Brian Rountree

Introduction to Ratios
Assessing the Business Environment
• Interpretation of financial information requires an understanding of the
broader business context
• Operations
• Environment in which a business operates
• Analysts must ask questions about:

• Life cycle • Customers • Labor

• Competition • Outputs • Technology
• Politics • Inputs • Capital
Ratios
• Ratios level the playing field across time and competition.
• Provide a mechanism for assessing the effectiveness of a company relative to:
• Past
• Competition
• Strategy portrays itself in financials
• Differentiators should have higher prices, more advertising, research and development,
patents, etc.
• Low-cost producer should have smaller margins, but more turnover (volume)
Assessing Financial Information

Sales $3.9 billion Sales $126 billion

Net Income $48 million Net Income $13.7 billion
Total Assets $7.1 billion Total Assets $244 billion

• Cannot compare U.S. Cellular to Verizon in terms of sales, net income, etc.
since so different in size
• Ratios account for size and determine how efficient a company is in
generating sales/net income with the capital that it employs
Ratios
Samsung Panasonic
• Samsung Korean Won DEC '15 MAR '16
• Panasonic Japanese Yen Sales 200,653 7,554
Cost of Goods Sold (COGS) incl. D&A 125,733 5,341
Gross Income 74,920 2,213
SG&A Expense 48,507 1,798
Other Operating Expense 0 0
EBIT (Operating Income) 26,413 415
Nonoperating Income—Net –501 –46
Interest Expense 777 17
Unusual Expense—Net 276 135
Pretax Income 24,859 217
Income Taxes 6,901 15
Equity in Earnings of Affiliates 1,102 13
Consolidated Net Income 19,060 215
Minority Interest 366 22
Net Income 18,695 193
 Brian Rountree

Common Size Financial Statements

Learning Objective

Prepare and analyze

common-size financial statements
Ratios
Samsung Panasonic
• Samsung Korean Won Dec '15 Mar '16
• Panasonic Japanese Yen Sales 200,653 7,554
Cost of Goods Sold (COGS) incl. D&A 125,733 5,341
Gross Income 74,920 2,213
SG&A Expense 48,507 1,798
Other Operating Expense 0 0
EBIT (Operating Income) 26,413 415
Nonoperating Income—Net –501 –46
Interest Expense 777 17
Unusual Expense—Net 276 135
Pretax Income 24,859 217
Income Taxes 6,901 15
Equity in Earnings of Affiliates 1,102 13
Consolidated Net Income 19,060 215
Minority Interest 366 22
Net Income 18,695 193
Vertical Analysis
• Restates financial statement information in ratio form
• Income statement items as a percentage of net sales
• Also called margin analysis
• Balance sheet items as a percent of total assets
• Facilitates comparison
• Across companies of different sizes
• Between accounts within a set of financial statements

Also called common-size financial statements

Vertical Analysis of Income Statements
Lowe’s Companies’ common-size income statements for years ending January
30, 2015 and January 31, 2014:

Percentages
Jan 30, Jan 31, Jan 30, Jan 31,
Year ending 2015 2014 2015 2014
Total revenue $56,223 $53,417 100.00% 100.00%
Cost of sales 36,665 34,941 65.21% 65.41%
Gross profit 19,558 18,476 34.79% 34.59%
Selling, general and administrative 13,281 12,865 23.62% 24.08%
Depreciation 1,485 1,462 2.64% 2.74%
Total operating expenses 14,766 14,327 26.26% 26.82%
Earnings before interest and 4,792 4,149 8.52% 7.77%
Interest—net 516 476 0.92% 0.89%
Income before tax 4,276 3,673 7.61% 6.88%
Income tax expense 1,578 1,387 2.81% 2.60%
Net income $2,698 $2,286 4.80% 4.28%

$36,665/$56,223 = 65.21%
Vertical Analysis of Balance Sheets
Jan 30, Jan 31, Jan 30, Jan 31,
Year ending 2015 2014 2015 2014
Lowe’s Companies’ Assets
Current assets
common-size balance Cash and cash equivalents $466 $391 1.46% 1.19%
sheets fiscal years Short -term investments
Inventory
125
8,911
185
9,127
0.39%
28.00%
0.57%
27.88%
2014–2015 Other current assets 578 593 1.82% 1.81%
Total current assets 10,080 10,296 31.67% 31.46%
Long term investments 354 279 1.11% 0.85%
Property plant and equipment, net 20,034 20,834 62.95% 63.65%
Other assets 1,359 1,323 4.27% 4.04%
Total assets $31,827 $32,732 100.00% 100.00%
Liabilities

