Handout-2 Introduction to Financial Ratios Fall-2024

FINANCIAL ANALYSIS

INTRODUCTION TO FINANCIAL RATIOS

Various tools and techniques are used to convert financial statement data into formats that
facilitate analysis. These include ratio analysis, common-size analysis, graphical analysis, and
regression analysis.

Ratio Analysis
Ratios are useful tools for expressing relationships among data that can be used for internal
comparisons and comparisons across firms. They are often most useful in identifying
questions that need to be answered, rather than answering questions directly. Specifically,
ratios can be used to do the following:

Project future earnings and cash flow.

Evaluate a firm’s flexibility (the ability to grow and meet obligations even when
unexpected circumstances arise).
Assess management’s performance.
Evaluate changes in the firm and industry over time.
Compare the firm with industry competitors.
Analysts must also be aware of the limitations of ratios, including the following:
Financial ratios are not useful when viewed in isolation. They are only informative
when compared to those of other firms or to the company’s historical performance.
Comparisons with other companies are made more difficult by different accounting
treatments. This is particularly important when comparing U.S. firms to non-U.S.
firms.
It is difficult to find comparable industry ratios when analyzing companies that operate
in multiple industries.
Conclusions cannot be made by calculating a single ratio. All ratios must be viewed
relative to one another.
Determining the target or comparison value for a ratio is difficult, requiring some range
of acceptable values.

It is important to understand that the definitions of ratios can vary widely among the
analytical community. For example, some analysts use all liabilities when measuring
leverage, while other analysts only use interest-bearing obligations. Consistency is
paramount. Analysts must also understand that reasonable values of ratios can differ among
industries.

Financial Analysis UCP-Business School

Handout-2 Introduction to Financial Ratios Fall-2024

Common-Size Analysis
Common-size statements normalize balance sheets and income statements and allow the
analyst to more easily compare performance across firms and for a single firm over time.
A vertical common-size balance sheet expresses all balance sheet accounts as a
percentage of total assets.
A vertical common-size income statement expresses all income statement items as a
percentage of sales.
In addition to comparisons of financial data across firms and time, common-size analysis is
appropriate for quickly viewing certain financial ratios. For example, the gross profit margin,
operating profit margin, and net profit margin are all clearly indicated within a common-size
income statement. Vertical common-size income statement ratios are especially useful for
studying trends in costs and profit margins.
income statement account
vertical common-size income statement ratios =
sales

Balance sheet accounts can also be converted to common-size ratios by dividing each balance
sheet item by total assets.
balance sheet account
vertical common-size balance-sheet ratios = total assets

Vertical Common-Size Balance Sheet and Income Statement

Financial Analysis UCP-Business School

Handout-2 Introduction to Financial Ratios Fall-2024

Vertical Common-Size Balance Sheet and Income Statement (continued)

Beginning at the bottom, we can see that the profitability of the company has increased nicely
in 20X6 after falling slightly in 20X5. We can examine the 20X6 income statement values to
find the source of this greatly improved profitability. Cost of goods sold seems to be stable,
with an improvement (decrease) in 20X6 of only 0.48%. SG&A was down approximately
one-half percent as well.
These improvements from (relative) cost reduction, however, only begin to explain the 5%
increase in the net profit margin for 20X6. Improvements in two items, “amortization” and
“interest and other debt expense,” appear to be the most significant factors in the firm’s
improved profitability in 20X6. Clearly the analyst must investigate further in both areas to
learn whether these improvements represent permanent improvements or whether these items
can be expected to return to previous percentage-of-sales levels in the future.
We can also note that interest expense as a percentage of sales was approximately the same in
20X4 and 20X6. We must investigate the reasons for the higher interest costs in 20X5 to
determine whether the current level of 2.85% can be expected to continue into the next
period. In addition, more than 3% of the 5% increase in net profit margin in 20X6 is due to a
decrease in amortization expense. Since this is a noncash expense, the decrease may have no
implications for cash flows looking forward.
This discussion should make clear that common-size analysis doesn’t tell an analyst the
whole story about this company, but can certainly point the analyst in the right direction to
find out the circumstances that led to the increase in the net profit margin and to determine
the effects, if any, on firm cash flow going forward.
Another way to present financial statement data that is quite useful when analyzing trends
over time is a horizontal common-size balance sheet or income statement. The divisor
here is the first-year values, so they are all standardized to 1.0 by construction.

