F P A C Certification

1 Liquidity Ratios

Chapter 4
2 Leverage Ratios

3 Activity Ratios

Ratio 4 Profitability Ratios

Analysis 5 Market Ratios

A. Introduction
6 Limitations and uses of Ratios

Common size and percentage change

7 financial statements
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Introduction
 F P A C Certification

Primary Uses of Financial Ratios

Basic Calculations for management purposes

• Financial Reporting
Comparisons and Benchmarking
• Trend analysis / time series
• Cross - sectional
Financial Planning & Forecasting
• Basic optimization
Limitations on comparisons across firms: need consistent accounting policies / procedures

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Types of Ratios

Ability to generate
Ability to meet short-term future revenues and
debt obligations, while Liquidity meet long-term
still funding current (Working Leverage obligations (DFL, DOL)
operations
Capital) Market

Ability to generate Ability to generate

earnings compared to Efficiency in turning
expenses, & financial
Activity assets into sales /
positive market

rewards sufficient to
Profitability (Efficiency) cash
expectations / how
org. is valued by
retain financing investors

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Types of Ratios
Type of Ratio What Is Measured
Liquidity An organization’s ability to pay off its short-term debt obligations while still
funding ongoing operations
(Working Capital)

The types of force multipliers (i.e., financial and operational) an organization

Leverage uses to increase its value and the extent to which it relies on them

Activity
How efficiently an organization is able to turn its assets into sales or cash
(Efficiency)

An organization’s ability to generate earnings as compared to its expenses and

Profitability other costs over a specified time-period.

Market Value How an organization is valued by investors

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Elements of Analysis

x X
x x
x x X VS. X x

Combined Benchmarked Contextualized Interpreted

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Liquidity Ratios
 F P A C Certification

Liquidity Ratios: Current Ratio

Current assets may include: Current liabilities may include:

• Cash • Accounts payable

• Marketable securities • Short-term notes payable
• Accounts receivable • Currently-maturing long-
term debt
• Inventories
• Accrued taxes and other
expenses
Current Assets
Current Ratio = Current Liabilities

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Liquidity Ratios
Objective: ability to pay off ST obligations. Focus is on working Capital. The greater the fluctuations in
a firm’s demand and revenue streams—the more volatile the business — the more important liquidity
measures become.

• Current Ratio (CA / CL)

• Cash • Accounts payable

• Marketable securities • Short-term notes payable
• Accounts receivable • Currently-maturing long-term
debt
• Inventories
• Accrued taxes and other
expenses
Excel File for calculations

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Liquidity Ratios

• Quick Ratio
𝐜𝐮𝐫𝐫𝐞𝐧𝐭 𝐚𝐬𝐬𝐞𝐭𝐬 − 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐢𝐞𝐬 − 𝐨𝐭𝐡𝐞𝐫 𝐜𝐮𝐫𝐫𝐞𝐧𝐭 𝐚𝐬𝐬𝐞𝐭𝐬 𝐜𝐚𝐬𝐡 + 𝐜𝐚𝐬𝐡 𝐞𝐪𝐮𝐢𝐯𝐚𝐥𝐞𝐧𝐭𝐬 +
𝐜𝐮𝐫𝐫𝐞𝐧𝐭 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬 𝐬𝐡𝐨𝐫𝐭 𝐭𝐞𝐫𝐦 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭𝐬 + 𝐚𝐜𝐜𝐨𝐮𝐧𝐭𝐬 𝐫𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞
𝐜𝐮𝐫𝐫𝐞𝐧𝐭 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬

• Cash Ratio

𝐜𝐚𝐬𝐡 + 𝐜𝐚𝐬𝐡 𝐞𝐪𝐮𝐢𝐯𝐚𝐥𝐞𝐧𝐭𝐬 +

𝐦𝐚𝐫𝐤𝐞𝐭𝐚𝐛𝐥𝐞 𝐬𝐞𝐜𝐮𝐫𝐢𝐭𝐢𝐞𝐬
𝐜𝐮𝐫𝐫𝐞𝐧𝐭 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬

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Leverage Ratios
 F P A C Certification

Leverage Ratios
Objective: assesses company’s ability to meet LT financial obligations. Firm’s use of natural debt to finance our
assets.

