Introductory Corporate Finance: Financial Statement Analysis - Ratio Analysis, Liquidity Asset Management Debt Management Profitability Market Value PE M/B EV/EBITDA

What This Is

Ratio analysis is a crucial tool in corporate finance that helps investors and creditors evaluate a company's financial performance and position. By analyzing various financial ratios, stakeholders can gain insights into a company's liquidity, asset management, debt management, profitability, and market value. For instance, let's consider Apple Inc. (AAPL). In 2022, Apple had a current ratio of 1.44, indicating that it had sufficient liquidity to meet its short-term obligations. However, its debt-to-equity ratio of 0.73 suggests that Apple relies heavily on debt financing.

Key Formulas & Models

• Current Ratio = Current Assets / Current Liabilities – measures a company's ability to pay its short-term debts.
  • Current Assets: cash, accounts receivable, inventory, and other assets that can be converted to cash within one year.
  • Current Liabilities: accounts payable, short-term loans, and other debts due within one year.
• Quick Ratio = (Current Assets - Inventory) / Current Liabilities – a more conservative measure of liquidity, excluding inventory.
• Debt-to-Equity Ratio = Total Debt / Total Equity – indicates a company's reliance on debt financing.
• Interest Coverage Ratio = EBIT / Interest Expenses – measures a company's ability to pay its interest expenses.
  • EBIT: earnings before interest and taxes.
  • Interest Expenses: interest paid on debt.
• Return on Equity (ROE) = Net Income / Total Equity – measures a company's profitability.
• Price-to-Earnings (P/E) Ratio = Market Price per Share / Earnings per Share (EPS) – indicates a stock's valuation relative to its earnings.
• Enterprise Value (EV) / EBITDA = (Market Value of Equity + Total Debt - Cash) / EBITDA – measures a company's valuation relative to its operating cash flow.
• Sustainable Growth Rate = Retention Ratio * ROE – measures a company's potential for long-term growth.
• Degree of Operating Leverage (DOL) = (Q(P-V) / (Q(P-V)-F)) – measures a company's sensitivity to sales.
  • Q: quantity sold.
  • P: price per unit.
  • V: variable costs per unit.
  • F: fixed costs.
• Weighted Average Cost of Capital (WACC) = wd × rd(1-T) + wps × rps + we × re – the minimum return required by investors and creditors.
  • wd: weight of debt.
  • rd: cost of debt.
  • T: tax rate.
  • wps: weight of preferred stock.
  • rps: cost of preferred stock.
  • we: weight of equity.
  • re: cost of equity.

Step-by-Step Calculation

1. Calculate the current ratio: Current Assets / Current Liabilities.
2. Calculate the quick ratio: (Current Assets - Inventory) / Current Liabilities.
3. Calculate the debt-to-equity ratio: Total Debt / Total Equity.
4. Calculate the interest coverage ratio: EBIT / Interest Expenses.
5. Calculate the return on equity (ROE): Net Income / Total Equity.
6. Calculate the price-to-earnings (P/E) ratio: Market Price per Share / Earnings per Share (EPS).

Common Mistakes

1. Mistake: Using book value instead of market value for WACC.
   • Correction: Use market value for equity and debt to accurately reflect the cost of capital.
2. Mistake: Ignoring flotation costs when calculating WACC.
   • Correction: Include flotation costs in the cost of equity to reflect the true cost of capital.
3. Mistake: Confusing sunk cost with opportunity cost.
   • Correction: Sunk costs are irreversible, while opportunity costs represent the potential benefits of alternative choices.
4. Mistake: Using the wrong formula for the degree of operating leverage (DOL).
   • Correction: Use the correct formula: (Q(P-V) / (Q(P-V)-F)).

Exam / CFA Tips

1. Tip: Be aware of the differences between M&M Proposition I (no taxes) and M&M Proposition II (with taxes).
2. Tip: Understand the distinction between IRR and NPV ranking.
3. Tip: Recognize the bird-in-hand effect, where investors prefer dividends over future growth.

Quick Practice Problem

A company has EBIT of $10M, interest expenses of $2M, and a tax rate of 25%. Calculate the degree of financial leverage (DFL).

Answer: DFL = (EBIT / (EBIT - Interest Expenses)) = ($10M / ($10M - $2M)) = 5.

Explanation: The degree of financial leverage measures a company's sensitivity to interest rate changes.

Last-Minute Cram Sheet

1. Current Ratio = Current Assets / Current Liabilities.
2. Quick Ratio = (Current Assets - Inventory) / Current Liabilities.
3. Debt-to-Equity Ratio = Total Debt / Total Equity.
4. Interest Coverage Ratio = EBIT / Interest Expenses.
5. Return on Equity (ROE) = Net Income / Total Equity.
6. Price-to-Earnings (P/E) Ratio = Market Price per Share / Earnings per Share (EPS).
7. Enterprise Value (EV) / EBITDA = (Market Value of Equity + Total Debt - Cash) / EBITDA.
8. Sustainable Growth Rate = Retention Ratio * ROE.
9. Weighted Average Cost of Capital (WACC) = wd × rd(1-T) + wps × rps + we × re.
10. In M&M Proposition I (no taxes), firm value is independent of capital structure.