Adopted from “Foundations of Finance” – Martin Petty Keown

For TCHE302/TCH302E Classes in FTU only, no further distribution/reproduction allowed.

4.1 Explain the purpose and importance of financial analysis.
4.2 Calculate and use a comprehensive set of measurements to evaluate a
company’s performance.
4.3 Describe the limitations of financial ratio analysis.
Financial Analysis using Ratios
A popular way to analyze the financial statements is by computing ratios. A ratio is a
relationship between two numbers, e.g., a given ratio of A:B = 30:10 means A is 3
times B.
A ratio by itself may have no meaning. Hence, a given ratio is compared to:
ratios from previous years
ratios of other firms and/or leaders in the same industry
Identify deficiencies in a firm’s performance and take corrective action.
Evaluate employee performance and determine incentive compensation.
Compare the financial performance of the firm’s different divisions.
Prepare, at both firm and division levels, financial projections.
Understand the financial performance of the firm’s competitors.
Evaluate the financial condition of a major supplier.
Financial ratios are used by:
Lenders in deciding whether or not to lend to a company.
Credit-rating agencies in determining a firm’s credit worthiness.
Investors (shareholders and bondholders) in deciding whether or not to invest in a
company.
Major suppliers in deciding to whether or not to extend credit to a company and/or in
designing the specific credit terms.
A liquid asset is one that can be converted quickly and routinely into cash at the
current market price.
Liquidity measures the firm’s ability to pay its bills on time. It indicates the ease
with which non-cash assets can be converted to cash to meet the financial
obligations.
Liquidity is measured by two approaches:
Comparing the firm’s current assets and current liabilities
Examining the firm’s ability to convert accounts receivables and inventory into cash on
a timely basis
Compare a firm’s current assets with current liabilities using:
Current Ratio
Acid Test or Quick Ratio
Sales $ 45,998
Cost of goods sold (17,889)
Gross profit $ 28,109
Operating expenses:
Selling, general and administrative expenses $ (16,426)
Depreciation expenses (1,976)
Total operating expenses $ (18,402)
Operating income (earning before interest and taxes) $ 9,707
Interest expense (483)
Income before tax (taxable income) $ 9,224
Income tax expense (2,126)
Net income (earnings available to common shareholders) $ 7,098
Additional information:
Number of common shares (millions) 4,450

 net income 
Earnings per share =   $ 1.60
 number of shares 

Dividends paid to stockholders $ 5,350

Dividends per share $ 1.20
Cash $ 21,675
Accounts receivable 4,466
Inventory 3,100
Other current assets 3,745
Total current assets $ 32.986
Gross plant and equipment $ 26,674
Accumulated amortization (12,041)
Net plant and equipment $ 14,633
Long-term investments 13,625
Goodwill, trademarks, and other intangible assets 30,779
Total assets $ 92,023
Liabilities (Debt) and Equity
Accounts payable $ 9,634
Short-term notes payable 22,740
Total current liabilities $ 32,374
Long-term debt 29,329
Total liabilities $ 61,703
Stockholders' equity
Common stock (par value) $ 1,760
Paid-in capital 13,154
Retained earnings 63,408
Treasury stock (48,002)
Total stockholder equity $ 30,320
Total liabilities and equity $ 92,023
Current ratio compares a firm’s current assets to its current liabilities.

current assets
Current ratio =
current liabilities

$32,986M
Coca−Cola = = 1.02
$32,274M
Quick ratio compares cash and current assets (minus inventory) that can be
converted into cash during the year with the liabilities that should be paid
within the year.

cash + accounts receivable

Acid−test ratio =
current liabilities

$21,675 + $4,466M
Coca−Cola = = 0.81
$32,374M
Measures a firm’s ability to convert accounts receivable and inventory into cash:
Days in Receivables or Average Collection Period
Inventory Turnover
How long does it take to collect the firm’s receivables?

accounts receivable accounts receivable

Days in receivables = =
daily credit sales annual credit sales
365

$4,466M
Coca−Cola = = 35.44 days
$45,998M
365
How many times are the accounts receivable “rolled-over” each year?

annual credit sales

Accounts receivable turnover =
accounts receivable

$45,998M
Coca−Cola = = 10.30X
$4,466M
How long is the inventory held before being sold?

