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RATIO EXAMPLE: Ratio Analysis Gi Company BALANCE SHEET December 31 20X2 20X1 Current Assets: Cash and cash equivalents $ 50,000 $ 35,000 Trading securities (at fair value) 75,000 65,000 Accounts receivable 300,000 290,000 Inventory (at lower of cost or market) 290,000 275,000 Total current assets 715,000 665,000 Investments available-for-sale (at fair value) 350,000 300,000 Fixed Assets: Property, plant, and equipment (at cost) 1,900,000 1,800,000 Less: Accumulated depreciation (380,000) (350,000) 1,520,000 1,450,000 Goodwill 30,000 35,000 Total assets $2,615,000 $2,450,000 Current Liabilities: Accounts payable $ 150,000 $ 125,000 Notes payable 325,000 375,000 Accrued and other liabilities 220,000 200,000 Total current liabilities 695,000 700,000 Long-term Debt: Bonds and notes payable 650,000 600,000 Total liabilities 1,345,000 1,300,000 Stockholders' Equity: Common stock (100,000 shares outstanding) 500,000 500,000 Additional paid-in capital 350,000 350,000 Retained earnings 420,000 300,000 Total equity 1,270,000 1,150,000 Total liabilities and equity $2,615,000 $2,450,000 In addition, assume the following information for Gi Company for the year ended December 31, 20X2 Sales $1,800,000 Cost of goods sold (1,000,000) Gross profit 800,000 Operating expenses (486,970) Interest expense (10,000) Net income before income taxes 303,030 Income taxes (34%) (103,030) Net income after income taxes $ 200,000 Earnings per share $2 Operating cash flows $255,000 Dividends for the year $0.80 per share Market price per share $12 Liquidity Ratios 1. Working capital = Current assets - Current liabilities 20X2: $715,000 - $695,000 = $20,000 20X1: $665,000 - $700,000 = ($35,000) Current assets 2. Current ratio (working capital ratio) = Current liabilities $715,000 (20X2) = $695,000 = 1.03 $665,000 (20X1) = $700,000 = 0.95 (Industry average = 1.5) The ratio, and therefore Gi's ability to meet its short-term obligations, has improved, though it is low compared to the industry average. Cash equivalents + Marketable securities + Net receivables 3. Acid-test (quick) ratio = Current liabilities $50,000 + $75,000 + $300,000 (20X2) = $695,000 = 0.61 $35,000 + $65,000 + $290,000 (20X1) = $700,000 = 0.56 (Industry average = 0.80) The industry average of .80 is higher than Gi's ratio, which indicates that Gi may have trouble meeting short-term needs. Cash equivalents + Marketable securities 4. Cash ratio = Current liabilities $50,000 + $75,000 (20X2) = $695,000 = 0.18 $35,000 + $65,000 (20X1) = $700,000 = 0.14 Activity Ratios Net credit sales 1. Accounts receivable turnover = Average gross receivables $1,800,000 = ($300,000 + $290,000) / 2 $1,800,000 = $295,000 = 6.10 times This ratio indicates the receivables' quality and indicates the success of the firm in collecting outstanding receivables. Faster turnover gives credibility to the current and acid-test ratios. Average gross receivables 2. Accounts receivable turnover in days = Net credit sales / 365 365 days = Receivable turnover 365 = 6.1 = 59.84 days This ratio indicates the average number of days required to collect accounts receivable. Cost of goods sold 3. Inventory turnover = Average inventory $1,000,000 = ($290,000 + $275,000) / 2 $1,000,000 = $282,500 = 3.54 times This measure of how quickly inventory is sold is an indicator of enterprise performance. The higher the turnover, in general, the better the performance. Average inventory 4. Inventory turnover in days = Cost of goods sold / 365 365 days = Inventory turnover 365 days = 3.54 = 103.11 days This ratio indicates the average number of days required to sell inventory. 5. Operating cycle = AR turnover in days + Inventory turnover in days = 59.84 days + 103.11 days = 162.95 days The operating cycle indicates the number of days between acquisition of inventory and realization of cash from selling the inventory. Sales 6. Working capital turnover = Average working capital $1,800,000 = [($715,000 - $695,000) + ($665,000 - $700,000)] / 2 = 240 times This ratio indicates how effectively working capital is used. Net sales 7. Total asset turnover = Average total assets $1,800,000 = ($2,615,000 + $2,450,000) / 2 $1,800,000 = $2,532,500 = 0.71 times This ratio is an indicator of how Gi makes effective use of its assets. A high ratio indicates effective asset use to generate sales. Profitability Ratios Note: Some forms of the profitability ratios below use net income less preferred dividends in the numerator to better measure returns accruing to common shareholders. Net income 1. Net profit margin = Net sales $200,000 = $1,800,000 = 11.11% This ratio indicates profit rate and, when used with the asset turnover ratio, indicates rate of return on assets, as shown in item 3 below. 