FINANCIAL RATIO ANALYSIS FOR
NON-FINANCIAL MANAGERS
DR. KHALED FOUAD SHERIF
SECTOR MANAGER
EASTERN EUROPE & CENTRAL
ASIA DEPARTMENT
THE WORLD BANK
WASHINGTON DC
Web: http:\\www.ksherif.com
WORLD BANK
FINANCIAL RATIO ANALYSIS FOR
NON-FINANCIAL MANAGERS
Introduction to Balance Sheets and Income Statements:
The balance sheet summarizes the financial position of
an organization at a given moment, it is a snapshot of
the firm. The balance sheet reflects the status of the
organization’s assets, (the economic resources owned
by the organization), liabilities (debts owned to
creditors), and equity (the owner’s investment in the
organization).
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FINANCIAL RATIO ANALYSIS FOR
NON-FINANCIAL MANAGERS
As its name implies the balance sheet should
indicate that these elements are in balance.
Assets = Liabilities + Equity
This fundamental relationship must always exist,
because the assets represent the things owned by
the organization and the liabilities and equity
indicate how much was supplied by both creditors
and owners.
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FINANCIAL RATIO ANALYSIS FOR
NON-FINANCIAL MANAGERS
In contrast to the balance sheet, the income
statement shows the organization's financial
progress over a given period of time. The income
statement is also based on equation:
Revenues - Expenses = Profit (or Loss)
WORLD BANK
FINANCIAL RATIO ANALYSIS FOR
NON-FINANCIAL MANAGERS
Revenues are the resources, primarily cash, coming into the organization
as a result of goods sold or services rendered. Expenses are the
resources used by the organization to provide goods or services. If
revenues are greater than expenses, the business has realized a profit.
If expenses exceed revenue the business has realized a loss from
operations. As you read the following detailed descriptions of balance
sheets and income statements, keep in mind that there is a direct and
important relationship between the two. The profit (or loss) realized by a
business over a period of time affects the amount of equity. Equity in a
business comes from two sources: Direct investment by the owners and
profits from business operations. Therefore, the bridge between the
income statement and the balance sheet is in the relationship between
equity and profit or loss.
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FINANCIAL RATIO ANALYSIS FOR
NON-FINANCIAL MANAGERS
Income Statements:
Exhibit 1 shows a sample income statement (see next page)
for a period covering January 1 to December 31, 1989. The
company in question earned revenues from two sources:

Net sales: All sources earned by the company from the
sale of its products and services.

Other income: Generally resources from sources as
interest on bank accounts, cash dividends from
investments in other companies, and interest on bonds.
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FINANCIAL RATIO ANALYSIS FOR
NON-FINANCIAL MANAGERS
The following expenses are subtracted from
revenues:

Cost of goods sold: all the expenses
incurred in making the products sold
during the period, including the cost of
materials, labor, and factory overhead
(rent, utilities and maintenance).
WORLD BANK
EXHIBIT 1
SAMPLE INCOME STATEMENT
Company X
For year ending December 31, 1989
(In LE)
Revenues
Net Sales
Other Income
Total Revenues
3,787,248
42,579
Expenses
Cost of Goods Sold
Administrative & Selling Expenses
Interest Expenses
Total Expenses
2,796,459
637,509
47,516
3,829,827
3,503,545
Earnings Before Income Taxes
326,282
Income Taxes
152,039
Net Earnings
174,243
WORLD BANK
FINANCIAL RATIO ANALYSIS FOR
NON-FINANCIAL MANAGERS
 Administrative
and selling expenses: The
costs of running and promoting the business,
including items like the president’s salary, the
salaries of all management personnel,
advertising costs and sales commissions.
 Interest expenses: The interest that the
company paid during the year on money that
it borrowed.
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FINANCIAL RATIO ANALYSIS FOR
NON-FINANCIAL MANAGERS
 Other
Expenses: This would include any
other unusual expenses incurred by the
company to run the business not otherwise
accounted for above (e.g. research and
development expenses, and organizational
costs).
WORLD BANK
FINANCIAL RATIO ANALYSIS FOR
NON-FINANCIAL MANAGERS
Expenses are subtracted from revenues to yield a
figure that indicates the company’s earnings, but
this figure still does not reflect the company’s
profit. During 1989 the company paid over 46
percent of its earnings to the tax department in
the form of taxes. Thus, its net earnings, or the
amount of profit the company earned in 1989, is
LE 174, 243.
WORLD BANK
FINANCIAL RATIO ANALYSIS FOR
NON-FINANCIAL MANAGERS
Balance sheets
Exhibit 2 is the balance sheet for Company X as of
December 31, 1989. The first component is assets,
current and fixed. Current assets, are those the
business expects to turn into cash during the next
year. The cash generated from current assets is
used to pay expenses and repay liabilities. Current
assets include:
WORLD BANK
FINANCIAL RATIO ANALYSIS FOR
NON-FINANCIAL MANAGERS





