Introduction to Management
Understanding Financial Reports
and Financial Ratios
How to Read A Financial Report
Goal is to understand what data is
included in financial reports.
Use the data to analyze the firms
position relative to competitors, and the
industry as a whole.
Basic Financial Statements
Balance Sheet-shows what the company owns and
what it owes at the time of the report.
Income Statement-a report on how a company
performed during the period(s) presented, and shows
whether the companys operations have resulted in a
profit or loss.
Note terminology differences exist!
Net Revenue=Net Sales
Net Income=Net Profit after Tax
What do these statements tell us ???
Ratio analysis: involves evaluating a set of financial ratios, looking at trends in
those ratios, and comparing them to the average values for other companies in
the industry.
Three categories of ratios are especially important:
Solvency (Liquidity)
Efficiency (Activity)
Provides a Lenders Perspective: Is the company able to meet its financial obligations
on time? How much is on hand that can be converted to cash to pay the bills?
These figures are of prime interest to credit managers of commercial companies and
financial institutions.
Provides Management Perspective: How effective are the operations of the firm?
How effective is the company at using and controlling its assets? How actively are
the firms assets being deployed?
These figures are useful for credit, marketing and investment purposes.
Profitability
Provides The Owners Perspective: Is the firm yielding advantageous returns or
results? How profitable is a company in relation to the assets and the sales that made
its profits possible?
Those interested in mergers and acquisitions consider this key data for selecting
candidates.
Solvency/Liquidity
Current Ratio
Formula: Current assets / Current liabilities.
This ratio measures the degree to which current assets cover current liabilities,
and is a measure of the financial liquidity, or cash generating ability, of a firm.
The higher the ratio, more assurance exists that the retirement of current
liabilities can be made. A low current ratio typically means that a company may
have difficulty meeting its obligations (debts or liabilities) that are payable over
the next year with the assets that it can turn into cash over the next year.
A ratio >1 shows liquidity. It shows that there is leeway in the current
assets available to pay for current liabilities.
A current ratio of 2 or more generally indicates a strong financial condition.
Quick Ratio (Acid test ratio)
Formula: (Current assets-Inventories) / Current liabilities
This ratio answers the question "Can this firm meet its current obligations from its
liquid assets if suddenly all sales stop? More stringent than current ratio, it
excludes inventories (typically the least liquid of current assets) to concentrate on
the more liquid assets of the firm.
Usually an acid test ratio of 1.0 or higher is considered satisfactory by
lenders and investors.
An investor should be wary if the quick ratio is below 0.5, out of line with its
industry, and/or showing a declining trend.
Solvency/Liquidity-contd
Note: Net worth =Total assets - total liabilities.
Current Liabilites to Net Worth
Formula: Current liabilities/Net worth (%)
This ratio indicates the amount due to creditors within a year as a percentage of
owners' (or stockholder's) capital. In other words, it contrasts the funds that
creditors temporarily are risking with the funds permanently invested by the
owners. The smaller the net worth and the larger the liabilities, the less security
for the creditors.
As a rule of thumb, should not exceed 60 percent; higher percentages
mean significant pressure on future cash flows.
Total Liabilites to Net Worth
Formula: Total liabilities/Net worth (%)
This ratio helps to clarify the impact of long-term debt, which can be seen by
comparing this ratio with Current Liabilities: Net Worth. The difference will
pinpoint the relative size of long-term debt, which, if sizable, can burden a firm
with substantial interest charges.
In general, total liabilities shouldnt exceed net worth (100%) since in such
cases creditors have more at stake than owners.
Solvency/Liquidity-contd
Current Liabilities to Inventories
Formula: Current Liabilities/Inventories (%)
Indicates reliance on the available inventory for payment of debt.
Note: Fixed Assets=(Total Property, plant, Equipment)Accumulated Depreciation
Fixed Assets to Net Worth
Formula: Fixed Assets/ Net Worth (%)
Indicates the extent to which the owners' cash is frozen in the form of
brick and mortar and machinery, and the extent to which funds are
available for the firm's operations.
A ratio higher than 0.75 indicates possible over-investment and that the
firm is vulnerable to unexpected events and changes in the business
climate.
Efficiency
Collection Period (days)
Formula: Accounts Receivable/Sales x 365
Indicates the average time period for which receivables are outstanding. The
quality of the receivables of a company can be determined by this relationship
when compared with selling terms and industry norms.
Generally, where most sales are for credit, any collection period more than onethird over normal selling terms (ie, 40.0 for 30-day terms) is indicative of some
slow-turning receivables.
