RATIOS

II. Financial Ratios Overview

Financial ratios are quantitative metrics that provide valuable insights into different aspects of a
company's performance. They help analysts and investors make informed decisions. We'll categorize
these ratios into different groups:

1. Profitability Ratios:

Measure a company's ability to generate profit relative to its revenue.

Key ratios: Net Profit Margin, Return on Equity (ROE), Return on Assets (ROA).

Example: Net Profit Margin = (Net Income / Revenue) * 100

2. Efficiency Ratios:

Assess how effectively a company utilizes its assets to generate sales and income.

Key ratios: Asset Turnover, Inventory Turnover, Receivables Turnover.

Example: Asset Turnover = Revenue / Average Total Assets

3. Leverage Ratios:

Evaluate the extent to which a company relies on debt for financing.

Key ratios: Debt-to-Equity Ratio, Interest Coverage Ratio.

Example: Debt-to-Equity Ratio = Total Debt / Shareholders' Equity

4. Liquidity Ratios:

Measure a company's ability to meet its short-term obligations.

Key ratios: Current Ratio, Quick Ratio.

Example: Current Ratio = Current Assets / Current Liabilities

5. Coverage Ratios:
Assess a company's ability to cover its financial obligations.

Key ratios: Interest Coverage Ratio.

Example: Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expenses

6. Growth Percentage:

Calculate the growth rate of key financial metrics.

Example: Growth Percentage = [(Current Value - Past Value) / Past Value] * 100

7. Ratios with Market Value Information:

Integrate market data into the analysis.

Key ratios: Price-to-Earnings (P/E) Ratio, Market-to-Book Ratio.

III. Business Performance Analysis

1. Key Drivers of Sales, Cost Structure, and Profitability:

Identify factors influencing revenue, cost of goods sold, and overall profitability.

Comparative analysis with industry peers for benchmarking.

2. Trend Analysis for Extrapolation:

Use historical data to identify trends.

Extrapolate future performance based on historical patterns.

3. Competitive Advantage Analysis:

Compare the company's performance with industry peers.

Identify unique strengths and weaknesses.

IV. Financing (Funding) Performance Analysis

1. Solvency, Liquidity, and Coverage Ratios:

Assess financial risk and stability.

Evaluate the company's ability to cover its debts and maintain liquidity.

Conclusion:

Business analysis tools provide a comprehensive view of a company's financial health, aiding in
decision-making processes for investors, creditors, and management. Utilizing these tools allows for a
deeper understanding of a company's profitability, efficiency, and financial stability.

KEY RATIOS

GUIDE PAGE 155

II. Key Principles of Ratio Analysis

Quick and Dirty Analysis:

Ratio analysis is an initial, rapid assessment of a company's financial health.

It provides a snapshot of key performance indicators.

Context is Crucial:

Ratios alone are meaningful when compared with external benchmarks.

Benchmarking with sector peers is essential for context and industry standards.

Example: If a company has a current ratio of 2.5, it's important to compare this against the average
current ratio of similar companies in the industry.

Time Series Comparison:

Ratios become more insightful when compared over time.

Analyzing trends helps identify evolving patterns in a company's performance.

Example: A declining net profit margin over several years may indicate deteriorating profitability.

Structural vs. Incidental Developments:

Understand whether changes in ratios are due to fundamental shifts in the company's structure or
are temporary incidents.
Example: An increase in debt might be due to a strategic decision (structural) or a one-time
investment (incidental).

Accounting Differences:

Be aware of accounting practices and changes.

Consistent accounting methods enhance the reliability of ratio analysis.

Example: A change in depreciation method can impact the asset turnover ratio.

Risk Measurement:

Deviations from sector averages indicate potential risks.

Identify areas where a company differs significantly from its peers.

Example: A much higher debt-to-equity ratio compared to industry averages may signal higher
financial risk.

Detecting Inconsistencies:

Scrutinize ratios for inconsistencies and anomalies.

