3RD SESSION
Ratio Analysis
• “Ratio is the mathematical relationship of one
number to another number”.
• Most important benefit
– Facilitation of unbiased comparison
5 main categories of
Financial Statement
ratios
Liquidity
ratios
Asset
Management
Ratio
Debt
utilization
ratio
Profitability
ratio
Market value
ratio
Example
2014
2013
Cash (in hand & in bank)
30,000
20,000
A/R
150,000
100,000
Inv.
200,000
150,000
Prepaid expenses
20,000
15,000
A/P
125,000
100,000
Accrued expenses
25,000
20,000
Fixed assets
600,000
400,000
Sales
1500,000
-
Gross profit
40% of sales
-
1. Liquidity Ratios
• ‘Liquidity ratios give us an idea about firm’s ability to
pay off debts that are maturing within an year’.
• Liquidity ratio measures how capable a firm is in
meeting its short term debt obligations in full and on
time.
• Most commonly used liquidity ratios:
– Current ratio
– Quick ratio or Acid test ratio
– Cash ratio or Super Quick or Super Acid test ratio
i.
Current Ratio
• Formula (CA/CL)
• Ideal
• ‘It indicates the extent to which current liabilities are
covered by those assets expected to be converted to
cash in near future’.
As for large discrepancies
Lower ratio than industry
average:
Higher ratio than industry average:
- Creditor less protected than
other firms in industry
- Greater inventory level
- Strong, safe liquidity position
- Trouble moving things
ii. Quick Ratio
• Formula (CA-inv/CL)
• Ideal
• ‘It measures firm’s ability to pay off STO without
relying on sales of inventories’.
iii. Cash Ratio
• Formula (Cash and cash equiv./CL)
• Ideal
• ‘It measures amount of cash, cash equivalent or
short term investment that a firm has to cover
current liabilities’.
iv. Cash conversion cycle *
• Number of days from outlay of cash for purchasing R/M to
receiving payment from customers
v. Working Capital * (CA – CL)
• WC is a measure of cash and liquid assets available to fund a
company’s day to day operations.
2. Asset Management Ratios
• ‘Asset management ratios measure how effectively a
firm is managing its assets’.
• Most commonly used AMR:
– Inventory turnover ratio (times/days)
– Receivable turnover ratio (times/days)
– Accounts Payable turnover (times/days)
– Fixed asset turnover
– Total asset turnover
i.
Inventory turnover ratio
• Formulas: (COGS/avg. inv.) (365/inv. turnover)
• Inventory turnover times measures how many times
in an year the firm’s inventory has been sold.
– What if inventory turnover ratio is low or high?
• Inventory turnover days measure how many days the
inventory stays with us before we are able to sell it.
ii. Receivable turnover ratio
• Formulas: (Sales/avg. rec.) (365/rec. turnover)
• Receivable turnover times measures how many
times in an year the business can turn it’s A/R into
cash’.
– What if A/R turnover ratio is low or high?
• High turnover: conservative credit policy, aggressive collect. dept.
• Low turnover: loose credit policy, inefficient collect. dept.
• Receivable turnover days/DSO/RP/CP measure how
many days the firm must wait after making a sale to
receive cash.
4TH SESSION
iii. Accounts Payable turnover
• Formulas: (Purchases/avg. A/P) (365/pay. turnover)
• ‘Accounts payable times measure how many times
per period the co. pays its avg. payable amount’.
• Accounts payable in days measure number of days
the company takes to pay its suppliers.
– What if A/P (no. of days) increase or decrease?
• Increasing number of days
• Decreasing number of days
iv. Fixed Assets Turnover
• Formula: (Sales/fixed assets)
• ‘The ratio measures the extent to which firm uses
existing plant and equipment to generate sales’.
• How many sales generated from $1 of fixed assets, a
ratio of 2.5 means by utilizing $1 of fixed assets the
firm has generated $2.5 of sales.
v. Total Assets Turnover
• Formula: (Sales/total assets)
• ‘The ratio measures the extent to which firm uses its
total resources to generate sales’.
• How many sales generated from $1 of total assets, a
ratio of 1.5 means by utilizing $1 of total assets the
firm has generated $1.5 of sales.
3. Debt Management Ratios
• Also known as ‘Financial Leverage Management
Ratios’.
• Leverage
• FLMR measure the extent to which firm uses
financial leverage and is of interest to both creditors
and owners alike.
• Debt management ratios under discussion:
– Debt ratio
– Times interest earned ratio
– EBITDA coverage ratio
i.
Debt Ratio
(Total Debt to Total Assets Ratio)
• Formula: (Total Debt/Total assets)
• ‘It measures portion of firm’s total assets that is
financed through creditors funds”.
• Total debt here means: Current liabilities + long term liabilities
• Debt ratio is a ratio carrying huge importance for
creditors.
• High debt ratio rings a warning bell for the creditors.
Question
• From the following data you are required to calculate
Debt Ratio and Times Interest Earned.
• EBIT ……………………………………………….. Rs. 300,000
• 10% bonds payable ………………………… Rs. 500,000
• Ordinary share capital Rs. 10 each…… Rs. 800,000
• Reserves and surplus………………………..Rs. 200,000
• Current liabilities……………………………….Rs. 250,000
ii. Times Interest Earned
• Formula: (EBIT/Interest)
• ‘The ratio between EBIT and Interest measures firm’s
ability to meet its annual interest payments’.
• Also known as ‘Interest coverage ratio’.
• ICR measures the number of times a company can
make interest payments on its debt with its EBIT.
• For e.g. an Interest coverage ratio of 2 means
company has enough profitability to bear twice the
amount of its current financial cost.
Question
• From the following data you are required to calculate
Debt Ratio and Times Interest Earned.
• EBIT ……………………………………………….. Rs. 300,000
• 10% bonds payable ………………………… Rs. 500,000
• Ordinary share capital Rs. 10 each…… Rs. 800,000
• Reserves and surplus………………………..Rs. 200,000
• Current liabilities……………………………….Rs. 250,000
iii. EBITDA Coverage Ratio
• Formula:
• (EBIT+D+A+Lease payment/Interest+Principal payment+Lease payment)
• ‘A ratio whose numerator includes all CFs available to meet
fixed financial charges and whose denominator includes all
fixed financial charges’.
• TIE had 2 basic flaws:
– Interest is not the only fixed financial cost
– EBIT does not represent all the cash available to service esp. if firm has high
non-cash expenditures like Depreciation and amortization
• EBITDA coverage ratio covers these flaws.
iii. EBITDA Coverage Ratio
• Limitation:
– In the numerator we want to know how much funds do we
have to pay interest, principal and lease payments.
However, while arriving at EBIT we already subtracted
lease payments. We thus add back lease payments to the
numerator to cover the limitation of the formula.
• Sinking fund provision:
– If the company has a sinking fund provision we’ll add that
in denominator otherwise we’ll assume it as 0.
• EBITDA is calculated using the
company’s income statement.
• The formula for EBITDA is:
EBITDA = EBIT + Depreciation + Amortization
• To calculate EBITDA, we find the line
items for EBIT ($750,000), depreciation
($50,000) and amortization (n/a) and
then use the formula above:
• EBITDA = 750,000 + 50,000 + 0 = $800,000
Practice Question
• Willis Publishing has $30 billion in total assets.
The company’s TIE ratio is 8.0. It’s EBIT is $6
billion. Willis depreciation and amortization
expense total $3.2 billion. It has to make $2
billion in lease payments and $1 billion must
go towards principal payments on outstanding
loan and long-term debt. What is Willis
EBITDA coverage ratio?