FIN 440 LECTURE 4

FINANCIAL RATIO ANALYSIS

CHAPTER REFERENCE – CHP 3

Liq > Liability mgt > x/y

Relative valuation means ratio analysis
The comparative analysis through ratio is called Relative valuation
Use the terms like: comparative, relative, risk of liquidity
In a job viva, the more special words in an ans is the best answer

1) Ratio Analysis - form of comparitive analysis- we can measure a company's financial standing and we call it
relative valuation (relative valuation means to determine the value through ratio analysis) - it can be done in two
ways -
a. Horizontal (time series analyses): comparing current ratio with the previous year’s ratio. Not used much in the real
world
b. vertical (Cross section anaysis): comapring the ratio with the industry average. This is the most common analysis.

1) Calculation
2) Interpretation - it gives the ratio meaning
3) Comparison - by time or by industry average (Industry average: is the fundamental benchmark measuring success.
you can never beat the benchmark the idea is to stay as close as possible)
4) Decision - Are our decisions maximizing shareholder wealth

5 types of ratio:
a. Liquidity: liabilities management ratio
b. activity ratio: Asset management ratio
c. Debt ratio: its debt management ratio
these 3 ratios focus on measuring the risk of illiquidity - the closer to benchmark the less risk of illiquidity
however, having lot of cash or having no cash is not ideal one... here it comes the benchmark

benchmark: is the ideal liquidity measurement of the industry

Now we start measuring return:

d. Profitability ratio: Income management ratio

e.market ratio: share price management

it's an externalized measurement. it determines the impact of risk or return in the market due to company's
performance

Annual report means audited financial statement.

Cashflow statement is the most reliable statement

Asset side: Operational

liabilities part: combination of operational & non-operational

Accrued Expenses: recognizing a cashflow before it happens.

account is based on accrual and finance is based on cashflow

in bangladesh we use provision for the word accruall

NPL ratio: Non Perfoming Loan - intermediation spread: the ratio of deposits to loans - in our country it is the worst
that is (6% saving - 9% lending) 3% it is. (this is the fundamental/primary source of income)

Provisioning: when a bank is going to give loans, it has to keep the same amount as researve. it can also say that it is
provision of bad debt.

LIQUIDITY RATIOS

1. Current Ratio = Current Asset / Current Liability (x or %) 

 CR= 3 = I have 3 times more current asset than current liability. Suppose, industry average is 5
then we are in risk of illiquidity is high the decision we take is we can increase current asset and
decrease liability and we have to reduce liablity. Now, suppose industry average is 1.5 then it is
also not good because we are missing opportunity. Our risk of liquidity is less and we have
opportunities to increase liability. That is can take loans and short term debt.
We have to compare with the companies with the similar size.
2. Quick Ratio = (Current Asset - Inventory) / Current Liability (x or %)
It exists because inventory is typically an illiquid asset and inventories could be any type and they
might not be liquidate easily.
We have to calculate any of the ratio, current ratio or quick ratio not the both. A stupid you do that.
If the inventory is less and can be easy
3. NWC (net working capital) to TA (total asset) ratio = NWC/TA (x or %)
Nwc= (current asset – current liability)/ta
It calculates the net working capital to its total asset and it can never be more than 1
And when we see the value is less than 1 suppose .3 then we have 30%
If the
4. Cash Ratio = (Cash + Marketable Securities)/CL (x or %)
Cash Ratio = Cash/CL
Cash ratio 50% and Industry average is 70% we are in risk or illiquidity and
5. Interval Measure = (Cash + Mkt Sec + A/R) / Avg Daily Expenses (days)
Interval Measure = Cash + AR/ Avg Daily Expenses (days)
How much cash we have to cover our daily expenses
If the value is 10 that means we cash to cover 10 days of expense
If the I.Avg is 40 then we have opportunity to decrease daily expense
6. Average Daily Expenses = (COGS + Admin. Exp + Operating Expenses) / 360 ($/day)

7. Gross Working Capital = Current Assets ($)

8. Net Working Capital = CA - CL ($)
9. Payables Deferral Period = (Average A/P) / Daily Sales or Daily COGS (days)
It measured amader a/p balance ta daily sales theke kotobar pay off kora jabe.
If the I avg is high we to decrease accounts payable and if it is low th
10. Daily Expenses = (COGS + Other Expenses) / 360 (TK)
11. CCC (cash conversion cycle) = (Inv/Daily COGS) + (Rec/ Daily Credit Sales) – (A/P/ Daily
Expenses)
– It’s a consolidate ration
– It measures the health of the business
– Cash >(a/p)> Inventory > sales > (a/r)> Cash > Inventory
– The less the better and if the value is negative than it is even better.
City Brokerage: is the fastest growing brokerage in the country. The main thing is city
touch.

ACTIVITY RATIOS

This is the arms and legs of ratio

It also called asset management ratio
It has more scope than the liquidity ratio
Through asset management ratio we find how utilize the asset
2 types – over utilizing | under utilizing
This ratio is also called turnover ratio: it means how many times an asset turned over
Most important ratio: total asset turnover: sales/ta: it never goes over 1:
We have three types of asset primary(knitting machine), complementary (generator), supplementary

