FINANCIAL MANAGEMENT

Chapter 3
Financial Analysis
Financial Ratios
Learning Objectives

1 Calculate and interpret financial ratios.

2 Compare different company performances using financial
ratios, historical financial ratio trends, and industry ratios.
 Financial Ratios
• Financial ratios are relationships between different
accounts from financial statements—usually the income
statement and the balance sheet—that serve as
performance indicators.
• Being relative values, financial ratios allow for meaningful
comparisons across time, between competitors, and with
industry averages.
Financial Ratios
Five key areas of a firm’s performance can be analyzed using financial
ratios:
1. Liquidity ratios: Can the company meet its obligations over the short
term?
2. Solvency ratios: (also known as financial leverage ratios): Can the
company meet its obligations over the long term?
3. Asset management ratios: How efficiently is the company managing
its assets to generate sales?
4. Profitability ratios: How well has the company performed overall?
5. Market value ratios: How does the market (investors) view the
company’s financial prospects?
Can also conduct a Du Pont analysis which involves a breakdown of the
return on equity into its three components, i.e. profit margin, turnover, and
leverage.
Short-Term Solvency: Liquidity Ratios

• Measure a company’s ability to cover its short-term debt

obligations in a timely manner.
• Three key liquidity ratios include: The current ratio, quick
ratio, and cash ratio.
 Short-Term Solvency: Liquidity Ratios

Current Ratio

●  It indicates the ability of a company to meet current obligations

from current assets as a going concern.
●  It is also a measure of adequate working capital.
●  A widely accepted rule of thumb is a ratio of 2 to 1.
Short-Term Solvency: Liquidity Ratios
Quick Ratio/ Acid Test Ratio

●  This ratio provides a severe test of immediate liquidity, revealing a

company’s ability to meet sudden demands upon liquid current
assets.
●  Quick assets usually include the current assets that are readily
converted into cash.
●  The rule of thumb is 1 to 1
Short-Term Solvency: Liquidity Ratios

Cash Ratio

• This ratio shows the extent to which short term liabilities

and satified with the existing cash and cash equivalents
• It reveals how much of the short term liabilities of the
business can be compensated if the business stops selling
and can not collect its receviables
• It is generally expected to be at least %20 or more
 Long-Term Solvency:
Solvency or Financial Leverage Ratios
• Measure a company’s ability to meet its long-term debt
obligations based on its overall debt level and earnings
capacity.
• Show how the assets of a company are financed and provide
information about the long-term liquidity of a company.
• Failure to meet its interest obligation could put a firm into
bankruptcy.
• There are three key financial leverage ratios: the debt ratio,
short-term dept ratio and times interest earned ratio
 Long-Term Solvency:
Solvency or Financial Leverage Ratios
Dept Ratio(Leverage Ratio)

•It shows the percentage of assets that is financed by creditors, and

thus is an indication of the level of financial leverage used by the
company.
•When these ratios are high, a company is expected to have
difficulties in debt service requirements in the future.
•It is generally expected to be at most %50 or less
 Long-Term Solvency:
Solvency or Financial Leverage Ratios
Short-term Dept Ratio

Short –term dept ratio

•It shows the percentage of assets that is financed by short term

liabilities
•It is generally expected to be around %30
• When the rate increases, the business can get into financial
difficulties very quickly since the short-term liability turnover is
very fast.
 Long-Term Solvency:
Solvency or Financial Leverage Ratios

Times Interest Earned

•It shows how well the interest expense is covered by the

earnings.
• A higher ratio indicates that a company generates enough
revenues from operations to cover its ınterest expenses
 Asset Management Ratios

• Measure how efficiently a firm is using its assets to generate

revenues or how much cash is being tied up in other assets
such as receivables and inventory.
• The three key asset management ratios;
Account Receviable Turnover
Inventory Turnover
Total Asset Turnover
 Asset Management Ratios
Accounts Receviable Turnover

Accounts Receviable Turnover

Collection Period

●  The accounts receivable turnover gives an indication of the

collection efficiency.
●  The shorter the period to collect credit sales and without
losses, the more liquid a firm will be.
 Asset Management Ratios
Inventory Turnover

Inventory Turnover

Days in Inventory

●  This measure indicates the speed of the sale of inventory, and thus it
will signal possible under- or over- stocking.
● The higher the inventory turnover, the more goods are sold during a
period.
 Asset Management Ratios

Total Asset Turnover

Total Asset Turnover

●  This measures the efficiency of all assets owned by the business

 Profitability Ratios

Profitability ratios consist of net profit margin, returns on

assets, and return on equity and measure a firm’s
effectiveness in turning sales or assets into profits.
 Profitability Ratios
Net Profit Margin

Net Profit Margin

• Net profit margin measure a firm’s effectiveness in turning

sales into profit
 Profitability Ratios
Return on Assets

Return on Assets (ROA)

● This ratio measures the profitability of total resources available

to the business.
• This ratio measures the business’ effectiveness in turning
assets into profit
 Profitability Ratios

Return on Equity

Return on Equity (ROE)

● It provides an indication of how well managers are employing

the invested funds in business to generate returns.
• This ratio measures the business’ effectiveness in turning
investments of owners into profit
 Market Value Ratios
Used to gauge how attractive or reasonable a firm’s current
price is relative to its earnings and book value.