Financial Analysis UCP-Business School

Handout-2 Introduction to Financial Ratios Fall-2024

Horizontal Common-Size Balance Sheet Data

20X4 20X5 20X6

Inventory 1.0 1.1 1.4
Cash and marketable securities 1.0 1.3 1.2
Long-term debt 1.0 1.6 1.8
PP&E (net of depreciation) 1.0 0.9 0.8

Trends in the values of these items, as well as the relative growth in these items, are readily
apparent from a horizontal common-size balance sheet.

We can view the values in the common-size financial statements as ratios. Net income is
shown on the common-size income statement as net income/revenues, which is the net profit
margin, and tells the analyst the percentage of each dollar of sales that remains for
shareholders after all expenses related to the generation of those sales are deducted. One
measure of financial leverage, long-term debt to total assets, can be read directly from the
vertical common-size financial statements. Specific ratios commonly used in financial
analysis and interpretation of their values are covered in detail in this review.

Graphical Analysis
Graphs can be used to visually present performance comparisons and composition of
financial statement elements over time.

Financial Analysis UCP-Business School

Handout-2 Introduction to Financial Ratios Fall-2024

FINANCIAL RATIOS

Financial ratios can be segregated into different classifications by the type of information
about the company they provide. One such classification scheme is:

Activity ratios. This category includes several ratios also referred to asset utilization or
turnover ratios (e.g., inventory turnover, receivables turnover, and total assets
turnover). They often give indications of how well a firm utilizes various assets such as
inventory and fixed assets.

Liquidity ratios. Liquidity here refers to the ability to pay short-term obligations as
they come due.

Solvency ratios. Solvency ratios give the analyst information on the firm’s financial
leverage and ability to meet its longer-term obligations.

Profitability ratios. Profitability ratios provide information on how well the company
generates operating profits and net profits from its sales.

p ratios. Sales per share, pearnings

Valuation g per share, and price to cashpflow per share
are exam les of ratios used in com arin the relative valuation of com anies.

Profitability Ratios
Profitability ratios measure the overall performance of the firm relative to revenues, assets,
equity, and capital.
The net profit margin is the ratio of net income to revenue:
net income
net profit margin = revenue

Analysts should be concerned if this ratio is too low. The net profit margin should be
based on net income from continuing operations, because analysts should be primarily
concerned about future expectations, and below-the-line items such as discontinued
operations will not affect the company in the future.
Operating profitability ratios look at how good management is at turning their efforts
into profits. Operating ratios compare the top of the income statement (sales) to profits
The different ratios are designed to isolate specific costs.

Know these terms:

gross profits = net sales – COGS

operating profits = earnings before interest and taxes = EBIT

net income = earnings after taxes but before dividends

total capital = long-term debt + short-term debt + common and preferred equity

total capital = total assets

Financial Analysis UCP-Business School

Handout-2 Introduction to Financial Ratios Fall-2024

How they relate in the income statement:

The gross profit margin is the ratio of gross profit (sales less cost of goods sold) to
sales:
gross profit
gross profit margin = revenue

An analyst should be concerned if this ratio is too low. Gross profit can be increased by
raising prices or reducing costs. However, the ability to raise prices may be limited by
competition.
The operating profit margin is the ratio of operating profit (gross profit less selling,
general, and administrative expenses) to sales. Operating profit is also referred to as
earnings before interest and taxes (EBIT):
operating income EBIT
operating profit margin = revenue
or revenue

Strictly speaking, EBIT includes some nonoperating items, such as gains on

investment. The analyst, as with other ratios with various formulations, must be
consistent in his calculation method and know how published ratios are calculated.
Analysts should be concerned if this ratio is too low. Some analysts prefer to calculate
the operating profit margin by adding back depreciation and any amortization expense
to arrive at earnings before interest, taxes, depreciation, and amortization (EBITDA).

