Dr. Md.

Rezaul Kabir
M.Sc. (UK), Ph.D. (UK)

Associate Professor &

Coordinator, Executive MBA Program
Institute of Business Administration
University of Dhaka

E-mail: mrkabir@iba-du.edu

1
 Learning Objectives
By the end of this session you will be able to:

1. Identify the tools of comparative analysis: horizontal

analysis, vertical analysis, ratio analysis

2. Calculate the relevant ratios

3. Explain how ratios can be used to analyse the financial

performance and position of a business

4. Explain the limitations of ratio analysis

2
 What Is Financial Statement Analysis (1)

• Single items on financial statements don’t tell the whole

story

• For critical analysis we need relative figures in order to

compare company’s performance with previous years,
target values and industry norms

• Ratio analysis is a tool:

 to assess performance/position of the company
 to identify opportunities for improvement

3
 What Is Financial Statement Analysis (1)

Examples:
• Investors use financial statement analysis to
– Predict future returns
– Assess the risks associated with those returns
• Creditors are primarily concerned with
– Short-term liquidity – how much cash a company
has on hand to meet current payments when due
– Long-term solvency – a company’s ability to
generate cash to repay long-term debts when due

4
 Sources of Information
about Companies
• Company annual reports include:
– The financial statements
– Footnotes to the financial statements

– A summary of the accounting principles/methods used

– The directors’ report
– The auditor’s report

– Comparative financial data for a series of past years

– Narrative information about the company
5
 Types of Financial Statement Analysis

A. Cross-sectional analysis (inter-company analysis)

B. Time series analysis (intra-company analysis)

C. Vertical analysis (common size analysis)

D. Ratio analysis

6
A. Cross-sectional Analysis (Inter-company Analysis)

Co.A Co.B

£’ 000 £’ 000

Net Profit 200 1,000

Net Asset 500 10,000

Return
Return on Asset (ROA) 40% 10%

7
 B. Time Series Analysis (Intra-company Analysis)

Previous Current Year

Year
£’000 £’000
Net Profit 900 1000
Net Assets 8000 10000
Return on Asset (ROA) 11.25% 10%

8
 Trend Analysis [Over More than 2 years]
• Trend analysis compares financial statement changes
over time and identifies patterns that have occurred
• To compute percentage changes, the change for an
item (like net profit) is divided by the base year
amount:

1993 £ - 1992 £
Percentage change = x 100
1992 £

9
 Trend Analysis 1

1992 1993 1994 1995 1996

£’000 £’000 £’000 £’000 £’000

Net Profit 150 195 249 309 375

% Change +30% +27.69% +24.10% +21.36%

195-150 249-195 309-249 375-309

----------- ----------- ----------- -----------
150 195 249 309
= 0.3 = 0.2769 = 0.2410 = 0.2136
= 30% = 27.69% = 24.10% = 21.36%

10
 Trend Analysis

• The change in net profit is in 1993:

£195 - £150
Percentage change = x 100
£150
= +30%

11
 Trend [Horizontal] Analysis 2

1992 1993 1994 1995 1996

£’000 £’000 £’000 £’000 £’000

Net Profit 150 195 249 309 375

Index No. 100 130 166 206 250

       
= 0.3 = 0.66 = 1.06 = 1.50
= 30% = 66% = 106% = 150%
So, So, So, So,
100 +30 100+66 100+106 100+150
=130 =166 =206 =250

12
 Vertical
Vertical (Common-size)
(Common-size) Analysis
Analysis

An analysis of percentage change where all

balance sheet items are divided by total assets and
all income statement items are divided by sales or
revenues.
Vertical Analysis of Balance Sheets
Example
Example of
of Common
Common Size
Size Income
Income
Statements
Statements
Figure 1. Percentage change income statements.
Figure 2. Common-size vertical income statements.
Figure 3. Percentage change balance sheets.
Figure 4. Common-size vertical balance sheets.
 Financial Statement and Ratio Analysis

• Financial ratios are a popular way for users of financial statements

to develop insights into the financial performance of companies.

