Ratio Analysis

Report
© 2013 www.thefundamentalinvestor.com
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Used by investors, creditors, management, and regulators to
assess a firm’s financial condition and performance
Ratios can “standardize” F/S information and make it
possible to compare companies of varying sizes
Anyone can crunch the numbers and generate the
ratios…the real skill is putting life into the numbers
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© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
(1) Determine the purpose of the analysis
 (2) Gather data
 (3) Process the data : calculate ratios, etc.
 (4) Analyze and interpret the data
 (5) Make conclusions
 (6) Follow-up, as necessary
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© 2013 www.thefundamentalinvestor.com
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Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
The analyst should set the stage properly for the analysis by
understanding the landscape. Failure to do so could lead to
wasted time, effort, and resources as the analyst keeps
bumping into brick walls:
 What is the purpose of the analysis?
 What level of detail will be needed?
 What data are available?
 What are the factors and relationships that will influence the analysis?
 What are the analytical limitations? Will these impair the analysis?
The analyst can then select the appropriate
tools to be used for the analysis
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© 2013 www.thefundamentalinvestor.com
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Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Analysis goes beyond merely gathering data, compiling data
into a spreadsheet, and generating graphs or charts
Effective analysis of historical performance includes
understanding WHAT happened, WHY it happened, and
HOW it fits into the overall company strategy
 What aspects of performance are critical for the company to
successfully compete?
 How well did the company’s performance meet these critical aspects?
(Compare the company’s performance vs. benchmarks)
 What were the key causes of this performance, and how does this
performance reflect the company’s strategy?
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© 2013 www.thefundamentalinvestor.com
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Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Additional guide questions for forward-looking analysis:
 What is the likely impact of the trends in the company, industry, and
economy on future cash flows?
 What is the likely response of management to trends?
 What are the recommendations of the analyst?
 What risks should be highlighted?
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© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Motorola ($ Millions)
Net sales
Operating earnings
Nokia Corporation (EUR Millions)
Net sales
Operating earnings
12/31/2005
12/31/2004
12/31/2003
36,843
31,323
23,155
4,696
3,132
1,273
12/31/2005
12/31/2004
12/31/2003
34,191
29,371
29,533
4,639
4,326
4,960
Analysis notes:
 The raw numbers are not directly comparable due to different currencies…thus, look at trends and percentages.
 Note: at that time, Nokia was the industry leader
 Compare the following for the two companies:
 Trends in sales and operating earnings growth
 Motorola shifted strategies: increase its presence in consumer marketing / consumer products to complement its
historically strong technological position
 From Motorola’s 10-K in 2005:
 The introduction of the RAZR in 2004, which sold more than 23 million units since being launched.
 The handset segment reprsented 54% of 2004 sales, and 58% of 2005 sales.
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© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Compare apples vs. apples: use F/S of companies that cover
the same time period
 Use audited F/S whenever possible
 Garbage in, garbage out
 Cost vs. benefit tradeoff:
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 A core set of 25 to 30 ratios will usually provide you with just about the
same important information that 100 ratios will give you
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© 2013 www.thefundamentalinvestor.com
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Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
The numbers, by themselves, are meaningless
Benchmarks are needed to make meaningful comparisons:
 Budgets, goals, and strategies
 Own historical performance
 General industry averages
 Similarly-situated peers
 Regulatory requirements
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© 2013 www.thefundamentalinvestor.com
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Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Care must be taken when using industry norms:
 Some ratios are industry-specific
 A single company might have several different lines of businesses,
thereby distorting the value of ratios calculated at the Parent (or
aggregate) level
 Difference in strategies for each division can affect the usefulness of
some ratios
 Different accounting methods
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© 2013 www.thefundamentalinvestor.com
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Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Evaluation of past performance
Assessment of the current
financial position
Gain insights useful for projecting
future results:
 Microeconomic relationships within a
company
 Financial flexibility: ability to obtain
cash to grow the business, ability to
pay obligations, etc.
 Management’s capability
Ratios are not the end-game answers.
Ratios are just the starting point and indicate
where to conduct further investigation.
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© 2013 www.thefundamentalinvestor.com
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Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
The goal is to understand the reasons for differences
between a company’s performance vs. its peers…hence, the
importance of selecting appropriate benchmarks
Even ratios that remain stable require understanding (and
analysis) because there could be accounting policies selected
to smooth out the trends
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What is a good or bad ratio?
Ratios tell you “what” happened, but not “why” it happened.
 Analysts must understand WHY things happened.
ABC Inc.
Net Income
Revenue
Net Profit Margin (NPM)
XYZ Inc.
Php 500,000
Php 12,000,000
Php 10,000,000
Php 400,000,000
5.0%
3.0%
Which company is more
profitable?
WHY does ABC Inc. have a higher NPM? Is
it due to higher selling price or better cost
control or something else?
What is the better measure
of profitability? Is it the 5.0%
or the Php 1,200,000?
Are there economies of scale that would
make the absolute Peso value more
important than the NPM percentage?
