# Using Financial Ratios: Interested Parties

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1 Using Financial Ratios: Interested Parties Ratio analysis involves methods of calculating and interpreting financial ratios to assess a firm s financial condition and performance. It is of interest to shareholders, creditors, and the firm s own management. 2-1 Using Financial Ratios: Types of Ratio Comparisons Trend or time-series analysis Used to evaluate a firm s performance over time 2-2 Using Financial Ratios: Types of Ratio Comparisons (cont.) Trend or time-series analysis Cross-sectional analysis Used to compare different firms at the same point in time 2-3

2 Using Financial Ratios: Types of Ratio Comparisons (cont.) Trend or time-series analysis Cross-sectional analysis Industry comparative analysis One specific type of cross sectional analysis. Used to compare one firm s financial performance to the industry s average performance 2-4 Using Financial Ratios: Types of Ratio Comparisons (cont.) Trend or time-series analysis Cross-sectional analysis Benchmarking A type of cross sectional analysis in which the firm s ratio values are compared to those of a key competitor or group of competitors that it wishes to emulate 2-5 Using Financial Ratios: Types of Ratio Comparisons (cont.) Trend or time-series analysis Cross-sectional analysis Combined Analysis Combined analysis simply uses a combination of both time series analysis and cross-sectional analysis 2-6

3 Using Financial Ratios: Types of Ratio Comparisons (cont.) Table 2.5 Industry Average Ratios for Selected Lines of Business a 2-7 Using Financial Ratios: Types of Ratio Comparisons (cont.) Figure 2.1 Combined Analysis 2-8 Using Financial Ratios: Cautions for Doing Ratio Analysis 1. Ratios must be considered together; a single ratio by itself means relatively little. 2. Financial statements that are being compared should be dated at the same point in time. 3. Use audited financial statements when possible. 4. The financial data being compared should have been developed in the same way. 5. Be wary of inflation distortions. 2-9

4 Ratio Analysis Example We will illustrate the use of financial ratios for analyzing financial statements using the Bartlett Company Income Statements and Balance Sheets presented earlier in Tables 2.1 and Ratio Analysis Current Ratio Current ratio = total current assets total current liabilities Current ratio = \$1,233,000 = 1.97 \$620, Current Ratio Quick Ratio Quick ratio = Total Current Assets - Inventory total current liabilities Quick ratio = \$1,233,000 - \$289,000 = 1.51 \$620,

5 Inventory Turnover Inventory Turnover = Cost of Goods Sold Inventory Inventory Turnover = \$2,088,000 = 7.2 \$289, Average Age of Inventory Average Age of Inventory = 365 Inventory Turnover Inventory Turnover = 365 = 50.7 days Average Collection Period ACP = Accounts Receivable Net Sales/365 ACP = \$503,000 = 59.7 days \$3,074,000/

6 Average Payment Period APP = Accounts Payable Annual Purchases/365 APP = \$382,000 = 95.4 days (.70 x \$2,088,000)/ Total Asset Turnover Total Asset Turnover = Net Sales Total Assets Total Asset Turnover = \$3,074,000 =.85 \$3,597, Table 2.6 Financial Statements Associated with Patty s Alternatives 2-18

7 Financial Leverage Ratios Debt Ratio Debt Ratio = Total Liabilities/Total Assets Debt Ratio = \$1,643,000/\$3,597,000 = 45.7% 2-19 Times Interest Earned Ratio Times Interest Earned = EBIT/Interest Times Interest Earned = \$418,000/\$93,000 = Fixed-Payment coverage Ratio (FPCR) FPCR = EBIT + Lease Payments Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]} FPCR = \$418,000 + \$35,000 = 1.9 \$93,000 + \$35,000 + {(\$71,000 + \$10,000) x [1/(1-.29)]} 2-21

8 Common-Size Income Statements 2-22 Table 2.7 Bartlett Company Common-Size Income Statements 2-23 Gross Profit Margin GPM = Gross Profit/Net Sales GPM = \$986,000/\$3,074,000 = 32.1% 2-24

9 Operating Profit Margin (OPM) OPM = EBIT/Net Sales OPM = \$418,000/\$3,074,000 = 13.6% 2-25 Net Profit Margin (NPM) NPM = Earnings Available to Common Stockholders Sales NPM = \$221,000/\$3,074,000 = 7.2% 2-26 Earnings Per Share (EPS) EPS = Earnings Available to Common Stockholders Number of Shares Outstanding EPS = \$221,000/76,262 = \$

10 Return on Total Assets (ROA) ROA = Earnings Available to Common Stockholders Total Assets ROA = \$221,000/\$3,597,000 = 6.1% 2-28 Return on Equity (ROE) ROE = Earnings Available to Common Stockholders Total Equity ROE = \$221,000/\$1,754,000 = 12.6% 2-29 Market Ratios Price Earnings (P/E) Ratio P/E = Market Price Per Share of Common Stock Earnings Per Share P/E = \$32.25/\$2.90 =

11 Market Ratios Market/Book (M/B) Ratio BV/Share = Common Stock Equity Number of Shares of Common Stock BV/Share = \$1,754,000/72,262 = \$ Market Ratios Market/Book (M/B) Ratio M/B Ratio = Market Price/Share of Common Stock Book Value/Share of Common Stock M/B Ratio = \$32.25/\$23.00 = Summarizing All Ratios Table 2.8 Summary of Bartlett Company Ratios ( , Including 2009 Industry Averages) 2-33

12 Summarizing All Ratios (cont.) Table 2.8 Summary of Bartlett Company Ratios ( , Including 2009 Industry Averages) 2-34 DuPont System of Analysis The DuPont system of analysis is used to dissect the firm s financial statements and to assess its financial condition. It merges the income statement and balance sheet into two summary measures of profitability. The Modified DuPont Formula relates the firm s ROA to its ROE using the financial leverage multiplier (FLM), which is the ratio of total assets to common stock equity: ROA and ROE as shown in the series of equations on the following slide and in Figure 2.2 on the following slide DuPont System of Analysis 2-36

13 DuPont System of Analysis (cont.) Figure 2.2 DuPont System of Analysis 2-37 Modified DuPont Formula (cont.) Use of the FLM to convert ROA into ROE reflects the impact of financial leverage on the owner s return. Substituting the values for Bartlett Company s ROA of 6.1 percent calculated earlier, and Bartlett s FLM of 2.06 (\$3,597,000 total assets \$1,754,000 common stock equity) into the Modified DuPont formula yields: ROE = 6.1% X 2.06 = 12.6% 2-38

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