LECTURE 3: FINANCIAL RATIOS

RATIOS AND SHAREHOLDERS VALUE

PERFORMANCE MEASURES
MARKET CAPITALIZATION: total market value of equity = share price X number of shares outstanding

(1) MARKET VALUE ADDED → market capitalization – book value of equity.

Example: Company’s common stock closed fiscal 2014 at a price of $114.75 per share. There were 1,307
million shares outstanding,

so Company’s market capitalization or “market cap” was $114.75 × 1,307 = $149,978.

market value added, the difference between the market value of the firm’s shares and the amount of
money that shareholders have invested in the firm, was $149,978 − $9,322 = $140,656 million.

(2) MARKET-TO-BOOK RATIO → market value of equity ·/· book value of equity

- Ratio of market value of equity to book value of equity (relación entre el valor de mercado de los
fondos propios y su valor contable)

MEASURING ECONOMIC EFFICIENCY

FIXED ASSETS AS A PERCENTAGE OF CAPITAL EMPLOYED → indicates what portion of the total capital
employed is held (se mantiene) in the form of fixed assets.

CAPITAL INTENSITY RATIO (CIR) tells how effectively and efficiently a firm utilizes its capital or assets to
generate revenue.

CIR = Total Assets / Sales

or 1 / Asset Turnover Ratio

or Capital Expenditure / Labor Costs

PROFITABILITY MEASURES
(1) ECONOMIC VALUE ADDED (EVA) → also called residual income. Measures how many euros a business
is earning after deducting the cost of capital.

EVA = after-tax interest + net income − (cost of capital × total capitalization)

EVA = after-tax operating income − (cost of capital × total capitalization)

- RATES OF RETURN

(2) RETURN ON CAPITAL (ROC) → net income + after-tax interest as a percentage of long-term capital.

ROC = after tax operating income / total capitalization (= long-term debt + equity)

Example:

operating income 6,885 million.

total capitalization (long-term debt plus shareholders’ equity) $27,213 million.

ROC = 6,885/27,213 = 0,253 or 25,3%

(3) RETURN ON ASSETS (ROA) → net income plus after-tax interest as a percentage of total assets.
ROA = after tax operating income / (average) total assets

= 6,885/40,518 = 0,17 or 17%

The calculation ignores entirely the income that the firm’s assets have generated for debt investors.

(4) RETURN ON EQUITY (ROE) → net income as a percentage of shareholders’ equity.

ROE = net income / (average) equity

Example: net income 6,345 million. Shareholders’ equity 12,522 million at the start of the year

ROE = 6,345/12,522 =0,507 or 50,7%

EXPLAIN THE DIFFERENCE ROC, ROA AND ROE.

- ROE: It measures the efficiency with which a company generates profits from (a partir)
shareholders' equity.
- ROC: It measures the efficiency with which a company generates profits from its total capital (debt
and equity).
- ROA: It measures the efficiency with which a company uses its assets to generate profits.

EFFICIENCY MEASURES
(1) ASSET TURNOVER RATIO → or sales-to-assets, shows how much sales are generated by each dollar of
total assets, and therefore it measures how hard the firm’s assets are working.

ASSET TURNOVER RATIO = sales/total assets (average or at start of the year)

= 83176 / 40518 = 2,05

(2) INVENTORY TURNOVER = cost of goods sold / inventory at start of year (average)

= 54,222/11,057= 4,9

(3) AVERAGE DAYS IN INVENTORY = inventory at start of year / daily cost of good sold

= 11,057/(54,222/365) = 74 (days)

(4) RECEIVABLES TURNOVER = sales / receivables at start of year (average)

= 83,176/1,398=59,6

(5) AVERAGE COLLECTION PERIOD = receivables at start of year (average) / average daily sales

= 1,398/(83,176/365) = 6,1 days

(6) PROFIT MARGIN → measures the proportion of sales that finds its way into profits.

PM= net income / sales

= 6,346 / 83, 176 = 0,076 or 7,6%

(7) OPERATING PROFIT MARGIN = after-tax operating income / sales

= [6,345+(1- 0,35) X 830] / 83,176 = 0,083 or 8,3%

RETURN ON ASSETS: THE DU PONT SYSTEM

DUPONT EQUATION → A formula that shows that the rate of return on equity can be found as the product
of profit margin, total assets turnover, and the equity multiplier. It shows the relationships among asset
management, debt management, and profitability ratios.

DUPONT EQUATION EXPLAINED

The profit margin tells us how much the firm earns on its sales.

The total assets turnover tells us how many times the profit margin is earned each year

The equity multiplier relates to the firm’s use of debt. The industry equity multiplier can be obtained by
using the industry ROE and ROA.

The equity multiplier = Total assets / common equity.

FINANCIAL LEVERAGE – THE LEVERAGE EFFECT

FINANCIAL LEVERAGE results from using borrowed capital as a funding source when investing to expand
the company's asset base and generate returns on risk capital.

LEVERAGE is an investment strategy of using borrowed money (specifically, the use of various financial
instruments or borrowed capital) to increase the potential return of an investment.

Leverage can also refer to the amount of debt a firm uses to finance assets.
The LEVERAGE EFFECT describes the effect of debt on the return on equity - additional debt can increase
the return on equity for the owner.

CALCULATING LEVERAGE

(1) Debt-to-Assets Ratio = Total Debt / Total Assets

(2) Debt-to-Equity Ratio = Total Debt / Total Equity

(3) Debt-to-EBITDA = Total Debt / Earnings Before Interest, Taxes, Depreciation, and Amortization

(4) Equity Multiplier = Total Assets / Total Equity

FINANCIAL LEVERAGE

DEBT RATIO → Financial leverage is usually measured by the ratio of long-term debt to total long-term
capital (that is, to total capitalization). Here long-term debt should include not just bonds or other
borrowing, but also financing from long-term leases.

