FINANCIAL STATEMENT

And Ratio ANALYSIS

(FSA)

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 Contents

 Section I : Introduction to Financial Statement

 Section II : Financial Statement Analysis (FSA)
 Section III : Evaluating a Company’s Performance
 Section IV : Evaluating Financial Risk
 Section V : DUPONT FORMULA
 Section VI : Fact Sheet

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 INTRODUCTION TO FINANCIAL STATEMENTS
Financial statements (or financial reports) are formal records of the financial activities of a firm. The objective
of financial statements is to provide information about the financial position and performance of an enterprise
that is useful to a wide range of users in making economic decisions. Generally the financial Statements are
affected by:
 External Events: This includes the exchange of assets/liabilities and/or any transaction between an
entity and another external party such as borrowing from a bank.
 Internal Events: This doesn’t include any exchange but it takes place internally and directly affects the
company such as a fire.
Purpose of Financial Statements:
Financial statements are intended to be understandable by readers who have a reasonable knowledge of
business, economic activities, accounting and who are willing to study the information diligently. Financial
statements may be used by users for different purposes:
 Owners and managers require financial statements to make important business decisions that affect its
continued operations. Financial analysis is then performed on these statements to provide management with
a more detailed understanding of the figures. These statements are also used as part of management's
annual report to the stockholders.
 Prospective investors make use of financial statements to assess the viability of investing in a business.
Financial analyses that are prepared by professionals (financial analysts) are often used by investors to
provide them with the basis for making investment decisions.
 Financial institutions (banks and other lending companies) use them to decide whether to grant a
company with fresh working capital or extend debt securities to finance expansion and other significant
expenditures.
 Governmental entities (such as tax authorities) need financial statements to ascertain the propriety and
accuracy of taxes and other duties declared or paid by a company.
 Vendors/Suppliers who extend credit to a business require financial statements to assess the
creditworthiness of the business.

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  Employees also need these reports in making collective bargaining agreements with the management, in
the case of labor unions or for individuals in discussing their compensation, promotion and rankings.
 Media and the general public are also interested in financial statements for a variety of reasons.
Main assumptions for preparing the Financial Statements:
 Going Concern: The company will continue operating after the financials
 Consistency: The idea in accounting that once an accounting method is adopted, it should be followed
consistently from one accounting period to the next. If, for any reason, the accounting method is
changed, a full disclosure of the change and an explanation of its effects on the items of the financial
statements must be given.

 Accrual Basis: Under the accrual basis accounting, revenues and expenses are recognized as follows:
- Revenue recognition: Revenue is recognized when both of the following conditions are met:
 Revenue is earned when products are delivered or services are provided (regardless of the time
of receiving cash payment).
 Revenue is realized or realizable (i.e. cash is received or expected to be received in the future).
- Expense recognition: Expense is recognized in the period in which related revenue is recognized
(Matching Principle).
 Materiality: relative small amounts not likely to influence decisions are to be recorded in most cost
beneficial way.
 Separate Entity: the business is treated as distinct and separate from its owners. The business stands
apart from other organizations as a separate economic unit. It is necessary to record the business's
transactions separately, to distinguish them from the owner's personal transactions. This concept can be
extended to accounting separately for the various divisions of a business in order to ascertain the
financial results for each division.
Component of Financial Statements: a complete financial statement would include the following:
 Balance sheet: also referred to as statement of financial position. It reports the company's economic
resources (i.e. assets) and how it is financed (i.e. liabilities and equites).
 Income statement: also referred to as Profit and Loss statement (or a "P&L"). It reports the company's
Revenues, Expenses, and Profits over a period of time. Income statement provides information on the
operation of the enterprise including sales and various expenses incurred during the processing state.
 Statement of Retained Earnings: explains the changes in a company's retained earnings over the
reporting period.

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  Statement of Cash Flows: reports on a company's cash flow activities, particularly its operating, investing
and financing activities.
 Supporting Documents: which are the Auditor's report and Footnotes or Clarification for Financial
Statements items
I) Balance Sheets:
It is the financial position of a company at a specific date. A balance sheet is often described as a “snapshot” of
a company’s financial condition. A standard company’s balance sheet is segregated into three parts, which are:
 Assets are the economic resources owned by the business at a specific point of time. The main
categories of assets are usually listed in order of liquidity.
 Current Assets (CA): These are assets which the company has the intention and ability to liquidate
during a year.
 Non-Current Assets (NCA): These are assets which the company is not able or does not have the
intention to liquidate within a year (such as the fixed assets).

 Liabilities are probable future economic costs. They arise from present obligations of a particular
entity to transfer assets or provide services to other entities in the future as a result of past transactions
or events. They are listed based on the priority and due of the debt.
 Current liabilities (CL): obligations that the company should settle during a year
 Non-Current liabilities (NCL): obligations that the company should settle after a year
 Owners’ Equity is the amount of financing provided by the owners of the business and earning. It
mainly represents the owners’ residual claim over assets.
 Note: Assets are considered uses of funds, while Liabilities and Equity are considered as sources of
funds
It should be pointed out that for any given company, the assets is financed either internally through owner’s
equity and/or externally through liabilities. Accordingly the general accounting rule for preparing the balance
sheet is: Assets = Liabilities + Owner’s Equity
II) Income Statement
Income statement (also referred to as Profit and Loss statement – P&L) reveals how the business’s revenues are
transformed into net income (the result after all revenues and expenses have been accounted for). It shows
managers and investors whether the company has achieved gains or incurred losses during the period being
reported. The important thing to remember about an income statement is that it represents a period of time. The
income statement is mainly segregated into three main sections; which are:

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Operating section:
 Sales/Revenues: earning from the sale of goods or providing services to customers during a period of
time. It is usually presented as sales minus sales discounts, returns, and allowances. It should be noted
that “sales” is used when referring to sold goods while “revenues” is used when referring to provided
service. Sales Revenue = Number of Unit Sold x Price Per Unit
 Expenses: amount of used-up assets or incurred liabilities to generate revenues during a period of time.
The major expenses are:
- Costs of Goods Sold (COGS): represents the costs associated with the goods that have been sold
during the period covered by the income statement. For a manufacturer, these consist of the costs of
material, labor and overhead.
- Selling, General and Administrative expenses (SG & A): represent expenses to manage the
business and sell products (such as salaries, legal fees, utilities, commissions, advertising…etc.).
- Depreciation: – is the charge for a specific period (i.e. year, accounting period) with respect to fixed
assets that have been capitalized on the balance sheet (note: for fixed assets it is called Depreciation,
for natural resources call Depletion and for intangible assets it is called Amortization).
Non-operating section:
 Other revenues or gains: revenues and gains generated from sources other than the company’s main
business activities (e.g. rent revenue or FX gain).
 Other expenses or losses: expenses or losses not related to the company’s main business operations
(e.g. interest paid or FX losses).
Irregular items:
 These are items that have occurred during period of time and are not expected to recur regularly,
accordingly they are reported separately. These items can include revenue, income, expenses or losses
resulting from Discontinued operations (such as closing a production line), Extraordinary events (such
as an earthquake), changes in accounting principle (for example deciding to depreciate an investment
property that has previously not been depreciated) …etc.

The Income Statement Presentation used over these notes is as follows:

_____________________________
Revenues are inflows from delivering or producing goods, rendering services, or Sales
other activities that constitute the entity's ongoing major or central operations.
Production costs incurred related to the revenue - COGS
Allocation of the cost of production Fixed Assets over its useful life - Depreciation

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 Gross Profit: Amount that remains after the direct costs of producing a product or GP
service are subtracted from revenue.
Allocation of the cost of other Fixed Assets over its useful life - Depreciation
Selling, General and Administrative Expenses related to operations - SG&A
Provisions related to working investments and operations - Operating Provisions
Allocation of the cost of an intangible asset over its useful life - Amortization
Net Operating Profits: Amount that remains after the direct and indirect operating NOP
costs of producing a product or service are subtracted from revenue
Expenses incurred due to all interest bearing debt - Interest Expense
Income received due to Marketable Securities + Interest Income
Increases and decreased in equity and investments assets and dividends received +/- Investment Gain/Loss
Increases and decreased in Fixed Assets sold above or below net book value +/- Sale of Plant Gain/Loss
Increases and decreases in Foreign Exchange +/- FX Gain/Loss
Net Profit Before Tax NPBT
Governmental Obligation, Tax on NPBT - Tax
Net Profit After Tax NPAT
Items either unusual in nature or infrequent in occurrence +/-Unusual Items
Net Profit After Unusual Items NPAUI

Operating Leverage
The cost structure of a company consists of a mix of fixed costs and variable costs. Fixed costs are those that do
not vary with sales but remain the same regardless of how much the company produces and sells, such as rent
and other fixed overhead expenses. Variable costs are those that vary with the volume of sales, such as direct
material costs associated with units produced and sold. Some costs, such as labor costs, will have both fixed and
variable elements. It may be desirable to retain skilled workers during periods of recession and low sales
volume in order to have workers available when sales volume increases, whereas the unskilled or semi-skilled
labor may be laid off during recessions. Each company, based on its cost structure, will have a breakeven point,
at which sales revenues equal expenses. If sales revenues fall below this point, the company will experience a
loss; sales revenues above the point will result in profit, as illustrated in the following Figure.

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Figure: 2

$
Revenue or
Sales

profit

Total Cost = FC + VC
Variable
Costs
Total Breakeven (VC)
Cost Point

Loss

Fixed Costs (FC)

0 Units sold during month

Operating Leverage = Fixed Cost

Total Costs

High operating leverage indicates the company has a high composition of fixed costs and, therefore, there must
be a much higher volume of sales before the company reaches its breakeven point.
Low operating leverage indicates the company has a high level of variable costs and that cost will tend to
increase proportionately with sales volume, i.e., the breakeven point is much lower and fixed costs are a small
proportion of total unit costs.

