Finance1.Assignment.analysis and Ratios

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Horizontal Analysis or Trend Analysis:

Definition and Explanation of Horizontal or Trend Analysis:

Comparison of two or more year's financial data is known as horizontal analysis, or trend analysis.

Horizontal analysis is facilitated by showing changes between years in both dollar and percentage form

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Quite simply, the horizontal analysis is the financial statements of a company of successive yearspresented side-by-side. The goal of horizontal analysis is to compare the figures of the current periodwith that of the past period. This helps the company and its shareholders analyze their performance anfind out areas of improvement. Read on to know more about trend analysis.

Horizontal analysis is done for both income statements and balance sheets. The idea is the same. The

figures for the different heads under the income statements and the balance sheets are placed side-byside so that the reader can compare the two and understand how the company is doing. The horizontaanalysis also includes two more columns: the column denoting actual numerical change over two perioand another denoting percentage change over the two periods. The first column gives the difference

between the past period and the current period, while the percentage column shows what percentage othe past figure is the figure denoting the change. Read on for more on balance sheet analysis.

Horizontal analysis is an important part of the financial statements and annual reports. It places thefacts very simply in front of the shareholder and makes the job of analyzing the improvements or thelack of it very simple for the shareholder. Horizontal analysis helps the shareholder understand thechange and the percentage change. And if there is no improvement or in fact a reduction, then theboard is compelled to explain the situation to the shareholder and what they intend to do in the future fix it. Read on for more on financial planning and budgeting to help you manage your costs better.

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The two simplest ways to analyze your financial statements are vertically and horizontally. A verticalanalysis shows you the relationships among components of one financial statement, measured aspercentages. On your balance sheet, each asset is shown as a percentage of total assets; each liabilityor equity item is shown as a percentage of total liabilities and equity. On your statement of profit andloss, each line item is shown as a percentage of net sales.

A horizontal analysis provides you with a way to compare your numbers from one period to the next, using financial statements from at least two distinct periods. Each line item has an entry in a currentperiod column and a prior period column. Those two entries are compared to show both the dollardifference and percentage change between the two periods.

Vertical Analysis and Common Size Statements:

Definition and Explanation of Vertical Analysis and Common Size Statements:

Vertical analysis is the procedure of preparing and presenting common size statements.Common sizstatement is one that shows the items appearing on it in percentage form as well as in dollar form.

Each item is stated as a percentage of some total of which that item is a part. Key financial changes antrends can be highlighted by the use of common size statements.



C ommon size statements are particularly useful when comparing data from different companies.

Example: Balance Sheet

One application of the v ertical analysis idea is to state the separate assets of a company as percentage

of total sales.

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Another application of the v ertical analysis idea is to place all items on the income statement inpercentage form in terms of sales.

&URVV6HFWLRQDO$QDO\VLVWhat Does Cross-Sectional Analysis Mean?A type of analysis an investor, analyst or portfolio manager may conduct on a company in relation tothat company's industry or industry peers. The analysis compares one company against the industry itoperates within, or directly against certain competitors within the same industry, in an attempt todiscover the best of the breed.

Investopedia explains Cross-Sectional Analysis When conducting a cross-sectional analysis, the analyst seeks to identify, by using comparative metricthe valuation, debt-load, future outlook and/or operational efficiency of the target company. This allowthe analyst to evaluate the target company's efficiency in these areas, and to make the best investmenchoice among a group of competitors or the industry as a whole.

When comparing the target firm to competitors, the analyst must be careful to consider the uniqueoperating characteristics of each company and how that will affect any comparative metrics used.

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A method of analysis that compares a firm's ratios with some chosen industry benchmark.

The benchmark usually chosen is the average ratio value for all firms in an industry for the time period

under study.

The analysis of a financial ratio of a company with the same ratio of different companies in the sameindustry. For example, one may conduct a cross-sectional ratio analysis of the debt ratios of multiplecompanies in the telecommunications industry. Quite simply, one does this by taking the debt ratios ofeach company and comparing them to one another. An analyst does this in order to find the company

with healthiest financial status. This is helpful in making informed investment decisions.

%HQFKPDUNLQJDefinition: Benchmarking is a tool used by financial analysts of all types, including (but not limited

to) controllers and securities analysts. It involves finding useful points of comparison for a company's o

a business unit's results, and putting them in the context of how peer companies are performing. Thus

for example, a company's growth in revenues might be benchmarked against the growth experienced

over the same period by other companies in the same industry, of similar size and selling a similar mix

of products or services.

Also Known As: comparisons against peer groups.

Benchmarking is a process of comparing an organization's or company's performance to that of other

organizations or companies using objective and subjective criteria. The process compares programs and strategic

positions of competitors or exemplary organizations to those in the company reviewing its status for use as referenc



points in the formation of organization decisions and objectives. Comparing how an organization or company

performs a specific activity with the methods of a competitor or some other organization doing the same thing is a

way to identify the best practice and to learn how to lower costs, reduce defects, increase quality, or improve

outcomes linked to organization or company excellence.

