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Faculty: Ms. Luvnica Rastogi Amity International Business School Imp Website: www.investorwords.com

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### Faculty: Ms. Luvnica RastogiAmity International Business SchoolImp Website: www.investorwords.com

Financial Statement Analysis

Financial Analyst and Financial Analysis

- Financial Analyst:
- The financial analyst can be viewed as any user of available information concerning firms who wishes to use the information for the purpose of decision making.
- Financial Analysis:
- It is the procedure the financial analyst uses to interpret the information.

Financial Statement Analysis

- The art of transforming data from Financial Statements into information that is useful for informed decision making is called Financial Statement Analysis.
- The firm itself and outside providers of capital (creditors and investors) all undertake financial statement analysis.
- The type of analysis varies according to the specific interest of the party involved.

Examples of External Uses of Financial Statement Analysis

- Trade Creditors-- Focus on the liquidity of the firm.
- Their claims are short term, and the ability of the firm to pay these claims quickly is best judged by an analysis of the firm’s liquidity.

Bondholders-- Focus on the long-term cash flow of the firm.

- Because the Bondholder are more interested in the cash flow ability of the firm to service Debt over a long period of time.
- They may evaluate this ability by analyzing the capital structure of the firm, the major sources and uses of funds, the firm’s profitability over time and projection of future profitability.

Shareholders -- Focus on the profitability and long-term health of the firm.

- They would also be concerned with the firm financial condition.

Examples of Internal Uses of Financial Statement Analysis

- Plan-- Focus on assessing the current financial position and evaluating potential firm opportunities in relation to this current position.
- Control– With respect to internal control, the financial manager is particularly concerned with the return on investment provided by the company and with the efficiency of assets management.

Understand –To bargain effectively for outside funds, Financial Manager need to Focus on all aspect of financial analysis for understanding how suppliers of funds analyze the firm.

Primary Types of Financial Statements

Income Statement

- A summary of a firm’s revenues and expenses over a specified period, ending with net income or loss for the period.

- Balance Sheet
- A summary of a firm’s financial position on a given date that shows total assets = total liabilities + owners’ equity.

Basket Wonders’ Balance Sheet (Asset Side)

a. How the firm stands on a specific date.

b. What BW owned.

c. Amounts owed by customers.

d. Future expense items already paid.

e. Cash/likely convertible to cash within 1 year.

f. Original amount paid.

g. Acc. deductions for wear and tear.

Cash and C.E. $ 90 Acct. Rec.c 394 Inventories 696 Prepaid Expd 5 Accum Tax Prepay 10Current Assetse $1,195 Fixed Assets (@Cost)f 1030 Less: Acc. Depr. g (329) Net Fix. Assets $ 701 Investment, LT 50 Other Assets, LT 223Total Assets b $2,169

Basket Wonders Balance Sheet (thousands) Dec. 31, 2003a

Basket Wonders’ Balance Sheet (Liability Side)

a. Note, Assets = Liabilities + Equity.

b. What BW owed and ownership position.

c. Owed to suppliers for goods and services.

d. Unpaid wages, salaries, etc.

e. Debts payable < 1 year.

f. Debts payable > 1 year.

g. Original investment.

h. Earnings reinvested.

Notes Payable $ 290 Acct. Payablec 94 Accrued Taxesd 16 Other Accrued Liab.d 100Current Liab.e $ 500 Long-Term Debtf530Shareholders’ Equity Com. Stock ($1 par)g200Add Pd in Capitalg 729 Retained Earningsh 210 Total Equity $1,139

Total Liab/Equitya,b $2,169

Basket Wonders Balance Sheet (thousands) Dec. 31, 2003

Basket Wonders’ Income Statement

a. Measures profitability over a time period.

b. Received, or receivable, from customers.

c. Sales comm., adv., officers’ salaries, etc.

d. Operating income.

e. Cost of borrowed funds.

f. Taxable income.

g. Amount earned for shareholders.

Net Sales b $ 2,211 Cost of Goods Sold1,599 Gross Profit $ 612 SG&A Expenses c 402EBITd$ 210 Interest Expense 59 EBT f$151Income Taxes 60 EATg$ 91 Cash Dividends 38 Increase in RE $ 53

Basket Wonders Statement of Earnings (in thousands) for Year Ending December 31, 2003a

Cross Sectional Financial Statement Studies

- There is little to be gained by analyzing the financial statements of a company for one year alone.
- A “benchmark” is needed by which to judge a company’s performance.
- This “benchmark” can be obtained by comparing companies with in the same industries with other companies.
- This is known as a cross-sectional study.

Time Series Financial Statement Studies

- To compare the accounts of one company with its own previous years. Possible to see if a company is improving in certain areas or not.
- This is known as a Time series study.

