These are the financial analysis of financial statements

1. 1
Chapter 2
Financial Ratio Analysis

2. 2
Learning Objectives
n Calculate and explain a variety of financial
ratios.
n Explain the value of common-size and
common-base-year financial statements.
n Use the DuPont equation to calculate a
company’s return on equity.
n Understand the strengths and weaknesses of
financial statement analysis.

3. 3
Common-Size and Common-Base-Year
Financial Statements
n Income statement items as a percentage of
total sales.
v Provides insight into how the relative items
contribute to revenues and expenses.
n Balance sheet items as a percentage of total
assets.
v Provides a insight into the structure of the
company’s assets and financing.
n Common-base-year financial statements
provide such comparisons to a base year.

4. 4
General Procedure
n Compute financial ratios for the company,
using financial statements from the last few
years.
n Compare trends in key financial ratios for the
company.
n Compare the company’s financial ratios to
industry averages.

5. 5
Financial Ratio Analysis
RATIO means comparison of one figure with
other relevant figure or figures.
ACCOUNTING RATIO means comparison of one
accounting figure with the other relevant
accounting figure or figures of a concern over a
period of time or of different concerns for the
same period.
RATIO ANALYSIS is a widely used tool of
financial analysis. It defined as the systematic
use of ratio to interpret current financial condition
can be determined.

6. 6
Purpose of Ratio Analysis
n Ratio analysis of different items of financial
statements are used as a yardstick to
measure the financial position, profitability
and operational efficiency of a concern on
current date.

7. 7
Users of Financial Statements Analysis
n Investors or shareholders: Shareholders
are main users of financial analysis and seek
information relating to return in investment
and the earning per share that will form the
basis of dividend declarations.
n Creditors: creditors are concerned with the
security of their debts and seek information
relating to the liquidity of the company
n Management :
n Others:

8. 8
Use of Ratios
n Help in tracking the weak spots of business and
tracking corrective and remedial measure.
n Helps in comparing operational efficiency of
business over a period of time
n Helps in formulating future plans and program on the
basis of past performances
n Helps the financial institutions to take decisions
regarding grant of loan to a company
n Helps the interested parties like the potential
investors to take decision about their investment
plan

9. 9
Classification of Financial Ratios
n Liquidity Ratios
n Efficiency ratios/Turnover ratios
n Leverage Ratios/ Solvency Ratios
n Profitability Ratios

10. 10
Liquidity Ratios: Liquidity ratios reflect the short –term
financial strength of a firm. In other words these ratios measure the ability
of a firm to meet its short-term obligations. The liquidity ratio include
n Current Ratio
n Quick Ratio
n Working Capital Ratio
n Cash Ratio

11. 11
Current Ratio: measures the ability of a company to
meet the short-term obligations. It provides a margin of safety to
the creditors. 2
Current Ratio
Current Assets
Current Liabilities
s
=
= =
$
$
.
400
253
158

12. 12
Quick Ratio:The quick ratio or acid test ratio is a liquidity ratio
that measures the ability of a company to pay its current liabilities only with
quick assets.
Quick Ratio
Current Assets Inventories
s
Current Liabilities
s
=
-
=
-
=
$ $140
$
.
400
253
103

13. 13
Working Capital:
n Working Capital: Working Capital measures
both a company’s efficiency and its short –
term financial health.
Working Capital = C.A- CL

14. 14
Working Capital Ratio
Working Capital Ratio
Current Assets Current Liabilities
Sales
=
=
-
=
-
=
$ $
$ ,
.
400 253
1080
13 61%

15. 15
Cash Ratio
CashRatio
Cash Equivalents
Total Assets
=
= =
&
$
$ ,
.
26
1150
2 26%

16. 16
Summary of Liquidity Ratios
Ratio 1996 1995 Ind. Average
(1996)
Current
Quick
Working Capital
Cash
1.58
1.03
13.61%
2.26%
1.98
1.30
20.48%
2.05%
2.00
1.00
18.00%
2.61%

17. 17
Leverage Ratios/Solvency Ratios :The term
‘Solvency’ generally refers to the capacity of business to meet its short-
term and long-term obligations.
Here are the most common financial leverage
ratios.
n Debt Ratio/Debt to assets Ratio
n Equity Ratio
n Debt-to-Equity Ratio
n Long term debt ratio
n Time interest earned ratio

18. 18
Debt Ratio: Debt ratio is a solvency ratio that measures a firm’s
total liability as a percentage of its total assets. 0.5
Debt Ratio =
= =
Total Debt
Total Assets
$ .
$ , .
.
48850
115000
0 42

19. 19
Equity Ratio: the equity ratio is an investment leverage or
Solvency ratio that measures the amount of assets that are financed by
owner’s investment by comparing the total equity in the company total
assets.
n Equity Ratio: Total Equity/Total Assets

20. 20
Debt-to-Equity Ratio: The debt to equity ratio is a
financial liquidity ratio that compares a company’s total debt to total
equity.0.33
Debt / Equity Ratio =
= =
Total Debt
Shareholder s Equity
'
$ .
$ .
.
48850
66150
074

21. 21
Long term Debt to equity Ratio: it indicates the
extent to which a company relies on external long term debt
financing to meet its capital requirement
Long term Debt to
equity Ratio
Long term debt
Total Equity
=
= =
$ .
$ .
.
7,250
8,500
0.85:1

