Transcript Slide 1

Foundations of Business
Financial Ratios & Ratio Analysis
to Evaluate and Compare Company
Performance
Financial Ratios
•
Ratios are meaningful relationships between 2
numbers (or among several numbers).
•
5 Types of Financial Ratios:
1.
2.
3.
4.
5.
Liquidity ratios
Operating ratios
Debt management ratios
Profitability ratios
Valuation ratios
Champ Creemee Company
Liquidity Ratios
• The higher the Liquidity ratio, the better the company’s ability to
pay current obligations with current assets.
• The higher the Liquidity ratio, the more liquid the company is.
1. Current Ratio:
CurrentAssets
CurrentLiabilities
Cash + accounts receivable + inventory
$15,190

 6.1X
Accounts Payable + other payables + ST Debt $2,500
2. Quick Ratio:
CurrentAssets  Inventory $15,190 - $3,500

CurrentLiabilities
$2,500
Creemee
Balance Sheet
 4.7 X
Creemee
Income Statement
Liquidity:
Trends and What If ???
2006
2007
Current Ratio
18.5 X
6.1 X
Quick Ratio
14.3 X
4.7 X We have a lot
of money tied
up in inventory!
What If … ??
 Current Ratio
 Quick Ratio
The Current Ratio should be 1X or higher so
that the company is able to pay its current
liabilities with current assets.
6.1 X
.6 X
We may have to sell
inventory to pay our
company’s debts!
Champ Creemee Company
Operating Ratios
• How efficiently a company uses assets
• The higher the ratio, the more efficient
1. Total Assets Turnover
AnnualSales  $3,000  0.2 X
TotalAssets $18,190
The Total Assets
Turnover ratio must be
compared with other
companies in the
industry.
2. Inventory Turnover
 How many times inventory must be restocked to meet sales
AnnualSales $3,000

 .9 X
Inventory
$3,500
The inventory turnover
ratio is different in different
industries.
Creemee
Balance Sheet
Creemee
Income Statement
Champ Creemee Company
Debt Management Ratios
Using outside
Leverage Ratios =sources
of financing to
• Degree of Financial risk
increase the return to
stockholders.
• Ability to repay money borrowed
• The higher the ratio, the greater the financial risk
1. Debt/Equity Ratio = Relationship of money owed
to Stockholders’ Investment in the Company
L.T.Debt
$5,000

 0.47  47%
S.H.Equity $10, 690
Creemee
Balance Sheet
Creemee
Income Statement
Champ Creemee Company
Debt Management Ratios
Coverage Ratios
2. Times Interest Earned (TIE)
• Ability of company to pay (cover) interest expense
• The higher the ratio, the better the ability to cover
• The higher the ratio, the lower the financial risk
Earnings before Interest and Taxes ( EBIT ) Money available to pay interest

Interest Expense
Interest Expense
$1,100

 2.2X interest
$500
Creemee
Balance Sheet
Creemee
Income Statement
Champ Creemee Company
Profitability Ratios
• How profitable is the company?
• What kind of return is the company generating on
sales for stockholders?
• The higher the ratio, the better the profitability.
1. Profit Margin (Return on Sales)
What percentage of sales dollar ends up as net income ?
Net Income
$390

 0.13  13%  13cents
Sales
$3, 000
Champ Creemee Company
Profitability Ratios
2. Return on Equity = Return generated on
stockholders’ investment in the company
Net Income
$390

 0.037  3.7%(=3.7cents)
ROE =
Owners' Equity $10, 690
Remember:
Stockholders’ Equity = Common Stock + Retained
Earnings
Creemee
Balance Sheet
Creemee
Income Statement
Impact of Leverage on ROE
CO. A
EBIT
Interest Exp.
Earnings
before taxes
Taxes
Net Income
Debt
Equity
Assets
$100
10
the “loan
company”
CO. B
$100
0
90
36
$54
100
40
$60
$500
500
$1000
0
1000
$1000
The “stock
company”
Borrowing
increases ROE,
but borrowing
also increases
RISK.
Stockholders
require an
increased return
to balance the
risk.
Return on
Assets
54/1000
= 5.4%
60/1000
= 6.0%
Return on
Equity
54/500 = 0.108
= 10.8%
60/1000 = 0.06
= 6.0%
Net Income / Total Assets
Net income / equity
Champ Creemee Company
Earnings Per Share (EPS)
Net Income
$390

 $19.50
• EPS =
# of Common Shares Outstanding
20
= $ earned per share of common stock
• Spreads the net income across the shares
Champ Creemee Company
Valuation Ratios
•
•
How is the company valued compared to other
companies
Relatively more or less expensive???
Price/Earnings Ratio: How many dollars investors
are willing to pay for a dollar of future/projected
net income
CurrentStock Pr ice
$100

 20 X
P/E =
Pr ojectedEarningsperShare
$5
Price / Earnings Ratio
Current stock
price per
share/EPS
projected
P/E ratio
Investors are
willing to pay:
Company A
Company B
$ 25/$1
$50/$5
25 X
10X
$25 per $1 of
future net
income
$10 per $1 of
future net
income
Champ Creemee Company
The Concept of Market Value
Market Value: Current aggregate value in the
market for all the common shares outstanding
(issued)
MV = Number of common shares
outstanding x current stock price
MV = $ 50 stock price x 1,000 shares
= $ 50,000
Champ Creemee Company
Balance Sheet
(as of 12/31/07)
Cash
Accounts Receivable
Inventory
Current Assets
Equipment
Total Assets
$8,690
3,000
3,500
15,190
3,000
$18,190
Accounts Payable
Wages Payable
Current Liabilities
Notes Payable (L.T.)
Total Liabilities
Common Stock
Retained Earnings
Total Shareholders’
Equity
Total Liab. & SH Equity
$2,000
500
2,500
5,000
7,500
10,000
690
10,690
$18,190
Champ Creemee Company
Income Statement
(for the Year ending 12/31/07)
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•
•
•
•
•
Sales
Expenses:
Cost of Goods sold
Gross Profit
Waste/Spoilage
Wages
Salaries
Payroll Remittances
Rent/Permits
Advertising
Maintenance and Repair
Operating Expenses
Operating Profit (EBIT)
Interest
Pre-Tax Profit
Taxes (35%)
Net Income
$3,000
(1,000)
2,000
50
500
50
50
100
100
50
(900)
1,100
(500)
600
(210)
$ 390