Ratio Analysis Formula and its Interpretation

Presented to: Sir Aqeel Ahmed Presented by Group II:

Muhammad Siddique Bokhari

Syed Muhammad Mudassir Qutb

20351
19827

Asad Iftikhar Bhatti

Hassan Munir

21610
18582
1

Ratio Analysis & Interpretation

1. Analysis by Common stockholder Common stockholders and potential investors in common stock look first at a companys earnings record. Their investment is in share of stock so earnings per share and dividends per share are of particularly interest.
2. Revenue and Expense Analysis It indicates the earning and expense trend of a company and helps the investor in its decision making. 3. Return on Investment The rate of return on investment (often called ROI) is a measure of managements efficiency in using available resources, regardless of the size of the organization , capital is scarce resource and must be used efficiently. 4. Analysis for Long Term Credit Bond holders and other long-term creditors are primarily interested in there factors: 1. The rate of return on their investment 2. The firms ability to meet its interest requirement 3. The firms ability to repay the principal of the debt when it falls due. 5. Analysis for Short-Term Credit Bankers and other short-term creditors share the interest of stockholders and bondholders in the profitability and long-run stability of a business.
2

1. Ratio Analysis (Common Stockholder)

Earnings per share of Common Stocks

Significance Indicates the amount of earning applicable to a share of common stocks

Formula: Earning per share of common stock = Example Sea Cliff Company Net Income Less: Preferred Dividend requirements Income applicable to common stocks Share of common stock outstanding , during the year 1993 $75000 (9000) $65000 5000 1994 $90000 (9000) $ 81000 4000 Net income preferred Dividends Shares of common outstanding

Computation Dec, 31 1993 Earnings per share of common stock = $81000 = 20.25 4000 Dec, 31 1994 Earnings per share of common stock = $66000 = 13.20 5000 Notice that earning per share have decreased by 7.05 in 1994, representing a decline of nearly 35% from the their level in 1993(7.05/20.25=34.8%) Interpretation Common stocks consider a decline in earnings per share to be an extremely unfavorable development. A decline in earnings per share generally represents decline in profitability of the company and creates doubts as the company prospects for the future.

1. Ratio Analysis (Common Stockholder)

Price Earning Ratio Significance Indicates if price of stock is in line with earnings . Formula: Price-earning ratio = Market price per share Earnings per share Example Sea Cliff Company Assumed market Value Per share $160 $132 Earning Per Share $20.25 $13.20 Price Earnings Ratio 8 10

Date Dec, 31 1994 Dec, 31 1993 Computation

Dec, 31 1993 Dec, 31 1994 Price-Earnings Ratio= 132 = 10 Price-Earnings Ratio= 160 = 8 13.2 20.25 Interpretation At the end of 1993, Sea Cliffs earning per ratio was approximately 8 to 1, suggesting that investor were expecting earnings to decline in 1994.At December 31 1994 the price earnings per ratio was 10 to 1 , suggesting that investors expect future earning to stabilize around the current level . 4

1. Ratio Analysis (Common Stockholder)

Dividend Yield Significance Shows the rate of return earned by stockholders based on current price for a share of stock . Formula: Dividend yield = Example Sea Cliff Company Assumed Market value per Share $160 $132 Earnings per Share $20.25 $13.20 Price Dividends Earnings Ratio per Share 8 $5.00 10 $4.80 Dividend yields % 3.1% 3.6%

Dividend per share Market price per share

Date Dec, 31 1993 Dec, 31 1994 Computation

Dec,31 1993 Dividend yield = 5 = 3.1% 160

Dec,31 1994 Dividend yield = 4.8 = 3.6% 132

Interpretation The decline in market value during 1994 presumably reflects the decrease in both earnings and dividends per share. Investors appraising this stock at December 31, 1994, should consider whether a price-earning ratio of 10 and a dividend yields of 3.6% represents a satisfactory situation in the light of alternative investment opportunities. 5

1. Ratio Analysis (Common Stockholder)

Book value per share of common stock Significance Measures the recorded value of net assets behind each share of common stock. Formula Book value per share of common stock= Common Stock Holders Equity Share of Common outstanding Example Sea Cliff Company Total stockholders equity Less: Equity of preferred stockholders (1000 shares at Sale price of $150) Equity of common stockholders

638000 (105,000) $533,000

516000 (105,000) $411,000

Shares of common stockholders

Computation Dec 31, 1993 Book value per share of common stock= 411000 = 102.75 4000 Dec31, 1994 Book value per share of common stock= 533000 = 106.60 5000 Interpretation Book value indicates the net assets represented by each share of stocks .

