A. Why are ratios useful? What three groups use ratio analysis and for what reasons?

The tool which is very useful for the financial statement analysis is the ratio analysis because of
many reasons. Firstly the main reason is that the financial analysis shows the complete picture of
the firm financials with the past performances and also with the players in the industry. The
second reason for ratio analysis is to see the performance to predict the future of the company
this is happened with the help of forecasted income statement and cash flow.
Management, Stockholders & investors and Potential lender to the business or creditors are the
three main groups or users of ratio analysis.
Lenders and Creditors:
Profitability, liquidity and capacity are the major things which lender or creditor are very much
interested to know for the repayment of the loan which is taken from the borrower. Credit
worthiness of the client is also an important thing for the creditors. The past experience of the
firm for honoring the repayments. Only ratio analysis helps lenders to know these parameters for
the investment.
Management and internal Users:
Ratio analysis is also useful tool for the management as they use it as a tool for the
measurement of the performance of the firm and also check the accounts who needs attention
to match the entitys expectations. For management, ratio analysis could answer following
queries:
1- Firms ability to honor short term commitments
2- Inventory turnover cycle
3- Accounts having irregularities in payment
4- Profitability of the business
Internal users can take benefit from the ratio analysis as if the competency increase it will secure
the job and the provision of the bonuses.
Stockholders, investors, or owners:
Owners use ratio analysis to measure the performance of the management and for the decisions
which management takes.
One of the reason to see the ratio analysis is to take decision whether to invest or divest in the
firm. Future of the company and the investment is predicted on the basis of the decision taken by
the stockholders. So it is an important to for the investors to take decision about the companys
future.

B. Calculate the 2014 current and quick ratios based on the projected balance sheet
and income statement data.
Formula which is used to calculate Current Ratio (CR) is:
Current Assets (CA)/ Current Liabilities (CL)
CR= $ 2,680,112/$ 1,039,800= 2.58
Formula for the Quick Ratio (QR) is: (Current Assets- Inventory)/ Current Liabilities
QR=$2,680,112-$1,716,430/$1,039,800=0.9267=0.93

What can you say about the companys liquidity position in 2012, 2013, and as projected for
2014?
Liquidity Position:
Year

2012

2013

2014 - Projected

Current Ratio

2.33

1.46

2.58

Quick Ratio

0.85

0.5

0.93

Short term commitments of the company is revealed through the liquidity ratio. For the data
given above the ratio for 2012 was better the 2013. The current ratio is 2.33 in the year 2012
which means the firms current assets are 2.33 times higher than the current liabilities. It is
necessary to know that the higher the liquidity ratio is better for the company. In 2014 it is
predicted that the ratio is increased to 2.58 which is more than 2012 and 2013. It shows that the
company has enough resources to payback their current liabilities.
Another tool which is used for the companys liquidity is quick ratio. The quick ratio of year
2012 is higher than the quick ratio of 2013. The predicted quick ratio of year 2014 is higher than
the previous two years. The quick ratio of year 2014 which is predicted is 0.93. Higher the quick
ratio is better for the company because it indicates that the chances of default is lower.
Furthermore it shows that how quickly the firm converts its assets in to cash to pay off firms
liabilities.
We often think of ratios as being useful (1) to managers to help run the business, (2) to bankers for credit analysis, and (3) to stockholders for stock valuation. Would these
different types of analysts have an equal interest in the liquidity ratios?
Liquidity ratio is a useful tool for the stakeholders and having the interest on liquidity ratio. It
helps manager to see or visualize the future of the firm as ability to commit or payback the short
term commitments and also managers interested to know the performance of the company.

Creditors are concern with their payments as the short term probabilities that shows that with in
how much time creditors recover their payments and firms ability to repay for the liabilities.
From the business shareholders are only concerned with the decisions which they made to invest
in the businesses and the return which they earn in the shape of dividend. For stakeholders
liquidity ratio is important as the earnings of stakeholders depends on the performance of the
firm,
C. Calculate the 2014 inventory turnover, days sales outstanding (DSO), fixed assets
turnover, and total assets turnover. How does Computrons utilization of assets stack up
against that of other firms in its industry?
Formula for inventory turnover is: Cost of goods sold/ Inventory
Inventory turnover= (5,800,000+120,000)/1,715,480= 3.45
Whereas Industry average of inventory turnover is 6.1
Inventory turnover for the year 2014 was less than the industry average i.e 3.45<6.1
If the inventory turnover is lesser it is better for the business. As is shows that business has the
ability to convert finished inventory to cash with in lesser time. This ratio shows that firm is
converting the inventory to cash with in half of the time as the industry is doing. Furthermore the
firm is taking 3.45 days to convert inventory to cash and the industry average is 6.1 days so our
firm is better than the industry.
Formula for Days to Sales Outstanding (DSO) =Receivables/(Average sales / number of day)
DSO= 878,000/(7,035,600/365)= 45.5
Industry average= 32.0
This ratio is used to convert the credit sales into cash. Lesser the ratio is better for the firm to
converting in to cash sales from credit sales. DSO of the firm is 45.5 days to convert credit sales
to cash sales and the ratio which industry indicated is 32 days which is lesser then our firm. It is
bad for the company that our company has slack time of 13 days. Firm has to make efforts to
recover the cash from the creditors within lesser time to meet the industry average.
Formula for Fixed assets turnover=Sales/Net fixed assets
Fixed Asset Turnover =7,035,600/836,840=8.41
Industry average=7.0

