Financial Ratio Analysis

1.Profitability Ratios
• Measure of financial performance of a company
2.Liquidity Ratios
• Measure of financial position of a company in the S/T
• Ability to settle S/T obligation when they become due
• Sometimes profitable business face financial crisis
because of overtrading
• Means that a company has invested too much in fixed
assets and inventory but too little liquid assets and thus
short of cash 1
 Financial Ratio Analysis
3.Leverage Ratios
• Measure of financial position of a company in the L/T
• Ability to pay L/T debts when they become due
• A business that is unable to do so is said to be insolvent,
and will usually be forced into compulsory liquidation by its
creditors
4.Efficiency/Activity Ratios
• Measure of how efficient the firm’s asset utilization
5.Market Ratios
• Measure of business performance and use to screen
potential investment. 2
 5 categories of Financial Ratios

• Liquidity, Activity (efficiency) and Leverage ratios

primarily measure risks (both operating and
financing risks)
• Profitability ratios measure return
• Market ratios measure of business performance and
use to screen potential investment (exp:P/E Ratio
compare the share’s price to the earnings, measure
of how expensive a stock is)
3
 CyberDragon’s Balance Sheet
($000)

Assets: Liabilities & Equity:

Cash $2,540 Accounts payable 9,721
Marketable securities 1,800 Notes payable 8,500
Accounts receivable 18,320 Accrued taxes payable 3,200
Inventories 27,530 Other current liabilities 4,102
Total current assets 50,190 Total current liabilities 25,523
Plant and equipment 43,100 Long-term debt (bonds) 22,000
less accum deprec. 11,400 Total liabilities 47,523
Net plant & equip. 31,700 Common stock ($10 par) 13,000
Total assets 81,890 Paid in capital 10,000
Retained earnings 11,367
Total stockholders' equity 34,367
Total liabilities & equity 81,890
4
 CyberDragon’s
Income Statement ($000)
Sales (all credit) $112,760
Cost of Goods Sold (85,300)
Gross Profit 27,460
Operating Expenses:
Selling (6,540)
General & Administrative (9,400)
Total Operating Expenses (15,940)
Earnings before interest and taxes (EBIT) 11,520
Interest charges:
Interest on bank notes: (850)
Interest on bonds: (2,310)
Total Interest charges (3,160)
Earnings before taxes (EBT) 8,360
Taxes (40%) (3,344)
5
Net Income 5,016
 CyberDragon
Other Information ($000)

Dividends paid on common stock $2,800

Earnings retained in the firm $2,216
Number of shares of common stock issued and
outstanding 1,300,000
Market price per share $20
Book value per share *** $26.44
Earnings per share *** $3.86
Dividends per share *** $2.15
6
 CyberDragon
Other Information ($000)
• Book Value per share = Common Stock Equity
Number of Shares
= $34,367,000 / 1,300,000
= $26.44
(Note: Total Stockholders’ Equity may include Preferred Stock Equity.
Thus, Common Stock Equity = Total Stockholders’ Equity minus Preferred
Stock Equity)
(Note: Common Stock Equity = Total Assets minus Total Liabilities minus
Preferred Stock Equity)
To calculate per share value of a company based on its equity available

7
 CyberDragon
Other Information ($000)
• Earnings per share (EPS)
= Earnings attributable to common stockholder
Number of Shares
= $5,016,000 / 1,300,000 = $3.86
**measure of the return on each ordinary share hold

• Dividends per share

= Dividends paid on common stocks
Number of Shares
= $2,800,000 / 1,300,000 = $2.15
**Dividends are a form of profit distribution to the shareholder.
Having a growing dividend per share can be a sign that the
company's management believes that the growth can be 8
sustained.
1. Liquidity Ratios

9
 What is CyberDragon’s Current Ratio?

current assets
current liabilities
50,190
25,523 = 1.97
If the average current ratio for the
industry is 2.4, is this good or not?

Indicate as to whether a company has sufficient current assets to

meet its short term obligation 10
 What is the firm’s Acid Test Ratio?

current assets - inventories

current liabilities
50,190 - 27,530 = 0.89
25,523
Suppose the industry average is .92.
What does this tell us?