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The use of alternative accounting
methods can distort the comparability
of ratios…hence, analyst adjustments
might be necessary.
Some ratios that would be affected:
1.
Inventory turnover
2. Days to sell inventory
3.
Operating cycle
4. Cash conversion cycle
5.
Gross profit margin
6. Operating profit margin
7.
Net profit margin
8. Return on assets
9. Return on equity
10. Current ratio
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Some ratios are not relevant to certain
companies or industries.
Conglomerates may have divisions
operating in many different industries,
which can make it difficult to find
comparable industry ratios at the parent
company level.
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Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
The need to use human judgment in gathering data,
interviewing management, selecting the ratios, and
analyzing results.
Some ratios might indicate conflicting signals.
Inflationary conditions can distort ratios.
The number of ratios that can be created is practically
limitless. When faced with a new ratio, simply analyze each
component separately in order to understand it.
Financial ratios will eventually vary across time
and across industries. The challenge is to
interpret the differences properly…in some
cases, interpretation can be situation-specific.
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Rule of thumb: if the numerator comes from the Income
Statement and the denominator comes from the Balance
Sheet, then:
Ratio =
Income Statement figure
Average of the Balance Sheet figure
Jan 1 + Dec 31
Average =
2
Average =
Average =
Mar 31 + June 30 + Sept 30 + Dec 31
4
Jan 31 + Feb 28 + Mar 31 + ⋯ + Oct 31 + Nov 30 + Dec 31
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The analyst can average using end-Quarter or
end-Month figures to account for seasonalities.
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Other possible types of “averages”:
Average =
Average =
Average =
Jan 1 + June 30 + Dec 31
3
Jan 1 + Mar 31 + June 30 + Sept 30 + Dec 31
5
Jan 1 + Jan 31 + Feb 28 + Mar 31 + ⋯ + Nov 30 + Dec 31
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The analyst can average using end-Quarter or
end-Month figures to account for seasonalities.
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Intuitively: it’s not practical to take the sum of the
denominator for 365 days, then divide it by 365 days, in order
to match it with the 365 days of the numerator:
Income Statement item: Sum for 365 days
Average =
Balance Sheet item: Sum for 365 days
365 days
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© 2013 www.thefundamentalinvestor.com
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Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
If the denominator (i.e. B/S item) is fairly stable all
throughout the year(s), then it would not matter if
“beginning”, “ending”, or “average” amounts are used.
If the denominator (i.e. B/S item) either increased or
decreased substantially during the year, then use the
“average” amount:
 It is difficult to ascertain whether the numerator (i.e. I/S item) was
generated by February assets or November assets.
Intuitively:
Revenues and Expenses are generated by
Assets, Liabilities, or Equity. Conceptually,
more of the denominator (B/S item) should
lead to more of the numerator (I/S item).
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Two powerful tools to begin the number crunching:
transform the Financial Statements from Peso amounts into
percentages in order to perform:
 Vertical Analysis
 Horizontal Analysis or “trend analysis”
These can reveal possible red flags even before specific
ratios are calculated.
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Common-size Balance Sheet:
 All items as a % of Total Assets
 Total Assets = 100%
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The analyst can dissect the composition of the B/S:
 What is the mix of assets?
▪ Current, non-current, tangible, intangible, etc.
 How is the company financing itself?
▪ Short-term debt, long-term debt, interest-bearing vs. non-interesting-bearing debt,
investor investments, accumulated profits, etc.
 How does the company’s B/S compare to its peers, and what are the
reasons for differences?
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What are your observations?
Alaska Milk
Balance Sheet
December 31
Actual
2010
Actual
2009
Vertical
2010
Vertical
2009
(in Php)
Notes to FS
ASSETS
Current Assets
Cash and cash equivalents
5, 26, 27
ST investments
6, 24, 26, 27
Trade and other receivables
7, 26, 27, 30
Inventories
8
Prepaid expenses and other current assets
26, 27
Total current assets
1,110,623,996
1,833,983,891
827,839,418
2,117,670,472
38,970,814
5,929,088,591
857,054,066
1,044,563,465
893,566,768
1,153,181,393
33,263,909
3,981,629,601
12.15%
20.07%
9.06%
23.17%
0.43%
64.87%
11.79%
14.37%
12.29%
15.86%
0.46%
54.76%
Noncurrent Assets
Available-for-sale investments
Property, plant and equipment
Intangible assets - net
Deferred tax assets
Net pension assets
Other noncurrent assets
Total noncurrent assets
2,556,403
1,562,810,605
1,310,444,899
260,587,503
44,836,138
29,460,456
3,210,696,004
2,556,403
1,515,257,935
1,481,438,498
197,984,388
49,260,438
42,786,207
3,289,283,869
0.03%
17.10%
14.34%
2.85%
0.49%
0.32%
35.13%
0.04%
20.84%
20.37%
2.72%
0.68%
0.59%
45.24%
9,139,784,595
7,270,913,470
100.00%
100.00%
TOTAL ASSETS
9, 26, 27
10
11, 25
21
20
26, 27
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Alaska Milk
Balance Sheet
December 31
What are your observations?
(in Php)
Notes to FS
LIABILITIES AND STOCKHOLERS' EQUITY
Current liabilities
Trade and other payables
12, 25, 26, 27
Acceptances payable
26, 27
Income tax payable
Dividends payable
14, 26, 27
Current portion of obligation under finance
25, 26, 27
leases
Total current liabilities
Actual
2010
2,096,022,469
Actual
2009
Vertical
2010
Vertical
2009
131,913,063
125,099,266
7,227,315
3,065,044,593
1,839,819,125
560,124,762
109,980,839
52,097,499
4,019,227
2,566,041,452
22.93%
7.71%
1.44%
1.37%
0.08%
33.54%
25.30%
7.70%
1.51%
0.72%
0.06%
35.29%
Noncurrent liabilities
Obligation under finance leases - net25,
of 26,
current
27 portion 28,638,522
Total liabilities
3,093,683,115
27,465,248
2,593,506,700
0.31%
33.85%
0.38%
35.67%
%704,782,480
Stockholders' Equity
26
Capital stock
13, 22
971,432,578
APIC
22
152,393,329
Retained earnings
14
Appropriated for various cpaital investment projects
and share buy-back program
2,075,000,000
Unappropriated
3,249,867,801
Treasury stock
13, 14
(402,592,228)
Total SHE
6,046,101,480
968,074,878
118,361,998
10.63%
1.67%
13.31%
1.63%
1,625,000,000
2,318,019,622
(352,049,728)
4,677,406,770
22.70%
35.56%
-4.40%
66.15%
22.35%
31.88%
-4.84%
64.33%
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
7,270,913,470
100.00%
