Chapter 4 Financial Ratios

Overview and Background:

After learning how to prepare financial statements, one can then analyze them for decision making. In the previous chapter, we learned how to do basic analysis using common size balance sheet and common size income statement. The purpose of this chapter is to assess how to use the numbers from balance sheet and/ or income statement for making appropriate business decisions. The disciplines of accounting and finance view the same numbers in financial statements differently. While accounting is about looking at the same point in time (balance sheet) or looking back (income statement), financial decision is all about looking forward. Both of these fields (accounting and finance) are very important in making strategic business decisions for the organization. This is the reason why this module delves into preparation and analysis of financial statements using MS Excel.

4.1 Financial Ratios

In the previous chapter, we studied aspects of finance and accounting related to a corporation through their balance sheets, income statements, the statement of cash flows and associated corporate taxes. One issue we realized in that chapter was how to compare balance sheets and income statements of two firms with unequal sizes. For example, if Delta airlines operates all over the US, can we compare its financials with Hawaiian airlines? The size of Delta airlines Inc. as of 2019 was $ 60 billion while that of Hawaiian Holdings was $ 4.1 billion. Does that mean one airline is better than other? How do we find out?

In response to the uneven size of these companies, we can use a simple method of common size balance sheet and common size income statement to compare different categories such as cash percentage, shareholders’ equity etc. While the previous chapter introduced common size balance sheets and common size income statements, in this chapter, we will further explore the ratio analysis to see the implications that different ratios have on the interpretation of business operations of two companies of different sizes.

If company A earns 4% of its revenues as net profits while company B earns 8%, at least we know that company B returns a greater proportion of revenues to shareholder equity.¹ But if company A had revenues of $ 100 million while company B had revenues of $ 50 million, then A and B both earned the same net profit².

To return to our original example, in 2019, Delta Airlines earned a net income of $ 4.8 billion on net sales of $ 47 billion giving a net income (or profit margin as we will call it later) ratio of 10%. Likewise in 2019, Hawaiian holdings earned a net income of $ 224 million on a revenue of $ 2.8 billion translating to a net income ratio of 7.9%. So we can infer that Delta airlines earned more net profit margin in 2019 than Hawaiian Holdings as a percentage of revenues and earned greater net profits as well. This example demonstrates how useful financial ratios are in comparing two corporations which are similar in some aspects (sector of operation) but different in scale and scope of operations. Financial ratios are measured in many areas of operation of a firm and are extremely useful not only in comparing two or more firms but also in comparing the performance of the same firm over a period of time.  These ratios are also useful in comparing two or more industries.

Broadly, there are five types of ratios:

Liquidity ratios 

Liquidity is the ability of a firm to convert its assets into cash. Assets such as balance in checking account can be easily converted into cash (through check or electronic transfer) and hence is highly liquid. However, assets such as property and plant and machines are not easy to sell because of both complicated paperwork or special nature such as either geographical location (property and plant) or nature of operation (plant and machines) and hence are not as liquid. Liquidity ratios therefore measure the ability of a firm to overcome short term-cash requirements.

Solvency ratios 

At the other end of the spectrum of liquidity is the long-term solvency of a firm. Solvency is the ability of a firm to be profitable and remain profitable. Some firms start out as not profitable but eventually become profitable (Apple, Google etc.). Some firms start and remain evenly profitable with stable business over large periods of time (IBM, AT&T, Verizon and utilities etc.). It is said that Apple once almost went bankrupt in the 90’s. We have seen in the previous chapter that when a company is close to filing for bankruptcy, the stakeholders that get paid first after liquidation are lenders such as bondholders and banks. For an organization, it can be a scary situation talking to its lenders to renew loans and debt obligations when there is talk in financial markets that the financial situation of the organization is not good. According to the New York Times, similar situation was hounding Apple Inc. in the 90s. So, when Steve Jobs took over as a Apple CEO for the second time in 1997, his main objective was to not borrow through any loans. Hence for a long time Apple did not have any debt on its balance sheet. Solvency ratios are used to measure the ability of a firm to service its debt obligations. More important is the cash coverage – can a firm’s cash flow cover its debt obligations?