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 Sales Sales

Total
Costs Total
Costs

Low Operating Leverage High Operating Leverage

Breakdowns of fixed and variable costs will seldom be available, and you will probably not be able to actually
calculate the breakeven point or operating leverage for a particular company. However, these concepts can be
applied in general based on an understanding of the types of costs within the company and will be useful in
anticipating how costs and profits will change with changes in sales revenue for a particular company. You
should recognize, for example, the implied relationship to capacity to produce; that is, the greater the sales
volume, the more units absorbing the fixed expenses, therefore, the lower proportion of fixed costs to total costs
per units. Obviously, the closer a company is to full utilization of capacity, the greater the coverage of the asset
investment cost and the greater the per unit and overall profitability.
III) Statement of Retained Earnings
The Statement of Retained Earnings explains the changes in a company’s retained earnings over the reporting
period. It breaks down changes affecting the account, such as profits or losses from operations, dividends paid,
and any other items charged or credited to retained earnings. This statement uses information from the income
statement and provides information to the balance sheet, where Retained earnings are part of the balance sheet
under Owners’ Equity section. Accordingly, the retained earnings account on the balance sheet is said to
represent an “accumulation of earnings” since net profits (losses) are added (deducted) from the account from
period to period, where the general equation can be expressed as following:
Ending Retained Earnings = Beginning Retained Earnings – Dividends Paid + Net Income

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IV) Cash flow statement
The Cash flow statement is a financial statement that shows how changes in balance sheet and income statement
accounts affected the company’s cash position (i.e. reflects a firm's liquidity). Essentially, the cash flow
statement is concerned with the flow of cash in and out of the business. Accordingly, the cash flow statement
includes only inflows and outflows of cash; and it excludes transactions that do not directly affect cash receipts
and payments (such as depreciation expense which is known as non-cash item).
It should be noted that in the cash flow statement, the activities of a given company are divided into three main
fields which are operating, investing and financing activities. The summation of the change in cash flow
resulting from these activities should be equal to the change in the company’s cash presented in balance sheet
(i.e. change in cash from Year (t-1) to Year (t)).
V) Supporting Documents
Auditor’s Report: A financial audit, or more accurately, an audit of financial statements, is the verification
of the financial statements of a legal entity, with a view to express an audit opinion. The audit opinion is a
reasonable assurance that the financial statements are presented fairly, in all material respects, or give a true and
fair view in accordance with the financial reporting framework. The purpose of an audit is to enhance the
degree of confidence of intended users in the financial statements and enable users to make decisions based on
the results of the audit. There are mainly four types of Auditor’s opinion, which are:
 Unqualified Opinion: An opinion is said to be unqualified when the auditor does not have any significant
reservation in respect of matters contained in the Financial Statements. In other words, the company’s
financial condition, position, and operations are fairly presented in the financial statements. More
specifically, an Unqualified Opinion indicates the following:
 The Financial Statements have been prepared using the Generally Accepted Accounting Principles.
 The Financial Statements comply with relevant statutory requirements and regulations.
 There is adequate disclosure of all material matters relevant to the proper presentation of the
financial information subject to statutory requirements, where applicable;
 Any changes in the accounting principles or in the method of their application and the effects
thereof have been properly determined and disclosed in the Financial Statements.
 Qualified Opinion report: A Qualified Opinion report is issued when the auditor encounters one of two
types of situations which do not comply with Generally Accepted Accounting Principles, however the rest
of the financial statements are fairly presented. The two types of situations which would cause an auditor to
issue this opinion over the unqualified opinion are:
 Single deviation from GAAP: this type of qualification occurs when one or more areas of the
financial statements do not conform to GAAP (e.g. are misstated), but do not affect the rest of the
financial statements from being fairly presented when taken as a whole. For example, if a company

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 did not correctly calculate the depreciation expense of its building. If the rest of the financial
statements do conform to GAAP, then the auditor qualifies the opinion by describing the
depreciation misstatement in the report and continues to issue a clean opinion on the rest of the
financial statements.

 Limitation of scope: this type of qualification occurs when the auditor could not audit one or more
areas of the financial statements, and although they could not be verified, the rest of the financial
statements were audited and they conform to GAAP. Examples of this include an auditor not being
able to observe and test a company’s inventory of goods. If the auditor audited the rest of the
financial statements and is reasonably sure that they conform to GAAP, then the auditor simply
states that the financial statements are fairly presented, with the exception of the inventory which
could not be audited.
 Adverse Opinion report: It is issued when the auditor determines that the financial statements of an
auditee are materially misstated and considered as a whole not conforming with GAAP (for example when
a company fails to consolidate a material subsidiary). It is considered the opposite of unqualified opinion,
essentially stating that the information contained is materially incorrect, unreliable, and inaccurate in order
to assess the auditee’s financial position and results of operations. This type of opinion is rarely accepted
by financial statements users who request the auditee to correct the financial statements and obtain another
audit report.
 Disclaimer of Opinion report (commonly referred to as a Disclaimer): It is issued when the auditor could
not form, and consequently refuses to present, an opinion on the financial statements. This type of report is
issued when the auditor tried to audit an entity but could not complete the work due to various reasons and
does not issue an opinion. For example, a lack of independence or material conflict of interest exists
between the auditor and the auditee. Financial statements users reject an auditee’s financial statements if
the auditor disclaimed an opinion, and will request the auditee to correct the situations the auditor
mentioned and obtain another audit report.
The other types of supporting documents are Footnotes or Clarification for the financial statements which
are considered an integral part of the financial statements. These footnotes typically describe each item on the
balance sheet and income statement in more details, in addition to providing supplement information about the
financial condition of a company. Footnotes are useful in terms of the following:
 Describing the applied accounting rules (such as LIFO or FIFO).
 Present additional details/break down about an item in the financial statements, such as the breakdown of
inventory into raw materials, materials in progress and finished goods.
 Provide additional information about an item or event that is not included in the financial statements such
as the details of a fire.

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  Provide information about events that took place after the date of the statements and during the review

FINANCIAL STATEMENT ANALYSIS (FSA)

Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the
firm by properly establishing relationship between the items of financial statements. The role of Financial
Statement Analysis is to use the information in a company's financial statements, along with other relevant
information, to make economic decisions. Examples of such decisions include granting credit facilities to a
company (whether from a bank or supplier). Also, analysts may use financial statement data to evaluate a
company's past performance and current financial position in order to form opinions about the company's ability
to earn profits and generate cash flow in the future.
There are various techniques that are used in analyzing financial statements. The main three techniques are:
 Horizontal Analysis
 Vertical Analysis
 Ratio Analysis

The main advantages of Financial Statement Analysis are:

 Compare company’s current performance with past performance.
 Benchmark with other companies of different sized in the industry, where ratios adjust for size
differences.
 Helps to evaluate the performance and show the connection between activities and performance
 Used as a guidance for preparing the company’s projections
Limitations of Financial Statement Analysis:
 Since analysis is based on financial statement data, accordingly any interpretation must consider the
accounting principles used in the preparation of the statements. The comparison of performance between
firms may be distorted by the use of different accounting principles.
 When comparing ratios between period for the same firm, consideration must also be given to conditions
that have changed between the periods being compared and the impact of these changes on the financial
statements (for example changes in economic conditions).
 There is no rule of thumb or standard for interpreting the results of financial statement analysis, as the
norms may differ for different firms depending upon the nature of industry and business conditions.

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  Ratios are not the end of analysis and do not by themselves indicate favorable or unfavorable conditions
in the company's operation or management. Ratios merely indicate areas that might be further
investigated. For example, a decrease in the turnover of raw materials inventory, ordinarily considered
to be an undesirable trend, may reflect the accumulation of scarce materials that will keep the plant
operating at full capacity during shortages when competitors have been forced to restrict operations or to
close down. Therefore, results derived from financial statements analysis must be combined with an
investigation of other factors (or rational assumptions made in the absence of information) before valid
decision can be drawn and recommendations for action made.

It should be noted that the first step for Financial Statement Analysis is the spreading of the items of the balance
sheet and income statement. Financial Statements Spreading stands for the reallocating of the financial
statements’ contents of different companies working in different industries into a standardized sheet in order to
unify the financial performance assessment criteria and easily understand the different business models. The
Financial Statements Spreading enables the financial analyst to (1) compare the trend of activities on a yearly
basis, (2) compare a company with its peers, (3) have a clear basis for projections and (4) take a proper and
justified credit decision.

I) Horizontal Analysis:
This technique is concerned with the comparison of two or more years’ financial data. The horizontal analysis is
facilitated by showing changes between years in both amount and percentage form, which helps financial
analysts to focus on key factors that have affected profitability or financial position as per below examples.
Comparative Balance Sheet as at 31.12.2006
(in Thousands of EGP)
Changes in
2005 2006 Amounts % Change
Assets
Cash 5,000 3,000 -2,000 -40.0%
Account Receivables 7,000 6,500 -500 -7.1%
Inventory 4,500 8,300 3,800 84%
Total Fixed Assets 160,000 149,500 -10,500 -6.6%

Total Assets 176,500 167,300 -9,200 -5.2%

Liabilities and Owners Equity

Liabilities
Accounts Payable 20,000 8,300 -11,700 -58.5%
Bank's Debt 1,000 1,500 500 50.0%

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 Long term debt 2,000 2,000 0 0.0%
Total Liabilities 23,000 11,800 -11,200 -48.7%

Owner’s Equity
Paid in Capital 100,000 100,000 0 0.0%
Reserves 3,500 3,500 0 0.0%
Retained Earning 50,000 52,000 2,000 4.0%
Total Owners' Equity 153,500 155,500 2,000 1.3%
Total Liabilities and Owners Equity 176,500 167,300 -9,200 -5.2%
Since we are measuring the change between 2005 and 2006, the EGP amounts for 2005 become the base figure for expressing these
changes in percentage form. For example, cash decreased by EGP 2,000 between 2005 and 2006 which represents 40% decrease.
Other percentage figures in this example are computed by the same way.

