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igFinancial ratio analysisgt

By Joan Holmes,2014-11-12 20:10
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igFinancial ratio analysisgt

    Financial ratio analysis

    Financial ratio analysis is an important topic and is covered in all mainstream corporate finance textbooks. It is also a popular agenda item in investment club meetings. It is widely used to summarize the information in a company's financial statements in assessing its financial health. In today's information technology world, real time financial data are readily available via the Internet. Performing financial ratio analysis using publications, such as Robert Morris Associates’ Annual Statement

    Studies, Dun & Bradstreet’s Key Business Ratios, Moody’s Manuals, Standard & Poor’s Corporation Records, Value Line Investment Survey, etc., is no longer efficient. Since students and investors now have easy access to on-line databases, the assignments on financial ratio analysis can be modified accordingly to enhance learning. Based upon my experience as a finance professor and as a member of a local investment club, I have prepared this teaching note to help students and investors in performing financial ratio analysis via an on-line database, Dow Jones Interactive. This database is a Web based, enterprise wide business news and research solution supported by Dow Jones & Company, the parent company of The Wall Street

    Journal. The class assignment presented herein is designed to demonstrate how to assess a company's overall operations over time and its current financial standing in the industry.

    Students will work on the assignment collaboratively in groups of three or four students. Each group will select an industry of interest to the group, and each student will select a company within that industry. Students will download the relevant financial data from the Internet and perform ratio analysis for the selected companies. Since successful financial ratio analysis is as much an art as it is a science, students must use common sense and sound judgment throughout the analysis. The purpose of this assignment is to provide students with the opportunity to:

    ; retrieve real time financial data via the Web;

    ; analyze the financial performance of selected companies;

    ; practice communication skills, both in writing (through word processing) and

    in speaking (through giving a Power Point presentation);

    ; enhance teamwork skills.

    To evaluate how the selected company is performing over time, more than one year's financial ratios are required. Students are instructed to follow the path shown below to retrieve the financial profile for the selected company via Dow Jones Interactive. (The initial steps may differ depending on how your library's site is organized.)

    ; Go to the University Library home page

    ; Click on Research Resources

    ; Click on Dow Jones Interactive (DJI)

    ; On DJI page, click on Company and Industry Center

    ; Click on Financial Profile

    ; Select Region: Worldwide

    ; Enter Company Symbol: ____________

    ; Display as: Formatted report

    ; Click on Get Report

    ; Download the report including Key Financial Ratios, Balance Sheets, Income

    Statements and Key Competitors (see APPENDIX 1 for an excerpt Financial

    Profile of Intel)

    Trend analysis provides signals as to whether the company's financial health is likely to improve or deteriorate. Each student will perform the trend analysis based upon the following financial ratios:

    ; Leverage Ratios: to measure the extent to which the company's assets are

    financed with debt;

    ; Liquidity Ratios: to measure the company's ability to pay its bills;

    ; Profitability Ratios: to measure the company's ability to generate earnings;

    ; Efficiency Ratios: to measure the company's ability to utilize its assets;

    ; Market Value Ratios: to measure the market perception about the company's

    future prospects.

    The downloaded four years' balance sheets and income statements are to be used to

    calculate the financial ratios not reported in the DJI. For example, four leverage ratios

    (Debt/Equity, LT Debt/ Cap, LT Debt/Tot Debt, and LT Debt/Tot Assets) are reported,

    but the interest coverage ratio (= earnings available for interest/interest expenses) is

    missing in the DJI. Students are required to obtain the earnings and interest expenses

    information from the income statements and calculate this ratio to measure the

    company's ability to service the debt. In the area of liquidity, current ratio (= current

    assets/current liabilities) and quick ratio (= quick assets/ current liabilities) are

    reported, but the interval measure (= quick assets/daily operating expenditures) is not.

    Students are required to obtain quick assets (= cash & equivalent + receivables) from

    the balance sheets and operating expenditures from the income statements, and

    calculate this ratio to measure how long the company can keep up with its bills using

    only existing quick assets. As the financial ratios in each of the five performance

    areas are compiled, they are analyzed across time. A sample trend analysis for Intel is

    presented (below) in Table 1.

    Table 1. Intel Trend Analysis

Performance Area 1998 1997 1996 1995 Trend

    Leverage:

    Debt % Tot Assets 25.7 33.2 28.9 30.6 Drop in

    leverage

    during 1998

    Interest Coverage 269.7 395.8 318.4 195.4 Lower coverage

    during 1998

    Liquidity:

    Current Ratio 2.3 2.6 2.8 2.2 Lower

    liquidity

    since 1996

    Quick Ratio 1.0 1.3 1.6 1.3 Lower

    liquidity

    since 1996

    Interval Measure (days) 63.8 90.8 115.3 86.4 Lower

    liquidity

    since 1996

    Profitability:

Profit Margin (%) 23.1 27.7 24.7 22.0 Lower

    profitability

    during 1998

    Return on Assets (%) 19.3 24.0 21.7 20.4 Lower ROA

    during 1998

    Return on Equity (%) 26.0 36.0 30.6 29.4 Lower ROE

    during 1998

    Efficiency:

    Asset Turnover .835 .868 .878 .926 Lower

    efficiency

    since 1995

    Receivables Turnover 7.5 7.0 6.1 6.4 Increased

    efficiency

    since 1996

    Inventory Turnover 5.7 5.2 4.4 4.1 Increased

    efficiency

    since 1995

    Market Value:

    Price/Book Value 8.41 5.92 6.37 3.83 Good market

    perceptions

    Du Pont Analysis

    Since it is important to understand how the company's profitability, efficiency, and

    leverage are linked in its financial performance, students are required to demonstrate

    and evaluate its Du Pont system over time. The company's return on assets, ROA

    (=net income/assets), can be expressed as:

    ROA = (Net Income/Revenue) * (Revenue/Assets) = Profit Margin * Asset Turnover

    And the company's return on equity, ROE (=net income/equity), can be expressed as

    ROE = (Net Income/Revenue) * (Revenue/Assets) * (Assets/Equity) = ROA * Equity

    Multiplier

    Both the company's profitability (as measured in terms of profit margin) and

    efficiency (as measured in terms of asset turnover) determine its ROA. This ROA,

    along with the company's financial leverage (as measured in terms of its equity

    multiplier), contributes to its ROE. As the company's use of leverage magnifies its

    ROE, students are required to examine ROE carefully. The changes in the company's

    ROE are to be noted and explained through its profit margin, asset turnover, and

    equity multiplier over time. The objective is to identify the company's strong area that

    can be capitalized upon and/or its weak area that must be improved upon. See Table 2

    (below) for a sample Du Pont analysis for Intel.

    Table 2. Intel Du Pont Analysis

Item / Ratio 1998 1997 1996 1995 Evaluation

    6068 6945 5157 3566 Net Income, $million

    (from Income statements)

    26273 25070 20847 16202 Revenue, $million

    (from Income statements)

    31471 28880 23735 17504 Assets, $million

    (from balance sheets)

    23377 19295 16872 12140 Equity, $million

    (from balance sheets)

    23.1 27.7 24.70 22.0 Drop in Profit Margin %

    profitability

    (Net Income/Revenue) during 1998

    .835 .868 .878 .926 Lower Asset Turnover

    efficiency

    (Revenue/Assets) since 1995

    19.3 24 21.7 20.4 Drop in ROA Return on Assets %

    during 1998

    (Profit Margin* Asset

    Turnover)

    1.35 1.50 1.41 1.44 Decrease in Equity Multiplier

    leverage

    (Assets/Equity) during 1998

    26.0 36.0 30.6 29.4 Sharp decline Return on Equity %

    in ROE during

    (ROA* Equity Multiplier) 1998

    To explain the variation in the company's financial ratios over time, the industry comparative analysis must be performed along with the trend analysis. To evaluate the company's financial performance against its key competitors, the company-to- company comparison report is retrieved from the following path.

    ; On DJI page, click on Company/Industry Comparison Reports

    ; Select Report: Company to Company Comparison

    ; Enter First Company's Symbol: _____________

    ; Enter Second Company's Symbol: _____________

    ; Select Display as: Formatted report

    ; Click on Get Report

    ; Download the report (see APPENDIX 2 for a Company to Company

    Comparison Report for Intel)

    The financial ratios in each of the performance areas are then analyzed across companies in the industry/group. Students compare their company's financial ratios with those of its key competitors and determine whether managerial or environmental factors cause the trend of the company's financial performance. To further assess the company's financial standing in its primary industry, the company to industry comparison report is retrieved. (See below.)

    ; Back to DJI page, click on Company/Industry Comparison Reports

    ; Select Report: Company to Industry Comparison

    ; Enter Company Symbol: _____________

    ; Select Compare to: this Company's Primary Industry (as identified by DJI)

    ; Select Display as: Formatted report

    ; Click on Get Report

    ; Download the report (see APPENDIX 3 for a Company to Primary Industry

    Comparison Report for Intel)

    The following specific industry norms are available in DJI and used as benchmarks in this analysis:

    ; Liquidity: Current Ratio;

    ; Leverage: Debt/Equity, Interest Coverage;

    ; Profitability: Profit Margin, Return on Equity, Return on Assets;

    ; Efficiency: Revenue/Assets;

    ; Market Value: Price/Book Value, Price/Earnings, Dividend Yield.

    Students will report on how the company performs as compared to the industry norms

    and where the company stands relative to its competitors in the industry. The

    company's weak and/or strong areas of performance must be identified and

    recommendations for improvement presented. See Table 3 (below) for a sample

    industry comparative analysis for Intel.

    Table 3. Intel Industry Comparative Analysis

Performance Area Intel AMD* Semiconductors Evaluation

    Leverage: Excellent

    Debt/Equity (%) 3 73 19 Low leverage

    Interest Coverage 269.7 - 20.8 High coverage

    Liquidity: Good

    Current Ratio 3.2 2.8 Above average 1.7 liquidity

    Profitability: Excellent

    Profit Margin (%) 26.1 11.1 High -0.9 profitability

    Return on Assets (%) 19.3 -2.4 7.2 High ROA

    Return on Equity (%) 28.9 - 14.1 High ROE

    Efficiency: Good

    Revenue/Assets .86 .64 .82 Above average

    Market Value: Good

    Price/Book Value 8.41 2.10 6.04 High price to book

    Price/Earnings 36.3 - 67.3 Below average PE

Dividend Yield (%) 0.2 0.0 0.1 Average

* AMD, Advanced Micro Devices, is one of Intel's key competitors in

semiconductors industry.

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