• By controlling for the effect of firm size on the level of

performance, ratios enable financial statement users to examine
how a firm has performed relative to its peers and relative to its
own historical performance.

• A firm’s ratios can differ from its peers or its own historical
performance because it has selected a different product market
strategy, because its management team has become more effective
at implementing its strategy, or because it has selected a different
financial strategy.
 Financial Statement and Ratio Analysis

• Sometimes firms can appear to perform differently because they

have selected different accounting methods for reporting the
same underlying economic events.

• For this reason, a precursor to effective financial ratio analysis is

the development of a clear understanding of how a firm’s
accounting decisions compare with those of its competitors, or
with its own decisions in prior years.

• Common adjustments include: adjusting LIFO inventories to a

FIFO basis; changing the depreciation method for assets;
changing the policy for bad debts; revaluing tangible and
intangible assets to reflect their fair market value.
 Financial Statement and Ratio Analysis
• One way of looking at a set of financial statements is in terms of the
information they convey about an organization's financial strengths
and weaknesses.

• In particular, properly analyzed, the income statement, balance sheet,

and statement of cash flows can convey a great deal of information
about an organization's day to day operations and financial
management activities.

• The asset side of the balance sheet contains those items that an
organization owns or has claim to, whereas the liability and equity
side shows how the assets have been financed.
23
 Accounting Equation 2

Current Liabilities
+Long Term
Liabilities
Current Assets
+ Long term
Assets

Capital
+ Retained
Earnings
 Income Statement for the year ended June 30, 2017
Sales Revenue: 220
Cost of Goods Sold (COGS):   125

Gross Profit   95

Operating Expenses:
Salary expense 16
Utilities expense OPEX 15
Rent expense 16
Depreciation Partial CAPEX 18
Total Operating Expenses 65
Operating Profit/ Earnings Before Interest & Tax 30
Interest Payment Partial FINEX 10
Earnings Before Tax 20
Tax for the year @ 40% 8
Net income after tax   12
Proposed dividends 5
Retained earnings for the year 7
 Cont’d from previous slide

% of Operating Profit (EBIT)

Interest Payment
33%
Here,
Net Income
40%
EBIT = 30
Interest = 10
Tax = 8
Net Income = 12

Tax
27%

26
 WHY USE RATIO ANALYSIS?

Imagine yourself with, say, $1,000 to invest in one of two

companies: Company A or Company B. You are given the
following information about each company:

Company A Company B
Net income last year $100,000 $1,000,000
Current assets as of the end of 50,000 $500,000
last year
 WHY USE RATIO ANALYSIS?
Imagine yourself with, say, $1,000 to invest in one of two companies:
Company A or Company B. You are given the following information
about each company:

Company A Company B
Net income last year $100,000 $1,000,000
Current assets as of the end of last year 50,000 $500,000

In which company would you invest? Before deciding, suppose you were
given the following information about the two companies:

Company A Company B
Shareholders' equity as of the end of the last $500,000 $100,000,000
year
Current liabilities as of the end of last year 25,000 $10,000,000

28
 WHY USE RATIO ANALYSIS?

Company A Company B
Net income last year $100,000 $1,000,000
Current assets as of the end of last year 50,000 $500,000

Company A Company B
Shareholders' equity as of the end of the last $500,000 $100,000,000
year
Current liabilities as of the end of last year 25,000 $10,000,000

Formula Company A Company B

Return on Equity (ROE) Net Income/Total Equity 20% 1%

Current Ratio Current Asset/Current Liabilities 2 0.05
29
 WHY USE RATIO ANALYSIS?

•This information has told us about two factors that might

be of considerable importance to an investor: the relationship
between net income and equity, and the relationship between
current assets and current liabilities.

•Each is important for different reasons. If, for example,

you are interested in investing in a company that will earn
the highest return possible on your $1,000, you presumably
would prefer to have it invested in Company A, where net
income is 20 percent of equity ($100,000 ÷ $500,000),
rather than Company B, where net income is only 1 percent
of equity ($1 million ÷ $100 million).

•Of course, these are the figures for last year only, and the
future may be quite different from the past. Nevertheless, the
notion of a return on investment would lead you in a quite
different direction than simply looking at net income in
isolation.
 WHY USE RATIO ANALYSIS?

