I would like to make an assignment on financial ratios to give you a little practice working with these important ratios. I have put up a thorough set of notes on financial ratios under “chapter notes and comments” under content. In addition the Appendix to Chapter 13 talks a good bit about financial ratios. What I would like for you to do is as follows: Calculate all the important ratios and be sure to interpret each one and what it tells you about the company. Don’t just calculate the ratios, interpret them in terms of if it is a good number and what you know about the company by doing the calculation. Also provide a general overview of what this company looks like in terms of their financial performance. What are the good points and what are the challenges? What do you like and what do you not like?

Be sure to calculate:

current ratio, quick ratio, cash ratio, total debt ratio, debt to equity, debt coverage ratios such as cash coverage and TIE, inventory turnover and days in inventory, receivables turnover and average collection period, total asset turnover, gross margin, net margin, ROA, ROE, EPS, P/E, market to book, and any other ratios you would like to add.

Let me add this little discussion on a ratio I like to look at:

DuPont Analysis: I like this little analysis because it gives you insight on how a management team creates value and makes a company successful. It is also a good tool for comparing two or more companies and figuring out what each does well and where each could do better. The bottom line is that ROE (return on equity) is perhaps the most important indicator of how well management is doing in generating wealth for stockholders. Of course ROE is simply profits or net income divided by average equity.

But ROE is composed of and influenced by three aspects of the company and we can actually show in ratio form how each aspect is influential. DuPont Analysis combines operating efficiency as measured by profit margin (net income/sales), asset management efficiency as measured by asset turnover (sales/total assets), and financial leverage as measured by the equity multiplier (total assets/total equity). If we multiply these three, we get ROE. Please take note of how important financial leverage is and take this to heart when determining your mix of debt and equity for the game. Bottom line, if you can easily afford the payments and interest rates are very low, it almost always make sense to take on more debt (if you can get it) rather than issuing more equity. Leverage is proven here to be a major determinant of company success (keep this in mind in the simulation)!

ROE = net income/sales X sales/total assets X total assets/total equity

Companies are successful for different reasons and the ratio above captures some of these reasons. Some companies have great margins (first ratio, net margin), some are very asset efficient (second ratio, asset turnover), and some do a lot with a little bit of equity (third ratio known as the leverage ratio). You remember from your algebra classes how to reduce these three fractions that are being multiplied into a much simpler fraction. Recall that sales (in the first term) over sales (in the second term) equals one (and can be cancelled out) and total assets (in the third term) over total assets (in the second term) equals one (and can be cancelled out) and we can reduce the three fractions down to net income/total equity (which is the simple formula for ROE). But by looking at the different components of ROE, we gained a lot more information about how ROE is actually generated by a company.