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5/19/2018 Unit 28_Financial Analysis Techniques_2013
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Financial Analysis
TechniquesReading - 28
FINANCIAL REPORTING AND ANALYSIS
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Activity Ratios
Activity ratios are also known as asset utilization ratios andthey measure how efficiently a company performs day to day
tasks such as collection of receivables and management of
inventory. Various activity ratios are :-
a. Inventory turnover ratio : It is a measure of a firms effectiveinventory management . Higher the ratio, shorter the period
that inventory is held.
b. Days of inventory on hand (DOH) : It is the average inventory
processing period or the number of days of inventory on
hand.
Cost of goods sold
Average Inventory
Inventory turnover ratio =
Number of days in period
Inventory TurnoverDays of inventory on hand =
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Activity Ratios
c. Payable turnover ratio : It is the measure of company making
use of available credit facilities.
d. Number of days of payables : It is the average number of
days the company takes to pay its suppliers .
e. Total Asset turnover ratio : It measures the companys
overall ability to generate revenue with a given level of
assets.
purchases
average rade payablesPayables turn over =
365
payable turnover ratioNumber of days of payables =
revenue
average total assets
Total asset turnover =
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Activity Ratios
f. Fixed asset turnover : It indicates the companys use of fixedassets in generating revenue.
g. Working capital turnover ratio : It indicates the companys
efficient use of working capital in generating revenue .
revenue
average net fixed assets
Fixed asset turnover =
revenue
average working capitalWorking capital turnover =
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Liquidity Ratios
Liquidity ratios measure the companys ability to meet itsshort term cash requirements. Various liquidity ratios are :
a. Current ratio : It is the ratio of current assets to current
liabilities.
Working capital equals current assets minus current liabilities.
b. Quick ratio (Acid test ratio) is the ratio of quick assets to
current liabilities where quick assets are those assets whichcan be readily converted to cash.
Current AssetCurrent Liabilities
CurrentRatio =
cash + short term marketable securities + receivables
current liabilitesQuick Ratio =
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Liquidity Ratios
c. The Cash conversion cycle or net operating cycle is ameasure of the time it takes to turn the firms cash
investment from paying suppliers for materials to
collecting cash from sales of inventory.
A conversion cycle that is too high shows that the
company has its excess amount invested as working
capital.
d. Defensive interval ratio : It indicates the number of days
the company can pay its expenditures with its existing
liquid assets .
Number of Number of Number ofdays of inventory days of receivables days of payables
Net operating cycle = + -
cash + short term marketable investments + receivables
daily cash expenditures=Defensive interval ratio
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Solvency Ratios
a. Debt-to-assets ratio: This ratio measures the percentageof total assets financed with debt, thus a higher ratio
means a weaker solvency.
b. Debt-to-capital ratio : This ratio measures the percentageof a companys capital (debt plus equity) represented by
debt.
c. Debt-to-equity ratio : This ratio measures the amount ofdebt capital relative to equity capital.
total debt
total assetsDebt to Assets =
total debt
total debt + total shareholders equityDebt-to-capital =
total debt
total shareholders equityDebt-to-equity ratio =
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Solvency Ratios
d. Financial leverage ratio: This ratio is defined in terms of average of totalassets and average total equity. It is also known as leverage ratio.
e. Interest coverage ratio : This ratio determines the firms ability to repay
its debt obligations.
f. Fixed charge coverage ratio : This ratio measures the number of times a
companys earnings can cover the companys interest and leasepayments.
average total assets
average total equityFinancial leverage =
EBIT
interst paymentsInterestcoverage =
EBIT + lease payments
interest payments + lease paymentsFixed charge coverage =
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Profitability Ratios
Profitability ratios measure the companys ability to generateprofitable sales from its assets. Various ratios are :
a. Gross profit margin : It indicates the available revenue to cover up
the operating expenditures.
b. Operating profit margin : It is the ratio of operating profit to
revenue or sales.
c. Pretax margin : Pretax income is calculated as operating profit
minus interest.
gross profitrevenue
Gross profit margin =
operating income
revenueOperating profit margin =
EBT
revenuePretax margin =
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Profitability Ratios
d. Net profit margin: It is a ratio of net income to revenue. It isrevenue minus all expenses.
e. Return on assets : It measures the return earned by acompany on its assets.
f. Operating return on assets : It measures the return on all
assets invested in the company financed with liabilities debt
or equity.
net income
revenueNet profit margin =
netincome
average total assetsReturn on assets(ROA) =
EBIT
average total assets
Operating return on assets =
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Profitability Ratios
g. Return on total capital : It measures the profits a companyearns on all the capital that it employs be it short term or
long term debt.
h. Return on equity (ROE) : It is the ratio of net income to
average total equity (including preferred stock).
EBIT
average total capitalReturn on total capital =
net incomeaverage total equity
Return on Equity =
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Valuation Ratios
a. Price to Earnings (P / E) ratio : This ratio expresses therelationship between price per share and the earnings per
share. It is expressed as
b. Price to cash flow ratio :
c. Price to sales ratio : It is used as a comparative price metric
when a company does not have positive net income.
price per share
earnings per shareP/E =
price per share
cash flow per shareP / CF =
price per share
sales pershareP / S =
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Valuation Ratios
d. Price to book value ratio : It is a ratio of price per share tobook value per share and it indicates the relationship
between a companys required rate of return and its actual
rate of return.
price per share
book value per shareP / BV =
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DuPont Expression
DuPont analysis is a tool used by analysts to make inferences
about a companys performance and target the areas of
concern.
The break down of return on assets into a two component
model is simplest form of the DuPont approach.
Return onassets
Net profitmargin
Total assetturnover
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DuPont Expression . .
Return on assets ratio is net income divided by
the average of total assets of the company and
it is extended into two components as shown :
Net income Net income Revenue
Average total assets Revenue Average total assets
Return on Assets = = *
*=Return on Assets Net Profit margin Total asset turnover
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DuPont Expression . .
The return on shareholders equity can be represented as athree-component DuPont model as shown :
Net income Net income Revenues Average total assets
Average shareholders equity Revenues Average total assets Average shareholders equity
* financial leverage
Return on Equity = = * *
ROE = Net Prof it Mragin * Total asset turnover
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DuPont Expression . .
The extended DuPont expression which is a 5- partdecomposition of ROE has the effect of non
operating income items as one of the components as
shown :
operating income income before taxes taxes revenues average total assetsrevenues operating income income before taxes average total assets average shareholders equity
* *( )ROE = * * 1 -
Tax effect * Total asset turnover * Financial leverageROE = Operating profit margin * Effect of nonoperating items *
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Dividend related Quantities
It measures the percentage of earnings that the companypays out as dividends to shareholders.
Dividendpayout
ratio
It is the percentage of earnings that a company retains.
It is complement of the payout ratio (1- payout ratio).
Retentionratio
The companys growth rate is a function of its profitability
and its ability to finance itself without external equity issues .
Here growth rate g = RR* ROE
Sustainablegrowth rate
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