Introduction to

Finance
Course Code: FIN201
Lecturer: Tahmina Ahmed
Section: 7
Chapter: 3
Email: tahmina98ahmedsbe@iub.edu.bd
 Asset Utilization Ratios
6. Inventory turnover refers to how many times a company may replace its sold inventory in a certain time period. A
slow turnover ratio indicates low sales and whereas a faster ratio indicates high sales. Inventory turnover is high in
industries like retail and supermarkets.
The speed with which a company can sell their inventory is a key indicator of its success.
Inventory turnover is particularly crucial for maximizing efficiency when selling perishable and other time-sensitive
commodities. Milk, eggs, fruit, and things that have less number of days before it gets expired are a few examples.

Fashion companies can also be overburden with their seasonal stocks. For example, unsold cashmere sweaters during
winter season can lead to lost profits as retailers will restock with new and different seasonal inventory. Such stock is
known as dead stock.
Assume Company ABC has $1 million in sales and $25,000 in inventory. We can see that the company has an inventory
turnover of 40, or $1 million divided by $25,000. In other words, within a year Company ABC tends to turn over its
inventory 40 times.

Taking it a step further, dividing 365 days by the inventory turnover shows how many days on average it takes a company
to sell its inventory. In the case of Company ABC, it’s 9.1. 2
 Asset Utilization Ratios
7. Fixed Asset Turnover (FAT) is a sales efficiency ratio that measures how well a company utilises fixed assets
to generate revenue. This ratio is calculated by dividing net sales by net fixed assets over a year.
The ratio is frequently calculated in manufacturing businesses when a company makes large purchases in
equipment, the investors then keep a careful eye on this ratio in coming years to determine if the additional fixed
assets reward the company with higher sales.

8. The Total Asset Turnover ratio is a metric that measures how efficiently a company uses its total assets to
generate sales. The asset turnover ratio is calculated by dividing net sales by a company's total or average assets.
A business that has net sales of $10,000,000 and total assets of $5,000,000 has a total asset turnover ratio of 2, that
means the company generates $2 in sales for every dollar in total asset.

Difference Between the Fixed Asset Turnover Ratio and total Asset Turnover Ratio:-
The asset turnover ratio uses total assets instead of focusing only on fixed assets as done in the fixed asset turnover
ratio. 3
 Liquidity Ratios
9. The current ratio is a calculation that analyses a company's current assets and liabilities. The assets that are
cash or will be converted to cash in a year or less, and liabilities are those which will be paid in a year or less.
Investors can then use the current ratio to learn more about a company's ability to cover short-term
debt with current assets.

In other words, current ratio is the ability of the company to pay its short term debts and payables by its short term
assets such as cash, inventory or receivables.
Current ratio equals to current assets divided by current liabilities.
A current ratio with less than one usually means that the company does not have enough capital to pay its
short term debts or payables if they were due all at once. While a current ratio greater than one indicates
that the company has enough financial resources or assets to pay for the short term.

Example, company A had current assets 9,000 TK while 10,000 TK was the current liability, then the ratio would be
0.9. This means for every 10 TK debt, company A had only 9 TK to pay.

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 Liquidity Ratios
10. The Quick Ratio assesses a company's ability to meet short-term debts by identifying assets that can be
converted into cash quickly. Cash, marketable securities, and accounts receivable are examples of these assets.
These assets are referred to as "quick" assets since they can be converted into cash rapidly.

The Quick Ratio Formula:

Quick Ratio = [Cash & equivalents + marketable securities + accounts receivable] / Current liabilities

Or, alternatively,

Quick Ratio = [Current Assets – Inventory] / Current Liabilities

Difference between current ratio and quick ratio is that current ratio are assets that can be converted into cash
within a year and quick ratio is assets to cash as quickly as possible, so which means quick ratio are the assets
without inventory and prepaid expense.
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 Liquidity Ratios
Liquidity Ratios: after considering profitability and asset utilization, the analyst needs to examine the liquidity of
the firm. Liquidity is a firm’s ability to raise cash when it needs it.

The Saxton Company’s liquidity ratios fare well in comparison with the industry. Notice that the company’s current
ratio is higher than the industry average because it has more current assets, relative to its current liabilities. This
suggests that the company should be in a relatively good position to pay its current debts as they come due.
Likewise, the company’s quick ratio is higher than its average competitor. Further analysis might involve building a
cash budget to determine if the firm can meet each maturing obligation as it comes due.
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 Debt Utilization Ratios
11. The debt-to-total-assets ratio indicates how much debt has been utilized to fund a company's assets.

The ratio is used by investors to determine whether a firm has enough cash to cover its present debt obligations
and whether it can pay a return on its investment. Creditors use the ratio to determine how much debt the
company now owes and if it can repay it.

For example, if the total assets are 80,000 tk and the total debt is 50,000 tk, the debt to asset ratio is calculated as
follows:

Debt to Asset Ratio = 50,000 / 80,000 = 0.625= 62.5%

Therefore, the figure indicates that 62.5% of the company’s assets are funded via debt.

