FINANCIAL ANALYSIS

Financial ratios are ways of comparing and investigating the relationships between
different pieces of financial information. In other words, financial ratios are a tool
used for analysis the company’s performance based on their financial statement.

Financial ratios are generally grouped into the following categories:-

1. Short-term solvency, or liquidity ratios

2. Long-term solvency or financial leverage ratios.

3. Asset management, or turnover ratios

4. Profitability ratios

5. Market value ratios

For easy reference, I construct the financial analysis by using P.MJ Corporation’s
Financial Statement for year 2007. (Refer to Table A and Table B)

Short-Term Solvency/Liquidity Ratios

The primary concern is the firm’s ability to pay its debt over the short run without
undue stress.

1. Current Ratio = Current Assets / Current Liabilities

= $708/ $540

= 1.31 times

In principle, the current ratio gauges how capable a business is in paying current
liabilities by using current assets only. Current ratio is also called the working
capital ratio. A general rule of thumb for the current ratio is 2 to 1 (or 2:1 or 2/1). To
a firm, a high current ratio indicates liquidity, but it also may indicate an inefficient
use of cash and other short-term assets. However, for a creditor such as a supplier
the higher current ratio, the better.

2. Quick Ratio = (Current Assets – Inventory)/ Current Liabilities

=( $708 -$422)/$540

= .53 times

Quick ratio focuses on immediate liquidity (i.e., cash, accounts receivable, etc.) but
specifically ignores inventory. Also called the acid test ratio, it indicates the extent
to which company could pay current liabilities without relying on the sale of
inventory. Quick assets are highly liquid and are immediately convertible to cash. A
general rule of thumb states that the ratio should be 1 to 1 (or 1:1 or 1/1).

3. Cash Ratio = Cash/Current Liabilities

=$98/$540
= 0.18 times

Long-Term Solvency Ratios

Long-term solvency ratios are intended to address the firm’s long-run ability to
meet its obligations or synonym with the financial leverage.

1. Total debt ratio = (Total Assets- Total Equity)/ Total Assets

= ($3,588-$2,591)/$3,588
=.28 times

Total debt ratio in this example that the company use 28 percent debt.

2. Times Interest Earned =EBIT/ Interest

=$691/$141
=4.9 times

This ratio shows how well a company has its interest obligations covered and it is
often called the interest coverage ratio. The higher the ratio, the greater the
company's ability to make its interest payments or perhaps take on more debt.

3. Debt-to-Equity =Total Liability/Total Equity

=$997/$2,591
=.38 times

Debt to equity is also called debt to net worth. It quantifies the relationship between
the capital invested by owners and investors and the funds provided by creditors.
The higher the ratio, the greater the risk to a current or future creditor. A lower ratio
means the company is more financially stable and is probably in a better position to
borrow now and in the future. However, an extremely low ratio may indicate that
the company is too conservative and is not letting the business realize its potential.
Asset Management / Turnover Ratio

Asset Management Ratios also called as Utilization Ratios. This measurement ratios
describe how efficiently, or intensively, or a firm uses its assets to generate sales.

1. Inventory Turnover =Cost of Goods Sold/Inventory

=$1,344/$422
=3.2 times

This ratio shows how many times in one accounting period the company turns over
(sells) its inventory and is valuable for spotting under-stocking, overstocking,
obsolescence and the need for merchandising improvement. Faster turnovers are
generally viewed as a positive trend; they increase cash flow and reduce
warehousing and other related costs.

2. Day Inventory =365 days/Inventory turnover

=365 days/ 3.2 times
=114 days

This ratio identifies the average length of time in days it takes the inventory to turn
over. As with inventory turnover (above), fewer days mean that inventory is being
sold more quickly.

3. Receivables Turnover = Sales/Account Receivable

=$2,311/$188
=12.3 times

This ratio shows the number of times accounts receivable are paid and
reestablished during the accounting period. The higher the turnover, the faster the
business is collecting its receivables and the more cash the client generally has on
hand.

4. Account Receivables Collection Period =365 days/Receivables

turnover
=365/12.3 times
=30 days

This reveals how many days it takes to collect all accounts receivable. As with
accounts receivable turnover (above), fewer days means the company is collecting
more quickly on its accounts.
 5. Asset Turnover = Sales/Total Assets
=$2,311/$3,588
=.64 times

This indicates how efficiently the company generates sales on each dollar of assets.
A volume indicator, this ratio measures the ability of the company's assets to
generate sales.

6. Account Payable Turnover =Cost of Goods Sold/Account Payable

=$1,344/$344
=3.9 times

This ratio shows how many times in one accounting period the company turns over
(repays) its accounts payable to creditors. A lower number indicates either that the
business has decided to hold on to its money longer or that it is having greater
difficulty paying creditors.

Profitability Ratios

This measurement intends to show how efficiently the firm uses its assets and how
efficiently the firm manages its operations.

1. Profit Margin =Net Income/Sales

=$363/$2,311
=15.7%

Profit margin shows how much net profit is derived from every dollar of total sales.
It indicates how well the business has managed its operating expenses. It also can
indicate whether the business is generating enough sales volume to cover minimum
fixed costs and still leave an acceptable profit.

2. Return On Assets =Net Income/Total Assets

=$363/$3,568
=10.12%

This evaluates how effectively the company employs its assets to generate a return.
It measures efficiency.
 3. Return On Equity =Net Income/Total Equity
=$363/$2,591
=14%

This is also called return on investment (ROI). It determines the rate of return on the
invested capital. It is used to compare investment in the company against other
investment opportunities, such as stocks, real estate, savings, etc. There should be
a direct relationship between ROI and risk (i.e., the greater the risk, the higher the
return).

Market Value Ratios

Obviously, this ratios can be calculated directly only for publicly traded companies.

We assume that P. MJ has 33 million outstanding and the stock sold for $88 per
share at the end of year.

1. Earnings Per Share(EPS) =Net Income/Shares Outstanding

=$363/33
=$11

2. Price-Earnings Ratios = Price per share/EPS

=$88/$11
=8 times

In the vernacular, we would say that P. MJ Corporation shares sell for 8 times
earnings, or we might say that P. MJ Corporation shares have Price-Earnings
multiple of 8.
Table A

P. MJ Corporation
Balance Sheet As At 31 December 2007
($ in million)
Assets
Current Assets
Cash 98
Account Receivable 188
Inventory 422
Total 708
Fixed Asset
Net Plant & Equipment 2,880
Total Asset 3,588

Liabilities & Owners’ Equity

Current Liabilities
Accounts Payable 344
Notes Payable 196
Total 540
Long-Term Liabilities 457

Owners’ Equity
Common Stock & paid-in Surplus 550
Retained Earnings 2,041
Total 2,591
Total Liability & Owners’ Equity 3,588

Table B
P. MJ Corporation
Income Statement For The Year Ended 2007
($ in million)
Sales 2,311
Less: Cost of Goods Sold 1,344
Depreciation 276
Earnings before Interest & taxes (EBIT) 691
Less: Interest paid 141
Taxable Income 550
Taxes (34%) 187
Net Income 363
 STRATEGIC MANAGEMENT
(BT31303)
INDIVIDUAL ASSIGNMENT 1

(Due Date:28.1.2011)

Name : Mahfuzah Mansur

Matric No. : BB08110472