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# Ratio Analysis

Accounting for Managers

Financial Analysis
• Assessment of the firm’s past, present and future financial conditions • Done to find firm’s financial strengths and weaknesses • Primary Tools:
– Financial Statements – Comparison of financial ratios to past, industry, sector and all firms

Objectives of Ratio Analysis
• Standardize financial information for comparisons • Evaluate current operations • Compare performance with past performance • Compare performance against other firms or industry standards • Study the efficiency of operations • Study the risk of operations

Uses for Ratio Analysis • • • • • Evaluate Bank Loan Applications Evaluate Customers’ Creditworthiness Assess Potential Merger Candidates Analyze Internal Management Control Analyze and Compare Investment Opportunities .

Types of Ratios • Financial Ratios: – Liquidity Ratios • Assess ability to cover current obligations – Leverage Ratios • Assess ability to cover long term debt obligations • Operational Ratios: – Activity (Turnover) Ratios • Assess amount of activity relative to amount of resources used – Profitability Ratios • Valuation Ratios: • Assess profits relative to amount of resources used • Assess market price relative to assets or earnings .

Liquidity Ratios • Current Ratio – Current Assets / Current Liabilities • Current Assets include Cash.2 : 1 Current Liabilities 1555.75 . Marketable Securities. Accounts Receivable and Inventory • Current Liabilities include Accounts Payable. Debt Due within one year.92 Current Ratio    1. and Other Current Liabilities Current Assets 1870.

75 .Inventory 720.Liquidity Ratios • Quick Ratio or Acid Test – Current Assets minus Inventory / Current Liabilities – A more precise measure of liquidity.46 : 1 Current Liabilities 1555. especially if inventory is not easily converted into cash.53 Quik Ratio    0. Current Assets .

08   0.Liquidity Ratios • Cash Ratio Cash Ratio  Cash  Marketable Securities 26.17 Current Liabilities 1555.75 – Reserve borrowing capacity .the credit limit sanctioned by the bank .

369.870.39   77 Days 3.92  1.94 / 360 .Liquidity Ratios Interval Measure •Calculated to asses a firms ability to meet its regular cash outgoings Current As sets  Inventory Interval Measure  Average Daily operating expenses 1.150.

the higher this ratio. the more risky a creditor will perceive its exposure in your business. Thus. – Leverage ratios include: – Debt Ratio – Debt--Equity Ratio – Generally.Leverage Ratios – Leverage ratios measure the extent to which a firm has been financed by debt. . high leverage ratios make it more difficult to obtain credit (loans).

. and the easier it will be to obtain credit (loans). Fixed coverage Ratio etc.  Leverage ratios also include the Interestcoverage Ratio.  . the more credit worthy the firm is. In contrast to the leverage ratios discussed on previous slide. the higher the Interest Coverage Ratio (Times-Interest-Earned Ratio).Leverage Ratios Cont.

87 . Total Debt 1. the better.229.Total Debt Ratio – Proportion of interest bearing debt in the Capital structure.646 Net Assets 1901.06 Debt Ratio    0. the lower the number. – In general.

– This ratio indicates the extent to which the business relies on debt financing (creditor money versus owner’s equity).81 . Total Debt 1.06 Debt  Equity Ratio    1.Debt-Equity Ratio – The Debt-Equity Ratio indicates the percentage of total funds provided by creditors versus by owners.229.83 Net Worth 972.

• Treatment of – Preference Capital – Lease Payments .

this calculation shows how many times the firm could pay back (or cover) its annual interest expenses out of earnings before interest and taxes (EBIT). – Also called the Times-Interest-Earned Ratio.46 .Interest Coverage Ratio – interest coverage ratio indicates the extent to which earnings can decline without the firm becoming unable to meet its annual interest costs.61 Interest Coverage Ratio    2.4 Interest 143. EBIT 342.

46 DA = Depreciation and Amortization expenses .59 Interest Coverage Ratio    2.Interest Coverage Ratio EBITDA 342.7 Interest 143.61  41.

