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 TM

SELF-LEARNING MANAGEMENT SERIES

FINANCIAL
MANAGEMENT
ESSENTIALS
YOU ALWAYS WANTED TO KNOW

FIFTH EDITION

A simple and essential guide to making good financial

management decisions

KALPESH ASHAR
Financial Management Essentials
You Always Wanted To Know
Fifth Edition

© 2022, By Vibrant Publishers, USA. All rights reserved. No part of this publication
may be reproduced or distributed in any form or by any means, or stored in a database
or retrieval system, without the prior permission of the publisher.

Paperback ISBN 10: 1-63651-100-7

Paperback ISBN 13: 978-1-63651-100-9

Ebook ISBN 10: 1-63651-101-5

Ebook ISBN 13: 978-1-63651-101-6

Hardback ISBN 10: 1-63651-102-3

Hardback ISBN 13: 978-1-63651-102-3

Library of Congress Control Number: 2011911768

This publication is designed to provide accurate and authoritative information

in regard to the subject matter covered. The Author has made every effort in the
preparation of this book to ensure the accuracy of the information. However,
information in this book is sold without warranty either expressed or implied. The
Author or the Publisher will not be liable for any damages caused or alleged to be
caused either directly or indirectly by this book.

Vibrant Publishers books are available at special quantity discount for sales
promotions, or for use in corporate training programs. For more information please
write to [email protected]

Please email feedback / corrections (technical, grammatical or spelling) to

[email protected]

To access the complete catalogue of Vibrant Publishers, visit

www.vibrantpublishers.com
 About the Author
Kalpesh Ashar is a management consultant and
corporate trainer holding an MBA (Dean’s
Award Winner) from SPJIMR, one of Asia’s top
business schools, and an Engineering degree
with honors in Electronics. He has over 24 years
of experience in large organizations and start-
ups in Asia, USA, and Europe.
Kalpesh has worked in several project management roles, like
senior project manager, delivery manager, and program manager.
He is passionate about writing on management subjects. His
techno-business background gives him a unique position to write
on management topics that are easy to understand for non-MBA
graduates. His books are authored in a simple to understand manner
without unnecessary use of management jargon.
Other contributors
We would like to whole-heartedly thank Dr. Mark Koscinski for
contributing the text on Commercial Loans in Chapter 5, Working
Capital Management. Dr. Mark Koscinski CPA D.Litt. is an assistant
professor of accounting practice at Moravian College in Bethlehem,
Pennsylvania where he teaches a wide variety of accounting and
management courses. Prior to joining Moravian College, Mark had
significant experience in public and private accounting. He has been
the chief financial officer of a publicly traded defense contractor and a
privately held toy company.

We would also like to sincerely thank Brodie Schultz for providing

solutions to all the practice exercises that were unsolved till the
previous editions of this book. Brodie is a young aspiring engineer
currently working in the areas of marketing, financial management,
and innovative manufacturing processes at Ford Motor Company and
has received his Masters of Business Administration and Bachelor
of Science in Mechanical Engineering. Brodie is also an active board
member for his local Penn State Alumni Association Chapter, an avid
cook, fisherman, and golfer.
 What experts say about this book!
The book is well structured and covers the core financial concepts
that are essential for any business student to know. The concepts are
explained in an easy-to-understand manner, and the examples and
content is translated well into end-of-chapter practice problems. I would
definitely recommend this book to both finance and non-finance majors.

– Prateek Sharma, Ph.D., Assistant Professor of Finance,

Labovitz School of Business and Economics

This book fills an important void for managers responsible for

corporations and non-profits. It begins by opening access to finance
to people with no experience in finance and moves steadily on to
present well-developed business tools for decision making in complex
organizations with significant revenues and budgets. I highly recommend
this book.

– Drew Hession-Kunz, Senior Lecturer, Finance Department,

Boston College

I think the book would be a good primer or assigned text for those
enrolled in a college or AP Finance course, as it introduces financial
concepts in basic terms. The illustrations and flow charts are a plus, as
they will help students navigate the book and visualize applications of
the lessons therein.

– Carl Lew, School Librarian,

The Park School
 What experts say about this book!
Financial Management Essentials is a concise book which is exactly
what's needed for a short introductory level course or for someone who
would like a short course that covers all the essentials. The book has
many examples and includes solutions to several problems as well. It is an
excellent book to start learning finance in an 'applied' way.

– Javier Mella, PhD, CFA, Assistant Professor of Finance,

Universidad de los Andes

Very comprehensive and informative. The book covers all of the topics
that I normally teach my undergraduate students. In my opinion, this
would be a useful tool for a classroom setting. Additionally, the book
will assist someone who is considering starting an investment/relations
company, or a creative business owner to dig deeper into the world of
financial management.

– Xihui Chen, Assistant Professor of Accounting and Finance,

Heriot-Watt University

In Essentials of Financial Management, author Kalpesh Ashar, simplifies

some of the most complex issues in Financial Management in a down-to-
earth manner. Every aspect of financial management is expounded upon
in a concise and well-illustrated manner and backed up with exercises.
Readers of this book will be able to decipher the various elements of
financial management that lead to the decision-making process.

