Ratio Analysis

(1)

Ratio Analysis

Accounting for Managers

(2)

Financial Analysis

• Assessment of the firm’s past, present and future financial conditions

• Done to find firm’s financial strengths and weaknesses

• Primary Tools:

– Financial Statements

– Comparison of financial ratios to past,

industry, sector and all firms

(3)

Objectives of Ratio Analysis

• Standardize financial information for comparisons

• Evaluate current operations

• Compare performance with past performance

• Compare performance against other firms or industry standards

• Study the efficiency of operations

• Study the risk of operations

(4)

Uses for Ratio Analysis

• Evaluate Bank Loan Applications

• Evaluate Customers’ Creditworthiness

• Assess Potential Merger Candidates

• Analyze Internal Management Control

• Analyze and Compare Investment

Opportunities

(5)

Types of Ratios

• Financial Ratios:

– Liquidity Ratios

• Assess ability to cover current obligations

– Leverage Ratios

• Assess ability to cover long term debt obligations

• Operational Ratios:

– Activity (Turnover) Ratios

• Assess amount of activity relative to amount of resources used

– Profitability Ratios

• Assess profits relative to amount of resources used

• Valuation Ratios:

• Assess market price relative to assets or earnings

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Liquidity Ratios

• Current Ratio

– Current Assets / Current Liabilities

• Current Assets include Cash, Marketable Securities, Accounts Receivable and Inventory

• Current Liabilities include Accounts Payable, Debt Due within one year, and Other Current Liabilities

1 : 2 . 75 1

. 1555

92 .

1870 



 Current Liabilities Assets Current

Ratio Current

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Liquidity Ratios

• Quick Ratio or Acid Test

– Current Assets minus Inventory / Current Liabilities – A more precise measure of liquidity, especially if

inventory is not easily converted into cash.

1 : 46 . 75 0

. 1555

53 . 720 Inventory

-  

 Current Liabilities Assets

Current Ratio

Quik

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Liquidity Ratios

• Cash Ratio

– Reserve borrowing capacity - the credit limit sanctioned by the bank

17 . 75 0

. 1555

08 . 26 Securities

Marketable  

 

s Liabilitie Current

Ratio Cash Cash

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Liquidity Ratios

Days 360 77

/ 94 . 369 ,

3 39 . 150 ,

1 92

. 870 ,

1 expenses operating

Daily

Inventory Measure As

 



 

Average

sets Current

Interval

Interval Measure

•Calculated to asses a firms ability to meet its regular cash outgoings

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Leverage Ratios

– Leverage ratios measure the extent to which a firm has been financed by debt.

– Leverage ratios include:

– Debt Ratio

– Debt--Equity Ratio

– Generally, the higher this ratio, the more risky a creditor will perceive its exposure in your business. Thus, high leverage ratios make it more difficult to obtain credit (loans).

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Leverage Ratios Cont.

 Leverage ratios also include the Interest-

coverage Ratio, Fixed coverage Ratio etc,.

 In contrast to the leverage ratios discussed on previous slide, the higher the Interest

Coverage Ratio (Times-Interest-Earned Ratio), the more credit worthy the firm is, and the

easier it will be to obtain credit (loans).

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Total Debt Ratio

– Proportion of interest bearing debt in the Capital structure.

– In general, the lower the number, the better.

0.646 87

. 1901

06 . 229 ,

1 Assets  

 Net

Debt Total

Ratio

Debt

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Debt-Equity Ratio

– The Debt-Equity Ratio indicates the percentage of total funds provided by creditors versus by owners.

– This ratio indicates the extent to which the business relies on debt financing (creditor money versus owner’s equity).

81 1.83 .

972

06 . 229 ,

1 Worth

Equity   

 Net

Debt Total

Ratio Debt

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• Treatment of

– Preference Capital

– Lease Payments

(15)

Interest Coverage Ratio

– interest coverage ratio indicates the extent to which earnings can decline without the firm becoming unable to meet its annual interest costs.

– Also called the Times-Interest-Earned Ratio, this calculation shows how many times the firm could pay back (or cover) its annual interest expenses out of earnings before interest and taxes (EBIT).

2.4 46 . 143

61 .

Coverage   342 

Interest Ratio EBIT

Interest

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Interest Coverage Ratio

46 2.7 .

143 59 . 41 61

.

Coverage 342  



 Interest EBITDA Ratio

Interest

DA = Depreciation and Amortization expenses

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Fixed Coverage Ratio

– Principal repayments are added to interest payments

•

Rate Tax - 1

Dividend Pref.

repayment Loan

Rate Tax - 1

repayment Loan

rentals Lease

Coverage Coverage

 



 

Interest

EBITDA Ratio

Fixed

Interest

EBITDA Ratio

Fixed

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Activity Ratios

– Activity ratios measure how effectively a firm is using its resources, or how efficient a company is in its operations and use of assets.

– In general, the higher the ratio, the better.

– Activity ratios include:

 Inventory turnover

 Accounts receivable turnover

 Average collection period.

 Total assets turnover

 Fixed assets turnover

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Inventory Turnover Ratio

– The inventory turnover ratio indicates how fast a firm is selling its inventories

– This ratio indicates how well inventory is being managed, which is important because the more times inventory can be turned (i.e., the higher the turnover rate) in a given

operating cycle, the greater the profit.

days Avg

Ratio Cost Inventory

Turnover 42 Inventory

Holding 360 Inventory

of Days

8.6 2

/ ) 81 . 7461 26

. 244 (

66 . 053 , 3 Inventory

Sold Goods

Turnover of



 



(20)

Inventory Turnover Ratio Cont.

– In the absence of information. Instead of CGS we can use Sales

– In the case of CGS and Inventory both are valued at cost. While the sales are valued at market prices

– Therefore better to use CGS

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Accounts Receivable Turnover

– The accounts receivable turnover ratio, indicates the

average length of time it takes a firm to collect credit sales (in percentage terms), i.e., how well accounts receivable are being collected.

– If receivables are excessively slow in being converted to cash, liquidity could be severely impaired.

18 7.7 . 483

23 . 717 ,

3 AR

Turnover AR R



Avg Sales

Avg

Sales Credit

A

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Average Collection Period

– The average collection period is the average length of time (in days) it takes a firm to collect on credit sales.

days Turnover 47

CP  360 

A AR

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Net Assets Turnover

– The total assets turnover ratio, indicates how efficiently a firm is using all its assets to generate revenues.

– This ratio helps to signal whether a firm is generating a sufficient volume of business for the size of its asset investment

times 1901.87 1.95

3,717.23

Turnover   

Assets Net

Sales Assets

Net

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Profitability Ratios

– Profitability ratios measure management’s overall

effectiveness as shown by returns generated on sales and investment.

Profitability ratios include

– Gross profit margin

– Operating profit margin – Net profit margin

– Return on total assets (ROA)

– Return on stockholders’ equity (ROE) – Earnings per share (EPS)

– Price-earnings ratio (P/E).

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Gross Profit Margin

– The gross profit margin is the total margin available to cover operating expenses and yield a profit. This ratio indicates how efficiently a business is using its labor and materials in the production process, and shows the percentage of net sales remaining after subtracting cost of goods sold.

– The higher the ratio, the better. A high gross profit margin indicates that a firm can make a reasonable profit on sales, as long as it keeps overhead costs under control.