Organizations and companies use benchmarking to determine where inputs, processes, outputs, systems, an

functions are significantly different from those of competitors or others. The common question is, What is the best

practice for a particular activity or process? Data obtained are then used by the organization or company to introduc

change into its activities in an attempt to achieve the best practice standard if theirs is not best. Comparison with

competitors and exemplary organizations is helpful in determining whether the organization's or company'scapabilities or processes are strengths or weaknesses. Significant favorable input, process, and output benchmark

variances become the basis for strategies, objectives, and goals. Often, a general idea that improvement is possible i

the reason for undertaking benchmarking. Benchmarking, then, means looking for and finding organizations or

companies that are doing something in the best possible way and learning how they do it in order to emulate them.

Organizations or companies often attempt to benchmark against the best in the world rather than the best in their

particular industry.

A problem with benchmarking is it may restrict the focus to what is already being done. By emulating curren

exemplary processes, benchmarking is a catch-up managerial tool or technique rather than a way for the organizatio

or company to gain managerial dominance or marketing share. Benchmarking can foster new ideas or processes whe

management uses noncompetitive organizations or companies outside its own industry as the basis of benchmarking

What if new ideas are not generated? It is possible that no one in some other organization or company has had a gre

idea that is applicable to the input, process, or outcome that the organization is attempting to improve or change by

benchmarking.

Benchmarking is not a competitive analysis. Benchmarking is the basis for change. It is about learning. The

organization performing the benchmark analysis uses the information found in the process to establish priorities and

target process improvements that can change business or manufacturing practices. Benchmarking commonly takes

one of four forms.

Generic benchmarking investigates activities that are or can be used in most businesses. This type of

benchmarking makes the broadest use of data collection. One difficulty is in understanding how processes translate

across industries. Yet generic benchmarking can often result in an organization's drastically altering its ideas about it

performance capability and in the reengineering of business processes.

Functional benchmarking looks at similar practices and processes in organizations or companies in other

industries. This type of benchmarking is an opportunity for breakthrough improvements by analyzing high-performance processes across a variety of industries and organizations.

C ompetitive benchmarking compares the organization's processes to those of direct competitors. In

competitive benchmarking, a consultant or other third party rather than the organization itself collects and analyzes

the data because of its proprietary nature.

Internal benchmarking compares processes or practices within the organization or company over time in ligh

of established goals. Advantages of internal benchmarking include the ease of data collection and the definition of

areas for future external investigations. The primary disadvantage of internal benchmarking is a lower probability tha

it will yield significant process improvement breakthroughs.

Each form of benchmarking has advantages and disadvantages, and some are simpler to conduct that others

Each benchmarking approach can be important for process analysis and improvement. Breakthrough improvements

are generally attributed to the functional and generic types of benchmarking.Eight steps are typically employed in the benchmarking process.

y Identify processes, activities, or factors to benchmark and their primary characteristics.

y Determine what form is to be used: generic, functional, competitive, or internal.

y Determine who or what the benchmark target is: company, organization, industry, or process.

y Determine specific benchmark values by collecting and analyzing information from surveys, interviews,

industry information, direct contacts, business or trade publications, technical journals, and other sources of

information.

y Determine the best practice for each benchmarked item.

y Evaluate the process to which benchmarks apply and establish objectives and improvement goals.



y Implement plans and monitor results.

y Recalibrate internal base benchmarks.

A recurring problem that must be addressed during the eight steps is the determination of criteria to ensure that

inaccuracies or inconsistencies do not occur that will make any comparison meaningless.

The eight steps of the benchmarking process can be summarized as an improvement analysis. That is, the

organization investigates another organization to find out what it does and how it is done. During the investigation,

what goes right and what goes wrong is determined. This information is then used for the improvement of activities

processes. When the activities and processes of the organization making the investigation are equal to or better thanthe measurements found during the investigation, no change is warranted because the investigating organization ha

the better practice.

Another view of benchmarking is as an organization gap analysis. The organization deter mines what it lacks

terms of what it knows and how it does things. The shortfalls that initiate the gap analysis can be activities and

processes or they can be tactics and strategies. The organization must then determine what other organization is go

at doing those things that can be improved or changed for the better. A very systematic investigation is made of the

organization with the best practices to discover what is done, how it is done, how it is implemented, and how it fits

into the organization's operations. The findings of the systematic investigation then become the basis of revision or

modification for the organization doing the investigation.

Benchmarking efforts typically collect information on responsibilities, program design, operating facilities,

technical know-how, brand images, levels or integration, managerial talent, and cost or financial performance.

Financial or cost data are often the category of greatest concern because these are factors in the input, pro cessing,

and output activities of the organization or company.

Benchmarking is frequently referred to as a "wake-up call." Organizations and companies benchmark for ma

reasons: They want to determine where they spend their time and how much value they add, or they are curious

about how they stack up against others. Through the knowledge gained by benchmarking, organizations and

companies redefine their roles, add more value, reduce costs, and improve performances.

