Dubai Women’s College
BADM 300
Financial Management Fundamentals
Analyzing Financial Statements Ratio Analysis
Analyzing financial statements is a process of evaluating a firm's past financial performance and its future prospects. The process requires the application of common sense and judgement in addition to analytical techniques. As we already know, there are many users of a firm's financial data : Creditors, owners and management, suppliers, competitors etc. The analysis helps the above users in understanding the numbers presented in statements and serves as a basis for financial decision making. Ratio analysis is perhaps the most commonly used analytical tool in financial statement analysis. It helps to reveal the overall financial condition of a firm. For example, Investors look at ratios to evaluate a company's performance and growth. Banks and creditors look at ratios to determine how much credit/loan to grant a firm. Creditors worry when a firm does not generate enough earnings to make periodic payment of interest on outstanding debt. Managers use financial ratios to monitor operations, to make sure that their firms are using the available resources efficiently. The idea is to see whether the firm's financial and operating status is improving over time and whether its overall ratios are better or worse than the ratios of competing companies. Ratios are classified into FOUR major categories: Classification LIQUIDITY Types of ratios a) Current ratio b) Quick ratio (acid-test ratio) What is the purpose? They measure the firm's ability to meet short-term obligations/liabilities from its current assets. It measures how frequently a firm converts its current assets into cash. It also measures how well a firm uses its Fixed assets and total assets to generate sales. It measures the amount of debt financing used by the company. It also measures the firm's ability to meet interest payments. It measures the effectiveness of management in generating profits on sales, total assets and owners' equity.
ASSET UTILIZATION
a) b) c) d) e)
A/R turnover ratio Average collection period Inventory turnover ratio Fixed assets turnover ratio Total assets turnover ratio
DEBT UTILIZATION
a) Debt to Total assets ratio b) Times interest earned ratio c) Fixed charges coverage ratio
PROFITABILITY
a) Profit margin ratio b) Return on Assets c) Return on equity
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Dubai Women’s College
BADM 300
Financial Management Fundamentals
1. Liquidity ratios
1.1 Current ratio Current assets --------------Current liabilities
Current ratio =
Purpose :
It measures the firm's ability to meet its current liabilities out of Its current assets.
Implication : High current ratio A high ratio may suggest that the firm is holding too much capital in the Form of current assets 1.2 Quick ratio Low current ratio A low ratio suggests that the firm may have difficulty paying its bills
Quick ratio
Current assets -- Inventories -- Prepaid expenses = ---------------------------------------------Current liabilities
Purpose :
Also known as the acid-test ratio; it measures short-term liquidity by removing the least liquid current assets, such as inventories and prepaid Items.
Implication : High Quick ratio A high ratio suggests that the firm is in a position to meet its short term commitments out of the most liquid assets. Low Quick ratio A low ratio suggests that a large portion of current assets is in the form of less liquid assets
Task 1 :
Calculate the liquidity ratios for Falcon manufacturing company given in the appendix.
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2
Dubai Women’s College
BADM 300
Financial Management Fundamentals
2. Asset Utilization ratios OR Activity ratios OR Efficiency ratios
Asset utilization ratios ( Fixed assets turnover ratio and Total assets turnover ratio ) usually compare sales with the level of investment in assets. The purpose is to determine how well a firm utilizes its assets. Other activity ratios ( A/R turnover ratio and Inventory turnover ratio ) determines the efficiency of management in using these assets. 2.1 Accounts receivable turnover ratio
A/R turnover ratio
=
Net sales -------------Accounts receivable
Note : If information is available on Credit sales; then Net sales should be replaced by Credit sales in the numerator. Purpose : This ratio indicates how many times accounts receivable are collected during the year.
Implication : High A/R turnover ratio A high turnover ratio suggests that the firm is very efficient in collecting its receivables. It could also mean that the firm may be giving a very short credit period to its customers Low A/R turnover ratio A low turnover ratio may suggest that the company is too lenient in its credit policy or is not quite effective in collecting its receivables
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Dubai Women’s College 2.2 Average Collection period
BADM 300
Financial Management Fundamentals
Average collection period
Accounts receivable = ---------------------Average daily credit sales
OR
Accounts receivable = -----------------Net sales
Average collection period
X 365 days
Purpose :
The measure indicates how many days a firm takes to convert its receivables into cash. This ratio is used to evaluate credit and collection policies of the firm. This measure should always be compared with the credit terms of the company.
