1. This material is from chapter 3.  You definitely should read it!  We will not go into each ratio is class, but you will be responsible for them.
2. Tip: Table 3.5 is a very good summary!
3. Turned in the first two quizzes
   
4. Posted one message on the class bulletin board introducing yourself
5. Read the first chapter.
6. Investigated various Finance jobs .
7. Learned about internships in Finance.
8. Decided that this is the most fun class you have EVER had.--It is Right??? 
9. Called home to tell your parents what a great class you have and to tell them you miss them!

	Red Alert!  Calculating and interpreting ratios make great test questions!

Standardized Financial Statements

In the last chapter we went through the various financial statements that firms release. In this chapter we are going to go a bit further and actually use the statements.  We will begin off by making some adjustments for size. 

Suppose that you heard that both XYZ grocery (of course it must be Park and Shop!) and Microsoft each made a million dollars last year.  (not we did not!)
What would your reaction be? Probably that the grocery store did well and that Microsoft had a bad year. Why? Because the two are vastly different sizes. For this reason we need to some how make adjustment to be able to compare across firms. 

Common sized financial statements

These adjustments are actually very easy to do.  All we have to do is to scale the numbers by something. 

Common-sized balance sheets--everything is listed as a percentage of total assets. Here the two sides of the balance sheet each sum to 100%.

Common-sized income statements--Everything is listed as a percentage of sales.(hence it is also known as (AKA) as the the percentage of sales method).
  

Financial Ratios

Ratios are based on the same basic idea as standardized financial statements: that is we are going to scale the various accounting numbers by something.  In fact it can be argued that standardized financial statements are nothing more than ratios.
 
Ratios are useful in that they summarize much data and put it in a usable format that can be compared across different firms and also the same firm over different times.  

Firms and investors both use ratios to quickly look over the vast array of data that is available.  One problem is that different firms calculate ratios in different ways.  This makes it hard to compare ratios at different firms without first making sure the ratios are calculated in a similar way.  Moreover, it makes it very difficult to make comparisons  internationallywhere the actual ffinancialsstatementsmay differ greatly.  

How are ratios used?  They can be used as an early warning system, as a means of monitoring management, and as a screening tool.  Ratios are used by both firms and investors.  As such they are useful when comparing other firms within the industry or the same firm at different points of time.  For industry comparisons http://Finance.yahoo.com is excellent.  Merely type in a ticker symbol, go to profile, and then ratio comparison.

Generally ratios are broken into four or 5 categories.  Each book and firm will call the categories something slightly different but the idea of the categories is the same.

1. Short-term solvency (or liquidity) ratios 

Current ratio = Current Assets/Current Liabilities
Quick ratio   = (Current assets - Inventory) / Current liabilities
                    the Quick ratio is also called the acid test 
Cash ratio    = Cash / Current Liabilities

These all measure how well the firm can meet short-term obligations.  Higher is better, but again too high suggests waste and can lead to a lack of discipline.      

Want to jump ahead again?  this lack of discipline that results of having too much financial flexibility is called the Free Cash flow problem (Jensen 1986).  At first glance this maybe counter-intuitive: it is a problem of too much cash.  This is a problem since managers may waste it. 

 2. Long-term solvency (or financial leverage or capital structure) ratios

Total debt ratio  =  (Total Assets - Total Equity) / Total Assets
Debt to equity    = Total DEbt / Total Equity
Equity Multiplier = Total Assets / Total Equity 
                          = 1 +  Debt to equity ratio
Times interest Earned = TIE
                                 = EBIT / Interest
Fixed charges coverage = EBIT / (Interest expense + lease payments)
Cash coverage = (EBIT + Depreciation) / Interest

3.  Asset management (AKA turnover or efficiency ratios)

Inventory Turnover = COGS/Inventory
(some firms use sales / inventory, but COGS is more accurate)
Days Sales in inventory = 365 days / Inventory 

Receiveables Turnover   = Credit sales / (accounts receivable)
Days sales in receivables = 365 / (Receivables turnover)

Total Asset Turnover = Sales / Total Assets
 

4. Profitability ratios 

Profit margin       = Net Income / Sales 
Return on Assets = Net Income / Total Assets
Return on Equity = Net Income / Total Equity

5. Market Value Measures

EPS      = Net Income / Shares Outstanding
PE ratio = Market Price per share / Earnings per share
Market to book value = Market value per share / Book value per share
Tobin's Q = Market value / Replacement Value
 

Dupont Identity

This shows the relationship between the various ratios.

ROE = (NI / Total Equity)  if you want you can multiply by assets/assets
         =  NI / Assets * Assets / Total Equity
         = ROA * equity multiplier

Now multiply each by sales/sales

        = (net income / sales) * (sales/assets) * (assets/ total Equity)
        = profit margin * total asset turnover * equity multiplier

This shows that ROE is affected by profit margins, asset use efficiency, and financial leverage. 

Ratios are like an odometer. they tell you some things but not everything. If you are driving 55 miles per hour is that fast or slow? Don't know?  Whay not?

Internal and sustainable growth

Dividend payout ratio = Cash dividends / net income

Retention ratio = addition to retained earnings / net income
                      = plowback ratio
                      = (1 - payout ratio)

Sustainable growth rate = ROE * plowback
      
or more accurately:

g = ROA * plowback / (1-ROA*plowback)
 

Ratios and the percentage of sales methods will be used again when we make cash flow projections.  These projections are out "crystal ball" where we try to determine how much a firm or project is worth.  This is done largely by making assumptions about ratios and the percentages of sales we expect in the future. 

Quick Quiz: 
1. Why are ratios used? 

2. How are ratios useful when used across the industry?

3. How can ratios be used for monitoring management?

4. What is a difficulty in using ratios for firms in different countries?

5. Why are ratios like odometers?

 
 

Assignment: go to Yahoo's Finance Page and look up 3 stocks that trade on the NYSE and three that trade on the Nasdaq.  What do you see different?  Hint: how many letters are in the stocks ticker symbol?

You have now completed the first chapter.  You are expected to go to the Text's web page and take the end of chapter quiz .  You can take it as many times as you want.  When you get a satisfactory score, copy the page and email it to FinanceProfessor@yahoo.com
 
 

 
 

Any questions?  Email me: JimMahar@FinanceProfessor.com

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