100.00%
9,139,784,595
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Common size Income Statement:
 All items as a % of Total Revenues
 Total Revenues = 100%
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Several key profitability ratios will be revealed:
 The analyst should understand where the profits came from, as well as
which types of expenses are eating up the profits
 Cost control is just as important as revenue growth
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[See Excel file “FS Analysis Examples” for further illustration]
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Alaska Milk
Income Statement
December 31
Actual
2010
(in Php)
Net sales
Cost of sales
GROSS PROFIT
Actual
2009
Actual
2008
Vertical
2010
Vertical
2009
Vertical
2008
12,162,709,978
(7,558,650,096)
4,604,059,882
10,580,440,474
(6,821,522,353)
3,758,918,121
9,967,757,268
(7,903,815,821)
2,063,941,447
100.00%
-62.15%
37.85%
100.00%
-64.47%
35.53%
100.00%
-79.29%
20.71%
Operating expenses
(2,277,295,199)
Interest income
48,748,735
Foreign exchange gain (loss)
(40,319,512)
Gain on disposals of PPE and investment properties3,216,898
Interest expense on obligation under finance leases
(2,100,081)
Casualty loss
Interest expense on bank loans
Rent income
Dividend income and others
(1,998)
Total expenses
(2,267,751,157)
(1,869,510,056)
24,646,247
(26,700,674)
766,164
(1,867,856)
(156,536,291)
(2,453,962)
13,892
(2,031,642,536)
(1,599,921,570)
4,952,263
13,985,346
9,431,114
(60,321,826)
427,891
1,174,323
(1,630,272,459)
-18.72%
0.40%
-0.33%
0.03%
-0.02%
0.00%
0.00%
0.00%
0.00%
-18.65%
-17.67%
0.23%
-0.25%
0.01%
-0.02%
-1.48%
-0.02%
0.00%
0.00%
-19.20%
-16.05%
0.05%
0.14%
0.09%
0.00%
0.00%
-0.61%
0.00%
0.01%
-16.36%
2,336,308,725
1,727,275,585
433,668,988
19.21%
16.33%
4.35%
583,312,875
(62,603,115)
520,709,760
361,555,720
(43,668,855)
317,886,865
80,034,252
62,536,013
142,570,265
4.80%
-0.51%
4.28%
3.42%
-0.41%
3.00%
0.80%
0.63%
1.43%
TOTAL COMPREHENSIVE INCOME / NET INCOME
1,815,598,965
1,409,388,720
291,098,723
14.93%
13.32%
27
2.92%
INCOME BEFORE INCOME TAX
PROVISION FOR (BENEFIT FROM) INCOME TAX
Current
Deferred
Subtotal
© 2013 www.thefundamentalinvestor.com
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The potential for growth of a business is important.
Trend analysis shows whether the company has experienced
growth in the recent past:
 If there has been growth, can it be sustained? How will it be sustained
or increased?
 If there has been little growth, why? Is there any growth in the future?
Where will it come from?
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If the company expects growth in the coming years, does it
have the necessary resources to support it?
 Ex: cash, equipment, employees, funding sources, etc.
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If the company does not foresee growth, what does it plan to
do with its existing assets and liabilities?
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© 2013 www.thefundamentalinvestor.com
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Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Growth in receivables and inventory vs. growth in revenues:
 It is generally more desirable for inventory and receivables to grow at
the same or slower pace than revenue growth
 If receivables grow faster than revenues, this can indicate operational
issues, such as lower credit standards or aggressive accounting
policies for revenue recognition
 If inventory grows faster than revenue growth, this can indicate
operational problems such as obsolescence or aggressive accounting
policies (improper overstatement of inventory to increase profits)
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Trends!!!
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Operating Efficiency Ratios | Activity Ratios:
 Measures how efficiently a company performs day-to-day tasks, such
as collecting receivables
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Liquidity Ratios:
 Measures the ability to meet short-term obligations
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Solvency Ratios:
 Measures the ability to meet long-term obligations
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Coverage Ratios:
 Measures the ability to meet regular debt (re)payments
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Profitability Ratios
 Return on Sales
 Return on Investment
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Different ratios measure
different aspects of the business
Cash Flow Ratios
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RATIO
CALCULATION
WHAT IT MEASURES
BETTER IF
Inventory Turnover (ITO)
Cost of Goods Sold ÷ Average
Inventory
How long it takes to sell inventory
Higher
Days to Sell Inventory
365 days ÷ ITO
How long it takes to sell inventory
Lower
Accounts Receivable
Turnover (ARTO)
Net Credit Sales ÷ Average A/R
How long it takes to collect accounts
receivable from customers
Higher
Average A/R Collection
Period
365 days ÷ ARTO
How long it takes to collect accounts
receivable from customers
Lower
Allowance Adequacy
ADA ÷ (A/R, net + ADA)
The proportion of receivables covered
by allowance for bad debts
Higher
Accounts Payable
Turnover (APTO)
Cost of Goods Sold ÷ Average
A/P
How long it takes to pay suppliers
Lower
APTO variant
Purchases ÷ Average A/P
How long it takes to pay suppliers
Lower
Average A/P Payment
Period
365 days ÷ APTO
How long it takes to pay suppliers
Higher
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Inventory Turnover : Measures how many times per year the
entire inventory was theoretically “turned over” or sold.
Cost of Goods Sold Php 240,000
ITO =
=
= 24x
Average Inventory
Php 10,000
Days to Sell =
365 days 365 days
=
= 15.21 days
ITO
24x
 Inventory was theoretically sold out 24 times during the year.
 Every 15 days, the warehouse would be emptied, then become full
again…then become empty after 15 days…and so forth.
The same logic / intuition
applies to Receivables Turnover
and Payables Turnover
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Jan 1
Jan 16
10,000
Full
–Empty
10,000
Full
Jan 31
Feb 15
March 2
March 17
April 1
April 16
May 1
May 16
–Empty
10,000
Full
–Empty
10,000
Full
The cycle of “full” then “empty”
happens 24x during the year
–Empty
10,000
Full
–Empty
10,000
Full
–Empty
10,000
Full
–Empty
10,000
Full
–Empty
…
10,000
Full
…
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If interim (i.e. less than full-year) data are used, calculate the
corresponding “annualized” figure:
 COGS for 1Q 2013 : Php 3,500,000
 Average inventory for 1Q 2013 : Php250,000
Cost of Goods Sold Php 3,500,000
1Q 2013 ITO =
=
= 14.00x for 1Q 2013
Average Inventory
Php 250,000
Annualized ITO =
Annualized ITO =
12 months
3 months
365 days
90 days
∗ 14x = 56.00x for FY2013
∗ 14x = 56.78x for FY2013
365 days 365 days
Days to Sell =
=
= 6.43 days
ITO
56.78x
