Advanced Financial Management

CAPTER TWO

Financial Statement Analysis: Using Ratio

 Introduction
• Ratios are an analyst's microscope; they allow us
get a better view of the firm's financial health
than just looking at the raw financial statements.
• Ratios are useful both to internal and external
analysts of the firm.
 Introduction
• Internal purposes:
• Ratios can be useful in planning for the future, setting
goals, and evaluating the performance of managers.
• External purposes:
• External analysts use ratios to decide whether to grant
credit, to monitor financial performance, to forecast
financial performance, and to decide whether to invest in
the company.
 Categories of Ratios

1.Liquidity ratios: describe the ability of a firm to meets

its current obligations.
2. Efficiency ratios: describe how well the firm is using its
investment in assets to produce sales.
3. Leverage ratios: reveal the degree to which debt has
been used to finance the firm's asset purchases.
4. Coverage ratios: are similar to liquidity ratios in that
they describe the ability of a firm to pay certain
expenses.
5. Profitability ratios: provide indications of how
profitable a firm has been over a period of time.
 Liquidity Ratios
• Activity:
1. What is liquidity in financial management context?
2. How the liquidity of a firm is assessed?
 Liquidity Ratios
• The term liquidity refers to the speed with which an
asset can be converted into cash without large discounts
to its value.
• Some assets, such as accounts receivable, can easily be
converted to cash with only small discounts.
• Other assets, such as buildings, can be converted into
cash very quickly only if large price concessions are given.
• We therefore say that accounts receivable are more
liquid than buildings.
• All other things being equal, a firm with more liquid
assets will be more able to meet its maturing obligations
(i.e., its bills) than a firm with fewer liquid assets.
 Liquidity Ratios
• The Current Ratio
• Generally, a firm's current assets are converted to cash (e.g.,
collecting on accounts receivables or selling its inventories)
and this cash is used to retire its current liabilities.

• The higher the current ratio, the higher the likelihood that a
firm will be able to pay its bills.
 Liquidity Ratios
 The Quick Ratio
• Inventories are often the least liquid of the firm's current
assets. For this reason, many believe that a better
measure of liquidity can be obtained by ignoring
inventories. The result is known as the quick ratio
(sometimes called the acid-test ratio), and is calculated
as:

• Quick ratio will always be less than the current ratio. This
is by design. However, a quick ratio that is too low relative
to the current ratio may indicate that inventories are
 Efficiency Ratios
• Activity 2.2
1. What information of a company is assessed
using efficiency ratios?
2. Could you list important ratios to measure
efficiency of a firm?
 Efficiency Ratios
• Efficiency ratios provide information about
how well the company is using its assets to
generate sales.
 Efficiency Ratios
• Inventory Turnover Ratio
• The inventory turnover ratio measures the number of dollars of
sales that are generated per dollar of inventory. It also tells us the
number of times that a firm replaces its inventories during a year. It
is calculated as:

• Note that it is also common to use sales in the numerator. Since the
only difference between sales and cost of goods sold is a markup,
this causes no problems.
 Efficiency Ratios
• Accounts Receivable Turnover Ratio
• Businesses grant credit for one main reason: to increase sales. It is
important, therefore, to know how well the firm is managing its
accounts receivable. The accounts receivable turnover ratio (and the
average collection period, below)

• We can say that higher is generally better, but too high might indicate
that the firm is denying credit to creditworthy customers (thereby losing
sales).
• If the ratio is too low, it would suggest that the firm is having difficulty
collecting on its sales. This is particularly true if we find that accounts
receivable are increasing faster than sales over a prolonged period.
 Efficiency Ratios
• Average Collection Period
• The average collection period tells us, on average, how
many days it takes to collection a credit sale.

• Note that this ratio actually provides us with the same

information as the accounts receivable turnover ratio.
In fact, it can easily be demonstrated by simple algebraic
manipulation:
•

• Since the average collection period is (in a sense) the

inverse of the accounts receivable turnover ratio, it should
be apparent that the inverse criteria apply to judging this
ratio. In other words, lower is usually better, but too low
may indicate lost sales.
• Fixed Asset Turnover Ratio
• The fixed asset turnover ratio describes the
dollar amount of sales that are generated by
each dollar invested in fixed assets. It is given
by:
• Total Asset Turnover Ratio
• The total asset turnover ratio describes how efficiently the firm is
using its assets to generate sales. In this case, we look at the firm's
total asset investment:

• We can interpret the asset turnover ratios as follows:

• Higher is better. However, We should be aware that some industries
will naturally have lower turnover ratios than others.
 Leverage Ratios
• Leverage refers to a multiplication of changes in
profitability measures. For example, a 10%
increase in sales might lead to a 20% increase in
net income The amount of leverage depends on
the amount of debt that a firm uses to finance its
operations, so a firm which uses a lot of debt is
said to be highly leveraged. Leverage ratios
describe the degree to which the firm uses debt in
its capital structure.
 Leverage Ratios
• Activity 2.3
1. What information do you think the users may assess
using leverage ratios?
2. What financial benefit may the company get from
the use of debt?
 Leverage Ratios
• This is important information for creditors and
investors in the firm.
• Creditors might be concerned that a firm has
too much debt and will therefore have of debt
can lead to a large amount of volatility in the
firms earnings.
• However, most firms use some debt. This is
because the tax deductibility of interest can
increase the wealth of the firm's shareholders.
 Leverage Ratios
• The Total Debt Ratio
• The total debt ratio measures the total amount of debt
(long-term and short-term) that the firm uses to finance
its assets:

