Financial Ratio

Analysis
 Brief Revision/ Overview
of Financial Statements
 Liquidity Ratios
Leverage Ratios
Efficiency Ratios
Profitability Ratios
Equity Ratios
 Brief Revision/ Overview
of Financial Statements
 Useful to the Firm’s Managers in
Managing the Firm
 Provide Information to Present &
Potential Creditors, Lenders,
Investors & Other Interested
Parties
 End Result of the process of
recording, classifying &
Summarizing firm’s transactions.
 Balance Sheet
A Statement of Firm’s Financial Position at
a Specific Point in time

Income Statement
A Statement Summarizing the
Firm’s Revenues & Expenses Over
An Accounting Period, generally a
Quarter or a Year.
 Balance Sheet & Income Statements are imp
Financial Statements however they do not provide
answers to Qs Such as
 Does the Firm have too much inventory on hand ?
 Is the firm too Debt heavy ?
 Is the firm well managed ?
 To seek answers the financial Mgr or Analyst
combines & transforms selective B/S & I/S items to
calculate ratios & Compare them to similar ratios
for the industry & for other firms in the Industry
 Facilitates Evaluation of Financial Statements
 Financial Ratios

 Liquidity Ratios
 Leverage Ratios
 Efficiency Ratios
 Profitability Ratios
 Equity Ratios
 Liquidity Ratios
 Measures the Ability of the Firm
to Meet its Short term Financial
Obligations

 Show The Relationship of a Firm’s

Cash & Other Current Assets to
its Current Liabilities
 Current Ratio
 Best Indicator of the extent to which the
claims of short term creditors (current
liabilities) are covered by assets expected to
be converted to cash in near future.
 Well managed firms are above Industry
Average while good firms are below it.
 If a firm’s ratios are far removed from the Avg.
of its Industry , an analyst should be
concerned about why this variance occurs.
 A deviation from Industry Avg. should signal
the analyst (or management) to check further.
 Quick Ratio
 The ratio is same as Current Ratio
except that it excludes inventories,
presumably the least liquid portion
of current assets.
 Measures the firm’s ability to pay off
short term obligations without
relaying on sale of its inventories
 The ratio provides a more
penetrating measure of liquidity
than does the current ratio.
 Debt Financing/ Financial
Leverage
 Three Implications
 By Raising Funds through Debt,
Stockholders can maintain control of the
firm without increasing their investment.
 Creditors look to the Equity, or Own
Supplied Fund, to provide a Margin of
Safety, so the higher the proportion of total
capital provided by stockholders, the less
the Risk faced by creditors
 Firm earns more on Inv Financed with
borrowed funds than it pays in interest, the
return on the owners’ capital is magnified
or leveraged
 Leverage Ratios
 Accomplishes Two Goals
 Measure Of The Extent to Which Firms Finance
their Assets through Debt
 Indicators of Financial Risk of the Firm
 Leverage as a Debt Financing Indicator is Imp b/c
Whenever a Firm’s Rate of Return is in Access of
Interest Rate, the Profits to Equity Inv are
Magnified in Direct Proportions to Increases in
Leverage.
 Leverage Ratios
 On the Contrary, Whenever a Firm’s
Rate of Return falls below Interest
Rate, the Profits to Inv Decline with
increases in Leverage.
 If the Firm is sufficiently levered,
interest expense may be so high that
under advance economic conditions
the firm may not be capable of paying
them i.e. financial risk is directly
proportional to leverage.
 Leverage Ratios
 Firms with relatively high debt ratios have
higher expected returns when the economy is
normal, but they are exposed to risk of loss
when the economy goes in to a recession.
 Therefore, decisions about the use of debt
require firms to balance higher expected
returns against increased risk.
 Ratios varies according to the nature of
business & the volatility of cash flows.
 Leverage Ratios
 TotalDebt to Total Asset Ratio
 Times Interest Earned
 Funded Capital to Net Working
Capital
 Total Debt to Total Asset
Ratio
 Also Known as Debt Ratio
 Debt Ratio = Total Liab/Total
Assets
 Creditors Prefer Low Debt Ratios
b/c lower the ratio, the greater the
cushion against creditors’ losses in
the event of Liquidation
 On the Contrary, Stockholders may
want more Leverage coz it
magnifies expected earnings.
 Total Debt to Total Asset
Ratio
 A debt Ratio of 53.2 % reflects that
creditors have supplied for more than
half of the total financing
 For Companies having such high debt
ratios, it is imp that they should raise
more equity capital before borrowing
additional funds.
 Creditors may be reluctant to lend
money to such firms & Mgmt would be
subjecting the firm to the risk of
bankruptcy if it increased the Debt Ratio
by Borrowing Additional Funds
 Times Interest Earned
 EBIT/Interest Charges
 Ratio measures the extent to
which the firm is capable of
servicing its interest expense from
funds available from Operations.
 Ratio measures the extent to
which the Income can decline
before the firm is unable to meet
its annual interest costs.
 Times Interest Earned
 As a Rule, a value of at least 3.0 &
Preferably closer to 5 is suggested.
 Suppose Firms EBIT is $ 418000 &
Interest Expenses amount to $ 93,000,
then the Ratio comes to around 4.5
 If the firms’ EBIT Shrinks by 78%,the
firm would still be able to pay interest it
owns.
 Thus it is a good margin of safety.
 Funded Debt
to Net Working Capital
 Funded Debt is defined as Debt
with a Maturity of more than 1
Year that includes Bonds,
Debentures, Term Loans &
Mortgages.
 Net Working Capital is defined as
the difference between Current
Assets & Current Liabilities
 Efficiency Ratios
 Indicator of managerial capabilities in
effectively utilizing the firm’s asset
 Capture firm’s managerial efforts in
managing Inventories of Raw & Finished
Goods, its Production Process, Its Credit &
Asset Management Policies & the
Effectiveness of its Marketing & Sales
Force
 Useful in in Judging the performance of
the firm
 Efficiency Ratios
 Avg Collection Period
 Avg Payment Period
 Inventory Turnover
 Total Assets Turnover
 Net Working Capital Turnover
Average Collection Period
 Also Known as Days Sales Outstanding
 Useful in Evaluating credit & collection
Policies.
 ACP = A/R/Avg Sales Per Day
 Sales Per Day = Annual Sales/ 365
 Meaningful in relation to firm’s credit
terms
 However, for accurate Analysis u need
to know the credit terms extended to
Customers
 Average Payment Period
 Usefulin Evaluating Payment Policies.
 APP = A/P/Avg Purchases Per Day
 Purchases Per Day = Annual Purchases/
365
 Meaningful in relation to Credit terms
extended to the Firm.
 The Difficulty in calculating this Ratio
stems from the need to find annual
Purchases.
 Average Payment Period
 This Value is generally not available in
the Financial Statements
 Ordinarily Purchases are estimated as
given %age of CoGS.
 However, for accurate Analysis u need to
know the credit terms extended to the
Firm.
 Prospective Lenders & Suppliers of Trade
Credit are specially interested in APP,
since it provides them sense of bill paying
patterns of the firm.
 Inventory Turnover
 Measures the Activity, or Liquidity
of a firm’s inventory.
 Sales/Inventories
 CoGS/Avg. Inv
 Excess Inv is unproductive, b/c it
represents investment with a zero
rate of return
 For Seasonal Industries (like Sugar
Ind) it is better to use Avg Inv
Formula.
 Total Asset Turnover
 Indicates the Efficiency with which the
firm uses all its assets to generate sales.
 Sales/ Total Assets
 Generally higher the ratio, the more
efficiently its assets have been used.
 This measure is of greatest interest to the
Management, since it indicates whether or
not the firm’s Operations have been
financially efficient.
 Fixed Asset Turnover
 Indicates the Efficiency with
which the firm uses all its fixed
assets to generate sales.
 Sales/ Net Fixed Assets
 Generally higher ratio is
preferred, since they reflect
greater efficiency of fixed Asset
Utilization.
 Net Working Capital
Turnover
 Net Sales / Net Working Capital
 Net Working Capital is the difference
between current Assets & Current
Liabilities = CA - CL
 An intuitive interpretation is that Net
Working Capital could be viewed as the
firm’s conscious commitment in current
assets to generate sales.
 This Ratio is a direct measure of firm’s
productivity in generating sales
 Profitability Ratios
 Measure of the profitability of the firm
 Key Ratios that are strong Measure of firm’s
overall performance
 Shows the combined effects of Liquidity, Asset
Management & Debt on Operating Results
 2 Types
 Showing Profitability in Relation to Sales
 Showing Profitability in Relation to Investment
 Profitability Ratios
 ProfitMargin
 Return on Total Assets
 Return on Net Worth.
 Return on Net Working Capital.
 Profit Margin
 Gross Profit Margin
 Oprating Profit Margin
 Net Profit Margin
 Gross Profit Margin
 Measures the %age of each sales
$ remaining after the firm has
paid for its goods
 Sales – CoGS/Sales = Gross
Profit/Sales
 The higher the ratio, the better
& lower the relative cost of
merchandise sold.
 Operating Profit Margin
 Measures Pure Profits earned on
each sales Dollar.
 They Are Pure in the sense that
they ignore any financial or Govt
Charges & measures only the
profits earned on operations.
 = Operating Profit/Sales
 The higher ratio is preferred.
 Net Profit Margin
 Measures the %age of each sales
$ remaining after all the
expenses, including taxes have
been deducted.
 = Net Profit (after taxes)/Sales
 The higher the ratio, the better.
 Commonly Citied Measure of
firm’s success with respect to
earnings on sales.
 Return on Total Assets
 Reflects the Earning Productivity of
Total Assets.
 = Net Profits/ Total Assets

