FINANCIAL STATEMENT

ANALYSIS

RATIO ANALYSIS

prof.dr hab. Magdalena

Jerzemowska

Financial Statement

• A

financial statement

(or

financial

report

) is a formal record of the

financial activities of a business,
person, or other entity.

• For a business enterprise -

all the

relevant financial information

,

presented in a structured manner and
in a form easy to understand.

Financial Statements

• Balance sheet

(BS):

(also referred to as

statement of financial position or condition)

reports on a company's assets, liabilities,

and ownership equity at a given point in

time.

• Income statement

(PLA):

(also referred to

as Profit and Loss statement) provides

information on the operation of the

enterprise, reports on a company's income,

expenses, and profits over a period of time.

Financial Statements

• Statement of Owner's Equity

shows the

change in owner's equity during a given

time period. Additions come from owner

investments and income; subtractions
from owner withdrawals and losses.

• Statement of cash flows:

reports on a

company's cash flow activities, particularly

its operating, investing and financing

activities. Indicates whether enough cash

is available to carry on routine operations.

Financial Statements

• For large corporations, these

statements are often complex and

may include an extensive set of notes

to the financial statements and

management discussion and analysis.

• Notes to financial statements are

considered an integral part of the

financial statements.

RATIO ANALYSIS

Ratio analysis is a diagnostic tool that

helps to identify problem areas and

opportunities within a company.

Ratio Analysis involves methods of

calculating and interpreting financial

ratios in order to assess a firm's

performance and status

Purpose of financial

statements

• is

to provide information about the

financial position, performance and

changes in financial position of an

enterprise that is useful to a wide range

of users in making economic decisions.

Financial statements should be

understandable, relevant, reliable and

comparable.

Identification of the user

• The IASB Framework states:

The

objective of financial statements

is to

provide information … that is useful to a wide

range of users in making economic decisions.

• Owners, prospective investors and

managers

require financial statements to

make

important business (investment)

decisions

(buy/sell/hold) that affect its

continued operations.

Financial statements - users

• Employees

they need to be able to assess the stability

and performance of the entity in order to assess how

reliable it is to be employed in it in the longer term.

• Suppliers

- interested in information that helps them to

decide whether or not to supply goods or services to an
entity.

• Lenders and potential lenders

- are interested in

assessing whether or not the loans that they have made

are likely to be repaid, and whether or not the related

interest charge will be paid in full and on time.

Financial statements - users

• Customers

- interested in assessing the risks

which threaten their supplier.

• Government entities

require special-purpose

reports, especially tax computations, general-

purpose reports- statistics.

• Media and the general public

are also interested

in financial statements for a variety of reasons.

THE USE OF FINANCIAL RATIOS

– Financial Ratio are used as a relative

measure that facilitates the evaluation of
efficiency or condition of a particular
aspect of a firm's operations and status

- Ratios also allow for better comparison

through or time between companies.

Standards and regulations

•

Different countries have developed their own

accounting principles

over time, making international

comparisons of companies difficult.

•

Recently there has been a push towards standardizing

accounting rules made by the International

Accounting Standards Board ("IASB"). IASB develops

International Financial Reporting Standards that have

been adopted by e.g.Australia, Canada and the

European Union (for publicly quoted companies only)

•

It ensures

uniformity and comparability

between

financial statements prepared by different companies

( a set of guidelines and rules).

Financial statement analysis

…

is the application of analytical tools and

techniques to general-purpose financial

statements and related data to derive

estimates and inferences useful in business

analysis.

…

refers to an assessment of the viability,

stability and profitability of a business.

…

decreases the uncertainty of business

analysis, and provides a systematic and

effective basis for it.

Comparability problems

(Accounting risk )

1. Lack of uniformity

in accounting leads

to comparability problems.

2.

Discretion and imprecision

in accounting can

distort financial statement information(

errors, omissions

).

3. Managers might use their discretion in accounting
to manipulate or

window-dress

financial statements.

Methods of financial

statements

analysis

• Horizontal analysis

–

a comparison of

financial statement items over a period of
time.

• Vertical analysis

–

a comparison of

various financial statement items within a
single period with the use of commonsize
statements.