– Dr. Felix Lessambo, Adjunct Associate Professor,

Fordham University
 Table of Contents

1 Introduction to Financial Management 1

2 Financial Statement Analysis 5

2.1 Ratio Analysis 6
2.2 DuPont Framework 18
2.3 Benchmarking 19
2.4 Limitation of Financial Ratios 20
2.5 Common-size Financial Statements 21
Case Study 25
Solved Examples 27
Practice Exercise 33
Chapter Summary 36

3 Cost of Capital 39
3.1 Cost of Debt (kd) 40
3.2 Cost of Preferred Stock (kp) 40
3.3 Cost of Retained Earnings (ks) 41
3.4 Cost of New Common Stock (ke) 45
3.5 Weighted Average Cost of Capital (WACC) 46
Solved Examples 48
Practice Exercise 52
Chapter Summary 54

4 Capital Budgeting 55
4.1 Free Cash Flow 56
4.2 Timing of Cash Flows 58
4.3 Estimating Cash Flows over Life of Project 59
4.4 Payback Period 63
4.5 Discounted Payback Period 65
 4.6 Net Present Value (NPV) 67
4.7 Internal Rate of Return (IRR) 69
4.8 Modified Internal Rate of Return (MIRR) 70
4.9 Usage of Capital Budgeting Methods 71
Case Study 73
Solved Examples 74
Practice Exercise 80
Chapter Summary 83

5 Working Capital Management 85

5.1 Cash Conversion Cycle 87
5.2 Current Asset Investment Policies 90
5.3 Current Asset Financing Approaches 90
5.4 Short-Term Financing Options 95
Case Study 105
Solved Examples 106
Practice Exercise 111
Chapter Summary 113

6 Capital Structure 115

6.1 Debt 116
6.2 Optimal Capital Structure 118
6.3 Capital Structure Theories 121
Solved Examples 123
Practice Exercise 127
Chapter Summary 129

7 Distribution to Shareholders 131

7.1 Factors in setting Dividend Distribution Policy 132
7.2 Residual Dividend Model 134
7.3 Dividend Payment Procedures 136
7.4 Dividend Reinvestment Plan (DRIP) 137
 7.5 Stock Splits and Stock Dividends 138
7.6 Stock Repurchases 139
Solved Examples 140
Practice Exercise 144
Chapter Summary 145

8 Forecasting Financial Statements 147

8.1 Step 1 – Forecast Sales 148
8.2 Step 2 – Forecast Income Statement 149
8.3 Step 3 – Forecast Balance Sheet – 1st Pass 152
8.4 Step 4 – Raising Additional Funds Needed (AFN) 155
8.5 Step 5 – Forecast Balance Sheet – 2nd Pass 155
8.6 AFN Formula 157
Case Study 160
Solved Examples 162
Practice Exercises 165
Chapter Summary 168

9 International Finance 169

9.1 Exchange rates 170
9.2 Purchasing Power Parity and Interest Rate Parity 176
Solved Examples 180
Practice Exercise 182
Chapter Summary 183

Glossary 185
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 Preface
Finance is an area that is important in our everyday life. It is needed
at work and at home. It is important to understand that finance and
financial management are not the same. Financial management is a
part of the world of finance that helps us understand our finances and
make important decisions, like when to make a new investment in a
new product line or when to buy a new home. Traditionally, this skill
has been restricted to individuals in the finance department or those
who studied the subject in school. Over time, we have come to realize
that everybody should have financial acumen, as it is a key skill
required to succeed in personal life and in professional life.

‘Financial Management Essentials You Always Wanted to Know’

provides that set of bare minimum skills that you need in order to
make good financial decisions. It consists of only those key areas that
are considered critical. The objective of the book is not to teach you
everything in finance, but to equip you with enough information to
be more productive and accurate in your decision-making, with the
financial perspective in mind.
This page is intentionally left blank
 Who can benefit from the book?
This book can be used by anyone who needs to make financially
sound decisions, like:

● Managers in an organization

● Individuals who need to make investment decisions

● Senior management of an organization

It can also be beneficial for those interested in the field of financial

management, like:

● Students learning finance as part of their university course

● Anybody else who is interested in learning how financial

numbers help in decision making

How to use this book?

The recommended approach to reading this book is to start from
the first chapter and go in sequence, even if you are experienced in
finance. This will ensure that you get a solid base of the previous
chapters that will be needed to understand the later chapters
better. There is a lot of financial management terminology in each
chapter that could be new to you, and understanding it will help
you with the later material in the book.
This page is intentionally left blank
Chapter 1

Introduction to Financial
Management

In this chapter, we shall look at the fundamentals of

financial management. These will form the pillars for
our understanding of the later chapters.

The key learning objectives of this chapter include the

reader's understanding of the following:

● Financial statement analysis techniques

● Financial management decision-making tools

Financial Management is a field of finance that involves using

a company’s financial information to make decisions. The diagram
below shows the steps in the analysis of financial information.

Figure 1.1

Make Decisions in
Prepare Financial Analyze Financial Operating, Investing
Statements Statements & Financing
2 Financial Management Essentials You Always Wanted To Know

Financial Accounting is a field that deals with the preparation

of financial statements (refer to the book “Financial Accounting
Essentials You Always Wanted to Know” of this series).

