Financial Theories

Ratio Analysis Paper

Before beginning an analysis of a company it is necessary to have a complete set of financial statements, preferably for the pas few years so that historical trends can be obtained. Ratios are a way for anyone to get an idea of the financial performance of a company by using the information contained in the financial statements. Ratios are grouped into four basic categories, liquidity, activity, profitability, and financial leverage. This document will use a variety of these ratios to analyze the firm, Sample Company, as of December 31,2000.

Financial Statement Ratios

Profitability Ratios

The ratios returns on investment (ROI) and return on equity (ROE) are two of the most popular measure of profitability of a company and, along with the P/E ratio, have the most significant value of any of the ratios. The DuPont Model expands on the ROI calculation by inserting sales and it's relationship to the companies' generation of profits and utilization of assets into the calculation. Additional profitability ratios include the price earnings ratio (P/E), the dividend payout and the dividend yield. The price earnings ratio helps to indicate to investor how expensive the shares of common stock of a firm are. Dividend yield is part of the stockholders ROI and is represented by the annual cash dividend. Dividend yields have historically been between 3% to 6% for common stock and 5% to 8% for preferred stock. Dividend payout ratio shows the proportion of the earnings paid to common shareholders. Dividend payout for manufacturing companies range from 30% to 50%, but can vary widely.

Dupont Analysis (ROI) - Return on Investment

The return on Investment (ROI) is important because it describes the rate of return the company was able to make on its assets. The ROI, use net income or operating income, as amount of return and average total assets as the amount invested. In general, the average ROI for American merchandising companies is between 8% and 12% when using net income, and average margin is 5% to 10%. When using operating income it is between 10 and 15% and average margin is also 10% - 15%. Asset turnover is another important component of the DuPont model and is usually in the range of 1% to 1.5%

ROE - Return on Equity

The return on equity conveys the profits of the company as a rate of return on the amount of owners' equity. ROE uses average owners equity over the specified time period and net income. Historically a ROE of between 10% and 15% were considered average. Recently higher rates in growth industries have been greater.

Price earnings ratio (P/E)

In general, the higher the ROI and rate of earnings growth, the higher the P/E. . In the past, for a very long period of time P/E ratios in the range of 12 to 18 were consider good P/E ratios for a company. In recent years, the 12 to 18 values have been abandoned as a norm and what can be considered the norm now is under debate.

Sample Companies' Profitability Ratios

ROI for Sample CO. is $350 / $7,196 = 4.8% using net income. If operating Income is used we have $498 / $7,196 = 6.9%. An additional measure used for ROI is the DuPont Model. The DuPont model figures are ($498 / $8,251) * ($8,251 / $7,196) = 6.0% using operating income. These are somewhat low when compared to the average.

ROE is $350 / $3,357 = 10.4% and is also below average. The P/E ratio is $42 / $3.51 = 12, which seems very good, and the dividend payout ratio is 14.2%

Activity Measures

Activity measures of Inventory turnover, number of days sales in AR, and turnover in building, equipment, and land, look at the relationship between asset levels and sales. They indicate how efficiently a firm is using its assets in relation to its' ROI.

Inventory Turnover

Inventory turnover uses costs of good sold / average inventory and is an indicator of the efficiency of the firms' management practices. Because inventories are carried at cost, not selling price, costs of goods sold is use in the calculation.

Number of days sales in AR

Number of days in accounts receivable is an indication of how well the companies collection policies are. The faster they can collect on what they are owed the faster they can put that money to use. Number of days in AR is accounts receivable by average days sales.

Sample Companies' Profitability Ratios

Inventory turnover for Sample CO. is $6,523 / (($1,323 +$1,211)/2) = 5.1 times. Number of day's sales in AR is $22.6 / 365 = 96.2. To know if these numbers are significant requires a look at the historical trend. Generally the higher the turnover or a lower number of days sales in AR the greater the efficiency.

Financial Leverage Measures

Two main financial leverage measures are debt ratio and debt/equity ratio. These indicate the extent that the firm is using financial leverage. The higher the ratios the more risk the company is exposing itself to, especially as the return on investment falls closer to the cost of borrowing. As a rule, most companies will keep the debt in their capital structure to a maximum of 50% of the total capital.

Debt ratio

The debt ratio is simply the ratio of total liabilities