Ratio Analysis

1
Financial Ratio Analysis & Interpretation

OBJECTIVES

Explain how ratios can be used to assess the

position and performance of a business.

Identify the major categories of ratios that

can be used for analysis purposes.

Calculate key ratios for assessing the profitability,

efficiency, liquidity, Financial Leverage and Market
performance of a business.

Explain the significance of the ratios calculated.

2
Financial ratio classification

Categories

1.Profitability

2.Efficiency/Asset Utilization

3.Liquidity

4.Long term solvency or Leverage

5.Market Ratios
3
 Ratios benchmarks

Bases of comparison:

Past periods

Similar businesses during the same

period

Planned performance

4
Exhibit CC.3
CAMPBELL SOUP COMPANY
Balance Sheets
Year11 Year 10 Year 9 Year 8 Year 7 Year 6
Assets
Current assets:
Cash and cash equivalents $ 178.90 $ 80.70 $ 120.90 $ 85.80 $ 145.00 $ 155.10
Other temporary investments 12.80 22.50 26.20 35.00 280.30 238.70
Accounts receivable 527.40 624.50 538.00 486.90 338.90 299.00
Inventories 706.70 819.80 816.00 664.70 623.60 610.50
Prepaid expenses 92.70 118.00 100.40 90.50 50.10 31.50
Total current assets $1,518.50 $1,665.50 $ 1,601.50 $1,362.90 $ 1,437.90 $ 1,334.80
Plant assets, net of depreciation $1,790.40 $1,717.70 $ 1,540.60 $1,508.90 $ 1,349.00 $ 1,168.10
Intangible assets, net of amortization 435.50 383.40 466.90 496.60 — —
Other assets 404.60 349.00 323.10 241.20 310.50 259.90
Total assets $4,149.00 $4,115.60 $ 3,932.10 $3,609.60 $ 3,097.40 $ 2,762.80
Liabilities and Shareowners’ Equity
Current liabilities:
Notes payable $ 282.20 $ 202.30 $ 271.50 $ 138.00 $ 93.50 $ 88.90
Payable to suppliers and others 482.40 525.20 508.20 446.70 374.80 321.70
Accrued liabilities 408.70 491.90 392.60 236.90 182.10 165.90
Dividend payable 37.00 32.30 29.70 — — —
Accrued income taxes 67.70 46.40 30.10 41.70 43.40 49.60
Total current liabilities $1,278.00 $1,298.10 $ 1,232.10 $ 863.30 $ 693.80 $ 626.10
Long-term debt $ 772.60 $ 805.80 $ 629.20 $ 525.80 $ 380.20 $ 362.30
Other liabilities, mainly deferred tax 305.00 319.90 292.50 325.50 287.30 235.50
Shareowner’s equity:
Preferred stock; authorized 40,000,000 sh.;
none issued — — — — — —
Capital stock, $0.15 par value;
authorized 140,000,000 sh.;
issued 135,622,676 sh. 20.30 20.30 20.30 20.30 20.30 20.30
Capital surplus 107.30 61.90 50.80 42.30 41.10 38.10
Earnings retained in the business 1,912.60 1,653.30 1,775.80 1,879.10 1,709.60 1,554.00
Capital stock in treasury, at cost (270.40) (107.20) (70.70) (75.20) (46.80) (48.40)
Cumulative translation adjustments 23.60 63.50 2.10 28.50 11.90 (25.10)
Total shareowner’s equity $1,793.40 $1,691.80 $ 1,778.30 $1,895.00 $ 1,736.10 $ 1,538.90
Total liabilities and shareowners’ equity $ 4,149.00 $ 4,115.60 $ 3,932.10 $ 3,609.60 $ 3,097.40 $ 2,762.80 5
Income statement

6
7
1. Profitability Ratios
• Measure the overall performance
of a firm and its efficiency in
managing assets, liabilities, and
equity.
• The ability of firm to generate
profitable sales from its resources

8
1. Profitability Ratios
Profitability ratios include
• gross profit margin
• operating profit margin
• net profit margin
• return on assets (ROA)
• return on equity (ROE)

9
1. Profitability Ratios
I. Gross Profit Margin
A measure of how well a company controls its direct costs. Or
it shows the ability of a company to control cost of goods
sold or manufacturing costs of products.
The higher the gross profit margin is, the better the company
is thought to control costs.