Implication : Long collection period If the collection period considerably exceeds the credit period, it means the firm is not effective in collecting its receivables. A long collection period reduces the liquidity of the receivables and affects the firm's ability to meet short-term maturing commitments Short collection period A short collection period may suggest that the firm is too restrictive in its credit policy. That is, it does not offer sufficient credit and hence may be losing out on sales
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Dubai Women’s College 2.3 Inventory turnover ratio
BADM 300
Financial Management Fundamentals
Inventory turnover ratio
=
Sales ----------Inventory
Purpose :
It measures the efficiency of the firm in terms of managing and selling inventory.
(The type of industry would also play a part in assessing this ratio. For instance, a grocery store would have a higher inventory turnover than a firm selling furniture.)
Implication : High inventory turnover ratio A high inventory turnover generally indicates good buying practices. It also means that the firm is selling items quickly implying improved liquidity and profitability because less money is tied up in inventory. On the other hand, it might also suggest that the firm may not be keeping sufficient inventory on hand and thereby losing out on sales. Low inventory turnover ratio A low inventory turnover may suggest that the firm is carrying excess inventory or obsolete inventory. It could also suggest that the firm is piling up inventory because of higher anticipated sales in the near future.
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Dubai Women’s College 2.4 Fixed assets turnover ratio
BADM 300
Financial Management Fundamentals
Fixed assets turnover ratio
=
Net Sales ----------------Net Fixed Assets
Purpose : Implication :
It indicates management's efficiency in managing fixed assets.
High Fixed assets turnover ratio A high turnover ratio suggests that fixed assets are being used productively.
Low Fixed assets turnover ratio A low turnover ratio may suggest too much of investment in fixed assets, low sales or a combination of both. Analysts must further investigate and ask questions such as : a) How old are the assets? b) Is the machinery & equipment obsolete?
2.5
Total Assets turnover ratio Net Sales ----------Total assets
Total assets turnover ratio
=
Purpose :
It measures how well total assets are used in generating sales. It is a composite measure of all other asset utilization ratios.
Implication : High Total assets turnover ratio A high ratio suggests greater efficiency in using its assets to generate sales. Low Total assets turnover ratio A low ratio suggests less efficiency in using its assets to generate sales.
Task 2 :
Calculate the asset utilization ratios for Falcon manufacturing company given in the appendix.
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Dubai Women’s College
BADM 300
Financial Management Fundamentals
3. Debt Utilization Ratios
These are also known as solvency ratios or leverage ratios. The ratios in this category show the extent to which a firm uses debt (borrowings) to finance its investments and its ability to meet interest charges and other fixed payments. 3.1 Debt to Total Assets ratio Total liabilities = -------------Total Assets
Debt to total assets ratio
Purpose :
It measures the percentage of assets that have been financed by debt (borrowings). Financial leverage is the extent to which a firm uses debt financing. As the percentage of debt financing increases, the firm becomes highly leveraged. The amount of financial leverage implies risk to creditors and owners.
Implication : High Debt to total assets ratio A high debt to total assets ratio implies more of the firm's assets are financed by debt relative to owners' funds. A high ratio requires the commitment of more funds to pay interest and repay principal amount. The failure to meet these requirements may force a company to bankruptcy. A highly leveraged firm may also find it difficult to attract additional debt financing. Positive aspects of high leverage Although leverage implies risk, it also provides the common shareholders with the opportunity to enhance their return. Shareholders also maintain control because using debt avoids the sale of new shares. Low Debt to assets ratio A low debt to total assets ratio implies that the firm is using more of owners capital and retained earnings to finance its assets. It implies less risk to creditors. Company can borrow additional funds with relative ease.
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Dubai Women’s College 3.2 Times Interest Earned ratio
BADM 300
Financial Management Fundamentals
Earnings before interest and taxes (EBIT) Times interest earned ratio = -----------------------------------Interest expense
Purpose :
The purpose is to measure the firm's ability to meet interest payments out of its operating profit.
Implication : High Times interest earned A high ratio suggests that the firm is quite safe in meeting its interest payments. In other words, earnings could fall slightly without jeopardizing the firms ability to meet interest payments. Low Times interest earned ratio A low ratio suggests more risk to creditors because they may not get the interest that is due to them. Therefore the firm may face difficulty in borrowing additional funds.
3.3
Fixed charges coverage ratio
Fixed charges coverage ratio
EBIT + Lease payments = -----------------------------Interest expense + lease payments
Purpose :
A lease is a contract between the owner of an asset called the lessor, and the another party called the lessee, who makes periodic payments to the owner for the right to use the asset.
Implication : High Ratio A high ratio implies that the firm has a bigger cushion in case of worsening financial position. It means less risk to creditors. Low Ratio A low ratio suggests that the creditors are more at risk. If earnings decline, the company may not be able to meet its obligations.
It is a broad measure of the firm's ability to meet all fixed charges and interest payments.