Effective businesses is having the higher fixed asset ratio. Fixed asset ratio of our company is
higher than the industry which is good for the firm. As the industry average is 7.0 whereas our
firm is having 8.41 which is higher than the industry. This ratio shows that efficiency of business
to invest in different sectors in fixed assets for the generation of profits.
Formula for Total assets turnover (TST)=Sales/Total assets
Total Asset Turnover =7,035,600/3,515,952=2.0
Industry average=2.5
Total asset turnover is used to generate sales efficiency. The industry average shows that the TST
of the firm is less than the industry which is not a good sign. At this time industry is having TST
at 2.5 and the firms TST is 2 which is less than the industry.
D. Calculate the 2014 debt ratio, liabilities to assets ratio, times interest earned, and
EBITDA coverage ratios. How does Computron compare with the industry with respect to
financial leverage? What can you conclude from these ratios?
Formula for Debt ratio (DR)=Total Debt/ Total Assets
DR= (300,000+500,000)/3,516,952= 22.75%
Industry average= 32%
If debt ratio is less than the industry average than it is better for the firm. The firms debt ratio is
22.75 and the industry average is 32 so the firm is in the better position. This ratio indicates the
firm that at the time of bankruptcy firm is having the assets through which firm can easily sets
off its short term as well as long term debts without affecting the profits of the firm.
Formula for Liabilities to assets ratio (LAR)=Total liabilities/Total assets
LAR= (1,039,800+500,000)/3,516,652= 43.8%
Industry average=50%
This ratio indicates businesss liabilities over its assets.
Formula of Times interest earned (TIE)= EBIT/ Interest Expense
TIE= 502,640/ 80,000= 6.3
Industry average=6.2

It is better for the business to have higher ratio. This ratio shows how quickly the firm covers its
interest expense from the earnings which the firm has.
Formula for EBITDA coverage ratios= (EBITDA + Lease payments)/( Interest + Principle
payments +lease payments)
EBITDA coverage ratio=( 502,640 + 120,000 + 40,000)/(80,000 + 0 + 40,000)= 5.5
Industry average=8.0
Lesser the EBITDA is a wrong or weak signal for the firm or the company. So it the EBITDA is
higher it is better for the business. In this firm is having lesser EBITDA than the industry.
E. Calculate the 2014 profit margin, basic earning power (BEP), return on assets (ROA),
and return on equity (ROE). What can you say about these ratios?
Formula for Profit margin (PM)= Net income available to common stock holders/ Sales
PM= 253,584/7,035,500= 3.6%
Industry average=3.6%
This ratio of the firm is equal to the industry as the industry is having 3.6% and the firm is
also having 3.6% so it equals to the industry. The higher is the percentage is better for the
business.
Formula for Basic earning power (BEP)= EBIT/ Total assets
BEP= 502,640/3,516,952= 14.3%
Industry average=17.8%
The better percentage is that which is higher. But the company is having 14.3% of BEP ratio
which is less than the industry ratio of 17.8%. This is not a good sign for the firm and weak
company than the industry average.
Formula of Return on assets (ROA)= Net income available for shareholders/total assets
ROA= 253,584/ 3,516,952= 7.2%
Industry average=9.0%

Higher the ratio, better it is for the business.

It measures the profitability of the business, firm is achieving 7.2% of profitability
which is less than the industry average of 9%.
Return on equity (ROE)= Net income available for shareholders/Common Equity
ROE= 253,584/1,977,152= 12.8%
Industry average=17.9
Industry is having higher percentage which is better for the business. The firm is having 12,8%
ROE.
F. Calculate the 2014 price/earnings ratio, price/cash flow ratio, and market/book ratio. Do these
ratios indicate that investors are expected to have a high or low opinion of the company?

