Ratio Analysis

Dr. Mahmood Osman Imam 1

Professor & Chairman, Department of Finance, DU
Analyzing Financial Performance through Ratio

Financial ratios, calculated from the

information of financial statements, are
used to analyze a firms past financial
performance.
Financial ratios are no substitute for a crystal ball, says it
all. Such convenient summaries as ratios are always to be
viewed with healthy skepticism. Financial ratios seldom
provide answers. Rather they provide the basis for asking the
right questions about a firms financial performance.
Financial ratios are used to compare the
risk and return of different firms in order
to help investors and creditors make
intelligent investment and credit
decisions.
Dr. Mahmood Osman Imam 2
Professor & Chairman, Department of Finance, DU
Analyzing Financial Performance through Ratio

Such decisions range from an evaluation of changes in

performance over time for a particular investment to a
comparison among all firms within a single industry or
peer firm (Matched firm) at a specific point in time.
Purpose and Use of Ratio Analysis
Ratios can be used to compare the risk and return
relationships of different firms of different sizes.
Ratios can provide a profile of a firm, its economic
characteristics and competitive strategies, and its unique
operating, financial and investment characteristics.
Given the differences between industries and of the
effect of varying capital structures, and differences in
accounting & reporting methods, changes (trends) in a
ratio and variability over time may be more informative
than the level at any point in time.

Dr. Mahmood Osman Imam 3

Professor & Chairman, Department of Finance, DU
Analyzing Financial Performance through Ratio

Four broad ratio categories

To create
Liquidity value,
Analysis the financial
Measures the adequacy of a firms cash
manager
resources should:
to meet its near-term cash obligations.
Efficiency or Activity Analysis Evaluate revenues and
Trygenerated
1.output to make by the smart investment
firms assets.
decisions.
Leverage or Solvency Analysis Examines the firms capital
2. Try to make smart financing
structure in terms of the mix of its debt financing sources and
the ability of the firm to satisfy its longer-term debt and
decisions.
investment obligations.
Profitability Analysis Measures the income of the firm
relative to its revenues and invested capital.

Dr. Mahmood Osman Imam 4

Professor & Chairman, Department of Finance, DU
 Liquidity Ratio
to judge a firms ability to meet short-term
(recurring) financial obligations.
Current Ratio.
Current Assets Tk . 24,000
Current Ratio = = = 2.4 times.
Current Liabilities Tk .10,000

Quick Ratio or Acid Test Ratio

24,000 12,000
Quick Ratio = = 1.2 times
10,000

Dr. Mahmood Osman Imam 5

Professor & Chairman, Department of Finance, DU
 Efficiency or Activity Ratio
to measure how efficiently the firm uses its
resources (assets) to generate sales..
Average Collection Period

Accounts Receivables 10,000

Average Collection Period = = = 70.6 days
Annual Sales / 360 51,000 / 360

Accounts Receivables Turnover

Annual Sales 51,000

Receivables Turnover = = = 5.1 times
Accounts Receivables 10,000

The average collection period of a firm should not

exceed the time allowed for payment in the credit
terms by more than 10 days.
Dr. Mahmood Osman Imam 6
Professor & Chairman, Department of Finance, DU
 Efficiency or Activity Ratio
to measure how efficiently the firm uses its
resources (assets) to generate sales..

Inventory Turnover
Cost of Goods Sold 38,000
Inventory Turnover = = = 3.17 times
Inventory 12,000

Inventory period
Days in a year 360
Inventory Period = = = 113.6 days
Inventory Turnover 3.17

Total Operating Cycle = A/C Receivable period + Inventory Period

Dr. Mahmood Osman Imam 7

Professor & Chairman, Department of Finance, DU
 Efficiency or Activity Ratio
to measure how efficiently the firm uses its
resources (assets) to generate sales..
Total Asset Turnover

Annual Sales 51,000

Total Assets Turnover = = = 1.65 times
Total Assets 31,000

If the ratio is low, the firm could not use its

assets up to their capacity and must either
increase sales or dispose of some of its assets.

