Finance 3

a standardized financial statemeent presenting all items in percentage terms.

current assets/ current liabilities

• ex: 708/540= 1.31
• $1.31 in current assets for every $1 of current liabilities or current liabilities covered 1.31 times over

the higher the ration the better, it indicates liquidity

less than one is unhealthy and unable to cover liabilities

(current assets- inventory)/ current liabilities

cash/current liabilities

• Current Ratio
• Quick Ratio
• Cash Ratio

• Total debt ratio
• Debt Equity Ratio
• Equity multiplier
• Times interest earned
• Cash Coverage ratio

(total assets-total equity)/total assets

• (3588-2591)/3588= .28 times
• 28% debt OR .28 for every $1 in assets, therefore .72 in equity and .28 in debt

total debt/total equity

.28/.72= .39 times

Total Assets/Total Equity

1/.72= 1.39 times

also 1 plus debt equity ratio

• also can be equated by
• (total debt + total equity)/ total equity

EBIT/Interest

691/141= 4.9 times

covered 4.9 times over

measures how well a company has its interest obligations covered

*problem with measure is its not really a measure of cash available to pay interest because depreciation, a non cash expense, has been deducted out

(EBIT+Depreciation)/Interest

(691+276)/141= 6.9 times

• EBITD= earnings before interest taxes and depreciation
• EBITDA= earnings before interest taxes, depreciation and amortization (amort is a intangible asset, like a machine)

intended to describe how efficiently or intensively a firm uses its assets to generate sales

• Inventory Turnover
• Days Sales in inventory
• Receivables turnover
• Days sales in receivables
• total asset turnover
• capital intensity

COGS/Inventory

1344/422=3.2 times

we sold off or turned over the entire inventory 3.2 times (per year usually)

as long as we arent running out of stock and forgoing sales, the higher the ratio the more efficiently we are managing inventory

365/inventory turnover

365/3.2=114

inventory sits 114 days on average before it is sold

also it will take 114 days to work off current inventory

COGS/[(Yr 1 inventory + yr 2 inventory)/2]

1344/[393+422)/2]=3.3

if you are worried about the past- average inventory turnover

future- the ending figure (inventory at the end of the year)

ending figures also common for comparing industries

Sales/Account Receivables

2311/188=12.3 times

we collected our outstanding credit accounts and reloaned the money 12.3 times during the year

365/receivable turnovers

365/12.3= 30 days

on average, we collected on our credit sales in 30 days

also say that we have 30 days worth of sales currently unallocated

Sales/Total Assets

2311/3588= .64 times

for every dollar in assets we generated .64 in sales

• reciprocal ratio= capital intensity ratio= 1/total asset turnover
• known as the dollar amount needed to generate $1 in sales

ex: 1/.64= 1.56 it takes 1.56 in assets to create $1 in sales

intended to measure how efficiently the firm uses its assets and how efficiently the firm manages operations

focus is bottom line, net income

• Profit margin
• Return on assets
• return on equity

net income/sales

363/2311= 15.7%

firm generates a littles less than 16 cents in profit for every dollar in sales

all things equal, a high profit  margin is desirable

corresponds to low expense ratios relative to sales

Net income/total assets

363/3588= 10.12%

profit per dollar of assets

accounting rates of return, return on book assets

Net Income/ Total Equity

363/2591= 14%

for every dollar in equity firm generated 14 cents in profit

• OR
• (Net income/Sales)*(Sales/Assets)*(Assets/Equity)

• OR
• Profit Margin*Total Asset Turnover*Equity Multiplier

• OR
• ROA*Equity Multiplier= ROA* (1 + Debt Equity Ratio)

also known as return on net worth

accounting rates of return, return on book equity

Not necessarily on the financial statements

• Earnings per share (EPS)
• Price Earnings Ratio (PE)
• Price Sales Ratio
• Market to Book Ratio

