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Financial Ratio AnalysisFinancial Ratio Analysis

Mohammad AzamMohammad Azam

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Corporation’s Financial StatementsCorporation’s Financial Statements

With diverse ownership, corporations do not With diverse ownership, corporations do not enjoy the secrecy that proprietorships and enjoy the secrecy that proprietorships and partnerships have.partnerships have.

Corporation must send each shareholder an Corporation must send each shareholder an annual report detailing the financial condition annual report detailing the financial condition of the firm.of the firm.

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Importance of Financial Ratios:Importance of Financial Ratios:

• To evaluate a company’s operating To evaluate a company’s operating performance, managers and external users performance, managers and external users may may perform ratio analysis.perform ratio analysis.

• Financial Ratios are ways of comparing and Financial Ratios are ways of comparing and investigating the relationships between investigating the relationships between different pieces of financial information.different pieces of financial information.

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Importance Importance (Continued…)(Continued…)

• The ratios are benchmarks used to compare The ratios are benchmarks used to compare a company’s performance with that of a company’s performance with that of previous periods and with that of other previous periods and with that of other companies.companies.

• Ratio analysis is used by external users to Ratio analysis is used by external users to evaluate a company’s profitability.evaluate a company’s profitability.

• Financial ratio analysis evaluates the Financial ratio analysis evaluates the financial performance and condition of a financial performance and condition of a business unit by measuring its progress business unit by measuring its progress toward financial goals.toward financial goals.

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Common-Size and Common-Base-Year Common-Size and Common-Base-Year Financial StatementsFinancial Statements

Income statement items as a percentage of Income statement items as a percentage of total sales.total sales. Provides insight into how the relative items Provides insight into how the relative items

contribute to revenues and expenses.contribute to revenues and expenses.

Balance sheet items as a percentage of total Balance sheet items as a percentage of total assets.assets. Provides a insight into the structure of the Provides a insight into the structure of the

company’s assets and financing.company’s assets and financing.

Common-base-year financial statements Common-base-year financial statements provide such comparisons to a base year.provide such comparisons to a base year.

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Retail Company Ltd.Retail Company Ltd.Income StatementIncome Statement

for the Years Ending for the Years Ending 2008 2009 2010

Net Sales 2,188 2,123 2,715CGS 1,692 1,667 2,105Gross Income 496 456 610Operating Expenses:General & Admin 188 203 238Selling Exp. 193 210 282Dep. Office Equipment 37 37 35Total operating Expenses 418 450 555Net Operating Income 78 6 55Other Expenses-Interest 8 6 8Net Income before tax 70 0 47Estimated Income tax 18 0 12Net Earnings 52 0 35

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Louise Eliason & CompanyBalance Sheet

December 31, 2010

ASSETS US $ LIABILITIES US $

Current Assets   Current Liabilities  

Cash 96,000 Accounts payable 246,000

Net accounts receivable 367,000 Short-term notes 24,000

Inventory 177,000 Accruals & other payables 28,000

Temporary investment 12,000 Total Current Liabilities 298,000

Prepaid expenses 2,000 Total Current Assets 654,000 Long-term Liabilities  

    Mortgage 897,000

Fixed Assets   Other long-term liabilities 443,000

    Total Long-term Liabilities 1,340,000

Land 656,000    

Buildings (net of depreciation) 903,000 SHAREHOLDERS' EQUITY  

Plant & equipment (net) 608,000 Capital stock 300,000

Furniture & fixtures (net) 61,000 Retained earnings 944,000 Total Net Fixed Assets 2,228,000 Total Shareholders' Equity 1,244,000

TOTAL ASSETS 2,882,000 TOTAL LIABILITIES & EQUITY 2,882,000

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RatiosRatios

Ratios are indicators of change and simplify Ratios are indicators of change and simplify relationships. relationships.

The ratio does not tell us if the change was The ratio does not tell us if the change was good or bad or even why it occurred. good or bad or even why it occurred.

A ratio changes if the numerator or A ratio changes if the numerator or denominator or both change.denominator or both change.

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Classification of Financial RatiosClassification of Financial Ratios

• Liquidity RatiosLiquidity Ratios

• Leverage RatiosLeverage Ratios

• Profitability RatiosProfitability Ratios

• Market Value RatiosMarket Value Ratios

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Liquidity RatiosLiquidity Ratios

• Also called Short-term Solvency ratios.Also called Short-term Solvency ratios.

• The primary concern is the firm’s ability to The primary concern is the firm’s ability to pay its bills over the short run without undue pay its bills over the short run without undue stress. Following are the considered liquidity stress. Following are the considered liquidity ratios:ratios:

• Current RatioCurrent Ratio

• Quick RatioQuick Ratio

• Working Capital RatioWorking Capital Ratio

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Current RatioCurrent Ratio

Current RatioCurrent RatioCurrent AssetsCurrent Assets

Current LiabilitiesCurrent Liabilities

$400$400

$253$2531.581.58

• 5 Stars corporation has $1.58 in current 5 Stars corporation has $1.58 in current assets for every $1 in current liabilities. Orassets for every $1 in current liabilities. Or

• 5 Stars corporation has its current liabilities 5 Stars corporation has its current liabilities covered 1.58 times over.covered 1.58 times over.

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Quick Ratio or Acid-Test Ratio:Quick Ratio or Acid-Test Ratio:

QuickQuick RatioRatioCurrentCurrent AssetsAssets InventoriesInventoriesss

CurrentCurrent LiabilitiesLiabilitiesss

$400-$140$400-$140

$253$2531.031.03

• Inventory is often the least liquid current asset. Some of Inventory is often the least liquid current asset. Some of the inventory may later turn out to be damaged, obsolete the inventory may later turn out to be damaged, obsolete or lost.or lost.

