Financial management

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Financial ManagementFinancial Management

� The maintenance and creation of economic value or wealth.

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Financial Management

It measures and reports financial andnonfinancial information that helps

managers make decisions to fulfill thegoals of an organization.

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Goal of the FirmGoal of the Firm

1) Profit Maximization?

This Goal Ignores:

a) Timing of Returns

b) Uncertainty of Returns

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Goal of the FirmGoal of the Firm

2) Shareholder Wealth Maximization?

this is the same as:

a) Maximizing Firm Value

b) Maximizing Stock Price

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OBJECTIVES OF FINANCIAL MANAGEMENT

� Relevant To Making Decisions

� Types Of Decisions

• Operating

• Investing

• Financing

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Management Accounting� Management accounting measures and reports financial

and non-financial information that helps managers make decisions to fulfill the goals of an organization

� Managers use management accounting information to• choose, communicate and implement strategy• coordinate product design, production and marketing

decisions

� Management accounting focuses on internal reporting

� Management accounting is future oriented

1 - 7Functions of Management Accounting

Management accountants perform three functions

� Attention-directing--make visible opportunities and problems on which managers need to focus

� Problem-solving--conduct comparative analysis to identify the best alternatives in relation to the organization’s goals

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� Scorekeeping--accumulate data and report reliable results to all levels of management

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Key Themes in Management Decision Making

Key Success Factors� 1.Cost and

2.Efficiency� 3.Quality� 4.Time � 5.Innovation

ContinuousImprovement

AndBenchmarking

Value-ChainandSupply-ChainAnalysis

Customer Focus

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Financial and Management Accounting

� The primary questions about an organization’s success that decision makers want to know are:

What is the financial picture of the organization on a given day?

How well did the organization do during a given period?

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� Accountants answer these primary questions with three major financial statements.• Balance sheet – shows financial picture on a given

day• Income statement – shows performance over a given

period• Statement of cash flows – shows performance over a

given period

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� Annual report - a document prepared by management and distributed to current and potential investors to inform them about the company’s past performance and future prospects• The annual report is one of the most common

sources of financial information used by investors and managers.

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1. The major distinction between financial and management accounting is the users of the information.• Financial accounting serves external users,

such as investors, creditors, and suppliers.• Management accounting serves internal

users, such as top executives, management, and administrators within organizations.

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Management Accounting and Financial Accounting

Help managers plan andcontrol business operations

Help managers plan andcontrol business operations

Help investors, creditors, and others makeinvestment, credit, and other decisions

Help investors, creditors, and others makeinvestment, credit, and other decisions

2. Purpose of Information

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RelevanceRelevance

Reliability, objectivity, and focus on the pastReliability, objectivity, and focus on the past

3. Focus and Time Dimension

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Internal reports not restricted by GAAPInternal reports not restricted by GAAP

Financial statements restricted by GAAPFinancial statements restricted by GAAP

4. Type of Report

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No independent auditNo independent audit

Annual independent audit Annual independent audit

5.Verification

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Detailed reports onparts of the company

Detailed reports onparts of the company

Summary reports primarilyon the company as a wholeSummary reports primarilyon the company as a whole

6.Scope of Information

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Concern about how reportswill affect employees behavior

Concern about how reportswill affect employees behavior

Concern about adequacy of disclosureConcern about adequacy of disclosure

7.Behavioral Implications

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Fund Flow Statement

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Fund Flow StatementFFS is a method to study changes in the financial position of a business enterprise between beginning and ending financial statements dates. IT is a statement showing sources and uses of funds for a period of Time.

Anthony

“ The fund flow statement describes the sources from which additional funds were derived and the use to which these sources were put.”

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A summary of a firm’s changes in financial position from one period to

another; it is also called a sources and uses of funds statement or a statement

of changes in financial position.

Fund Flow Statement

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•Fund means working capital i.e. excess of current assets over current liabilities.

•Flow means movement and includes both inflow and outflow of working capital.

Fund Flow Statement

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� Includes important noncash transactions while the cash flow statement does not.

� Is easy to prepare and often preferred by managers for analysis purposes over the more complex cash flow statement.

� Helps you to better understand the cash flow statement, especially if it is prepared under the “indirect method.”

