Financia

Financial
l
Management
Manage
Chapter Three ment

( FMI ) Romario
RomarioKhaled
Khaled
2024 01271535731
01271535731
01149154059
01149154059
Financial Management [CHAPTER]Three

Chapter ( Three )
Financial Ratio Analysis
Learning objective
1. Introduction
2. Main users of the financial ratios.
3. Types of ratio comparisons
4. Main concerns about using ratio analysis.
5. Financial ratios.
6. DuPont system of analysis.
7. The firm’s cash flows and financial planning

1. Introduction
Ratio analysis involves methods of calculating and interpreting financial ratios to analyze
and monitor the firms performance.
Stockholders Reports
The annual stockholders’ report must provide to stockholder’s, documents and presents
the firm’s financial activities of the past year.
It includes the letter to stockholders. It also includes key five financial statements which
are:
- The income statement,
- The financial position statement (the balance sheet),
- The statement of changes in shareholder's equity,
- The statement of cash flows,
- The comprehensive income statements.

2. Main users of the financial ratios.

- Current and prospective shareholders are interested in the firm’s current and future
level of risk and return, which directly affect share price.
- Creditors are interested in the short-term liquidity of the company and its ability to make
interest and principal payments.
- Company's management is concerned with all aspects of the firm’s financial situation,
and it attempts to produce financial ratios that will be considered favorable by both
owners and creditors.

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3 - Types of ratio comparisons

A) Cross-sectional analysis ( Dell with HP )

Comparison of different firms’ financial ratios at the same point in time; involves
comparing the firm’s ratios with those of other firms in its industry or with industry
averages.
Benchmarking ( Dell with Computers industry )
A type of cross-sectional analysis in which the firm’s ratio values are compared with
those of a key competitor or with a group of competitors that it wishes to emulate ‫محاكتها‬
B ) time-series analysis ( Dell 2022 with Dell 2023 )
Evaluation of the firm’s financial performance over time using financial ratio analysis.
C) Combined Analysis (Time – series / Crosse section analyses)
The most informative approach to ratio analysis combines cross sectional and time-
series analyses
4. Main concerns about using ratio analysis.
1- Ratios that reveal large deviations from the norm merely indicate the possibility of
having a problem.
2- A single ratio does not generally provide sufficient information to judge the overall
performance of the firm.
3- The ratios being compared should be calculated using financial statements dated at
the same point in time during the year.( First Q of 2023 With First Q of 2024 )
4- It is preferable to use audited financial statements.
5- The financial data being compared should have been developed in the same way.
6- Results can be distorted by inflation.

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5. Financial ratios.
• Liquidity ratios,
• Activity ratios,
• Debt ratios,
• Profitability ratios,
• Market Ratios.

1 - LIQUIDITY RATIOS
liquidity A firm’s ability to satisfy its short-term obligations as they come due.

A)
current ratio

A measure of liquidity calculated by dividing the firm’s current assets

by its current liabilities.

B)
Quick ratio

A measure of liquidity calculated by dividing the firm’s current assets

minus inventory by its current liabilities.

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Financial Management [CHAPTER]Three

2 - Activity ratios
Measure the speed with which various accounts are converted into sales or cash, or
inflows or outflows
Measures the activity, or liquidity, of a firm’s inventory
A)
inventory
turnover

Average number of days’ sales in inventory

B)
average \\
age of
inventory 365 / 7.2 = 50.7 Days

The average amount of time needed to collect accounts receivable.

C)
average
collection
period

The average amount of time needed to pay accounts payable.

.D )
Average
payment
period If we assume that Bartlett Company’s purchases equaled 70 percent of its
cost of goods sold in 2015, its average payment period is

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Financial Management [CHAPTER]Three

Indicates the efficiency with which the firm uses its assets to generate
sales.
E)
Total
Assets
turnover

3 - DEBT / LEVERAGE RATIOS:

The magnification of risk and return through the use of fixed cost financing, such as
debt and preferred stock.
Measures the proportion of total assets financed by the firm’s creditors.

A)
Debt ratio

Measures the relative proportion of total liabilities and common stock equity
B) used to finance the firm’s total assets.
debt-to-
equity ratio

C)
Equity
multiplier
D) Measures the firm’s ability to make contractual interest payments;
Times sometimes called the interest coverage ratio
interest
earned
ratio

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Financial Management [CHAPTER]Three

E) Measures the firm’s ability to meet all fixed-payment obligations.

