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Using Financial Ratios

Interested Parties
• Ratio analysis involves methods of calculating

and interpreting financial ratios to assess a

firm’s financial condition and performance.

• It is of interest to shareholders, creditors, and

the firm’s own management, investment

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analysts.
 Using Financial Ratios
Types of Ratio Comparisons

• Trend or time-series analysis

Used to evaluate a firm’s performance

over time

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 Using Financial Ratios
Types of Ratio Comparisons

• Trend or time-series analysis

• cross-sectional analysis

Used to compare different firms at the same

point in time

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 Using Financial Ratios
Types of Ratio Comparisons

• Trend or time-series analysis

• cross-sectional analysis
– industry comparative analysis

One specific type of cross sectional analysis. Used to

compare one firm’s financial performance to the
industry’s average performance
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 Using Financial Ratios
Types of Ratio Comparisons

• Trend or time-series analysis

• cross-sectional analysis
– industry comparative analysis

• Combined Analysis
Combined analysis simply uses a combination of both
time series analysis and cross-sectional analysis
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 Using Financial Ratios
Cautions for Doing Ratio Analysis
• Ratios must be considered together; a single ratio by itself
means relatively little.
• Financial statements that are being compared should be
dated at the same point in time.
• Use audited financial statements when possible.
• The financial data being compared should have been
developed in the same way.
• Be wary of inflation distortions. 7
 We Need to Know …..

How Liquid is the firm in terms of its

ability:
1. to meet the liability from current
assets .
2. convert its current assets into cash

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How Liquid is the firm in terms of its:
1. ability to meet the liability from
current assets

Current Ratio:
Current Assets
Current Liabilities
It indicates a firm’s liquidity, as
measured by its liquid assets (CA)
relative to its liquid debt (CL) 9
Acid-Test Ratio:
Current Assets – Inventories
Current Liabilities
It indicates a firm’s liquidity, as
measured by its liquid assets (CA)
excluding inventories, relative to
its liquid debt (CL)

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How Liquid is the firm
in terms of its:
2. convert its current
assets into cash (Assets
Utilization)
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 Accounts Receivable:
Average Collection Period:
It indicates how rapidly a firm is
collecting its credit, as measured by
the average number of days it takes
to collect its accounts receivable.

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 Or Accounts Receivable
Turnover Ratio =
Credit Sales / Accounts
Receivable = X
ِAverage Collection Period =
360 / X 13
 Inventories:
Inventories Turnover Ratio =
Cost of Goods Sold /
Average Inventories = Y
ِAverage Inventories
Holding Period = 360 / Y
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 Raw Materials in Days
Raw Material Consumption

WIP in Days Cost of Production

FGI in Days Cost of |Goods Sold

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 Accounts Payable in Days Credit Purchase:

Total Credit Purchase / Accounts

Payable = Z
360 / Z

How can you decide on the number of

days credit from supplier?

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 Assets Utilization

How effectively does a company utilize its

assets in generating sales?

Are the levels of debtors and inventories

relative to sales reasonable, given the firm’s
competitive and operating characteristics?

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 Liquidity Analysis

What is the level of current assets

relative to current liabilities? Is
reasonable given the nature of the
company’s business?

What is the mix of current assets ? Is

the proportion of slow moving
inventories high?
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How promptly does the company
pay its creditors ?

How far can it stretch payment to

creditors without jeopardising its
relations with them ?

How efficiently and frequently does

the company convert its current into
cash ? 19
 Is Management Generating
Adequate Operating Profits on
the Firm’s Assets?

Fixed Assets Turnover Ratio :

Sales / Net Fixed Assets

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 Operating Income Return on
Investment (OIROI) =
Operating Income (EBIT) / Total
Assets
OIROI= Operating Profit Margin *
Total Assets Turnover Ratio
= (Operating Income / Sales)
* (Sales / Total Assets)
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Operating Profit Margin =
Total Sales – COGS – General Administration
Expenses – Marketing Expenses / Sales

Factors affecting OPM are:

Number of units sold, average selling
price per unit, manufacturing cost,
general administrative expenses and
selling and distribution expenses.

