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C H A P T E R
Analyzing and
Interpreting
Financial
Statements
LEARNING OUTCOMES
When you have completed this chapter,
you should be able to:
1 Identify the major categories of ratios
that can be used for analysis
purposes.
2 Calculate important ratios for assessing the financial performance of a
business, and explain the significance
of the ratios calculated.
3 Discuss the limitations of ratios as a
tool of financial analysis.
INTRODUCTION
In this chapter we consider the analysis and interpretation of the financial statements. We
will see how financial (or accounting) ratios can help in assessing the financial health of
a business. We will also discuss the problems that are encountered when applying this
technique.
Financial ratios can be used to examine various aspects of financial performance, and
are widely used for planning and control purposes. As we will see in later chapters, they can
be very helpful to managers in a wide variety of decision areas, such as profit planning,
working capital management, financial structure, and dividend policy.
FINANCIAL RATIOS
Financial ratios provide a quick and relatively simple means of assessing the financial
health of a business. A ratio simply relates one figure appearing in the financial statements to some other figure appearing there (for example, net income in relation to
capital employed) or, perhaps, to some resource of the business (for example, net
income per employee, or sales revenue per square metre of counter space).
Ratios can be very helpful when comparing different businesses financial health.
Differences may exist between businesses in the scale of operations, and so a direct
comparison of the profits generated by each business may be misleading. By expressing
net income in relation to some other measure (for example, sales revenue), the problem
of scale is eliminated. A business with a profit of $10,000 and sales revenue of $100,000
can be compared with a much larger business with a profit of $80,000 and sales revenue
of $1,000,000 by the use of a simple ratio. The net income to sales revenue ratio for the
smaller business is 10% [i.e., ($10,000/$100,000) 100%], and the same ratio for the
larger business is 8% [i.e., ($80,000/$1,000,000) 100%]. These ratios can be directly
compared, whereas comparison of the absolute profit figures would be less meaningful.
The need to eliminate differences in scale through the use of ratios can also apply when
evaluating the performance of the same business over time.
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Analyzing and Interpreting Financial Statements
By calculating a small number of ratios, it is often possible to develop a good

picture of a businesss performance. The ratios can highlight financial strengths and
weaknesses, and so it is not surprising that ratios are widely used by those who have an
interest in businesses and business performance. However, ratios provide only
the starting point for further analysis. Changes in a particular ratio may be due to a
variety of factors and a ratio cannot, by itself, explain why certain strengths or weaknesses exist, or why certain changes have occurred. Only a detailed investigation will
reveal these underlying reasons.
Ratios can be expressed in various formsfor example, as a percentage or as a
proportion. The way that a particular ratio is presented will depend on the needs of
those who will use the information. Although it is possible to calculate a large number
of ratios, only a few, based on key relationships, tend to be helpful to a particular user.
Many ratios that could be calculated from the financial statements (for example, rent
expense in relation to current assets) may not be considered because there is no clear
or meaningful relationship between the two items.
There is no generally accepted list of ratios that can be applied to the financial
statements, nor is there a standard method of calculating many ratios. Variations in
both the choice of ratios and their calculation will be found in practice. However, it is
important to be consistent in how ratios are calculated for comparison purposes. The
ratios discussed below are widely used because many consider them to be important
for decision making purposes.
L.O. 1
FINANCIAL RATIO CLASSIFICATION

Ratios can be grouped into categories, each of which relates to a particular aspect of
financial performance. Five broad categories provide a useful basis for explaining the
nature of the financial ratios to be dealt with.
Profitability. Profitability ratios measure a businesss success in creating wealth

for its owners. They express the profits made (or figures bearing on profit, such as
overheads) in relation to other key figures in the financial statements or to some
business resource.
Efficiency. Some ratios measure the efficiency with which particular resources have
been used within the business. These ratios are also referred to as activity ratios.
Liquidity. It is vital to the survival of a business for there to be sufficient liquid
resources available to meet debts that must be paid in the near future. Some
liquidity ratios examine the relationship between liquid resources held and
payables due in the near future.
Financial leverage. This is the relationship between the shareholders contribution to
the businesss financing and the amount contributed by others in the form of loans.
The amount of leverage has an important effect on the degree of risk associated with
a business. Leverage is, therefore, something that managers must consider when
making financing decisions. Leverage ratios tend to highlight the extent to which the
business uses debt to finance its operations.
Investment. Certain ratios are concerned with assessing the returns and performance of shares held in a particular business from the perspective of shareholders
who are not involved with the management of the business.
The analyst must be clear who the target users are and why they need the information. Different users of financial information are likely to have different information
needs, which will in turn determine which ratios they find useful. For example,
shareholders are likely to be interested in their returns in relation to the level of risk
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associated with their investment. Thus profitability, investment, and leverage ratios will
be of particular interest. Long-term lenders are concerned with the long-term viability
of the business, so the businesss profitability and leverage ratios are likely to be of
particular interest. Short-term lenders, such as suppliers of goods and services on credit,
may be interested in the businesss ability to repay the amounts owing in the short term.
As a result, the liquidity ratios should be of interest to them.
THE NEED FOR COMPARISON

Merely calculating a ratio will not tell us very much about the position or performance
of a business. For example, if a ratio revealed that the business was generating $10,000
in sales revenue per employee, it would not be possible to determine from this information alone whether this particular level of performance was good, bad, or indifferent. Only when we compare this ratio with some benchmark can the information be
interpreted and evaluated.
ACTIVITY 4.1
Can you think of any benchmarks that could be used to compare with a ratio you have
calculated from the financial statements of a particular period?
You might have thought of the following bases:
Past periods. By comparing the ratio we have calculated with the same ratio, but for a
previous period, it is possible to detect whether there has been an improvement or deterioration in performance. Indeed, it is often useful to track particular ratios over time (say,
five or ten years) to see whether it is possible to detect trends. The comparison of ratios
from different time periods brings certain problems, however. In particular, there is always
the possibility that business conditions may have been quite different in the periods being
compared. There is the further problem that, when comparing the performance of a
single business over time, operating inefficiencies may not be clearly exposed. For example, the fact that sales revenue per employee has risen by 10% over the previous period
may at first sight appear to be satisfactory. This may not be the case, however, if similar
businesses have shown an improvement of 50% for the same period. Finally, there is the
problem that inflation may have distorted the figures on which the ratios are based.
Inflation can lead to an overstatement of profit and an understatement of asset values.
Similar businesses. In a competitive environment, a business must consider its
performance in relation to that of other businesses operating in the same industry.
Survival may depend on the ability to achieve comparable levels of performance. Thus it
is very useful to compare a particular ratio with the ratio achieved by similar businesses
during the same period. This strategy is not without its problems, however. Competitors
may have different year-ends, and therefore business conditions may not be identical.
They may also have different accounting policies, which can have a significant effect on
reported profits and asset values (for example, different methods of calculating amortization or valuing inventory). Finally, it may be difficult to obtain competitors financial
statements. Sole proprietorships and partnerships, for example, as well as privately
owned corporations, are not obliged to make their financial statements available to the
public. Publicly listed corporations are legally obligated to disclose their financial statements; however, a diversified business might not provide a breakdown of activities
detailed enough for analysts to compare it with the activities of other businesses.
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Planned or budgeted performance. Ratios may be compared with the targets that
management developed before the start of the period under review. Comparing
planned performance with actual performance may therefore be useful for revealing
the level of achievement attained. However, the planned levels of performance must
be based on realistic assumptions if they are to be useful for comparison purposes.
Planned performance is likely to be the most valuable benchmark for the managers
to assess their own business. Businesses tend to develop planned ratios for each aspect
of their activities. When planning, a business may usefully take account of its own past
performance and that of other businesses. There is no reason, however, why a particular business should seek to achieve either its own previous performance or that of other
businesses. Neither of these may be seen as an appropriate target.
Analysts outside the business do not normally have access to the businesss plans.
For these people, past performance and the performance of other similar businesses
may be the only practical benchmarks.
KEY STEPS IN FINANCIAL RATIO ANALYSIS

When undertaking ratio analysis, analysts follow a sequence of steps:
1. Identify the key indicators and relationships that require examination. In carrying
out this step, the analyst must be clear who the target users are and why they need
the information. We saw earlier that different types of users of financial information are likely to have different information needs that will, in turn, determine
which ratios they find useful.
2. Calculate ratios that are considered appropriate for the particular users and the
purpose for which they require the information.
3. Interpret and evaluate the ratios. Interpretation involves examining the ratios along
with an appropriate basis for comparison and any other information that may be
relevant. The ratios significance can then be established. Evaluation involves judging the value of the information uncovered in the calculation and interpretation of
the ratios. Whereas calculation is usually straightforward, interpretation and evaluation are more difficult and often require high levels of skill. This skill can only
really be acquired through much practice.
The three steps are shown in Figure 4.1.
FIGURE 4.1
The Three Key Steps of Financial Ratio Analysis

Identify the
key indicators
and relationships
that require
examination.
Calculate
ratios that
are considered
appropriate.
Interpret
and
evaluate the
ratios.
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CALCULATING THE RATIOS
L.O. 2
Example 4.1 provides a set of financial statements from which we can calculate
important ratios.
Example 4.1
The following financial statements relate to Alexis Corporation, which operates
in the wholesale carpet business:
Alexis Corporation
Balance Sheet
As at March 31
(in $ millions)
Current assets
Cash
Accounts receivable
Inventory
Total current assets
Property, plant, and equipment
Land
Buildings (net)
Equipment (net)
Total property, plant,
and equipment
Total assets
Current liabilities
Bank overdraft
Accounts payable
Income taxes payable
Dividends payable
Total current liabilities
Long-term liabilities
Bonds payable (9%)
Total liabilities
Shareholders equity
Common shares (Note 1)
Retained earnings
Total shareholders equity
Total liabilities and
shareholders equity
2008
2007
273
406
679
4
240
300
544
100
327
160
100
281
129
587
510
1,266
1,054
76
314
2
40
432
221
30
40
291
300
732
200
491
300
234
534
300
263
563
1,266
1,054
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Alexis Corporation
Income Statement
For the year ended March 31
(in $ millions)
Sales (Note 2)
Less: Cost of goods sold (Note 3)
Gross profit
Less: Operating costs
Earnings before interest and taxes (EBIT)
Less: Interest expense
Earnings before taxes
Less: Income tax expense
Net income
2008
2007
2,681
2,272
409
362
47
32
15
4
11
2,240
1,745
495
252
243
18
225
60
165
Alexis Corporation
Statement of Retained Earnings
For the year ended March 31
(in $ millions)
Opening retained earnings, April 1

Add: Net income
Less: Dividends declared
Closing retained earnings, March 31 (Note 4)
2008
2007
263
11
(40)
234
138
165
(40)
263
Notes
1. The market value per share of the 600 million shares outstanding on March 31 was $1.50 for
2008 and $2.50 for 2007.
2. All sales and purchases were made on credit.
3. Cost of goods sold details are as follows:
(in $ millions)
Opening inventory
Plus: Purchases (Note 2)
Goods available for sale
Less: Closing inventory
Cost of goods sold
2008
2007
300
2,378
2,678
406
2,272
241
1,804
2,045
300
1,745
4. Closing balance of retained earnings appears on the balance sheet.

5. The business employed 13,995 staff at March 31, 2007, and 18,623 at March 31, 2008.
6. At April 1, 2006, the total shareholders equity stood at $438 million, long-term debt was
$200 million, and current liabilities were $400 million.
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A BRIEF OVERVIEW
Before we start our detailed look at the ratios for Alexis Corporation (in Example 4.1),
it is helpful to take a quick look at what information is obvious from the financial statements. This will usually reveal some issues that the ratios may not be able
to identify. It may also highlight some points that could help us in our interpretation
of the ratios. Starting at the top of the balance sheet, the following points can
be noted:
Reduction in the cash balance. The cash balance fell from $4 million to a $76 million
overdraft, between 2007 and 2008. The bank may be pressuring the business to
reverse this, which could raise difficulties.
Major expansion in the elements of working capital. Inventory increased by about
35% [i.e., ($406 $300) $300 100%], receivables by about 14%, and accounts
payables by about 42% between 2007 and 2008. These are major increases, particularly in inventory and payables (which are linked because the inventory is all
bought on creditsee Note 2).
Expansion of property, plant, and equipment. These have increased by about
15% [i.e., ($587 $510) $510 100%] over the year. However, as the
closing figure reflects the position after amortization for the year has been
deducted, the amount actually invested in those assets during the year will be
higher than the difference between the opening and closing figures. We are not
told when these new assets were added, but it is quite possible that it was well
into the year. This could mean that not much benefit was reflected in terms of
additional sales revenue or cost savings during 2008. Sales revenue, in fact,
expanded by about 20% (from $2,240 million to $2,681 million), more than
the expansion in capital assets.
Apparent debt capacity. Comparing either the property, plant, and equipment
assets or the net assets with the long-term debt implies that the business may
well be able to offer security on further borrowing. This is because potential
lenders usually look at the value of assets that can be offered as security,
when assessing loan requests. Lenders seem particularly attracted to land and
buildings as security. For example, at March 31, 2008, land and buildings had a
balance sheet value of $427 million, but long-term borrowing was only
$300 million (though there was also an overdraft of $76 million). Balance sheet
values are not normally market values, of course. Land and buildings tend to
have a market value higher than their balance sheet value owing to inflation in
property values.
Lower profit. Although sales revenue expanded by 20% between 2007 and 2008,
both cost of goods sold and operating costs rose by a greater percentage, leaving
both gross profit and, particularly, net income significantly reduced. The level of
staffing, which increased by about 33% (from 13,995 to 18,623), may have greatly
affected the operating costs. (Without knowing when during 2008 the additional
employees were recruited, we cannot be sure of the effect on operating costs.)
Increasing staffing by 33% must put an enormous strain on management, at least
in the short term. It is not surprising, therefore, that 2008 was not a good year for
the business.
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PROFITABILITY
The following ratios may be used to evaluate the profitability of the business:
Return on equity
Return on capital employed
Operating profit margin
Gross profit margin.
Return on Equity
The return on equity (ROE) compares the amount of profit for the period available to
the owners, with the owners average stake in the business during that same period. The
ratio (which is normally expressed in percentage terms) is as follows:
Return on equity =
Net income after preferred dividends (if any)

Average shareholders equity
* 100% 4.1
Shareholders equity consists of common shares plus retained earnings.

