Lecture 05 Ratio Analysis

Noorulhadi : Lecturer GCMS Peshawar

Ratio Analysis

Annual report components that are financial statements, these statements report current position and past period. These statements help to predict future earnings, dividends, and free cash flow. For investors standpoint its predicting the future and for management ‘s standpoint it is useful both for future prediction and for planning actions that will improve future performance.

Financial ratio are designed to help evaluate a financial statements.

Ratio Analysis

1. Liquidity Ratios:

2. Asset management Ratios:

3. Debt Management Ratios:

4. Profitability Ratios:

5. Market Value Ratio:

Ratio AnalysisLiquidity Ratios,:

A Liquid asset is one that trades in an active market and hence can be quickly converted to cash at the going market price and a firm’s liquidity ratio deal with that firm will be able to pay off its debts, Liquidity analysis requires the use of cash budgets, but they related the amount of cash and other current assets to current obligation.

Two ratios are the components of liquidity ratio:

1. Current Ratio = Current Assets / Current liabilities

• Current asset include cash, marketable securities, account receivable, and inventories. Current liabilities include account payable, short term notes payable accrued taxes and expenses.

• For MicroDrive = 1000/310 = 3.2 times while industry average = 4.2 times.

• Creditors like to see high current ratio. Current ratio provide best indicator to cover the short term creditors.

• From shareholders perspective, high current ratio mean cash is in useless form.

Liquidity Ratio2. Acid test or quick ratio = (Current asset – inventory ) / Current liability

Or

=Quick Asset / Current Liabilities

Quick Asset = Current asset – Current liabilities

The acid test or quick ratio is calculated by deducting inventories from current assets and then dividing the remainder by current liabilities.

Quick Ratio= 385/ 310=1.2 times

Industry average = 2.1 times

In case of bankruptcy, inventories may be liquidated on losses. Therefore measuring of the firm ability without inventories is important.

In this case industry average quick ratio is 2.1, so Micro Drives 1.2 ratio is low.

Asset Management Ratio:These ratios measure that how effectively the firm

is managing its assets. Following ratios are used for asset management ratio.

1. Inventory Turnover ratio: is defined as sale divided by inventories

Inventory turnover ratio = sale / inventories.

= 3000 /615= 4.9 times

Industry average = 9 times.

Its indicates that 4.9 times inventory is sold out and re-stock in one fiscal period.

Asset Management Ratio:2. The Days sale outstanding (Evaluating

Receivables)It is also known average collection period (ACP) DSO= Receivable / Average sale per dayOr =Receivable / annual sales/ 360= 375 / 3000/360 = 45 daysIndustry average = 36 daysIn this case 15 days refers that customer

outstanding for 15 days.For better appraisal = (op A/R + Ending A/R) / Average sale per day

Asset Management Ratio:3. The fixed asset turnover: evaluating fixed asset

The fixed assets turnover ratio measures how effectively the firm uses plant and equipment; it is the ratio of sale to net fixed assets =

= Sale / Net Fixed asset

= 3000 / 1000 = 3 times

Industry average = 3 time

This ratio show only the effective usage of plant and machinery.

Asset Management Ratio:4. Total Asset turnover ratio (evaluating total assets)

It measures the turnover of all the firms’ assets, it is calculated as

= Sale / Total assets = 3000/ 2000 = 1.5 time

Industry average = 1.8 time

It is indicating the sufficient volume of business with total investment assets. Sale should be increased by selling assets.

Debt Management RatioThese ratios reveal the extent to which the firm is

finance to debt, and probability of defaulting on its debt obligation.

1. Total Debt to Total Asset (how firm is financed)

The ratio of debt to total assets, generally called the debt ratio, its measured the percentage of fund provided by creditors.

Debt Ratio = Total Debt (current and long) / Total Assets.

= 1064 / 2000 = 53.2%

Creditors prefer low debt ratio because the lower the ratio for compensation in insolvency, share holder need high debt ratio, for more investment and expected earning. In this case the company is more financed by creditors.

Debt Management Ratio2. Time interest Earned Ratio:

It measure the ability to pay interest., Time interest earned ratio = EBIT / Interest Charges.

=283.8 / 88 = 3.2 timesIndustry average = 6 times

It means micro drive can not afford to borrow more money. Lower the ratio leads to bankruptcy.

Debt Management Ratio3. EBITDA Coverage Ratio

It measure ability to service Debt, it is most useful for relatively short term lenders such as banks,.

EBITDA coverage ratio =

(EBITDA + Lease payment)

/ (Interest + Principal payment +Lease payment)

=(283.8+100+28) / 88 + 20 + 28

=3 times Industry average = 4.3 times

Profitability Ratio• Profitability ratio shows the combined effects

of liquidity, asset management and debt management policies on operating result.

1. Profit Margin on Sale = Net income / Sale

The profit margin on sale measure the profit per dollar sale.

=113.5 / 3000 = 3.8 % Industry average = 5%

It is less than industry average because, cost is too high by operation.

Profitability Ratio2. Basic Earning Power (BEP) Ratio

This ratio shows the raw earning power of the firm’s assets before the influence of taxes and leverage.

= BEP Ratio = EBIT / Total Assets

= 283.8 / 2000 = 14.2% Industry average = 17.2%

It also indicate return on assets.

Profitability Ratio3. Return on Total Assets (ROA)This ratio measure the return on total assets. ROA = Net income / Total Asset= 113.5 / 2000 = 5.7 % Industry avg = 9%ROA could be lower because of low basic earning power

and high interest cost. 4. Return of Common Equity (ROE)It measure return on common equity which is the bottom

line. = Net income / Common equity=113.5 / 896 = 12.7% industry avg = 15%Stockholders invest to get a return on their money and

this ratio helps to postulate the performance on ROE.

Market Value Ratio

Market value ratios relate the firm’s stock price to its earning, cash flow and book value per share, thus giving management an indication of what investors think of the company’s past performance and future prospects. These include the price/earning ratio, price/cash-flow ratio and the market /book ratio.

Market Value Ratio

1. Price/ Earning Ratio: The P/E ratio shows how much investors are willing to pay per dollar of reported profit.

= Price per share / Earning Per Share

= 23/2.27 = 10.1 times, Industry avg = 12.5

Higher ratio indicate high growth potential and also risk is associated with it.

Market Value Ratio

Price / Cash Flow Ratio

In some companies stock price is tied more closely with cash flow rather than net income.

= Price per share / Cash flow per Share

=23 / 4.27 = 5.4 times, industry avg =6.8 times

Net cash flow is calculated as Net income plus depreciation and amortization.

Market Value Ratio

Market/Book RatioThe ratio of a stock’s market price to its book value gives another

indication of how investors regard the company.

Book Value per Share = Common Equity / Share Outstanding.

=896 /50 = 17.92 M/B Ratio = Market Price per share / Book value per share.

=23 / 17.92 = 1.3 times industry avg = 1.7 times