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Ratio Analysis

Financial Analysis

• Assessment of the firm’s past, present and


future financial conditions
• Done to find firm’s financial strengths and
weaknesses
• Primary Tools:
– Financial Statements
– Comparison of financial ratios to past,
industry, sector and all firms
Objectives of Ratio Analysis
• Standardize financial information for
comparisons
• Evaluate current operations
• Compare performance with past
performance
• Compare performance against other
firms or industry standards
• Study the efficiency of operations
• Study the risk of operations
Uses for Ratio Analysis

• Evaluate Bank Loan Applications


• Evaluate Customers’ Creditworthiness
• Assess Potential Merger Candidates
• Analyze Internal Management Control
• Analyze and Compare Investment
Opportunities
Types of Ratios

• Financial Ratios:
– Liquidity Ratios
• Assess ability to cover current obligations
– Leverage Ratios
• Assess ability to cover long term debt obligations
• Operational Ratios:
– Activity (Turnover) Ratios
• Assess amount of activity relative to amount of
resources used
– Profitability Ratios
• Assess profits relative to amount of resources
used
• Valuation Ratios:
• Assess market price relative to assets or earnings
Liquidity Ratios

• Current Ratio
– Current Assets / Current Liabilities
• Current Assets include Cash, Marketable Securities, Accounts
Receivable and Inventory
• Current Liabilities include Accounts Payable, Debt Due within one
year, and Other Current Liabilities

Current Assets 1870.92


Current Ratio = = = 1.2 : 1
Current Liabilities 1555.75
Liquidity Ratios

• Quick Ratio or Acid Test


– Current Assets minus Inventory / Current Liabilities
– A more precise measure of liquidity, especially if
inventory is not easily converted into cash.

Current Assets - Inventory 720.53


Quik Ratio = = = 0.46 : 1
Current Liabilitie s 1555.75
Liquidity Ratios

• Cash Ratio
Cash + Marketable Securities 26.08
Cash Ratio = = = 0.17
Current Liabilities 1555.75

– Reserve borrowing capacity - the credit limit sanctioned


by the bank
Liquidity Ratios

Interval Measure

•Calculated to asses a firms ability to meet its


regular cash outgoings

Current Assets − Inventory


Interval Measure =
Average Daily operating expenses
1,870.92 − 1,150.39
= = 77 Days
3,369.94 / 360
Leverage Ratios
– Leverage ratios measure the extent to which a firm has
been financed by debt.

– Leverage ratios include:


– Debt Ratio
– Debt--Equity Ratio

– Generally, the higher this ratio, the more risky a creditor


will perceive its exposure in your business. Thus, high
leverage ratios make it more difficult to obtain credit
(loans).
Leverage Ratios Cont.
 Leverage ratios also include the Interest-
coverage Ratio, Fixed coverage Ratio etc,.

 In contrast to the leverage ratios discussed on


previous slide, the higher the Interest
Coverage Ratio (Times-Interest-Earned Ratio),
the more credit worthy the firm is, and the
easier it will be to obtain credit (loans).
Total Debt Ratio

– Proportion of interest bearing debt in the Capital


structure.
– In general, the lower the number, the better.

Total Debt 1,229.06


Debt Ratio = = = 0.646
Net Assets 1901.87
Debt-Equity Ratio
– The Debt-Equity Ratio indicates the percentage of total
funds provided by creditors versus by owners.

– This ratio indicates the extent to which the business relies


on debt financing (creditor money versus owner’s equity).

Total Debt 1,229.06


Debt − Equity Ratio = = = 1.83
Net Worth 972.81
• Treatment of
– Preference Capital
– Lease Payments
Interest Coverage Ratio
– interest coverage ratio indicates the extent to which
earnings can decline without the firm becoming unable
to meet its annual interest costs.
– Also called the Times-Interest-Earned Ratio, this
calculation shows how many times the firm could pay
back (or cover) its annual interest expenses out of
earnings before interest and taxes (EBIT).