Earnings per Share

 Market Value Ratios

• Potential investors and analysts often use these ratios as

part of their valuation analysis.
• Typically, if a firm has a high price to earnings and a high
market to book value ratio, it is an indication that investors
have a good perception about the firm’s performance.
• However, if these ratios are very high, it could also mean
that a firm is over-valued.
 DuPont Analysis
Involves breaking down ROE into three components of the firm:
1. operating efficiency, as measured by the profit margin (net income
÷ sales);
2. asset management efficiency, as measured by asset turnover
(sales ÷ total assets); and
3. financial leverage, as measured by the equity multiplier (total
assets ÷ total equity).
The following equation shows that if we multiply a firm’s net profit margin
by its total asset turnover ratio and its equity multiplier, we will get its
return on equity.
 DuPont Analysis

Cogswell has better operational efficiency, i.e. it is better able to move sales
dollars into income, but Spritzer is more efficient at utilizing its assets, and since
it uses more debt, it is able to get more of its earnings to its shareholders.
Although these 14 ratios are not the only ones that can be used to assess a
firm’s performance, they are the most popular ones.
It is important to look at the overall picture of the firm in all five areas and
accordingly reach conclusions or make recommendations for changes.
Problem
Compute and analyze financial ratios.
Using the following 2017 income statement and balance
sheet of Trimark Products Inc.,compute its financial ratios.
How is the firm doing relative to its industry in the areas of
liquidity, asset management, leverage, and profitability?
Problem
Tri-mark Products Incorporated
Income statement for the year ended 31st Dec. 2017 ('000s)
Revenue $950,500
Cost of goods sold $730,000
Gross profit $220,500
Operating expenses
Selling, general and administrative expenses $85,000
R&D $5,200
Depreciation $50,000
Operating income $80,300
Other income $1,350
EBIT $81,650
Interest expense $3,540
Taxable income $78,110
Taxes $27,339
Net income $50,772
Shares outstanding $16,740
EPS $3.03
Tri-mark Products Inc. Balance Sheet as at year ended 31st December
2017(‘000s)

Current Assets Blank Blank Current Liabilities Blank

Cash $6,336 Blank Accounts payable $57,000

Accts. rec. $43,000 Blank Short-term debt $1,500

Inventory $42,000 Total current liabilities. Blank $58,500
42

Other current $12,000 Blank Long-term debt $74,000

Total current Assets $103,336 Blank Other liabilities $15,000
L- T Inv. $25,340 Total liabilities Blank $147,500
PP&E $225,000 Blank Owner’s equity Blank
Other assets $44,000 Common stock Blank $189,676
Retained earnings Blank $60,500
Blank Blank Total OE Blank $250,176
Total assets $397,676 Total liab. and OE Blank $397,676
Problem
Ratio Industry Average
Current ratio 2.200
Quick ratio (or acid test ratio) 1.500
Cash ratio 0.135

Debt ratio 0.430

Cash coverage 10.600
Day’s sales in receivables 12.000
Total asset turnover 2.800
Inventory turnover 30.100
Day’s sales in inventory 11.500
Receivables turnover 30.000
Profit margin 0.045
Return on assets 0.126
Return on equity 0.221
Problem
Blank Trimark Industry Average

Current ratio 1.766 2.200

Quick ratio (or acid ratio test) 1.048 1.500
Cash ratio 0.108 0.135
Debt ratio 0.371 0.430
Cash coverage 37.189 10.600
Day’s sales in receivables 16.512 12.000
Total asset turnover 2.390 2.800
Inventory turnover 17.381 30.100
Day’s sales in inventory 20.999 11.500
Receivables turnover 22.105 30.000
Profit margin 0.053 0.045
Return on assets 0.128 0.126
Return on equity 0.203 0.221
Problem
Analysis:
Liquidity: Trimark’s liquidity ratios are below the industry average
indicating that they might need to look into their management of
current assets and liabilities.
Leverage: Trimark’s debt ratio is much lower than the industry average
and indicating that if it needs to borrow long-term debt it should not
have much of a problem.
Asset management: Trimark’s asset turnover ratios are all below the
average. It needs to tighten up collections, and manage its inventory
more efficiently.
Profitability: Trimark has a good control on cost of goods sold. Its net
profit margin is better than the industry and so is its ROA. The industry,
however, is returning a higher rate to the shareholders on average,
primarily due to the higher debt levels.
Problem
DuPont Analysis.
Based on the ratios calculated above, and in conjunction
with the industry averages given, conduct a DuPont analysis
on Trimark’s key profitability ratios.
Problem
Blank Trimark Industry
Debt ratio 0.371 0.430
Total asset turnover 2.390 2.800
Profit margin 0.053 0.045
Return on assets 0.128 0.126
Return on equity 0.203 0.221
Equity multiplier 1.59 1.75

Despite a lower total asset turnover ratio, Trimark’s ROA

(12.8%) is better than that of the industry (12.6%), primarily
due to its higher net profit margin. The industry, however, has
a higher ROE (22.1%) due to its higher debt ratio and
correspondingly higher equity multiplier.
 Questions
Compute the day in inventory for 2017.

a. 64,4 b. 6. c. 60,8 d. 24 e. 67,2

Compute the current ratio for 2017.

a. 1 b. 0,80 c. 3,00 d. 3,75 e. 0,21

Compute the profit margin for 2017.

a. 60,9%. b. 37,9% c. 18,1% d. 17,1% e. 56,6%