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Week 2

Financial Ratios: the Basics

Reminder: CAMPARI
 Character
 Ability
 Margin
 Purpose
 Amount
 Repayment
 Insurance (Security)

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 Financial Ratios
• Lenders commonly analyse the basic information provided to them
by borrowers via financial ratio analysis.
• This section will talk about some commonly used financial ratios
and the pitfalls associated with their use.
• There exists a huge number of financial ratios used to analyse
financial statement.
• Some are specific to a particular industry.
• Some lending institutions have a particular set they prefer over all
others.
• This section will provide an overview of some commonly used ratios
grouped into four categories.
• Liquidity Ratios.
• Efficiency Ratios.
• Profitability Ratios.
• Leverage Ratios.

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 Liquidity ratios.
• These attempt to measure the ability of the
firm to meet its short-term obligations.
– Remember ‘cash is king’ and bills must be paid.
Many businesses with great products and
excellent long term prospects have failed due to
lack of liquidity.
– The two main ratios are:
• The Current ratio
• The Quick ratio.

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 The Current Ratio
•
• The benchmark is a value of 2, with 1.5 to 2 OK. Below
1.5 is a problem.
– Note that industry benchmarks and practices are relevant
here (as they are with all financial ratios.)
– Watch for less liquid assets being classified as current.
– Excess liquidity is also a concern as it can indicate that the
firm is failing to invest in profitable projects. But, timing
effects could simply mean a build up of liquidity prior to an
investment phase.
– High current ratios can also indicate inventory build up, so
again understanding the industry cycle is important.
• Does an increase in inventory mean the firm is getting ready for
Christmas or it has a large amount of unsellable stock that should be
written off / written down?

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 Quick Ratio

•
• A more severe version of the current ratio, so
often called the Acid test Ratio.
– Quick Assets = Current Assets – Inventory.
• This more stringent ratio removes concerns
about the value of raw materials, work in
progress and finished goods.
• A rule of thumb is that a ratio of 1 (one) is
acceptable.
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 Efficiency Ratios
• These attempt to measure the ability of a firm
to correctly run the financial aspects of their
business.
• The main ratios are:
– Inventory turnover
– Average collection period
– Average payment period.
• Some industries have measures of efficiency
very specific to their circumstances. In some
cases these will be more important than those
above.
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 Net Sales Turnover.
•
• It measures the number of times inventory turns over in one year.
– Note it is not unusual to see net sales replaced by cost of goods sold. (In
some case this is all the information available).
• A higher number is considered better, with the caveat that high sales
can be accompanied by unmet demands.
• A subset of net sales turnover (inventory turnover) is
•
• Again industry specific benchmarks are relevant.
– Note that within the industry turnover can be quite different; e.g. luxury
cars versus consumer cars.
• Note that this ratio can be manipulated:
– Changes in inventory values.
– Sales should be net sales (Gross Sales – returns)
– Year end figures may not be appropriate (use average figures).
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 Average Collection period
•
• Measure the firm’s efficiency in collection of
receivables. Firms that are better in managing
receivables tend to be better liquidity managers.
– Some accounts will list receivables as debtors.
– Average sales per day = annual sales / 365
• Average collection periods should be roughly equal to
the firm’s policy on credit terms for its customers.
• Average collection period should be viewed in
conjunction of schedule of age of receivables.
– If there are a large number (or value) of receivables in
arrears for long period (use industry benchmarks), there are
potential liquidity problems.
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 Average Payment Period
•
– Accounts payable includes notes payable.
• If average payment period increase it indicates
cash shortages.
• However, a low value is also a warning:
– The firm may not be taking full advantage of credit
terms from suppliers (inefficient managers)
– Suppliers are not granting credit terms (those inside
the industry have doubts on long term viability and
are insisting on cash settlements)
– If available liquidity is high it is the first issue, if
liquidity is low it is the second problem.
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 Profitability Ratios
• These address the question: “Is the firm
earning a profit reasonable for its industry?”
– The concept of risk and return is fundamental to
finance, so a higher value is not always better.
• Main Ratios:
– Gross profit to net sales.
– Net profit to net sales.
– Return on assets (RoA).
– Return on equity (RoE).

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 Gross profits to net sales.
!
•
• The higher the ratio the better (holding risk constant).

• Net Profits to Sales.