Task 3 :
Calculate the debt utilization ratios for Falcon manufacturing company given in the appendix.
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Dubai Women’s College
BADM 300
Financial Management Fundamentals
4.
Profitability Ratios
These ratios measure the earning power of the firm. They are used to evaluate the overall management effectiveness. Specifically, they indicate how effectively a firm's management generates profits on sales, total assets and equity.
4.1
Profit Margin Ratio (Net Profit Margin)
Profit Margin Ratio =
Net Income --------------Sales
Purpose :
It measures the percentage of each sales dollar remaining after deducting all expenses.
Implication : High Ratio A high ratio suggests that expenses as a percentage of sales are under control indicating operational efficiency. It could also suggest that price realization is very good or a combination of both the factors mentioned above. Low Ratio A low ratio may suggest that expenses as a percentage of sales are high or the firm is losing out on sales.
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Dubai Women’s College
BADM 300
Financial Management Fundamentals
4.2
Return on Assets Net Income --------------Total Assets
Return on Assets
=
Return on Assets
= =
Profit Margin Ratio Net income ---------Net sales
X
Total Asset turnover Net Sales --------Total Assets
X
Purpose :
This ratio measures the overall effectiveness of management in generating profits from its total investment.
Implication : High Ratio A high ratio is favorable. It implies that net income as a percentage of total sales is good (Profit margin ratio) or the firm is able to generate a high level of sales given its investment in assets (Total assets turnover) or a combination of both. Low Ratio A low ratio is unfavorable. Further analysis needs to be done to ascertain the reasons. Is it due to lower profit margin or is it due to low asset turnover?
4.3
Return on Equity (ROE) Net Income -----------------Shareholders' equity
Return on Equity
=
OR
Return on Equity =
Profit margin X Total assets ratio turnover
Net income Net Sales ----------- X ---------Net sales Total assets
X Financial
leverage
=
Total assets X ----------Sh. Equity
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Dubai Women’s College
BADM 300
Financial Management Fundamentals
Purpose :
It measures the rate of return realized by a firm's shareholders on their investment and is the indicator of management performance.
Implication : High Ratio A high ratio is generally associated with effective management performance. Further analysis might indicate the reasons of a higher ROE. How ever, a higher ROE may also suggest that a firm is more risky due to higher leverage. Low Ratio A low ratio suggests ineffective management performance. Further analysis must be done to find the reasons. Is it due to Profit margin, or is it due to lower asset turnover? A low ROE may also suggest that the firm is more conservatively financed (lower leverage).
Task 4 :
Calculate the profitability ratios for Falcon manufacturing company given in the appendix.
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11
Dubai Women’s College
BADM 300
Financial Management Fundamentals
The following information has been extracted from the accounts of Falcon Manufacturing company. Falcon Manufacturing Company Income Statement for the years ended Dec 31, 1997 & 1998 (all figures in '000 AED) 1997 1998 Sales (all credit) 7,650 11,500 Less : Cost of sales 5,800 9,430 Gross profit 1,850 2,070 Less : Operating expenses 100 120 Lease payments 50 150 50 170 Operating income (EBIT) 1,700 1,900 Less : Interest expense 50 350 Earnings before Tax 1,650 1,550 Less : Taxes 600 550 Earnings after Tax 1,050 1,000 Dividends paid(common shares) 300 300 Transferred to Retained Earnings 750 700 Falcon Manufacturing Company Balance Sheet as at Dec 31, 1997 & 1998 Current Assets Cash Accounts receivable Inventory Total Current Assets Net Fixed Assets Total Assets Current Liabilities Accounts payable Tax payable Total Current liabilities Long-term debt Total Liabilities Shareholders' Equity Common shares, AED 10 par Retained Earnings Total Shareholders' equity Total liabilities & Sharholders' equity 900 1,200 1,500 3,600 10,050 13,650 50 3,800 2,450 6,300 11,350 17,650
1,800 600 2,400 350 2,750
2,150 550 2,700 3,350 6,050
5,900 5,000 10,900 13,650
5,900 5,700 11,600 17,650
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Dubai Women’s College
BADM 300
Financial Management Fundamentals
RATIOS LIQUIDITY Current ratio
Falcon Manufacturing Company-RATIOS 1997 1998
COMMENTS
Quick ratio (acid-test ratio) UTILIZATION A/R turnover ratio Average collection period
Inventory turnover ratio Fixed assets turnover ratio Total assets turnover ratio DEBT RATIOS Debt to Total assets ratio Times interest earned ratio Fixed charges coverage ratio PROFITABILITY Profit margin ratio Return on Assets
Return on equity
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