• Many analysts believe that it is more useful to focus on

just the long-term debt (LTD) instead of total debt. The
long-term debt ratio is the same as the total debt ratio,
except that the numerator includes only long-term debt:
 Leverage Ratios
• The Long-Term Debt to Total Capitalization Ratio
• The long-term debt to total capitalization ratio tells us the
percentage of long-term sources of capital that is provided
by long-term debt (LTD). It is calculated by:

• Note that common equity is the total of common stock and

retained earnings.
 Leverage Ratios
• The Long-Term Debt to Equity Ratio
• Once again, many analysts prefer to focus on the
amount of long-term debt that a firm carries. For
this reason, many analysts like to use the long-term
debt to total equity ratio:
 Coverage Ratios
• The coverage ratios are similar to liquidity ratios in that
they describe the quantity of funds available to cover
certain expenses.
• We will examine two very similar ratios that describe the
firm's ability to meet its interest payment obligations. In
both cases, higher ratios are desirable to a degree.
• However, if they are too high, it may indicate that the firm
is under-utilizing its debt capacity, and therefore not
maximizing shareholder wealth.
 Coverage Ratios
• The Times Interest Earned Ratio
• The times interest earned ratio measures the
ability of the firm to pay its interest obligations by
comparing earnings before interest and taxes
(EBIT) to interest expense
 Coverage Ratios
• The Cash Coverage Ratio
• EBIT does not really reflect the cash that is available to
pay the firm's interest expense.
• That is because a non-cash expense (depreciation) has
been subtracted in the calculation of EBIT.
• To correct for this deficiency, some analysts like to use
the cash coverage ratio instead of times interest earned.
The cash coverage ratio is calculated as:
 Coverage Ratios
• Note that the cash coverage ratio will always be
higher than the times interest earned ratio.
• The difference depends on the amount of
depreciation expense and other non-cash expenses
on the statement.
 Profitability Ratios
• Activity 2.4
• 1. What important information is assessed by
profitability rations?
• 2. who are more concerned to this rations among the
users of financial information? Give justification for
your answer
• Investors, and therefore managers, are particularly
interested in the profitability of the firms that they own.
• There are many ways to measure profits.
• Profitability ratios provide an easy way to compare
profits to earlier periods or to other firms. Furthermore,
by simultaneously examining the first three profitability
ratios, an analyst can discover categories of expenses
that may be out of line.
• Profitability ratios are the easiest of all of the ratios to
analyze.
• Without exception, high ratios are preferred.
• However, the definition of high depends on the industry
in which the firm operates.
• Generally, firms in mature industries with lots of
competition will have lower profitability measures than
firms in younger industries with less
• competition.
• The Gross Profit Margin
• The gross profit margin measures the gross
profit relative to sales.
• It indicates the amount of funds available to
pay the firm’s expenses other than its cost of
sales. The gross profit margin is calculated by:
• The Operating Profit Margin
• We can calculate the profits that remain after
the firm has paid all of its usual (non-financial)
expenses.
• The Net Profit Margin
• The net profit margin relates net income to sales.
Since net income is profit after all expenses, the
net profit margin tells us the percentage of sales
that remains for the shareholders of the firm.
• It is given by
• Taken together, the three profit margin ratios that
we have examined show a company that may be
losing control over its costs.
• Of course, high expenses mean lower returns, and
well see this confirmed by the next three
profitability ratios.
• Return on Total Assets
• The total assets of a firm are the investment that the
shareholders have made.
• Much like you might be interested in the returns
generated by your investments, analysts are often
interested in the return that a firm is able to get from
its investments. The return on total assets is:
• Return on Equity
• While total assets represent the total investment in the
firm, the owners investment (common stock and retained
earnings) usually represent only a portion of this amount
(some is debt). For this reason it is useful to calculate the
rate of return on the shareholder's invested funds. We
can calculate the return on (total) equity as:
• Note that if a firm uses no debt, then its return on
equity will be the same as its return on assets.

