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Financial%20Ratios

Financial%20Ratios - FINANCIAL RATIOS“ Managers use...

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Unformatted text preview: FINANCIAL RATIOS“ Managers use ratios to monitor operations and answer such questions as: ' -How well are resources being employed? “Is the Firm able to meet its Financial obligations on a timely basis? -How does the company's performance compare to that of its competition? BANKERS AND OTHER LENDERS EXAMINE RATIOS SUCH AS DEBT— TO—EQUITY, WHICH GIVES THEM AN IDEA OF WHETHER A COMPANY WILL BE ABLE TO PAY BACK A LOAN. COMPANY OWNERS AND THEIR TOP MANAGERS WATCH RATIOS SUCH AS GROSS MARGIN, WHICH HELPS THEM BE AWARE OF RISING COSTS OR INAPPROPRIATE DISCOUNTING. CREDIT MANAGERS ASSESS FINANCIAL HEALTH BY INSPECTING THEIR QUICK RATIO. SHAREHOLDERS LOOK TO PRICE/ EARNINGS. There are five major categories of ratios: -Ratios appraising liquidity - the quality of being readily convertible into cash -Ratios measuring solvency - the ability to pay debts as they come due ~Ratios evaluating Funds management - activity ra tias —Ratios measuring profitability —Market ratios The key to effective management is the art of asking the significant questions. LIQUIDITY RATIOS The main question to ask is whether or not a company can generate sufficient cash to pay its suppliers and creditors on a timely basis. A popular rule of thumb For the current ratio is considered to be a 2:1 relationship. But much depends on the quality and character of the assets. CURRENT RATIO The current ratio is the relationship between current assets and current liabilities: Current Ratio = Current Assets Current Liabilities IN MOST INDUSTRIES, A CURRENT RATIO IS TOO LOW WHEN IT IS GETTING CLOSE TO I. A CURRENT RATIO IS TOO HIGH WHEN IT SUGGESTS TO SHAREHOLDERS THAT THE COMPANY IS SITTING ON CASH. QUICK RATIO Add cash, short-term investments, and receivables to calculate the acid test ratio. Quick Ratio 2 Quick Assets Current Liabilities KNOWN AS THE ACID TEST. INVENTORY IS SUBTRACTED FROM CURRENT ASSETS BECAUSE IT TAKES TIME TO CONVERT THEM TO CASH. SOLVENCY RATIOS Solvency ratios measure a company's Financial capacity to meet long— term debt obligations. These ratios are designed to give some measure of the extent to which operating cash Flows and asset values provide protection to creditors. SOLVENCY OPINIONS TALK ABOUT THREE TESTS: DO ASSETS EXCEED LIABILITIES? IS THE COMPANY PROPERLY CAPITALIZED? CAN THE COMPANY PAY ITS DEBT WHEN IT COMES DUE? TIMES INTEREST EARNED (TIE) TIE = Operating Profit + Interest Expense Interest This coverage ratio is calculated on a pre—tax basis, since bond interest is a tax- deductible expense. The ratio assesses the Firm's ability to meet its interest payments. There’s a wonderful invention called the operating lease. Rather than buying equipment, a company leases it. The lease payments are expensed, but there is no asset and no debt related to that asset on the books. ACTIVITY RATIOS Activity ratios determine the speed with which a company can generate cash. The quicker a firm can convert inventories and accounts receivable into cash, the better OFF it is. AVERAGE COLLECTION PERIOD This teils you how long a company must wait to convert receivables into cash. Firms that are able to collect promptly From their customers, to hold relatively little inventory, or to get suppliers to Finance inventory are able to use less than their Funds For working capital, increasing turnover. Days Receivable Accounts Receivable Annual Sales/360 THE NUMERATOR IS ENDING A/R, TAKEN FROM THE BALANCE SHEET. THE DENOMINATOR IS REVENUE PER DAY - THE ANNUAL SALES FIGURE DIVIDED BY 360. 