ACCOUNTING FOR

BUSINESS DECISION
MAKING
(MBSA 1413/ MRC 1413/
MRF 1023/ MRD 1023)

Financial Statement Analysis - Ratio

 Course Learning Outcome
• In the end of the lesson, the student shall be able to
define, describe and calculate the liquidity ratio,
activity ratio, leverage (gearing ratio), profitability
ratio, and market ratio.
• (CLO1: Plan appropriate accounting techniques to
maximize management decision-making.)
 Ratio Analysis Outline

1. Basic Financial Analysis

2. Using financial ratio: Types of Ratio Comparisons
3. Ratio Analysis
– Liquidity Ratio
– Activity Ratio
– Leverage (Gearing Ratio)
– Profitability Ratio
– Market Ratio
Basic Financial Analysis

• Ratio analysis involves

methods of calculating and
interpreting financial ratios
to assess a firm’s financial
condition and performance.
• It is of interest to
shareholders, creditors, and
the firm’s own management
 Using Financial Ratios:
Types of Ratio Comparisons

• Trend or time-series analysis

– Used to evaluate a firm’s performance
over time

• Cross-sectional analysis
– Used to compare different firms at the same point in time
 Using Financial Ratios:
Types of Ratio Comparisons
(cont.)
• Cross-sectional analysis
– Industry comparative analysis
• One specific type of cross sectional analysis.
Used to compare one firm’s financial
performance to the industry’s average
performance
– Benchmarking
• A type of cross sectional analysis in which the
firm’s ratio values are compared to those of a
key competitor or group of competitors that it
wishes to emulate
 Using Financial Ratios:
Types of Ratio Comparisons
(cont.)
• Combined Analysis
– Combined analysis simply uses a combination of
both time series analysis and cross-sectional
analysis
 Ratio Analysis
• Liquidity Ratios – measures capacity to meet
short term obligation
• Activity Ratios – measures effective use of
resources
• Leverage (gearing) Ratios – measures
indebtedness
• Profitability Ratios – measures overall
profitability
• Market Ratios – measures based on market price
of shares - important to investors
 LIQUIDITY RATIOS

1. CURRENT RATIO
•Measures firm’s ability to meet its short-term
obligation
The higher the ratio, the more liquid the firm
is.
A current ratio of 2.0 is occasionally acceptable
Current ratio = Current Assets
Current liabilities
 CURRENT RATIO
• A company has total assets of RM150,000,
equity of RM 75,000 and non-current assets of
RM 50,000 and non-current liabilities of RM
50,000. Calculate the current ratio of the
company.
 CURRENT RATIO

• Asset= Liabilities + Equity

• Total asset= current+ non current
– Current asset = 150k – 50 k = 100k
• Total liabilities = Total Asset – Equity = 150k – 75k
= 75k
• Current liabilities = 75k – 50k =25k
• Current ratio = 100k/25k = 4
 CURRENT RATIO
• Enough cash to be able to pay its debts
• But not too much finance tied up in current
assets which could be reinvested or
distributed to shareholders
• A low current ratio suggest that the business is
not well placed to pay its debts
 LIQUIDITY RATIOS
2. Quick (acid-test) Ratio
• Similar to current ratio but excludes inventory
 A quick ratio of 1.0 or greater is occasionally
recommended – but depends on the
industry
 Quick ratio = current asset – Inventory
current liabilities
 LIQUIDITY RATIOS