Ensure that the financial statements are reliable.

Example: A sudden spike in inventory turnover might indicate aggressive sales practices or inventory
management issues.

III. Examples of Key Ratios and Their Interpretations

Current Ratio:

Formula: Current Assets / Current Liabilities

Interpretation: A ratio above 1 indicates the company's ability to cover short-term obligations.

Net Profit Margin:

Formula: (Net Income / Revenue) * 100

Interpretation: Indicates the percentage of revenue that translates into profit.

Debt-to-Equity Ratio:

Formula: Total Debt / Shareholders' Equity

Interpretation: Measures the proportion of debt used for financing.

Return on Assets (ROA):

Formula: Net Income / Average Total Assets

Interpretation: Evaluates how efficiently assets are used to generate profit.

Conclusion:

Ratio analysis provides a powerful tool for assessing a company's financial health. However, its
effectiveness lies in careful interpretation, benchmarking, and consideration of broader economic and
industry factors. Being mindful of potential distortions, accounting changes, and industry benchmarks
enhances the accuracy and usefulness of ratio analysis in decision-making processes.

Lecture Notes: Profitability Analysis in Corporate Advanced Finance

I. Introduction to Profitability Analysis

Profitability analysis is a critical aspect of assessing a company's financial health and performance. In
this lecture, we will explore key tools and formulas for profitability analysis, including the Dupont
formula, added value, and breakeven calculations.

II. Dupont Formula for ROA and ROE

1. Return on Assets (ROA):

 Formula: ROA= NetIncome/ Average Total Assets

 Interpretation: Measures how efficiently a company generates profit from its assets.

Example: If a company has an ROA of 10%, it means it is generating $0.10 of profit for every dollar of
assets.

2. Return on Equity (ROE):

 FormulaROE=NetProfitMargin×AssetTurnover×(1−TotalAssetsDebt)

 Interpretation: Evaluates the return earned on shareholders' equity.

Example: An ROE of 15% implies that the company is providing a 15% return on shareholders' equity.

Dupont Formula Components:

 Net Profit Margin: NetProfitMargin=NetIncome/Turnover

 Asset Turnover: AssetTurnover=TurnoverAverageTotal/Assets

 Leverage (1 - Debt/Total Assets): Represents the impact of leverage on ROE.

III. Added Value Analysis

1. Gross Margin Ratio:

 Formula: GrossMarginRatio=NetSales−COGS/NetSales

 Interpretation: Measures the proportion of revenue retained after accounting for the
cost of goods sold.

Example: If the gross margin ratio is 30%, it means the company retains 30 cents from every dollar of
sales after covering the cost of goods sold.

2. Added Value:

 Represents the value a company adds to its products or services.

 Calculated by subtracting variable costs from sales revenue.

Example: If a company's total revenue is $1 million and variable costs are $300,000, the added value
is $700,000.

IV. Breakeven Analysis

1. Fixed versus Variable Costs:

 Fixed Costs: Do not vary with the level of production.

 Variable Costs: Vary with the level of production.

Example: Rent is a fixed cost, while raw materials are variable costs.

2. Breakeven Analysis:

 Calculates the level of sales at which total revenue equals total costs.

 Formula: BreakevenPoint= FixedCosts/SellingPrice−VariableCosts

Example: If fixed costs are $50,000, selling price is $20, and variable costs are $10, the breakeven
point is 5,000 units.

3. Cash Breakeven Analysis:

 Includes cash investments in fixed assets and working capital for additional turnover.

 Assesses the minimum level of sales required to cover cash expenses.

Conclusion: Profitability analysis is crucial for understanding how efficiently a company generates
returns for its stakeholders. Utilizing tools like the Dupont formula, added value analysis, and
breakeven calculations provides a comprehensive view of a company's financial performance and aids
in strategic decision-making. As with any financial analysis, careful interpretation and consideration of
industry benchmarks are essential for accurate assessments.