Asset management ratios 

Asset management is extremely important for a firm’s efficiency. Asset management ratios include the credit given to customers and the turnaround of raw materials into finished goods and finally selling these goods. Asset management ratios are related to such transactions. In summary, asset management is defined as the ability of a firm to utilize its assets in order to make sales.

Profitability ratios 

One of the most important ratios shareholders look at are profitability ratios. We have already discussed one type of profitability ratio previously – the profit margin. Two other important profitability ratios are return on assets and return on equity. Profitability ratios are the ratios that deal with profits as a proportion of sales, assets or equity.

Market value ratios 

Shareholders and investors not only look at efficiency of a company and profitability, but also at how the company is performing with respect to share price. Market value ratios deal with this aspect of corporations. Market value ratios of a company deal with share price or stock market related information of a company. Very broadly, these ratios are utilized by investors to infer whether the company’s stock is worth investing.

We will be studying the above ratios in context of two hypothetical airlines KMZ and MKZ airlines. KMZ has a larger balance sheet as well as greater absolute profits. MKZ is smaller in size and also has smaller profits. This is shown in figure 4.1 and 4.2 below.

4.2 Liquidity ratios: 

Current ratio

As discussed previously, liquidity ratios reveal how much a company has in terms of liquid assets that can be used to pay off obligations. This section will review three kinds of liquidity ratios: current, quick and cash ratios. The first ratio is current ratio:

current ratio=current assets/ current liabilities  …(1)

If current ratio is 1, then the company can pay off all its current liabilities with its current assets. This is mostly useful to gauge performance under extreme stress such as the ability to repay short term liabilities, particularly under stress. Importantly, in many sectors of the industry, there is a determined time frame in which current liabilities need to be paid off that also must be considered. Typical supplier credit is 90 days. However, this can be longer for airlines because aircraft manufacturers may give them longer durations to repay capital expenses of aircraft purchases through either deferred payments or installment plans. Additionally, supplier credit could also be provided by refiners on fuel purchase and other operating expenses.

Quick ratio

The second ratio, the quick ratio, is stricter than current ratio because inventories of goods that need to be sold are removed from the calculation. This is based on the assumption that if the company needs to be liquidated or if there is an urgent need for cash or liquid assets, then the inventories are not worth anything more than scrap (they are only useful for the company that is using them to produce finished product). Therefore only current assets (minus inventory) are useful in paying short-term obligations of the firm.

quick ratio = (current assets−inventories) /current liabilities  …(2)

Cash Ratio

Cash ratio, the third ratio, is stricter than current ratio because cash is usually a very specific and small part of current assets. This is based on the assumption that in a hypothetical situation where if all creditors want to demand their money, the firm will only have its cash to pay these off. The greater the cash ratio, the greater is the ability of the firm to pay off these commitments.

 cash ratio=cash/ current liabilities …(3)

Now let’s apply these different kinds of liquidity ratios in an example. Liquidity ratios of MKZ and KMZ airlines are as follows:

Looking at the current ratio, quick and cash ratios, KMZ airlines is in a more comfortable position than MKZ airlines and KMZ is able to tide its short-term debt better. This is because all three liquidity ratios are higher for KMZ. These ratios also signal that MKZ is more confident of paying its liabilities if a need does arise by replacing one liability with another and hence maintaining a tighter situation in liquidity ratios than MKZ.

