Financial Accounting 004: Ratio Analysis

Before embarking on ratio analysis, do keep in mind that ratios are contextual and you have to decipher the underlying activity that the ratios represent. Also, the absolute value of the ratios are useless; ratios have to be observed over a period, or be compared across the industry, to paint a meaningful picture of the company.

Common Pitfalls

There is no common standard for calculating ratios across companies, therefore be careful when comparing the figures.

Ratios can be disrupted by major changes in a company, reducing the effectiveness of time series analysis, and if the changes cause the company to pivot from the original industry and market, it will also disrupt cross section analysis.

Ratios can be manipulated by management, so do look at multiple ratios to get a complete picture.


1. Return on Equity (ROE)

ROE = Net Income / Average Shareholders’ Equity (of beginning and ending balances).

ROE measures the return on investment. Typically with higher risks, the investment will provide higher ROE.

There are 2 drivers of ROE, one is the operating performance of the business, and the other is the level of financial leverage.

2. Return on Assets (ROA)

ROA = Net Income / Average Assets.

ROA measures the effectiveness of the company in generating profit from existing company resources.

3. Financial Leverage

Financial Leverage = Average Assets / Average Shareholders’ Equity.

This ratio can only exceed the value of 1 with leverage. This particular measure is more effective for analysing ROE.

This measures how much of the existing company resources are funded by debts.

ROE Drivers

ROE = ROA x Financial Leverage.

Increasing either ROA or Financial Leverage will improve ROE.


A Closer Look at Return on Assets

There are also 2 drivers of ROA, one is the profitability of the company, while the other is the efficiency in generating sales.

4. Return on Sales (ROS)

ROS = Net Income / Sales

This measures the profit generated per dollar of sales.

5. Asset Turnover (ATO)

ATO = Sales / Average Assets

This measures the amount of sales generated based on the existing available resources.

ROA = ROS x ATO.

To look at the operating performance more objectively, it would be wise to use de-levered net income in all the calculations, so that the after-tax interest expense had been compensated. This reflects the true efficiency and profitability of the business regardless of the capital structure.

De-levered net income = net income + ( interest expense x (1-tax rate) )

However, ROE should use levered net income instead as you want to take into account the effect of leverage. Therefore when analysing ROE and all its component, consider the effect of leverage.


DuPont Ratio Analysis

DuPont Analysis

The DuPont formula equates Return on Equity to the drivers mentioned above:

ROE = (Net Income / Sales) x (Sales / Assets) x (Assets / Equity)
ROE = Profitability x Efficiency x Leverage

When evaluating companies using this analysis, you should be mindful of the business strategy to ensure that you are making an apple-to-apple comparison. Huge retail discount stores for example, typically have low profitability but high efficiency. Luxury retails on the other hand has low efficiency but high profitability.

Common Size

Common-sizing the financial statements can help to reduce the effect of growth and other volatility on the numbers and make it easier for us to identify trends.

  • Balance sheet numbers can be expressed as a percentage of total assets
  • Income statement can be expressed as a percentage of total sales

Profitability in Details

To make better analysis, we can look at more detailed ratios of sales and expenses.

  • Gross Margin = (Sales – COGS) / Sales
    The extra premium charged for the goods above the cost of production.
  • SG&A to Sales = SG&A Expenses / Sales
    Selling, General and Administration (Operating) cost compared to sales.
  • Operating Margin = Operating Income / Sales
    Earnings before interest and taxes compared to sales.
  • Interest Expense to Sales = Interest Expense / Sales
    Cost of borrowing compared to sales.
  • Effective Tax Rate = Income Taxes / Pre-tax Income
    Amount of income paid to taxes.

Asset Turnover in Details

To have a closer look at asset turnover, we can start from the following ratios.

  • Accounts Receivables Turnover = Sales / Avg. Accounts Receivable
  • Inventory Turnover = COGS / Avg. Inventory
  • Accounts Payable Turnover = Purchases / Avg. Accounts Payable
    (Purchases = Ending Inventory – Opening Inventory + COGS)
  • Fixed Asset Turnover = Sales / Avg. Net PPE

The equivalent of the above, from the perspective of days outstanding ratios, are the following.

  • Days Receivables = 365 / Accounts Receivables Turnover
    The average number of days company have to wait to receive payment from customers, after delivering the goods.
  • Days Inventory = 365 / Inventory Turnover
    The average number of days the company took to turn incoming raw materials into goods and deliver it to customers.
  • Days Payable = 365 / Accounts Payable Turnover
    The average number of days the company took to pay off suppliers.
  • Net Trade Cycle = Days Inventory + Days Receivable – Days Payable
    This is the average number of days of cash shortfall, during which the company will have to borrow to pay off suppliers while waiting to receive payments from customers.

Other Ratios

Short-term liquidity ratios help us to gauge if the company has sufficient cash to pay off short term liabilities.

  • Current Ratio = Current Assets / Current Liabilities
    Measures if current assets are able to cover current liabilities. But not all components of current assets can be quickly converted to cash.
  • Quick Ratio = (Cash + Receivables) / Current Liabilities
    Measures if the company has sufficient cash to cover current liabilities.
  • CFO to Current Liabilities = Cash from Ops / Avg. Current Liabilities
    Measures if cash generated from operations is able to cover current liabilities.

Short-term interest coverage ratios  help us to gauge if the company has sufficient cash to cover for interest payments.

  • Interest Coverage = (Operating Income before Depreciation) / Interest Expense
    This measures if the income from operations is able to cover interest payment.
  • Cash Interest Coverage = (Cash from Ops + Cash Interest Paid + Cash Taxes) / Cash Interest Paid
    This measures if the cash from operations able to cover interest payment.

Long-term Debt Ratios describes how the company finance growth and is a measure of bankruptcy risk.

  • Debt to Equity = Total Liabilities / Shareholders’ Equity
    This measures for every dollar of shareholders’ investment, how much did the company borrow to finance itself. Sometimes, total assets is used in the denominator is SE is too small.
  • Long-Term-Debt to Equity = Total Long-Term Debt / Total Shareholders’ Equity
    This measures how much long-term borrowing the company took as compared to shareholders’ investment.
  • Long-Term Debt to Tangible Assets = Total Long-Term Debt / (Total Assets – Intangible Assets)
    This compares the amount of borrowings with the amount of assets that can be collaterised.

 

(Reference: Coursera Wharton Online Introduction to Financial Accounting)

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s