Ratio Analysis

PROF. G. MODUGNO
UNIVERSITY OF TRIESTE

Financial Statement Analysis

2

The examination of both the relationships

among financial statement numbers and the

trends in those numbers over time.
Examples:
Assets

profitability;
Stock turnover
% change of sales
% composition of operating expenses
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Common reasons for performing financial

statement analysis:
3

1. Making an investment in a rms stock.

2. Extending credit (short or long-term)
3. Assessing the opera@ng performance

and nancial posi@on of a supplier,

customer, or compe@tor.
4. Valuing a rm as an acquisi@on
candidate.
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The context of Financial Statement Analysis:

4

1.

Identify the economic characteristics of the

particular industry.
Examine:
Porters Five Forces
Industry Market Structure
Competition
Role of Technology
Industry Growth Rate
Value Chain Analysis

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The Context of Financial Statement Analysis:

5

2. Identify the strategies that a particular firm

pursues to gain competitive advantage.
Examine:
Nature of product or service
Degree of integration within Value Chain
Degree of Geographical and Industrial
Diversification

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The Purposes of Financial Statement Analysis:

6

1. Assess the firms financial position:

i.e. the firms ability to meet its

obligations.
2. Assess the firms financial
performance: i.e. profitability
3. Find out information about the level
of risk of the firm.
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Method
7

OVERVIEW OF THE
WHOLE PICTURE

FINANCIAL
STATEMENTS

RECOGNITION OF POTENTIAL WEAKNESSES:

HORIZONTAL AND VERTICAL ANALYSIS
CALCULATION OF RATIOS FOR MORE DETAILED ANALYSIS

STOP

NO

CONFIRM
THE
PROBLEM?

YES

ANALYSIS OF CAUSES

RECOGNITION OF POSSIBLE SOLUTIONS

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Horizontal and Vertical

Analysis
RECOGNITION OF
POTENTIAL WEAKNESSES

Horizontal Analysis
9

The study of percentage changes in comparative

statements is called horizontal analysis

Computing a percentage change in comparative
statements requires two steps:
Computing the amount of the change from the base period
to the later period
Dividing the amount of change by the base-period amount

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Horizontal Analysis in Mattel Inc.

10

Use the horizontal analysis to infer the % change

of the operating revenues and expenses of Mattel.

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Horizontal Analysis
11

Trend percentages
Are a form of horizontal analysis that examine more than a
two- or three-year period
Use a selected base year whose amounts are set equal to 100
percent
To compute trend percentages, each item for following years is
divided by the corresponding amount during the base year

Trend % =

Any Year
Base Year

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Vertical Analysis
12

Vertical analysis of a financial statement reveals the

relationship of each statement item to a specified

base, which is the 100% figure
Every other item on the financial statement is then
reported as a percentage of that base
When an income statement is analyzed vertically, net
sales is usually the base

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Vertical Analysis
13

Vertical analysis of balance sheet amounts are

shown as a percentage of total assets

The next exhibit shows the vertical analysis of
Mattels Balance Sheet as a percentage of total
assets

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Vertical and Horizontal Analysis in Mattel

14

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Common-size Statements
15

A common-size statement simplifies the comparison

of different companies because their amounts are

stated in percentages
On a common-size income statement, each item is
expressed as a percentage of the net sales amount
In the balance sheet, the common size is total assets
or the sum of total liabilities and stockholders
equity

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Benchmarking
16

Benchmarking is the practice of comparing a

companys performance with a standard set by:
other companies
or the industry average
or the companys previous years performance

Managers, investors, and creditors need to know

how one company compares with similar companies
and with past results
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Benchmarking
17

The

next exhibit gives the common-size

income statement of Bristol-Myers Squibb
Company compared with the average for
the pharmaceuticals industry
Its gross profit percentage is much higher
than the industry average
Its percentage of net income is significantly
higher that the industry average
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BRISTOL-MYERS SQUIBB COMPANY

Common-Size Income Statement for Comparison with Industry Avg.
Year Ended December 31, 1998
Bristol-Myers Squibb Industry Avg.

