![• FPCR = EBIT + Lease Payments________________
Interest + Lease Payments + {(Principal Payments + PSD) x [1/(1-t)]}](https://image.slidesharecdn.com/fmlec3-250702073310-ae5796cf/85/FINANCIAL-STATEMENTS-AND-RATIO-ANALYSIS-LECTURE-3-21-320.jpg)
FINANCIAL STATEMENTS AND RATIO ANALYSIS LECTURE 3
- 1. TOPIC: FINANCIAL STATEMENTS AND RATIO ANALYSIS Lecture No. 3 & 4 INSTRUCTOR: NIDA RASHEED DATED: 12/09/2023 & 19/09/2023 COURSE: FINANCIAL MANAGEMENT
- 2. 3.1 LIQUIDITY RATIOS • 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 bills. • The two basic measures of liquidity are the current ratio and the quick (acid-test) ratio.
- 3. 3.11 CURRENT RATIO • The current ratio, one of the most commonly cited financial ratios, measures the firm’s ability to meet its short-term obligations. • 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
- 4. • Current ratio = Total current assets Total current liabilities
- 5. 3.12 QUICK (ACID-TEST) RATIO • The quick (acid-test) ratio is similar to the current ratio except that it excludes inventory (the least liquid current asset) • Two primary factors: (1) Many types of inventory cannot be easily sold because they are partially completed items, special-purpose items (2) Inventory is typically sold on credit (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 dire need for liquidity, when business is bad, are precisely the times when it is most difficult to convert inventory into cash by selling it.
- 6. • Quick ratio = Total Current Assets - Inventory Total current liabilities
- 7. 3.2 ACTIVITY RATIO • Activity ratios measure the speed with which various accounts are converted into sales or cash. • 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.
- 8. 3.21 INVENTORY TURNOVER • Inventory turnover commonly measures the activity, or liquidity, of a firm’s inventory. • 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.
- 9. • Inventory Turnover = Cost of Goods Sold Inventory
- 10. 3.22 AVERAGE AGE OF INVENTORY • Another inventory activity ratio measures how many days of inventory the firm has on hand. Inventory turnover can be easily converted into an average age of inventory by dividing it into 365. Average Age of Inventory = 365 Inventory Turnover
- 11. 3.23 AVERAGE COLLECTION PERIOD • The average collection period, or average age of accounts receivable, is useful in evaluating credit and collection policies. • The average collection period is meaningful only in relation to the firm’s credit terms. • EXAMPLE; If Bartlett Company extends 30-day credit terms to customers, an average collection period of 59.7 days may indicate a poorly managed credit or collection department, or both.
- 12. AVERAGE COLLECTION PERIOD ACP = Accounts Receivable Net Sales/365
- 13. 3.24 AVERAGE PAYMENT PERIOD • This figure is meaningful only in relation to the average credit terms extended to the firm. The difficulty in calculating this ratio stems from the need to find annual purchases; a value not available in published financial statements. Ordinarily, purchases are estimated as a given percentage of cost of goods sold • EXAMPLE: If Bartlett Company’s suppliers have extended, on average, 30-day credit terms, an analyst would give Bartlett a low credit rating because it was taking too long to pay its bills. • Prospective lenders and suppliers of trade credit are interested in the average payment period because it provides insight into the firm’s bill-paying patterns.
- 14. AVERAGE PAYMENT PERIOD • APP = Accounts Payable Annual Purchases/365
- 15. 3.25 TOTAL ASSET TURNOVER • The total asset turnover indicates the efficiency with which the firm uses its assets to generate sales. • 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. Total Asset Turnover = Net Sales Total Assets
- 16. 3.3 FINANCIAL LEVERAGE • The magnification of risk and return through the use of fixed cost financing, such as debt and preferred stock. • 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 are also concerned about the firm’s indebtedness.
- 17. • In general, the more debt a firm uses in relation to its total assets, the greater its financial leverage. • With increased debt comes greater risk as well as higher potential return. Therefore, the greater the financial leverage, the greater the potential risk and return. HIGH RISK = HIGH RETURN.
