+Chapter ThreeFINANCIAL STATEMENT ANALYSIS

TYPES OF RATIO COMPARISONS

Ratio analysis is not merely the calculation of a given ratio. More important is
the interpretation of the ratio value. A meaningful basis for comparison is
needed to answer such questions as “Is it too high or too low?” and “Is it
good or bad?”

Two types of ratio comparisons can be made, cross-sectional and time-

series.

Cross-Sectional Analysis

Cross-sectional analysis involves the comparison of different firms’

financial ratios at the same point in time. Analysts are often interested in
how well a firm has performed in relation to other firms in its industry.
Frequently, a firm will compare its ratio values to those of a key competitor
or group of competitors that it wishes to emulate. This type of cross-sectional
analysis, called benchmarking,
has become very popular. Comparison to industry averages is also popular.

For example we are interested to analyze Fauji Cement as well as Maple Leaf
Cement and for this purpose we decided to take Lucky Cement as
benchmark and also obtained information about overall cement industry
ratios to compare both companies performance.

Analysts have to be very careful when drawing conclusions from ratio

comparisons. It’s tempting to assume that if one ratio for a particular firm is
above the industry norm, this is a sign that the firm is performing well, at
least along the dimension measured by that ratio. However, ratios may be
above or below the industry norm for both positive and negative reasons,
and it is necessary to determine why
a firm’s performance differs from its industry peers. Thus, ratio analysis on
its own is probably most useful in highlighting areas for further investigation.

Time-Series Analysis

Time-series analysis evaluates performance over time. Comparison of

current to past performance, using ratios, enables analysts to assess the
firm’s progress. Developing trends can be seen by using multiyear
comparisons. Any significant year-to-year changes may be symptomatic of a
problem, especially if the same trend is not an industry-wide phenomenon.
CATEGORIES OF FINANCIAL RATIOS

Financial ratios can be divided for convenience into five basic categories:

a) liquidity
b) activity
c) debt
d) profitability
e) market ratios

1. Liquidity ratios, which give us an idea of the firm’s ability to pay off debts
that are maturing within a year.

2. Asset management ratios, which give us an idea of how efficiently the firm
is using its assets.

3. Debt management ratios, which give us an idea of how the firm has
financed its assets as well as the firm’s ability to repay its long-term debt.

4. Profitability ratios, which give us an idea of how profitably the firm is

operating and utilizing its assets.

5. Market value ratios, which bring in the stock price and give us an idea of
what investors think about the firm and its future prospects.

Liquidity, activity, and debt ratios primarily measure risk. Profitability ratios
measure return. Market ratios
capture both risk and return.

As a rule, the inputs necessary for an effective financial analysis include, the
income statement and the balance sheet.

We will use the 2014 income statements and balance sheets for Hudson
Company, to demonstrate ratio calculations. Note, however, that the ratios
presented in the remainder of this chapter can be applied to almost any
company other than financial sector. Of course, many companies in different
industries use ratios that focus on aspects peculiar to their industry.
 Hudson Co.
Balance Sheet
As at December 31, 2014

Assets Rs. Equities Rs.

Cash 710 Current

Liabilities
A/c Receivable 2106 1215
A/c Payable
Inventory 4982 948
Accrued
7798 expenses

4190

Long Term Debt

Owner’s Equities

Common 10,000
Stock(Rs.10)
Plant 18,584 10,029
Retained
26,382 26,382
Earnings

Income Statement
For The Year Ended December 31, 2014
Rs.

Sales 28,000

Less: Cost of Goods Sold 13,740

Gross Profit 14,260

Less: Operating Expenses 6,000

Operating 8,260
Profit(EBIT)
419
 Interest expenses 7,841

EBT 3,136

Less: Tax (40%) 4,705

Net Income

Sales $28,000
Less: Cost of goods sold 11,600
Depreciation 2,140

Earnings before interest and

taxes $14,260
Less: Interest paid 980

Taxable Income $13,280

Taxes (35%) 4,648
Net Income $8,632

LIQUIDITY RATIO

The liquidity of a firm is measured by its ability to satisfy its short-term

obligations as they come due. Liquidity refers to the solvency of the firm’s
overall financial position—the ease with which it can pay its liabilities. These
ratios can provide early signs of cash flow problems and impending business
failure. Clearly it is desirable that a firm is able to pay its liabilities, so having
enough liquidity for day-to-day operations is important. However, liquid
assets, like cash held at banks and marketable securities, do not earn a
particularly high rate of return, so shareholders will not want a firm to
overinvest in liquidity. Firms have to balance the need for safety that
liquidity provides against the low returns that liquid assets generate for
investors. The two basic measures of liquidity are the current ratio and the
quick (acid-test) ratio.