Comparative Income Statement as at 31.12.2006

(in Thousands of EGP)
Change in
2005 2006 Amounts % Change
Sales 100,000 120,000 20,000 20.0%
Cost of Goods Sold 70,000 75,000 5,000 7.1%
Gross Margin 30,000 45,000 15,000 50.0%

Selling Expenses 5,000 6,000 1,000 20.0%

Administrative Expenses 4,000 4,500 500 12.5%
Total Operating Expenses 9,000 10,500 1,500 16.7%

Net Operating Income 21,000 34,500 13,500 64.3%

Interest Expense (deducted) 500 750 250 50.0%
Net income before Taxes 20,500 33,750 13,250 64.6%
Income Tax (deducted) 6,150 10,125 3,975 64.6%
Net Income 14,350 23,625 9,275 64.6%
Sales for 2006 increased by EGP 20 million over 2005 (20% increase), resulting in a net income increase by EGP 9.2 million (64.6%
increase).
It should be noted that knowing the percentage change in an item is more useful than just knowing the amount
change. Using the Horizontal Analyst technique enables the financial analyst to concentrate on key trends that
affected the company’s performance. This analysis should be used in conjunction with industry and competitor
comparisons. Also, the horizontal analysis helps to identify trends that may be used as a basis to anticipate the
company's future performance.

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II) Vertical Analysis
Vertical analysis is the procedure of preparing and presenting common size statements. Common size statement
is one that shows the items appearing on it in percentage form as well as in amount form. Each item is stated as
a percentage of some total of which that item is a part, as clarified below:
 A vertical common-size balance sheet expresses all balance sheet accounts as a percentage of total assets.
 A vertical common-size income statement expresses all income statement items as a percentage of sales.
Example for Common Size Balance Sheet:
Common Size Balance Sheet as at 31.12.2006 (in Thousands of EGP)
Common Size Percentages
2005 2006 2005 2006
Cash 5,000 3,000 3% 1.79%
Account Receivables 7,000 14,500 4% 3.89%
Total Current Assets 12,000 17,800 7% 10.64%
Total Fixed Assets 160,000 149,500 93% 89.36%
Total Assets 172,00 167,000 100% 100.00%
Bank's Debt 4,000 6,000 2% 3.5%
Long Term Debt 15,000 6,000 9% 3.5%
Paid in Capital 153,000 155,000 89% 93%
Total Liability and Equity 172,00 167,000 100% 100%
Another application of the vertical analysis idea is to place all items on the income statement in percentage form
in terms of sales.
Common Size Income Statement as at 31.12.2006
(in Thousands of EGP)
Common Size
Percentages
2005 2006 2005 2006
Sales 100,000 120,000 100.00% 100.00%
Cost of Goods Sold 75,000 75,000 75.00% 62.50%
Gross Margin 25,000 45,000 25.00% 37.50%

Selling Expenses 8,000 6,000 8.00% 5.00%

Administrative Expenses 5,550 4,500 5.55% 3.75%
Total Operating Expenses 13,550 10,500 13.55% 8.75%

Net Operating Income 11,450 34,500 11.45% 28.75%

Interest Expense (deducted) 500 750 0.50% 0.63%
Net income before Taxes 10,950 33,750 10.95% 28.13%
Income Tax (deducted) 3,285 10,125 3.29% 8.44%
Net Income 7,665 23,625 7.67% 19.69%

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Note that the percentage figures for each year are expressed in terms of total sales for the year. By placing all items on the income
statement in common size in terms of sales, it is possible to see at a glance how each amount of sales is distributed among the various
costs, expenses, and profits. And by placing successive years' statements side by side, it is easy to spot interesting trends. For example,
as shown above, the cost of goods sold as a percentage of sales decreased from 75% in 2005 to 62.50% in 2006.
The main advantages for using the Vertical Analysis Technique are:
 Knowing the asset composition of the company throughout the years and comparing it with the
industry’s norm (balance sheet).
 Determining the financial structure of the company throughout the years (balance sheet)
 Knowing the effect of the company’s costs on the generated sales (income statement).
In vertical analysis, a company's performance and present financial position as indicated in its ratios, are
compared to that of similar companies or to the industry norm. If a company's performance differs significantly
from the industry norm, the reason should be determined, and the credit impact assessed.
III) Ratio Analysis
The Ratio analysis is considered the most powerful tool of financial statement analysis where it is used as a
statistical yardstick to assess the relationship between different financial figures. There are several types of
Ratio Analysis that can be extracted from the financial statements. In this course we will concentrate on four
major ratios analysis that are used by creditors, which are:
I) Liquidity Ratios
II) Asset management or Activity Analysis Ratios
III) Solvency Ratios
IV) Profitability Ratios

I) Liquidity Ratios
A basic concern of credit analysis is the liquidity of a business: that is, can the firm meet its maturing
obligations with its available cash, or near cash resources? The most useful tool for determining whether cash
will be available when claims come due would be a schedule of anticipated cash receipts and disbursements for
several periods in the future. Such budgets of cash receipts and disbursement may be prepared by the
management of a company to assist in planning and managing cash, but they are not generally made available to
outsiders. The bank, therefore, must use other tools for assessing short-term liquidity. Short-term liquidity is
usually assessed by looking at a company's current liabilities in relation to its current assets.
A) Current ratio: it is the relationship between the firm’s current assets and current liabilities.

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Equation: Current Ratio = Current Assets / Current Liabilities. It means that each pound of current
liability is covered by X times from current assets.
A relatively high current ratio is an indication that the firm is liquid and has the ability to pay its current
obligations on time. On the other hand, a relatively low current ratio (less than 1) represents that the
liquidity position of the firm is not good and the firm may not be able to pay its current liabilities on time
without facing difficulties. An increase in the current ratio represents improvement in the liquidity
position of the firm; while a decrease in the current ratio shows that there has been deterioration in the
liquidity position of the firm.
This ratio should be used very carefully because it suffers from many limitations, such as:
 It is crude ratio because it measures only the quantity and not the quality of the current assets.
 Even if the ratio is favorable, the firm may be in financial trouble, because of more stock and work
in process which is not easily convertible into cash, and, therefore firm may have less cash to pay
off current liabilities.
 Valuation of current assets and window dressing is another problem. This ratio can be very easily
manipulated by overvaluing the current assets. An equal increase in both current assets and current
liabilities can decrease the ratio and vice versa.
B) Quick or Acid Test Ratio: It is a modification for the current ratio, where it measures the ability of
the most liquid assets to meet the current liabilities of a firm when they become due.
Equation: Quick or Acid Test Ratio = Quick Assets / Current Liabilities. The Quick assets are the most
liquidated assets such as the cash and near cash item (such as marketable securities) The Quick ratio is
very useful in measuring the liquidity position of a firm (it is used as a complementary ratio to the current
ratio). It measures the firm's capacity to pay off current obligations immediately and is more rigorous test
of liquidity than the current ratio because it eliminates current assets items that may face the following:
 Need time in order to be liquidated such as accounts receivables
 May lose part of their value in case of immediate liquidation such as inventory.
 Not under the company’s control/hand such as prepaid expenses or down payments.
C) Working Capital: Measures both the company's efficiency and its short-term financial health. The
working capital ratio is calculated as: Current Assets – Current Liabilities
Positive working capital means that the company is able to pay off its short-term
liabilities. Negative working capital means that a company’s current assets are not sufficient to meet its
short-term liabilities with its current assets (cash, accounts receivable and inventory); accordingly the
company is under liquidity squeeze risk. Working Capital is a very powerful tool where it will be
explicitly discussed in later sections.
D) Shrinkage Ratio: measures the caution for the company’s shrinkage in current assets that will keep
the company still able to cover its current liabilities.

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 Shrinkage Ratio = [Working Capital / Current Assets] x 100%
This equation means that the company’s current liabilities will still be covered even when the current
asset’s value decrease (shrink) by the percentage of the shrinkage ratio.
II) Solvency Ratios
In order for a firm to finance its assets it uses both the firm’s own sources (such as capital and reserves) and
external sources such as banks’ borrowings. Long-term solvency is the ability of a firm to meet its interest and
principal payments on long-term debt and similar obligations as they become due.
A) Debt Ratio: It measures the percentage of funds provided by external sources.
Equation: Debt Ratio = Total Liabilities / Total Assets
This ratio shows that every 1 pound of assets was financed by X pounds from external resources
(liability). In general, creditors prefer low debt ratio because the lower the ratio the greater the self-
financing of assets. Multiplying this percentage by 100 will show the percentage of external financing for
company’s assets.
B) Debt-to-Equity Ratio (Financial Leverage): indicates the relationship between the external funds
and internal funds.
Equation: Debt Equity Ratio = Total Liability / Tangible Net Worth
Note: Tangible net worth is the book value of Equity (net worth) less intangible assets as shown on the
spread sheets. Grey area Items are excluded from the calculation of Financial Leverage- since grey area
items are an appropriation of net worth, this is an appropriately conservative calculation.
This equation shows that for every one pound invested from the owners (i.e. equity), the company owns X
pounds to external creditors.. Financial leverage is, in short, a measure of how much a company is relying
on creditors to fund its assets at any point in time. Firms with high leverage rely heavily on external
funding to finance their asset investments, while firms with low leverage generate most of their funding
internally. In general, the higher the ratio, the greater the financial risk- that is, the likelihood that the firm
might be unable to meet interest and principal payments in the future.
C) Gearing Ratio: indicates the relationship between the external fixed-cost financing (which is banks
debt) and internal funds.
Equation: Gearing Ratio = All Bank Debts / Tangible Net Worth
This equation shows that for every one pound invested from the owners (i.e. equity), the company
borrowed X pounds from banks. Gearing ratio measures how much a company is relying on banks to
finance its assets at any point in time. Firms with high gearing rely heavily on banks’ financing to finance
their asset investments.

