https://rb.gy/n89u77 Understand who uses financial ratios and how. Use ratios to analyze a firm’s liquidity and activity. Discuss the relationship between debt and financial leverage and the ratios used to analyze a firm’s debt. Use ratios to analyze a firm’s profitability and its market

1. 6-1
Chapter 3
Financial Ratio
Analysis
Qasim Raza Khan
Lecturer in Department of Management Sciences
CUI-Lahore
YouTube Link for lecture:
https://rb.gy/te0xqz

2. 6-2
Financial Ratio
Types of
Comparisons
Internal
Comparisons
External
Comparisons
A Financial Ratio is
an index that relates
two accounting
numbers and is
obtained by dividing
one number by the
other.

3. 6-3
Basket Wonders’ Balance
Sheet (Asset Side)
a. How the firm stands on
a specific date.
b. What BW owned.
c. Amounts owed by
customers.
d. Future expense items
already paid.
e. Cash/likely convertible
to cash within 1 year.
f. Original amount paid.
g. Acc. deductions for
wear and tear.
Cash and C.E. $ 90
Acct. Rec.c 394
Inventories 696
Prepaid Exp d 5
Accum Tax Prepay 10
Current Assetse $1,195
Fixed Assets (@Cost)f 1030
Less: Acc. Depr. g (329)
Net Fix. Assets $ 701
Investment, LT 50
Other Assets, LT 223
Total Assetsb $2,169
Basket Wonders Balance Sheet (thousands) Dec. 31, 2003a

4. 6-4
Basket Wonders’ Balance
Sheet (Liability Side)
a. Note, Assets =
Liabilities + Equity.
b. What BW owed and
ownership position.
c. Owed to suppliers for
goods and services.
d. Unpaid wages,
salaries, etc.
e. Debts payable < 1 year.
f. Debts payable > 1 year.
g. Original investment.
h. Earnings reinvested.
Notes Payable $ 290
Acct. Payablec 94
Accrued Taxes d 16
Other Accrued Liab. d 100
Current Liab. e $ 500
Long-Term Debt f 530
Shareholders’ Equity
Com. Stock ($1 par) g 200
Add Pd in Capital g 729
Retained Earnings h 210
Total Equity $1,139
Total Liab/Equitya,b $2,169
Basket Wonders Balance Sheet (thousands) Dec. 31, 2003

5. 6-5
Basket Wonders’
Income Statement
a. Measures profitability
over a time period.
b. Received, or receivable,
from customers.
c. Sales comm., adv.,
officers’ salaries, etc.
d. Operating income.
e. Cost of borrowed funds.
f. Taxable income.
g. Amount earned for
shareholders.
Net Sales $ 2,211
Cost of Goods Sold b 1,599
Gross Profit $ 612
SG&A Expenses c 402
EBITd $ 210
Interest Expensee 59
EBT f $ 151
Income Taxes 60
EATg $ 91
Cash Dividends 38
Increase in RE $ 53
Basket Wonders Statement of Earnings (in thousands)
for Year Ending December 31, 2003a

6. 6-6
Liquidity Ratios
Current
Current Assets
Current Liabilities
For Basket Wonders
December 31, 2003
Shows a firm’s
ability to cover its
current liabilities
with its current
assets.
Balance Sheet Ratios
Liquidity Ratios
$1,195
$500
= 2.39

7. 6-7
Liquidity Ratio
Comparisons
BW Industry
2.39 2.15
2.26 2.09
1.91 2.01
Year
2003
2002
2001
Current Ratio
Ratio is stronger than the industry average.

8. 6-8
Liquidity Ratios
Acid-Test (Quick)
Current Assets - Inv
Current Liabilities
For Basket Wonders
December 31, 2003
Shows a firm’s
ability to meet
current liabilities
with its most liquid
assets.
Balance Sheet Ratios
Liquidity Ratios
$1,195 - $696
$500
= 1.00

9. 6-9
Liquidity Ratio
Comparisons
BW Industry
1.00 1.25
1.04 1.23
1.11 1.25
Year
2003
2002
2001
Acid-Test Ratio
Ratio is weaker than the industry average.