Net sales

100.0%

100.0%

Cost of products sold

26.6

54.7

Gross profit

73.4

45.3

Operating expenses

50.1

36.5

Earnings from continuing operation

Before Income Tax

23.3

8.8

6.1

2.3

17.2

6.5

17.2%

1.4
5.1%

Income tax expense

Earnings from continuing operations
Special items (discontinued operations,
extraordinary gains and losses, and effect
of accounting changes)
Net earnings
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18

Benchmarking Against a Key Competitor

19

Common-size statements are also used to compare the

company to another specific company.

The next exhibit presents the common-size income statements

of Bristol-Myers Squibb and Procter & Gamble

Bristol-Myers Squibb has higher percentages of gross profit,

earnings from continuing operations, and net earnings

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BRISTOL-MYERS SQUIBB COMPANY

Common-Size Income Statement for Comparison with Key Competitor
Year Ended December 31, 1998
Bristol-Myers Squibb Procter & Gamble
100.0%
100.0%
Net sales
Cost of products sold

26.6

56.7

Gross profit

73.4

43.3

Operating expenses

50.1

27.9

Earnings from continuing operation

before income tax

23.3

15.4

6.1

5.2

17.2

10.2

17.2%

10.2%

Income tax expense

Earnings from continuing operations
Special items (discontinued operations,
extraordinary gains and losses, and effect
of accounting changes)
Net earnings
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20

ACCOUNTING
RATIOS

Use Of Accounting Information In

Decision Making

Ratio Analysis
22

The way to compare companies of different sizes is to

use standard measures

Financial ratios are standard measures that enable
analysts to compare companies of different sizes

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Using Ratios To Make Business Decisions

23

1.

2.

3.

4.
5.

Ratios that measure the companys ability to

pay current liabilities
Ratios that measure the companys ability to
manage the working capital
Ratios that measure the companys ability to
pay long-term debt
Ratios that measure the companys profitability
Ratios that assess the risk of the company

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Measuring A Companys Ability To Pay Current

Liabilities: NWC
24

Working Capital (or Net Working Capital) is

defined as follows:
WC = Current Assets Current Liabilities

The Operating NWC is also calculated as the

difference between non financial current assets
and current liabilities arising from operations: it
is also called Working Capital Requirement
(WCR)
WCR = (Inventory + Acc. Rec.) (Acc.Payables)
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Measuring A Companys Ability To Pay Current

Liabilities
25

Working Capital is widely used to measure a

businesss ability to meet its short-term obligations

with its current assets

The larger the working capital, the more likely the

company will meet its short term debts

but: what if inventory or account receivables are

very big? Is this a signal of health for the company?

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Working Capital Financing Policies

26

Moderate: Match the maturity of the assets with

the maturity of the financing.

Aggressive: Use short-term financing to finance
permanent assets.
Conservative: Use permanent capital (i.e. equity,
long term financing, spontaneous current
liabilities) for permanent assets and temporary
assets.

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Aggressive Financing Policy

27

$ Temporary Curr.Assets
S-T
Loans
Permanent Current Assets

Fixed Assets

L-T Financing:
Stocks, Bonds,
Loans,
Spontaneous
Current Liab.
Years

Lower dashed line, more aggressive.

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Conservative Financing Policy

28

Marketable Securities
Zero S-T
debt
Permanent Current Assets

Fixed Assets

L-T Financing:
Stocks, Bonds,
Spontaneous
Current Liab.

Years
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What is short-term credit, and what are the

major sources?
29

S-T credit: Any debt scheduled for repayment

within one year.

Major sources:
Accounts
Short

payable (trade credit)

term bank loans

Accrued

expenses

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What is trade credit?

