financial ratios

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Compound & Prosper

GEK2507Frederick H. Willeboordse

[email protected]

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Financial Ratios

Lecture 5

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Excel

Liquidity Ratios

Efficiency Ratios

Leverage Ratios

Profitability Ratios

Today’s Lecture

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Excel Basics – DBSyntax:

Note that generally speaking, round-off errors in Excel mean that a small sum is left to be depreciated in the last year. We need to add this manually!

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Excel Basics – DB

Depreciation 30.1%

This method is useful for items like computer etc.

Depreciation 30.1%Depreciation 30.1%

Each year, the rate of depreciation is the same.

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Excel Basics – DDBThe Double declining balance depreciation function is similar to the DB function but the rate of depreciation is faster.

Note that due to the way the depreciation rate is determined, the depreciation in the last year is zero in this example.

Double refers to double the amount of a straight line depreciation to zero here.

Depreciation 40%

Depreciation 40%

Syntax:

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Excel Basics – SLNStraight line depreciation.

Straight line depreciation is good for items that keep their values reasonably well or for items that have a clear economic life span like certain factories.

Syntax:

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Excel Basics – VDBVariable Declining Balance

Note how the depreciation switches from declining balance to straight line at this point. This happens when the SLN of the remaining amount is larger than the DDB.

Syntax:

Depreciation 20%Depreciation 20%Depreciation 20%

Fixed Depreciation

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Excel Basics – DDB

Compare this to the previous slide. After 7 years, the amount remaining to be depreciated is $2,517-$1,000 = $1,517. With SLN over the remaining 3 years this would mean $1,517/3 = $506 of depreciation per year. This is indeed bigger than the $503 that one gets by continuing with the DDB.

Depreciation 20%Depreciation 20%Depreciation 20%

Let us consider the same example with the DDB function

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• Current Ratio

• Quick Ratio

Liquidity is a measure of how quickly an asset can be converted to cash.

E.g. Accounts receivable = quite liquidBuilding = not very liquid

There are two important liquidity ratios:

Liquidity Ratios

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Current Ratio:

Under normal circumstances, a company will pay its current liabilities (bills due) with its current assets. The ratio between the two is therefore a good indicator for how well a company can pay its bills.

Current Ratio =Current Assets

Current Liabilities

Liquidity Ratios

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Current Ratio:

A high current ratio means that the company should more easily be able to pay its bills. So that’s good to know if the company owes you money.But … if you’re an investor, too high a current ratio could mean that the company is not using its assets optimally.

Think a bit of it like water in a lake. Good to have some, bad to have none and so-so to have too much.

Liquidity Ratios

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Current Ratio:

Most successful businesses have a current ratio of about 1.5 – 2.0.

Let’s have a look at the Balance Sheet of Lecture 2 again and add the current ratio.

Liquidity Ratios

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A B C D E F G

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6 Assets Ratios:7 Cash and Equivalents 100008 Accounts Receivable 1200 Current 2.29 =G10/G189 Inventory 830010 Total Current Assets 1950011 Plant and Equipment 80012 Accumulated Depreciation 50013 Net fixed assets 30014 Total Assets 19800

15 Liabilities and Owner's Equity16 Accounts Payable 760017 Other Current Liabilities 90018 Total Current Liabilities 850019 Long Term Debt 120020 Total Liabilities 970021 Common Stock 600022 Retained Earnings 410023 Total Shareholder's Equity 1010024 Total Liabilities and owner's Equity 19800

Golden Win Double Dragon InternationalBalance Sheet, As of Dec 31 2000

Pretty good!

Adding Ratios

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Quick Ratio:

While inventories are necessary for many businesses, they may at times be difficult to sell rapidly.It is therefore useful to also consider a current ratio that takes out inventory from the Current Assets.

Quick Ratio =Current Assets - Inventories

Current Liabilities

Liquidity Ratios

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Quick Ratio:

The quick ratio is sometimes called acid-test ratio.

In general, a quick ratio of 1 is considered safe, but in some industries it may be much lower, e.g. in the car industry, 0.2 is common.