10. 6-10
Summary of the Liquidity
Ratio Comparisons
 Strong current ratio and weak acid-test
ratio indicates a potential problem in the
inventories account.
 Note that this industry has a relatively
high level of inventories.
Ratio BW Industry
Current 2.39 2.15
Acid-Test 1.00 1.25

11. 6-11
Current Ratio -- Trend
Analysis Comparison
Trend Analysis of Current Ratio
1.5
1.7
1.9
2.1
2.3
2.5
2001 2002 2003
Analysis Year
RatioValue
BW
Industry

12. 6-12
Acid-Test Ratio -- Trend
Analysis Comparison
Trend Analysis of Acid-Test Ratio
0.5
0.8
1.0
1.3
1.5
2001 2002 2003
Analysis Year
RatioValue
BW
Industry

13. 6-13
Summary of the Liquidity
Trend Analyses
 The current ratio for the industry has
been rising slowly at the same time the
acid-test ratio has been relatively stable.
 This indicates that inventories are a
significant problem for BW.
 The current ratio for BW has been rising
at the same time the acid-test ratio has
been declining.

14. 6-14
Financial Leverage Ratios
Debt-to-Equity
Total Debt
Shareholders’ Equity
 The ratio tells us that creditors
are providing 90 cents of
financing for each $1 being
provided by shareholders.
Creditors would generally like
this ratio to be low.
Shows the extent to
which the firm is
financed by debt.
Balance Sheet Ratios
Financial Leverage
Ratios
$1,030
$1,139
= .90

15. 6-15
Financial Leverage
Ratio Comparisons
BW Industry
.90 .90
.88 .90
.81 .89
Year
2003
2002
2001
Debt-to-Equity Ratio
BW has average debt utilization
relative to the industry average.

16. 6-16
Financial Leverage Ratios
Debt-to-Total-Assets
Total Debt
Total Assets
 47 percent of the firm’s
assets are financed with
debt and the remaining 53
percent of the financing
comes from equity
Shows the percentage
of the firm’s assets
that are supported by
debt financing.
Balance Sheet Ratios
Financial Leverage
Ratios
$1,030
$2,169
= .47

17. 6-17
Financial Leverage
Ratio Comparisons
BW Industry
.47 .47
.47 .47
.45 .47
Year
2003
2002
2001
Debt-to-Total-Asset Ratio
BW has average debt utilization
relative to the industry average.

18. 6-18
Financial Leverage Ratios
Total Capitalization
Total Debt
Total Capitalization
For Basket Wonders
December 31, 2003
Shows the relative
importance of long-term
debt to the long-term
financing of the firm.
Balance Sheet Ratios
Financial Leverage
Ratios
$1,030
$1,669
= .62
(i.e., LT-Debt + Equity)

19. 6-19
Financial Leverage
Ratio Comparisons
BW Industry
.62 .60
.62 .61
.67 .62
Year
2003
2002
2001
Total Capitalization Ratio
BW has average long-term debt utilization
relative to the industry average.

20. 6-20
Coverage Ratios
Interest Coverage
EBIT
Interest Charges
 the higher the ratio, the
greater the likelihood that
the company could cover
its interest payments
without difficulty
Indicates a firm’s
ability to cover
interest charges.
Income Statement
Ratios
Coverage Ratios
$210
$59
= 3.56 times

21. 6-21
Coverage
Ratio Comparisons
BW Industry
3.56 5.19
4.35 5.02
10.30 4.66
Year
2003
2002
2001
Interest Coverage Ratio
BW has below average interest coverage
relative to the industry average.