The electronics industry has a unique style of benchmarking. Here benchmarking involves running a set of standard

tests on a system to compare its performance with that of others. That is, it is a tool for measuring the power and

performance of hardware and software systems and applications as well as the capacity of a system. There are four

categories of benchmarking in the electronics industry:

y An application-based benchmark runs real applications or parts of applications either in full or modified

versions.

y A synthetic benchmark emulates applications activity.

y A playback test uses logs of one type of system call (e.g., disk calls) and plays the calls back in isolation.

y An inspection test exercises a system or component to emulate an application activity.

The synthetic and playback benchmarks are used to get a rough idea of how a system or component performs. If

application-based benchmarks are available that match the application, they are used to refine the evaluation. The

inspection benchmarks are used to determine whether a system or component is functioning properly. These

benchmarks use a well-defined testing methodology based on real-world use of a computer system. They measure

performance in a deterministic and reproducible manner that allows the system administrator to judge the

performance and capacity of the system. Benchmarks provide a means of determining tuning parameters, reliability

bottlenecks, and system capacity that can provide marketing and buying information.Although benchmarking in the electronics industry is a testing mechanism or process, it, too, is a technique for

learning, change, and process improvement. Benchmarking is an effective way to ensure continuous improvement o

progress toward strategic goals and organizational priorities. A real benefit of benchmarking comes from the

understanding of processes and practices that permit a transfer of best practices or performances into the

organization. At its best, benchmarking stresses not only processes, quality, and output but also the importance of

identifying and understanding the drivers of the activities.



Benchmarking measures the effectiveness of business processes compared to industry standards. It is classic management tool that companies use to determine the profitability of their products andservices. While there are several forms of benchmarking, such as process or performance, financialbenchmarking is probably the relevant, because it measures the effectiveness of money spent onoperations.

1. The Facts

o Benchmarking takes broad segments of a company's operations and breaks them down in to small, complete processes that can be measured for overall effectiveness. While benchmarking takes time andetail to implement, it is one part of company's strategic management process to ensure industrycompetitiveness.

Strategic Management

y

Strategic management is the implementation and evaluation of certain goals or objectives a businesswants to achieve. In order to measure effectiveness, a business will use benchmarking to review smallprocesses or a large division. By starting with the small processes, businesses will discover deficienciesquickly and determine how to correct them; in turn, this will make the entire division more competitive

Financial Benchmarks

y Financial benchmarking examines monetary processes within business division to determine their

industry competitiveness. Some examples of financial benchmarks include: Does the company spendabove industry average for rent and utilities? How does the cost of materials compare to the industry?Are employee salaries and benefits competitive with the rest of the industry?In addition, financial ratios are helpful when reviewing divisions for effectiveness. For example, thiscould mean figuring the ratio of sales of notebooks to desktop PCs against the benchmarks of industrypeers. Ratios should be tracked regularly to determine where fluctuations occur and what drives thesedifferences.

Benchmark Advantages

y

Benchmarking provides quantitative results for business processes. Measuring the financial strengthsand weaknesses of a divisional process gives management a clear picture of whether goals have beenachieved. Another advantage of benchmarking is that it begins with smaller processes; once problems

are identified, they may be easier to change than an entire division process.

Benchmark Disadvantages

y

Benchmarking is a very detailed process; breaking down divisions into a small, finite process is time-consuming and labor-intensive, and can be rendered completely ineffective if done improperly.Additionally, specific benchmark goals do not exist. A company must use benchmarks to determine if itis competitive to rivals and within industry standards. Benchmarking is also a continuous process thatmust be reviewed often to ensure that the information being gathered is still useful to the company.Refining benchmarks is a managerial process that must occur to ensure bad measurements are notbeing taken of division processes.

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A time series is a collection of observations of well-defined data items obtained through repeatedmeasurements over time. For example, measuring the value of retail sales each month of the year

would comprise a time series. This is because sales revenue is well defined, and consistently measured

at equally spaced intervals. Data collected irregularly or only once are not time series.

An observed time series can be decomposed into three components: the trend (long term direction),

the seasonal (systematic, calendar related movements) and the irregular (unsystematic, short term

fluctuations).



Accounting Ratios | Financial Ratios:

Ratios simply means one number expressed in terms of another. A ratio is a statisticalyardstick bymeans of which relationship between two or various figures can be compared or measured.

Definition of Accounting Ratios:

The term "accounting ratios" is used to describe significant relationship between figures shown on a

balance sheet, in a profit and loss account, in a budgetary control system or in any other part of accounting organization. Accounting ratios thus shows the relationship between accounting data.

