Financial Ratio Analysis

Name: M. Kaleem Uz Zaman Siddiqui

Topic: Financial Ratio Analysis

What is Financial Ratio Analysis?

Financial Ratio Analysis is a form of Financial Statement Analysis that is used to obtain a quick indication of a firm's financial performance in several key areas.

PurposeAssessment of the firms past and present financial conditionsDone to find firms financial strengths and weaknessesStudy the efficiency of operationsStudy the risk of operationsPrimary Tools:Financial StatementsComparison of financial ratios to past, industry, sector and all firms

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Types of RatiosLiquidity Ratios: Indicate the firms ability to pay its bills over the short run without undue stress.

Efficiency Ratios: Describe how efficiently (intensively) a firm uses its assets to generate sales.

Financial Leverage: Describe a firms long-term ability to meet its financial obligations

Profitability Ratios: Describes how efficiently the firm manages its overall operations (the higher, the better !!!!!)

Market Value Ratios: Compares the current stock price to a financial indicator on the company's financial statements.

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Liquidity RatiosCurrent RatioQuick Ratio

Liquidity is a measure of how quickly an asset can be converted to cash.

E.g.Accounts receivable = quite liquidBuilding = not very liquid

There are two important liquidity ratios:

Liquidity RatiosCurrent Ratio:

Under normal circumstances, a company will pay its current liabilities (bills due) with its current assets. The ratio between the two is therefore a good indicator for how well a company can pay its bills.


A high current ratio means that the company should more easily be able to pay its bills. So thats good to know if the company owes you money.But if youre an investor, too high a current ratio could mean that the company is not using its assets optimally.Think a bit of it like water in a lake. Good to have some, bad to have none and so-so to have too much.


Most successful businesses have a current ratio of about 1.5 2.0.

Lets have a look at the Balance Sheet of Lecture 2 again and add the current ratio.

Adding RatiosPretty good!

Sheet1

ABCDEFG

3Golden Win Double Dragon International

4Balance Sheet, As of Dec 31 2000

5

6AssetsRatios:

7Cash and Equivalents10000

8Accounts Receivable1200Current2.29^=G10/G18

9Inventory8300

10Total Current Assets19500

11Plant and Equipment800

12Accumulated Depreciation500

13Net fixed assets300

14Total Assets19800

15Liabilities and Owner's Equity

16Accounts Payable7600

17Other Current Liabilities900

18Total Current Liabilities8500

19Long Term Debt1200

20Total Liabilities9700

21Common Stock6000

22Retained Earnings4100

23Total Shareholder's Equity10100

24Total Liabilities and owner's Equity19800

Liquidity RatiosQuick Ratio:

While inventories are necessary for many businesses, they may at times be difficult to sell rapidly.It is therefore useful to also consider a current ratio that takes out inventory from the Current Assets.

Liquidity RatiosQuick Ratio:

The quick ratio is sometimes called acid-test ratio.

In general, a quick ratio of 1 is considered safe, but in some industries it may be much lower, e.g. in the car industry, 0.2 is common.

Let us enter this into the Balance Sheet as well

Adding RatiosPretty good too!

Sheet1

ABCDEFG



5

6AssetsRatios:



9Inventory8300Quick1.32^=(G10-G9)/G18


11Plant and Equipment800

12Accumulated Depreciation500


14Total Assets19800







21Common Stock6000




Efficiency Ratios

As indicated by the name, efficiency ratios indicate how efficient a company is in its operation.Two of the most useful turnover ratios are:

Inventory Turnover Ratio Total Asset Turnover Ratio

Efficiency Ratios

Inventory Turnover Ratio

The inventory turnover ratio indicates how many times the inventory is turned over in one year. In other words, it shows how quickly inventory can be sold.Actually, it would be better to replace Inventory with Average Inventory (defined as beginning inventory + ending inventory)/2.

Efficiency Ratios

Inventory Turnover Ratio

Let us apply this to our Balance Sheet again.Only the Cost of Goods sold are not on the Balance Sheet. We need to get this item from the Income Statement in Lecture one.

In general, a higher Inventory Turnover Rate is good but the number may differ greatly per industry. Dell, e.g, is somewhere above 40 but to many around 4 would already be good.

Adding RatiosQuite meager!But! What happened here???

Balance

ABCDEFG



5

6AssetsRatios:





11Plant and Equipment800Inventory0.87^=Income!D7/

12Accumulated Depreciation500Balance!G9


14Total Assets19800







21Common Stock6000




Income

ABCDEFG

2


4Income Statement

5

6Sales11,330100%^=D6/D$6

7Cost of Sales7,20064%^=D7/D$6

8Gross Profit4,13036%^=D8/D$6

9Other Expenses1,20011%^=D9/D$6

10EBITDA2,93026%^=D10/D$6

11ITDA8007%^=D11/D$6

12Net Income2,13019%^=D12/D$6

13

Efficiency Ratios

Total Asset Turnover Ratio

The Total Asset Turnover Ratio shows how well a company is able to generate sales (and hence hopefully profits) from the assets it owns.