Operational leverage Financial leverage

This is the extent to which an This is the extent to which an
organization’s operations involve organization uses debt rather than
fixed rather than variable costs. (The equity to finance its asset or how
more capital-intensive an much debt the company has in
organization is, the greater the relation to its assets and/or to its
proportion of fixed costs and the shareholders’ equity.
more highly leveraged the company
is) .

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Leverage Ratios

• Debt to Total • Long-term Debt

Assets Ratio to Equity Ratio

Total Debt Long-Term Debt

Total Assets Shareholder’s Equity

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Leverage Ratios
Debt levels:
• Debt to total assets ratio
• Total debt to equity ratio and long-term debt to equity ratio

• Coverage ratios

𝑬𝑩𝑰𝑻
Cash coverage=
Interest coverage= 𝑬𝑩𝑰𝑻 + 𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 𝒆𝒙𝒑𝒆𝒏𝒔𝒆
𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒆𝒙𝒑𝒆𝒏𝒔𝒆
𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒆𝒙𝒑𝒆𝒏𝒔𝒆

Degree of Operating leverage https://afp.mycrowdwisdom.com/diweb/catalog/launch/scorm/eid/2552512 from 16:30min

Degree of Financial Leverage

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Leverage Ratios: Coverage Ratios

• Interest Coverage • Cash Coverage

EBIT EBIT + Depreciation

Interest Expense Interest Expense

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Leverage Ratios

• Degree of operating • Degree of financial

leverage ratio leverage ratio

% 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐏𝐒
% 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐁𝐈𝐓 % 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐁𝐈𝐓
% 𝐜𝐡𝐚𝐧𝐠𝐞𝐢𝐧 𝐬𝐚𝐥𝐞𝐬
OR

% 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐍𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞

% 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐁𝐈𝐓

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Leverage Ratios: Degree of Total Leverage

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Leverage Ratios
Objective: assesses company’s ability to meet LT financial obligations

• Financial Leverage: the extent to which debt is used vs. Equity to finance assets
• Operational Leverage: the degree to which an org. operations involves Fixed vs Variable Costs. The
more capital-intensive an organization is, the greater the proportion of fixed costs and the more
highly leveraged the company is.

- Debt / Equity Ratio

- Degree of Operating leverage
- Degree of Financial Leverage
- Interest Coverage

Excel File for calculations

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Discussion Question
What is defined as “The extent to which an organization
uses debt rather than equity to finance its assets, or how
much debt the company has in relation to its assets and/or
to its shareholders’ equity”?
A. Operational Leverage
B. Debt to Equity
C. Financial Leverage
D. High Operating Leverage

Answer:
C: Financial Leverage

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Activity/Efficiency
Ratios
 F P A C Certification

Activity Ratios

• Average Accounts • Days’ Sales Outstanding

Receivable Turnover (Average Accounts Receivable
Days)

Net Credit Sales Average Accounts Receivable

Average Accounts Receivable Net Credit Sales
x Number of Days in the Period

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Activity Ratios

• Average Inventory • Days’ Inventory Outstanding

Turnover (Inventory Days)

COGS
Average Inventory
Average Inventory
COGS*
x Number of Days in the Period
* or Cost of Sales

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Activity Ratios

• Average A/P Turnover • Days Payable Outstanding

Total Supplier Purchases (Accounts Payable Days)
Average Accounts Payable
OR Average Accounts Payable
COGS COGS*
Average Accounts Payable x Number of Days in the Period
OR
* or Cost of Sales
Period Purchases
Accounts Payable @ Ending Balance

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Activity Ratios

• Average Asset • Average Fixed Asset

Turnover Turnover

Revenue
Revenue
Average Fixed Assets
Average Total Assets
OR

Revenue
Average Net PP&E

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Activity Ratios

• Average Working
Capital Turnover

Revenue
Average Current Assets – Average Current Liabilities

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Activity/Efficiency Ratios
Objective: measure how efficiently an organization is able to use its assets to generate revenue. The
thinking behind activity ratios is that every $ invested in an asset is a $ not used elsewhere. The more
quickly assets can be converted to sales or cash, the better.