30

Trade credit is credit furnished by a

firms suppliers.
Trade credit is often the largest
source of short-term credit, especially
for small firms.
Spontaneous, easy to get, but cost can
be high.
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Current Ratio
31

The current ratio

Is the ratio of any entity's current assets to its current
liabilities
Measures the companys ability to pay current
liabilities with current assets

Current Ratio =

Total Current Assets

Total Current Liabilities

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NOKIA: calculate the Current and the Quick

Ratio for 2005 and 2006
32

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ACID TEST RATIO (Quick Ratio)

33

The acid-test (or quick ratio)

Indicates whether the entity could pay all its current liabilities if
they came due immediately

Is computed by Current Assets, net of Inventory, by current

liabilities

Quick Ratio =

Total Current Assets - Inventory

Total Current Liabilities

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Inventory Turnover
34

Inventory turnover is

A measure of the number of times a company sells its average

level of inventory during a year

Computed by dividing the cost of goods sold by the average

inventory for the period

InventoryTurnover =
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COGS
Avg.Inventory

Inventory Turnover
35

A high rate of turnover indicates relative ease in selling

inventory; a low turnover indicates difficulty in selling

In general, companies prefer a high inventory turnover
Inventory turnover varies widely with the nature of the

business

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Acc. Receivable Turnover and DSO

36

Acc. Rec. Turnover =

This

Sales
Avg. Acc. Receivable

ratio measures a companys ability to collect cash from credit

customers
The

resulting ratio indicates how many times during the year the

average level of receivables was turned into cash

The

inverse ratio is often called DSO (Days of Sales Outstanding)

DSO =
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Avg.Acc. Receivable
365
Sales

Accounts Receivable Turnover

37

In general, the higher the ratio, the more

successfully the business collects cash and the

better off its operations
A receivable turnover that is too high may

indicate that credit is too tight, causing the loss

of sales to good customers

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D.S.O.
38

The Days of Sales Outstanding ratio tells

How
It

many sales days remain in Accounts Receivable

can also be computed by a two-step process

First,

divide net sales by 365 days to figure the

average sales amount for one day

Second,

divide this average days sales amount into

the average net accounts receivable

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Measuring A Companys Ability To Pay

Long-term Debt
39

The most widespread indicators of a businesss ability

to pay long-term liabilities are the:
1.
2.

Debt ratio (or Gearing Ratio)

Times-interest-earned ratio
(Interest Coverage Ratio)

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Debt Ratio
40

The debt ratio

Is the ratio of total liabilities to total assets

Measures a businesss ability to pay both current and long-term debts

Sometimes this ratio is defined as Long-term liabilities divided by

Total assets

Debt Ratio =

Total Liabilities
Total Assets

A low debt ratio is safer than a high debt ratio

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Debt to Equity Ratio (or Leverage Ratio)

41

The functional reclassification of the Balance Sheet is

often used nowadays.

In the sources of capital, only equity and debts (long
term and short term borrowings) are represented.

Debts
Debt to Equity Ratio =
Equity

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Times-Interest-Earned Ratio
(or: Interest Coverage Ratio)
42

The Times-Interest-Earned ratio (or Interest Coverage

Ratio) measures the number of times that operating

income covers the interest expenses.

A high times-interest-earned ratio indicates ease in paying interest

expense

A low value suggests difficulty

EBIT
T.I.E. (or I.C.R.) =
Interest exp.
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Risk Analysis
43

1.

Business risk: it depends on business factors

such as competition, product liability, and
operating leverage.

2.

Financial risk: it depends only on the capital

structure of the company. More debt, more
financial risk.

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What Is Business Risk?

44

Uncertainty about future EBIT, i.e., how well can

we predict operating income?
Probability
Low risk

High risk

E(EBIT)

EBIT

Note that business risk does not include financing effects.

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Business risk is affected primarily by:

45

Uncertainty about demand (sales).

Uncertainty about output prices.
Uncertainty about costs.
Operating leverage.

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Profitability & Risk: The Operating Leverage

Sales Volume: 1.000
A
B
46

Turnover = p x Q0 = 10 x 1.000

Variable costs = unit var. cost x Q0

Contribution Margin
Fixed costs

Operating Income

Sales Volume: 800

Fixed costs

Operating Income

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-6.000

5.600

-5.000

600

- 70%
8.000

Variable costs = unit var. cost x Q0

4.000

-2.000

2.000

10.000

-3.000

Turnover = p x Q0 = 10 x 1.000
Contribution Margin

7.000

-5.000

2.000

10.000

-2.400

3.200

-2.000

1.200

-40%
8.000

-4.800

Profitability & Risk: The Operating Leverage

COST STRUCTURE A

47

COST STRUCTURE B

12000

12000

10000

10000
revenues

8000

var. costs
8000

6000

fixed
costs
6000
total cost

4000

4000

2000

2000

0
0

100 200 300 400 500 600 700 800 900 1000

100 200 300 400 500 600 700 800 900 1000

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What is operating leverage, and how does it

affect a firms business risk?
48

Opera@ng leverage is the use of xed costs rather

than variable costs.