5000

4000

2. Ratio Analysis (Revenue & Expenses)

Operating Expense Ratio Significance Indicates managements ability to control expense. Formula Operating expense ratio= Operating expense Net sales Example Sea Cliff Company 1994 1993 $243000 $170000 $900000 $750000

Operating Expenses Net Sales Computation

Dec31, 1993 Operating expenses ratio= 170000 = 22.7% 750000 Dec 31, 1994 Operating expenses ratio= 243000 = 27% 900000 Interpretation An unfavorable trend in the ratio for Sea Cliff is shown above for the year 1994. Operating expenses (243000 / 170000) = 1.4 increased and net sales (900000 / 750000) = 1.2 increase, which represents increase in operating expense is more than net sales. 7

3. Ratio Analysis (Return on Asset)

Return on Asset Significance Measures the productivity of assets regardless of capital structure. Formula Return on Asset = Operating income Average total assets Example Sea Cliff Company 1994 $127,000 (a)$860,000 b)$950,000 $905,000 1993 $160,000 $820,000 $860,000 $840,000

Operating income Total assets , beginning of the year Total assets, end of the year Average investment in assets [(a/b) / 2)
Computation

Dec 31, 1993 Return on Assets = 160,000 = 19 % 840,000 Dec 31, 1994 Return on Assets = 127,000 = 14 % 905,000 Interpretation This ratio shows that the rate of return earned on the companys assets has fallen off in 1994 .
8

3. Ratio Analysis (Return on Asset)

Return on Common Stocks Equity Significance Indicates the earning power of common stocks. Formula Return on common stocks equity = Net Income Preferred Dividends Average Common Stockholders equity Example Sea Cliff Company 1994 Net income $75000 Less: Preferred dividend requirements 9000 Net income applicable to common stock $66000 Common stockholders equity , beginning year (a)$416000 Common stockholders equity , end of year (b)$538000 Average common stockholders equity [(a / b) / 2) $477000

1993 $90000 9000 $81000 $355000 $416000 $385500

Computation Dec 31, 1993 Return on common stocks equity = 81000 = 21% 385500 Dec 31, 1994 Return on common stocks equity = 66000 = 13.8% 477000 Interpretation In both years, the rate of return on common stockholders equity was higher than the 12 % rate of interest paid to long-term creditors or the 9% dividends rate paid to preferred stockholders and it represents favorable condition. 9

3. Ratio Analysis (Return on Asset)

Equity Ratio Significance Shows the protection to creditors and the extent of leverage being used. Formula Equity ratio = Total stockholders equity Total assets Example Sea Cliff Company 1994 Total stockholders equity $638000 Total assets ( or total liabilities & stockholders equity $950000 Computation Dec 31, 1993 Equity ratio = 516000 = 60 % 860000 Dec 31, 1994 Equity ratio = 638000 = 67.2% 950000 Interpretation A low equity ratio will produce maximum benefits if management is able to earn a rate of return on asset greater than the rate of interest paid to creditors. However, a low equity ratio can be very unfavorable if the return on total asset falls below the rate of interest paid to creditors. Since the return on total assets earned by Sea Cliff company has declined from 19% in 1993 to a relatively low 14% in 1994, but it is still above the creditors rate which was 12%. 10 1993 $516000 $860000

4. Ratio Analysis (Long Term Credit)

Debit Ratio Significance Indicates the percentage of assets financed through borrowing; it shows the extent of leverage being used. Formula Debit ratio = Total Liabilities Total Assets Example

Sea Cliff Company 1994 Total liabilities $312000 Total assets (or total liabilities & stockholders equity) $950000
Computation Dec 31, 1993 Debit ratio = 344000 = 40% 860000

1993 $344000 $860000

Dec 31, 1994 Debit ratio = 312000 = 32.8% 950000

Interpretation From a creditors viewpoint, the lower the debit ratio (or the higher the equity ratio)the better , since this means that stockholder have contributed the bulk of the funds to the business , and therefore the margin of protection to creditors against a shrinkage of the asset is high.