Let us enter this into the Balance Sheet as well…

Liquidity Ratios

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A B C D E F G

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6 Assets Ratios:7 Cash and Equivalents 100008 Accounts Receivable 1200 Current 2.29 =G10/G189 Inventory 8300 Quick 1.32 =(G10-G9)/G1810 Total Current Assets 1950011 Plant and Equipment 80012 Accumulated Depreciation 50013 Net fixed assets 30014 Total Assets 19800



Pretty good too!

Adding Ratios

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As indicated by the name, efficiency ratios indicate how efficient a company is in its operation.Two of the most useful “turnover” ratios are:

Efficiency Ratios

• Inventory Turnover Ratio

• Total Asset Turnover Ratio

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Inventory Turnover Ratio

The inventory turnover ratio indicates how many times the inventory is ‘turned over’ in one year. In other words, it shows how quickly inventory can be sold.

Inventory TurnoverRatio

Cost of Goods Sold

Inventory=

Actually, it would be better to replace Inventory with Average Inventory (defined as beginning inventory + ending inventory)/2.

Efficiency Ratios

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Inventory Turnover Ratio

Let us apply this to our Balance Sheet again.Only … the Cost of Goods sold are not on the Balance Sheet. We need to get this item from the Income Statement in Lecture one.

In general, a higher Inventory Turnover Rate is good but the number may differ greatly per industry. Dell, e.g, is somewhere above 40 but to many around 4 would already be good.

Efficiency Ratios

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A B C D E F G

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6 Assets Ratios:7 Cash and Equivalents 100008 Accounts Receivable 1200 Current 2.29 =G10/G189 Inventory 8300 Quick 1.32 =(G10-G9)/G1810 Total Current Assets 1950011 Plant and Equipment 800 Inventory 0.87 =Income!D7/12 Accumulated Depreciation 500 Balance!G913 Net fixed assets 30014 Total Assets 19800



Quite meager!

But! What happened here???

Adding Ratios

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Excel can have several named worksheets. A worksheet is basically a spreadsheet on a single page with a name.

This means that we can avoid making a complicated single page spreadsheet with an area for the Balance Sheet, and area for the Income Statement and so on.Instead, we can make a separate worksheet for each. In the previous slide, I have added the Income Statement from Lecture 1 as a second worksheet.

Cells from other worksheets can be referred to by using the ! mark.

Interlude – Excel Worksheets

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Total Asset Turnover Ratio

The Total Asset Turnover Ratio shows how well a company is able to generate sales (and hence hopefully profits) from the assets it owns.

It is defined as:

Asset TurnoverRatio

Sales

Total Assets=

Again we need to get the Sales from the Income Statement

Efficiency Ratios

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A B C D E F G

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6 Assets Ratios:7 Cash and Equivalents 100008 Accounts Receivable 1200 Current 2.29 =G10/G189 Inventory 8300 Quick 1.32 =(G10-G9)/G1810 Total Current Assets 1950011 Plant and Equipment 800 Inventory 0.87 =Income!D7/12 Accumulated Depreciation 500 Balance!G913 Net fixed assets 300 Total As. 0.57 =Income!D6/14 Total Assets 19800 Balance!G14



Ouch!?

Adding Ratios

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Leverage in business refers to how much debt a company uses to finance its operations.The idea is that if a company can borrow money at say 7% and then use this money to make a 27% profit, it’s clever to take out the loan.

Two of the most important leverage ratios are:

Leverage Ratios

• Total Debt Ratio

• Debt to Equity Ratio

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Total Debt Ratio

The Total Debt Ratio shows how much of a company’s assets are financed through loans.

It is defined as:

Total DebtRatio

Total Debt

Total Assets=

Leverage Ratios

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Total Debt Ratio

In general, a low Total Debt Ratio is good with the critical number being 1.

Smaller than one means that the company has more assets than debts.

Vice versa, larger than one mean that the company has more debts than assets. If this is the case you’d better hope they will not go out of business …

Leverage Ratios

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A B C D E F G

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15 Liabilities and Owner's Equity16 Accounts Payable 7600 Total De. 0.49 =G20/G1417 Other Current Liabilities 90018 Total Current Liabilities 850019 Long Term Debt 120020 Total Liabilities 970021 Common Stock 600022 Retained Earnings 410023 Total Shareholder's Equity 1010024 Total Liabilities and owner's Equity 19800


So so..

