Design a blended learning environment
Course: Introduction to Financial Management.
Topic: The analysis and applications of financial ratios in FS.
Target audience: DSM Students Semester 3
Learners are able to define a type of Financial Statements likes Trading Account, Profit
and Loss Account and Balance Sheets Account.
Learners are able to analyze and applied all the five broad categories of ratios that have
been used by Financial Analyst to analyze financial stability of the organization.
The accounting data from the Financial statements will help the analysts to interpret and
evaluate the firm’s performance
-Financial ratio will allow the analysis to create comparable measures of a firm’s
financial data across time (trend analysis) and with other firms within the same industry
(cross sectional analysis) in order to locate the symptoms.
-Thus the analysis must determine the cause and find a solution to it.
-In learning about ratio, five broad ratio categories are discussed here:
a. Liquidity Ratios-to know how liquid is the firm-to measure the adequacy of a
firm’s is cash resources to meet short term obligation on time.
b. Activity Ratios-to evaluate the firm’s efficiency in utilizing the firm’s
c. Solvency Ratios-to know how the firm finances its assets-to examine the firm’s
capital structure and the ability of the firm to pay its debt.
d. Profitably Ratios-to measure the efficiency of the firm’s activities in generating
e. Ownership Ratios-to assist the stockholders in evaluating the firm’s activities and
policies that affect the market prices of the common stock.
-Two ratios are commonly used to measure liquidity of the firm:
a. Current Ratio = Current Asset
CR Current Liabilities
- Low ratio will indicate that firms are not able to pay its bill on time.
- A high ratio may indicate an excessive amount of current asset meaning,
management’s failure to utilize the current assets efficiently.
- As general rule, 2/1 ratio is considered acceptable.
b. Quick Ratio = Current Assets-Inventories
QR Current Liabilities
-inventories are excluded from current assets because inventories are the least liquid
assets because inventories take longer time to be converted into cash.
-as general rule 1/1ratio is considered reasonable
c. Cash Ratio = Cash + Marketable Securities
CR Current Liabilities
-the use of current and quick ratios implicitly assumes that all the current assets will be
converted to cash.
-in reality, firms do not liquid their current assets to pay their current liabilities.
-minimum levels of inventories and receivables are always needed to keep the operation
going if not the firms are seemed to cease operation.
-therefore, cash ratio helps to measure the actual cash resources of a firm.
-these ratios measure how efficient the firm is managing its resources.
-it is also known as turnover ratios because it involve with sales and all assets of the firm
a. Receivables Ratio
-these ratios indicate mode of selling and effectiveness of collection:
Accounts receivable turnover = Sales
(ARTO) Account Receivable
Average collection period = 365
acp ar turnover
-accounts receivable turnover has to be compared to the firm’s sales with its uncollected
bills from the customers as a result of credit sales.
-high ratio indicates that the firm has more cash sales than credit sales and low ratio may
indicate that the firm has more credit sales and or an increased in uncollected bills.
-average collection period determines how many days on average the firm can collect its
bill from customers.
-more days than the agreed credit period could indicate slow collection and vice versa.
b. Inventory Turnover Ratios
-These ratios indicate the effectiveness of inventory management.
Inventory Turnover = Cost of Goods Sold
-inventory turnover determines how many times the inventory could be turned into
-high ratios indicate the effectiveness of management in managing its inventory and vice
c. Assets Turnover Ratio
-it measures the effectiveness of management in utilizing all the firm’s assets which
indicates the amount sales generated for every dollar invested into assets.
Total Assets Turnover = Sales
(TATO) Total Assets
-Eg if the answer is 0.25 times, meaning that the firm is able to generate rm0.25 of sales
for every rm1 invested in total assets
-whether good or not, its depend on past year’s or its competitor total assets turnover.
-these ratios determine the relationship between debt and equity components of the firm’s
-that is, it indicate how much of the firm’s assets are financed by debt and equity and as
indication for future prospects financing and financial risk of the firm.
-if the ratios are too high, the firm has difficulty in additional debt financing.
-as general, the debt should not exceed 50% of the total sources fund.
Debt Ratio = Total Debt
(DR) Total Assets
Debt Equity Ratio = Total Debt
(DTE) Total equity
Time Interest Earned = Operating Income
-in term of an obligation, times interest earned provides an indication of the firm’s ability
in servicing its interest payment to its lenders.
-high ratio means that the firm’s paying ability is good and vice versa.
-profitability is the ability of a firm to generate earning or income from the used of assets,
sales or investments.
-this ratio is important to:
1. Stockholders for receiving dividends increase in market price that leads to capital
2. Creditors as a measure of ability and capacity of debt coverage.
3. Management as a measure of performance for the firm
Gross Profit Margin = Gross Profit
Operating Profit Margin = EBIT
Net Profit Margin = Net Income
-high profit margin will indicate that the firm is reducing its costs or increasing its selling
price or increasing its sales or vice versa.
Return on Total Assets = Net Income
(ROTA) Total Asset
-the ratio will indicate that the return generated for every dollar invested in total assets.
Return on Total Equity = Net Income
-it measures the return to both common and prefered stockholders on every dollar that
they invested in the firm
-the ratio will help the shareholders to analyze the present and future investment in a
Earning Per Share = Net Income
(EPS) No of common Shares outstanding
Price Earning Ratio = Market Price Per Share
(P/E Ratio) EPS
-EPS is the ratio refers to an earning that might be available in a form of dividend to the
common shareholders or the growth in the firm’s earnings.
-P/E ratio is the ratio that measure used by the investors in making stock purchases.
-If the stock has low P/E multiple then the stock is under valued and high P/E multiple it
is considered as overvalued.
Dividend Per Share = Dividend Payment
(DPS) Number of Sales
Dividend Payout Ratios = Dividend Per Share
(DPR) Earnings Per Share
Dividend Yield = Dividend Per Share
DY Market Price Per Share
-DPS is the total dividend payment per share which indicates an amount of cash to be
received by a shareholder for every share held.
-DPR is the percentage of the firm’s earnings being allocated to dividend payment.
DY is the current return to investor as a percentage of his or her investment.
Book Value Per Share (BVPS)
-this ratio is equal to stockholders equity divided by number of shares outstanding.
BVPS= Equity Stockholder
Number of shares outstanding
-the book value is a benchmark for the price of the common stock.
If the market price is below the book value, then the stock is undervalued stock.
-these ratios are concerned about payment or cash dividends.
-As such, low dividend declared, means unattractive to investors and high dividend
payment will result inadequate funds to finance future growth.
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