4.3 Solvency Ratios

Debt ratio

As discussed previously, solvency ratios are related to levels of debt, servicing of debt with cash and profits… Debt ratio of a firm is the ratio of total short- and long-term debts to assets. Besides using their retained earnings, every firm has two options to raise fund for investments: either issue more debt or issue more shares. A higher debt ratio indicates that company is leveraging its balance sheet by borrowing more.

debt ratio = (total assets −total equity) /total assets  …(4)

From Table 4.2 below, it seems that the debt ratio (or capital structure) of both MKZ and KMZ is almost the same. About 75% of total assets are created through the debt route. It does need to be determined whether most of this debt is short-term or long-term. If it is former, then the company has to keep refinancing the debt often. If it is the latter, then the company does not have to worry about repaying or creating new debt to fund the old debt. Rarely, companies let their debt mature and not raise new debt. This is called balance sheet contraction (or shrinking) because it reduces total assets (some assets are sold off to create cash to pay off the debt) as well as total liabilities.

Times interest earned

This ratio describes how well the company can service its debt through its pre-interest earnings. If the company makes positive operating revenue, then it can pay off interest on its debt more comfortably than if the company is making an operating loss. As an example, during difficult times such as during the COVID pandemic all airlines made negative operating profits and were not in a position to service their interest expense through earnings – one reason why they needed government support.

times interest earned= EBIT/ interest expense  …(5)

Table 4.2 shows that times interest earned for MKZ is much better (19.8) than KMZ (11.9) although both are in relatively good condition to service their interest expenses.

Cash coverage ratio

This ratio describes how well the company can service its interest expenses through its operating cash flow. It should be noted that depreciation is a non-cash expense. So, the company does not spend depreciation expense in cash. Therefore, the net profit shown by income statement underestimates cash earned by the firm by depreciation expense (assuming all revenues and other expenses are made in cash). So, when we add back depreciation to EBIT, we are estimating the cash a company has in order to meet its interest payment obligations. A greater cash coverage ratio implies better ability to pay off interest expense.

cash coverage ratio= (EBIT+Depreciation) / interest expense  …(6)

From Table 4.2 below, cash coverage for MKZ is much higher than that for KMZ. However, both are in a great position to pay interest obligations. As must be getting clear, a much better picture is obtained when we compare financial ratios of the two companies with each other and over a period of time and with the overall sector/ industry/ market.

Solvency Ratios of KMZ and MKZ airlines are as follows:

4.4 Asset Management ratios

Asset management ratios measure how quickly raw materials are turned over into finished goods and sold. Greater turnover implies more efficient production and sales. Also important is how quickly accounts receivable are converted into cash. Faster conversion means that company’s cash flows are quick and healthy. It should be noted that capital intense companies such as aircraft manufacturers like Boeing may be expected to have different asset management ratios from the overall sector just because of the capital intensity of product produced. This is because a bottle of ketchup can be produced several thousand times in a week (this definition is also intuitively used for inventory turnover), but an aircraft is not produced that quickly. Asset management ratios are listed below:

• Inventory turnover: Inventory turnover ratio deals with how quickly raw materials are converted into finished product and sold. Higher turnover ratio implies quicker turnaround and faster conversion of raw materials into sales.
• Days’ sales in inventory: Days’ sales in inventory refers to the number of days of sales that the company holds in inventory. Greater inventory turnover implies lower days’ sales lies in inventory. It may or may not be a good thing depending on the sector and industry. Capital intensive industries such as aircraft production may have greater days’ sales in inventory. On the other hand, items that involve quicker sales may or may not have lower days’ sales in inventory. This is a factor of seasonality, cyclicality and demand for final product.
• Receivable turnover: Receivable turnover refers to the speed with which receivables are converted into cash. Higher receivable turnover implies either greater proportion of sales being on credit or implies greater speed with which credit sales are converted into cash.
• Days’ sales in receivables : Similar to days’ sales in inventory, days’ sales in receivables refer to the number of days receivables are converted into cash per year. Usually, greater turnover is good for the firm because it implies that receivables are converted into cash quicker. By that yardstick, days’ sales in receivables should be lower implying most sales are either made in cash or are quickly turned into cash.
• Total asset turnover: Total asset turnover is a representation of the magnitude of sales vis-à-vis total size of a company. Capital intense companies such as aircraft or engine production companies may have smaller or larger total asset turnover depending on the business cycle and seasonality considerations. However, a higher total asset turnover ratio is considered to be good.