Ratios can be found out by dividing one number by another number. Ratios show how onenumber isrelated to another. It may be expressed in the form of co-efficient, percentage, proportion, or rate. Forexample the current assets and current liabilities of a business on a particular date are $200,000 and$100,000 respectively. The ratio of current assets and current liabilities could be expressed as 2 (i.e.200,000 / 100,000) or 200 percent or it can be expressed as 2:1 i.e., the current assets are two timesthe current liabilities. Ratio sometimes is expressed in the form of rate. For instance, the ratio betweentwo numerical facts, usually over a period of time, e.g. stock turnover is three times a year.

Advantages of Ratios Analysis:

Ratio analysis is an important and age-old technique of financial analysis. The following are some of thadvantages / Benefits of ratio analysis:

1. Simplifies financial statements: It simplifies the comprehension of financial statements. Rat

tell the whole story of changes in the financial condition of the business

2. Facilitates inter-firm comparison: It provides data for inter-firm comparison. Ratios highlighthe factors associated with with successful and unsuccessful firm. They also reveal strong firmsand weak firms, overvalued and undervalued firms.

3. Helps in planning: It helps in planning and forecasting. Ratios can assist management, in itsbasic functions of forecasting. Planning, co-ordination, control and communications.

4.

Makes inter-firm comparison possible: Ratios analysis also makes possible comparison of thperformance of different divisions of the firm. The ratios are helpful in deciding about theirefficiency or otherwise in the past and likely performance in the future.

5. Help in investment decisions: It helps in investment decisions in the case of investors andlending decisions in the case of bankers etc.

Limitations of Ratios Analysis:

The ratios analysis is one of the most powerful tools of financial management. Though ratios are simpleto calculate and easy to understand, they suffer from serious limitations.

1. Limitations of financial statements: Ratios are based only on the information which has bee

recorded in the financial statements. Financial statements themselves are subject to severallimitations. Thus ratios derived, there from, are also subject to those limitations. For example, non-financial changes though important for the business are not relevant by the financialstatements. Financial statements are affected to a very great extent by accounting conventionsand concepts. Personal judgment plays a great part in determining the figures for financialstatements.

2. Comparative study required: Ratios are useful in judging the efficiency of the business onlywhen they are compared with past results of the business. However, such a comparison onlyprovide glimpse of the past performance and forecasts for future may not prove correct since



several other factors like market conditions, management policies, etc. may affect the futureoperations.

3. Ratios alone are not adequate: Ratios are only indicators, they cannot be taken as final regardingood or bad financial position of the business. Other things have also to be seen.

4. Problems of price level changes: A change in price level can affect the validity of ratioscalculated for different time periods. In such a case the ratio analysis may not clearly indicate thtrend in solvency and profitability of the company. The financial statements, therefore, beadjusted keeping in view the price level changes if a meaningful comparison is to be madethrough accounting ratios.

5.

Lack of adequate standard: No fixed standard can be laid down for ideal ratios. There are no weaccepted standards or rule of thumb for all ratios which can be accepted as norm. It rendersinterpretation of the ratios difficult.

6. Limited use of single ratios: A single ratio, usually, does not convey much of a sense. To maa better interpretation, a number of ratios have to be calculated which is likely to confuse theanalyst than help him in making any good decision.

7. Personal bias: Ratios are only means of financial analysis and not an end in itself. Ratios have

to interpreted and different people may interpret the same ratio in different way.

8. Incomparable: Not only industries differ in their nature, but also the firms of the similarbusiness widely differ in their size and accounting procedures etc. It makes comparison of ratiosdifficult and misleading.

Classification of Accounting Ratios:

Ratios may be classified in a number of ways to suit any particular purpose. Different kinds of ratios arselected for different types of situations. Mostly, the purpose for which the ratios are used and the kindof data available determine the nature of analysis. The variousaccounting ratios can be classified asfollows:

Classification of Accounting Ratios / Financial Ratios

(A)

Traditional Classification orStatement Ratios

(B)

Functional Classification orClassification According to Tests

(C)

Significance Ratios or RatiosAccording to Importance

y Profit and loss accountratios or revenue/incomestatement ratios

y Balance sheet ratios orposition statement ratios

y Composite/mixed ratios orinter statement ratios

y Profitability ratios

y Liquidity ratios

y Activity ratios

y Leverage ratios or long

term solvency ratios

y Primary ratios y Secondary ratios

Financial-Accounting-Ratios Formulas:

This is a collection of financial ratio formulas which can help you calculate financial ratios in a givenproblem.