CURRENT RATIO
The current ratio, one of the most commonly cited financial ratios,
measures the firm’s ability to meet its short-term obligations. It is expressed
as follows:

Current Ratio = Current assets/current liabilities

A higher current ratio indicates a greater degree of liquidity. How much

liquidity a firm needs depends on a variety of factors, including the firm’s
size, its access to short-term financing sources like bank credit lines, and the
volatility of its business. For example, a grocery store whose revenues are
relatively predictable may not need as much liquidity as a manufacturing
firm who faces sudden and unexpected shifts in demand for its products. The
more predictable a firm’s cash flows, the lower the acceptable current ratio.
Generally 2:1 shows quite satisfactory and stable liquidity position.

QUICK RATIO

The quick (acid-test) ratio is similar to the current ratio except that it
excludes inventory, which is generally the least liquid current asset. The
generally low liquidity of inventory results from two primary factors:

(1) Many types of inventory cannot be easily sold because they are partially
completed items, special-purpose items, and the like; and (2) inventory is
typically sold on credit, which means that it becomes an account receivable
before being converted into cash. An additional problem with inventory as a
liquid asset is that the times when companies face the most urgent need for
liquidity, when business is bad, are precisely the times
when it is most difficult to convert inventory into cash by selling it. The quick
ratio is calculated as follows:

Quick Ratio = Current Assets-Inventory/Current Liability

As with the current ratio, the quick ratio level that a firm should strive to
achieve depends largely on the nature of the business in which it operates.
The quick ratio provides a better measure of overall liquidity only when a
firm’s inventory cannot be easily converted into cash. If inventory is liquid,
the current ratio is a preferred measure of overall liquidity.

ACTIVITY RATIOS

Activity ratios measure the speed with which various accounts are
converted into sales or cash—inflows or outflows. In a sense, activity ratios
measure how efficiently a firm operates along a variety of dimensions such
as inventory management, disbursements, and collections. A number of
ratios are available for measuring the activity of the most important current
accounts, which include inventory, accounts receivable, and accounts
payable. The efficiency with which total assets are used can also be
assessed.

INVENTORY TURNOVER

Inventory turnover commonly measures the activity, or liquidity, of a

firm’s inventory. It is calculated as follows:

(a) Cost of Goods Sold/Average Inventory = Times

(b) Inventory in days = 365 days/……Times = days

If you are interested to find days, u can use alternative formulae for this
purpose as given below:

Inventory in days = Average inventory *365/ Cost of goods sold

Average inventory is computed with the support of beginning inventory and

ending inventory provided both information is given. If information is not
given then use ending inventory as average inventory.

In case question does not provide information about ‘cost of goods sold’,
then we can use ‘sales’ information as an alternative.

This ratio indicates, on average, in how many days firm is able to sell its
inventory which varies from industry to industry. The resulting turnover is
meaningful only when it is compared with that of other firms in the same
industry or to the firm’s past inventory turnover. An inventory turnover of 20
would not be unusual for a grocery store, whose goods are highly perishable
and must be sold quickly, whereas an aircraft manufacturer might turn its
inventory just four times per year.

