CHAPTER 3 RATIO ANALYSIS

Firms financial ratios

Financial ratio analysis is a standard techniques used by a financial analyst to compare and analyze information.

Under this financial ratio analysis is a set of numbers that are form one or more of the financial statements and compared to each other to form ratios.

For instance to calculate the current asset ratios, firm’s current liabilities are divided with the firm’s current assets.

This ratio gives the measurement of the firm’s capacity to meet its current obligations.

Firm’s ratio provide an insight into particular firm operation

Provide analysts with a better picture about the firm, if the value of the ratios obtained, are compared with other ratios values.

Comparison of ratios can occurs in 3 categories:1. Historical comparison

2. Competitive analysis

3. A budget analysis

A common size statement analysis is also a form of ratio analysis. This analysis is used to compare firms of different sizes. (refer table 1 and table 2, page 40 & 41)

Financial ratios are used by three main groups;Managers

○ They employ ratios to help analyze, control and improve their firm’s operations

Credit analysts○ Employ ratios to help ascertain a company’s

ability to pay its debt

Stockholders○ Employ ratios to measure a firm’s growth

prospect

Ratio analysis is divided into four categories based on the type of issues they address.

Liquidity ratio○ Used to measure a firm’s ability to meet its curent obligation as they

come due

Asset management ratio○ Measure how effective a firm is managing its assets and whether or

not level of those assets is properly related to the level of operations as measured by sales

Debt management ratio○ Measure the extent to which a firm is using debt financing and the

degree of safety that the firm provides to the creditors

Profitability ratio○ Show the combined effects of liquidity, assets management and

debt operatin results

Liquidity ratio Liquidity ratios measure the ability of a company

to repay its short-term debts and meet unexpected cash needs.

The current ratio is also called the working capital ratio, as working capital is the difference between current assets and current liabilities.

This ratio measures the ability of a company to pay its current obligations using current assets. The current ratio is calculated by dividing current assets by current liabilities.

Example:

In this case, the company has a comfortable current ratio based on this rule. This means that at any point in time, the company has the ability to meet its short- term obligations the creditors of the company.

However Azmi’s current ratio is below the average of the industry, 4.2. So its liquidity position in comparison to other firms in the same industry, is relatively weak.

The quick ratio

The quick ratio or acid test ratio is calculated by deducting inventory from current assets and then dividing the reminder by the current liabilities.

Inventories are excluded because they are normally the least liquid in a firm’s current assets. In other words, they are the assets on which, losses are most likely to occur in the event of liquidation (selling inventory to generate cash).

By subtracting inventories, this ratio will measure the firm’s ability to meet its short-term obligations without having to rely on its inventories.

The current ratio is above 1.0. This means that the firm can meet its short term obligations without its inventories being liquidated. The industry average quick ratio is 2.5. So Azmi’s 1.72 ratio is low in comparison; with other firm’s in the industry.

Asset management ratios

The inventory turnover ratio measures how many times per year a firm uses its average inventory. A high turnover indicates the firm’s is rapidly converting its inventory into sale.

This is a good indication as high sales of product will eventually lead to higher profit. Low inventory turnover, on the other hand , indicates slow conversion of inventory into saleable products. This is bad for the company because holding excess inventory (due to slow conversion process) is expensive due to warehousing costs.

At the same time, too high a turnover ratio is also detrimental to accompany. A significantly high ratio may mean customer’s orders cannot be quickly filled or that there are work stoppages due to inadequate supplies of raw materials.

As a rough approximation, each item of Azmi’s inventory is sold out and restocked 3.125 times per year. This is much lower than the industry average. This may suggest that Azmi is holding excessive stocks of inventory. Excess stocks are, of course, unproductive, and they represent a investment with low or zero rate of return.

The day sale outstanding or average collection period ratio is used to determine the number of days after making a sale that firm must wait before receiving cash. In other words it gives an indication of the firm’s average collection period.

A firm with an efficient sales collection policy normally have lower average collection period ratio. This situation is preferred because; it will improve the cash flows of the firm.

Azmi has 104.4 days outstanding, which is well above the 60 days industry average.

This indicates that Azmi’s customers takes longer period to pay their bills in comparison to other firms’ customer in the industry.

As the result, this problem will then deprive Azmi of funds (cash), that could be used to invest in productive assets.

Fixed Assets Turnover

The Fixed Asset Turnover ratio measures how effectively a firm in using its plant and equipment to generate sales and profit.

Computing fixed assets turnover ratio is especially appropriate for companies in which their operations require significant amount fixed equipment (i.e; Machinery). For example, companies involved in manufacturing.

Azmi’s ratio of 2.2 times is smaller compared to the industry’s average, indicating that the firm is using its fixed assets not as extensively as other firms in the industry.

Total Assets Turnover Ratio

The total assets turnover ratio measures the utilization rate, or turnover rate, of all the firm’s assets.

Azmi’s ratio is somewhat below the industry average, indicating that the company is not generating sufficient volume of business (sales) given its total asset investment.

Sales should be increased, some assets should be disposed of or a combination of these steps should be taken.

In general, investors prefer firms that can generate more sales for a given level of assets and this can only be accomplished if the assets are used extensively and efficiently.

However, it is also bad if the ratio excessively high. This may mean that assets are being overstretched and may wear out prematurely.

Debt management ratio

The debt managemen ratio tell us what percentage of a firm’s assets are financed with borrowing.

The higher the percentage, the higher the risk

Azmi’s debt Ratio is 72.5%, which means that his creditors has supplied for more than half of the firm’s total financing.

Furthermore, to make things worst, Azmi’s debt ratio exceeds the industry average of 40% and this may make it costly for Azmi to borrow additional funds without first raising more equity capital..

The cost to borrow additional funds in the future may go up for Azmi perhaps because future creditors are concerned that the present excessive amount of debt the firm carries might expose it to higher bankruptcy risk.

In order to bear with this high bankruptcy risk, the future creditor may require a higher interest rate on loan before they provide Azmi’s any future loan.