FINANCIAL STATEMENT
ANALYSIS
RATIO ANALYSIS
prof.dr hab. Magdalena
Jerzemowska
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
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
(CA- I)/CL
- is a liquidity indicator that further refines
the current ratio by measuring the amount
of the most
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
and the
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
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
/sales
ratio,
/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
its
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
(
) 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
. While the parts are the
same - receivables,
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.