Financial Management uses this information to first analyze the

company’s health and then make appropriate decisions.

Consider, for example, the Balance Sheet and Income Statement

of two companies as below:

Balance Sheet (in million $) ABC Inc. XYZ Inc.

Current Assets
Cash $20 $10
Inventory $50 $20
Total Current Assets $70 $30
Long-term Assets
Long-term investment $230 $70
Property, plant & equipment (net) $1,000 $800
Total Assets $1,300 $900
Current Liabilities $30 $5
Long-term Liabilities
Long-term debt $100 $40
Bonds $500 $50
Total Liabilities $630 $95
Stockholders’ Equity
Paid-in capital $200 $300
Retained earnings $470 $505
Total stockholders' equity $670 $805
Total Liabilities & Equity $1,300 $900

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Introduction to Financial Management 3

Income Statement (in million $) ABC Inc. XYZ Inc.

Sales revenues $150 $100
Cost of Goods Sold $100 $60
Gross Profit $50 $40
Selling, general, and administrative $10 $8
expenses
Depreciation expense $20 $15
Operating income (EBIT) $20 $17
Interest expense $5 $2
Profit before taxes (PBT) $15 $15
Income tax expense $3 $3
Net Income $12 $12

From the above financial statements, it is evident that both the

companies have the same Net Income ($12 million). However, the
following questions arise:

a) As a banker, is this information enough to extend a loan to

both companies?

b) As an investor, is this a good return on investment?

c) As a manager, are these returns the best in the industry?

Just by looking at the individual numbers in the financial

statements, it is not possible to answer the above questions. In
order to answer them one needs to perform a financial statement
analysis that looks at a combination of numbers, which provides
more information. This analysis compares a combination of
financial numbers (ratios) over a period of time for a company and
also compares these with other companies in the same industry.
This analysis is done using two tools given below:

a) Ratio analysis

b) Common-size financial statements

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4 Financial Management Essentials You Always Wanted To Know

Using the data from the financial statement analysis,

companies make appropriate decisions to ensure that they meet
their ultimate business objective – maximization of their stock
price. The decisions are taken in the following areas:

a) Cost of Capital

b) Capital Budgeting

c) Working Capital Management

d) Capital Structure & Leverage

e) Dividend Policy

Finally, companies use pro forma financial statements to carry

out a what-if analysis and estimate their financial statements
for the next period (quarter/year). Companies also use financial
control systems to maintain control over their financial decisions.

The later chapters describe each of the above areas in detail,

starting with the financial statement analysis, followed by
financial decision making, and finally forecasting financial
statements.

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Chapter 2

Financial Statement
Analysis

T his chapter concentrates on the techniques to analyze

financial statements.

The key learning objectives of this chapter include the

reader's understanding of the following:

● Financial ratio analysis

● Preparing common-size financial statements for

analysis

Analysis of Financial Statements is done using financial ratios

and common-size financial statements. In this chapter, we shall
discuss both techniques in detail.
6 Financial Management Essentials You Always Wanted To Know

2.1 Ratio Analysis

The financial statements of a company report the company’s

position at a given point in time (Balance Sheet) and its operations
over a period of time (Income Statement and Statement of Cash
Flows). This data can be used by the company’s management,
bankers, and investors to predict the future and to plan actions
that improve it. But this analysis is more useful when done
using financial ratios instead of individual numbers from the
financial statements. For example, consider a company paying
$100,000 interest on its debt of $1,000,000, and another company
paying $50,000 interest on its debt of $700,000. If one needs to
know which company is financially stronger, it can be done by
comparing the company’s interest expense with respect to its
debt, studying the company’s debt with respect to its total assets,
comparing the interest paid against the income of the company
and comparing its debt structure with that of other firms in the
same industry.

In order to perform the above analysis, ratios have to be

formed using data from the balance sheet, income statement, and
the statement of cash flows of the company. There are several
ratios that exist, and each has a different purpose. Some ratios
involve only balance sheet items, or income statement items,
or items from the statement of cash flows. Others involve a
combination of items from these three statements. In the sections
below, we will see how ratios are computed and used for decision-
making with the help of the financial statements of All Fresh, a
food-producing company.

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Financial Statement Analysis 7

Balance Sheet (in million $) 2020

Assets
Cash $20
Accounts receivable $20
Inventories $60
Total Current Assets $100
Plant & equipment (net) $100
Total assets $200
Liabilities & Equity
Accounts payable $10
Notes payable $20
Total current liabilities $30
Long-term bonds $70
Total liabilities $100
Stockholders’ Equity
Common stock (paid-in capital – 10,000,000 shares) $20
Retained earnings $80
Total liabilities & equity $200

Income Statement (in million $) 2020

Sales revenue $300
Operating costs $272
Earnings before interest, tax, depreciation & $28
amortization (EBITDA)
Depreciation & amortization expense $10
Operating income (EBIT) $18
Interest expense $7
Profit before tax (PBT) $11
Income tax expense $1
Net Income $10
Common Dividends $0
Retained earnings $10

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8 Financial Management Essentials You Always Wanted To Know

Statement of Cash Flows (in million $) 2020

Net Income $10
Add: Depreciation & amortization $10
Subtract: Increase in inventory ($10)
Net cash provided by operating activities $10
Cash used to acquire long-term assets ($20)
Increase in notes payable $10
Increase in long-term bonds $10
Net cash provided by financing activities $20
Net increase in cash $10
Opening cash balance $10
Closing cash balance $20

Liquidity Ratios

These ratios provide an idea of the liquidity position of a

company. They are important to know whether the company
would be able to pay off its debts as they become due – interest,
loan payments, accounts payable, etc. Two commonly-used
liquidity ratios are described below:

Current Ratio

Current ratio = Current Assets/Current Liabilities

For All Fresh, Current ratio = $100 million/$30 million = 3.33

This means that current assets of All Fresh cover over 3 times its
current liability payments.

