Jamil Ahmed Assistant Professor

FINANCIAL INFORMATION

The results of business operations stated in money terms

Basis for projecting financial results

Responsibility of management

Users of Financial Information

Investors and Financial Analysts
Make judgments about the firms securities Financial Analysts report to investment community

Vendors

Sell to the firm on credit

Management

Hi-light areas in which attention will improve performance

 Annual Report

SOURCES OF FINANCIAL INFORMATION

Other Sources
Reports from brokerage firms and advisory services

Management's report card to stockholders on own performance

Positively biased
The primary source of financial information

Value Line

Required of publicly traded companies

Must be audited
4

ORIENTATION OF FINANCIAL ANALYSTS Critical and investigative Looking for current or potential problems Looking for the physical reasons behind financial results

Belfry Company

 Pairs of financial statement numbers formed into ratios Ratios highlight different aspects of performance
The current ratio measures liquidity - ability to pay bills in the short run

RATIO ANALYSIS

Current ratio = current assets current liabilities

Current Assets: Money coming in within a year Current Liabilities: Money going out within a year Needed for solvency: Current ratio >> 1.0

COMPARISONS
Ratios are most meaningful when compared with similar figures
Three comparisons: History

Prior performance - look for trends Identify strong - weak spots relative to competitors

Competitors

Budget

Is performance better or worse than expected

CATEGORIES OF RATIOS
Five Classifications Liquidity Asset Management Debt Management Profitability Market Value Ratios Dont Provide Answers They Help You Ask the Right Questions
9

LIQUIDITY RATIOS
Measure the ability to meet short term financial obligations: Current Ratio primary measurement of a companys liquidity

current ratio =

current assets current liabilitie s

$7,500 current ratio = = 3.0 $2,500

10

LIQUIDITY RATIOS
Quick Ratio (Acid Test) A liquidity measure that does not depend on inventory

current assests - inventory Quick Ratio = current liabilitie s Quick Ratio = $7,500 - $3,200 = 1.72 $2,500

11

ASSET MANAGEMENT RATIOS

The fundamental efficiency with which a company is run
AVERAGE COLLECTION PERIOD (ACP) the time it takes to collect on credit sales
ACP =

Interpretation: Customers pay accounts receivable ACP = 360 slowly OR there are sales a few very old $2,900 ACP = 360 = 104.4 days accounts that will $10,000 probably never be collected.
12

accounts receivable average daily sales

ASSET MANAGEMENT RATIOS

INVENTORY TURNOVER Measures efficiency of inventory use
cost of goods sold inventory OR sales Inventory turnover = inventory Inventory turnover = Inventory turnover = $6,000 = 1.9 $3,200 $10,000 = 3.1 $3,200

Inventory turnover =

Interpretation: Too much inventory is expensive to carry. Too little causes stockouts which lead to inefficient production and lost sales
13

ASSET MANAGEMENT RATIOS

FIXED ASSET TURNOVER AND TOTAL ASSET TURNOVER

Measure the relationship of the firms assets to a years sales

Fixed asset turnover = Total asset turnover =

sales fixed assets sales total assets

Fixed asset turnover = $10,000 = 2.2 $4,500 Total asset turnover = $10,000 = .83 $12,000
Interpretation: Are there idle or inefficient assets?

14

DEBT MANAGEMENT RATIOS

Measures the firms debt level relative to assets, equity, and income DEBT RATIO
Uses a broad concept of debt including current liabilities
long- term debt + current liabilities Debt ratio = total assets $6,200 + $2,500 Debt ratio = = 72.5% $12,000

A high debt ratio is viewed as risky by investors

15

DEBT MANAGEMENT RATIOS

DEBT TO EQUITY RATIO
Measures the mix of debt and equity within total capital. An important risk measurement - a high debt level burdens the income statement with excessive interest making failure more likely.

Debt to Equity Ratio = Long Term Debt : Equity Debt to Equity = $6,200 : $3,300 = 1.9 : 1
(Stated as 1.9 to 1, since $6,200/$3,300 = 1.9)

16

DEBT MANAGEMENT RATIOS

TIMES INTEREST EARNED (TIE)
Measures the number of times interest can be paid out of earnings before interest and taxes (EBIT)

TIE =

EBIT interest

$1,900 TIE = = 4.8 $400

17

DEBT MANAGEMENT RATIOS

Cash Coverage
A variation on TIE. Adds depreciation to EBIT to better approximate the cash available to interest.

Cash coverage =

EBIT + depreciati on interest

$1,900 + $500 Cash coverage = = 6.0 $400

18

DEBT MANAGEMENT RATIOS

FIXED CHARGE COVERAGE
A variation on TIE to include lease payments as fixed financial charges equivalent to interest
Fixed charge coverage = EBIT + lease payments interest + lease payments

$1,900 + $700 Fixed charge coverage = = 2.4 $400 + $700

Interpretation: Business failure is often a result of the inability to pay interest. Coverage ratios measure the interest burden relative to the ability to pay.
19

PROFITABILITY RATIOS
Relative measures of the firms money-making success

RETURN ON SALES (ROS)/Profit Margin

ROS = net income sales $1,000 = 10% $10,000

ROS =

20

PROFITABILITY RATIOS
RETURN ON ASSETS (ROA)
Measures the overall ability of the firm to utilize the which it has invested to earn a profit assets in

ROA =

net income total assets $1,000 = 8.3% $12,000

ROA =

21

PROFITABILITY RATIOS
RETURN ON EQUITY (ROE)
The most fundamental profitability ratio Measures the firms ability to earn a return on the owners invested capital.

net income ROE = equity ROE = $1,000 = 30.3% $3,300

22

MARKET VALUE RATIOS

PRICE / EARNINGS RATIO (P/E)
Measures the markets opinion of the stock as an investment
P/E Ratio = stock price EPS

EPS =

$1,000 = $3.33 300

$38 = 11.4 $3.33 Interpretation: The amount investors will pay for each dollar of earnings. Based primarily on expected growth. P/E =

23

MARKET VALUE RATIOS

MARKET TO BOOK VALUE RATIO
Total value of the equity on the balance sheet

stock price Market to book value ratio = book value per share $38 Market to book value ratio = = 3.5 $11

24

Financial Ratios

25

Financial Ratios

26

Financial Ratios

27

Limitations and Weaknesses of Ratio Analysis

Diversified Companies

Analysis of consolidated results generally offers limited insight

Yearend efforts to make ratios look good Allow a great deal of reporting latitude

Window Dressing

Accounting Principles

28

Common Size Statements

29