Gross profit (Sales – Cost of Sales)

Revenue/Sales
10
 Gross Profit Margin
• Assume Jack's Clothing Store spent $100,000
on inventory for the year. Jack was able to sell
this inventory for $500,000. Unfortunately,
$50,000 of the sales were returned by
customers and refunded. What is Jack’s gross
margin ratio?

11
1. Profitability Ratios
II. Operating Profit Margin
- Measures overall operating efficiency and incorporates all of the
operating expenses associated with ordinary business activities.
- Operating margin takes a wider look at costs than profit margin.
By taking into account indiret variable costs, such as wages,
operating margin is a better reflection of the effectiveness of the
company's overall pricing strategy

Operating income
Revenue
12
1. Profitability Ratios
III. Net Profit Margin

Measures profitability after consideration

of all revenue and expenses, including
interest, taxes.

Net Income
Revenue
13
Comparing profit margin and operating margin

• profit margin and operating margin can be

telling and can help a firm identify potential
areas of waste.
• If profit margin ratio is large while operating margin is
small, we can indicate that company is more efficient in
creating and selling its products, but perhaps less
efficient in managing training, administration, research
or other day-to-day business costs.

14
15
1. Profitability Ratios
Return on Assets (ROA)

Measures overall efficiency of firm in

managing investment in assets and
generating profits
Net Income
Average Total Assets

16
1. Profitability Ratios
Return on Equity (ROE or ROCE)
Measures rate of return on stockholders’ investment
Net Income
Average Stockholders’ equity
•Useful for justifying the retaining equity in
company and for using non-equity capital
•Might be affected by accounting policies e.g.
adverse impact of upward revaluation of Non-
current assets on ROE 17
Calculate: ROA,
ROE, Profit
margin and
Operating Profit
Margin

18
 2. Assets Utilization Ratios
How effectively a company uses its assets
• Activity and Turnover ratios measure the operating
efficiency of a firm.
• These ratios reflect the efficient management of
both working capital and long term assets
• Efficiency has a direct impact on liquidity so some
activity ratios are also useful in assessing liquidity
• By calculating the total assets turnover, one can find
out whether the company is efficiently employing its
total assets to obtain sales revenue. A low ratio may
indicate too high an investment in assets in
comparison to the sales generated.
19
 Formula

Receivable Turn Over Sales

Average accounts Receivables

Days of sales Number of days in period

outstanding Receiveable turn over

Inventory Turnover Cost of goods sold

Average Inventory

Sales revenue
Fixed Asset Turnover
Average Fixed assets

Sales revenue
Total assets turnover
AverageTotal Assets

20
 Asset Utilization Ratios
• The accounts receivable turnover provides the number of times
accounts receivable are collected in the year.
• The average collection period, also called days sales outstanding
(DSO), is the length of time it takes to collect receivables. It
represents the number of days receivables are held.
• Inventory ties up cash. Holding large amounts of inventory can result
in lost opportunities for profit as well as increased storage costs.
• Average age of inventory = 365/Inventory turn over
• The operating cycle is the number of days its takes to convert
inventory and receivables to cash.
Operating cycle = Average collection period + Average age of inventory

21
 3. Liquidity Ratios
• Specially important to creditors, suppliers,
management, and others who are concerned
with the ability of a firm to meet near-term
demands for cash
• Should include analysis of selected financial
ratios and a comparison with industry averages
• Predicts the future ability of the firm to meet
prospective needs for cash

22
 10-23

Liquidity and Working Capital

Basics
• Liquidity - Ability to convert assets into cash or to obtain
cash to meet short-term obligations.
• Short-term - Conventionally viewed as a period up to
one year.
• Working Capital - The excess of current assets over
current liabilities.