22. 6-22
Coverage Ratio -- Trend
Analysis Comparison
Trend Analysis of Interest Coverage Ratio
3.0
5.0
7.0
9.0
11.0
2001 2002 2003
Analysis Year
RatioValue
BW
Industry

23. 6-23
Summary of the Coverage
Trend Analysis
 This indicates that low earnings (EBIT)
may be a potential problem for BW.
 Note, we know that debt levels are in
line with the industry averages.
 The interest coverage ratio for BW has
been falling since 2001. It has been
below industry averages for the past
two years.

24. 6-24
Activity Ratios
Receivable Turnover
Annual Net Credit Sales
Receivables
The higher the turnover, the shorter the
time between the typical sale and cash
collection
Indicates quality of
receivables and how
successful the firm is in
its collections.
Income Statement /
Balance Sheet
Ratios
Activity Ratios
$2,211
$394
= 5.61 times
(Assume all sales are credit sales.)

25. 6-25
Activity Ratios
Avg Collection Period
Days in the Year
Receivable Turnover
This figure tells us the average number
of days that receivables are outstanding
before being collected
Average number of days
that receivables are
outstanding.
(or RT in days)
Income Statement /
Balance Sheet
Ratios
Activity Ratios
365
5.61
= 65 days

26. 6-26
Activity
Ratio Comparisons
BW Industry
65.0 65.7
71.1 66.3
83.6 69.2
Year
2003
2002
2001
Average Collection Period
BW has improved the average collection
period to that of the industry average.

27. 6-27
Activity Ratios
Payable Turnover (PT)
Annual Credit Purchases
Accounts Payable
The higher the turnover, the shorter the
time between the credit purchase and
cash payment.
-promptness of payment to suppliers.Indicates the
promptness of payment
to suppliers by the firm.
Income Statement /
Balance Sheet
Ratios
Activity Ratios
$1551
$94
= 16.5 times
(Assume annual credit
purchases = $1,551.)

28. 6-28
Activity Ratios
PT in Days
Days in the Year
Payable Turnover
This figure tells us the average number
of days that payables are yet to be paid
Average number of days
that payables are
outstanding.
Income Statement /
Balance Sheet
Ratios
Activity Ratios
365
16.5
= 22.1 days

29. 6-29
Activity
Ratio Comparisons
BW Industry
22.1 46.7
25.4 51.1
43.5 48.5
Year
2003
2002
2001
Payable Turnover in Days
BW has improved the PT in Days.
Is this good?

30. 6-30
Activity Ratios
Inventory Turnover
Cost of Goods Sold
Inventory
Tells us how many times inventory is turned
over into receiveables through sales during
the year
Higher the inventory turnover, the more
efficient the inventory management
Indicates the
effectiveness of the
inventory management
practices of the firm.
Income Statement /
Balance Sheet
Ratios
Activity Ratios
$1,599
$696
= 2.30 times

31. 6-31
Activity
Ratio Comparisons
BW Industry
2.30 3.45
2.44 3.76
2.64 3.69
Year
2003
2002
2001
Inventory Turnover Ratio
BW has a very poor inventory turnover ratio.

32. 6-32
Inventory Turnover Ratio --
Trend Analysis Comparison
Trend Analysis of Inventory Turnover Ratio
2.0
2.5
3.0
3.5
4.0
2001 2002 2003
Analysis Year
RatioValue
BW
Industry

33. 6-33
Activity Ratios
Total Asset Turnover
Net Sales
Total Assets
The total asset turnover ratio tells us the
relative efficiency with which a firm
utilizes its total assets to generate sales.
Indicates the overall
effectiveness of the firm
in utilizing its assets to
generate sales.
Income Statement /
Balance Sheet
Ratios
Activity Ratios
$2,211
$2,169
= 1.02 times

34. 6-34
Activity
Ratio Comparisons
BW Industry
1.02 1.17
1.03 1.14
1.01 1.13
Year
2003
2002
2001
Total Asset Turnover Ratio
BW has a weak total asset turnover ratio.
Why is this ratio considered weak?