Fund Flow Statement

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Uses of Fund Flow Statement� It helps in the analysis of financial operations� It throws light on many perplexing questions of

general interest� It helps in the formation of a realistic dividend

policy� It helps in the proper allocation of resources� It acts as a future guide� It helps in appraising the use of working capital� It helps knowing the overall creditworthiness of a

firm

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Statement of schedule of changes in working capitalParticulars Previous Year Current Year Effect of working Capital

Increase Decrease

Current Assets: Cash in hand Cash at bankBills ReceivableSundry DebtorsTemp. InvestmentsStocks/InventoriesPrepaid ExpensesAccrued IncomesTotal Current Assets Current Liabilities: Bills Payable Sundry Creditors Outstanding Expenses Bank Overdraft Short-term Expenses Dividends Payable Proposed dividends Provision for taxationTotal Current Liabilities Working Capital(CA-CL) Net increase or decrease in working capital

1 - 26SOURCES AND APPLICATIONS OF FUNDS

SOURCES APPLICATIONS

Funds from operations Funds lost in operations

Issue of Share Capital Redemption of Preference Share

Capital

Issue of Debentures and Repayment of Long-term Loans

Raising of Long-term Loans and Redemption of debentures

Sales of Non-Current Assets Purchase of Non-current Assets

Non-trading Receipts Payment of Dividend and tax

Decrease in Working capital Non-Trading Payments

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Cash Flow Statement

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Introduction to Statementof Cash Flows

� The statement of cash flows gives a direct picture of where cash came from and where cash went.

� Preparation of the statement of cash flows• List the activities that increased (inflow) or decreased

(outflow) cash.

• Place each inflow or outflow into the proper categories.

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� The statement of cash flows provides a thorough explanation of the changes that occurred in a firm’s cash balance during the entire accounting period.• The statement of cash flows reports cash receipts and

payments of a company during a given period for operating, financing, and investing activities.

• “Cash” includes cash and cash equivalents.

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� Income does not measure an entity’s performance in generating cash, especially if the income is measured using the accrual basis.

� In a way, accountants use both the accrual and cash bases.• The accrual basis is used in the income statement.

• The cash basis is used in the statement of cash flows.

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� Statement of cash flows - reports the cash receipts and cash payments of an entity during a particular period• It summarizes activity over a period of time, so it

must be labeled with the exact period covered.• It details the changes in the cash account,

much like the income statement which shows changes in retained earnings.

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CASH AND CASH EQUIVALENTS

� Generally items that are cash or can be converted into cash within 90 days or less

� Cash on hand, cash in bank, certificates of deposit, money market funds, Treasury notes

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Purposes of Cash Flow StatementStatement of cash flows.

• shows the relationship of net income to changes in cash balances.

• It reports past cash flows as an aid to:– Predicting future cash flows

– Evaluating the way management generates and uses cash– Determining a company’s ability to pay interest and

dividends and to pay debts when they are due

• It identifies changes in the mix of productive assets.

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Purposes of Cash Flow Statement� The statement of cash flows, along with the

income statement, explains why balance sheet items have changed during the period.• The balance sheet shows the status of a

company at a point in time.• The statement of cash flows and the

income statement show the performance of a company over a period of time.

December 2003

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Purposes of Cash Flow Statement� The relationship among the balance sheet, income

statement, and statement of cash flows:

Balance SheetDecember 31,

20X3


20X3


20X2

Income Statement

Statement of Cash Flows

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Typical Activities Affecting Cash� Cash is affected by two primary areas of a firm.

• Operating management - largely concerned with the major day-to-day activities that generate revenues and expenses

• Financial management - largely concerned with where to get cash and how to use cash for the benefit of the entity

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Typical Activities Affecting Cash� Operating activities - transactions that affect the income

statement

� Investing activities - activities that involve (1) providing and collecting cash as a lender or as an owner of securities and (2) acquiring and disposing of plant, property, equipment, and other long-term productive assets

� Financing activities - activities that include obtaining resources as a borrower or issuer of securities and repaying creditors and owners