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 D) Interest Coverage Ratio: This ratio relates the fixed interest charges to the income earned by the
business. It indicates whether the business has earned sufficient profits to pay periodically the interest
charges.
Equation: Interest Coverage Ratio = NOP / Fixed Interest Charges
The interest coverage ratio is very important from the lender's point of view since it indicates the number
of times interest is covered by the profits available to pay interest charges. A high interest coverage ratio
assures the lenders a regular and periodical interest payment, while a weak ratio will make creditors avoid
extending funds to the company. Moreover, it is very important for the lender to ensure that interest
charges are covered by the profit’s generated from the company’s main activities (NOP) and not covered
by other income/revenues (such as interest income)

III) Asset Management / Activity Ratios

These ratios are calculated to measure the efficiency with which the resources of a firm (i.e. assets) have been
employed. They are also called turnover ratios because they indicate the speed with which assets are being
turned over into sales.
A) Inventory Turnover: This ratio indicates the number of times the inventory has been turned over
during the period and evaluates the efficiency with which a firm is able to manage its inventory. A further
extension for this equation is the Inventory Days on Hand, which shows the number of days the company
needed to produce and sell its product.
Equation: Inventory Turnover Ratio = Cost of Goods Sold / Inventory.
Inventory Days on Hand (Inv. DOH) = 365 / Inventory Turnover
It should be highlighted that every firm has to maintain a certain level of inventory of finished goods so as
to be able to meet the requirements of the business, where this level of inventory should neither be too
high nor too low. A too high inventory means higher carrying costs and higher risk of stocks becoming
obsolete, whereas too low inventory may mean the loss of business opportunities. Accordingly, it is very
essential to keep sufficient stock in business. Inventory turnover ratio measures the velocity of conversion
of stock into sales. Usually a high inventory turnover indicates an efficient management of inventory
because the more frequently the stocks are sold; the lesser amount of money is required to finance the
inventory. A low inventory turnover ratio may indicate an inefficient management of inventory which
may implies an over-investment in inventories or poor quality of goods.
B) Receivables turnover ratio: measures the number of times the firm was able to convert receivables
into cash. The inverse of the receivables turnover times 365 is the average collection period, which is the
average number of days it took the company's customers to pay their bills
Equation: Receivables Turnover Ratio = Net Sales / Accounts Receivables.
Receivables Days on Hand (Rec. DOH) = 365 / Receivables Turnover.

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 It should be noted that the higher the value of this ratio the more efficient is the company’s management in
managing its receivables. Worth highlighting that each firm should have its own credit policy (depending
on business nature) which will have an effect on the company’s liquidity position.
Note: We have shown DOH calculations based on annual turnover and a 365-day year. If turnover ratios are for a quarter rather than
a year, the number of days in the quarter should be divided by the quarterly turnover ratios in order to get the "days".

C) Fixed Assets Turnover Ratio: It measures the effectiveness of the firm's fixed assets to generate
revenue
Equation: Net Fixed Assets Turnover Ratio = Net Sales / Net Fixed Assets
It is desirable to have a fixed asset turnover ratio close to the industry norm. Low fixed asset turnover
might mean that the company has too much capital tied up in its asset base or is using the assets it has
inefficiently. A turnover ratio that is too high might imply that the firm has obsolete equipment, or at a
minimum, that the firm will probably have to incur capital expenditures in the near future to increase
capacity to support growing revenues. Since "net" here refers to net of accumulated depreciation, firms
with more recently acquired assets will typically have lower fixed asset turnover ratios.
There are three other useful calculations regarding a firm’s fixed assets. They are known as the plant life
ratios and are important in that they may indicate plant obsolescence that may require gross plant
expenditure in the future.
 Gross Plant / Depreciation Expense: This calculates the average life of plant. It is more accurate
with straight-line depreciation. It should be noted that calculations can be significantly affected by
the mix of assets.
 Accumulated Depreciation/ Depreciation Expense: Indicates number of years of plant life already
used
 Net Plant / Depreciation Expense: Indicates number of years remaining in plant life.

D) Assets Turnover Ratio: It measures the effectiveness of the firm's use of its total assets to create
revenue
Equation: Assets Turnover Ratio = Net Sales / Total Assets
Different types of industries might have considerably different turnover ratios. Manufacturing businesses
that are capital-intensive might have asset turnover ratios near one, while retail businesses might have
turnover ratios near 10. As was the case with the current asset turnover ratios discussed previously, it is
desirable for the total asset turnover ratio to be close to the industry norm. Low asset turnover ratios might
mean that the company has too much capital tied up in its asset base. A turnover ratio that is too high
might imply that the firm has too few assets for potential sales, or that the asset base is outdated.

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IV) Profitability Ratios:
Profitability ratios provide information on how well the company generates operating profits and net profits
from its sales. It is considered the results of business operations or the overall performance where it shows the
combined effect of the company’s liquidity, asset management efficiency and debt management.
A) Return on Assets: this ratio indicates the amount of profit generated for each pound invested in
assets. It is a key measure of management's performance in using assets to generate profits. The higher the
ratio, the more profitable the company’s assets
Equation: ROA = NPAT / Total Assets.

B) Return on Equity: this ratio shows the amount of profit generated for each pound invested in Equity.
Equation: ROE = NPAT / Owners’ Equity
This ratio is very important for a company’s owners where it mainly measures their return on investment
in the business. The owners should compare this risk with available returns from other investments in the
market enjoying lower risk or risk free (such as the banks offered interest rates on deposits)
C) Return on Sales (Net Profit Margin): this ratio indicates every pound of sales has resulted in X
pounds of net profit before.
Equation: ROS = NPAT / Net sales
Profit Margin or ROS ratio is used to measure the overall profitability of the business. It also indicates the
firm's capacity to face adverse economic conditions such as price competition, low demand, etc.
Obviously, the higher the ratio the better is the profitability, and the better the company’s ability to face
adverse economic conditions.
In order to understand why a company has a particular ROS in relation to other companies or to evaluate
changes in a company's profit performance over time, it is necessary to look at the determinants of
profitability-sales revenue and the various expenses that are deducted from sales to arrive at net profit.
Therefore, credit analyst should test the company’s Gross Profit Margins and Operating profit Margins
before evaluating the company’s Net Profit Margin
Gross Profit Margin (GPM)
The gross profit margin (Equation: GPM = Gross Profit/Sales) shows how much gross profit was achieved
from each pound of sales. This ratio shows the return received for the risks taken in adding value to the
product during the asset conversion cycle. A business, such as a supermarket chain, that adds little value
to its products and sells them for little more than cost, would have a low gross profit margin. Its level of
profits, therefore, would be dependent on selling a high volume of goods.

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Gross profit margin is a key indicator of a company's ability to pass along its increased costs to its
customers. The need to keep its product competitively priced, for example, might mean that the company
will limit its profit margin and absorb increased costs for inventory or labor without making
corresponding increases in selling prices.
Changes in the gross profit margin overtime should be analyzed to determine the cause. Changes may be
due to a number of factors such as general economic conditions, the introduction of a new product line
with a different margin of profit than the firm's other products, change in inventory valuation methods,
etc. A decreasing gross profit margin may reflect a successful, planned pricing policy by which
management is purposefully reducing the gross profit margin to increase sales volume and capture a larger
market share. On the other hand, a decreasing gross profit margin may mean the company is unable to
pass along price increases. As with other ratios, the amount or trend in itself is not a basis for judgment
but merely an indication of where additional analysis is required.

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NOP Margin or Net Operating Profit Margin
The Net Operating Profit margin (Equation: NOP Margin= NOP / Sales) shows the amount of net
operating profit which was achieved from each pound of sales.
NOP Margin is a key indicator of a firm’s core earnings ability. It indicates the firm’s ability to generate
profits from the completion of its asset conversion cycle(s), before consideration of other income or
expense items of a non-operational nature (e.g. interest income/expense). Since this ratio excludes the
effects of individual managements’ decisions on how to finance its asset investments, it is particularly
useful in comparing the operating performance of a company to its competitors.
Important Comments about profit margins
 The greater the value added to the product during the asset conversion cycle, the greater the reward, or
profit, expected.
 Following the risk/return principle, the greater the risk involved in selling a product, the greater the
expected return, or profit.
 The impact of value added and selling risk on the ROS may be modified by other non-operating items
such interest expense and interest income
 Inefficiency and inability of management to control costs would result in lower profit margins.

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 EVALUATING A COMPANY'S PERFORMANCE
The Asset Conversion Cycle
The Asset Conversion Cycle (ACC) is the process by which a business invests in raw materials, converts these
raw materials to finished good, sells the goods and collects cash. The Asset Conversion Cycle describes the
basic operations of a business enterprise. Each company has a unique Asset Conversion Cycle, which is
determined by the nature of the business and how it operates in the marketplace.
Studying what is involved in a particular company's Asset Conversion Cycle provides a basis by which to
understand and evaluate its financial statement. A company's asset investments and its financial structure, as
reflected in its balance sheets, are determined to a large extend by its Asset Conversion Cycle. In this section we
will be looking at the relationships between a company's asset conversion cycle, its asset investment, and its
financial structure. We will see how the process of completing the Asset Conversion Cycle gives rise to a need
for financing and will discuss the role of the bank in assisting business in their borrowing needs.