Each account balance Current liabilities

Accounts payable $5,124 $5,008 16.10% 15.30%
is expressed as a Current portion long term debt 552 49 1.73% 0.15%
Other current liabilities 3,672 3,819 11.54% 11.67%
percentage of total Total current liabilities 9,348 8,876 29.37% 27.12%

assets. Long-term debt

Other liabilities
10,815
1,599
10,086
1,626
33.98%
5.02%
30.81%
4.97%
Deferred income taxes-net 97 291 0.30% 0.89%
Total liabilities 21,859 20,879 68.68% 63.79%
Common stock 480 515 1.51% 1.57%
Capital surplus 0 0 0.00% 0.00%
Retained earnings 9,591 11,355 30.13% 34.69%
Other stockholders’ equity (103) (17) -0.32% -0.05%
Total stockholders’ equity 9,968 11,853 31.32% 36.21%
Total liab. and stockholders' equity $31,827 $32,732 100.00% 100.00%
Common Size Income Statement
Samsung Panasonic
Dec ‘15 Mar ‘16
Sales 100.0% 100.0%
Cost of Goods Sold (COGS) incl. D&A 62.7% 70.7%
Gross Income 37.3% 29.3%
SG&A Expense 24.2% 23.8%
Other Operating Expense 0.0% 0.0%
EBIT (Operating Income) 13.2% 5.5%
Nonoperating Income—Net –0.2% –0.6%
Interest Expense 0.4% 0.2%
Unusual Expense—Net 0.1% 1.8%
Pretax Income 12.4% 2.9%
Income Taxes 3.4% 0.2%
Equity in Earnings of Affiliates 0.5% 0.2%
Consolidated Net Income 9.5% 2.8%
Minority Interest 0.2% 0.3%
Net Income 9.3% 2.6%
Horizontal Analysis
• Examines changes in data across time
• Assists in analyzing company performance and in predicting future
performance

Percent Change =

[Second Year Amount – Base Year Amount]

Base Year Amount*

* Base year amount must be a positive number to calculate percent change.

Horizontal Analysis of Income Statements
Lowe’s Companies’ income statements for fiscal years 2014–2015:

Jan 30, Jan 31,

Year ending 2015 2014 Percentage
Total Revenue $56,223 $53,417 5.3%
Cost of Sales 36,665 34,941 4.9%
Gross Profit 19,558 18,476 5.9%
Selling General and ($56,223 – $53,417)
Administrative 13,281 12,865 3.2%
Depreciation 1,485 1,462 1.6% $53,417
Total Operating Expenses 14,766 14,327 3.1%
Earnings Before Interest And Taxes 4,792 4,149 15.5%
Interest—net 516 476 8.4%
Income Before Tax 4,276 3,673 16.4%
Income Tax Expense 1,578 1,387 13.8%
Net Income $2,698 $2,286 18.0%
Net income is 18% higher in the year ending
January 30, 2015 compared to the prior year.
 Brian Rountree

ROE and ROA

Learning Objective 2

Compute and interpret measures of

return on investment, including
return on equity (ROE)
return on assets (ROA), and
understand their relationship
How Do Firms Create Value?
• Pricing advantages
• Firm’s ability to charge a relatively high price for its product
• Differential quality; brand equity; private information; monopoly power; regulatory
protection
• Efficiency differences
• Firm’s ability to produce and distribute its product at a relatively low cost
• Technological advantages; access to low-cost labor pool; strategic operating
choices; distribution technology
How Do Firms Create Value?
• Asset utilization
• Firm’s ability to generate relatively high sales volume given its capital
base
• Technological advantages; high quality labor force; strategic operating choices
Basic Ratios: ROE

Net income
Return on equity (ROE) =
Average stockholders' equity

Average stockholders’ equity = beg year stockholders’ equity + end year stockholders’ equity) /2

• ROE reflects the return to the stockholders, which is different than the
return to the entire company
DuPont Analysis
Return on Equity = Net Income
Avg. Equity

= Net Income × Avg. Assets

Avg. Assets Avg. Equity

= ROA × Leverage

• Leverage is typically thought of as debt to equity. How is

the DuPont notion of leverage related?
• Hint: Accounting Equation: Assets = Liabilities + Equity
ROA

Net income
Return on assets (ROA) =
Average assets
Average assets = (beginning - year assets + ending - year assets) / 2

• ROA reflects the return to the entire company

• Illustrates how efficient companies are at generating income with
their assets
ROE = ROA × Leverage
DuPont Analysis Samsung Panasonic
ROE 10.8% 10.0%
ROA 7.9% 3.3%
Leverage (Assets/Equity) 1.36 3.00
ROE = ROA × Leverage 10.8% 10.0%

• What do we learn from the DuPont breakdown?

