Chapter 12. Financial Ratio Analysis.

The firm's purpose is not only internal control but also better understanding of what capital suppliers seek in financial condition and performance from it.

INTRODUCTION TO FINANCIAL ANALYSIS.
The type of analysis varies according to the specific interests of the party involved:
 Trade creditors are interested primarily in the liquidity of a firm.
 Bondholders are more interested in the cash-flow ability of the company to service debt over the long run.
 Investors in a company's stock are concerned principally with present and expected future earnings and the stability of these earnings about a trend, as well as their covariance with the earnings of other companies.
 Management also employs financial analysis for purposes of internal control. In particular, it is concerned with profitability on investment in the various assets of the company and in the efficiency of asset management.

Use of financial ratios.
Financial ratios help us size up a company as to trends and relative to others.

The analysis of financial ratios involves two types of comparison:
Trend Analysis. Compare a present ratio with past and expected future ratios for the same company.
Comparison with Others. Compare the ratios of one firm with other similar firms or the industry average.

Some Caveats
The analyst should avoid using rules of thumb indiscriminately for all industries. The analysis must be in relation to the type of business in which the firm is engaged and to the firm itself.

Similarly, analysis of the deviation from the norm should be based on some knowledge of the distribution of ratios for the companies involved.

Comparisons with the industry must be approached with caution. The industry ratios should not be treated as target asset and performance norms. Rather, they provide general guidelines.

The analyst should realize that the various companies within an industry grouping may not be homogeneous.

Because reported financial data and their ratios are numerical, there is a tendency to regard them as precise portrayals of a firm's true financial status. The analyst should use caution in interpreting the comparisons between the data of different firms, even with standardized figures.

Types of Ratios.
Financial ratios can be grouped into five types: liquidity, debt, profitability, coverage, and market value ratios.


LIQUIDITY RATIOS.
Liquidity ratios allow assessment of whether a company is likely to be able to pay its bills.

Current Ratio = Current assets / Current liabilities

Quick Ratio = Current assets less inventories / Current liabilities
or Acid-Test

Liquidity of Receivables.
A longer average collection period results in more funds being tied up in receivables, which are liquid only insofar as the can be collected in a reasonable amount of time:

Average collection period = (Receivables x 365) / Annual credit sales
Receivable turnover ratio = Annual credit sales / Receivables

Year-End versus Average Receivables. When sales are seasonal or have grown considerable over the year, using the year-end receivable balance may not be appropriate: an average of the monthly closing balance should be used.

Interpreting the information. Either ratio must be analysed in relation to the billing terms given on the sales.

Aging of Accounts. With this method, we categorize the receivables at a moment in time according to the proportions billed in previous months. This gives us considerably more information than the calculation of the average collection period because it pinpoints the trouble spots more specifically.

Duration of payables.

Average payable period = (Accounts payable x 365) / Purchases

Liquidity of Inventories.
Inventory turns tell us the funds being tied up in inventories as well as give us a hint as to possible obsolescence.

Inventory turnover ratio = Cost of goods sold / Average inventory

DEBT RATIOS.
Debt ratios reflect the relative proportion of debt funds employed.

Debt-to-equity ratio = Total debt / Shareholders' equity
Long-term capitalization = Long-term debt / Total capitalization

Cash Flow to Debt and Capitalization.
The cash flow is defined as earnings before interest, taxes, depreciation, and amortization (EBITDA).

Cash-flow-to-total-liabilities ratio = Cash flow (EBITDA) / Total liabilities

This ratio is useful in assessing the creditworthiness of a company seeking debt funds.
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Cash-flow-to-long-term-debt-ratio = Cash flow (EBITDA) / Long-term debt

This ratio is used to evaluate the bonds of a company.
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Enterprise value-to-EBITDA ratio = (Total borrowings + Equity / Cash flow (EBITDA)

The higher this ratio, the greater the value that is being placed on the securities. When the ratio exceeds 8 the possibility of default is significant.


COVERAGE RATIOS.
Coverage ratios are designed to relate the financial charges of a firm to its ability to service them. Coverage ratios give insight into the ability of a company to service its debt.

Interest Coverage Ratio.

Interest coverage ratio = Earnings before interest and taxes / Interest charges

There are different methods to calculate the interest charges:
 Overall coverage method. A company must meet all fixed interest, regardless of the seniority of the claim.
 Prior deductions method. We deduct interest on the senior bonds from average earnings and then divide the residual by the interest on the junior bonds. This method is the most objectionable, as it gives the illusion that junior bonds are more secure than senior obligations.
 Cumulative deduction method. It is the most widely used method. Carrying charges of all debt ranking ahead or pari passu with the issue in question is divided into available earnings. For example, coverage for senior bonds are calculated only using their interest charges (and not considering junior bonds). On the other hand, coverage for the junior bonds is determined by adding the interest charges on both bonds and relating the total to average earnings.

Cash-Flow Coverage Ratios.