Indicate as to whether a company has sufficient current assets to

11
meet its short term obligation
• Consequences of too low liquidity ratios are:
1) late payments to trade creditors, resulting loss of cash
discounts for prompt payment and creditors withhold
further supplies
2) essential maintenance and replacement of fixed assets
are frequently postponed, resulting in rising operating
expenses (exp: selling expenses and depreciation
expenses)
3) new investment projects are delayed, which may reduce
future growth rate of the firm (exp: marketable securities)

12
• If the current ratio and acid test ratio are too high, anxiety
over cash flows are removed, but equally undesirable
consequences are:
1) idle cash are tied up unproductively, without investing
in potential profitable projects, which could affect future
growth of the firm
2) unnecessarily large inventories (but sometimes might
due to expecting price will increase in future), resulting in
high storage and other carrying costs, and potential
loss in market value of inventories that become
obsolete (exp: electrical products, HP)
3) a valuable discipline on credit control will be lost,
resulting in unwise amount and length of credit being
advanced to customers (potential for bad debts increase)
exp: a/c receivable turnover period too long might expose
to the risk of bad debt) 13
2. Operating Efficiency Ratios (Operating
activity Ratios)

• Measure how efficiently the firm’s

assets generate operating profits.

14
What is the firm’s Operating Income Return
on Investment (OIROI)?

operating income (EBIT)

total assets
11,520 = 14.07%
81,890
•Slightly below the industry average of 15%.
•The OIROI reflects rate of return based on net operating
income and total assets invested.
•OIROI also reflect products pricing and the firm’s ability to
keep the costs down 15
 What is Operating Profit margin?

• The operating margin ratio, also known as the operating

profit margin, is a profitability ratio that measures what
percentage of total revenues is made up by operating
income.
• In other words, the operating margin ratio demonstrates
how much revenues are left over after all the variable or
operating costs have been paid.
• this ratio shows what proportion of revenues is available
to cover non-operating costs like interest expense.
16
 What is Operating Profit margin?
• This ratio is important to both creditors and investors because it helps
show how strong and profitable a company's operations are.
• The operating profit margin ratio is a key indicator for investors and
creditors to see how businesses ( company sales) are supporting their
operations.
• If companies can make enough money from their operations to
support the business, the company is usually considered more stable

17
 What is Operating Profit margin?
• if a company requires both operating and non-operating income to
cover the operation expenses, it shows that the business' operating
activities are not sustainable.
• A higher operating margin is more favourable compared with a
lower ratio because this shows that the company is making enough
money from its ongoing operations to pay for its variable costs as
well as its fixed costs.
• Exp:a company with an operating margin ratio of 20 percent means
that for every dollar of income, only 20 cents remains after the
operating expenses have been paid. This also means that only 20
cents is left over to cover the non-operating expenses. 18
 What is their Operating Profit Margin?

operating income
sales
11,520 = 10.22%
112,760
•This is below the industry average of 12%.
•Measure of how much of each dollar sold is available after deducted
the operating expenses. ( how much revenue left over to cover non-
operating expenses)
19
 What is their Total Asset Turnover?

sales
total assets
112,760 = 1.38 times
81,890
• The industry average is 1.82 times.
• Measure of how efficiently and effectively a company’s
management has utilized the assets to generate the sales
• The firm needs to figure out how to squeeze more sales dollars
20
out of its assets.
• Note: OIROI is actually operating profit margin times
total asset turnover
• A reduction in operating profit margin could still lead to
higher OIROI. A firm may want to reduce selling price in
order to achieve higher sales volume, especially if that
business line is in nature very price competitive. When sales
volume increase, given no new investment in fixed assets,
total asset turnover ratio will increase. If the effects of sales
volume increase is larger than selling price decrease (elastic
demand), OIROI could increase.
• If demand is inelastic, the increase in total asset turnover
will be lower than the decrease in operating profit margin,
hence OIROI could decrease.
21
 What is the firm’s Accounts Receivable
Turnover?
credit sales
accounts receivable
112,760 = 6.16 times
18,320
• CyberDragon turns their A/R over 6.16
times per year. The industry average
is 8.2 times. Is this efficient?
• (Note: if not stated, assume credit sales = total sales)
• Measure of how many times a credit sale is made and subsequently collected

22
 What is the firm’s Accounts
Receivable Turnover?
• High  extension of credit low, collection of a/c
receivable is efficient
• Low  company should re-access their company credit
policies in order to ensure the timely collection
 as impacted credit is not earning i/r for the
firm.