In order to know whether this value is good or bad, one needs

to obtain the industry average figure. We further find that the
industry average is 5.0. It means that All Fresh has a lower than
average current ratio, which could mean lower than expected

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Financial Statement Analysis 9

liquidity. This ratio is frequently used by lenders, like banks,

before extending a loan.

Quick (Acid Test) Ratio

Quick ratio = (Current Assets – Inventories)/Current Liabilities

For All Fresh, Quick ratio = ($100 million – $60 million)/$30 million
= 1.33

For calculating Quick ratio, we have to subtract inventories

from current assets. This is done as it is difficult to convert
inventories to cash at short notice. Hence, the Quick ratio provides
a better indication of the company’s liquidity position.

Once again, a comparison is needed with the industry average

to compare. If the industry average is 1.0, it means that All Fresh
has a stronger liquidity position when computed using the quick
ratio.

Asset Management Ratios

These ratios show how well the company is managing its

assets. These are also called efficiency ratios. Some commonly-
used ratios are given below:

Inventory Turnover Ratio

Inventory Turnover ratio = Sales/Inventory

For All Fresh, Inventory Turnover ratio = $300 million/$60 million

= 5.0

This ratio tells us how well the company is managing its

inventory against the sales it has. We can take an average of the
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10 Financial Management Essentials You Always Wanted To Know

inventory over the year as inventory mentioned in the balance

sheet is at a particular point of time and that value could give
incorrect results if the inventory has suddenly increased or
decreased. A higher value of this ratio is generally preferable as it
means that the company is holding lower inventory.

If the industry average is 4.0, then All Fresh has a better value
of inventory turnover ratio. It means that it is carrying lower
inventory than its competitors for the same sales volume.

Days Sales Outstanding

Days Sales Outstanding = Accounts receivable/Sales per day

For All Fresh = $20 million/($300 million/365) = 24.33 days

Days Sales Outstanding (DSO) is the average number of days

that a company takes to make the collection of its receivables.
A lower number means it is able to collect the payments more
promptly.

If the industry average is 20 days, then All Fresh takes longer

than other companies and can look at improving the receivables
collection mechanism.

Asset Turnover Ratio

Asset Turnover ratio = Sales/Total Assets

For All Fresh = $300 million/$200 million = 1.5

Every company invests in assets in order to generate sales and

profits. This measure is about how successful the company is in
doing this. A higher asset turnover ratio indicates better asset
utilization.

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Financial Statement Analysis 11

If the industry has 1.25 units as their average asset turnover

ratio, it means that All Fresh is performing better than other
companies in producing sales from its assets.

Leverage (Debt Management) Ratios

Companies have mainly two modes of raising capital – debt

and equity. Both of these modes have their pros and cons which
will be discussed in the later chapters. Lenders and investors use
debt management ratios to see how risky the company’s capital
structure is and how it stands against the industry’s norms.

Below are the most frequently used ratios:

Debt Ratio

Debt ratio = Total Liabilities/Total Assets

For All Fresh, Debt ratio = $100 million/$200 million = 0.5 or

50% This ratio tells the company’s creditors and lenders how
risky it is to lend to the company. They would prefer a lower
debt ratio. If the industry average debt ratio is 0.6, then creditors
would be happy to lend to All Fresh as it has a lower debt ratio
as compared to its competitors. The amount of debt and equity
taken by a company largely depends on the industry it belongs
to. Some industries like power production have several capital
assets that can be used to take cheaper secured loans. Hence, they
are generally high on debt and therefore have a higher debt ratio.
Services industries, on the other hand, have few physical assets
that can be mortgaged. Hence, they generally have a lower debt
ratio.

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12 Financial Management Essentials You Always Wanted To Know

Debt-to-Equity Ratio

Debt-to-equity ratio = Total Liabilities/Stockholders’ Equity

For All Fresh, Debt-to-equity ratio = $100 million/$100 million

= 1.0. A debt-to-equity ratio of 1.0 means the company has equal
amount of liabilities and equity. Creditors and lenders would
prefer this ratio to be lower. Equity investors of the company,
on the other hand, would prefer a higher ratio as the additional
debt (liability) taken by the company can lead to greater profits
and hence, better returns for common stockholders. This is called
leverage.

Times Interest Earned (TIE)

TIE = EBIT/Interest expense

For All Fresh, TIE = $18 million/$7 million = 2.57

This ratio gives a comparison of the company’s earnings

against its interest expense for the debt it has taken. In the above
case, All Fresh has enough earnings to serve its interest expense
2.57 times. Lenders would like this to be high as it means that they
are better covered on the interest payments.

