CHAPTER THREE

FINANCIAL ANALYSES AND PLANNING

1
 Financial Analysis
• As a manager, you may want to know the answers for
the following questions.
• How to finance a company?

• As an investor, how do you predict how well the securities

of one firm will perform relative to that of another?
• How can you tell whether one security is riskier than
another?
• As a lender, how do decide the borrower will be able to
pay back as promised?

• All of these questions can be addressed through

financial analysis. 2
 FINANCIAL ANALYSES
• Financial analysis is the selection, evaluation, and
interpretation of financial data, along with other
pertinent information, to assist in investment and
financial decision-making.
• Financial analysis depends on the basic financial
statements to diagnose financial performance.
• The analysis of these statements combined with the
preparation and analysis of related financial
statements is called financial statement analysis.
• If properly analysed and interpreted, FSs can provide
valuable insights into a firm’s performance.
 The need for Financial Analysis
• Financial analysis is not an end in itself but is performed for
the purpose of providing information that is useful in
making the right decisions.
• Thus, financial statement analysis serves the following
purposes:
1. Measuring the profitability
• The main objective of a business is to earn a satisfactory return on
the funds invested in it.
– Financial analysis helps in ascertaining whether adequate
profits are being earned on the capital invested in the
business or not.
– It also helps in knowing the capacity to pay the interest and
dividend.
2. Indicating the trend of Achievements
• Financial statements of the previous years can be compared and
the trend regarding various expenses, purchases, sales, gross
profits and net profit etc. can be ascertained. Value of assets and
liabilities can be compared and the future prospects of the
business can be predicted. 4
3. Assessing the growth potential of the
business
• The trend and other analysis of the business provide
sufficient information indicating the growth
potential of the business.

4. Comparative position in relation to other

firms
• The purpose of financial statements analysis is to help
the management to make a comparative study of the
profitability of various firms engaged in similar
businesses. Such comparison also helps the
management to study the position of their firm in
respect of sales, expenses, profitability and utilising
capital, etc.
5
5. Assess overall financial strength
• The purpose of financial analysis is to assess the
financial strength of the business. Analysis also
helps in taking decisions, whether funds required
for the purchase of new machines and equipments
are provided from internal sources of the business
or not if yes, how much? And also, to assess how
much funds have been received from external
sources.

6. Assess solvency of the firm

• The different tools of an analysis tell us whether the
firm has sufficient funds to meet its short term and
long term liabilities or not.

6
 Source of Financial data
• Financial data can be obtained from many sources.
– The primary source is the data provided by the
company itself in its annual report and required
disclosures.
– The annual report includes the income statement,
the balance sheet, and the statement of cash
flows, as well as footnotes to these statements.
– Certain businesses are required by law to
disclose additional information.

7
• Besides information that companies are
required to disclose through financial
statements, other information is readily
available for financial analysis.
• Like, information such as the market prices
of securities of publicly-traded corporations
can be found in the financial press and the
electronic media daily.
• Similarly, information on stock price indices
for industries and for the market as a whole
are available in the financial press.
8
• Another source of information is economic data,
such as the Gross Domestic Product and
Consumer Price Index, which may be useful in
assessing the recent performance or future
prospects of a firm or industry.

9
 Financial Analysis
• Financial Statement analysis involves:
a comparison of the firm's performance with certain
standards or benchmark
An evaluation of trends in the firm’s position over
time.
•  Generally financial analysis can be made using
the following techniques:
– Horizontal Analysis
– Vertical Analysis (Common-size analysis)
– Trend Analysis
– Ratio Analysis and Index Analysis
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 1. Horizontal Analysis

Using comparative financial

statements to calculate dollar
or percentage changes in a
financial statement item from
one period to the next

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 Horizontal Analysis

Comparing an item in a current

statement with the same item
in prior statements is called
horizontal analysis.

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 Horizontal Analysis Example

• The management of XYZ Company provides you

with comparative balance sheets of the years ended
December 31, 2012 and 2011.

• Management asks you to prepare a horizontal

analysis on the information.

