FINANCIAL ANALYSIS

USING RATIO
OVERVIEW
WHY FINANCIAL STATEMENT ANALYSIS?
 The primary goal of financial managers is to maximize
the stock price, not accounting measures such as net
income or earnings per share.

 However, accounting data do influence stock prices, and

to understand why a company is performing the way it
is and to forecast where it is heading, one needs to
evaluate the accounting statements.

 If management is to maximize a firm’s value, it must

take advantage of the firm’s strengths and correct its
weaknesses. Financial statement analysis involves
comparing the firm’s performance with that of other
firms in the same industry and evaluating trends in the
firm’s financial position over time.
STEPS IN FINANCIAL ANALYSIS
Financial analysis consists of four major steps
1. Set objectives of the analysis
2. Gather relevant data
3. Select and apply appropriate tools
and techniques to gain a basic
understanding of the firm’s financial
status and performance
4. Evaluation and interpretation
Ratio Analysis
 Ratio analysis is a financial technique that
involves dividing various financial statement
numbers into one another.

 Ratios are computed by dividing one amount on

the financial statements into another.

 They are percentages that are easily obtained by

entering the numbers from financial data into a
calculator.
WHY ARE RATIOS USEFUL?
 Standardize numbers; facilitate comparisons

 Used to highlight weaknesses and strengths

TYPES OF RATIO COMPARISONS
Three types of ratio comparisons are
1. Cross-sectional analysis
2. Time series analysis (trend
analysis)
3. Combined analysis
TYPES OF FINANCIAL RATIOS
Many types of ratios can be calculated from financial
statement data or stock market information. However, it is
common practice to group ratios into five basic categories:
1. Liquidity ratios
2. Asset-management ratios
3. Financial-leverage ratios
4. Profitability ratios
5. Market-value ratios
WHAT MAJOR QUESTIONS DO THESE
FIVE CATEGORIES OF RATIOS ANSWER?

 Liquidity: Can we make required payments as

they fall due?
 Asset management: Do we have the right
amount of assets for the level of sales?
 Debt management: Do we have the right mix of
debt and equity?
 Profitability: Do sales prices exceed unit costs,
and are sales high enough as reflected in PM,
ROE, and ROA?
 Market value: Do investors like what they see as
reflected in P/E and M/B ratios?
ILLUSTRATION
Dire Company
Balance Sheet
As at December 31 2010 2009
Assets
Cash and marketable securities 60,000 80,000
Accounts Receivable 300,000 295,000
Prepaid Insurance 25,000 20,000
Inventories 615,000 415,000
Total current assets 1,000,000 810,000
Net plan and equipment 1,000,000 870,000
Total Assets 2,000,000 1,680,000
Liabilities and stockholders' equity

Liabilities
Accounts payable 200,000 90,000
Accruals 50,000 70,000
Notes Payable-Short term 60,000 60,000
Total Current liability 310,000 220,000
Long term bonds payable 754,000 580,000
Total liabilities 1,064,000 800,000
Stockholders' equity
Preferred stock (2,000 shares outstanding) 40,000 40,000
Common stock (10,000 shares outstanding) 130,000 130,000
Retained earnings 766,000 710,000
Total stockholders Equity 936,000 880,000
Total liabilities and stockholders' equity 2,000,000 1,680,000
ILLUSTRATION, CONTD……..
Dire Company
Income Statement
For the year ended December 31 2010 2009
Sales 3,125,000 2,955,000
Sales returns and allowances 125,000 105,000
Net sales 3,000,000 2,850,000
Costs of goods sold 2,150,000 1,950,000
Gross profit 850,000 900,000
Operating expenses excluding depreciation 466,200 547,000
Earnings before interest, taxes and depreciation 383,800 353,000
Depreciation 100,000 90,000
Earnings before interest and taxes (EBIT, or operating income) 283,800 263,000
Less interest 88,000 60,000
Earnings before taxes (EBT) 195,800 203,000
Taxes (40%) 78,320 81,200
Net income before preferred dividends 117,480 121,800
Preferred dividends 4,000 4,000
Net income available for common stockholders 113,480 117,800
Common dividends 57,500 53,000
Addition to retained earnings 55,980 64,800
ILLUSTRATION, CONTD……..
Additional Data:
 Bonds (long-term debt) are settled with annual
payment of Br 50,000.
 Annual lease payment of Br 40,000 was included
in the operating expenses during each period.
 Net purchases for the 2009 were Br 1,095,000.