cash 60 000 Account payable 30000

Marketable 10000 Accrued 20000
securities expenses
Account 40000 Notes payable 5000
receivables
Inventory 50000 Current portion 10000
of long term debt
 LIQUIDITY RATIOS
• Quick ratio = (160k – 50k )/65K
= 1.69
• Quick ratio of greater than 1.0 are sufficiently able to
meet their short-term liabilities with its most liquid
assets.
• Assets such as cash and marketable securities are quick
sources of cash. Inventories generally take time to be
converted into cash.
• Low or decreasing quick ratios generally suggest that a
company is over-leveraged, struggling to maintain or
grow sales, paying bills too quickly or
collecting receivables too slowly.
 ACTIVITY RATIO
• Inventory Ratio – measures the activity/liquidity of a firm’s
inventory
– COGS/ Inventory OR Sales/ Inventory
A high ratio implies either strong sales or ineffective
buying.
A low turnover implies poor sales and, therefore, excess
inventory.
 Average Collection Period – average amount of time
needed to collect accounts receivable
– Account receivable/Average sales per day
Meaningful only in relation to the firm’s credit terms
(credit-terms 30 days and average collection period
60days – poorly managed credit)
 ACTIVITY RATIO
• Average Payment Period – average amount of time
needed to pay accounts payable
– Account payable/ Average purchase per day
Meaningful only in relation to the average credit
terms extended to the firm (credit terms 30 days,
average payment period 90 days – low credit
rating)
• Total Asset Turnover – indicates the efficiency with
which the firm uses its assets to generate sales
– Sales/ Total assets
Generally, the higher the firm’s total asset
turnover, the more efficiently its assets have been
used
 ACTIVITY RATIOS
*Account receivable turnover ratio
• = Net Credit sales/ Average Account Receivables
• Measures the efficiency of a business in collecting its
credit sales
• High value of accounts receivable turnover is
favorable
• Lower figure may indicate inefficiency in collecting
outstanding sales
 ACTIVITY RATIOS
Account payable turnover ratio
• = Total purchases/ Average Account Payable
• * Purchase = COGS+ ending inventory - opening
inventory
• Evaluates how fast a company pays off its creditors
• A high ratio means there is a relatively short time
between purchase of goods and services and
payment for them.
• A lower account payable turnover ratio signifies that
a company is slow in paying its suppliers.
 DEBT RATIO
• Debt Ratio – measures the proportion of total assets financed by
the firm’s creditors
– Total liabilities/ Total assets
– The higher this ratio, the greater the firms’ degree of
indebtedness, the more financial leverage it has
• Times Interest Earned Ratio – measures the firms’ ability to
make contractual interest payments
– EBIT (Earnings Before Interest and Tax)/Interest
– The higher the better – a value of at least 3.0 and preferably
closer to 5.0 is often suggested
• Fixed-Payment Coverage Ratio – measures the firms’ ability to
meet all fixed-payment obligations (loan interest and principal,
lease payments, preferred stock dividend)
= EBIT+LP/I+LP +((PP +PSD)*(1/1-T))
– The higher, the better. Also measures risk, the lower the ratio,
the greater the risk to both lenders and owners
 DEBT RATIO
*Debt to equity ratio
•= Total liabilities/ shareholders equity
•Higher ratio is unfavorable because it means that the
business relies more on external lenders thus it is at
higher risk, especially at higher interest rates.
•Lower ratio is favorable indicating less risk.
 PROFITABILITY RATIOS
• Gross Profit Margin – measures the percentage of each sales dollar
remaining after the firm has paid for its goods
– Gross profit/ Sales
– The higher, the better
• Operating Profit Margin – measures the percentage of each sales
dollar remaining after all costs and expenses other than interest,
taxes, and preferred stock dividends are deducted
– Operating profit/ Sales
– A higher operating profit margin is preferred
• Net Profit Margin - measures the percentage of each sales dollar
remaining after all costs and expenses including interest, taxes, and
preferred stock dividends are deducted
– Earnings for stockholders/Sales
– The higher the firm’s net profit margin, the better
 PROFITABILITY RATIOS
• Earnings per share (EPS) – represents the dollar amount earned
on behalf of each outstanding share of common stock
– Earnings for stockholder/Number of shares of stock
outstanding
– The higher, the better
• Return on Total Assets (ROA) – how efficient management is at
using its assets to generate earnings.– return on investment
– Earnings for stockholder/ Total assets
– The higher, the better
• Return on Common Equity (ROE) – how much profit a company
generates with the money shareholders have invested.
– Earnings for stockholder/ Common stock equity
– The higher, the better
 MARKET RATIOS
• Price/Earnings (P/E) Ratio – measures the amount that
investors are willing to pay for each dollar of a firm’s
earnings
– Market price per share of common stock/EPS
– Indicates the degree of confidence that investors have
in the firm’s future performance (the higher, the
greater the confidence)
• Market/Book (M/B) Ratio – compare a company's
current market price to its book value
– Market price per share of common stock/ Book value
per share of common stock
– Performing stocks – higher M/B ratios
 MARKET RATIOS
*Price/Earnings (P/E) Ratio
•ratio tells how much the market is willing to pay for a
company’s earnings
•Higher ratio indicates that the market has high hopes for the
future of the share and therefore it has bid up the price.
•A lower ratio indicates the market does not have much
confidence in the future of the share.
•if a company is currently trading at $43 a share and earnings
over the last 12 months were $1.95 per share, the P/E ratio for
the stock would be 22.05 ($43/$1.95).
•the interpretation is that an investor is willing to pay $22.05 for
$1 of current earnings.
 Summarizing All Ratios
Table 2.8 Summary of Bartlett Company Ratios
(2007–2009, Including 2009 Industry Averages)

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 Summarizing All Ratios (cont.)
Table 2.8 Summary of Bartlett Company Ratios
(2007–2009, Including 2009 Industry Averages)

2-27