• Samsung’s operations (ROA) is significantly larger than Panasonic’s
• Panasonic’s almost equal ROE is thus achieved by more leverage, which
indicates more risk
• More on return on leverage later
Return on Investment Metrics
• Textbook divides ROE into ROA and ROFL
• Purpose is to eliminate capital structure differences by using net income before
interest expense for ROA
• ROA then measures return on assets ignoring how the assets are financed

Return Return Return

on
on
Equity
(ROE)
= on
Assets
(ROA)
+ Financial
Leverage
(ROFL)
Return on Assets (ROA)
• Textbook ROA, which corrects for differences in debt financing

Earnings without interest expense (EWI)

ROA = Average total assets

Net income + [Interest expense × (1 ‒ statutory tax rate)]*

=
(Beginning total assets + Ending total assets) ÷ 2

EWI measures the income generated by the firm

before taking into account any of its financing costs.

*Interest is tax deductible, thus multiplying by (1-tax rate)

accounts for the effect of interest expense on taxes
Return on Assets (ROA) Example
Lowe’s Companies’ ROAs
Net income $2,698 million
Interest expense 516 million
Total assets, January 30, 2015 31,827 million
Total assets, January 31, 2014 32,732 million

Earnings without interest expense (EWI)

ROA = Average total assets

$2,698 + [$516 x (1 – 0.35)]

ROAEWI = = 9.4%
[($31,827 + $32,732) ÷ 2

$2,698
ROA = = 8.4%
[($31,827 + $32,732) ÷ 2
ROE and ROA

Net income
Return on equity (ROE) =
Average stockholders' equity
Net income
Return on assets (ROA) =
Average assets

• ROE can be derived from operational performance, meaning ROA

and through leverage
• If firm can borrow at 4% but return 10% from its operations, this is beneficial to
shareholders (increases ROE)
 Brian Rountree

Margins vs. Turnovers

Learning Objective

Develop tools to assess ROA by breaking

ROA into margins versus turnovers
ROE
DuPont Analysis Samsung Panasonic
ROE 10.8% 10.0%

• Both firms providing similar returns to shareholders

• Next step?
• Break ROE into ROA and leverage
DuPont Analysis
Return on Equity = Net Income
Avg. Equity

= Net Income × Avg. Assets

Avg. Assets Avg. Equity

= ROA × Leverage
ROE = ROA × Leverage

DuPont Analysis Samsung Panasonic

ROE 10.8% 10.0%
ROA 7.9% 3.3%
Leverage (Assets/Equity) 1.36 3.00
ROE = ROA × Leverage 10.8% 10.0%

• ROA is much higher at Samsung

• How is Samsung generating so much higher returns from its operations?
• Margins—pricing differences, cost efficiency differences (economies of scale)
• Turnovers—greater volume, more efficient management of working capital, better productivity from
investment in long-term assets
DuPont Analysis
Return on Equity = Net Income
Avg. Equity

= Net Income × Avg. Assets

Avg. Assets Avg. Equity

= Net Income × Sales_ × Avg. Assets

Sales Avg. Assets Avg. Equity

= Profit Margin × Asset Turnover × Lev.

ROA
Net income Net income
Return on assets (ROA) = Profit margin (PM) =
Average assets Sales
Average assets = (beginning - year assets + ending - year assets) / 2 Sales
Asset turnover (AT) =
ROA = PM× AT Average assets

• ROA reflects the return to the entire company

• Why is PM referred to as profitability?
• PM measures how many cents of profit are realized for every dollar of sales
• Why is AT referred to as productivity?
• AT measures how many dollars of sales are realized for every dollar of assets
ROA = PM × AT
DuPont Analysis Samsung Panasonic
Profit Margin 9.3% 2.6%
Total Asset Turnover 0.85 1.31
ROA 7.9% 3.3%
• Samsung profit margin advantage
• Pricing differences?
• Cost differences?
• Look at common size income statement to get insight into driver of differences
• Panasonic asset turnover advantage
• Not enough to catch up for margin disadvantage
• Working capital differences?
• Long-term asset efficiency differences?
Profit Margin and Turnover Across Industries
Profit Margin and Turnover Across Industries
2.5

