financial statement analysis , competencies for ratio analysis , function and purposes of ratio analysis , classes of ratios , liquidity ratios , activity ratios / asset management ratios , profitability ratios , debt or leverage ratios/solvency ratios , debt ratio , times interest earned ratio , market ratios , return on common equity (roe) , fixed-payment coverage ratio , gross profit margin , earnings per share (eps) , price/earnings (p/e) ratio , operating profit margin , market/book (m/b) ratio , return on total assets (roa) , net profit margin

1. © 2001, Educational Institute
Financial Statement
Analysis

2. © 2001, Educational Institute (continued)
1. Explain what ratio analysis is, identify
standards against which the results of ratio
analysis can be computed, describe the
function and purposes of ratio analysis,
and identify what ratios express.
2. Identify common classes of ratios,
calculate liquidity and solvency ratios, and
describe how club board members,
creditors, and managers view them.
Competencies for Ratio Analysis

3. © 2001, Educational Institute
3. Calculate common activity, profitability,
and operating ratios and describe how club
board members, creditors, and managers
view them.
4. Explain the limitations of ratio analysis.
Competencies for Ratio Analysis
(continued)

4. © 2001, Educational Institute
For Managers:
Monitor the club’s operating performance
 Evaluate goal achievement
For Creditors:
Evaluate the solvency of the club
 Assess riskiness of future loans
For Board Members:
 Assess the overall financial health of the club
Function and Purposes
of Ratio Analysis

5. © 2001, Educational Institute

6. © 2001, Educational Institute

7. © 2001, Educational Institute
• Liquidity ratios;
• Activity Ratios / Asset Management Ratios
• Debt or leverage ratios/Solvency Ratios;
• Profitability ratios;
• Market value ratios.
Classes of Ratios

8. © 2001, Educational Institute
Liquidity ratios
• Current ratio= CA/CL
• Quick (Acid-Test) Ratio
• = (Current assets-Inventory)/CL

9. © 2001, Educational Institute
Activity Ratios / Asset
Management Ratios
Inventory turnover
= Cost of goods sold/Inventory
Average collection period
= Accounts receivable/ Average sales per day
= Accounts receivable/ (Annual sales/360)
Average payment period
= Accounts payable/ Average purchases per day
Total asset turnover= Sales/Total assets

10. © 2001, Educational Institute
Debt or leverage ratios/Solvency
Ratios
• Debt or Leverage ratios are those which
measure the long-term solvency of a firm.
That is whether a firm has enough financial
solvency to meet its long-term obligations is
measured by debt or leverage ratios.

11. © 2001, Educational Institute
Debt or leverage ratios/Solvency Ratios
Financial leverage: The magnification of risk and
return introduced through the use of fixed-cost
financing, such as debt and preferred stock.
Degree of indebtedness: Measures the amount of
debt relative to other significant balance sheet
amounts.
Ability to service debts: The ability of a firm to
make the payments required on a scheduled basis
over the life of a debt.

12. © 2001, Educational Institute
Debt or leverage ratios/Solvency
Ratios
• i) Debt ratio:
• ii) Times Interest Earned Ratio
• iii) Fixed-Payment Coverage Ratio

13. © 2001, Educational Institute
Debt Ratio
• Measures the proportion of total assets
financed by the firm’s creditors.

14. © 2001, Educational Institute
Times Interest Earned Ratio
• Measures the firm’s ability to make
contractual interest payments; sometimes
called the interest coverage ratio.

15. © 2001, Educational Institute
Fixed-Payment Coverage Ratio
• Measures the firm’s ability to meet all
fixed-payment obligations.

16. © 2001, Educational Institute
Profitability refers to the expression of profits in relation to
sales, investment and equity of a firm. Here, profits may be
gross profits, net profits before and after interest and taxes.
Whenever profits are related to any one of these
parameters; then we get profitability ratio. This ratio helps
measuring earning capacity of a firm. These ratios mainly
include :
i) Gross Profit Margin
ii) Operating Profit Margin
iii) Net Profit Margin
iv) Earnings per Share (EPS)
v) Return on Total Assets (ROA)
vi) Return on Common Equity (ROE)
Profitability Ratios

17. © 2001, Educational Institute
Gross Profit Margin
• Measures the percentage of each sales
dollar remaining after the firm has paid
for its goods.

18. © 2001, Educational Institute
Operating Profit Margin
• Measures the percentage of each sales dollar
remaining after all costs and expenses other
than interest, taxes, and preferred stock
dividends are deducted; the “pure profits”
earned on each sales dollar.

19. © 2001, Educational Institute
Net Profit Margin
• Measures the percentage of each sales
dollar remaining after all costs and
expenses, including interest, taxes, and
preferred stock dividends, have been
deducted.

20. © 2001, Educational Institute
Earnings per Share (EPS)
• EPS represents the dollar amount earned on
behalf of each share—not the amount of
earnings actually distributed to shareholders.

21. © 2001, Educational Institute
Return on Total Assets (ROA)
• Measures the overall effectiveness of
management in generating profits with
its available assets; also called the return
on investment (ROI).

22. © 2001, Educational Institute
Return on Common Equity (ROE)
• Measures the return earned on the
common stockholders’ investment in the
firm.

23. © 2001, Educational Institute
Market Ratios
• Relate a firm’s market value, as measured by
its current share price, to certain accounting
values.
i) Price/Earnings (P/E) Ratio
ii) Market/Book (M/B) Ratio

24. © 2001, Educational Institute
Price/Earnings (P/E) Ratio
• Measures the amount that investors are
willing to pay for each dollar of a firm’s
earnings; the higher the P/E ratio, the
greater is investor confidence.

25. © 2001, Educational Institute
Market/Book (M/B) Ratio
• Provides an assessment of how investors
view the firm’s performance. Firms
expected to earn high returns relative to
their risk typically sell at higher M/B
multiples.

26. © 2001, Educational Institute
Ratios are only indicators.
 Ratios must compare two related numbers to
be meaningful.
 Ratios must be compared to a standard.
 No single ratio tells the entire story.
 Inflation can render some of the figures used
in some ratios less useful.
Limitations of Ratio Analysis

27. © 2001, Educational Institute
Home Work
• Book Name: Principles of Managerial
Finance- Lawrence J. Gitman. (12th
Edition)
• Page: 81(P2-1), 90 (P2-18), 94 (P2-23), 98
(case-2).