53:11pm)! x has 100,000 in a/r at the end of the year. Sales were 1,000,000. WHAT ARE THE DAYS OUTSTANDING? 100,000/1,000.000/36O = 37 DAYS AVERAGE PAYMENT PERIOD How many days of credit is provided by suppliers? Or you may ask: “How much working capital is provided by a company's suppliers?" Days Payable Ending Accounts Payable COGS/360 INVENTORY TURNOVER ReFers to the number of times a Firm sells out its average inventory during a Fiscal year. The average inventory For the year should be calculated iF there has been a significant change in inventory cost From the beginning to the end of the period. Usually ii" is suFFicienT To add The beginning and ending Inventory amounl's and To use one-half of Thai" To’ral as an average Inven’rory For the year. DAYS INVENTORY = AVERAGE INVENTORY/ COGS/ DAY THE NUMERATOR IS THE AVERAGE INVENTORY, WHICH IS BEGINNING INVENTORY PLUS ENDING INVENTORY DIVIDED BY TWO. THE DENOMINATOR IS THE COST OF GOODS SOLD (COGS) PER DAY, WHICH IS A MEASURE OF HOW MUCH INVENTORY IS ACTUALY USED IN EACH DAY. EX: COMPANY X HAS REVENUES OF 120,000 DURING THE YEAR. ITS COGS IS 40%. BEGINNING INVENTORY WAS 20,000 AND ENDING INVENTORY WAS 10,000. WHAT ARE THE DAYS INVENTORY? AVERAGE INVENTORY = 20,000 + 10,000 / 2 = 15,000 COGS = 120,000 X 40% = 48,000 COGS PER DAY 48,000 / 360 = 133 RATIO 15,000/ 133 = 113 DAYS INVENTORY TURNS IS A MEASURE OF HOW MANY TIMES , INVENTORY TURNS OVER IN A YEAR. INVENTORY TURNS z 360/DAYS INV = 360/113 = 3.2 WORKING CAPITAL TURNOVER (WOT) WCT is a measure of The speed with which Funds are provided by curren’r assets ’ro safisfy curremL liabili’ries. Working capi’ral is defined as receivables plus inven’rory less payables. Working Capital Turnover (WCT) =Net Sales Average Current Assets — Average Current Liabilities WORKING CAPITAL INTENSITY IS WC DIVIDED BY REVENUES. ASSET TURNOVER This ratio measures the company's effectiveness in utilizing all of its assets. Asset Turnover = Net Sales Total Assets GAUGES NOT 'JUST THE EFFICIENCY IN THE USE OF FIXED ASSETS, BUT THE EFFICIENCY IN THE USE OF ALL ASSETS. DEBT STATUS OF A COMPANY - LEVERAGE RATIOS Operating leverage is the ratio between fixed costs and variable costs; increasing your operating leverage means adding to fixed costs with the objective of reducing variable costs. A retailer that occupies a bigger, more efficient store and a manufacturer that builds a bigger, more productive Factory are both increasing their Fixed costs. But they hope to reduce their variable costs, because the new collection of assets is more efficient than the old. Financial leverage, by contrast, simply means the extent to which a company's asset base is financed by debt. The airline industry is an example of high operating leverage - all those airplanes - and high financial leverage, since most of the planes are financed through debt. DEBT RATIO The debt ratio indicates the percentage of total assets that is Financed by debt. The lower the debt ratio, the lower the Financial leverage. The higher the debt ratio, the higher the Financial leverage. Debt Ratio = Total Liabilities Total Assets The ratio tells how much debt the company has for every dollar of shareholders' equity. DEBT/EQUITY RATIO This ratio reflects the relationship between long—term debt and stockholders' equity. It measures the degree to which a firm’s activities are supported by debt relative to owner’s equity. Debt/Equity Ratio = Total long-term liabilities Equity PROFITABILITY RATIOS Profitability ratios measure rates of return on revenues and capital employed by the company. The newer of the percent (If sales. It will be tracked over time to establish trend lines. The percent of sales calculation gives