Financial Statements Analysis

• Common-Size Balance Sheets

(

Vertical)

– Compute all accounts as a percent of total assets

• Common-Size Income Statements

– Compute all line items as a percent of sales

Standardized statements make it easier to compare

financial information, particularly as the company
grows.

They are useful for comparing companies of different

sizes, particularly within the same industry.



An approach that views all aspects of the

firm's activities to isolate key areas of

concern



Ratios are not very helpful by themselves:

they need to be compared to something



Comparisons are made to industry standards

(

cross-sectional analysis

)



Comparisons to the firm itself over time are

also made

(

time-series analysis

)



Combined Analysis

Types of Ratio Comparisons

19

Benchmarking Financial

Ratios

Financial ratios are not very useful on a

stand-alone basis; they must be

benchmarked against something. Analysts

compare ratios against the following:

1.The Industry norm

–most common type

of comparison. Analysts will look for

companies within the same industry and

develop an industry average, which they

will compare to the company they are

evaluating.

Benchmarking Financial Ratios

2. Aggregate economy

- It is sometimes

important to analyze a company's ratio over a
full economic cycle. This will help the analyst
understand and estimate a company's
performance in changing economic conditions,
such as a recession.

3. The company's past performance

– This is a

very common analysis. It is similar to a time-
series analysis, which looks mostly for trends
in ratios.

Words of Caution Regarding Ratio

Analysis



A single ratio rarely tells enough to make
a sound judgment.



Financial statements used in ratio analysis
must be from similar points in time.



Audited financial statements are more
reliable than unaudited statements.



The financial data used to compute ratios
must be developed in the same manner.



Inflation can distort comparisons.

HarperCollins Publishers

Copyrigh
t

Ratio Analysis

• As we look at each ratio, ask yourself:

– How is the ratio computed?
– What is the ratio trying to measure and

why?

– What is the unit of measurement?
– What does the value indicate?
– How can we improve the company’s ratio?

Groups of Financial Ratios



Liquidity



Activity



Debt



Profitability



Capital Market Ratios

They inform how well the firm is

doing

1994, HarperCollins Publishers

Copyrigh
t

Analyzing Liquidity



Liquidity - the ability of the firm to
meet its short-term obligations as
they come due.



A second meaning includes the
concept of converting an asset into
cash with little or no loss in value
(cost, time).

1994, HarperCollins Publishers

Copyrigh
t

Three Important Liquidity

Measures

Net Working Capital (NWC)

NWC = Current Assets - Current

Liabilities

Current Ratio (CR)

Current Assets

CR =

Current Liabilities

Quick (Acid-Test) Ratio (QR)

Current Assets - Inventory

QR =

Current Liabilities

Net Working Capital

A measure of both a company's efficiency

and its short-term financial health.

Net Working Capital ≡

Current Assets – Current Liabilities

NWC usually grows with the firm

Short-Term Asset Management

How should

short-term

assets be

managed and

financed?

Net

Working

Capital

Shareholde

rs’ Equity

Current

Liabilities

Long-Term

Debt

Current

Assets

Fixed

Assets

1 Tangible

2

Intangible

Net Working Capital

• Positive working capital

means that the company is

able to pay off its short-term liabilities.

•  

Negative working capital

means that a company

currently is unable to meet its short-term liabilities

with its current assets (cash, accounts receivable

and inventory).

• A

declining working capital ratio

over a longer time

period could also be a red flag that warrants

further analysis.

CC C Balance Sheet

($ in thousands)

Assets

2007

2008

Change

Cash & equivalents

683

1638

955

Short –term
investments

966

207

-759

Accounts receivable

2142

2531

389

Inventories

1310

1342

32

Prepaid expenses

752

695

- 57

Total current assets

5853

6413

560

Net plant, property &

equipment

14879

16390

1511

Other long-term assets

966

671

- 295

Total Assets

21698

23474

1776

CC C Balance Sheet

($ in thousands)

Liabilities

2007

2008

Chan

ge

Accounts

payable

4998

6052

1054

Long-term

liabilities

8023

8131

108

Total labilities

13021

14183

1162

Common stock
Retained

earnings

1309
7368

1517
7774

208

406

Total owners’

equity

8677

9291

614

Total liabilities &

owners’ equity

21698

23474 1776

CCC Abbreviated Income Statement

($ in thousands)

Account

2007

2008

change

Sales

23252

25112

1860

Cost of goods
sold

10452

11497

1045

Selling, general
& administrative

6658

7457

799

Depreciation

1156

1112

-44

EBIT

4986

5046

60

Interest

178

178

0

Taxes

1536

1555

19

Net income

3272

3313

41

NWC = CA - CL

• 2007:

5853 – 4998 =

855

• 2008:

6413 – 6052 =

361

• Deviation:

- 494

C

urrent Ratio (CA / CL)

- is used to test a company's 

liquidity

by

dividing current assets by current
liabilities.

