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Unformatted text preview: Chapter 3 - Strategy and Financial Ratios Financial ratios allow for the comparison of one financial measure to another. The quality of the numbers upon which they are based and how they are calculated are both very important. However, the crucial skill is interpreting what they mean and relating this to the firm's current strategy. Doing LLAPS There is a simple acronym that helps to categorize the different types of ratios. It is the word LLAPS spelled with two L's. This words stands for: Liquidity, Leverage, Activity, Profitability, and Shareholders. Each of these is a category of financial ratios. For each category there are many different ratios. The ones that have the greatest value for thinking about strategy are of the greatest interest here. Other ratios can be used to isolate more specifically the cause of a problem in one of these areas. The categories are defined below. Liquidity - how much cash or "near cash" does the firm have? Leverage - refers to the extent to which the firm's capital structure relies on debt. Activity - measures efficiency of assets. Profitability - measures accounting surplus after costs are subtracted from sales. Shareholder - measures the returns to shareholders from investing in the firm. For each of these there is a ratio or several ratios worth looking at. These are: Liquidity = Current Ratio (CR): current assets over current liabilities Leverage = Debt over Equity (D/E): total debt over total equity. Debt over Assets (DR): total debt over total assets. Activity= Total Asset Turn-Over (TAT): net sales over total assets. Profitability = Profit Margin (PM): net profit* over net sales (also called return on sales or ROS; in some cases it may be helpful to adjust for extraordinary items). Return on Assets (ROA): net profit over total assets. Return on Equity (ROE): net profit over equity. Shareholder =Total Shareholder Return (TSR): dividends+share price at end of period (adjusted for splits)/share price at the beginning of the period. Price/Earnings Ratio: stock price over either the coming year's projected net income or last year's actual income. (*note: where net income is used it's important to examine any "extraordinary" items) Some of these are associated with "rules of thumb" that are used as a last resort if there is no benchmark to use for comparison. For example, the rule of thumbs says PM should be about 5%, CR should be between one and two, and DR should be equal to or less than 50%. It is much better is to compare the ratios for the firm of interest to a carefully selected "benchmark" such a competitor or comparable peer group. Each of these ratios should be examined over time to help recognize any short-term trends as well as the overall value of the ratio. For example, following are the ratios for a particular firm along with a benchmark ratio: Exhibit 3.1 - Financial Ratios and Benchmarks 2005 2004 2003 2002 2001 2000 Assessment CR F 1.0 1.1 1.0 1.7 2.0 1.9 Steady decline; negative trend CR...
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- Fall '09