23
 What is the firm’s Inventory Turnover?

cost of goods sold

Avg.inventory
85,300
27,530 = 3.10 times
• CyberDragon turns their inventory over 3.1 times per year.
The industry average is 3.9 times. Is this efficient?
• The number of times, on average the inventory is sold and replaced during the
fiscal year (3.87 months or 118 days)
• To measure the liquidity of inventory, also figure as “turnover firm”
24
 Low inventory turnover:

The firm may have too much inventories, which is

expensive because:
1) Inventories take up costly warehouse space.
2) Some inventories may become spoiled or
obsolete.
3) Higher risk of stock pilferage.

25
• Overtrading: a situation where a firm experiences liquidity problem
due to its trading beyond capital resources available to it. Usually has
low liquidity ratios (current ratio and acid test ratio) and abnormally
high turnover ratios (A/R turnover ratio, inventory turnover ratio and
total asset turnover ratio).
• Exp:
Overtrading is a symptom of fast-growing businesses, which chase sales
and profitability at the expense of liquidity.(trading without having
enough capital)
This is common in new businesses, which tend to offer long credit
periods to customers in order to establish themselves in a new market.
At the same time many suppliers offer only short credit periods (or
insist on cash payments) as the new business has no track record.
This gap between paying suppliers and receiving cash from customers is
often financed via overdrafts.
26
• Overcapitalization: a situation where a firm has excess
capital, under-utilized probably due to lack of attractive
investment opportunities. Usually has high liquidity ratios
(current ratio and acid test ratio) and abnormally low
turnover ratios (A/R turnover ratio, inventory turnover
ratio and total asset turnover ratio).

27
What is the firm’s Average Collection
Period?
accounts receivable  365
credit sales
18,320 365
112,760 = 59.3 days
• If the industry average is 47 days, what does this tell
us?
• Measure of the length of time it takes for a company’s
account rec to pay what they owe 28
What is the firm’s Average Inventory
Holding Period?
Avg. inventory  365
COGS
27,530 365
85,300 = 117.80 days
• If the industry average is 93.59 days, what does this tell
us?
• Indicate the average number of days that items of
inventories are held 29

• The lower is better

 Activity Ratios:
Working Capital Management
• Average Collection Period (also known as Receivables
Conversion Period)
= Accounts Receivable  365
Credit Sales
• Average Inventory Holding Period (also known as Inventory
Conversion Period)
= Inventory  365
COGS
• Average Creditors Payment Period (also known as Payables
Conversion Period)
= Accounts Payable  365
Purchases
30
 Activity Ratios:
Working Capital Management
• The cash conversion cycle is also referred to as the cash
cycle, asset conversion cycle or net operating cycle.
• is the length of time between a firm's purchase of inventory
and the receipt of cash from accounts receivable
• It is the time required for a business to turn purchases into cash
receipts from customers.
• It is actually the total time period required to first convert
resources into inventories, then inventories into finished goods,
then goods into sales, and then sales into cash.
31
 Activity Ratios:
Working Capital Management
• A cash flow analysis using CCC also reveals in, an overall
manner, how efficiently the company is managing its
working capital.
• The Cash Conversion Cycle (CCC) is equal to the time is
takes to sell inventory and collect receivables less the time it
takes to pay the company's payables:
• CCC = Average Collection Period
add Average Inventory Holding Period
minus Average Payment Period

32
 Norms and Limits
• A short cycle allows a business to quickly acquire cash that
can be used for additional purchases or debt repayment.
• The lower the cash conversion cycle, the more healthy a
company generally is.
• Businesses attempt to shorten the cash conversion cycle by
speeding up payments from customers and slowing down
payments to suppliers
• CCC can even be negative; for instance, if the company has
a strong market position and can dictate purchasing terms
to suppliers (i.e. can postpone its payments). 33
• Generally, the lower the CCC the better. It indicates that the firm can
convert resources into cash faster and the firm manages its working
capital more efficiently.
• However, one must be careful to investigate the reason behind the
decrease in CCC. If the decrease in CCC is because of increasing
average payment period to creditors (exp:supplier), it is not a good
signal. Trade creditors may not want to supply goods to the company
in the future.
• Research: Relationship between CCC and firm’s profitability or share
price

34
 What is the firm’s Fixed Asset
Turnover?

sales
fixed assets
112,760
31,700 = 3.56 times
If the industry average is 4.6 times, what
does this tell us about CyberDragon?
35
 3. Leverage Ratios
(financing decisions)
• Measure the impact of using debt capital to finance
assets.
• Firms use debt to lever up (increase) returns on common
equity.

