FINANCE

Analysis of Financial
Statements
«Ratios»
INTRODUCTION

 The primary goal of financial management

is to maximize the stock price, not to
maximize accounting measures such as
net income or EPS.
 However, accounting data do influence
stock prices, and to understand why a
company is performing the way it is and
to forecast where it is heading, one needs
to evaluate the accounting information
reported in the financial statements.
RATIO ANALYSIS

 Financial statements report both on

a firm’s position at a point in time
and on its operations over some
past period. However, the real
value of financial statements lies in
the fact that they can be used to
help predict future earnings and
dividends.
1. Liquidity Ratios

Liquid Asset : An asset that can be converted to cash

quickly without having to reduce the asset’s price
very much.
 Current ratio : It indicates the extent to which
current liabilities are covered by those assets
expected to be converted to cash in the near future.
 Quick (Acid Test) Ratio : The quick, or acid test,
ratio is calculated by deducting inventories from
current assets and then dividing the remainder by
current liabilities:
2. Asset Management
Ratios
The second group of ratios, the asset
management ratios, measures how effectively the
firm is managing its assets.
a) Inventory Turnover Ratio : The inventory turnover
ratio is defined as sales divided by inventories.
b) Days Sales Outstanding (DSO) : indicates the average
length of time the firm must wait after making a sale
before it receives cash.
c) Fixed Assets Turnover Ratio : measures how
effectively the firm uses its plant and equipment.
d) Total Assets Turnover Ratio : measures the
turnover of all the firm’s assets.
3. Debt Management Ratios

a) Debt Ratio : measures the percentage of

funds provided by creditors.
b) Times-interest-earned (TIE) ratio : measures
the extent to which operating income can
decline before the firm is unable to meet its
annual interest costs.
c) EBITDA Coverage Ratio : A ratio whose
numerator includes all cash flows available to
meet fixed financial charges and whose
denominator includes all fixed financial
charges.
4. Profitability Ratios

a) The profit margin on sales : calculated by dividing net

income by sales, gives the profit per dollar of sales.
b) Basic earning power (BEP) : This ratio shows the raw
earning power of the firm’s assets, before the influence
of taxes and leverage, and it is useful for comparing
firms with different tax situations and different degrees
of financial leverage.
c) Return on Total Assets (ROA) : The ratio of net income
to total assets measures the return on total assets (ROA)
after interest and taxes.
d) Return on Common Equity (ROE) : The ratio of net
income to common equity; measures the rate of return
on common stockholders’ investment.
5. Market Value Ratios

a) Price/Earnings Ratio : The ratio of the

price per share to earnings per share;
shows the dollar amount investors will
pay for $1 of current earnings.
b) Price/Cash Flow Ratio : The ratio of price
per share divided by cash flow per share;
shows the dollar amount investors will
pay for $1 of cash flow.
c) Market/Book (M/B) Ratio : The ratio of a
stock’s market price to its book value.
TREND ANALYSIS
 An analysis of a firm’s financial ratios
over time; used to estimate the likelihood
of improvement or deterioration in its
financial condition.
THE DU PONT CHART AND
EQUATION
 Du Pont Chart : A chart designed to show
the relationships among return on
investment, asset turnover, profit margin,
and leverage.

 Du Pont Equation : A formula which

shows that the rate of return on assets
can be found as the product of the profit
margin times the total assets turnover.
COMPARATIVE RATIOS and
“BENCHMARKING”

 Ratio analysis involves comparisons

— a company’s ratios are compared
with those of other firms in the
same industry, that is, to industry
average figures.
USES AND LIMITATIONS of RATIO
ANALYSIS
 Many large firms operate different divisions in different
industries, and for such companies it is difficult to
develop a meaningful set of industry averages.
 Most firms want to be better than average, so merely
attaining average performance is not necessarily good.
 Inflation may have badly distorted firms’ balance sheets—
recorded values are often substantially different from
“true” values. judgment.
 Seasonal factors can also distort a ratio analysis.
 Firms can employ “window dressing” techniques
to make their financial statements look stronger.
 Different accounting practices can distort
comparisons.
 It is difficult to generalize about whether a
particular ratio is “good” or “bad.”
 A firm may have some ratios that look “good” and
others that look “bad,” making it difficult to tell
whether the company is, on balance, strong or
weak.
LOOKING BEYOND THE
NUMBERS
 Are the company’s  Competition.
revenues tied to one Generally, increased
key customer? competition lowers
 To what extent are the prices and profit
company’s revenues margins.
tied to one key  Future prospects. Does
product? the company invest
 To what extent does heavily in research and
development?
the company rely on a
single supplier?.  Legal and regulatory
environment. Changes
 What percentage of
the company’s in laws and regulations
business is generated have important
overseas? implications for many
industries.