Sometimes profitability is measured using earnings before tax (EBT), which can be
calculated by subtracting interest from EBIT or from operating earnings. The pretax
margin is calculated as:
EBT
pretax margin = revenue

Financial Analysis UCP-Business School

Handout-2 Introduction to Financial Ratios Fall-2024

Another set of profitability ratios measure profitability relative to funds invested in the
company by common stockholders, preferred stockholders, and suppliers of debt
financing. The first of these measures is the return on assets (ROA). Typically, ROA is
calculated using net income:
net income
return on assets (ROA) = average total assets

This measure is a bit misleading, however, because interest is excluded from net
income but total assets include debt as well as equity. Adding interest adjusted for tax
back to net income puts the returns to both equity and debt holders in the numerator.
The interest expense that should be added back is gross interest expense, not net
interest expense (which is gross interest expense less interest income). This results in
an alternative calculation for ROA:
net income+ interest expense (1−tax rate)
return on assets (ROA) =
average total assets

A measure of return on assets that includes both taxes and interest in the numerator is
the operating return on assets:
operating income EBIT
operating return on assets = average total assets
or average total assets

The return on total capital (ROTC) is the ratio of net income before interest and taxes
to total capital:
EBIT
return on total capital = average total capital

Total capital includes short- and long-term debt, preferred equity, and common equity.
Analysts should be concerned if this ratio is too low.
An alternative method for computing ROTC is to include the present value of operating
leases on the balance sheet as a fixed asset and as a long-term liability. This adjustment
is especially important for firms that are dependent on operating leases as a major form
of financing.
The return on equity (ROE) is the ratio of net income to average total equity (including
preferred stock):
net income
return on equity = average total equity

Analysts should be concerned if this ratio is too low. It is sometimes called return on
total equity.
A similar ratio to the return on equity is the return on common equity:
net income – preferred dividends
return on common equity =
average common equity
net income available to common
= average common equity
This ratio differs from the return on total equity in that it only measures the accounting
profits available to, and the capital invested by, common stockholders, instead of
common and preferred stockholders. That is why preferred dividends are deducted
from net income in the numerator. Analysts should be concerned if this ratio is too low.
The return on common equity is often more thoroughly analyzed using the DuPont
decomposition, which is described later in this topic review.

Financial Analysis UCP-Business School

Handout-2 Introduction to Financial Ratios Fall-2024

EXAMPLE: Calculating ratios

A balance sheet and income statement for Sedgwick Company are shown in the following tables for this
year and the previous year.
Using the company information provided, calculate the following ratios for the current year: current ratio,
total asset turnover, net profit margin, return on common equity, and total debt to equity.

Sedgwick Company Balance Sheet

Year Current Year Previous Year
Assets
Cash and marketable securities $105 $95
Receivables 205 195
Inventories 310 290
Total current assets 620 580
Gross property, plant, and equipment 1,800 $1,700
Accumulated depreciation 360 340
Net property, plant, and equipment 1,440 1,360
Total assets $2,060 $1,940
Liabilities
Payables $110 $90
Short-term debt 160 140
Current portion of long-term debt 55 45
Current liabilities 325 $275
Long-term debt 610 $690
Deferred taxes 105 95
Common stock at par 300 300
Additional paid in capital 400 400
Retained earnings 320 180
Common shareholders equity 1,020 880
Total liabilities and equity $2,060 $1,940

Sedgwick Company Income Statement

Year Current Year
Sales $4,000
Cost of goods sold 3,000
Gross profit 1,000
Operating expenses 650
Operating profit 350
Interest expense 50
Earnings before taxes 300
Taxes 100
Net income 200
Common dividends 60

Financial Analysis UCP-Business School