Fixed Coverage Ratio – Principal repayments are added to interest payments • Fixed Coverage Ratio  EBITDA repay m ent Interest  Loan 1-Tax Rate EBITDA  Lease rentals Fixed Coverage Ratio  m ent  Pref.Dividend Interest  Lease rentals  Loan repay 1-Tax Rate .

Activity Ratios – Activity ratios measure how effectively a firm is using its resources.  Total assets turnover  Fixed assets turnover . the better. – Activity ratios include:  Inventory turnover  Accounts receivable turnover  Average collection period. or how efficient a company is in its operations and use of assets. the higher the ratio. – In general.

26  7461.6 Avg Inventory (244.Inventory Turnover Ratio – The inventory turnover ratio indicates how fast a firm is selling its inventories – This ratio indicates how well inventory is being managed.053..81) / 2 360  42 days InventoryTurnover Days of InventoryHolding  .e. which is important because the more times inventory can be turned (i. Inventory Turnover Ratio  Cost of Goods Sold 3. the higher the turnover rate) in a given operating cycle. the greater the profit.66   8.

Inventory Turnover Ratio Cont. – In the absence of information. While the sales are valued at market prices – Therefore better to use CGS . Instead of CGS we can use Sales – In the case of CGS and Inventory both are valued at cost.

how well accounts receivable are being collected.Accounts Receivable Turnover – The accounts receivable turnover ratio.717..23    7.e. indicates the average length of time it takes a firm to collect credit sales (in percentage terms).18 .7 Avg AR 483. liquidity could be severely impaired. i. – If receivables are excessively slow in being converted to cash. Credit Sales A R Turnover  Avg AR Sales 3.

360 ACP   47 days AR Turnover .Average Collection Period – The average collection period is the average length of time (in days) it takes a firm to collect on credit sales.

– This ratio helps to signal whether a firm is generating a sufficient volume of business for the size of its asset investment Sales 3.95 times Net Assets 1901.87 . indicates how efficiently a firm is using all its assets to generate revenues.23 Net Assets Turnover    1.Net Assets Turnover – The total assets turnover ratio.717.

Profitability Ratios – Profitability ratios measure management’s overall effectiveness as shown by returns generated on sales and investment. . Profitability ratios include – – – – – – – Gross profit margin Operating profit margin Net profit margin Return on total assets (ROA) Return on stockholders’ equity (ROE) Earnings per share (EPS) Price-earnings ratio (P/E).

the better.9% Sales 3.717. This ratio indicates how efficiently a business is using its labor and materials in the production process. – The higher the ratio.Gross Profit Margin – The gross profit margin is the total margin available to cover operating expenses and yield a profit.179 or 17. and shows the percentage of net sales remaining after subtracting cost of goods sold.23 . GP Margin  Gross Profit 663. A high gross profit margin indicates that a firm can make a reasonable profit on sales.57   0. as long as it keeps overhead costs under control.

The DuPont System • Method to breakdown ROE into: – ROA and Equity Multiplier • ROA is further broken down as: – Profit Margin and Asset Turnover • Helps to identify sources of strength and weakness in current performance • Helps to focus attention on value drivers .

The DuPont System ROE ROA Profit Margin Equity Multiplier Total Asset Turnover .

The DuPont System ROE ROA Profit Margin Equity Multiplier Total Asset Turnover ROE  ROA  Equity Multiplier Net Income Total Assets   Total Assets Common Equity .

The DuPont System ROE ROA Profit Margin Equity Multiplier Total Asset Turnover ROA  Profit Margin  Total Asset Turnover Net Income Sales   Sales Total Assets .

The DuPont System ROE ROA Profit Margin Equity Multiplier Total Asset Turnover ROE  Profit Margin  Total Asset Turnover  Equity Multiplier Net Income Sales Total Assets    Sales Total Assets Common Equity .