a manager much more information than the raw numbers alone. PROFITABILTY IS A MEASURE OF A COMPANY'S ABILITY TO GENERATE SALES AND CONTROL EXPENSES. GROSS PROFIT MARGIN Gross profit margin shows how efficiently a company's management uses material and labor in the production process. Saies -— Cost of Goods Sold Sales Gross Profit Margin GROSS MARGIN SHOWS THE BASIC PROFITABILITY OF THE PRODUCT OR SERVICE ITSELF, BEFORE EXPENSES OR OVERHEAD ARE ADDED IN. OPERATING PROFIT MARGIN The operating profit margin reflects how successful a company has been in generating a profit after cost of goods sold and operating expenses. Operating Profit Margin = Earnings pre- Financial charges and tax / sales OPERATING PROFIT OR EBIT IS GROSS PROFIT MINUS OPERATING EXPENSES, SO THE LEVEL OF OPERATING PROFIT INDICATES HOW WELL A COMPANY IS RUNING THE ENTIRE BUSINESS FROM AN OPERATIONAL STANDPOINT. NET PROFIT MARGIN This is the bottom line margin that tells management how much of every sales dollar is left after deducting the cost of goods sold, operating expenses, Financial charges, and taxes. Net Profit Margin = Net Profits after Taxes Sales RETURN ON EQUITY (ROE) Measures the rate of return to shareholders on their investment. The ratio indicates how profitably the firm has been able to invest shareholder Funds for the period. Firms are able to generate high ROEs for their shareholders if they are in a superior industry, if they make more risky investments and so have to provide investors with a higher return, or if they are able to execute their strategy more effectively than their competitors. A company with low profit margins can artificially drive ROE by loading up on debt or buying back stock. Conversely, a company with no leverage can look mediocre on an ROE basis even if it has fat margins and a ton of cash. Target has a higher ROE (18%) than cash-rich Microsoft (12%). Companies that have consistently high ROE tend to be clustered in less cyclical industries like pharmaceuticals, consumer products, and financial services. The denominator represents the stock of resources used to generate profits. Three fundamental factors drive ROE: net profit margins (reflecting how well the firm manages its operations), asset turnover (reflecting how efficiently it uses its assets), and its financial leverage. ROE = Net Profits after Taxes Stockholder's Equity RETURN ON ASSETS This ratio is most useful as a measure of the effectiveness of resource utilization without regard to how those resources have been obtained and financed. It’s a critical metric because investment capital is a business Fuel, and if a company can't deliver a satisfactory ROA, its flow oF capital will dry up. NET INCOME/REVENUE X REVENUE/ASSETS = NET INCOME/ASSETS = RCA THE FIRST TERM, NET INCOME DIVIDED BY REVENUE, IS THE NET PROFIT MARGIN, OR RETURN ON SALES. THE SECOND TERM, REVENUE DIVIDED BY ASSETS, IS ASSET TURNOVER. SO NET PROFIT MARGIN TIMES ASSET TURNOVER EQUALS ROA. Return on Assets (ROA) = Net Income Assets RETURN ON INVESTED CAPITAL Relates all net income to all resources committed to the firm For long periods of time. It is calculated by dividing net income by the total amount of non-current liabilities and shareholders' equity. Return on Invested Capital (ROIC) = Net Income Total Liabilities 8: Equity - Current Liabilities ' MARKET RATIOS These are ratios used by investors in making trading decisions. The P/ E is the price multiple investors are willing to pay For each dollar of earnings per share. Earnings Per Share = Net Earnings - Preferred Dividends Number of Outstanding Common Shares Operating earnings exclude write—offs, while reported earnings include write-offs. Over the past 75 