Retail
2.0
Asset Turnover

1.5 Food
Restaurants, Products Appeal
Hotel, Motel
Consumer Goods
Steel Works, etc.
1.0 Health Care Chemicals
Computers Business Services
Transportation Tobacco
Printing and Publishing
Petroleum and Natural Gas Products
Telecommunications
0.5
Utilities
Pharmaceutical
Products
0.0
0% 5% 10% 15% 20% 25% 30% 35%
Profit Margin
Trade-Off Between Profit Margin and Asset Turnover
• ROA can be increased by:
• Targeting higher profit margins
• Increasing asset turnover
• Results from strategic decisions are made by management.
• Mix of margin and turnover is often dictated by a company’s industry
and competitive positioning within industry.
• We will disaggregate PM and AT to gather further insights into drivers
of ROA.
 Brian Rountree

Margin Breakdown
Learning Objective

Breaking down margins

DuPont Analysis
DuPont Analysis of Return on Equity

ROE = Net income/Average equity

Return on Assets Financial Leverage

Profitability Productivity

Gross Profit Margin Accounts Receivable Turnoverꜛ Total Liabilities-to-Equity

Operating Expense Margin Inventory Turnover ꜛ Times Interest Earned

Profit Margin Accounts Payable Turnover ꜛ

Cash Conversion Cycle

PPE Turnover

Profit Margin x Asset Turnover = ROA

Disaggregation of Profit Margin (PM)
Using Gross Profit Margin (GPM)
Gross Profit Margin (GPM)
Sales revenue – Cost of goods sold
GPM =
Sales revenue
Measures the percentage of each sales dollar that is left over
after product costs are subtracted.

Lowe’s $56,223 – $36,665

2014 GPM = $56,223 = 34.8%

Lowe’s has 34.8% of each sales dollar left over after

product costs are subtracted.
Disaggregation of Profit Margin (PM)
Using Expense-to-Sales (ETS)

Expense-to-Sales (ETS)
Expense
ETS =
Sales revenue
• Measures the percentage of each sales dollar that goes to
cover a specific expense item
• Can be applied to any category of expenses
2014 ETS for Lowe’s SG&A $13,281
expense = $56,223 = 23.62%

Lowe’s spends just under 24% of each sales dollar

for selling, general, and administrative costs.
Common Size Income Statements
Lowe’s Companies’ Margin Analysis
Percentages
Jan 30, Jan 31, Jan 30, Jan 31,
Year ending 2015 2014 2015 2014
Total revenue $56,223 $53,417 100.00% 100.00%
Cost of sales 36,665 34,941 65.21% 65.41%
Gross profit 19,558 18,476 34.79% 34.59%
Selling, general and administrative 13,281 12,865 23.62% 24.08%
Depreciation 1,485 1,462 2.64% 2.74%
Total operating expenses 14,766 14,327 26.26% 26.82%
Earnings before interest and 4,792 4,149 8.52% 7.77%
Interest—net 516 476 0.92% 0.89%
Income before tax 4,276 3,673 7.61% 6.88%
Income tax expense 1,578 1,387 2.81% 2.60%
Net income $2,698 $2,286 4.80% 4.28%
Common Size Income Statement
Samsung Panasonic
Dec ‘15 Mar ‘16
Sales 100.0% 100.0%
Cost of Goods Sold (COGS) incl. D&A 62.7% 70.7%
Gross Income 37.3% 29.3%
SG&A Expense 24.2% 23.8%
Other Operating Expense 0.0% 0.0%
EBIT (Operating Income) 13.2% 5.5%
Nonoperating Income—Net –0.2% –0.6%
Interest Expense 0.4% 0.2%
Unusual Expense—Net 0.1% 1.8%
Pretax Income 12.4% 2.9%
Income Taxes 3.4% 0.2%
Equity in Earnings of Affiliates 0.5% 0.2%
Consolidated Net Income 9.5% 2.8%
Minority Interest 0.2% 0.3%
Net Income 9.3% 2.6%
Profit Margin
Samsung Panasonic