The net income after any preferred dividend is used in calculating the ratio, as this
figure represents the amount of profit that is left for the owners (that is, the common
shareholders).
In the case of Alexis Corporation, the ratio for the year ended March 31, 2007, is:
ROE =
165
* 100% = 33.0%
(438 + 563)/2
Note that, in calculating the ROE, the average of the figures for shareholders equity at
the beginning and the end of the year has been used. It is preferable to use an average
figure, as this might be more representative: shareholders equity did not have the same
total throughout the year, yet we want to compare it with the profit earned during
the whole period. We know, from Note 6, that the total of the shareholders equity at
April 1, 2006, was $438 million. By a year later, however, it had risen to $563 million,
according to the balance sheet as at March 31, 2007.
The easiest approach to calculating the average amount of shareholders equity is to
take a simple average based on the opening and closing figures for the year. This is often the
only information available, as is the case here. Where the beginning-of-year figure is not
available, it is usually acceptable to use just the year-end figure, provided that this approach
is adopted consistently. This is generally valid for all ratios that combine a figure for a period
(such as net income) with one taken at a point in time (such as shareholders equity).
ACTIVITY 4.2
Calculate the ROE for Alexis for the year ended March 31, 2008.
The ROE for 2008 is:
ROE =
11
* 100% = 2.0%
(563 + 534)/2
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Businesses seek to generate as high as possible a value for this ratio, provided that it
is not achieved at the expense of potential future returns, by, for example, taking on
more risky activities. In view of this, the 2008 ratio is very poor by any standards; a bank
deposit account will yield a better return than this. We need to try to find out why things
went so badly wrong in 2008. As we look at other ratios, we should find some clues.
Return on Capital Employed

The return on capital employed (ROCE) is a fundamental measure of business
performance. This ratio expresses the relationship between the net income generated
during a period and the average long-term capital invested in the business during that
period.
The ratio is expressed in percentage terms and is as follows:
Earnings before interest and taxes
=
(Average shareholders equity + Preferred shares

+ Long-term debt)
* 100%
4.2
Note, in this case, that the profit figure used is the earnings before interest and taxation. This is because the ratio attempts to measure the returns to all suppliers of long-term
capital before any deductions for interest payable to lenders or payments of dividends to
shareholders are made.
For the year ended March 31, 2007, the ratio for Alexis is:
ROCE =
243
* 100% = 34.7%
[(438 + 200) + (563 + 200)]/2
ROCE is considered by many to be a primary measure of profitability. It compares

inputs (capital invested) with outputs (profit), which is important in assessing how
effectively funds have been used. Once again, an average figure for capital employed
may be used where the information is available.
ACTIVITY 4.3
Calculate the ROCE for Alexis Corporation for the year ended March 31, 2008.
For 2008, the ratio is:
ROCE =
47
* 100% = 5.9%
[(563 + 200) + (534 + 300)]/2
This ratio tells much the same story as ROE: namely a poor performance in 2008,
with the return on capital employed being less than the rate that the business has to pay
for most of its borrowed funds (that is, 9% for the bonds).
Real World 4.1 shows how financial ratios are used by businesses as a basis for
setting profitability targets.
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WORLD
4.1
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Setting Profitability Targets
Earnings, ROE, and ROCE are widely used by businesses when establishing targets for profitability. Here are a few
examples of these targets being made public:
Canadian Tire, a major Canadian retailer, is very forthright in its annual report, indicating that its 20012007 strate-
gic plan aimed for a 10%15% compound annual growth rate for earnings before interest, taxes, depreciation, and
amortization (EBITDA), and at least a 10% after-tax return on invested capital. Actual results for the 20012005
period were 11.7% and 8.7% respectively. The 20052009 strategic road map maintains the same targets.
The Royal Bank of Canada (RBC), Canadas largest bank, set 2005 performance objectives of 18%20% ROE
and 20%+ EPS growth. Actual results came in at 18.0% and 21.3% respectively. Both would have been
considerably higher except for an Enron litigation reserve set aside by the bank. Enron was the largest corporate
fraud and bankruptcy in U.S. history at the time. RBC maintained its EPS growth target for 2006 and upped its
target for ROE to 20%+.
While Telus Corp., Canadas second largest telecommunications company, does not publish targets for ROE
(9.9% actual ROE in 2005), it does target EPS growth of 22%33% and EBITDA growth of 6%9% for 2006.
Source: 2005 annual reports of Canadian Tire, Royal Bank of Canada, and TELUS Corp.
Operating Profit Margin

The operating profit margin ratio relates the earnings before interest and taxes (EBIT)
for the period to the sales revenue during that period. The ratio is expressed as follows:
Operating profit margin =

Sales revenue
* 100%
4.3
EBIT is used in this ratio as it represents the profit from business operations before
the interest costs are taken into account. This is often regarded as the most appropriate measure of operational performance, when used as a basis of comparison, because
differences arising from the way in which the business is financed will not influence the
measure.
For the year ended March 31, 2007, Alexiss operating profit margin ratio is:
243
* 100% = 10.8%
2,240
This ratio compares one output of the business (profit) with another output (sales
revenue). The ratio can vary considerably between types of business. For example,
supermarkets tend to operate on low prices and, therefore, low operating profit margins
in order to stimulate sales and thereby increase the total amount of profit generated.
Jewellers, on the other hand, tend to have high operating profit margins, but have much
lower levels of sales volume. Factors such as the degree of competition, the type of customer, the economic climate, and the industry characteristics (such as the level of risk)
will influence the operating profit margin of a business.
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ACTIVITY 4.4
Calculate the operating profit margin for Alexis Corporation for the year ended March 31, 2008.
The operating profit margin for 2008 is:
47
* 100% = 1.8%
2,681
Once again, Alexis showed a very weak performance compared with that of 2007.
After paying the cost of the carpets sold and other expenses of operating the business,
for every $1 of sales revenue an average of 10.8 cents (that is, 10.8%) was left as profit
in 2007; for 2008, this had fallen to only 1.8 cents for every $1. Thus, the poor ROE and
ROCE ratios were partiallyor perhaps whollydue to a high level of expenses relative to sales revenue. The next ratio should provide us with a clue as to how the sharp
decline in this ratio occurred.
Real World 4.2 describes margins for an oil and gas high-tech service company.
Gross Profit Margin

The gross profit margin ratio relates the gross profit of the business to the sales
revenue generated for the same period. Gross profit represents the difference between
sales revenue and the cost of sales. The ratio is therefore a measure of profitability in
buying (or producing) and selling goods before any other expenses are taken into
account. As cost of goods sold represents a major expense for many businesses, a
change in this ratio can have a significant effect on the bottom line (that is, the net
income for the year). The gross profit margin ratio is calculated as follows:
Gross profit margin =
REAL
WORLD
4.2
Gross profit
Sales revenue
* 100%
4.4
Booming Margins in the Oil Fields
Pason Systems Inc., based in Calgary, is the worlds largest provider of rental oilfield instrumentation systems for
use on land-based rigs. Pason generated rental product margins of 71% for the years ended December 31, 2005
and 2004. In the fourth quarter of each year, margins stood at 76%. Margin improvements at Pason stem from
increases in rental revenues for additional services sold per oil well site and increases in market share, rather than
from price increases. The margin for geological services rose from 33% in 2004 to 37% in 2005. These rental
product and geological services margins may improve in 2006 with increased volume.
Source: Pason Systems Inc. 2005 Annual Report.
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For the year ended March 31, 2007, the ratio for Alexis Corporation is:
495
* 100% = 22.1%
2,240
ACTIVITY 4.5
Calculate the gross profit margin for Alexis Corporation for the year ended March 31, 2008.
The gross profit margin for 2008 is:
409
* 100% = 15.3%
2,681
The decline in this ratio means that gross profit was lower relative to sales revenue
in 2008 than it had been in 2007. Bearing in mind that:
Gross profit = Sales revenue - Cost of goods sold
This means that cost of goods sold was higher relative to sales revenue in 2008 than in
2007. This could mean that sales prices were lower and/or that the purchase cost of
goods sold had increased. It is possible that both sales prices and cost of goods sold
prices had decreased, but with sales prices having fallen at a greater rate than cost of
goods sold prices. Similarly, they may both have increased, but with sales prices having
increased at a lesser rate than costs of the goods sold.
Clearly, part of the decline in the net profit margin ratio is linked to the dramatic
decline in the gross profit margin ratio. After paying for the carpets sold, from each $1
of sales revenue 22.1 cents were left to cover other operating expenses and leave a profit
in 2007, whereas this was only 15.3 cents in 2008.
The profitability ratios for the business over the two years can be set out as follows:
Return on equity
Gross profit margin
2008
(%)
2007
(%)
2.0
5.9
1.8
15.3
33.0
34.7
10.8
22.1
ACTIVITY 4.6
What can you conclude from a comparison of the declines in the operating profit and gross
profit margin ratios?
We can see that the decline in the operating profit margin was 9% (that is, from 10.8%
to 1.8%), whereas the decline in the gross profit margin was only 6.8% (that is, from
22.1% to 15.3%). This can only mean that operating expenses were greatercompared
with sales revenuein 2008 than they had been in 2007. Thus, the declines in both
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ROE and ROCE were caused partly by the business incurring higher inventory purchasing
costs relative to sales revenue, and partly through higher operating expenses relative to
sales revenue. We would need to compare these actual ratios with the planned ratios
before we could usefully assess the businesss success.
The analyst must now carry out some investigation to discover what caused the
increases in both cost of goods sold and operating costs, relative to sales revenue,
from 2007 to 2008. This will involve checking on what has happened with sales and
inventory prices over the two years. Similarly, it will involve looking at each of the
individual expenses that make up operating costs to discover which ones were responsible for the increase, relative to sales revenue. Other ratiosfor example, staff costs
(wages and salaries) to sales revenuecould be calculated in an attempt to isolate
the cause of the change from 2007 to 2008. In fact, as we discussed in the overview of
the financial statements, the increase in staffing may well account for most of the
increase in operating costs.
Real World 4.3 shows how two well-known international businesses are seeking
to improve their return on capital employed.
REAL
WORLD
4.3
Sale of Non-Strategic Assets at Abitibi-Consolidated

and EnCana to Improve ROCE
In late 2005 Abitibi-Consolidated, a large newsprint and wood products company headquartered in Montreal,
completed the sale of its 50% interest in the Pan Asia Paper Company for approximately $600 million. AbitibiConsolidated decided to sharpen its focus on its North American portfolio of assets in an effort to return to
profitability and pay down the debt. In addition, high-cost mills in Newfoundland and Ontario were permanently
closed.
In 2005 EnCana, a major Canadian natural gas company based in Calgary, divested itself of over $4 billion
of non-core investments in order to more clearly focus on its main North American strategy. Proceeds were used
for debt reduction and repurchase of the companys shares on the open market.
Source: 2005 annual reports of Abitibi-Consolidated and EnCana.
EFFICIENCY
Efficiency ratios examine the ways in which various resources of the business are managed. The following ratios consider some of the more important aspects of resource
management:
Average inventory turnover period

Average collection period for receivables
Average payment period for payables
Sales revenue to capital employed
Sales revenue per employee.
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Average Inventory Turnover Period

Inventory often represents a significant investment for a business. For some types of
businesses (for example, manufacturers), inventory may account for a substantial proportion of the total assets held. The average inventory turnover period measures the
average period for which inventory is being held. The ratio is calculated as follows:
Average inventory turnover period =
Average inventory held

