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# Ratio Analysis F F M

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• If a firm has too many assets its cost of capital will be too high, hence its profits will be depressed. On the other hand if the assets are too low profitable sales will be lost.
• ### Ratio Analysis F F M

1. 1. FINANCE FOR MANAGERS COURSE LECTURER Shumaila Paracha Assistant Professor Course Code: 0387 MBA Program Academic Year Fall 2010
2. 2. Today Ratio Analysis Types of ratios
3. 3. Ratio Analysis • Financial ratios are just a convenient way to summarize large quantities of financial data & to compare firms performance. • Financial statement analysis from:  Investors view point: about predicting the future  Managements view point: to anticipate future conditions and to get a starting point for planning actions that will improve firms future performance.
4. 4. Ratio Analysis • Ratio analysis helps you conduct comparison among companies within same industry and across different industries. • Example: • Q.)Which company is stronger? A.) Need to do ratio analysis • (compare its debt to asset ratio and compare its interest coverage ratio) Company Debt Interest charges ABC Rs. 5,000,000 Rs.500,000 XYZ Rs. 50,000,000 Rs. 5,000,000
5. 5. Types of Ratios Liquidity Ratios: show the relationship of a firms cash and other current assets to its current liabilities. Asset Management Ratios: a set of ratios that measure how effectively a firm is managing its assets. Debt Management Ratios: show how heavily company is in debt.
6. 6. Types of Ratios Profitability Ratios: a group of ratios that show the combined effects of liquidity, asset management, and debt on operating results (assess a business's ability to generate earnings as compared to its expenses ). Market Value Ratios: a set of ratios that relate the firms stock price to its earnings, cash flows and book value per share (show how the firm is valued by investors)
7. 7. LIQUIDITY RATIO 1. Current ratio = current assets / current liabilities 2. Quick ratio = (cash + marketable securities + receivables) / current liabilities 3. Cash ratio = (cash + marketable securities ) / current liabilities
8. 8. ASSET MANAGEMENT RATIO • These ratios are designed to answer the question: • Q.)Does the total amount of asset on the balance sheet seems reasonably too high or too low in view of current and projected sales level?
9. 9. ASSET MANAGEMENT RATIO • If a firm has too many assets its cost of capital will be too high, hence its profits will be depressed. On the other hand if the assets are too low profitable sales will be lost.
10. 10. ASSET MANAGEMENT RATIO 1. Inventory turnover ratio = sales / inventories 2. Days sales outstanding (DSO) = receivables / (annual sales/365) 3. Fixed asset turnover ratio = sales / net fixed assets 4. Total assets turnover = sales / total assets
11. 11. DEBT MANAGEMENT RATIOS • The extent to which a firm uses debt financing or financial leverage has three important implication: 1. By raising funds through debt SH can maintain control of a firm while limiting their investments 2. Creditors look to the equity as it provides margin of safety to them 3. If a firm earns more on investments financed with borrowed funds than it pays in interest, the return on the owners capital is magnified or leveraged
12. 12. DEBT MANAGEMENT RATIOS The leveraging effect results in: o Since the interest is deductible, the use of debt lowers the tax bill and leaves more of the firms operating income available to its investors o If operating income as a % of assets exceeds the interest rate on debt, as it generally does, then a company can use debt to acquire assets, pay the interest on the debt and have something left over as a bonus for its stock holders
13. 13. FIRM U (UNLEVERAGED) Balance Sheet Income Statement Currentassets 50 Debt 0 Fixedassets 50 Equity 100 Totalassets 100 TotalL+E 100 Expected Bad Sales 100.0 82.5 OperatingCost 70.0 80.0 Operatingincome(EBIT) 30.0 2.5 Interest 0.0 0.0 EBT 30.0 2.5 Taxes(40%) 12.0 1.0 NetIncome 18.0 1.5 ROE(U)=NI/Equity 18% 1.50%
14. 14. FIRM L (LEVERAGED) Balance Sheet Income Statement Currentassets 50 Debt 50 Fixedassets 50 Equity 50 Totalassets 100 TotalL+E 100 Expected Bad Sales 100.0 82.5 OperatingCost 70.0 80.0 Operatingincome(EBIT) 30.0 2.5 Interest(15%) 7.5 7.5 EBT 22.5 -5.0 Taxes(40%) 9.0 -2.0 NetIncome 13.5 -3.0 ROE(U)=NI/Equity 27% -6%
15. 15. DEBT MANAGEMENT RATIOS • Thus a debt can leverage up the ROE , if the conditions are as expected. • In worst or bad condition the leveraged firms ROE falls sharply and losses occur. • Under bad condition Firm U is profitable whereas Firm L has negative profits, its b/c firm L needs cash to service its debt charges. • Under this situation Firm L cash would be depleted and firm need to raise additional funds b/c its in loss. Due to loss its hard to sell stock to raise capital and also losses could cause lenders to raise the interest rate, increasing L’s problem still further
16. 16. DEBT MANAGEMENT RATIOS • Firms with relatively high debt ratios have higher expected returns when economy is normal, but they are exposed to risk of loss when the economy goes into recession • Therefore the decisions about the use of debt require firms to balance higher expected returns against increased risk. • Determining the optimal amount of debt is a complicated process
17. 17. DEBT MANAGEMENT RATIOS 1. Debt ratio = Total debt / Total Asset 2. Times interest earned = EBIT / Interest charges 3. EBITDA coverage ratio = (EBITDA+lease payments)/(Interest+Principal payments+Lease payments)
18. 18. DEBT MANAGEMENT RATIOS • Times interest earned • Shortcomings of this ratio: 1. Interest is not the only fixed financial charge companies must also reduce debt on schedule, and many firms lease assets and thus must make lease payments (if they fail to pay debt or lease payments they can b forced into bankruptcy) 2. EBIT does not represent all the cash flow available to service debt especially if a firm has high depreciation or amortization charges. • To account for these deficiencies bankers and other have developed EBITDA coverage ratio
19. 19. PROFITABILITY RATIOS 1. Profit margins on sales = Net income / Sales if two companies have identical operations in the sense that their sales, operating cost and EBIT are the same but if one firm uses more debt than the other it will have higher interest charges. These interest charges will pull net income down and since sales are constant the result will be relatively low profit margin. In this case low profit margin is not due to operating problem but just due to difference in financing strategies. Thus the firm with low profit margin might end up with a higher rate of return on SH investment due to its financial leverage.
20. 20. PROFITABILITY RATIOS 1. Basic earning power = EBIT / Total assets 2. Return on total assets = Net income / Total assets 3. Return on common equity = Net income / equity
21. 21. MARKET VALUE RATIOS 1. Price earning ratio = price per share / earning per share 2. Book value per share = equity / shares outstanding 3. Market to book ratio = market price per share / book value per share