36
• Firms with more real assets (land and buildings) are able to
finance more of their assets with debt.
• Amount of debt a firm uses depend on
1) income record
2) amount of assets available as collateral

37
 How does Leverage work?
• Suppose we have an all equity-financed firm worth
$100,000. Its earnings this year total $15,000.

15,000
ROE = 100,000 = 15%

• If use more debts, NI will increase, ROE will increase,

CS will earn more
• Measure of how much return generated relative to the
capital provided by the shareholders
38
 What is CyberDragon’s Debt Ratio?

total debt
total assets
47,523 = 58%
81,890
If the industry average is 47%, what
does this tell us?
Can leverage make the firm more profitable?
Can leverage make the firm riskier? 39
 Gearing Ratio (Debt-to-Equity Ratio)

Long-term liabilities
Common Stock Equity
The higher the gearing level, the higher the financial risk.
High leverage or debt-to-equity ratio is acceptable if the
firm can still cover its interest payments.
**Automobile companies tend to have high DTE ratio

40
 Gearing Ratio (Debt-to-Equity Ratio)
• High DTE indicate a company not be able to generate
enough cash to satisfy its debt obligation
• However low DTE also indicate a company is not taking
advantage of the increased profit that financial leverage may
bring
• Capital intensive industry tend to have high DTE than low
capital industry because they must buy/invest more property,
plants and equipment to expand their business

41
Gearing Ratio (Debt-to-Equity Ratio)

• However, lender and investors are more prefer low DTE

because their interest are better protected in the event of
a business decline
• Firm with high DTE may not be able to attract additional
capital

42
 What is the firm’s Times Interest Earned
Ratio?
operating income
interest expense
11,520
3,160 = 3.65 times
The industry average is 6.7 times.
Shows whether a company is earning enough operating profits before the
payment of interest.
Times interest earned ratio (also known as
interest coverage ratio) reflects the ability of
operating income (EBIT) to cover interest
expenses. 43
• Although generally high leverage (financed by more debt)
will increase financial risk, financing with debt could help
to reduce the firm’s cost of capital because cost of debt
capital are usually lower than cost of raising funds
through new issuance of equity shares. Cost of debt
capital is lower due to tax deductibility of interest
payments and low risk premium.
• Thus, a firm should finance by more debt capital until
the point where it can still comfortably cover its interest
payments. Therefore, usually analyze these two ratios
together.

44
 4. Profitability Ratios

How well are the firm’s managers maximizing

shareholder wealth? Are owners (ordinary
shareholders) and other investors receiving an
adequate return on their investment?
45
 What is CyberDragon’s
Return on Equity (ROE)?

net profit
common equity
5,016
34,367 = 14.6%
The industry average is 17.54%.
Is this what we would expect, given
the firm’s leverage? 46
 Profit Margins and Rates of Return

• Gross Profit Margin

= (Sales – COGS) / Sales  100%
• Operating Profit Margin
= Operating Income / Sales  100%
• Net Profit Margin
= Net Income / Sales  100%
• Return on Asset (ROA)
= Net Income / Total Assets  100%
Note: Net Income also known as Profit attributable to
common or ordinary stockholders
47
• Other things being equal, the higher the gross profit margins
the better. However, it must be noted that a firm, within its
limit, can manipulate its profit margins by setting its pricing
policy.
• A reduction in operating profit margins should be taken
seriously as it could be due to following reasons: (a) rising
COGS which are not passed on to customers; (b) careless
stock control which lead to pilferage or obsolescence; (c)
reduction in selling price due to competition in the product
market; (d) rising marketing or administrative expenses.

48
•Common-Size Income Statements: Calculate
each components of expenses as a percentage of
sales, and compare it to previous years or industry
average. This could help to isolate the type of
costs that the firm need to control.