Cost of goods sold
* 365
4.5
The average inventory for the period can be calculated as a simple average of the
opening and closing inventory levels for the year. However, in the case of a highly
seasonal business, where inventory levels may vary considerably over the year, a
monthly average may be more appropriate.
In the case of Alexis Corporation, the inventory turnover period for the year ended
March 31, 2007, is:
(241 + 300)/2
* 365 = 56.6 days
1,745
This means that, on average, the inventory held is being turned over every 56.6 days.
So, a carpet bought by the business on a particular day would, on average, have been sold
about eight weeks later. A business will normally prefer a short inventory turnover period
to a long one, as funds tied up in inventory cannot be used for other purposes. In judging the amount of inventory to carry, the business must consider such things as the likely
demand for the inventory, the possibility of supply shortages, the likelihood of price
increases, the amount of storage space available, and the perishability of the inventory. At
the individual store level, store managers responsible for ordering inventory should strive
to minimize the inventory held without jeopardizing sales. This would result in a lower
average inventory turnover period and would eventually increase company profitability.
The management of inventory is considered in more detail in Chapter 12.
This ratio is sometimes expressed in terms of months rather than days. Multiplying
by 12 rather than 365 will achieve this.
ACTIVITY 4.7
Calculate the average inventory turnover period for Alexis Corporation for the year ended
March 1, 2008.
The average inventory turnover period for 2008 is:
(300 + 406)/2
* 365 = 56.7 days
2,272
Thus the average inventory turnover period is virtually the same in both years.
Average Collection Period for Receivables

A business will usually be concerned with how long it takes for customers to pay the
amounts owing. The speed of payment can have a significant effect on the businesss
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cash flow. The average collection period for receivables calculates how long, on average, credit customers take to pay the amounts that they owe to the business. The ratio
is as follows:
Average accounts receivable
Average collection period
* 365
=
for receivables
Credit sales revenue
4.6
A business will normally prefer a shorter average settlement period to a longer one
as, once again, funds are being tied up that may be used for more profitable purposes.
Though this ratio can be useful, it is important to remember that it produces an average figure for the number of days for which receivables are outstanding. This average
may be badly distorted by, for example, a few large customers who are very slow or very
fast payers.
Since all sales made by Alexis Corporation are on credit, the average collection
period for receivables for the year ended March 31, 2007, is:
Average collection period for receivables =
240
* 365 = 39.1 days
2,240
As no figures for opening accounts receivable are available, only the year-end accounts
receivable figure is used. This is common practice.
Activity 4.8
Calculate the average collection period for Alexis Corporations receivables for the year ended
March 31, 2008. (In the interest of consistency, use the year-end receivables figure rather than
an average figure.)
The average collection period for 2008 is:
Average collection period for receivables =
273
* 365 = 37.2 days
2,681
On the face of it, this reduction in the average collection period is welcome. It
means that less cash was tied up in receivables for each dollar of sales revenue in 2008
than in 2007. The desirability of the reduction might be questioned only if the reduction were achieved at the expense of customer satisfaction or at a high direct financial
cost. For example, the reduction might have been a result of chasing customers too
vigorously for payment, or a result of incurring higher costs (such as discounts allowed
to customers who pay quickly).
Average Payment Period for Payables

The average payment period for payables measures how long, on average, the business takes to pay its suppliers. The ratio is calculated as follows:
Average payment period for payables =
Average accounts payable

Credit purchases
* 365 4.7
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This ratio provides an average figure, which, like the average collection period
for receivables ratio, can be distorted by the payment period for one or two large
suppliers.
As accounts payable provide a free source of financing for the business, it is
perhaps not surprising that some businesses attempt to increase their average payment
period. However, such a policy can be taken too far and result in a loss of support
from the suppliers. We return to the issues concerning the management of accounts
receivable and accounts payable in Chapter 12.
For the year ended March 31, 2007, Alexiss average payment period is:
221
* 365 = 44.7 days
1,804
Once again, the year-end figure rather than an average figure for accounts payable
has been used in the calculations.
ACTIVITY 4.9
Calculate the average payment period for payables for Alexis Corporation for the year ended
March 31, 2008. (For the sake of consistency, use a year-end figure for payables.)
The average payment period is:
314
* 365 = 48.2 days
2,378
There was an increase, between 2007 and 2008, in the average length of time that
elapsed between buying inventory and paying for it. On the face of it, this is beneficial
because the business is using free loans provided by suppliers. If, however, this is alienating the suppliers, the longer payment period is not necessarily advantageous to Alexis.
Sales Revenue to Capital Employed

The sales revenue to capital employed ratio (or net asset turnover ratio) examines
how effectively the assets of the business are being used to generate sales revenue. It is
calculated as follows:
Sales revenue to
= Net asset turnover
capital employed
Sales revenue
4.8
1Average long-term liabilities + Total shareholdersequity)
Sales revenue
=
1Average total assets - Current liabilities2
=
Recall from Chapter 1 that these two versions of Equation 4.8 are identical since
the denominators form the balance sheet equation (Assets = Liabilities + Shareholders
equity).
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Preferred shares, if any, are included in total shareholders equity.

Generally speaking, a higher sales revenue to capital employed (net asset
turnover) ratio is preferred. A higher ratio will normally suggest that the capital
invested in assets is being used more productively in the generation of revenue.
However, a very high ratio may suggest that the business is overtrading on its assets;
that is, it has insufficient capital (assets) to sustain the level of sales revenue achieved.
(Overtrading is discussed in more detail later in this chapter.) When comparing this
ratio for different businesses, such factors as the age and condition of assets held, the
valuation bases for assets, and whether assets are rented or purchased outright can
complicate interpretation.
For the year ended March 31, 2007, this ratio for Alexis Corporation is as
follows:
Sales revenue to capital employed =
2,240
= 3.20 times
(638 + 763)/2
ACTIVITY 4.10
Calculate the sales revenue to capital employed ratio for Alexis Corporation for the year
ended March 31, 2008.
The sales revenue to capital employed ratio for 2008 is:
Sales revenue to capital employed =
2,681
= 3.36 times
(763 + 834)/2
This seems to be an improvement, since in 2008 more sales revenue ($3.36) was
being generated for each $1 of capital employed than was the case in 2007 ($3.20).
Provided that overtrading is not an issue, this is to be welcomed.
Sales Revenue per Employee

The sales revenue per employee ratio relates sales revenue to a particular business
resource, that is, labour. It provides a measure of the productivity of the workforce. The
ratio is:
Sales revenue per employee =
Sales revenue
Number of employees
4.9
Generally, businesses would prefer to have a high value for this ratio, implying
that they are using their staff efficiently. Marketing managers and human resources
staff should keep the sales revenue per employee ratio in mind when hiring plans are
being developed. Sometimes managers bonuses depend on the value of these types
of ratios.
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For the year ended March 31, 2007, the ratio for Alexis Corporation is:
$2,240,000,000
= $160,057
13,995
ACTIVITY 4.11
Calculate the sales revenue per employee for Alexis Corporation for the year ended March 31,
2008.
The ratio for 2008 is:
$2,681,000,000
= $143,962
18,623
This represents a fairly significant decline and probably merits further investigation. As we discussed previously, the number of employees has increased quite notably
(by about 33%) during 2008, and the analyst will probably try to discover why this has
not generated sufficient additional sales revenue to maintain the ratio at its 2007 level.
It could be that the additional employees were not hired until late in the year ended
March 31, 2008.
The efficiency, or activity, ratios may be summarized as follows:

(net asset turnover)
Sales revenue per employee
2008
2007
56.7 days
37.2 days
48.2 days
56.6 days
39.1 days
44.7 days
3.36 times
$143,962
3.20 times
$160,057
ACTIVITY 4.12
What do you conclude from a comparison of the efficiency ratios over the two years?
Maintaining the inventory turnover period at the 2007 level seems reasonable,
although whether this period is satisfactory can probably only be assessed by looking
at the businesss planned inventory holding period. The inventory holding period for
other businesses operating in carpet retailingparticularly those regarded as the
market leadersmay have been helpful in formulating the plans. On the face of things,
a shorter collection period for receivables and a longer payment period for payables are
both desirable. On the other hand, these may have been achieved at the cost of alienating both customers and suppliers. The increased net asset turnover ratio seems
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beneficial, provided that the business can manage this increase. The decline in the
sales revenue per employee ratio is undesirable but, as we have already seen, is probably related to the dramatic increase in the level of staffing. As with the inventory
turnover period, these other ratios need to be compared with the planned or budgeted
standard of efficiency.
THE RELATIONSHIP BETWEEN PROFITABILITY

AND EFFICIENCY
In our earlier discussions concerning profitability ratios, we saw that return on capital
employed (ROCE), Equation 4.2, is regarded as a key ratio by many businesses. The
ratio is:
=
* 100%
Long-term capital employed
* 100%
=
Shareholders equity + Preferred shares + Long-term debt
This ratio can be broken down into two elements, as shown in Figure 4.2. The first
ratio is the operating profit margin ratio, and the second is the sales revenue to capital
employed (net asset turnover) ratio, which we discussed earlier.
FIGURE 4.2
The Main Elements Comprising the ROCE Ratio
Earnings
taxes
Operating profit
margin ratio
Return on capital
employed
Sales revenue to capital

employed ratio
By breaking down the ROCE ratio in this manner, we highlight the fact that the
overall return on funds used within the business will be determined both by the profitability of sales and by the efficient use of capital.
Example 4.2
Consider the following information concerning two different businesses operating
in the same industry:
EBIT
Long-term capital employed
Sales revenue
Antler Ltd.
Baker Ltd.
$ 20 million
$100 million
$200 million
$ 15 million
$ 75 million
$300 million
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The ROCE for both businesses is identical (20%). However, the manner in
which the return was achieved by each business was quite different. In the case of
Antler, the operating profit margin is 10% and the sales revenue to long-term
capital employed ratio is 2 times (so, ROCE = 10% 2 = 20%). In the case of
Baker, the operating profit margin is 5% and the sales revenue to long-term
capital employed ratio is 4 times (and so, ROCE = 5% 4 = 20%).
Example 4.2 demonstrates that a relatively low operating profit margin can be compensated for by a relatively high sales revenue to capital employed ratio, and a relatively
low sales revenue to capital employed ratio can be compensated for by a relatively high
operating profit margin. In many areas of retail and distribution (for example, supermarkets and delivery services), the operating profit margins are quite low, but the ROCE
can be high, provided that the assets are used productively.
ACTIVITY 4.13
Show how the ROCE ratio for Alexis Corporation can be analyzed into the two elements for each
of the years 2007 and 2008.
What conclusions can we draw from your figures?
2007
2008
Equation
4.2
ROCE
=
=
34.7%
5.9%
=
=
Equation
4.3
Operating
profit margin
10.8%
1.8%

Equation
4.8
Sales revenue to
capital employed
3.20
3.36
Thus the relationship among the three ratios holds for Alexis Corporation for both years.
The small rounding differences arise because the three ratios are stated above only to one
or two decimal places.
Though the business was more effective at generating sales (sales revenue to capital
employed ratio increased) from 2007 to 2008, this ratio was well below the level necessary to compensate for the sharp decline in the effectiveness of each sale (operating profit
margin). As a result, the 2008 ROCE was well below the 2007 value.
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SELF-ASSESSMENT QUESTION
113
4.1
Both Ali Limited and Bhaskar Corp. operate electrical stores throughout the Maritimes. The financial statements of
each business for the year ended June 30, 2008, are as follows:
Balance Sheets
As at June 30, 2008
(in $ thousands)
Ali Limited
Current assets
Cash
Accounts receivable
Inventory
84.6
176.4
592.0

Land
Buildings, net
Plant and equipment, net
Total property, plant, and equipment
160.0
200.0
87.0
Bhaskar Corp.
91.6
321.9
403.0
853.0
Total assets
Current liabilities
Accounts payable
Dividends payable
210.0
300.0
91.2
447.0
601.2
1,300.0
1,417.7
271.4
16.0
135.0
180.7
17.4
95.0
Bonds payable
Total liabilities
Shareholders equity
Common shares
Retained earnings
422.4
293.1
190.0
250.0
612.4
543.1
320.0
367.6
Total liabilities and shareholders equity
816.5
250.0
624.6
687.6
874.6
1,300.0
1,417.7
Income Statements
For the year ended June 30, 2008
(in $ thousands)
Ali Limited
Sales
Less: Cost of goods sold
Opening inventory
Plus: Purchases
Bhaskar Corp.
1,478.1
480.8
1,129.5
1,610.3
592.0
1,790.4
372.6
1,245.3
1,617.9
403.0
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Cost of goods sold

Gross profit
Less: Operating expenses
Interest expenses
Net income
1,018.3
459.8
308.5
151.3
19.4
131.9
32.0
99.9
1,214.9
575.5
408.6
166.9
27.5
139.4
34.8
104.6
Statements of Retained Earnings

For the year ended June 30, 2008
(in $ thousands)
Opening retained earnings, July 1