.
AVERAGE COLLECTION PERIOD

The average collection period, or average age of accounts receivable, is

useful in evaluating credit and collection policies. It is arrived at by dividing
the average daily sales into the accounts receivable balance:

The average collection period is meaningful only in relation to the firm’s

credit terms. If Company has given 30-day credit terms to customers, an
average collection period of 55 days may indicate a poorly managed credit
or collection department, or both. It is also possible that the lengthened
collection period resulted from an intentional relaxation of credit-term
enforcement in response to competitive pressures. If the firm had extended
60-day credit terms, the 55-day average collection period would be quite
acceptable. Clearly, additional information is needed to evaluate the
effectiveness of the firm’s credit and collection policies. It can be calculated
as follows;

(a) Sales/Average A/c Receivable = Times

(b)365 days/ Times = days

You can also use straight formulae to calculate Average A/c Receivable
days:

Average A/c Receivable *365/Sales

AVERAGE PAYMENT PERIOD

The average payment period, or average age of accounts payable, is

calculated in the same manner as the average collection period:

(a) Purchases /Average A/c Payable = Times

(b)365 days / Times = days

You can use alternative formulae to calculate days:

Average A/c Payable *365/ Purchases

This days is meaningful only in relation to the average credit terms extended
to the firm. If Company’s suppliers have extended, on average, 30-daycredit
terms, an analyst would give company a low credit rating because it was
taking too long to pay its liabilities. Prospective lenders and suppliers of
trade credit are interested in the average payment period because it
provides insight into the firm’s liabilities paying patterns.

TOTAL ASSET TURNOVER

The total asset turnover indicates the efficiency with which the firm uses
its assets to generate sales. Total asset turnover is calculated as follows:

Assets Turnover = Sales /Total Assets

Generally, the higher a firm’s total asset turnover, the more efficiently its
assets have been used. This measure is probably of greatest interest to
management because it indicates whether the firm’s operations have been
financially efficient.

Fixed Assets Turnover Ratio

The fixed assets turnover ratio, which is the ratio of sales to net fixed assets,
measures how effectively the firm uses its plant and equipment:

Fixed Assets Turnover = Sales / Fixed Assets

DEBT RATIO

Debt, the amount borrowed by firm for short term or long term is always
attached with cost. Firm obtains loan to get more benefits than its cost. The
debt position of a firm indicates the amount of other people’s money being
used to generate profits. In general, the financial analyst is most concerned
with long-term debts because these commit the firm to a stream of
contractual payments over the long run. The more debt a firm has, the
greater its risk of being unable to meet its contractual debt payments.
Because creditors’ claims must be satisfied before the earnings can be
distributed to shareholders, current and
prospective shareholders pay close attention to the firm’s ability to repay
debts.

Lenders (who given funds) are also concerned about the firm’s
indebtedness. In general, the more debt a firm uses in relation to its total
assets, the greater its financial leverage.

Financial leverage is the magnification of risk and return through the use
of fixed-cost financing, such as debt and preferred stock. The more fixed-cost
debt a firm uses, the greater will be its expected risk and return.

TIMES INTEREST EARNED RATIO

The times interest earned ratio, sometimes called the interest coverage ratio, measures the
firm’s ability to make contractual interest payments. The higher its value, the better able the firm
is to fulfill its interest obligations. The times interest earned ratio is calculated as follows:

EBIT/Interest expense = time interest earned

The figure for earnings before interest and taxes (EBIT) is the same as that for operating profits
shown in the income statement. Higher the time interest earned, better for firm.

Debt-to-Equity Ratio.

To assess the extent to which the firm is using borrowed money, we may use
several different debt ratios.

debt-to-equity ratio = total debt of the firm/ shareholders’ equity

For example if debt to equity ratio is 0.81, it means that creditors are
providing 0.81 rupee of financing for each Rs.1 being provided by
shareholders.
Creditors would generally like this ratio to be low. The lower the ratio, the
higher the level of the firm’s financing that is being provided by
shareholders, and the larger the creditor cushion (margin of protection) in
the event of shrinking asset values or outright losses.

Debt-to-Total-Assets Ratio.

The debt-to-total-assets ratio = total debt/ total assets:

This ratio serves a similar purpose to the debt-to-equity ratio. It highlights

the relative importance of debt financing to the firm by showing the
percentage of the firm’s assets that is supported by debt financing. If this
ratio is 40%, means that 40 percent of the firm’s assets are financed with
debt, and the remaining 60 percent of the financing comes from
shareholders’ equity. Theoretically, if the firm were liquidated right now,
assets could be sold to net as little as 40percent on the rupee before
creditors would face a loss. Once again, this points out that the greater the
percentage of financing provided by shareholders’ equity, the larger the
cushion of protection afforded the firm’s creditors. In short, the higher the
debt-to-total-assets ratio, the greater the financial risk; the lower this ratio,
the lower the financial risk.
Profitability Ratios

Profitability ratios are of two types – those showing profitability in relation

to sales and those showing profitability in relation to investment. Together,
these ratios indicate the firm’s overall effectiveness of operation.