Return on Net Worth

 Is the Measure of the Returns to the
Firm’s Stockholders.
 = Net Profits/Net Worth
 Return on Net Working
Capital
 Viewed as the Firm’s Direct
Efforts in Generating Sales and
the ratio of return on net working
capital identifies the profitability
of managerial decisions regarding
investment on current assets.
 = Net Profits/Net Working Capital
 Equity Ratios
 Primary Interest to the Firm’s Stock
Holders
 It Includes
Price to Earnings Ratio
Dividend Payout
Dividend Yield
Book Value Per Share
 Price to Earning Ratio
 Commonly Known as P/E Ratio.
 = Price/Earning
 Is an overall measure of the
Desirability of the Firm
 The more attractive the firm is to
the Investor, the higher the P/E
Ratio.
 Dividend Payout Ratio
 Isthe Ratio of Dividends per Share
to Earnings per Share or total
dividends to Net Income.
 = Dividend/Share
Earnings/Share
 %age of Earning Paid out as
Dividends.
 Different Stakeholders have
Specific Interests
 Trade Creditors - Primarily Interested in
Liquidity of Firm. As their claims are short
term so they go for Liquidity Ratios
 Bondholders - Have Long-term claims –
interested in analyzing cash flow ability,
capital structure, sources & uses of funds &
profitability over time, projections of future
profitability – Leverage Ratios/ Equity Ratios
& Profitability Ratios
 Investors – Concerned Principally with
Present & Expected Future Earnings &
stability of these earnings –Profitability
Ratios
Different Stakeholders have
Specific Interests
 Management – Interested in all
aspects of financial analysis –
although concerned with all
ratios but specifically with
Profitability & Efficiency Ratios