Dr.

Ndeye Salimata Fall

GSM
CORPORATE FINANCE BA
Session III: Ratio Analysis

Dr.
Ndeye
Salimata
Fall

ANALYZING STATEMENTS

What is it About?

Help to analyze internal and external information

Review and Examination of financial statements
Make recommendation concerning the activities of the
company
Make projections

Dr. Ndeye Salimata Fall

Actors and Roles

Banker Evaluation of the portfolio of institutional

clients
Investors (investment manager) look for investments
that are profitable and buy shares for clients
CFO financial control (price and cost) and reviews
performance; analyzes the competitiveness of the
company, the process of sales and purchases
Auditor checks financial statements
Dr. Ndeye Salimata Fall

Internal Analysis

Gives an overview of the state of the company

Help management in decision-making
Explains how the company is running and its strengths
and weaknesses
Help answer questions such as:
How to ensure coherence between the activities, results and
investments?
How to finance the activities and improve performance?
How to ensure and finance growth or restructuring?
How to ensure financial equilibrium while respecting the
requirements of bankers, shareholders and the state?

Dr. Ndeye Salimata Fall

External Analysis

Concerns the economic partners (clients, suppliers,

bankers) and the shareholders
The aim is to understand the results, performance and
risks taken by the company
Based on:
-

accounting information:
sectoral and macroeconomic information
National and international trends
Interest rates and exchange rates

Dr. Ndeye Salimata Fall

Specific Objectives of an External Analysis

Study of returns, financial risk and levier effect: informs the

shareholders on the returns of their investments, the expected
gains and compensation for the risks taken
Helps bankers manage reimbursements: they examine the
liquidity of the company, the risk of bankruptcy and cash flows
Informs on the sustainability of the company: going concern
Helps financial managers establish a database concerning the
economic situation of a sector
Is used by other companies and investors so that they could
make a situation analysis of the competition and establish a
growth strategy
Financial journalists and the public at large use financial
statement analysis to evaluate the performance of a company
Dr. Ndeye Salimata Fall

Diagnostic

Identify the company to be evaluated

Know the objectives of the company
Analyze the different activities
Look for dysfunctions
Look at the opportunities, strengths and weaknesses
Make recommendations

Dr. Ndeye Salimata Fall

Tools

Use the information given by the financial statements:

the balance sheet, income statement, cash flow
statement, statement of stockholders equity
-

any formal enterprise has to present its financial

statements at the end of its fiscal year
the information is standardized and homogeneous and,
hence, this facilitates comparison

Use available documents: bills and budget

Use ratios to analyze companies in terms of financial
and economic returns, and to analyze the risks linked
to the activities
Dr. Ndeye Salimata Fall

Synopsis of the Financial Statements

The financial statements help us answer three major
questions:
the status what is the current financial status of the
company? The answer is found in the balance sheet
the performance what was the performance of the
organization during the chosen period, for example, last year?
Look at the income statement
perspectives what are the perspectives of the company? This
is particularly of interest to the investors and bankers who
would like to know the future cash inflows and outflows? Look
at the cash flow statement

Dr. Ndeye Salimata Fall

Financial Statement Analysis And

Comparisons
Financial Statement Analysis takes the form of:
Intra-company Comparisons
Inter-company Comparisons
Management Discussions and Analysis
Component Statements
Common-size Statements
Trend Analysis
Ratio Analysis
Dr. Ndeye Salimata Fall

Objectives of Ratio Analysis

Standardize financial information for

comparisons
Evaluate current operations
Compare performance with past
performance
Compare performance against other firms
or industry standards
Study the efficiency of operations
Study the risk of operations
Dr. Ndeye Salimata Fall

Rationale Behind Ratio Analysis

A firm has resources

It converts resources into profits through
production of goods and services
sales of goods and services

Ratios
Measure relationships between resources and financial flows
Show ways in which firms situation deviates from

Its own past

Other firms
The industry
All firms-

Dr. Ndeye Salimata Fall

Types of Ratios

Financial Ratios:

Liquidity Ratios

Leverage Ratios

Assess ability to cover long term debt obligations

Operational Ratios:

Activity (Turnover) Ratios

Assess amount of activity relative to amount of resources used

Profitability Ratios

Assess ability to cover current obligations

Assess profits relative to amount of resources used

Valuation Ratios:

Assess market price relative to assets or earnings

Dr. Ndeye Salimata Fall

RATIOS BASED ON THE BALANCE

SHEET
FINANCIAL RATIOS

How to calculate it?