Lack of liquidity can limit: Severe illiquidity often precedes:

Advantages of discounts Lower profitability
Profitable opportunities Restricted opportunities
Management actions Loss of owner control
Coverage of current obligations Loss of capital investment
Insolvency and bankruptcy
 Current assetsFormula
Current ratio
Current liabilities

Cash + short term marketable

Acid investments + Receivables
test/Quick
ratio Current liabilities

Cash Days sales Days inventory Days Payable

+ -
Conversion outstanding outstanding Outstanding
(DSO) (DIO) (DPO)
Cycle

24
 Item Fiscal Year 2013 Fiscal Year 2012

Revenue 9,000 Not needed

Fiscal Fiscal Year
Item
Year 2013 2012

COGS 3,000 Not needed

Not
Revenue 9,000
needed

Inventory 1,000 2,000

Not
COGS 3,000
needed

A/R 100 90
Inventory 1,000 2,000

A/P 800 900

A/R 100 90

Calculate Cash covert cycles - CCC

A/P 800 900

25
 Item

Average Inventory (1,000 + 2,000) / 2 = 1,500

Fiscal Fiscal Year
Item
Year 2013 2012

Average AR (100 + 90) / 2 = 95

Not
Revenue 9,000
needed

Average AP (800 + 900) / 2 = 850

Not
COGS 3,000

DIO = $1,500 / DSO = $95 / DPO = $850 /

needed

($3,000/ 365 days) ($9,000 / 365 ($3,000/ 365 days)

= 182.5 days days) = 3.9 days = 103.4 days
Inventory 1,000 2,000

CCC = 182.5 + 3.9 - 103.4 = 83 days

A/R 100 90

Calculate Cash covert cycles - CCC

A/P 800 900

26
4. Capital Structure & Solvency Ratios

• The capital structure is how a firm finances its overall

operations and growth by using different sources of funds
(A mix of a company's long-term debt, specific short-term
debt, common equity and preferred equity.)
• Analytical process includes an evaluation of the amount and
proportion of debt in a firm’s capital structure as well as the
ability to service debt.
• Debt financing implies risk and leverage.

27
 Liquidity vs Solvency
• Solvency and liquidity are both terms that refer to an
enterprise’s state of financial health, but with some notable
differences (short-term and long-term obligations).
• Solvency refers to an enterprise's capacity to meet its long-
term financial commitments.
• Liquidity refers to an enterprise’s ability to pay short-term
obligations; the term also refers to its capability to sell assets
quickly to raise cash.

28
 Formula of
Solvency

Debt to Assets Total Debt

Total Assets

Interest Cover EBIT

Interest payable

Total debt
Debt to equity ratio
Total Shareholder’s equity

Average Total Assets

Financial Leverage
Ratio
Average Total Equity 29
30
5. Market Ratios
Market ratios measure returns to stockholders
and the value the marketplace puts on a
company’s stock. Market ratios include
• earnings per share (EPS)
• price-to-earnings (P/E Ratio)
• dividend payout (DP ratio)
• dividend yield

31
i. Earnings per Share (EPS)
•The portion of a company's profit allocated to each
outstanding share of common stock.
• It is the single most important variable in
determining a share's price
• Investors are concerned about what comes in their
pockets.

Net Income
Shares outstanding

32
 ii. Price-to-Earnings
It shows how much money that investors in the
market are willing to pay for 1 dollar of company’s
earnings per share.

Market price of common stock

Earnings per share
•If P/E Ratio = $88/$11= 8 ;Means capital value of share
is 8 times higher than current level of earnings
• P/E ratio measures market confidence on future
earning powers

33
iii. Dividend Payout Ratio
Determined by the formula cash dividends
per share divided by earnings per share.
Dividends per share
Earnings per share

34
 iv. Retension Rate
–This can be also measured as 1- dividend pay
out ratio. It shows how many percentage of
earnings is held to reinvest by a company.

