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C:\Fakepath\44 Ratio Analysis 1

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C:\Fakepath\44 Ratio Analysis 1

  1. 1. Ratio Analysis Accounting for Managers
  2. 2. Financial Analysis <ul><li>Assessment of the firm’s past, present and future financial conditions </li></ul><ul><li>Done to find firm’s financial strengths and weaknesses </li></ul><ul><li>Primary Tools: </li></ul><ul><ul><li>Financial Statements </li></ul></ul><ul><ul><li>Comparison of financial ratios to past, industry, sector and all firms </li></ul></ul>
  3. 3. Objectives of Ratio Analysis <ul><li>Standardize financial information for comparisons </li></ul><ul><li>Evaluate current operations </li></ul><ul><li>Compare performance with past performance </li></ul><ul><li>Compare performance against other firms or industry standards </li></ul><ul><li>Study the efficiency of operations </li></ul><ul><li>Study the risk of operations </li></ul>
  4. 4. Uses for Ratio Analysis <ul><li>Evaluate Bank Loan Applications </li></ul><ul><li>Evaluate Customers’ Creditworthiness </li></ul><ul><li>Assess Potential Merger Candidates </li></ul><ul><li>Analyze Internal Management Control </li></ul><ul><li>Analyze and Compare Investment Opportunities </li></ul>
  5. 5. Types of Ratios <ul><li>Financial Ratios: </li></ul><ul><ul><li>Liquidity Ratios </li></ul></ul><ul><ul><ul><li>Assess ability to cover current obligations </li></ul></ul></ul><ul><ul><li>Leverage Ratios </li></ul></ul><ul><ul><ul><li>Assess ability to cover long term debt obligations </li></ul></ul></ul><ul><li>Operational Ratios: </li></ul><ul><ul><li>Activity (Turnover) Ratios </li></ul></ul><ul><ul><ul><li>Assess amount of activity relative to amount of resources used </li></ul></ul></ul><ul><ul><li>Profitability Ratios </li></ul></ul><ul><ul><ul><li>Assess profits relative to amount of resources used </li></ul></ul></ul><ul><li>Valuation Ratios: </li></ul><ul><ul><ul><li>Assess market price relative to assets or earnings </li></ul></ul></ul>
  6. 6. Liquidity Ratios <ul><li>Current Ratio </li></ul><ul><ul><li>Current Assets / Current Liabilities </li></ul></ul><ul><ul><ul><li>Current Assets include Cash, Marketable Securities, Accounts Receivable and Inventory </li></ul></ul></ul><ul><ul><ul><li>Current Liabilities include Accounts Payable, Debt Due within one year, and Other Current Liabilities </li></ul></ul></ul>
  7. 7. Liquidity Ratios <ul><li>Quick Ratio or Acid Test </li></ul><ul><ul><li>Current Assets minus Inventory / Current Liabilities </li></ul></ul><ul><ul><li>A more precise measure of liquidity, especially if inventory is not easily converted into cash. </li></ul></ul>
  8. 8. Liquidity Ratios <ul><li>Cash Ratio </li></ul><ul><ul><li>Reserve borrowing capacity - the credit limit sanctioned by the bank </li></ul></ul>
  9. 9. Liquidity Ratios <ul><li>Interval Measure </li></ul><ul><ul><li>Calculated to asses a firms ability to meet its regular cash outgoings </li></ul></ul>
  10. 10. Leverage Ratios <ul><li>Leverage ratios measure the extent to which a firm has been financed by debt. </li></ul><ul><li>Leverage ratios include: </li></ul><ul><ul><li>Debt Ratio </li></ul></ul><ul><ul><li>Debt--Equity Ratio </li></ul></ul><ul><li>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). </li></ul>
  11. 11. Leverage Ratios Cont. <ul><li>Leverage ratios also include the Interest-coverage Ratio, Fixed coverage Ratio etc, . </li></ul><ul><li>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). </li></ul>
  12. 12. Total Debt Ratio <ul><ul><li>Proportion of interest bearing debt in the Capital structure. </li></ul></ul><ul><ul><li>In general, the lower the number, the better. </li></ul></ul>