These ratios are defined below in equations 7, 8, 9, 10 and 11 respectively and calculated in Table 4.3 below. It can be observed that MKZ’s inventory turnover is much slower than that of KMZ. It could be because of higher cost of goods sold, lower inventory or both. Airline inventory is composed of fuel inventory and seat inventory. Seat inventory control happens by allocating seats to each fare class such as economy, premium economy etc. and to routes with different fares¹³. According to Table 4.3, because KMZ’s inventory turnover is higher, its days’ sales in inventory is much lower. Carrying higher inventory turnover rates also means good asset management. Receivables turnover for both airlines are almost the same, which translates into 21-22 days’ sales in receivables. Similarly, total asset turnover for MKZ is slightly higher than that for KMZ indicating it is slightly more efficient (i.e. better sales as compared to total assets). It should be noted that more and more airlines are shifting toward lease (as compared to buy model) indicating that for the same assets, there are greater sales (and higher turnover, as in equation 11).

Asset Management Ratios of KMZ and MKZ airlines are as follows:

4.5 Profitability ratios

Profitability ratios measure how profits of a firm are related to items in balance sheet and income statement of a firm such as sales, assets and owners’ equity. Profitability ratios of a firm include:

• Profit margin
• Return on assets
• Return on equity

Each ratio is very important for investors and shareholders. We will now discuss each of those components in greater detail below.

Profit margin

Profit margin is the proportion of sales that is achieved as profits. The greater the profit margin of a corporation, the more efficient it is in controlling its cost and interest expenses.

profit margin= net income /sales  …(12)

From Table 4.4 below, profit margin for MKZ is much higher than for KMZ, by almost 2.5 percentage points implying greater efficiency of making sales. We know that the size of MKZ is larger and by displaying greater profit margin, MKZ is showing greater economies of scale.

Return on assets

Return on assets is the ratio of net profits (net income or earnings after taxes) to total assets. Typically, more capital-intense corporations have relatively smaller return on assets as compared to service-based firms. This is another reason comparing firms in different sectors may not be optimal.

return on assets= net income/ total assets  …(13)

From Table 4.4 below, return on assets for MKZ is about 2 percentage points better than that for KMZ. This is in line with the profit margin ratio.

Return on equity

Return on equity is the ratio of profits to the value of shareholders’ equity (equity capital plus retained earnings). Greater return on equity implies shareholders are getting better benefits from the profitability of the firm. This is one reason why many firms like to borrow money through debt, particularly when interest rates are low. By paying lower rate on debt instruments on their borrowing, firms can then return better profits to shareholders yielding a higher return on their equity. This is the advantage of borrowing versus raising money through issuance of shares. Another way to lower the total amount of outstanding equity for shareholders is by buying back stock using profits from previous period. This way, all else constant same net income can be calculated on a lower base of equity capital implying greater return to shareholders.

return on equity= net income/ total owners′ equity  …(14)

From Table 4.4 below, return on equity for MKZ is 31% and almost 10 percentage points more than KMZ. This, again underscores the importance of raising debt for corporations. On debt the interest rate (i.e. return on debt for lenders) is much lower than the return on equity that is assured to shareholders. Lower return on equity has negative consequences for stock price of the company.

Profitability Ratios of MKZ and KMZ airlines are as follows:

4.6 Market value ratios

Market value ratios of a firm are related to its stock performance and include, for example, how profitable a firm is with respect to how much a shareholder is willing to pay. Market value ratios include:

• Earnings per share
• Price to earnings (P/E) ratio
• Price to earnings growth (PEG) ratio
• Market to book value (M/BV) per share

Earnings per share (EPS)

Earnings per share is the value of profits available for shareholder appropriation after taxes have been paid per unit value of share (total net income divided by the number of shares outstanding). EPS is a very important ratio that shareholders look at in order to determine what price they think is right to pay for each share. Since this ratio deals with how much the company earns per share, it can be both due to greater earnings as well as lower number of shares outstanding. Therefore, some companies buy back shares with their profit to return larger future profits.