•Similarly, if you are interested in investing in a company that can

meet its current obligations when they come due, you presumably
would be somewhat more concerned about Company B than
Company A.

•That is, Company B has $10 million of liabilities that are

current (will be due and payable sometime in the next year), and
only $500,000 of current assets at the moment to provide the cash
needed to meet those obligations. Company A, by contrast, while
having only $50,000 in current assets, has only $25,000 in current
liabilities, giving it a comfortable margin of safety.
 WHY USE RATIO ANALYSIS?

•Clearly there are many other factors you would consider in

making an investment decision. The purpose of this example is
only to illustrate that the absolute dollar amounts, by
themselves, tell you relatively little about an organization's
financial strength.

•Moreover, if we are to make comparisons of any sort—

between two or more companies, or between different years of
operations for the same company—we must use something
other than flat dollar amounts. Ratios allow us to do this.

•Ratios link income statement amounts to balance sheet

amounts. When doing so, one typically uses the end-of-year
balance sheet amount associated with a given year’s income
statement amount.

32
 WHY USE RATIO ANALYSIS?

•Even ratios have limitations, and we must supplement them if

we are to fully understand and analyze a company's financial
statements.

•Nevertheless, by permitting us to move beyond the absolute

magnitude of the numbers on the financial statements to a set of
relationships between and among the numbers, ratios can assist
us greatly in the analytical effort.
•CATEGORIES OF RATIOS

• There are many ratios that can be used for purposes of analyzing a
set of financial statements. There are three broad categories of ratios:
profitability, operating efficiency, and leverage (the use of debt
financing).

•In this session, we will look at only a few ratios in each

category.
 Profitability Ratios
• Profitability ratios evaluate the degree to which operations are providing an
acceptable return on investment. The return can be evaluated relative to all
investments (assets) or just to the investment made by shareholders (equity).

• Whenever an ROI (i.e. ROA, ROE, ROC) is calculated, it is important to

distinguish between book values and market values. Book values, taken
from the financial statements, reflect past actions.

• For example, the book value of total assets is equal to the sum of the
amounts paid when the asset was acquired less the depreciation taken over
time.

• Similarly, the equity accounts reflect the proceeds received from equity
financings at the time the financing occurred along with the earnings
retained at the time they were earned.
 Profitability Ratios
•The current value of either assets or equity is likely to have
changed substantially.

•A return should reflect what is obtained relative to the current

value of an investment, not its historic value, although this is not
always implemented.

•Whenever an ROI (i.e. ROA, ROE, ROC) is calculated, the

inputs are often obtained from financial statements and are,
therefore, book values.

•However, this analysis can still provide insight into changes

over time and may allow comparisons across firms.
 Three important profitability ratios

• Return on Asset (ROA) = Net Income/Total Asset

• Return on Equity (ROE) = Net Income/Total Owner’s

Equity

• Return on Capital (ROC) = Net Income/Total Capital

* Capital = Long-term liability + Total Owner’s Equity
 Two Other Variations of ROC
 

37
 Other Profitability Ratios
•In addition to the measures above, there are a number of other common
measures focused on earnings and dividends. The most common are shown
in the following table.
Earnings per NI/Shares The net income generated by
share (EPS) the firm for each share
outstanding
Dividend per Total The dividend paid to each
share (DPS) dividend/Shares share outstanding
Earnings yield EPS/Price The net income per share
provide by the firm for each
dollar of share value
Dividend yield DPS/Price The return provided to
shareholders that they receive
through a dividend
Price–Earnings Market Price/EPS The magnitude of the current
ratio price relative to the current
earnings of a firm
 Operating Profitability
•A wide variety of operating ratios are used to
evaluate those activities. The most commonly
employed are shown in the following table.
Gross margin (Sales − COGS) / The amount a firm earns above
(%) Sales the cost of the goods it has sold,
as a percentage of the selling
price
Operating Operating income The amount the firm earns
margin (%) (i.e. EBIT) / Sales above all costs except financing
costs and taxes, as a percentage
of the selling price
Net Profit Net Profit after The amount the firm earns after
Margin (%) Interest and taking into account of all costs, as
Tax/Sales a percentage of the selling price
 P/ E Ratio
  Company A Company B

Mkt Price Per Share 100 100

Earning Per Share 10 5

P/E 10/1=10 20/1=20

44
 P/ E Ratio: Factors to Consider
• Although a higher P/ E ratio means that the earning is lower relative to
the current market price.