Profitability in Relation to Sales.

gross profit margin:

Gross Profit margin = Gross Profit/Sales

This ratio tells us the profit of the firm relative to sales, after we deduct the
cost of producing the goods. It is a measure of the efficiency of the firm’s
operations, as well as an indication of how products are priced. If gross
profit margin is significantly above the industry, indicating that it is relatively
more effective at producing and selling products above cost.

net profit margin:

Net Profit margin = Net Profit / Sales

The net profit margin is a measure of the firm’s profitability of sales after
taking account of all expenses and income taxes. It tells us a firm’s net
income per rupee of sales.

By considering both ratios jointly, we are able to gain considerable insight

into the operations of the firm. If the gross profit margin is essentially
unchanged over a period of several years but the net profit margin has
declined over the same period, we know that the cause is either higher
selling, general, and administrative expenses relative to sales, or a higher
tax rate. On the other hand, if the gross profit margin falls, we know that the
cost
of producing goods relative to sales has increased. This occurrence, in turn,
may be due to lower prices or to lower operating efficiency in relation to
volume.

Return on Total Assets

Net income divided by total assets gives us the return on total assets (ROA):

ROA = Net Profit / Total Assets

You must look at a number of ratios, see what each suggests, and then look
at the overall situation
when you judge the performance of a company and consider what actions it
should undertake to improve.

Return on Equity (ROE).

Another summary measure of overall firm performance is return on equity.

Return on equity (ROE) compares net profit after taxes (minus preferred
stock dividends, if any) with the equity that shareholders have invested in
the firm. Analysts and financial managers often evaluate the firm’s return on investment by
comparing its income to its investment using ratios such as the firm’s return on equity

ROE = Net Profit / Stock holder’s equity

A high ROE may indicate the firm is able to find investment opportunities that are very
profitable. Of course, one weakness of this measure is the difficulty in interpreting the book
value of equity. ROE reflects the effects of all of the other ratios, and it is the single best
accounting
measure of performance. Investors like a high ROE, and high ROEs are correlated with high
stock prices. However, other things come into play. For example, financial leverage generally
increases the ROE but also increases the firm’s risk; so if a high ROE is achieved by using a
great deal of debt, the stock price might end up lower than if the firm had been using less debt
and had a lower ROE.

Valuation Ratios/Market value ratios

We use market value ratios, which relate the stock price to earnings and book value price. If the
liquidity,
asset management, debt management, and profitability ratios all look good and if investors think
these ratios will continue to look good in the future, the market value ratios will be high, the
stock price will be as high as can be expected, and management will be judged to have been
doing a good job.

The market value ratios are used in three primary ways: (1) by investors when they are deciding
to buy or sell a stock, (2) by investment bankers when they are setting the share price for a new
stock issue (an IPO), and (3) by firms when they are deciding how much to offer for another firm
in a potential merger.

Analysts and investors use a number of ratios to gauge the market value of the firm. The
most important is the firm’s price-earnings ratio (P/E):
P/E Ratio = Share Price/Earnings per Share

That is, the P/E ratio is the ratio of the value of equity to the firm’s earnings, either on a
total basis or on a per-share basis. The P/E ratio is a simple measure that is used to assess
whether a stock is over- or under-valued, based on the idea that the value of a stock should be
proportional to the level of earnings it can generate for its shareholders.

P/E ratios can vary widely across industries and tend to be higher for industries with high growth
rates.

Market/Book Ratio

The ratio of a stock’s market price to its book value gives another indication of how investors
regard the company. Companies that are well regarded investors, which mean low risk and high
growth—have high M/B ratios.

