RatiosRatios• Analyze and calculate specific values that Analyze and calculate specific values that

give some measure of performancegive some measure of performance• Compare 3 ways:Compare 3 ways:

• Within the firm over timeWithin the firm over time• To competing firmsTo competing firms• To the industry standardTo the industry standard

• One ratio by itself does not tell you muchOne ratio by itself does not tell you much

RatiosRatios• Types – different aspects of a firmTypes – different aspects of a firm

– LiquidityLiquidity – can they pay the bills as they come – can they pay the bills as they come due?due?

– SolvencySolvency – can they survive for a long period of – can they survive for a long period of time? – can they pay their long term debt?time? – can they pay their long term debt?

– ProfitabilityProfitability – can they earn a satisfactory rate of – can they earn a satisfactory rate of return?, how efficient are they?return?, how efficient are they?

– Activity or effectivenessActivity or effectiveness – indicate efficiency and – indicate efficiency and effectiveness of operations and asset effectiveness of operations and asset management and usemanagement and use

• ProfitabilityProfitability–Gross margin percentageGross margin percentage – what proportion of – what proportion of

revenue can be used to cover the firm’s period revenue can be used to cover the firm’s period expenses – very closely watchedexpenses – very closely watched

–Profit marginProfit margin – how many cents of every sales – how many cents of every sales dollar is profitdollar is profit

–Return on assetsReturn on assets – success in using its assets to – success in using its assets to earn income, the cents in profits for every dollar earn income, the cents in profits for every dollar of assetsof assets

–Return on common equityReturn on common equity – how much is earned – how much is earned with common shareholder’swith common shareholder’s investment investment

• ProfitabilityProfitability–Gross margin percentageGross margin percentage = =

gross margin = sales – cost of salesgross margin = sales – cost of salespercentage = gross margin / salespercentage = gross margin / sales

–Profit marginProfit margin – net earnings / sales – net earnings / sales–Return on assetsReturn on assets – net earnings / average – net earnings / average

total assetstotal assets–Return on common equityReturn on common equity – net earnings / – net earnings /

average total equityaverage total equity

• EffectivenessEffectiveness– Accounts receivable turnoverAccounts receivable turnover – ability to collect – ability to collect

cash from credit customerscash from credit customers– Days in A/RDays in A/R – how long does it take to collect – how long does it take to collect– Inventory turnoverInventory turnover – how often to they sell their – how often to they sell their

inventoryinventory– Days in InventoryDays in Inventory – days in the store – days in the store– Accounts payable turnoverAccounts payable turnover – how effectively a firm – how effectively a firm

pays its own billspays its own bills– Days in A/PDays in A/P – how long it takes to pay – how long it takes to pay– Operating cycleOperating cycle – cash to cash cycle – cash to cash cycle

• LiquidityLiquidity– Working capitalWorking capital – not a ratio – ability to meet short- – not a ratio – ability to meet short-

term obligations – (CA-CL)term obligations – (CA-CL)– Current ratioCurrent ratio – ability to pay current liabilities with – ability to pay current liabilities with

currentcurrent assets assets – (CA/CL) – (CA/CL)

– Quick ratioQuick ratio – only the very liquid assets – ((CA- – only the very liquid assets – ((CA-Inv)/CL)Inv)/CL)

– Defensive interval ratioDefensive interval ratio – how much cash is on – how much cash is on hand to cover an average day’s expenseshand to cover an average day’s expenses

• SolvencySolvency– Debt to assetsDebt to assets – what proportion of a firm’s assets – what proportion of a firm’s assets

are financed by debtare financed by debt– Debt to equityDebt to equity – compares debt to owner’s – compares debt to owner’s

investmentinvestment– Times interest earnedTimes interest earned – tests the ability of the firm – tests the ability of the firm

to meet its interest paymentsto meet its interest payments

• Horizontal analysis (trend) – previous yearHorizontal analysis (trend) – previous year• (Current year – previous year)/previous year(Current year – previous year)/previous year

• Vertical analysis (common sizing) – within yearVertical analysis (common sizing) – within year• Income statement – divideIncome statement – divide

• Ways to improve revenue/profitWays to improve revenue/profit

• Revenue recognition principleRevenue recognition principle

• VariationsVariations• Point of sale - defaultPoint of sale - default• Proportional performance – not wait until entire Proportional performance – not wait until entire

product is delivered, ie. magazinesproduct is delivered, ie. magazines• Cost recovery – not sure will collect, recognize Cost recovery – not sure will collect, recognize

revenue after cover the cogsrevenue after cover the cogs• Completed contract – recognize revenue when Completed contract – recognize revenue when

product completedproduct completed• Percentage of completion – proportion Percentage of completion – proportion

completed, same proportioncompleted, same proportion

• Which products or customers to keepWhich products or customers to keep

Contract specifications:Contract specifications:Purchase price:  $15,000,000Purchase price:  $15,000,000Cost of construction:  $10,000,000Cost of construction:  $10,000,000The contract will take three years to complete.The contract will take three years to complete.Contract Progress:Contract Progress:Year 1                          Year 2                                    Year 3Year 1                          Year 2                                    Year 330% complete       70% complete                 100% complete30% complete       70% complete                 100% completeRevenue           Revenue           $4,500,000           $6,000,000                              $4,500,000$4,500,000           $6,000,000                              $4,500,000Costs Costs     3,000,0003,000,000                        4,000,000  4,000,000                                                              3,000,000  3,000,000Margin             Margin             $1,500,000           $2,000,000                              $1,500,000$1,500,000           $2,000,000                              $1,500,000

• Assign #3 – Target income statement and Assign #3 – Target income statement and balance sheet: balance sheet: – Years 09, 08Years 09, 08

– Horizontal analysisHorizontal analysis

– Vertical analysisVertical analysis

– ½ – what½ – what does it mean? does it mean?

• Assign #4 Profitability ratios – Target:Assign #4 Profitability ratios – Target:• Gross margin, profit margin - 09, 08, 07, return on Gross margin, profit margin - 09, 08, 07, return on

assets, return on equity – years 09, 08 - ½ - 1-page – assets, return on equity – years 09, 08 - ½ - 1-page – what does it mean?what does it mean?