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# Ratio analysis

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# Ratio analysis

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Engineering Economy.

Engineering Economy.

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### Ratio analysis

1. 1. FinancialHealth&FinancialRatios Financial Health Indicators Analyses Financial Ratios 1. Debt Management 1. Debt ratio 2. Times-Interest-Earned Ratio 2. Liquidity 1. Current Ratio 2. Quick Ratio 3. Asset Management 1. Inventory turnover Ratio 2. Day’s Sales Outstanding Ratio 3. Total AssetsTurn over Ratio 4. Profitability 1. Profit Margin on Sales 2. Return onTotal Assets 3. Return on Common Equity 5. MarketValue (Trend) 1. Price to Earnings Ratio 2. Market/Book Ratio (Book value per share)
2. 2. 1.DebtManagementAnalyses Equity Preferred Stocks Common Stock Debt Financing Bank loans: Short-term Bonds: Long term Capital for Financing Business Expansion comes in two ways Debt Equity Contemporary Engineering Economics, 5th edition. ©2010
3. 3. DebtFinancing(FinancialLeverage) Analyses 2.Times-Interest-Earned Ratio From the Income Statement to see the extent to which Interest (Fixed charges) are covered by Operating Profits 1. Debt Ratio From the Balance Sheet to determine the extent to which borrowed funds have been used to finance Assets Contemporary Engineering Economics, 5th edition. ©2010
4. 4. 1.1DebtRatio Debt Ratio = Total Debt Total Assets • If the Debt Ratio is One (Unity), then the Company has used all its Assets to finance its Debts • A ratio more than one indicates that the company has more debt than its assets • Creditor’s prefer low Debt Ratios, because the lower the ratio, the greater is the cushion against creditor’s losses Contemporary Engineering Economics, 5th edition. ©2010
5. 5. 1.2Times-Interest-EarnedRatio Times Interest Earned Ratio = Operating Profit (Earnings before Interest & taxes (EBIT) Interest Expenses • Higher values will favor the company in repaying its interest and debts. • Value below 1.5 is unsafe for the company • Failure to meet this obligation (value of 1 ) possibly results in bankruptcy. Contemporary Engineering Economics, 5th edition. ©2010
6. 6. Illustration Question A) A Company has SR 10 million of debts in its balance sheet and SR 15 million of assets. Calculate the Debt ratio. B) If that company’s interest expenses are SR239,000 and EBIT 3,493,000; calculate Times-Interest-Earned ratio. Contemporary Engineering Economics, 5th edition. ©2010
7. 7. Answer A) Debt Ratio = Total Debt = 10 million = 0.67 (67%) Total Assets 15 million B)Times-Interest-Earned Ratio = EBIT Interest Expenses = 3493,000 = 14.6 239,000 Contemporary Engineering Economics, 5th edition. ©2010
8. 8. 2.LiquidityAnalysis Ratios Current Ratio Quick Ratio A Company’sWorking Capital (Excess of CurrentAssets over Current Liabilities) is treated as a measure of liquidity Extent to which Current Assets can be converted to cash to meet current obligations Contemporary Engineering Economics, 5th edition. ©2010
9. 9. 2.1CurrentRatio Current Ratio = Current Assets Current Liabilities It shows the company’s ability to pay back its short-term liabilities with short term assets. A ratio above 1 is required for the survival (ratio above 2 is favorable) Contemporary Engineering Economics, 5th edition. ©2010
10. 10. 2.2Quick Ratio Quick Ratio = Current Assets – Inventories Current Liabilities  It is an indicator of a company’s short-term liquidity  It ,measure how a company can meet its obligations, without depending on its inventory (Least liquid of current assets)  The ratios of the company should be compare with that of industry average. Contemporary Engineering Economics, 5th edition. ©2010
11. 11. Illustration Question  The balance sheet of SABIC for January 2012 provides the following details. Calculate the Current Ratio and Quick Ratio of SABIC and comment on it. Total CurrentAssets – SR 138,216 million Total Current Liabilities – SR 49,847 million Inventories – SR 31,442 million Contemporary Engineering Economics, 5th edition. ©2010
12. 12. Answer Current Ratio = Current Assets Current Liabilities = 138,216 = 2.77 49,847 Quick Ratio = Current Assets – Inventories Current Liabilities = 138,216 - 31442 = 106,774 = 2.14 49,847 49,847 Comment: Both the ratios are above 2 and the company’s liquidity is so strong Contemporary Engineering Economics, 5th edition. ©2010
13. 13. 3.AssetManagementAnalysis Ratios InventoryTurnover Day’s Sales Outstanding (Accounts ReceivableTurnover) TotalAssetsTurnover How effectively a company is managing its Assets It indicate how successfully a company is utilizing its assets to generate revenues (Sales) Contemporary Engineering Economics, 5th edition. ©2010
14. 14. 3.1InventoryTurnoverRatio InventoryTurnover Ratio = Sales Average Inventory  It measures how many times the company sold and replaced its inventory during the period.  The ratio should be compared with the industry averages (Low turn over implies poor sales and excess inventory & high ratio implies strong sales) Contemporary Engineering Economics, 5th edition. ©2010