Add: Net income
Closing retained earnings, June 30
Ali Limited
Bhaskar Corp.
402.7
99.9
(135.0)
367.6
615.0
104.6
(95.0)
624.6
Notes
1. All purchases and sales were on credit.
2. The market value of the shares on June 30, 2008, was $6.50 for Ali Limited and $8.20 for Bhaskar Corp.
3. Ali Limited has 320,000 shares outstanding, and Bhaskar Corp. has 250,000 shares outstanding.
Required:
For each business, calculate three ratios that are concerned with each of profitability and efficiency (six ratios in
total). What can you conclude about the ratios you calculated?
LIQUIDITY
Liquidity ratios are concerned with the ability of the business to meet its short-term
financial obligations. The following ratios are widely used:
Current ratio
Acid test ratio.
Current Ratio
The current ratio compares the businesss liquid assets (that is, cash and those assets that
will soon be turned into cash) with the current liabilities. The ratio is calculated as follows:
Current ratio =
Current assets
Current liabilities
4.10
Some people suggest that there is an ideal current ratio (usually 2 times, or 2:1) for all
businesses. However, this fails to take into account the fact that different types of
businesses require different current ratios. For example, a manufacturing business will
often have a relatively high current ratio because it is necessary to hold inventories of
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finished goods, raw materials, and work in progress. It will also normally sell goods on
credit, thereby incurring receivables. A supermarket chain, on the other hand, will have
a relatively low ratio, as it will hold only fast-moving inventories of finished goods and
will generate mostly cash sales revenue.
The higher the ratio, the more liquid the business is considered to be. As liquidity
is vital to the survival of a business, a higher current ratio might be thought to be
preferable to a lower one. If a business has a very high ratio, however, funds might be
tied up in cash or other liquid assets that could be used more productively elsewhere.
As at March 31, 2007, the current ratio of Alexis is:
Current ratio =
544
= 1.9 times (or 1.9:1)
291
ACTIVITY 4.14
Calculate the current ratio for Alexis as at March 31, 2008.
The current ratio as at March 31, 2008, is:
Current ratio =
679
= 1.6 times (or 1.6:1)
432
Though this is a decline from 2007 to 2008, it is not necessarily a matter of

concern. The next ratio may provide a clue as to whether there seems to be a problem.
Acid Test Ratio

The acid test ratio is very similar to the current ratio, but it represents a more stringent test of liquidity. It can be argued that, for many businesses, inventory cannot be
converted into cash quickly. (Note that in the case of Alexis, the inventory turnover
period was about 57 days in both years.) Because of the delay in converting inventory
to cash, it may be better to exclude this particular asset from any measure of liquidity.
The acid test ratio is a variation of the current ratio, but it excludes inventory.
The minimum level for this ratio is often stated as 1.0 times (or 1:1; that is, current
assets (excluding inventory) equals current liabilities). In many highly successful businesses that are regarded as having adequate liquidity, however, it is not unusual for the
acid test ratio to be below 1.0 without causing particular liquidity problems.
The acid test ratio is calculated as follows:
Acid test ratio =
Current assets - Inventory

Current liabilities
4.11
The acid test ratio for Alexis as at March 31, 2007, is:
Acid test ratio =
544 - 300
= 0.8 times (or 0.8:1)
291
We can see that the liquid current assets do not quite cover the current liabilities,
and so the business might be experiencing some liquidity problems.
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ACTIVITY 4.15
Calculate the acid test ratio for Alexis as at March 31, 2008.
The acid test ratio as at March 31, 2008, is:
Acid test ratio =
679 - 406
= 0.6 times
432
The 2008 ratio is significantly below that for 2007. The 2008 level may well be a
cause for concern. The rapid decline in this ratio should lead to steps being taken, at
least, to stop further decline.
The liquidity ratios for the two-year period may be summarized as follows:
Current ratio
Acid test ratio
2008
2007
1.6
0.6
1.9
0.8
ACTIVITY 4.16
What do you conclude from the liquidity ratios set out above?
Though it is not really possible to make a valid judgment without knowing the budgeted
ratios, there appears to have been an alarming decline in liquidity. This is indicated by
both of these ratios. The apparent liquidity problem may, however, be planned, short-term,
and linked to the expansion in non-current assets and staffing. It may be that when the
benefits of the expansion are realized, liquidity will improve. On the other hand, shortterm creditors (suppliers) may become anxious when they see signs of weak liquidity. This
anxiety could lead to steps being taken by creditors to press for payment, and this could
cause problems for Alexis Corporation.
LEVERAGE
Financial leverage occurs when a business is financed, at least in part, by borrowing,
instead of by funds provided by the owners (the shareholders). A businesss degree of
leverage (that is, the extent to which it is financed from sources that require a fixed return)
is an important factor in assessing risk. Where a business borrows heavily, it takes on a
commitment to pay interest charges and make capital repayments. This can be a significant financial burden; it can increase the risk of the business becoming insolvent.
Nevertheless, most businesses are leveraged to some extent.
Given the risks involved, we may wonder why a business would want to take on
debt. One reason may be that the owners have insufficient funds and therefore the
only way to finance the business adequately is to borrow from others. Another reason is that leverage can be used to increase the returns to owners. This is possible
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provided the returns generated from borrowed funds exceed the cost of paying
interest. The issue of leverage is important and we leave a detailed discussion of this
topic until Chapter 10.
Two ratios are widely used to assess leverage:
Leverage ratio
Times interest earned ratio.
Leverage Ratio
The leverage ratio measures the contribution of long-term lenders to the long-term
capital structure of a business. It may be calculated as follows:
Leverage ratio =
Long-term (non-current) debt

Shareholders equity +
* 100%
4.12
The leverage ratio for Alexis as at March 31, 2007, is:

Leverage ratio =
200
* 100% = 26.2%
(563 + 200)
This ratio reveals a degree of leverage that would not normally be considered to be
very high.
ACTIVITY 4.17
Calculate the leverage ratio of Alexis as at March 31, 2008.
The leverage ratio as at March 31, 2008, is:
Leverage ratio =
300
* 100% = 36.0%
(534 + 300)
This ratio reveals a substantial increase in the degree of leverage over the year.
Times Interest Earned Ratio

The times interest earned ratio measures the amount of profit available to cover interest expense. The ratio may be calculated as follows:
Times interest earned ratio =

Interest expense
4.13
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The ratio for Alexis for the year ended March 31, 2007, is:
243
= 13.5 times
18
This ratio shows that the level of profit is considerably higher than the level
of interest expense. Thus, a significant decrease in profits could occur before profit
levels would fail to cover interest payments. The lower the level of profit coverage, the
greater the risk to lenders that interest payments will not be met, and the greater the
risk to the shareholders that the lenders will take action against the business to recover
the interest due.
ACTIVITY 4.18
Calculate the times interest earned ratio of Alexis for the year ended March 31, 2008.
The times interest earned ratio for 2008 is:
47
= 1.5 times
32
Alexis Corporations leverage ratios are:
Leverage ratio
Times interest earned ratio
2008
2007
36.0%
1.5 times
26.2%
13.5 times
ACTIVITY 4.19
What do you conclude from a comparison of the leverage ratios over the two years?
The leverage ratio altered significantly. This is mainly due to the substantial increase in
the long-term debt during 2008, which has had the effect of increasing the relative
contribution of long-term lenders to the financing of the business.
The times interest earned ratio has declined dramatically, from a position where profit
covered interest 13.5 times in 2007, to one where profit covered interest only 1.5 times in
2008. This was partly caused by the increase in borrowing in 2008, but mainly caused by the
dramatic decline in profitability in that year. The latter situation looks hazardous; even a small
decline in future profitability in 2009 would leave the business with insufficient profit to cover
the interest payments. The leverage ratio at March 31, 2008 would not necessarily be
considered to be very high for a business that was operating successfully. It is the low
profitability that is the problem.
Without knowing what the business planned these ratios to be, it is not possible to
reach a totally valid conclusion on Alexis Corporations leverage.
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119
Real World 4.4 discusses leverage for Canadian corporations.
REAL
WORLD
4.4
Leverage Declining as Corporate Balance Sheets Repaired
Following a trend that began in 2000, Canadian corporate leverage (defined in this case as corporate debt as a
percentage of corporate equity) at non-financial institutions has continued to decline from nearly 80% to around
50% as of December 2006. Corporations continued to generate surplus funds and remain a net lender to the
rest of the economy. That is, corporations generate an excess of funds which then are loaned to individuals and
governments through financial intermediaries such as the banks.
A 2005 study linked trade-liberalizing tariff reductions and leverage ratios (in this case, measured as debt to total
assets). The study concluded that reductions in import tariffs increase leverage and reductions in export tariffs
decrease leverage. The reason for this was that importing firms earned fewer profits due to increased competition
from other importers due to lowered tariffs. This tended to increase leverage. Profits not paid out as dividends appear
as retained earnings. All things being equal, if retained earnings growth is slowed due to lower profits or is negative
if losses are incurred, incremental financing must be made up with extra debt. The opposite was the case for
exporters, whose profits improved after export duties were lowered, thereby decreasing leverage.
In addition, many Canadian firms with U.S. dollar-denominated debt benefited from the appreciation of the
Canadian dollar because, in Canadian dollar terms, they owed less. This tended to cause the leverage ratios of
Canadian firms to decrease.
Sources: Adapted from the Statistics Canada publications: The Daily, Catalogue 11-001, National Balance sheet accounts, Friday,
December 15, 2006, http://www.statcan.ca/Daily/English/061215/d061215a.htm and National balance sheet accounts, Thursday, March
25, 2004, http://www.statcan.ca/Daily/English/040325/d040325a.htm; and Summary of: Trade Liberalization, profitability, and Financial
Leverage, Analytical Studies Branch Research Paper Series, Catalogue 11F0019MIE2005257, no. 257, released June 22, 2005,
http://www.stancan.ca/english/research/bin/11F0019MIE/11F0019MIE2005257.
INVESTMENT RATIOS
Various ratios designed to help investors assess the returns on their investment are
available. The following are widely used:
Dividend payout ratio

Dividend yield ratio
Earnings per share
Price/earnings ratio.
Dividend Payout Ratio

The dividend payout ratio measures the proportion of earnings that a business pays
out to shareholders in the form of dividends. The ratio is calculated as follows:
Dividend payout ratio =
Annual dividends to common

shareholders for the year
Net income available
to common shareholders
* 100%
4.14
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In the case of common shares, the earnings available for dividends will normally
be the net income after any preferred dividends announced during the period. This
ratio is normally expressed as a percentage.
The dividend payout ratio for Alexis Corporation for the year ended March 31,
2007, is:
40
* 100% = 24.2%
165
The information provided by this ratio is often expressed slightly differently as the
dividend cover ratio. Here, the calculation is:
Dividend cover ratio =
Net income available to common shareholders

Annual dividends to common shareholders
4.15
In the case of Alexis Corporation for 2007, the dividend cover ratio would be
165/40 = 4.1 times. That is to say, the earnings available for dividends cover the actual
dividends just over four times.
Activity 4.20
Calculate the dividend payout ratio of Alexis Corporation for the year ended March 31, 2008.
The ratio for 2008 is:
40
* 100% = 363.6%
11
This would normally be considered to be a very alarming increase in the ratio over
the two years. Paying a dividend of $40 million on net income of only $11 million in
2008 would probably be regarded as very imprudent.
Dividend Yield Ratio

The dividend per share is a ratio that divides the dividends announced for a period by the
number of shares outstanding. For Alexis Corporation, for the year ended March 31, 2007:
Dividend per share =
$40
Dividend declared
=
= $0.067
Number of shares
600
The dividend yield ratio relates the dividend on a share to its current market
value. This can help investors to assess the cash return on their investment in the business. The ratio is:
Dividend yield =
Dividend per share

Market value per share
* 100%
4.16
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The dividend yield ratio is also expressed as a percentage.

