financial ratio analysis chap 2_2

8/8/2019 Financial Ratio Analysis Chap 2_2

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Financial RatioFinancial Ratio

AnalysisAnalysis

Brief Revision/ OverviewBrief Revision/ Overview

of Financial Statementsof Financial Statements

Liquidity RatiosLiquidity RatiosLeverage RatiosLeverage Ratios

Efficiency RatiosEfficiency Ratios

Profitability RatiosProfitability RatiosEquity RatiosEquity Ratios


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Brief Revision/ Overviewof Financial Statements

Useful to the Firms Managers inManaging the Firm

Provide Information to Present &Potential Creditors, Lenders,Investors & Other InterestedParties

End Result of the process ofrecording, classifying &Summarizing firms transactions.


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Balance Sheet

A Statement of Firms Financial Position ata Specific Point in time

Income Statement

A Statement Summarizing theFirms Revenues & Expenses OverAn Accounting Period, generally a

Quarter or a Year.


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Balance Sheet & Income Statements are impFinancial Statements however they do not provideanswers to Qs Such as

Does the Firm have too much inventory on hand ? Is the firm too Debt heavy ?

Is the firm well managed ?

To seek answers the financial Mgr or Analystcombines & transforms selective B/S & I/S items to

calculate ratios & Compare them to similar ratiosfor the industry & for other firms in the Industry

Facilitates Evaluation of Financial Statements


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Financial Ratios

Liquidity RatiosLiquidity Ratios

Leverage RatiosLeverage Ratios

Efficiency RatiosEfficiency Ratios

Profitability RatiosProfitability Ratios

Equity RatiosEquity Ratios


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Liquidity Ratios

Measures the Ability of the Firmto Meet its Short term Financial

Obligations

Show The Relationship of a Firms

Cash & Other Current Assets toits Current Liabilities


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Current RatioBest Indicator of the extent to which the

claims of short term creditors (currentliabilities) are covered by assets expected tobe converted to cash in near future.

Well managed firms are above Industry

Average while good firms are below it. If a firms ratios are far removed from the Avg.

of its Industry , an analyst should beconcerned about why this variance occurs.

A deviation from Industry Avg. should signal

the analyst (or management) to check further.


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Quick Ratio

The ratio is same as Current Ratioexcept that it excludes inventories,presumably the least liquid portion

of current assets.Measures the firms ability to pay off

short term obligations without

relaying on sale of its inventoriesThe ratio provides a more

penetrating measure of liquiditythan does the current ratio.


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Debt Financing/ FinancialLeverage

Three Implications By Raising Funds through Debt,

Stockholders can maintain control of thefirm without increasing their investment.

Creditors look to the Equity, or OwnSupplied Fund, to provide a Margin ofSafety, so the higher the proportion of totalcapital provided by stockholders, the lessthe Risk faced by creditors

Firm earns more on Inv Financed withborrowed funds than it pays in interest, thereturn on the owners capital is magnifiedor leveraged


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Leverage Ratios

Accomplishes Two Goals Measure Of The Extent to Which Firms Finance

their Assets through Debt

Indicators of Financial Risk of the Firm

Leverage as a Debt Financing Indicator is Imp b/cWhenever a Firms Rate of Return is in Access ofInterest Rate, the Profits to Equity Inv areMagnified in Direct Proportions to Increases inLeverage.


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Leverage Ratios

On the Contrary, Whenever a FirmsRate of Return falls below InterestRate, the Profits to Inv Decline with

increases in Leverage. If the Firm is sufficiently levered,

interest expense may be so high thatunder advance economic conditions

the firm may not be capable of payingthem i.e. financial risk is directlyproportional to leverage.


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Leverage Ratios

Firms with relatively high debt ratios havehigher expected returns when the economy isnormal, but they are exposed to risk of losswhen the economy goes in to a recession.

Therefore, decisions about the use of debtrequire firms to balance higher expectedreturns against increased risk.