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OPERATING ACTIVITIES

� SALES (MARKETING)� MANUFACTURING� PURCHASING� ADMINISTRATION� COMPLIANCE WITH GOVERNMENT

REGULATIONS

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INVESTING ACTIVITIES

� PURCHASE AND SALE OF PROPERTY, PLANT, AND EQUIPMENT

� PURCHASE AND SALE OF STOCK OF OTHER COMPANIES

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FINANCING ACTIVITIES

� ISSUING AND REPURCHASING OF A FIRM’S OWN STOCK

� BORROWING AND REPAYMENT OF LOANS

� PAYMENT OF DIVIDENDS

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Typical Activities Affecting Cash

Cash inflows� Collections from customers� Interest and dividends

collected� Other operating receipts

Cash outflows� Cash payments to suppliers� Cash payments to employees� Interest and tax payments� Other operating cash payments

Typical operating activities

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Cash inflows� Sale of property, plant, and

equipment� Sale of securities that are not

cash equivalents� Receipt of loan repayments

Cash outflows� Purchase of property, plant, and

equipment� Purchase of securities that are

not cash equivalents� Making loans

Typical investing activities

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Cash inflows� Borrowing cash from

creditors� Issuing equity securities� Issuing debt securities

Cash outflows� Repayment of amounts

borrowed� Repurchase of equity shares

(including treasury stock)� Payment of dividends

Typical financing activities

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Computing Cash Flows from Investing and Financing

Activities� Analysis of balance sheet items for investing and

financing activities:• Increases in cash (cash inflows) stem from

– Increases in liabilities or stockholders’ equity– Decreases in non cash assets

• Decreases in cash (cash outflows) stem from– Decreases in liabilities or stockholders’ equity– Increases in noncash assets

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Activities� Changes in fixed assets can usually be explained

by:• Assets acquired• Asset dispositions• Depreciation

Increase innet plant

assets= Acquisitions - Disposals - Depreciation

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Activities� Changes in stockholders’ equity can be explained

by:• New issuances of stock• Net income• Dividends

Increase instockholders’

equity= New issuance + Net income - Dividends

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Approaches to Calculating theCash Flow from Operating Activities

� Two approaches may be used to compute cash flow from operating activities.• Direct method - the method that calculates net cash

provided by operating activities as collections minus operating distributions

• Indirect method - the method that adjusts the accrual net income to reflect only cash receipts and outlays

� Under either method, the final cash flow from operating activities will be the same.

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� Under the direct method, income statement amounts are adjusted for changes in related asset and liability accounts.• Each revenue and expense account calculated under

the accrual method is adjusted to reflect the actual cash paid or received.

� Under the indirect method, accrual net income is adjusted to reflect only cash transactions.

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� The FASB prefers the direct method because it shows operating cash receipts and payments in a way that is easy for investors to understand.

� The indirect method is more common because many people are used to thinking in terms of net income.

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Transactions Affecting Cash Flows from All Sources

Effects of operating transactions on cash:Sales of goods and services for cash +

Sales of goods and services on credit 0

Receive dividends or interest +

Collection of accounts receivable +

Recognize cost of goods sold 0

Purchase inventory for cash -

Purchase inventory on credit 0

Pay trade accounts payable -

“0” denotes that the transaction has no effect on cash.

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Effects of operating transactions on cash:Accrue operating expenses 0Pay operating expenses -Accrue taxes 0Pay taxes -Accrue interest 0Pay interest -Prepay expenses for cash -Write off prepaid expenses 0Charge depreciation or amortization 0


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Effects of investing activities on cash:Purchase fixed assets for cash -

Purchase fixed assets by issuing debt 0

Sell fixed assets +

Purchase securities that are not cash equivalents -

Sell securities that are not cash equivalents +

Make a loan -


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Effects of financing transactions on cash:Increase long-term or short-term debt +

Reduce long-term or short-term debt -

Sell common or preferred shares +

Repurchase or retire common or preferred shares -

Purchase treasury stock -

Pay dividends -

Convert debt to common stock 0

Reclassify long-term debt to short-term debt 0


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A Detailed Exampleof the Direct Method

ECO-BAG COMPANYBalance Sheet (in thousands)December 31, 20X3 and 20X2

Current assets: Current liabilities: Cash Rs 16 Rs 25 Accounts payable Rs 74 Rs

6 Accounts receivable 45 25 Wages and salaries payable 25 4 Inventory 100 60 Total current assets Rs161 Rs110 Total current liabilities 99 10Fixed assets, gross 581 330 Long-term debt 125 5 Accum. depreciation (101) (110) Stockholders’ equity 417 315 Net 480 220