Net Income/Shares outstanding

363/33=$11

Price per share/ Earning per share

88/11=8 times

firm's shares sell for 8 times earnings or shares "carry" a PE multiple of 8

measures how much investors are willing to pay per dollar of current earnings

HIgher PEs are meant that the firm has significant prospects for future growth, careful as if there are little to no earnings the number could be quite small and misleading

helpful in new companies with negative earnings

Price per share/ sales per share

88/(2311/33)= 88/70=1.26

market value per share/book value per share

88/(2591/33)= 88/78.5= 1.12 times

book value per share= total equity (not just common stock) divided by # shares outstanding

a value less than 1 could indicate that the firm hasnt been successful in creating value for its stockholders

a famous way of decomposing ROE into its component parts

• net income/total equity
• OR
• (Net income/Sales)*(Sales/Assets)*(Assets/Equity)

Profit margin*total asset turnover*Equity multiplier

• ROE is affected by 3 things:
• Operating efficiency (measured by profit margin)
• Asset Use Efficiency (measured by total asset turnover)
• Financial Leverage (measured by the Equity Multiplier)

Weakness in either operating or asset use efficiency (or both) will show up in a diminished ROA, which will translate to a lower ROE

Increasing amount of debt, this will only happen if the ratio of EBIT to total assets is greater than the interst rate

increase sales and reducing one or more of COGS, selling, general or admin expenses

also reducing inventory holdings reduces current assets, which reduces total assets which improves the total asset turnover

• Dividend Payout Ratio
• Earnings Retention Ratio

Cash Dividends/ Net Income

• 121/363= 33.3%
• Firm pays out 1/3 of net income in dividends

What the firm doesnt pay in dividends must be retained in the firm

addition to retained earnings/Net income

• 242/363= 66.6%
• retains 2/3 of net income

aka plowback ratio, because a portion of net income is plowed back into the business

• internal- what a firm earns and plows back into the business 
• external- funds raised by borrowing money or selling stock

can be used to determine growth if the firm intends to not borrow any funds or sell any new stock

(ROA*b)/(1-ROA*b)

where b= retention or plowback ratio

[.1012*(2/3)]/[1-.1012*(2/3)]= 7.23%

only relies on internal financing, through time debt ratio will decline

• - wish to maintain a particular total debt ratio
• - unwilling to sell new stock

(ROE*b)/(1-ROE*b)

[.14*(2/3)]/[1-.14*(2/3)]= 10.29%

as the firm grows it will need to borrow additional funds to maintain a constant debt ratio

anything that increases ROE will increase the sustainable groth rate by making the top bigger and the bottom smaller. Increasing the plowback ration will have the same effect

1. Profit margin. An increase in profit margin will increase the firm's ability to generate funds internally and thereby increase its sustainable growth

2. Total Asset Turnover. An increase in the total asset turnover increases the sales generated for each dollar in assets. This decreases the firm's need for new assets as sales grow and thereby increase the sustainable growth rate. (increasing the Total asset turnover is the same thing as decreasing the capitial intensity)

3. Financial Policy. An increase in the debt-equity ratio increases the firm's financial leverage. Since this makes additional debt financing available, it increases the sustainable growth rate

4. Dividend polidy. A decrease in the % of net income paid out as dividends will increase the rentention ratio. This increases internally generated equity and thus increases internal and sustainable growth


If sales are to grow at a rate higher than the sustainable growth rate, the firm must increase profit margins, increase total asset turnover, increase financial leverage, increase earnings retention OR sell new shares

can also see it calculated as ROE*b, which is used if total equity is used from the beginning of the period

if the total equity is used at the end of the period, use (ROE*b)/(1-ROE*b)

If there is a conflict between market data and accounting data, market data should be given precendence

Internal Uses: performance evaluation, planning for the future, checking realism of assumptions made in those projections

External Uses: short term and long term potential investors, evaluate suppliers (credit), assessing creditworthiness/ financial health, competitors financial strength

Time trend analysis- example: current ratio for a firm is 2.4, but it has been steadily declining for the past ten years..

peer group analysis- (no two companies are the same so there will be some problems with this). Standard Industrial Classification Codes (SIC)- 4 digit codes est'b by the US govt for statistical reporting purposes, firms with the same codes are assumed to be similiar.

NAICS- North American Industry Classification System- 1997, intended to replace SIC codes