Profitability Ratios

These show how profitable the company is in doing business.

Profitability can be computed using various bases – equity, assets,
and sales. Accordingly, there are several ratios as below:

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Financial Statement Analysis 13

Return on Equity (ROE)

ROE = Net Income/Stockholders’ Equity

For All Fresh, ROE = $10 million/$100 million = 0.1 or 10%

This is the most important and the most frequently looked

at ratio. It gives an idea of the amount a common stockholder
gets when he or she invests in the company. In the above case, a
stockholder received 10% returns on his investment in the year
2020. This measure would have a direct impact on the company’s
stock price.

If the industry average ROE is 9%, then All Fresh is considered

to be giving higher returns and hence, would be preferred by
stockholders over its competitors.

Return on Assets (ROA)

ROA = Net Income/Total Assets

For All Fresh, ROA = $10 million/$200 million = 0.05 or 5%

This ratio determines how much profit the company is making

using the assets it has. It shows the company’s efficiency in using
its assets.

If the industry average happens to be 7% then it means that All

Fresh is not utilizing its assets as well as its competitors.

Return on Sales (ROS)

ROS = Net Income/Sales

For All Fresh, ROS = $10 million/$300 million = 0.0333 or 3.33%

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14 Financial Management Essentials You Always Wanted To Know

This ratio is often referred to as the sales margin or profit

margin. For every dollar of sales, All Fresh is earning about 3
cents. This needs to be seen in light of the industry average. Some
industries have a lower profit margin but a higher sales volume.

If the industry average is 2.5% then it means that All Fresh has
a better return on sales.

Basic Earning Power (BEP)

BEP = EBIT/Total Assets

For All Fresh, BEP = $18 million/$200 million = 0.09 or 9%

This ratio shows the raw earning power of a company without

getting influenced by its taxes and leverage (debt). Different
companies in the same industry may have different tax situations
and debt structures. This ratio is useful when comparing such
companies.

Market Value Ratios

When a company’s stock price is compared to other values,

such ratios are called market value ratios. They give useful insight
into what the investors think about the company.

Price/Earnings Ratio (P/E)

P/E ratio = Market Price per share/Earnings per share

For All Fresh, assume that the current stock price is $20

Earnings per share = Net Income/Number of common shares = $10

million/10 million = $1

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Financial Statement Analysis 15

Hence, P/E ratio = $20/$1 = 20

P/E ratio shows how much the investors are willing to pay
per dollar of company’s profit. A higher P/E ratio means that the
investors see strong growth prospects in the company.

If the industry average P/E ratio is 15 then it means that

investors are looking at All Fresh to provide better growth than its
competitors.

Market/Book Ratio (M/B)

M/B ratio = Market Price per share/Book value per share

For All Fresh, assume current stock price is $20

Book value per share = Total Common Equity/Number of common

shares = $100 million/10 million = $10

Hence, M/B ratio = $20/$10 = 2

This ratio is also a measure of how much the investors expect

the company to grow and are willing to invest. A higher value of
M/B ratio means that the investors are willing to pay more to buy
the company’s stock.

If the industry average is 1.8 then it means that the investors

are willing to pay more for All Fresh than its competitors, as they
expect better returns.

Cash Flow Ratios

Until now all ratios described above have been either on

balance sheets items, income statement items or on the market
price of the stock. There are also some important ratios based on
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16 Financial Management Essentials You Always Wanted To Know

the cash flows of a company. These ratios give vital information

as the statement of cash flows is the only financial statement that
gives “real” values. Both the balance sheet and income statement
have values that are either based on estimates or on historical
costs.

Cash Flow to Net Income Ratio

Cash Flow to Net Income ratio = Cash from Operating Activities/Net

Income

For All Fresh, Cash Flow to Net Income ratio = $10 million/$10
million = 1

This ratio shows the extent to which company has used accrual
accounting assumptions and adjustments in computing its Net
Income. It will generally be equal to or greater than 1, due to non-
cash expenses like depreciation and amortization. A company
should have a stable cash flow to net income ratio over the years
unless there has been a significant change in its accounting
assumptions.

It may be noted that cash flow from operations is used to

compute this ratio. Hence, a lower value of this ratio will also
highlight those companies that are not having adequate cash
inflow from normal business activities which could lead to cash
problems in the future.

Cash Flow Adequacy Ratio

Cash Flow Adequacy ratio = Cash from Operating Activities/Cash used

in Investing Activities

For All Fresh, Cash Flow Adequacy ratio = $10 million/$20 million
= 0.5
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Financial Statement Analysis 17

This ratio tells us whether a company is able to generate

enough cash to pay for all its investing activities. It would be
greater than 1 for a “cash cow” that is able to pay for its capital
expansion using the cash generated from operations alone. It does
not need any further financing in form of debt or equity. All Fresh
is not a cash cow.