!
•
• Allows for the impact of the costs of operating the
business

• Again in both cases the industry benchmarks should be

considered.
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 RoA and RoE
• These can be measured either before or after
tax.
• Lenders will generally look on a before tax
basis as their obligations are paid from before
tax income.
• Again industry benchmarking is necessary.
– Higher is better but also indicate more risk.
• A time series approach is best, looking at 3 to 5 years.
• The difference between RoA and RoE will
reflect gearing.
– As RoA tends toward RoE then leverage tends
toward 0. MONASH
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 Leverage Ratios.
• These indicate the level of debt the firm has and
its ability to meet the obligations on firm cash
flow created by that debt.
• Main ratios.
– Debt / Equity Ratio
– Interest Coverage ratio
– Fixed charges coverage ratio

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 Debt / Equity Ratio
•
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• Indicates the degree to which the firm’s assets are owned by the
shareholders.
• A general benchmark for most firms (outside of financial services, insurance
and similar), is that Debt / Equity (D/E) ratios should not exceed 2.
– Thus at least 33.33% of the firm’s assets should be funded by equity.
• For D/E ratios lower is better for the lender; but industry benchmarks are
important.
• Notes:
– Equity may be on the balance sheet at historical value and so may be understated
(especially in unlisted companies).
– Some debts (e.g. debentures) may already be secured against the firm’s assets.
• Low debt ratios may indicate a firm is badly managed (not taking advantage of
the tax benefits of debt), but may also indicate industry factors (firms with
high levels of intangible assets such as biotechnology find it hard to borrow).
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 Interest coverage ratio

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•
• Measure the ability of a firm to pay its interest bill on
an ongoing basis.
• There is no real benchmark, although a value of 2 is
suggested in some cases.

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 Fixed charges ratio
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• )*+, -./+01.,2
'[ ]
342+5 -+2.
• Again higher is better. Some authors suggest rule
of thumb is that the ratio should be above 1.25,
other say that there is no benchmark (others say
it should be above 1 at least, which should be
considered a minimum)
• The ratio allows for the costs of acquiring an
asset and maintaining it as well as the tax
deductions of the borrowing used to fund the
asset.
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 Step-by-step approach to financial
statements analysis
• Step 1: Obtain relevant financial statements
• Obtain Statement of Financial Performance, Statement of
Financial Position and Cashflow statements for generally
three years

• Step 2: Check for consistency

• Verify names on financial statements, signatures of partners,
corporate seals etc.

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• Step 3: Undertake preliminary scrutiny of
financial statements
• Statement of Financial Performance
• Statement of Financial Position
• Cashflow Statement
• Step 4: Collect data about industry and general
economic trends
• Strength of economy and relevant industry

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• Step 5: Comparison with industry averages
• How does firm’s financial ratios compare with
competitor’s in same industry
• Step 6: Do supplementary analysis
• Break-even and Sensitivity Analysis
• Step 7: Summarise main features
• Provide an analytical overview from all relevant data
obtained

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Detecting window dressing, frauds and
errors
• Overwhelming accounting complexities lead
to potential abuses of the notion of ‘true
and fair’ via manipulation of:
• Valuation of receivables inventory, property,
marketable securities and other assets
• Liabilities including off-balance sheet items
• Changes to accounting methods

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 Use of financial ratios by loan
officers
• Top ten ratios of importance in loan
assessment

1 Debt/Equity 6 Net Interest Earned

2 Current Ratio 7 Net Profit Before Tax
3 Cash Flow/LT Debt 8 Financial Leverage
4 Fixed Charge Cover 9 Inv T/O in Days
5 Net Profit After Tax 10 A/c Rec T/O in Days

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 Combining financial statement and nonfinancial
statement information

• Other information that may be incorporated

into the analysis include:
– Changes in market share
– Market perceptions via share price
– Changes in key management
– Impact of macroeconomic changes

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 Using ratios
• It is important to note that a single ratio is isolation
is nearly valueless.
• A time series is needed as well as comparison with
the average industry practices.
• Some ratios are best used in combination with
others to create a fuller picture.
• However, in reality a mixed picture can result.
– This will usually result in a need to request further
details, and dig deeper.
• The rule of GIGO should also be kept in mind, the
ratios are only as good as the reports they are
drawn from.
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 Overtrading
• In the context of bank lending overtrading refers to the
situation where the firm is experiencing rapid growth and
is finding it difficult to generate the necessary financial
resources to meet its objectives.
• Symptoms:
– High revenue growth but profit margins declining.
– Increased overdraft / reduced liquidity.
– Increased collection and payment periods.
– Reduced inventory turnover.
• If it grows too fast it could be a weed!

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 Undertrading
• Undertrading is the reverse of overtrading and results in
idle funds, excessive liquidity and the under-employment
of assets.
• Undertrading is typically sourced in falling sales and slow
growth.
• Symptoms:
– High current ratios and low stock turnover.
– Falling sales
– Remember, slow growth can also generate liquidity problems.
• Bear in mind that in the lending cases and the real world
the symptoms are not always clear-cut.
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