inventory
Days in inventory =
daily cost of goods sold

inventory
=
annual cost of goods sold
365

$3,100M
Coca−Cola = = 63.25 days
$17,899M
365
How many times are the firm’s inventories sold and replaced during the year?

cost of goods sold

Inventory turnover =
inventory

$17,889M
Coca−Cola = = 5.77X
$3,100M
This question focuses on the profitability of the assets in which the firm has
invested. We consider the following ratios to answer the question:
Operating Return on Assets
Operating Profit Margin
Total Asset Turnover
Fixed Assets Turnover
ORA indicates the level of operating profits relative to the firm’s total assets.

operating profits
Operating return on assets =
total assets

$9,707M
Coca−Cola = = 0.105 or 10.5%
$92,023M
Calculated as follows:

Operating return on assets = operating profit margin × total asset turnover

operating profits sales

Operating return on assets = ×
sales total assets
OPM examines how effective the company is in managing its cost of goods sold
and operating expenses that determine the operating profit.

operating profits
Operating profit margin =
sales

$9,707M
Coca−Cola = = 0.211 or 21.1%
$45,998M
This ratio measures how efficiently a firm is using its assets in generating sales.

sales
Total asset turnover =
total assets

$45,998M
Coca−Cola = = .50X
$92,023M
Examines efficiency in generating sales from investment in “fixed assets”

sales
Fixed−assets turnover =
net fixed assets

$45,998M
Coca−Cola = = 3.14X
$14,633M
Does the firm finance its assets by debt or equity or both?
We use the following two ratios to answer the question:
Debt Ratio
Times Interest Earned
This ratio indicates the percentage of the firm’s assets that are financed by debt
(implying that the balance is financed by equity).

total debt
Debt ratio =
total assets

$61,703M
Coca−Cola = = 0.671 or 67.1%
$92,023M
This ratio indicates the amount of operating income available to service interest
payments.

operating profits
Times interest earned =
interest expense

$9,707M
Coca−Cola = = 20.1X
$483M
Interest is not paid with income but with cash.
Oftentimes, firms are required to repay part of the principal annually.
Thus, times interest earned is only a crude measure of the firm’s capacity to service its
debt.
This is analyzed by computing the firm’s accounting return on common
stockholder’s investment or return on equity (ROE).

net income
Return on equity =
total common equity

$7,098M
Coca−Cola = = 0.234 or 23.4%
$30,320M
Note: Common equity includes both common stock and retained earnings.
We can use two approaches to answer this question:
Market value ratios (P/E)
Economic Value Added (EVA)
These ratios indicate what investors think of management’s past performance
and future prospects.
Measures how much investors are willing to pay for $1 of reported earnings.

market price per share

Price/earnings ratio =
earnings per share

$42.00
Coca−Cola = = 26.25X
$1.60
Compares the market value of a share of stock to the book value per share of the
reported equity on the balance sheet.

market price per share

Price/book ratio =
equity book value per share

$42.00
Coca−Cola = = 6.17X
$6.81
Shareholder value is created if the firm earns a return on capital that is greater
than the investors’ required rate of return.
EVATM attempts to measure a firm’s economic profit, rather than accounting
profit. EVA recognizes the cost of equity in addition to the cost of debt (interest
expense).

EVA = operating return assets − cost of capital × total assets

Operating return on assets = 10.5%
Total assets = $92.023 billion
Assume cost of capital = 10%

EVA = .105% − .10 × $92.023B = $460.115M

It is sometimes difficult to identify industry categories or comparable peers.
The published peer group or industry averages are only approximations.
Industry averages may not provide a desirable target ratio.
Accounting practices differ widely among firms.
A high or low ratio does not automatically lead to a specific conclusion.
Seasons may bias the numbers in the financial statements.
Accounts receivable turnover ratio Liquidity
Acid-test (quick) ratio Operating profit margin
Asset efficiency
Operating ROA (OROA)
Current ratio
Days in inventory Price/book ratio
Days in receivables (average collection Price/earnings ratio
period) Return on equity
Debt ratio
Times interest earned
Economic value added
Financial ratios Total asset turnover

Fixed-asset turnover
Inventory turnover