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Financing Module

Topics Covered

Financial Ratios DuPont System Using Financial ratios Measuring Company Performance The Role of Financial Ratios

all numbers stated within FedEx's income statement in figure 7. can seem daunting.Analyzing Financial Statements Financial Ratio: A) ANALYZING FINANCIAL STATEMENTS I. It requires close examination to determine whether operating expenses are increasing or decreasing. Example: FedEx Common Size Balance Sheet and Income Statement At first glance. Common-Size Balance Sheet is a balance sheet where every dollar amount has been restated to be a percentage of total assets. Common-Size Financial Statements Common-size balance sheets and income statements are used to compare the performance of different companies or a company's progress over time. Common-Size Income Statement is an income statement where every dollar amount has been restated to be a percentage of sales. .1. or which particular expense comprises the highest percentage total operating expenses.

Income Statement .

Operating profitability relates the company’s overall profitability.Classification of Financial Ratios B) Classification of Financial Ratios Ratios were developed to standardize a company’s results.e. Ratios can be classified in terms of the information they provide to the reader. Growth potential . i. Operating performance . the risk of not generating consistent cash flows over time. The ratios found in this classification can be divided into ‘operating profitability’ and ‘operating efficiency’. Financial risk is the risk that relates to the company’s financial structure. They allow analysts to quickly look through a company’s financial statements and identify trends and anomalies. Business risk relates the company’s income variance.The ratios found in this classification can be divided into ‘business risk’ and ‘financial risk’. There are four classifications of financial ratios: Internal liquidity – The ratios used in this classification were developed to analyze and determine a company’s financial ability to meet short-term liabilities. and allows creditors to estimate the company’s ability to pay .The ratios used in this classification were developed to analyze and determine how well management operates a company. i. and operating efficiency reveals if the company’s assets were utilized efficiently.The ratios used in this classification are useful to stockholders and creditors as it allows the stockholders to determine what the company is worth.e. Risk profile . use of debt.

as they may be difficult to dispose of Quick ratio = (cash+ marketable securities + accounts receivables) current liabilities 3. Cash ratio = (cash + marketable securities)/current liabilities 4. Too small a ratio indicates that there is some potential difficulty in covering obligations. A high ratio may indicate that the firm has too many assets tied up in current assets and is not making efficient use to them. Cash Ratio The cash ratio reveals how must cash and marketable securities the company has on hand to pay off its current obligations.Internal Liquidity Ratios 1. Current ratio = current assets / current liabilities 2. Inventory and other assets are excluded. Working Capital Ratio Working Capital Ratio = CA – CL / Sales . In general. Current Ratio: This ratio is a measure of the ability of a firm to meet its shortterm obligations. Only liquid assets are taken into account. a ratio of 2 to 3 is usually considered good. Quick Ratio The quick (or acid-test) ratio is a more stringent measure of liquidity.

Receivable turnover = net annual sales / average receivables Where: Average receivables = (previously reported account receivable + current account receivables)/2 6. and may be a sign that sales are perhaps overstated. Average number of days receivables outstanding = 365 days_ receivables turnover . this may indicate that the company does not offer its clients a long enough credit facility. and as a result may be losing sales. A decreasing receivable-turnover ratio may indicate that the company is having difficulties collecting cash from customers. If this ratio is too high compared to the industry. The high receivable turnover will indicate that the company collects its dues from its customers quickly.Efficiency / Turnover Ratios 5. Receivable Turnover Ratio This ratio provides an indicator of the effectiveness of a company's credit policy. Average Number of Days Receivables Outstanding (Average Collection Period) This ratio provides the same information as receivable turnover except that it indicates it as number of days.

It could also indicate inadequate production levels for meeting customer demand Inventory turnover = cost of goods sold / average inventory Where: Average inventory = (previously reported inventory + current inventory)/2 8. perhaps resulting in frequent shortages of stock and the potential of losing customers. which may mean there is less risk that the inventory reported has decreased in value. Inventory Turnover Ratio This ratio provides an indication of how efficiently the company's inventory is utilized by management. Average number of days in stock = 365 / inventory turnover 9. Payable Turnover Ratio This ratio will indicate how much credit the company uses from its suppliers.7. Average Number of Days in Stock This ratio provides the same information as inventory turnover except that it indicates it as number of days. Payable turnover = Annual purchases / average payables . Payable turnover that is too small may negatively affect a company's credit rating. A high inventory ratio is an indicator that the company sells its inventory rapidly and that the inventory does not languish. Too high a ratio could indicate a level of inventory that is too low. Note that this ratio is very useful in credit checks of firms applying for credit.

Average number of days payables outstanding = 365_____ payable turnover II. Other Internal-Liquidity Ratios 11. A high conversion cycle indicates that the company has a large amount of money invested in sales in process. Cash conversion cycle = average collection period + average number of days in stock .Where: Annual purchases = cost of goods sold + ending inventory – beginning inventory Average payables = (previously reported accounts payable + current accounts payable) / 2 10.Defensive Interval This measure is essentially a worst-case scenario that estimates how many days the company has to maintain its current operations without any additional sales.average age of payables 12.Cash Conversion Cycle This ratio will indicate how much time it takes for the company to convert collection or their investment into cash. .average age of payables Cash conversion cycle = average collection period + average number of days in stock . Average Number of Days Payables Outstanding (Average Age of Payables) This ratio provides the same information as payable turnover except that it indicates it by number of days.

