Ratio Analysis

Ratio analysis: compares the proportional

relationship between different items within a single years financial statements There are literally dozens of ratios that can be computed from a single years financial statements The important task for an analyst is to focus on the ratios that have primary meaning for the decision at hand

23-1

Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Ratio Analysis (cont.)

There are many ways of grouping ratios

but we will group our ratios as follows:
profitability ratios efficiency ratios solvency ratios liquidity ratios

23-2

Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Profitability Ratios

Profitability ratios: those that compare a

measure of earnings (the numerator) to a measure of investment (the denominator) Some types of profitability ratios: capital employed or total capitalization return on long-term capital, before taxes return on long-term capital, after taxes return on total assets, before taxes return on total assets, after taxes return on gross assets, after tax

23-3

Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Summary of Profitability Ratios

23-4

Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Summary of Profitability Ratios

23-5

Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Components of Profitability Ratios

Ratios are based on accounting numbers that

are the result of the companys accounting policies and that include the effects of many estimates made by management Despite the fact that ratios can be computed to many decimals, they really are very approximate measures that must be interpreted with extreme caution

23-6

Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Efficiency Ratios

Efficiency ratios: ratios that attempt to measure

selected aspects of the companys operational efficiency e.g., inventory turnover or the accounts receivable collection period Efficiency ratios must be used with great caution by an external analyst because the balance sheet amounts may not be typical of the balances throughout the period

23-7

Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Efficiency Ratios (cont.)

Some types of efficiency ratios are:

asset turnover ratios accounts receivable turnover inventory turnover the average collection period of accounts receivable accounts receivable aging schedule

23-8

Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Summary of Eficiency Ratios

23-9

Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Summary of Eficiency Ratios

23-10

Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Solvency Ratios

Solvency ratio: the basic objective is to

Ratios can be further classified as:
leveraged ratios debt service ratios

assess the ability of the company to make both the interest and principal payments on its longterm debt

23-11

Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Solvency Ratios (Cont.)

Leveraged ratios: measure the relative amount Leverage: the extent to which a company uses

fixed term obligations to finance its assets The most basic measure of leverage is debt-toequity ratio of the companys financing that was obtained through debt

23-12

Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Solvency Ratios (cont.)

Debt service ratios: test the ability of the

company to generate sufficient cash flow from operations to pay the debt interest or the debt interest plus principal payments A traditional ratio used in solvency analysis is the times interest earned ratio A broader debt service ratio is times debt service earned that includes the amount of interest to be paid, and the amount of principle payments to be made

23-13

Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Summary of Solvency Ratios

23-14

Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Summary of Solvency Ratios

23-15

Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Liquidity Ratios

Liquidity ratios: ratios that test the companys

Some types of liquidity ratios are:
current ratio quick ratio defensive-interval ratio ability to cover its short-term obligations with its existing monetary assets

23-16

Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Summary of Liquidity Ratios

23-17

Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Conclusion: Observations on Ratio Analysis

Ratios are only as good as the underlying data Analyze the correct set of financial statements:
consolidated or separate-legal-entity Financial statements adjust to suit the analysts needs before meaningful ratio analysis can be performed There is no assurance that the industry averages (or quartiles) are right or are based on similar accounting policies and measurements

23-18

Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Conclusion: Observations on Ratio Analysis (cont.)

Assessments of profitability, solvency, and liquidity are not really industry-dependent, but they do depend to some extent on an analysis of risk for each line of business There is no point in computing masses of ratios; it is more important to identify one or two key ratios in each category that are relevant Given the many estimates and approximations underlying both the numerator and denominator of all ratios, it is absurd to calculate them to more than two significant digits

23-19

Copyright 2003 McGraw-Hill Ryerson Limited, Canada