  13. 13. Debt-Equity Ratio <ul><li>The Debt-Equity Ratio indicates the percentage of total funds provided by creditors versus by owners. </li></ul><ul><li>This ratio indicates the extent to which the business relies on debt financing (creditor money versus owner’s equity). </li></ul>
  14. 14. <ul><li>Treatment of </li></ul><ul><ul><li>Preference Capital </li></ul></ul><ul><ul><li>Lease Payments </li></ul></ul>
  15. 15. Interest Coverage Ratio <ul><li>interest coverage ratio indicates the extent to which earnings can decline without the firm becoming unable to meet its annual interest costs. </li></ul><ul><li>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). </li></ul>
  16. 16. Interest Coverage Ratio DA = Depreciation and Amortization expenses
  17. 17. Fixed Coverage Ratio <ul><ul><li>Principal repayments are added to interest payments </li></ul></ul>
  18. 18. Activity Ratios <ul><li>Activity ratios measure how effectively a firm is using its resources, or how efficient a company is in its operations and use of assets. </li></ul><ul><li>In general, the higher the ratio, the better. </li></ul><ul><li>Activity ratios include: </li></ul><ul><ul><li>Inventory turnover </li></ul></ul><ul><ul><li>Accounts receivable turnover </li></ul></ul><ul><ul><li>Average collection period . </li></ul></ul><ul><ul><li>Total assets turnover </li></ul></ul><ul><ul><li>Fixed assets turnover </li></ul></ul>
  19. 19. Inventory Turnover Ratio <ul><li>The inventory turnover ratio indicates how fast a firm is selling its inventories </li></ul><ul><li>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. </li></ul>
  20. 20. Inventory Turnover Ratio Cont. <ul><ul><li>In the absence of information. Instead of CGS we can use Sales </li></ul></ul><ul><ul><li>In the case of CGS and Inventory both are valued at cost. While the sales are valued at market prices </li></ul></ul><ul><ul><li>Therefore better to use CGS </li></ul></ul>
  21. 21. Accounts Receivable Turnover <ul><li>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. </li></ul><ul><li>If receivables are excessively slow in being converted to cash, liquidity could be severely impaired. </li></ul>
  22. 22. Average Collection Period <ul><li>The average collection period is the average length of time (in days) it takes a firm to collect on credit sales. </li></ul>
  23. 23. Net Assets Turnover <ul><ul><li>The total assets turnover ratio, indicates how efficiently a firm is using all its assets to generate revenues. </li></ul></ul><ul><ul><li>This ratio helps to signal whether a firm is generating a sufficient volume of business for the size of its asset investment </li></ul></ul>
  24. 24. Profitability Ratios <ul><li>Profitability ratios measure management’s overall effectiveness as shown by returns generated on sales and investment. </li></ul><ul><li>Profitability ratios include </li></ul><ul><ul><li>Gross profit margin </li></ul></ul><ul><ul><li>Operating profit margin </li></ul></ul><ul><ul><li>Net profit margin </li></ul></ul><ul><ul><li>Return on total assets (ROA) </li></ul></ul><ul><ul><li>Return on stockholders’ equity (ROE) </li></ul></ul><ul><ul><li>Earnings per share (EPS) </li></ul></ul><ul><ul><li>Price-earnings ratio (P/E). </li></ul></ul>
  25. 25. Gross Profit Margin <ul><li>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. </li></ul><ul><li>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. </li></ul>
  26. 26. The DuPont System <ul><li>Method to breakdown ROE into: </li></ul><ul><ul><li>ROA and Equity Multiplier </li></ul></ul><ul><li>ROA is further broken down as: </li></ul><ul><ul><li>Profit Margin and Asset Turnover </li></ul></ul><ul><li>Helps to identify sources of strength and weakness in current performance </li></ul><ul><li>Helps to focus attention on value drivers </li></ul>
  27. 27. The DuPont System
  28. 28. The DuPont System
  29. 29. The DuPont System
  30. 30. The DuPont System

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