Ratios varies according to the nature ofbusiness & the volatility of cash flows.


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Leverage Ratios

Total Debt to Total Asset Ratio

Times Interest Earned

Funded Capital to Net WorkingCapital


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Total Debt to Total AssetRatio

Also Known as Debt RatioDebt Ratio = Total Liab/Total

Assets

Creditors Prefer Low Debt Ratiosb/c lower the ratio, the greater thecushion against creditors losses inthe event of Liquidation

On the Contrary, Stockholders maywant more Leverage coz itmagnifies expected earnings.


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Total Debt to Total AssetRatio

A debt Ratio of 53.2 % reflects thatcreditors have supplied for more thanhalf of the total financing

For Companies having such high debt

ratios, it is imp that they should raisemore equity capital before borrowingadditional funds.

Creditors may be reluctant to lend

money to such firms & Mgmt would besubjecting the firm to the risk ofbankruptcy if it increased the Debt Ratioby Borrowing Additional Funds


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EBIT/Interest Charges

Ratio measures the extent towhich the firm is capable ofservicing its interest expense fromfunds available from Operations.

Ratio measures the extent to

which the Income can declinebefore the firm is unable to meetits annual interest costs.


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As a Rule, a value of at least 3.0 &Preferably closer to 5 is suggested.

Suppose Firms EBIT is $ 418000 &Interest Expenses amount to $ 93,000,

then the Ratio comes to around 4.5If the firms EBIT Shrinks by 78%,the

firm would still be able to pay interest itowns.

Thus it is a good margin of safety.


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Funded Debtto Net Working Capital

Funded Debt is defined as Debtwith a Maturity of more than 1

Year that includes Bonds,

Debentures, Term Loans &Mortgages.

Net Working Capital is defined as

the difference between CurrentAssets & Current Liabilities


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Efficiency Ratios

Indicator of managerial capabilities ineffectively utilizing the firms asset

Capture firms managerial efforts in

managing Inventories of Raw & FinishedGoods, its Production Process, Its Credit &Asset Management Policies & theEffectiveness of its Marketing & SalesForce

Useful in in Judging the performance ofthe firm


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Efficiency Ratios

Avg Collection Period

Avg Payment Period

Inventory TurnoverTotal Assets Turnover

Net Working Capital Turnover


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Average Collection Period

Also Known as Days Sales OutstandingUseful in Evaluating credit & collection

Policies.

ACP = A/R/Avg Sales Per Day

Sales Per Day = Annual Sales/ 365Meaningful in relation to firms credit

terms

However, for accurate Analysis u needto know the credit terms extended toCustomers


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Average Payment Period

Useful in Evaluating Payment Policies.

APP = A/P/Avg Purchases Per Day

Purchases Per Day = Annual Purchases/

365Meaningful in relation to Credit terms

extended to the Firm.

The Difficulty in calculating this Ratio

stems from the need to find annualPurchases.


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Average Payment PeriodThis Value is generally not available in

the Financial StatementsOrdinarily Purchases are estimated as

given %age of CoGS.

However, for accurate Analysis u need to

know the credit terms extended to theFirm.

Prospective Lenders & Suppliers of TradeCredit are specially interested in APP,since it provides them sense of bill payingpatterns of the firm.


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Inventory Turnover

Measures the Activity, or Liquidityof a firms inventory.

Sales/Inventories

CoGS/Avg. InvExcess Inv is unproductive, b/c it

represents investment with a zerorate of return

For Seasonal Industries (like SugarInd) it is better to use Avg InvFormula.


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Total Asset TurnoverTotal Asset Turnover

Indicates the Efficiency with which thefirm uses all its assets to generate sales.

Sales/ Total Assets

Generally higher the ratio, the moreefficiently its assets have been used.

This measure is of greatest interest to theManagement, since it indicates whether ornot the firms Operations have been

financially efficient.


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Fixed Asset TurnoverFixed Asset Turnover

Indicates the Efficiency withwhich the firm uses all its fixedassets to generate sales.