It is defined as:Again we need to get the Sales from the Income Statement

Adding RatiosOuch!?

Balance

ABCDEFG



5

6AssetsRatios:







13Net fixed assets300Total As.0.57^=Income!D6/

14Total Assets19800Balance!G14







21Common Stock6000




Income

ABCDEFG

2


4Income Statement

5

6Sales11,330100%^=D6/D$6




10EBITDA2,93026%^=D10/D$6

11ITDA8007%^=D11/D$6

12Net Income2,13019%^=D12/D$6

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Leverage Ratios

Leverage in business refers to how much debt a company uses to finance its operations.The idea is that if a company can borrow money at say 7% and then use this money to make a 27% profit, its clever to take out the loan.

Two of the most important leverage ratios are:

Total Debt Ratio Debt to Equity Ratio

Leverage Ratios

Total Debt Ratio

The Total Debt Ratio shows how much of a companys assets are financed through loans.

It is defined as:

Leverage Ratios

Total Debt Ratio

In general, a low Total Debt Ratio is good with the critical number being 1.

Smaller than one means that the company has more assets than debts.

Vice versa, larger than one mean that the company has more debts than assets. If this is the case youd better hope they will not go out of business

Adding RatiosSo so..

Balance

ABCDEFG



5

6AssetsRatios:










16Accounts Payable7600Total De.0.49^=G20/G14





21Common Stock6000




Income

ABCDEFG

2


4Income Statement

5

6Sales11,330100%^=D6/D$6




10EBITDA2,93026%^=D10/D$6

11ITDA8007%^=D11/D$6

12Net Income2,13019%^=D12/D$6

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Leverage Ratios

Debt to Equity Ratio

A favorite with many investors. It is similar to the Total Debt Ratio, but rather than dividing by the Total Assets, the Total Debt is divided by the Total Equity.

It is defined as:

Leverage Ratios

Debt Equity Ratio

As with the Total Debt Ratio, a low Debt Equity Ratio is good with the critical number being 1.

Smaller than one means that the company has more equity than debts.Vice versa, larger than one mean that the company has more debts than equity.

Investors prefer this number since Equity is after all that which belongs to the stock holders.

Adding RatiosSo so too..

Balance

ABCDEFG



5

6AssetsRatios:











17Other Current Liabilities900Debt-Eq.0.96^=G20/G23




21Common Stock6000




Income

ABCDEFG

2


4Income Statement

5

6Sales11,330100%^=D6/D$6




10EBITDA2,93026%^=D10/D$6

11ITDA8007%^=D11/D$6

12Net Income2,13019%^=D12/D$6

13

Profitability Ratios

PROFIT. Of course thats what business is all about!

Most commonly used profitability ratios are:

Gross Profit Margin (Ratio or Percentage) Operating Profit Margin (Ratio or Percentage) Net Profit Margin (Ratio or Percentage)Return on Equity (ROE) (Percentage)Return on Asset (ROA) (Percentage)


Gross Profit Margin

The Gross Profit Margin is the gross difference between the actual cost of a product and its sales price.

It is defined as:Where Gross Profit = Sales Cost of Sales

Adding Ratios

Balance

ABCDEFG



5

6AssetsRatios:













19Long Term Debt1200Gross P.0.36^=Income!D8/

20Total Liabilities9700Income!D6

21Common Stock6000




Income

ABCDEFG

2


4Income Statement

5

6Sales11,330100%^=D6/D$6




10EBITDA2,93026%^=D10/D$6

11ITDA8007%^=D11/D$6

12Net Income2,13019%^=D12/D$6

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Operating Profit Margin

The Gross Profit Margin is important but does not indicate how much (or whether) the company can make a profit from its running operations. This is indicated by the Operating Profit Margin:


Net Profit Margin

The Net Profit Margin tells you how many cents out of every dollar are actual profit and thus attributable to the shareholders.

Adding Ratios

Balance

ABCDEFG



5

6AssetsRatios:













19Long Term Debt1200Gross P.0.36^=Income!D8/

20Total Liabilities9700Income!D6

21Common Stock6000Net Prof.0.19^=Income!D12/

22Retained Earnings4100Income!D6



Income

ABCDEFG

2


4Income Statement

5

6Sales11,330100%^=D6/D$6




10EBITDA2,93026%^=D10/D$6

11ITDA8007%^=D11/D$6

12Net Income2,13019%^=D12/D$6

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Summary of Ratios Liquidity RatiosEfficiency Ratios

Summary of Ratios Leverage RatiosProfitability Ratios

Summary of Ratios Ratios help to:Evaluate performanceStructure analysisShow the connection between activities and performanceBenchmark withPast performance of the companyIndustryRatios adjust for size differences

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Documents

Financial Ratio Analysis