Financial Ratio Analysis

Ratio Analysis

 

Now that we better understand the effects the supply chain have on cash, the cash to cash cycle and the firm, we change our focus to ratio analysis and this can help diagnose the problems in the firm and help us to better target supply chain initiatives.

 

One of the difficulties with looking at financials for comparison is that companies can vary by size, scope and industry.  To start making comparisons, one might try to “standardize” the financial statements.  Two ways to do this is to use common size analysis and ratio analysis.

 

A common size financial statement presents all items in percentage terms.  A common size balance sheet shows all line items as a percentage of total assets, and a common size income statement shows all line items as percentages of sales.  In this form, financial statements are relatively easy to read and compare.  If a percentage of line item increases or decreases, then one can see easily whether a line item went up or went down.  The investigation behind the number is the key to finding out the reason why a line item went up or down.  In addition, common size statements are a good way to look at trends over time to see overall changes.

 

Another way to compare companies and standardize the analysis is to compute financial ratios.  As stated before, ratios do not mean much unless one compares them to prescribed standards or other companies.  When one computes a ratio, there are several things to keep in mind:

 

  • How is the ratio computed?
  • What is the ratio intended to measure, and why might we be interested?
  • What is the unit of measurement?
  • What might a high or low value tell us?
  • How could we improve this measure?

 

The first type of ratio we will analyze is a short-term solvency or liquidity ratio.  The definition of solvency is where a firm has the capacity to meet its financial obligations when due.  The definition of liquidity means that the firm has assets which are readily convertible to cash.  On the balance sheet, this is why assets are listed by order of liquidity, because assets listed first are more readily convertible to cash than assets listed later.

 

Financial statement give the value of assets at book value, or the value of assets as listed per the procedures required by generally accepted accounting principles (GAAP).  Assets also have market value, which means that asset may have a value listed on its books but have different value if the asset was liquidated in the market place.  In many cases, book value and market value greatly differ, which means that asset have different values.  Ratios give any indication of book values relative to market values based on the financial health on the firm.  The types of liquidity ratios are as follows:

 

  • The current ratio measures the amount of short term assets available to cover short-term obligations.  The equation is current assets /current liabilities.  A ratio of 1 or greater indicates that there are more short-term assets that can cover short term obligations (which generally is good).  From a creditor perspective (such as a supplier), the higher the current ratio, the better the liquidity of the firm.  From a firm’s perspective, a high current ratio could indicate high liquidity or an inefficient use of cash or other short-term assets.   

 

  • The quick (or acid-test) ratio measures the liquidity of the firm with the absence of inventory.  Inventory is often the least liquid asset, and is the asset for which book values are the least reliable as measures of market value since the quality of the inventory isn’t considered.  Some of the inventory may later turn out to be damaged, obsolete, or lost.  Large inventories are often a sign of trouble.  The firm may have overestimated sales and overbought or overproduced as a result.  A firm may have a substantial portion of its liquidity tied up in slow moving inventory.  The quick ratio = current assets-inventory/current liabilities.  Just like in the current ratio, one would want a ratio of one or greater.

 

  • The cash ratio shows how much liquidity is made up cash.  One would want a ratio of one or greater.

 

Long-term solvency ratios are intended to address the firm’s long-run ability to meet its obligations.  Sometime these ratios are called leverage ratios.  The types of long-term solvency ratios are:

 

  • The total debt ratio measures the debt levels (obligations to creditors) relative to the assets of the firm.  The total debt ratio is equal to total assets – total equity/total assets.  Other ratios which are derivations of the total debt ratio include the debt to equity ratio and the equity multiplier.  The debt to equity ratio equals total debt/total equity, and equity multiplier equals total assets/total equity or total equity + total debt/total equity.
  • The times interest earned (TIE) ratio measures how well company has its interest obligations covered, and it is often called the interest coverage ratio. The TIE ratio equals EBIT (earnings before interest and taxes)/interest.  EBIT many times is the same thing as “operating profit”, but it can differ depending on the financial statements
  •  The cash coverage ratio is very similar to the times interest ratio, except that it takes non-cash items (depreciation and amortization) into account so that one gets a total view of cash flow and how much available to cover interest.  The cash coverage ratio equals EBITDA/interest; the high the number the better.

 

Asset management or “turnover” ratios measures tell how well a firm utilizes its assets to make sales.  A good way to think about this is that one would want the lowest amount of assets possible making the most amount of sales.

