Ratio Analysis and financial performance
- 1. Financial Performance Metrics – Financial Ratios Dr. Imran Umer
- 2. Financial Performance Metrics – Financial Ratios • Financial ratio analysis is the systematic use of ratios to interpret financial statements so that the existing strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined and evaluated. For Example: • Short-term creditors, such as banks and trade creditors, use ratios to determine the firm’s immediate liquidity. • Longer-term creditors such as bondholders use them to determine its long-term solvency. Ratio is a quantitative relation between two amounts showing the number of times one value contains or is contained within the other.
- 3. Financial Performance Metrics – Financial Ratios When we calculate a ratio, all we get is a number. In order for this number to be meaningful to us, we need to put it into some kind of context by comparing it with another number. We can make these comparisons through: 1) Trend analysis of a single company by comparing current ratios to previous years. Trends can be particularly useful in analyzing a firm’s financial condition. If ratios are becoming less favorable over time, for example, this is an indication of trouble. 2) Comparison with other companies in the same industry or with industry averages after any necessary adjustments have been made to assure that the accounting data is comparable. 3) Comparison with management’s expectations.
- 4. Types of Financial Ratios 1. Profitability Ratio Measures the firm’s profit in relation to its total revenue, or the amount of net income from each dollar of sales and its return on invested assets; 2. Assets Utilization Ratio / Efficiency Ratio or Activity Analysis Activity ratios, which relate information on a firm's ability to manage its current assets (accounts receivable and inventory) and current liabilities (accounts payable) efficiently; 3. Short Term Solvency Ratios / Liquidity Ratio Measures the ability of the firm’s cash resources to meet its short-term cash obligations; 4. Long Term Solvency Ratios / Debt Utilization Ratio Evaluates the firm’s ability to satisfy its longer-term debt and investment obligations by looking at the mix of its financing sources;
- 5. Profitability Ratio Profitability ratios allow us to measure the ability of the firm to earn an adequate return on sales, assets and invested capital. The higher ROA & ROE, the better, or more effectively, the company is using its assets and capital.
- 6. Assets Utilization Ratio / Efficiency Ratio / Activity Analysis Under this type, ratios are used to measure the speed at which the firm is turning over accounts receivable, inventory and long term assets to generate sales and revenue. a) Accounts Receivable Turnover It is the measure of the efficiency of a firm’s credit policy. It estimates the number of days it takes for a dollar in sales to be collected by the firm. • An increase in the accounts receivable turnover ratio indicates that receivables are being collected more rapidly. A decrease indicates slower collections. Collection Period = 360/Times
- 7. Assets Utilization Ratio / Efficiency Ratio / Activity Analysis b) Inventory Turnover It Indicates how quickly inventory is sold during the year. If a company has a high inventory turnover ratio, • It may mean the company is using good inventory management and is not holding excessive amounts of inventories that may be obsolete, unmarketable goods. • However, it can also mean that the company is not holding enough inventory and may be losing sales if prospective customers are unable to make purchases because items are out of stock.
- 8. Assets Utilization Ratio / Efficiency Ratio / Activity Analysis c) Fixed Assets Turnover It indicates how well the investment in long term (fixed) assets is being managed. d) Assets Turnover The Asset Turnover Ratio measures the amount of sales revenue the company is generating from the use of all of its assets. It provides a means to measure the overall efficiency of the company’s use of all of its investments, as represented by both short-term assets and long-term assets.
- 9. Short Term Solvency Ratio / Liquidity Ratio These ratios measure firm’s ability to pay off short term obligations as they are due. a) Current Ratio A measure of short term debt paying ability. The “norm” is 2:1. A lower ratio indicates a possible liquidity problem. b) Quick Ratio / Acid Test Ratio An improved measurement of short term debt paying ability. Note: Quick Assets = Current Assets – Inventories – Prepaid
- 10. Short Term Solvency Ratio / Liquidity Ratio c) Working Capital Indicates the cash generated by operations after allowing for cash payment of expenses and operating liabilities.
- 11. Long Term Solvency Ratio / Debt Utilization Ratio It shows the overall debt position of the firm in the light of its assets base and earning power. a) Debt Ratio Percentage of assets financed by creditors, and also indicates relative size of the equity position. Note: Assets = Liabilities + Shareholders Equity b) Debt to Equity Ratio • The Debt to Equity ratio can serve as a screening device for the analyst when looking at capital structure ratios. If this ratio is extremely low (for instance, 0.1:1), then there is no need to calculate other capital structure ratios because there is no real concern with this part of the company’s financial situation. The analyst’s time could be better spent looking at other aspects of the company’s operations. • However, if the Debt to Equity ratio is in the neighbourhood of 2:1 or higher, it would be important to do some extended analysis that focuses on other ratios such as profitability, as well as the company’s future prospects.
- 12. Long Term Solvency Ratio / Debt Utilization Ratio c) Coverage Ratios Coverage ratios measures the degree to which fixed payments are “covered” by operating profits. we use earnings coverage ratios to focus on the company’s earning power, because that will be the source of interest payments, as well as the source for the principal repayments. I. Times Interest Earned / Interest Coverage Ratio Indicator of a company's ability to meet its interest payment obligations. • The Interest Coverage ratio compares the funds available to pay interest. This ratio gives an indication of how much the company has available for the payment of its fixed interest expense. • A high ratio is desirable. An interest coverage ratio of greater than 3.0 is excellent. When the interest coverage ratio gets down to 1.5, a company has a heightened risk of default, which becomes higher the further the ratio declines below 1.5.
- 13. Other Important Ratios a) Earnings Per Share (EPS) EPS is essentially the measure of the amount of income that each share of common stock would have earned if the profit of the company had been “paid” (distributed) to all of the common shares outstanding. b) Price Earnings Ratio (P/E) The P/E ratio gives an indication of what shareholders are paying for continuing Earnings Per Share. Investors view it as an indication of what the market considers to be the firm’s future earning power. • The P/E ratio is greatly influenced by where a company is in its cycle. A company in a growth stage will usually have a high P/E ratio because of the market’s expectations of future profits (which makes the market price higher) despite the fact that at the current time, profits may be low. • Companies with low growth generally have lower P/E ratios. • This ratio is meaningless when a company is experiencing losses (the P/E would be negative because earnings are negative)
- 14. Other Important Ratios c) Dividend Payout Ratio The dividend payout ratio measures the proportion of earnings paid out as dividends to common stockholders. Generally, a new company or a company that is growing will have a low or no dividend payout, because it is retaining earnings in the company to finance its growth.
- 15. Thank You