Sales to Inventory (Inventory Turnover)
Formula: Annual Net Sales/Inventory (times)
Indicates the rapidity at which merchandise is being moved and the effect on the
flow of funds into the business.
This figure varies widely from industry to industry, and is only meaningful when
compared with industry norms. Low figures are usually the biggest problem, as
they indicate excessively high inventories (and inventory usually has a rate of
return of zero). However, extremely high turnover compared to industry norms
might reflect insufficient merchandise to meet customer demand and result in lost
sales.
NOTE: often times, service industries (software, hotels, consulting, etc) report $0
inventory, so this is meaningless for these industries.
Efficiency
Asset to Sales (%)
Formula = (Total Assets/Net Sales)*100
This ratio indicates whether a company is handling too high a volume of
sales in relation to investment. This figure varies widely from industry to
industry, and is only meaningful when compared with industry norms.
Abnormally low percentages (above the upper quartile) can indicate
overtrading which may lead to financial difficulty if not corrected.
Extremely high percentages (below the lower quartile) can be the result
of overly conservative sales efforts or poor sales management.
Accounts Payable to Sales (%)
Formula = Accounts Payable/Annual Net Sales*100
This ratio measures the speed with which a company pays vendors
relative to sales. Numbers higher than typical industry ratios suggest
that the company is using suppliers to float operations.
This ratio is especially important to short-term creditors since a high
percentage could indicate potential problems in paying vendors.
Profitability
Return on Sales (Profit Margin)
Formula: Net After Tax Profit (or Net Income) / Annual Net Sales
This ratio indicates the level of profit from each dollar of sales, and therefore
measures the efficiency of the operation. This ratio can be used as a predictor of
the company's ability to withstand changes in prices or market conditions.
Return on Assets
Formula: Net After Tax Profit (or Net Income) / Total Assets
A critical indicator of profitability. Companies which use their assets efficiently will
tend to show a ratio higher than the industry norm.
Return on Net Worth (Return on Equity)
Formula: Net After Tax Profit (or Net Income) / Net Worth
This is the 'final measure' of profitability to evaluate overall return. This ratio
measures return relative to investment in the company. Put another way, Return
on Net Worth indicates how well a company leverages the investment in it.
Generally, a relationship of at least 10 percent is regarded as a desirable
objective for providing dividends plus funds for future growth.
Financial Ratios
In isolation, a financial ratio is a useless
piece of information. In context, however, a
financial ratio can give a financial analyst an
excellent picture of a company's situation
and the trends that are developing.
A ratio gains utility by comparison to other
data and standards.
Two Useful Comparisons:
Historical data
Benchmarking
Benchmarking & Industry Norms
Quartiles: each ratio has three points, or
cut-off values that divide an array of values
into four equal sized groups, called quartiles.
Upper Median: mid-point of the upper half of all
companies sampled
Median: the midpoint of all companies samples
Lower Median: mid-point of the lower half of all
companies sampled
Strong Ratios
25% of
ratios
Upper Quartile
- Upper Median (UQ)
25% of
ratios
Upper Middle Quartile
- Median
25% of
ratios
Lower Middle Quartile
- Lower Median (LQ)
25% of
ratios
Lower Quartile
Weak Ratios
Financial Ratios
2005
Indus
try
norm
Data
Exxon
Mobile
Corp.
Chevron
UQ
Media
n
LQ
Solvency
Quick Ration (times)
1.58
1.37
2.30
1.30
0.90
Current Ratio (times)
1.38
1.20
3.60
2.00
1.40
Current Liabilities to Net
Worth (%)
41.64
39.90
22.20
49.60
103.6
0
237.70
571.6
0
Current Liabilities to
Inventories (%)
496.80
606.91
121.7
0
Total Liabilities to Net Worth
(%)
87.37
100.76
29.30
100.80
181.5
0
Fixed Assets to Net Worth (%)
96.20
101.61
22.70
53.70
96.20
Efficiency
Collection Period (days)
27.00
32.39
18.30
38.90
55.30
Sales to Inventory (times)
39.76
46.98
33.80
22.60
9.00
Assets to Sales (%)
56.20
64.98
28.80
39.40
65.70
Accounts Payable to Sales
(%)
9.74
8.30
3.20
6.10
9.80
Profitability
Return on Sales (%)
10.06
7.28
7.00
3.80
0.30
Return on Assets (%)
17.34
11.20
16.70
6.80
0.50