Steps in the Asset Conversion Cycle

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 Taxes

SG & A
Cash
(1) COGS
(5) Purchase of RM Depreciation
Collection of And A/P are Interest
A/Rs created Expense
(4) (2)
Sale of goods WIP Value added
Creation of A/Rs
(3)
FG, Value
SG & A Added

Step 1: Cash is used to purchase raw materials where accounts payable may be created.
Step 2: raw materials are converted to work in process (WIP) where value is added and accrued expenses are
incurred.
Step 3: Finished Good are completed and additional accrued expenses are incurred.
Step 4: Finished goods are sold, SG&A expenses are incurred and account's receivables are created.
Step 5: Accounts receivables are collected.
For illustration, we will follow the "Glass Corporation Company" which is a manufacturer of glasses through its
Asset Conversion Cycle.
Step 1: on January 1, Glass Corporation purchases LE 100 worth of raw materials which is necessary for the
production. It does not pay cash for these raw materials but obtains them on credit from the supplier; where it
should be paid after 30 days.
This step will affect the financial statement as follows
Balance Sheet
Assets Liabilities
Inventory

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 Raw Materials LE 100 Accounts Payable LE 100

Income Statement
No effect of these
materials

Step 2: the company starts the process of converting the raw materials to finished goods. As soon as the
materials enter the processing phase of the Asset Conversion Cycle, the value of these materials is transferred
on the company's books from the raw materials category to the work in process category. At the end of the 5th
day, the raw materials are being processed. The cost for labor and manufacturing overhead to complete this
work is LE 25. The company does not pay these expenses in cash, since the salaries/wages are paid at the end of
the month; therefore these expense are recorded as accrued expense.
This step will affect the financial statement as follows:
Balance Sheet
Assets Liabilities
Inventory
Raw Materials 0 Accounts Payable LE 100
WIP LE 125 Accrued LE 25
Expenses
Finished Goods 0

Income Statement No effect of these materials

Step 3: after five more days, on January 10, the company completes the manufacturing process (i.e. the raw
materials have been converted to finished goods). The completion of the production process costs the company
another LE 25 in labor and manufacturing expenses, which it carries on its books as accrued expenses until the
end of the month when actual payment is due.
This step will affect the financial statement as follows:
Balance Sheet
Assets Liabilities
Inventory
Raw Materials 0 Accounts Payable LE 100
WIP 0 Accrued LE 50
Expenses
Finished Goods LE 150
Income Statement No effect of these materials
Step 4: on January 11th, the company starts selling its production. Since the company has added value to the
raw materials and has accepted considerable risk (such as the product will not meet the customer's preference);
then the company deserves to receive a return in excess of its costs for taking this risk. Therefore, the company

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decided a profit margin of LE 30 over its costs. The company does not require payment in cash, but offers its
customers 20 days credit period.
This step will affect the financial statement as follows:
Balance Sheet
Assets Liabilities
Accounts Receivables LE 180 Accounts Payable LE 100
Inventory Accrued Expenses LE 50
Raw Materials 0
WIP 0 Equity
Finished Goods 0 Retained Earnings LE 30

Income Statement
Sales LE 180
Cost of Goods Sold (LE 150)
Net Income LE 30

Step 5: on January 31, the company receives cash from the customer that bought the glass production.
Moreover, since the payment is now due to the suppliers for the raw materials in addition that the labor costs
and manufacturing overhead must also be paid, therefore the company uses part of the cash received to meet
these obligations
This step will affect the financial statement as follows:
Balance Sheet
Assets Liabilities
Cash LE 30 Accounts Payable 0

Accounts Receivables 0 Accrued Expenses 0

Inventory 0
WIP 0 Equity
Finished Goods 0 Retained Earning LE 30

Income Statement
No effect

In this example, the "Glass Corporation Company" exhibits a perfectly timed Asset Conversion Cycle. That is,
its asset conversion cycle and collects cash exactly when its accounts payable and accrued expense are due.
In reality, as companies conduct their business, rarely does the flow of funds from completion of sales
transactions parallel the outflows associated with purchasing raw materials, salary disbursements,
manufacturing costs, and other costs involved in carrying out the business. Most companies have imperfectly
timed Asset Conversion Cycles; which can occur for several reasons. For example the length of the

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manufacturing process which is often longer than the amount of time that spontaneous financing is available. In
addition most companies maintain a base stock of inventory to guard against shortages; matter which extends
the company's Asset Conversion Cycles. Also, difficulties in selling finished goods or in collecting accounts
receivables can contribute to creating the time lag and thus the need for financing. Moreover, a company may
take advantage of discounts on their accounts payable by paying these accounts before they fall due.
It should be noted that each company and each industry has its own Asset Conversion Cycle. In general, the
Asset Conversion Cycle summarizes how a company manufacturers its product and how they sell it and
generate cash. The asset conversion cycle is reflected in the balance sheet, on the left-hand side by a level of
assets in each stage of the cycle and on the right-hand side by the financing needed to support these assets. The
income statement summarizes the results of the completion of successive asset conversion cycles during one
period of time and indicates the profitability of a firm.
Evaluating a company's ability to complete its Asset Conversion Cycle:
In order to assess the company's ability to complete its Asset Conversion Cycle, we must identify the potential
risks in each stage of the cycle that may hinder or prevent its successful completion. These potential risks are
known as Business Risk
Business Risk, is defined as the risk inherent in a company’s method of operations and the basic nature or
characteristics of the business that may prevent it from converting its asset to cash. Business risk is segregated
into four main types, which correspond with the main staged of the Asset Conversion Cycle.
 Supply Risk: It occurs as a result of disability to get the required raw materials or other components of
input on time at a reasonable price that may lead to disability to produce due to getting out of stock or
shortage of any other input (including shortage of labor, shortage of power supply source, etc).
 Production/Performance risk is the risk of company’s disability to convert the acquired raw materials
into finished goods due to lack of labor, obsolete production lines, management inefficiency, etc.
 Demand risk: it is the risk of unexpected demand (either high or lower than forecasted), the real risk
exist when actual demand is below the forecasted one, which will lead to disability to sell the produced
product and consequently no cash will be available to repay its supplier or to settle bank facility.
 Collection risk: it is of not collecting the company's account's receivables due to bad customers quality,
bad credit policy, etc.
Important comments about the Business Risk:
 Every time a cost is incurred (i.e. value is added) there is a corresponding risk that this cost will not be
recovered through sale of the product and collection of cash. This risk is termed business risk and is the
uncertainty that management will be able to recover the costs invested in the asset conversion cycle.
 Business risk differs from industry to industry, from asset conversion cycle to asset conversion cycle.

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  Business risk is a function of the length of the asset conversion cycle and the value added during the
cycle. Generally, the longer the asset conversion cycle and more value added during the production
process, the greater is the business risk in the company's operations.
 Business risk may be identified by an examination of the nature of the asset conversion cycle and the
structure of the balance sheet; particularly the left hand side.
 In examining business risk, we look at the company's ability or inability to convert its assets to cash. The
objective of the analysis is to identify problems a company may encounter in converting its assets to
cash (i.e. complete the cycle).
Determining the Financing Needs of a Business

I) Current Assets Financing Needs: Working Investment

The concept of working investment quantifies the need for financing in order to be able to complete the Asset
Conversion Cycle. It is defined as the portion of trading assets which is not financed spontaneously.
 Working Investment = Trading Assets – Spontaneous Finance
 Trading Assets: It is the current assets that are related directly to the company's activities which are
mainly the account receivables, inventory and advance payments to suppliers.
 Spontaneous Finance: It is the current liabilities that represent the obligations related directly to the
company's activities which are mainly the accounts payables, accrued expenses and down payments
from customers.
 Accordingly Working Investment is equal to [Accounts Receivables + Inventory + Advance Payments
to suppliers] minus [Accounts Payable + Accrued Expenses + Down Payments from Customers)
Hence, Working Investment represents the amount of funds required to be financed by external sources - rather
than spontaneous finance – namely banks or equity. It represents the financial gap needed to finance the
required Trading Assets to enable the company to complete its Asset Conversion Cycle.
In case the working investment is negative (i.e. spontaneous finance is greater than trading assets), this means
that the spontaneous finance is sufficient to finance all the trading assets. In this case, it will be hard for the
bank to justify granting short term credit facilities unless:
 The company is planning to increase its sales (i.e. there will be a projected working investment need).
 The company will extend the credit tenor of its clients
 The company will change its inventory policy
 The company will change its advance payment and accounts payables policy.
In any case, granting short term credit lines by banks should be properly justified and representing an actual
need to finance the company's business activities.

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The main Sources for financing the Working Investment are:
 Internal Sources: represented by equity such as capital, reserves and retained earnings. These sources are
used mainly to finance capital expansions (fixed assets) in industrial projects. However, it also can be
used to finance working investment needs if it exceeds the required finance for fixed assets. For
example, in trading business there is no need to have excessive investments in fixed assets (rather than
industrial projects) where equity is commonly used to finance working investment.
 External sources: mostly represented by bank finance or any other external source of finance (such as
owner's loan).

Types of Working Investment:

 Permanent Working Investment:
It is the permanent level of working investment that is continuously required by the project in order to
have the minimum level of stock of raw materials to ensure the continuity of production. This is justified
by the overlapping nature of the Asset Conversion Cycles, where new cycle will start while other cycles
are in the process. Permanent level of working investment is ideally financed by permanent funds (i.e.
equity or long term bank loans) because it represents long term continuous needs that cannot be
converted in cash at the end of assets conversion cycle.
 Increasing level of working investment:
There is a direct relation between sales figure and working investment required to finance the business.
Hence, if sales increase we will expect that an increase of working investment will be required to
support the sales increase. Ideally, business should be able to support at least part of its growth
internally; that is by profits generated by sales. However, since profits are only a small portion of sales
revenue, there is a time lag before the increased level of working investment can be financed internally.
Banks may provide additional financing (an external financing source) to assist business in supporting
their increasing working investment that results from sales growth.
 Seasonal Working Investment:
There are season for raw material purchases such as purchases of fruits for a juice production company
(Seasonality of Supply). Also, there are seasonal sales such as the demand on the air conditioners
(Seasonality of Demand). Therefore, seasonal companies need short term financing to finance their
seasonal needs due to the nature of their business.
II) Non-current Assets Financing
Depending on the nature of its business activities and its asset conversion cycle, a business will have some level
of fixed assets that are necessary to the asset conversion process and that represent long-term financing needs.