Cash Times Interest Earned Ratio

Cash Times Interest Earned ratio = Cash earned before Interest and Tax/
Interest expense

where, Cash earned before Interest and Tax = Cash from

Operating Activities + Interest expense + Income tax expense

For All Fresh, Cash earned before Interest and Tax = $10 million +
$7 million + $1 million = $18 million

Hence, Cash Times Interest Earned ratio = $18 million/$7 million =

2.57

This ratio is similar to TIE described above but it considers cash

instead of net income. Hence, this is a more accurate measure of
how well the company can cover its interest expenses. All Fresh
generates cash that is enough to pay 2.57 times its interest expense
for the year. In this case, it turns out that All Fresh’s TIE ratio and
Cash Times Interest Earned ratio is the same. This is because the
company has paid the same amount of cash in interest expense
and income tax expense as it has accrued in its income statement.
But these two values could differ and, in such cases, Cash
Times Interest Earned ratio would give a better visibility of the
company’s cash strength to pay for interest and income tax.

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18 Financial Management Essentials You Always Wanted To Know

2.2 DuPont Framework

This framework is used to break and analyze a company’s

Return on Equity (ROE), which is the ultimate ratio that investors
look at. Return on Equity is given as:

ROE = Net Income/Stockholders’ Equity

A company borrows money from stockholders and invests

in Assets that help the company generate Sales which finally
generate profit. This gives us the following below three entities:

Borrowing from Stockholders to invest in Assets

Assets-to-Equity ratio = Total Assets/Stockholders’ Equity

Assets help generate Sales

Asset Turnover ratio = Sales/Total Assets

Sales generate Profit

Return on Sales = Net Income/Sales

If we combine all the three entities above, we get ROE as below:

ROE = (Net Income/Sales) x (Sales/Total Assets) x (Total Assets/

Stockholders’ Equity)

The above expanded ROE equation helps us understand

where the company needs to improve if its ROE is low. Does
the company have lower profitability, lower efficiency, or lower
leverage? It can also be a combination of some or all of these. With
this new insight, the company can take steps for improvement.

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Financial Statement Analysis 19

Let’s take an example. Company ABC has a ROE of 12%,

whereas, its competitor, XYZ, has a ROE of 15%. Company ABC
needs to find out how to improve its ROE. Hence, it finds out the
three other ratios – Profitability, Efficiency, and Leverage. Below is
the data available:

Table 2.1

Ratio ABC XYZ

Profitability 5% 5%
Efficiency 0.8 0.6
Leverage 3.0 5.0

ROE of ABC = 5% x 0.8 x 3.0 = 12%

ROE of XYZ = 5% x 0.6 x 5.0 = 15%

From the above data it is clear that ABC is actually more

efficient than XYZ in generating sales for the assets that it holds.
Its profitability is also equal to that of XYZ. However, its leverage
is lower. This means that ABC is unable to generate enough
assets against its equity investment. One way of doing this is by
taking up more debt and converting that money into assets. This
technique is called leveraging.

2.3 Benchmarking

All the ratios in the previous section need to be considered

with similar ratios of other companies in the same industry.
That is when a company can see if it needs to make any changes
in its capital structure, margins, etc. This activity is called

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20 Financial Management Essentials You Always Wanted To Know

benchmarking. It involves comparison against the best in the

industry and trying to match the performance.

Companies also need to continuously benchmark against their

own performance over the years. For example, if a company has
a ROE of 10% in one year and 8% in the next, it needs to find the
reason for this change. Ratios are expected to remain stable across
years unless there has been a significant change in the company’s
business, capital structure, or the market itself.

2.4 Limitation of Financial Ratios

Although financial ratios are a powerful tool to analyze

companies, they come with several limitations as below:

a) Different companies follow different accounting practices.

This makes direct comparison difficult. Sometimes, even
when a company changes its own accounting practices, it
becomes difficult to compare with ratios from the previous
years.

b) It is often difficult to classify values of ratios as being good

or bad. If a company has a lower profit margin (lower ROS)
than its competitors, it may not always be bad if that lower
margin is able to generate higher sales volume.

c) Conglomerates conduct business in diversified industries

and sectors. This makes it difficult to benchmark them
against any single industry. A similar difficulty is faced
by other companies when trying to benchmark against a
conglomerate.

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Financial Statement Analysis 21

d) Values of assets and liabilities in a company’s balance sheet

are carried at historical costs. This can bring in significant
differences between the ratios of old and new companies.

e) If ratios are computed on a quarterly basis, they could be

affected by seasonality or business cycle.

f) Companies often use “window dressing” techniques that

could distort financial ratios. For example, borrowing cash
for the long-term just before the end of the year could
increase the company’s current ratio. Once the financial
statements have been prepared, the company may return
the loan.

2.5 Common-size Financial Statements

Ratio analysis is just one tool for financial statement analysis.

However, it may not be enough to analyze a company’s finances.
Common-size financial statement analysis fills that gap.

This tool helps in comparing a company’s financial statements

over the years and with other companies of different sizes.
Consider the following financial statements of All Fresh seen
earlier. It now has data for the past two years for comparison.