- 18. 3.31 DEBT RATIO • The debt ratio measures the proportion of total assets financed by the firm’s creditors. The higher this ratio, the greater the amount of other people’s money being used to generate profits. • The higher this ratio, more the financial leverage. Debt Ratio = Total Liabilities Total Assets
- 19. 3.32 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. Times Interest Earned = EBIT Interest
- 20. 3.33 FIXED-PAYMENT COVERAGE RATIO • The fixed-payment coverage ratio measures the firm’s ability to meet all fixed payment obligations, such as loan interest and principal, lease payments, and preferred stock dividends. • As is true of the times interest earned ratio, the higher this value the better. • Like the times interest earned ratio, the fixed-payment coverage ratio measures risk. • The lower the ratio, the greater the risk to both lenders and owners, and the greater the ratio, the lower the risk. • This ratio allows interested parties to assess the firm’s ability to meet additional fixed-payment obligations without being driven into bankruptcy
- 21. • FPCR = EBIT + Lease Payments________________ Interest + Lease Payments + {(Principal Payments + PSD) x [1/(1-t)]}
- 22. 3.4 PROFITABILITY RATIOS • These measures enable analysts to evaluate the firm’s profits with respect to a given level of sales, a certain level of assets, or the owners’ investment. • Without profits, a firm could not attract outside capital. • Owners, creditors, and management pay close attention to boosting profits because of the great importance the market places on earnings.
- 23. COMMON-SIZE INCOME STATEMENT • A useful tool for evaluating profitability in relation to sales is the common- size income statement. • Each item on this statement is expressed as a percentage of sales. • Common-size income statements are especially useful in comparing performance across years because it is easy to see if certain categories of expenses are trending up or down as a percentage of the total volume of business that the company transacts. • Three frequently cited ratios of profitability that come directly from the common-size income statement are (1) the gross profit margin, (2) the operating profit margin, and (3) the net profit margin.
- 24. 3.41 GROSS PROFIT MARGIN • The gross profit margin measures the percentage of each sales dollar remaining after the firm has paid for its goods. • The higher the gross profit margin, the better (the lower the relative cost of merchandise sold). GPM = Gross Profit Net Sales
- 25. 3.42 OPERATING PROFIT MARGIN • The operating profit margin measures the percentage of each sales dollar remaining after all costs and expenses other than interest, taxes, and preferred stock dividends are deducted. • It represents the “pure profits” earned on each sales dollar. • A high operating profit margin is preferred. • Note: Earnings before interest and taxes (EBIT) is also called operating income. OPM = EBIT Net Sales
- 26. 3.43 NET PROFIT MARGIN • The net profit margin is a commonly cited measure of the firm’s success with respect to earnings on sales. • “Good” net profit margins differ considerably across industries. • A net profit margin of 1 percent or less would not be unusual for a grocery store, whereas a net profit margin of 10 percent would be low for a retail jewelry store. • Note: Earnings available for common stockholders is also called Net Income or Net Profit after taxes. NPM = Earnings Available to Common Stockholders Sales
- 27. 3.44 EARNINGS PER SHARE • The firm’s earnings per share (EPS) is generally of interest to present or prospective stockholders and management. • EPS is closely watched by the investing public and is considered an important indicator of corporate success EPS = Earnings Available to Common Stockholders Number of Shares Outstanding
- 28. 3.45 THE RETURN ON TOTAL ASSETS • The return on total assets (ROA), often called the return on investment (ROI), measures the overall effectiveness of management in generating profits with its available assets. The higher the firm’s return on total assets the better • Note: Earnings available for common stockholders is also called Net Income or Net Profit after taxes. ROA = Earnings Available to Common Stockholders Total Assets
- 29. 3.46 THE RETURN ON COMMON EQUITY • The return on common equity (ROE) measures the return earned on the common stockholders’ investment in the firm. • Generally, the owners are better off the higher is this return. • Note: Earnings available for common stockholders is also called Net Income or Net Profit after taxes. ROE = Earnings Available to Common Stockholders Total Equity
- 30. 3.5 MARKET RATIOS • These ratios give insight into how investors in the marketplace feel the firm is doing in terms of risk and return. • They tend to reflect, on a relative basis, the common stockholders’ assessment of all aspects of the firm’s past and expected future performance.
- 31. 3.51 PRICE PER EARNING RATIO • The price/earnings (P/E) ratio is commonly used to assess the owners’ appraisal of share value. • The P/E ratio measures the amount that investors are willing to pay for each dollar of a firm’s earnings. • The level of this ratio indicates the degree of confidence that investors have in the firm’s future performance. • The higher the P/E ratio, the greater the investor confidence. P/E = Market Price Per Share of Common Stock Earnings Per Share
- 32. 3.52 MARKET/BOOK (M/B) RATIO • The market/book (M/B) ratio provides an assessment of how investors view the firm’s performance. It relates the market value of the firm’s shares to their book (strict accounting value). • The stocks of firms that are expected to perform well improve profits, increase their market share, or launch successful products, typically sell at higher M/B ratios than the stocks of firms with less attractive outlooks. • Simply stated, firms expected to earn high returns relative to their risk typically sell at higher M/B multiples. BV/Share = Common Stock Equity Number of Shares of Common Stock
- 33. MARKET PER BOOK RATIO • M/B Ratio = Market Price per Share of Common Stock Book Value per Share of Common Stock