Dec ‘15 Mar ‘16

Sales 100.0% 100.0%

Cost of Goods Sold (COGS) incl. D&A 62.7% 70.7%

Gross Income 37.3% 29.3%

• Gross margin primary driver of differences between Panasonic and Samsung

• Pricing and/or cost efficiency differences
• Look at types of products sold
• Segment reporting
• Supplier networks
 Brian Rountree

Turnover Breakdown
Learning Objective

Breaking down turnovers

DuPont Analysis
DuPont Analysis of Return on Equity

ROE = Net income/Average equity

Return on Assets Financial Leverage

Profitability Productivity

Gross Profit Margin Accounts Receivable Turnoverꜛ Total Liabilities-to-Equity

Operating Expense Margin Inventory Turnover ꜛ Times Interest Earned

Profit Margin Accounts Payable Turnover ꜛ

Cash Conversion Cycle

PPE Turnover

Profit Margin x Asset Turnover = ROA

ROA = PM × AT
DuPont Analysis Samsung Panasonic

Profit Margin 9.3% 2.6%

Total Asset Turnover 0.85 1.31

ROA 7.9% 3.3%

• Panasonic has an asset turnover advantage

• Does this stem from better working capital* management?
• Faster collection of accounts receivable
• Lower investments in inventory
• Slower payments to suppliers
• Does this stem from more efficient use of long-term assets (PP&E) in generating
sales?
*Working Capital = Current Assets – Current Liabilities
Accounts Receivable Turnover

Accounts Receivable Turnover (ART)

Sales revenue
ART =
Average accounts receivable

Measures how many times receivables have been

collected during the period

Days Sales in Receivables (DSO)

Days AR = 365
ART
Inventory Turnover

Inventory Turnover (INVT)

Inventory Cost of goods sold

=
Turnover (INVT) Average inventory
Measures the flow of goods out of inventory relative
to the balance that is held in inventory

Days Sales in Inventory (DSI)

365
Days Inventory =
INVT
Accounts Payable Turnover

Accounts Payable Turnover (APT)

Accounts Payable Purchases*

=
Turnover (APT) Average AP

Measures speed of payments to suppliers

*Purchases = COGS + End Inventory – Beg Inventory

Days Purchases in Payables

365
Days Purchases =
APT
Asset Turnover Analysis
• Working capital turnover
• Cash conversion cycle or net trade cycle
• From the day a company invests in inventory, how long does it take to get that dollar back?
Cash Conversion Cycle
Samsung Panasonic
Days Sales Outstanding 52 44
Days Sales in Inventory 52 52
Days Payables 20 62
Cash Conversion Cycle 84 34
Cash Conversion Cycle
• What does a negative cash conversion cycle mean?
Property, Plant and Equipment (PP&E) Turnover

PP&E Turnover (PPET)

Sales revenue
PPET = Net of accumulated
Average PP&E depreciation

Provides insights into asset utilization and how

efficiently a company operates given its productive
technology
PP&E Turnover

Samsung Panasonic
PPE Turnover 2.4 5.6
PPE Analysis
• Do assets have similar lives?
• Average useful life = depreciable asset cost ÷ depreciation expense
• How old are the fixed assets?
• Percent used up = accumulated depreciation ÷ depreciable cost
• Depreciable cost excludes land and construction-in-progress (CIP) because not
depreciated
• If PPE is old, then might forecast increases in capital expenditures
moving forward to replace outdated equipment
 Brian Rountree

Introduction to Leverage
Learning Objective

Understand the effects of financial

leverage on ROE
Dupont Analysis
DuPont Analysis of Return on Equity

ROE = Net income/Average equity

Return on Assets Financial Leverage

Profitability Productivity

Gross Profit Margin Accounts Receivable Turnoverꜛ Total Liabilities-to-Equity

Operating Expense Margin Inventory Turnover ꜛ Times Interest Earned

Profit Margin Accounts Payable Turnover ꜛ

Cash Conversion Cycle

PPE Turnover

ROA x Financial Leverage = ROE

Effect of Financing on ROE When ROA
Is Greater Than the Interest Rate
Company A Company B Company A is
Assets (average) $1,000 $1,000 financed with 100%
EWI $100 $100 equity.
ROA (EWI/Assets) 10% 10%
Equity (average) $1,000 $500
Company B is
Debt $0 $500
financed 50% with
Interest expense (4% of debt) $0 $20
Net income (EWI—Interest) $100 $80
debt.
ROE (Net income/equity) 10% 16%
ROFL (ROE–ROA) 0% 6%

Company B made effective use of its financing to improve its ROE.

