Ratio Analysis By transforming dollar figures into ratios, they may be compared to ratios of past periods, ratios of other firms or to industry norms.

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1 Chapter Four Financial analysis and Planning, Control and Analysis The CONCEPT : So why divide? Dividends (Return) Company A: $15.00 Company B: $21, Company C: $73, The CONCEPT : Why divide? Equity Company A: $ Company B: $267, Company C: $1,468, The CONCEPT : Why divide? Yield / Equity ROE Comp. A: $15 / $ = 10% Comp. B: $21,400 / $267,402 = 8% Comp. C: $73,400 / $1,468,000 = 5% By transforming dollar figures into ratios, they may be compared to ratios of past periods, ratios of other firms or to industry norms. Ratio analysis is the use of values taken from financial statements - such as the balance sheet and income statement - in order to measure certain aspects of a firm s financial condition. The CONCEPT : So why divide? Liquidity Profitability Efficiency Solvency Ratios Profitability Ratios - Relate income of the firm to other important financial figures. Useful in evaluating the management of the of the firm s resources. Compare firm s profit to the resources invested or sales. Activity Ratios - Measure how well the firm is utilizing its resources. Useful in indicating why the firm has not been as profitable as expected. Used to monitor the progress of the firm. Used to flag problems before they occur. Ratios Liquidity Ratios - indicate the firms ability to meet its short-term debt. Solvency or Leverage Ratios indicate the firms ability to meet its long-term debt. Total liabilities / net worth = debt to equity ratio.

2 Ratio should be less than one, meaning owners have more invested in firm than creditors have debt. Total liabilities divided by total liabilities and net worth = debt ratio. Amount of debt is measured relative to total amount of financing. The CURRENT RATIO is the ratio of current assets to current liabilities. Current assets / Current liabilities Joe s Bar & Grill has $10 mill in current assets and $5 mill in current liabilities. $10 million / $5 million = 2 General rule is that a current ratio of 1.5 or greater is good. The ACID TEST (QUICK) RATIO, the ratio of current assets minus inventory to current liabilities, is more rigorous. (Current assets inventories)/current liabilities Joe s Bar & Grill has $2.5 mill of its current assets in hamburger buns setting in inventory. ($10 mm - $2.5 mm)/ $5 mm = 1.5 General rule is that a quick ratio of 1 or greater is good. There is enough cash on hand to pay the bills and keep going. WORKING CAPITAL is the amount of current assets less current liabilities. Working Capital = (Current assets - Current liabilities) Market Cap (Shares X Share price) + Debt Joe s Bar & Grill has no debt,one million shares at $10 per share. = $10 mm - $5 mm = $5 mm = 0.5 = 50% (1MMx$10) $10MM Financial Ratios: Can the Business Pay Its Debts? (continued) ACCOUNTS RECEIVABLE TO WORKING CAPITAL shows the riskiness of the company's ability to make current payments. Accounts receivable/ Working capital INVENTORY TO WORKING CAPITAL states the riskiness in terms of inventory. Inventory/Working capital Profitability Ratios: Are Profits Satisfactory? RETURN ON EQUITY (ROE) is the percentage of net profit your equity earns, before taxes. Net profit before taxes Net Worth - Owners' equity NET PROFIT (INCOME) TO NET SALES shows how much return your company makes on its sales dollar.

3 Net profit after taxes Profitability Ratios: Are Profits Satisfactory? RETURN ON Assets (ROA) reflects the return to the firm s total resources. Net operating profit Total assets GROSS MARGIN PERCENT shows the gross margin generated by each dollar of sales. Sales - COGS Activity Ratios: Is the firm utilizing its resources well? ASSET TURNOVER shows the efficiency with which company used its assets to generate sales. Total sales Total assets NET SALES TO OWNERS' EQUITY shows the relationship of sales to the amount of investment. Owners Equity When combined with the net profit to net sales ratio, the RETURN ON EQUITY (ROE) ratio is obtained. Activity Ratios: Is the firm utilizing its resources well? NET SALES TO FIXED ASSETS shows if the company is obtaining enough sales from its producing assets Fixed assets NET SALES TO OWNERS' EQUITY shows the relationship of sales to the amount of investment. Owners Equity When combined with the net profit to net sales ratio, the RETURN ON EQUITY (ROE) ratio is obtained. Financial Ratios: How Good are the Business s Assets? The COLLECTION PERIOD ratios and accounts receivable to average daily credit sales provide a guide to the quality of accounts receivable. Accounts receivable Average daily credit sales* *Assume that 80 percent of sales are on credit; then the average daily credit sales would be: Annual sales x.80 = $453,146 x.80 = $1, Financial Ratios: How Good are the Business s Assets? (continued) The turnover rate of inventory is expressed by the ratio of NET SALES TO INVENTORY. Inventory The NET SALES TO WORKING CAPITAL shows the support you receive from your current assets.

4 Working capital Financial Ratios: Is Your Equity in the Business Satisfactory? LONG-TERM LIABILITIES TO WORKING CAPITAL. Long-term liabilities/working capital DEBT TO OWNERS' EQUITY. Total liabilities/owners' equity Financial Ratios: Is Your Equity in the Business Satisfactory? (cont d) CURRENT LIABILITIES TO OWNERS' EQUITY Current liabilities/owners' equity FIXED ASSETS TO OWNERS' EQUITY Fixed assets/owners' equity Book Value: Is Your Equity in the Business Satisfactory? Book Value = OWNERS' EQUITY / SHARES Owners' equity/number of share Owners' equity = Number of share X Share Price Price to Book = Share Price / Book Value An old idea, good for manufacturing Book Value: Is Your Equity in the Business Satisfactory? TOTAL ASSETS TOTAL LIABILITIES RELATIVE TO NUMBER OF SHARES (Total assets - total liabilities)/number of share OWNERS' EQUITY / SHARES Owners' equity /Number of share Profitability Ratios 1. Return on Equity = (Net Profit / Net Worth) 2. Return on Assets = (Net Operating Profit/Sales) 3. Gross Margin Percent = (Sales - Cost of Goods Sold / Sales) 4. Net Income Percent = (Net Income / Sales)X100% Activity Ratios 1. Asset Turnover = (Total Sales / Total Assets ) 2. Operating Expense Percent = (Total Operating Expenses/Sales) 3. Inventory Turnover = (Cost of Goods Sold/Average Inventory) 4. Accounts Receivable Turnover = (Sales/Average Accounts Receivable) Liquidity Ratios 1. Current Ratio = (Current Assets/Current Liabilities) 2. Acid test ratio = (Cash + Marketable Securities / Total Current liabilities) Solvency Ratios 1. Debt to Equity Ratio = (Total Liabilities / Net Worth) 2. Debt Ratio = (Total Liabilities

5 / Total Liabilities + Net Worth) Trend and Graphical Analysis Trends may be identified by constructing a table of financial figures of interest. Addition of graphical analysis may help to visualize a trend

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