Basics of Financial Statement Analysis: Ratios

Transcription

1 Basics of Financial Statement Analysis: Ratios The current presentation covers the second part of the basics of financial statement analysis. In this second part we will learn how to construct financial ratios. The presentation continues the general steps for conducting financial analysis please keep in mind that I am not intending to indicate that you must always follow the steps in order. 5. Calculate profitability ratios for the organization 6. Calculate liquidity and debt (or, financing) ratios for the organization 7. Calculate efficiency (or, activity) ratios for the organization 8. Calculate ratios for a comparison group General Mills will continue to serve as our organization under analysis. Thus, you may want to print the financial statements from the previous presentation for General Mills and the comparison statements, you do not need the common-size nor comparative statements. An Excel File containing all calculations for this presentation has been posted to our course webpage. You can use the file to see how I constructed the ratios. Thus, I will not attempt to demonstrate how to calculate the ratios in this presentation. It will be more beneficial for you to look at the actual Excel file.

2 5. Calculate profitability ratios for the organization Gross Profit Margin = Gross Pr ofits Sales = Sales COGS Sales Net Profit Margin = Net Income Sales Return on Assets (ROA) = Operating Income Average Total Assets = Avg. EBIT Total Assets Gross = Pr ofit Operating Expenses Avg. Total Assets Return on Equity (ROE) = Net Income Pr eferred Divdends Average Common Shareholders' Equity Profitability ratios are normally stated in percentage form. Though, you may find it useful at times to interpret them as straight ratios. For example, a net profit margin of 25% can be interpreted as saying for every $1 in sales, we make 25 cents in net profit. As another example, a return on equity of 10% says that for every $1 in equity, we make 10 cents in net profit. Before putting these to use for General Mills, it is worth taking a moment to consider one of the complications with financial ratios.

3 A Complication Some financial ratios (e.g., ROA, ROE, Asset Turnover, Inventory Turnover, A/R Turnover) use an income statement account (e.g., sales, net income) and a balance sheet account (e.g., assets, inventory, account receivables). In these cases, it is common to use an average amount for the balance sheet account. The average can be constructed using two consecutive annual balance sheets or consecutive quarterly balance sheets. The issue concerns the nature of the income statement and balance sheet. The income statement provides information about what happens during a period of time (e.g., year). The balance sheet provides information on a point in time (e.g., Jan. 1 st ). Thus, ratios that use accounts taken from both financial statements have a bit of a timing problem. The numerator may state an amount over the course of a year, while the denominator states an amount on a particular day. This is why an average balance sheet amount is normally used as an attempt to estimate just how much of the account (e.g., assets, inventory, etc.) was being held during the time period. Thus, it is technically correct to use an average amount for the balance sheet account in forming financial ratios pulled from both statements. At times, however, we will use the ending balance sheet amount as an approximation to the true ratio. We will do this often for any examples that we do by hand. Moreover, we may use the approximation at times even with Excel in order to simplifying things a bit. You will notice that at the end of this presentation the results for the financial ratios for our comparison groups uses ending balance sheet amounts (why? Because it was going to take a bit longer to get the exact numbers). Normally the approximation will not do very much harm, unless significant changes are taking place in the balance sheet account. The most important thing to remember is to be consistent in your use of either the average or ending balance! Mixing these methods can be misleading. Let s see the profitability ratios for General Mills.

4 General Mills, Inc. (GIS) Financial Ratios 2009 Profitability Gross Profit Margin 35.6% Net Profit Margin 8.3% Return on Assets (ROA) 12.6% Return on Equity (ROE) 21.3% Well? Do these say much to you? We can provide a fairly mechanical interpretation of each. In 2009, for every $1 in sales, General Mills made 35.6 cents in gross profit In 2009, for every $1 in sales, General Mills made 8.3 cents in net profit In 2009, for every $1 in assets, General Mills made 12.6 cents in operating income (or, EBIT) In 2009, for every $1 in equity, General Mills made 21.3 cents in net income However, in order to gain any real understanding of the implications for General Mills we really need some references. Let s see more years

5 General Mills, Inc. (GIS) Financial Ratios Profitability Gross Profit Margin 35.6% 35.7% 36.1% 35.6% 35.2% Net Profit Margin 8.3% 8.7% 8.6% 8.7% 10.1% Return on Assets (ROA) 12.6% 12.0% 11.4% 10.8% 12.5% Return on Equity (ROE) 21.3% 20.5% 19.3% 17.8% 20.2% We can now begin to analyze the profitability of General Mills. We see that their gross profit margins and return on assets are holding fairly steady. Recall, we already saw their gross profit margin (and net profit margin for that matter) on their common-size income statement. Their net profit margin shows a decline during the time period, causing us some concern. Their ROA held fairly steady, even though we know that their operating income (EBIT) declined relative to sales. How has the ROA held steady? Looking back at their balance sheet (or, even better, their comparative balance sheet), we realize that their total assets took a significant decline between 2008 and 2009, which has helped to keep their ROA steady. What is the point? Begin to think about how to combine all of the information that we ve formed.