- to ascertain whether a company's short-

term assets (cash, cash equivalents,
marketable securities, receivables and
inventory) are readily available to pay off
its short-term liabilities (notes payable,
current portion of term debt, payables,
accrued expenses and taxes).

C

urrent ratio (CA / CL) -

commentary

• The current ratio is used extensively in

financial reporting. However, it can be
misleading in both a positive and
negative sense - i.e., a high current
ratio is not necessarily good, and a low
current ratio is not necessarily bad.

• Banchmarking: 2:1, 1,6-1,8, 1,5 – 2

(overliquidity)

Current ratio = CA / CL

2007:

5853 / 4998 =

1,17 times

2008:

$ 6413/ $6052 =

1,06 times

Deviation:

- 0,11

 

Quick ratio

(CA- I)/CL

- is a liquidity indicator that further refines

the current ratio by measuring the amount

of the most 

liquid

current assets there are

to cover current liabilities.

- It is more conservative than the current

ratio because it excludes inventory and

other current assets, which are more

difficult to turn into cash.

- Banchmarking: 1:1, 0,7 – 0,9.

Q

uick ratio -

(CA- I)/CL

-

commentary:

• beneficial is to compare the quick ratio with
the current ratio. If the current ratio is
significantly higher, it is a clear indication that
the company's current assets are dependent
on inventory.

• both the quick and the current ratios assume
a liquidation of accounts receivable and
inventory as the basis for measuring liquidity.

• as a going concern a company must focus on
the time it takes to convert its working capital
assets to cash - that is the true measure of
liquidity.

Quick Ratio = CA – I / CL

2007:

5853 – 1310 / 4998 =

0, 91

time

2008:

6413 – 1342 / 6052 =

0,84 time

Deviation:

- 0,07

Cash ratio - C / CL

• is an indicator of a company's

liquidity that further refines both
the

current ratio

 and the

quick

ratio

 by measuring the amount of

cash or cash and cash equivalents
there are in current assets to
cover current liabilities.

The cash ratio

- commentary:

•

The cash ratio

-

is the most stringent and

conservative of the three short-term 

liquidity ratios

It looks at the most liquid short-term assets of the

company.

•

Companies do not purposefully maintain high levels

of cash assets to cover current liabilities, as it's

seen as poor asset utilization to hold large amounts

of cash on its balance sheet. This money could be

returned to shareholders or used elsewhere to

generate higher returns.

•

The usefulness of this ratio is limited.

•

Cash Ratio – Cash / CL

• 2007:

683 / 4998 =

0,14

• 2008:

1638 / 6052 =

0,27

• Change:

0,13

Cash Flow Indicator Ratios:

• The nature of accrual accounting is

such that a company may be
profitable but nonetheless experience
a shortfall in cash. Even companies
that appear very profitable can
actually be at a financial risk if they
are generating little cash from these
profits. (not able to pay its
obligations)

Cash Flow Indicator Ratios:

• use cash flow compared to other company

metrics to determine how much cash they
are generating from their sales, the amount
of cash they are generating free and clear,
and the amount of cash they have to cover
obligations.

• We will look at the

operating cash flow

/sales

ratio,

free cash flow

/operating cash flow

ratio and cash flow coverage ratios.

Operating Cash Flow/Sales

Ratio

• The CF statement has three distinct sections, which

relates to a company's cash flow activities - operations,

investing and financing. In this ratio, we use the figure

for operating cash flow.

• This ratio, compares a company's 

operating cash flow

to

its 

net sales

or revenues, which gives investors an idea

of the company's ability to turn sales into cash (%).

•

The greater the amount of operating cash flow, the

better. There is no standard guideline for the operating

cash flow/sales ratio, but the ability to generate

consistent and/or improving percentage comparisons

are positive investment qualities.

Free Cash Flow/Operating Cash

Flow Ratio

Free cash flow

is defined as

operating cash flow

minus capital expenditures

, which, in analytical

terms, are considered to be an essential outflow of

funds to maintain a company's competitiveness and

efficiency.

The

free cash flow

remaining after this deduction

becomes available to a company for expansion,

acquisitions, and/or financial stability.
The higher the percentage of free cash flow

embedded in a company's operating cash flow, the

greater the financial strength of the company.

Free Cash Flow/Operating Cash Flow

Ratio - commentary

Numerous studies have confirmed that
institutional investment firms rank free
cash flow ahead of earnings as the
single most important financial metric
used to measure the investment quality
of a company.

In simple terms, the larger the number the

better.

Cash Flow Coverage Ratios

Capital Expenditure Coverage =
Operating Cash Flow / Capital

Expenditure

Dividend Coverage =
Operating Cash Flow / Cash Dividends

Cash Flow Coverage Ratios

• The larger the operating cash flow coverage for

these items, the greater the company's ability to

meet its obligations, along with giving the

company more cash flow to expand its business,

withstand hard times, and not be burdened by

debt servicing and the restrictions typically

included in credit agreements.

• The dividend coverage ratio provides dividend

investors with a narrow look at the safety of the

company's dividend payment.

• If a company is able to cover capital expenditures

and cash dividends from internal sources and still

have cash left over this circumstance is a highly

favorable investment quality.

Analyzing Activity

• Activity ratios measure different segments of a

company's overall operational performance.

• These ratios look at how well a company turns its

assets into revenue as well as how efficiently a

company converts its sales into cash.

• Basically, these ratios look at how efficiently and

effectively a company is using its resources to generate

sales and increase shareholder value (manangement).

•

In general, the better these ratios are, the better it is

for shareholders.

Inventory Turnover (IT)

Average Collection Period (ACP)

Average Payment Period (APP)

Fixed Asset Turnover (FAT)

Total Asset Turnover (TAT)

Cost of Goods Sold

IT =

Inventory

Accounts

Receivable
ACP =

Annual Sales/365

Accounts

Payable
APP=

Annual

Purchases/365

Sales

FAT =

Net Fixed Assets

Sales

TAT =

Total Assets

Five Important Activity Measures

Five Important Activity

Measures plus

•

Days Sales in Inventory – DSI

Total Asset Turnover

• It compares the turnover with the assets that

the business has used to generate that

turnover.

• It indicates how effectively a firm is using all of

its assets.

• If the ratio is low, the firm is not using its

assets to their capacity and must either

increase the sales or dispose of some of the

assets.

Total Asset Turnover – S/TA

2007

23252 / 21698 =

1,0716

2008

25112 / 23474 =

1,0698

Deviation:

1,0698 – 1,0716 =

-

0,0018

Fixed-Asset Turnover

• This ratio is a rough measure of the

productivity of a company's 

fixed assets

(

property, plant and equipment

) with respect to

generating sales.

• For most companies, their investment in fixed

assets represents the single largest component

of their total assets.

• The higher the yearly turnover rate, the better.

Fixed-Asset Turnover -

commentary

•

There is no exact number that determines whether

a company is doing a good job of generating

revenue from its investment in fixed assets. This

makes it important to compare the most recent

ratio to both the historical levels of the company

along with peer company and/or industry averages.

Before putting too much weight into this ratio, it's

important to determine the type of company that

you are using the ratio on because a company's

investment in fixed assets is very much linked to the

requirements of the industry in which it conducts its

business. Fixed assets vary greatly among

companies.

Fixed-Asset Turnover – S/FA

• 2007

FAT:

23252/14879 =

1,57

• 2008

FAT:

25112 / 16390 =

1,53

Deviation:

- 0,04

Inventory Turnover (

COGS

/I)

• 2007:

10452 : 1310 =

7,98

• 2008:

11497 : 1342 =

8,57

• Deviation

: 8,57 – 7,98 =

0,59

time

Days Sales in Inventory

DSI for CCC ($ millions) :

2007:

(1) cost of sales per day: 10452 ÷ 365 =

28,63

(2) average inventory: 1310
(3) days’ sales in inventory : (I/COGS)365

(

1310

/28,63) =

45, 76 days

2008:

(1) cost of sales per day: 11497 : 365 = 31,50
(2)days’ sales in inventory :

1342

/31,50 =

42,60 days

Deviation

: 42,60 – 45,76 =

- 3,16 days

Inventory Turnover

• The inventory ratios maesure how quickly

inventory is produced and sold.

