FINANCIAL RATIOS

Ratio analysis involves the construction of ratios using specific elements from the
financial statements in ways that help identify the strengths and weaknesses of the firm.
Financial ratios are useful indicators of a firm's performance and financial situation.
Ratios generally hold no meaning unless they are benchmarked against something else.

Financial ratios allow for comparisons

between companies
between industries
between different time periods for one company
between a single company and its industry average

LIQUIDITY RATIOS

Liquidity ratios provide information about a firm's ability to meet its short-term financial
obligations using short-term assets.
They are of particular interest to those extending short-term credit to the firm.
The short-term obligations are the ones recorded under current liabilities that come due
within one financial year. Short-term assets are the current assets.

Current Ratio (Cr)

Formula:
Current Assets / Current Liabilities
Meaning:
Is the most common liquidity measure and provides an indication of a
firms ability to which current liabilities can be paid off through current assets.
Though the ideal current ratio depends to some extent on the type of business, a
general rule of thumb is that it should be at least 2:1. A healthy current ratio is greater
than 2.
A lower current ratio means that the company may not be able to pay its bills on time,
While a higher ratio means that the company has money in cash or safe investments
that could be put to better use in the business.
Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders
may prefer a lower current ratio so that more of the firm's assets are working to grow
the business.

Quick Ratio (Acid-Test Ratio): Alternative Measure Of Liquidity

= Quick Assets/ Current Liabilities

QR provides a stricter measure of a firms liquidity than the CR.
One Key problem with the current ratio is that it assumes that all current assets can be
converted in to cash.

However, some firms carry current assets, such as inventory and pre-paid expenses
which cannot be converted into cash quickly. To correct this problem, the quick asset
ratio (QAR) is used which includes:
Cash
Marketable securities
Receivables
Ideally, this ratio should be 1:1.
If it is higher, the company may keep too much cash on hand or have a poor collection
program for accounts receivable.
If it is lower, it may indicate that the company relies too heavily on inventory to meet
its obligations.

Working capital:

Principal measure of liquidity; Target for working capital should be at least one-half of
operating budget
Working capital= Current Assets - Current Liabilities

ASSET TURNOVER RATIOS

Also called efficiency ratios/ asset management ratios/asset utilization ratios

Indicate the efficiency of the use of assets in generating sales.
These ratios can show how quickly the company is collecting money for its credit sales
or how many times inventory turns over in a given time period.

Receivables Turnover (Sales To Receivables)

is an indication of how quickly the firm collects its accounts receivables and is defined
as follows:
Receivables Turnover=

Annual Credit Sales

Accounts Receivable

Average Collection Period (ACP)

also known as Days Sales Outstanding (DSO), indicates the average length of time the firm
must wait after making a credit sale before it collects cash.

The receivables turnover often is reported in terms of the number of days that credit
sales remain in accounts receivable before they are collected. This number is known as
the collection period.
Average Collection Period =
Accounts Receivable
Annual Credit Sales / 365

The collection period also can be written as:

Average Collection Period =

365
Receivables Turnover

This is an important ratio (The length of the ACP) used to evaluate the credit policy of the firm
in relation to the industry norms.
A higher ACP indicates a liberal policy in that the firm gives more times to debtors for making
payments.

If the ACP is too low, the firm may have too tight of credit policy and might be losing
sales.
If CS is not available, we often use total sales as an estimate of CS.
If all sales were cash sales, then ACP = 0

The Average Payment Period, App (Days Purchases Outstanding)

Measures the average number of days taken to pay for purchases made today on credit
and is defined as:
APP = AP/credit purchase/day = AP/(Annual credit purchases/365)
Sometimes COGS is used to approximate credit purchases.
The correct level of APP depends on credit terms and the cost of violating credit
agreements.

Inventory Turnover/ Stock Turnover

Shows how efficiently the company is managing its production, warehousing, and
distribution of product, considering its volume of sales.
Inventory Turnover =
Cost of Goods Sold
Average Inventory
Average inventory = beg inventory+ ending inventory/2
Higher ratiosover six or seven times per yearare generally thought to be better,
although extremely high inventory turnover may indicate a narrow selection and
possibly lost sales.
A low inventory turnover rate, on the other hand, means that the company is paying to
keep a large inventory, and may be overstocking or carrying obsolete items.