Dr. Mahmood Osman Imam 8

Professor & Chairman, Department of Finance, DU
 Solvency or Leverage Ratio
to judge a firms ability to meet long-term
debt obligations.
Debt ratio
Total Liabilities 10,000 + 10,700
Debt Ratio = = = 0.668 or 66.8%
Total Assets 31,000

Debt-equity ratio
Long Term Debt 10,700
Debt - equity ratio = = = 1.039
Total Equity 10,300

Time Interest Earned or Interest

Coverage Ratio.
Earning Before Interest and Taxes 4,000
Interest coverage = = = 4.0 times
Interest Expenses 1,000

Dr. Mahmood Osman Imam 9

Professor & Chairman, Department of Finance, DU
 Solvency or Leverage Ratio
to judge a firms ability to meet long-term
debt obligations.
Cash Flow Coverage ratio
EBIT + Depreciation
Cash Flow Coverage Ratio =
Principal Payment
Interest Expense +
(1 Tax rate )

4,000 + 500
Cash Flow Coverage Ratio = = 2.45 times
500
1,000 +
(1 0.4)

Dr. Mahmood Osman Imam 10

Professor & Chairman, Department of Finance, DU
 Profitability Ratio
to judge the degree to which a firm is
profitable in relation to some variable.
Profit Margin
Gross Profit 13,000
Gross Profit Margin = = = 0.255 or 25.5%
Sales 51,000

Operating Profit EBIT 4,000

Operating Profit Margin = = = = 0.078 or 7.8%
Sales Sales 51,000

Net Profit 1,800

Net Profit Margin = = = 0.035 or 3.5%
Sales 51,000

Dr. Mahmood Osman Imam 11

Professor & Chairman, Department of Finance, DU
 Profitability Ratio
to judge the degree to which a firm is
profitable in relation to some variable.
Return on Assets:

Net Income 1,800

Return on Assets = = = .058 or 5.8%
Total Assets 31,000

EBIT 4,000
Gross Return on Assets = = = .129 or 12.9%
Total Assets 31,000

Return on Equity
Net Income 1,800
Return on Equity = = = .175 or 17.5%
Common Equity 10,300

Dr. Mahmood Osman Imam 12

Professor & Chairman, Department of Finance, DU
Ratio Analysis: Cautionary Notes

Ratio computations and

comparisons are confounded by
the lack or inappropriate use of
benchmarks, the timing of
transactions, negative numbers,
and differences in reporting
methods.

Dr. Mahmood Osman Imam 13

Professor & Chairman, Department of Finance, DU
 Bechmarks

Ratio analysis often lacks appropriate benchmarks

to indicate optimum levels. (Lender vs equity
investors with respect to liquidity).
Using an industry average as the benchmark may
be useful for comparisons within industry, but not for
comparisons between companies in different
industries.
Even for intraindustry analysis, the benchmark
may have limited usefulness if the whole industry or
major firms in that industry are doing poorly.

Dr. Mahmood Osman Imam 14

Professor & Chairman, Department of Finance, DU
 Negative Numbers

Return on Equity = Income / Equity

Company Income Equity ROE

A Tk 10,000 Tk 100,000 10%
B (10,000) (100,000) 10%

Dr. Mahmood Osman Imam 15

Professor & Chairman, Department of Finance, DU
 Accounting Methods

Ratios are not comparable between

firms with differing accounting
methods or for the same firm over
time when it changes accounting
methods.

Dr. Mahmood Osman Imam 16

Professor & Chairman, Department of Finance, DU
 Timing and Window dressing

For annual reports, the fiscal year-end may

correspond to the low point of a firms operating
cycle, when reported levels of assets and libilities may
not reflect the levels typical of normal operations. As
a result, especially in the case of seasonal businesses,
ratios may not reflect normal operating relationships.

Transaction at year-end lead to manipulation of the

ratios to show the firm in more favorable light, often
called window dressing.

Dr. Mahmood Osman Imam 17

Professor & Chairman, Department of Finance, DU
 Thanks

Dr. Mahmood Osman Imam 18

Professor & Chairman, Department of Finance, DU