49
 Table 2.7
Bartlett Company Common-Size Income Statements

50
 5. Market Ratios
• Price/Earnings (P/E) ratio
= Market price per share
Earnings per share
• P/E ratio measures the amount that investors are willing to pay
for each dollar of the firm’s earnings. The higher the P/E ratio,
the higher the degree of confidence that the investors have in the
firm’s future prospects.
• However, P/E ratio that is too high could signal that ordinary
shares of the company are overvalued in the stock market.
• Also compare the share’s price to the earnings, measure how
expensive a stock is

51
 5. Market Ratios
• Market/Book (M/B) ratio
= Market price per share
Book value per share
M/B ratio relates the market value of the firm’s shares
to their strict accounting book value (historical value).
Usually, book value is viewed as the minimum value of
a firm. Therefore, firms that perform well (earn higher
return relative to their risks) tend to have higher M/B
ratio. If M/B is less than one, it is usually a buy signal
for investors (1/4=0.25) 0r sell signal if more than one
(6/4=1.5). 52
 5. Market Ratios

• Dividend yield
= Dividends per share  100%
Market price per share
• Earnings yield
= Earnings per share  100%
Market price per share
Both these ratios measured rate of return to shareholders,
based on current market value of shares they owned.
Easier for shareholders to compare with rate of returns
from other alternative investments.
53
 SUMMARY
Ratios CyberDragon Industry

Liquidity Current Ratio 1.97 2.4

Quick Ratio 0.89 0.92
Ave Colln Pd 59.3 d 47 d

Operating OIROI 14.07% 15%

Efficiency Profit Margin 10.22% 12%
Total Assets T/O 1.38X 1.82X
AC Rec T/O 6.16X 8.2X

Inventory T/O 3.1X 3.9X

Fixed Assets T/O 3.56X 4.6X

54
 SUMMARY
Ratios CyberDragon Industry

Leverage Debt Ratio 58% 47%

Times Interest 3.65X 6.7X

Earned

Profitability ROE 14.6% 17.54%

DuPont Model

55
 Limitations of Financial Ratio
Analysis
Accounting policies/ treatments differ among firms.
• This may distort cross-sectional ratio analysis between two
similar firms. Examples: depreciation method (straight line,
reducing balance, unit of production), stock valuation method
(FIFO, LIFO, AVCO), treatment of purchased goodwill,
treatment of development cost etc.
• Affect all ratios that use ‘profit’ figure in the calculation.
• Furthermore, some firms may have chosen to revalue some of
their fixed assets whereas other firms have not do so. This may
affect ratios that use balance sheet items like ‘reserves’ and
‘total assets’ in the formula.
56
• Many firms experienced seasonality in their operations. Balance
sheet items and their corresponding ratios vary with time of the year
when the statements are prepared.
• Balance Sheet shows the company’s financial position at one point
of time (last day of accounting period), whereas P&L shows the
company’s financial performance throughout the accounting period.
• Using closing figures of balance sheet items in the ratios
computation may not be accurate. For example, toy manufacturer
that has financial year ended 31st December might have much lower
inventory than toy manufacturer that has financial year ended 30th
June.
• Cross-sectional analysis between competitors in the same industry
that have different financial year-ends might not be accurate if the
industry has seasonality in sales.

57
• Difficult to identify the industry category to which a firm
should belongs to, especially if the firm engages in
multiple lines of businesses. For such firm, it is difficult to
find a competitor firm that involves in similar multiple lines
of businesses for cross-sectional analysis. Segmentation
technique is used. Can use segmentation analysis.
• Comparing to industry average means benchmarking to the
‘average’ firm and not the ‘stars’ and leaders of the industry.
• Window dressing and off-balance sheet financing can be
done near the year-end to manipulate the closing balance
sheet figures and hence distort results of corresponding
ratios.
58
• Non-financial information must be considered in order
to have a complete and more accurate picture of the
performance and prospects of a company.
• Examples: (1) general industry and economic data – Is the
country’s economy in recession or booming? Which
stage of life cycle is the product/ industry in?
• (2) Recent developments of the company’s markets at home
and abroad,
• (3) any recent acquisition or disposal of a subsidiary?
• (4) Inherent goodwill of the company due to advancement
in technology, skilful workforce, good atmosphere at the
place of work, highly calibre and experienced management,
good reputations with suppliers and customers and so on.
59