11

4. Ratio Analysis (Long Term Credit)

Interest Coverage Ratio Significance Measures the coverage of interest requirements, particularly on long-term debt. Formula Interest coverage ratio = Operating income Annual interest expense Example Sea Cliff Company 1994 Operating income (before interest and income taxes) $127000 Annual interest expense $24000

1993 $160000 $30000

Computation Dec 31, 1993 Interest coverage ratio = 160000 = 5.3 times 30000 Dec 31, 1994 Interest coverage ratio = 127000 = 5.3 times 24000 Interpretation The ratio remains unchanged at a satisfactory level during 1994.A ratio 5 times interest earned would be considered strong in many industries. The ratio of individuals companies varying from 2 to 6.
12

4. Ratio Analysis (Long Term Credit)

Preferred Dividend Coverage Ratio Significance Shows the adequacy of current earning to cover dividends on preferred stocks. Formula Preferred Dividend Coverage Ratio = Net income Annual preferred dividends Example Sea Cliff Company 1994 1993 Net income $75000 $90000 Annual preferred dividend requirements $ 9000 $ 9000 Computation Dec 31, 1993 Preferred Dividend Coverage Ratio = 90000 = 10 times 9000 Dec 31, 1994 Preferred Dividend Coverage Ratio = 75000 = 8.3 times 9000 Interpretation Although the margin of protection declined in 1994, the annual preferred dividends requirement still appears well protected. When interest rates are moving up, preferred stocks prices tend to decline, when interest rates are dropping, preferred stock prices rise.
13

5. Ratio Analysis (Short Term Credit)

Working Capital Significance Measures short-run debit paying ability.

Formula Working capital = current assets current liabilities

Example Sea Cliff Company 1994 1993 $390000 $288000 $112000 $94000

Total current assets Total current liabilities

Computation

Dec 31, 1993 Working capital = 288000 94000 = 194000 Dec 31, 1994 Working capital = 390000 112000 = 278000 Interpretation Current assets increased $120000, while current liabilities rose by only $18000, with the result that working capital increase.
14

5. Ratio Analysis (Short Term Credit)

Accounts Receivable Turnover Rate Significance Indicates reasonableness of accounts receivable balance and effectiveness of collection. Formula Accounts receivable turnover rate = Example 1994 $900000 $86000 $117000 $101500 Sea Cliff Company 1993 $750000 $80000 $86000 $83000

Net sales Average receivables

Net sales Receivable, begging of year Receivable, end of year Average receivables

Computation Dec 31, 1993 Accounts receivable turnover per year = 750000 = 9 times 83000 Average number of days to collect receivables = 365 = 41 days 9 Dec 31, 1994 Accounts receivable turnover per year = 900000 = 8.9 times 101500 Average number of days to collect receivables = 365 = 41 days 9 Interpretation There is no significant change in the average time required to collect receivables.

15

5. Ratio Analysis (Short Term Credit)

Current Ratio Significance Measures short-run debit paying ability, it measures liquidity and solvency.

Formula Current ratio = Current assets Current liabilities Example

Sea Cliff Company 1994 1993 $390000 $288000 $112000 $94000

Total current assets Total current liabilities

Computation Dec 31, 1993 Current ratio = 288000 = 3.1 94000 Dec 31 1994 Current ratio = 390000 = 3.5 112000

Interpretation Sea Cliff Companys current ratio appears quite in both years. A widely used rule of thumb is that a current ratio of 2 to 1 is better or satisfactory .
16

5. Ratio Analysis (Short Term Credit)

Quick Ratio Significance Measures the short-run liquidity of current asset of a firm.

Formula Quick ratio = Quick assets Current liability

Example Sea Cliff Company 1994 1993 $155000 $126000 $112000 $94000

Quick assets (cash and receivables) Current liabilities Computation De 31, 1993 Quick assets = 126000 = 1.3 94000 Dec 31 , 1994

Quick assets = 155000 = 1.4 112000 Interpretation Analysis reveals a favorable trend and a strong position.
17

5. Ratio Analysis (Short Term Credit)

18