Total liabilities andTotal assets Rs641 Rs330 stockholders’ equity Rs641

Rs330======== ======== ======== ========

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ECO-BAG COMPANYStatement of Income (in thousands)

for the Year Ended December 31, 20X3

Sales Rs200 Costs and expenses:

Cost of goods sold Rs100 Wages and salaries 36

Depreciation 17 Interest 4Total costs and expenses 157Income before income taxes 43Income taxes 20Net income Rs 23

========

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ECO-BAG COMPANYStatement of Cash Flows (in thousands)for the Year Ended December 31, 20X3

CASH FLOWS FROM OPERATING ACTIVITIES:Cash collections from customers Rs 180Cash payments: To suppliers Rs 72 To employees 15 For interest 4 For taxes 20 Total cash payments (111)Net cash provided by operating activities Rs 69

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(continued)

CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of fixed assets Rs(287)Proceeds from sale of fixed assets 10Net cash used by investing activities (277)

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(continued)

CASH FLOWS FROM FINANCING ACTIVITIES:Proceeds from issue of long-term debt Rs120Proceeds from issue of common stock 98Dividends paid (19)Net cash provided by financing activities 199Net decrease in cash (9)Cash, December 31, 20X2 25Cash, December 31, 20X3 Rs 16

========

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� The first step in developing the statement of cash flows is to compute the amount of the change in cash from the beginning to the end of the period.• This calculation is often included at the bottom of the

statement.• The net change is added to the beginning

balance to compute the ending balance.

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� In this example, cash decreases by Rs9,000.• Operating activities contribute Rs69,000 cash during

the period.• Investing activities use Rs277,000 cash during the

period.• Financing activities contribute Rs199,000 cash during

the period.

� This example shows how a firm may have net income but still have a decline in cash.

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Computing Cash Flows fromOperating Activities

� Collections from sales to customers are usually the largest source of operating cash inflows.

� Disbursements for purchases of goods to be sold and operating expenses are usually the largest sources of operating cash outflows.

� Operating cash inflows minus operating cash outflows equals the net cash provided by (or used by) operating activities.

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Working from Income Statement Amounts to Cash Amounts

� Accountants often compute collections and other operating cash flow items from figures in the income statement.• Many accountants use the balance sheet along with

additional information and familiarity with the causes of certain changes in balance sheet amounts to compute the cash flow items.

• However, many accounting systems are not capable of providing detailed information needed for that method.

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� In our example, Rs180,000 was collected from customers. That amount is determined as follows:

Sales Rs200,000+ Beginning accounts receivable 25,000

Potential collections Rs225,000– Ending accounts receivable 45,000

Cash collections from customers Rs180,000===============

orSales Rs200,000Decrease (increase) in accounts receivable (20,000)Cash collections from customers Rs180,000

===============

� Note that the increase in A/R means that sales > collections.

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� The difference between cost of goods sold and cash payments to suppliers can be determined by looking at inventory and accounts payable.

Ending inventory Rs100,000+ Cost of goods sold 100,000

Inventory to account for Rs200,000– Beginning inventory (60,000)

Purchases of inventory Rs140,000===============

Beginning trade accounts payable Rs 6,000+ Purchases of inventory 140,000

Total amount to be paid in cash Rs146,000– Ending trade accounts payable (74,000)

Accounts paid in cash Rs 72,000===============

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� The effects of inventory and accounts payable on the previous slide can be combined into one calculation as follows:

Cost of goods sold Rs1,00,000Increase (decrease) in inventory 40,000Decrease (increase) in trade accounts payable (68,000)Payments to suppliers Rs 72 ,000

===============

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� Cash payments to employees can be determined by examining wages and salaries payable.