 Common stock price per share was Br 180.00

during 2010 and Br 190 during 2009.
ILLUSTRATION, CONTD……..
Different Ratios for the Industry Average:

Required
Compute all the above ratios for Dire Co and comment the
strength and weakness of the Co in light with the industry
LIQUIDITY RATIO

current assets 1,000,000

Current ratio = = 3.2 times
= 310,000
current liabilities
Industry Average= 4.2 times

Dire Company has a lower current ratio than the average for its industry.
Is this good or bad?
Sometimes the answer depends on who is asking the question.

IN GENERAL:
Too low current ratio may suggest that a firm may face difficulty
in paying its short term liabilities. Too high current ratio
indicates that too much capital is tied up in current assets and
the firm may be sacrificing some returns possibilities, or a firm is
not making full use of its current borrowing capacity (short term
sources are less expensive than long term ones.)
LIQUIDITY RATIO

Quick assets 360,000

Quick ratio = = = 1.2 times
Current Liabilities 310,000

Industry Average = 2.1 times

Still, if the accounts receivable can be collected, the company can pay off its
current liabilities without having to liquidate its inventory.

Activity:
A company has current liabilities of Br 800,000, and its current ratio is 2.5.

What is its level of current assets?

If this firm’s quick ratio is 2, how much inventory does it have if there
are no prepaid expenses?
ASSET MANAGEMENT RATIOS:
1) Inventory Turnover Ratio (ITO)

Cost of Goods Sold 2,150,000

ITO = = = 3.5 times
Inventory 615,000
Industry Average= 5 times

➢An ITO significantly higher than the industry average may indicate: Superior
selling practice, improved liquidity and profitability, fewer cases of damaged or
obsolete inventory, use of just in time inventory management

➢An ITO significantly lower than the industry average may indicate; over
investment in inventory, inferior quality goods, stock of un-sellable or obsolete
inventory, funds locked up in inventory and higher inventory carrying costs such as
rent of space, insurance cost, property tax.
ASSET MANAGEMENT RATIOS:
2)Inventory Period (Average age of inventory)
365 Inventory x 365 365
IP = = = = 104 days
ITO Cost of Goods Sold 3.5
Industry Average= 73 days

The same conclusion with ITO

ASSET MANAGEMENT RATIOS: CONTINUED…
3) Accounts Receivable Turnover

Annual Credit Sales 3,000,000

ARTO = = = 10t
Accounts Re ceivableBalance 300,000

Industry Average= 12 times

ASSET MANAGEMENT RATIOS: CONTINUED…
4)Days sales outstanding (DSO)
Accounts Re ceivable x 365 300,000x 365
DSO =
Annual (Credit) Sales
= = 36.5 days
3,000,0000
Industry Average= 30 days
ASSET MANAGEMENT RATIOS: CONTINUED…
5)Fixed Assets Turnover Ratio(FATO)
Net Sales 3,000,000
FATO =
Net fixed assets
= = 3 times
1,000,000
Industry Average= 3 times

6)Total Assets Turnover Ratio(TATO)

Net Sales 3,000,000

TATO = = = 1.5 times
Total assets 2,000,000
Industry Average= 1.8 times

7)Average Payment Period(APP)

Accounts payablex 365 200,000 x 365
APP = = = 31days
Annual net purchases 2,350,000
Industry Average=35 days
 DEBT MANAGEMENT RATIOS:
1) Debt Ratio(DR)

DR =
Total Liabilities = 1,064,000
Total Assets = 0.532 = 53.2%
2,000,000
Industry Average=45%

2) Debt to Equity Ratio(DE)

Total Liabilities 1,064,000

DE = = = 1.14 = 114%
Stockholders Equity 936,000
Industry Average=82%
Debt to assets and debt to equity ratios are simply transformations of each other.
Both of the two indicate the same thing – the extent to which the firm has relied
on debt in financing its assets. Therefore:

DE = TD DR
This leads us to
TA − TD DE =
1 − DR
DEBT MANAGEMENT RATIOS: CONTINUED…

3)The equity multiplier ratio

Total Assets TA 1
EM =
Stockholders Equity
= =
TA(1 − Debt Ratio) 1 − DR
2,000,000
= 2.14 times Industry Average= 1.82 times
936,000

4)Times Interest Earned Ratio(TIE)

EBIT 283,800
TIE = = = 3.2 times
Interest Expense 88,000
Industry Average=5 times
DEBT MANAGEMENT RATIOS: CONTINUED…

5)Fixed Charge Coverage Ratio(FCCR)

EBIT + Lease Payments

FCCR =
Pr incipal Re ayment + Pr eferred Dividend
Interest Expense + LeasePayments +
1 − Tax Rate