• NoteNote: Using cash to buy inventory doesn’t affect the : Using cash to buy inventory doesn’t affect the current ratio, but it reduces the quick ratio.current ratio, but it reduces the quick ratio.

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Working Capital RatioWorking Capital Ratio

Working Capital Ratio =Working Capital Ratio =

Current Assets – Current LiabilitiesCurrent Assets – Current Liabilities

SalesSales

$$ $$

$$ ,,..

400400 253253

110800801313 61%61%

• What Does What Does Working CapitalWorking Capital Mean? Mean?A measure of both a company's efficiency and its A measure of both a company's efficiency and its short-term financial health.short-term financial health.

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Leverage RatiosLeverage Ratios

Debt RatioDebt Ratio

Debt-to-Equity RatioDebt-to-Equity Ratio

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Debt RatioDebt Ratio

Debt RatioDebt Ratio

TotalTotal DebtDebt

TotalTotal AssetsAssets

$$ ..

$$ ,, ....

488488 5050

11150150 000000 4242

• It tells us how much the It tells us how much the company relies on debt to  relies on debt to finance  assets. The lower the company. The lower the company’s reliance on  reliance on debt for debt for asset formation, the less  formation, the less risky the company is  the company is since since excessive debt can lead to a very heavy interest  debt can lead to a very heavy interest  and  and principal repayment burden.  repayment burden.

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Debt-to-Equity RatioDebt-to-Equity Ratio

DebtDebt // EquityEquity RatioRatio

TotalTotal DebtDebt

ShareholdeShareholde rr ss EquityEquity''

$$ ..

$$ ....

488488 5050

661661 505000 7474

• A measure of a A measure of a company's  financial leverage. . Debt/equity Debt/equity ratio is equal to  is equal to long-term debt divided by  divided by common common shareholders' equity.  .  Investing in a  in a company with a higher debt/equity ratio may be riskier, especially  with a higher debt/equity ratio may be riskier, especially in times of rising in times of rising interest rates, due to the , due to the additional  interest that has to be  that has to be paid out for the  out for the debt..

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Profitability RatiosProfitability Ratios

Gross Profit MarginGross Profit Margin

Net Profit MarginNet Profit Margin

Return on AssetsReturn on Assets

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Gross Profit MarginGross Profit Margin

GrossGrossGrossGross

SalesSalesProfit MarginProfit Margin

ProfitProfit

$$ ..

$1$1,, ....

520520 0000

080080 00004848 15%15%

• What remains from What remains from sales after a  after a company  pays out the  out the cost of goods sold, gross profit. , gross profit.

• The 48.15% gross profit margin means that for every The 48.15% gross profit margin means that for every dollar generated in sales, the company has 48.15  generated in sales, the company has 48.15 cents  left over to cover basic  over to cover basic operating costs and profit. and profit.

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Net Profit MarginNet Profit Margin

NetNetNetNet IncomeIncome

SalesSalesProfit MarginProfit Margin

$$ ..

$1$1,, ....

4242 0000

080080 000033 89%89%

• This This number is an indication of how effective a  is an indication of how effective a company is  is at at cost control. .

• The higher the net profit margin is, the more effective the The higher the net profit margin is, the more effective the company is at converting revenue into actual profit. The company is at converting revenue into actual profit. The net profit margin is a good way of comparing companies in net profit margin is a good way of comparing companies in the same industrythe same industry

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Return on AssetsReturn on Assets

ReRe

$$ ..

$1$1,, ....

turnturn onon AssetsAssetsNetNet IncomeIncome

TotalTotal AssetsAssets

4242 0000

150150 000033 65%65%

• An indicator of how An indicator of how profitableprofitable a company is relative to its a company is relative to its total assets. total assets. 

• ROA gives an idea as to how efficient management is at ROA gives an idea as to how efficient management is at using its assets to generate earnings.using its assets to generate earnings.

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Market Value RatiosMarket Value Ratios

P/E RatioP/E Ratio

Earnings YieldEarnings Yield

Dividend YieldDividend Yield

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P/E RatioP/E Ratio

PP //PrPr

$$ ..

$$ ....

EE RatioRatioiceice perper ShareShare

EarningsEarnings perper ShareShare

2929 0000

22 25251212 8989

• A valuation ratio of a company's current share price A valuation ratio of a company's current share price compared to its per-share earnings.compared to its per-share earnings.

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Earnings YieldEarnings Yield

EarningsEarnings YieldYieldEarningsEarnings perper ShareShare

iceice perper ShareShare

PrPr

$$ ..

$$ ....

22 2525

2929 000077 76%76%

• The earnings yield (which is the inverse of the P/E ratio) The earnings yield (which is the inverse of the P/E ratio) shows the percentage of each dollar invested in the stock shows the percentage of each dollar invested in the stock that was earned by the company.that was earned by the company.

• The earnings yield is used by many investment The earnings yield is used by many investment managers to determine optimal asset allocations.managers to determine optimal asset allocations.

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Dividend YieldDividend Yield

DividendDividend YieldYieldDividendsDividends perper ShareShare

iceice perper ShareShare

PrPr

$$ ..

$$ ....

112525

2929 000044 31%31%

• Dividend yield shows how much a company pays out in Dividend yield shows how much a company pays out in dividends each year relative to its share price.dividends each year relative to its share price.

• In the absence of any capital gains, the dividend yield is the In the absence of any capital gains, the dividend yield is the return on investment for a stock.return on investment for a stock.

• Dividend yield is a way to measure how much cash flow you Dividend yield is a way to measure how much cash flow you are getting for each dollar invested.are getting for each dollar invested.