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©2012 KEAW v5

Financial Ratio Review

Kenneth EA Wendeln

‘Top 8’ Plus

Capstone

Financial Ratios

J411 Financial Ratio Review 2

Asset Turnover

Liquidity

Financial Leverage

Profitability

‘Top 8’ Key Financial Ratios

Return on Owners’ Equity %

EPS – Earnings per Share $ DD.00

Return on Sales % Accounts Receivable

Turnover X (times/year) or # days

Inventory Turnover X (times/year) or # days

Current Ratio # n.nn

Acid Test or Quick Ratio # n.nn

Total Liabilities to Equity %


Summary of Financial Ratios

*Return on

Equity

Return on Total Assets (ROA)

Return to

Investors

*Earnings Per

Share

Price to

Earnings Ratio

Dividend Yield

Return to Investors

Derived from: Fraser/Ormiston, Understanding the Corporate Annual Report; Understanding Financial Statements 6e

*A/R Turnover

*Inventory Turnover

Fixed Asset

Turnover

Total Asset

Turnover


Asset Management

Operating Efficiency

*‘Top 8’ & CAPSTONE Financial

Ratios

Other Common

Ratios

*Return on

Equity

Returns


Cash Return

on Assets

Profitability

*Net Profit

Margin (ROS)

Margins

Operating Profit Margin

Gross Profit

Margin

Product Contri- bution Margin

Cash Flow

Margin

Amount of

Debt

LEVERAGE Assets/ Equity

Debt/ Equity

Debt/ Assets

*Total Liabilities/

Equity

Coverage of

Debt

Times Interest Earned

Fixed Charge

Coverage

Cash Flow

Adequacy

Cash Interest Coverage

Leverage /Debt Management

LT Debt/ Total

Capital- ization

Short Run

Solvency

*Current Ratio

*Quick or

Acid Test Ratio

Cash Flow

Liquidity Ratio

Current Assets

*A/R Average

Collection Period

*Days Inventory

Held

Days Payables

Out- standing

Liquidity

Days of

Working Capital


Key Financial Statements

Current (12mo)

Long-Term

TOTAL ASSETS

● Cash ● A/R ● Inventories

● PPE ● Fixed Assets

Current (12mo)

Long-Term

TOTAL LIABILITIES

● A/P ● ST Debt

● LT Debt

● Stock @ par ● Paid-in Capital

● Accumulated Net Income ● less Dividends

Contributed Capital

Retained Earnings

TOTAL OWNERS’/ SHAREHOLDERS’ EQUITY

Assets =

Liabilities +

Ow

ners’ E

quity

Balance Sheet Period Ending

Net Sales

TOTAL REVENUES

● Units Sold ● @ Price ● less Returns & Allowances

Change in cash - Sources & (Uses) - between Periods

Other Expenses

● Interest ● Taxes ● One-time

Operating Profit

TOTAL NET INCOME or (LOSS) CASH provided (used) by

FINANCING Activities

Stock ● Sale (Purchase)

Dividends Debt/ Borrowing

● (Paid)

● Increase (Decrease)

CASH provided (used) by INVESTING Activities

PPE ● (Additions) Sale

Other Investments

● (Additions) Sale

TOTAL OP EXPENSES

Expenses for Period

● R & D ● Marketing ● Distribution ● Sales ● Admin

Cost of Goods Sold

● Units Sold ● @ Material ● @ Labor ● @ Overhead

CASH provided (used) by OPERATING Activities

Net Income ● Income Statement ● Accrual Based

● Depreciation ● A/R & A/P ● Inventory ● Other Accruals

Adjustments for Non-cash Items

Income Statement for Period

Reven

ues –

Exp

enses =

Net In

com

e

Cash Flow Statement ∆C

ash =

Operatin

g +

Investin

g +

Finan

cing


Profitability and Return to Investors

ROE *Return on Owners’ Equity

%

ROS *Return on Sales

%

ROA Return on Total Assets

%

Net Income (after taxes) Owners’ Equity

Net Income or Loss (after taxes) Average # of Common Stock

Shares Outstanding

Net Income (after taxes) Net Sales Revenue

Net Income (after taxes) Total Assets

EPS *Earnings per Share

$ DD.00


Return on Owners’ Equity Profitability ratio that provides an overall measure of a business’s performance. Net income earned (after tax) per dollar of owners’ investment accumulated in the business.

Typically between 15% and 25% for profitable companies

Net Income (after taxes) Owners’ Equity


Return on Sales or Net Profit Margin

This profitability ratio measures how well the company generated net profit (after tax) per dollar of net sales revenue.

This ratio is best evaluated by analyzing a firm’s year to year trends and by comparing to businesses within appropriate industries.