- DSO / DIO / DPO DIO = (Av inv / COGS) x 365

- Cash Conversion Cycle DSO = (Av AR / Rev) x 365
- AR / AP / Inventory / Asset Turnover DPO = (Av. AP / COGS) x 365

To help memorize the ratios: any ratio with “Turnover”, means revenues are scaled by the account item
listed excel Inventory / Payables Turnover, they use COGS not revenues.

Excel File for calculations

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Activity/Efficiency Ratios (Also covered in chapter 2)

• Cash conversion cycle

DIO + DSO - DPO

The shorter the better,
resulting in improved
liquidity

Where: DIO = (Av inv / COGS) x 365

DIO = Day’ inventory outstanding DSO = (Av AR / Rev) x 365
DSO = Days’ sales outstanding
DPO = (Av. AP / COGS) x 365
DPO = Days’ payables outstanding

Excel File for calculations

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Profitability Ratios
 F P A C Certification

Profitability Ratios
• Gross Margin

Revenue – COGS
Revenue

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Profitability Ratios

• EBITDA Margin • EBIT Margin

EBITDA EBIT
Revenue Revenue

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Profitability Ratios

• Pretax Profit Margin • Profit Margin

Income Before Tax Net Income

Revenue Revenue
OR

Revenue – Total Costs

Revenue

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Profitability Ratios

• ROA • ROE

Net Income Net Income

Average Total Assets Average Shareholders’ Equity

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Profitability Margins

Measures How effectively

sales is turned into profit.
All (ANY MARGIN RATIO)
are divided by REVENUE

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Profitability Ratios
Objective: they are the bottom line measures. They assess a Company’s ability to generate more
earnings than the costs and expenses it incurs over a set period of time.

Types of Profitability Ratios:

- Margin Ratios: How effectively sales is turned into profit. (GM, EBITDA margin, Net profit
margin)
- Return Ratios: Company’s ability to provide return for investors (ROA, ROE, FCF)

- DUPONT ANALYSIS: deconstructs the ROE value to reveal its sources, providing information about the
organization’s ability to balance operating efficiency, asset efficiency and financial leverage.

Excel File for

calculations
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DuPont Analysis

GOAL Operating Efficiency Asset Efficiency Financial Leverage

Average Total Assets

METRIC Profit Margin Average Equity Multiplier
Turnover
Net Income × Revenue × Average Total Assets
EQUATION Revenue Average Total Assets Average Equity

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Profitability Ratios

• ROI • ROCE

Gains from Investment – Cost of Investment EBIT

Cost of Investment Total Assets – Current Liabilities

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Earnings per Share (EPS)

• Basic EPS • Diluted EPS

Net Income – Preferred Dividends (Net Income – Preferred Dividends) +

Weighted Average Outstanding Shares (Conv. Preferred Dividends + After-Tax Interest)

Weighted Average Outstanding Shares
+ Diluted Shares

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Economic Profit

W eighed
A verage EVA =
NOPAT –
(Average Capital Employed x WACC)
C ost of
C apital

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Free Cash Flow (FCF)

• Free Cash Flow • Free Cash Flow

(FCF) to Equity (FCFE)

Cash Flow from Operating Activities + Net Income – Change in Net CapEx –

(Interest Expense x (1 – Tax Rate)) – CapEx Change in Net Working Capital +

Change in Total Debt

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Free Cash Flow Uses

1. Dividends

2. Acquisitions or investments

3. Share Repurchases

4. Net debt reduction

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Market Ratios
 F P A C Certification

Market Ratios
Objective: Market ratios compare the current stock price of the company to various balance sheet,
income statement and CF items. Whereas many of the ratios discussed so far look at the organization
from management’s perspective, market value ratios view it with an investor’s eye.