If most costs are xed, hence do not decline when

demand falls, then the rm has high opera@ng

leverage.

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Operating Leverage
49

Probability

Low operating leverage

High operating leverage

EBITL

EBITH

Typical situation: Can use operating leverage

to get higher E(EBIT), but risk increases.
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A Furnitures Manufacturer: Profitability & Risk

50
2009
2008
4.561.119 100,0 5.776.780 100,0

1. Net Sales
2. change in inventories of nished products and work in progress
4. other opera@ng revenues
5. cost of goods materials and services

19.191

0,4

-40.544 -0,7

218.422

4,8

226.409

3,9

4.216.888 92,5 5.214.635 90,4

a) cost of goods and material sold, and cost of materials used 3.365.527 73,8 4.084.498 70,7
b) cost of services

851.361 18,7 1.130.137 19,6

6. Labour costs

644.443 14,1

712.445 12,3

7. Other labour costs

235.849

5,2

155.988

2,7

12.433

0,3

44.440

0,8

8. other opera@ng expenses

OPERATING PROFIT OR LOSS

-310.880 -6,8 -164.864 -2,9

1.

Is this a risky company because of its cost structure?

2.

The company has a nega@ve and declining protability: what might be the main reasons?

3.

What should the company do in such cases?

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After one year: Not Risky But Even Not Profitable

51

2010

2009

2008

9.520.460 100,0 4.561.119 100,0 5.776.780 100

1. Net Sales
2. Change in inventories of n.prod. and W.I.P.

-26.061 -0,6

4. Other opera@ng revenues

275.520

6,0

19.191

0,4

-40.544 -0,7

218.422

4,8

226.409 3,9

8.793.766 92,4 4.216.888 92,5 5.214.635 90

5. Cost of goods materials and services

a) Cost of goods and mat. sold, cost of mat
used
b) Cost of services

7.725.468 81,1 3.365.527 73,8 4.084.498 70,7

1.068.297 11,2

851.361 18,7 1.130.137 19,6

875.892

9,2

644.443 14,1

712.445 12

7. Write downs in value

83.643

0,9

235.849

5,2

155.988 2,7

8. Other opera@ng expenses

56.869

0,6

12.433

0,3

44.440 0,8

6. Labour costs

-40.250 -0,4 -310.880 -6,8 -164.864 -2,9

OPERATING PROFIT OR LOSS

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Decline In Profitability: Definition and Indicators

52

At this stage, the company show a deteriora@on of performance, even

though not irreversible:
Drop in Sales
Decline of Margins: Added Value, Gross Prot, EBITDA, Oper. Income
Opera@onal goals are not achieved
Sales revenues

Changes in inventory of finished prod. and W.I.P.
Work performed by the enterprise and capitalized
-Cost of goods, materials and services
ADDED VALUE
- Labour costs
EBITDA
-Depreciation and Amortization

-Provisions

EBIT

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Determinants Of Poor Performance:

A First Analysis
53

EBIT declines
Operating Expenses
Increase

Sales Drop

Products Price

Unitary Cost of
Inputs

Sales Volume

MKT

Volumes of
Inputs per
Output

Administrative
and Selling
Expenses

MKT SHARE

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Determinants Of Poor Performance: Further Analysis

54

Main
Factor

Detail

Reduc@on of
Products Price
SALES
DROP
Sales Volume
Reduc@on

Possible Determinants

Time
horizon

Possible SoluNons /
Notes

Compe@@ve Pressure
Companys weakness
in the rela@onship with
clients

Usually Long
Term

Dieren@ate!
Sectors where price is
the main compeFFve
factor

Companys Aggressive
Policy

Short Term

In few months the sales

volume increase should
more than compensate
price reducFons

Demand downturn

N.A.

