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3RD SESSION

Ratio Analysis
Ratio is the mathematical
relationship of one number to
another number.
Most important benefit
Facilitation of unbiased comparison

5 main categories
of Financial
Statement ratios

Liquidity
ratios

Asset
Manageme
nt Ratio

Debt
utilization
ratio

Profitability
ratio

Market
value ratio

Example
2014

2013

Cash (in hand & in


bank)

30,000

20,000

A/R

150,000

100,000

Inv.

200,000

150,000

Prepaid expenses

20,000

15,000

A/P

125,000

100,000

Accrued expenses

25,000

20,000

Fixed assets

600,000

400,000

Sales

1500,000

Gross profit

40% of sales

1. Liquidity Ratios
Liquidity ratios give us an idea about
firms ability to pay off debts that are
maturing within an year.
Liquidity ratio measures how capable a
firm is in meeting its short term debt
obligations in full and on time.
Most commonly used liquidity ratios:
Current ratio
Quick ratio or Acid test ratio
Cash ratio or Super Quick or Super Acid test
ratio

i. Current Ratio
Formula (CA/CL)
Ideal
It indicates the extent to which current
liabilities are covered by those assets
expected to be converted to cash in near
As for large
future.
discrepancies

Lower ratio than


industry average:
- Creditor less protected
than other firms in
industry

Higher ratio than industry


average:
- Strong, safe liquidity
position
- Greater inventory level
- Trouble moving things

ii. Quick Ratio


Formula (CA-inv/CL)
Ideal
It measures firms ability to pay off STO
without relying on sales of inventories.

iii. Cash Ratio


Formula (Cash and cash equiv./CL)
Ideal
It measures amount of cash, cash
equivalent or short term investment that a
firm has to cover current liabilities.

iv. Cash conversion cycle *


Number of days from outlay of cash for purchasing
R/M to receiving payment from customers

v. Working Capital * (CA CL)


WC is a measure of cash and liquid assets available
to fund a companys day to day operations.

2. Asset Management Ratios


Asset management ratios measure how
effectively a firm is managing its assets.
Most commonly used AMR:
Inventory turnover ratio (times/days)
Receivable turnover ratio (times/days)
Accounts Payable turnover (times/days)
Fixed asset turnover
Total asset turnover

i. Inventory turnover ratio


Formulas: (COGS/avg. inv.) (365/inv.
turnover)
Inventory turnover times measures how
many times in an year the firms inventory
has been sold.
What if inventory turnover ratio is low or high?

Inventory turnover days measure how


many days the inventory stays with us
before we are able to sell it.

ii. Receivable turnover ratio


Formulas: (Sales/avg. rec.) (365/rec.
turnover)
Receivable turnover times measures how
many times in an year the business can
turn its A/R into cash.
What if A/R turnover ratio is low or high?
High turnover: conservative credit policy, aggressive
collect. dept.
Low turnover: loose credit policy, inefficient collect.
dept.

Receivable turnover days/DSO/RP/CP


measure how many days the firm must
wait after making a sale to receive cash.

4TH SESSION

iii. Accounts Payable


turnover
Formulas: (Purchases/avg. A/P) (365/pay.
turnover)

Accounts payable times measure how


many times per period the co. pays its
avg. payable amount.
Accounts payable in days measure number
of days the company takes to pay its
suppliers.
What if A/P (no. of days) increase or decrease?
Increasing number of days
Decreasing number of days

iv. Fixed Assets Turnover


Formula: (Sales/fixed assets)
The ratio measures the extent to which
firm uses existing plant and equipment to
generate sales.
How many sales generated from $1 of
fixed assets, a ratio of 2.5 means by
utilizing $1 of fixed assets the firm has
generated $2.5 of sales.

v. Total Assets Turnover


Formula: (Sales/total assets)
The ratio measures the extent to which
firm uses its total resources to generate
sales.
How many sales generated from $1 of
total assets, a ratio of 1.5 means by
utilizing $1 of total assets the firm has
generated $1.5 of sales.

3. Debt Management Ratios


Also known as Financial Leverage
Management Ratios.
Leverage
FLMR measure the extent to which firm
uses financial leverage and is of interest
to both creditors and owners alike.
Debt management ratios under discussion:
Debt ratio
Times interest earned ratio
EBITDA coverage ratio

i. Debt Ratio
(Total Debt to Total Assets Ratio)
Formula: (Total Debt/Total assets)
It measures portion of firms total assets
that is financed through creditors funds.
Total debt here means: Current liabilities +
long term liabilities

Debt ratio is a ratio carrying huge


importance for creditors.
High debt ratio rings a warning bell for the
creditors.

Question
From the following data you are required to
calculate Debt Ratio and Times Interest Earned.
EBIT .. Rs.
300,000
10% bonds payable Rs.
500,000
Ordinary share capital Rs. 10 each Rs. 800,000
Reserves and surplus..Rs.
200,000
Current liabilities.Rs.
250,000

ii. Times Interest Earned


Formula: (EBIT/Interest)
The ratio between EBIT and Interest
measures firms ability to meet its annual
interest payments.
Also known as Interest coverage ratio.
ICR measures the number of times a
company can make interest payments on
its debt with its EBIT.
For e.g. an Interest coverage ratio of
2 means company has enough
profitability to bear twice the amount

Question
From the following data you are required to
calculate Debt Ratio and Times Interest Earned.
EBIT .. Rs.
300,000
10% bonds payable Rs.
500,000
Ordinary share capital Rs. 10 each Rs. 800,000
Reserves and surplus..Rs.
200,000
Current liabilities.Rs.
250,000

iii. EBITDA Coverage Ratio


Formula:

(EBIT+D+A+Lease payment/Interest+Principal
payment+Lease payment)

A ratio whose numerator includes all CFs


available to meet fixed financial charges and
whose denominator includes all fixed financial
charges.
TIE had 2 basic flaws:
Interest is not the only fixed financial cost
EBIT does not represent all the cash available to service esp. if
firm has high non-cash expenditures like Depreciation and
amortization

EBITDA coverage ratio covers these flaws.

iii. EBITDA Coverage Ratio


Limitation:
In the numerator we want to know how much
funds do we have to pay interest, principal and
lease payments. However, while arriving at
EBIT we already subtracted lease payments.
We thus add back lease payments to the
numerator to cover the limitation of the
formula.

Sinking fund provision:


If the company has a sinking fund provision
well add that in denominator otherwise well
assume it as 0.

EBITDA is calculated using the


companys income statement.
The formula for EBITDA is:
EBITDA = EBIT + Depreciation +
Amortization

To calculate EBITDA, we find the


line items for EBIT ($750,000),
depreciation ($50,000) and
amortization (n/a) and then use
the formula above:

EBITDA = 750,000 + 50,000 + 0 =


$800,000

Practice Question
Willis Publishing has $30 billion in
total assets. The companys TIE ratio
is 8.0. Its EBIT is $6 billion. Willis
depreciation and amortization
expense total $3.2 billion. It has to
make $2 billion in lease payments
and $1 billion must go towards
principal payments on outstanding
loan and long-term debt. What is
Willis EBITDA coverage ratio?

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