22. 22
Interest Coverage Ratio(TIE): the ability of
a company to pay its interest charges.2
Interest CoverageRatio
EBIT
Interest Expense
=
=
= =
$
$
.
85
15
5 67

23. 23
Summary of Leverage Ratios
Ratio 1996 1995 Ind. Average
(1996)
Debt Ratio
Debt - To - Equity
Equity Multiplier
0.43
0.74
1.74
0.37
0.58
1.58
0.40
0.67
1.67

24. 24
Asset Activity Ratios/Turnover
n Receivables Turnover Ratio
n Days Sales Outstanding
n Inventory Turnover Ratio
n Days Sales in Inventory
n Fixed Asset Turnover Ratio
n Total Asset Turnover Ratio

25. 25
Receivables Turnover Ratio:
Receivables
Receivable
$ ,
$
.
Turnover Ratio
Annual Credit Sales
Accounts
=
=
= =
1080
234
4 62

26. 26
Days Sales Outstanding (DSO)
Days Sales Outs ding
Turnover
tan
Receivables
.
.
=
=
= =
365
365
4 62
7908

27. 27
Inventory Turnover Ratio
Inventory Turnover Ratio
Cost of Goods Sold
Inventory
=
=
= =
$
$
.
560
140
4 00

28. 28
Days Sales In Inventory
Days Sales In Inventory =
=
= =
365
365
400
9125
Inventory Turnover
.
.

29. 29
Fixed Asset Turnover Ratio
Fixed Asset Turnover Ratio =
=
= =
Sales
Net Fixed Assets
$ ,
$
.
1080
750
144

30. 30
Total Asset Turnover Ratio
Total Asset Turnover Ratio =
=
= =
Sales
Total Assets
$ ,
$ ,
.
1080
1150
094

31. 31
Accounts Payable
n Purchases/cog/a/p
n 365/Acc.p turnover

32. 32
Summary of Asset Activity Ratios
Ratio 1996 1995 Ind. Average
(1996)
Receivables T.O.
Days Sales Outst.
Inventory T.O.
Days Sales in Inv.
Fixed Asset T.O.
Total Asset T.O.
4.62
79.08
4.00
91.25
1.44
0.94
4.00
91.25
3.57
102.34
1.59
0.96
6.02
60.63
4.15
87.95
1.53
1.16

33. 33
Profitability Ratios
n Gross Profit Margin
n Net Profit Margin
n Operating Profit Ratio
n Return on Assets
n Return on Equity
n Return on capital employed

34. 34
Gross Profit Margin
Gross
Gross
Sales
Profit Margin
Profit
$ .
$1
, .
.
=
= =
52000
08000
4815%

35. 35
Net Profit Margin
Net
Net Income
Sales
Profit Margin
$ .
$1
, .
.
=
= =
42 00
080 00
3 89%

36. 36
Operating Profit Ratio
OPR
EBIT/o.p
Net sales
=
= =
$ .
$1
, .
.
8500
15000
739%

37. 37
Return on Assets
Re
$ .
$1
, .
.
turn on Assets
Net Income
Total Assets
=
= =
4200
15000
3 65%

38. 38
Return on Equity
Return on Equity =
= =
Net Income to Common
CommonEquity
$ .
$ .
.
3600
64150
635%

39. 39
Return on capital employed
ROCE= PBIT/CAPITAL EMPLOYED

40. 40
Summary of Profitability Ratios Ratios
Ratio 1996 1995 Ind. Average
(1996)
Gross Profit Margin
Net Profit Margin
Earning Power
Return on Assets
Return on Equity
48.51%
3.89%
7.39%
3.65%
6.35%
49.05%
3.69%
7.42%
3.54%
5.58%
48.28%
3.75%
8.25%
3.98%
6.65%

41. 41
Market Value Ratios
n P/E Ratio
n Market-to-Book Ratio
n Earnings Yield
n Dividend Yield

42. 42
Price Earning Ratio
P /
Pr
$ .
$ .
.
E Ratio
ice per Share
Earnings per Share
=
= =
2900
2 25
1289

43. 43
Market-to-Book Ratio
Market to Book Ratio
ice per Share
Book Value per Share
=
=
= =
Pr
$ .
$ .
.
2900
4009
072

44. 44
Earnings Yield
Earnings Yield
Earnings per Share
ice per Share
=
= =
Pr
$ .
$ .
.
2 25
2900
776%

45. 45
Dividend Yield
Dividend Yield
Dividends per Share
ice per Share
=
= =
Pr
$ .
$ .
.
125
2900
4 31%

46. 46
Summary of Market Value Ratios
Ratio 1996 1995 Ind. Average
(1996)
P/E
Earnings Yield
Dividend Yield
Market - to - Book
12.89
7.76%
4.31%
0.72
15.60
6.41%
3.85%
0.73
16.25
6.15
4.50
1.20

47. 47
DuPont Analysis
ROE = (Profit marg.)(Asset TO)(Eq. Mult.)
ROE = (3.889%) (0.939) (1.738)
ROE= 0.0635 or 6.35%
Therefore,
Net Inc. , Sales , Tot. Assets = NI to Common
Sales Tot. Assets Shldr. Eq Common Eq.

48. 48
Using Financial Statements
n Requires judgment, experience, hard work.
n Does not provide new information.
n Can provide insight into why the company’s
stock has its current selling price.