EBIT 342.61
Interest Coverage Ratio = = = 2.4
Interest 143.46
Interest Coverage Ratio

EBITDA 342.61 + 41.59


Interest Coverage Ratio = = = 2.7
Interest 143.46

DA = Depreciation and Amortization expenses


Fixed Coverage Ratio
– Principal repayments are added to interest payments

• EBITDA
Fixed Coverage Ratio =
Interest + Loan repayment
1-Tax Rate

EBITDA + Lease rentals


Fixed Coverage Ratio = + Pref. Dividend
Interest + Lease rentals + Loan repayment
1-Tax Rate
Activity Ratios
– Activity ratios measure how effectively a firm is using its
resources, or how efficient a company is in its operations
and use of assets.
– In general, the higher the ratio, the better.
– Activity ratios include:
 Inventory turnover
 Accounts receivable turnover
 Average collection period.
 Total assets turnover
 Fixed assets turnover
Inventory Turnover Ratio
– The inventory turnover ratio indicates how fast a firm is
selling its inventories
– This ratio indicates how well inventory is being managed,
which is important because the more times inventory can
be turned (i.e., the higher the turnover rate) in a given
operating cycle, the greater the profit.

Cost of Goods Sold 3,053.66


Inventory Turnover Ratio = = = 8.6
Avg Inventory (244.26 + 7461.81) / 2

360
Days of Inventory Holding = = 42 days
Inventory Turnover
Inventory Turnover Ratio Cont.
– In the absence of information. Instead of CGS
we can use Sales
– In the case of CGS and Inventory both are
valued at cost. While the sales are valued at
market prices
– Therefore better to use CGS
Accounts Receivable Turnover
– The accounts receivable turnover ratio, indicates the
average length of time it takes a firm to collect credit sales
(in percentage terms), i.e., how well accounts receivable
are being collected.
– If receivables are excessively slow in being converted to
cash, liquidity could be severely impaired.
Credit Sales
A R Turnover =
Avg AR

Sales 3,717.23
= = = 7.7
Avg AR 483.18
Average Collection Period
– The average collection period is the average length of
time (in days) it takes a firm to collect on credit sales.

360
ACP = = 47 days
AR Turnover
Net Assets Turnover
– The total assets turnover ratio, indicates how efficiently
a firm is using all its assets to generate revenues.
– This ratio helps to signal whether a firm is generating a
sufficient volume of business for the size of its asset
investment

Sales 3,717.23
Net Assets Turnover = = = 1.95 times
Net Assets 1901.87
Profitability Ratios
– Profitability ratios measure management’s overall
effectiveness as shown by returns generated on sales
and investment.

Profitability ratios include


– Gross profit margin
– Operating profit margin
– Net profit margin
– Return on total assets (ROA)
– Return on stockholders’ equity (ROE)
– Earnings per share (EPS)
– Price-earnings ratio (P/E).
Gross Profit Margin

– The gross profit margin is the total margin available to cover


operating expenses and yield a profit. This ratio indicates
how efficiently a business is using its labor and materials in
the production process, and shows the percentage of net
sales remaining after subtracting cost of goods sold.
– The higher the ratio, the better. A high gross profit margin
indicates that a firm can make a reasonable profit on sales,
as long as it keeps overhead costs under control.
Gross Profit 663.57
GP Margin = = = 0.179 or 17.9%
Sales 3,717.23
The DuPont System
• Method to breakdown ROE into:
– ROA and Equity Multiplier
• ROA is further broken down as:
– Profit Margin and Asset Turnover
• Helps to identify sources of strength and
weakness in current performance
• Helps to focus attention on value drivers
The DuPont System

ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r
The DuPont System

ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r

ROE = ROA × Equity Multiplier


Net Income Total Assets
= ×
Total Assets Common Equity
The DuPont System

ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r

ROA = Profit Margin × Total Asset Turnover


Net Income Sales
= ×
Sales Total Assets
The DuPont System

ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r

ROE = Profit Margin × Total Asset Turnover × Equity Multiplier


Net Income Sales Total Assets
= × ×
Sales Total Assets Common Equity