Ratio Analysis

Understanding business health through market value ratio analysis

Lesson Overview

Instructor Presentation

Introduction

Ratio analysis represents one the most mathematically straightforward and most important analysis concepts that Business, Finance and Accounting students should know.  Ratio analysis is used by business in contexts of both internal and external exercises.  The basis for the analysis always begins with the financial statements for the business.  Two ideas should be stressed.  First, even amongst business of similar nature and industry, variations in accounting techniques do exist and therefore, care should be taken in relying exclusively on the results of ratio analysis.  Second, when using financial statements, the more current the statement the more accurately we can make conclusions.

Goals

Students will be able to identify the basic categories of ratio analysis and where this type of analysis could be used appropriately.

Students will be able to calculate appropriate ratios.

Students will be able to describe business improvements that could effect the ratios being investigated.

Notes

Ratio analysis is one of the first steps in most processes.  Ratios are used to give us a generalized indication of the health of a business.  Ratio analysis should be used as a part of the evaluation process, not as the sole set in the evaluation process.
Ratios analysis is based on the reported financial statements of businesses.   We use industry financial data within this lesson plan with permission from Risk Management Associates. 
This notebook is part three of a three part series on Ratio Analysis.

Concept Exploration

Basic Categories of Ratio Analysis

Business are compared and evaluated for many different reasons and in many different ways.  The two primary ways are through Trend Analysis and through Ratio Analysis.  Trend Analysis is used to measure year to year within the business.  This lesson covers Ratio Analysis; the analysis of the performance of business against other businesses in it's industry.

First of all realize that not all ratios are created equal.  Most people, depending on their focus, are only concerned with a few of the different ratios.  Ratios can be categorized as:

Liquidity Ratios

Leverage Ratios

Operational Ratios

Profitability Ratios

Market Value Ratios

Financial ratio analysis groups the ratios into categories which tell us about different facets of a company's finances and operations.  An overview of some of the categories of ratios is given below.

Further Exploration

Defining Basic Purposes for Ratio Use

Depending on the goal of the financial analysis, different ratio categories may be used.  Here is a simple overview of some common ratio categories.

Liquidity Ratios

Liquidity rations are also known as Short term Solvency ratios.  These ratios are important when cash reserves are important, when payments are expected, and for industries that use cash in many transactions.  This ratio category tell people about the capability of the company to pay near term payment requirements.

Leverage Ratios

Leverage Ratios are also know as Debt Management ratios.  These ratios are important to people who are offering the business loans and for people interested in investing in the company.  This ratio informs people about how well the business controls its outstanding debt.

Operational Ratios

Firms use their assets to generate revenue.  A business may buy machines to increase production or they may retain cash for short term obligations.  The decisions that the business managers make determine how much revenue is generated.  This ratio category helps us understand Management decisions and asset balance decisions.

Profitability Ratios

Investors and owners are very interested in getting a return on the money they have invested in the business.  Therefore, Profitability Ratios have been developed to monitor how likely an investment will pay its owners back.

Market Value Ratios

Market Value Ratios deal with publicly traded businesses and deal with the trading price of the stock and its underlying value.

Deeper Exploration

Market Value Ratios

Earnings Per Share (EPS) is a measure of a companies profits available to ordinary shareholders, which can either be paid out as dividends to the shareholders or retained in the business.EPS measures the profit earned per share.

Earnings Per Share =  ((Net Income - Dividends for Preferred Stock)/(Shares of Stock Outstanding))

Price/Earnings ratio This ratio measures the investors’ confidence in a company.  Uses current trading price for a share divided by the earnings.  Earnings can be calculated using last four quarters or can be an estimate of future earnings.

Price/Earnings  =  ((Market Value per Share)/(Earnings per Share))

Dividends Per Share (DPS) is a measure of paid out earnings for each share of stock owned.  Dividends per share is what is actually paid to the owner, while Earnings Per Share is what the company earns divided by the number of shares.  The difference includes retained earnings and dividends to Preferred Stockholders.

Dividends Per Share  =  ((Dividends paid)/(Shares of Stock Outstanding))

Examples

5. Market Value Ratios - Examples

5.1  Johnsonville Pulp and Potatoes earns $3.5M and pays out dividends at 12% of earnings.  If there are 650,000 shares outstanding, what are the EPS and DPS for Johnsonville?

5.2  What is the current Price/Earnings Ratio for IBM?

www.wolframalpha.com

5.3  Market Value Ratios are most often used by investors.  Investors looking for a large steady income stream tend to look for companies with large EPS.  Why might a company with a high EPS not be a good investment for this type of investor?

5. Market Value Ratios - Examples

5.1  Johnsonville Pulp and Potatoes earns $3.5M and pays out dividends at 12% of earnings.  If there are 650,000 shares outstanding, what are the EPS and DPS for Johnsonville?

earnings=3500000;dividendpayout=.12;shares=650000;eps=N[earnings/shares,3]
dps=N[earnings*dividendpayout/shares,3]

Earnings per share for Johnsonville are $5.38 per share.  Dividends per share for Johnson are $0.64 per share.  Quite a difference, yes?

5.2  What is the current Price/Earnings Ratio for IBM?

www.wolframalpha.com

5.3  Market Value Ratios are most often used by investors.  Investors looking for a large steady income stream tend to look for companies with large EPS.  Why might a company with a high EPS not be a good investment for this type of investor?

The difficulty with looking only at Earnings per share is that some companies don't pay any dividends.  Microsoft was a good example of this.  For years, the company did not pay any dividends and therefore, an investor looking for a steady income stream would should be looking at DPS as well as EPS.

Initializations

Data found below are copyrighted by Risk Management Associates, Financial Statement Studies: Financial Ratio Benchmarks, 2008-2009.  Permission given to author for non-commercial use in this demonstration.

industry532291={{13.0,22.2,5.5,2.9,40.9,7.6,8.0},{9.8,9.6,8.5,0.1,10.4,29.4,0.6,3.7,27.9},{100,0.0,84.8,3.5},{{1.9,1.1,0.6},{1.4,0.9,0.5},{238.9,7.1,4.9},{2.4,1.6,1.0},{0.7,2.2,-21.8},{0.9,2.8,-63.1}}};

industry532210= {{7.7,12.5,15.9,4.3,46.1,4.9,8.6},{17.1,8.2,9.0,0.1,7.0,30.5,0.5,9.5,18.0},{100,0.0,89.3,6.4},{{2.1,1.0,0.3},{1.4,0.4,0.1},{500,57.6,12.6},{2.3,1.5,0.7},{0.5,4.1,-16.0},{1.5,6.2,-23.3}}};

industry532120={{7.5,10.5,7.8,4.1,61.8,1.7,6.5},{11.4,11.7,4.5,0.3,6.0,38.0,2.0,3.9,22.2},{100,0.0,86.6,5.8},{{1.6,0.9,0.4},{1.1,0.5,0.2},{183.2,12.9,8.2},{1.6,0.8,0.4},{1.3,2.7,7.3},{1.8,3.6,10.2}}};

industry532111={{6.8,4.6,17.8,8.1,53.5,3.2,5.9},{34.9,6.1,3.9,0.2,5.9,26.2,0.7,4.5,17.5},{100,0.0,91.9,6.8},{{1.2,0.7,0.2},{0.5,0.2,0.1},{90.4,28.9,14.7},{1.1,0.7,0.5},{0.3,3.2,11.1},{2.4,6.1,17.3}}};