• But it also means that the market is ready to pay a higher price for this
low earning - which may indicate the high earning potential of the
company in the future.

• P/E ratio is often subject to various interpretations. (For example, a

higher P/E ratio can mean that the company is overvalued, or it can also
mean that the company has huge expected growth opportunity).

• It is important to look at the industry average and other similar

companies to determine whether the P/E ratio is appropriate or not.

• So, it is better to see whether the expected growth potential of the

company requires the premium and look at the relative valuation to
determine whether the premium is worth the cost of the investment.
 Other Profitability Ratios (2)
•There is one common measure used to capture the ability of a
firm to create value from its investments.
•If we consider the current market value of the firm (the sum of
equity value and debt value) to reflect the total value created by
firm actions, and we consider the book value of the firm to reflect
the total amount invested, then the so-called market-to-book ratio
reflects the value created for each dollar of investment:

Market-to- (Price × Shares + The ratio of the market value

book ratio Debt) / (OE + Debt) of equity (price per share
    multiplied by shares
    outstanding) plus the book
  value of debt to the book
value of equity and debt
 Other Profitability Ratios (3)
 

47
 Liquidity Ratios
• The liquidity ratios describe the ability of the firm to meet its
payment obligations related to short-term commitments,
specifically the ability to make payments related to current
liabilities.

• Market liquidity refers to the extent to which a market, such as

a country's stock market or real estate market, allows assets to
be bought and sold at stable prices. Cash is considered the
most liquid asset, while real estate and fine art are all relatively
illiquid.

• Accounting liquidity measures the ease with which an

individual or company can meet their immediate financial
obligations with the liquid assets available to them. There are
several ratios that express accounting liquidity.
 Concept of Liquidity
• Cash is considered the standard for liquidity, because it can most
quickly and easily be converted into other assets. If a person
wants to buy a $1,000 refrigerator, cash is the asset that can
most easily be used to obtain it.
• If that person has no cash but a rare book collection that has
been appraised at $1,000, she or he is unlikely to find someone
willing to trade them the refrigerator for their book collection.
• Instead, she/he will have to sell the collection and use the cash
to purchase the refrigerator. That may be fine if the person can
wait months or years to make the purchase, but it could present
a problem if the person only had a few days.
• S/he may have to sell the books at a discount, instead of waiting
for a buyer who was willing to pay the full value. Rare books are
an example of an illiquid asset.
 Concept of Liquidity
In the example above, the market for refrigerators in exchange
for rare books is so illiquid that it does not exist. The stock
market, on the other hand, is characterized by higher market
liquidity.

If an exchange has a high volume of trade, the price a buyer

offers per share (the bid price) and the price the seller is willing
to accept (the ask price) will be fairly close to each other. When
the spread between the bid and ask prices grows, the market
becomes more illiquid.

Markets for real estate are usually far less liquid than stock
markets.
 Accounting Liquidity

In practical terms, assessing accounting liquidity

means comparing liquid assets to current
liabilities, or financial obligations that come due
within one year. There are a number of ratios
that measure accounting liquidity, which differ in
how strictly they define "liquid assets."
 Current Ratio
• The current ratio is the simplest and least strict
ratio. Current assets are those that can
reasonably be converted to cash within a year.

• Current Ratio = Current Assets / Current

Liabilities
 Acid-Test or Quick Ratio
• This quick or acid test ratio is a variant of the current ratio. It
distinguishes current assets that can be converted quickly into
cash from those that cannot.

• The quick ratio is an indicator of a company’s short-term

liquidity position, and measures a company’s ability to meet its
short-term obligations with its most liquid assets.