Adding Ratios

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Debt to Equity Ratio

A favorite with many investors. It is similar to the Total Debt Ratio, but rather than dividing by the Total Assets, the Total Debt is divided by the Total Equity.

It is defined as:

Debt EquityRatio

Total Debt

Total Equity=

Leverage Ratios

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Debt Equity Ratio

As with the Total Debt Ratio, a low Debt Equity Ratio is good with the critical number being 1.

Smaller than one means that the company has more equity than debts.Vice versa, larger than one mean that the company has more debts than equity.

Investors prefer this number since Equity is after all that which belongs to the stock holders.

Leverage Ratios

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A B C D E F G

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15 Liabilities and Owner's Equity16 Accounts Payable 7600 Total De. 0.49 =G20/G1417 Other Current Liabilities 900 Debt-Eq. 0.96 =G20/G2318 Total Current Liabilities 850019 Long Term Debt 120020 Total Liabilities 970021 Common Stock 600022 Retained Earnings 410023 Total Shareholder's Equity 1010024 Total Liabilities and owner's Equity 19800


So so too..

Adding Ratios

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PROFIT. Of course that’s what business is all about!

Three of the most commonly used profitability ratios are:

Note: Though these are ratios they are often just called margin which generally refers to the difference between a certain cost and sales price (taken from the top).


• Gross Profit Margin

• Operating Profit Margin

• Net Profit Margin

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Gross Profit Margin

The Gross Profit Margin is the ‘gross’ difference between the actual cost of a product and its sales price.

It is defined as:

Gross ProfitMargin

Gross Profit

Sales=

Where Gross Profit = Sales – Cost of Sales


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A B C D E F G

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15 Liabilities and Owner's Equity16 Accounts Payable 7600 Total De. 0.49 =G20/G1417 Other Current Liabilities 900 Debt-Eq. 0.96 =G20/G2318 Total Current Liabilities 850019 Long Term Debt 1200 Gross P. 0.36 =Income!D8/20 Total Liabilities 9700 Income!D621 Common Stock 600022 Retained Earnings 410023 Total Shareholder's Equity 1010024 Total Liabilities and owner's Equity 19800



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Operating Profit Margin

The Gross Profit Margin is important but does not indicate how much (or whether) the company can make a profit from its running operations. This is indicated by the Operating Profit Margin:

Operating ProfitMargin

Net Operating Income

Sales=

Net Operating Income = EBIT (at least usually), the profit after taking all the expenses related to the daily running of the company into account. (Note: Depreciation and Amortization should be included)


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Operating Profit Margin

Since we did not separate Depreciation and Amortization out in our Income Statement, let’s leave this ratio as an exercise.


Net Profit Margin

The Net Profit Margin tells you how many cents out of every dollar are actual profit and thus attributable to the shareholders.

Net ProfitMargin

Net Income

Sales=

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A B C D E F G

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15 Liabilities and Owner's Equity16 Accounts Payable 7600 Total De. 0.49 =G20/G1417 Other Current Liabilities 900 Debt-Eq. 0.96 =G20/G2318 Total Current Liabilities 850019 Long Term Debt 1200 Gross P. 0.36 =Income!D8/20 Total Liabilities 9700 Income!D621 Common Stock 6000 Net Prof. 0.19 =Income!D12/22 Retained Earnings 4100 Income!D623 Total Shareholder's Equity 1010024 Total Liabilities and owner's Equity 19800


Adding Ratios

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Current Ratio =Current Assets

Current Liabilities

Quick Ratio =Current Assets - Inventories

Current Liabilities

Inventory TurnoverRatio

Cost of Goods Sold

Inventory=

Asset TurnoverRatio

Sales

Total Assets=

Liq

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Rat

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Summary of Ratios

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Total DebtRatio

Total Debt

Total Assets=

Debt EquityRatio

Total Debt

Total Equity=

Gross ProfitMargin

Gross Profit

Sales=

Operating ProfitMargin

Net Operating Income

Sales=

Net ProfitMargin

Net Income

Sales=

Lev

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Pro

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bili

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Summary of Ratios

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We have seen how various Ratios can give insight into the performance, liquidity and profitability of a company

The Ratios can be calculated easily with Excel.

Key Points of the Day

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