Fixed-
Payment
Coverage
Ratio
(FPCR)

common-size income statement An income statement in which each item is expressed

as a percentage of sales.
4 - PROFITABILITY RATIOS:
Measures the percentage of each sales dollar remaining after the firm has
paid for its goods.
A)
gross profit
margin

B)
operating
profit
margin

C)
net profit
margin

.D )
return on Measures the overall effectiveness of management in generating profits with
total assets its available assets; also called the return on investment (ROI)
(ROA)

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E) Measures the return earned on the common stockholders’ investment in the

return on firm.
equity
(ROE)

5 – Market RATIOS:

A)
price/earning
s (P/E) ratio

Measures the amount that investors are willing to pay for each dollar of a
firm’s earnings; the higher the P/E ratio, the greater the investor confidence
This figure indicates that investors were paying $11.12 for each $1.00 of
earnings.

B)
market/book
(M/B) ratio

C)
Dividends
Yield Ratio.

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6. DuPont system of analysis.

System used to dissect ‫ تحليل‬the firm’s financial statements and to assess its financial
condition.

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True Or False
2) Both current and prospective shareholders are interested in the firm's current and future level of risk and return,
which directly affect share price. (T)
3) Creditors are primarily interested in short-term liquidity of the company and its ability to make interest and
principal payments. (T)
4) Time-series analysis is the evaluation of a firm's financial performance in comparison to other firm(s) at the
same point in time.(F)
5) Cross-sectional analysis involves the comparison of different firms' financial ratios at the same point in time.
(T)
6) Benchmarking is a type of cross-sectional analysis in which a firm's ratios are compared to a key competitor
firm within the same industry, primarily to identify areas for improvement. (T)
7)Time-series analysis evaluates the performance of various firms at the same point in time using financial
ratios.(F)
8) Benchmarking is a type of time-series analysis in which the firm's ratio values are compared to those of a key
competitor or group of competitors, primarily to isolate areas of opportunity for improvement. (F)
10) Asingle key ratio of a firm provides all the information required to judge the overall performance of the
firm.(F)
13) The use of the unaudited financial statements for ratio analysis is preferable because it reflects the firm's true
financial condition(F).
15) Market ratios only measure the risk. (F) (liquidity, activity, and debt)
16) Profitability ratios capture both risk and return. (F)(profitability )(Return only)
17) The liquidity of a firm is measured by its ability to satisfy its short-term obligations as they come due. (F)
(current ratio)
Liquidity is the ability to convert assets into cash quickly
1) The liquidity of a business firm refers to the solvency(easy to transfer to cash ) of the firm's overall financial
position. (T)
2) The two basic measures of liquidity are the debt-to-equity ratio and the asset turnover ratio. (F)
3) liquidity of a business firm is measured by its ability to satisfy its long-term obligations as they come due. (F)
4) Current ratio provides a firm's ability to meet its long-term obligations. (F)
5) Average age of inventory is viewed as the average length of time inventory is held by a firm or as the average
number of days' sales in inventory. (T)
Answer: TRUE
6) Average age of inventory can be calculated as inventory divided by 365. (F)
7) Average age of inventory can be calculated as inventory turnover divided by 365. (F) ‫العكس‬
8) Average age of inventory can be calculated as 365 divided by inventory turnover.
9) Average payment period can be calculated as accounts payable divided by average sales per day. (F)
10) Average payment period can be calculated as accounts payable divided by average purchases per day.(T)
11) Total asset turnover commonly measures the liquidity of a firm's total assets. (F)(efficiency to use assets)
1) The magnification of risk and return introduced through the use of fixed-cost financing, such as debt and
preferred stock is called financial leverage. (T)
2) The less fixed-cost debt (financial leverage) a firm uses, the greater will be its risk and return. (F)
3) In general, the more debt a firm uses, the smaller its financial leverage. (F)
4) The lower the fixed-payment coverage ratio, the lower is the firm's financial leverage. (F)
5) Higher the debt ratio, more the financial leverage a firm has and thus, the greater will be its risk and return. (T)
4) Return on total assets (ROA) measures the overall effectiveness of management in generating profits with its
available assets. (T)
5) The price/earnings (P/E) ratio represents the degree of confidence ‫ ثقة‬that investors have in a firm's future
performance. (T)
1) The financial leverage multiplier is the ratio of a firm's total assets to common stock equity. (T)

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MCQ

52) A firm has the following accounts and financial data for 2014:

The firm's earnings per share for 2014 is ________. (3.060 -1.800-126-600=534 EBIT)
A) $0.5335 534 * .6 =320.4 income after tax
B) $0.5125 320.4 – 18 = 302.4
C) $0.3204 302.4/1000 = .3024
D) $0.3024
18) Ratios provide a ________ measure of a company's performance and condition.
A) definitive ‫حاسم‬
B) gross ‫صافي‬
C) relative ‫نسبية‬
D) absolute ‫مطلق‬
19) Present and prospective shareholders are mainly concerned with a firm's ________.
A) risk and return
B) profitability
C) leverage
D) liquidity
20) The primary concern of creditors when assessing the strength of a firm is its ________.
A) profitability
B) leverage
C) short-term liquidity
D) share price
21) ________ analysis involves the comparison of different firms' financial ratios at the same point in time.
A) Time-series
B) Cross-sectional
C) Marginal
D) Technical
22) ________ analysis involves comparison of current to past performance and the evaluation of developing
trends.
A) Time-series
B) Cross-sectional
C) Marginal
D) Break-even
23) Which of the following is used to analyze a firm's financial performance over different years?
A) time-series analysis
B) break-even analysis
C) gap analysis
D) marginal analysis
24) Which of the following is true of benchmarking?
A) It is an analysis in which a firm's ratio values are analyzed to project the fundamental values of the assets for
upcoming years or business cycle.
B) It is an analysis in which a firm's ratio values are compared with those of a key competitor or with a group of
competitors that it wishes to emulate.
C) It is an analysis in which a firm's financial performance over time is evaluated using financial ratio analysis.
D) It is a financial statement analysis technique which combines cross-sectional and time-series analyses.

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25) Cross-sectional ratio analysis is used to ________.

A) correct expected problems in operations
B) isolate the causes of problems
C) provide conclusive evidence of the existence of a problem
D) measure relative performance of a firm with its peers ‫المنافسين‬
26) Time-series analysis is often used to ________.
A) assess developing trends
B) correct errors of judgment
C) evaluate the value of a firm or its assets
D) standardize results
28) Which of the following is a limitation of ratio analysis?
A) Financial ratios cannot reveal certain specific aspects of a firm's financial position.
B) Ratios that reveal large deviations from the norm merely indicate the possibility of a problem.
C) It is difficult to access audited financial statements for ratio analysis.
D) Ratio analysis assumes that inflation has no effect on a firm's business.
33) Which of the following groups of ratios primarily measure risk?
A) liquidity, activity, and profitability
B) liquidity, profitability, and market
C) liquidity, activity, and debt
D) activity, debt, and profitability
34) The ________ ratios are primarily used as measures of return.
A) liquidity
B) activity
C) debt
D) profitability
12) The ________ of a business firm is measured by its ability to satisfy its short-term obligations as they come
due.
A) activity
B) liquidity
C) debt
D) profitability
13) The two categories of ratios that should be utilized to assess a firm's true liquidity are the ________.
A) liquidity and market ratios
B) liquidity and profitability ratios
C) market and debt ratios
D) liquidity and activity ratios
14) The two basic measures of liquidity are ________.
A) inventory turnover and current ratio
B) current ratio and quick ratio
C) gross profit margin and ROE
D) current ratio and total asset turnover
15) A firm has a current ratio of 1; in order to improve its liquidity ratios, this firm might ________.
A) improve its collection practices by providing extended credit policy.
B) improve its collection practices and pay accounts payable, thereby decreasing current liabilities and decreasing
the current and quick ratios.
C) decrease current liabilities by utilizing more long-term debt, thereby increasing the current and quick ratios.
D) increase inventory, thereby increasing current assets and the current and quick ratios.
17) Which of the following is true of current ratio?
A) The more predictable a firm's cash flows, the higher the acceptable current ratio.
B) A higher current ratio indicates a higher return on equity.
C) The more predictable a firm's current ratio, the higher the current liabilities.
D) A higher current ratio indicates a greater degree of liquidity.

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18) Which of the following is excluded when calculating quick ratio?