2. Return on total assets = Net income ÷ Average total assets = $200,000 / $2,532,500 = 7.9% 3. DuPont return on assets = Net profit margin x Total asset turnover Net income Net sales = Net sales x Average total assets = 11.11% x 0.71 times = 7.9% Note that this ratio uses both net profit margin and the total asset turnover. This ratio allows for increased analysis of the changes in percentages. The net profit margin indicates the percent return on each sale while the asset turnover indicates the effective use of assets in generating that sale. Net income + Interest expense (1 - Tax rate) 4. Return on investment = Average (Long-term liabilities + Equity) $200,000 + $10,000 (1 - 0.34) = ($650,000 + $1,270,000 + $600,000 + $1,150,000) / 2 = 11.3% ROI measures the performance of the firm without regard to the method of financing. Net income - Preferred dividends 5. Return on common equity = Average common equity $200,000 - $0 = ($1,270,000 + $1,150,000) / 2 = 16.5% Net operating income 6. Net operating margin percentage = Net sales $800,000 – 486,970 = $1,800,000 = 17.39% Gross (profit) margin 7. Gross (profit) margin percentage = Net sales $800,000 = $1,800,000 = 44% Operating cash flow 8. Operating cash flow per share = Common shares outstanding $255,000 = 100,000 shares = $2.55 per share Investor Ratios Earnings before interest and taxes 1. Degree of financial leverage = Earnings before taxes $303,030 + $10,000 = $303,030 = 1.033 The degree of financial leverage is the factor by which net income will change with a change in earnings before interest and taxes. The degree of financial leverage indicates the leverage factor for recurring earnings. Net income - Preferred dividends 2. Earnings per share = Weighted average number of common shares outstanding $200,000 - $0 = 100,000 shares = $2/share Market price per share 3. Price/earnings ratio = Diluted earnings per share $12 = $2 = 6 This statistic indicates the investment potential of an enterprise; a rise in this ratio indicates that investors are pleased with the firm's opportunity for growth. Dividends per common share 4. Dividend payout ratio = Diluted earnings per share $0.80 = $2 = 40% This ratio indicates the portion of current earnings being paid out in dividends. Dividends per common share 5. Dividend yield = Market price per common share $0.80 = $12 = 6.67% This ratio indicates the relationship between dividends and market price. Total stockholders' equity - Preferred stock 6. Book value per share = Number of common shares outstanding $1,270,000 = 100,000 shares = $12.70 This ratio indicates the amount of stockholders' equity that relates to each share of common stock. Note that preferred stock should be stated at liquidity value if other than book value. Long-term Debt-paying Ability Ratios Total liabilities 1. Debt / Equity = Common stockholders' equity (20X2) = $1,345,000 / $1,270,000 = 1.06 (20X1) = $1,300,000 / $1,150,000 = 1.13 This ratio indicates the degree of protection to creditors in case of insolvency. The lower this ratio the better the company's position. In Gi's case, the ratio is very high, indicating that a majority of funds come from creditors. However, the ratio is improving. Total liabilities 2. Debt ratio = Total assets (20X2) = $1,345,000 / $2,615,000 = 51.4% (20X1) = $1,300,000 / $2,450,000 = 53.1% This debt ratio indicates that more than half of the assets are financed by creditors. Recurring income before taxes and interest 3. Times interest earned = Interest $303,030 + $10,000 = $10,000 = 31.30 times This ratio reflects the ability of a company to cover interest charges. It uses income before interest and taxes to reflect the amount of income available to cover interest expense. Operating cash flow 4. Operating cash flow / Total debt = Total debt $255,000 = $1,345,000 = 18.96% This ratio indicates the ability of the company to cover total debt with yearly cash flow.