Post on 01-Jan-2016
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Financial Ratio AnalysisFinancial Ratio Analysis
Mohammad AzamMohammad Azam
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Corporation’s Financial StatementsCorporation’s Financial Statements
With diverse ownership, corporations do not With diverse ownership, corporations do not enjoy the secrecy that proprietorships and enjoy the secrecy that proprietorships and partnerships have.partnerships have.
Corporation must send each shareholder an Corporation must send each shareholder an annual report detailing the financial condition annual report detailing the financial condition of the firm.of the firm.
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Importance of Financial Ratios:Importance of Financial Ratios:
• To evaluate a company’s operating To evaluate a company’s operating performance, managers and external users performance, managers and external users may may perform ratio analysis.perform ratio analysis.
• Financial Ratios are ways of comparing and Financial Ratios are ways of comparing and investigating the relationships between investigating the relationships between different pieces of financial information.different pieces of financial information.
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Importance Importance (Continued…)(Continued…)
• The ratios are benchmarks used to compare The ratios are benchmarks used to compare a company’s performance with that of a company’s performance with that of previous periods and with that of other previous periods and with that of other companies.companies.
• Ratio analysis is used by external users to Ratio analysis is used by external users to evaluate a company’s profitability.evaluate a company’s profitability.
• Financial ratio analysis evaluates the Financial ratio analysis evaluates the financial performance and condition of a financial performance and condition of a business unit by measuring its progress business unit by measuring its progress toward financial goals.toward financial goals.
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Common-Size and Common-Base-Year Common-Size and Common-Base-Year Financial StatementsFinancial Statements
Income statement items as a percentage of Income statement items as a percentage of total sales.total sales. Provides insight into how the relative items Provides insight into how the relative items
contribute to revenues and expenses.contribute to revenues and expenses.
Balance sheet items as a percentage of total Balance sheet items as a percentage of total assets.assets. Provides a insight into the structure of the Provides a insight into the structure of the
company’s assets and financing.company’s assets and financing.
Common-base-year financial statements Common-base-year financial statements provide such comparisons to a base year.provide such comparisons to a base year.
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Retail Company Ltd.Retail Company Ltd.Income StatementIncome Statement
for the Years Ending for the Years Ending 2008 2009 2010
Net Sales 2,188 2,123 2,715CGS 1,692 1,667 2,105Gross Income 496 456 610Operating Expenses:General & Admin 188 203 238Selling Exp. 193 210 282Dep. Office Equipment 37 37 35Total operating Expenses 418 450 555Net Operating Income 78 6 55Other Expenses-Interest 8 6 8Net Income before tax 70 0 47Estimated Income tax 18 0 12Net Earnings 52 0 35
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Louise Eliason & CompanyBalance Sheet
December 31, 2010
ASSETS US $ LIABILITIES US $
Current Assets Current Liabilities
Cash 96,000 Accounts payable 246,000
Net accounts receivable 367,000 Short-term notes 24,000
Inventory 177,000 Accruals & other payables 28,000
Temporary investment 12,000 Total Current Liabilities 298,000
Prepaid expenses 2,000 Total Current Assets 654,000 Long-term Liabilities
Mortgage 897,000
Fixed Assets Other long-term liabilities 443,000
Total Long-term Liabilities 1,340,000
Land 656,000
Buildings (net of depreciation) 903,000 SHAREHOLDERS' EQUITY
Plant & equipment (net) 608,000 Capital stock 300,000
Furniture & fixtures (net) 61,000 Retained earnings 944,000 Total Net Fixed Assets 2,228,000 Total Shareholders' Equity 1,244,000
TOTAL ASSETS 2,882,000 TOTAL LIABILITIES & EQUITY 2,882,000
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RatiosRatios
Ratios are indicators of change and simplify Ratios are indicators of change and simplify relationships. relationships.
The ratio does not tell us if the change was The ratio does not tell us if the change was good or bad or even why it occurred. good or bad or even why it occurred.
A ratio changes if the numerator or A ratio changes if the numerator or denominator or both change.denominator or both change.
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Classification of Financial RatiosClassification of Financial Ratios
• Liquidity RatiosLiquidity Ratios
• Leverage RatiosLeverage Ratios
• Profitability RatiosProfitability Ratios
• Market Value RatiosMarket Value Ratios
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Liquidity RatiosLiquidity Ratios
• Also called Short-term Solvency ratios.Also called Short-term Solvency ratios.
• The primary concern is the firm’s ability to The primary concern is the firm’s ability to pay its bills over the short run without undue pay its bills over the short run without undue stress. Following are the considered liquidity stress. Following are the considered liquidity ratios:ratios:
• Current RatioCurrent Ratio
• Quick RatioQuick Ratio
• Working Capital RatioWorking Capital Ratio
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Current RatioCurrent Ratio
Current RatioCurrent RatioCurrent AssetsCurrent Assets
Current LiabilitiesCurrent Liabilities
$400$400
$253$2531.581.58
• 5 Stars corporation has $1.58 in current 5 Stars corporation has $1.58 in current assets for every $1 in current liabilities. Orassets for every $1 in current liabilities. Or
• 5 Stars corporation has its current liabilities 5 Stars corporation has its current liabilities covered 1.58 times over.covered 1.58 times over.
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Quick Ratio or Acid-Test Ratio:Quick Ratio or Acid-Test Ratio:
QuickQuick RatioRatioCurrentCurrent AssetsAssets InventoriesInventoriesss
CurrentCurrent LiabilitiesLiabilitiesss
$400-$140$400-$140
$253$2531.031.03
• Inventory is often the least liquid current asset. Some of Inventory is often the least liquid current asset. Some of the inventory may later turn out to be damaged, obsolete the inventory may later turn out to be damaged, obsolete or lost.or lost.