• It is slightly more strict. It excludes inventories and other current

assets, which are not as liquid as cash, accounts receivable and
short-term investments.
 Acid-Test or Quick Ratio

1. Quick Ratio = (Cash + Short-Term Investments + Accounts

Receivable) / Current Liabilities

• A variation of the acid-test ratio simply subtracts inventory

from current assets, making it a bit more generous:

2. Quick Ratio (Variation) = (Current Assets - Inventories) /

Current Liabilities
 Example of Quick Ratio
Johnson & Kimberly-
(in millions) Procter & Gamble
Johnson Clark Corp.
Quick Assets
$26,490 $43,090 $5,210
(A)
Current Liabilities
$30,210 $30,540 $14,210
(B)
Quick Ratio
0.88 1.41 0.367
(A/B)

With a quick ratio of higher than 1, Johnson & Johnson appears to

be well positioned to cover its current liabilities and has liquid
assets available to cover each dollar of short-term debt.
However, Procter & Gamble and Kimberly-Clark may not be able
to pay off their current debts using only quick assets since both
companies have a quick ratio below 1.
 Interpreting Quick Ratio (1)

• A company that has a quick ratio of less than 1 may not be able to fully pay off
its current liabilities in the short term, while a company having a quick ratio
higher than 1 can instantly get rid of its current liabilities.
• For instance, a quick ratio of 1.5 indicates that the company has $1.50 of liquid
assets available to cover each $1 of its current liabilities.
• While such numbers-based ratios offer insights into certain aspects of liquidity,
they may not provide a complete picture of the liquidity position of the
business. It is important to additionally look at other associated measures to
assess the true picture.
• Limitations of Balance Sheet (Single Date, Prone to manipulation)
• While calculating the quick ratio, one should be careful about the constituents
to be considered in the formula. The numerator that comprises of liquid assets
should include the assets that can be easily converted to cash in the short-
term (like, within 90 days) without compromising on their price to a great
extent.
 Interpreting Quick Ratio (2)
• Whether accounts receivable is a source of quick ready cash
remains a debatable topic, and depends on the credit terms that
the company extends to its customers.

• Only those accounts receivable should be considered which can be

realized in the short term. Accounts receivable refers to the
money that is owed to a company by its customers for goods or
services that are already delivered.

• Inventory is not included in the equation, because its liquidation

or sale is uncertain and attempts to instantly liquidate it can lead
to compromising on valuations and accept a lower price than the
book value. Inventory includes raw materials, components and
finished products.
 Interpreting Quick Ratio (3)
• For instance, a business may have a large amount of money as
accounts receivable which may bump up the quick ratio.
However, if the payment from the customer is delayed due to
unavoidable circumstances, or if the payment is due after a long
period (like, 120 days) based on the terms of sale, the company
may not be able to meet up its short term liabilities which may
include essential business expenses and accounts payable that
may be due for immediate payment.

• Despite having a healthy quick ratio, the business is actually at

the verge of running out of cash. On the other hand, if the
company negotiates rapid receipts of payments from its
customers and secures longer terms of payments from its
suppliers, it may have a very low quick ratio but may be fully
equipped to pay off its current liabilities.
 Interpreting Quick Ratio (4)
• A company that needs advance payments or allows only 30
days to the customers for payment will be in a better liquidity
position than the one that gives 90 days.
• Additionally, a company’s credit terms with its suppliers also
affects its liquidity position. If a company gives its customers 60
days to pay, but has 120 days to pay its suppliers, its liquidity
position may be reasonable.
 Cash Ratio
• The cash ratio is the most stringent measure of the
liquidity position, excluding accounts receivable and
short-term Investments, as well as inventories and
other current assets.
• It assesses an entity's ability to stay solvent in the case
of an emergency. Even highly profitable companies can
run into trouble if they do not have the enough cash to
react to unforeseen events.
• Cash Ratio = Cash/ Current Liabilities
 Working Capital Ratios
• The operating cycle covers the time from when a company
purchases inventory to when it collects cash payment from
its customers for the sale of that inventory.

• It is the amount of time a company takes to turn its

purchase of inventory into cash received from customers.