 

Turnover ratios deal with the working capital account (accounts receivable, inventory, and account payable) we dealt with in week one.  As was stated in week one, one would desire to free up as much cash as possible and not have cash tied up in the working capital accounts.  The more sales one can generate from the least amount of assets, the better.  The types of turnover ratios are as follows:

 

Inventory turnover and days sales in inventory indicate how well inventory turns or flows in and out of a business.  As long as a business keep enough availability for customers, a business typically desires a high inventory turnover number and a low days sales of supporting inventory.  Inventory turnover equals cost of goods sold/inventory; in many cases one would use average inventory if comparing more that one year’s data.  Days sales in inventory equals 365/inventory turnover.  Many of these concepts for inventory were discussed in week one, so this is only a refresher.

Inventory measures give some indication of how fast we can sell products.  We now look at how fast we collect on those sales.  We do this by analyzing receivable turnover.  Receivables turnover equals sales/accounts receivable.  Once we calculate receivable turnover, we can calculate days sales in receivables which equals 365/receivables turnover.  Both answers will be the same

 

We calculate payables turnover and days sales in payables the same way as we calculate inventory turns and days sales of inventory.  One would use the payables balance in the denominator instead of the inventory balance.

 

To get the larger, strategic picture of asset turnover, one would need to compare total sales to total assets; total asset turnover is equal to Net Sales/Total Assets.  Preferably, the higher the number for total asset turnover the better.  It might seem that a high asset turnover is always a good sign for a company, but it isn’t necessarily.  Consider a company with old assets.  The assets would be almost fully depreciated and might be very outdated.  In this case, the book value of assets is low contributing to a high assets turnover.  Plus, the high turnover might mean that will need to make major capital outlays in the near future.  A low asset turnover might seem bad but the company could have just purchased new equipment, which would drive asset turnover down.  From a supply chain perspective, we have to do a breakout of current assets and long term assets to get a better gist of how each asset affects return on assets and return on equity.  We will further discuss return on assets and return on equity and asset turnover when we cover the DuPont/Strategic Profit Model.

 

Profitability measures show how efficiently the firm uses its assets and efficiently the manages its operations.  The profit margin tells a firm how much profit it makes relative to each sales dollar.  Profit margin is equal to net income/sales.  All other things being equal, a relatively high profit margin is obviously desirable.  This situation corresponds to low expense ratios relative to sales.  Many times, however, situations are often not equal.  For example, lowering the sales price will usually increase unit volume but lower profit margins.  Operating cash flow may decrease, which could detrimental to the business.  Profit margin is a key measure on if the business cash keep sustainable cash flow and if the business can generate residual cash flow above what is required based on risk and the required return.  This “residual” cash flow is key to ensuring an increasing stock price and financing capital expenditures without borrowing.

 

The return on assets ratio (ROA) is a measure of the per dollar profit of assets.   ROA equals net income/total assets.  This measure is a powerful measure of whether assets are delivering the required return for investors.

 

The return on equity (ROE) is a measure of the per dollar profit of equity and how stockholders fared during the year(s).  Since benefiting shareholders (profit maximization) is the ultimate goal of any business, ROE is the true bottom-line measure of performance.  ROE is equal to net income/total equity. 

 

Because ROA and ROE are such commonly cited numbers, it is important to remember that these numbers are accounting rates of return.  It would be inappropriate to compare accounting numbers to market interest rates.  When ROE is greater than ROA, this denotes that the firm used financial leverage (debt) to increase return on equity.

 

Market value measures use accounting profit to compare stock prices of different companies.  Investors use these measures to select stocks which provide the best returns to the risk involved.  Earnings per share (EPS) measures net income to the number of shares outstanding to investors, which is equal to net income/shares outstanding.  EPS helps to use to calculate the Price-Earnings Ratio (PE) which is equal to the price per share/earnings per share.  The PE ratio measures how much investors are willing to pay per dollar of current earnings, and higher PEs denote that a firm has significant prospects for the future.  In some cases, companies will have negative earnings for an extended period, so the price-sales ratio is a better performance measure.  The price to sales ratio equals the price per share/sales per share.  The price to sales ratio is used more when a business is a start up firm and will have negative cash flow from period to period.  The market to book ratio compares the market value of the firm’s investments to their cost.  A market to book ratio of less than one could mean that a firm has not been successful overall in creating value for it shareholders.  The market to book ratio is equal to the market value per share/book value per share

 

This concludes our analysis of financial ratios.  We will take a look at these ratios together to see how the supply chain can add or “destroy” shareholder value.  We will use the DuPont Identity/Strategic Profit Model to strategically look to see how supply chain decision affect corporate results.