Cash.
Marketable securities: Temporary investments (generally 90 days)
of excess or idle cash; listed at cost, or market value since they are
converted into cash within one year.
Accounts Receivable: Money owned to the company by debtors,
generally for the purchase of goods and services.
Inventories: The value of products that have been completed and
are in storage waiting to be sold (finished goods), products that
have been partially completed (work in process), and raw materials.
Prepaid Expenses: The value of items that the company has paid
for in advance, such as insurance premiums.
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FINANCIAL RATIO ANALYSIS FOR
NON-FINANCIAL MANAGERS

Fixed assets are things of value that will provide benefits to
the company for one or more years. Fixed assets are
reported in three categories: land, buildings, machinery and
equipment. Fixed assets are reported on the balance sheet at
the cost to purchase or acquire the asset minus the
depreciation accumulated on the assets since the time of
purchase. Depreciation is the estimated decline in the useful
value of an asset due to gradual wear and tear. Since this
decline in value cannot be estimated with certainly,
accountants use various standards methods to approximate it.
WORLD BANK
SAMPLE BALANCE SHEET
Company X
December 31, 1989
Assets
Current Assets:
Cash
Marketable securities
Accounts receivable
Inventory
Prepaid Expenses
Total Current Assets
Fixed Assets:
Land
Buildings
Machinery & Equipment
Less allowances for depreciation
Total Fixed Assets
Total Assets
WORLD BANK
59,770
87,466
559,144
618,120
49,986
1,374,486
25,807
716,076
1,010,770
800,103
952,550
2,327,036
Liabilities:
Current Liabilities
Notes Payable
Trade accounts payable
Payrolls & other accurables
Income taxes
Total Current Liabilities
Long-Term Liabilities
Total Liabilties
48,563
207,887
411,362
124,684
792,496
431,350
1,223,846
Shareholders’ Equity
1,103,190
Total Liabilties & Equity
2,327,036
FINANCIAL RATIO ANALYSIS FOR
NON-FINANCIAL MANAGERS
The second major section in a balance sheet is
devoted to liabilities. Current liabilities are the
debts that a company must pay off within the
coming year:

Notes payable: Money owned to banks or
other lending institutions; generally shortterm loans (up to one year) used to finance
short-term needs.
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FINANCIAL RATIO ANALYSIS FOR
NON-FINANCIAL MANAGERS

Accounts payable: Money owed to vendors for the
purchase of goods and services.

Payrolls and other accurables: Money owed to people for
institutions that have performed services, including
salaries owed to employees, salaries owed to employees
on vacation, attorney fees, insurance premiums, and
pension funds.

Income taxes: Money owed to the Tax Department; may
sometimes be deferred and paid later but must always be
paid.
WORLD BANK
FINANCIAL RATIO ANALYSIS FOR
NON-FINANCIAL MANAGERS
Long-term liabilities are obligations, usually
loans, that are due to be paid not in the current
year but in some future period. The amount
specified in the balance sheet is equal to the
total amount borrowed.
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FINANCIAL RATIO ANALYSIS FOR
NON-FINANCIAL MANAGERS
The final major section, the equity section
summarizes the owners‘ investment in the
business. Individuals and institutions become
owners of a company by purchasing shares of
the company’s stock. Equity increases as more
people purchase stock and the company retains
increased profit.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
Each type of analysis of financial data has a
purpose or use that determines the different
relationships emphasized. Therefore, it is
useful to classify ratios into four fundamental
types:

Liquidity ratios, measure the firm’s ability to
meet its maturing short-term obligations.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 Leverage
ratios, measure the extent to which
the firm has been financed by debt.
 Activity ratios, measure how effectively the
firm is using its resources.
 Profitability ratios, measure managements
overall effectiveness as shown by the returns
generated on sales and investment.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS

Liquidity Ratios
Generally, the first concern of the financial analyst is
liquidity. they measures the short-run solvency of a
company its ability to meet current debts.
 Current
Ratio
The current ratio indicates whether there are
enough current assets to meet current liabilities.
Current ratio = Current assets
Current liabilities
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
Current assets normally include: Cash, marketable
securities, accounts receivable, and inventories.
Current liabilities consist of: accounts payable, shortterm notes, payable, current maturities of long-term
debt, accrued income taxes, and other accrued
expenses (principally wages).
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
When is the company solvent? When the current ratio
is 1.0 or greater; that is, the company should have
more current assets than current liabilities.
Method for Calculating the Current Ratio:
Add cash, marketable securities, accounts receivable,
and inventories to get current assets.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 Add
notes payable, trade accounts payable,
payrolls and other accurables and income
taxes to get current liabilities.
 Divide
the derived current assets figure by the
calculated current liabilities figure.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 You
have now derived the current ratio. Now,
compare the value derived to 1.0. If the
current ratio is 1.0 or greater, the company
should have more current assets than current
liabilities and is financially viable or solvent. If
the current ratio is less than 1.0, the company
will have more current liabilities than current
assets and is financially unviable or insolvent.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 For
significance this ratio should be
compared to previous years (e.g. the current
ratio for five previous years should be
derived). This is necessary in order to derive
a trend. If the current ratio is rising n an
upward fashion, the company is becoming
more financially viable. If the current ratio is
falling and assuming a downward trend, the
company is becoming less financially viable.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 One
helpful activity is to also compare the
current ratio of the company in question to the
current ratio of similar competing companies.
If the company in question has a higher
current ratio on a regular basis over a number
of years than this company is more financially
viable. On the other hand, if the company in
question has a lower current ratio on a
regular basis over a number of years than
this company is less financially viable.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
b - Quick Ratio, or Acid Test
The quick ratio is calculated by deducting inventory
from current assets, and dividing the remainder by
current liabilities. Inventories are deducted since they
are typically the least liquid of a firm’s current assets.
Quick ratio = Current assets - Inventory
Current Liabilities
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
When is the company solvent? When the Quick
ratio is 1.0 or greater.
Which liquidity ratio is more accurate, the
current ratio or the quick ratio? The quick ratio,
since it excludes inventory, the least liquid
asset, and the asset on which losses are most
likely to occur in the event of liquidation.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
Method for Calculating the Quick Ratio:
 Add cash, marketable securities and
accounts receivable (items 16, 17, & 18 on
the sample balance sheet on page 6) to get
quick assets (quick assets by definition is
current assets - inventory).
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 Add
notes payable, trade accounts payable,
payrolls and other accurables and income
taxes (items 31, 32, 33 & 34 on the sample
balance sheet on page 6) to get current
liabilities.
 Divide
the derived quick assets figure by the
calculated current liabilities figure.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 You
have now derived the quick ratio. Now,
compare the value derived to 1.0. If the quick
ratio is 1.0 or greater, the company should
have more quick assets than current liabilities
and is financially viable or solvent. If the
quick ratio is less than 1.0, the company will
have more current liabilities than quick assets
and is financially unviable or insolvent.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 For
significance this ratio should be
compared to previous years (e.g. the quick
ratio for five previous years should be
derived). This is necessary in order to derive
a trend. If the quick ratios is rising in an
upward fashion, the company is becoming
more financially viable. If the quick ratio is
falling and assuming a downward trend, the
company is becoming less financially viable.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 One
helpful activity is to also compare the
quick ratio of the company in question to the
quick ratio of similar competing companies. If
the company in question has a higher quick
ratio on a regular basis over a number of
years then this company is more financially
viable.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 Leverage
Ratios
Leverage ratios measure the funds supplied
by owners as compared with the financing
provided by the firm’s creditors.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
Implications of leverage ratios:
Equity, or owner-supplied funds, provide a
margin of safety for creditors. Thus, the less
equity, the more the risks of the enterprise to
the creditors.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 Debt
funding enables the owners to maintain
control of the firm with a limited investment.
 If the firm earns more on the borrowed funds
than it pays in interest, the return to the
owners is magnified.
 If the firm earns more on the borrowed funds
than it pays in interest, the return to the
owners is magnified.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
Low leverage ratios: Indicate less risk of loss
when the economy is in a downturn, but lower
expected returns when the economy booms.
High leverage ratios: indicate the risk of large
losses, but also have a chance of gaining high
profits.
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ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
Therefore, decisions about the use of leverage
must balance higher expected returns against
increased risk.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
Approaches to examining leverage ratios:
 Debt
ratio:
The debt ratio is the ratio of total debt to total
assets and measures the percentage of total
funds provided by creditors.
The debt ratio is: Total debts
Total assets
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
Method for Calculating the Debt Ratio:
 Add notes payable to long-term liabilities to
get total debts.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 Add
cash, marketable securities, accounts
receivable, inventories, prepaid expenses,
land, buildings, machinery and equipment
and subtract depreciation to derive the total
assets figure.
 Divide
the total debts figure by the calculated
total assets figure.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 For
significance this ratio should be compared to
previous year (e.g. the debt ratio for five previous
years should be derived). This is necessary in order
to derive a trend. If the debt ratio is rising in an
upward fashion, the company is developing a
leverage problem. If the debt ratio is falling and
assuming a downward trend, the company is
investing more of its own resources to generate
assets and is becoming less dependent on debts.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 One
helpful activity is to also compare the debt ratio
of the company in question to the debt ratio of similar
competing companies. If the company in question
has a higher debt ratio on a regular basis over a
number of years, then this company is over leveraged
in comparison to its competitors. On the other hand,
if the company in question has a lower debt ratio on a
regular basis over a number of years, then this is less
dependent on debt as a source of financing in
comparison to its competitors.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
B - Debt-to-Equity- Ratio:
This ratio is a variation of the debt ratio that is
commonly used. It compares the amount of money
borrowed from creditors to the amount of shareholder’s
investment made within a firm.
Debt-to-Equity ratio =
Total Debts
Shareholder’s investment (equity)
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
Method for Calculating the Debt-to-Equity Ratio:
 Add notes payable to long-term liabilities to
get total debts.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 Look
up the shareholder’s investment or
equity line item in the blance sheet.
 Divide
the total debts figure by the calculated
shareholders’ investment figure.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 For
significance this ratio should be compared to
previous years (e.g. the debt to equity ratio for five
previous years should be derived). This is necessary
in order to derive a trend. If the debt to equity ratio is
rising in an upward fashion, the company is
developing a leverage problem. If the debt ito equity
ratio is falling and assuming a doward trend, the
company is investing more of its owners resources to
generate assets and is becoming less dependent on
creditors.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS

One other helpful activity is to also compare the debt to
equity ratio of the company in question to the debt equity
ratio of similar competing companies. If the company in
question has a higher debt to equity ratio on a regular
basis over a number of years, then this company is over
leveraged in comparison to its competitors. On the other
hand, if the company in question has lower debt to equity
ratio on a regular basis over a number of years, then this
company is less dependent on debt as a source of
financing in comparison to its competitors.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
Profitability ratios
Profitability ratios indicate how successful a
company really is and how effective
management is in operating the business.
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ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
A - Return on assets
This ratio shows how much money the company
earned on each dollar it invested in assets. It is a
measure of overall company earning power or
profitability.
Return on Assets (ROA) = Net Earnings
Total Assets
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
Method for Calculating the Return on Assets Ratio:
 Derive
the net earnings, or net profit figure from the
income statement. Net earnings is simply total
revenues minus total expenses.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 Add
cash, marketable securities, accounts
receivable, inventories, prepaid expenses,
land, buildings, machinery and equipment
and subtract depreciation to derive the total
assets figure.
 Divide
the net earnings figure by the derived
total assets figure to get return on assets.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 For
significance this ratio should be compared to
previous years (e.g. the return on assets ratio for five
previous years should be derived). This is necessary
in order to derive a trend. If the return on assets ratio
is rising in an upward fashion, the company is making
a larger return on funds invested in assets. If the
return on assets ratio is falling and assuming a
downward trend, the company is making a lower
return on funds invested in assets.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 One
other helpful activity is to also compare the return
on assets ratio of the company in question to the
return on assets of similar competing companies. If
the company in question has a higher ROA on a
regular basis over a number of years, then this
company is financially better off in comparison to its
competitors. On the other hand, if the company in
question has a lower ROA on a regular basis over a
number of years, then this company is financially
worse off in comparison to its competitors.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
B - Profit Margin:
 The
profit margin is a ratio that shows the
relationship between net earnings and net
sales and indicates how much profit the
company is earning on each dollar in sales.
Profit Margin = Net Earnings
Net Sales
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
Method for calculating the profit margin ratio:
 Derive
the net earnings, or net profit figure
from the income statement. Net earnings is
simply total revenues minus total expenses.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 Derive
the net sales line item from the income
statement.
 Divided
the net earnings figure by the derived
net sales figure to get the profit margin.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 For
significance this ratio should be compared to
previous years (e.g. the profit margin ratio for five
previous years should be derived). This is
necessary in order to derive a trend. If the profit
margin ratio is rising in an upward fashion, the
company is making a larger return on sales. If the
profit margin is falling and assuming a downward
trend, the company is making a lower return on
sales.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 One
other helpful activity is to also compare the profit
margin of the company in question to the profit margin
of similar competing companies. If the company in
question has a higher profit margin on a regular basis
over a number of years, then this company is making
a larger return on sales in comparison to its
competitors. On the other hand, if the company in
question has a lower profit margin on a regular basis
over a number of years, then this company is making
a lower return on sales in comparison to its
competitors.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
C - Return on equity (or return on net worth)
This ratio indicates the amount of net earnings resulting
from investments in equity. Shareholders are
particularly interested in this ratio, because it shows
them how much they are earning on their investments.
Return on equity =
Net Earnings
Shareholders’ investment (Equity)
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
Method for calculating the return on equity ratio:
 Derive
the net earnings, or net profit figure
from the income statement. Net earnings is
simply total revenues minus total expenses.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 Lookup
the shareholder’s investment or
equity line item in the balance sheet.
 Divide
the net earnings figure by the derived
shareholder’s investment figure to get return
on equity.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 For
significance this ratio should be compared to
previous years (e.g. the return on equity ratio for five
previous years should be derived). This is necessary
in order to derive a trend. If the return on equity ratio
is rising in an upward fashion, the company is making
a larger return on funds invested by shareholders. If
the return on equity is falling and assuming a
downward trend, the company is making a lower
return on funds invested by shareholders.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS

One other helpful activity is to also compare the return on
equity of the company in question to the return on equity
of similar competing companies. If the company in
question has a higher return on equity on a regular basis
over a number of years, then this company is making a
larger return on shareholder’s investment in comparison
to its competitors. On the other hand, if the company in
question has a lower return on equity on a regular basis
over a number of years, then this company is making a
lower return on shareholder’s investment in comparison to
its competitors.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
Activity ratios
 Activity
ratios measures how effectively the
firm employs its resources. These ratios
involve comparisons between the level of
sales and the investment in various asset
accounts, like inventories and accounts
receivable.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
A - Inventory turnover
 Inventory
turnover tells us how many times
during the year the entire stock of inventory
was sold.
 Inventory
turnover is calculated as follows:
Inventory turnover = Sales
Inventory
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
Method for calculating the inventory turnover ratio:
 Derive the net sales line item from the income
statement.
 Derive
the inventory valuation figure from the
balance sheet.
 Divide
the sales figure by the derived inventory
figure to get the inventory turnover.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
Problems in arising in calculating and analyzing this ratio:

Sales are at market prices. If inventories are carried at
cost, as they generally are, it is more appropriate to use
cost of goods sold in place of sales in the numerator of
the formula.

Sales occur over the entire year, whereas the inventory
figure is for one point in time. This makes it better to
use an average inventory, computed by adding
beginning and ending inventories and dividing by 2.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
B - Average collection period:
 The average collection period indicates how
quickly the company collects its accounts
receivable.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
It is computed in the following way:

Annual sales (derived from the income
statement) are divided by 365 to get average
daily sales.