• A large increase in the ratio of days in

inventory could suggest high inventory of

unsold finished goods.

• The method of inventory valuation can

materially affect the computed inventory

ratios.

Average Collection Period

ACP

for CCC( $ millions) :

2007

(1) sales per day: 23252 ÷ 365 = 63.70
(2) average accounts receivable:

2142

(3)

Average Collection Period

:

2142

: 63.70 =

33,63

days

2008

(1) sales per day : 25112 : 365 = 68,8
(2)

Average Collection Period

:

2531

: 68,8 =

36,79 days

Deviation

: 36,79 – 33,63 =

3,16 days

Average Payment Period

APP

for CCC ($ millions)

2007:

(1) sales per day: 23252 ÷ 365 = 63,70
(2) average accounts payable:

4998

(3) Average Payment Period

:

4998

: 63,70 =

78,46

days

2008:

(1) sales per day: 25112 : 365 = 68,8

(2) Average Payment Period

:

6052

: 68,8 =

87,96 days

Deviation:

87,96 – 78,46

= 9,5days

Commentary

• The receivables turnover ratio and the average

collection period provide some information on
the success of the firm in managing its
investment in accounts receivable.

• The actual value of these ratios reflects the

firm’s credit policy.

• The rule of thumb: The average collection

period should not exceed the time allowed for
payment in the credit terms by more than 10
days.

The Operating Cycle

Expressed as an indicator (days) of
management performance efficiency, the
operating cycle is a "twin" of the

cash

conversion cycle

. While the parts are the

same - receivables, 

inventory

and

payables - in the operating cycle, they are
analyzed from the perspective of how well
the company is managing these critical
operational capital assets, as opposed to
their impact on cash.

Operating Cycle for CCC :

2007

2008

DSI

45, 76

42,60

ACP

33,63

36,79

APP

78,46

87,96

OC

0, 93

- 8,57

Computing OC - Is Shorter Better?

• One would assume that "shorter is

better" when analyzing a company's

operating cycle. It isn't necessarily true.

• There are numerous variables attached

to the management of receivables,

inventory and payables that require a

variety of decisions as to what's best for

the business.

For example, strict (short) payment

terms might restrict sales.

Minimal inventory levels might mean

that a company cannot fulfill orders on a

timely basis, resulting in lost sales.

If a company is experiencing solid sales

growth and reasonable profits, its

operating cycle components should

reflect a high degree of historical

consistency.

Analyzing Debt



Debt is a true "double-edged" sword as it

allows for the generation of profits with the

use of other people's (creditors) money, but

creates claims on earnings with a higher

priority than those of the firm's owners.



Financial Leverage

is a term used to describe

the magnification of risk and return resulting

from the use of fixed-cost financing such as

debt and preferred stock.

12

Prof. Kuhle

Measures of Debt



There are Two General Types of
Debt Measures

– Degree of Indebtedness

– Ability to Service Debts

13

Debt Ratio
(DR)
LTDebt-Equity Ratio
(DER)

Times Interest Earned
Ratio (TIE)

Fixed Payment Coverage

Ratio (FPC)

Total Liabilities

DR=

Total Assets

Long-Term Debt

DER=

Stockholders’ Equity

Earnings Before Interest

& Taxes (EBIT)
TIE=

Interest

Earnings Before

Interest & Taxes +

Lease Payments

FPC=

Interest + Lease

Payments +{(Principal

Payments + Preferred

Stock Dividends) X

[1 / (1 -T)]}

Four Important Debt

Measures

14

The Debt Ratio - commentary:

• It gives users a quick measure of the amount of

debt that the company has on its balance sheet

compared to its assets.

• The higher the ratio the more leveraged the

company is, and the riskier it is.

• Generally, well-established companies can push

the liability component of their balance sheet

structure to higher percentages without getting

into trouble.

Benchmark: 0,57 – 0,67

The Debt Ratio - commentary:

• The use of leverage creats

tax shields

for the

company.

