Common-size balance sheets: The firm’s assets and liabilities are shown as a %age of total assets, as opposed to nominal amounts. This makes it easier to compare balance sheets of firms small and large.
Common-size income statement: The firm’s income and expense items are shown as a %age of sales, rather than nominal amounts.
Common-size financial statements allow trends in financial performance to be detected and monitored more easily than with financial statements showing only nominal ($) amounts.
Financial ratios are relationships determined from a firm’s financial information and used for comparison purposes.
When you see a financial ratio, you should think about these 3 questions:
There are 5 types of financial ratios:
Current Ratio: interpretation – For every $1 in current liabilities, there are $CR in current assets. Alternatively, current liabilities are covered CR times over by current assets.
Read example 3.1 in book.
Quick ratio (Acid test): Inventory is subtracted from current assets, because it is the least liquid, and its book value unreliable. The inventory may be obsolete, damaged, etc.
Cash ratio: cash and cash equivalents are divided by current liabilities. Cash is the most liquid of all current assets. A very short term creditor may be interested in the cash ratio of the company.
Total debt ratio: Total liabilities/Total Assets (Total Liabilities=Total Assets-Total Equity)
Times Interest Earned (TIE): EBIT/Interest
TIE tells us how well the company has its interest obligations covered. Also known as interest coverage ratio.
Cash coverage: Since interest is a cash expense, and depreciation is noncash, depreciation is added to EBIT in the numerator.
Asset mgt ratios tell us how efficiently the company uses its assets.
Inventory Turnover= CGS/Inventory
Interpretation: The company turns inventory over IT times per year/quarter.
Days’ sales in inventory= 365/Inventory Turnover (for annual statements)
=90/Inventory Turnover (for quarterly statements)
interpretation: It takes the company xx days on average to completely turn over inventory.
Receivables Turnover=Sales/Accounts Receivable
Loosely speaking, we collected our outstanding credit accounts (AR) and reloaned the money RT times during the year/quarter.
Average Collection Period= 365/Receivables Turnover (for annual statements)
= 90/Receivables Turnover (for quarterly statements)
On average we collect our credit in ACP days. Alternatively, we can say that we have ACP days’ worth of sales uncollected.
Total Asset Turnover=Sales/Total Assets
For every $1 in assets, we generated $TAT in sales. The inverse of Total Asset Turnover is known as Capital Intensity Ratio.
These are the most widely known and used financial ratios. The focus in this case is on the bottom line.
Net margin (Profit Margin) a higher profit margin is desirable to a lower profit margin. Profit margins may depend on factors other than the company’s own profitability, such as industry, location of company, etc.
Return on Assets (ROA) gives us profit per dollar of assets (%age figure). Note that quarterly ROAs will be lower than annual ROAs.
Return on Equity (ROE) gives us profit per dollar of equity. Note that this is only the book value of equity. The quarterly and annual ROEs will also be different.
Earnings per share (EPS)
PE Ratio (Price-Earnings Ratio) tells us how much investors are willing to pay for a dollar of current earnings.
Market-to-Book Ratio compares the value of a firm’s investments to their cost. A value of less than one could mean that the firm has not been successful in creating value for shareholders.
Equity Multiplier = Assets/Equity
The ROE of a firm is affected by three things
If a firm’s ROE is too low, DuPont Identity can tell you where to start looking for reasons.
We are interested in how fast a firm can grow. For sales to grow in the long run, assets usually need to grow at the same rate. Asset growth needs to be financed. Internal growth rate tells us how fast the company can expect to grow (increase assets and sales), if all growth is financed by additions to retained earnings.
Sustainable growth rate tells us how fast the company can grow (increase assets and sales), if it keeps its debt-to-equity (or equity multiplier, or debt-to-asset ratio) constant. SGR is always larger than IGR, why?
From SGR and the DuPont Identity, we can infer that the company’s growth depends on the following factors: