chapter_3_financial_ratios

Chapter 3Working with Financial StatementsLast class we went over how to organize a balance sheet and income statement. This class we are going to learn more how to use a financial statement.∙Maybe we want to compare two companies. Financial statements are what make that possible.∙What if we want to know how liquid a company is – or how quickly or easily will it be for them to get cash.∙How good of a job did the company do managing its cash – how profitable are they?Financial RatiosWe calculate ratios in order to compare and investigate relationships between different pieces of information•For each ratio, ask yourself:–What the ratio is trying to measure–Why that information is importantCategories of Financial Ratios:∙Solvency – assets – the firm owns them and they make money for the firm. Liabilities – the firm pays its liabilities making money go out or leave the firmo We use the money we make from our assets to pay our liabilities.▪If the firm has more money coming in then going out – we say the firm is solvent.∙The firm has enough money to pay its bills.▪If the firm has less money coming in then going out – we say the firm isinsolvent.∙Asset management – measures how well a firm is using its assets.o Is the firm making the most money it can from assets?∙Profitability ratios – a firm makes a profit when the revenue is greater than its costs o Are the firm’s costs too high?Short-term Solvency / Liquidity Measures1.Short-term solvency, or liquidity, ratios measures a firm’s ability to pay bil ls in the short-run (ayear or less)∙Current Ratio = Current Assets / Current Liabilitieso We talked about last class Current Assets and Current Liabilities being short –term.▪ A Current Asset is something that the firm expects will be converted to cashwithin a year and Current Liabilities are bills the firm will have to pay within ayear.2.Long-term solvency ratios measure a firm’s ability to pay long-term liabilities?Assets = Liabilities + Shareholder Equityo A company wants to buy more assets. How are they going to pay for those assets?Where are they going to get the money to buy those assets?o Sometimes, the company will borrow the money – they will go in debt. If the company wants to borrow money, it will issue a bond.∙Total Debt Ratio –(Total Assets – Total Equity) / Total Assetso M easures what proportion of the firm’s assets are financed with borrowed moneyo How much of the assets we have are purchased with borrowed money?∙Debt-Equity Ratio = Total Debt / Total Equityo Compares the amount of funds supplied by creditors relative to owners.Asset Management, or Turnover, MeasuresWhen talking about asset management – we want to know how efficiently the management is using the assets – are they using the assets effectively to make profits, or are they being wasted?∙Inventory Turnover = Cost of Goods Sold / Inventoryo If we know that we turned our inventory over 3.2 times, then we can use that number to figure out how long it took to turn it over on average∙Days’ Sales in Inventory = 365 days / Inventory Turnovero Take 365 / 3.2 = 114 days. Inventory sits on the shelve for 114 days before it is sold Profitability MeasuresAgain how efficiently the firm uses its assets and how efficiently it manages its operations ∙Profit Margin = Net Income / Saleso Net Income is how much we have left over after we subtract our costs and expenses So Net Income is a firm’s profito Out of all the revenue I make – I want to keep as much of that as I can so I want my costs as low as possible.o For every dollar in sales, the firm generates how much will I have left after I pay my costs?∙Return on Assets = Net Income / Total Assetso Are the assets I own making me money?o Measures profit per RMB of assets∙Return on Equity = Net Income / Total Equityo Measures the return to stockholderso Are we doing our job as managers to make the stockholders money?With ROA and ROA it is always important to remember that these are based off the book values and not market valuesMarket Value Measures∙Earnings per Share = Net Income / Shares OutstandingPrice-Earnings Ratio = Price per Share / Earnings per Shareo Measures how much investors are willing to pay per RNB of current earningso Most times investors will look for companies with high PE ratios because it means that means there is a good outlook for future growth. Investors will buy the stock becausethey want a share of those earnings.o A high PE ratio can also mean that the stock is too expensive.。