1. Inventory Turnover Ratio = Sales / Inventory (x)

– If we have more inventory then we’ll have more illiquid asset
– For FMCG company it is a very important
– Having too much takes away our operating ability
– Suppose our ans is 4 then we have turned over our inventory 4 times in
a year
– If the ind. Avg is 7 then we had more inventory then every one
– We have to reduce the inventory
– If the ind avg is 1.5
2. Inventory Turnover Period = 360 / Inventory Turnover Ratio (day or Inv / Daily Sales)
 – Daily inventory turnover: how many times
3. Daily Sales = sales / 360 ($/day)
4. Receivable Turnover Ratio = Sales / Receivables
5. Daily Sales Outstanding = Accounts Receivable / Daily sales (day)
– Daily credit sales
6. Daily Sales Outstanding = 360 / (Sales / Receivables) = Receivables / Daily Sales (day)
– Credit turnover ratio
7. Daily Sales Outstanding = 360 / Receivables Turnover Ratio (day)
– Receivable turnover ratio calculate the time we take to collect the
credits.
8. Fixed Asset Turnover Ratio = Sales / Avg Fixed Asset (x)
9. Fixed Asset Turnover Period = 360 / Fixed Asset Turnover Ratio (day or Avg. FA / DS)
– The percentage of total fixed asset that we are using to generate sales
daily
10. Total Asset Turnover Ratio = Sales / Avg Total Asset (x)
– If it’s .4 we convert it to percentage
– It calculates the percentage of total assets that we are using to generate sales
– If indus. Avg is 60% then we are underutilizing asset
– If indus. avg is 30% then we are over utilizing asset
1. Total Asset Turnover Period = 360 / Total Asset Turnover Ratio (day)
– The percentage of total asset that we are using to generate sales daily
2. Capital Intensity Ratio = Fixed Asset / Total Asset (x or %)
– What percentage of our total asset is fixed asset or longterm asset
– Fixed asset are more expensive
3. Current Asset Intensity Ratio = Current Asset / Total Asset (x or %)
– What percentage of our total asset is current asset or longterm asset
– We use the last 2 ratio to utilize our capital structure.
1. Total Asset Turnover Ratio = Sales / Average TA (x or %)
2. Fixed Asset Turnover Ratio = Sales / Avg Fixed Asset (x or %)
3. NWC Turnover Ratio = Sales / Avg. NWC (x or %)
4. Inventory Turnover Ratio = COGS / Avg Inventory (x or %)
– Consider the products for sale
5. Days Sales in Inventory or Inventory Turnover Period = Average Inventory / Daily COGS (days)

DEBT RATIOS
In finance when there is a decision related to investment, we have two questions
Can we make this investment?
Should we make this investment?
In case of debt,
Can we borrow more money? Ability to borrow
Should we borrow more money? Ability to pay-off
1. Debt Ratio = Total Debt / Total Asset (x or %)
• Most common ratio
• Always less than 1 and we have to convert it to percentage
• The 60% of our total asset is financed by debt
• If the ind. Avg. is 40% than we cannot borrow more money
• Then we have high risk of illiquidity
2. Long Term Debt Ratio = Long Term Debt / Total Asset (x or %)
•
3. Long Term Debt to Debt Ratio = Long Term Debt / Total Liability (x or
%)
4. Debt Equity Ratio = Long Term Debt / Total Equity (x or %)
• We use equity instead of asset, how much money we have
• The more debt to equity ratio is riskier and they will pay more
dividend
5. Debt Equity Ratio = Total Liability / Total Equity (x or %)
6. TIE Ratio = EBIT / Interest Charges (x or %)
• The times interest earned ratio
• Operating income divided by interest
• Basically, the idea is, in simple terms income divided by
interest
• Interest Is the primary cost of debt
 • The tie ration how many times our income has ability to pay the
interest/debt.
• The biggest weakness: it does not take in to account any other
expense of the business
7. Fixed payment Coverage Ratio = (EBIT + Lease Payment) /{Interest +
[Sinking Fund /(1 - Tax Rate)]} (x or %)
• Measuring income against fixed payment obligations
• We have 5 types of expense: i. interest ii. Principle iii. Lease
expense/operating expense iv. Tax v. Preferred stock dividend
8. Cash Coverage Ratio = (EBIT + Dep.) /Interest
• Same as tie ratio

PROFITABILITY RATIOS
Here we measure the income or income management ratio
2 types: i. Primary (here we measure the profit margin > Common size income statement) ii. Secondary
We can calculate profit 3 times
Percentage of Sales: to measure each item of income statement by the percentage of sale

1. Profit Margin = Net Income / Sales (x or %)

• If we have less profitability ratio than ind. Avg.: we have to
reduce expense, in that case we will compare everything with
the industry average and find out where we have the lacking.
2. Basic Earning Power (BEP) = EBIT / TA (x or %)
3. Return on Asset = Net Income / Total Asset (x or %)
4. Return on Asset = (Net Income+ Interest) / (Debt+Equity)
5. Return on Asset = (Net Income+ Interest) / Total Assets
6. Return On Equity = Net Income / Total Equity (x or %)
7. WACC = [{Debt(1-Tax)/(Debt+Equity)}*Rd] + [{Equity/(Debt+ Equity)}* Re] (rd = min req rate, re =
cost of equity )
The CAPM
8. Payout Ratio (POR) = Dividend / Earning (%)
9. Plowback Ratio = 1 - POR = (Earning - Div)/Earning (%)

MARKET RATIOS

1. Earning Per Share = Net Income / Shares Outstanding ($/share)

2. Price = Price per Share (Tk/share)
3. Book Value per Share (BVPS) = Total Equity / SOS ($/share)
4. Market / Book = Market Price / BVPS (x or %)
5. Market Value = Price * SOS ($)
6. Book Value = Total Equity ($)
7. Price / Earning Ratio = market price per share / EPS (x)

The DUPONT MODEL

Ration analysis: Relative valuation
If a ratio is good or bad completely depends on the company, money market and country
Ratio analysis means measuring the
2) liquidity,
3) activity,
4) debt,
5) profitability, and
6) Market

4 steps:
i. Calculate
ii. Interpretation
iii. Compare (the benchmark is set based on Industry average)
iv. Decision

Liq, Act, Debt: risk of illiquidity

Liquidiy > Liability Management