Sales/ Net Fixed AssetsGenerally higher ratio is

preferred, since they reflect

greater efficiency of fixed AssetUtilization.


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Net Working CapitalTurnover

Net Sales / Net Working CapitalNet Working Capital is the difference

between current Assets & CurrentLiabilities = CA - CL

An intuitive interpretation is that NetWorking Capital could be viewed as thefirms conscious commitment in currentassets to generate sales.

This Ratio is a direct measure of firmsproductivity in generating sales


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Profitability Ratios

Measure of the profitability of the firm

Key Ratios that are strong Measure of firmsoverall performance

Shows the combined effects of Liquidity, Asset

Management & Debt on Operating Results2 Types

Showing Profitability in Relation to Sales

Showing Profitability in Relation to Investment


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Profitability Ratios

Profit Margin

Return on Total Assets

Return on Net Worth.

Return on Net Working Capital.


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Profit Margin

Gross Profit Margin

Oprating Profit Margin

Net Profit Margin


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Gross Profit Margin

Measures the %age of each sales$ remaining after the firm haspaid for its goods

Sales CoGS/Sales = GrossProfit/Sales

The higher the ratio, the better& lower the relative cost ofmerchandise sold.


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Operating Profit Margin

Measures Pure Profits earned oneach sales Dollar.

They Are Pure in the sense that

they ignore any financial or GovtCharges & measures only theprofits earned on operations.

= Operating Profit/SalesThe higher ratio is preferred.


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Net Profit Margin

Measures the %age of each sales$ remaining after all theexpenses, including taxes have

been deducted.= Net Profit (after taxes)/Sales

The higher the ratio, the better.

Commonly Citied Measure offirms success with respect toearnings on sales.


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Return on Total Assets

Reflects the Earning Productivity ofTotal Assets.

= Net Profits/ Total Assets

Return on Net Worth

Is the Measure of the Returns to theFirms Stockholders.

= Net Profits/Net Worth


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Return on Net WorkingCapital

Viewed as the Firms DirectEfforts in Generating Sales andthe ratio of return on net working

capital identifies the profitabilityof managerial decisions regardinginvestment on current assets.

= Net Profits/Net Working Capital


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Equity Ratios

Primary Interest to the Firms StockHolders

It Includes

Price to Earnings RatioDividend Payout

Dividend Yield

Book Value Per Share


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Price to Earning Ratio

Commonly Known as P/E Ratio.

= Price/Earning

Is an overall measure of theDesirability of the Firm

The more attractive the firm is tothe Investor, the higher the P/ERatio.


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Dividend Payout Ratio

Is the Ratio of Dividends per Shareto Earnings per Share or totaldividends to Net Income.

= Dividend/ShareEarnings/Share

%age of Earning Paid out as

Dividends.


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Different Stakeholders haveSpecific Interests

Trade CreditorsTrade Creditors -- Primarily Interested inPrimarily Interested inLiquidity of Firm. As their claims are shortLiquidity of Firm. As their claims are shortterm so they go for Liquidity Ratiosterm so they go for Liquidity Ratios

Bondholders -Bondholders - HaveHave Long-term claims claims interested in analyzing cash flow ability,interested in analyzing cash flow ability,

capital structure, sources & uses of funds &capital structure, sources & uses of funds &profitability over time, projections of futureprofitability over time, projections of futureprofitability Leverage Ratios/ Equity Ratiosprofitability Leverage Ratios/ Equity Ratios& Profitability Ratios& Profitability Ratios

Investors Investors Concerned Principally withConcerned Principally with

Present & Expected Future Earnings &Present & Expected Future Earnings &stability of these earnings Profitabilitystability of these earnings ProfitabilityRatiosRatios


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Different Stakeholders haveSpecific Interests

Management Interested in allaspects of financial analysis although concerned with all

ratios but specifically withProfitability & Efficiency Ratios

financial ratio analysis chap 2_2

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