3RD SESSION

Ratio Analysis

• “Ratio is the mathematical relationship of one number to another number”.

• Most important benefit– Facilitation of unbiased comparison

5 main categories of Financial Statement

ratios

Liquidity ratiosAsset

Management Ratio

Debt utilization

ratio

Profitability ratio

Market value ratio

Example2014 2013

Cash (in hand & in bank) 30,000 20,000

A/R 150,000 100,000

Inv. 200,000 150,000

Prepaid expenses 20,000 15,000

A/P 125,000 100,000

Accrued expenses 25,000 20,000

Fixed assets 600,000 400,000

Sales 1500,000 -

Gross profit 40% of sales -

1. Liquidity Ratios

• ‘Liquidity ratios give us an idea about firm’s ability to pay off debts that are maturing within an year’.

• Liquidity ratio measures how capable a firm is in meeting its short term debt obligations in full and on time.

• Most commonly used liquidity ratios:– Current ratio– Quick ratio or Acid test ratio– Cash ratio or Super Quick or Super Acid test ratio

i. Current Ratio

• Formula (CA/CL)• Ideal• ‘It indicates the extent to which current liabilities are

covered by those assets expected to be converted to cash in near future’.

As for large discrepancies

Lower ratio than industry average:

- Creditor less protected than other firms in industry

Higher ratio than industry average:- Strong, safe liquidity position

- Greater inventory level- Trouble moving things

ii. Quick Ratio

• Formula (CA-inv/CL)• Ideal• ‘It measures firm’s ability to pay off STO without

relying on sales of inventories’.

iii. Cash Ratio

• Formula (Cash and cash equiv./CL)• Ideal• ‘It measures amount of cash, cash equivalent or

short term investment that a firm has to cover current liabilities’.

iv. Cash conversion cycle *• Number of days from outlay of cash for purchasing R/M to

receiving payment from customers

v. Working Capital * (CA – CL)• WC is a measure of cash and liquid assets available to fund a

company’s day to day operations.

2. Asset Management Ratios

• ‘Asset management ratios measure how effectively a firm is managing its assets’.

• Most commonly used AMR:– Inventory turnover ratio (times/days)– Receivable turnover ratio (times/days)– Accounts Payable turnover (times/days)– Fixed asset turnover– Total asset turnover

i. Inventory turnover ratio

• Formulas: (COGS/avg. inv.) (365/inv. turnover)• Inventory turnover times measures how many times

in an year the firm’s inventory has been sold.– What if inventory turnover ratio is low or high?

• Inventory turnover days measure how many days the inventory stays with us before we are able to sell it.

ii. Receivable turnover ratio

• Formulas: (Sales/avg. rec.) (365/rec. turnover)• Receivable turnover times measures how many

times in an year the business can turn it’s A/R into cash’.– What if A/R turnover ratio is low or high?

• High turnover: conservative credit policy, aggressive collect. dept.• Low turnover: loose credit policy, inefficient collect. dept.

• Receivable turnover days/DSO/RP/CP measure how many days the firm must wait after making a sale to receive cash.

4TH SESSION

iii. Accounts Payable turnover

• Formulas: (Purchases/avg. A/P) (365/pay. turnover)

• ‘Accounts payable times measure how many times per period the co. pays its avg. payable amount’.

• Accounts payable in days measure number of days the company takes to pay its suppliers. – What if A/P (no. of days) increase or decrease?

• Increasing number of days• Decreasing number of days

iv. Fixed Assets Turnover

• Formula: (Sales/fixed assets)

• ‘The ratio measures the extent to which firm uses existing plant and equipment to generate sales’.

• How many sales generated from $1 of fixed assets, a ratio of 2.5 means by utilizing $1 of fixed assets the firm has generated $2.5 of sales.

v. Total Assets Turnover

• Formula: (Sales/total assets)

• ‘The ratio measures the extent to which firm uses its total resources to generate sales’.

• How many sales generated from $1 of total assets, a ratio of 1.5 means by utilizing $1 of total assets the firm has generated $1.5 of sales.

3. Debt Management Ratios

• Also known as ‘Financial Leverage Management Ratios’.

• Leverage• FLMR measure the extent to which firm uses

financial leverage and is of interest to both creditors and owners alike.

• Debt management ratios under discussion:– Debt ratio– Times interest earned ratio– EBITDA coverage ratio

i. Debt Ratio (Total Debt to Total Assets Ratio)

• Formula: (Total Debt/Total assets)• ‘It measures portion of firm’s total assets that is

financed through creditors funds”.• Total debt here means: Current liabilities + long term liabilities

• Debt ratio is a ratio carrying huge importance for creditors.

• High debt ratio rings a warning bell for the creditors.

Question

• From the following data you are required to calculate Debt Ratio and Times Interest Earned.

• EBIT ……………………………………………….. Rs. 300,000• 10% bonds payable ………………………… Rs. 500,000• Ordinary share capital Rs. 10 each…… Rs. 800,000• Reserves and surplus………………………..Rs. 200,000• Current liabilities……………………………….Rs. 250,000

ii. Times Interest Earned

• Formula: (EBIT/Interest)• ‘The ratio between EBIT and Interest measures firm’s

ability to meet its annual interest payments’.• Also known as ‘Interest coverage ratio’.• ICR measures the number of times a company can

make interest payments on its debt with its EBIT.• For e.g. an Interest coverage ratio of 2 means

company has enough profitability to bear twice the amount of its current financial cost.

Question

• From the following data you are required to calculate Debt Ratio and Times Interest Earned.

• EBIT ……………………………………………….. Rs. 300,000• 10% bonds payable ………………………… Rs. 500,000• Ordinary share capital Rs. 10 each…… Rs. 800,000• Reserves and surplus………………………..Rs. 200,000• Current liabilities……………………………….Rs. 250,000

iii. EBITDA Coverage Ratio• Formula: • (EBIT+D+A+Lease payment/Interest+Principal payment+Lease payment)

• ‘A ratio whose numerator includes all CFs available to meet fixed financial charges and whose denominator includes all fixed financial charges’.

• TIE had 2 basic flaws:– Interest is not the only fixed financial cost– EBIT does not represent all the cash available to service esp. if firm has high

non-cash expenditures like Depreciation and amortization

• EBITDA coverage ratio covers these flaws.

iii. EBITDA Coverage Ratio• Limitation:– In the numerator we want to know how much funds do we

have to pay interest, principal and lease payments. However, while arriving at EBIT we already subtracted lease payments. We thus add back lease payments to the numerator to cover the limitation of the formula.

• Sinking fund provision:– If the company has a sinking fund provision we’ll add that

in denominator otherwise we’ll assume it as 0.

• EBITDA is calculated using the company’s income statement.

• The formula for EBITDA is: EBITDA = EBIT + Depreciation + Amortization

• To calculate EBITDA, we find the line items for EBIT ($750,000), depreciation ($50,000) and amortization (n/a) and then use the formula above:

• EBITDA = 750,000 + 50,000 + 0 = $800,000

Practice Question

• Willis Publishing has $30 billion in total assets. The company’s TIE ratio is 8.0. It’s EBIT is $6 billion. Willis depreciation and amortization expense total $3.2 billion. It has to make $2 billion in lease payments and $1 billion must go towards principal payments on outstanding loan and long-term debt. What is Willis EBITDA coverage ratio?