283,800 + 40,000
= 1.16 times
50,000 + 4,000
88,000 + 40,000 +
1 − 0.40

Industry Average=2.5 times

6)Cash Coverage Ratio(CCR)

EBIT + depreciation 283,800 + 100,000

CCR =
Interest Expense
= = 4.36 times
88,0000
Industry Average=6 times
PROFITABILITY RATIO
1)Net Profit Margin(Profit Margin)Ratio

Net Income 117,480 = 3.9%

PM = =
Net sales 3,000,000
Industry Average=5%

2)Operating Profit Margin Ratio

EBIT 283,800
OPM = = = 9.5%
Net sales 3,000,000
Industry Average=10.2%

3)Gross Profit Margin Ratio

GrossPr ofit 850,000
GPM = = = 28%
Net sales 3,000,000
Industry Average=30 %
PROFITABILITY RATIO, CONTINUED…..
4)Basic Earning Power(BEP) Ratio

EBIT 283,800 = 14%

BEP = =
Total Assets 2,000,000
Industry average = 16%

5)Return on Total Asset(ROA)

Net Income 117,480
ROA = = = 5.9%
Total Assets 2,000,000
Industry Average=8%

Can we see ROA from other angle?

Return on assets=Profit Margin X Total Asset Turnover

3.9% X 1.5 = 5.9%

ROA= Net income Net Sales
X
Net Sales Total Assets
PROFITABILITY RATIO, CONTINUED…..
6)Return on Equity(ROE)

Net Income 117,480

ROE =
Total Stockholders' Equity = = 12.55%
936,000
Industry Average=15%

Can we see ROE from other angle?

Net income Net Sales Total Assets
ROE = X X
Net Sales Total Assets Total Shareholders' Equity
3.9% X 1.5 X 2.14 = 12.55%

7)Earning Per share(EPS)

net income − preferreddividend 113,480
EPS = = = Br 11.35
number of common sharesouts tan ding 10,000
Industry Average= Br 13
MARKET VALUE RATIO
1)Price/Earning (P/E) Ratio
MarketPr ice Per Shareof Common Stock 180
P/E = = = 15.86 times
Earning Per Share 11.35
Industry Average=18 times

2)Price/Cash flow Ratio

MarketPr ice Per Shareof Common Stock 180
P/CF = = = 8.43times
Cashflow per share 23.35
Industry Average of price-cash flow ratio=10 times

3)Market/Book value Ratio

MarketPr ice Per Shareof Common Stock 180
M/BV = = = = 2 times
Book Value Per Share 89.60
Industry average=2.5 times
THE DU PONT SYSTEM OF FINANCIAL ANALYSIS
COMMON SIZE ANALYSIS
 In a common size analysis, all income statement
items are divided by sales and all balance sheet items
are divided by total assets.

 Thus, a common size income statement shows each

item as a percentage of sales, and a common size
balance sheet shows each item as a percentage of
total assets.

 The advantage of common size analysis is that it

facilitates comparisons of balance sheets and income
statements over time and across companies.
COMMON SIZE ANALYSIS ILLUSTRATED
Dire Company Dire Company
Common Size Income Statement Common Size Balance Sheet
For the year ended December 31 2010 2009 As at December 31 2010 2009

Sales 100.00% 100.00% Assets

Sales returns and allowances 4.00% 3.55% Cash and marketable securities 3.00% 4.76%
Net sales 96.00% 96.45% Accounts Receivable 15.00% 17.56%
Costs of goods sold 68.80% 65.99% Prepaid Insurance 1.25% 1.19%
Gross profit 27.20% 30.46% Inventories 30.75% 24.70%
Operating expenses excluding depr. 14.92% 18.51% Total current assets 50.00% 48.21%

Earnings before interest, taxes and depr. 12.28% 11.95% Net plan and equipment 50.00% 51.79%

Depreciation 3.20% 3.05% Total Assets 100.00% 100.00%

Liabilities and stockholders'
Earnings before interest and taxes (EBIT) 9.08% 8.90% equity
Less interest 2.82% 2.03% Liabilities
Earnings before taxes (EBT) 6.27% 6.87% Accounts payable 10.00% 5.36%
Taxes (40%) 2.51% 2.75% Accruals 2.50% 4.17%

Net income before preferred dividends 3.76% 4.12% Notes Payable-Short term 3.00% 3.57%
Preferred dividends 0.13% 0.14% Total Current liability 15.50% 13.10%
Net income available for common stock. 3.63% 3.99% Long term bonds payable 37.70% 34.52%
Common dividends 1.84% 1.79% Total liabilities 53.20% 47.62%
Addition to retained earnings 1.79% 2.19% Stockholders' equity
Preferred stock (2,000 shares o/s) 2.00% 2.38%
Common stock (10,000 shares o/s) 6.50% 7.74%
Retained earnings 38.30% 42.26%
Total stockholders Equity 46.80% 52.38%
Total liabilities and stockholders'
equity 100.00% 100.00%
PERCENTAGE CHANGE ANALYSIS

 In percentage change analysis, growth rates are

calculated for all income statement items and
balance sheet accounts relative to a base year.