Cash-flow coverage of interest =
EBITDA / Annual interest payments

This ratio is very useful in determining whether a borrower is going to be able to service interest payments on a loan. Lenders want a coverage ratio comfortably above 2.0. To be investment grade it usually must be 4.0.
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Cash-flow coverage of interest and principal ratio = EBITDA / Interest + Principal payments [1/(1-t)]
where t is the income tax rate and principal payments are annual.

PROFITABILITY RATIOS.
These ratios indicate the firm's efficiency of operation.

Profitability in Relation to Sales.

Gross profit margin = Sales less cost of goods sold / Sales

This ratio indicates the efficiency of operations as well as how products are priced.
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Net profit margin = Net profits after taxes / Sales

If the gross profit margin is essentially unchanged over a period of several years, but the net profit margin has declined, we know that the cause is either higher selling, general, and administrative expenses (SG&A) relative to sales or a higher tax rate.

On the other hand, if the gross profit margin falls, we know that the cost of producing the goods relative to sales has increased, This ocurrence, in turn, may be due to problems in pricing or costs.
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SG&A to sales = Selling, general & administrative expenses / Sales

When the SG&A-to-sales increases over time and/or is large relative to peer companies it gives us cause for concern.

Net profit margin is a combination of the gross profit margin and SG&A to sales.

Profitability in Relation to Investment.

Rate of return on equity = (Net profits after taxes - Preferred stock dividend) / Shareholders' equity

This ratio tells us the earning power on shareholders' book investment.
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Return on assets (ROA) = Net profits after taxes / Total assets

Net operating profit rate of return =
Earnings before interest and taxes / Total assets

Turnover and Earning Power.
Higher asset turnover means less investment in assets is necessary to produce sales.

Asset turnover ratio = Sales / Total assets

This ratio tells us the relative efficiency with which the firm utilizes its resources in order to generate output. It varies according to the type of company being studied.
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Earning power = Net profits after taxes / Total assets

Another way to look at the return on equity is to gross it up by the equity multiplier associated with the use of debt.

Return on equity (ROE) = Earning power x (1 + Debt/Equity)

MARKET VALUE RATIOS.
There are several widely used ratios that relate the market value of a company's stock to profitability, to dividends, and to book equity.

Price/earnings, dividend yield, and market/book give indication of the relative valuation of a stock.

Price/Earnings Ratio.
The higher this ratio, the more value of the stock that is being ascribed to future earnings as opposed to present earnings. That is to say, likely future growth is what is being valued.

P/E ratio = Share price / Earnings per share

Dividend Yield.
Typically companies with good growth potential retain a high proportion of earnings and have a low dividend yield, whereas companies in more mature industries pay out a high portion of their earnings and have relatively high dividend yield.

Dividend yield = Dividends per share / Share price

Market-to-Book Ratio.
The market-to-book value ratio is a relative measure of how the growth option for a company is being valued vis-à-vis its physical assets. The greater the expected growth and value placed on such, the higher this ratio.

M/B ratio = Share price / Book value per share

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Another ratio used is the Tobin's Q ratio, in which the market value of a company is the sum of the market values of all debt instruments plus the total market value of the stock.

Q ratio = Market value of company / Replacement costs of assets

Similar to the ratio above, companies with Q ratios of less than 1.0 often are harvest situation that are worth more dead than alive (a company earns less than what financial markets require). The higher the Q ratio, the greater the industry attractiveness and/or competitive advantage.


PREDICTIVE POWER OF FINANCIAL RATIOS.
A number of empirical studies have tested the predictive power of financial ratios. The best ratios for predictive purposes are debt-to-equity, cash-flow-to-debt, net operating profit margin, debt coverage and its stability, return on investment, size, and earnings stability.

Predicting Financial Distress.
Ratios have predictive power when it comes to financial distress. It appears that a handful of ratios can be used to predict the long-term credit standing of a firm.

Altman found that five financial ratios were able to discriminate rather effectively between bankrupt (Z<1.81) and nonbankrupt companies(Z>2.99), beginning up to 5 years prior to the bankruptcy event.

The Z-score model itself was the following:
Z = 1.2 X₁ + 1.4 X₂ + 3.3 X₃ + 0.6 X₄ + 1.0 X₅
where:
X₁ = Working capital to total assets
X₂ = Cumulative retained earnings to total assets
X₃ = Earnings before interest and taxes to total assets
X₄ = Market value of equity to book value of total liabilities
X₅ = Sales to total assets

This model was expanded into what is known as the Zeta model, which includes Z scores for thousands of companies.


COMMON SIZE AND INDEX ANALYSES.
It is often useful to express balance sheet and income statement items as percentages. The percentages can be related to totals (common size analysis), or to some base year (index analysis).

The evaluation of trends in financial statemente percentages over time affords the analyst insight into the underlying improvement or deterioration in financial condition and performance.

Statement Items as Percentages of Totals.
Common size expresses assets and liabilities as a percent of total assets, and expenses and profits as a percent of sales.

Statement Items as Indexes Relative to a Base Year.
Index analysis expresses balance sheet and income statement items in index form relative to a base year.

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EJERCICIOS - Serie 1 - Capítulo 12