Reading 37

Tools: ratio analysis, common-size analysis, graphical analysis, regression.

Ratio Analysis

Ratios identify questions rather than answer them. Uses:

• Project future earnings and cash flow
• Evaluate flexibility (growth and meeting obligations under unexpected circumstances)
• Assess management performance
• Evaluate firm and industry changes over time
• Compare firm with industry competitors

Limitations:

• Not useful in isolation — need peer/historical comparison
• Different accounting treatments (esp. U.S. vs non-U.S.) make comparison harder
• Hard to find comparable industry ratios for multi-industry firms
• Conclusions cannot be made from a single ratio
• Determining target/comparison value requires judgment

Common-Size Analysis

Vertical: B/S items as % of total assets; I/S items as % of revenue. Useful for cost-margin trends.

Horizontal: each item as % of base-year value (Y1 = 1.0).

Graphical & Regression Analysis

Stacked column/bar graphs, line graphs visualize trends. Regression identifies relationships for forecasting (e.g., GDP → sales).

Activity (Asset Utilization / Turnover) Ratios

\[\text{Receivables turnover} = \dfrac{\text{annual sales}}{\text{avg receivables}};\quad \text{DSO} = \dfrac{365}{\text{receivables turnover}}\]

\[\text{Inventory turnover} = \dfrac{\text{COGS}}{\text{avg inventory}};\quad \text{DOH} = \dfrac{365}{\text{inventory turnover}}\]

\[\text{Payables turnover} = \dfrac{\text{purchases (or COGS)}}{\text{avg trade payables}};\quad \text{Days of payables} = \dfrac{365}{\text{payables turnover}}\]

Purchases = ending inventory − beginning inventory + COGS.

\[\text{Total asset turnover} = \dfrac{\text{revenue}}{\text{avg total assets}}\]

\[\text{Fixed asset turnover} = \dfrac{\text{revenue}}{\text{avg net fixed assets}}\]

\[\text{Working capital turnover} = \dfrac{\text{revenue}}{\text{avg working capital}}\]

High receivables turnover → either excellent collections or overly strict credit (look at revenue growth vs peers). High inventory turnover → either efficient or stock-outs (compare growth). Low payables turnover → either cash flow problems or favorable supplier terms.

Liquidity Ratios

\[\text{Current ratio} = \dfrac{\text{current assets}}{\text{current liabilities}}\]

\[\text{Quick (acid-test) ratio} = \dfrac{\text{cash + marketable securities + receivables}}{\text{current liabilities}}\]

\[\text{Cash ratio} = \dfrac{\text{cash + marketable securities}}{\text{current liabilities}}\]

\[\text{Defensive interval} = \dfrac{\text{cash + marketable securities + receivables}}{\text{average daily expenditures}}\]

Days the firm could pay current cash expenditures (COGS, SG&A, R&D — exclude noncash like depreciation).

\[\text{Cash conversion cycle} = \text{DSO} + \text{DOH} - \text{Days of payables}\]

Lower CCC is generally better. Firms that collect from customers before paying suppliers can run with current ratio < 1.

Solvency Ratios

\[\text{D/E} = \dfrac{\text{total debt}}{\text{total equity}};\quad \text{Debt-to-capital} = \dfrac{\text{total debt}}{\text{total debt + total equity}};\quad \text{Debt-to-assets} = \dfrac{\text{total debt}}{\text{total assets}}\]

\[\text{Financial leverage} = \dfrac{\text{avg total assets}}{\text{avg total equity}}\]

\[\text{Interest coverage} = \dfrac{\text{EBIT}}{\text{interest}};\quad \text{Debt-to-EBITDA} = \dfrac{\text{total debt}}{\text{EBITDA}}\]

\[\text{Fixed charge coverage} = \dfrac{\text{EBIT + lease payments}}{\text{interest + lease payments}}\]

Lease-heavy companies benefit from the fixed-charge measure. Also useful for U.S. GAAP firms with operating leases (no interest recorded in I/S).

Profitability Ratios

\[\text{Gross profit margin} = \dfrac{\text{gross profit}}{\text{revenue}};\quad \text{Operating margin} = \dfrac{\text{operating income}}{\text{revenue}};\quad \text{Pretax margin} = \dfrac{\text{EBT}}{\text{revenue}};\quad \text{Net profit margin} = \dfrac{\text{NI}}{\text{revenue}}\]

\[\text{ROA} = \dfrac{\text{NI}}{\text{avg total assets}};\quad \text{ROA (adjusted)} = \dfrac{\text{NI + interest}\times(1-t)}{\text{avg total assets}}\]

\[\text{Operating ROA} = \dfrac{\text{EBIT or operating income}}{\text{avg total assets}}\]

\[\text{ROIC} = \dfrac{\text{after-tax operating profit}}{\text{avg long-term capital}}\]

\[\text{ROE} = \dfrac{\text{NI}}{\text{avg total equity}};\quad \text{Return on common equity} = \dfrac{\text{NI − preferred div}}{\text{avg common equity}}\]

2-stage:

\[\text{ROE} = \text{ROA} \times \text{Financial Leverage}\]

3-stage (original DuPont):

\[\text{ROE} = \dfrac{\text{NI}}{\text{Sales}} \times \dfrac{\text{Sales}}{\text{Avg assets}} \times \dfrac{\text{Avg assets}}{\text{Avg equity}}\]

= net profit margin × total asset turnover × financial leverage (equity multiplier).

Low ROE → at least one of: low margin, low turnover, low leverage.

5-stage (extended DuPont):

\[\text{ROE} = \dfrac{\text{NI}}{\text{EBT}} \times \dfrac{\text{EBT}}{\text{EBIT}} \times \dfrac{\text{EBIT}}{\text{Sales}} \times \dfrac{\text{Sales}}{\text{Avg assets}} \times \dfrac{\text{Avg assets}}{\text{Avg equity}}\]

= tax burden × interest burden × EBIT margin × asset turnover × leverage.

Tax burden = NI/EBT = (1 − tax rate). Interest burden = EBT/EBIT (lower = higher interest burden). More leverage adds interest cost — leverage helps but interest burden offsets.

• Services/consulting: Net income per employee, sales per employee.
• Retail/restaurants: Same-store sales growth (organic vs new locations), sales per square foot.
• Hotels: Average daily rate (ADR = room revenue / rooms sold), occupancy rate.
• Subscription services: Average revenue per user (ARPU).

Financial institutions face regulation:

• Capital adequacy — risk vs equity capital. Value at risk (VaR) estimates loss exceeded only X% of the time.
• Reserve requirements / liquid asset requirements for banks.
• Net interest margin = interest income / interest-earning assets (key for lenders).

Business Risk (Coefficient of Variation)

\[\text{CV} = \dfrac{\text{standard deviation}}{\text{mean}}\]

Applied to sales, operating income, net income — a size-adjusted measure of variability. Lower CV = lower business risk.

Process: forecast sales → apply common-size ratios or expected margins to forecast each line item → produce pro forma I/S.

Three methods to explore variability around point estimates:

• Sensitivity analysis — "what if" on one variable at a time.
• Scenario analysis — specific bundled scenarios.
• Simulation — probability distributions for key variables, computer-generated outcomes.