Beginning wages and salaries payable Rs 4,000+ Wages and salaries expense 36,000

Total to be paid in cash Rs 40,000– Ending wages and salaries payable (25,000)

Cash payments to employees Rs 15,000==============

orWages and salaries expense Rs 36,000Decrease (increase) in wages & sal. payable (21,000)

Cash payments to employees Rs 15,000 ==============

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� Notice in this example that both interest payable and income taxes payable were zero at the beginning and end of the period.• This means that the entire amounts of interest expense

and income tax expense were incurred and paid during the period, so the cash flows are the amounts of the expenses, Rs4,000 and Rs20,000, respectively.

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Preparing a Statement of Cash Flows - The Indirect Method

� In calculating cash flows from operating activities, the alternative to the direct method is the indirect method.• The indirect method is generally more convenient.• The indirect method reconciles

accrual net income to cash flows from operating activities.

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Reconciliation of Net Income to Net Cash Provided by Operations

� The indirect method begins with net income.• Additions or deductions are made for changes in

related asset or liability accounts (items that affect net income and net cash flow differently).

� If a company uses the direct method, the FASB requires such a reconciliation using the indirect method.

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� Items included in the reconciliation:• Depreciation is added back to net income because it

was deducted in arriving at net income, but it does not represent a use of cash.

• Increases in noncash current assets result in less cash flow from operations, so such increases are deducted from net income.

• Decreases in noncash current assets result in more cash flow from operations, so such decreases are added back to net income.

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� Items included in the reconciliation (continued):• Increases in current liabilities result in more cash flow

from operations, so such increases are added back to net income.

• Decreases in current liabilities result in less cash flow from operations, so such decreases are deducted from net income.

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� The general rules for additions and deductions to adjust net income using the indirect method are the same as those for adjusting line items on the income statement under the direct method.

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� The cash flows from operating activities for Eco-Bag Company:

Net income Rs23Adjustments to reconcile net income to net cash provided by operating activities Depreciation Rs 17 Net increase in accounts receivable (20) Net increase in inventory (40) Net increase in accounts payable 68 Net increase in wages and salaries payable 21 Total additions and deductions 46Net cash provided by operating activities Rs 69

=======

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� As stated earlier, depreciation is an allocation of historical cost to expense over a period of time.

� Depreciation does not entail a current outflow of cash, therefore, it is a noncash expense.

� Depreciation is added back to net income to compute cash flows from operating activities simply to cancel its deduction in calculating net income.

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Reconciling ItemsAdd charges (expenses) not requiring cash

DepreciationDepletionAmortization of intangible assetsNonoperating lossesAmortization of bond discount

Deduct credits to income (revenue) not providing cashNonoperating gainsAmortization of bond premium

Adjust for changes in current assets and liabilities relating to operating activities Changes in noncash Current Assets Changes in noncash Current Liabilities

deduct increases add increases add decreases deduct decreases

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Reconciling Items� Non operating gains and losses are gains and

losses that are not part of the normal ongoing activities of the business but are included in net income.

� Gains (losses) must be deducted (added back) from net income because they arise from activities other than operations.• The transaction that created the gain or loss must be

included elsewhere on the statement of cash flows, including the gain or loss; removing it from net income keeps the gain or loss from being included twice.

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Reconciling ItemsBoyd Corporation sells a piece of land for Rs50,000 in cash. The land originally cost Rs75,000. The loss on the sale is Rs25,000. How does this transaction affect the operating activities section of the statement of cash flows?

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Reconciling Items� Net income includes the loss of Rs25,000. The

cash flow from the sale is Rs50,000, but this is not cash from operations.

� The Rs50,000 cash flow from the sale is included in the investing activities section (sale of long-lived asset).

� The Rs25,000 is added back to net income in the reconciliation to avoid including elements of the sale in two places on the statement of cash flows.

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Cash Flow and Earnings� The income statement and the statement of cash flows

fill different critical information needs.• The income statement shows how a

company’s owners’ equity changes as a result of operations.

• It matches revenues and expenses using the accrual concept and provides a measure of economic activity.

• The statement of cash flows focuses on the net cash flow from operating activities.

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CASH FLOW STATEMENT

� PRINCIPAL USES

• ASSESS THE ABILITY TO GENERATE POSITIVE NET CASH

• DETERMINE THE ABILITY TO MEET OBLIGATIONS, TO PAY DIVIDENDS, TO USE EXTERNAL FINANCING

• ASSESS THE DIFFERENCES BETWEEN NET INCOME AND CASH FLOWS

• ASSESS THE EFFECTS ON FINANCIAL POSITION (BALANCE SHEET)

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Ratio Analysis

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Ratio Analysis

The key concept of The key concept of ratio analysisratio analysis is is establishing theestablishing the

relationshiprelationship of one number to another of one number to another number.number.