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For a manufacturer, fixed assets may represent a substantial investment in plant and equipment necessary to
manufacture the product. A commodity dealer on the other hand may have a much smaller fixed asset
investment.
As with the growth of working investment in relation to sales, fixed assets will also generally increase with the
level of sales. The increase in fixed asset investments is a step function of the increase in sales. That is when a
company invests in additional plant or equipment; it generally plans for sufficient capacity to be able to support
not only current sales levels but also future growth
In addition, fixed assets need to be replaced as they depreciate or become obsolete. Banks may provide loans to
assist in the financing of fixed assets; such loans are generally of a longer term loans to finance working
investment needs because the amount of the investment in relation to sales is usually larger and, therefore, it
will take longer to recoup their cost through profits.
Summary for the company's financial needs
To summarize, the process of completing the Asset Conversion Cycle requires a company to invest in a certain
level of current assets, such as inventory and account receivables, and a certain level of non-current assets such
as property, plant and equipment. These asset investments, represented on the left –hand side of the balance
sheet, must be supported by a liability or owners' equity. We have briefly considered some sources of financing
supporting a company's asset investment; like spontaneous financing and bank loan.
It is important to understand each company's asset conversion cycle and determine the ability of the company to
complete its cycle. The continued successful completion of asset conversion cycles is the key to the viability of
a business enterprise. The bank is interested in the company's ability to successfully complete its asset
conversion cycle, both from the standpoint of ensuring that the business is a going concern and also because the
successful completion of the asset conversion cycle and collection of cash provides the primary source of
repayment for the bank's loan.
Therefore, banks are concerned with both the quality and efficiency of assets. Quality means the likelihood that
the current assets can and will be converted to cash; whereas efficiency means the company's ability to achieve
the maximum results (i.e. sales or revenues) with a minimum investment in resources whether current and/or
fixed assets.
Accordingly, banks should identify the potential risk in each stage of the cycle that may hinder or prevent its
successful completion. To do so, we mainly concentrate on evaluating four major areas; which are supply,
production, demand and collection. These areas correspond with the steps in the asset conversion cycle: the
acquisition of raw materials, the conversion of raw materials to finished goods, the sale of the finished goods,
and the collection of cash. The emphasis placed on this analysis will vary depending on the particular lending
situation and source of repayment.

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 EVALUATING FINANCIAL RISK
Having examined areas of risk as indicated in a company's asset structure and its operations or cost structure,
we turn now to an evaluation of how a company finances its asset investment and its operations as reflected in
the right-hand side of its balance sheet. The objective of this evaluation will be to identify risks in a company's
financial structure. Financial risk, from the bank's point of view, may be defined as the possibility that a
company may not be able to meet its debt obligations in a timely manner or at all.
Our evaluation of financial risk will concentrate on three areas, which are: short-term liquidity, long-term
solvency and appropriate capital structure
I) Short-term liquidity means the ability of the company to meet its current obligations out of its available
cash or near-cash resources. Short-term liquidity is particularly important if the bank is ex-tending a loan that
will become payable in the near future, but it is also important in longer term lending situations. Liquidity
problems indicate a weak financial position that may also affect the company's long-term cash - generating
ability. Accordingly, we use the Liquidity ratios - from the Financial Statement Analysis – in order to evaluate
the company's liquidity.
II) Long-term solvency may be defined as a company's ability to meet interest and principal payments on long-
term debt and similar obligations as they become due. If payments cannot be made, the company becomes
insolvent and may have to be reorganized or liquidated. In order to remain solvent, it is essential that the
company keep its reliance on external funding within prudent limits. We use the Solvency ratios - from the
Financial Statement Analysis – as the primary tools for measuring long-term solvency.
III) The capital, or financial, structure of a company is directly related to its set of investment, its operating
performance and cost structure, and ultimately its asset conversion cycle. The level of debt or leverage
considered acceptable varies from company to company, industry to industry. Identifying a company's prudent
level of debt in relation to equity and the appropriate mix of short-term and long-term debt is a major objective
of credit analysis. This section will discuss considerations in determining the most appropriate capital structure
for a particular company. First we will need to give more elaborations regarding Working Capital Concept.
What is Working Capital?
 Working capital is the excess of current assets over current liabilities. It is an important measure of a
company's liquidity. Working Capital = Current Assets - Current Liabilities
 Working Capital is the basic measure of a firm's ability to meet the claims of current creditors from the
conversion of current assets to cash. As long as a company can meet these current obligations as they
come due, it is not likely that the company will be forced into liquidation.

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  Working capital is provided by permanent funds such as long-term debt and equity.
 Working Capital represents a cushion or margin of protection for current creditors. It shows that current
assets could shrink by the amount of working capital before current creditors would incur a loss/default
(shrinkage ratio = (WC ÷ CA) x 100).
 Positive working capital is required to ensure that a firm is able to continue its operations and that it has
sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses.
 On the other side, negative working capital is an indication that the company is suffering from
inappropriate capital/financing structure (liquidity squeeze) where current liabilities are used to finance
current asset in addition to partial finance for non-current assets (this is known as tenor mismatching).
 The management of working capital involves managing inventories, accounts receivable, cash, accounts
payables and accrued expenses.
 From the bank's point of view, Working Capital should be in a sufficient amount to provide adequate
protection to current creditors. Determining the adequacy of Working Capital is, therefore, one of the
objectives of our analysis. There are two primary considerations in this determination:
- The nature of the operations of a particular business and the length of the asset conversion cycle
- The quality of its current assets.
The nature of the operations and the length of the Asset Conversion Cycle:
 The nature of a company's operations involves the type of business, the nature of the product, and the
competitive and economic conditions within which the company operates; all must be considered when
determining the desired level of working capital.
 For example, a manufacturer would ordinarily require a larger amount of working capital in order to
protect creditors than would an importer who buys against confirmed sales orders. The manufacturer
must make and stock inventory in anticipation of future sales orders. Since there is no real assurance that
this inventory can be sold, creditors will want to see a larger amount of working capital as a protection
against the possibility of a forced sale at below cost prices. On the other hand, since the importer has
confirmed sales orders, the risk of sale at a price below the stated inventory value has been minimized.
 The length of the production cycle must also be considered when evaluating the adequacy of working
capital. A company with a relatively long cycle that produces, for example, heavy machinery would
carry a greater risk than one producing small electrical motors in a short production cycle. A short cycle
means a higher turnover of Inventory and, therefore, less risk of obsolescence, and a greater ability to
change product style or product mix in response to changing consumer trends. A creditor being exposed
to less risk in this case might require a smaller working capital than would be required for the heavy
machinery manufacturer.

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  The competitive climate in which a company operates should also be considered. A company that
manufactures a product for which there are few or no substitutes would have greater stability than
another company manufacturing a product, such as wool, where other products, such as synthetic fibers,
are available substitutes. In the latter case, a larger working capital might be desired to provide sufficient
protection to current creditors.
 The economic climate within which a company operates will also affect the level of working capital
required to protect its creditors. Periods of growth in the economy or in a particular industry may permit
a lower level of working capital because of an extensive demand for the product than would be the case
of periods of recession or industry stagnation. It should be noted that there is relation between the
economic climate (whether booming or suffering recession) and the demand/risk of a business.

The quality of current assets:

 The quality of current assets must also be considered when determining an adequate level of working
capital. The term quality is used here to indicate the risk that the realizable value of the current assets
will be lower than the stated value of these assets as given on the balance sheet.
 The "Shrinkage" of current assets from stated value can occur for a variety of reasons, such as accounts
receivable from customers with poor paying records that may be uncollectible or an obsolete inventory
that is unsaleable.
Example: How to calculate shrinkage of current assets:
Balance Sheet
Assets Liabilities
Cash 25 N/P – Banks 80
A/R 100 A/P 190
Inventory 300
Total Current Assets 425 Total Current Liabilities 270
Non-Current Assets 175 Net Worth 330
Total 600 Total 600
Assumptions:
1) Shrinkage margins: Cash 100%, A/R 10%, Inventory 15% and Non-Current Assets 100%
2) Total available bank lines: LE 200M

Solution:
 Step 1: in high point liquidation, we assume that the company will fully utilize the available bank lines
(LE 200M). Therefore, N/P will be increased by LE 120M to reach full approved lines/limits.

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  Step 2: inflate current assets by allocating the portion of the credit line that was utilized. Since the
utilization of bank line should be mainly to finance the company's trading assets (i.e. A/R and Inventory
in this example), therefore the increase in bank line will be distributed on these trading assets on pro-rate
share (percentage of receivable and percentage of inventory from the total sum of A/R and Inventory).
 Step 3: Make new Balance Sheet after the inflation
Inflate Balance Sheet (High Point)
Assets Liabilities
Cash 25 N/P – Banks 200
A/R 130 A/P 190
Inventory 390
Total Current Assets 545 Total Current Liabilities 390
Non-Current Assets 175 Net Worth 330
Total 720 Total 720

 Step 4: calculate the shrinkage margin and the shrinkage amount:

Current Asset Amount Shrinkage % Shrinkage Net Value
Item amount
Cash 25 100% 25 0
A/R 130 10% 13 117
Inventory 390 15% 59 331
Total Current 445 97 448
Assets
Total NCA 175 100% 175 0
Net Value 448

 Step 5: if Net Value > Senior Debt (i.e. positive inflated working capital), then the bank can consider
granting the company short-term financing on unsecured bases.

Working Capital is considered very important from the bank's point of view. Later in this section, when we
discuss appropriate capital structures we will quantify some important considerations and calculate a working
capital figure that the bank considers appropriate for a particular company. For the moment, however, it is
important to understand the Importance of a detailed understanding of the nature of a company's business and
the quality of its assets as a prerequisite to determining the level of working capital sufficient to protect current
creditors.