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22 Financial Management Essentials You Always Wanted To Know

Balance Sheet (in million $) 2020 2019

Assets
Cash $20 $10
Accounts receivable $20 $20
Inventories $60 $50
Total Current Assets $100 $80
Plant & equipment (net) $100 $90
Total assets $200 $170
Liabilities & Equity
Accounts payable $10 $10
Notes payable $20 $10
Total current liabilities $30 $20
Long-term bonds $70 $60
Total liabilities $100 $80
Stockholders’ Equity
Common stock (paid-in capital – 10,000,000 $20 $20
shares)
Retained earnings $80 $70
Total liabilities & equity $200 $170

Income Statement (in million $) 2020 2019

Sales revenue $300 $250
Operating costs $272 $227
EBITDA $28 $23
Depreciation & amortization expense $10 $8
Operating income (EBIT) $18 $15
Interest expense $7 $5
Profit before tax (PBT) $11 $10
Income tax expense $1 $1
Net Income $10 $9
Common Dividends $0 $2
Retained earnings $10 $7

The first step in analyzing using common-size financial

statements is to convert the above balance sheet and income
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Financial Statement Analysis 23

statements into common-size formats. In a common-size balance

sheet, all values are represented as a percentage of the Total
Assets. This tells us in what percentage each asset, liability and
equity is divided in the company. In a common-size income
statement, all expenses are represented as a percentage of the total
revenues. This gives us a view of where the company is spending
its money. The balance sheet in common-size format is given
below:

Balance Sheet (in million $) 2020 % 2019 %

Assets
Cash $20 10.00% $10 5.88%
Accounts receivable $20 10.00% $20 11.76%
Inventories $60 30.00% $50 29.41%
Total Current Assets $100 50.00% $80 47.06%
Plant & equipment (net) $100 50.00% $90 52.94%
Total assets $200 100.00% $170 100.00%

Liabilities & Equity

Accounts payable $10 5.00% $10 5.88%
Notes payable $20 10.00% $10 5.88%
Total current liabilities $30 15.00% $20 11.76%
Long-term bonds $70 35.00% $60 35.29%
Total liabilities $100 50.00% $80 47.06%
Stockholders’ Equity
Common stock (paid-in capital $20 10.00% $20 11.76%
– 10,000,000 shares)
Retained earnings $80 40.00% $70 41.18%
Total liabilities & equity $200 100.00% $170 100.00%

It can be seen that the company has increased its current

assets from 47% to 50% from 2019 to 2020. Most of this increase
can be attributed to an increase in cash. In fact, the company has
managed to bring down the percentage of accounts receivable,
probably by following up on pending dues more rigorously. In
the same period, it has increased its current liabilities from 12% to

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24 Financial Management Essentials You Always Wanted To Know

15%. This is mainly due to increased short-term loans in the form

of notes. The company’s financing mix has also changed from
47:53 (Total Liabilities: Total Equity) to 50:50.

Similarly, the company’s income statement in common-size

format is shown below:

Income Statement (in million $) 2020 % 2019 %

Sales revenue $300 100.00% $250 100.00%
Operating costs $272 90.67% $227 90.80%
EBITDA $28 9.33% $23 9.20%
Depreciation & amortization expense $10 3.33% $8 3.20%

Operating income (EBIT) $18 6.00% $15 6.00%

Interest expense $7 2.33% $5 2.00%
Profit before tax (PBT) $11 3.67% $10 4.00%
Income tax expense $1 0.33% $1 0.40%
Net Income $10 3.33% $9 3.60%

Common Dividends $0 0.00% $2 0.80%

Retained earnings $10 3.33% $7 2.80%

Even though the company’s revenues have increased, the

profits have gone down from 3.6% to 3.33% from 2019 to 2020.
This is mainly due to additional interest expense that has gone
up from 2% to 2.33% of revenues. The company can use this
information to decide whether to go for greater debt funding.
If the interest expense rises further in terms of percentage of
revenues, then it may reduce the profits. Another thing to note
is that the company has managed to reduce its operating costs
from 90.8% to 90.67%. The above analysis can also be carried
out between two or more companies to see how their expenses
compare in relation to sales and where there is an opportunity for
improvement.

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Financial Statement Analysis 25

CASE STUDY:
Case on Ratio Analysis – Ping-pong Company

Data given below belongs to the Ping-pong Company. Also

provided are the industry averages.

Balance Sheet
Cash $77,500 Accounts payable $129,000
Receivables $336,000 Notes payable $84,000
Inventory $241,500 Other current liabilities $117,000
Total current assets $655,000 Total current liabilities $330,000
Net fixed assets $292,500 Long-term debt $256,500
Common equity $361,000
Total assets $947,500 Total liabilities $947,500
and equity

Income Statement
Sales $1,607,500
Cost of goods sold
Labor $453,000
Materials $717,000
Utilities $68,000
Others $113,000
Depreciation $41,500
$1,392,500
Gross profit $215,000
SGA $145,000
EBIT $70,000
Interest expense $24,500
PBT $45,500
Income tax expense $18,200
Net income $27,300

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26 Financial Management Essentials You Always Wanted To Know

Ratio Data

Ratio Industry Average

Current ratio 2.0
DSO 35 days
Inventory turnover 6.7
Asset turnover 3.0
ROS 1.2%
ROA 3.6%
ROE 9.0%
Debt ratio 60.0%

Case Assignment
i. Calculate the mentioned ratios for the Ping-pong Company.

ii. Compare Ping-pong Company’s ratios with the industry

average.

iii. Discuss Ping-pong Company’s strengths and weaknesses

based on the ratio analysis.

