DEPARMENT OF ELECTRICAL ENGINEERING

MIRPUR UNIVERSITY OF SCIENCE AND TECHNOLOGY (MUST), MIRPUR

Engineering Economics & Management
GS-355

Lecture 5: Financial Ratio Analysis

Hirra Arshid
Lecturer

Date:
 Financial Ratios

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 Debt Management Analysis
• Two essential indicators of a business’s ability to pay its long term liabilities are Debt Ratio &
Times-Interest-Earned Ratio.

I. Debt Ratio – Relationship between total liabilities and total assets.

• Tells about the proportion of company’s assets that it has financed with debt.

• Total debt includes both current liabilities and long term debt.

• Unity debt ratio indicates that company has used debt to finance all of its assets.

• Debt Ratio = Total debt / Total asset

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 Debt Management Analysis
II. Times-Interest-Earned Ratio – Most common measure of the ability of a company to meet
its debt obligations (interest payments on debt).

• This ratio is found by dividing earnings before interest and income tax by the yearly interest
charges that must be met.

• Times-Interest-Earned Ratio = EBIT / Interest Expense

• It measures the extent to which operating income can decline before the firm is unable to
meet its annual interest costs.

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 Liquidity Analysis
• It refers to the use of ratios to determine the ability of an organization to pay the bills in timely
manner.

• Working capital – excess of current asset over current liabilities, a figure that indicates the
extent to which current assets can be converted to cash to meet current obligations.

I. Current Ratio : Current Asset / Current Liabilities

II. Quick Ratio : (Current Asset – Inventory) / Current Liabilities

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 Liquidity Analysis
• Quick ratio tells whether company could pay all of its current liabilities if they came due
immediately.

• Quick ratio measures how well a company can meet its obligations without having to liquidate
or depend too heavily on its inventory.

• Liquidity analysis is especially important for lenders and creditors who want to gain some idea
of the financial situation of a borrower or customer before granting them credit.

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 Asset Management Analysis
• It measures how efficiently firm is managing its assets.

I. Inventory Turnover Ratio – It measures how many times company sold and replaced its
inventory over a specific period.

• Inventory Turnover Ratio = Sales / Average Inventory Balance

• Average inventory is computed by taking the average of beginning and ending inventory
figures.

• Excess inventory represents investment with a low or zero rate of return.

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 Asset Management Analysis
II. Day’s Sales Outstanding – It is a rough measure of how many times a company’s accounts
receivable have been turned into cash during the year.
• DSO indicates average length of time the firm must wait after making a sale before
receiving cash.

• DSO = Receivables / Average sales per day

• Average sales per day = Annual sales / 365

III. Total Assets Turnover – It measures how efficiently the firm uses its total assets in
generating its revenues.

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 Asset Management Analysis
• Total Asset Turnover Ratio = Sales / Total Assets

• Higher the TATR, better the company is performing.

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 Profitability Analysis
• Profitability ratios show the combined effects of liquidity, asset management and debt on
operating results.
I. Profit Margin on Sales = Net income / Sales

II. Return on Total Assets = It measures a company’s success in using its assets to earn a
profit.
• ROTA = Net income / Total Asset

III. Return on Common Equity = It shows relationship between net income and shareholders’
investment in company.
• Return on Common Equity = Net income / Stockholders’ Equity

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 Market Value Analysis
• These ratios indicate what investors think of company’s past performance and future prospects.

• If firm’s asset and debt management is sound and its profit is rising, its market value ratios will
be high and its stock price will be high.

I. Price to Earning Ratio = Price per share / Earning per share

II. Book value per share = (Total stockholders’ equity – Preferred stock) / Average shares
outstanding
• A relatively high book value per share in relation to stock price often occurs when a stock is
undervalued.

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 Balance Sheet

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Income Statement

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 Exercise Question

Calculate Financial Ratios by using the given balance sheet

and income statement.

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THANKS