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Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Inventory Turnover =
Cost of Goods Sold
Average Inventory
Days to Sell Inventory =
365 Days
ITO
General analytical guidelines:
 Low ITO (and high Days to Sell Inventory) means more resources tied up in inventory…i.e. potentially idle assets.
 Potential indicator of slow-moving inventory.
 Possible reasons: technological obsolescence, change in trends or fashion, etc.
 Analytical questions:
 WHY is inventory slow moving? (or fast moving?)
 WHAT are the implications for future growth? Are the effects temporary or permanent?
 WHAT can be done to address the situation?
 Useful benchmarks: (1) peers; and (2) industry norms.
 Analysis: compare the company’s ITO and revenue growth trend vs. the industry.
 GOOD: Higher ITO (vs. industry) + Same or higher revenue growth (vs. industry)
 Effective inventory management.
 BAD: Higher ITO (vs. industry) + Slower revenue growth (vs. industry)
 Inadequate inventory levels…which could result to inventory shortage and lost sales.
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A/R Turnover =
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Net Credit Sales
Average A/R
Average A/R Collection Period =
365 days
ARTO
General analytical guidelines:
 Ideally, use “Net Credit Sales”. If this is not available, then just use “Sales” as reported in the Income Statement.
 Low ARTO (and high A/R Collection Period) means more resources tied up in receivables.
 Potential indicator of uncollectible receivables…i.e. problems in the credit and collection system.
 Analytical questions:
 WHY is A/R collection slow? (or fast?)
 WHAT are the implications for future growth? Are the effects temporary or permanent?
 WHAT can be done to address the situation?
 Useful benchmarks: (1) peers; and (2) industry norms.
 Analysis: compare the company’s ARTO and revenue growth trend vs. the industry.
 GOOD: Higher ARTO (vs. industry) + Same or higher revenue growth (vs. industry)
 Effective credit and collection system…receivables (and collection) are supporting sales growth properly.
 BAD: Higher ARTO (vs. industry) + Slower revenue growth (vs. industry)
 Possible indicator of very tight credit policy that could lead to lost sales (to competitors with more lenient terms)
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Sales
Source: Fraser and Ormiston (2013). Understanding Financial Statements, 10th edition. Pearson.
2011
2010
Php 6,700,000
Php 7,500,000
202,000
320,000
3,000
12,000
A/R, net
Allowance for doubtful accounts
Analysis of accounts
ADA ÷ (A/R, net + ADA)
2011
2010
1.5%
3.6%
Growth rate: Sales
− 10.7%
---
Growth rate: A/R, net
− 36.9%
---
Growth rate: A/R, gross
− 38.3%
---
Growth rate: ADA
− 75.0%
---
-
Sales have decreased so it is expected that the A/R and ADA would also decrease.
A/R has decreased at a faster rate than sales while the ADA has decreased at a faster rate than
accounts receivable.
- The percentage of estimated bad accounts has dropped by more than a percentage point relative
to the prior year. Possible explanations for this inconsistency could be:
1. The company has tightened its credit policy;
2. Prior bad debt estimates were too high and the company is correcting for this; or
3. Management has intentionally reduced bad debts to report a higher net income.
38
Source: Fraser and Ormiston (2013). Understanding Financial Statements, 10th edition. Pearson.
© 2013 www.thefundamentalinvestor.com
Growth rate
Net sales
10.5%
Total accounts receivable
21.3%
Allowance for doubtful accounts
`
ADA as a % of total A/R
2.6%
2011
2010
3.8%
5.4%
-
Sales, accounts receivable and the allowance for doubtful accounts have all grown, but not proportionately.
The allowance account increased only slightly, and as a percentage of total accounts receivable, the allowance
account has declined from 5.4% to 3.8%. This is not a normal pattern. Possible explanations are:
1. Management overestimated the account in prior years and is now correcting for that overestimation;
2. Customers are not defaulting as anticipated and management is adjusting the allowance account accordingly, or
3. Management is reducing the allowance account in order to decrease bad debt expense and increase net income
in the current year.
-
Other information that would be useful to the analyst would be the valuation schedule required by the SEC and
any notes or information in the management's discussion and analysis related to accounts receivable and bad
debts.
39
© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Cost of Goods Sold
A/P Turnover =
Average A/P
Average A/P Payment Period =
365 Days
APTO
To calculate “Purchases”
+
Cost of Goods Sold
+
Ending Inventory
−
Beginning Inventory
=
Purchases
General analytical guidelines:
 Implicit assumption: all purchases are made on credit (i.e. no outright cash payments).
 Use “Purchases” in the numerator
 Alternative: Use “Cost of Goods Sold” instead of “Purchases”
 High APTO (and low A/P Payment Period) could mean that the company is either:
 [NOT GOOD] Not making full use of abilities to delay payment (and thus retain cash inside the business); or
 [GOOD] Taking advantage of early payment discounts.
 Low APTO (and high A/P Payment Period) could mean that the company is either:
 [NOT GOOD] Experiencing liquidity problems…i.e. unable to pay on time; or
 [GOOD] Exploiting lenient payment terms from the supplier.
40
© 2013 www.thefundamentalinvestor.com
A/P Turnover =
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Cost of Goods Sold
Average A/P
Average A/P Payment Period =
365 Days
APTO
General analytical guidelines:
 Compare APTO vs. Liquidity Ratios:
 If the Liquidity Ratios indicate sufficient amount of liquid assets, then a low APTO (and high A/P Payment Period)
could probably mean that the company is taking advantage of lenient payment terms…i.e. extending the payment
period in order to retain the cash inside the business
 Analytical questions:
 WHY is A/P payment slow? (or fast?)
 WHAT are the implications for future growth? Are the effects temporary or permanent?
 WHAT can be done to address the situation?
41
© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
RATIO
CALCULATION
WHAT IT MEASURES
BETTER IF
Operating Cycle
Days Inventory + Average A/R
Collection Period
How long it takes to complete one cycle of
purchasing and selling inventory
Lower
Cash Conversion
Cycle
Days Inventory + Average A/R
Collection Period − Average A/P
Payment Period
How long it takes to complete one cycle of
purchasing and selling inventory, and paying
the suppliers (i.e. “cash to cash” cycle)
Lower
The operational efficiency of a business (i.e. Activity Ratios) has a
direct impact on liquidity (i.e. Liquidity Ratios)
How efficient are the resources used in generating revenues?
(Assets are acquired in order to generate revenue)
OPERATING CYCLE (in days)