• If the company manages to generate returns

above their cost of capital, investors will

benefit. However, with the added risk of the

debt on its books, a company can be easily

hurt by this leverage if it is unable to

generate returns above the cost of capital.

• Basically, any gains or losses are magnified

by the use of leverage in the company's

capital structure. 

CC Company Balance Sheet

($ in thousands)

Liabilities

2008

2007

Chan

ge

Accounts

payable

6052

4998 1054

Long-term

liabilities

8131

8023 108

Total debt

14183

13021 1162

Common stock
Retained

earnings

1517
7774

1309
7368

208

406

Total owners’

equity

9291

8677 614

Total liabilities &

owners’ equity

23474

21698 1776

The Debt Ratio (TD/TA) for CCC

• 2007:

13021 : 21698 =

60,01%

• 2008:

14183 : 23474 =

60,42%

• Deviation:

60,42% - 60,01% =

0,41%

Debt-Equity Ratio

• It is another leverage ratio that compares a company's

total liabilities to its total shareholders' equity.

• This is a measurement of how much suppliers, lenders,

creditors and obligors have committed to the company

versus what the shareholders have committed.

• A lower the percentage means that a company is using

less leverage and has a stronger equity position.

• Benchmark: 1 : 1

Debt-Equity Ratio for CCC

• 2007

13021 : 8677 =

1,50

• 2008

14183 : 9291 =

1,53

Deviation:

1,53 -1,50 =

0,03

Capital Structure

(Capitalization) Ratio

• Long-term debt is divided by

shareholders’ equity

or the

sum of long-term debt and shareholders'

equity

.

• There is no right amount of debt. Leverage varies

according to industries, a company's line of

business and its stage of development.

• Common sense tells us that low debt and high

equity levels in the capitalization ratio indicate

investment quality.

Capital Structure (Capitalization)

Ratio - commentary:

• A company considered too highly leveraged (too much

debt) may find its freedom of action restricted by its

creditors and/or have its profitability hurt by high

interest costs.

• Positive and negative covenants. The Pecking Order

Theory.

• A company in a highly competitive business, if hobbled

by high debt, will find its competitors taking advantage

of its problems to grab more market share.

Benchmark: 0,5 – 1,0

Capital Structure Ratio for CCC

• 2007

8023 : 8677 =

0,92

• 2008

8131 : 9291 =

0,87

• Deviation

: 0,87 – 0,92 =

- 0,05

Capitalization Ratio for CCC

• 2007

[LTD / (SE +LTD)] x

100%

[8023 : (8677 + 8023)] x 100% =
(8023 : 16700) x 100% =

48,04%

• 2008

[8131 : (9291 + 8131)] x 100% =
(8131 : 17422) x 100% =

46,67%

Deviation:

46,67% - 48,04% =

-1,37%

Times Interest Earned or

I

nterest

Coverage Ratio

• The interest coverage ratio (TIE) is calculated by

dividing a company's EBIT by the company's interest

expenses for the same period.

• It is used to determine how easily a company can

pay interest expenses on outstanding debt.

• The lower the ratio, the more the company is

burdened by debt expense.

• When a company's ICR is only 1.5 or lower, its

ability to meet interest expenses may be

questionable.

Interest Coverage Ratio for CCC

• 2007

(EBIT/I)

4986 : 178 =

28,01

• 2008

5046 : 178 =

28,35

• Deviation:

28,35 – 28,01 =

0,34

Analyzing Profitability

– Profitability measures assess the firm's

ability to operate efficiently and are of
concern to owners, creditors, and
management

– A Common-Size Income Statement,

which expresses each income
statement item as a percentage of
sales, allows for easy evaluation of the
firm’s profitability relative to sales.

15

Profitability Ratios

• In the

income statement

, there are four levels of profit or

profit margins -

gross profit, operating profit, pretax profit

and net profit.

• Current profits can be a poor reflection of true future

profitability.

They ignore risk. (

comparisons among firms

)

• The absolute numbers in the income statement don't tell

very much, and therefore margin analysis is used to

discern a company's true profitability.

• Profit margin

analysis uses the percentage calculation to

provide a comprehensive measure of a company's

profitability on a historical basis (3-5 years) and in

comparison to peer companies and industry benchmarks.