• Several things happen during that operating cycle. The

company purchases inventory, makes payment to suppliers
for that inventory, sells that inventory to customers, and
collects payment from customers.

• These events are depicted in the next slide:

• The time between the purchase of inventory and the sale
of that inventory to customers is called Days In
Inventory (DIO).

• The time between the sale of inventory and the collection

of cash payment from customers is called Days Sales
Outstanding (DSO).

• The operating cycle is the total of DIO and DSO. If the

company pays its suppliers for the inventory purchase at
the time it makes the purchase, it will have cash tied up in
working capital for the total operating cycle.
• Note that the company can decrease the proportion of the
operating cycle during which cash is tied up by purchasing
its inventory on account and paying its suppliers later
(depends on bargaining power).

• The time between the purchase of inventory and the

payment to suppliers is called Days Payables
Outstanding (DPO).

• Finally, the time between the payment to suppliers and the

collection of cash from customers is called the Cash
Conversion Cycle (CCC); it is the amount of time that
cash is tied up before the company collects cash from
customers.
• Industries that are involved in the production of complex durable goods
tend to have longer operating and cash conversion cycles.
• This is most clearly demonstrated by observing the construction industry.
Long lead-time projects such as housing developments tie up working
capital for extended periods of time as projects are slowly built.

• Cash may not be collected until the end of the projects when the projects
are handed over to their owners, which explains the long cash
conversion cycle.

• On the other hand, A restaurant’s operating cycle is expected to be low

since much of their goods are perishable and are in constant need of
replenishing. In addition, most customers pay either in cash or by credit
card, which when combined with normal trade terms for suppliers,
explains the near zero cash conversion cycle.
Exhibit 3: From the data we can see a stark difference
between Amazon and Wal-Mart’s DPO. Amazon is pressuring
its suppliers significantly, with DPO around 107 days
compared with Wal-Mart’s 40 days.

This is consistent with Amazon’s aggressive strategy to

squeeze its suppliers in all manners and not just in terms of
desiring the absolute lowest cost possible.

It also raises certain red flags about Amazon’s model, most

notably the potential that suppliers may become less
interested about working with Amazon and in time may offer
worse pricing terms.
Exhibit 4: This data illustrates the difference between two of the largest
manufacturers and exporters of goods in the United States. Both produce
complex high-value products in their respective markets.

• Boeing illustrates why it has long operating and cash-conversion cycles.

The production of an entire aircraft clearly takes longer and ties up
significantly more capital in inventory than does the production of high-end
electronics, with Boeing having a DIO of around six months compared to
Apple’s DIO of just one week.

• These two companies were recognized as highly capable and effective

operators and as such illustrate the range of outcomes even when
companies are well run.

• It should also be noted that Boeing manufactures much of its product in-
house, whereas Apple outsources production to low-cost manufacturers.
Exhibit 6: The comparison of two U.S. auto manufacturers competing in the same
fundamental market but with very different strategies and business models, with the
two most noteworthy differences being in their DIO and DSO.

• Ford, the traditional auto maker, has very low DIO; as soon as it produces
inventory that inventory is immediately sold into the dealer network, which assumes
ownership. Ford does not own its dealers. This means the majority of inventory
Ford has in its system is raw materials and work in process.

• Conversely, Tesla has a radically different business model, at least within the auto
industry, of direct sales. As a result, the company retains ownership of all finished
vehicles, significantly increasing the value of inventory it holds and increasing its
DIO.

• With DSO, we see the benefit of Tesla’s model. Its very low DSO is a function of
its sales being direct to customers. Conversely, Ford manufactures large stocks of
inventory that sit on dealers’ lots. These large bulk purchases of inventory have
been acquired by the dealers but are often only paid for once the inventory has
been sold from its dealer lots.
 Leverage Ratios

• How a firm chooses to finance its operations can dramatically affect

performance. For example, the use of debt financing will have a large
impact on the ROE (as seen in the next few slides), and both interest
payments and principal repayments are an inflexible drain on operating
cash flows.

• A wide variety of ratios are used to describe a firm’s financial choices.