Book value per share= Common equity/Shares outstanding

We then divide the market price per share by the book value per share to get the market/book
(M/B) ratio:

Market to Book Value = Market price per share/Book value per share

Exercise:
Q No. 1 Prepare a multiple-step income statement for ABC Company from the
following data:

Cost of goods sold $450

Interest expense 30
Depreciation expense 120
Net sales 990
Interest income 80
Income tax expense 70
Advertising expense 100
General and administrative expenses 150

Q No.2 Using the following information to prepare a common size income

statement:
 Net sales $1,000
Cost of goods sold 600
Gross profit $ 400
General and administrative expenses 250
Selling expenses 120
Operating profit $ 30
Income tax expense 10
Net profit $ 20

Q No.3 Use the following information to analyze the BJ Company. Calculate any profit
measures deemed necessary in order to discuss the profitability of the company .
 BJ Company
Income Statements
For the Years Ended Dec. 31, 2014 and 2015

2014 2015
Net sales Rs.174,000 Rs.167,000
COGS 114,000 115,000
Gross profit 60,000 52,000
General and administrative expenses 54,000 46,000
Operating profit 6,000 6,000
Interest expense (1,000) (1,000)
Earnings before taxes 5,000 5,000
Income taxes 2,000 2,000
Net income 3,000 3,000

Q No.4 Use the following selected financial data for Happy Valley Co. to answer questions.

Net sales Rs.200,000

Cost of goods sold 90,000
Operating expenses 80,000
 Net income 10,000
Total assets 180,000
Total liabilities 120,000

Calculate (1)debt ratio (2) operating profit margin (3) return on equity (4) net profit
margin (5) Gross Profit ratio (6) Operating expense ratio (7) Assets turnover

Q No.5
Use the following selected financial information for Cascabel Corporation to answer
questions
Cascabel Corporation
Balance Sheet
 December 31, 2015

Assets Liabilities and stockholders' equity

Current assets Current liabilities
Cash 2 Accounts payable 36
Short-term investments 10 Accrued liabilities 25
Accounts receivable 52 Total current liabilities 61

Inventory 57
Other current assets 8 Long-term debt 102
Total current assets 129 Total liabilities 163

Long-term assets Stockholders' equity

Net Plant 195 Common stock (10) 110
Retained earnings 51
Total stockholders' equity 161
Total assets 324 Total liabilities and equity 324

Cascabel Corporation
Income Statement
For the Year Ended December 31, 2015

Net sales 345

Cost of goods sold 248
Gross profit 97
Operating expenses 74
Operating profit 23
Interest expense 8
Earnings before taxes 15
Income tax expense 4
Net profit 11

Additional information: Market price of stock is Rs.25. Firm declared and paid
dividend 20% on par value of stock.
Compute following ratios:

Current ratio (2) Quick ratio (3)Debt ratio (4)Equity ratio (5)Inventory turnover in
days(use 360 days) (6) Receivable turnover in days(use 360 days) (7) Earnings per share
(8)Book value per share (9)Interest coverage ratio (10) Gross Profit ratio
Q No.6

Belmont Industries

Balance Sheet

As at 31-Dec-01

Assets Liabilities & Equity

Cash $ 100,000 Current Liabilities

Receivables Long Term Debt

Inventory Total Debt

Plant Common Equity $ 600,000

Total Assets Total Claims

Current Ratio 2.5

Average Collection Period 54 days

Total Debt to Total Assets 40%

Total Asset Turnover 2

Inventory Turnover 5

Q No. 7
 Illinois Paper Products

Balance Sheet

As at 31-Dec-01

Assets Liabilities & Equity

Cash Current Liabilities

Receivables Long Term Debt

Inventory Total Debt $ 700,000

Plant Common Equity

Total Assets Total Claims

Total debt to Net Worth 1.4

Total Asset Turnover 3

Inventory Turnover 9

Average Collection Period 20 days

Current Ratio 3.3

Quick Ratio 1.3

Q No.8 The Shannon Corporation has Sales of $750,000. Given the following ratios, fill in the balance
sheet below:

Total asset turnover 2.5 times

Cash to total assets 2.0 percent
Accounts Receivable Turnover 10.0 times
Inventory turnover 15.0 times
Current Ratio 2.0 times
Debt to Total assets 45.0 percent
Q No.9 The following data are from the U Guessed it Company’s financial statements. This company
is a manufacturer of board games for young adults. The market is fiercely competitive, therefore all
sales ($20 million) for the year 1983 were on credit. Given the following ratios, fill in the balance
sheet below:

Sales to total assets 2 times

Total debt to assets 40%
Current Ratio 3.0 times
Inventory turnover 5.0 times
Average collection period 18 days
Fixed asset turnover 5.0 times
 Q No.10

Smolira Golf Corp.