• The higher a firm's debt ratio, the higher its return

on equity will be relative to its return on assets.
Why?
• Return on Common Equity
• For firms that have issued preferred stock in addition to
common stock, it is often helpful to determine the rate
of return on just the common stockholders investment:

• Net income available to common equity is net income

less preferred dividends.
 The Du Pont Analysis
• The return on equity (ROE) is important to both managers
and investors.
• The effectiveness of managers is often measured by
changes in ROE over time.
• Therefore, it is important that they understand what they
can do to improve the firm's ROE, and that requires
knowledge of what causes changes in ROE over time.
• The Du Pont system is a way to break down
the ROE into its components.
• The ROA shows the combined effects of profitability (as
measured by the net profit margin) and the efficiency of
asset usage (the total asset turnover).
• Therefore, the ROA could be improved by increasing
profitability through expense reductions, or by increasing
sales relative to total assets.
• As mentioned earlier, the amount of
leverage a firm uses is the linkage between
the ROA and ROE. Specifically
• We can now see that the ROE is a function of the
firm's ROA and the total debt ratio.
• If two firms have the same ROA, the one using
more debt will have a higher ROE.
• We can make one more substitution to
completely break down the ROE into its
components.
 Financial Distress Prediction
• The last thing any investor wants is to invest in a
firm that is nearing a bankruptcy filing or about
to suffer through a period of severe financial
distress.
 The Original Z-Score Model
• The Z-score model was developed using a statistical
technique known as Multiple Discriminant Analysis.
• This technique allows an analyst to place a company into
one of two (or more) groups depending on the score.
• If the score is below the cutoff point, it is placed into
group 1 (soon to be bankrupt), otherwise it is placed into
group 2
• Altman also identified a third group that fell into a so-
called gray zone
• These companies could go either way, but should
definitely be considered greater credit risks than those in
group 2.
• Generally, the lower the Zscore, the higher the risk of
financial distress or bankruptcy.
• Where the variables are the following financial ratios:
• X1 = net working capital/total assets
• X2 = retained earnings/total assets
• X3 = EBIT/total assets
• X4 = market value of all equity/book value of total
liabilities
• X5 = sales/total assets
• Altman reports that this model is between 80.90%
accurate if we use a cutoff point of 2.675.
• That is, a firm with a Z-score below 2.675 can
reasonably be expected to experience severe
financial distress, and possibly bankruptcy, within
the next year.
• The predictive ability of the model is even better if
we use a cutoff point of 1.81. There are, therefore,
three ranges of Z-scores:
• Z < 1.81 Bankruptcy predicted within one year
• 1.81 < Z < 2.675 Financial distress, possible
bankruptcy
• Z > 2.675 No financial distress predicted
 The Z-Score Model for Private Firms
• Because variable X4 in requires knowledge of the firm's
market capitalization (including both common and
preferred equity), we cannot easily use the model for
privately held firms.
• Estimates of the market value of these firms can be
made, but the result is necessarily very uncertain.
Alternatively, we could substitute the book value of
equity for its market value, but that wouldn't be correct
• The new model for privately held firms is:

• Where all of the variables are defined as before, except

that X4 uses the book value of equity. Altman reports
that this model is only slightly less accurate than the
one for publicly traded firms when we use the new
cutoff points shown below.
 Using Financial Ratios
• Calculating financial ratios is a pointless exercise unless
you understand how to use them.

• One overriding rule of ratio analysis is this: A single ratio

provides very little information, and may be misleading.
You should never draw conclusions from a single ratio.
Instead, several ratios should support any conclusions
that you make.
 Trend Analysis
• Trend analysis involves the examination of ratios over
time.
• Trends, or lack of trends, can help managers gauge
their progress towards a goal.
• Furthermore, trends can highlight areas in need of
attention.
• One potential problem area for trend analysis is
seasonality. We must be careful to compare similar
time periods.
 Comparing to Industry Averages
• one of the most beneficial uses of financial ratios is
to compare similar firms within a single industry.
• Most often this is done by comparing to the industry
average ratios.
• These industry averages provide a standard of
comparison so that we can determine how well a
firm is performing relative to its peers
 Automating Ratio Analysis
• We can use Excel's built-in IF statement to
implement our automatic analysis.
• Formula for the current ratio would be:
=IF(C3/D3>=1,"Good","Bad")
• AND(LOGICAL1, LOGICAL2, . . .)
• OR(LOGICAL1, LOGICAL2, . . .)
 Economic Profit Measures of Performance
• profit earned in excess of the firm's costs, including its
implicit opportunity costs (primarily its cost of capital).
Accounting profit (net income).
• The basic idea behind economic profit measures is that
the firm cannot increase shareholder wealth unless it
makes a profit in excess of its cost of capital
 Where NOPAT is net operating profit after taxes. The after-tax cost
of operating capital is the dollar cost of all interest-bearing debt
instruments (i.e., bonds and notes payable) plus the dollar cost of
preferred and common equity.
 Generally, the firm's after-tax cost of capital (a percentage
amount) is calculated and then multiplied by the amount of
operating capital to obtain the dollar cost .
• To calculate the economic profit, we must first
calculate NOPAT, total operating capital and the
firm's cost of capital.
• For our purposes in this chapter, the cost of
capital will be given.8 NOPAT is the after-tax
operating profit of the firm:
• Note that the NOPAT calculation does not include interest expense
because it will be explicitly accounted for when we subtract the
cost of all capital.

• Total operating capital is the sum of non-interest-bearing current

assets and net fixed assets, less non-interest-bearing current
liabilities. We ignore interest-bearing current assets because they
are not operating assets, and we ignore interest-bearing current
liabilities (e.g., notes payable) because the cost of these liabilities
is included in the cost of capital.
• END Of THE PRESENTATIN TWO

• THANK!