Gross Profit Margin

(GPM)

Operating Profit Margin

(OPM)

Net Profit Margin (NPM)

Return on Total Assets

(ROA)

Return On Equity (ROE)

Earnings Per Share (EPS)

Gross Profits

GPM=

Sales

Operating Profits (EBIT)

OPM =

Sales

Net Profit After Taxes

NPM=

Sales
Net Profit After Taxes

ROA=

Total Assets
Net Profit After Taxes

ROE=

Stockholders’ Equity
Earnings Available for

Common Stockholder’s

EPS =

Number of Shares of

Common

Stock

Outstanding

Six Basic Profitability Measures

16

Profitability Ratios

-

commentary:

• Profitability ratios help to keep score, as measured over

time, of management's ability to manage costs and

expenses and generate profits.

• Profit margin

is an indicator of a company's pricing

policies and its ability to control costs. (low cost or a

high price).

• The ratio's percentage represents the number of pennies

there are in each dollar of sales.

•

Gross Profit Margin

• To obtain the gross profit amount, simply

subtract the cost of sales (cost of goods sold)

from net sales/revenues.

• Generally, operating expenses would include

such account captions as selling, marketing

and administrative, research and

development, depreciation and amortization,

rental properties, etc.

Gross Profit Margin 

A company's

cost of sales

is deducted from the

company's

net sales/revenue

, which results in a

company's first level of profit, or gross profit.

The gross profit margin is used to analyze how

efficiently a company is using its raw materials, labor

and manufacturing-related fixed assets to generate

profits.

A higher margin percentage is a favorable profit

indicator.

Gross Profit Margin for CCC

• 2007

GPM =

(GP/S)x100%

[(23252 -10452) / 23252]x100% =
(12800/23252)x100% =

55,05%

• 2008

[(25112 – 11497) / 25112]x100% =
(13615 / 25112)x100% =

54,22%

Deviation:

54,22% - 55,05% =

- 0,83%

Operating Profit Margin 

By subtracting selling, general and administrative

expenses from a company's gross profit number,

we get operating income.

Positive and negative trends in this ratio are, for

the most part, directly attributable to

management decisions.

A company's operating income figure is often the

preferred metric of investment analysts, versus its

net income figure, for making inter-company

comparisons and financial projections

.

Operating Profit Margin for

CCC

• 2007

OPM =

(EBIT/S)x100%

(4986 : 23252) X 100% =

21,44%

• 2008

(5046 : 25112) X 100% =

20,09%

Deviation:

20,09% - 21,44% =

- 1, 35%

Net Profit Margin

• It is mostly used for internal

comparisons, as it is difficult to
accurately compare the net profit ratio
for different entities.

• A low profit margin indicates a low

margin of safety: higher risk that a
decline in sales will erase profits and
result in a net loss.

Net Profit Margin for CCC

• 2007

NPM =

(NI/S)x100%

(3272 : 23252)x100% =

14,07%

• 2008

(3313 : 25112)x100% =

13,19%

• Deviation:

13,19% - 14,07% =

- 0,88%

Return On Assets

•  ROA gives an idea as to how

efficient management is  at using
its assets to generate earnings.

• As a rule of thumb, investment

professionals like to see a
company's ROA come in at no less
than 5%.

Return On Assets for CCC

• 2007

ROA=(NI/TA)x100%

(3272 : 21698) =

15,08%

• 2008

(3313 : 23474) =

14,11%

Deviation:

14,11% - 15,08% =

- 0,97%

Return On Assets

• Interesting aspect is how some

financial ratios can be linked
together to compute ROA.

• DuPont system of financial control:

ROA =NI /S x S/ATA

• The firms can increase ROA by

increasing profit margins or asset
turnover.

Return On Equity (ROE) -

Commentary

• This ratio indicates how profitable a

company is by comparing its net income to
its average shareholders' equity.

• ROE measures how much the shareholders

earned for their investment in the company.

• The higher the ratio percentage, the more

efficient management is in utilizing its
equity base and the better return is to
investors.

Return On Equity- Commentary

•

Is highly regarded as a profitability indicator.

Investors need to be aware that a disproportionate

amount of debt in a company's capital structure

would translate into a smaller equity base. Thus, a

small amount of net income (the numerator) could

still produce a high ROE off a modest equity base

(the denominator).

