5TH AND 6TH SESSION

iv. Long term debt to Total Capitalization

• Formula: (Long term debt/Total Capitalization)

• where, Total Capitalization = L.T.D. + S.E.• A company’s capitalization refers to co’s long term or

permanent capital which consists of both long term debt and stock holders’ equity.

• It measures proportion of company’s LTD to its available capital.

• Formula: (Total debt/Equity)

v. Debt to Equity Ratio

4. Profitability Ratios

• Profitability is a measure of business efficiency.• Earning more profits with optimum use of use available

business resources is called profitability.• More than any other ratio a firm’s profits determine how

well its management is making investment and financing decisions.

• Profitability ratios measure how well company is generating profits on sales, total assets and most importantly share holder’s investment.

• Profitability ratios are of importance to shareholders and creditors alike.

4. Profitability Ratios

• Profitability ratios under discussion:– Increase/decrease in sales %– Gross profit margin %– Net profit margin %– Operating expenses to sales %– Basic earning power %– Return on assets %– Return on equity %– Return on capital employed %– Du Pont Analysis

i. Increase decrease in Sales• Formula: (Sales n – Sales o / Sales o)

• Formula: (Gross profit/Sales)• It shows what percentage of revenue a company is able to

convert to gross profit.• Gross profit is the result of relationship between sales and

cost. It can be increased or decreased by changing any of these variables.

• High or low GPM may indicate:

ii. Gross Profit Margin

iii. Net Profit Margin• Formula: (Net Profit/Sales)• Used to relate Net Profits to Sales.• Used to compare profitability of competitors in the same industry.• Example• Within the financial services industry the Sales, NP of Goldman Sachs, JP

Morgan and Morgan Stanley is given. Compare their NPMs.

• This table shows that GS is the most profitable company as it managed to convert 23.89% of its sales into net income (or $1 of sales into 0.2389 cents of net income) while MS is the least profitable.

GS JPM MS

Revenue 34.66 96.33 31.59

NI 8.28 16.98 3.28

NPM

iv. Operating Profit Margin• Formula: (EBIT/Sales)• EBIT is also known as Operating Income.• EBIT/OI will be a lot lower than GP.• Higher the company’s profit margin the better it is.• Increasing OPM means company earning more per dollar of

sales.• A OPM ratio of 20% means that every $1 of sales earns a

operating profit of 20 cents for the business.

v. Operating Expense to Sales %• Formula: (Operating Expense/Sales)• A OE/S ratio of 17.5% means that for every $1 of sales, the

company spends 17.5 cents to create the sales.

• Formula: (EBIT / Total Assets)• A BEP ratio of 26.01% means that $1 worth of total assets

generate EBIT worth 26.01 cents.• Measures ability of firm’s total assets to generate OI or EBIT.• Measures the earning power of firm’s total assets. • BEP is very useful for comparing firms using different degrees

of financial leverage.

vi. Basic Earning Power

vii. Return on Assets• Formula: (NI / Total Assets)• A ROA ratio of 13.87% means that on each $1 of investment in

total assets company earned 13.87 cents. • ROA measure the effectiveness with which a company can

earn return on its investment in assets. • In other words ROA measure the number of $ earned on each

$1 of investment. • High Value• Low Value• ROA most useful for comparing companies within the same

industry.

viii. Return on Equity• Formula: (NI / Equity)• Net Income• A ROE ratio of 0.2 means that every $1 of common

shareholders’ equity earned around 20 cents in net income.• ROE help investors know what they really want to know, i.e.,

“How many cents of profit they will earn on $1 they invest”.• This amount called ROE is the overall measure of performance

of a company.• Aids in – comparison

ix. Return on Capital Employed• Formula: (EBIT/CE)• where, CE = A – CL or CE = LTD + CE• It measures the rate of return on long term funds such as LTD

and OE. • A company is bound to pay interest on long term liabilities

and dividend on shares capital.• ROCE must be able to cover cost of capital.

