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Ratio Analysis

Accounting for Managers

Financial Analysis

• Assessment of the firm’s past, present and future financial conditions

• Done to find firm’s financial strengths and weaknesses

• Primary Tools:– Financial Statements– Comparison of financial ratios to past,

industry, sector and all firms

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

Uses for Ratio Analysis

• Evaluate Bank Loan Applications

• Evaluate Customers’ Creditworthiness

• Assess Potential Merger Candidates

• Analyze Internal Management Control

• Analyze and Compare Investment Opportunities

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

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

1:2.175.1555

92.1870

sLiabilitieCurrent

AssetsCurrentRatioCurrent

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.

1:46.075.1555

53.720

Inventory -

sLiabilitieCurrent

AssetsCurrentRatioQuik

Liquidity Ratios

• Cash Ratio

– Reserve borrowing capacity - the credit limit sanctioned by the bank

17.075.1555

08.26

Securities Marketable

sLiabilitieCurrent

CashRatioCash

Liquidity Ratios

Days 77360 /94.369,3

39.150,192.870,1

expenses operatingDaily

Inventory As Measure

Average

setsCurrentInterval

Interval Measure

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

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).

Leverage Ratios Cont.

Leverage ratios also include the Interest-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).

Total Debt Ratio

– Proportion of interest bearing debt in the Capital structure.

– In general, the lower the number, the better.

0.646 87.1901

06.229,1

Assets

Net

DebtTotalRatioDebt

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 owner’s equity).

1.83 81.972

06.229,1

Worth

Equity

Net

DebtTotalRatioDebt

• Treatment of – Preference Capital – Lease Payments

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 the Times-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).

2.4 46.143

61.342 Coverage

Interest

EBITRatioInterest

Interest Coverage Ratio

2.7 46.143

59.4161.342 Coverage

Interest

EBITDARatioInterest

DA = Depreciation and Amortization expenses

Fixed Coverage Ratio

– Principal repayments are added to interest payments

•

RateTax -1Dividend Pref.repaymentLoan

RateTax -1repaymentLoan

rentals Lease

rentals Lease Coverage

Coverage

Interest

EBITDARatioFixed

Interest

EBITDARatioFixed

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

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.

days

Avg

CostRatioInventory

42TurnoverInventory

360 HoldingInventory of Days

8.6 2 / )81.7461 26.244(

66.053,3

Inventory

Sold Goods of Turnover

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

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.

7.7 18.483

23.717,3

AR

AR

Turnover R

Avg

Sales

Avg

SalesCreditA

Average Collection Period

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

days 47 Turnover

360CP

ARA

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

times1.95 1901.87

3,717.23

Turnover

AssetsNet

SalesAssetsNet

Profitability Ratios

– Profitability ratios measure management’s 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).

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.

17.9%or 0.179 3,717.23

663.57

Profit Margin

Sales

GrossGP

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

The DuPont System

Profi t M argin T ota l A sse t T urnover

RO A E quity M ultip l ie r

RO E

The DuPont System



RO E

EquityCommon

Assets Total

Assets Total

IncomeNet MultiplierEquity ROAROE

The DuPont System



RO E

Assets Total

Sales

Sales

IncomeNet TurnoverAsset TotalMarginProfit ROA

The DuPont System



RO E

EquityCommon

Assets Total

Assets Total

Sales

Sales

IncomeNet MultiplierEquity TurnoverAsset TotalMarginProfit ROE