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Financial Ratio Analysis

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Financial Ratios

A financial ratio is a number, that

expresses the value of one financial

variable relative to another

It is the result you get when you

divide one financial number by

another

Calculation of ration is simple but

each ratio must be analyzed carefully

to effectively measure the firms

performance

Financial Ratios

Comparability ratios are comparative measures

because the ratios show relative value

Ratios allow financial analysts to compare

information that couldnt be compare in raw its

form

Ratios may be used to compare

- one ratio to a related ratio

- the firms performance to managements goal

- the firms past and present performance

- the firms performance to similar firms

Financial ratios are generally divided into five

categories namely:

profitability ratios measure how much company revenue

is eaten up by expenses, how much a company earns

relatively to sales generated and the amount earned

related to the value of the firms assets and equity

liquidity ratios indicate how quickly and easily a company

can obtain cash for its needs

debt ratios measure how much a company owes to others

assets activity ratios measure how efficiently a company

uses its assets

market value ratios measure how the market value of the

companys stock compares to its accounting values

Profitability Ratios

Profitability ratios measure how the firms

returns compare to its sales, assets

investments and equity

Basic Profitability Ratios

- Gross Profit Margin = Gross Profit / Sales

- Operating Profit Margin = EBIT / Sales

- Net Profit Margin = Net Income / Sales

- Return on Assets (ROA) = Net Income / Assets

- Return on Equity (ROE) = Net Income / Equity

Profitability Ratios

Gross profit margin measure how much profit

remains out of each sales rupee after the cost

of goods sold is subtracted and it shows how

well a firm generates revenue compared to its

cost of goods sold. The higher the ratio, the

better the cost controls compared to the sales

revenues.

Operating profit margin ratio measure the cost

of goods sold as reflected in the gross profit

margin ratio as well as all other operating

expenses

Profitability Ratios

Net profit margin measures how much profit

out of each sales rupee is left after all expenses

are subtracted. Net income / net profit margin

ratio are often referred to as bottom line

measures. The net profit margin includes

adjustments for non-operating expenses such

as interest and taxes and operating expenses

Return on assets ratio indicates how much

income each rupee of assets produces on

average. It shows whether the business is

investing in its assets effectively

Profitability Ratios

Return on equity ratio measures the

average return on the firms capital

contributions from its owners (for a

corporation, that means the contributions

of stockholders). It indicates how many

rupees of income were produced for each

rupee invested by the common

stockholders

GPM, OPM, NPM, ROA and ROE express in

% age

Liquidity Ratios

Liquidity ratios measure the ability of a firm to meets

its short term obligations. These ratios are important

because failure to pay such obligations can lead to

bankruptcy

Bankers and lenders use this ratio to check whether

to extend short term credit to a firm

Generally, the higher the liquidity ratio, the more

able a firm is to pay its short term obligations

Stockholders, however, use liquidity ratios to see

how the firm has invested in assets. Too much

investment in current as compared to long term

assets indicates inefficiency

Liquidity Ratios

Two main liquidity ratios are current

ratio and quick ratio, quick ratio

often termed as Acid test ratio

- Current Ratio = CA / CL

- Quick Ratio = QA / CL

Quick Assets = CA - Inventory but

most of the time financial analysts

calculate it as:

CA - (Inventory + Prepayments)

Liquidity Ratios

The current ratio compares all the current

assets of the firm (cash and other assets

that can easily converted to cash) to all

the firms current liabilities (liabilities that

must be paid with cash soon)

The quick ratio is similar to the current

ratio but its a more rigorous measure of

liquidity because it excludes inventory

(plus prepayments) from current assets

Debt Ratios

Financial analysts use debt ratios to assess the

relative size of firms debt load and the firms

ability to pay off debt. The three primary debt

ratios are the debt to assets, debt to equity and

times interest earned ratios

Current and potential lenders of long term funds

such as banks and bondholders are interested in

debt ratios. When a firms debt ratios increase

significantly, bondholder and lender risk increase

because more creditors compete for that firms

resources if the firm runs into financial trouble

Debt Ratios

Stockholders are also concerned with the

amount of debt a business has because

bondholders are paid before stockholders

The optimal debt ratio depends on several

factors such as type of business and the

amount of risk lenders and stockholders

will tolerate. Generally, a profitable firm in

a stable business can handle more debt

and a higher debt ratio than a growth firm

in a volatile business

Debt Ratios

Debt to Total Assets = total debt / total assets

Debt to Equity = Total Debt / Equity

Time Interest Earned = EBIT / Interest Expense

Debt to total assets ratio measures the % age

of the firms assets that are financed with debt

Debt to equity ratio is the % age of debt

relative to the amount of equity of the firm

Debt Ratios

Time interest earned ratio is often used to asses companys

ability to service the interest on its debt with EBIT

A high TIE ratio suggests that the company will have ample

operating income to cover its interest expense. A low TIE

ratio signals that the company may have insufficient

operating income to pay its interest as it becomes due. If so,

the business might need to liquidate assets or raise new debt

or equity funds to pay the interest due

However, you have to know that the operating income is not

the same as cash flow. Operating income figures do not show

the amount of cash available to pay interest and interest

payments are made with cash so therefore, TIE ratio is only a

rough measure of a firms ability to pay interest with current

funds

Financial analysts use asset activity

ratios to measure how efficiently a

firm uses its assets. They analyze

specific assets and classes of assets.