Inventory Period
The inventory turnover often is reported as the inventory period, which is the number of
days worth of inventory on hand, and calculated as
Inventory Period=
Average Annual Inventory
Cost of Goods Sold / 365

The inventory period also can be written as:

Inventory Period =
365
Inventory Turnover

Fixed Asset Turnover

FAT = Sales /Average Net Fixed Assets (long-term assets)

The fixed asset turnover ratio measures the efficiency of the use of fixed assets in
generating sales.
The average net fixed assets are equal to the simple average of beginning and ending
balance sheet values of net fixed assets.
Net fixed assets are gross fixed assets less accumulated depreciation.
A lower fixed asset turnover relative to the industry may indicate that the firm carries
excessive fixed assets.
A higher turnover may indicate inadequate, low, outdated or depreciated fixed assets.
In general, the more sales generated with a given level of assets, the more efficient the
firm is operating.

Total Asset Turnover

TAT = Sales / Average Total Assets

Total asset turnover ratio measures the efficiency of the use of total assets in generating
sales.
Total assets are sum of current and net fixed assets.
The average total assets are the simple average of total assets at the beginning and end
of the period.

FINANCIAL LEVERAGE RATIOS (DEBT MANAGEMENT RATIOS)

The use of debt financing is called financial leverage.

(Focus is on the long-term solvency of the firm)
Leverage ratios look at the extent to which a company has depended upon borrowing to
finance its operations. As a result, these ratios are reviewed closely by bankers and
investors.
A high leverage ratio may increase a company's exposure to risk and business
downturns, but along with this higher risk also comes the potential for higher returns.

We want to know the level of financial leverage used by the business as well as the ability of
the firm to service its debt obligations. The debt ratio, debt-equity ratio and interest cover is
discussed below.

Debt Ratios (Debt-Asset Ratio)

Debt Ratio = Total Debts /Total Assets

The debt ratio indicates the proportion of assets financed through both short-term and
long-term debt.
Note that, from the balance sheet, A = D + E.
In general, having a lower debt-asset ratio is preferred by creditors because more equity
funds are available to meet the firms financial obligations.
A debt ratio greater than 1.0 means the company has negative net worth, and is
technically bankrupt.

Debt-To-Equity

It indicates the relative mix of the company's investor-supplied capital.

= total debt/ total equity
D/A = D/(D+E) because A = D + E
A company is generally considered safer if it has a low debt to equity ratiothat is, a
higher proportion of owner-supplied capitalthough a very low ratio can indicate
excessive caution.
In general, debt should be between 50 and 80 percent of equity.
Total equity includes both preferred equity and common equity. A higher debt equity
ratio indicates greater leverage and potentially higher financial risk.

Interest Coverage

(Times Interest Earned)

Interest Coverage = EBIT/ Interest Charges (expenses)

measures the ability of firm`s current operating earnings (EBIT) to meet current interest
obligations.
The ratio shows number of times the interest payment are covered by the firm`s
operating earnings.
In general, we hope that TIE > 1, otherwise the firm wont even be able to make its
interest payments using the current income.
The larger the coverage, the better the ability of the firm to service interest obligations
on debt.

PROFITABILITY OR RETURN ON INVESTMENT RATIOS

Profitability ratios measure the firms efficiency in generating profits.

provide information about management's performance in using the resources

The profitability ratios, also known as performance ratios, assesses the firm`s ability to
earn profits on sales, assets and equity. These are critical to determining the
attractiveness of investing in company shares, and investors use these ratios widely.
We will examine five important profitability ratios, namely, gross profit margin,
operating profit margin, net profit margin, return on assets, and return on equity.

