Financial Ratio Analysis

Financial Ratio Analysis

Ratios are quantities that establish relationship between two variables. Ratio analysis helps in studying various aspects like liquidity, efficiency, profitability and solvency of the firm.

Purpose

Through ratio analysis, the financial statements user comes into possession measures w/c provide insight into the profitability of operations, the soundness of the firms short-term and long-term financial condition and the efficiency with w/c management has utilized the resources entrusted to it.

Ratio analysis can be performed in two ways:

-Comparative

Analysis: It helps in analyzing whether the ratios computed for the firm are within limits when compared to certain standards or other firms in the industry. Ratios of the firm can also be compared with the previous ratios, in order to identify the existing trend.

Limitations of Financial Ratios

Ratios must be used only as financial tools, that is, as indicators of weakness or strength and not to be regarded as good or bad per se. Financial ratios are generally computed directly from the companys financial statements, without adjustment. Ratios are composite of many different figures some covering a time period, others are instant time and still others representing averages.

Ratios to be meaningful should be evaluated with the use of certain yardsticks. The most common of these are: Company's own experience (prior years) Other companies in the same industry (industry averages) A standard set by management ( a budget)

Financial Ratio Analysis

Liquidity ratios Liquidity ratios measure the ability of the firm to meet its current obligations. ( payment of accounts payable, bank loans and operating costs) Activity ratios/ Turnover ratios These ratio indicate the efficiency of the firm in dealing with the current assets. They indicate the pace at which the assets are turned into sales.

Profitability ratios :- Profitability ratios help in measuring the operating efficiency of the firm. Besides the management of the company, creditors, owners and shareholders are also interested in the profitability of the firm.
There are two categories of profitability ratios: a)gross profit margin b) net profit margin.

Ownership ratios :-Ownership ratios help in analyzing the value of the shareholders investments in the firm. They help in evaluating the firms value with respect to different aspects like earnings of the firm, dividends declared, debt employed by the firm, market price of the firm, etc.
Ownership ratios can be divided into three different categories:
Earnings Ratios Leverage Ratios Dividend Ratios

Summary of most Commonly Used Ratios : Their Formulas and Basic Significance

Ratios Used To Evaluated Short-Term Financial Position ( Short-Term Solvency And Liquidity ) LIQUIDITY RATIO
NAME Current Ratio FORMULA total current assets total current liabilities SIGNIFICANCE primary test of solvency to meet current obligations from current assets as a going concern; measure of adequacy of Ideal ratio 2:1 working capital a more severe test of immediate solvency test of ability to meet demands Ideal ratio 1:1 from current assets indicates relative liquidity of total assets and distribution of resources employed

Acid-test ratio or quick ratio

total quick assets total current liabilities

Working capital to total assets Working capital

working Capital total assets current assets less current liabilities

Cash flow liquidity ratio

Cash + marketable securities+ cash flow from operating activities current liabilities

measures short-term liquidity by considering as cash resources (numerator)cash plus cash flow from operating activities

Bank finance to working capital gap

Short term bank finance Working capital gap

ratio indicates the extent to which the firm relies on short-term bank finance for financing its working capital.

Ratios Used To Evaluate the Asset Liquidity and Management Efficiency (TURNOVER RATIO)
NAME Average account receivable turnover FORMULA SIGNIFICANCE gives the number of times receivables are generated and collected during the year.

net credit sales average account receivable(net)

360 days average collection Period Average account receivable turnover or average account receivable(net) net sales/360

helps in measuring the creditworthiness of the debtors as it indicates the time by which the debtors pay back their obligation arising on account of credit sales.

inventory turnover cost of goods sold ave. inventory measures efficiency of the firm in managng and selling inventories

Ratios Used To Measure Profitability And Returns To Investors (PROFITIBILITY RATIO)

NAME FORMULA SIGNIFICANCE
measures profit generated after considering of cost

Gross profit margin

gross profit net sales

of product sold

Operating profit margin

Operating profit net sales

measures profit generated after consideration of operating profits

Net profit margin (rate of return on net sales

net profit net sales

measures profit generated after consideration of all expenses and revenues

Cash flow margin

Cash flow for operating activities net sales

measures ability of the firm to translate sales to cash

Rate of return on assets (ROA)

Net Profit Ave. Total Assets alternative formula: asset turnover x net profit margin

measures overall efficiency of the firm in managing assets and generating profits