Balance Sheet
As at 31-Dec-15
Assets Liabilities & Equity
Cash 100000 Current Liabilities
Receivables Long Term Debt
Inventory Total Debt 200000
Plant Common Equity
Total Assets Total Claims

Total Debt to Total Assets 0.25

Total Asset Turnover 1.5

Inventory Turnover 7

Average Collection Period 29 days

Current Ratio 2.25

Required: Complete balance sheet

Assignment

Q No.11

SMOLIRA GOLF CORP.

Balance Sheet as of
December 31, 2015

LIABILITIES & OWNER'S

ASSETS EQUITY

Current Assets: Current Liabilities:

Cash Rs.710 Accounts Payable Rs.1,215
Accounts
Receivable 2106 Notes Payable 718
Inventory 4982 Other 230
Total Rs.7,798 Total C L Rs.2,163

Fixed Assets: Long-term debt Rs.4,190

Net plant and
Equipment Rs.18,584 Owner's Equity:
Common Stock and
paid-in surplus Rs.10,000
Retained Earnings Rs.10,029
Total Rs.20,029

Total Assets Rs.26,382 Total Rs.26,382

SMOLIRA GOLF CORP.
Income Statement as on
December 31, 2011

Sales Rs.28,000
Less: Cost of goods sold 11,600
Depreciation 2,140

Earnings before interest and

taxes Rs.14,260
Less: Interest paid 980

Taxable Income Rs.13,280

Taxes (35%) 4,648
Net Income Rs.8,632

Dividend Rs.4000
 Addition to retained
earnings 4,632

Calculate following ratios:

Short-term solvency ratios

a. Current Ratio
b. Quick Ratio
c. Cash Ratio

Asset utilization ratios

d. Total asset turnover

e. Inventory turnover
f. Receivables turnover

Long-term solvency ratios

g. Total debt ratio

h. Debt-equity ratios
i. Equity multiplier
j. Times interest earned ratio

Profitability Ratios:

k. Profit Margin
l. Return on Assets
m. Return on equity

Q No.12
1. The December 31, 2015, balance sheet and income statement for Mayberry Cafeterias, Inc.
are given
a. Compute the specified ratios, and compare them to the industry average (better or
worse).
b. If you were appointed financial manager of the company, what decisions would you
make based on your findings?

Balance Sheet

Cash $ 17 Accounts Payable $7

Marketable Securities 5 Notes Payable 3

Accounts Receivable 3 Taxes Payable 2

Inventory 16 Other Accruals 3

Prepaid Expenses 6 Current Liabilities $ 15

Current Assets $ 47

Long-term debt $ 35

Gross plant and $ 126 Preferred Stock 10

equipment
(57) Common Stock 20
Less: Accumulated Dep.
69 Capital contributed in excess
Net Plant and Equipment of par
10

Retained Earnings
26

Total Assets $ 116 Total Liabilities and $ 116

Stockholders’ equity

Income Statement

Net Sales $ 1,072

Cost of Goods sold
921
 Gross Profit 152

Selling Expense 86

General and Administrative expense 26

Depreciation 6

Net Income $ 33

Interest Expense 4

Profit Before taxes $ 29

Taxes 12

Net Income $ 17

2015 Better 2015 Industry Average (%)

Ratios to Compute or
Mayberry Worse

Current 2.86

Quick 2.31

Debt-Equity 0.51

Times interest period 12.36

Average Collection period 1.06

Inventory Turnover 95.71

Fixed-asset turnover 16.15

Operating profit margin 0.036

Net profit margin 0.019

Book return on assets 0.192

Book return on equity 0.271