Gross Profit Margin

The gross profit margin (GPM) shows the firm`s profit margin after deducting costs of
goods sold but before deducting operating expenses, interest expenses, and taxes.
This ratio is also known as gross profit ratio.
It can be an indication of manufacturing efficiency, or marketing effectiveness.
Gross Profit Margin = Gross Profit / Net Sales

Or

=Sales - Cost of Goods Sold/ Net Sales

Operating Profit Margin

= EBIT/Net Sales Or Operating Income/ Net Sales

The operating profit margin (OPM) shows the firm`s profit margin after deducting cost
of goods sold and operating expenses but before interest expenses and taxes.
The operating profit is the earnings before interest and taxes or EBIT as a percent of
sales.
The OPM reflects the true profitability of firm`s business in that it is calculated before
deducting interest costs, which are a result from firm`s financing decision, and taxes,
which are outside the control of the firm.
In other words, regardless of the way the firm is financed, whether through debt or
equity, and regardless of the taxes imposed by the government, the firm is able to earn
this margin.

Net Profit Margin

= Net Income/Net Sales
It measures the overall profitability of the company, or how much is being brought to

the bottom line.

In general terms, net profitability shows the effectiveness of management.
Though the optimal level depends on the type of business, the ratios can be compared
for firms in the same industry.
This is the bottom line profitability, which most analysts and investors pay attention to
on a regular basis
It is the profit available for distribution to common shareholders as a %age of sales.

Return On Assets (ROA)

= Net Income/ Total Assets

It is a measure of how effectively the firm's assets are being used to generate profits.
Indicates how effectively the company is deploying its assets.

A very low return on asset, or ROA, usually indicates inefficient management,

Whereas a high ROA means efficient management. However, this ratio can be distorted
by depreciation or any unusual expenses.

Return On Equity

= Net Income/ Shareholder Equity

It is the bottom line measure for the shareholders, measuring the profits earned for
each dollar invested in the firm's stock.
The return on equity (ROE) measures the return earned on the capital provided by the
common stockholders (Equity holders).
It is the net income as a percent of the average common equity, where the average
common equity is the simple average of the common equity at the beginning and
ending balance sheets.
The net income is the income available for distribution to ordinary shareholders after
deducting any preferred dividends

VALUATION RATIOS

The valuation ratios indicate the market valuation of a stock in terms of some
measure of company fundamentals such as earnings, book value, cash flows, and
dividends.
These are the ratios that investors tend to look at on a daily basis.

Earnings Per Share(EPS)

= Net Income/Number of Shares Outstanding

EPS states a corporation's profits on a per-share basis.
It can be helpful in further comparison to the market price of the stock.

Price / Earnings Ratio (P/E)

= Market price/share.
EPS
It indicates the market price of a share in terms of earnings.
This ratio measures the value of a publicly traded firms stock relative to the firms
current earnings..
Generally, the higher the value relative to current earnings, the greater the expected
increase in future earnings and/or the lower the perceived risk in future earnings.

Price / Book Value Ratio (P/BV)

Market/Book Ratio = Market Price Per Share/ Book Value Per Share
Where book value per share = common equity/ no. Of ordinary shares outstanding
It indicates the market price of a share in terms of the book value of equity. It is the
rupee amount an investor has to pay for each rupee of book value.

DIVIDEND POLICY RATIOS

Dividend policy ratios provide insight into the dividend policy of the firm and the
prospects for future growth.
Two commonly used ratios are the dividend yield and payout ratio.

The Dividend Yield

The dividend yield indicates the dividend income as a percentage of the investment.
This is a particularly an important valuation measure for investors seeking regular
income.
Typically, higher dividend yields are associated with more stable and mature companies
such as utilities.
Growth -oriented companies tend to pay lower dividends such as at a higher multiple,
and as a result, produce lower dividend yields.
DIVIDEND PER SHARE (DPS) = Total Ordinary Dividend/ Number of Ordinary Shares

Dividend Payout Ratio (DPO)

Payout Ratio = Dividends per Share/ Earnings per Share

This ratio measures the amount of dividends (as withdrawals) generated as a proportion
of profits.

NOTE: 1) The remaining materials like Du Pont equation,

uses and limitations of ratio analysis will be discussed in
the next class IN-SHAA-ALLAH.
LIST of formulas will also be sent to you separately