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Appropriate Capital Structure
In the preceding discussion, we suggested that the acceptable level of debt in relation to equity in a company's
capital structure and the desired liquidity, as measured by working capital, are dependent on the nature of the
business and our perception of the risks inherent in that business. A related issue, integral to an evaluation of
risks in how a firm is financing itself, is consideration of the particular mix of short-term borrowings, long-term
debt, and equity in the firm's capital structure.
This section will discuss factors to consider when determining the most appropriate mix of these funds. The
desired levels of short-term borrowings, long-term debt, and equity are dependent on the composition of the
firm's asset structure and on its profitability. When we see what the left-hand side of the balance sheet and the
income statement look like, we can decide what the right-hand side of the balance sheet should look like.
Two criteria -will govern our analysis of a firm's capital structure:
 Tenor Matching: The tenor of the financing should match the tenor of the assets being financed. Short-
term funds should support short-term needs whereas long-term funds should finance long-term needs.
For example, inventory is financed through short term finance, whereas new machine purchase should
be financed through long term loan. Tenor matching, applied to business finances is best thought of in
terms of stability and flexibility. Short-term financing provides management with flexibility, i.e., the
ability to borrow and repay funds to correspond with a temporary expansion and contraction of current
assets. Longer term financing provides stability in the funding base.
 Business Risks: Equity owners, rather than creditors, must absorb business risk. Since owners stand to
make substantial return on a successful business, they must be ready to absorb the losses in an
unsuccessful venture. Banks are not in the position to provide risk capital to business enterprises.
Therefore, from the bank’s point of view, the higher the business risk a company has, the lower the
financial risk it should have. A company with high business risk should provide more equity buffer to
absorb such risk. A study on the industry players can suggest an appropriate equity level of a company
should have. However, company size, diversification and management strategy etc. all play a part in
determining the level.
Returning to our objective of determining the most appropriate mix of short-term borrowings, long-term debt,
and equity, we will apply the criteria of tenor matching and business risk to the financing of current assets and
determine the types of funds we would like to see supporting these assets.
Appropriate Financing of Short-Term Needs
In the following discussion we will be concerned with determining the most appropriate financing of working
investment. Two caveats should be kept in mind. First, our discussion ignores the existence of cash and
marketable securities, as these represent a relatively minor part of the overall current asset investment; semi-
spontaneous liabilities will be ignored for the same reason. This is not to imply that they may not be important
in any particular analysis, but only that we wish to concentrate here on the major sources and uses of cash.
Second, for conceptual or theoretical purposes, it will be useful to distinguish various uses of cash and assign to

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them specific sources of financing. It is important to keep in mind, however that liabilities and equity are
fungible, i.e., indistinguishable as to use. Our primary intention in the following discussion is to show that the
tenor and type of financing that is most appropriate must be determined based on an evaluation of the liquidity
of assets, the business risks inherent in the nature of the business, and the profit performance of the company.
We have already introduced the concepts of working investment as a net asset and the concept of working
capital as the excess of current assets over current liabilities. The working capital represents the investment in
current assets that is financed by permanent funds that are not financing non-current assets. This can be shown
diagrammatically:

Cash and Other CA Other CL

A/Ps
A/Rs
A/Es

Short Term Borrowings

Inventory STB
WI

WC

Permanent Funds
Non-Current Assets
(LTD & NW)

From this figure we can say: WI = WC + STB

When assessing a company’s needed short term finance, the following concerns should be noted:
 Is the liquidity of the investment in accounts receivable and inventory of sufficiently high quality so that
any shrinkage will be absorbed by permanent funds and short-term creditors can be paid in full - that is,
is working capital adequate?
 We have indicated that a portion of the investment in accounts receivable and inventory is permanent
even though individual units will liquidate relatively rapidly. The size of this permanent investment in
inventory and receivable is dependent on the nature of the business, the length of the asset conversion
cycle, the quality and salability of the product, the collectability of the receivables, and the market,

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 industry and economic conditions - in short on the business risks of the particular company. Business
risk should be carried by the owners' investment in the business.
 Permanent funds are composed of owner’s equity and long-term debt. The proportion of long-term debt
in relation to equity is a function of (a) business risks inherent in the business and (b) management's
performance in obtaining a consistently high level of profits in the normal operations of the business
(and the retention of those profits in the business) so as to assure the long-term lenders that the company
can service the debt.
 To determine, then, the most appropriate mix of short-term borrowings, long-term debt, and equity
supporting working Investment, we will apply the principles of tenor matching and business risk. We
can make the following observations:
- Tenor matching may seem to imply that all of working investment, a current asset, should be
supported by short-term funds, but there is permanent component of working investment needs, and
although the individual assets to be financed are of a short-term nature, the aggregate need may
rarely, if ever, diminish. The permanent level of working investment should be financed by
permanent funds in order to provide stability in financing. Since lenders may demand payback of
short-term borrowings at any lime, a firm should maintain sufficient permanent funds, in the form of
long-term debt or equity to support the minimum level of working investment necessary to carry on
normal operations. The other part of working investment which fluctuates or increases because of
seasonal growth in sales should be financed by short-term borrowings. If all working investment is
financed with permanent funds, the firm might end up with an unnecessarily large cash account, and
hence investment in a non-earning asset, at those times in the year when working investment needs
are at a low point. Short-term borrowings provide management with the flexibility to borrow and
repay funds to correspond with the temporary expansion and contraction of working investment.
NOTE: When the level of increased working investment due to increased sales becomes permanent,
this increased level should be financed by the retention of profits or by conversion of short-term
borrowings to long-term debt, i.e., by permanent funds.
- A second important reason why working investment, from the lender's point of view, should not be
completely financed by short-term borrowings is due to the principle that business risk should be
absorbed by equity owners. Business risk has been defined as the uncertainty that management will
be able to recover fully ifs investment in current assets. Although there is no absolute measure of
business risk, we can attempt to quantify the business risk that the firm may be exposed to in the
current cycle by shrinking or revaluing current assets down to their net realizable value. That portion
of current assets which we doubt its convertibility to cash represents business risk. Since business risk
should be absorbed by equity owners, not creditors, this component of working investment should be
supported not by short-term borrowings but by permanent funds - specifically the equity component
of permanent funds.

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To summarize, working investment is financed by a combination of short-term borrowing and non-current
liabilities or permanent funds, which may consist of long-term debt or equity. Since working capital is
equivalent to the permanent funds that are supporting current assets, a determination of the desired level of
permanent funds will yield a figure for the desired level of working capital.

STB
WI Examine issues of tenor
LTD risk to determine allocation
Permanent Funds
Equity

A determination of the most appropriate allocation of funds must be based on knowledge of the firm's
operations, the composition of its current assets, and conditions in the industry and general economy. The
following generalizations can be made:
 The longer the asset conversion cycle and the more value added:
- The more stability required in financing working investment, since large amounts of working
investment are permanent, and
- The greater the business risk inherent in the cycle, and therefore, the more shrinkage in value of
current assets we would expect in liquidation.
- Thus, we would like to see a large part of the working investment need financed by permanent funds,
with the equity component of permanent funds at least equal to potential shrinkage.
 The shorter the asset conversion cycle and the less value added to the product.
- The more flexibility required in financing working investment, since there is great potential volatility
in current assets, and
- The less business risk inherent in the cycle and the less shrinkage we would expect in liquidation.
- Therefore, we would accept to see large amounts of working investment financed with short-term
borrowings and proportionately less financed with permanent funds. However, the equity portion of
permanent funds should at least equal potential shrinkage.
When evaluating capital structure using these criteria, it is important to remember that, although these concepts
are useful theoretically, in practice we cannot break working investment (or any other assets to be financed) into
separate pieces and assign specific liabilities as funding for their specific assets; liabilities are fungible. In order

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to evaluate, the firm's capital structure, we would need to know something about its operations, the quality of its
current assets, and the level of working investment that is relatively permanent

Exercise I: Determining Shrinkage in Current Assets

A trading company listed its current assets as follows:
 Cash= LE 20,000
 A/R= LE 45,000
 Inventory= LE 80,000
 Totl current Assets = LE 145,000

From an examination of the company's operations, we learn that approximately 10% of the accounts receivables
are uncollectible. Moreover, because of price cutting by competitos, the inventory can be sold for only 80% of
its stated value.
Based on this information, we can shrink the current assets to their net realizable value (NRV):
 Cash = 20,000 x 100% = LE 20,000
 A/R= 45,000 x 90% = LE 40,500
 Inventory= 80,000 x 80% = LE 64,000
 Net Realizabke Value = LE 124,500

Accordingly, we can say that the Buisness risk can be quantified as LE 20,500 which represents the possible
shrinkage value in the current asset (LE 145,000 – LE 124,500).

Exercise II: example to compute the desired level of short term borrowings

Balance Sheet

Cash 85 A/Ps 200

Net A/Rs 735 A/Es 155
Inv. 1,065 N/P 800
Current Assets 1,885 Div/P 500
Plant 915 Current Liabilities 1,655
Equity 1,145
Total Assets 2,800 Total Liabilities 2,800

 The permanent level of working investment is 20% of what is shown on the balance sheet.
 The firm has a history of not being able to collect 10% of its accounts receivable.

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  The quality of the inventory is such that in liquidation the net realizable value would be 20% of the
value stated on the balance sheet.
 The notes payable listed on the balance sheet represent what the company is currently using of a $1,400
line of credit from its bank.
Given these assumptions, we can follow these steps to calculate the desired level of short-term borrowings and
permanent funds which should be supporting working investment.

1) Calculate working investment

WI = (Net AIRs + Inv.) - (A/Ps + A/Es)
WI = ((735 + 1,065) - (200 + 155)
WI = 1,445

2) Calculate actual working capital at statement date

WC = 1,885 - 1,665
WC = 230
This represents the level of permanent funds that are supporting current assets.