35. 6-35
Profitability Ratios
Gross Profit Margin
Gross Profit
Net Sales
Measures the efficiency of the firm’s
operations, as well as an indication of
how products are priced.
Indicates the efficiency
of operations and firm
pricing policies.
Income Statement /
Balance Sheet
Ratios
Profitability Ratios
$612
$2,211
= .277

36. 6-36
Profitability
Ratio Comparisons
BW Industry
27.7% 31.1%
28.7 30.8
31.3 27.6
Year
2003
2002
2001
Gross Profit Margin
BW has a weak Gross Profit Margin.

37. 6-37
Gross Profit Margin --
Trend Analysis Comparison
Trend Analysis of Gross Profit Margin
25.0
27.5
30.0
32.5
35.0
2001 2002 2003
Analysis Year
RatioValue(%)
BW
Industry

38. 6-38
Profitability Ratios
Net Profit Margin
Net Profit after Taxes
Net Sales
measure of the firm’s profitability of
sales after taking account of all
expenses and income taxes.
Indicates the firm’s
profitability after taking
account of all expenses
and income taxes.
Income Statement /
Balance Sheet
Ratios
Profitability Ratios
$91
$2,211
= .041

39. 6-39
Profitability
Ratio Comparisons
BW Industry
4.1% 8.2%
4.9 8.1
9.0 7.6
Year
2003
2002
2001
Net Profit Margin
BW has a poor Net Profit Margin.

40. 6-40
Net Profit Margin --
Trend Analysis Comparison
Trend Analysis of Net Profit Margin
4
5
6
7
8
9
10
2001 2002 2003
Analysis Year
RatioValue(%)
BW
Industry

41. 6-41
Profitability Ratios
Return on Investment
Net Profit after Taxes
Total Assets
This ratio is an indicator of
management’s efficiency in using its
assets to generate profits
Indicates the
profitability on the
assets of the firm (after
all expenses and taxes).
Income Statement /
Balance Sheet
Ratios
Profitability Ratios
$91
$2,160
= .042

42. 6-42
Profitability
Ratio Comparisons
BW Industry
4.2% 9.8%
5.0 9.1
9.1 10.8
Year
2003
2002
2001
Return on Investment
BW has a poor Return on Investment.

43. 6-43
Return on Investment –
Trend Analysis Comparison
Trend Analysis of Return on Investment
4
6
8
10
12
2001 2002 2003
Analysis Year
RatioValue(%)
BW
Industry

44. 6-44
Profitability Ratios
Return on Equity
Net Profit after Taxes
Shareholders’ Equity
For Basket Wonders
December 31, 2003Indicates the profitability
to the shareholders of
the firm (after all
expenses and taxes).
Income Statement /
Balance Sheet
Ratios
Profitability Ratios
$91
$1,139
= .08

45. 6-45
Profitability
Ratio Comparisons
BW Industry
8.0% 17.9%
9.4 17.2
16.6 20.4
Year
2003
2002
2001
Return on Equity
BW has a poor Return on Equity.

46. 6-46
Return on Equity --
Trend Analysis Comparison
Trend Analysis of Return on Equity
7.0
10.5
14.0
17.5
21.0
2001 2002 2003
Analysis Year
RatioValue(%)
BW
Industry

47. 6-47
Summary of the Profitability
Trend Analyses
 The profitability ratios for BW have ALL
been falling since 2001. Each has been
below the industry averages for the past
three years.
 This indicates that COGS and
administrative costs may both be too
high and a potential problem for BW.
 Note, this result is consistent with the low
interest coverage ratio.

48. 6-48
Summary of Ratio Analyses
 Inventories are too high.
 May be paying off creditors
(accounts payable) too soon.
 COGS may be too high.
 Selling, general, and
administrative costs may be too
high.