Three set of asset activity ratios are

common: average collection period,

inventory turnover and total assets

turnover. Many analysts also check

fixed assets turnover in order to

examine that which class of assets

Basic activity ratios are:

- Average collection period calculated

as:

A/C Receivable / Average Daily Credit

Sales

- Inventory Turnover calculated as:

Sales / Inventory or COGS / Inventory

- Total Asset Turnover calculated as:

Sales / Total Assets

The average collection period ratio

measures how many days, on

average, the firms credit customers

take to pay their accounts. Credit

managers use this ratio to decide

who the firm should extend credit to.

Slow payers are disliked and not

welcome customers. Financial

analysts usually calculate this ratio

using the total sales figure when they

The inventory turnover ratio tells how

efficiently the firm converts inventory

to sales. If the firm has inventory that

sells well, the value of the ratio will

be high. If the inventory doesnt sell

well due to lack of market demand or

if there is excess inventory or if the

firm has old inventory stocks piled up

then the value of the ratio will be low

Total asset ratio turnover ratio measures

how efficiently the firm utilizes its assets.

Stockholders, bondholders and managers

know that the more efficiently the firm

operates, the better the returns. If a firm

has many assets that do not help generate

sales, that the total asset turnover ratio

will be relatively low. A firm that has a high

asset utilization ratio suggests that its

assets help promote sales revenue

So far the ratios we have examined

above rely on financial statements

figures but market value ratios

mainly rely on financial marketplace

data such as the market price of a

firms common stock

Market value ratios measure the

markets perception of the future

earning power of a firm, as reflected

in the stock share price

The two common market value ratios are price-toearning ratio and market-to-book value ratio

- Price-to-Earning Ratio (P/E) is define as:

Market Price Per Share of Stock / Earning Per Share

Earning Per Share (EPS) is calculated as

Earning Available to Stockholders / Number of

Common Shares Outstanding

- Market-to-Book Value Ratio is defines as:

Market Price Per Share / Book Value Per Share

Book Value Per Share (BPS) is calculated as

Common Stock Equity / Number of Common Shares

Outstanding

Investors and managers use P/E ratio to

gauge the future prospects of a company.

It measures how much investors are

willing to pay for claim to one rupee of the

earnings per share of the firm. The more

investors are willing to pay over the value

of EPS for the stock, the more confidence

they are displaying about the firms future

growth that is higher the P/E ratio, the

higher are investors growth expectations

The market-to-book value (M/B) ratio is the

market price per share of a companys

common stock divided by the accounting book

value per share (BPS). It is the amount of

common stock equity on the firms balance

sheet divided by the number of common

shares outstanding. The book value per share

is a proxy for the amount remaining per share

after selling the firms assets for their balance

sheet values and paying the debt owed to all

creditors and preferred stockholders

When the MPS > BPS, analysts often

conclude that the market believes the

companys future earnings are worth more

than the firms liquidation value

The difference b/w the firms future

earnings and liquidation value is the going

concern value of the firm. The higher the

M/B ratio, the greater the going concern

value of the company seems to be

Firms having market to book value of less than 1 are sometimes

considered to be worth more dead than alive. Such an M/B ratio

suggests that if the company liquidated and paid off all creditors

and preferred stockholders, it would have more left over for the

common stockholders than what the common stockholders could

be sold in the marketplace

The M/B ratio is useful but its only a rough approximation of how

liquidation and going concern values compare. This is because

the M/B ratio uses an accounting based book value. The actual

liquidation value of a firm is likely to be different than the book

value. For e.g. the assets of the firm may be worth more or less

than the value at which they are currently carried on the BS.

Additionally, current MP of the firms bond and preferred stock

may also differ from the accounting values of these claims

The Du Pont System

Du Pont Equation

- ROA = NPM x TAT

NI / TA = NI / Sales x Sales / TA

Modified Du Pont Equation

- ROE = NPM x TAT x EM (equity

multiplier)

NI / Eq = NI / Sales x Sales / TA x TA /

Eq

The Du Pont System

The Du Pont System of ratio analysis is named

for the company whose managers developed

the general system. It first examines the

relationships b/w total revenues relative to

sales and sales relative to total assets. This

version of the Du Pont equation helps to

analyze factors that contribute to a firms

return on assets

Modified version of Du Pont Equation measures

how the ROE is affected by NPM, Asset Activity

and debt financing

Application of Ratios

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