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 XYZ CORPORATION
Comparative Balance Sheets
December 31, 2012 and 2011

Inc
2012 2011 A
Assets
Current assets:
Cash $ 12,000 $ 23,500
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
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Total assets $ 315,000 $ 289,700
 Horizontal Analysis Example

Calculating Change in Dollar Amounts

Dollar Current Year Base Year

Change = Figure – Figure

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 Horizontal Analysis Example

Calculating Change in Dollar Amounts

Dollar Current Year Base Year

Change = Figure – Figure

Since we are measuring the amount of the

change between 2011 and 2012, the dollar
amounts for 2011 become the “base” year
figures.
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 Dollar and Percentage Changes

Dollar Change:
Dollar Analysis Period Base Period
Change = Amount – Amount

Percentage Change:
Percent Base Period
Change = Dollar Change
÷ Amount

17
 Horizontal Analysis Example
XYZ CORPORATION
Comparative Balance Sheets
December 31, 2012 and 2011
Increase (Decrease)
2012 2011 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets $12,000 – $23,500 = $(11,500)
155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
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 Horizontal Analysis Example
XYZ CORPORATION
Comparative Balance Sheets
December 31, 2012 and 2011
Increase (Decrease)
2012 2011 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
Total current assets 155,000 164,700 (9,700) (5.9)
Property and equipment:
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment 160,000 125,000 35,000 28.0
Total assets $ 315,000 $ 289,700 $ 25,300 8.7
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 Horizontal Analysis Example

Now, let’s apply the

procedures to the
income statement.

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 XYZ CORPORATION
Comparative Income Statements
For the Years Ended December 31, 2012 and 2011
Increase (Decrease)
1999 1998 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

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 XYZ CORPORATION
Comparative Income Statements
For the Years Ended December 31, 2012 and 2011
Increase (Decrease)
2012 2011 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

Sales increased by 8.3% while net income decreased by

21.9%.
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 There were increases in both cost of goods sold (14.3%) and operating
expenses (2.1%). These increased costs more than offset the increase
in sales, yielding an overall decrease in net income.

XYZ CORPORATION
Comparative Income Statements
For the Years Ended December 31, 2012 and 2011
Increase (Decrease)
2012 2011 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

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 2. Vertical Analysis
For a single financial
statement, each item
is expressed as a
percentage of a significant
total,
e.g., all income statement
items are expressed as a
percentage of sales

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 Vertical Analysis
• Vertical analysis of a financial statement shows
the relationship of each item to its base amount.
• In performing vertical analysis for the balance
sheet, total assets is assigned 100 percent.
• Each asset account is expressed as a percentage
of total assets.

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 Vertical Analysis Example

• The management of ABC Company asks you

to prepare a vertical analysis for the
comparative balance sheets of the company.

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 Vertical Analysis Example
ABC Company
Balance Sheet (Assets)
At December 31, 2012 and 2011
% of Total Assets
2012 2011 2012 2011
Cash $ 82,000 $ 30,000 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
Inventory 87,000 82,000 18% 21%
Land 101,000 90,000 21% 23%
Equipment 110,000 100,000 23% 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total $ 483,000 $ 387,000 100% 100%
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 Vertical Analysis Example
ABC Company
Balance Sheet (Assets)
At December 31,2012 and 2011
% of Total Assets
2012 2011 2012 2011
Cash $ 82,000 $ 30,000 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
Inventory 87,000 82,000 18% 21%
Land$82,000 ÷ $483,000
101,000 = 17%90,000
rounded 21% 23%
$30,000 ÷ $387,000
Equipment 110,000 = 8% rounded 23%
100,000 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total $ 483,000 $ 387,000 100% 100%
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 3. Trend Percentages

Show changes over time in

given financial statement items
(can help evaluate financial information of
several years)

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 Trend Analysis
 The change in financial statement items from
a base year to following years are often
expressed as trend percentages to show the
extent and direction of change.
 Two steps are necessary to compute trend
percentages.
1) Select base year and assign a weight of
100% for each item in the base year
2) Express each item following years as a
percentage of its base year amount.

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 Trend Percentages Example
• MEDROC Company provides you with the
following operating data and asks that you
prepare a trend analysis.
MEDROC Company
Operating Data
2012 2011 2010 2009 2008
Revenues $ 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820
Expenses 2,033 1,966 1,870 1,803 1,701
Net income $ 372 $ 278 $ 242 $ 188 $ 119

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 Trend Percentages Example
MEDROC Company provides you with the following
operating data and asks that you prepare a trend
analysis.
MEDROC Company
Operating Data
2012 2011 2010 2009 2008
Revenues $ 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820
Expenses 2,033 1,966 1,870 1,803 1,701
Net income $ 372 $ 278 $ 242 $ 188 $ 119

$1,991 - $1,820 = $171

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 Trend Percentages Example
Using 2008 as the base year, we develop the
following percentage relationships.
MEDROC Company
Operating Data
2012 2011 2010 2009 2008
Revenues 132% 123% 116% 109% 100%
Expenses 120% 116% 110% 106% 100%
Net income 313% 234% 203% 158% 100%