What it tells you?

Working Capital Ratio

Current Assets Current

Liabilities

Determines if the company will be able to meet its

current obligations (pay its bills, meet its payroll,
make a loan payment, etc.) If a company has
current assets exactly equal to current liabilities, it
has no working capital. The greater the amount of
working capital the more likely it will be able to
make its payments on time.

Current Ratio

Current Assets/ Current

Liabilities

How many times a company can meet its short

term obligations using its current assets

Quick Ratio (Acid Test

Ratio)

[(Cash+Cash Equivalents +
Temporary Investments +
Accounts Receivable) /
Current Liabilities]/ 1

This indicates the relationship between the amount

of assets that can quickly be turned into cash versus
the amount of current liabilities.

Dr. Ndeye Salimata Fall

RATIOS BASED ON THE BALANCE

SHEET
FINANCIAL RATIOS

How to calculate it?

What it tells you?

Accounts Receivable
Turnover

Net Credit Sales for the

Year/ Average Accounts
Receivable for the Year

The number of times per year that the accounts

receivables turn over.

Days Sales in Accounts

Receivable

365 days in the year/

Accounts Receivable Turnover

The average number of days that it took to collect the

average amount of accounts receivable during the
year. This statistic is only as good as the Accounts
Receivable Turnover figure.

Inventory Turnover

Cost of Goods Sold for the

Year/ Average Inventory for
the Year

The number of times per year that Inventory turns

over. Since inventory is at cost (not sales value), it is
important to use the Cost of Goods Sold. Also be
sure to use the average balance of inventory during
the year.

Days Sales in Inventory

365 Days in the Year/

Inventory Turnover in the Year

The average number of days that it took to sell the

average inventory during the year. This statistic is only
as good as the Inventory Turnover figure.

Debt to Equity

(Total Liabilities/Total
Stockholders Equity)/ 1

The proportion of a company's assets supplied by the

company's creditors versus the amount supplied the
owner or stockholders.
Dr. Ndeye Salimata Fall

RATIOS BASED ON THE INCOME

STATEMENT

FINANCIAL
RATIOS

How to calculate it?

What it tells you?

Gross Margin

Gross Profit/ Net Sales

Indicates the percentage of sales dollars available for expenses and

profit after the cost of merchandise is deducted from sales. The gross
margin varies between industries and often varies between companies
within the same industry.

Profit Margin after

Tax

Net Income after Tax/

Net Sales

Tells you the profit per sales dollar after all expenses are deducted
from sales.

Earnings per Share

(EPS)

Net Income after Tax /

Weighted Average
Number of Common
Shares Outstanding

Expresses the corporation's net income after taxes on a per share of

common stock basis. The computation requires the deduction of
preferred dividends from the net income if a corporation has
preferred stock. Also requires the weighted average number of
shares of common stock during the period of the net income.

Times Interest
Earned

Earnings Before Interests

and Income Tax (EBIT)/
Interest Expenses for the
Year

Indicates a company's ability to meet the interest payments on its debt.

Return on
Stockholders
Equity

Net Income after Tax for

the Year / Average
Stockholders Equity

It is the percentage of profit after income taxes that the corporation

earned on its average common stockholders' balances during the year.
If a corporation has preferred stock, the preferred dividends must be
deducted from the net income.
Dr. Ndeye Salimata Fall

An Example: ABC
Abbreviated Balance Sheet

Assets:
Current

Assets:
Non-Current Assets:
Total Assets:

$7,681.00
$3,790.00
$11,471.00

Liabilities:
Current

Liabilities:
LT Debt & Other LT Liab.:
Equity:
Total Liab. and Equity:
Dr. Ndeye Salimata Fall

$5,192.00
$971.00
$5,308.00
$11,471.00

Review: Major Income Statement Items

Gross Profit = Sales - Costs of Goods Sold

EBITDA
= Gross Profit - Cash Operating Expenses
EBIT = EBDIT - Depreciation - Amortization
EBT = EBIT - Interest
NI or EAT = EBT- Taxes
Net Income is a primary determinant of the firms
cashflows and, thus, the value of the firms shares