years, most market peaks topped at around 20x reported earnings, and troubles occurred at around 10x earnings. The financial mania of the late 19905 pushed P/Es to over 40x reported earnings, and the Following bust never brought P/Es below 18x reported earnings. P/E Ratio = Market Pricejer Share of Common Stock EPS The P/E Ratio tells you how much a stock costs relative to a company’s performance. The higher the ratio, the more expensive the stock is - and the stronger the argument that it won't do very well going forward. Stocks in the S&P SOD—stock index had an average P/E ratio of about 16.5, which by historical standards is quite normal. Since WWll, THE AVERAGE P/E RATIO HAS BEEN 16.1. During the bubbles of the 19205 and 19905, the ratio shot above forty. More recently, p/e ratios have plummeted as a result of the liquidity crisis. SHAREHOLDER VALUE Shareholder value is the market value of a company's outstanding stock at any given time. It is also referred to as “market capitalization” or “market cap.” Shareholder value = Number of Shares Outstanding X Market Price P/E RATIO IN ACQUISITIONS WHENEVER THE ACQUIRING COMPANY'S P/ E MULTIPLE IS GREATER THAN THE SELLING COMPANY'S P/ E MULTIPLE, EPS RISES. THE INVERSE IS ALSO TRUE. WHENEVER THE ACQUIRING COMPANY'S P/ E MULTIPLE IS LOWER THAN THE SELLING COMPANY'S P/ E MULTIPLE, EPS DECLINES. IN NEITHER CASE DOES THE EPS TELL US ANYTHING ABOUT THE DEAL'S LONG-TERM POTENTIAL TO ADD VALUE. TOTAL RETURN TO THE INVESTOR INCLUDES BOTH PRICE APPRECIATION AND DIVIDEND YIELD. TEN WAYS TO INCREASE SHAREHOLDER VALUE 1. DO NOT MANAGE EARNINGS NOR PROVIDE EARNINGS GUIDANCE. 2. MAKE STRATEGIC DECISIONS THAT MAXIMIZE SHAREHOLDER VALUE, EVEN AT THE EXPENSE OF LOWERING NEAR—TERM EARNINGS. 3. MAKE ACQUISITIONS THAT MAXIMIZE EXPECTED VALUE. 4. CARRY ONLY ASSETS THAT MAXIMIZE VALUE. 5. RETURN CASH TO SHAREHOLDERS WHEN THERE IS NO CREDIBLE VALUE-CREATING OPPORTUNITIES TO INVEST IN THE BUSINESS. 6. REWARD CEOS AND OTHER SENIOR EXECUTIVES FOR DELIVERING SUPERIOR LONG—TERM RETURNS. 7. REWARD OPERATING-UNIT EXECUTIVES FOR ADDING SUPERIOR MULTIYEAR RETURNS. 8. REWARD MIDDLE MANAGERS AND FRONTLINE EMPLOYEES ON THE KEY VALUE DRIVERS THAT THEY INFLUENCE DIRECTLY. 9. REQUIRE SENIOR EXECUTIVES TO BEAR THE RISKS OF OWNERSHIP JUST AS SHAREHOLDERS DO. 10. PROVIDE INVESTORS WITH VALUE—RELEVANT INFORMATION. EVA MOMENTUM EVA (ECONOMIC VALUE ADED) IS ESSENTIALLY PROFIT AFTER DEDUCTING AN APPROPRIATE CHARGE FOR ALL THE CAPITAL IN THE BUSINESS. BECAUSE IT ACCOUNTS FOR ALL CAPITAL COSTS, ITS PROPONENTS SAY EVA IS THE BEST MEASURE OF VALUE CREATION. THE CHANGE IN A BUSINESS'S EVA DIVIDED BY THE PRIOR PERIOD'S SALES. IF A COMPANY INCREASES ITS EVA BY $10M AND THE PRIOR PERIOD'S SALES WERE $lBN, THEN ITS EVA MOMENTUM IS 1%. ACHIEVING HIGH EVA MOMENTUM REQUIRES A BUSINESS TO DO TWO DIFFICULT THINGS AT ONCE. IT MUST GROW WHILE AT THE SAME TIME MAINTAINING HEALTHY PROFIT MARGINS OR IMPROVING POOR ONES. LODGING RATIOS CURRENT RATIO = CURRENT ASSETS/CURRENT LIABILITIES ACID TEST RATIO = QUICK ASSETS/ CURRENT LIABILITIES ACCOUNTS RECEIVABLE TURNOVER = TOTAL REVENUE/ AVERAGE ACCTS RECEIVABLE AVERAGE COLLECTION PERIOD = DAYS IN YEAR/ACCTS RECEIVABLE TURNOVER SOLVENCY RATIO = TOTAL ASSETS/TOTAL LIABILITIES FOOD INVENTORY RATIO = COST OF FOOD SALES/AVERAGE FOOD INVENTORY GROSS OPERATING PROFIT PER AVAILABLE ROOM = GROSS OPERATING PROFIT/ ROOMS AVAILABLE CASH ON CASH RETURN = ADJUSTED OPERATING INCOME - DEBT SERVICE/ AVERAGE OWNER'S EQUITY AVERAGE ROOM RATE a TOTAL ROOMS REVENUE/ROOMS OCCUPIED REVPAR = TOTAL ROOMS REVENUE/ ROOMS AVAILABLE AVERAGE FOOD CHECK = TOTAL FOOD REVENUE/ NUMBER OF COVERS ...
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