The dividend yield for Alexis Corporation for the year ended March 31, 2007, is:
Dividend yield =
$0.067
* 100% = 2.7%
$2.50
ACTIVITY 4.21
Calculate the dividend yield for Alexis Corporation for the year ended March 31, 2008.
The dividend yield for Alexis Corporation for the year ended March 31, 2008 is:
Dividend yield =
$0.067*
* 100% = 4.4%
$1.50
*$40/600 = $0.067
Earnings per Share

The earnings per share (EPS) ratio relates the earnings generated by the business and
available to common shareholders during a period to the number of shares outstanding. For common shareholders, the amount available will be represented by the net
income (less any preferred dividend, where applicable). The ratio for common shareholders is calculated as follows:
Earnings per share =

Number of common shares outstanding
4.17
In the case of Alexis, the earnings per share for the year ended March 31, 2007, are
as follows:
EPS =
$165
= $0.275
600
Many investment analysts regard the EPS ratio as a fundamental measure of share
performance. The trend in earnings per share over time is used to help assess the
investment potential of a businesss shares. Though it is possible to make total profits
rise through common shareholders investing more in the business, this will not necessarily mean that the profitability per share will rise as a result.
It is not usually very helpful to compare the earnings per share of one business
with those of another. Differences in capital structure (degree of leverage) can render
any such comparison meaningless. However, it can be very useful to monitor the
changes that occur in this ratio for a particular business over time.
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ACTIVITY 4.22
Calculate the earnings per share of Alexis Corporation for the year ended March 31, 2008.
The earnings per share for the year ended March 31, 2008, are:
EPS =
$11
= $0.018
600
Price/Earnings Ratio
The price/earnings (P/E) ratio relates the market value of a share to the earnings per
share. This ratio can be calculated as follows:
Price/earnings ratio =

Earnings per share
4.18
The P/E ratio for Alexis Corporation as at March 31, 2007, is:
P/E ratio =
$2.50
= 9.1 times
$0.275
This ratio reveals that the capital value of the share is 9.1 times higher than its
current level of earnings. The ratio is a measure of market confidence in the future of a
business. The higher the P/E ratio, the greater the confidence in the future earning power
of the business and, consequently, the more investors are prepared to pay in relation to
the earnings stream of the business.
P/E ratios provide a useful guide to market confidence concerning the future and
they can, therefore, be helpful when comparing different businesses. However, differences in accounting policies between businesses can lead to different profit and earnings per share figures, and this can distort comparisons.
Often P/E ratios are used to help investors determine whether a businesss stock
price is expensive or inexpensive. For example, if the average P/E ratio for a Toronto
Stock Exchange (TSX) listed company is 16.5, then you might figure that a stock with
a P/E ratio of 12.0 is a bargain and a stock with a P/E ratio of 30 is too expensive.
However, sometimes a stock with a high P/E ratio is a better investment because its
sales and profits are growing rapidly compared with the average company. Investors are
confident that the company can maintain this tremendous growth rate and they bid up
the price of the stock. Thus the high P/E ratio is justified by the high growth rates. For
example, one of Canadas fastest growing firms, Gildan Activewear, is accorded a P/E
ratio of 34.8, compared to 16.5 for the TSX composite index.1
http://www.tsx.com/en/index.html, accessed April 3, 2007.
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ACTIVITY 4.23
Calculate the P/E ratio of Alexis Corporation as at March 31, 2008.
The P/E ratio of Alexis Corporation as at March 31, 2008, is:
P/E ratio =
$1.50
= 83.3 times
$0.018
The investment ratios for Alexis Corporation over the two-year period are as follows:

Earnings per share
Price/earnings ratio
2008
2007
363.6%
4.4%
$0.018
83.3 times
24.2%
2.7%
$0.275
9.1 times
ACTIVITY 4.24
What do you conclude from the investment ratios set out above? Explain why the share price has
not fallen as much as it might have done, considering the very poor (relative to 2007) operating
performance in 2008.
Although the EPS has fallen dramatically, and the dividend payment for 2008 seems
very imprudent, the share price seems to have held up remarkably well (falling from
$2.50 to $1.50). This means that dividend yield and P/E value for 2008 look better
than those for 2007. This is an anomaly of these two ratios, which stems from using
a forward-looking value (the share price) in conjunction with historic data (dividends
and earnings). Share prices are based on investors assessments of the businesss
future. At the end of 2008 the market was not happy with Alexis, relative to 2007,
given that the share price had fallen by $1 a share. On the other hand, the share price
has not fallen as much as profits. Investors believe that the business will perform
better in the future than it did in 2008, perhaps because the large expansion in assets
and employee numbers that occurred in 2008 will yield benefits in the future that the
business was not able to generate during 2008.
Real World 4.5 gives some information about the shares of several large, wellknown Canadian businesses. This type of information is provided on a daily basis by
several newspapers, notably the Globe and Mail, although some newspapers are now
moving detailed stock tables online.
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REAL
WORLD
4.5
Stock Market Data for Some Well-Known Businesses
The following stock market quotes from companies trading on the TSX were compiled from the website of
StockHouse Canada: www.stockhouse.ca. This website has free membership. You enter a companys ticker symbol
or name to obtain a great deal of trading information, some of which is shown below.
Ticker
Symbol
52-Week
High
52-Week
Low
Current
Intraday
Price
Change
Volume
Yield
P/E Ratio
EPS
Bid/Ask
AL
BNS
G
MFC
RIM
L
64.99
53.39
45.99
40.00
171.00
58.69
41.78
41.55
22.97
33.83
67.95
44.92
56.65
50.60
29.67
38.99
156.53
50.84
+1.53
0.12
+0.17
0.03
2.34
+0.36
1,809,089
1,647,540
2,764,449
1,235,267
337,565
317,552
1.707
3.312
0.718
2.050
0.000
1.664
18.678
14.128
21.330
16.225
63.094
18.766
2.951
3.590
1.383
2.405
2.518
2.690
56.58/56.65
50.58/50.62
29.66/29.69
38.99/39.00
156.41/156.49
50.80/50.84
Ticker Symbol.
A stock symbol is used rather than the company name when an order is placed with a broker.
For example: ALAlcan; BNSBank of Nova Scotia; GGoldcorp; MFCManulife Financial Corporation;
RIMResearch in Motion; and LLoblaw.
52-Week High/Low. The highest and lowest closing price for the shares in the last year (stated in dollars).
Current Intraday Price. The latest price at which the stock traded (in dollars). Often there is a 20-minute
delay in the prices websites can provide, so this is the price as of 20 minutes ago.
Change. The change in the intraday price from the previous days close (in dollars).
Volume. The number of shares traded so far today.
Yield. Dividend per share (based on the most recent annual dividend) divided by current share price.
P/E ratio. The price/earnings ratio is based on the current price and the most recent earnings per share.
EPS. The stocks earnings per share value.
Bid/Ask. The bid is the highest price potential buyers have bid on the stock, while the ask is the lowest
price potential sellers have demanded for their shares. So the bid price is lower than the ask price. The
greater the spread between the bid and ask prices, the more inefficient the market for that particular stock is.
No transaction will occur until there is a meeting of the minds on the price. Also given, although not shown
above, is the number of bids and asks.
Source: From StockHouse Canada, http://www.stockhouse.ca/comp_info.asp?symbol=ASRNF&table=LIST. Accessed

January 11, 2007.
Real World 4.6 shows some investment ratios for between different industries.
REAL
WORLD
4.6
How Investment Ratios Vary Between Industries
Investment ratios can vary significantly between businesses and between industries. To give some indication of the
range of variations that occur, the average dividend yield ratios and average P/E ratios for listed businesses in 13
different industries plus the S&P TSX composite index are shown in Figures 4.3 and 4.4 respectively.
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These ratios are calculated from the current market value of the shares and the most recent years dividend paid
(in the case of the dividend yield ratio) or earnings per share (in the case of the P/E ratio).
Some industries tend to pay out lower dividends than others, leading to lower dividend yield ratios. Gold miners tend
to invest heavily in developing new mines, hence their tendency to pay low dividends compared with their share prices.
Utilities probably tend to invest less heavily than gold miners, hence their rather higher level of dividend yields. Some
of the inter-industry differences in the dividend yield ratio can be explained by the nature of the calculation of the ratio.
The prices of shares at any given moment are based on expectations of their economic futures; dividends are actual past
events. A business that had a good year recently may have paid a dividend that, in the light of investors assessment of
the businesss economic future, may be high (a high dividend yield).
FIGURE 4.3
Average Dividend Yields by Industry

5
Percent
4
3
2
1
Utilities
Telecom
Info Tech
Real Estate
Financials
Consumer
Disc.
Consumer
Staples
Health Care
Industrials
Gold
Metal/Mining
Material
Energy
S&P/TSX
Industry Component
Source: Graph constructed from data appearing in the National Post, December 2, 2006.
Average Price/Earnings Ratios by Industry

80
60
40
20
Utilities
Telecom
Info Tech
Real Estate
Financials
Consumer
Disc.
Consumer
Staples
Health Care
Industrials
Gold
Metal/Mining
Material
Energy
0
S&P/TSX
Price / Earnings Ratio
FIGURE 4.4
Industry Component
Source: Graph constructed from data appearing in the National Post, December 2, 2006.
Businesses that have a high share price relative to their recent earnings have high P/E ratios. This may be
because their future is regarded as economically bright, which may be as a result of investing heavily in the future
at the expense of current profits (earnings).
Government agencies have made industry data available to anyone. Owners and
prospective entrepreneurs developing a business plan can go online and get industry
statistics for comparison to their situation. This of course can lead a company to modify
its business practices in an effort to emulate successful companies. Real World 4.7
examines industry statistics in the pub industry.
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Comparing Your Company with Industry Averages
Statistics Canada has made it relatively easy for companies to compare their economic performance with the industry
average for their particular industry. At the website http://sme.ic.gc.ca/epic/site/pp-pp.nsf/en/Home, you can generate
reports on many different industry classifications and compare the average results to your company.
The screenshots that follow are for industry classification number 7224Drinking Places (Alcoholic Beverages)
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Income statements based on percentage of total revenue are presented for the whole industry, for the lower half of
companies, for the upper half of companies, and for the upper quartile (the top 25% of companies in this industry).
Other report choices could have been made at the discretion of the user.
In the report on the previous page, we see that the top quartile has a net profit of 2.2% of sales, more than
double the industry average. The cost of sales line in the report is obtained as follows:
Cost of sales = Wages and benefits + Opening inventory + Purchases Closing inventory
The bottom-half companies have less wage expense and carry more inventory. The smaller wage expense likely indicates a lower staffing level, and is perhaps a reflection that these businesses have poor service, which directly reflects
back on poor sales. Rent expense at 8.7% of sales is significantly higher for the bottom-half companies. At the same
time, advertising at 2% of sales is about 40% lower [i.e., (3.3 2.0)/3.3] for these underperforming companies
compared to the top-quartile of companies.
The bottom of the screenshot below shows industry averages for several key financial ratios. The debt ratio, total
liabilities divided by total assets, is 25% higher for the bottom-half companies [i.e., (1 0.8)/0.8]. The revenue to
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closing inventory ratio is much lower for the bottom-half companies, suggesting that they should cut back on the
size of their inventory. The gross margins in this business are around 50% for both the bottom-half and top-tier
companies.
Source: Industry Canada, http://sme.ic.gc.ca/epic/site/pp-pp.nsf/en/Home, accessed May 27, 2007. Reproduced with the permission
of the Minister of Public Works and Government Services, 2007.
SELF-ASSESSMENT QUESTION
4.2
Use the same data for Ali Limited and Bhaskar Corp. as in Self-Assessment Question 4.1 on pages 113114.
Required:
For each business, calculate two ratios that are concerned with liquidity, leverage, and investment (six ratios in
total). What can you conclude about the ratios you calculated?
FINANCIAL RATIOS AND THE PROBLEM

OF OVERTRADING
Overtrading occurs when a business is operating at a level of activity that cannot be
supported by the amount of funds that have been invested. An example is a business
that has inadequate cash to fund the level of receivables and inventory necessary for the
level of sales revenue that it is achieving. This situation usually reflects a poor level of
financial control over the business.
The reasons for overtrading are varied. It may occur in young, expanding businesses that fail to prepare adequately for the rapid increase in demand for their goods
or services. It may also occur in businesses whose managers may have miscalculated
the level of expected sales demand or failed to control escalating project costs. It may
occur as a result of a fall in the value of money (inflation), causing more funds to be
invested in inventory and receivables, even when there is no expansion in the real
volume of trade. It may occur when the owners are unable to inject further funds
into the business or to persuade others to invest in the business. Whatever the reason
for overtrading, the problems that it brings must be dealt with if the business is to
survive.
Overtrading results in liquidity problems such as exceeding borrowing limits, or
slow repayment of lenders and creditors. It can also result in suppliers withholding
supplies, thereby making it difficult to meet customer demand. The managers of the
business might be forced to direct all their efforts to dealing with immediate and pressing problems, such as finding cash to meet interest charges due or paying wages.
Longer-term planning becomes difficult and managers may spend their time going
from crisis to crisis. At the extreme, a business may fail because it cannot meet its debt
obligations.
To deal with an overtrading problem, a business must ensure that the funds
available are commensurate with the level of operations. If a business that is overtrading is unable to raise new funds, it should cut back its level of operations to be in line
with the funds available. Although this may mean lost sales and lost profits in the short
term, it may be necessary to ensure survival over the longer term.
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ACTIVITY 4.25
If a business is overtrading, would the following be higher or lower than normally expected?
(a)
(b)
(c)
(d)
Current ratio
A business that is overtrading would show the following:
(a) The current ratio would be lower than normally expected. This is a measure of liquidity,
and lack of liquidity is an important symptom of overtrading.
(b) The average inventory turnover period would be lower than normally expected. When
a business is overtrading, the level of inventory held will be low because of the problems of financing inventory. In the short term, sales revenue may not be badly
affected by the low inventory levels and therefore inventory will be turned over more
quickly.
(c) The average collection period for receivables may be lower than normally expected.
When a business is suffering from liquidity problems, it may chase customers more
vigorously in order to improve cash flows.
(d) The average payment period for payables may be higher than normally expected.
The business may try to delay payments to suppliers because of the liquidity
problems.
TREND ANALYSIS
It is often helpful to see whether ratios are indicating trends. Key ratios can be plotted
on a graph to provide a simple visual display of changes occurring over time. The
trends occurring within a business may, for example, be plotted against trends for rival
businesses or for the industry as a whole for comparison purposes. An example of
trend analysis is shown in Real World 4.8.
REAL
WORLD
4.8
Trend Setting
In Figure 4.5, the return on equity (ROE) ratio is plotted for three Canadian banksRoyal Bank of Canada (RBC),
Bank of Montreal (BMO), and the Canadian Imperial Bank of Commerce (CIBC) over a five-year period. While return
on equity at RBC and BMO is quite similar and trending gently upward, it is much more erratic at CIBC and even
turned negative in 2005.
The return on equity (ROE) ratio is plotted for the financial years 20012005 for all three companies on the
same graph, enabling an easy visual comparison.
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FIGURE 4.5
Graph of Return on Equity Versus Time