•

The lesson here for investors is that they cannot

look at a company's return on equity in isolation. A

high, or low, ROE needs to be interpreted in the

context of a company's

debt-equity relationship

. The

answer to this analytical dilemma can be found by

using the return on capital employed (ROCE) ratio.

Return On Equity for CCC

• 2007

(3272 : 8677)x100% =

37,71%

• 2008

(3313 : 9291) x100% =

35,66%

Deviation:

35,66% - 37,71% =

- 2,05%

DuPont System of Analysis

– DuPont System of Analysis is an

integrative

approach used to

dissect

a firm's financial

statements and assess its financial condition

– It ties together the income statement and

balance sheet to determine two summary

measures of profitability, namely

ROA

and

ROE.

–

Financial leverage magnifies ROE only when

ROA (gross) is greater than the interest rate on

debt.

17

The Du Pont Identity

• ROE

= NI / TE

• ROE

= (NI / TA) (TA / TE) = ROA * EM

• ROE

= (NI / Sales) (Sales / TA) (TA /

TE)

Using the Du Pont Identity

• ROE =

PM

* TAT *

EM

– Profit margin

is a measure of the firm’s

operating(financial) efficiency

– how

well it controls costs.

– Total asset turnover

is a measure of

the firm’s

asset use efficiency

– how

well it manages its assets.

– Equity multiplier

is a measure of the

firm’s

financial leverage

.

Calculating the Du Pont Identity for

CCC

• 2007

• ROE = NI/TE

ROE =

37, 7%

• ROE = ROA * EM

ROE = 15,08% x 21698/8677= 15,08% x 2,50

=

37,7%

•

ROE = PM * TAT * EM

ROE = 14,07% x 23252/ 21698 x 2,50 =

14,07% x 1,07 x 2,50 =

37,64%

Calculating the Du Pont

Identityfor CCC

• 2008

• ROE = NI/TE

ROE =

35,66%

• ROE = ROA * EM

ROE = 14,11% x 23474/9291 = 14,11% x 2,53
=

35,69%

•

ROE = PM * TAT * EM

ROE = 13,19% x 25112/ 23474 x 2,53 =

13,19% x 1,07 x 2,53 =

35,70%

Return On Capital Employed

• The return on capital employed (ROCE) ratio

complements ROE ratio by adding a company's debt

liabilities to equity to reflect a company's total

"capital employed".

• By comparing net income to the sum of a company's

debt and equity capital, investors can get a clear

picture of how the use of leverage impacts a

company's profitability.

• Financial analysts consider the ROCE measurement

to be a more comprehensive profitability indicator

because it gauges management's ability to generate

earnings from a company's total pool of capital.

Return On Capital Employed

Earnings per Share (EPS)

• The portion of a company's profit allocated to

each outstanding share of common stock.

•  Earnings per share serves as an indicator of a

company's profitability.

• When calculating, it is more accurate to use

a weighted average number of shares

outstanding over the reporting term, because

the number of shares outstanding can change

over time.

• Diluted EPS expands on basic EPS by

including the shares of convertibles or warrants

outstanding in the outstanding shares number.

Price-to-Earning Ratio

(P/E)

• A valuation ratio of a company's current share

price compared to its per-share earnings.

• A high P/E suggests that investors are

expecting higher earnings growth in the

future compared to companies with a lower

P/E.

• It shows how much investors are willing to

pay per dollar of earnings.

Dividend Payout Ratio

• This ratio identifies the

percentage of earnings (net
income) per common share
allocated to paying cash dividends
to shareholders.

• The dividend payout ratio is an

indicator of how well earnings
support the dividend payment.

Dividend Payout Ratio

Dividend Payout Ratio -

Commentary

• You only use this ratio with dividend-

paying companies. Investors in
dividend-paying stocks like to see
consistent and/or gradually
increasing dividend payout ratios.

• It should also be noted that

exaggerated (i.e. very high) dividend
ratios should be looked at skeptically.

Dividend Payout Ratio

• Dividend payout ratios vary widely

among companies. Stable, large,
mature companies (i.e. public utilities
and "blue chips") tend to have larger
dividend payouts.

• Growth-oriented companies tend to

keep their cash for expansion
purposes, have modest payout ratios
or choose not to pay dividends.