Rate of return on equity

net income ave. ordinary equity

measures rate of return on resources provided by owners

OWNERSHIP RATIOS

LEVERAGE RATIO

Ratios Used To Evaluate Long-Term Financial Position Or Stability/Leverage

NAME
Debt Ratio

FORMULA
total liabilities total assets

SIGNIFICANCE
shows proportion of all assets that are financed with debt indicates proportion of assets provided by owners. Reflects financial strength and caution to creditors measures debt relative to amounts of resources provided by owners

Equity ratio

total equity
total assets

Debt to equity ratio

total liabilities total equity

Price/earnings ratio

market value per share

measures relationship b/w price of ordinary shares in the open market and profit earned on per share basis

of ordinary shares earnings per share of ordinary shares

Dividend Payout

dividend per share earnings per share

shows percentage of earnings paid to shareholders

Dividend Yield

Annual Dividends per share

shows the rate earned by shareholders

market value per share of ordinary shares

from dividends relative to current price of stock

Du Pont system
Du Pont system analyzes the return ratios (like return in assets and return on equity) in terms of net profit margin and turnover ratios. According to Du Pont analysis, Return on Assets can be measured in the following manner: Return on Assets (ROA) = Net Profit Margin x Average Asset Turnover

that return earned on assets is a function of the net profit margin (which measures the profit earned by the firm on its sales) and the average asset turnover (which measures the companys ability to generate sales with the assets that it has). We can extend the above equation, to compute the return on equity in the following manner: Return on Equity (ROE) = Net Profit Margin x Average Asset Turnover x Equity Multiplier i.e. Return on Equity = Return on Assets x Equity Multiplier

Financial Ratios Analysis

I. Analysis of Liquidity or Short-Term Solvency II. Analysis of Asset Liquidity and Asset Management Efficiency III. Analysis of Leverage : Debt Financing and Coverage

IV. Operating Efficiency and Profitability

I. Analysis of Liquidity or Short-Term Solvency

Current Ratio is widely regarded as a measure of short-term debt-paying ability. Quick or Acid test ratio is a much more rigorous test of a companys ability to meet in short term debts. Cash flow liquidity ratio considers cash flow from operating activities in addition to the truly liquid assets, cash and marketable securities.

II. Analysis of Asset Liquidity and Asset Management Efficiency

Accounts Receivable Turnover roughly measures how many times a companys accounts receivable have been turned into cash during the year. Average Collection Period helps evaluate the liquidity of accounts receivable and the firms credit policies. Inventory Turnover measures the efficiency of the firm in managing and selling inventory.

III. Analysis of Leverage : Debt Financing and Coverage

Debt Ratio measures the proportion of all assets that are financed with debt.

Debt Equity Ratio measures the riskiness of the firms capital structure in terms of relationship between the funds supplied by creditors (debt) and investors (equity).

IV. Operating Efficiency and Profitability

Gross Profit Margin which shows the relationship between sales and the cost of products sold, measures the ability of a company both to control costs and inventories or manufacturing of products and to pass along price increases through sales to customers. Operating Profit Margin is a measure of overall operating efficiency and incorporates all of the expenses associated with ordinary or normal business activities

Net Profit Margin measures profitability after considering all revenue and expenses, including interest, taxes and non operating items such as extraordinary items, cumulative effect of accounting change, etc. Cash Flow Margin is another important measure or perspective on operating performance. ROA and ROE are two ratios that measure the overall efficiency of the firm in managing its total investment in assets and in generating return to shareholders.

Illustrative Problem 5.2

Financial Ratio Analysis

EBC Enterprises, Inc. Balance Sheet at December 31, 2006 and 2005 (In thousands)
2006 Assets Current Assets Cash Marketable securities Accounts Receivable Allowance for doubtful accounts Inventories Prepaid expenses Total current assets Property, Plant, Equipment Land Buildings and leasehold improvements Equipment Less Accum. Depreciation & amortization Net property, plant,equipment Other Assets Total Assets 2030.5 2636.0 4704.0 -224.0 25520.5 256.0 32923.0 11981.0 4002.0 48383.5 -208.5 18384.5 379.5 28132.0 2005

405.5 9136.5 10761.5 20303.5 -5674.0 14539.5 186.5 47649.0

405.5 5964.0 6884.0 13523.5 -3765.0 9488.5 334.0 37488.5

Liabilities and Equity Current Liabilities Accounts payable notes payable current maturities of long-term debt Accrued liabilities Total Current liabilities Deferred Income Taxes Long -term debt Total Liabilities Equity ordinary shares par value P 1, authorized 10,000,000 shares; issued 2,297,000 shares in 2006 and 2,401,500 shares in 2005 Additional paid- in capital Retained earnings Total Equity Total Liabilities and Equity 7147.0 2807.0 9842.0 2834.5 13730.5 421.5 10529.5 24681.5 3795.5 3006.0 758.0 2656.5 10216.0 317.5 8487.5 19021.0

