Strategic Management

Financial Ratios

MF Daniel Martínez
Catholic University of Guayaquil
 Financial Analysis

 Why do it?
– Identify strengths & weaknesses of your business
 May be financial, production, marketing, etc.
 Build on your strengths
 Improve your weaknesses

– Identify possible corrective actions

– Identify limiting factors in obtaining credit

 What might a lender not like?
Financial Analysis

 When managers get to act like doctors (or vets)

– Recognize symptoms of problems
 Financial ratios point you in the right direction
– Gather information to pinpoint the problem
 Narrow down the search through ratios
– Make a diagnosis
 Identify possible problems
– Prescribe a remedy
 Take action to improve the problem area
– Follow up to see if problem is cured
 Control the business through ratios, common sense
Needs

 Balance Sheets
– Current Balance Sheet
– 3-5 Historic Balance Sheets & Pro forma
 Income Statements
– May use tax records as a proxy
– Current Year’s Income Statement
– 3-5 Year’s Historic Income Statements & Pro forma
 Cash Flow Statements
– Not necessary for ratio analysis, but extremely helpful!!
 Types of Financial Analysis

 Ratio Analysis
– Calculate “industry accepted” ratios for your firm
– Compare your performance to industry “norms”
 Farm Financial Standards Council (FFSC)

 Trend Analysis
– Analyze your financial ratios over a period of time
 3-5 years
– Look for positive and negative trends
 Uses of Ratio Analysis

 Compare ratio to industry average (norm)

– FFSC (RMA for non-ag businesses)
 Look for trends over time
– Identify ongoing problems
 Look at ways to improve a bad ratio!!!
– This helps you identify the problem and possible
curative actions
– “What factors impact this ratio, positively and
negatively?”
Time series analysis
 Horizontal analysis
 Using a multi-year information base
 Trend percentages
– Select a base year
– Set item amounts of that year = 100%
– Corresponding amount of each following year = % of base
mount
 Impact of inflation
Time series analysis- Illustration

Trend percentages of total sales (2000 = 100%)

2005 2004 2003 2002 2001 2000

Sales 617 583 492 413 627 445

(€million)
Sales – 139% 131% 111% 93% 141% 100%
trend %
Cross-sectional analysis
 Comparison with other companies in the
same industry for the same year
– Differences in company characteristics should
always be accounted for in interpretation
 Comparison with industry averages
– Multi-product companies
– Definition and size of industry groupings
Common-size financial statements

 Standardizing financial statements by introducing a

common denominator
 In a common-size balance sheet each component of
the balance sheet is expressed as a percentage of
total assets
 In a common-size income statement each item is
expressed as a percentage of sales
Common-size financial statements
(cont.)

 Allow comparison of companies of different size (in

terms of total assets and sales)
 Allow (internal) structural analysis of the financial
statements of a company
– Relative magnitude of asset, liability, equity and income
statement components
 Combination of horizontal and vertical analysis
Common-size balance sheet - Illustration
Common-size income statement - Illustration
 Use of financial ratios

 A financial ratio expresses the mathematical relationship

between two or more financial statement items that are
logically linked
 Comparison over time and in space
– Like must always be compared with like
 Combined use of financial ratios is more informative
 Financial ratios as indicators of management performance
and financial strength
 Areas of Importance
 Repayment Ability
– How able are you to meet your debt payments?
 Liquidity
– Are you able to meet current obligations?
 Solvency/Collateral
– Are you able to meet all obligations?
 Profitability
– How much is your firm earning, after all expenses?
 Financial Efficiency
– How well are you using your capital and assets?
 Limitations of Ratio Analysis

 Requires good, accurate data/information

 Ratios do NOT identify the specific problem
– They point you towards the problem
 Ratios may fluctuate during the year
 Pogo stick syndrome due to accounting methods
 Requires knowledge of statements and ratios
 Requires common sense!!!
 Don’t fall in love with one ratio - need a balanced
approach
Strategic Ratios

 Profit Ratios
 Liquidity Ratios
 Activity Ratios
 Leverage Ratios
 Shareholder-Return Ratios
Profit Ratios

 Profit Ratios: Profit ratios measure the efficiency with

which the company uses its resources. The more
efficient the company, the greater is its profitability. It
is useful to compare a company's profitability against
that of its major competitors in its industry. Such a
comparison tells whether the company is operating
more or less efficiently than its rivals. In addition, the
change in a company's profit ratios over time tells
whether its performance is improving or declining.
Profit Ratios (Continued)

 Gross profit margin. The gross profit margin

simply gives the percentage of sales
available to cover general and administrative
expenses and other operating costs.

Gross Profit Margin = Sales Revenue - Cost of Goods Sold

Sales Revenue
Profit Ratios (Continued)

 Net profit margin. Net profit margin is the

percentage of profit earned on sales. This
ratio is important because businesses need
to make a profit to survive in the long run.

Net Profit Margin = Net Income

Sales Revenue
Profit Ratios (Continued)

 Return on total assets. This ratio measures the profit

earned on the employment of assets.

Return on Total Assets = Net Income Available to Common

Stockholders
Total Assets
Net income is the profit after preferred dividends (those set
by contract) have been paid. Total assets include both
current and non-current assets.
 Profit Ratios (Continued)

 Return on stockholders' equity. This ratio measures the

percentage of profit earned on common stockholders'
investment in the company. In theory, a company
attempting to maximize the wealth of its stockholders
should be trying to maximize this ratio.