Ratios:
- Dividend Yield
- Earnings Yield
- PE ratio
- Price to Book Ratio

Excel File for calculations

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 F P A C Certification

Market Ratios

• Dividend Yield

Annual Dividends per Share

Stock Price Per Share

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Market Ratios

• Earnings Yield • Price to Earnings

EPS Stock Price Per Share

Stock Price Per Share EPS

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Market Ratios

• Price to Book
Stock Price Per Share
Book Value Per Share

Where:

Book Value Per Share = Total Assets – (Intangible Assets + Liabilities)

Number of Common Shares Outstanding
or
Book Value Per Share = Shareholders’ Equity
Number of Common Shares Outstanding

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Market Ratios

• Price to Sales

Stock Price Per Share

Revenue Per Share

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Market Ratios

• Price to Cash Flow

Stock Price Per Share
Operating Cash Flow Per Share

Where:

Operating Cash Flow Per Share =

Net Cash from Operating Activities

Weighted Avg. Number of Common Shares Outstanding

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Market Ratios
• Price to EBITDA • EBITDA Multiple

Stock Price Per Share Enterprise Value (EV)

EBITDA Per Share EBITDA

Where:

EV = Market Value of Equity + Market Value of Debt

or

EV = Market Value of Equity + Debt + Preferred

Stock + Minority Interest – Cash

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Discussion Question

What is the formula for the Market Value

Ratio “Price to Earnings?”

Answer:
Stock Price Per Share
Price to Earnings =
EPS

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Using Ratios in Forecasting

• Provide INPUT values.

Predict
• Define historical trends to extrapolate forward.

• Define constraints on INPUT values.

Restrict
• May be imposed by debt covenants or strategic decisions.

• Provide reality check on OUTPUT results.

Validate
• Are they in line with past performance or expectations?

• Provide OUTPUT values/trends for benchmarking against industry, peer

Evaluate or past performances.
• Help to draw conclusions, make recommendations.

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Using Ratios at the Input Stage

To predict To restrict

Ratios can help define and

refine historical trends Ratios can also define constraints for
forecast values

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Debt Covenants
• Maximum allowable debt ratio
• Minimum liquidity ratios
• Minimum coverage ratios
• Conditions to be met before dividends are paid
• Limitations on increased debt / types of debt
• Operating restrictions

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Using Ratios at the Output Stage

To validate To evaluate

Ratio analysis can provide Ratio analysis can perform its classic function when
a first-line validation test of projection values. applied to validated projection results

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Discussion Question
What input values are used for ratio
analysis roles?
Choose all that apply:
• Predict
• Restrict
• Analyze
• Validate
• Evaluate
• Limit

Answer:
Predict and Restrict

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Limitations and uses of
Ratios
 F P A C Certification

Limitations of Ratios
Company A Company B

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Limitations of Ratios
• External Forces (Seasonality, inflation)

• Differences in accounting practices (inventory methods,

depreciation methods)

• When using ratios in forecasting, you should define historical

trends, restrict or define constraints on input values, validate
output.

• Debt covenants restrictions (set of ratios that must not be

exceeded):
• Debt to equity ratio
• Minimum liquidity ratios
• Interest coverage ratio

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Common Size Financial
Statements
 F P A C Certification

Common Size Financial Statements

• Common-size financial statements compare every item in a statement to a single base value.
• In a common-size income statement, all income statement values are displayed as a % of sales
• In a common-size balance sheet, all balance sheet values are displayed as a % of total assets.

The smaller LittleInc. is actually (at least insofar as

gross profit) is the more profitable firm, in as much
as it has better control of its cost of sales.

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Remember

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Conclusion

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Thank
you Approved Learning Partner in Egypt and Middle East