Net Income (after taxes) Net Sales Revenue


EPS Earnings per Share

This profitability ratio tells the owner of a share of stock how much of the net earnings for the year belongs to him or her.

These earnings may be paid to the stockholders as dividends . . . or reinvested

(as retained earnings) back into the business to fund its growth.

Net Income or Loss (after taxes) Average # Shares of Common

Stock Outstanding


Liquidity and Asset Management

*Current Ratio #.#

Current Assets Current Liabilities

*Acid Test or Quick Ratio #.#

Current Assets - Inventory Current Liabilities

*Accounts Receivable Turnover

X (times/year) or # days

Net Sales . Average Accounts Receivable

# days = 365 days/AR turnover

*Inventory Turnover

X (times/year) or # days

Cost of Goods Sold Average Inventory

# days = 365 days/Inventory turns


Current Ratio Measures liquidity - the capacity of a firm to meet its current obligations using liquid assets that are in cash or other resources that can be quickly converted to cash.

Capstone requires a current ratio >2.0, to indicate that the firm can pay its current

liabilities using its current assets.

Current Assets Current Liabilities


Acid-Test or Quick Ratio Measures liquidity - the ability of a firm to pay current liabilities ‘quickly’ – without selling inventory.

For all businesses the desired acid-test ratio is ~1.0

indicating firm can pay its current liabilities from its non-inventory current assets.

Current Assets - Inventory Current Liabilities


Accounts Receivable Turnover - Activity Ratio

Determines the number of times during the year a company is ‘turning over’ or collecting its accounts receivable. Measured in X times per year. Can be converted to ‘days outstanding’ by dividing turnover ratio into 365 days.

Customers will give a preference to companies that extend payment terms and, in effect, provide a loan.

6X turnover is equivalent to 60 days of outstanding receivables, 9X is 45 days, 12X is 30 days.

Net Sales Average Accounts Receivable


Inventory Turnover Activity Ratio

Determines the number of times during the year a company is ‘turning over’ its inventory. Measured in X times per year. Can also be converted to ‘days of inventory’ by dividing ratio into 365 days.

The average inventory turnover for all firms is about 9 times per year, or about once every 45 days. It varies

considerable by industry. Capstone penalizes firms with excessive inventory carrying costs

(>120 days of current sales).

Cost of Goods Sold Average Inventory


Working Capital Asset Management

Working Capital = Current Assets – Current Liabilities

Working Capital ~ Accts Receivable + Inventory - Accts Payable

Example

A/R = 35 days

Inventory = 70 days

less A/P = -15 days

Working Capital = 90 days

Capstone Ideal Range


Better Returns via Asset Management

Asset Turnover

ROA Return on

Assets

ROS Return on

Sales X =

Sales Assets X Profits

Sales = Profits

Assets

How good are we at producing wealth with our assets?

1.2 3.6% 4.3% Aircraft - Boeing

3.1 1.7% 5.3% Grocery - Kroger


Capital Structure - Leverage Using Equity + Debt for Financing

Using DEBT provides ‘LEVERAGE’ for the shareholders & increases their “Return on Owners’ Equity”

BUT………using more debt (which must be repaid) increases the RISK to the lenders & shareholders


Leverage and Debt Management

*Total Liabilities to Equity %

Total Liabilities Owners’ Equity


Total Liabilities to Owners’ Equity Ratio

This financial leverage ratio indicates the degree to which a firm’s operations are financed through debt, borrowings & other liabilities - determines a firm’s financial risk and ability to borrow money.

The liabilities-to-owners’ equity ratio typically ranges between 33 and 50%.

The higher this ratio, the riskier the situation for lenders and shareholders.



Leverage and Debt Management

*Total Liabilities to Equity %


Financial Leverage #.#

Total Assets Owners’ Equity

Total Owners’ Liabilities + Equity

Owners’ Equity

or

50% Liabilities 50% Equity

60% Liabilities 40% Equity

2.0 =

2.5 =

Examples

Capstone Ideal Range


Leverage & Risk Impact on Firm’s Cost of Capital

10.0%

10.1%

10.2%

10.3%

10.4%

10.5%

10.6%

10.7%

10.8%

10.9%

11.0%

0% 20% 40% 60% 80% 100%

Weighted Cost of Capital (Debt & Equity WCC)

Low Financial Leverage High

Debt financing is lower risk & cost than equity, lowering the WCC.

Equity investors require a return at least as great as the ‘best alternative opportunity forgone’.

As ‘Leverage’ increases with more debt, the risk increases to the lenders & the shareholders, increasing the cost of both debt & equity.

‘Optimum’ Leverage & WCC

Source: adapted from The Real Cost of Capital

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