As such. it indicates the efficiency of operations as well as how products are priced. Gross Profit Margin This shows the average amount of profit considering only sales and the cost of the items sold.Operating Profitability Ratios Operating Profitability can be divided into measurements of return on sales and return on investment Return on Sales 1.Defensive interval = 365 * (cash + marketable securities + accounts receivable) projected expenditures Where: Projected expenditures = projected outflow needed to operate the company 7. Gross profit margin = gross profit / net sales Gross profit = net sales – cost of goods sold . Wide variations occur from industry to industry.3 . This tells how much profit the product or service is making without overhead considerations.

Contribution Margin This ratio indicates how much each sale contributes to fixed expenditures. Per-Tax Margin (EBT margin) This ratio indicates the profitability of Company's operations. This ratio does not take into account the company's tax structure. Net Margin (Profit Margin) This ratio indicates the profitability of a company's operations. Operating profit margin = operating income/net sales 3. Net margin = net income/sales 5. Pre-tax margin = Earning before tax/sales 4.2. Operating Profit Margin This ratio indicates the profitability of current operations. Contribution margin = contribution / sales Where: Contributions = sales . This ratio does not take into account the company's capital and tax structure.variable cost .

Return on Investment Ratios 1. Return on common equity = (net income – preferred dividends) average common equity 3. Return on Total Equity (ROE) This is a more general form of ROCE and includes preferred stockholders. Return on total equity = net income/average total equity . Return on Assets (ROA) This ratio measures the operating efficacy of a company without regards to financial structure Return on assets = (net income + after-tax cost of interest) average total assets OR Return on assets = earnings before interest and taxes average total assets 2. Return on Common Equity (ROCE) This ratio measures the return accruing to common stockholders and excludes preferred stockholders.

A ratio of 3 will mean that for every dollar invested in total equity. the company will generate 3 dollars in revenues. the difference is that only fixed assets are taken into account. 3. Fixed-asset turnover = net sales / average net fixed assets Equity Turnover This ratio measures a company's ability to generate sales given its investment in total equity (common shareholders and preferred stockholders). Total asset turnover = net sales / average total assets Fixed-Asset Turnover This ratio is similar to total asset turnover. Total Asset Turnover This ratio measures a company's ability to generate sales given its investment in total assets. Capitalintensive businesses will have a lower total asset turnover than non-capitalintensive businesses. Equity turnover = net sales / average total equity 2. . A ratio of 3 will mean that for every dollar invested in total assets. the company will generate 3 dollars in revenues.Operating Efficiency Ratios 1.

Debt to equity = total debt / total equity Analysis of the Interest Coverage Ratio 3. Debt to Equity This ratio is similar to debt to capital. making the overall business riskier. A large debt-to-capital ratio indicates that equity holders are making extensive use of debt. Times interest earned = earnings before interest and tax interest expense .FINANCIAL RISK RATIOS Financial Risk – This is risk related to the company's financial structure. Debt to capital = total debt / total capital Where: Total debt = current + long-term debt Total capital = total debt + stockholders' equity 2.Debt to Total Capital This measures the proportion of debt used given the total capital structure of the company. Times Interest Earned (Interest Coverage ratio) This ratio indicates the degree of protection available to creditors by measuring the extent to which earnings available for interest covers required interest payments. Analysis of a Company's Use of Debt 1.

Dividend Payout = Dividend Declared/Net Income Let's consider an example: . Therefore. Sustainable Growth Rate G = RR * ROE Where: RR = retention rate = % of total net income reinvested in the company or. RR = 1 – (dividend declared / net income) ROE = return on equity = net income / total equity Note that dividend payout is the residual portion of RR. If RR is 80% then 80% of the net income is reinvested in the company and the remaining 20% is distributed in the form of cash dividends. Market Ratios 1.

Market Ratios Dividend Yield: It is the return on dividend on the investment. And can be calculated as follows: DPS / EPS . expressed in percentage and can be calculated as follows: Dy = D / price P/E Multiple = Price / Earning This ratio show how much will you willing to pay for a stock against a single rupee earning of a company. Payout Ratio: This show how mush you pay for dividends out of the total income.

DuPont System A system of analysis has been developed that focuses the attention on all three critical elements of the financial condition of a company: the operating management. The DuPont Formula shows the interrelationship between key financial ratios. It can be presented in several ways. we get: ROE = (net income / sales) * (sales / assets) * (assets / equity) Said differently: ROE = net profit margin * asset turnover * equity multiplier . management of assets and the capital structure. This analysis technique is called the "DuPont Formula". The first is: Return on equity (ROE) = net income / total equity If we multiply ROE by sales. we get: Return on equity = (net income / sales) * (sales / total equity) Said differently: ROE = net profit margin * return on equity The second is: Return on equity (ROE) = net income / total equity If in a second instance we multiply ROE by assets.

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