Dr. Ndeye Salimata Fall

An Example: ABC
Abbreviated Income Statement
Sales
Costs of Goods Sold
Gross Profit
Cash operating expense
EBITDA
Depreciation & Amortization
Other Income (Net)
EBIT
Interest
EBT
Income Taxes
Special Income/Charges
Net Income (EAT)
Dr. Ndeye Salimata Fall

$25,265.00
-$19,891.00
$5,374.00
-$2,761.00
2,613.00
-$156.00
-$6.00
$2,451.00
-$0.00
$2,451.00
-$785.00
-$194.00
$1,666.00

Liquidity Ratio Examples: ABC

Current Ratio:
Current Ratio :

Current Assets
$7,681.00

1.48
Current Liabilitie s $5,192.00

Quick (AcidCurrent
Test)As
Ratio:
sets - Inventorie s

Acid Test Ratio :

Current Liabilitie s

Dr. Ndeye Salimata Fall

$7,681.00 $391.00
1.40
$1,107,000

Leverage Ratio Examples: ABC

Debt Ratio:
Total Liabilitie s $6,163.00
Debt Ratio :

53.73%
Total Assets
$11,471.00

Dr. Ndeye Salimata Fall

Ratio Comparison: Debt Ratio

Debt Ratio

0,8

0,7
0,6
0,5
0,4
0,3

0,2
0,1
0

janv.-96

janv.-97

janv.-98

janv.-99

janv.-00

Dell

54,70%

73,07%

69,70%

66,25%

53,73%

Industry

62,96%

60,00%

52,38%

62,96%

Dr. Ndeye Salimata Fall

Profitability Ratio Examples: Dell

Return on Assets (ROA):

ROA :

Net Income
$1,666.00

14.52%
Total Assets $11,471.00

Return on Equity (ROE):

ROE :

Net Income
$1,666.00

31.39%
Total Common Equity $5,308.00
Dr. Ndeye Salimata Fall

Profitability Ratio Examples: Dell

Net Profit Margin:

EBIT $2,451.00
Net Profit Margin :

6.59%
Sales $25,265.00

Retention Ratio

EPS - Div $0.66 $0

Retention Ratio ( ) :

100%
EPS
$0.66
Dr. Ndeye Salimata Fall

Ratio Comparison: ROE

80%

70%
ROE

60%
50%
40%
30%

20%
10%
0%

janv.-96

janv.-97

janv.-98

janv.-99

janv.-00

Dell

28,13%

64,27%

73,01%

62,90%

31,39%

Industry

22,30%

30,60%

25,50%

18,00%

Dr. Ndeye Salimata Fall

Ratio Comparison: ROA

25%

ROA

20%

15%
10%
5%
0%

Dell

Industry

janv.-96

janv.-97

janv.-98

janv.-99

janv.-00

12,66%

17,31%

22,12%

21,23%

14,52%

6,80%

10,90%

7,20%

5,70%

Dr. Ndeye Salimata Fall

Activity (Turnover) Ratio Examples:

ABC

Total Asset Turnover Ratio:

Total Asset Turnover :

Sales
$25,265.00

2.20
Total Assets $11,471.00

Inventory Turnover Ratio:

Sales
$25,265.00
Inventory Turnover :

64.62
Inventory
$391.00
Dr. Ndeye Salimata Fall

The DuPont System

Method to breakdown ROE into:

ROA

and Equity Multiplier

ROA is further broken down as:

Profit

Margin and Asset Turnover

Helps to identify sources of strength and weakness

in current performance
Helps to focus attention on value drivers

Dr. Ndeye Salimata Fall

The DuPont System

ROE
ROA
Profit Margin

Equity Multiplier

Total Asset Turnover

Dr. Ndeye Salimata Fall

The DuPont System

ROE

ROA
Profit Margin

Equity Multiplier

Total Asset Turnover

ROA Profit Margin Total Asset Turnover

Net Income
Sales

Sales
Total Assets
Dr. Ndeye Salimata Fall

The DuPont System: ABC

Net Income
Sales
Total Assets

Sales
Total Assets Common Equity
Profit Margin Total Asset Turnover Equity Multiplier
ROA Equity Multiplier

