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Accountants have irrelevant, but objective historical costs. This means that it is the
user’s responsibility to make adjustments.
• They are also useful for comparing companies of different sizes, particularly
within the same industry
A firm has inventory of $700, accounts payable of $300, cash of $80, fixed assets of
$1,600, long-term debt of $1,400, accounts receivable of $320, and total equity of
$1,000. What is the common-size percentage for the accounts receivable?
Or:
Ratio Analysis
• Ratios also allow for better comparison through time or between companies
• How it is computed?
Benchmarking
• Time-Trend Analysis
• Profitability ratios
Numbers in millions
Numbers in millions
1.Short Term Solvency Or Liquidity Ratios
Current Ratio = CA / CL
• This may be true if you are a short-term creditor, but liquid assets are generally
less profitable for the company.
• Consequently, too large an investment in current assets may reduce the earnings
power of the firm and actually reduce the stock price.
A Firm has current liabilities of $5,600, net working capital of $2,100, inventory of
$3,900, and sales of $13,500. What is the quick ratio?
– The firm finances slightly over 28% of their assets with debt.
• Debt/Equity = TD / TE
Roy’s Shop has sales of $639,320, total assets of $527,200, a debt-equity ratio of .75,
and a profit margin of 5 percent. What is the equity multiplier?
If equity is $1, then debt must be $.75, which means that total assets are $1.75.
B- Coverage Ratios
EBIT $17000
Interest ($3,400)
A Company has sales of $984,600, cost of goods sold of $702,100, and inventory of
$5,120. How long on average does it take to sell its inventory?
B- Receivables Ratios
A Company has sales of $498,000, cost of goods sold of $263,000, and accounts
receivable of $61,000. How long on average does it take the firm’s customers to pay
for their purchases?
• Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets
A firm has $61,300 in receivables and $391,400 in total assets. The firm has a total
asset turnover rate of 1.4 and a profit margin of 6.3 percent. What is the days’ sales in
receivables?
A manufacturer would typically consider inventory at cost and thus relate inventory to
cost of goods sold. However, a retailer might maintain its inventory level based on retail
price. In the latter case, inventory should be related to sales to compute inventory
turnover.
Suppose a firm’s average collection period is significantly higher than the industry norm.
What questions might one ask to make a final determination about the firm’s ability to
manage its assets?
What are the firm’s credit terms?
Has the average collection period been trending upward, or is this an aberration?
Which consumers are contributing to the relatively high average collection period?
For example, a high fixed asset turnover ratio relative to that of the industry can be the
result of efficient asset utilization, or it can indicate that the firm is utilizing old or
inefficient equipment, while others in the industry have invested in modern equipment.
The firm using inefficient equipment would display a favorable fixed asset turnover
ratio, but would be likely to display a higher level of expenses, lower profitability –
based on cash flow.
A firm has total debt of $364,000, total equity of $520,000, and a return on equity of
12.5 percent. What is the return on assets?
A Firm has total assets of $212,000, a debt-equity ratio of .6, and net income of
$9,500. What is the return on equity?
• These measures are based on book values, so they are not comparable with
returns that you see on publicly traded assets
= 363/ 33 = $11
88/ 11 = 8 times
Market-to-book ratio = market value per share / book value per share
Computers Inc., has a market-to-book ratio of 3.5, net income of $84,000, a book
value per share of $20.16, and 50,000 shares of stock outstanding. What is the
price-earnings ratio?
a. 21 b. 27 c. 42 d. 49
• If the benchmark market P/E is higher than it used to be, what does that
suggest for the interpretation of company P/Es?
• How the market-to-book ratio could be interpreted if one was considering the
purchase of a company’s stock?
The market is evaluating the company’s future earning power, while the book value
figures reflect the cost at which stock had previously been issued and the earnings that
had been retained in the firm.
Economic Value Added (EVA) is relatively recent addition to the analyst’s toolbox.
EVA is the difference between the firm’s after-tax net operating profit and its cost of
funds.
Problem
Complete the balance sheet and sales information in the table that follows using the
following financial data:
(0.50)($300,000) = $150,000.
(1.5)($300,000) = $450,000.
5. Cost of goods sold = (Sales)(1 - 0.25) = ($450,000)(0.75) = $337,500.
= ($450,000/36.5) = $45,000.
= $160,500.
Deriving the Du Pont Identity
The Du Pont identity provides a way to breakdown ROE and investigates what areas of
the firm need improvement.
• ROE = NI / TE
• ROE = ROA * EM
• ROA = PM * TAT
• ROE = PM * TAT * EM
• ROE = PM * TAT * EM
• Total asset turnover is a measure of the firm’s asset use efficiency – how
well does it manage its assets
A firm has a return on assets of 6.75 percent, a total asset turnover rate of 1.3, and an
equity multiplier of 1.6. What is the return on equity?
ROE = ROA * EM
A Firm has total assets of $12,500, a total asset turnover rate of 1.2, a debt-equity
ratio of .8, and a return on equity of 14.04 percent. What is the firm’s net income?
a. $975 b. $1,150 c. $1,200 d. $1,275
Another Solution
ROE = PM × TAT × EM
TAT = Sales / TA
1 - 33.33% = 66.67%
• The internal growth rate tells us how much the firm can grow assets using
retained earnings as the only source of financing.
A firm has sales of $84,000, total assets of $92,000, net income of $4,600, and
dividends paid of $1,610. What is the internal growth rate?
Internal growth rate = {0.05 * .65} / {1 − 0.05 * 0.65} = 0.0325 / .9675 = 3.36
percent
• The sustainable growth rate tells us how much the firm can grow by using
internally generated funds and issuing debt to maintain a constant debt ratio.
A Firm maintains a constant debt-equity ratio of 0.60. This year the firm has net
income of $43,200 and is paying $15,120 in dividends. The firm has total assets of
$525,000. What is the maximum growth rate of the firm given this information?
Determinants of Growth
• Internal uses
• External uses