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 Is the improvement in fixed assets turnover
due to :
depreciated book-value of fixed
assets ?
Sale of some fixed assets ?
Is the profitability (RONA) of the company
high / low / average ? Is it due to :
profit margin
asset utilization
window dressing
change in accounting policy
inflationary condition ?
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How is the Firm Financing its Assets?
Total Debt Indicates Financial Risk
Debt Ratio: Total Assets

Operating Income
Times Interest Earned:
Interest Expense
Indicates firm’s ability to meet interest expense
from operating income
Interest Coverage, Cash Coverage, Lease
Rentals 24
Given the company’s riskiness and future
financial needs, how soundly is it financed ?

 What is the mix of debt and equity ?

 What is the maturity structure of debt?

Is the company faced with large debt
repayments in the near future?

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Does the company generate
enough profit and cash flows to
service its debt adequately ?

Is the company close to its

borrowing limits of restrictive
convenants ?

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 Are Owners Receiving an Adequate
Return on their Investment?
Net Profits After Taxes
ROE =
Stockholders Equity (Net Worth)
Earnings Available to Common Stockholders
EPS =
Number of Shares Outstanding

Market Price Per Share of Common Stock

PE Ratio =
Earnings Per Share

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Is the return on equity (ROE) high / low /
average ? Is it due to :
return on investment
financial mix
capitalization of reserves

What is the trend in profitability ? Is it

improving because of better utilization of
resources or reduction of expenses of
strategic importance ? What is the impact of
cyclical factors on profitability trend ?
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 DuPont System of Analysis
• The DuPont system is used to dissect the firm’s financial
statements and to assess its financial condition.
• It merges the income statement and balance sheet into two
summary measures of profitability: ROA and ROE
• The top portion focuses on the income statement, and the
bottom focuses on the balance sheet.
• The advantage of the DuPont system is that it allows you to
break ROE into a profit on sales component, an efficiency-
of-asset-use component, and a use-of- leverage component.

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Ratios from Different Perspectives
MANAGEMENT OWNERS LENDERS
Operational analysis Profitability Liquidity
Gross Margin Return on total Current Ratio
Profit Margin net worth Acid test
Operating expense Return on
analysis Common equity Cash flow pattern
Contribution analysis Earnings per share
Operating leverage Cash flow per share
Total shareholder return
Shareholder value analysis

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Resource Disposition of Financial
Management Earnings Leverage
Asset turnover Dividends per share Debt to assets
Working Capital mgmt. Dividend yield Debt to
Inventory turnover Payout / retention capitalization
Accounts receivable Dividend coverage Debt to equity
patters
Accounts payable
pattern
Human resource
effectiveness

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Profitability Market indicators Debt service
Return on assets P/E Ratio Interest coverage
(post tax)
Return Before Interest Market to book Interest & Capital
& Taxes Value Coverage
Return on current Relative Price Cash Flow
value basis Movements Analysis
Cash flow multiples

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 Strategic Analysis
A number of other questions go beyond the scope of
ratio analysis. They need to be answered while
addressing the financial health of the company. These
questions are :

What are the goals and strategies of the company ?

How successfully has the company pursued its goals

and strategies ? Is change in them warranted ?

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Are the company’s goals, strategies,
product-market choices, investment
requirements, financing needs, and
financing capabilities in balance ?

What would happen to the above referred

balance if the company will have to face
an adversity ?

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If the company is struck by adversity :
What kinds of competitive, operating and
environmental risks would occur ?
How would management respond in
strategic and operating terms?
What kinds of financial pressures would be
faced ?
Would it be able to raise necessary funds on
acceptable terms ?
 Would the company be able to use its
resources ? In what sequence would these
resources be used ?
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 Limitations of Ratio Analysis
Sometimes it is difficult to identify the company into
a particular industry because of diversifications.

Industry average may be an approximation not precise.

Different accounting practices followed by different

companies
Different financial year – ending 31st December or
31st March
Financial variables derived from balance sheet can
be manipulated
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