Diversify markets!

Products posi@oning

Usually Long
Term

InnovaFon: Launch new

products!

N.A.

Futures, Forward,
OpFons

Unfavorable
Macroeconomic factors
Exchange Rate
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Sources of Sales Growth

55

When a company reports increased sales over the

previous year, what are the possible causes?

Increasing sales of current products (price or volume)
New product introductions
Buy another company

If you were to rank these sources, which do you think

are generally the most favorable, and which are
generally the least favorable for shareholders?

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Determinants Of Poor Performance: Further Analysis

Main
Factor

Detail

Possible
Determinants

56

Macro-economic
Factors
Unitary Cost
of
Produc@on
Companys
Factors is
Weakness in
increasing Rela@onship with
OPERATING
Suppliers
EXPENSES
INCREASE
Volume of Old Equipments
Input per
Poor Quality of
Output
Inputs / Process
increased
Unfavorable
Exchange
Rate
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Macroeconomic
factors

Time horizon

Possible SoluNons /
Notes

N.A.

Futures on Materials
Make or Buy choices:
outsourcing?

Usually Long
Term

Improve management
of suppliers porSolio
Transfer price increases
on clients

Long term

Renovate!

Usually Long
Term

Implement quality
control on input and
process

N.A.

Futures, Forward,
OpFons

Poor Performance: The Increase Of Operating

Expenses
57

Company XZ

(Manufacturer of colors for building)

2007

Net Sales

VAR%

8.720.054

15,9

-158.232

2006

7.524.502

-574,3

33.362

338.084

319,2

80.644

VALUE OF PRODUCTION

8.899.906 100

16,5

7.638.508 100

Materials and goods

6.109.700 68,6

23,6

4.941.649 55,5

Services

1.363.558 15,3

1,0

1.349.658 15,2

210.703 2,4

812,4

Change in the inventory of products & w.i.p.

Other revenues

Other opera@ng expenses

ADDED VALUE

23.093 0,3

1.215.945 13,7

-8,2

Labour Costs

997.893 11,2

6,2

1.324.108 14,9
939.165 10,6

EBITDA

218.052 2,5

-43,3

384.943 4,3

Deprecia@on and amor@za@on

229.377 2,6

18,2

194.012 2,2

EBIT (OPERATING INCOME)

-11.325 -0,1

-105,9

190.931 2,1

EBIT decreases notwithstanding the good performance on sales: to which expense can be attributed
the downturn in profitability?
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Poor Performance: The Increase Of Operating

Expenses
58

Company XZ
VALUE OF PRODUCTION

2007

8.899.906 100,0 16,51

2006

7.638.508 100,0

WEIGHTED
AVERAGE
CHANGE
EXPENSES

Materials and goods

6.109.700 68,6

23,6

4.941.649 66,4

15,68

services

1.363.558 15,3

1,0

1.349.658 18,1

0,19

other opera@ng expenses

210.703 2,4

812,4

23.093 0,3

2,52

Labour Costs

997.893 11,2

6,3

939.165 12,6

0,79

Deprecia@on and amor@za@on

229.377 2,6

18,2

194.012 2,6

0,47

TOTAL OPERATING EXPENSES

8.911.231 100,0

7.447.577 100,0

19,65

-105,9

190.931 2,1

EBIT

-11.325 -0,1

Opera@ng Expenses increases by 19,65% as a whole, while the value of produc@on increases by only
16,51%
Most of the cost increase depends on materials and goods (15,98%)
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Measuring A Companys Profitability

59

There are at least 5 rate-of-return

measurements that help evaluate a companys

profitability:
ROS: Rate of Return on net Sales
ROA: Rate of Return on Total Assets
ROE: Rate of Return on common stockholders Equity
ROCE: Rate of Return on Capital Employed
EPS: Earnings per share of common stock