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RATIOS

RatiosRatios are tools that enable management to:

� Measure and compare information within a business over several periods

� Compare similar businesses in the same industry

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Sources of information Information used in ratios comes from:� Statement of Financial Position

– Current ratio

– Liquid or quick asset ratio

– Debt to equity ratio

� Statement of Financial Performance– Gross profit ratio

– Net profit ratio

� Both Statement of Financial Position and Performance– Accounts receivable turnover

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KEY RATIO

� Current ratio� Equity Ratio� Gross Profit Ratio� Inventory Turnover Ratio� Net Profit Ratio� Quick Asset Ratio� Accounts receivable turnover ratio

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KEY RATIO

� Return on Equity Ratio� Return on Asset Ratio� Working capital ratio� Debt Ratio� Debt to Equity ratio

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TYPES OF RATIOS:

100% salesNet

profit Gross ratioprofit Gross ×=

100% salesNet

profitNet ratioprofit Net ×=

PROFITABILITY RATIOS

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TYPES OF RATIOS:

100% equity sowner' Average

profitNet equity on Return ×=

100% assets total Average

profitNet assets on Return ×=


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TYPES OF RATIOS:

sliabilitieCurrent

assetsCurrent ratio capital Working =

overdraft bank - sliabilitieCurrent

sprepayment - sinventorie - assetsCurrent ratioasset Quick =

100% assets Total

equity sowner' Total ratio Equity ×=

FINANCIAL STABILITY

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TYPES OF RATIOS:

EFFICIENCY RATIOS� Inventory efficiency ratios

sinventorie Average

sold goods ofCost turnover Inventory =

turnover Inventory

365 days in Inventory =

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TYPES OF RATIOS:

� Accounts receivable

receivable Accounts

salescredit Annual turnover receivable Accounts =

turnover receivable Accounts

365 period collection receivable Accounts =

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Financial Ratios

• Debt Ratio• Earnings per Share (EPS)

• Price-Earnings (P-E) Ratio• Dividend-Yield Ratio• Dividend-Payout Ratio

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Debt Ratio

The The debt ratiodebt ratio measures the proportion measures the proportionof company’s assets financed by debt.of company’s assets financed by debt.

Total liabilities ÷ Total assetsTotal liabilities ÷ Total assets

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Debt ratio = Total liabilities ÷ Total assets

Debt Ratio

The debt ratio indicates the proportionof assets that is financed with debt.

This ratio measures a business’sability to pay total liabilities

A low debt ratio is safer than a high debt ratio.

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Debt-to-Equity Ratio

This ratio expresses the relationshipThis ratio expresses the relationshipbetween liabilities and equity.between liabilities and equity.

Total liabilities ÷ Total equityTotal liabilities ÷ Total equity

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Earnings per Share (EPS)� EPS is shown on the face of the income

statement.

� Earnings per share is the net income per common share of stock outstanding during a period.

goutstandin shares ofnumber Average

incomeNet EPS =

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Price-Earnings (P-E) Ratio� The P-E ratio measures how much investors are

willing to pay for a chance to share the company’s potential earnings.

shareper Earnings

shareper priceMarket Ratio E-P =

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Price-Earnings (P-E) Ratio� A high P-E ratio indicates that investors predict

that the company’s net income will grow rapidly.

� The ratio is determined by the marketplace because the market price of the stock is used to compute the ratio.

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Dividend-Yield Ratio� The dividend-yield ratio measures dividends paid

for a period compared to the market prices of the stock on a given day.

shareper priceMarket

shareper dividendCommon =

Dividend-Yield Ratio

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Dividend-Payout Ratio� The dividend-payout ratio measures the

percentage of earnings per share distributed in the form of cash dividends.

shareper Earnings

shareper dividendsCommon =Dividend-Payout

Ratio

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Current ratio= Total current assets

÷ Total current liabilities

Current ratio= Total current assets

÷ Total current liabilities

The current ratio measuresthe company’s ability to pay

current liabilities with current assets.