6 6. Calculate liquidity and debt (or, financing) ratios for the organization Quick Ratio = Current Assets Inventory Current Liabilities Current Ratio = Current Assets Current Liabilities Times Interest Earned Ratio = Earnings Before Interest & Taxes ( EBIT ) Interest Expense Debt Ratio = Total Liabilities Total Assets Long-Term Debt Ratio = Total Long Term Total Assets Liabilities Total = Liabilities Current Total Assets Liabilities Debt-Equity Ratio = Total Liabilities Total Equity Equity Ratio = Total Total Equity Assets These ratios provide measurements on how the organization finances itself, how liquid it is, and its potential to meet financial obligations. We will look at these ratios for General Mills over the time period.

7 Liquidity, Debt, & Coverage Quick Ratio Current Ratio Debt Ratio 71.1% 67.4% 70.7% 68.1% 68.6% Equity Ratio 28.9% 32.6% 29.3% 31.9% 31.4% Debt-Equity Ratio Interest Coverage (EBIT/Interest) The quick ratio and current ratio give us an idea of how liquid General Mills is, and provide an indication of whether they should be able to meet their financial obligations coming due shortly (i.e., current liabilities). A mechanical interpretation of the ratios can be stated as follows. (Quick Ratio) In 2009, General Mills had 61 cents of very short term assets (close to cash) to meet every $1 of current liabilities. (Current Ratio) In 2009, General Mills had 98 cents of current assets for every $1 of current liabilities. The Interest Coverage ratio measures something similar to the quick and current ratio, but focuses on if the organization is making enough income (operating income, or EBIT) to meet interest expenses. (Interest Coverage) In 2009, General Mills generated $5.96 in operating income (EBIT) for every $1 of interest expense. The Debt, Equity, and Debt-Equity ratios all tells us how the organization has financed its total assets. (Debt Ratio) In 2009, General Mills financed its assets from 71.1% debt (liabilities). In other words, for every $1 in assets, it has 71.1 cents of debt. (Equity Ratio) In 2009, General Mills financed its assets from 28.8% equity. In other words, for every $1 in assets, it has 28.8 cents of equity. (Debt-Equity Ratio) In 2009, for every $1 in equity, General Mills had $2.45 of debt. In other words, for every $1 invested by the shareholders, it combined that with $2.45 of debt to purchase $3.45 in assets.

8 Are the movements General Mills ratios good or bad? There is no absolutely correct numbers for any of these ratios. The financing ratios (debt ratio, equity ratio, debt-equity ratio) are largely a matter of choice. Each organization must decide how to finance their assets although, there are times when choices become limited. For General Mills, the upward movement in these ratios is probably a very good thing. In 2005, these ratios probably were too low. The liquidity ratios (quick ratio, current ratio) can be chosen. Though at times, these ratios indicate possible problems. If these ratios were very low (however defined), it would be a sign of possible problems in meeting their financial obligations coming due soon. On the other hand, if these ratios were very high, it might be a sign that the organization is not using its assets wisely. For example, a current ratio of 50 would mean that the organization has $50 of assets close to cash (probably not making much income on these) to meet every dollar of short-term liabilities. We would have to wonder why the organization didn t have a better use for these assets. Thus, we don t want these ratios too low, but don t necessarily want them too high either. But, it must be said that it would be much easier to deal with high ratios --- simply pay out some of this cash (or near cash) to shareholders in the form of dividends. For General Mills, all that we can say for now is that they seem to have decided to use more debt to finance their assets. We can say similar things about the interest coverage ratio. Though, it is much easier to make a case for a higher rather than lower interest coverage ratio. We do want to make sure that we can meet the interest expense. Keep in mind though that there are some advantages (especially tax benefits) associated with taking on debt and incurring interest expense. Some corporations prefer to operate with as little debt and therefore interest expense as possible in order to avoid any dangers of bankruptcy or having to answer to lenders. For General Mills, the upward movement is probably a good sign.

9 7. Calculate efficiency (or, activity) ratios for the organization Asset Turnover = Sales Average Total Assets Fixed Asset Turnover = Sales Average Fixed Assets = Total Sales Assets Current Assets Inventory Turnover = Cost of Goods Sold Average Inventory Days in inventory = 365 Inventory turnover Accounts Receivable Turnover = Average Credit Sales Accounts Re ceivables Days in accounts receivables = 365 Accounts Re ceivables Turnover These ratios provide measures of how well management uses the assets of the organization. As with the other ratios, we could develop more measures as well as break-up these into components. Let s see how efficient General Mills is at utilizing its assets. You should note that the correct measure of the accounts receivable turnover uses Credit Sales (revenue) rather than total sales (revenue). I did not have this information available to me, so will use total revenue as an approximation (you can at times get just the credit sales from the footnotes to the financial statements).