Analysis of Profitability:

General profitability:

y Gross profit ratio = (Gross profit / Net sales) × 100 y Operating ratio = (Operating cost / Net sales) × 100



y Expense ratio = (Particular expense / Net sales) × 100 y Operating profit ratio = (Operating profit / Net sales) × 100

Overall profitability:

y Return on shareholders' investment or net worth = Net profit after interest and tax /Shareholders' funds

y Return on equity capital = (Net profit after tax ± Preference dividend) / Paid up equity capital y Earnings per share (EPS) ratio = (Net profit after tax ± Preference dividend) / Number of equity

shares y Return on gross capital employed = (Adjusted net profit / Gross capital employed) × 100 y Return on net capital employed = (Adjusted net profit / Net capital employed) × 100 y

Dividend yield ratio = Dividend per share / Market value per share y Dividend payout ratio or pay-out ratio = Dividend per equity share / Earnings per share

Short Term Financial Position or Test of Solvency:

y Current ratio = Current assets / Current liabilities y Quick or acid test of liquid ratio (for immediate solvency) = Liquid assets / Current liabilities y Absolute liquid ratio = Absolute liquid assets / Current liabilities

Current Assets Movement, Efficiency or Activity Ratios:

y Inventory / Stock turnover ratio = Cost of goods sold / Average inventory at cost y Debtors of receivables turnover ratios = Net credit sales / Average trade debtors y Average collection period = (Trade debtors No. of working days) / Net credit sales y Creditors or payables turnover ratio = Net credit purchase / Average trade creditors y Average payment period = (Trade creditors No. of working days) / Net credit purchase y Working capital turnover ratio = Cost of sales / Net working capital

Analysis of Long Term Solvency:

y

Debt to equity ratio = Outsiders funds / Shareholders funds or External funds / Internal funds y Ratio of long term debt to shareholders funds (Debt equity) = Long term debt / Shareholders

funds y Proprietary of equity ratio = Shareholders funds / Total assets y Fixed assets to net worth = Fixed assets after depreciation / Shareholders' funds y Fixed assets ratio or fixed assets to long term funds = Fixed assets after depreciation / Total long

term funds y Ratio of current assets proprietors' funds = Current assets / Shareholders' funds y Debt service or interest coverage ratio = Net profit before interest and tax / Fixed interest chargy Capital gearing ratio = Equity share capital / Fixed interest bearing funds

3URILWDELOLW\5DWLRVWhat Does P rofitability Ratios Mean? A class of financial metrics that are used to assess a business's ability to generate earnings ascompared to its expenses and other relevant costs incurred during a specific period of time. For mosof these ratios, having a higher value relative to a competitor's ratio or the same ratio from aprevious period is indicative that the company is doing well.

Investopedia explains P rofitability Ratios Some examples of profitability ratios are profit margin, return on assets and return on equity. It isimportant to note that a little bit of background knowledge is necessary in order to make relevantcomparisons when analyzing these ratios.



For instances, some industries experience seasonality in their operations. The retail industry, forexample, typically experiences higher revenues and earnings for the Christmas season. Therefore, itwould not be too useful to compare a retailer's fourth-quarter profit margin with its first-quarter promargin. On the other hand, comparing a retailer's fourth-quarter profit margin with the profit marginfrom the same period a year before would be far more informative.

Every firm is most concerned with its profitability. One of the most frequently used tools of financialratio analysis is profitability ratios which are used to determine the company's bottom line.Profitability measures are important to company managers and owners alike. If a small business hasoutside investors who have put their own money into the company, the primary owner certainly hasto show profitability to those equity investors.

Profitability ratios show a company's overall efficiency and performance. We can divide profitabilityratios into two types: margins and returns. Ratios that show margins represent the firm's ability totranslate sales dollars into profits at various stages of measurement. Ratios that show returnsrepresent the firm's ability to measure the overall efficiency of the firm in generating returns for itsshareholders.

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What Does Liquidity Ratios Mean? A class of financial metrics that is used to determine a company's ability to pay off its short-terms debtobligations. Generally, the higher the value of the ratio, the larger the margin of safety that thecompany possesses to cover short-term debts.

Investopedia explains Liquidity Ratios Common liquidity ratios include the current ratio, the quick ratio and the operating cash flow ratio.Different analysts consider different assets to be relevant in calculating liquidity. Some analysts willcalculate only the sum of cash and equivalents divided by current liabilities because they feel that theyare the most liquid assets, and would be the most likely to be used to cover short-term debts in an

emergency.

A company's ability to turn short-term assets into cash to cover debts is of the utmost importance whecreditors are seeking payment. Bankruptcy analysts and mortgage originators frequently usethe liquidity ratios to determine whether a company will be able to continue as a going concern.

A liquidity ratio measures a company's ability to pay its bills. The denominator of a liquidity ratio is the

company's current liabilities, i.e., obligations that the company must meet soon, usually within one yeaThe numerator of a liquidity ratio is part or all of current assets. Perhaps the most common liquidity

ratio is the current ratio, or current assets/current liabilities. Because current assets are expected to beconverted to cash within one year, this liquidity ratio includes assets and liabilities of equal longevity.The problem with the current ratio as a liquidity ratio is that inventories, a current asset, may not beconverted to cash for several months, while many current liabilities must be paid within 90 days. Thus

more conservative liquidity ratio is the acid test ratio -- (current assets - inventory)/current liabilities -which excludes relatively illiquid inventories. The most conservative liquidity ratio is the cash assetratio or the cash ratio, which includes only cash and cash equivalents (usually marketable securities) in

the numerator. Finally, note that the liquidity ratio sometimes means the cash ratio.

