Ratio Analysis

Accounting for Managers 21/08/04

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, Marketable Securities, Accounts Receivable and Inventory • Current Liabilities include Accounts Payable, Debt Due within one year, and Other Current Liabilities

Current Assets 1870.92 Current Ratio = = = 1.2 : 1 Current Liabilities 1555.75

Liquidity Ratios
• Quick Ratio or Acid Test
– Current Assets minus Inventory / Current Liabilities – A more precise measure of liquidity, especially if inventory is not easily converted into cash.
Current Assets - Inventory 720.53 Quik Ratio = = = 0.46 : 1 Current Liabilitie s 1555.75

Liquidity Ratios
• Cash Ratio
Cash Ratio = Cash + Marketable Securities 26.08 = = 0.17 Current Liabilities 1555.75

– Reserve borrowing capacity - the credit limit sanctioned by the bank

Liquidity Ratios
Interval Measure
•Calculated to asses a firms ability to meet its regular cash outgoings

Current Assets − Inventory Interval Measure = Average Daily operating expenses 1,870.92 − 1,150.39 = = 77 Days 3,369.94 / 360

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

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

Total Debt Ratio
– Proportion of interest bearing debt in the Capital structure. – In general, the lower the number, the better.

Total Debt 1,229.06 Debt Ratio = = = 0.646 Net Assets 1901.87

Debt-Equity Ratio
– The Debt-Equity Ratio indicates the percentage of total funds provided by creditors versus by owners. – This ratio indicates the extent to which the business relies on debt financing (creditor money versus owner’s equity).
Debt − Equity Ratio = Total Debt 1,229.06 = = 1.83 Net Worth 972.81

• Treatment of
– Preference Capital – Lease Payments

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. – Also called the Times-Interest-Earned Ratio, 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).

EBIT 342.61 Interest Coverage Ratio = = = 2.4 Interest 143.46

Interest Coverage Ratio
EBITDA 342.61 + 41.59 Interest Coverage Ratio = = = 2.7 Interest 143.46
DA = Depreciation and Amortization expenses

Fixed Coverage Ratio
– Principal repayments are added to interest payments •

Fixed Coverage Ratio =

EBITDA repayment Interest + LoanTax Rate 1-

EBITDA + Lease rentals Fixed Coverage Ratio = Pref. Interest + Lease rentals + Loan repayment+Rate Dividend 1-Tax

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

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, which is important because the more times inventory can be turned (i.e., the higher the turnover rate) in a given operating cycle, the greater the profit.
Inventory Turnover Ratio = Cost of Goods Sold 3,053.66 = = 8.6 Avg Inventory (244.26 + 7461.81) / 2 360 = 42 days Inventory Turnover

Days of Inventory Holding =

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

Accounts Receivable Turnover
– The accounts receivable turnover ratio, indicates the average length of time it takes a firm to collect credit sales (in percentage terms), i.e., how well accounts receivable are being collected. – If receivables are excessively slow in being converted to cash, liquidity could be severely impaired.
Credit Sales A R Turnover = Avg AR Sales 3,717.23 = = = 7.7 Avg AR 483.18

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

360 ACP = = 47 days AR Turnover

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

Sales 3,717.23 Net Assets Turnover = = = 1.95 times Net Assets 1901.87

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).

Gross Profit Margin
– The gross profit margin is the total margin available to cover operating expenses and yield a profit. This ratio indicates how efficiently a business is using its labor and materials in the production process, and shows the percentage of net sales remaining after subtracting cost of goods sold. – The higher the ratio, the better. A high gross profit margin indicates that a firm can make a reasonable profit on sales, as long as it keeps overhead costs under control.
GP Margin = Gross Profit 663.57 = = 0.179 or 17.9% Sales 3,717.23

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 P ro fit M a rg in E q u ity M u ltip lie r

T o ta l A s s e t T u rn o v e r

The DuPont System
ROE ROA P ro fit M a rg in E q u ity M u ltip lie r

T o ta l A s s e t T u rn o v e r

ROE = ROA × Equity Multiplier Net Income Total Assets = × Total Assets Common Equity

The DuPont System
ROE ROA P ro fit M a rg in E q u ity M u ltip lie r

T o ta l A s s e t T u rn o v e r

ROA = Profit Margin × Total Asset Turnover Net Income Sales = × Sales Total Assets

The DuPont System
ROE ROA P ro fit M a rg in E q u ity M u ltip lie r

T o ta l A s s e t T u rn o v e r

ROE = Profit Margin × Total Asset Turnover × Equity Multiplier Net Income Sales Total Assets = × × Sales Total Assets Common Equity

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