Earnings per share (EPS)= net income/total shares outstanding  …(15)

In Table 4.5 below, EPS of MKZ is 16.17 and that of KMZ is 6.25 indicating that each share of MKZ should be more expensive than that of KMZ, all else constant.

Price to earnings (P/E) ratio

Price to earnings (P/E) ratio is the ratio of market price investors are willing to pay per unit earnings per share. Generally speaking, shareholders should pay same price for two companies in the same sector for same earnings per share. Therefore, P/E of companies in the same industry should be close to each other. P/E can be different if shareholders are willing to pay more price for same earnings per share if they think a company is going to do well in the future due to reasons such as better management or better execution or new innovation. In Table 4.5 below KMZ airlines has a better P/E of 2.4 as compared to 1.98 of MKZ airlines. This could be due to higher future expectations which makes current stock price expensive. We will be seeing this connection of future cash flows with present value in detail in the next chapter.

Price−to−earnings ratio (P/E)= Share Price/ earnings per share  …(16)

If a company has better growth prospects, then for the same current earnings, investors may prefer to pay more in terms of share price. Hence, it is better to look at price to earnings growth ratio, which we will discuss below.

Price to earnings growth (PEG)

If we know a company is growing faster, then with same earnings per share, investors are willing to pay a greater price. However, this inflates the value of P/E all else constant and gives a misleading picture. In order to account for this growth, we often look at PEG ratio by deflating the growth rate of earnings in the past few periods. Therefore, PEG ratio is important. If two companies have same growth rate, and everything is similar, they should be expected to have the same P/E ratio. Sometimes both P/E and price to earnings growth ratio may provide a misleading picture because a company takes a one-time charge or makes a one-time profit due to sale of assets. This is the reason why experts always recommend investors to “do their homework” about the stocks they want to buy.

[latex]\frac{Price}{earnings\;to\;growth\; ratio}=\left( \frac{price}{earnings\;per\;share\;} \right) {\large /} earnings\;growth\;rate×100[/latex]  …(17)

In Table 4.5 below, the price to earnings growth rate for MKZ is 0.09 while that of KMZ is -0.62. As discussed before, these numbers could be a little awry because of a variety of market conditions. It is negative for KMZ because of deceleration (negative growth) in earnings of the company.

Market to book value (M/BV) per share

Another metric for comparing two shares is the price (market value) of one share divided by value of assets per share (book value). Typically, investors expect shares with M/BV above 1 to grow rapidly and believe in paying a premium above the value of assets. Theoretically that means investors believe paying a premium on shares is worth the wait for asset values to catch up due to growth in future profits. Some stocks can have an M/BV below 1 for many years. For example, many banks share price was below book value per share for several years after the shocks of the great recession of 2008. In table 4.5 below M/ BV of MKZ is 61%, while that of KMZ is 50% (approx.).

Market to book value= market value per share/book value per share …(18)

Market value ratios of MKZ and KMZ airlines are as follows:

4.7 DuPont Ratios

The DuPont company in 1919 wanted to do some internal analysis of return on equity and for ease break down that ratio into three parts: asset turnover, financial leverage and profit margin. In other words, they wanted to trace the return for every dollar of shareholders (or profit per unit shareholder equity). This return is composed of the value of profit per unit revenue; revenue per unit total assets and assets per unit equity. Put differently, profit per unit shareholder equity is composed of profit margin, asset turnover and financial leverage. Profit margin is how efficiently a company converts a dollar of revenue into profits (cutting costs). Asset turnover is how much revenue per unit assets are made. In other words, sales made per unit of balance sheet size are another component of DuPont ratio. Third and final part is the financial leverage – the ratio of assets to equity. This is where the debt portion comes in. If a firm can borrow through cheaper cost debt and create assets to return high profits, then it can provide better return on equity to shareholders.