Graph plotting ROE against time
25.00
ROE (%)
20.00
15.00
RBC
10.00
BMO
5.00
CIBC
0.00
5.00
2001
2002
2003
2004
2005
Year
Source: Graphs constructed from data appearing in the 2005 annual reports of Royal Bank of Canada (RBC), Bank of Montreal (BMO),
and Canadian Imperial Bank of Commerce (CIBC).
ACTIVITY 4.26
Using the graph in Figure 4.5, what do you think might have caused CIBC to have a negative
return on equity in 2005 while the other banks had good results?
Some company-specific event must have affected CIBCs return on equity. In this case, it
was a US$2.4 billion settlement in regard to an Enron-related class-action lawsuit that
arose when the latter went bankrupt. While admitting no wrongdoing, CIBC agreed to
settle to eliminate the uncertainties and expense of a lengthy litigation. We will encounter
this idea of company-specific risk again in Chapter 9 when we discuss diversifiable and
non-diversifiable risk.
Source: Adapted from CBC News, http://www.cbc.ca/money/story/2005/08/02/CIBC-enron050802.html,
accessed July 19, 2007.
Many larger businesses publish certain key financial ratios as part of their annual
reports to help users identify significant trends. These ratios typically cover several
years activities. Real World 4.9 is based on extracts from tables of key performance
measures of BCE, the well-known Canadian communications company, which were
published in its 2005 annual report.
REAL
WORLD
4.9
Key Performance Measures at BCE
After long being known as a blue-chip company, BCE suffered a recent decline in fortunes due to increased
competition from wireless, cable, and internet telephony. BCEs risk profile has worsened in recent years, as
shown by fluctuating earnings per share and return on equity results. Companies would prefer to have smooth
growth in both these ratios, since that is what the stock market values the most and rewards with a higher
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stock price. The earnings before interest, taxes, depreciation, and amortization (EBITDA) margin does not seem
to be the problem, as it has held steady at around 40%. The company has a very safe cash flow, as its times
interest earned ratio is over 7. BCEs operating margin seems to bounce around between 14% and 22%. The
2004 operating margin was hurt by huge restructuring expenses likely caused by write-downs of unprofitable
business lines. However, management believes that BCE has turned the corner and results in the future will
be better, as evidenced by the companys first increase in the dividends per share in many years. We will see
more on dividend theory in Chapter 11. BCE was the subject of a takeover bid by a private equity group headed
by the Ontario Teachers Pension Fund in July 2007.
EBITDA margin (%)

EBITDA to interest (times)
Operating margin (%)
ROE (%)
EPS ($)
Dividends per share ($)
2005
2004
2003
2002
2001
39.80
7.74
21.20
14.80
2.04
1.32
40.50
7.44
15.80
12.50
1.65
1.20
40.30
6.62
22.30
15.20
1.89
1.20
39.70
6.51
19.40
17.80
2.62
1.20
37.50
7.01
14.70
2.40
0.46
1.20
Source: 2005 BCE Annual Report.
Managers use trend analysis techniques to spot areas where changes are required.
For example, trend analysis may indicate that the companys current ratio is deteriorating. (Recall that the current ratio is current assets divided by current liabilities.)
Management may decide to obtain more funds by obtaining a long-term bank loan or
by issuing some new shares. Both options improve the current ratio by increasing cash.
Further improvement to the current ratio could be made by paying off some of the
current liabilities.
The value of trend analysis is that it allows managers to act sooner rather than
later; they can achieve the best deals available at the right time without having to rush
into things at the last minute. For example, they might obtain a long-term bank loan
to take advantage of a low interest rate environment, using the cash to pay off the
accounts payable balance. In this way, trend analysis can help managers solve problems
before they become crises, in this case by substituting long-term debt for current
liabilities.
USING RATIOS TO PREDICT FINANCIAL FAILURE

Financial ratios based on current or past performance are often used to help predict
the future. However, both the choice of ratios and the interpretation of results
normally depend on the judgment and opinion of the analyst. In recent years,
however, attempts have been made to develop a more rigorous and systematic
approach to the use of ratios for prediction purposes. In particular, researchers
have shown an interest in the ability of ratios to predict the financial failure of a
business.
By financial failure, we mean a business either going out of business or being
severely adversely affected by its inability to meet its financial obligations. It is often
referred to as going bust or going bankrupt. This, of course, concerns all those connected with the business.
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Using Single Ratios

Many methods and models employing ratios have now been developed that claim to
predict future financial failure. Early research focused on the examination of ratios
on an individual basis to see whether they were good or bad predictors of financial
failure. A particular ratio (for example, the current ratio) for a business that had
failed was tracked over several years leading up to the date of the failure. This was
to see whether it was possible to say that the ratio had showed a trend that could
have been taken as a warning sign.
William Beaver carried out the first research in this area. 2 He calculated the
average (mean) of various ratios for 79 businesses that had actually failed, over the
10-year period leading up to their failure. Beaver then compared these average ratios
with similarly derived ratios for a sample of 79 businesses that did not fail over this
period. Beaver found that some ratios exhibited a marked difference between the
failed and non-failed businesses for up to five years prior to failure. This is shown
in Figure 4.6.
To explain Figure 4.6, let us take a closer look at graph (a). This plots a ratio: cash
flow (presumably the operating cash flow figure, taken from the cash flow statement)
divided by total debt. For the non-failed businesses, this stayed fairly steady at about
+0.45 over the period. For the failed businesses, however, this was already well below
the non-failed businessesat about +0.15even five years before those businesses
eventually failed. It then declined steadily until, by one year before the failure, it was
less than 0.15. Note that the scale of the horizontal axis shows the most recent year
(Year 1) on the left and the earliest year (Year 5) on the right. Graphs (b) to (f) show
a similar picture for five other ratios. In each case, there is a deteriorating average ratio
for the failed businesses as the time of failure approaches, even for graph (c), which
shows dramatically rising debt levels for failed businesses.
What is shown in Figure 4.6 implied that failure could be predicted by careful
assessment of the trend shown by particular key ratios. Research by M.E. Zmijewski,
using a sample of 72 failed and 3,573 non-failed businesses over a six-year period, found
that failed businesses were characterized by lower rates of return, higher leverage, lower
levels of coverage for their fixed interest payments, and more variable returns on
shares.3 While we may not find these results very surprising, it is interesting to note that
Zmijewski, like a number of other researchers in this area, did not find liquidity ratios
particularly useful in predicting financial failure. Intuition might have led us (wrongly
it seems) to believe that the liquidity ratios would have been particularly helpful in
this context.
Using Combinations of Ratios

We may also wish to test whether two ratios (say, the current ratio and the return on
capital employed) can help to predict failure. To do this, we can calculate these ratios,
first for a sample of failed businesses and then for a matched sample of non-failed
businesses. From these two sets of data, we can produce a scatter diagram that plots
William H. Beaver, Financial Ratios as Predictors of Failure, in Empirical Research in Accounting:

Selected Studies, supplement to Journal of Accounting Research, Autumn 1966, pp. 71111.
3 M.E. Zmijewski, Predicting Corporate Bankruptcy : An Empirical Comparison of the Extent of Financial
Distress Models, Research Paper, State University of New York, 1983.
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FIGURE 4.6
Average (Mean) Ratios of Failed and Non-Failed Businesses
Each of the ratios (a) to (f) above indicates a marked difference in the average ratio between
the sample of failed businesses and a matched sample of non-failed businesses. The vertical
scale of each graph is the average value of the particular ratio for each group of businesses
(failed and non-failed). The horizontal axis is the number of years before failure. Thus, Year 1
is the most recent year and Year 5 is the earliest of the years. For each of the six ratios, the
difference between the average for the failed and the non-failed businesses can be detected
five years prior to the failure of the former group.
Source: Financial ratios at predictors of failure, W.H. Beaver, Empirical Research in Accounting: Selected
Studies, supplement to Journal of Accounting Research, 1966, pp. 71111. Journal of Accounting Research.
Published by Blackwell Publishing on behalf of The Institute of Professional Accounting, Graduate School of
Business, University of Chicago.
each business according to these two ratios to produce a single coordinate. Figure 4.7
illustrates this approach. Using the observations plotted on the diagram, we try to
identify the boundary between the failed and the non-failed businesses. This is the
diagonal line in Figure 4.7.
133
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FIGURE 4.7
Scatter Diagram Showing the Distribution of Failed and Non-Failed

Businesses
We can see that those businesses to the bottom left of the line are predominantly failed
ones, and those to the upper right are predominantly non-failed ones. Note that there
is some overlap between the two populations. The boundary produced is unlikely, in
practice, to eliminate all errors. Some businesses that fail may fall on the side of the
boundary with non-failed businesses, and vice versa. However, the boundary will minimize the misclassification errors.
The boundary shown in Figure 4.7 can be expressed in the form:
Z = a + (b Current ratio) + (c ROCE)
where a is a constant and b and c are weights to be attached to each ratio. A weighted
average or total score (Z) is then derived. The weights given to the two ratios will
depend on the slope of the line and its absolute position.
Z-Score Models
Edward Altman was the first to develop a model using financial ratios to predict financial
failure.4 His model, the Z-score model, is based on five financial ratios and is as follows:
Z = 1.2a + 1.4b + 3.3c + 0.6d + 1.0e
where: a = Working capital/Total assets
b = Retained earnings/Total assets
c = Earnings before interest and taxes/Total assets
d = Market value of common and preferred shares/Total liabilities at book
value
e = Sales revenue/Total assets.
In developing this model, Altman carried out experiments using a paired sample of
failed businesses and non-failed businesses and collected relevant data for each business
for five years prior to failure. He found that the model represented by the formula above
4 Edward I. Altman, Financial Ratios, Discriminant Analysis and the Prediction of
Journal of Finance, September 1968, pp. 589609.
Corporate Bankruptcy,
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was able to predict failure for up to two years before it occurred. However, the predictive
accuracy of the model became weaker the longer the time before failure.
The ratios used in this model were identified by Altman through a process of trial and
error, as there is no underlying theory of financial failure to help guide researchers in their
selection of appropriate ratios. According to Altman, those businesses with a Z-score of
less than 1.81 tended to fail, and the lower the score the greater the probability of failure.
Those with a Z-score greater than 2.99 tended not to fail. Those businesses with a Z-score
between 1.81 and 2.99 were difficult to classify. However, the model was able to classify
95% of the businesses correctly overall. Altman based his model on U.S. businesses.
In recent years, this model has been updated and other models, using a similar
approach, have been developed throughout the world. In the U.K., Richard Taffler
developed separate Z-score models for different types of business.5
The prediction of financial failure is not the only area where research into the predictive ability of ratios has taken place. Researchers have also developed ratio-based
models that claim to assess the vulnerability of a business to takeover by another. This
is another area of importance to all those connected with the business.
LIMITATIONS OF RATIO ANALYSIS

Although ratios offer a quick and useful method of analyzing the performance of a
business, they are not without their problems and limitations. Some of the more
important limitations are as follows:
Accounting conventions. It must always be remembered that ratios are based on

financial statements, and the results of ratio analysis are dependent on the quality
of these underlying statements. Ratios will inherit the limitations of the financial
statements on which they are based. An example would be whether research and
development costs are capitalized or expensed.
Creative accounting. Despite the proliferation of accounting rules and the independent checks that are imposed, there is evidence that the management of some
companies has employed particular accounting policies or structured particular
transactions to portray the companys financial performance unfairly. This practice is referred to as creative accounting, and it can pose a major problem for
those seeking to estimate the financial health of a business.
ACTIVITY 4.27
Why might the management of a business engage in creative accounting?
Management might engage in creative accounting to:
Get around restrictions (for example, to report sufficient profit to pay a dividend)
Avoid government action (for example, the taxation of excessive profits)
Hide poor management decisions
Achieve sales or profit targets, thereby ensuring that performance bonuses are paid
Attract new financing by showing a healthy financial position
Satisfy the demands of major investors concerning levels of return
Deliver on the guidance statements already made to the market.
5 Richard Taffler, The Assessment of Company Solvency and Performance Using a Statistical Model: A
Comparative UK-Based Study, Accounting and Business Research, Autumn 1983, pp. 295307.
L.O. 3
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Creative accounting was significantly involved in the fraud perpetrated by management at Enron and WorldCom that led to those companies spectacular downfall. The
U.S. has reacted to these and other huge business failures by passing the SarbanesOxley Act (SOx) of 2002, which bolsters internal controls that help prevent creative
accounting, requires CEOs and CFOs to certify financial reports, and increases jail
terms and fines for willful misstatements.
The particular methods that unscrupulous managers use to manipulate the financial statements are many and varied. They can involve overstatement of revenues and
asset values, manipulation of expenses, and concealment of losses and liabilities.
Overstatement of revenues has been a particularly popular goal of creative accounting.
The methods used often involve the early recognition of sales revenue or the reporting of
sales transactions that have no real substance. Real World 4.10 describes Nortel Networks
Corporations third restatement of its financials in recent years.
REAL
WORLD
4.10
Nortels Third Restatement Involves Revenue Recognition