x. DuPont Analysis• DuPont Analysis was developed by DuPont Corporation in 1920’s.• DPA is another way of looking at 2 previously discussed ratios: ROA

and ROE • In essence we try to get an insight on how a company’s ROE was

generated by decomposing the ratio into 3 components:– NET PROFIT MARGIN (NP/SALES)– TOTAL ASSET TURNOVER (SALES/TOTAL ASSETS)– EQUITY MULTIPLIER (ASSETS/EQUITY)

• ROE = NPM x TAT x EM• ROE = ROA x EM

5. Market Value Ratios

• The financial ratios discussed in the previous four groups are all derived from accounting IS and BS and thus are under management’s control.

• Market value ratios compare financial statement figures to the value stock market places on the firm.

• This market value is reflected in the going price of stock.

5. Market Value Ratios

• Market Value ratios under discussion:– Market value to book value of common stocks outstanding– P/E ratio– P/cash flow ratio– EPS– DPS– Earning yield ratio– Dividend payout ratio

i. Market value to book value of common stock outstanding

• The market to book value also called price to book ratio measure the market value of a company relative to its book value.

• Formula: (MV per share/ BV per share)• where, MV per share = share price • BV per share = common equity/# of shares out.• CE = Amount that all common shareholders have invested in the firm. This includes value of common shares + retained earning.

ii. Price to Earning Ratio

• Theoretically, P/E ratio measures what the market is willing to pay for a stock based on its current earnings.

• Formula: (Price per share/ EPS) where, EPS = NIcs / # of shares out.• For example if P/E = 3 it means to earn $1 the market is

willing to pay $3. PIE IN THE SKY DOWN TO EARTH Comparison• Trading at $1• EPS = 0.1• P/E = 10

• Trading at $5• EPS = 1• P/E = 5

• When looking at 2 companies we need to select the one with lower P/E ratio as it means its shares are selling at a low price.• Low P/E is good because we are paying less for a company that earns more.• High P/E ratio means we are paying more for a money that pays less.

iii. Price to Cash Flow Ratio

• Theoretically, P/CF ratio measures the amount investor is willing to pay for $1 generated from company’s operations.

• Formula: (Market price of share / CF per share) where, *CF/share = NI + D + A – PD / # of shares out.• Low ratio is considered better.• Low ratio means cash flow of company is greater than

its stock price.

iv. EPS• Formula: (NIcs/ # of shares outstanding)• EPS of 2.12 means that if co. distributed each dollar of income

to its shareholders each share would receive $2.12.

• Formula: (Ordinary dividend paid / # of shares outstanding)• DPS is the amount of dividend that each shareholder will

receive for each share they own.

v. DPS

vi. Earning Yield Ratio• Formula: (EPS/Price per share) or (1 / P to E ratio)• The stock provides with a yield of 13.25 cents per stock.

• Formula: (Total Dividend paid / NIcs)• The company is giving 75% of its income to shareholders.

viii. Dividend Yield• Formula: (DPS/ Price per share)• The company’s investors receive 9.94 cents in dividends for

every dollar they invested in the company.

vii. Dividend Payout Ratio

Problem Solving

• Comprehensive problems related to:– Profitability and Market Value Ratios

• Connect to Excel Sheet

PROBLEM SOLVING

Van Horne and Wachowicz: Fundamentals of Financial Management

13th edition

Problem (6-1)

Problem (6-2)

Problems (6-3)

a. The ROI (NP/TA) declined because (NPM= NP/SALES) AND (TAT=SALES/TA) declined also sales couldn’t keep with asset expansion or while the level of sales decreased level of assets did not.

b. The increase in debt came from short term debt sources. Current assets increased relative to sales as indicated by inventory turnover and collection period.

The (CR = CA/CL) and (QR = CA-Inv/CL) declined which indicates a substantial increase in current liabilities.

Problems (6-4)

Problem (6-5)

PROBLEM SOLVING

Problem (4-1 to 4-4)

Problem (4-5 & 4-6)