial performance of a company by using the information contained in the financial statements. Ratios are grouped into four basic categories, liquidity, activity, profitability, and financial leverage. This document will use a variety of these ratios to analyze the firm, Sample Company, as of December 31,2000.

The ratios returns on investment (ROI) and return on equity (ROE) are two of the most popular measure of profitability of a company and, along with the P/E ratio, have the most significant value of any of the ratios. The DuPont Model expands on the ROI calculation by inserting sales and it’s relationship to the companies’ generation of profits and utilization of assets into the calculation. Additional profitability ratios include the price earnings ratio (P/E), the dividend payout and the dividend yield. The price earnings ratio helps to indicate to investor how expensive the shares of common stock of a firm are. Dividend yield is part of the stockholders ROI and is represented by the annual cash dividend. Dividend yields have historically been between 3% to 6% for common stock and 5% to 8% for preferred stock. Dividend payout ratio shows the proportion of the earnings paid to common shareholders. Dividend payout for manufacturing companies range from 30% to 50%, but can vary widely.

Dupont Analysis (ROI) - Return on Investment

The return on Investment (ROI) is important because it describes the rate of return the company was able to make on its assets. The ROI, use net income or operating income, as amount of return and average total assets as the amount invested. In general, the average ROI for American merchandising companies is between 8% and 12% when using net income, and average margin is 5% to 10%. When using operating income it is between 10 and 15% and average margin is also 10% - 15%. Asset turnover is another important component of the DuPont model and is usually in the range of 1% to 1.5%

The return on equity conveys the profits of the company as a rate of return on the amount of owners’ equity. ROE uses average owners equity over the specified time period and net income. Historically a ROE of between 10% and 15% were considered average. Recently higher rates in growth industries have been greater.

In general, the higher the ROI and rate of earnings growth, the higher the P/E. . In the past, for a very long period of time P/E ratios in the range of 12 to 18 were consider good P/E ratios for a company. In recent years, the 12 to 18 values have been abandoned as a norm and what can be considered the norm now is under debate.

Sample Companies’ Profitability Ratios

ROI for Sample CO. is $350 / $7,196 = 4.8% using net income. If operating Income is used we have $498 / $7,196 = 6.9%. An additional measure used for ROI is the DuPont Model. The DuPont model figures are ($498 / $8,251) * ($8,251 / $7,196) = 6.0% using operating income. These are somewhat low when compared to the average.

ROE is $350 / $3,357 = 10.4% and is also below average. The P/E ratio is $42 / $3.51 = 12, which seems very good, and the dividend payout ratio is 14.2%

Activity measures of Inventory turnover, number of days sales in AR, and turnover in building, equipment, and land, look at the relationship between asset levels and sales. They indicate how efficiently a firm is using its assets in relation to its’ ROI.

Inventory turnover uses costs of good sold / average inventory and is an indicator of the efficiency of the firms’ management practices. Because inventories are carried at cost, not selling price, costs of goods sold is use in the calculation.

Number of days in accounts receivable is an indication of how well the companies collection policies are. The faster they can collect on what they are owed the faster they can put that money to use. Number of days in AR is accounts receivable by average days sales.

Sample Companies’ Profitability Ratios

Inventory turnover for Sample CO. is $6,523 / (($1,323 +$1,211)/2) = 5.1 times. Number of day’s sales in AR is $22.6 / 365 = 96.2. To know if these numbers are significant requires a look at the historical trend. Generally the higher the turnover or a lower number of days sales in AR the greater the efficiency.

Two main financial leverage measures are debt ratio and debt/equity ratio. These indicate the extent that the firm is using financial leverage. The higher the ratios the more risk the company is exposing itself to, especially as the return on investment falls closer to the cost of borrowing. As a rule, most companies will keep the debt in their capital structure to a maximum of 50% of the total capital.

The debt ratio is simply the ratio of total liabilities to the total liabilities and owners equity.

The debt equity ratio is the ratio of total liabilities to the total and owners equity only.

Sample Companies’ Profitability Ratios

The debt ratio for Sample Co. is $1,287 / $4,852 = 26.5% and the debt to equity ratio is $1,287 / $3,565 = 36.1%. Both these ratios are well below the 50% guideline.

Liquidity is a firm’s ability to meet its current obligations. It is measured by the relationship of it s current liabilities and assets from the balance sheet. Firms that are termed liquid generally have enough cash to pay their upcoming payments. These ratios are the working capital, current ratio, and the acid-test ratio. The working capital ratio should Ideally, they should be 2.0 and 1.0 respectfully, but being lower could mean that the company is trying to reduce the cash, AR, and inventories because these are not very productive investments.

Working Capital is the excess of the firm’s current assets over its current liabilities or put another way, current assets less current liabilities. Firms with a positive working capital are generally said to be in good financial health. It is also an indicator of the firms’ ability to meet its obligations

The Current ratio is simply the current assets divided by current liabilities, generally the higher the ratio the better indication of a companies debt paying ability. At any given period, the current ratio may not have a lot of meaning. It is the trend of this ratio over time that is significant is judging the firms ability to pay its bills.

The acid-test ratio is a better, more conservative measure of liquidity. It basically shows whether or not a firm can pay its’ bills in the event that none of its’ inventory can be sold.

Sample Companies’ Profitability Ratios

For Sample Co. the working capital is $4,006 – $2,758 = $1,248, the current ratio is $4,006 / $2,758 = 1.45, and the acid test ratio is $155 + $2,174 / 2,758 = .84.

Both the current ratio and the acid-test ratio are slightly low. Ideally, the current ratio should be 2.0 and the acid-test around 1.0.

Clearly trends are another important factor here. The company has good points and some not so good points. Taken as a single snapshot some of the ratios can be very misleading. Many of the ratios, particularly the activity ratios, should be assessed over time in order to verify their meaning.

For our Sample Co. there are several ratios that are low, for the average manufacturing company. The ROI and ROE are below average as are the current ratio and the acid-test ratio. The P/E ratio is $42 / $3.51 = 12, which seems very good and both the debt ratio and debt to equity ratio are within the guideline. With the good and bad of these ratios hard to tell what sort of industry this is. With the ROI, ROE, and acid-test low like they are it doesn’t seem like a retailer/merchandising company, and a e-commerce for 2000 would probably have a P/E greater than 12. What that leaves is an international service company of some kind, so I’ll go with that.

Marshall, D. H., McManus, W. W, & Viele, D. (2002). Accounting: What the Numbers Mean. 5th ed. San Francisco: Irwin/McGraw-Hill.

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