C:\Fakepath\44 Ratio Analysis 1 Presentation Transcript
Ratio Analysis Accounting for Managers
Assessment of the firm’s past, present and future financial conditions
Done to find firm’s financial strengths and weaknesses
Comparison of financial ratios to past, industry, sector and all firms
Objectives of Ratio Analysis
Standardize financial information for comparisons
Evaluate current operations
Compare performance with past performance
Compare performance against other firms or industry standards
Study the efficiency of operations
Study the risk of operations
Uses for Ratio Analysis
Evaluate Bank Loan Applications
Evaluate Customers’ Creditworthiness
Assess Potential Merger Candidates
Analyze Internal Management Control
Analyze and Compare Investment Opportunities
Types of Ratios
Assess ability to cover current obligations
Assess ability to cover long term debt obligations
Activity (Turnover) Ratios
Assess amount of activity relative to amount of resources used
Assess profits relative to amount of resources used
Assess market price relative to assets or earnings
Current Assets / Current Liabilities
Current Assets include Cash, Marketable Securities, Accounts Receivable and Inventory
Current Liabilities include Accounts Payable, Debt Due within one year, and Other Current Liabilities
Quick Ratio or Acid Test
Current Assets minus Inventory / Current Liabilities
A more precise measure of liquidity, especially if inventory is not easily converted into cash.
Reserve borrowing capacity - the credit limit sanctioned by the bank
Calculated to asses a firms ability to meet its regular cash outgoings
Leverage ratios measure the extent to which a firm has been financed by debt.
Leverage ratios include:
Generally, the higher this ratio, the more risky a creditor will perceive its exposure in your business. Thus, high leverage ratios make it more difficult to obtain credit (loans).
Leverage Ratios Cont.
Leverage ratios also include the Interest-coverage Ratio, Fixed coverage Ratio etc, .
In contrast to the leverage ratios discussed on previous slide, the higher the Interest Coverage Ratio (Times-Interest-Earned Ratio), the more credit worthy the firm is, and the easier it will be to obtain credit (loans).
Total Debt Ratio
Proportion of interest bearing debt in the Capital structure.
In general, the lower the number, the better.
The Debt-Equity Ratio indicates the percentage of total funds provided by creditors versus by owners.
This ratio indicates the extent to which the business relies on debt financing (creditor money versus owner’s equity).
Interest Coverage Ratio
interest coverage ratio indicates the extent to which earnings can decline without the firm becoming unable to meet its annual interest costs.
Also called the Times-Interest-Earned Ratio , this calculation shows how many times the firm could pay back (or cover) its annual interest expenses out of earnings before interest and taxes (EBIT).
Interest Coverage Ratio DA = Depreciation and Amortization expenses
Fixed Coverage Ratio
Principal repayments are added to interest payments
Activity ratios measure how effectively a firm is using its resources, or how efficient a company is in its operations and use of assets.
In general, the higher the ratio, the better.
Activity ratios include:
Accounts receivable turnover
Average collection period .
Total assets turnover
Fixed assets turnover
Inventory Turnover Ratio
The inventory turnover ratio indicates how fast a firm is selling its inventories
This ratio indicates how well inventory is being managed, which is important because the more times inventory can be turned (i.e., the higher the turnover rate) in a given operating cycle, the greater the profit.
Inventory Turnover Ratio Cont.
In the absence of information. Instead of CGS we can use Sales
In the case of CGS and Inventory both are valued at cost. While the sales are valued at market prices
Therefore better to use CGS
Accounts Receivable Turnover
The accounts receivable turnover ratio, indicates the average length of time it takes a firm to collect credit sales (in percentage terms), i.e., how well accounts receivable are being collected.
If receivables are excessively slow in being converted to cash, liquidity could be severely impaired.
Average Collection Period
The average collection period is the average length of time (in days) it takes a firm to collect on credit sales.
Net Assets Turnover
The total assets turnover ratio, indicates how efficiently a firm is using all its assets to generate revenues.
This ratio helps to signal whether a firm is generating a sufficient volume of business for the size of its asset investment
Profitability ratios measure management’s overall effectiveness as shown by returns generated on sales and investment.
Profitability ratios include
Gross profit margin
Operating profit margin
Net profit margin
Return on total assets (ROA)
Return on stockholders’ equity (ROE)
Earnings per share (EPS)
Price-earnings ratio (P/E).
Gross Profit Margin
The gross profit margin is the total margin available to cover operating expenses and yield a profit. This ratio indicates how efficiently a business is using its labor and materials in the production process, and shows the percentage of net sales remaining after subtracting cost of goods sold.
The higher the ratio, the better. A high gross profit margin indicates that a firm can make a reasonable profit on sales, as long as it keeps overhead costs under control.
The DuPont System
Method to breakdown ROE into:
ROA and Equity Multiplier
ROA is further broken down as:
Profit Margin and Asset Turnover
Helps to identify sources of strength and weakness in current performance