10 Efficiency Asset Turnover Inventory Turnover Days in Inventory Accounts Rec. Turnover Days in Accounts. Rec The asset turnover ratio measures how well the organization uses its assets to generate profits. In 2009, for example, for every $1 in assets General Mills was able to generate 80 cents in sales. This ratio can also be used in forecasting as a way to estimate the assets that will be needed to generate a certain amount of sales revenue. The upward trend is a positive sign for General Mills. Turnover ratios are always a bit difficult to interpret. We want to turnover our assets more often. An increase in the inventory turnover ratio means that the organization is buying inventory then selling it then buying more inventory then selling it. more often. The same would be true for something like accounts receivable turnover. An increase means that we are making a sale on credit, receiving the cash, making another sale on credit, receiving the cash etc. To take an extreme case, an accounts receivable turnover of 1 would mean that we made a sale on credit and it took us a year to collect the cash. In general, an increase in any asset turnover ratio is a positive sign. Because turnover ratios tend to be difficult to interpret, we often state these as Days in measures. For General Mills in 2009, we can say that on average it took days from the time it purchased (or manufactured) the inventory (say a box of cereal on the shelf) until the time it sold it. Thus, the slight increase in the Days in Inventory is not a good sign (we could see this as a decrease in the inventory turnover number as well). In 2009, it took General Mills on average took collect the cash from customers that had made a purchase on credit. We would like to see this number decrease thus, collect the cash as quickly as possible.

11 General Mills, Inc. (GIS) Financial Ratios Profitability Gross Profit Margin 35.6% 35.7% 36.1% 35.6% 35.2% Net Profit Margin 8.3% 8.7% 8.6% 8.7% 10.1% Return on Assets (ROA) 12.6% 12.0% 11.4% 10.8% 12.5% Return on Equity (ROE) 21.3% 20.5% 19.3% 17.8% 20.2% Efficiency Asset Turnover Inventory Turnover Days in Inventory Accounts Rec. Turnover Days in Accounts. Rec Liquidity, Debt, & Coverage Quick Ratio Current Ratio Debt Ratio 71.1% 67.4% 70.7% 68.1% 68.6% Equity Ratio 28.9% 32.6% 29.3% 31.9% 31.4% Debt-Equity Ratio Interest Coverage (EBIT/Interest)

12 Students get frustrated with financial ratios when first learning them (not just memorizing the formulas either). The reason is understandable. We want some definite correct number for each ratio to decide if an organization s ratios are good or bad. Unfortunately, there simply is no correct number for any of these ratios. We can often say a higher number is better (in the case of the profitability ratios) or a lower number is better (in the case of Days in ratios), but what is high and what is low still remains a question. However, keep in mind a few of points. If you were actually working within the organization, then deciding a good and bad number might be much easier. In fact, you might set targets or target ranges for financial ratios. You might use these targets to judge the success of the organization. As outsiders we may not know what the organization wants the ratios to be. However, after studying the organization in greater depth by studying a corporation s 10K form for example - and understanding its strategy, then ratios can be used to judge success even by outsiders. In general, once you have studied an organization in greater depth then financial ratios will be of more use. Financial ratios are widely used and can matter in significant ways. For example, a bank may write into a loan contract that the borrower (e.g., corporation) must keep the debt ratio below a certain number. If the debt ratio rises above this number, then the loan could be recalled or more collateral could be required. Credit rating agencies, as another example, may use the interest coverage ratio to rate a corporation s bonds. If for example the interest coverage ratio slips below a certain number, then the credit rating agency may downgrade the corporation s bonds. This will imply higher interest rates for the corporation if it wishes to issue more bonds (thus, borrow more). Finally, we have seen that even without knowing much about an organization, the trend in certain financial ratios can give us an indication of performance. Even more, once we compare the financial ratios of an organization with a similar group, then we can draw further implications. Let s see this for General Mills. What are the conclusions you draw from the comparison (e.g., quick ratio a problem? Inventory management?, etc.)

13 8. Calculate ratios for a comparison group Comparison for General Mills Financial Ratios* General Mills Kellogg Post Kraft Average Profitability Gross Profit Margin 35.7% 41.9% 17.9% 33.2% 32.2% Net Profit Margin 8.7% 9.0% 5.2% 7.4% 7.6% Return on Assets (ROA) 11.7% 17.8% 4.4% 6.1% 10.0% Return on Equity (ROE) 19.0% 79.3% 6.1% 14.1% 29.6% Efficiency Asset Turnover Inventory Turnover Days in Inventory Accounts Rec. Turnover Days in Accounts. Rec Liquidity, Debt, & Coverage Quick Ratio Current Ratio Debt Ratio 67.4% 86.8% 54.9% 64.8% 68.5% Equity Ratio 32.6% 13.2% 45.1% 35.2% 31.5% Debt-Equity Ratio Interest Coverage (EBIT/Interest)

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