ROE

$1,666.00 $25,265.00 $11,471.00

ROE

$25,265.00 $11,471.00 $5,308.00

0.0659 2.2025 2.1611
0.1452 2.1611
31.39%
Dr. Ndeye Salimata Fall

Dr.
Ndeye
Salimata
Fall

WORKING CAPITAL
MANAGEMENT

INTRODUCTION

Appraising any project requires to look carefully at

three areas:
Working

capital
Seasonal fund needs
Projecting long-term fund requirements

Working Capital Management: is about managing

current assets and finding funds to finance these
current assets

WORKING CAPITAL

It measures a company short term financial health

and its efficiency
It helps determine if the firm is able to continue is
operations, meaning that:
It

can meet its short term maturing debts

It can face its operating expenses

Managing working capital involves managing:

Account

receivable
Inventories
Account payable
Cash

GROSS VS. NET WORKING CAPITAL

Gross Working Capital: the firms investment in

current assets
Net working capital: current assets minus current
liabilities
Managing net working capital requires attention to
day-to-day details

WORKING CAPITAL MANAGEMENT

It includes:
Determining minimum cash requirements, maintaining the
checking account and managing the cash balance
Setting credit policy and managing the collection of account
receivable
Establishing inventory target level and managing inventory
turnover
Establishing and maintaining banking relationships to ensure
access to short term funds due to seasonality and other
needs
Negotiating and monitoring trade credit terms and
managing supplier relationship
Monitoring and evaluating operating expenses, interests
and taxes, and maintaining efficient payment patterns

WORKING CAPITAL MANAGEMENT

For any manager, the most important in working capital

management is to forecast the optimal cash balance
A companys current assets consist of unpaid bills from
other companies
Its current liabilities consist of account payable
To finance its needs in current assets, a company may
rely on a variety of short term loans
Go to commercial banks
Offer its account receivable and inventories as security

OPTIMAL CASH BALANCE

Seasonal sales can create cash flows problems

Most expenses are fixed while sales fluctuate, thus creating
sometimes cash shortages
A monthly cash budget helps firms determine their cash
needs in advance
The twelve month cash budget is redone each month

Long term capital requirements affect working capital

When the long term financing does not cover cumulative
capital requirement, the firm must raise short term capital
When long term financing more than covers the cumulative
capital requirement, the firm has surplus cash available for
short term investment

SHORT TERM FINANCING PLAN

Unsecured bank borrowing

Stretch account payable
Reduce account receivable

DETERMINING OUTSIDE FUNDS

NEEDED (OFN)
Firms usually have recourse to debt instead of
equity because it is cheaper
OFN = Total Assets minus Total Liabilities and Equity
(leaving all financing decisions variables constant)
OFN = Change in Total Assets minus (change in
spontaneous liabilities + change in retained
earnings)
Change in Retained Earnings = [So + (g)(So)](Net
Profit Margin) Div 1

DETERMINING NEW COMMON

STOCK FUNDING NEEDED

Determine the ideal debt ratio

Calculate long term debt needed
New Common Stock = Total Assets minus Total
Liabilities and Equity

EXERCISE 1

Good Chicken Inc, had sales of $150 000 000 last year and its
gross margin was 40% of sales. For the past 5 years, the company
took the discount (credit terms 2/10 net 60) offered by its suppliers
and paid 75% of its merchandises within 10days.
The companys own credit policy of 3/15 net 40 entice 80% of its
customers who pay almost immediately.
Good Chicken Inc purchased this year a new building at a cost of
$20 000 000 and it will be depreciated for 40 years using the
straight line method. The funds were borrowed from Ecobank which
charged interest rates of 10% per year.
Other operating expenses represented 10% of sales. Income tax is
currently at 20%.
Construct a Profit and Loss Statement
Calculate the Cash flows from operations

EXERCISE 2
CASH

400 000

ACCOUNTS RECEIVABLE

900 000

INVENTORY

1 200 000

NET PROPERTY AND PLANT

2 500 000

TOTAL ASSETS

5 000 000

ACCOUNTS PAYABLE

800 000

LONG TERM DEBT

1 500 000

COMMON STOCK

1 800 000

RETAINED EARNINGS

900 000

TOTAL LIABILITIES AND EQUITY

5 000 000

EXERCISE 2

Sales for 2006 = 8 000 000

Projected Sales for 2007 = 10 000 000
Dividend Payout Ratio = 40%
Net Profit Margin = 4%

Calculate the Outside Funds Needed to reach the

projected sales for 2007