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 Debt Utilization Ratios
12. The times interest ratio shows the number of times that a company could pay its periodic
interest expenses, should it give all of its EBIT to debt repayment.

A company is currently applying for a new loan to buy equipment. The bank asks for the owner's
financial statements before they will consider his loan. His income statement shows that he made
5 lakh taka of income before interest expense and income taxes. Tim’s overall interest expense
for the year was only 50,000 tk. His time interest earned ratio would be calculated like this:
5,00,000 / 50,000 = 10

As you can see, the owner has a ratio of ten. This means that his income is 10 times greater than
his annual interest expense. In other words, he can afford to pay additional interest expenses. In
this respect, his business is less risky and the bank shouldn’t have a problem accepting his loan.
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 Debt Utilization Ratios

13. The fixed-charge coverage ratio measures how successfully a company's

earnings cover fixed expenses including rent, utilities, and debt payments. When
deciding whether or not to lend money to a company, banks frequently look at
this ratio.

A higher ratio value – preferably 2 or above – indicates a more financially healthy,

and less risky, company or situation. A lower ratio value – less than 1 – indicates
that the company is struggling to meet its regularly scheduled payments.

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Debt Utilization Ratios
Debt utilization ratios: allows the analyst to measure the carefulness of the debt management policies of the
firm.

Ratios for times interest earned and fixed charge coverage show that the Company debt is being well managed compared
to the debt management of other firms in the industry. Times interest earned indicates the number of times that income
before interest and taxes covers the interest obligation (11 times). The higher the ratio, the stronger is the interest-paying
ability of the firm. The figure for income before interest and taxes ($550,000) in the ratio is the equivalent of the operating
profit figure presented in the table 3-1. 10
Debt Utilization Ratios

Fixed charge coverage measures the firm’s ability to meet all fixed obligations rather than interest payments
alone, on the assumption that failure to meet any financial obligation will endanger the position of the firm.

In the present case, the Company has lease obligations of $50,000 as well as the $50,000 in interest expenses.
Thus the total fixed charge financial obligation is $100,000. We also need to know the income before all fixed
charge obligations. In this case, we take income before interest and taxes (operating profit) and add back the
$50,000 in lease payments.

The fixed charges are safely covered 6 times, exceeding the industry norm of 5.5 times. The various ratios are
summarized in Table 3-3. The conclusions reached in comparing the Saxton Company to industry averages are
generally valid, though exceptions may exist. For example, a high inventory turnover is considered “good”
unless it is achieved by maintaining unusually low inventory levels, which may hurt future sales and profitability.
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Ratio Analysis

12
Ratio Analysis

In summary, the Saxton Company more than compensates for a lower return on the sales dollar by a
rapid turnover of assets, principally inventory and receivables, and a wise use of debt.

You should be able to use these 13 measures to evaluate the financial performance of any firm.

Over the course of the business cycle, sales and profitability may expand and contract, and ratio analysis
for any one year may not present an accurate picture of the firm. Therefore, we look at the
trend analysis of performance over a number of years. However, without industry comparisons even
trend analysis may not present a complete picture.

Do read the Trend Analysis from book pg. 67

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Impact of Inflation on Financial Analysis

Inflation is a general rise in the prices of goods and services, decreasing the purchasing power of your
money.

Inflation occurs when prices rise due to increases in production costs, such as raw materials and
wages. A rise in demand for products and services can also cause inflation as consumers are willing to
pay more for the product.

A company may have a profit due to the result of inflation. The major problem during inflation times is
that revenue is stated in current dollars but plant and equipment or inventory may have been purchased
at lower price. However the increased cost of replacing inventory and equipment’s may not be reflected
in the financial analysis. During inflation profit may be more of a function of increasing prices than of
satisfactory performance. Inflation changes the reported earnings figure and overstates true economic
earnings. Hence the price earnings (P/E) ratio drops.

Do read the impact of disinflation on financial analysis from the book.

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 Problem Solving: Ratio Analysis
22. The balance sheet for Stud Clothiers is shown next. Sales for the year were $2,400,000, with 90 percent of sales sold
on credit.

STUD CLOTHIERS
Balance Sheet 20X1

Assets Liabilities and Equity

Cash…………………… $ 60,000 Accounts payable…………….. $ 220,000

Accounts receivable…... 240,000 Accrued taxes………………… 30,000

Inventory……………… 350,000 Bonds payable 150,000

(long-term)……………………

Plant and equipment…... 410,000 Common stock……………….. 80,000

Paid-in capital………………… 200,000

Retained earnings…………….. 380,000

Total assets………... $1,060,000 Total liabilities and equity… $1,060,000

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 Problem Solving: Ratio Analysis
22. Compute the following ratios:
a. Current ratio.
b. Quick ratio.
c. Debt-to-total-assets ratio.
d. Asset turnover.
e. Average collection period.

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Problem Solving: Ratio Analysis

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Thank You
Course Code: FIN201
Lecturer: Tahmina Ahmed
Section: 7
Chapter: 3
Email: tahmina98ahmedsbe@iub.edu.bd