Issues
A company experiencing duress will often change its CEO, and with that usually comes wholesale write-offs and other
accounting changes and corrections. Nortel has had three major restatements of its financial statements in recent
years. After the appointment of Mike Zafirovski as president and CEO of Nortel, the 2005 annual report discussed
its third major restatement for the years ended December 31, 2002, 2003, 2004, and 2005. The justification for
these restatements was that accounting errors were made in the interpretation and application of generally accepted
accounting principles, involving the percentage-of-completion method of revenue recognition for complex contractual arrangements relating to multiple deliveries. Essentially Nortel had in the past four years prematurely recognized
revenue that properly belonged in future accounting periods (when Mr. Zafirovski had become the boss).
Data from Nortels interim financial statements shows the impact of shifting revenues from the past to the future.
2006
1st Quarter 2nd Quarter 3rd Quarter Cumulative
(Millions of U.S. dollars)
Restated from 2005 to 2006
Revenue increase
Net income increase
EPS increase
147
55
0.01
236
78
0.02
137
31
0.01
520
164
0.04
Source: 2005 Nortel Annual Report and 2006 Quarterly Financial Statements.
When examining the financial statements of a business, a number of checks may be

carried out to help gain a feel for their reliability. These can include checks to see whether:
The reported profits are significantly higher than the operating cash flows for the
period, which may suggest that profits have been overstated
The income tax expense is low in relation to reported profits, which may suggest, again,
that profits are overstated, although there may be other, more innocent, explanations
There have been any changes in accounting policies over the period, particularly in
key areas such as revenue recognition, inventory valuation, and amortization
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The accounting policies adopted are in line with those adopted by the rest of the
industry
The auditors report gives a clean bill of health to the financial statements
The small printthat is, the notes to the financial statementsis not being used
to hide significant events or changes.
Although such checks are useful, they are not guaranteed to identify creative
accounting practices, some of which may be very deeply seated.
Other factors that may limit the usefulness of the results obtained from employing
ratio analysis include:
Inflation. A persistent (though recently less severe) problem is that the financial
results of businesses can be distorted as a result of inflation. One effect of inflation is
that the values of assets on the balance sheet held for any length of time may bear
little relation to current fair values. Generally speaking, the book value of assets will
be understated in current terms during a period of inflation as assets are usually
recorded at their original cost (less any amounts written off for amortization). This
means that comparisons, either between businesses or between periods, will be
hindered. A difference in return on capital employed may simply be owing to the fact
that assets in one of the balance sheets being compared were acquired more recently
(ignoring the effect of amortization on the asset values). Another effect of inflation
is to distort the measurement of profit. Sales revenue for a period is often reported
against expenses from an earlier period because there is often a time lag between
acquiring a particular resource and using it in the business. For example, inventory
may be acquired in one period and sold in a later period. During a period of inflation, this will mean that the costs do not reflect current prices. The cost of goods sold
figure is based on the historical cost of the inventory concerned. As a result, costs will
be understated in the current income statement and this, in turn, means that profit
will be overstated. One effect of this will be to distort the profitability ratios discussed
earlier.
The restricted vision of ratios. It is important not to rely exclusively on ratios, thereby
losing sight of information contained in the underlying financial statements. In comparing one figure with another, ratios measure relative performance and therefore
provide only part of the picture. For example, Business A may generate $1 million
profit and have a return on capital employed of 15%, and Business B may generate
$100,000 profit and have an ROCE of 20%. Although Business B has a higher level of
profitability, as measured by ROCE, it generates lower total profits.
The basis for comparison. No two businesses will be identical, and the greater the
differences between the businesses being compared, the greater the limitations of ratio
analysis. Also, differences in such matters as accounting policies, financing methods
(leverage levels), and financial year-ends will add to the problems of evaluation.
Balance sheet ratios. Because the balance sheet is only a snapshot of the business at a
particular moment in time, any ratios based on balance sheet figures, such as the liquidity ratios above, may not be representative of the financial position of the business for the year as a whole. For example, it is common for a seasonal business to
have a financial year-end that coincides with a low point in business activity. Thus
inventory and receivables may be low at the balance sheet date, and the liquidity
ratios may also be low as a result. A more representative picture of liquidity can only
be gained by taking additional measurements at other points in the year.
Real World 4.11 points out the very important role that people have to play in a
companys achieving its goals, even though those goals lean heavily toward the quantitative ratio end of the spectrum.
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Talent Management Is Central to Maximizing Value at Alcan
Alcans Integrated Management System (AIMS) targets four goals:
Target
Goal
ROCE
Operating EPS
Cash flow from operations
Debt to total capital
Earn cost of capital by 2008

15% annual growth
Minimum of $2 billion, starting in 2006
35%
Alcans people strategy is a key driver of AIMS, as the company formally recognizes that it is the employees who
ultimately determine the success of the company. Alcan is placing an enhanced focus on hiring, motivating, and
retaining high-potential employees and people with special skills. About half of Alcans employees are new within
the past six years.
Alcan adopts a world view of compensation management. An annual salary survey is conducted to ensure remuneration is at appropriate levels. Senior executives are responsible for developing tomorrows management team,
and presumably this is reflected in their compensation package.
In a recent development, Alcan received a takeover bid from an Anglo-Australian firm, Rio Tinto, on July 19,
2007. Alcan had sought a white knight rescue after receiving an earlier takeover bid from U.S.-based Alcoa.
Source: 2005 Alcan Annual Report.
S U M M A R Y
Financial Ratios
Ratios compare two related figures, usually both

from the same set of financial statements.
Ratios are an aid to understanding what the
financial statements portray.
Ratio analysis is an inexact science and so results
must be interpreted cautiously.
Past periods, the performance of similar businesses, and planned performance are often used
to provide benchmark ratios.
A brief overview of the financial statements
can often provide insights that may not be
revealed by ratios or may help in their interpretation.
Financial Ratio Classification

Profitability RatiosConcerned with Effectiveness
at Generating Profit
Return on equity (ROE)
Return on capital employed (ROCE)

Gross profit margin.
Efficiency RatiosConcerned with Efficiency of Using

Assets/Resources
Sales revenue per employee.
Liquidity RatiosConcerned with the Ability to
Meet Short-Term Obligations
Current ratio
Acid test ratio.
Leverage RatiosConcerned with the
Relationship Between Equity and Debt
Financing
Leverage ratio
Times interest earned ratio.
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Using Ratios to Predict Financial Failure
Investment RatiosConcerned with Returns

to Shareholders
Earnings per share
Price/earnings ratio.
Ratios can be used to predict financial failure by:

Looking at just one ratio over time
Looking at several ratios, put together in a
model, over time (such as with Z-scores).
Limitations of Ratio Analysis

Financial Ratios and the Problem
of Overtrading
Overtrading occurs when a business operates at

a level of activity that it is insufficiently funded
to sustain.
Trend Analysis
Individual ratios can be tracked (for example,

plotted on a graph) to detect trends.
K E Y
T E R M S
Average payment period for

payables
Sales revenue to capital
employed
Current ratio
Acid test ratio
Financial leverage
Leverage ratio

(ROCE)
Operating profit margin ratio
Gross profit margin ratio
Average inventory turnover
period
Average collection period for
receivables
L I S T
4.1 Return on equity =
Ratios are only as reliable as the financial statements from which they derive.
Creative accounting can distort the portrayal of
financial health.
Inflation can also distort the information.
Ratios have restricted vision.
It can be difficult to find a suitable benchmark
(for example, another business) to compare with.
Some ratios could mislead due to the snapshot
nature of the balance sheet.
O F
Times interest earned ratio

Dividend cover ratio
Dividend per share
Earnings per share (EPS)
Price/earnings (P/E) ratio
Overtrading
Creative accounting
E Q U A T I O N S
Net income after preferred dividends (if any)
* 100%
Average shareholders equity
Net income - Preferred dividends
=
* 100%
1Average common shares + Retained earnings2
4.2 Return on capital employed

1Average shareholders equity + Preferred shares + Long-term debt2
4.3 Operating profit margin =

Sales revenue
* 100%
* 100%
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Gross profit
4.4 Gross profit margin =
Sales revenue
4.5 Average inventory turnover period =
* 100%
Average inventory held
Cost of goods sold
4.6 Average collection period for receivables =
* 365
Average accounts receivable

Credit sales revenue
* 365
4.7 Average pay

4.8 Sales revenue to capital employed = Net asset turnover
Sales revenue
Average long-term liabilities + Total shareholders equity
Sales revenue
=
1Average total assets - Current liabilities2
=
4.9 Sales revenue per employee =

4.10 Current ratio =
Sales revenue
Number of employees
Current assets
Current liabilities
4.11 Acid test ratio =

4.12 Leverage ratio =
Current assets - Inventory

Current liabilities
Shareholders equity + Long-term (non-current) debt
4.13 Times interest earned ratio =
4.14 Dividend payout ratio =

4.15 Dividend cover ratio =
4.16 Dividend yield =

Interest expense
Annual dividends to common shareholders for the year


Annual dividends to common shareholders
Dividend per share

4.17 Earnings per share =
4.18 Price/earnings ratio =
* 100%
* 100%

Number of common shares outstanding
Earnings per share
* 100%
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R E V I E W
Q U E S T I O N S
Answers to the Review Questions can be found on

the Companion Website that accompanies this text
at www.pearsoned.ca/atrill.
4.1 Some businesses operate on a low operating
profit margin (for example, a supermarket
chain). Does this mean that the return on capital employed from the business will also be low?
4.2 What potential problems arise for the external
analyst from the use of balance sheet figures in
the calculation of financial ratios?
P R O B L E M S
4.3 Is it responsible to publish financial analyses of

businesses that are in financial difficulties?
What are the potential problems of doing this?
4.4 Identify and discuss three reasons why the P/E
ratios of two businesses operating within the
same industry may differ.
4.5 The times interest earned ratio for Burlington
Perfumes Inc. is 3.0, but the current ratio is only
1.2. Discuss future prospects for Burlington,
given that the industry average for these ratios is
2.1 for both. Suggest a plan for Burlington.
A N D
C A S E S
4.1 The following data have been selected from the annual report of Graphic Chips Limited.
($000)
Sales (80% on credit)
EBIT
Accounts receivable
Common shares
2,550
250
400
1,200
($000)
Cost of goods sold
Net income
Long-term debt
Retained earnings
1,750
140
300
800
Required:
Calculate the following ratios:
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
Gross profit margin