$1,991 - $1,820 = $171

$171 ÷ $1,820 = 9% rounded
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 Trend line
for Sales

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 Ratio Analysis

• A ratio is an arithmetical relationship between

two figures (logical relationships between items
in a financial statement)
• Ratios can be used to compare:
Past performance to present performance.
Other companies to your company.
To compare results with a target
To compare against industry averages

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 Cont…
• Financial ratio have been classified in several
ways.
• For our purpose, we divide them in to five broad
categories as follows:

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 Ratio Analysis
Liquidity ratios
Leverage ratios
Turnover ratios
Profitability ratios
Valuation ratios

a. Liquidity ratios: liquidity refers to the

ability of a firm to meet its obligations in the short-
run.
• Indicate a company’s short-term debt-paying ability
• Liquidity ratios are generally based on the r/p b/n
current assets and current liabilities.
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 Liquidity ratios
• Assets that may be converted into cash in a short
period of time are referred to as liquid assets; they
are listed in financial statements as current assets.
• Current assets are often referred to as working
capital, since they represent the resources needed
for the day-to- day operations of the firm's.
• Current assets are used to satisfy short- term
obligations, or current liabilities.
• The amount by which current assets exceed current
liabilities is referred to as the net working capital.
• There are three commonly used liquidity ratios:
Current ratio, Acid-test ratio, and Cash ratio.
38
 Liquidity ratios
1.Current ratio = CA/CL
• The current ratio is the ratio of current assets to
current liabilities; Indicates a firm's ability to
satisfy its current liabilities with its current assets.
• The current ratio measures the ability of the firm to
meet its current liabilities.
• The higher the CR, the greater the short-term
solvency.
• A high current ratio indicates that the business has
sufficient current assets to maintain normal business
operations.
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 Liquidity ratios
• A ratio of below one – meaning that current
liabilities exceed current assets – could imply
danger of insolvency.
• What is an acceptable current ratio?
• The answer depends on the industry/country.
• The norm for companies in most industries is
around 1.50, as reported by the Risk
Management Association (USA).
• The general norm for current ratio internationally
is 2. (in India, it is 1.33)
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 Liquidity ratios
• Keep in mind that we would not want to see a
current ratio that is too high, say 25.
• This would indicate that the company is too
liquid and, therefore, is not using its assets
effectively.

10/10/2022 41
 Liquidity ratios
2.Acid-test ratio or quick ratio = quick assets/CL
• Quick assets are defined as Current Assets excluding
inventories.
• The acid-test ratio is a fairly stringent measure of liquidity.
• It is based on those CAs which are highly liquid.
3.Cash ratio= cash & bank bal + Current
Inves./CLs
• Since cash & bank balances and short-term marketable
securities are the most liquid assets of a firm, financial
analysis look at cash ratio.
• Clearly, the cash ratio is perhaps the most stringent
measure of liquidity.
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 Leverage ratios
• A firm can finance its assets either with
equity or debt.
• Financing through debt involves risk
because debt legally obligates the firm to
pay interest and to repay the principal
as promised.
• Equity financing does not obligate the
firm to pay anything -- dividends are
paid at the discretion of the board of
directors.
• But how a firm chooses to finance its
operations mix of debt and equity
• Financial leverage ratios are used to
assess how much financial risk the firm
has taken on. 43
 Leverage ratios
Two types of ratios are commonly used to analyse
financial leverage:

i. Structural ratios and

ii. Coverage ratios

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 Leverage ratios
i. Structural ratios are based on the proportions
of debt and equity in the financial structure of
the firm. These are:
a) Debt-equity ratio and
b) debt-asset ratio.
ii. Coverage ratios show the r/p b/n debt servicing
commitments and the sources for meeting these
burdens.
c) Interest coverage ratio/Times Interest Earned Ratio/
d) Fixed charges coverage ratio, and
e) Debt service coverage ratio.
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 Leverage ratios
Debt-equity ratio = debt/equity
• The debt equity ratio shows the relative
contributions of creditors and owners.
• The numerator of the ratio consists of all debt,
short-term as well al long term.
• The denominator consists of net worth plus
preference capital plus deferred tax liability.
• In general, the lower the debt-equity ratio, the
higher the degree of protection enjoyed by the
creditors.
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 Leverage ratios
Debt-Asset Ratio = Debt/Assets
• The debt-asset ratio (DAR) measures the extent
to which borrowed funds support the firm’s
assets.
• The numerator of this ratio includes all debt,
short-term as well as long-term.
• The denominator of this ratio is the total of all
assets.
• This indicate the firm has financed % of asset with debt.