The current ratio measuresthe company’s ability to pay

current liabilities with current assets.

Current Ratio

Rule of thumb: A strong current ratio is 2.00.Rule of thumb: A strong current ratio is 2.00.

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CURRENT LIABILITIES

� ACCOUNTS PAYABLE� PAYROLL LIABILITIES� SHORT-TERM NOTES & INTEREST

PAYABLE� INCOME TAXES PAYABLE� WARRANTIES� UNEARNED REVENUES� CURRENT PORTION L-T DEBT

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Current Liabilities

Current liabilities are obligations due withinone year or within the company’s normal

operating cycle if it is longer than one year.

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Current Liabilities

Accounts payableShort-term notes payable

Sales tax payableCurrent portion of long-term debt

Accrued expensesPayroll liabilities

Unearned revenues

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Current Liabilities

Accounts payable are amounts owed to suppliersfor goods or services purchased on account.

Short-term notes payable are notespayable due within one year.

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TYPES OF RATIOS:

100% salesNet

expenses selling Total ratio expense Selling ×=

100% salesNet

expenses tionadministra Total ratio expense tionAdministra ×=

100% salesNet

expense operating Total ratio expense operating Total ×=

100% salesNet

expenses finance Total ratio expense Finance ×=

OTHER RATIOS

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INTERPRETATION OF RATIOS

� Profitability ratios

� Financial stability ratios

� Ratios of efficiency

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INTERPRETATION OF

RATIOS



Gross profit ratio � Shows the return on net sales prior to adding

revenue or deducting expenses• Reasons gross profit ratio increases:

– selling prices increase and purchase price remains unchanged

– opening inventory undervalued– closing inventory overvalued– purchase bought at lower price

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Gross profit ratio

• Reasons gross profit ratio decreases:– discounts given on sales products– closing inventory undervalued– obsolete or damaged stock written off

– purchases bought at higher price but sales values not adjusted

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Net profit ratio � Shows the amount earned by normal activities

after accounting for other revenue and expenses• Measures operation efficiency

• Reasons net profit ratio increases:– expenses decrease– operating revenue increases– fixed costs spread over higher sales revenue

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PROFITABILITY RATIOS Net profit ratio

• Reasons net profit ratio decreases:– expenses increase at higher rate than COGS– other operating revenue sources decline

• To arrest declining net profit margins:– investigate business selling plans and techniques– increase effective promotion and advertising– encourage areas of operating revenue– review alternative and cheaper interest rates– review all expenses

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Return on equity ratio� Shows the return on every dollar invested in the

business

Return on assets � Indicates the earning capacity of the business

• Measures efficiency of business asset usage

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FINANCIAL STABILITY RATIOS

Working capital ratio � Test of business solvency, to see if it can meet

short-term debts from its current assets• Shows amount of dollars to cover every dollar of

liabilities• The higher the ratio, the better the position of the

business

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FINANCIAL STABILITY RATIOS

Quick asset ratio � Only the liquid business items that easily convert

to cash are used• Inventories and prepayments are excluded from

current assets and the bank overdraft from current liabilities

• Ratio well above 1:1 is acceptable

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FINANCIAL STABILITY RATIOS Equity ratio � Shows relationship of owner’s equity invested in

business to the total assets of the business• It is the degree to which the business relies on owner

capital• The higher the ratio, the lower the need for externally

borrowed funds• High equity ratio = long-term financial stability

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RATIOS OF EFFICIENCY

Inventory turnover times� Means the number of times that inventories turn

over per year.

Inventory turnover in days• Low turnover rate indicates inventory levels are too

high.• Product demand may have slowed.

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Interpretation Of Ratios

Ratios Of Efficiency

Accounts receivable turnover � Measures the efficiency of management in

collecting the debts of the business• The shorter the period of collection, the greater the

cash flow of the business.• Long collection periods may lead to bad debt.

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LIMITATIONS OF RATIOS

� Ratio analysis and interpretation can be influenced by factors such as:• poor or inadequate accounting methods

• incomplete financial reports• changes in accounting methods• existence of unusual items during a financial year e.g.

losses by fire• management changes• changes to the economy, such as an industry recession

Documents

Financial management