Total dollar value of cash and marketable securities divided by current liabilities. For a bank this is thecash held by the bank as a proportion of deposits in the bank. The liquidity ratio measures the extent t

which a corporation or other entity can quickly liquidate assets and cover short-term liabilities, andtherefore is of interest to short-term creditors. also called cash asset ratio or cash ratio.

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What Does Leverage Ratio Mean? 1. Any ratio used to calculate the financial leverage of a company to get an idea of the company'smethods of financing or to measure its ability to meet financial obligations. There are several differentratios, but the main factors looked at include debt, equity, assets and interest expenses.

2. A ratio used to measure a company's mix of operating costs, giving an idea of how changes in outpuwill affect operating income. Fixed and variable costs are the two types of operating costs; depending othe company and the industry, the mix will differ.

Investopedia explains Leverage Ratio 1. The most well known financial leverage ratio is the debt-to-equity ratio. For example, if a companyhas $10M in debt and $20M in equity, it has a debt-to-equity ratio of 0.5 ($10M/$20M).

2. Companies with high fixed costs, after reaching the breakeven point, see a greater increase inoperating revenue when output is increased compared to companies with high variable costs. The reasfor this is that the costs have already been incurred, so every sale after the breakeven transfers to theoperating income. On the other hand, a high variable cost company sees little increase in operatingincome with additional output, because costs continue to be imputed into the outputs. The degree of operating leverage is the ratio used to calculate this mix and its effects on operating income.

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What Does Activity Ratio Mean? Accounting ratios that measure a firm's ability to convert different accounts within their balance sheetsinto cash or sales.

Investopedia explains Activity Ratio Companies will typically try to turn their production into cash or sales as fast as possible because thiswill generally lead to higher revenues.

Such ratios are frequently used when performing fundamental analysis on different companies. Theasset turnover ratio and inventory turnover ratio are good examples of activity ratios.

$FWLYLW\UDWLR An indicator of how rapidly a firm converts various accounts into cash or sales. In general, the soonermanagement can convert assets into sales or cash, the more effectively the firm is being run.

$6XPPDU\RI.H\)LQDQFLDO5DWLRVHow They Are Calculated and What They Show

Profitability Ratios

1. Gross profit margin Sales - Cost of goods sold

Sales

An indication of the total margin available to cover operating expenses and yield a profit.

2. Operating profit margin



(or Return on Sales)

Profits before taxes and interest

Sales

An indication of the firm's profitability from current operations without regard to the interest charges

accruing from the capital structure

3. Net profit margin (or net

Return on sales)

Profits after taxes

Sales

Shows after tax profits per dollar of sales. Subpar profit margins indicate that the firm's sales prices ar

relatively low or that costs are relatively high, or both.

4. Return on total Assets Profits after taxes

Total assets

or Profits after taxes + interest

Total assets

A measure of the return on total investment the enterprise. It is sometimes desirable to add interest toafter

tax profits to form the numerator of the ratio since total assets are financed by creditors as well as by

stockholders; hence, it is accurate to measure the productivity of assets by the returns provided to bot

classes of investors.

5. Return on stockholder's

equity (or return on net

worth)

Profits after taxes

Total stockholders' equity

A measure of the rate of return on stockholders' investment in the enterprise.

6. Return on common

equity



(Profits after taxes -Preferred stock dividends)

(Total stockholders" equity - Par value of preferred stock)

A measure of the rate of return on the investment the owners of the common stock have made in the

enterprise. More commonly referred to as "return on equity" or ROE.

7. Earnings per share (Profits after taxes - Preferred stock dividends)

Number of shares of common Stock outstanding

Shows the earnings available to the owners of each share of common stock.Liquidity Ratios

1. Current ratio Current assets

Current liabilities

Indicates the extent to which the claims of short-term creditors are covered by assets that are expecteto be

converted to cash in a period roughly corresponding to the maturity of the liabilities.

2. Quick ratio (or acid-test

ratio)

(Current assets-Inventory)

Current Liabilities

A measure of the firm's ability to pay off short-term obligations without relying on the sale of its

inventories.

3. Inventory to net working

capital

Inventory

(Current assets - Current Liabilities)

A measure of the extent to which the firm's working capital is tied up in inventory.

Leverage Ratios

1. Debt-to-assets ratio Total debt

Total assets

Measures the extent to which borrowed funds have been used to finance the firm's operations.

2. Debt-to-equity ratio Total debt



Total stockholders' equity

Provides another measure of the fund provided by creditors versus the funds provided by owners.

3. Long-term debt-toequity ratio

Long-term debt

Total shareholders' equity

A widely used measure of the balance between debt and equity in the firm's long-term capital structure

4. Times-interest-earned

(or coverage) ratio

Profits before interest and taxes

Total interest charges

Measures the extent to which earnings can decline without the firm becoming unable to meet its annua

interest costs.