Since the degree to which a firm uses debt is often referred to as “financial
leverage,” or simply “leverage” when the context is clear, the financing-
related ratios are referred to as leverage ratios.

• All leverage ratios measure, in some fashion, the use of debt and the
burden of debt payments. The most common ratios are shown in next slide.
 Table: Common leverage ratios.
Times interest earned EBIT/Interest The ability of a firm to meet its
required interest payments from
pretax operating cash flow
Debt service coverage EBIT/Total debt The ability of a firm to meet all its
service required debt payments (principle
plus interest) from pretax operating
cash flow

Debt ratio Debt/TA The magnitude of debt relative to the

total assets of a firm; also called the
debt-to-assets ratio

Gearing ratio Debt/Debt+OE The magnitude of debt relative to the

total long-term capital of a firm

Debt-to-equity ratio Debt/OE The magnitude of debt relative to the

use of equity financing
 Leverage Ratios
• Leverage ratios are often adjusted to suit various applications, and many
variants exist. This can be a source of frustration and confusion.

• In most of the cases, for example, debt may be limited to long-term debt.

• Furthermore, debt plus equity will not equal total assets due to the
existence of current liabilities. For this reason, some calculations will use
the sum of debt and equity for total assets in the debt ratio, and some
calculations will assume debt is equal to total assets less equity
(essentially including current liabilities in debt).

• Finally, in some instances, the amount of cash on hand will be subtracted

from debt (the result is referred to as “net debt”). Since these many
variants can lead to slightly different conclusions, leverage ratios require
extra care and attention.
 Example - Gearing
The long-term capital structures of three new businesses, Lee Ltd, Nova Ltd, and IBA
Ltd are as follows:
Lee Ltd
Nova Ltd IBA Ltd
£
£
£1 share (OE) 100,000 200,000
300,000
10% loan 200,000 100,000
0
300,000
300,000 300,000
Annual Interest expense 20,000 10,000
 Net Profit = EBIT-Interest-Tax
0
 Gearing Ratio = D/D+E
 of Interest
In their first year Coverage
operations, Ratio
they each = EBIT/Interest
make a profit before interest and taxation
 Return
[EBIT] of £50,000. The tax on
rateEquity = Calculate-
is 30%. NP/OE
 Lee Nova IBA

Earnings before Interest and Tax (EBIT) 50,000 50,000 50,000

(-) Interest (10%) . 20,000 10,000 0
Earnings Before Tax (EBT) 30,000 40,000 50,000
(-) Tax (30%) . 9,000 12000 15,000
Net Profit . 21,000 28,000 35,000

.
Gearing Ratio 200/(200+100) 100/(100+200) 0/300
=66.66% =33.33% =0%

Interest Coverage Ratio 50000/20000 50000/10000 50000/0

=2.5 times =5 times = NA

Return on Equity 21000/100,000 28000/200,000 35000/300,000

=21% =14% =11.67%
  

Lee Ltd     Lee Ltd

         

EBIT 100000   EBIT  25000

INT 20000   INT  20000

EBT 80000   EBT  5000

Tax (30%) 24000   Tax (30%)  1500

Net Income 56000   Net Income  3500

 OE 100000     OE 100000 

ROE 56.00%   ROE  3.50%

78
 ROE Drivers

•   •The DuPont Formula helps us to get a better understanding

of reasons for difference in ROEs across firms. It recognizes that
three fundamental factors drive ROE: net profit margins
(reflecting how well the firm manages its operations), asset
turnover (reflecting how efficiently it uses its assets), and its
financial leverage.

