Financial Ratio Analysis Lecture Notes

Introduction

• Financial ratio analysis: methods of calculating and interpreting financial ratios to monitor firm performance.
• Management aims to produce favorable financial ratios for owners and creditors.
• Ratio comparison is more objective than comparing figures from financial statements.

Example of Profitability Comparison

• Company A: Net Profit = $100,000, Sales = $1 million
• Company B: Net Profit = $10,000, Sales = $20,000
• Profit Margin:
  • Company A: 10%
  • Company B: 50%
• Conclusion: Company B is more efficient despite lower total profit.

Types of Ratio Comparisons

1. Trend Analysis (Time Series Analysis)
   • Evaluates a firm's performance over time.
2. Cross-Sectional Analysis
   • Compares different firms at the same point in time.
   • Industry Comparative Analysis: compares to industry's average performance.
   • Benchmarking: compares to industry leaders or key competitors.

Categories of Financial Ratios

1. Liquidity Ratios

   • Measure a firm's ability to meet obligations.
   • Current Ratio: Current Assets / Current Liabilities.
   • Acid Test Ratio (Quick Ratio): (Current Assets - Inventories) / Current Liabilities.
   • Liquidity indicates ability to convert assets to cash quickly.
   • Higher current ratio is better, but high inventory can distort this.

2. Activity Ratios (Efficiency Ratios)

   • Measure efficiency in using resources to generate sales.
   • Accounts Receivable Turnover: Credit Sales / Accounts Receivable.
     • Higher ratio indicates efficient collection.
   • Average Collection Period: (Accounts Receivable / Credit Sales) * 365.
     • Shorter period = better efficiency.
   • Accounts Payable Turnover: Credit Purchases / Accounts Payable.
     • Higher ratio indicates good payment practices.
   • Inventory Turnover: Cost of Goods Sold / Average Inventory.
     • Higher turnover indicates efficient inventory management.
   • Fixed Assets Turnover: Sales / Net Fixed Assets.
   • Total Assets Turnover: Sales / Total Assets.

3. Debt Ratios

   • Measure degree of financial leverage.
   • Debt Ratio: Total Debt / Total Assets.
     • Higher ratio = higher financial risk.
   • Debt-to-Equity Ratio: Total Debt / Common Equity.
     • Indicates aggressive financing through debt.
   • Times Interest Earned: EBIT / Interest Expense.
     • Higher ratio indicates better ability to cover interest payments.

4. Profitability Ratios

   • Measure ability to generate profit.
   • Gross Profit Margin: (Sales - COGS) / Sales.
   • Operating Profit Margin: Operating Income / Sales.
   • Net Profit Margin: (EAT - Preferred Dividend) / Sales.
   • Operating Income ROI: Operating Income / Total Assets.
   • Return on Assets (ROA): (EAT - Preferred Dividend) / Total Assets.
   • Return on Equity (ROE): (EAT - Preferred Dividend) / Common Equity.
   • Earnings Per Share (EPS): Earnings Available to Stockholders / Common Stocks Outstanding.
     • Indicates profit allocation per share.

5. Market Value Ratios

   • Assess firm performance as perceived by the market.
   • Price-to-Earnings Ratio (P/E): Market Price per Share / Earnings per Share.
   • Price-to-Book Ratio (P/B): Market Price per Share / Book Value per Share.

Limitations of Financial Ratio Analysis

• Different accounting policies can affect ratios (e.g., FIFO vs. LIFO).
• Different accounting year-ends can distort comparisons.
• Inflation not accounted for can misrepresent real values.
• Year-end figures may not reflect overall performance.
• Information can be outdated upon availability.
• Ratios should be used as a guide and not the sole basis for decisions.
• Multiple formulas may exist for calculating the same ratio.

Conclusion

• Financial ratios provide valuable insights but must be interpreted carefully considering context and limitations.

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