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Quality Of Earnings
60

The quality of earnings measures the sustainability of

a firms earnings
It takes into consideration how net income is
generated
Income from continuing operations is considered of
higher quality than gains from selling off assets
because it is a better predictor of future earnings

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ROS: Return On Sales

61

The ROS shows the percentage of each sales

earned as operating (or also: net) income

R.O.S. = EBIT/ SALES

The higher the rate of return, the more net sales

are providing income to the business and the fewer

net sales are absorbed by expenses

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ROA & ROCE (ROI)

62

The ROA (return on assets) measures a companys

success in using its assets to earn a profit

R.O.A. = INCOME / ASSETS

The ROCE (or ROI) uses the sum of interest

expense and net income in the numerator and the

value of funds provided by creditors and
shareholders in the denominator
R.O.C.E.= (INC.+INT. EXP)/(EQUITY+DEBTS)
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ROE (Return on Equity)

63

Profitability is the key to a companys long-run

survival.
A summary measure of profitability often used by
investors is ROE.
This ratio measures the ability of a firms
management to generate net income form the
resources that owners provide.

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The Du Pont analysis of ROE

64

Assets Income Sales

ROE =

Equity Sales Assets

FINANCIAL
LEVERAGE

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ROS

ASSET
TURNOVER

What is Financial Leverage?

Financial Risk?
65

Financial leverage arises from the use of debt.

Financial risk is the additional risk concentrated

on stockholders as a result of financial leverage.

FIN. LEVERAGE = DEBTS/EQUITY

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Financial Leverage and ROE

66

Debts "
Inter. Exp. %
ROE = ROI +
$ ROI'
Equity #
Debts &
When the difference between the Return on
Investments and the cost of borrowings (Int.exp./
Debts) is positive, an increase of the Leverage
Ratio results in an increase in the Return on
Equity.
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Profitability And The Structure Of Capital: The Financial

Leverage
67

The Financial Leverage effect is the increased volatility in profitability

(ROE) caused by the corporate use of sources of capital that carry fixed
financial costs (long term debts, borrowings, preferred shares, bonds).
ROE can be increased through the Financial Leverage under the condition
that return on capital exceeds the cost of it (ROI > kd).
%
ROE
ROI
kd
D/E
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Financial Leverage: The Concept

68

ROI i > 0

ROE
D/E

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Financial Leverage: A Formula

69

The goal

ROE =

The lever

NI
D
- i)
= ROI + (ROI
E
E

When this
dierence is
posi@ve, the
company
increases
ROE using
debts.

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Financial Leverage: An Example

Current:
Unlevered

Proposed:
Levered

Assets

5.000.000

5.000.000

Debt

2.500.000

RECESSION

0,06

0,1

-0,04

Equity

5.000.000

2.500.000

EXPECTED

0,13

0,1

0,03

EXPANSION

0,2

0,1

0,1

10

10

500.000

250.000

N/A

10%

Debt/Equity Ra@o
Share Par Value
Shares Outstanding
Interest rate

ROI

Current Capital Structure: No Debt

EBIT
Interest
Net Income
ROE
EPS

Recession Expected

Proposed Capital Structure: Debt = $2,5 million

Expansion

300.000
0

650.000
0

300.000

650.000

6,00%

13,00%

0,60

1,30

INT. RATE DIFFERENCE

EBIT
Interest
1.000.000 Net Inc.
20,00% ROE
2,00 EPS
1.000.000
0

Recession

Expected

300.000
250.000

Expansion

650.000 1.000.000
250.000
250.000

50.000

400.000

750.000

2,00%

16,00%

30,00%

0,20

1,60

3,00

Financial Leverage And Insolvency: A Brief

Summary
Leverage

ROI vs i

Scenario

Diagnosis

High

Positive

Positive

GOOD

Low

Positive

Positive

Not risky, very good

High

Negative

Positive

The company has internal

problems but also
opportunities from the
context

Low

Negative

Negative

Poor performance, but

solid

High

Negative

Negative

Close to DEFAULT:
escape asap!

Low

Negative

Positive

Profitability problems,
probably only in the
short term

Low

Positive

Negative

Early Impairments:
need for a plan