 To illustrate Dire Company’s income statement

percentage change analysis for 2010 relative to
2009 is shown below.
 Dire Company Dire Company
Income Statement Percentage Change Analysis Balance Sheet Percentage Change Analysis
For the year ended December 31 2010 As at December 31 2010
Sales 5.75% Assets

Sales returns and allowances 19.05% Cash and marketable securities -25.00%
Net sales 5.26% Accounts Receivable 1.69%
Costs of goods sold 10.26% Prepaid Insurance 25.00%
Gross profit -5.56% Inventories 48.19%

Operating expenses excluding depr. -14.77% Total current assets 23.46%

Earnings before interest, taxes and depr. 8.73% Net plan and equipment 14.94%
Depreciation 11.11% Total Assets 19.05%

Earnings before interest and taxes (EBIT) 7.91% Liabilities and stockholders' equity
Less interest 46.67% Liabilities

Earnings before taxes (EBT) -3.55% Accounts payable 122.22%

Taxes (40%) -3.55% Accruals -28.57%

Net income before preferred dividends -3.55% Notes Payable-Short term 0.00%
Preferred dividends 0.00% Total Current liability 40.91%

Net income available for common stock. -3.67% Long term bonds payable 30.00%
Common dividends 8.49% Total liabilities 33.00%

Addition to retained earnings -13.61% Stockholders' equity

Preferred stock (2,000 shares o/s) 0.00%
Common stock (10,000 shares o/s) 0.00%
Retained earnings 7.89%
Total stockholders Equity 6.36%

Total liabilities and stockholders' equity 19.05%

USE AND LIMITATION OF RATIO ANALYSIS
Advantages
Some of the advantages of ratio analysis are:-
 Ratios are easy to compute.

 Ratios provide a standard of comparison at a point in time and allow comparisons

to be made with industry averages.

 Ratios can be used to analyze a corporation’s financial time series in order to

discover trends, shifts in trends, and data outliers.

 Ratios are useful in identifying problem area of firm.

 When combined with other tools, ratio analysis makes an important contribution
to the task of evaluating a firm’s financial performance. While it is important to
understand and interpret financial statements, sound financial analysis involves
more than just calculating and interpreting numbers. Good analysts recognize that
certain qualitative factors must be considered when evaluating a company. Some of
these factors are:
 The extent to which the company’s revenues are tied to one key customer.
 The extent to which the company’s revenues are tied to one key product.
 The extent to which the company relies on a single supplier.
 The percentage of the company’s business generated overseas.
 Competition.
 Future prospects.
 Legal and regulatory environment
USE AND LIMITATION OF RATIO ANALYSIS
Limitations
Some potential problems include the following.
 Ratios are generally calculated from past period financial statements and they are not
absolute indicators of the future. Financial statements provide an assessment of
the costs and not value. For example, fixed assets are usually shown on the balance
sheet as the cost of the assets less their accumulated depreciation, which may not
reflect the actual current market value of those assets.
 Financial statements do not include all items. For example, it is hard to put a value
on human capital (such as management expertise). And recent accounting scandals
have brought light to the extent of financing that may occur off the balance sheet.
 Accounting standards and practices vary among countries, and thus hamper
meaningful global comparisons.
 Taken by itself, a ratio provides little useful information
 Ratios seldom provide the answers to the question they raise because generally they
do not identify the causes of a firm’s problems.
 Ratios may not be strictly comparable for different firms due to a variety of factors
such as different accounting practices or different fiscal year periods. Furthermore, if
a firm is engaged in diverse product lines, it may be difficult to identify the industry
category to which the firm belongs.
 There is considerable subjectivity involved, as there is no “correct” number for the
various ratios. Further, it is hard to reach a definite conclusion when some of the
ratios are favorable and some are unfavorable. Ratios can be easily misinterpreted.
For example a decrease in the value of a ratio does not necessarily mean that
something undesirable has happened. e.g. high inventory turn over does not
necessarily indicate good management.
 END of
Ratio Analysis