CASH CONVERSION CYCLE (in days)
+
Days Inventory
+
Days Inventory
+
Average A/R Collection Period
+
Average A/R Collection Period
=
Operating Cycle
−
Average A/P Payment Period
=
Cash Conversion Cycle
42
© 2013 www.thefundamentalinvestor.com
RATIO
CALCULATION
WHAT IT MEASURES
BETTER IF
Fixed Asset Turnover
(FATO)
Net Sales ÷ Average Fixed Assets
How much sales did the fixed assets
generate
Higher
Total Asset Turnover
(TATO)
Net Sales ÷ Average Total Assets
How much sales did the total assets
generate
Higher
Equity Turnover
(ETO)
Net Sales ÷ Average
Stockholders’ Equity
How much sales did the owners’
investments generate
Higher
Working Capital
(WC)
Current Assets − Current
Liabilities
How much short-term assets in excess
of short-term liabilities are available
Higher
Working Capital Turnover
(WCTO)
Net Sales ÷ Average Working
Capital
How much sales did the working capital
generate
Higher
Note: in the formulas, we use “Sales” and “Net
Sales” interchangeably
The operational efficiency of a business (i.e. Activity Ratios) has a
direct impact on liquidity (i.e. Liquidity Ratios)
43
© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Fixed Asset Turnover =
Sales
Average Fixed Assets
General analytical guidelines:
 FATO measures how efficiently the fixed assets generated revenues
 FATO can be erratic:
 Even if the numerator is steady (or steadily increasing), the increases in the denominator may not always follow a
smooth pattern.
 Thus, the year-to-year changes in FATO may not necessarily indicate important changes in efficiency.
 High FATO could indicate:
 Efficient use of fixed assets in generating revenues.
 Low FATO could indicate:
 Inefficient use of fixed assets in generating revenues; or
 The business is not yet operating at full capacity…hence, the “under utilization of fixed assets” cannot be directly
linked to the concept of efficiency; or
 The company has new fixed assets.
44
© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Total Asset Turnover =
Sales
Average Total Assets
General analytical guidelines:
 TATO measures overall ability to generate revenues with a given level of assets:.
 TATO includes both fixed assets and current assets:
 Inefficient working capital management can distort TATO.
 It’s best to analyze TATO, FATO, and WCTO separately
 TATO can be erratic:
 Even if the numerator is steady (or steadily increasing), the increases in the denominator may not always follow a
smooth pattern.
 Thus, the year-to-year changes in TATO may not necessarily indicate important changes in efficiency.
 High TATO could indicate:
 Efficient use of assets in generating revenues; or
 The business is not capital-intensive…i.e. it could be labor-intensive.
 Low TATO could indicate:
 Inefficient use of assets in generating revenues; or
 The business is capital-intensive; or
 The company has new fixed assets.
45
© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Equity Turnover =
Sales
Average Equity
Working Capital = Current Assets − Current Liabilities
Working Capital Turnover =
Sales
Average Working Capital
General analytical guidelines:
 Be careful when comparing ETO for different companies:
 Mature companies can have a capital structure comprised of lower equity and higher debt.
 A high ETO could mean a lower equity base…which could be a potential red flag.
 A low ETO could mean there was a fresh equity infusion…which is not necessarily a bad thing in itself, but the analyst
should find out the reason for the equity infusion.
 For some companies, Working Capital can be close to zero or negative…this renders the WCTO meaningless.
 A low WCTO could indicate higher Current Assets compared to Current Liabilities…which is not necessarily a bad thing.
46
© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
RATIO
CALCULATION
WHAT IT MEASURES
BETTER IF
Current Ratio
Current Assets ÷ Current Liabilities
Ability to pay short-term
obligations
Higher
Quick Ratio
(Cash + Short-term Marketable Securities +
A/R) ÷ Current Liabilities
Ability to pay short-term
obligations
Higher
Cash Ratio
(Cash + Short-term Marketable Securities) ÷
Current Liabilities
Ability to pay short-term
obligations
Higher
Defensive Interval
Ratio
(Cash + Short-term Marketable Securities +
A/R) ÷ Daily Cash Expenditures
Ability to pay short-term
obligations
Higher
General analytical guidelines:
 Liquidity: ability to settle short-term obligations.
 Liquidity ratios measure how quickly assets are converted into cash.
 Different industries require different levels of liquidity.
 Assess a company’s current state of liquidity by comparing it to:
 Its own historical funding requirements.
 Anticipated future funding needs.
 Ability to obtain financing in the future and from what sources.
 Consider the existence of contingent liabilities and the likelihood of being triggered.
47
© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Current Ratio =
Current Assets
Current Liabilities
Cash + Short term Marketable Securities + A/R
Quick Ratio =
Current Liabilities
Cash Ratio =
Cash + Short term Marketable Securities
Current Liabilities
General analytical guidelines:
 Current Ratio implicitly assumes that Inventories and Accounts Receivable are truly liquid:
 Double-check Current Ratio against the Inventory Turnover and A/R Turnover ratios.
 If ITO and ARTO are poor, then it’s better to use the Quick Ratio or Cash Ratio.
 Low Current Ratio indicates poor liquidity:
 Implication: greater reliance on Operating Cash Flow and external financing to meet short-term obligations.
 Quick Ratio implicitly assumes that inventories are not very liquid.
 Cash Ratio is an indicator of liquidity in a crisis situation:
 This is useful if the company seems to have problems selling inventory and / or collecting receivables.
48
© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Defensive Interval Ratio =
Cash + Short term Marketable Securities + A/R
Daily Cash Expenditures
General analytical guidelines:
 Defensive Interval Ratio is similar to the “burn rate” metric:
 DIR measures how long (i.e. number of days) a company can pay its daily cash expenditures using only the existing
liquid assets, without any additional cash inflow.
 If DIR is low compared to benchmarks, then determine if there are other sources of cash flow.
To estimate cash expenditures: EXCLUDE TAXES
+
Cost of Goods Sold
+
Selling, General, and Administrative expense
+
R&D expense
−
Non-cash expense: depreciation, amortization, etc.
=
Estimated TOTAL cash expenditure
÷
Number of days in the period
=
Estimated DAILY cash expenditure
49
© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
DELL, INC. for fiscal year ended:
January 28, 2005
January 30, 2004
January 31, 2003
+
Days to collect A/R
32
31
28
+
Days to sell inventory
4
3
3
−
Days to pay A/P
(73)
(70)
(68)
=
Cash conversion cycle
(37)
(36)
(37)
2004
2003
2002
Comparative data for Cash Conversion
Cycle, for fiscal year ended:

HP Compaq
27
37
61

Gateway
(7)
(9)
(3)

Apple
(40)
(41)
(40)
General analytical guidelines:
 For Dell, Inc.:
 What does the minimal Days to Sell Inventory say about the company’s business model and inventory system?
 Dell’s balance sheet indicates Cash and Short-term Investments of $10 billion. When compared with the Days to
Pay A/P, what can you say about the company’s REAL ability (and strategy) of paying suppliers?
 What does a negative Cash Conversion Cycle imply?
 How would you compare Dell’s liquidty vis-à-vis its peers?
50
© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
RATIO
CALCULATION
WHAT IT MEASURES
BETTER IF
Debt Asset Ratio
Total Debt ÷ Total Assets
The proportion of the assets that is funded by
interest-bearing debt
Lower
Debt Capital Ratio
Total Debt ÷ (Total Debt +
Total Equity)
The proportion of interest-bearing debt out of
all the total long-term capital sources
Lower
Debt Equity Ratio
Total Debt ÷ Total Equity
The proportion of interest-bearing debt vs.
owners’ investments
Lower
Financial Leverage
Ratio
Total Assets ÷ Total Equity
The proportion of liabilities vs. owners’
investments
Lower
Financial Leverage
Ratio
Average Total Assets ÷
Average Total Equity
The proportion of liabilities vs. owners’
investments
Lower
General analytical guidelines:
 Solvency ratios compare the capital structure components in order to measure ability to fulfill long-term obligations:
 Regular interest payments (see Coverage Ratios)
 Principal repayment
 Understanding how the company uses short-term and long-term debt gives insights into the company’s risk and
return profile…i.e. it affects the current and future cost of capital, as well as the ability to tap debt and equity
financing sources when needed.
51
© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Debt Asset Ratio =
Total Debt
Total Assets
Total Debt
Debt Capital Ratio =
Total Debt + Total Equity
Total Debt
Debt Equity Ratio =
Total Equity
General analytical guidelines:
 Debt acts like a “lever” in growing the company: the owners use lenders’ money to grow the business instead of
investing more equity.
 Total Debt = Interest-bearing Short-term Debt + Interest-bearing Long-term Debt
 For analytical purposes, do not include non-interest-bearing short-term debt such as accounts payable, salary
payable, etc…i.e. focus only on interest-bearing debt.
 Other possible variants of “Total Debt”:
 Use interest-bearing and non-interest bearing for both short-term and log-term debt.
 Use “long-term interest-bearing debt” only.
 Inconsistencies in the three ratios are worth analyzing further.
52
© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Total Assets
Financial Leverage Ratio =
Total Equity
Financial Leverage Ratio =
Average Total Assets
Average Total Equity
General analytical guidelines:
 “Leverage” magnifies the effects of using fixed costs (i.e. interest expense). It’s a double-edged sword:
 Earnings become better.
 Losses become worse.
 Zero debt: Php 1.00 of Equity will buy Php 1.00 of Assets.
 The use of debt will enable the company to buy more than Php 1.00 of Assets for every Php 1.00 of equity.
 Mature companies can operate with a high degree of leverage.
 The Financial Leverage Ratio will be used in the Du Pont ROE ratio.
 See examples:
 Excel file
 Lehman Brothers 2007
 Globe Telecom 2011
53
© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
RATIO
CALCULATION
WHAT IT MEASURES
BETTER IF
Earnings Interest
Coverage
EBIT ÷ Interest Expense
Sufficiency of earnings to meet
interest obligations
Higher
Cash Flow Interest
Coverage
OCF BIT ÷ Interest Paid
Sufficiency of cash flows to meet
interest obligations
Higher
Debt Coverage
Operating CF ÷ Total Liabilities
Financial risk and financial leverage
Higher
Debt Payment
Operating CF ÷ Cash paid for longterm debt repayment
Ability to pay debt using Operating CF
Higher
Fixed Charge Coverage
(EBIT + Lease Payments) ÷ (Interest
Expense + Lease Payments)
Sufficiency of earnings to cover fixed
payment obligations
Higher
General analytical guidelines:
 Coverage ratios measure the sufficiency of earnings or cash flows to cover fixed payment obligations:
 Keep in mind: Earnings ≠ Cash Flow
 Coverage ratios can use Income Statement accrual earnings or Statement of Cash Flows
 EBIT: Earnings Before Interest Expense and Income Tax
 OCF BIT: Operating Cash Flow Before Interest Paid and Income Tax
54
© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Earnings Interest Coverage =
EBIT
Interest Expense
Cash Flow Interest Coverage =
OCF BIT
Interest Paid
General analytical guidelines:
 Coverage ratios measure the sufficiency of earnings or cash flows to cover fixed payment obligations:
 Keep in mind: Earnings ≠ Cash Flow
 Coverage ratios can use Income Statement accrual earnings or Statement of Cash Flows
 EBIT: Earnings Before Interest Expense and Income Tax
 OCF BIT: Operating Cash Flow Before Interest Paid and Income Tax
 Operating CF + Interest Paid + Taxes Paid
55
© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
Debt Coverage =
Operating CF
Total Liabilities
Operating CF
Debt Payment =
Cash Paid for Long−term Debt Repayment
EBIT + Lease Payments
Fixed Charge Coverage =
Interest Payments + Lease Payments
General analytical guidelines:
 Coverage ratios measure the sufficiency of earnings or cash flows to cover fixed payment obligations:
 Keep in mind: Earnings ≠ Cash Flow
 Coverage ratios can use Income Statement accrual earnings or Statement of Cash Flows
 The Fixed Charge Coverage Ratio can be used as an indication of the quality of Preferred Stock cash dividend:
 The higher the FCC, the more assurance that the P/S cash dividend will be paid.
 See other examples:
 Lehman Brothers 2007
 SMB SEC Form 17A 2012
56
© 2013 www.thefundamentalinvestor.com
RETURN ON SALES
RATIO
CALCULATION
WHAT IT MEASURES
BETTER IF
Gross Profit Margin
(GPM)
Gross Profit ÷ Sales
Profitability before deducting any
expenses
Higher
Operating Profit
Margin (OPM)
Operating Income ÷ Sales
Recurring profitability before
interest expense and tax
Higher
Pre-tax Margin (PTM)
Earnings Before Tax ÷ Sales
Recurring profitability before tax
Higher
Net Profit Margin
(NPM)
Net Income ÷ Sales
Profitability after deducting all
expenses
Higher
Operating Cost Ratio
Marketing & Admin Expenses ÷ Sales
Ability to control costs
Lower
57
© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
RETURN ON SALES
Gross Profit Margin =
Gross Profit
Sales
Operating Income
Operating Profit Margin =
Sales
Operating Cost Ratio =
Marketing & Administrative Exp
Sales
General analytical guidelines:
 GPM indicates the percentage of revenue available to cover all types of expenditures:
 Gross Profit is affected by a combination of product pricing and product costing.
 The ability to charge a higher selling price is affected by the degree of competition and competitive advantage.
 Assess the extent to which product costing is affected by external factors beyond the company’s control.
 GOOD: If OPM increases faster than GPM, then it indicates improvements in controlling operating expenses.
 However, watch out for artificial increases in OPM brought about by deliberate cost-cutting measures. Cutting
costs in order to increase reported margins is not sustainable.
 EBIT is the common proxy for Operating Income:
 Make sure that non-operating items (such as dividend income; gains or losses on investment securities; etc.) are
not included in EBIT.
58
© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
RETURN ON SALES
Earnings Before Tax
Pretax Margin =
Sales
Net Profit Margin =
Net Income
Sales
General analytical guidelines:
 Assess whether Pre-tax Margin is due to operating or non-operating items:
 EBT: use Earnings Before Tax After Interest Expense
 EBT includes the effects of non-operating items, such as dividend income, gains or losses from investment
securities, etc.
 NPM considers all types of recurring and non-recurring revenues and expenses:
 If there are significant non-recurring items, then it might be better to use “net income adjusted for non-recurring
items” in assessing the sustainability
59
© 2013 www.thefundamentalinvestor.com
RETURN ON INVESTMENT
RATIO
CALCULATION
WHAT IT MEASURES
BETTER IF
Operating Return on
Assets (OROA)
Operating Income ÷ Average Total
Assets
Profitability of total assets
Higher
Return on Assets (ROA)
Net Income ÷ Average Total Assets
Profitability of total assets
Higher
Return on Total Capital
(ROTC)
EBIT ÷ (Average Total Interest-bearing
Debt + Average Total Equity)
Profitability of capital deployed
Higher
Return on Equity (ROE)
Net Income ÷ Average Total Equity
Profitability of the owners’
investments
Higher
Return on Common
Equity (ROCE)
(Net Income − Preferred Stock
Dividend) ÷ Average Common Equity
Profitability of the owners’
investments
Higher
60
© 2013 www.thefundamentalinvestor.com
RETURN ON INVESTMENT
Operating Income
Operating Return on Assets =
Average Total Assets
Return on Assets =
Net Income
Average Total Assets
General analytical guidelines:
 The common proxy for Operating Income is EBIT.
Income Statement
EBIT
The Recipient Is:
Accounting
Equation
The Recipient Is:
Earnings Before Interest
Expense and Tax
Lender, Government,
and Equity Owner
−
Interest expense
Lender
+ Equity
Residual Equity Owner
= EBT
Earnings Before Tax
Government and
Equity Owner
= Assets
Everyone
−
Income Tax
Government
= EAT
Net Income
Residual Equity Owner
Liabilities
Lender & Government
61
© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
RETURN ON INVESTMENT
ROTC =
EBIT
Average Total Interest Bearing Debt + Average Total Equity
Return on Equity =
Net Income
Average Total Equity
Return on Common Equity =
Net Income − P/S Dividends
Average Common Equity
General analytical guidelines:
 ROTC measures the operating profit generated by all sources of capital:
 Short-term interest-bearing debt
 Long-term interest-bearing debt
 Equity: common stock, preferred stock, retained earnings, minority equity, etc.
 ROE measures the profits generated by equity capital (common stock, preferred stock, retained earnings, minority
equity, etc.)
 ROCE focuses on Common Stock by removing the effects of Preferred Stock in the numerator and denominator:
 Numerator: Total net income less Preferred Stock cash dividends
 Denominator: Total SHE less Preferred Stock (par value and APIC)
62
© 2013 www.thefundamentalinvestor.com
Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
RETURN ON INVESTMENT
RATIO
CALCULATION
WHAT IT MEASURES
BETTER IF
Du Pont ROE: 3-level
breakdown
Net Profit Margin x Total Asset Turnover x
Financial Leverage Ratio
Profitability of the owners’
investments
Higher
Du Pont ROE: 5-level
breakdown
Tax Retention Rate x Interest Burden x
Operating Profit Margin x Total Asset
Turnover x Financial Leverage Ratio
Profitability of the owners’
investments
Higher
General analytical guidelines:
 Decomposing the ROE can reveal the drivers of ROE.
 The Du Pont ROE decomposition is actually a combination of several familiar ratios that measure efficiency, operating
profitability, taxes, and financial leverage.
 The decomposed ROE can be used by management to assess which areas of the business need improvement in
order to improve overall ROE.
Ideal for Manufacturing
or Retail Companies
63
© 2013 www.thefundamentalinvestor.com
Alternatives:
- Average Total Assets
- Average Total Equity
ROE 
Net income
Equity
3-Level