Accounts receivable (derived from the
balance sheet) are divided over daily sales to
find the number of days’ sales is tied up in
receivables.
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 The
average collection period represents the average
length of time the firm must wait to receive cash after
making a sale and is mathematically defined as
follows:
Average collection period = Accounts receivables
Sales/365 days
WORLD BANK
ANALYSIS OF BALANCE SHEETS
AND INCOME STATEMENTS
 Evaluation
of this ratio is based upon the
terms on which the firm sells its goods. For
example, if the collection period over the past
few years for a given company is lengthy
while its credit policy did not change, this
would be evidence that steps should be taken
to expedite the collection of accounts
receivable.
WORLD BANK
SUMMARY OF FINANCIAL RATIOS
Ratio
Liquidity
Current
Quick
Leverage
Debt
Debt-Equity
Profitability
Return on
Assets
Formula
Example for
Calculation
Industry
Average
Evaluation
Current Assets
Current Liabilities
Quick Assets
Current Liabilities
700,000 = 2.3
300,000
400,000 = 1.3
300,000
2.5
Satisfactory
1 time
Good
Total Debt
Total Assets
Total Equity
Total Assets
100,000 = 50%
200,000
1,000,000 = 50%
2,000,000
33%
Poor
33%
Poor
Net Earnings
Total Assets
120,000 = 6%
2,000,000
10%
Poor
WORLD BANK
SUMMARY OF FINANCIAL RATIOS
(CONT’D)
Ratio
Formula
Example for
Calculation
Industry
Average
Evaluation
ProfitMargin
Return
on Equity
Net Earnings
Net Sales
Net Earnings
Shareholder’s Inv.
120,000 = 4%
3,000,000
120,000 = 12%
3,000,000
5%
Fair
15%
Fair
Sales
Inventory
Accounts Receivables
Sales/365 days
3,000,000 = 10
300,000
times
2,00,000 = 24
8,333
Days
9 times
Satisfactory
20 Days
Satisfactory
Activity
Inventory
Turnover
Average
Collection
Period
WORLD BANK
FINANCIAL RATIOS
I. Ratios Indicating Current position or Relating to Analysis of Short-Term Solvency
Ratio
Formula
Significance
A. Tests of overall solvency
1.
Current ratio or working
capital ratio
WORLD BANK
Current Assets (Net)
Current Liabilities
Primary tests of liquidity
indicating ability to meet
current obligations from
current assets as a going
concern. Measure of
adequacy of working capital.
FINANCIAL RATIOS
2.
Acid-Test ratio or
quick ratio
WORLD BANK
Quick Assets (Net)
Current Liabilities
A more severe test of
immediate liquidity than
the current ratio. Test of
ability to meet sudden
demands from current
assets.
FINANCIAL RATIOS
3.
Working captial to Currents Assets-Current Liabilites Indicates relative
total assets
Total Assets (Net)
liquidity of total assets
and working capital
position; and distributes
of resources employed.
WORLD BANK
FINANCIAL RATIOS
B. Ratios indicating movement of current assets (turnover)
4. - Receivable turnover
WORLD BANK
Net Credit Sale
Average Receivable (Net)
Velocity of collection of
trade accounts and notes.
Test of efficiency of
collection
FINANCIAL RATIOS
- Number of days
receivables
WORLD BANK
365 (days)
Receivable turnover
(computed as above)
Velocity of collection of
trade accounts and notes.
Test of efficiency of
collection.
FINANCIAL RATIOS
5. Inventory turnover
a. merchancise turnover
WORLD BANK
Indicates liquidity of
inventory and will exhibit
tendency to over-stock.
Cost of Goods Sold
Average Mdse. Inventory
Number of times average
stock moved during the
year.
FINANCIAL RATIOS
Ratio
b. Finished goods turnover
(Manufcturing firm)
WORLD BANK
Formula
Cost of Goods Sold
Ave. Finished Goods Invty.
Significnce
As as (a).
FINANCIAL RATIOS
c.
Raw Material turnover
WORLD BANK
Cost of Raw Materials Used
Ave. Raw Material Inventory
Number of times raw
material inventory was
“used” on the average
during the period.
FINANCIAL RATIOS
d. Days supply in Inventory
WORLD BANK
365 (6 days)
Inventory turnover
(computed per (a),
(b) or (c).
Average number of days
supply in the ending
invenory over or
undestocking as the case
maybe.
FINANCIAL RATIOS
6.
Average Age of
Payables
WORLD BANK
Average Account Payable x 365 Indicates the aging of
Annual Purchase
accounts payable. this
figures can be compared
to the credit terms
extended by the
suppliers of the company
to see if any abusees of
these terms are being
made. Trends analysis
of the ratios may also be
significant.
FINANCIAL RATIOS
7.
Working capital
turnover
WORLD BANK
Net Sales
Working Capital
Indicates adequacy of
working capital and cash
cycle of firm.
FINANCIAL RATIOS
II. Ratios indicating asset relations and capital set-up or relating to analysis of long-term
solvency
A. Equities related to profits and sales