2401.5 478.5 20087.5 22967.5 47649.0

2297.0 455.0 16181.5 18933.5 37954.5

EBC Enterprises, Inc. Income Statement and Retained Earnings Fro the Years Ended December 31, 2006, 2005, and 2004
2006
Net Sales Cost of Goods sold 107,800.0 64,682.0

2005
76,500.0 45,939.5

2004
70,350.0 40,803.0

Gross Profit

43,118.0

30,560.5

29,547.0

Selling and Administrative expenses Advertising Lease Payments Depreciation and amortization Repairs and maintenance Total Operating Profit

16,332.0 7,129.0 6,529.0 1,999.0 1,507.5 33,496.5 9,621.5

13,191.0 5,396.0 3,555.5 1,492.0 1,023.0 24,657.5 5,903.0

12,749.0 47,770.5 3,633.5 1,250.5 1,515.5 23,919.0 5,628.0

Other income (expenses) Interest income interest expense

Earnings before income taxes

211.0 (1,292.5)

419.0 (1,138.5 )

369.0 (637.0 )

8,540.0

5,183.5

5,360.0

Income taxes Net Income

3,843.0 4,697.0

2,228.5 2,955.0

2,412.0 2,948.0

Earnings per common share Statements of retained Earnings

Retained earnings at beginning of year

2.0

1.29

1.33

16,181.5 4,697.0

14,157.5 2,955.0

13,130.0 2,948.0

Net Income Cash dividends (2006-0.33 per share; 2005-0.41 per share) Retained earnings at the end of year

(791.0) 20,087.5

(931.0) 16,181.5

(920.5 ) 14,157.5

Summary of Financial Statements Analysis of EBC, Inc.

Short Term Liquidity and Activity

Short term liquidity analysis is of particular significance to trade and short-term creditors, management and other parties concerned with the ability of a firm to meet near- term demands for cash. EBCs current and quick ratios decreased indicating a deterioration of short-term liquidity. However, the cash flow liquidity ratio improved in 2006 after a negative cash generation in 2005.

The average collection period for accounts receivable and the inventory turnover improved in 2006 which could indicate improvement in the quality of accounts receivable and liquidity of inventory. The increase in inventory level has been accomplished by reducing holdings of cash and cash equivalents. This represents a trade-off of highly liquid assets for potentially less liquid assets. The efficient management of inventories is critical for the firms ongoing liquidity.

Presently, there appears to be no major problems with the firms short-term liquidity position.

Long-Term Solvency
The debt ratios for EBC show a steady increase I the use of borrowed funds. Total debt has increased relative to total assets, long term debt has increased as a proportion of the firms permanent financing and external or debt financing has risen relative to internal financing. Why has debt increased? The statement of cash flows shows that EBC has substantially increased its investment in capital or fixed assets and their investments have been financed largely by borrowing especially in 2005 when the firm had a rather sluggish operating performance and no internal cash generation.

Given the increased level of borrowing the times interest earned and fixed charge coverage improved slightly in 2006. these ratios should however be monitored closely in the future particularly if EBC continues to expand.

Operating Efficiency and Profitability

As noted earlier, EBC has increased its investment in fixed asset as a result of store expansion. The asset turnover in 2006, the progress traceable to improved management of inventories and receivable. There has been substantial sale growth which suggests future performance potential.

The gross profit margin was stable, a positive sign in the light of new store openings featuring discounted and sale items to attract customers. The firm also managed to improved its operating profit margin in 2006 principally due to the firms ability to control operating costs. The net profit margin also improved despite increased interest and tax expenses and a reduction in interest income from marketable security investment. Return on assts and return on equity increased considerably in 2006. these ratios measure the overall success of the firm in generating profits from its investment and management strategies.

Conclusion
It appears that EBC Enterprises, Inc. is well positioned for future growth. Close monitoring the firms management of inventories is important considering the size of the companys capital tied up in it. The expansion in their operation may necessitate a sustained effort to advertised more, to attract customers to both new and old areas. EBC has financed much of its expansion with debt, and so far, its shareholders have benefited from the use of debt through financial leverage. The company should however be cautious of the increased risk associated with debt financing.