04 - ABATT - Session 16

Advance Business Analysis: Tools and Techniques
Objectives
In this session, you will learn to:
Calculate accounting ratios
Use accounting ratios to analyze a company’s financial position
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Accounting Ratios
Accounting ratios:
Are the relationship of two financial variables
Provide a link to the financial analysis of a company’s past, present, and future data
Have applications in cost accounting, financial accounting, budgetary control, and
auditing
Are used to make decisions regarding buying or selling a company’s shares
Liquidity ratios
Accounting ratios
Activity ratios
Capital structure ratios
Coverage ratios
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Current Assets
Scenario Cash and bank balances =
Blueberry Café $25,000
Loans and advances =
$50,000
Inventory = $160,000
Sundry debtors = $120,000
Liabilities
Current liabilities &
provisions = $150,000
Short-term debt = $90,000
Investments
Current investments =
$10,000
Long-term investments =
$20,000
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Liquidity Ratios
Liquidity ratios:
Are used to determine a company’s ability to meet its short-term obligations
Are often used by investors to perform a fundamental analysis on a firm
The most common liquidity ratios are:
Net working capital Liquidity
Current ratio ratios
Quick ratio
Net working
Current ratio Quick ratio
Let’s see how these three liquidity capital
ratios are calculated for Blueberry
Café.
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Liquidity Ratios (Contd.)

Net working capital:
Is a measure rather than a ratio
Is calculated as: Current assets – Current liabilities
Let’s calculate the net working capital for Blueberry Café:

Calculate current assets.
Current assets + Current investments = $355,000 + $10,000 = $365,000
Calculate current liabilities.

Current liabilities + Short-term debt = $150,000 + $90,000 = $240,000
Subtract current liabilities from current assets.

Net working capital = ($365,000 – $240,000) = $125,000
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Current ratio:
Measures the short-term liquidity of a firm
Current assets
Is calculated as:
Current liabilities
A current ratio of 2:1 is considered:
It means that the company has enough cash

Safe to meet its obligations.
If the company has blocked huge funds in

Unsafe
obsolete inventory or unnecessary assets
For Blueberry Café:

(Current assets + Current investments)
Current ratio =
(Current liabilities + Short−term debt)
(355,000 + 10,000)
=
(150,000 + 90,000)
= 1.52
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Quick ratio:
Measures the liquidity position of a firm
Is also popularly known as the acid test ratio
Quick Ratio
= Quick assets / Quick liabilities
= 1:1 is ideal
< 0.5 is a cause for alarm
Let’s calculate the quick ratio for Blueberry Café:
Quick assets = (Current assets + Current investments) – Inventory
= ($355,000 + $10,000) – $160,000 = $205,000
Quick liabilities = Current liabilities + Short-term debt
= $150,000 + $90,000 = $240,000
$205,000
Quick ratio = = 0.85
$240,000
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Demo: Calculating Liquidity Ratios

Problem statement:
In the balance sheet of A1B2C3, the current assets and liabilities are as shown.
Calculate the Net Working Capital, Current Ratio, and Quick Ratio for A1B2C3.
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Demo: Calculating Liquidity Ratios (Contd.)

Solution:
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Just a Minute
Which of the following ratio is considered the ideal quick ratio for a company?
a. 1:1
b. 1:3
c. 2:1
d. 1:2
Solution
a. 1 : 1
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Scenario
Liquidity ratios for Blueberry Café were Net sales = $1,065,000
obtained as listed. Will Sally’s loan be Cost of goods sold =
approved? $805,000
Current ratio = 1.52 : 1 Net credit sales = $450,000
Quick ratio = 0.85 Average inventory =
$149,000
Net working capital = $125,000
Debtors = $120,000
Average assets = $750,000
Creditors = $100,000
Credit purchase = $405,000
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Activity Ratios
Activity ratios:
Help to measure the efficiency in handling assets and other resources of a
business
Are generally calculated based on the company’s sales
Are expressed as integers rather than percentage
Are also known as turnover ratios Inventory turnover
Activity ratios
The higher the turnover ratio, the better is the Debtors turnover
profitability and use of capital and resources by
the company’s management.
Creditors turnover
Assets turnover
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Activity Ratios (Contd.)

Inventory turnover:
Is a ratio to measure the number of times the inventory is replaced in a year
Is also known as stock velocity
Should ideally be higher than the industry average
Inventory Turnover
= Sales / Inventory
= Cost of goods sold / Average inventory
A low turnover ratio = Poor sales
A high turnover ratio = Strong sales or ineffective buying
Inventory turnover for Blueberry Café can be calculated as:

Cost of goods sold
Inventory turnover =
Average inventory
$805,000
=
$149,000
= 5.40
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Debtors turnover:
Is a measure of a company's effectiveness in extending credit as well as collecting
debt
Is also known as the account receivables turnover ratio
Debtors turnover = Net credit sales / Average accounts receivable
High debtors turnover ratio = Greater efficiency of the management
Low debtors turnover ratio = Inefficient management of debtors or

less liquid debtors
Debtors turnover ratio for Blueberry Café can be calculated as:
Net credit sales
Debtors turnover ratio =
Average trade debtors
$450,000
=
$120,000
= 3.75
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Creditors turnover:
Is a measure the average credit period enjoyed by a business
Creditors Turnover
= Credit purchase / Average accounts payable
Too high = Creditors are not paid on time
Too low = The company is not taking full advantage of
the credit period offered by its credits
Creditors turnover ratio for Blueberry Café can be calculated as:

Credit purchase
Creditors turnover ratio =
Average creditors
$405,000
=
$100,000
= 4.05
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Assets turnover ratio:
Is a measure of the efficiency of a business in managing and utilizing its assets
Is useful for companies to check their growth in terms of revenue and sales
Cost of goods sold
Can be calculated as:
Assets
Assets turnover ratios

The asset turnover ratio for Total assets turnover
Blueberry Café will be:
Asset turnover ratio = Fixed assets turnover
Cost of goods sold
Total assets
$805,000 Capital turnover
=
$750,000
= 1.07 Current assets turnover
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Demo: Calculating Debtors and Creditors Turnover Ratios

Problem Statement:
The data of a X2Y2 Trading Co. is given as shown. Calculate the debtors and
creditors turnover ratios for the company.
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Demo: Calculating Debtors and Creditors Turnover Ratios (Contd.)

Solution:
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Scenario
Liquidity and activity ratios for Shareholders’ equity
Blueberry Café were obtained as Share capital = $125,000
listed: Reserves = $380,000
Current ratio = 1.52 : 1
Quick ratio = 0.85 Total Debt
Net working capital = $125,000 Long-term debt = $190,000
Inventory turnover = 5.4 Short-term debt = $90,000
Debtors turnover ratio = 3.75
Creditors turnover ratio = 4.05
Liabilities
Asset turnover ratio = 1.07 Current liabilities and
provisions = $150,000
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Capital Structure Ratios

Capital structure ratios:
Are a set of ratios used to analyze the capital structure of a firm
Help the management to take complex capital structuring decisions
Capital financial
decisions
Debt to total
Debt-equity ratio
capital ratio
Next, let’s see how to calculate capital structure ratios for Blueberry Café.
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Capital Structure Ratios (Contd.)

Debt-equity ratio:
Indicates the relative proportion on debt and equity for financing the assets of a firm
Is a measure of the company’s financial leverage
Total liabilities
Shareholders’ equity
A high debt-equity ratio means that a company has been aggressive in

financing its growth with debt.
The ideal debt-equity ratio can vary with the industry.
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The debt-equity ratio for Blueberry Café can be calculated as:
Total liabilities = Current liabilities and provisions + Long-term debts + Short-term
debts
= $150,000 + $190,000 + $90,000 = $430,000
Total liabilities
Debt-equity ratio =
Shareholder’s equity
$430,000
=
$505,000
= 0.85
Debt to total capital ratio:

Indicates what proportion of the permanent capital of a firm consists of debt
Is a measure of the company’s financial leverage
Debt
(Shareholders’ equity + Debt)
Is ideal when it is 1 : 2
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The debt to total capital ratio for Blueberry Café can be calculated as:
Debt
Debt to total capital ratio =
(Shareholders’ equity + Debt)
$430,000
=
($505,000 + $430,000)
$430,000
=
$935,000
= 1 : 2.17
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Demo: Calculating the Debt-Equity Ratio

Problem Statement:
M1N2 Inc. has applied for a loan. The lender needs to compute the debt-equity ratio
as part of the long-term solvency test of the company. The Liabilities and
Stockholders’ Equity section of the company’s balance sheet is shown. Calculate the
debt-equity ratio of M1N2 Inc., on behalf of the lender.
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Demo: Calculating the Debt-Equity Ratio (Contd.)

Solution:
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Just a Minute
For capital-intensive industries such as auto manufacturing, which one of the
following ratios is considered as an ideal debt-equity ratio?
a. More than 1
b. Less than 1
c. Less than 2
d. More than 2
Solution
d. More than 2
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Scenario
Liquidity and activity ratios for Blueberry EBIT = $170,000
Café are:
Current ratio = 1.52 : 1 Interest = $35,000
Quick ratio = 0.85
Net working capital = $125,000 Total fixed
Inventory turnover = 5.4 charges = $50,000
Asset turnover ratio = 1.07
Capital structure ratios for Blueberry

Café are:
Debt-equity ratio = 0.85
Debt to total capital ratio = 1 : 2.17
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Coverage Ratios
Coverage ratios:
Indicate a company’s ability to meet its financial obligations
Help to ascertain the change in a company’s financial position
Coverage ratios
Interest coverage ratio
Dividend coverage ratio
Total coverage ratio
High coverage ratios are considered a financially healthy condition for a

business.
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Coverage Ratios (Contd.)