15. 15. 3.2Day’sSalesOutstanding(DSO)/ AccountsReceivableTurnoverRatio DSO = Accounts Receivable Average Sales per day Average Sales per day = Annual Sales 365  It is a measure of the average number of days that a company takes to collect revenue after a sale has been made.  Low DSO means fewer days to collect the accounts receivable and favor in reinvesting money. Contemporary Engineering Economics, 5th edition. ©2010
16. 16. 3.3TotalAssetsTurnoverRatio Total AssetsTurnover = Sales Total Assets  It measure the effectiveness in usingTotal Assets to generate Revenue  Higher ratios will favor the company. Contemporary Engineering Economics, 5th edition. ©2010
17. 17. Illustration Question Calculate the Asset Management Ratios of SABIC using the following information for the quarterly ending June 2012. Sales – SR 46,528 million Average Inventory – SR 31,442 million Accounts Receivable – SR 30,517 million Average sales per day – SR 517 million Total Assets – SR 339,006 million Contemporary Engineering Economics, 5th edition. ©2010
18. 18. Answer InventoryTurnover Ratio = Sales = 46,528 = 1.48 Average Inventory 31,442 DSO = Accounts Receivable = 30,517 = 59 days Average Sales per day 517 Total AssetsTurnover = Sales = 46,528 = 0.14 Total Assets 339,006 Contemporary Engineering Economics, 5th edition. ©2010
19. 19. Answer (Comments)  InventoryTurnover Ratio is comparatively lower (1.48) and will not favor the company  The DSO is lower than 2 months (59 days) and will favor the company in reinvesting  Total AssetsTurn Over Ratio is comparatively lower (0.14) and will not favor the company Contemporary Engineering Economics, 5th edition. ©2010
20. 20. 4.ProfitabilityAnalysis Ratios Profit Margin on Sales Return onTotal Assets Return on Common Equity Shows the combined effects of liquidity, asset management & debt management on operating results Contemporary Engineering Economics, 5th edition. ©2010
21. 21. 4.1ProfitmarginonSales Profit Margin on Sales = = Net IncomeAvailable to Common Stockholders Sales  The higher margins shows higher returns to stockholders. Contemporary Engineering Economics, 5th edition. ©2010
22. 22. 4.2ReturnonTotalAssets Return onTotal Assets = = Net Income + Interest Expenses (1 – tax rate) AverageTotal Assets  It measures the return on total assets  Used for comparison & higher ratios are favorable Contemporary Engineering Economics, 5th edition. ©2010
23. 23. 4.3ReturnonCommon Equity Return on Common Equity = = Net IncomeAvailable to Common Stockholders AverageCommon Equity  It shows how much income is earned for every Riyal invested by common stockholders  Used for comparison and higher ratios favor the company's performance Contemporary Engineering Economics, 5th edition. ©2010
24. 24. IllustrationQuestion The following details of a Company are given for the quarter ending June 2012. Sales (Million SR) - 16,528 Net Income available to common stockholders (Million (SR) - 9076 Total Assets (Million SR) – 33,900 Net Income (Million SR) – 12,000 Interest Expenses (Million SR) – 250 Tax Rate – 2% Average Common Equity (million SR) - 19150 Calculate the ratios of the of the profitability analysis. Contemporary Engineering Economics, 5th edition. ©2010
25. 25. Answer Profit Margin on Sales = = Net IncomeAvailable to Common Stockholders Sales = 9076/16528 = 0.55 Return onTotal Assets = = Net Income + Interest Expenses (1 – tax rate) AverageTotal Assets = 12000 + 250 (1- 2%)/ 33,900 = 12000 + 245 / 33,900 = 0.36 Return on Common Equity = = Net IncomeAvailable to Common Stockholders Average Common Equity = 9076/19150 = 0.47 Contemporary Engineering Economics, 5th edition. ©2010
26. 26. 5. MarketValueAnalysis Ratios Price to earnings ratio BookValue per Share If the firm’s assets and debt management are sound and its profits is rising; then its market value ratios will be high Investors purchase stocks to earn a return on their investment Contemporary Engineering Economics, 5th edition. ©2010
27. 27. 5.1PricetoEarningsRatio(P/ERatio)  P/E Ratio = Price per Share Earnings Per Share  It shows how much investors are willing to pay per Riyal of reported profits  P/E Ratio is high for firms with high growth prospects Contemporary Engineering Economics, 5th edition. ©2010
28. 28. 5.2BookValueperShare  BookValue per Share = = Total Stockholders Equity – Preferred Stock Average Number of Shares Outstanding  It is used to calculate the per share value of a company based on its equity available to shareholders (public).  Higher values favor the company’s market value Contemporary Engineering Economics, 5th edition. ©2010
29. 29. Illustration Question The following details of a company are given and based on it calculate P/E ratio and BookValue per Share. Share Price (SR) – 1000 Earnings per Share (SR) – 250 Total Stockholders equity (million SR) – 50,000 Preferred Stockholders equity – 32,000 Number of Shares Outstanding – 10,000 Contemporary Engineering Economics, 5th edition. ©2010
30. 30. Answer P/E Ratio = Price per Share Earnings Per Share = 1000 = 4 250 BookValue per Share = Total Stockholders Equity – Preferred Stock Average Number of SharesOutstanding = 50,000 – 32,000 = 18,000 = 1.8 10,000 10,000 Contemporary Engineering Economics, 5th edition. ©2010