(1) LONG-TERM DEBT RATIO = long-term debt / (long-term debt + equity)

(2) LONG-TERM DEBT-EQUITY RATIO = long-term debt / equity

(3) TOTAL DEBT RATIO = total liabilities / total assets

TIMES INTEREST EARNED →Ratio Another measure of financial leverage is the extent to which interest
obligations are covered by earnings. Interest coverage is measured by the ratio of earnings before interest
and taxes (EBIT) to interest payments.

(4) TIMES INTEREST EARNED = EBIT / interest payments

CASH COVERAGE RATIO → (Depreciation is not a cash expense)

(5) CASH COVERAGE RATIO = (EBIT + depreciation) / interest payments

LEVERAGE AND RETURN ON EQUITY

CALCULATING THE RETURN

Total return = return on equity + cost of debt (%)

𝒓𝑻𝑪 = return on total capital

𝒓𝑬𝑸 = return on equity

𝑫𝒆𝒃𝒕 = borrowed capital

𝑬𝑸 = equity

𝒊 = interest rate on borrowed capital

𝒓𝑻𝑪∗𝑻𝑪 = 𝒓𝑬𝑸 ∗ 𝑬𝑸 + 𝒊∗𝑫𝒆𝒃𝒕

𝒓𝑬𝑸 = [ 𝒓𝑻𝑪∗𝑻𝑪−𝒊∗𝑫𝒆𝒃𝒕 ] / 𝑬𝑸

𝒓𝑬𝑸 = 𝒓𝑻𝑪 + ( 𝑫𝒆𝒃𝒕 / 𝑬𝑸 ) ∗ (𝒓𝑻𝑪−𝒊)

CALCULATING THE LEVERAGE EFFECT

1. Price of the property is 500,000 euro (300,000 is financed with equity and 200,000 – with debt
(mortgage). Rental incomes cover the mortgage payments.

The returns are leveraged 500,000/300,000

- In 1 year – increase in value by 5%. New equity amount is 325,000 (500,000*5% - 200,000).

ROE = 25,000/300,000 = 0,083 or 8,3%

2. Price of the property is 500,000 euro (200,000 is financed with equity and 300,000 – with debt
(mortgage). Rental incomes cover the mortgage payments.

The returns are leveraged 500,000/200,000

- In 1 year – increase in value by 5%. New equity amount is 225,000 (500,000*5% - 300,000).

ROE = 25,000/200,000 = 0,125 or 12,5%

3. In 10 years - the value of property is 815,000.

New equity is 515,000 (815,000 – 300,000).

ROE = 315,000/200,000 = 1,575 or 15,75% p.a.

4. Sell the property at 815,000.

Capital gains = 815,000 – 500,000 = 315,000

The return on equity rises with increasing leverage, as long as the return on total capital is higher than the
interest rate on borrowed capital.

LIQUIDITY AND SOLVENCY

Solvency and liquidity are both terms that refer to an enterprise's state of financial health.
 Solvency refers to an enterprise's capacity to meet its long-term financial commitments.

Liquidity refers to an enterprise's ability to pay short-term obligations.

A company must have more total assets than total liabilities to be solvent.

A company must have more current assets than current liabilities to be liquid.

SOLVENCY RATIOS

(1) Debt-to-Assets Ratio = Total Debt / Total Assets

(2) Debt-to-Equity Ratio = Total Debt / Total Equity

(3) Interest coverage ratio = EBIT / interest payments

LIQUIDITY MEASURES
LIQUIDITY → the ability to sell an asset on short notice at close to the market value (absolute liquidity).

(1) NET WORKING CAPITAL TO ASSETS = net working capital / total assets

(2) CURRENT RATIO → is the the ratio of current assets to current liabilities.

CURRENT RATIO = current assets / current liabilities

(3) QUICK RATIO (Acid-test ratio) = (cash + marketable securities + receivables) / current liabilities

(4) CASH RATIO → A company’s most liquid assets are its holding of cash and marketable securities

CASH RATIO = (cash + marketable securities) / current liabilities

(5) BASIC DEFENSE RATIO → measures the number of days a company can cover its cash expenses without
the help of additional financing from other sources.

BASIC DEFENSE RATIO = (cash + receivables + marketable securities) ÷ (Operating expenses

+Interest + Taxes) ÷ 365

TOTAL DEBT TO TOTAL CAPITAL

Last year Co. had earnings per share of $4 and dividends per share of $2.

Total retained earnings increased by $12 million during the year, while book value per share at year-end
was $40.

Co has no preferred stock, and no new common stock was issued during the year.

If its year-end total debt was $120 million, what was the company’s year- end total debt to total capital
ratio?

TOTAL DEBT TO TOTAL CAPITAL RATIO = total debt / (total debt + equity) = 120 / 8120 + 240) = 0.333 or
3.33%
PROBLEM TO SOLVE

Co has no preferred stock - only common equity, current liabilities, and long-term debt.

a) Find Co’s (1) accounts receivable, (2) current assets, (3) total assets, (4) ROA, (5) common equity,
(6) quick ratio, and (7) long-term debt.

b) In part a, you should have found that Co’s accounts receivable (A/R) = $111.1 million.

If Co could reduce its DSO from 40.55 days to 30.4 days while holding other things constant, how
much cash would it generate? If this cash were used to buy back common stock (at book value),
thus reducing common equity, how would this affect (1) the ROE, (2) the ROA, and (3) the total
debt/total capital ratio?