Measuring The Firm’s Performance

 A financial ratio is the relationship between 2

figures from a set of financial statements.
 Comparing absolute figures is not always
meaningful - ratios make comparison easier.
 A ratio by itself has little meaning unless it is
compared with some other figure such as:
 a target ratio; or
 a ratio achieved in an earlier year; or
 a ratio achieved by some other firm; or
 the industry average ratio.
 BASIC BALANCE SHEET STRUCTURE
ASSETS LIABILITIES
Current Assets Current Liabilities 
Long-term liabilities  Total Liabilities

Fixed Assets Share Capital 
Retained Earnings  Equity

TOTAL ASSETS = TOTAL LIABILITIES & EQUITY

Total Liabilities & Equity are the money owed by the firm to
lenders and other creditors, and to the owners of stock.
The Total Assets are what this money has been invested in.
Income Statement
Sales
- Cost of Sales (OS + Purchases – CS)
= Gross Profit
- Selling, General & Administrative Expenses
= Operating Income or Operating Profit (EBIT)
- Interest payable (Finance costs)
= Earnings (Profit) Before Tax
- Taxation
= Net Income (Earnings)
- Dividend payable
= Retained Earnings (carried to Balance Sheet)
 Profitability Ratios

 Operating Return on Assets (OROA)

= Operating Income/Total Assets
 Operating Profit Margin = Operating Income/Sales
 Total Asset Turnover = Sales/Total Asset

 Return on Equity = Net Income/Common Equity

 Solvency Ratios

 Debt Ratio = Total Debt/Total Assets)

 Times Interest Earned or Interest Cover

= (Operating Income/Interest Payable)
 Liquidity Ratios
 Current Ratio
= Current Assets/Current Liabilities
 Quick or ‘Acid Test’ ratio
= [Cash + Receivables]/Current Liabilities

 Average Collection Period

= ([Receivables x 365]/Credit Sales)
 Inventory Turnover
= Cost of Sales/Inventory
 Shareholder Value Ratios
 Earnings per Share
= Earnings/Number of shares in issue)
 Price/Earnings Ratio
= Market Price/Earnings
 Price/Book Ratio
= Market Price/Book Value of Equity
Note that ratios like P/E Ratio and Price/Book Ratio can be calculated either
on ‘per share’ basis or on whole company basis – e.g. P/E ratio is the same
whether calculated as Market Value per share/Earnings per share or as
Market Value of company/Earnings of company.
 Uses of Ratio Analysis

 Assessment of credit-worthiness & debt

repayment capacity.

 Analysis, control and improvement of

efficiency and growth.
 Limitations of Ratio Analysis
 Accounting values often have little relation to real
values; analysing one firm over time, or comparing old
& new companies, needs to be done with care.
 Different accounting practices can cause distortions.
 Seasonality can distort the analysis.
 Analysts have to be on the lookout for window-dressing
in financial statements.
 Individual ratios can be misleading in isolation - e.g. a
high current ratio could be more an indication of over-
capitalisation than sound liquidity.
 Industry comparisons can be difficult because:
 The industry average is a rough figure & is not necessarily ideal
 Multi-divisional companies may not fit any particular industry
Perspectives on Financial
Statement Analysis
A firm’s financial statements can be analysed from the
perspective of different stakeholders.
 Shareholder (share value: cash flow, dividend)
 Manager (same interests as shareholders,
feedbacks on decisions + their jobs security
depend on firm performance)
 Creditors (amount of debts, short term obligation,
ability to generate cash)

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 Selecting a Benchmark

A ratio analysis becomes relevant only when compared

against a benchmark.
Financial managers can create a benchmark for
comparison in three ways:

1. Time-trend (based on historical performance)

2. Industry average (firms grouped by size, sales and
product lines, to establish benchmark ratios)
3. Peer group (3-4 firms similar in size or sales, or who
compete in same market)

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