Professional Documents
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Ratio Analysis
Ratios can often be more informative that raw numbers
Puts numbers in perspective with other numbers Helps control for different sizes of firms Ratios provide meaningful relationships between individual values in the financial statements
Ratios can be used to evaluate four different areas of companys performance and conditions
A ratio of less than 1, means that the company has negative working capital and is probably facing liquidity crisis
Ra
Higher the quick ratio, more likely is that the company will be able to pay its short-term bills
Average collection period is the average number of days it takes for the companys customer to pay their bills
It is desirable to have a collections period closer to the industry norm
Collection period too high that customers are too slow in paying their bills which implies too much capital is tied up in assets
Inventory turnover measures firms efficiency with respect to its processing and inventory management
Balance sheet items are taken as average of the account
Given the turnover values, you can compute the average inventory processing time
It is desirable to have a collections period closer to the industry norm
Given the turnover values, we can compute the average payment period processing time
It is desirable to have a collections payment closer to the industry norm
Rat
Combines information from the receivables turnover, inventory turnover, and accounts payable turnover
High conversion cycle is undesirable Too high conversion cycle implies that company has excessive amount of capital investment in the sales process.
Total Asset Turnover ratio indicates effectiveness of a firms use of its total asset base to produce sales
Different types of industries have different asset turnovers. Infrastructure business are capital intensive and may have Asset Turnover closer to 1, however, retail business might have turnover ratios in double digits.
Low asset turnover may mean that the company has much capital tied up in its asset base
Ra
Operating profit margin measures the rate of profit on sales after operating expenses
Net Margin
Shows the combined effect of operating profitability and the firms financing decisions (since net income is after interest and tax payments)
Return on total equity indicates the rate of return earned on the capital provided by the stockholders after paying for all other capital used
Total Equity includes preferred stock
We begin with the operating profit margin ( EBIT divided by sales) and introduce additional ratios to derive an ROE value
Financial leverage involves acquiring assets with funds at a fixed rate of interest
Op. Profit Margin Asset Turnover Interest exp. rate Financial leverage Tax retention rat
Ra
If Return on Investment in Asset > Fixed rate of borrowing = Positive financial leverage If Return on Investment in Asset < Fixed rate of borrowing = Negative financial leverage
sis
Business Risk
Function of Business variability, Sales variability and Operating leverage Between five to ten years of data should be used for calculating business and sales variability
Also critical is the measure of how much companys production costs are fixed (as opposed to variable)
Greater the use of fixed costs, greater the impact of a change in sales on the operating income of a company and hence, higher is the risk
tiAnalys
Two sets of financial ratios help measure financial risk
Balance sheet ratios Earnings or cash flow available to pay fixed financial charges
Ra
How much debt does the firm employ in relation to its use of equity?
How much debt does the firm employ in relation to all long-term sources of funds?
Cash flow to long term debt ratio determines the ability of the firm to meet its long term debt through its cash flows.
o Analys
If the company doesnt grow, it stands a much greater chance of defaulting on its loans Sustainable growth rate is a function of two variables:
What is the rate of return on equity (which gives the maximum possible growth)? How much of that growth is put to work through earnings retention (rather than being paid out in dividends)? Growth = ROE x Retention rate