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 Long - term debt to assets ratio = Long - term debt
Total assets

 The long-term debt to assets ratio indicates the proportion

of the firm's assets that are financed with long-term debt.

48
 Turnover Ratio
• Turnover ratios, also referred to as activity ratios or
asset management ratios, measure how efficiently
the assets are employed by a firm.
• This ratio indicate how well the firm manages it’s
assets.
• Turnover ratios are based on the r/p b/n the level of
activity, represented by sales or COGS, and levels of
various assets.
• The important TOR are:
 Inventory turnover,
 Average collection period,
 Receivable turnover
 Fixed asset turnover & total assets turnover
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 Turnover Ratio
• Inventory turnover: measures how fast the
inventory is moving through the firm and generating
sales. It is defined as:
• = COGS/Average Inventory
• The inventory turnover reflects the efficiency of
inventory management.
• The higher the ratio, the more efficient the
management of inventories and vice versa.
• However, this may not always true.
• A high inventory turnover may be caused by a low
level of inventory which may result in frequent
stock outs and loss of sales and customer goodwill.
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 Turnover Ratio
Average Collection Period (ACP) : shows how long it
takes for A/R to be cleared(collected).
 It measures the average number of days it takes for a
firm to collect its accounts receivable.
ACP = Account Receivable x 360
Sales

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 Turnover Ratio
• The ACP may be compared with the firm’s credit
terms to judge the efficiency of credit management.
• Fore example, if the credit terms are 2/10, net 45, an
ACP of 85 days means that the collection is slow and
an ACP of 40 days means that the collection is
prompt.
• An ACP which is shorter than the credit period
allowed by the firm needs to be interpreted carefully.
• It may mean efficiency of credit mgt or excessive
conservatism in credit granting that may result in
the loss of some desirable sales.
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 Turnover Ratio
Fixed asset Turnover: This ratio indicates the
ability of the firm's management to put the fixed
assets to work to generate sales:
= Net Sales/ Ave. net fixed assets
• is supposed to measure the efficiency with which
fixed assets are employed.
• A high ratio indicates a high degree of
efficiency in asset utilisation and
• A low ratio reflects inefficient use of assets.
• However, in interpreting this ratio, one caution
should be borne in mind.
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 Turnover Ratio
• When FAs of a firm are sold & substantially
depreciated, the FAs TOR tend to be high because
the denominator of the ratio is very low.
Total assets Turnover: Akin to the output-capital
ratio in economic analysis, it is defined as:
= Net Sales/ Ave. total assets
• This ratio measures how efficiently assets are
employed, overall.

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 Profitability Ratio
• Profitability reflects the final result of business
operations.
• There are two types of profitability ratios:
1. Profit margins ratios and
2. Rate of return ratios
• Profit margin ratios show the r/p b/n profit &
sales.
• Since profit can be measured at different stages,
there are several measures of profit margin.
• The most popular profit margin ratios are: gross
profit margin ratio and net profit margin ratio.
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Net sales…………………………………………XX
Less: Cost of Good Sold…………………XX
Gross Profit…………………………………..XXX
Less: Operating Expense………………..XX
Net Income…………………………..........XXX
Less: Tax…………………………………….….XX
Net Profit after tax………………………..XXX
 Profitability Ratio
• Rate of return ratios reflect the r/p b/n profit and
investment.
• The important rate of return measures are:
1. Return on assets,
2. Earning power,
3. Return on capital employed, and
4. Return on equity
• Gross Profit Margin ratio = GP/NS
• GP is defined as the d/ce b/n NS and COGS.
• Shows the margin left after meeting
manufacturing costs /purchase costs/.
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 Profitability Ratio
• It measure the efficiency of the production process
and pricing policy of the firm.
• Net Profit margin ratio = NP/NS
• Shows the earnings left for shareholders (both equity
and preference) as a percentage of sales.
• What percent of every birr sale was converted by the firm in to net income
• It measures the overall efficiency of production,
administration, selling, financing, pricing, and tax
management.
• Jointly considered, the GPM & NPM ratios provide a
valuable understanding of the cost and profit structure
of the firm & enable the analyst to identify the sources
of business efficiency/inefficiency.
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 Profitability Ratio
• Return on Assets: is defined as:
• ROA = profit after tax / Ave. total assets
• This ratio measures the over all effectiveness of
management in generating profit with its
available profit.
• How profitability of the firm has used its asset.
• Earning Power: is defined as
• = PBIT / Ave. total assets
• Is a measure of business performance which is
not affected by interest charges and tax
burden.
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 Profitability Ratio
• It abstracts away the effect of capital structure and
tax factor and focuses on operating performance.
• Hence it is eminently suited for inter-firm
comparison.
• Further, it is internally consistent.
• The numerator represents a measure of pre-tax
earnings belonging to all sources of finance and the
denominator represents total financing.
• Return on capital employed: is defined as:
• ROCE = PBIT (1-Tax Rate) / Ave. total assets
• It considers the effect of taxation, but not the capital
structure.
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 Profitability Ratio
• The numerator of this ratio viz. PBIT (1-Tax
Rate) is also called net operating profit after tax.
• ROCE is the post-tax version of earning power.
• It considers the effect of taxation, but not the
capital structure.
• It is internally consistent.
• Its merits is that it is defined in such a way that it
can be compared directly with the post-tax
WACC of the firm.
• It does not take into account the impact of interest
on taxes.
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 Profitability Ratio
• Return on Equity: is defined as:
• = Equity Earnings / Ave. Equity Net income/total equity

