C:\Fakepath\44 Ratio Analysis 1

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  • 1.Ratio Analysis Accounting for Managers

2. Financial Analysis

  • Assessment of the firms past, present and future financial conditions
  • Done to find firms financial strengths and weaknesses
  • Primary Tools:
    • Financial Statements
    • Comparison of financial ratios to past, industry, sector and all firms

3. Objectives of Ratio Analysis

  • Standardize financial information for comparisons
  • Evaluate current operations
  • Compare performance with past performance
  • Compare performance against other firms or industry standards
  • Study the efficiency of operations
  • Study the risk of operations

4. Uses for Ratio Analysis

  • Evaluate Bank Loan Applications
  • Evaluate Customers Creditworthiness
  • Assess Potential Merger Candidates
  • Analyze Internal Management Control
  • Analyze and Compare Investment Opportunities

5. Types of Ratios

  • Financial Ratios:
    • Liquidity Ratios
      • Assess ability to cover current obligations
    • Leverage Ratios
      • Assess ability to cover long term debt obligations
  • Operational Ratios:
    • Activity (Turnover) Ratios
      • Assess amount of activity relative to amount of resources used
    • Profitability Ratios
      • Assess profits relative to amount of resources used
  • Valuation Ratios:
      • Assess market price relative to assets or earnings

6. Liquidity Ratios

  • Current Ratio
    • Current Assets / Current Liabilities
      • Current Assets include Cash, Marketable Securities, Accounts Receivable and Inventory
      • Current Liabilities include Accounts Payable, Debt Due within one year, and Other Current Liabilities

7. Liquidity Ratios

  • Quick Ratio or Acid Test
    • Current Assets minus Inventory / Current Liabilities
    • A more precise measure of liquidity, especially if inventory is not easily converted into cash.

8. Liquidity Ratios

  • Cash Ratio
    • Reserve borrowing capacity - the credit limit sanctioned by the bank

9. Liquidity Ratios

  • Interval Measure
    • Calculated to asses a firms ability to meet its regular cash outgoings

10. Leverage Ratios

  • Leverage ratios measure the extent to which a firm has been financed by debt.
  • Leverage ratios include:
    • Debt Ratio
    • Debt--Equity Ratio
  • Generally, the higher this ratio, the more risky a creditor will perceive its exposure in your business.Thus, high leverage ratios make it more difficult to obtain credit (loans).

11. Leverage Ratios Cont.

  • Leverage ratios also include theInterest-coverage Ratio, Fixed coverage Ratio etc, .
  • In contrast to the leverage ratios discussed on previous slide, the higher the Interest Coverage Ratio (Times-Interest-Earned Ratio), the more credit worthy the firm is, and the easier it will be to obtain credit (loans).

12. Total Debt Ratio

    • Proportion of interest bearing debt in the Capital structure.
    • In general, the lower the number, the better.

13. Debt-Equity Ratio

  • The Debt-Equity Ratio indicates the percentage of total funds provided by creditors versus by owners.
  • This ratio indicates the extent to which the business relies on debt financing (creditor money versus owners equity).


  • Treatment of
    • Preference Capital
    • Lease Payments

15. Interest Coverage Ratio

  • interest coverage ratio indicates the extent to which earnings can decline without the firm becoming unable to meet its annual interest costs.
  • Also called theTimes-Interest-Earned Ratio , this calculation shows how many times the firm could pay back (or cover) its annual interest expenses out of earnings before interest and taxes (EBIT).

16. Interest Coverage Ratio DA = Depreciation and Amortization expenses 17. Fixed Coverage Ratio

    • Principal repayments are added to interest payments

18. Activity Ratios

  • Activity ratios measure how effectively a firm is using its resources, or how efficient a company is in its operations and use of assets.
  • In general, the higher the ratio, the better.
  • Activity ratios include:
    • Inventory turnover
    • Accounts receivable turnover
    • Average collection period .
    • Total assets turnover
    • Fixed assets turnover

19. Inventory Turnover Ratio

  • The inventory turnover ratio indicates how fast a firm is selling its inventories
  • This ratio indicates how well inventory is being managed, which is important because the more times inventory can be turned (i.e., the higher the turnover rate) in a given operating cycle, the greater the profit.

20. Inventory Turnover Ratio Cont.

    • In the absence of information. Instead of CGS we can use Sales
    • In the case of CGS and Inventory both are valued at cost. While the sales are valued at market prices
    • Therefore better to use CGS

21. Accounts Receivable Turnover

  • The accounts receivable turnover ratio, indicates the average length of time it takes a firm to collect credit sales (in percentage terms), i.e., how well accounts receivable are being collected.
  • If receivables are excessively slow in being converted to cash, liquidity could be severely impaired.

22. Average Collection Period

  • The average collection period is the average length of time (in days) it takes a firm to collect on credit sales.

23. Net Assets Turnover

    • The total assets turnover ratio, indicates how efficiently a firm is using all its assets to generate revenues.
    • This ratio helps to signal whether a firm is generating a sufficient volume of business for the size of its asset investment

24. Profitability Ratios

  • Profitability ratios measure managements overall effectiveness as shown by returns generated on sales and investment.
  • Profitability ratios include
    • Gross profit margin
    • Operating profit margin
    • Net profit margin
    • Return on total assets (ROA)
    • Return on stockholders equity (ROE)
    • Earnings per share (EPS)
    • Price-earnings ratio (P/E).

25. Gross Profit Margin

  • The gross profit margin is the total margin available to cover operating expenses and yield a profit. This ratio indicates how efficiently a business is using its labor and materials in the production process, and shows the percentage of net sales remaining after subtracting cost of goods sold.
  • The higher the ratio, the better.A high gross profit margin indicates that a firm can make a reasonable profit on sales, as long as it keeps overhead costs under control.

26. The DuPont System

  • Method to breakdown ROE into:
    • ROA and Equity Multiplier
  • ROA is further broken down as:
    • Profit Margin and Asset Turnover
  • Helps to identify sources of strength and weakness in current performance
  • Helps to focus attention on value drivers

27. The DuPont System 28. The DuPont System 29. The DuPont System 30. The DuPont System