Lecture 7

Ratio Analysis (II)

Financial Leverage Effects

ROE = ROIC + [(ROIC Cost of debt)L-T Debt/Equity]
Leveraged firms accrue excess returns to their
shareholders so long as the rate of return on investments
financed by debt is greater than the cost of debt.
The higher the debt ratio, the riskier the firm;

Financial Leverage Effects

Equity
LTD
EBIT
Interest Expenses
EBT
Income tax
NI
ROIC
Interest rate
Debt-Equity ratio
ROE

2005
4000
4000
1200
600
600
96
504
13,8%
15,0%
1,0
12,6%

Company C
2004
2003
4000
4000
5200
4800
1300
1500
780
720
520
780
83,2
124,8
436,8
655,2
13,2%
15,6%
15,0%
15,0%
1,3
1,2
10,9%
16,4%

2002
4000
4400
1600
660
940
150,4
789,6
17,3%
15,0%
1,1
19,7%

2001
4000
4400
1800
660
1140
182,4
957,6
19,3%
15,0%
1,1
23,9%

How you interpret?

Case 1
ROIC
kd
LTD/Equity
ROE

Case 2

Case 3

Case 4

10%

10%

10%

10%

7%

9%

11%

12%

1,5

0,75

13,0%

13,0%

8,5%

8,5%

Analysis of Solvency
(Debt Utilization Ratios)
Ability to stay in business over the longterm
Times
Interest
Earned

Debt-toEquity
Ratio
Debt
Service
Coverage

Cash Flow
to Capital
Expenditures

Leverage Ratios
Leverage ratios are two types:
balance sheet ratios comparing leverage
capital to total capital or total assets, and
coverage ratios which measure the earnings
or cash-flow times coverage of fixed cost
obligations.

Leverage Ratios
How much debt does the firm have? Thats the
question answered by the leverage ratios
Especially be on the lookout for companies with a
high proportion of fixed costs (high operating
leverage) and with lots of debt. Airlines are a good
example
Debt-equity ratio = long-term debt/equity
Long-term debt ratio = long-term debt / ( longterm debt + equity)
Total debt ratio = total liabilities / total assets

Leverage Ratios- Coverage ratios

Often more informative than the leverage ratios
are coverage ratios.
These ratios tell us what the firm is earning each
year relative to the burden the debt imposes.
Times interest earned = EBIT / interest
expense
Times Cash flow coverage =
(OCF+Tax+Interest Exp)/ interest expense
Times burden covered =
EBIT/(Interest+Principal repayment/(1-t))

How you interpret?

Case 1

Case 2

Case 3

Case 4

Case 5

Leverage ratios
Total debt ratio

70%

70%

90%

90%

110%

Long term debt ratio

50%

20%

70%

20%

90%

Short term debt ratio

20%

50%

20%

60%

20%

Financial autonomy ratio

30%

30%

10%

10%

-10%

1,7

0,7

7,0

2,0

-9,0

Debt to equity ratio

Market Based Ratios

P/E Ratio = ratio of market price per share
to earnings per share
What investors are willing to pay for a $ of
earnings (Current / Forecast)
What creates a high P/E?

Market/Book Ratio = Market price per

share / Book value per share

Usually much different than 1.

Price/Cash Flow

Analyzing the market value ratios

P/E: How much investors are willing to pay
for $1 of earnings.
P/CF: How much investors are willing to
pay for $1 of cash flow.
M/B: How much investors are willing to
pay for $1 of book value equity.
For each ratio, the higher the number, the
better.
P/E and M/B are high if ROE is high and
risk is low.

Comparing Price/Earnings, Price/Cash flow,

and Market/Book ratios.

P/E
P/CF
M/B

2007
12.0x
8.21x
1.56x

2006
-1.4x
-5.2x
0.5x

2005
9.7x
8.0x
1.3x

Industry
14.2x
11.0x
2.4x

Payout policy ratios

Shows the percentage of a stocks market
value returned as dividends to stockholders
each period.

Dividend yield
= Dividend per share of common stock
Market price per share of common stock

Potential problems and limitations of

financial ratio analysis
No single ratio or one-year figure should
be relied upon to provide an assessment
of a companys performance.

Financial analysis may indicate that

something is wrong, but it may not identify
the specific problem or show how to
correct it.

Potential problems and limitations of

financial ratio analysis
Comparison with industry averages is difficult
for a conglomerate firm that operates in many
different divisions.
Average performance is not necessarily
good, perhaps the firm should aim higher.
Seasonal factors can distort ratios.
Window dressing techniques can make
statements and ratios look better.

Quick Quiz (I)

Find ways to improve accounts receivable
turnover.
When a leveraged firm accrues excess
returns to their shareholders?
Give examples of industry that are using
low margin/high turnover and high
margin/low turnover.

Quick Quiz (II)

In each of the following cases, explain briefly which of
the two companies is likely to be characterized by the
higher ratio:
a. Debt-equity ratio: a shipping company or a computer
software company
b. Payout ratio: United Foods Inc. or Computer Graphics
Inc.
c. Ratio of sales to assets: an integrated pulp and paper
manufacturer or a paper mill
d. Average collection period: Regional Electric Power
Company or Z-Mart Discount Outlets
e. Price-earnings multiple: Basic Sludge Company or
Fledgling Electronics

Quick Quiz (III)

Financial ratio analysis is conducted by four
groups of analysts: managers, equity investors,
long-term creditors and short-term creditors.
What is the primary emphasis of each of these
groups in evaluating ratios?
Over the past year, M.D. Ryngaert & Co. has
realized an increase in its current ratio and a
drop in its total assets turnover ratio. However,
the companys sales, quick ratio, fixed assets
turnover ratios have remained constant. What
explains these changes?

Quick Quiz (IV)

If the mean P/E ratio for an industry sector is 12,
and the company you are analyzing has a P/E of
18, what does this mean about investors view of
growth prospects?

Modify sectors P/E to be correct!

Sector

Sector average P/Es

Electricity

23

Leisure and hotels

21

Building materials

14

Food retailing