Return on Stockholders' Equity = Net Income Available to Common Stockholders

Stockholders' Equity
Profitability Ratios
Liquidity Ratios

A company's liquidity is a measure of its

ability to meet short-term obligations. An
asset is deemed liquid if it can be readily
converted into cash. Liquid assets are
current assets such as cash, marketable
securities, accounts receivable, and so on.
Liquidity Ratios (Continued)

 Current ratio. The current ratio measures the

extent to which the claims of short-term
creditors are covered by assets that can be
quickly converted into cash. Most companies
should have a ratio of at least 1, because
failure to meet these commitments can lead
to bankruptcy.

Current Ratio = Current Assets

Current Liabilities
Liquidity Ratios (Continued)

 Quick ratio. The quick ratio measures a

company's ability to payoff the claims of
short-term creditors without relying on the
sale of its inventories. This is a valuable
measure since in practice the sale of
inventories is often difficult.

Quick Ratio = Current Assets - Inventory

Current Liabilities
Liquidity Ratios
Asset Utilization Ratios

 Theseratios relate the balance sheet to the

income statement.
Asset Utilization Ratios (cont’d)
Leverage Ratios

 A company is said to be highly leveraged if it uses

more debt than equity, including stock and retained
earnings. The balance between debt and equity is
called the capital structure. The optimal capital
structure is determined by the individual company.
 Debt has a lower cost because creditors take less
risk; they know they will get their interest and
principal. However, debt can be risky to the firm
because if enough profit is not made to cover the
interest and principal payments, bankruptcy can
occur.
Leverage Ratios (Continued)

 Debt-to-assets ratio. The debt-to-asset ratio is the

most direct measure of the extent to which borrowed
funds have been used to finance a company's
investments. It is defined as follows:

Debt-to-Assets Ratio = Total Debt

Total Assets
Total debt is the sum of a company's current liabilities
and its long-term debt, and total assets are the sum
of fixed assets and current assets.
Leverage Ratios (Continued)

 Debt-to-equityratio. The debt-to-equity ratio

indicates the balance between debt and
equity in a company's capital structure. This
is perhaps the most widely used measure of
a company's leverage. It is defined as
follows:
Debt-to-Equity Ratio = Total Debt
Total Equity
 Long-term solvency risk ratios

 Main ratios:
– Debt/equity ratio
– Gearing ratio
– Interest and dividend cover
 Gearing as indicator of default risk
 Debt financing introduces financial risk because it
implies fixed commitments in the form of interest
payments and principal repayment and exposure to
interest rate movements.
Table 1 Long-term solvency risk ratios

Gearing
 Short-term liquidity risk ratios

 Main ratios:
– Current ratio and acid-test ratio
– Credit given and credit obtained
– Days inventory outstanding
 Liquidity tests focus on the make-up of working
capital and the activity level of its components
 Low liquidity implies financial risk as inability to
service short-term debt payments may lead to higher
interest expense and, eventually, bankruptcy
Table 2 Short-term liquidity risk ratios

Current ratio =

Acid test (or quick ratio) =

Days inventory
=
outstanding
Shareholder-Return Ratios

 Shareholder-return ratios measure the return earned

by shareholders from holding stock in the company.
Given the goal of maximizing stockholders' wealth,
providing shareholders with an adequate rate of
return is a primary objective of most companies. As
with profit ratios, it can be helpful to compare a
company's shareholders returns against those of
similar companies. This provides a yardstick for
determining how well the company is satisfying the
demands of this particularly important group of
organizational constituents.
 Earnings per share (EPS)
 Shows how much of a period’s net profit has been
earned by each ordinary share outstanding (basic EPS)
or by shares outstanding plus all potential shares
(diluted EPS)
 Potential shares are equity instruments issued that can
be converted into ordinary shares at the option of the
holder of the instrument
 IAS 33 Earnings per Share requires that listed
companies disclose both basic and diluted EPS on the
face of the income statement
Shareholder-Return Ratios (Continued)

 Price-earnings ratio. The price-earnings ratio

measures the amount investors are willing to
pay per dollar of profit.

Price-Earnings Ratio = Market Price per Share

Earnings per
Share
Shareholder-Return Ratios (Continued)

 Market to book value. Another useful ratio is

market to book value. This measures a
company's expected future growth prospects.

Market to Book Value = Market Price per Share

Book value per share of equity
 Price/earnings ratio

EPS is used as input to a market ratio, the

price/earnings or P/E ratio:
Price/Earnings = Market price per share

EPS

•Reflects how the market (market price) judges the company’s

performance (growth expectations)
•It is an inverted rate of return ratio
•Also called the Earnings Multiple
Dividend yield ratio

The dividend yield ratio reflects the relationship

between the dividends per share paid to shareholders
and the current market price of a share:

Dividend Yield = Dividend per share

Market price per share

Both P/E and dividend yield ratios of listed companies

are published daily by major financial newspapers
Table 3 Profitability ratios

Net profit m

Gross opera
 Figure 1 Capital employed

Assets Financing
Fixed assets Equity

Capital employed
Capital employed

Net working capital

LT Debt

Current assets Current liabilities