1. Sales to owners’ equity
WORLD BANK
Net Sales
Owners’ Equity
Numberof times net worth
is “turned over” in sales
Indicative of the utilization
of owner’s capital may
reflect over-capitalization
in relation to volume of
business done.
FINANCIAL RATIOS
3.
Earning rate of
market value per
share
WORLD BANK
Net Income per share
Market Value per share
Earnings rate based on
cost of share of stock in
the market. Indicates
profitability related to
market value of
stockholder’s equity.
FINANCIAL RATIOS
4.
Times Bond
Interest Earned
WORLD BANK
Net Income before Bond Interest
Bond Service requirements
Income Security Bonds.
FINANCIAL RATIOS
5.
Net Operating Net Income before income taxes Summary of operation
Income to
and non-operating items
position for year.
Net Sales
WORLD BANK
FINANCIAL RATIOS
6.
Operating expense
WORLD BANK
Total Operaing Expenses
Net Sales
Indicates effectively of
mnagement in controlling
operating expenses.
FINANCIAL RATIOS
IV.
Leverage and Capital-Structure Ratios
These ratios tell us the relative proportions of capital contributed by creditors
and by owners.
1. Debt-Equity
Ratio
WORLD BANK
Current Liabilities + Long-term Debt Total amount of debt
Total Common Equity
leverage per peso of
common equity
FINANCIAL RATIOS
2. Total Debt to Total
Assets
WORLD BANK
Current Liabilities + L.T.D. Proportion of assets
Total Assets
provided by creditors.
Extent of “trading on the
equity”.
FINANCIAL RATIOS
3. Long-term Debt to
Equity Ratio
WORLD BANK
Long-term Debt
Total Common Equity
Long-term debt leverage
per peso of common
equity.
FINANCIAL RATIOS
VI.
Asset-relation Ratios
1.
Plant and equipment
to Total assets
WORLD BANK
Net Plant + Net Equipment Proportion of operating
Total Assets
earning assets to total
assets.
FINANCIAL RATIOS
2. Inventory to Total
Assets
WORLD BANK
Average Inventory
Total Assets
Size of inventory and
tendency to overstock.
FINANCIAL RATIOS
3.
Fixed Assets to Fixed
Liabilities
WORLD BANK
Fixed assets (net)
Fixed Liabilities
Reflects extent of the
utilization of resources
from long-term debt.
Indicative of source for
additional funds. If the
fixed assets are pledged degree of security. It is
frequently more useful to
use present value rather
than book value.
FINANCIAL RATIOS
4. Fixed Assets to Total
Equity
WORLD BANK
Fixed Assets (net)
Total Owners’ Equity
Proportion of owners’
equity to fixed assets.
Indicative of over or underinvestment by owners;
also weakness in “trading
on the equity”.
FINANCIAL RATIOS
5.
Sales to Fixed Assets
(Plant Turnover)
WORLD BANK
Net Sales
Fixed Assets (net)
turnover index which tests
roughtly the efficiency of
management inkeeping
plant properties employed.
FINANCIAL RATIOS
6. Approximate Average
Asset Life
WORLD BANK
Net Plant and Equipment
Normalized Depreciation
Average life of plant and
equipment.
FINANCIAL RATIOS
II.
Common-Stock Security Ratios
1.
Book value per share
of common stock
WORLD BANK
Common Stock Equity
Number of peso security
No. of Outstanding Shares (at book value) per share
of common stock
HOW TO ANALYZE FINANCIAL
POSITION
POTENTIAL FOR BUSINESS FAILURE
Bankruptcy occurs when the company is unable
to meet maturing financial obligations. We are
thus particularly interested in predicted cash
flow. Financial difficulties affect the priceearnings ratio, and the effective interest rate.
WORLD BANK
HOW TO ANALYZE FINANCIAL
POSITION
POTENTIAL FOR BUSINESS FAILURE
A comprehensive quantitative indicator used to predict failure is
Altman’s “Z-score,” which equals
Working capital
Retained earnings
X 1.2 +
Total assets
X 1.4
Total assets
Operating income
MV of common & preferred
X 3.3 +
X 0.6
Total assets
Total liabilities
Sales
+
X 0.999
Total assets
N.B. Operating income = Net sales - cost of goods sold
WORLD BANK
THE SCORES AND THE PROBABILITY
OF SHORT-TERM ILLIQUIDITY FOLLOW.
Score
Probability of illiquidity or failure
1.80 or less
Very high
1.81- 2.99
Not sure
3.0 or greater
Unlikely
WORLD BANK
EXAMPLE
A company presents the following information
Working capital
280,000
Total assets
875,000
Total liabilities
320,000
Retained earnings
215,000
Sales
950,000
Operating income
130,000
Common stock
Book Value
220,000
Market Value
310,000
Preferred stock
Book value
115,000
Market value
170,000
WORLD BANK
Z-score equals
280,000
215,000
X 1.2 +
X 1.4 +
875,000
875,000
480,000
950,000
X 0.6 +
320,000
130,000
X 3.3 +
875,000
X 0.999 =
875,000
0.384 + 0.344 + 0.490 + 0.9 + 1.0846 = 3.2026
The probability of failure is not likely
WORLD BANK
QUANTITATIVE FACTORS IN
PREDICTING CORPORATE FAILURE