5. Fixed-charge coverage (Profits before taxes and interest + Lease obligations)

(Total interest charges + Lease obligations)

A more inclusive indication of the firm's ability to meet all of its fixed-charge obligations.Activity Ratios

1. Inventory turnover Sales

Inventory of finished goods

When compared to industry averages, it provides an indication of whether a company has excessive or

perhaps inadequate finished goods inventory.

2. Fixed assets turnover Sales

Fixed Assets

A measure of the sales productivity and utilization of plant and equipment.

3. Total assets turnover Sales

Total Assets

A measure of the utilization of all the firm's assets; a ratio below the industry average indicates thecompany

is not generating a sufficient volume of business, given the size of its asset investment.

4. Accounts receivable



turnover

Annual credit sales

Accounts receivable

A measure of the average length of time it takes the firm to collect the sales made on credit

5. Average collection period Accounts receivable

(Total sales / 365)

or Accounts receivable

Average daily sales

Indicates the average length of time the firm must wait after making a sale before it receives paymentThis

has implications for financial management and quality of customers (marketing).

Other Ratios

1. Dividend yield on

common stock

Annual dividends per share

Current market price per share

A measure of the return to owners received in the form of dividends.

2. Price-earnings ratio Current market price per share

After tax earnings per share

Faster-growing or less-risky firms tend to have higher price-earnings ratios than slower growing ormorerisky firms.

3. Dividend payout Annual dividends per share

After-tax earnings per share

Indicates the percentage of profits paid out as dividends.4. Cash flow per share (After tax profits +Depreciation)

Number of common shares outstanding

A measure of the discretionary funds over and above expenses that are available for use by the firm.



Ratio analysis is a useful way of gaining a "snapshot" picture of a company. These ratios can beanalyzed to identify the company's strengths and weaknesses and useful insights can be gained througthe process.

Very Important: However, it is important to realize this fact: the ratios have no financial theorybehind them. Theory tells us what SHOULD BE the case (or value). With financial ratios, we have noway to identify a "theoretically best" value for any of the ratios. In fact, financial ratios are nothingmore than common sense measures that have been developed and evolved over time. As such, theyare imperfect measures and should be treated as such.

U se of the Ratios

When using ratios, think of yourself as a detective who is looking for clues (like the little guy at the topof the page). Typically, ratios are excellent devices for uncovering clues about a company's financialcondition - but remember that clues simply raise more questions, not give definite answers. Ratios telus where to focus our attention and to ask relevant questions. We never want to depend of just oneratio to draw a conclusion, the ratios are complementary and one ratio can be used to confirm asuspicion raised by another ratio's value. It is only after looking at a variety of different ratios that apicture of the company's financial condition begins to form.

Types of Ratios

Financial ratios are generally grouped together by their purpose. Although there are many of theseclassifications, the most commonly used groups are:

1. Liquidity

2. Debt (or Leverage)

3. Activity (or Turnover)

4.

Profitability

Typically, you would not calculate the ratios in all of these categories for a single company. Usually, yowould approach the ratio analysis from the perspective of an individual interested in one particular areaFor example, assume that you show up for work one day and see a letter on your desk. In the letter, acompany named Dragon Celebrations, Inc., orders $30,000 of merchandise from you on standard credterms (which gives them up to 30 days to pay for the order). Accompanying the letter is a set of auditefinancial statements for the company. You're not familiar with Dragon Celebrations and don't have aprevious business relationship with it. Should you ship the merchandise to them?

Before doing so, you would like to determine the probability that they will pay you. You can purchase tcredit rating for the company from a credit bureau or standard credit reporting agency. However, if youdecide to do the analysis yourself , you can calculate the liquidity ratios using the company's balancesheet information. These ratios will evaluate the liquidity of the business and should offer valuableinformation as to the likelihood that Dragon will pay you within the 30 day period.

W ho U ses the Ratios?

Although generalizations are difficult here, here are some of the key users for the different types of ratios:

1. Liquidity - short-term creditors



2. Debt - existing lenders or potential lenders3. Activity - top management of the company

4. Profitability - both existing and potential investors in the company's common stock

Additional details on these classifications may be found on the "Commonly Used Ratios" handout shownbelow.

M ajor Ratios

Here is a handout that shows eleven basic, commonly used ratios and their construction. The secondpart of the handout describes nine more ratios that you may encounter, although they are not ascommon as the previous group.

Commonly Used Ratios

Although there are approximately 50 ratios that are used in practice, the ratios found on this handoutare used across a wide variety of industries and are a part of virtually any thorough financial analysis oa company.

Ratio Analysis on the W eb

Here is my favorite web site for looking up the value of companies' financial ratios and the industryaverage for each ratio. It's a great site for financial analysis of companies.