A) accounts receivable
B) accounts payable
C) cash
D) inventory
19) ________ ratios are a measure of the speed with which various accounts are converted into sales or cash.
A) Activity
B) Liquidity
C) Debt
D) Profitability
20) Nico Corporation has cost of goods sold of $300,000 and inventory of $30,000, then the inventory turnover is
________ and the average age of inventory is ________.
A) 36.5; 10
B) 10; 36.5
C) 36.0; 10
D) 30; 36.0
22) If an inventory turnover is divided into 365, it becomes a measure of ________.
A) financial efficiency
B) the average age of the inventory
C) sales turnover
D) the average collection period
23) The ________ measures the activity, or liquidity, of a firm's stock of goods.
A) average collection period
B) inventory turnover ratio
C) average payment period
D) total asset turnover ratio
24) A(n) ________ is useful in evaluating credit policies.
A) average payment period
B) current ratio
C) average collection period
D) inventory turnover ratio
25) The ________ ratio may indicate poor collections procedures or a relaxed credit policy.
A) average payment period
B) inventory turnover
C) average collection period
D) quick
26) ABC Corp. extends credit terms of 45 days to its customers. Its credit collection would likely be considered
poor if its average collection period was ________.
A) 30 days
B) 36 days
C) 44 days
D) 57 days
D) total asset turnover
28) Nico Corporation has annual purchases of $300,000 and accounts payable of $30,000, then average purchases
per day are ________ and the average payment period is ________.
A) 36.5; 821.9
B) 36.0; 833.3
C) 821.9; 36.5
D) 833.3; 36.0
29) ________ are especially interested in the average payment period, since it provides them with a sense of the
bill-paying patterns of the firm.
A) Employees
B) Stockholders
C) Lenders and suppliers
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30) The ________ ratio indicates the efficiency with which a firm uses its assets to generate sales.
A) inventory turnover
B) total asset turnover
C) quick
32) A firm with a total asset turnover that is lower than industry standard but with a current ratio that meets
industry standard must have excessive ‫________افراط‬.
A) fixed assets
B) inventory
C) accounts receivable
D) debt
33) A firm with a total asset turnover lower than industry standard may have ________.
A) excessive debt
B) excessive interest costs
C) insufficient sales
D) insufficient fixed assets
8) ________ is a term used to describe the magnification of risk and return introduced through the use of fixed-
cost financing, such as preferred stock and debt.
A) Financial leverage
B) Operating leverage
C) Fixed-payment coverage
D) Benchmarking
9) ________ ratio measures the proportion of total assets financed by the firm's creditors.
A) Total asset turnover
B) Inventory turnover
C) Current
D) Debt
10) ________ ratio measures a firm's ability to pay contractual interest payments.
A) Times interest earned
B) Fixed-payment coverage
C) Debt
D) Average payment period
13) When assessing the fixed-payment coverage ratio, ________.
A) the lower its value the more risky is the firm
B) the lower its value, the higher is the firm's financial leverage
C) preferred stock dividend payments can be disregarded
D) the higher its value, lesser is its reliability to pay up the debts

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Information (2013 values)

1. Sales totaled $110,000

2. The gross profit margin was 25 percent.
3. Inventory turnover was 3.0.
4. There are 360 days in the year.
5. The average collection period was 65 days.
6. The current ratio was 2.40.
7. The total asset turnover was 1.13.
8. The debt ratio was 53.8 percent.
14) Inventory for CEE in 2013 was ________. (See Table 3.1)
A) $36,667
B) $32,448
C) $27,500
D) $ 9,167
15) Notes payable for CEE in 2013 was ________. (See Table 3.1)
A) $113,466
B) $ 52,372
C) $ 41,372
D) $ 10,609
16) Accounts receivable for CEE in 2013 was ________. (See Table 3.1)
A) $14,056
B) $19,861
C) $14,895
D) $18,333
17) Net fixed assets for CEE in 2013 were ________. (See Table 3.1)
A) $45,484
B) $48,975
C) $54,511
D) $69,341
18) Total assets for CEE in 2013 were ________. (See Table 3.1)
A) $ 45,895
B) $124,300
C) $ 58,603
D) $ 97,345
19) Long-term debt for CEE in 2013 was ________. (See Table 3.1)
A) $30,763
B) $52,372
C) $10,608
D) $41,372

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14) A firm with sales of $1,000,000, net profits after taxes of $30,000, total assets of $1,500,000, and common
stockholders' investment of $750,000 has a return on equity of ________.
A) 20 percent
B) 15 percent
C) 3 percent
D) 4 percent
15) A ________ ratio is commonly used to assess owners' appraisal ‫ تقيم المالك‬of the share value.
A) debt
B) price/earnings
C) return on equity
D) return on total assets
Answer: B

16) P/E ratio measures the ________.

A) market value of the stock to earnings per share
B) intrinsic value of the stock to earnings per share
C) book value of the stock to earnings per share

5) The ________ is used by financial managers as a structure for dissecting a firm's financial statements to assess
its financial condition.
A) statement of cash flows
B) DuPont system of analysis
C) break-even analysis
D) technical analysis
6) In the DuPont system of analysis, the return on total assets (asset) is equal to ________.
A) (return on equity) × (financial leverage multiplier)
B) (return on equity) × (total asset turnover)
C) (net profit margin) × (fixed asset turnover)
D) (net profit margin) × (total asset turnover)

7) The modified DuPont formula relates the firm's return on total assets (ROA) to its ________.
A) return on equity (ROE)
B) operating leverage multiplier
C) net profit margin
D) total asset turnover
8) In the DuPont system of analysis, the return on equity is equal to ________.
A) (net profit margin) × (total asset turnover)
B) (stockholders' equity) × (financial leverage multiplier)
C) (return on total assets) × (financial leverage multiplier)
D) (return on total assets) × (total asset turnover)

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30) In an effort to analyze Clockwork Company finances, Jim realized that he was missing the company's net
profits after taxes for the current year. Find the company's net profits after taxes using the following information.

Return on total assets = 2%

Total asset turnover = 0.5
Cost of goods sold = $105,000
Gross profit margin = 0.30
Answer:

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