Ch3. Analysis of Financial
Statement
1. Why we need ratios?
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Specialized information
Comparison Issue
Predicting future performance
1) 5 types of financial ratios (handout)
Liquidity ratios
Asset management ratios
Debt management ratios
Profitability ratios
Market value ratios
Goals
• To calculate financial ratios
• To understand how to use them
I. Ratio analysis
[1] Liquidity ratios:
Liquidity: 1) Convertibility into cash on short notice with minimum possible loss.
2) Ability to meet all required obligations.
Current assests
(1) Current ratio =
Current liabilities
Current assests - Inventory
(2) Quick ratio (Acid test) =
Current liabilities
[2] Asset management ratios: measure how effectively a firm is managing its assets. Right
amount of assets vs. sales?
Sales
(1) Inventory turnover ratio =
[Note: Cost of goods sold is better than Sales.]
(Average) Inventory
The number of times per year that the firm fills up and then completely empties its
warehouse or store inventory.
Accounts receivable
(2) Days sales outstanding (DSO) =
 Average collection period (ACP)
Annual
sales
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365
The average number of days the firm must wait after making a sale before receiving
cash.
Sales
(3) Fixed assets turnover ratio =
Net fixed assets
Sales
(4) Total assets turnover ratio =
Total assets
[3] Debt management ratio
• Debt ratio =
total liabilities/total assets
• Debt to equity ratio = Total liabilities/(Total asset – total
liabilities). But it ignore the market value.
• Market debt ratio = Total liabilities / (Total liabilities +
market value of equity).
• Time-interest-earned (TIE) =
Earnings before interest and taxes (EBIT)/Interest
charges. But it ignores lease payment related to
bankruptcy. Lease payment was deducted when EBIT is
calculated.
• Many companies have debts and lease. Failure to pay
interests and to meet lease payments forces them into
bankruptcy. EBIT is affected by non-cash item such as
depreciation. Thus the next ratio is introduced.
• EBITDA coverage ratio = (EBITDA+ Lease payment) /
(Interest + Principal payments + Lease payment). It is
useful for short term lenders to evaluate financial status
of firms with large amount of depreciation and
amortization.
• Equity Multiplier=Total asset/ common equity
4) Profitability ratios
• Net profit margin = Net income / Sales
• Operating margin = Operating Income
(EBIT)/Sales
• Gross profit margin
• = (Sale – COGS)/Sales
• Basic Earning Power (BEP) = EBIT / Total
Assets
•Return on common equity = ROE
•=Net income /common equity
•Return on total assets = ROA
•=Net income /total assets
5) Market value ratio
• Price/ Earnings ratio = price / earnings per
share.
• Price / Cash flow ratio = price / cash flow
per share. Cash flow = NI + depreciation.
• Price/EBITDA
• Book value per share = common equity /
shares outstanding.
• Market / book ratio = market price per
share / book value per share.
• 2. Trend analysis, Common size analysis,
and Percentage change analysis:
• An analysis of a firm’s financial ratios over
time – plotting ratios over time periods
• It is used to estimate the likelihood of
improvement or deterioration in its
financial condition.
• 3. Du Pont Analysis:
• Decomposing the ROA and ROE
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ROA
= Net income / Total assets
= Net Income/Sales * Sales/Total assets
= Profit margin * Total asset turnover
• If a company has only equity without any
liability, ROA =ROE
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ROE
= Net Income /Common Equity
= Net Income/Total Assets*Total
asset/Common Equity
= Net Income/Sales * Sales/Total Assets *
Total assets/Common equity
=Profit margin * Total asset turnover*Equity
multiplier
Here Equity multiplier will increase with
debts
• 4. Benchmarking:
• The process of comparing a particular
company with a group of benchmark
companies
• The bench mark companies can be
leading companies, peer groups or
competitors in the industry
• Comparative ratios are available from a
number of sources, including value lines
5. Limits of ratio analysis
• Ratio analysis is more useful for small,
narrowly focused firms than for large,
multidivisional ones
• For high level performance, it is better to
focus on the industry leaders’ ratios
• Seasonal factors: impacts on the inventory
turnover ratio. Using monthly averages for
inventory can minimize this problem
• Window dressing: making financial
statements look better than they really are
• Different accounting practices: FIFO
&LIFO or Depreciation methods
• It is difficult to generalize whether a
particular ratio is good or bad.
6. Problems with ROE
• Some problems raises if ROE is used as
only sole measure of performance
• (1) ROE doesn’t consider risks
• (2) ROE doesn’t consider amounts of
invested capital
7. Working capital management
1. Working capital = current asset – current
liabilities
2. Conservative working capital policy:
larger working capital, low profitability and
high liquidity.
3. Aggressive working capital policy: smaller
working capital, high profit and low
liquidity.
4. Operating cycle = number of days in inventory +
number of days receivable
•Number of days in inventory = 365 or
360/inventory turn over
•(inventory turn over = net (credit) sale / average
inventory)
•Number of days receivable = 365 or
360/receivable turn over
•(receivable turn over = net (credit) sale / average
account receivable)
• 5. Cash conversion cycle: a length of time
between cash payments (raw materials)
and cash collection (sales of products).
• = number of days in inventory + number of
days receivable – days in payable deferral.
• (days in payable deferral is a length of
time between purchase and cash
payment)
• Figure 16-3