Leverage ratio
Times interest earned, assuming income tax expense was nil
Return on equity
4.2 Northern Electric Corporation has the following common share data:
Share price
P/E ratio
Yield
$60.00
20.0
4%
Required:
Calculate the following:
(a) EPS
(b) Dividend per share
(c) Dividend payout ratio
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4.3 The current ratio for Arrow Industries is 2.0 and the acid test ratio is 1.0. Current assets total $200,000
and cost of goods sold was $1,000,000.
Required:
(a) Calculate the amount of inventory on Arrows balance sheet.
(b) Determine the average inventory turnover period.
4.4 The following is a condensed balance sheet for the Albinitree Corporation.
Albinitree Corporation
Balance Sheet
As at December 31, 2008
($000)
Assets
Cash
Accounts receivable
Inventory
Land
Property, plant, and equipment, (net)
Total assets
50,000
90,000
65,000
130,000
95,000
430,000
Liabilities
Accounts payable
Taxes payable
Accrued wages payable
Bonds payable (due in 2020)
Total liabilities
25,000
65,000
50,000
150,000
290,000
Shareholders equity
Common shares
Retained earnings
80,000
60,000
140,000
430,000
Sales totalled $500 million, with 90% on credit; gross profit was $220 million; purchases were $300 million,
with 70% on credit; and Albinitree employed 4,000 employees.
Required:
Calculate the following:
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
Current ratio
Acid test ratio
Leverage ratio
Inventory at the start of the year
Gross profit margin
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4.5 There are four independent supermarkets in an isolated city in Northern Ontario. In your capacity as
a banker, you have obtained the following financial data for all four companies:
EBIT
Sales
Total assets
East Co.
West Co.
North Co.
South Co.
$ 75,660
600,000
200,000
$ 320,000
2,600,000
1,600,000
$ 50,300
420,000
950,000
$ 140,000
1,200,000
1,800,000
Required:
(a) Calculate the operating profit margin for each store and for the supermarket industry in the city as
a whole.
(b) Calculate the return on capital employed for each store and for the supermarket industry in the city
as a whole, assuming current liabilities are negligible.
4.6 Set out below are ratios relating to three different businesses. Each business operates within a different
industrial sector.
Ratio
Inventory turnover period
Collection period for receivables
Current ratio
A Co.
B Co.
C Co.
3.6%
2.4 times
18 days
2 days
0.8 times
9.7%
3.1 times
n/a
12 days
0.6 times
6.8%
1.7 times
44 days
26 days
1.5 times
Required:
State, with reasons, which of the above is:
(a) A holiday tour operator
(b) A supermarket chain
(c) A food manufacturer
4.7 Victoria Ltd. and Halifax Ltd. are both engaged in retailing, but they seem to approach it differently,
according to the following information:
Ratio
Return on capital employed (ROCE)
Gross profit margin
Inventory turnover period
Victoria Ltd.
Halifax Ltd.
20%
30%
63 days
50 days
40%
10%
52 days
17%
18%
21 days
45 days
15%
10%
25 days
Required:
Describe what this information indicates about the differences in approach between the two businesses. If
one of them prides itself on personal service and one of them on competitive prices, which do you think is
which and why?
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4.8 Conday Ltd., a small privately held firm, has been in operation for three years, and produces
antique reproduction furniture for the export market. The most recent set of financial statements is
shown below.
Conday Ltd.
Balance Sheet
As at November 30, 2008
(in $ thousands)
Current assets
Accounts receivable
Inventory
Land
Buildings
Less: Accumulated amortization
Plant and equipment
Total assets
820
600
1,420
100
228
100
942
180
128
762
990
2,410
Current liabilities
Bank overdraft
Accounts payable
432
665
48
1,145
9% Bonds payable (Note 1)
200
Total liabilities
Shareholders equity
Common shares (700,000 shares outstanding)
Retained earnings
1,345
700
365
1,065
2,410
Conday Ltd.
Income Statement
For the year ended November 30, 2008
(in $ thousands)
Sales (all on credit)
Gross profit
Less: Selling and distribution expenses (Note 2)
Administration expenses
Interest expenses
Net income
2,600
1,620
980
408
194
58
660
320
95
225
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145
Conday Ltd.
For the year ended November 30, 2008
(in $ thousands)
Opening retained earnings, December 1
Add: Net income
Less: Dividends paid
Closing retained earnings, November 30
300
225
(160)
365
Notes
1. The bonds are secured on the land and buildings.
2. Selling and distribution expenses include $170,000 of bad debts expense.
3. The company has invited an investor to buy a new issue of common shares in the business at $6.40 each, making a total
investment of $200,000. Management wishes to use the funds to finance a program of further expansion.
Required:
(a) Analyze the financial position and performance of the business and comment on any features that
you consider to be significant.
(b) State, with reasons, whether or not the investor should invest in the business on the terms outlined.
4.9 The financial statements of Helena Beauty Products Ltd. are presented below.
Helena Beauty Products Ltd.
Income Statements
For the year ended September 30
2008
2007
(in $ thousands)
Sales (all on credit)

Less: Cost of goods sold:
Opening inventory
Plus: Purchases
Cost of goods sold
Gross profit
Less: Expenses
Net income
3,840
3,600
400
2,350
2,750
500
320
2,240
2,560
400
2,250
1,590
1,500
90
2,160
1,440
1,360
80
Helena Beauty Products Ltd.

Balance Sheets
As at September 30
2008
2007
(in $ thousands)
Current assets
Cash
Accounts receivable
Inventory
4
960
500
1,464
1,860
8
750
400
1,158
1,900
Total assets
3,324
3,058
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Current liabilities
Shareholders equity
Common shares
Retained earnings
450
390
1,766
1,108
2,874
1,650
1,018
2,668
3,324
3,058
Required:
Using six ratios, comment on the profitability (three ratios) and efficiency (three ratios) of the business as
revealed by the financial statements. Assume there is no interest or taxes.
4.10 Threads Limited manufactures nuts and bolts, which are sold to industrial users. The abbreviated financial statements for 2008 and 2007 are as follows.
Threads Limited
Income Statements
For the year ended June 30
2008
2007
(in $ thousands)
Sales
Gross profit
Operating expenses
Amortization
Interest
Income tax expense
Net income
1,200
750
450
208
75
8
291
159
48
111
1,180
680
500
200
66
266
234
80
154
Threads Limited
Balance Sheets
As at June 30
2008
2007
(in $ thousands)
Current assets
Cash
Accounts receivable
Inventory
4
156
236
396
3
102
148
253
Property, plant, and equipment (net)
687
702
1,083
955
122
76
24
16
238
81
60
40
18
199
Total assets
Current liabilities
Bank overdraft
Accounts payable
Other accrued liabilities
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Bank loan
50
Total liabilities
288
199
Shareholders equity
Common shares
Retained earnings
500
295
795
500
256
756
1,083
955
147
Threads Limited
2008
2007
(in $ thousands)
Add: Net income
256
111
(72)
295
172
154
(70)
256
Required:
(a) Assuming that all sales and purchases are on credit, and that the interest expense relates to the longterm debt, calculate the following financial ratios for 2007 and 2008 (using year-end figures for
balance sheet items):
(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
(viii)

Gross profit margin
Current ratio
Acid test ratio
Collection period for receivables
Payment period for payables
Inventory turnover period.
(b) Comment on the performance of Threads Limited from the viewpoint of a business considering
supplying a substantial amount of goods to Threads Limited on usual credit terms.
4.11 The financial statements for Harridges Limited are given below for the two years ended June 30, 2008
and 2007. Harridges operates a retail and wholesale store in the centre of a small town.
Harridges Limited
Income Statements
2008
2007
(in $ thousands)
Sales
Gross profit
Wages and salaries
Amortization
Overhead expenses
3,500
2,350
1,150
350
250
200
800
2,600
1,560
1,040
320
150
260
730
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Earnings before interest and taxes (EBIT)

Interest expense
Income tax expense
Net income
350
50
300
125
175
310
50
260
105
155
Harridges Limited
Balance Sheets
As at June 30
2008
2007
(in $ thousands)
Current assets
Cash
Accounts receivable
Inventory
115
145
400
660
380
105
250
735
Net property, plant, and equipment
1,525
1,265
Total assets
2,185
2,000
300
75
110
485
235
65
100
400
Current liabilities
Accounts payable
Dividends payable
Other
Bank loan (10%)
Total liabilities
Shareholders equity
Common shares
Contributed capital
Retained earnings
500
985
500
900
490
260
450
1,200
490
260
350
1,100
2,185
2,000
Harridges Limited
2008
2007
(in $ thousands)
Add: Net income
350
175
(75)
450
260
155
(65)
350
Note: Harridges had 490,000 shares outstanding throughout 2007 and 2008.
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149
Required:
(a) Choose and calculate eight ratios that would be helpful in assessing the performance of Harridges
Limited. Use end-of-year values and calculate ratios for both 2007 and 2008.
(b) Using the ratios calculated in part (a) and any others you consider helpful, comment on the businesss performance from the viewpoint of a prospective purchaser of a majority of shares.
4.12 Genesis Ltd. was incorporated in 2005 and has grown rapidly over the past three years. The rapid
rate of growth has created problems for the business, which management has found difficult to deal
with. Recently, a firm of management consultants has been asked to help the company overcome these
problems.
In a preliminary report to management, the management consultants state: Most of the difficulties faced by the business are symptoms of an underlying problem of overtrading.
The most recent financial statements of the business are set out below.
Genesis Ltd.
Balance Sheet
As at October 31, 2008
(in $ thousands)
Current assets
Accounts receivable
Inventory
Land
Buildings
Plant and equipment
Trucks
104
128
232
200
330
88
168
52
118
54
242
116
64
622
Total assets
Current liabilities
Bank overdraft
Accounts payable
854
358
184
8
550
Bonds payable (10%, secured)
Total liabilities
Shareholders equity
Common shares
Retained earnings
120
670
60
124
184
854
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Chapter 4
9:47 PM
Page 150
Genesis Ltd.
Income Statement
For the year ended October 31, 2008
(in $ thousands)
Sales
Less:
Opening inventory
Plus: Purchases
Cost of goods sold
Gross profit
Less: Selling and distribution expenses
Administration expenses
Interest expenses
Net income
1,640
116
1,260
1,376
128
1,248
392
204
92
44
340
52
16
36
Genesis Ltd.
For the year ended October 31, 2008
(in $ thousands)
Opening retained earnings, November 1
Add: Net income
Closing retained earnings, October 31
92
36
(4)
124
Notes
1. All purchases and sales were on credit.
Required:
(a) Explain the term overtrading and state how overtrading might arise for a business.
(b) Discuss the kinds of problems that overtrading can create for a business.
(c) Calculate and discuss five financial ratios that might be used to establish whether or not the
business is experiencing overtrading.
(d) State the ways in which a business may overcome the problem of overtrading.
4.13 The most recent financial statements for Prairie Restaurants Ltd. are as follows.
Prairie Restaurants Ltd.
Income Statement
For the year ended December 31, 2008
(in $ millions)
Sales
Cost of goods sold
Gross profit
4,223
3,200
1,023
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Chapter 4
Operating expenses:
Selling expenses
Maintenance expenses
Lease expenses
Amortization
Other expenses
Total operating expenses
Interest expense
Less: Income tax expense (50%)
Net income
120
20
145
230
335
950
73
23
50
25
25

For the year ended December 31, 2008
(in $ millions)
Opening retained earnings, January 1
Add: Net income
Closing retained earnings, December 31
190
25
(15)
200

Balance Sheet
As at December 31, 2008
(in $ millions)
Current assets
Cash
Accounts receivable
Inventory
Land
Buildings
Furniture and fixtures
25
150
75
250
50
600
400
320
180
200
140
390
Total assets
Current liabilities
Accounts payable
Loans payable
640
140
30
5
175
151
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9:47 PM
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Long-term debt
Bonds, 10%
Total liabilities
Shareholders equity
Common shares
Retained earnings
220
395
45
400
445
840
Notes
1. There are 10 million shares outstanding, with the most recent price being $45 per share.
2. Prairie Restaurants employs 5,000 people.
3. Prairie Restaurants runs its own credit card program, which provides incentives for customers to pay within 10 days.
90% of sales are on credit.
4. The amount of inventory, all of which is purchased on credit, has remained the same during the year.
Industry data on the restaurant industry are as follows:

(a) ROE
(b) ROCE
(c) Operating profit margin
(d) Gross profit margin
(e) Average inventory turnover period
(f) Average collection period for receivables
(g) Average payment period for payables
(h) Sales revenue to capital employed
(i) Sales revenue per employee
(j) Current ratio
(k) Acid test ratio
(l) Leverage ratio
(m)Times interest earned ratio
(n) Dividend payout ratio
(o) Dividend cover ratio
(p) Dividend yield
(q) EPS
(r) P/E ratio
12%
30%
10%
18%
15 days
7 days
30 days
3 times
$1.5 million
2.0
1.0
80%
10 times
20%
5 times
2%
$1.50
25
Required:
(a) Prepare calculations for the same ratios as shown above for Prairie Restaurants.
(b) Based on comparisons to the industry ratios, how would you rate Prairie Restaurants?

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Analyzing and Interpreting Financial Statements

By calculating a small number of ratios, it is often possible to develop a good

FINANCIAL RATIO CLASSIFICATION

Profitability. Profitability ratios measure a businesss success in creating wealth

Analyzing and Interpreting Financial Statements

THE NEED FOR COMPARISON

Analyzing and Interpreting Financial Statements

KEY STEPS IN FINANCIAL RATIO ANALYSIS

The Three Key Steps of Financial Ratio Analysis

Analyzing and Interpreting Financial Statements

CALCULATING THE RATIOS

Analyzing and Interpreting Financial Statements

Opening retained earnings, April 1

4. Closing balance of retained earnings appears on the balance sheet.

Analyzing and Interpreting Financial Statements

Analyzing and Interpreting Financial Statements

Net income after preferred dividends (if any)

Shareholders equity consists of common shares plus retained earnings.

Analyzing and Interpreting Financial Statements

Return on Capital Employed

(Average shareholders equity + Preferred shares

ROCE is considered by many to be a primary measure of profitability. It compares

Analyzing and Interpreting Financial Statements

Setting Profitability Targets

Operating Profit Margin

Operating profit margin =

Earnings before interest and taxes

Analyzing and Interpreting Financial Statements

Gross Profit Margin

Gross profit margin =

Booming Margins in the Oil Fields

Analyzing and Interpreting Financial Statements

Gross profit margin =

Analyzing and Interpreting Financial Statements

Sale of Non-Strategic Assets at Abitibi-Consolidated

Average inventory turnover period

Analyzing and Interpreting Financial Statements

Average Inventory Turnover Period

Average inventory turnover period =

Average inventory held

Average inventory turnover period =

Average Collection Period for Receivables

Analyzing and Interpreting Financial Statements

Average Payment Period for Payables

Average payment period for payables =

Average accounts payable

Analyzing and Interpreting Financial Statements

Average payment period for payables =

Sales Revenue to Capital Employed

Analyzing and Interpreting Financial Statements

Preferred shares, if any, are included in total shareholders equity.

Sales revenue to capital employed =

Sales Revenue per Employee

Sales revenue per employee =

Analyzing and Interpreting Financial Statements

Sales revenue per employee =

Average inventory turnover period

Analyzing and Interpreting Financial Statements

THE RELATIONSHIP BETWEEN PROFITABILITY

The Main Elements Comprising the ROCE Ratio

Sales revenue to capital

Analyzing and Interpreting Financial Statements