In the best of times, financial leverage increases ROE.

Effect of Financing on ROE When ROA
Is Less Than the Interest Rate
Company A Company B Company A is
Assets (average) $1,000 $1,000 financed with 100%
EWI $30 $30 equity.
ROA (EWI/Assets) 3% 3%
Equity $1,000 $500
Company B is
Debt $0 $500
financed 50% with
Interest expense (4% of debt) $0 $20
Net income (EWI—Interest) $30 $10 debt.
ROE (Net income/equity) 3% 2%
ROFL (ROE–ROA) 0% -1%

Debt financing caused Company B to decrease its ROE.

Too much debt is risky. It causes interest expense which decreases

profit. When earnings are depressed,
financial leverage makes a bad year worse.
Effect of Leverage on ROE
Interest Rate = 10%; No Debt

Assets 100

Debt 0

Shareholders’ Equity 100

ROAEWI 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% 20.0%

Operating Income 0 2 4 6 8 10 12 14 16 18 20
Interest Expense 0 0 0 0 0 0 0 0 0 0 0
Net Income 0 2 4 6 8 10 12 14 16 18 20

ROE 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% 20.0%

ROE = ROA
Effect of Leverage on ROE
Interest Rate = 10%; Low Debt

Assets 100

Debt 20

Shareholders’ Equity 80

ROAEWI 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% 20.0%

Operating Income 0 2 4 6 8 10 12 14 16 18 20

Interest Expense 2 2 2 2 2 2 2 2 2 2 2

Net Income −2 0 2 4 6 8 10 12 14 16 18

ROE −2.5% 0.0% 2.5% 5.0% 7.5% 10.0% 12.5% 15.0% 17.5% 20.0% 22.5%

ROE < ROA ROE > ROA

Effect of Leverage on ROE
Interest Rate = 10%; High Debt

Assets 100

Debt 80

Shareholders’ Equity 20

ROAEWI 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% 20.0%

Operating Income 0 2 4 6 8 10 12 14 16 18 20

Interest Expense 8 8 8 8 8 8 8 8 8 8 8

Net Income −8 −6 −4 −2 0 2 4 6 8 10 12

ROE −40.0% −30.0% −20.0% −10.0% 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0%

ROE < ROA ROE > ROA

Effect of Leverage on ROE

0.8

0.6

0.4
Return on Equity

Debt = 0%
0.2 Debt = 20%
Debt = 80%
0
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22
-0.2

-0.4

-0.6
Return on Assets
Other Issues of Using Debt Financing
• Operating activities may be restricted by covenants.
• Covenants are restrictions on operating activities imposed by creditors.
• They help safeguard debt holders.
• Debt increases default risk.
• The risk is that companies may not be able to pay debt as it becomes
due.
• Ability to service the debt may be impaired.
Liabilities to Equity
Median Ratio of Liabilities to Equity for Selected Industries
 Brian Rountree

Liquidity
Learning Objective

Understand the difference between

liquidity and solvency, along with ways of
assessing liquidity
Liquidity and Solvency Analysis

Liquidity Analysis Solvency Analysis

The analysis of available The ability to generate
cash sufficient cash in the
future

• Ratios used to assess • Ratios used to assess

the degree of liquidity the degree of solvency
• Current ratio • Debt-to-equity
• Quick ratio • Times interest earned
• Operating cash flow to
current liabilities
Current Ratio
• The relative magnitude of current assets and current liabilities

Current Assets Current Liabilities

Those assets that the
company expects to convert Those liabilities
into cash or use within the that come due
next accounting cycle within the next year

Current assets
Current ratio =
Current liabilities
Working Capital
• An excess of current assets over current liabilities
• Positive working capital implies more expected cash inflows than
outflows in the short run
• Based on current balance sheet amounts
• Ignores cash inflows from future sales

A company can efficiently manage its working

capital by minimizing receivables and inventories
and maximizing payables, and still be liquid.
Quick Ratio
• Similar to the current ratio
• Reflects a company’s ability to meet its current liabilities using only those assets
that are easily converted to cash
• Excludes inventories and prepaid assets