Earnings per share - Dividends per share

Earnings per share
Or equal to

Earnings (Net income) - Dividends

Earnings (Net income)
35
 Connecting the Dots:
The Du Pont System
• Helpful to complete the evaluation of a firm
by considering the interrelationship among
the individual ratios

• Looks at how the various pieces of financial

measurement work together to produce an
overall return

• Helps analyst see how the firm’s decisions

and activities over the course of an
accounting period interact to produce
overall return to shareholders 36
Du Pont Equation:
The summary ratios used are the following:
Net income Total assets Net income
X =
Total assets Stockholder equity Stockholder equity
(1) (2) (3)
ROA Leverage Return on Equity

Net income sales Assets = ROE

X X
sales Assets Total equity
(1) (2) (3)
Profitability Total asset Leverage
margin turnover 37
 Dupont Ratio
• The first three ratios reveal that return
on equity is a product of the ROA and
leverage.

• The second three ratios show how the

return on equity is the product of
profitability margin, asset turnover and
financial leverage.
38
 Dupont Example
• - Calculating ROE by normal way and Dupont
formula.

39
 Relating the Ratios
The Du Pont System
• By reviewing this series of relationships, the analyst can
identify strengths & weaknesses as well as trace potential
causes of problems in the overall financial condition and
performance of the firm.
• The DuPont Analysis is important determines what is driving a
company's ROE; Profit margin shows the operating
efficiency, asset turnover shows the asset use efficiency,
and leverage factor shows how much leverage is being used.
• The DuPont analysis looks uses both the income statement as
well as the balance sheet to perform the examination.
• Analyst can evaluate changes in condition & performance.
Evaluation can then focus on specific areas contributing to
changes.

40
Exercise Ratio Analysis

41
42
43
 Limitations of ratio analysis

Quality of financial statements

Inflation

The restricted view of ratios

The basis for comparison

Statement of financial position ratios

44
 Summary of Analysis

• Analysis of any firm’s financial statements consists

of a mixture of steps and pieces that interrelate
and affect each other.
• No one part of the analysis should be interpreted
in isolation.
• The last step of analysis is to integrate the separate
pieces into a whole, leading to conclusions about
the business enterprise.

45
46
47
- Don’t have to calculate 10 - 12
- What is the limitation of current ratio?
48
• 1. [36] / [45] = $1,665.5 / $1,298.1 = 1.28
• 2. ($80.7 [31] + $22.5 [32] + $624.5 [33]) / $1,298.1 [45]
= 0.56
• 3. $6,205.8 [13] / [($624.5 [33] + $564.1)/2] = 10.44
• 4. $4,258.2 [14] / [($819.8 [34] + $816.0)/2] = 5.21
• 5. $624.5 [33] / ($6,205.8 / 360) = 36.23
• 6. $819.8 / ($4,258.2 / 360) = 69.31
• 7. 36.23 + 69.31 = 105.54
• 8. ($80.7 + $22.5) / $1,665.5 = 0.062
• 9. ($80.7 + $22.5) / $1,298.1 = 0.0795

49
 Disadvantages of Current Ratio:
• It relies on the quantity of current assets instead of quality of the asset.
• Current ratio includes inventory in the calculation, which may lead to overestimation of
the liquidity position in many cases. In addition, Current Ratio may be impacted due to
change in inventory valuation methodology by the company.
• In companies where sales are seasonal; current ratio may show lower numbers in some
months and higher current ratio in the other.
• An equal increase or decrease in the current assets and current liabilities can change
the ratio. Hence an overdraft against inventory can cause current ratio to change.
Hence it is very easy to manipulate current ratio.
• Liquidity depends to some extent on cash or cash equivalents balances, but to a
much more significant extent on prospective cash flows.
• Managerial policies directed at optimizing the levels of receivables and inventories
are mainly directed towards efficient and profitable asset utilization and only
secondarily towards liquidity.

50