•The following formula shows how these factors fit together

to make up ROE:

= Net Profit Margin x Asset Turnover x Financial

Leverage
 DuPont decomposition.
Profit margin NI/ Measures operating efficiency:
Sales Describes how much income is
generated from a dollar’s worth
of sales
Asset turnover Sales/ Measures asset utilization: Describes
TA how much revenue is generated
from a dollar’s worth of assets
Leverage TA/OE Measures the use of debt financing:
Describes how much is invested in
assets for each dollar’s worth of
equity investment
Return on assets (ROA) NI/TA The rate of return generated by
invested assets
Return on equity (ROE) NI/OE The rate of return earned by equity
investors
 Profitability Ratios

• In addition to the insights provided by each measure, there is a link

between these that is often emphasized.
• Specifically, that:

• ROA = Profit margin × Asset turnover

• ROE = Profit margin × Asset turnover × Leverage
= ROA × Leverage

• In this way, we see that the return earned on assets is a function of

(the product of) operating efficiency and asset utilization , and that the
return to equity holders is the ROA scaled up by the degree to which
debt financing is used.
 Some Cash Flow Ratios

 Quality  of   Earnings   = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑎𝑠h 𝐹𝑙𝑜𝑤

𝐸𝐵𝐼𝑇

  𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑎𝑠h 𝐹𝑙𝑜𝑤

𝐂𝐚𝐬𝐡 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐂𝐨𝐯𝐞𝐫𝐚𝐠𝐞 𝐑𝐚𝐭𝐢𝐨=
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑎𝑏𝑙𝑒

  Operating Cash Flows Per Share

82
 Operating Cash Flow (OCF)
Operating cash flow is a measure of the amount of cash generated
by a company's normal business operations.

Operating cash flow indicates whether a company can generate

sufficient positive cash flow to maintain and grow its operations, or
it may require external financing for capital expansion.

Investors also examine a company’s cash flow from operating

activities to determine where a company is really getting its money
from. In contrast to investing and financing activities which may be
one-time or sporadic, the operating activities are core to the
business and are recurring in nature.
Customized Ratios For a Garment Manufacturer

  𝑆𝑎𝑙𝑒𝑠
𝑆𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑒=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐸𝑚𝑝𝑙𝑜𝑦𝑦𝑒𝑠

  𝐴𝑛𝑛𝑢𝑎𝑙 𝑆𝑎𝑙𝑒𝑠
𝑆𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑆𝑞𝑢𝑎𝑟𝑒 𝐹𝑒𝑒𝑡 =
𝑇𝑜𝑡𝑎𝑙 𝐹𝑙𝑜𝑜𝑟 𝐴𝑟𝑒𝑎 (𝐼𝑛 𝑆𝑞𝑢𝑎𝑟𝑒 𝐹𝑒𝑒𝑡 )

  𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑊𝑎𝑠𝑡𝑎𝑔𝑒 𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑑 𝑖𝑛 𝑎 𝑌𝑒𝑎𝑟

𝑊𝑎𝑠𝑡𝑎𝑔𝑒 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡 =
𝑇𝑜𝑡𝑎𝑙 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑈𝑛𝑖𝑡𝑠 𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑑

 𝐸𝑛𝑒𝑟𝑔𝑦 𝑈𝑠𝑒𝑑 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝐸𝑛𝑒𝑟𝑔𝑦 𝑈𝑠𝑒𝑑 𝑖𝑛 𝑎 𝑌𝑒𝑎𝑟

𝑇𝑜𝑡𝑎𝑙 𝑈𝑛𝑖𝑡𝑠 𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑑

84
 6. THE LIMITATIONS OF RATIO ANALYSIS

1. Different accounting policies results in misleading

comparisons.

2. Historical cost data distorts comparisons.

3. Performance criteria/yardsticks are not appropriate for

all types of industries.

4. A single ratio provides limited information.

85
 Final Remarks
• Remember that ratios reveal financial performance

• But in recent times success of business probably depends

more on non-financial performance:

– Customer perspective
– Employee perspective
– Product innovation
– Quality
– Social, ethical and environmental performance.
86
 Lord Weinstock [1924-2002]
The operating ratios are of great value as measures of efficiency but
they’re only the measures not efficiency itself. Statistics will not
design a product better, make it lower cost or increase sales. If ill-
used, they may guide action as to diminish resources for the sake of
apparent but false signs of improvement.

Management remains a matter of judgement, of knowledge of

products and processes and of understanding and skill in dealing with
people. The ratios will indicate how well all these things are being
done and will show comparison with how they are done elsewhere.
But they will tell us nothing about how to do them. That what you
are meant to do.

[Memo to GEC managers published in Aris (1998) Arnold Weinstock

and the Making of GEC] 87