Quick ratio = Quick assets

Cash + Short-term securities + Accounts receivable

Current liabilities
Operating Cash Flow to Current Liabilities
• Relates the net amount of cash from operating activities to the
amount of current payment obligations
• A key factor in the ultimate ability of a company to pay its obligations

Operating Cash
Cash flow from operations
Flow to Current =
Average current liabilities
Liabilities
Liquidity Analysis for Lowe’s
$10,080M
Current ratio = = 1.78
$9,348M
$466M + $125M
Quick ratio = = 0.063
$9,348M

Working capital = $10,080M – $9,348M = $732M

Operating Cash
$4,929M
Flow to Current = = 0.54
($9,348M + $8,876M) ÷ 2
Liabilities

Lowe’s current ratio is above 1, but quick ratio is very small,

which indicates lots of investment in inventory.
Common Size Balance Sheets
Jan 30, Jan 31, Jan 30, Jan 31,
Year ending 2015 2014 2015 2014
Assets
Lowe’s Companies’ Current assets
Cash and cash equivalents $466 $391 1.46% 1.19%
common size balance Short -term investments 125 185 0.39% 0.57%

sheets fiscal years Inventory

Other current assets
8,911
578
9,127
593
28.00%
1.82%
27.88%
1.81%
2014–2015 Total current assets
Long term investments
10,080
354
10,296
279
31.67%
1.11%
31.46%
0.85%
Property plant and equipment, net 20,034 20,834 62.95% 63.65%
Other assets 1,359 1,323 4.27% 4.04%
Total assets $31,827 $32,732 100.00% 100.00%
Liabilities
Each account Current liabilities

balance is Accounts payable

Current portion long term debt
$5,124
552
$5,008
49
16.10%
1.73%
15.30%
0.15%
expressed as a Other current liabilities 3,672 3,819 11.54% 11.67%
Total current liabilities 9,348 8,876 29.37% 27.12%
percentage of Long-term debt 10,815 10,086 33.98% 30.81%
Other liabilities 1,599 1,626 5.02% 4.97%
total assets. Deferred income taxes-net 97 291 0.30% 0.89%
Total liabilities 21,859 20,879 68.68% 63.79%
Common stock 480 515 1.51% 1.57%
Capital surplus 0 0 0.00% 0.00%
Retained earnings 9,591 11,355 30.13% 34.69%
Other stockholders’ equity (103) (17) -0.32% -0.05%
Total stockholders’ equity 9,968 11,853 31.32% 36.21%
Total liab. and stockholders' equity $31,827 $32,732 100.00% 100.00%
Lowe’s Cash Conversion Cycle
2015
Days Sales Outstanding* 0
Days Sales in Inventory 90
Days Payables 51
Cash Conversion Cycle 39
It takes Lowe’s 39 days on average to get back its
investment in its inventory. As long as it manages this
figure appropriately, there is plenty of liquidity at Lowe’s.
*Since the majority of Lowe’s sales are cash and credit card
transactions for which they receive payment quickly from
companies like Visa and Mastercard. Thus, accounts receivable
are very small.
Solvency Analysis
• A company’s ability to meet its debt obligations
• Including both periodic interest payments and repayment of the principal
borrowed
• Two measurement approaches
• Use balance sheet data to assess the proportion of capital raised from
creditors
• Use income statement data to assess the profit generated relative to
debt payment obligations
Debt-to-Equity
• Conveys how reliant a company is on creditor financing compared
with equity financing
• Higher ratios imply less solvency, more risk

Total liabilities
Debt-to-equity ratio =
Stockholders’ equity

Debt-to-equity levels are affected by many factors,

including the mix of assets used and the stability of
business operations, so comparisons to similar
companies are very important.
Times Interest Earned (TIE)
• How much operating profit is available to pay interest
• Sometimes abbreviated as EBIT/I

Times
Earnings before interest and taxes
interest =
earned Interest expense

Lenders prefer this ratio to be sufficiently high, which implies a

smaller risk of default.
Solvency Analysis Example
• Lowe’s key solvency indicators for the year ending January 30, 2015:

$21,859
Lowe’s debt-to-equity ratio = $9,968 = 2.19

Lowe’s debt-to-equity ratio is higher than the retail industry average of

1.10, indicating a little less solvency. Have to look at relative
investment in long-term assets to see if this is driver of ratio.

Lowe’s times $4,792

interest earned = $516 = 9.29 times

Lowe’s is generating plenty of income to fund its debt obligations.