Chapter Four

Financial analysis and Planning,

Control and Analysis

Ratio Analysis
The CONCEPT : So why divide?
Dividends – (Return)
Company A: $15.00
Company B: $21,000.38
Company C: $73,400.00

Ratio Analysis
The CONCEPT : Why divide?
Equity
Company A: $145.29
Company B: $267,402.00
Company C: $1,468,000.00

Ratio Analysis
The CONCEPT : Why divide?
Yield / Equity ROE
Comp. A: $15 / $145.29 = 10%
Comp. B: $21,400 / $267,402 = 8%
Comp. C: $73,400 / $1,468,000 = 5%

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.

Ratio Analysis
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.
Ratio Analysis
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.
 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.
Liquidity Ratios: Can the Business Pay Its Debts?
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.

Liquidity Ratios: Can the Business Pay Its Debts?
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.

Liquidity Ratios: Can the Business Pay Its Debts?

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.
 Net profit after taxes
Net sales
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
Net sales
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.
Net sales
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
Net sales
Fixed assets

NET SALES TO OWNERS' EQUITY shows the relationship of sales to the amount of investment.
Net sales
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 = $1,015
365 365
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.

Net sales
Inventory

The NET SALES TO WORKING CAPITAL shows the support you receive from your current assets.
 Net sales
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
 / 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