Market Value Ratios

Price / earnings ratio = price per share / EPS = 12.17/1.014 = 12
Price / cash flow = price per share / cash flow per share =
12.17/[(253,584+120000)/250000]=8.17
Market /book ratio = market price per share / book value per share = 12.17/7.909 = 1.54
First opinion
Price to earnings ratio is indicator for the investors expectations for the future of the business. If
the ratio is higher than it is a good indicator for the growth of the business. In 2014 it is 12 and
the industry average is 16 which shows that the firm is having less Price to earnings ratio than
the industry and the firm has to improve it.
Second opinion
Firm is having higher price to cash ratio which is better for the firm. Firm is trading 8.1 times the
overall cash flow per share.
Third opinion
If the market to book ratio is less it indicates that the interest of investors are less in the firm. The
firm is having 1.4 which is less than the industry and it is not good for the business.

G. Perform a common size analysis and percentage change analysis. What do these analyses
tell you about Computron
Common Size Balance Sheet
2012

2013

2014E

Cash
Short - Term Investments
Accounts Receivable
Inventories
Total Current Assets
Gross Fixed Assets
Less: Accumulated Depreciation
Net Fixed Assets

0.6%
3.3%
23.9%
48.7%
76.5%
33.4%
10.0%
23.5%

0.3%
0.7%
21.9%
44.6%
67.4%
41.7%
9.1%
32.6%

0.4%
2.0%
25.0%
48.8%
76.2%
34.7%
10.9%
23.8%

Total Assets

100.0%

100.0%

100.0%

Accounts Payable
Notes Payable
Accruals
Total Current Liabilities
Long - Term Debt
Common Stock (100,000 shares)
Retained Earnings
Total Equity

9.9%
13.6%
9.3%
32.8%
22.0%
31.3%
13.9%
45.2%

11.2%
24.9%
9.9%
46.0%
34.6%
15.9%
3.4%
19.3%

10.2%
8.5%
10.8%
29.6%
14.2%
47.8%
8.4%
56.2%

Total Liabilities & Equity

100.0%

Assets

Liabilities & Equity

Common Size Income Statement

100.0%

100.0%

Percent Change Balance Sheets

Percent Change Income

Statement
Rise in the receivables and inventory is indicated by the common sized balance sheet of the firm.
This indicates that company may face difficulties in converting them in to the cash in near future.
It is also indicated that the manager of the firm who handles all cash items is also poor. The firm
is running on equity so there is also chance of the operations to slow down due to the slow
conversion from credit to cash. The profit margin is higher 3.6 which shows it is higher and there
is chances of growth but slow.
In 2014 the balance sheet indicates that the assets of the company is grown. There is also a
change and increase in the inventory as well as in the receivables of the company. This indicates
that company or firm may having difficulties in the recovery of the payments and also the
payables of the company also increased and show higher amount of debt. Common stocks of the
company increased which shows the company is financed the sale of common stocks.
H. Use the extended DuPont equation to provide a summary and overview of Computrons
financial condition as projected for 2014. What are the firms major strengths and
weaknesses?
Du Pont Equation
ROE = Net income/sales * Sales/Total assets * Total assets/Common
equity ROE= (profit margin)*(total assets turnover)*(equity multiplier)
ROE= (253,584/7,035,600)*(7,035,600/3,516,952)*(3,516,952/1,977,152)
ROE= (0.03604)*(2.0005)*(1.778)
ROE= 0.2055
ROE= 12.8
Firms major strength and weakness:
DuPont analysis shows that the firm is having lesser ratio or percentage from the industry
average. The results shown above indicates that the profit margin and the asset turnover is
increased and it shows the positive sign for the company. Total assets turnover ratio is less as
compared to the business and it is weaker for the business. Increase shown in the ROE is better
for the business and it also shows better picture of the business.

Overall, financial statement analysis indicators firm is having positive.

Liquidity
Asset management
Profitability

Market value

I. What are some potential problems and limitations of financial ratio analysis?
Potential problems and limitations of financial ratio analysis
Difficult to form a meaningful or unique ratio analysis for any of the business as every business
is having different focus. Industry is a bench mark set for the companys to compare the
performance with the industry. It is difficult for the firm to incorporate some indicators in the
balance sheet. Some bad indicators that affects the balance sheet is inflation, difference in values,
seasonal factors and certain monthly averages etc.
J. What are some qualitative factors that analysts should consider when evaluating
a companys likely future financial performance?
Customers, product and suppliers may create problems to increase the risk of the business so
analysts have to be aware of these kinds of problems. There are number of risks which is facing
by the business nowadays due to operations spread worldwide. Political instability and the
exchange rates are the risks of worldwide spread.
Market conditions and competitive forces are also threat to the firm and these are also be taken
into account. In depth focus or analysis is required to understand the future product pipeline.
There is also be an awareness of the economic, legal, social and political factors in the country
and the data is incorporated according to rules and regulations of that country.

References:
Financial Management- Theory and practice 14th edition. Brighsm and Ehrhsrdt.
NetMBA- Business Knowledge Center