Low cash flow to total liabilities.
High debt-to-equity ratio and high debt to total assets.
Low return on investment
Low profit margin
Low retained earnings to total assets
Low working capital to total assets and low working
capital to sales
Low fixed assets to noncurrent liabilities
Inadequate interest-coverage ratio
Instability in earnings
Small size company measured in sales and/or total
assets
WORLD BANK
QUANTITATIVE FACTORS IN
PREDICTING CORPORATE FAILURE






Sharp decline in price of stock, bond price, and
earnings
A significant increase in beta. (Beta is the variability in
the price of the company’s stock relative to a market
index)
Market price per share is significantly less than book
value per share
A significant rise in the company’s weighted-average
cost of capital
High fixed cost to total cost structure (high operating
leverage)
Failure to maintain capital assets. (e.g. decline in the
ratio of repairs to fixed assets
WORLD BANK
QUANTITATIVE FACTORS IN
PREDICTING FAILURE




New company
Declining industry
Inability to obtain adequate financing, and when
obtained there are significant loan restrictions
A lack in management quality
WORLD BANK
CONSOLIDATED BALANCE SHEETS
December 31,
1993
Assets
9,150,210
6,952,700
5,755,040
897,670
22,755,620
304,710
7,679,800
6,411,470
5,293,910
895,760
20,280,940
174,640
336,780
4,940,740
8,791,660
14,069,180
5,475,040
8,594,140
1,934,650
362,990
292,480
4,277,040
7,783,080
12,352,600
4,656,370
7,696,230
1,828,510
468,980
33,952,110
30,449,300
588,600
6,030,420
6,619,020
4,415,510
616,040
5,267,770
5,883,810
3,679,650
Shareholders’ Equity
Total Shareholder’s Equity
22,917,580
20,885,840
Total Liabilities and Shareholders’ Equity
33,952,110
30,449,300
Cash
Accounts receivable less allowances
Inventories
Other current assets
Total current assets
Investments
Property, plant and equipment
Land
Buildings
Machinery & Equipment
Total Property, Plant & Equipment
Less accumulated depreciation
Property plant & Equipment net of depreciation
Intangibles
Other assets
Total Assets
Liabilities
Loans payable to Banks
Accounts payable & Accrued Expenses
Total current liabilities
Long term Debt
WORLD BANK
1992
CONSOLIDATED STATEMENTS OF
INCOME
December 31,
1993
1992
Income before interest and taxes
Interest
47,443,200
18,371,190
16,959,630
35,330,820
12,112,380
1,136,970
45,684,060
17,995,370
15,944,040
33,939,410
11,744,650
1,243,780
Income before taxes
Taxes
10,975,410
3,804,010
10,500,870
3,942,590
7,171,400
6,558,280
Net Sales
Cost of goods sold
Selling, Admin. & General Expense
Net profit
WORLD BANK
Instruments of Long Term Finance
 Bond
--- A long term promissory note
 Mortgage
--- A mortgage is a pledge of
designated property for a loan. A mortgage
bond is a pledge by the corporation to certain
real assets as security for the bond.
 Debenture
--- Is a long term bond not
secured to specific property
WORLD BANK
Common Vs. Preferred Stock
 Preferred
Stock ---- avoids the provision of
equal participation in earnings in comparison
to common stock
 Common
Stock ---- does not entail fixed
charges. There is no legal obligation to pay
common stock dividends. Also, common
stock has no fixed maturity date
WORLD BANK
P/E Ratio Calculations
 Company
 1988

0.9
 Earnings
WORLD BANK
X -- Earnings Per Share
1989
0.8
1990
0.6
Per Share = Net profit/# of shares
issued
Company X Market Price Per Share,
Common Stock
1988
1989
1990
 High
9.0
5.0
6.0
 Low
7.0
4.0
3.0
 Average
8.0
4.5
4.5
WORLD BANK
Price to Earnings Ratio
Price to earnings ratio = Price/Earnings
1988
1989
1990
8.9
5.6
7.5
 P/E
WORLD BANK
Market to Book Ratio
 Market
 Market
to Book Ratio = Market value/book
Price Per Share -- Common
1988
1989
1990
 Average
8.0
4.5
4.5
 Book Value Common Stock (year end)

4.7
4.9
5.0
 MBR =
1.7
0.9
0.9
WORLD BANK
Eastern Carpets - Ratio Findings







Item
ROA
ROE
CR
DR
D/E
Z Score
WORLD BANK
94
12.3%
39.0%
.994
68%
217%
1.65
95
96
7.3%
8.7%
26.8% 29.5%
1.02
.947
72.7% 70.3%
260% 236%
1.38
1.35
Eastern Carpets - Issues
 Working
capital is WITHOUT the negative
sign
 Inventory is missing
 Accounts receivables is missing
 Why does total current assets appear when
accounts receivables and inventory do not?
 Where is retained earnings?
WORLD BANK
BOOK CASE ANALYSIS
Which U.S. Company is it?
ROA
ROE
PM
CR
QR
DR
1992
1993
21.5%
31.4%
14.3%
3.4
2.5
12%
21%
31.2%
15%
3.4
2.6
13%
WORLD BANK
1992
D/E
18%
IT
5.2
Z Score 6.25
1993
19%
5.9
5.94
Dr. Khaled Fouad Sherif
 Work
Tel: 202 473 4461
 Home Tel: 202 337 4027
 Fax:
202 522 0005
 Email: KSHERIF@WORLDBANK.ORG
 Web Site:http:\\www.ksherif.com
 Address The World Bank, 1818 H Street, NW
Washington DC 20043
WORLD BANK