Financial Statement Analysis
Ratio Analysis
• Shows the relative size of one financial statement component to another.
• Effective only when used in combination with other ratios, analysis, and information
– Ratio Analysis involves methods of calculating and interpreting financial ratios in order to assess a firm's
performance and status
A single ratio by itself is not very meaningful.
The discussion of ratios will include the following types of comparisons.
.
Financial Ratio Analysis
• Financial ratio analysis involves calculating and analysing ratios that use data from one, two or more financial statements. • Ratio analysis also expresses relationships between different financial statements. • Financial Ratios can be classified into 4 main categories:
– Liquidity ratios – Asset Management or Activity Ratios – Debt Ratios – Profitability Ratios
Ratio Analysis
Liquidity Ratios
Measure the shortterm ability of the company to pay its maturing obligations and to meet unexpected needs for cash.

Shortterm creditors such as bankers and suppliers are particularly interested in assessing liquidity.

Ratios include the current ratio, the Quick ratio.
Liquidity ratios
For example: Current ratio
•
Current Ratio =
Current Assets
Current Liabilities This ratio is calculated in times.
•

The ideal benchmark for the current ratio is $2:$1 where there are two dollars

of current assets (CA) to cover $1 of current liabilities (CL). The acceptable benchmark is $1: $1 but a ratio below $1CA:$1CL represents liquidity riskiness as there is insufficient current assets to cover $1 of current liabilities.

•

A ratio of 5 : 1 would imply the firm has $5 of assets to cover every $1 in liabilities

•

A ratio of 0.75 : 1 would suggest the firm has only 75c in assets available to
cover every $1 it owes

•

Too high – Might suggest that too much of its assets are tied up in unproductive activities – too much stock, for example?

Liquidity ratios
•
Quick Ratio = Current Assets – Inventory Current Liabilities
This ratio is calculated in times.
•

1:1 seen as ideal

•

The omission of stock gives an indication of the cash the firm has in relation to its liabilities.

•

A ratio of 3:1 therefore would suggest the firm has 3 times as much cash as it owes – very healthy!

•

A ratio of 0.5:1 would suggest the firm has twice as many liabilities as it has cash to pay for those liabilities. This might put the firm under pressure but is not in itself the end of the world!

Asset Management or Activity Ratios
• Efficiency of asset usage
– How
well
assets
are
used to generate
revenues
(income) will impact on the overall profitability of the
business.
For example: Asset Turnover
•
This
ratio
represents
the efficiency
of asset
usage to generate sales revenue
• All turnover ratios are calculated in times while all period ratios are calculated in days.
Asset Management or Activity Ratios
•

Asset Turnover =

Net Sales



Total Assets

•

Inventory Turnover =

Cost of Goods Sold Inventory

Inventory Period

=

Inventory Cost of goods sold/365

•

Average Payment Period (APP)


Accounts Payable


Annual Purchases/365

•

Average Collection Period =

Accounts Receivable Average daily net sales*


* Average daily net sales = net sales / 365
Inventory turnover
•

This ratio is calculated in times.

•

The rate at which a company’s stock is turned over

•

A high stock turnover might mean increased efficiency?

– But: dependent on the type of business – supermarkets might have high stock turnover ratios whereas a shop selling high value musical instruments might have low stock turnover ratio
– Low stock turnover could mean poor customer satisfaction if people are not buying the goods.
• Average Collection Period = Accounts Receivable Average daily net sales* • This ratio is calculated in days. • Shorter the better
• Gives a measure of how long it takes the business to recover debts
Debt Ratios
Long term funds management Measures the riskiness of business in terms of debt
•
For example: Debt/Equity
•
This ratio measures the relationship between debt and equity. A ratio of 1 indicates that debt and equity funding are equal (i.e. there is $1 of debt to $1 of equity) whereas a ratio of 1.5 indicates that there is higher debt in the business (i.e. there is $1.5 of debt to $1 of equity). This higher debt is usually interpreted as bringing in more financial risk for the business particularly if the business has profitability or cash flow problems.
•
Debt Ratios
Debt/Equity ratio = Long term debt / Total Equity
•
Debt/Total Assets ratio =
Total Liabilities
*100
Total Assets
•
Times Interest Earned = Earnings before Interest and Tax
Interest
Profitability Ratios
Measures the income or operating success of a company for a given period of time.
Profitability measures look at how much profit the firm generates from sales or from its capital assets.

All Profitability ratios are calculated in terms of percentage.

•

Gross Profit % = Gross Profit * 100



Net Sales

•

Net Profit % = Net Profit after tax * 100


Net Sales

•

Return on Assets =

Net Profit

* 100


Total Assets

•

Return on Equity =

Net Profit

*100

Total Equity
Gross Profit Margin Ratio
•
Gross Profit % = Gross Profit * 100
Net Sales
• The higher the better
• Enables the firm to assess the impact of its sales and how much it cost to generate (produce) those sales
• A gross profit margin of 45% means that for every $1 of sales, the firm makes 45c in gross profit
Return on Equity
•
Return on Equity =
Net Profit
*100
Total Equity
• The higher the better • Shows how effective the firm is in using its capital to generate profit • A ROE of 25% means that it uses every $1 of capital to generate 25c in profit
Report
• For the investor considering
the purchase of
shares in the company, the return they will earn
is the key financial factor but an overall
evaluation of the company’s performance and position is also important to get a better picture of how well the company is actually doing.
• ROE in 2006 is 26%. this return is certainly more attractive.
•
ROE has
decreased
by
6%
in
2006
but the
company’s ROE at 26% is still better than the industry average of 20%
• Profitability
– The NP% and ROA ratios show a small downward trend in % over the 2 year period. ROE% ratio show a
more significant decrease but is still better than the
industry average.
– Gross Profit Margin is slightly unfavourable at about 2.3% below the industry benchmark of 25%.
• Asset Management
– IT has gone down slightly from 5.8 to 5.58 times. – IT is still close to the industry benchmark of 6 times.
– AT
has
increased
showing
generated from asset usage
more
sales
being
• Liquidity
– Current ratios of 1.78:1 (2005) and 1.70: 1 are at above acceptable levels but below ideal level.
– Quick ratios appear more of a concern being below acceptable levels in both years and
even more so in 2006 (0.69:1).
– Raises some concerns over the liquidity of the business and inventory management (although IT ratio only shows a slight decline
in 2006).