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Similar to financial ratios for analysing the financial health of a company
financial ratios for analysing the financial health of a company
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- 2. Some Terminologies • Asset •Liability • Income • Revenue • Working capital • Taxes • Profit (PBT, PBIT) • Debt • Net worth • Gross margin • Sales • Cost • Net Profit • Over heads • Liquidity • Price • Dividend
- 3. Working capital • Workingcapital is a financial metric that is the difference between a company's curent assets and current liabilities. • For example, say a company has $100,000 of current assets and $30,000 of current liabilities. The company is therefore said to have $70,000 of working capital. This means the company has $70,000 at its disposal in the short term if it needs to raise money for a specific reason.
- 4. • + Workingcapital • - Working capital
- 5. • When aworking capital calculation is negative, this means the company's current assets are not enough to pay for all of its current liabilities. The company has more short-term debt than it has short-term resources. Negative working capital is an indicator of poor short-term health, low liquidity, and potential problems paying its debt obligations as they become due.
- 6. • When aworking capital calculation is positive, this means the company's current assets are greater than its current liabilities. The company has more than enough resources to cover its short-term debt, and there is residual cash should all current assets be liquidated to pay this debt.
- 7. • Current Assets •Current assets are economic benefits that the company expects to receive within the next 12 months. The company has a claim or right to receive the financial benefit, and calculating working capital poses the hypothetical situation of the company liquidating all items below into cash. • Cash and Cash Equivalents: All of the money the company has on hand. This includes foreign currency and certain types of investments such as money market accounts with very low risk and very low investment term periods. • Inventory: All of the unsold goods being stored. This includes raw materials purchased to manufacture, partially assembled inventory that is in process, and finished goods that have not yet been sold. • Accounts Receivable: All of the claims to cash for inventory items sold on credit. This should be included net of any allowance for doubtful payments. • Notes Receivable: All of the claims to cash for other agreements, often agreed to through a physically signed agreement. • Prepaid Expenses: All of the value for expenses paid in advance. Though it may be difficult to liquidate these in the event of needing cash, they still carry short-term value and are included. • Others: Any other short-term asset. An example is some companies may recognize a short-term deferred tax asset that reduces a future liability.
- 8. • Current Liabilities •Current liabilities are simply all debts a company owes or will owe within the next twelve months. The overarching goal of working capital is to understand whether a company will be able to cover all of these debts with the short- term assets it already has on hand. • Accounts Payable: All unpaid invoices to vendors for supplies, raw materials, utilities, property taxes, rent, or any other operating expense owed to an outside third party. Credit terms on invoices are often net 30 days, so essentially all invoices are captured here. • Wages Payable: All unpaid accrued salary and wages for staff members. Depending on the timing of the company's payroll, this may only accrue up to one month's worth of wages (if the company only issues one paycheck per month). Otherwise, these liabilities are very short-term in nature. • Current Portion of Long-Term Debt: All short-term payments related to long-term debt. Imagine a company finances its warehouse and owes monthly debt payments on the 10-year debt. The next 12 months of payments are considered short-term debt, while the remaining 9 years of payments are long-term debt. Only 12 months are included when calculating working capital. • Accrued Tax Payable: All obligations to government bodies. These may be accruals for tax obligations for filings not due for months; however, these accruals are usually always short-term (due within the next 12 months) in nature. • Dividend Payable: All authorized payments to shareholders. A company may decide to decline future dividend payments but must fulfill obligations on already authorized dividends. • Unearned Revenue: All capital received in advance of having completed work. Should the company fail to complete the job, it may be forced to return capital back to the client.
- 14. Financial Ratios • Indicatesfinancial health of a company • Liquidity Ratios • Solvency Ratios • Profitability Ratios • Efficiency Ratios • Coverage Ratios • Market Prospect Ratios
- 15. • 1. LiquidityRatios • Liquidity ratios measure a company's ability to pay off its short-term debts as they become due, using the company's current or quick assets. Liquidity ratios include the current ratio, quick ratio, and working capital ratio.
- 17. • Solvency Ratios •Also called financial leverage ratios, solvency ratios compare a company's debt levels with its assets, equity, and earnings, to evaluate the likelihood of a company staying afloat over the long haul, by paying off its long-term debt as well as the interest on its debt. Examples of solvency ratios include: debt-equity ratios, debt- assets ratios, and interest coverage ratios.
- 18. • Profitability Ratios •These ratios convey how well a company can generate profits from its operations. Profit margin, return on assets, return on equity, return on capital employed, and gross margin ratios are all examples of profitability ratios.
- 19. • Efficiency Ratios •Also called activity ratios, efficiency ratios evaluate how efficiently a company uses its assets and liabilities to generate sales and maximize profits. Key efficiency ratios include: turnover ratio, inventory turnover, and days' sales in inventory.
- 20. • Coverage Ratios •Coverage ratios measure a company's ability to make the interest payments and other obligations associated with its debts. Examples include the times interest earned ratio and the debt-service coverage ratio.
- 21. • Market ProspectRatios • These are the most commonly used ratios in fundamental analysis. They include dividend yield, P/E ratio, earnings per share (EPS), and dividend payout ratio. Investors use these metrics to predict earnings and future performance.
- 22. Examples • For example,suppose company ABC and company DEF are in the same sector with profit margins of 50% and 10%, respectively. An investor can easily compare the two companies and conclude that ABC converted 50% of its revenues into profits, while DEF only converted 10%. • Using the companies from the above example, suppose ABC has a P/E ratio of 100, while DEF has a P/E ratio of 10. An average investor concludes that investors are willing to pay $100 per $1 of earnings ABC generates and only $10 per $1 of earnings DEF generates.
- 23. • For example,if the average P/E ratio of all companies in the S&P 500 index is 20, and the majority of companies have P/Es between 15 and 25, a stock with a P/E ratio of seven would be considered undervalued. In contrast, one with a P/E ratio of 50 would be considered overvalued. The former may trend upwards in the future, while the latter may trend downwards until each aligns with its intrinsic value.
- 24. Case study -Motorola
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Editor's Notes
- #17 Activity ratios, also called efficiency ratios are used to measure a company's ability to convert their production into cash or income. Often measure over a three-to-five-year period, they provide insight into areas of your business such as collections, cash flow and operational results.
- #25 Price to Earnings Ratio
- #27 Price to Earnings Ratio