• NoteNote: Using cash to buy inventory doesn’t affect the : Using cash to buy inventory doesn’t affect the current ratio, but it reduces the quick ratio.current ratio, but it reduces the quick ratio.
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Working Capital RatioWorking Capital Ratio
Working Capital Ratio =Working Capital Ratio =
Current Assets – Current LiabilitiesCurrent Assets – Current Liabilities
SalesSales
$$ $$
$$ ,,..
400400 253253
110800801313 61%61%
• What Does What Does Working CapitalWorking Capital Mean? Mean?A measure of both a company's efficiency and its A measure of both a company's efficiency and its short-term financial health.short-term financial health.
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Leverage RatiosLeverage Ratios
Debt RatioDebt Ratio
Debt-to-Equity RatioDebt-to-Equity Ratio
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Debt RatioDebt Ratio
Debt RatioDebt Ratio
TotalTotal DebtDebt
TotalTotal AssetsAssets
$$ ..
$$ ,, ....
488488 5050
11150150 000000 4242
• It tells us how much the It tells us how much the company relies on debt to relies on debt to finance assets. The lower the company. The lower the company’s reliance on reliance on debt for debt for asset formation, the less formation, the less risky the company is the company is since since excessive debt can lead to a very heavy interest debt can lead to a very heavy interest and and principal repayment burden. repayment burden.
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Debt-to-Equity RatioDebt-to-Equity Ratio
DebtDebt // EquityEquity RatioRatio
TotalTotal DebtDebt
ShareholdeShareholde rr ss EquityEquity''
$$ ..
$$ ....
488488 5050
661661 505000 7474
• A measure of a A measure of a company's financial leverage. . Debt/equity Debt/equity ratio is equal to is equal to long-term debt divided by divided by common common shareholders' equity. . Investing in a in a company with a higher debt/equity ratio may be riskier, especially with a higher debt/equity ratio may be riskier, especially in times of rising in times of rising interest rates, due to the , due to the additional interest that has to be that has to be paid out for the out for the debt..
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Profitability RatiosProfitability Ratios
Gross Profit MarginGross Profit Margin
Net Profit MarginNet Profit Margin
Return on AssetsReturn on Assets
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Gross Profit MarginGross Profit Margin
GrossGrossGrossGross
SalesSalesProfit MarginProfit Margin
ProfitProfit
$$ ..
$1$1,, ....
520520 0000
080080 00004848 15%15%
• What remains from What remains from sales after a after a company pays out the out the cost of goods sold, gross profit. , gross profit.
• The 48.15% gross profit margin means that for every The 48.15% gross profit margin means that for every dollar generated in sales, the company has 48.15 generated in sales, the company has 48.15 cents left over to cover basic over to cover basic operating costs and profit. and profit.
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Net Profit MarginNet Profit Margin
NetNetNetNet IncomeIncome
SalesSalesProfit MarginProfit Margin
$$ ..
$1$1,, ....
4242 0000
080080 000033 89%89%
• This This number is an indication of how effective a is an indication of how effective a company is is at at cost control. .
• The higher the net profit margin is, the more effective the The higher the net profit margin is, the more effective the company is at converting revenue into actual profit. The company is at converting revenue into actual profit. The net profit margin is a good way of comparing companies in net profit margin is a good way of comparing companies in the same industrythe same industry
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Return on AssetsReturn on Assets
ReRe
$$ ..
$1$1,, ....
turnturn onon AssetsAssetsNetNet IncomeIncome
TotalTotal AssetsAssets
4242 0000
150150 000033 65%65%
• An indicator of how An indicator of how profitableprofitable a company is relative to its a company is relative to its total assets. total assets.
• ROA gives an idea as to how efficient management is at ROA gives an idea as to how efficient management is at using its assets to generate earnings.using its assets to generate earnings.
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Market Value RatiosMarket Value Ratios
P/E RatioP/E Ratio
Earnings YieldEarnings Yield
Dividend YieldDividend Yield
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P/E RatioP/E Ratio
PP //PrPr
$$ ..
$$ ....
EE RatioRatioiceice perper ShareShare
EarningsEarnings perper ShareShare
2929 0000
22 25251212 8989
• A valuation ratio of a company's current share price A valuation ratio of a company's current share price compared to its per-share earnings.compared to its per-share earnings.
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Earnings YieldEarnings Yield
EarningsEarnings YieldYieldEarningsEarnings perper ShareShare
iceice perper ShareShare
PrPr
$$ ..
$$ ....
22 2525
2929 000077 76%76%
• The earnings yield (which is the inverse of the P/E ratio) The earnings yield (which is the inverse of the P/E ratio) shows the percentage of each dollar invested in the stock shows the percentage of each dollar invested in the stock that was earned by the company.that was earned by the company.
• The earnings yield is used by many investment The earnings yield is used by many investment managers to determine optimal asset allocations.managers to determine optimal asset allocations.
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Dividend YieldDividend Yield
DividendDividend YieldYieldDividendsDividends perper ShareShare
iceice perper ShareShare
PrPr
$$ ..
$$ ....
112525
2929 000044 31%31%
• Dividend yield shows how much a company pays out in Dividend yield shows how much a company pays out in dividends each year relative to its share price.dividends each year relative to its share price.
• In the absence of any capital gains, the dividend yield is the In the absence of any capital gains, the dividend yield is the return on investment for a stock.return on investment for a stock.
• Dividend yield is a way to measure how much cash flow you Dividend yield is a way to measure how much cash flow you are getting for each dollar invested.are getting for each dollar invested.