CHAPTER
18
FINANCIAL STATEMENT ANALYSIS
Group Presentation will be either Dec
17 (Wed) or Dec 18 (Thur)
Ratio Analysis
• Ratio Analysis expresses the relationships between
selected financial statement items.
•There are 3 types of ratio analysis:
1. Liquidity Ratios : Measure short-term ability of
the enterprise to pay its debts and to meet
unexpected needs for cash.
2. Solvency ratios : Measure the ability of the enter
prise to survive over a long period of time.
3. Profitability ratios: Measure the income or
operating success of an enterprise for a given
period of time.
Liquidity Ratio
– It measures short-term ability of the enterprise
to pay its debts and to meet unexpected needs
for cash.
– Who would be interested in finding out
liquidity ratio of a company?
– Investors, bankers, suppliers, creditors, owners,
potential buyers
LIQUIDITY RATIOS
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Working Capital ratio
Current ratio
Acid test ratio
Cash current debt coverage ratio
Receivables turnover
Collection period
Inventory turnover
Days sales in inventory
Working Capital Ratio
• Current assets = cash, accounts receivable, inventory,
marketable securities, prepaid expenses and other liquid assets
that can be readily converted to cash in one year
• Working capital = Current Assets – Current Liabilities
• It shows a company’s ability to pay its short term debts.
• Example 1: Samsung
• WC = 368842 – 249428 = 119,414
• Example 2: Apple
• WC = 249428 – 368842 = -119,414
• Which company is in better situation?
CURRENT RATIO
• Measures short-term debt-paying ability
Current ratio =
Current assets
Current liabilities
(Discussed in Chapter 4)
Current Ratio
• Current Ratio is more useful than working capital ratio
because it is difficult to compare absolute dollar
amounts by themselves.
• For example: CA = 368,842, CL = 249,428 then current
ratio = $368,842 / $249,428 = 1.48
• This means that this company has $1.48 of current
assets for every dollar of current liabilities.
• Generally speaking higher current ratio indicates
better liquidity.
Current Ratio
• What is a normal current ratio number?
• It depends on the company and the industry, but it
should be minimum of 1.
• The higher the better it is.
• Ratios should never be interpreted without considering
certain factors such as
1. The ratio should be compared to the ratios for other
companies in the same or related industries
2. Other specific financial information over time needs to be
consdiered.
ACID TEST RATIO
• Measures immediate short-term debtpaying ability
Acid test ratio =
Cash + temporary investments + net receivables
Current liabilities
(Discussed in Chapter 9)
Acid Test Ratio
• This ratio is similar to Current Asset Ratio except that
the numerator does not include inventory.
• Numerator = current assets - inventory
• A strict indicator that determines whether a firm has
enough short-term assets to cover its immediate
liabilities without selling inventory. The acid-test ratio
is far more strict than the working capital ratio,
primarily because the working capital ratio allows for
the inclusion of inventory assets.
ACCOUNTS RECEIVABLE
TURNOVER RATIO
• The ratio used to assess the liquidity of the
receivables is the receivables turnover ratio.
Net Credit
Sales

Average Net
Receivables
=
Receivables
Turnover
• This ratio measures the number of times, on average, that
receivables are collected during the period.
• Unfortunatelly, companies rarely report the amount of net
sales made on credit in their financial statements.
ACCOUNTS RECEIVABLE
TURNOVER RATIO
• As a result, net sales (which includes both cash and credit
sales) is used as a substitute for Net Credit Sales number in
the formula.
• In addition, some companies do not report gross accounts
receivable, so net accounts receivable must be used.
O
• As long as we use same numerator and denominator for
this ratio (year over year or company over company), we
can use this ratio.
ACCOUNTS RECEIVABLE
TURNOVER RATIO
• Let’s do BE8.15 (P436) together.
• 23.96 times (or 24 times) indicates that they collected AR
24 times a year.
• If the term they allow for AR is 2,10, net 30 then you can
safely assume that AR Collection employees are doing a
O
decent job.
• Only when you compare this number either year over year
or with competitor’s AR Turnover ratio then we can see
that AR collection employees are doing a good job or bad
job.
COLLECTION PERIOD
• Measures number of days receivables
are outstanding
Collection period =
365 days
Receivables turnover
(Discussed in Chapter 9)
COLLECTION PERIOD
• The collection period (in days) is a variant of
the receivables turnover ratio and makes
liquidity even more evident.
• The general rule is that the collection period
should not exceed the credit term period. (such
as 30 days)
Days in Year
(365)
Receivables
Collection

=
Turnover
Period in Days
Collection Period
• From previous example, the collection period =
• 365 days / 23.96 times = 15.2 days
• It takes them 15.2 days to collect their AR which is
shorter than their 30 days credit policy. AR collection
employees are doing a decent job.
• Both receivables turnover and collection period are useful
for judging how efficiently a company converts its credit
sales to cash.
• These measures should be compared to industry average
number and to previous year’s number.
INVENTORY TURNOVER
• Measures liquidity of inventory
Inventory turnover =
Cost of goods sold
Average inventory
(Discussed in Chapter 5)
Inventory Turnover
• Inventory Turnover ratio measures the
number of times, on average, inventory is
sold during the period.
• It is calculated by dividing the cost of goods
sold by average inventory.
• Inventory Turnover = COGS / AI
• AI = Average Inventory = (BB + EB)/2
• Generally speaking, the more times (the higher
it is) that inventory turns over each year, the
more efficiently sales are being made.
DAYS SALES IN INVENTORY
• Measures number of days inventory is
on hand
Days in inventory =
365 days
Inventory turnover
(Discussed in Chapter 5)
Days Sales in Inventory
• The inventory turnover ratio is complemented
by the days sales in inventory ratio.
• It converts the inventory turnover ratio into a
measure of the average age of the inventory on
hand.
• DSI = 365 days / Inventory Turnover
• DSI = Days Sales in Inventory
Days Sales in Inventory
• Let’s say Inventory Turnover = 2.7 then what is
the days sales in inventory?
• DSI = 365 days / 2.7 = 135 days
• What does this 135 days mean?
• It means that it takes 135 days to sell their
product since purchase date.
• This ratio should be compared to the company’s
ratio in previous years and the industry average.
• However, this average number will be different
for each type of inventory item.
Classwork / Homework
• P959 E18.6, E18.7, E18.11(A)
December 17: (Wed)
• Anne, Xenia, Maryam (Tim Horton) : 35 min
• Stefan, Roohulah, Scott (Wal-mart) : 35 min
December 18: (Thu)
• Muss, Sharyar, Michael : 25 min
• Imran, Virginia : 25 min
• Kalesh, Ameen : 25 min