ROE= net income/ total equity …(19)

ROE= net income/ sales × sales/ total assets × total assets/ total equity …(20)

ROE=Profit margin×Asset turnover×Financial leverage …(21)

In Table 4.6 below, the return on equity for MKZ is (31%) which is higher than KMZ (20.7%). Most important part is the profit margin for MKZ (10%) is higher than KMZ (7.9%), as are asset turnover and financial leverage. This shows us that MKZ is not only doing better on profit margin, but also on making more revenue per unit value of assets (72.8% versus 68.6%) and has slightly more assets per unit equity (4.2 versus 3.8). All these combine together to feed into a much greater return on equity.

In a nutshell, three components of DuPont analysis help us understand how shareholders get highest possible return on equity (ROE). Therefore, we can break down the ROE into profit margin, asset turnover and financial leverage ratios. In increasing and optimizing each of these ratios, a firm must make careful balance in not going overboard in increasing any of these ratios too much. Higher sales margin may mean compromising advertising expenses and expansion plans; greater asset turnover may mean lower capital investments and potential future expansions and similarly lower financial leverage implying not enough debt on balance sheet. We will see that typically debt has lower cost for a firm (and better tax implications) as compared to additional equity.

DuPont Ratios of MKZ and KMZ airlines are as follows:

4.7 Overall comparison of MKZ and KMZ airlines

From the perspective of liquidity ratios, KMZ seems to have much better liquidity than MKZ airlines to manage its short-term obligations with greater liquidity ratios. In terms of ability to manage debt and solvency ratios, it seems MKZ is able to meet its debt obligations much better with its greater cash coverage ratio. While inventory turnover of KMZ is much more than MKZ, their receivable turnovers are similar. In terms of profitability and stock market performance, the larger MKZ seems to fare much better on account of superior profit margin. While its return on assets is only slightly superior, its return on equity is better (31% versus 20.7%) as are its market value ratios (EPS 16.2 versus 6.3). This can be further analyzed through DuPont ratios,. Considering DuPont ratios, it can be noted that MKZ has superior RoE on account of better profit margin, asset turnover, and financial leverage. As a competitor MKZ can improve on all these aspects of efficiency depending on its management’s comfort in taking on more debt if available at a cheaper cost.

Summary

In this Chapter, we have been concerned with deeper understanding of financial statements of the companies. We also developed several financial ratios by connecting different items related to both balance sheet and income statement.  With liquidity ratios ( cash, quick and current ratios), we evaluated the ability of a firm to repay its short-term liabilities at a relatively short notice (with short term assets such as cash and/ or other current assets). With solvency ratios, we looked at the firm’s debt structure (total debt to total assets) and then measured the ability of a firm to service this debt. With asset management ratios, we were more interested in analyzing the level of inventory and assets with respect to sales. Solvency ratios provided us more information about the ability of a firm to make sales during a reporting period of its income statement. Greater turnover meant more goods were being made and sold. Profitability ratios helped us determine not only the margin of profit with respect to sales (i.e. bottomline with respect to topline) but also the relationship between profits and levels of total assets and owners’ capital. Market value ratios were more concerned with stock market performance with respect to a single share in terms of earnings per share, stock price per unit earnings per share, investment in future earnings (PEG) and expensiveness of shares through price to book value.  Using DuPont ratios, we analyzed the performance of a firm.

In the next chapter, we will explore further applications of Excel in finance, that in the use of the time value of money. In that chapter, we will note that money today is more valuable than cash flows received in the future. This actually leads into a discussion of present value, discounting and the role of interest rates to compare cash flows across different periods, which is the topic of discussion of Chapter 5.