Chapter 2 Part 1 - Ratio Analysis

Chapter 2 – Financial
statements and Ratio

Analysis
DR. DOAA ISMAEL
Learning Goals
LG1 Understand who LG2 Use ratios to analyze

uses financial ratios and a firm’s liquidity and
how. activity.
LG3 Discuss the

relationship between debt LG4 Use ratios to analyze
and financial leverage a firm’s profitability and
and the ratios used to its market value.
analyze a firm’s debt.
What is financial statement?
• It is defined to be a financial report issued by the
firm periodically (normally quarterly or annually)
that present the firm’s past performance as well
as its financial position.
• There are 4 key financial statements:
Income statement Retained earnings
Balance sheet Cash flow
The Four Key Financial Statements:
Income Statement Balance Sheet

• ……presents a summary of a firm’s
•…..provides a financial summary of
a company’s operating results during financial position at a given point in
time.
a specified period.
•The statement balances the firm’s assets
•Although they are prepared quarterly
(what it owns) against its financing,
for reporting purposes, they are
which can be either debt (what it owes)
generally computed monthly by or equity (what was provided by
management. owners).
Income Statement
Sales minus Cost of Goods Sold = Gross Profit [ Earnings before interest, taxes, depreciation,
and amortization (EBITDA)]
Gross profit ( EBITDA) Minus Operating Expenses (selling expenses - General and
Administrative expenses - Depreciation and Amortization Expenses) = Operating income
{Earnings before interest and taxes (EBIT)}
Operating income (EBIT) Minus Interest Expense = Earnings before taxes (EBT)
Earnings before taxes (EBT) Minus Income taxes = Net income (EAT)
 Using the income statement, you can calculate:
1)Earning per share (EPS)=net income (EAT) ÷ number of common
shares outstanding
2)Dividends per share = dividends paid to stockholders ÷ number of share outstanding
Income
Statement
Balance Sheet
 Assets indicate what the firm owns, equity represents the

owners’ investment, and liabilities indicate what the firm has
borrowed (its debt).
 The statement balances the firm’s assets (what it owns)
against its financing, which can be either debt (what it owes)
or equity (what was provided by owners).
Balance
Sheet
The Four Key Financial Statements: Continued
statement of retained earnings statement of cash flows
……reconciles the net income earned • provides a summary of the firm’s
during a given year, and any cash operating, investment, and financing
dividends paid, with the change in retained cash flows and reconciles them with
earnings between the start and the end of changes in its cash and marketable
that year. securities during the period.
• It also ties together the income statement
and previous and current balance sheets.
Retained
earnings
Cash Flow
Using Financial Ratios: Who are the interested
parties
• Ratio analysis involves methods of calculating and interpreting
financial ratios to analyze and monitor the firm’s performance.
• Current and prospective shareholders are interested in the firm’s
current and future level of risk and return, which directly affect share
price.
• Creditors are interested in the short-term liquidity of the company and
its ability to make interest and principal payments.
• Management is concerned with all aspects of the firm’s financial
situation, and it attempts to produce financial ratios that will be
considered favorable by both owners and creditors.
Using Financial Ratios: Types of Ratio Comparisons
• Cross-sectional analysis is the comparison of different firms’ financial ratios

at the same point in time; involves comparing the firm’s ratios to those of
other firms in its industry or to industry averages
• Time-series analysis is the evaluation of the firm’s financial performance
over time using financial ratio analysis. Comparison of current to past
performance, using ratios, enables analysts to assess the firm’s progress.
• The most informative approach to ratio analysis combines cross-sectional and
time-series analyses.
Using Financial Ratios: Cautions about Using Ratio
Analysis
1. Ratios that reveal large deviations from the norm merely indicate the possibility of a
problem.
2. A single ratio does not generally provide sufficient information from which to judge
the overall performance of the firm.
3. The ratios being compared should be calculated using financial statements dated at
the same point in time during the year.
4. It is preferable to use audited financial statements.
5. The financial data being compared should have been developed in the same way.
6. Results can be distorted by inflation.
1- Liquidity ratios
Ratio Analysis: 2- Activity ratios

The Categories
3- Debt ratios
4- Profitability ratios
Liquidity Ratios:
The current ratio is a measure of the firm’s ability to meet its short-
term obligations. It is calculated as:
Current ratio = total current assets

total current liabilities
 The higher the current ratio the better the liquidity position.
 The current ratio should be greater than 1.
Liquidity Ratios: Interpretation
Interpretation:
The Firm can cover only about … % percent of their existing 1-year debt
obligations with their current liquid assets.
Or
The company has $....... in current assets for every dollar in current liabilities.
In principal we would like to see the CR > 1 because it suggests that the CA to be
liquidated this year are sufficient to cover the CL that will come due this year. If the
CR < 1, then the CA will be unable to service the maturing obligations as measured by
CL
Liquidity Ratios: Continued
The quick (acid-test) ratio is similar to the current ratio except that it excludes
inventory. It is calculated as:
Quick ratio = total current assets - inventory
total current liabilities
This is done because inventories are often the least liquid of the current assets
and their liquidation value is often the most uncertain. In some businesses, if a
firm were liquidated today, inventory would have little or no value. Thus the
QR provides a stricter measure of a firm’s liquidity than the CR.
Activity Ratios:
The inventory turnover ratio measures how well the firm manages its
inventory or the speed of converting inventory into sales and is calculated as:
Inventory turnover = Cost of Goods Sold

Inventory
Inventory turnover is the number of times a company sells and replaces its
stock of goods during a period. Inventory turnover provides insight as to how
the company manages costs and how effective their sales efforts have been.
Activity Ratios: Continued
Interpretation:
The number of times the firm has replaced its stock of goods
• The higher the inventory turnover, the better since a high inventory turnover
typically means a company is selling goods very quickly and that demand
for their product exists. In other words the higher inventory turnover the more
efficient is the inventory management.
• Low inventory turnover, on the other hand, would likely indicate weaker
sales and declining demand for a company’s products.
Activity Ratios: Continued
• The Average Age of Inventory measures how many days, on average, it takes the
company to change its inventory and is calculated as:
𝟑𝟔𝟓
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐠𝐞 𝐨𝐟 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲=
𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐓𝐮𝐫𝐧𝐨𝐯𝐞𝐫
• The shorter the period the more efficient is the inventory management.
Solved
Example
Calculate the liquidity and activity ratios and then interpret each
ratio.
Note: the firm`s purchases represent 70% of the annual sales
Ratio Actual 2011 Actual 2012 Industry Average
Current ratio 1.84 1.80
Quick ratio 0.78 0.70
Inventory turnover 2.59 2.50
Average age of inventory 48 days 53 days

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Chapter 2 Part 1 - Ratio Analysis

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Chapter 2 – Financial

statements and Ratio

LG1 Understand who LG2 Use ratios to analyze

LG3 Discuss the

Income Statement Balance Sheet

 Assets indicate what the firm owns, equity represents the

• Cross-sectional analysis is the comparison of different firms’ financial ratios

Ratio Analysis: 2- Activity ratios

Current ratio = total current assets

Inventory turnover = Cost of Goods Sold

Current ratio 1.84 1.80

Quick ratio 0.78 0.70

Inventory turnover 2.59 2.50

Average age of inventory 48 days 53 days

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