Interest coverage ratio:
Indicates how easily a company can pay on it’s outstanding debts
Should be at least be higher than 1.5
Is an indicator of a company’s short term health
Earnings before interest and taxes (EBIT)
Interest expense
EBIT
Blueberry Café’s interest coverage ratio =
Interest expense
$170,000
=
$35,000
= 4.86
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Dividend coverage ratio:
Indicates the ability of a company to pay on it’s declared dividends
Should be at least be higher than 2
Earnings per share (EPS)
Dividend per share (DPS)
Blueberry Café’s dividend coverage ratio is not calculated because:

The company has been in operation only for the last 1 year.
It is yet to declare any dividend.
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Total coverage ratio:
Indicates the overall ability of a company to meet its liabilities
EBIT
Total fixed charges
EBIT
Blueberry Café’s total coverage ratio =
Total charges
$170,000
=
$50,000
= 3.4
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Scenario
Liquidity and activity ratios for Blueberry Café
are:
Current ratio = 1.52 : 1
Quick ratio = 0.85
Net working capital = $125,000
Inventory turnover = 5.4
Asset turnover ratio = 1.07
Capital structure ratios for Blueberry Café are:

Debt-equity ratio = 0.85
Debt to total capital ratio = 1 : 2.17
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Scenario
Coverage ratios for Blueberry Café are:
Interest coverage ratio = 4.86
Total coverage ratio = 3.4
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Demo: Calculating the Dividend Cover

Problem statement:
John, a shareholder of CDE Plc., wants to know whether he will receive the
dividends that the company has declared. Help John find out the dividend cover for
CDE Plc. Details related to the company’s financial statements for the year ended
31 December 2012 are available as shown.
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Demo: Calculating the Dividend Cover (Contd.)

Solution:
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Just a Minute
Which set of ratios are considered to measure a company’s ability to meet its
financial obligations?
a. Coverage ratios
b. Capital structure ratios
c. Turnover ratios
Solution
a. Coverage ratios
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Summary
In this session, you learned that:
Financial ratios play an important role in analyzing financial data and forming
important corporate decisions.
Liquidity ratios are of the following types:
Net working capital
Current ratio
Quick ratio
Important turnover or activity ratios are:
Inventory turnover
Debtors turnover
Creditors turnover
Assets turnover
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Summary (Contd.)
Capital structure ratios are frequently used by the management to take complex
capital structuring decisions.
Capital structure ratios are of the following types:
Debt-equity ratio
Debt to total capital ratio
Coverage ratios indicate a company’s ability to meet its financial obligations.
Coverage ratios can be of the following types:
Interest coverage ratio
Dividend coverage ratio
Total coverage ratio
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What’s Next
Before the next session, please ensure to:
Read the following chapter from Book 1:
Chapter 25, “Financial Statement Analysis”
Cover the following topic in the e-learning session:
Financial Statement Analysis with Ratios – 1
Read KB – 2. Cover the following topic:
Analyzing a Business Using Financial Ratios
Attempt the Lab@Home exercises by clicking on the respective Lab@Home session
on the technology space on Cloudscape.
Attempt ABATT Cycle Test 2.
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Advance Business Analysis: Tools and Techniques

Capital structure ratios

Liquidity Ratios (Contd.)

Let’s calculate the net working capital for Blueberry Café:

Calculate current liabilities.

Subtract current liabilities from current assets.

Liquidity Ratios (Contd.)

A current ratio of 2:1 is considered:

It means that the company has enough cash

If the company has blocked huge funds in

For Blueberry Café:

Liquidity Ratios (Contd.)

Demo: Calculating Liquidity Ratios

Demo: Calculating Liquidity Ratios (Contd.)

Activity Ratios (Contd.)

Inventory turnover for Blueberry Café can be calculated as:

Activity Ratios (Contd.)

Debtors turnover = Net credit sales / Average accounts receivable

High debtors turnover ratio = Greater efficiency of the management

Low debtors turnover ratio = Inefficient management of debtors or

Activity Ratios (Contd.)

Creditors turnover ratio for Blueberry Café can be calculated as:

Activity Ratios (Contd.)

Assets turnover ratios

Demo: Calculating Debtors and Creditors Turnover Ratios

Demo: Calculating Debtors and Creditors Turnover Ratios (Contd.)

Capital Structure Ratios

Capital Structure Ratios (Contd.)

A high debt-equity ratio means that a company has been aggressive in

The ideal debt-equity ratio can vary with the industry.

Capital Structure Ratios (Contd.)

Debt to total capital ratio:

Capital Structure Ratios (Contd.)

Demo: Calculating the Debt-Equity Ratio

Demo: Calculating the Debt-Equity Ratio (Contd.)

Capital structure ratios for Blueberry

Dividend coverage ratio

Total coverage ratio

High coverage ratios are considered a financially healthy condition for a

Coverage Ratios (Contd.)

Coverage Ratios (Contd.)

Blueberry Café’s dividend coverage ratio is not calculated because:

Coverage Ratios (Contd.)

Capital structure ratios for Blueberry Café are:

Demo: Calculating the Dividend Cover

Demo: Calculating the Dividend Cover (Contd.)

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