• Measures the return earned on the owners(both

preferred and common shareholders) invested in the
firm. It shows what rate of return was earned on the
book value of owner equity.
• This ratio is also called the return on net worth.
• It measures the profitability of equity funds invested
in the firm.
• It is regarded as a very important measure b/c it
reflects the productivity of the ownership (or risk)
capital employed in the firm.
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 Profitability Ratio
• It is influenced by several factors:
earning power,
debt-equity ratio,
average cost of debt funds, and
tax rate.
• In judging all the profitability measures it should
be borne in mind that the historical valuation of
assets imparts an upward bias to profitability
measure during an inflationary period.
• This happens b/c the numerator of these measures
represents current values, whereas the
denominator represents historical values.
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 Profitability Ratio
• Earnings Per Share (EPS)
• Represents the amount of Birr earned on behalf
of each outstanding share of common stock.
• EPS is closely watched by the investing public.
• EPS = Earnings available for Common SHs
No. of shares of Common stock outstanding
• Earnings available for common stockholders =
Profit After Tax –Preferred Dividend

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 Valuation Ratios
• Valuation ratios indicate how the equity stock of
the company is assessed in the capital market.
• Since the market value of equity reflects the
combined influence of risk and return,
valuation ratios are the most comprehensive
measures of a firm’s performance.
• The important valuation ratios are:
1. Price-earnings ratio,
2. Yield, and
3. Market value to book value ratio
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 Valuation Ratios
• Price-earnings Ratio: perhaps it is the most
popular financial statistic in stock market
discussion. It is defined as:
PER = Mkt price per share / Earnings per share
• The P/E ratio represents the amount investors are
willing to pay for each birr of the firm's earnings
• The market price per share may be the price
prevailing on a certain day or the average price
over a period of time.
• The earnings per share is simply: profit after tax
less preference dividend divided by the number of
outstanding equity shares.
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 Valuation Ratios
• The price-earnings ratio (or the price-earnings
multiple as it is commonly referred) is a summary
measure which primarily reflects the following
factors:
i. Growth prospects,
ii. Risk characteristics,
iii. Shareholder orientation,
iv. Corporate image, and
v. Degree of liquidity
• Yield: a measure of the rate of return earned by SHs.
It is defined as:
• = [dividend + price change] / Initial price
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 Valuation Ratios
• This may be split into two parts:
• [Dividend/Initial price]+[Price change/Initial Price]

• Dividend Yield Capital gain

Yield
• Generally, companies with low growth prospects
offer a high dividend yield and a low capital gains
yield.
• On the other hand, companies with superior
growth prospects offer low dividend yield and a
high capital gain yield.
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 Valuation Ratios
• Market value to Book value Ratio: defined as
• = Mkt Value per share / Book value per share
• Reflects the contribution of a firm to the wealth
of society.
• When this ratio exceeds 1 it means that the firm has
contributed to the creation of wealth in the society.
• If the ratio is, say 2, the firm has created a wealth of
one birr for every birr invested in it.
• When this ratio is equal to 1, it implies that the
firm has neither contributed to nor detracted
from the wealth of society.
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 Valuation Ratios
• It may be emphasised here that if the market
value to book value is equal to 1, all the three
ratios, namely:
Return on equity,
Earnings-per share ratio (which is the
inverse of the price-earnings ratio), and
Total yield ratio
are equal.

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 So what……
• For judging whether the ratios are high or low,
one has to make a comparative analysis such as:
1. A cross-section analysis (in which the industry
average may be used as a benchmarks) or
2. Time series analysis (in which the ratios of the
firm are compared over time).
• Note that the industry averages often provide
useful benchmarks for comparisons.
• Sometimes the ratios of few competitor firms
may be used as benchmarks.
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