3) Calculate the minimum acceptable level of permanent funds required to:

 Absorb business risk (as measured by shrinkage in current assets) and
 Cover the permanent level of working investment.
 Shrinkage in current assets:

A/Rs 735 x 10% = 74

+INV 1,065 x 20% = 213
Total Shrinkage 287

 Permanent level of working investment: 1,445 x 20% = 289

 Permanent funds financing working investment should equal 287 + 289 = 576
(note: 287 represents the buisness risk whereas 289 represents the permanent level of WI)

4) Solve for the desired level of short-term borrowings:

STB = 869 (i.e. WI - PF)

WI shrinkage = 287
1,445

Permanent Funds = 576

Permanent WI= 289

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 5) Compare desired levels of permanent funds and short-term borrowings to actual levels and conclude as
to appropriateness of the firm’s capital structure:

Actual Desired
Available STB limits = 1,400 STB = 869 (plug)
WI = 1,445 WI = 1,445
Permanent funds (WC) = 230 Permanent Fund = 576

Result: based on the above analysis, we can conclude that company's capital structure does not have sufficient
stability. We must consider why this situation has occurred if we are to extend or refuse credit to the company.

Appropriate Financing of Long-Term Needs

To this point we have been considering the appropriate financing of short-term, i.e., working investment, needs,
of a business. Although some portion of permanent funds are available to support current assets, the greater part
of permanent funds on a firm's balance sheet represent financing for permanent assets. Our concern now is how
much of these permanent funds can be provided by long-term debt?
The presence of long-term debt on a firm’s balance sheet is contingent upon the generation of profits and a
positive cash flow. We have seen that profits are the primary source of cash that can be used to pay back or
amortize long-term debt.
The primary tool for determining whether profit is sufficient to amortize long-term debt is the cash flow
statement, which will be covered later in this course. Since the repayment of long-term debt should be
accomplished by the retention of profits over time, before extending a long-term loan, the bank will want to
make sure of the company's demonstrated ability to complete its asset conversion cycles many times in
succession and show a reliable profit performance. Long-term debt requires stability of profit performance.
Companies that use the most long-term debt usually have medium to long asset conversion cycles, hence high
business risk and large investments in long-term assets. Despite such risk, if these companies have successfully
mitigated the business risks in their asset conversion cycles, creditors may have confidence in their ability to
generate stable profits, because of the lengthy asset conversion cycle and high fixed asset investment, there
tends to be substantial value added to the products and, therefore, sufficient profit margins to amortize relatively
high levels of debt. Loans to these companies will be paid back out of this stable and relatively substantial level
of profits that have been retained in tile business.
Firms with very short asset conversion cycles, by contrast, usually have very few fixed assets requiring
permanent funding. The composition of their assets can change too quickly to Justify long-term exposure by
creditors. Therefore, these companies seldom have much long-term debt. Small firms with long conversion

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cycles are generally too dependent on their markets and too vulnerable to competition to give creditors
confidence in their future profit performance. Hence they have little, or no, long-term debt.

DUPONT FORMULA
(The ROE Equation)

The DuPont system of analysis is an approach that can be used to analyze return on equity (ROE). It uses basic
algebra to break down ROE into a function of different ratios, so an analyst can see the impact of leverage,
profit margins, and turnover on shareholder returns.
If ROE is relatively low, it must be that at least one of the following is true: The Company has a poor profit
margin, the company has poor asset turnover, or the firm has too little leverage.
Often candidates get confused and think the DuPont method is a way to calculate ROE. While you can calculate
ROE given the components of the DuPont equations, this isn't necessary if you have the financial statements
(i.e. if you have net income and equity, you can calculate ROE). The DuPont method is a way to decompose
ROE, to better see what changes are driving the changes in ROE.
The ROE Equation
 The return on equity (ROE) ratio -- the relationship of net profit after tax to net worth " is a basic
measure of overall performance and is calculated:

ROE = Net Profit After Tax

Net Worth

 This ratio can be segregated into three ratios as follows:

Net Profit After Tax = Net Profit After Tax x Sales x Total Assets
Net Worth Sales Total Assets Net Worth

ROE = ROS x ATO x ALEV

(Return on Equity) (Return on Sales) (Asset Turnover) (Asset Leverage)

 Moreover since ROS x ATO = ROA, therefore the ROE equation can be expressed as follows:
ROE = ROA x ALEV

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 FACT SHEET

The fact sheet is a listing of financial statement ratios. It is a useful tool in historical analysis. Various ratios
that are commonly calculated in constructing a fact sheet are summarized below:

RATIO CALCULATION/EXPLANATION

ROE Net profit After Tax/Net Worth: Indicates dollars of profit generated for each dollar
of net worth: represents return to equity owners; measure of overall performance.

ROA Net Profit After Tax/Total Assets: indicates dollars of profit generated for each dollar
invested in assets; a key measure of management's performance in using assets to
generate profits; this ratio can be disaggregated: ROA = ROS X ATD; changes in the
ROA can be evaluated by evaluating changes in ROS and ATO.

ROS Net Profit After Tax/Sales: indicates dollars of profit resulting from each dollar of
sales; overall measure of profitability; ROS can be analyzed by studying ratios of
earnings and various expenses to sales as calculated below.

Sales Absolute dollar amount

% % change in sales from previous period.

COGS/SALES Indicates dollars of COGS expenses incurred for each dollar of sales.

Gross Profit Margin Gross Profit/Sales Indicates dollars of gross profit resulting from each dollar of sales

SG&A Indicates dollars of SG & A expenses incurred for each dollar of sales
NOP/Sales Indicates dollars of net operating profits generated by each dollar of sales.

Interest Expense/Ave. Average Funded Debt is calculated:

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NPBT/Sales Indicates dollars of net profit before tax resulting from each dollar of sales.

Taxes/NPBT Indicates effective taxes rate.

NPAUI/Sales Indicates dollars of net profit after unusual items resulting from each dollar of sales.

ATO ... Sales/Total Assets

Indicates dollars of sales generated for each dollar invested in assets; overall measure
of efficiency in use of assets, change in the ATO should be analyzed through
studying turnover ratios for the various asset components.
WI/Sales Indicates dollars of financing need associated with each dollar of sales; broad
measure of efficiency; changes in this ratio should be analyzed by studying the
turnover (or days-on-hand) ratios for the components of working investment.
A/R Turnover ... Sales/Net Accounts Receivable
Indicates number of times in period A/Rs turnover.

A/R DOH ... (Net Accounts Receivable/Sales x 365

Indicates number of days accounts receivable are on hand before cash is collected.
Inv. Turnover ... Cost of Goods Sold/Inventory
Indicates number of times in period inventory turnover.
Inventory DOH ... (Inventory/Cost of Goods Sold) x 365
Indicates number of days inventory is on hand before sold.
A/P Turnover ... Cost of Goods Sold/Accounts Payable
Indicates number of times during a period that accounts payable turnover.
A/P DOH ... (Accounts Payable/Cost of Goods Sold) x 365
Indicates number of days accounts payable are held on books before being paid
A/E Turnover ... Cost of Goods Sold/Accrued Expenses
Indicates number of time during period accrued expenses turnover.
A/E DOH ... (Accrued Expenses/Cost of Goods Sold) x 365
Indicates number of days accrued expenses are held on books before being paid.
Gross Plant Turnover ... Sales/Average Gross Plant
Indicates dollars in sales generated for each dollar invested in gross plant.
Net Plant Turnover ... Sales/Average Net Plant

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 Indicates number of dollars in sales generated for each dollar invested in net plant.
ALEV Total Asset/Net Worth: Overall indicator of how a company is financing its asset
investment; capital structure can be. more closely evaluated by studying the liquidity,
leverage, and financing mix indicators below

Current Ratio Current Assets/Current Liabilities: A broad measure of liquidity; indicates relationship
between current assets and current liabilities.

Quick Ratio [Cash + Marketable Securities + Near to cash (such as A/R)]/ Current Liabilities: A more
severe measure of liquidity that shows the relationship between the more liquid current assets
and current liabilities.

Total Coverage Ratio Current Assets/Total Liabilities: Indicates portion of total liabilities that would be covered if
company liquidated its current assets at stated value.

Financial Leverage Total Liabilities/Tangible Net Worth. Indicates dollars owed creditors for each dollar of
internal funds.

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 Conclusion
It should be highlighted that the information provided in the financial statements is not an end in itself as no
meaningful conclusions can be drawn from these statements alone. However, the information provided in the
financial statements is of immense use in making decisions through analysis and interpretation of financial
statements.
The financial ratios and analysis that have been presented in this module are considered the most commonly
used ratios for the analysis of financial statements. Not only are there several other ratios that can be extracted
from the financial statements, but also the same ratio can be interpreted in more than one way (such as Du Pont
Form).
Moreover, there are several other techniques that can be used in analyzing the financial statements depending
on the purpose of the analyses. For example, for a prospect investor the market value analysis of the firm will be
necessary, while for a prospect creditor more detailed analyses for the company’s working capital will be more
essential.
Finally the Financial Statement Analysis (FSA) Process can be summarized as follows:
 Step 1: State the objective and context. Determine what questions the analysis seeks to answer, the form in
which this information needs to be presented, and what resources and how much time are available to
perform the analysis.
 Step 2: Gather data. Acquire the company's financial statements and other relevant data on its industry and
the economy. Ask questions of the company's management, suppliers, and customers, and visit company
sites.
 Step 3: Process the data. Make any appropriate adjustments to the financial statements. Calculate ratios.
Prepare exhibits such as graphs and common-size balance sheets.
 Step 4: Analyze and interpret the data. Use the data to answer the questions stated in the first step. Decide
what conclusions or recommendations the information supports.
 Step 5: Report the conclusions or recommendations. Prepare a report and communicate it to its intended
audience. Be sure the report and its dissemination comply with the Code and Standards that relate to
investment analysis and recommendations.
 Step 6: Update the analysis. Repeat these steps periodically and change the conclusions or
recommendations when necessary.

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