Net income
Sales
x
Sales
Assets
If Leverage is zero,
then ROE = ROA
Assets
Equity
x



Profitability/
Efficiency
Leverage
Cost Control
ROE 
Net income

Equity
5-Level
Net income
EBT

Tax Retention
Rate
x
EBT
EBIT

Interest
Burden
x
EBIT
Sales
x
Sales
Assets
x


Operating Efficiency
Assets
Equity

Leverage
Profit Margin
64
© 2013 www.thefundamentalinvestor.com
Alternatives:
- Average Total Assets
- Average Total Equity
ROE 
Net income
Equity
3-Level

Net income
Sales
x
Sales
Assets
If Leverage is zero,
then ROE = ROA
Assets
Equity
x



Profitability/
Efficiency
Leverage
Cost Control
ROE 
Net income

Equity
5-Level
Net income
EBT

Tax Retention
Rate
x
EBT
EBIT

Interest
Burden
x
EBIT
Sales
x
Sales
Assets
x


Operating Efficiency
Assets
Equity

Leverage
Profit Margin
See Excel for example
65
© 2013 www.thefundamentalinvestor.com
ROE =
ROE =
OPM ∗ TATO − Borrowing Cost ∗ Financial Leverage ∗ 1 − tax rate
EBIT
Sales
Interest Expense
∗
−
Sales
Total Assets
Total Assets
ROE =
EBIT − Interest Expense
Total Assets
∗
∗
Total Assets
∗ 1 − tax rate
Book Equity
Total Assets
∗ 1 − tax rate
Book Equity
General analytical guidelines:
 OPM: Operating Profit Margin using EBIT
 TATO: Total Asset Turnover
 Borrowing Cost:
 Interest Expense ÷ Total Assets
 This is a measure of financial stress (though not a commonly used version).
 Financial Leverage: If the ratio is high, then liabilities are high.
 Tax: This captures the effective tax rate.
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PERFORMANCE RATIOS
RATIO
CALCULATION
WHAT IT MEASURES
BETTER IF
Cash Flow to
Revenue
Operating CF ÷ Revenue
Quality of earnings: cash generated
per Peso of revenue
Higher
Cash ROA
Operating CF ÷ Average Total Assets
Cash generated from all assets
Higher
Cash ROE
Operating CF ÷ Average Total Equity
Cash generated from owners’
investments
Higher
Cash to Income
Operating CF ÷ Operating Income from Income
Statement
Quality of earnings: cash
generating ability of operations
Higher
Cash Flow Per
Share
(Operating CF − Preferred Stock Dividends) ÷
Weighted Average Number of C/S Outstanding
Operating CF on a per share basis
Higher
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CF to Revenue =
Operating CF
Net Revenue
Operating CF
Cash ROA =
Average Total Assets
Operating CF
Cash ROE =
Average SHE
Operating CF
Cash to Income =
Operating Income in Income Statement
Cash Flow Per Share =
Operating CF − P/S Dividends
Weighted Average Number of C/S Outstanding
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Source: Robinson, Greuning, Henry, and Broihahn (2009). International Financial Statement Analysis. John Wiley & Sons.
COVERAGE RATIOS
RATIO
CALCULATION
WHAT IT MEASURES
BETTER IF
Debt Coverage
Operating CF ÷ Total Debt
Financial risk and financial leverage
Higher
Cash Flow
Interest Coverage
OCF BIT ÷ Interest Paid
Sufficiency of cash flows to meet
interest obligations
Higher
Reinvestment
Operating CF ÷ Cash paid for long-term
assets
Ability to acquire assets using
Operating CF
Higher
Debt Payment
Operating CF ÷ Cash paid for long-term debt
repayment
Ability to pay debt using Operating
CF
Higher
Cash Dividend
Payment
Operating CF ÷ Cash paid for dividends
Ability to pay cash dividends using
Operating CF
Higher
Investing and
Financing
Operating CF ÷ (Investing Cash Outflow +
Financing Cash Outflow)
Ability to acquire assets, pay debts,
and make distributions to owners
Higher
General analytical guidelines:
 OCF BIT: Operating Cash Flow Before Interest Paid and Income Tax
 Operating CF + Interest Paid + Taxes Paid
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Debt Coverage =
Operating CF
Total Liabilities
Cash Flow Interest Coverage =
OCF BIT
Interest Paid
Operating CF
Reinvestment =
Cash Paid for Long−term Assets
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Debt Payment =
Operating CF
Cash Paid for Long−term Debt Repayment
Operating CF
Cash Dividend Payment =
Cash Dividends Paid
Operating CF
Investing and Financing =
Investing Cash Out + Financing Cash Out
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