After going to the company's homepage (see the link below), point to the "News and Markets" headingat the top of the screen. A sub-menu will pop up; under the "Markets" heading, click on "Stocks." Onthe next page's Search box, type in the ticker symbol for the company that you want to look up. (If yodon't know the ticker symbol, type in the company name and press Search. The next page will allowyou to type in the full company name.) When the company's screen appears, click on the box for"Financials." You will then see a side-by-side comparison (for the company, industry, sector, and S& P

500) of all the major ratios. It makes an analysis easy and convenient.

Reuters

How Do W e U se the Ratios?

There are two primary ways to use financial ratios:

1. C ompare a ratio's v alue ov er sev eral periods of time (trend analysis or time-series analysis). Ifwe see a deteriorating trend in any ratio's values over several quarters or years, we caninvestigate to find the cause.

2. C ompare the company's ratios to the industry av erage (cross-sectional analysis). A single ratiovalue by itself usually means nothing - we need a standard, orbenchmark , to compare it to. Thbenchmark is usually the industry average (i.e., the ratio's average value for all firms in theindustry).

There are some people who believe that the industry average should not be used - that this means thawe are trying to be average (mediocre). They advocate that we should compare our ratios to those of the leading firm in the industry and try to match the ratios of that company. Although this argumenthas a certain plausibility, it ignores the fact that the leading firm often has strengths that others in theindustry will have trouble meeting (outstanding marketing, superior management training programs,



etc.). The industry average is probably a more useful standard. After all, we aren't tryingto match these ratios; we are trying to exceed the average company's performance.

A Sample Comparison of Ratios

Click on the link to see a sample financial statement analysis for the restaurant industry.

A P articularly U seful Technique

A company's Return On Equity (ROE) ratio is one of the most commonly used ratios since it measuresexactly what investors want to know - how much the company is earning on every dollar that investorput into the company. A particularly useful technique is to conduct a DuPont analysis on the company,

i.e., break down ROE into the sources of those profits. Do the profits come from effective marketingtechniques, strong control of costs, and effective pricing (all highly desirable) or do they come from thecompany's high use of debt (a less desirable and riskier way of increasing profits)?

Cautions About U sing Ratios

When using ratios as a form of analysis, be very careful that you don't put more trust in them than thedeserve. After all, they are simply common sense measures with no financial theory underlying them.In fact, ratios have significant problems associated with them that should cause us to use them withcaution:

1. Ratios don't prove that a problem exists or provide definite answers to any of ourquestions. However they are very good at providing us with some guidance on the future stepthat our investigation should take. In other words, a ratio analysis indicates symptoms of aproblem and focuses our attention onpotential problems that deserve our attention. But theyrarely provide us with firm answers; usually, the best that they do is tell us what key questionswe need to ask.

2.

Realize that there may be significant differences between the characteristics of thecompany and the "average" firm in the industry. For example, you may be analyzing thefinancial statements of a steel manufacturer and want to compare the firm's ratios to the theindustry average. However, while primarily steel manufacturers, some of the other firms in theindustry may own their own captive finance companies, own railroad lines for transportation of the finished steel, and own an insurance company for diversification purposes. It is often verydifficult to honestly say that we are comparing apples with apples when the companies in theindustry have substantially different structures and characteristics.

3. Always make sure that you are calculating a ratio exactly as the industry average ratiois calculated. There are many variations on how to calculate the various ratios. For example,you look in several finance textbooks, you can easily find differences in suggested ways tocalculate Return on Investment, Inventory Turnover, and the Quick (or Acid Test) Ratio. Since

we typically depend on an outside firm (e.g., Reuters, Dun & Bradstreet, etc.) to provide us withthe values of the industry average for each ratio, we need to ensure that the formula that we ausing for a ratio is the same formula that the industry average source is using. For example, wmay calculate the I nv entory Turnov er ratio as ( C ost of Goods Sold)/(Av erage Monthly I nv entory) while the outside source calculates it as (Annual Sales)/(Year Ending I nv entory). Boversions are commonly used.

4. Companies frequently don't have the same fiscal year. Some companies' fiscal year endson December 31st, others' end on September 30th, others' end on June 30th, etc.. If you aredepending on the year-ending (end of the fiscal year) balance sheet's data, this date may varywidely among firms in the same industry. This is especially true of companies whose sales are



highly seasonal. For example, two companies who manufacture snowmobiles may have almostidentical performance numbers for the year. However, they will have vastly different inventoryand accounts receivable levels if one's year ends in June and the other's ends in December, resulting in considerable differences in the values of a ratio analysis.

5. Companies' accounting practices may differ considerably. Companies have a great deal odiscretion in their accounting procedures, particularly with regard to depreciation (straight line, double declining balance, etc.) and inventory (LIFO, FIFO, etc.). This makes comparisons moredifficult.

6. Be careful about depending too much on any one ratio. A ratio analysis is most valuablewhen we evaluate a number of ratios of a certain type (liquidity, profitability, etc.) and look for pattern in the results.

7. Audited financial statements should be used whenever possible. Small businesses'financial statements are often unaudited and may not be accurate.

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