What are some potential pitfalls of ratio analysis based on accounting data

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Financial ratio analysis will rarely be useful if practiced mechanically. lt requires a large dose of good judgment. Financial ratios seldom provide answers but they do help you ask the right questions. Moreover, accounting data do not necessarily reflect market values properly, and so must be used with caution. You need a benchmark for assessing a company's financial position. Therefore, we typically compare financial ratios with the company's ratios in earlier years and with the ratios of other firms in the same business.

TABLE A.17

Summary of financial ratios

Leverage ratios

Long-term debt ratio

Debt-equity ratio Total debt ratio =

long-term debt long-term debt + equity _ long-term debt equity total liabilities total assets

Times interest earned Cash coverage ratio =

EBIT

interest payments EBIT + depreciation interest payments

Liquidity ratios

NWC to assets

Current ratio = Quick ratio Cash ratio

Interval measure Efficiency ratios

Total asset turnover

_ net working capital total assets current assets current liabilities cash + marketable securities + receivables current liabilities cash + marketable securities current liabilities cash + marketable securities + receivables

Average collection period Inventory turnover Days' sales in inventories average daily expenditures from operations

_sales_

average total assets average receivables average daily sales cost of goods sold average inventory average inventory cost of goods sold/365

Profitability ratios

Net profit margin

Return on assets = Return on equity Payout ratio

_ net income + interest sales net income + interest average total assets net income average equity dividends earnings Plowback ratio = 1 - payout ratio

Growth in equity from plowback = plowback ratio X ROE

How do measures such as market value added and economic value added help to assess the firm's performance?

The ratio of the market value of the firm's equity to its book value indicates how far the value of the shareholders' investment exceeds the money that they have contributed. The difference between the market and book values is known as market value added and measures the number of dollars of value that the company has added.

Managers often compare the company's return on assets with the cost of capital, to see whether the firm is earning the return that investors require. It is also useful to deduct the cost of the capital employed from the company's profits to see how much profit the company has earned after all costs. This measure is known as residual income, economic value added, or EVA. Managers of divisions or plants are often judged and rewarded by their business's economic value added.

Related Web Links

www.cfonet.com/html/Articles/CFO/1998/98JAtist.html A look at the Du Pont model www.stockscreener.com/ How investors use financial analysis to value or screen firms www.onlinewbc.org/docs/finance/index.html Basics of financial analysis, with tutorials and tools

http://profiles.wisi.com/ Detailed information on 18,000 companies

www.hoovers.com/ Hoover's company directory reports on thousands of companies, IPOs, and industries biz.yahoo.com Useful financial profiles on thousands of firms www.reportgallery.com Annual reports on thousands of companies

www.prars.com Public Register's Annual Report Service is the largest annual report service in the United States, providing annual reports, prospectuses, and 10-K reports www.sternstewart.com Contains a good discussion of economic value added

Key Terms

Quiz income statement common-size income statement balance sheet common-size balance sheet liquidity

Du Pont system market value added residual income economic value added (EVA)

1. Calculating Ratios. Here are simplified financial statements of Phone Corporation from a recent year:

INCOME STATEMENT (figures in millions of dollars)

Net sales 13,194

Cost of goods sold 4,060

Other expenses 4,049

Depreciation 2,518

Earnings before interest and taxes (EBIT) 2,566

Interest expenses 685

Income before tax 1,881

Taxes 570

Net income 1,311

Dividends 856

BALANCE SHEET (figures in millions of dollars)

End of Year Start of Year

Assets

Cash and marketable securities 89 158

Receivables 2,382 2,490

Inventories 187 238

Other current assets 867 932

Total current assets 3,525 3,818

Net property, plant, and equipment 19,973 19,915

Other long-term assets 4,216 3,770

Total assets 27,714 27,503 Liabilities and shareholders' equity

Payables 2,564 3,040

Short-term debt 1,419 1,573

Other current liabilities 811 787

Total current liabilities 4,794 5,400

Long-term debt and leases 7,018 6,833

Other long-term liabilities 6,178 6,149

Shareholders' equity 9,724 9,121

Total liabilities and shareholders' equity 27,714 27,503

Calculate the following financial ratios:

a. Long-term debt ratio b. Total debt ratio c. Times interest earned d. Cash coverage ratio e. Current ratio f. Quick ratio g. Net profit margin h. Inventory turnover i. Days in inventory j. Average collection period k. Return on equity l. Return on assets m. Payout ratio

2. Interval Measure. Suppose that Phone Corp. shut down operations. For how many days could it pay its bills?

3. Gross Investment. What was Phone Corp.'s gross investment in plant and other equipment?

4. Market Value Ratios. If the market value of Phone Corp. stock was $17.2 billion at the end of the year, what was the market-to-book ratio? If there were 205 million shares outstanding, what were earnings per share? The price-earnings ratio?

5. Common-Size Balance Sheet. Prepare a common-size balance sheet for Phone Corp. using its balance sheet from problem 1.

6. Du Pont Analysis. Use the data for Phone Corp. to confirm that ROA = asset turnover X profit margin.

7. Du Pont Analysis. Use the data for Phone Corp. from problem 1 to a. calculate the ROE for Phone Corp.

b. demonstrate that ROE = leverage ratio x asset turnover ratio x profit margin x debt burden.

Practice Problems

8. Asset Turnover. In each case, choose the firm that you expect to have a higher asset turnover ratio.

a. Economics Consulting Group or Pepsi b. Catalog Shopping Network or Neiman Marcus c. Electric Utility Co. or Standard Supermarkets

9. Defining Ratios. There are no universally accepted definitions of financial ratios, but some of the following ratios make no sense at all. Substitute the correct definitions.

a. Debt-equity ratio b. Return on equity c. Profit margin long-term debt long-term debt + equity EBIT - tax d. Inventory turnover average equity net income + interest sales total assets e. Current ratio :

f. Interval measure average inventory current liabilities current assets current assets - inventories g. Average collection period h. Quick ratio average daily expenditure from operations sales average receivables/365 cash + marketable securities + receivables current liabilities

10. Current Liabilities. Suppose that at year-end Pepsi had unused lines of credit which would have allowed it to borrow a further $300 million. Suppose also that it used this line of credit to borrow $300 million and invested the proceeds in marketable securities. Would the company have appeared to be (a) more or less liquid, (b) more or less highly leveraged? Calculate the appropriate ratios.

11. Current Ratio. How would the following actions affect a firm's current ratio?

a. Inventory is sold at cost.

b. The firm takes out a bank loan to pay its accounts due.

c. A customer pays its accounts receivable.

d. The firm uses cash to purchase additional inventories.

12. Liquidity Ratios. A firm uses $1 million in cash to purchase inventories. What will happen to its current ratio? Its quick ratio?

13. Receivables. Chik's Chickens has average accounts receivable of $6,333. Sales for the year were $9,800. What is its average collection period?

14. Inventory. Salad Daze maintains an inventory of produce worth $400. Its total bill for produce over the course of the year was $73,000. How old on average is the lettuce it serves its customers?

15. Inventory Turnover. If a firm's inventory level of $10,000 represents 30 days' sales, what is the annual cost of goods sold? What is the inventory turnover ratio?

16. Leverage Ratios. Lever Age pays an 8 percent coupon on outstanding debt with face value $10 million. The firm's EBIT was $1 million.

a. What is times interest earned?

b. If depreciation is $200,000, what is cash coverage?

c. If the firm must retire $300,000 of debt for the sinking fund each year, what is its "fixed-payment cash-coverage ratio" (the ratio of cash flow to interest plus other fixed debt payments)?

17. Du Pont Analysis. Keller Cosmetics maintains a profit margin of 5 percent and asset turnover ratio of 3.

b. If its debt-equity ratio is 1.0, its interest payments and taxes are each $8,000, and EBIT is $20,000, what is its ROE?

18. Du Pont Analysis. Torrid Romance Publishers has total receivables of $3,000, which represents 20 days' sales. Average total assets are $75,000. The firm's profit margin is 5 percent. Find the firm's ROA and asset turnover ratio.

19. Leverage. A firm has a long-term debt-equity ratio of .4. Shareholders' equity is $1 million. Current assets are $200,000 and the current ratio is 2.0. The only current liabilities are notes payable. What is the total debt ratio?

20. Leverage Ratios. A firm has a debt-to-equity ratio of .5 and a market-to-book ratio of 2.0. What is the ratio of the book value of debt to the market value of equity?

21. Times Interest Earned. In the past year, TVG had revenues of $3 million, cost of goods sold of $2.5 million, and depreciation expense of $200,000. The firm has a single issue of debt outstanding with face value of $1 million, market value of $.92 million, and a coupon rate of 8 percent. What is the firm's times interest earned ratio?

22. Du Pont Analysis. CFA Corp. has a debt-equity ratio that is lower than the industry average, but its cash coverage ratio is also lower than the industry average. What might explain this seeming contradiction?

23. Leverage. Suppose that a firm has both floating rate and fixed rate debt outstanding. What effect will a decline in market interest rates have on the firm's times interest earned ratio? On the market value debt-to-equity ratio? Based on these answers, would you say that leverage has increased or decreased?

24. Interpreting Ratios. In each of the following cases, explain briefly which of the two companies is likely to be characterized by the higher ratio:

a. Debt-equity ratio: a shipping company or a computer software company b. Payout ratio: United Foods Inc. or Computer Graphics Inc.

c. Ratio of sales to assets: an integrated pulp and paper manufacturer or a paper mill d. Average collection period: Regional Electric Power Company or Z-Mart Discount Outlets e. Price-earnings multiple: Basic Sludge Company or Fledgling Electronics

25. Using Financial Ratios. For each category of financial ratios discussed in this material, give some examples of who would be likely to examine these ratios and why.

Challenge Problem

Financial Statements. As you can see, someone has spilled ink over some of the entries in the balance sheet and income statement of Transylvania Railroad. Can you use the following information to work out the missing entries:

Long-term debt ratio .4

Times interest earned 8.0

Current ratio 1.4

Quick ratio 1.0 Cash ratio .2

Return on assets 18%

Return on equity 41%

Inventory turnover 5.0

Average collection period 71.2 days

INCOME STATEMENT (figures in millions of dollars)

Selling, general, and administrative expenses 10

Depreciation 20

Earnings before interest and taxes (EBIT) •••

BALANCE SHEET (figures in millions of dollars)

This Year Last Year

Assets

Total assets ••• 105 Liabilities and shareholders' equity

Accounts payable 25 20

Notes payable 30 35

Total liabilities and shareholders'equity 115 105

Solutions to

Self-Test

Questions

1 Nothing will happen to the long-term debt ratio computed using book values, since the face values of the old and new debt are equal. However, times interest earned and cash coverage will increase since the firm will reduce its interest expense.

2 a. The current ratio starts at 1.2/1.0 = 1.2. The transaction will reduce current assets to $.7

million and current liabilities to $.5 million. The current ratio increases to .7/.5 = 1.4. Net working capital is unaffected: current assets and current liabilities fall by equal amounts.

b. The current ratio is unaffected, since the firm merely exchanges one current asset (cash) for another (inventories). However, the quick ratio will fall since inventories are not included among the most liquid assets.

3 Average daily expenses are (9,330 + 8,912 + 291)/365 = $50.8 million. Average accounts payable are (3,870 + 3,617)/2 = 3,743.5 million. The average payment delay is therefore 3,743.5/50.8 = 73.7 days.

4 a. The firm must compensate for its below-average profit margin with an above-average turnover ratio. Remember that ROA is the product of margin X turnover. b. If ROA equals the industry average but ROE exceeds the industry average, the firm must have above-average leverage. As long as ROA exceeds the borrowing rate, leverage will increase ROE.

5 Retailers maintain large inventories of goods, specifically the products they stock in their stores. This shows up in the high net working capital ratio. Their profit margin on sales is relatively low, but they make up for that low margin by turning over goods rapidly. The high asset turnover allows retailers to earn an adequate return on assets even with a low profit margin, and competition prevents them from increasing prices and margins to a level that would provide a better ROA. In contrast, manufacturing firms have low turnover, and therefore need higher profit margins to remain viable.

rchetts Green had enjoyed the bank training course, but it was good to be starting his first real job in the corporate lending group. Earlier that morning the boss had handed him a set of financial statements for The Hobby Horse Company, Inc. (HH). "Hobby Horse," she said, "has got a $45 million loan from us due at the end of September and it is likely to ask us to roll it over. The company seems to have run into some rough weather recently and I have asked Furze Platt to go down there this afternoon and see what is happening. It might do you good to go along with her. Before you go, take a look at these financial statements and see what you think the problems are. Here's a chance for you me of that stuff they taught you in the training course."

Burchetts was familiar with the HH story. Founded in 1990, it had rapidly built up a chain of discount stores selling materials for crafts and hobbies. However, last year a number of new store openings coinciding with a poor Christmas season had pushed the company into loss. Management had halted all new construction and put 15 of its existing stores up for sale.

Burchetts decided to start with the 6-year summary of HH's balance sheet and income statement (Table A.18). Then he turned to examine in more detail the latest position (Tables A.19 and A.20).

TABLE A.18

Financial highlights for The Hobby Horse Company, Inc., year ending March 31

TABLE A.18

Financial highlights for The Hobby Horse Company, Inc., year ending March 31

2000

1999

1998

1997

1996

1995

Net sales

3,351

3,314

2,845

2,796

2,493

2,160

EBIT

-9

312

256

243

212

156

Interest

37

63

65

58

48

46

Taxes

3

60

46

43

39

34

Net profit

-49

189

145

142

125

76

Earnings per share

-0.15

0.55

0.44

0.42

0.37

0.25

Current assets

669

469

491

435

392

423

Net fixed assets

923

780

753

680

610

536

Total assets

1,573

1,249

1,244

1,115

1,002

959

Current liabilities

680

365

348

302

276

320

Long-term debt

217

159

159

311

319

315

Stockholders' equity

676

725

599

502

407

324

Number of stores

240

221

211

184

170

157

Employees

13,057

11,835

9,810

9,790

9,075

INCOME STATEMENT FOR THE HOBBY HORSE COMPANY, INC., FOR YEAR ENDING MARCH 31, 2000 (all items in millions of dollars)

Net sales

3,351

Cost of goods sold

1,990

Selling, general, and administrative expenses

1,211

Depreciation expense

159

Earnings before interest and taxes (EBIT)

-9

Net interest expense

37

Taxable income

-46

Income taxes

3

Net income

-49

Allocation of net income

Addition to retained earnings

-49

Dividends

0

Note: Column sums subject to rounding error.

Note: Column sums subject to rounding error.

162 APPENDIX A TABLE A.20

CONSOLIDATED BALANCE SHEET FOR THE HOBBY HORSE COMPANY, INC.

(figures in millions of dollars)

Assets

Mar. 31, 2000

Mar. 31, 1999

Current assets

Cash and marketable securities

14

72

Receivables

176

194

Inventories

479

203

Total current assets

669

469

Fixed assets

Property, plant, and equipment (net of depreciation)

1,077

910

Less accumulated depreciation

154

130

Net fixed assets

923

780

Total assets

1,592

1,249

Liabilities and Shareholders' Equity

Mar. 31, 2000

Mar. 31, 1999

Current Liabilities

Debt due for repayment

484

222

Accounts payable

94

58

Other current liabilities

102

85

Total current liabilities

680

365

Long-term debt

236

159

Stockholders' equity

Common stock and other paid-in capital

155

155

Retained earnings

521

570

Total stockholders' equity

676

725

Total liabilities and stockholders' equity

1,592

1,249

Note: Column sums subject to rounding error.

Note: Column sums subject to rounding error.

Working Capital Management and Short-Term Planning

Cash and Inventory Management

Credit management and Collection

Interest Rate Long Terms Chat

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Responses

  • hanna
    What was phone corp's gross investment in plant and other equipment?
    8 years ago
  • linda
    What is the potential pitfalls in ratio analysis?
    8 years ago
  • miika sutinen
    How would the following actions affect a firms current ratio?
    8 years ago
  • yvonne
    Why does economic value added relate to financial ratio analysis?
    8 years ago
  • kimi
    Why pitfall of using ratio by the company?
    8 years ago
  • peter
    What is the times interest earned if depreciation is 200,000?
    8 years ago
  • toivo
    What is "fixedpayment cash coverage ratio"?
    8 years ago
  • hilda
    What are some pitfalls of a poor analysis.?
    8 years ago
  • tobias
    What is the interest earned ratio using net income 1,048, income taxes 435, and interest expense 212?
    8 years ago
  • william ortega
    What are pitfalls accounting?
    7 years ago
  • bernd
    What are potential pitfalls of ratio analysis based on accounting data?
    7 years ago
  • rebecca
    What effect will the loan and the investment have on the firms times interest earned ratio?
    6 years ago

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