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Financial Statement Analysis 27

Solved Examples

1. ABC Inc. has the following Balance Sheet at Dec 31, 2020:

Assets
Current assets
Cash $50,000
Accounts receivable (a)
Total Current Assets (b)
Long-term investments $40,000
Property, plant, and equipment $100,000
Total assets (c )
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable (d)
Short-term loans $30,000
Total current liabilities $40,000
Long-term liabilities (e)
Total liabilities (f)
Stockholders’ Equity
Paid-in capital $35,000
Retained earnings (g)
Total stockholders' equity (h)
Total liabilities and stockholders' equity (i)

The following information is also available:

Current ratio = 1.5

Debt ratio = 60%

Compute all the missing values in the Balance Sheet.

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28 Financial Management Essentials You Always Wanted To Know

Solution:

d = $40,000 – $30,000 = $10,000

Current ratio = Current assets/Current liabilities

Therefore, 1.5 = b/$40,000. This gives, b = $60,000.

Further, b = $50,000 + a. This gives, a = $10,000.

Total assets, c = b + $40,000 + $100,000 = $200,000

Total liabilities and equity = i = Total assets = $200,000

Debt ratio = Total liabilities/Total assets

Hence, Debt ratio = Total liabilities/Total assets

0.6 = f/$200,000. This gives, f = $120,000.

Further, e = $40,000 + f = $160,000

Also, h = i – f = $200,000 – $160,000 = $40,000

And g = h – $35,000 = $5,000

2. The following data has been given for XYZ Inc.:

Market value of stocks $500,000

Total liabilities $200,000
Debt ratio 25%
ROS 12%
Asset turnover ratio 3

Find out the Total assets, Sales, Net Income and P/E ratio.

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Financial Statement Analysis 29

Solution:

Debt ratio = Total liabilities/Total assets

Hence, Total assets = $200,000/0.25 = $800,000

Asset turnover ratio = Sales/Total assets

Hence, Sales = 3 x $800,000 = $2,400,000

ROS = Net Income/Sales

Hence, Net Income = 12% x $2,400,000 = $288,000

P/E ratio = Price per share/Earnings per share

We don’t know the number of shares, so it is not possible to

compute values per share. However, we know the total market
value and total earnings.

Hence, P/E ratio = $500,000/$288,000 = 1.74

3. The information of two companies, ABC Inc. and XYZ Inc.,

has been given below:

ABC Inc. XYZ Inc.

Current assets $15,000 $60,000
Long-term assets $20,000 $120,000
Current liabilities $8,000 $50,000
Long-term liabilities $15,000 $100,000
Sales $200,000 $800,000
Net Income $5,000 $10,000
Market price per share $20 $50
Number of shares 5,000 2,000

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30 Financial Management Essentials You Always Wanted To Know

a. Find the following:

Current ratio, Debt ratio, ROS, Asset turnover ratio, ROE,
P/E ratio

b. Comment on the health of the two companies and

compare their profitability.

Solution:

a. Below are the ratio computations:

Ratio ABC XYZ

Inc. Inc.
Current ratio Current assets/Current 1.88 1.20
liabilities
Debt ratio Total liabilities/Total assets 0.66 0.83
ROS Net Income/Sales 2.50% 1.25%
Asset turnover
Sales/Total assets 5.71 4.44
ratio
ROE Net Income/Total equity 8.62% 3.03%
Total equity = Total assets –
Total liabilities
P/E ratio Price per share/Earnings per 20.00 10.00
share

b. XYZ Inc. has greater sales and greater assets. However,

when looking at the ratios, it is clear that ABC Inc., although
a leaner company, is better in almost all respects. It has a
better current ratio (liquidity), lower debt, is more efficient
(higher asset turnover) and greater profitability (higher
ROE). The market also has higher expectations from ABC
Inc., as seen from a higher P/E ratio.

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Financial Statement Analysis 31

4. Below is the Income Statement of ZZZ Inc.:

2020 2019
Sales $275,000
Cost of goods sold $220,000 $150,000
Gross profit $80,000 $125,000
Selling, general, and administrative expense $50,000 $70,000
Operating Income (EBIT) $30,000 $55,000
Interest expense $35,000 $25,000
Profit (loss) before Tax (PBT) ($5,000) $30,000
Income tax expense (refund) ($2,000) $10,000
Net Income ($3,000) $20,000

a. Prepare common-size income statement.

b. Why did ZZZ Inc.’s profitability reduce significantly

during 2020?

c. ZZZ Inc.’s operating income is lower than its interest

expense. Does this mean that the company was unable to
pay interest to its debtors?

Solution:

a. Below is the common-size income statement

2020 % 2019 %
Sales $300,000 100% $275,000 100%
Cost of goods sold $220,000 73% $150,000 55%
Gross profit $80,000 27% $125,000 45%
Selling, general, and
$50,000 17% $70,000 25%
administrative expense
Operating Income (EBIT) $30,000 10% $55,000 20%
Interest expense $35,000 12% $25,000 9%
Profit (loss) before Tax (PBT) ($5,000) -2% $30,000 11%
Income tax expense (refund) ($2,000) -1% $10,000 4%
Net Income ($3,000) -1% $20,000 7%

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