3. Ratio Analysis
• Financial ratios are just a convenient way to
summarize large quantities of financial data &
to compare firms performance.
• Financial statement analysis from:
Investors view point: about predicting the future
Managements view point: to anticipate future conditions and
to get a starting point for planning actions that will improve
firms future performance.
4. Ratio Analysis
• Ratio analysis helps you conduct comparison
among companies within same industry and
across different industries.
• Example:
• Q.)Which company is stronger? A.) Need to do ratio
analysis
• (compare its debt to asset ratio and compare its interest
coverage ratio)
Company Debt Interest charges
ABC Rs. 5,000,000 Rs.500,000
XYZ Rs. 50,000,000 Rs. 5,000,000
5. Types of Ratios
Liquidity Ratios: show the relationship of a
firms cash and other current assets to its
current liabilities.
Asset Management Ratios: a set of ratios that
measure how effectively a firm is managing its
assets.
Debt Management Ratios: show how heavily
company is in debt.
6. Types of Ratios
Profitability Ratios: a group of ratios that show
the combined effects of liquidity, asset
management, and debt on operating results
(assess a business's ability to generate earnings
as compared to its expenses ).
Market Value Ratios: a set of ratios that relate the
firms stock price to its earnings, cash flows and
book value per share (show how the firm is
valued by investors)
7. LIQUIDITY RATIO
1. Current ratio = current assets / current
liabilities
2. Quick ratio = (cash + marketable securities +
receivables) / current liabilities
3. Cash ratio = (cash + marketable securities ) /
current liabilities
8. ASSET MANAGEMENT RATIO
• These ratios are designed to answer the
question:
• Q.)Does the total amount of asset on the
balance sheet seems reasonably too high or
too low in view of current and projected sales
level?
9. ASSET MANAGEMENT RATIO
• If a firm has too many assets its cost of capital
will be too high, hence its profits will be
depressed. On the other hand if the assets are
too low profitable sales will be lost.
10. ASSET MANAGEMENT RATIO
1. Inventory turnover ratio = sales / inventories
2. Days sales outstanding (DSO) = receivables /
(annual sales/365)
3. Fixed asset turnover ratio = sales / net fixed
assets
4. Total assets turnover = sales / total assets
11. DEBT MANAGEMENT RATIOS
• The extent to which a firm uses debt financing or
financial leverage has three important
implication:
1. By raising funds through debt SH can maintain
control of a firm while limiting their investments
2. Creditors look to the equity as it provides margin
of safety to them
3. If a firm earns more on investments financed
with borrowed funds than it pays in interest, the
return on the owners capital is magnified or
leveraged
12. DEBT MANAGEMENT RATIOS
The leveraging effect results in:
o Since the interest is deductible, the use of debt
lowers the tax bill and leaves more of the firms
operating income available to its investors
o If operating income as a % of assets exceeds the
interest rate on debt, as it generally does, then a
company can use debt to acquire assets, pay the
interest on the debt and have something left over
as a bonus for its stock holders
15. DEBT MANAGEMENT RATIOS
• Thus a debt can leverage up the ROE , if the conditions
are as expected.
• In worst or bad condition the leveraged firms ROE falls
sharply and losses occur.
• Under bad condition Firm U is profitable whereas Firm
L has negative profits, its b/c firm L needs cash to
service its debt charges.
• Under this situation Firm L cash would be depleted and
firm need to raise additional funds b/c its in loss. Due
to loss its hard to sell stock to raise capital and also
losses could cause lenders to raise the interest rate,
increasing L’s problem still further
16. DEBT MANAGEMENT RATIOS
• Firms with relatively high debt ratios have
higher expected returns when economy is
normal, but they are exposed to risk of loss
when the economy goes into recession
• Therefore the decisions about the use of debt
require firms to balance higher expected
returns against increased risk.
• Determining the optimal amount of debt is a
complicated process
17. DEBT MANAGEMENT RATIOS
1. Debt ratio = Total debt / Total Asset
2. Times interest earned = EBIT / Interest
charges
3. EBITDA coverage ratio = (EBITDA+lease
payments)/(Interest+Principal
payments+Lease payments)
18. DEBT MANAGEMENT RATIOS
• Times interest earned
• Shortcomings of this ratio:
1. Interest is not the only fixed financial charge
companies must also reduce debt on schedule, and
many firms lease assets and thus must make lease
payments (if they fail to pay debt or lease payments
they can b forced into bankruptcy)
2. EBIT does not represent all the cash flow available to
service debt especially if a firm has high depreciation
or amortization charges.
• To account for these deficiencies bankers and other
have developed EBITDA coverage ratio
19. PROFITABILITY RATIOS
1. Profit margins on sales = Net income / Sales
if two companies have identical operations in the sense
that their sales, operating cost and EBIT are the same
but if one firm uses more debt than the other it will have
higher interest charges. These interest charges will pull
net income down and since sales are constant the result
will be relatively low profit margin. In this case low profit
margin is not due to operating problem but just due to
difference in financing strategies. Thus the firm with low
profit margin might end up with a higher rate of return
on SH investment due to its financial leverage.
20. PROFITABILITY RATIOS
1. Basic earning power = EBIT / Total assets
2. Return on total assets = Net income / Total
assets
3. Return on common equity = Net income /
equity
21. MARKET VALUE RATIOS
1. Price earning ratio = price per share / earning
per share
2. Book value per share = equity / shares
outstanding
3. Market to book ratio = market price per share
/ book value per share
Notas do Editor
If a firm has too many assets its cost of capital will be too high, hence its profits will be depressed. On the other hand if the assets are too low profitable sales will be lost.
