2. Firms financial ratios
 Financial ratio analysis is a standard
techniques used by a financial analyst to
compare and analyze information.
 Under this financial ratio analysis is a set of
numbers that are form one or more of the
financial statements and compared to each
other to form ratios.
 For instance to calculate the current asset
ratios, firm’s current liabilities are divided with
the firm’s current assets.
 This ratio gives the measurement of the firm’s
capacity to meet its current obligations.

3.  Firm’s ratio provide an insight into
particular firm operation
 Provide analysts with a better picture
about the firm, if the value of the ratios
obtained, are compared with other ratios
values.

4.  Comparison of ratios can occurs in 3
categories:
1. Historical comparison
2. Competitive analysis
3. A budget analysis

5.  A common size statement analysis is
also a form of ratio analysis. This
analysis is used to compare firms of
different sizes. (refer table 1 and table 2,
page 40 & 41)

6.  Financial ratios are used by three main
groups;
 Managers
○ They employ ratios to help analyze, control
and improve their firm’s operations
 Credit analysts
○ Employ ratios to help ascertain a company’s
ability to pay its debt
 Stockholders
○ Employ ratios to measure a firm’s growth
prospect

7.  Ratio analysis is divided into four categories based on
the type of issues they address.
 Liquidity ratio
○ Used to measure a firm’s ability to meet its curent obligation as
they come due
 Asset management ratio
○ Measure how effective a firm is managing its assets and whether
or not level of those assets is properly related to the level of
operations as measured by sales
 Debt management ratio
○ Measure the extent to which a firm is using debt financing and the
degree of safety that the firm provides to the creditors
 Profitability ratio
○ Show the combined effects of liquidity, assets management and
debt operatin results

8. Liquidity ratio
 Liquidity ratios measure the ability of a company to
repay its short-term debts and meet unexpected
cash needs.
 The current ratio is also called the working capital
ratio, as working capital is the difference between
current assets and current liabilities.
 This ratio measures the ability of a company to pay
its current obligations using current assets. The
current ratio is calculated by dividing current assets
by current liabilities.

9.  Example:
 In this case, the company has a comfortable current ratio based on this
rule. This means that at any point in time, the company has the ability to
meet its short- term obligations the creditors of the company.
 However Azmi’s current ratio is below the average of the industry, 4.2. So
its liquidity position in comparison to other firms in the same industry, is
relatively weak.

10.  The quick ratio
 The quick ratio or acid test ratio is
calculated by deducting inventory from
current assets and then dividing the
reminder by the current liabilities.
 Inventories are excluded because they
are normally the least liquid in a firm’s
current assets. In other words, they are
the assets on which, losses are most
likely to occur in the event of liquidation
(selling inventory to generate cash).
 By subtracting inventories, this ratio will
measure the firm’s ability to meet its
short-term obligations without having to
rely on its inventories.
 The current ratio is above 1.0. This means
that the firm can meet its short term
obligations without its inventories being
liquidated. The industry average quick
ratio is 2.5. So Azmi’s 1.72 ratio is low in
comparison; with other firm’s in the
industry.

11.  Asset management ratios
 The inventory turnover ratio measures how
many times per year a firm uses its average
inventory. A high turnover indicates the firm’s
is rapidly converting its inventory into sale.
 This is a good indication as high sales of
product will eventually lead to higher profit.
Low inventory turnover, on the other hand
, indicates slow conversion of inventory into
saleable products. This is bad for the
company because holding excess inventory
(due to slow conversion process) is
expensive due to warehousing costs.
 At the same time, too high a turnover ratio is
also detrimental to accompany. A significantly
high ratio may mean customer’s orders
cannot be quickly filled or that there are work
stoppages due to inadequate supplies of raw
materials.
 As a rough approximation, each item of
Azmi’s inventory is sold out and restocked
3.125 times per year. This is much lower than
the industry average. This may suggest that
Azmi is holding excessive stocks of inventory.
Excess stocks are, of
course, unproductive, and they represent a
investment with low or zero rate of return.

12.  The day sale outstanding or average
collection period ratio is used to determine
the number of days after making a sale that
firm must wait before receiving cash. In other
words it gives an indication of the firm’s
average collection period.
 A firm with an efficient sales collection
policy normally have lower average
collection period ratio. This situation is
preferred because; it will improve the
cash flows of the firm.
 Azmi has 104.4 days outstanding, which
is well above the 60 days industry
average.
 This indicates that Azmi’s customers
takes longer period to pay their bills in
comparison to other firms’ customer in the
industry.
 As the result, this problem will then
deprive Azmi of funds (cash), that could
be used to invest in productive assets.

13.  Fixed Assets Turnover
 The Fixed Asset Turnover ratio
measures how effectively a firm
in using its plant and equipment
to generate sales and profit.
 Computing fixed assets
turnover ratio is especially
appropriate for companies in
which their operations
require significant amount
fixed equipment (i.e;
Machinery). For example,
companies involved in
manufacturing.
 Azmi’s ratio of 2.2 times is
smaller compared to the
industry’s average,
indicating that the firm is
using its fixed assets not as
extensively as other firms in
the industry.

14.  Total Assets Turnover Ratio
 The total assets turnover ratio measures
the utilization rate, or turnover rate, of all
the firm’s assets.
 Azmi’s ratio is somewhat below the
industry average, indicating that the
company is not generating sufficient
volume of business (sales) given its total
asset investment.
 Sales should be increased, some assets
should be disposed of or a combination of
these steps should be taken.
 In general, investors prefer firms that can
generate more sales for a given level of
assets and this can only be accomplished
if the assets are used extensively and
efficiently.
 However, it is also bad if the ratio
excessively high. This may mean that
assets are being overstretched and may
wear out prematurely.

15.  Debt management ratio
 The debt managemen ratio tell us what
percentage of a firm’s assets are financed
with borrowing.
 The higher the percentage, the higher the risk
 Azmi’s debt Ratio is 72.5%, which means
that his creditors has supplied for more
than half of the firm’s total financing.
 Furthermore, to make things worst, Azmi’s
debt ratio exceeds the industry average of
40% and this may make it costly for Azmi
to borrow additional funds without first
raising more equity capital..
 The cost to borrow additional funds in the
future may go up for Azmi perhaps
because future creditors are concerned
that the present excessive amount of debt
the firm carries might expose it to higher
bankruptcy risk.
 In order to bear with this high bankruptcy
risk, the future creditor may require a
higher interest rate on loan before they
provide Azmi’s any future loan.