Use of Financial Ratios

Types of Comparisons

Internal Comparisons

External Comparisons

A Financial Ratio is an index that relates twoaccountingnumbers and is obtained by dividing one number by the other.

Internal Comparisons

- To compare a present ratio with past and expected future ratios for the same company is called Internal comparisons.
- For example to compare the Kardan 2008 ratios with Kardan 2007 and 2006 ratios that either they have improved or not.

External Comparison

- This involves comparing the ratios of one firm with those of similar firms or with industry averages.
- Or
- To compare the ratios of one firm with those of similar firms or with industry averages at the same point in time is called External Comparisons.
- Similarity is important as one should compare “apples to apples.”
- Example: to compare the ratios of Kardan and Bakhtar

How a Ratio is expressed?

- As Percentage - such as 25% or 50% . For example if net profit is Rs.25,000/- and the sales is Rs.1,00,000/- then the net profit can be said to be 25% of the sales.
- As Proportion - The above figures may be expressed in terms of the relationship between net profit to sales as 1 : 4.
- As Pure Number /Times - The same can also be expressed in an alternatively way such as the sale is 4 times of the net profit or profit is 1/4th of the sales.

Why are ratios useful?

- Ratios standardize numbers and facilitate comparisons.
- Ratios are used to highlight weaknesses and strengths.

Types of Ratios

- (i) Liquidity Ratios
- (ii) Financial Leverage (Debt) Ratios
- (iii) Coverage Ratios
- (iv) Activity Ratios
- (v) Profitability Ratios
- (vi) Investment Ratios

Liquidity Ratios

Ratio’s that measure a firm’s ability to meet short term obligations.

Or

It shows that Can we make required payments?

Balance Sheet Ratios

Liquidity Ratios

Liquidity Ratios

- Liquidity ratios are used to measure a firm ability to meet short term obligations.
- They compare short term obligations with short term (or current) resources available to meet these obligations.
- From these ratios, much insight can be obtained into the present cash solvency of the firm.

Liquidity Ratios

Shows a firm’s ability to cover its current liabilities with its current assets.

Or

It is the relationship between the current assets and current liabilities of a firm.

Balance Sheet Ratios

Current Ratio

Liquidity Ratios

Current Ratio

Current Assets

Current Liabilities

If

Current Assets = Rs.1,195

and

Current Liabilities = Rs.500

Balance Sheet Ratios

Liquidity Ratios

Rs.1,195

Rs.500

= 2.39

Current Ratio

- Looks at the ratio between Current Assets and Current Liabilities
- Ideal level? – 1.5
- A ratio of 2.39 would imply the firm has $2.39 of current assets to cover every $1 in current liabilities
- Too high – Might suggest that too much of its assets are tied up in unproductive activities – too much stock, for example?
- Too low - risk of not being able to pay Current liabilities.

Liquidity Ratio Comparisons

BW Industry

2.39 2.15

2.26 2.09

1.91 2.01

Year

2003

2002

2001

CurrentRatio

Ratio is stronger than the industry average.

Liquidity Ratios

Shows a firm’s ability to meet current liabilities with its most liquid assets.

Or

It is the ratio between Quick Current Assets and Current Liabilities.

Balance Sheet Ratios

Acid test (quick) Ratio

Liquidity Ratios

Acid-Test (Quick)

Current Assets - Inv

Current Liabilities

If

Current Assets = $1,195

and

Current Liabilities = $500

Inventory = $696

Balance Sheet Ratios

Liquidity Ratios

$1,195 - $696

$500

= 1.00

Acid Test (quick) Ratio

- 1 seen as ideal
- It has been argued that Inventory takes a while to convert to cash so a more realistic ratio would ignore Inventory.
- The omission of Inventory gives an indication of the cash the firm has in relation to its liabilities (what it owes)
- A ratio of 1 would imply that the firm has $1 of cash to cover every $1 in current liabilities.
- Again if it is too high means that the business is very liquid – may be able to use the cash for other activities to increase performance.
- If it is too low then the business may face problems in payment of current liabilities.
- Some types of business need more cash than others so acid test would be expected to be higher

Liquidity Ratio Comparisons

BW Industry

1.00 1.25

1.04 1.23

1.11 1.25

Year

2003

2002

2001

Acid-Test Ratio

Ratio is weaker than the industry average.

Summary of the Liquidity Ratio Comparisons

- Strong current ratio and weak acid-test ratio indicates a potential problem in the inventories account.
- Note that this industry has a relatively high level of inventories.

RatioBWIndustry

Current 2.39 2.15

Acid-Test 1.00 1.25

Summary of the Liquidity Trend Analysis

- The current ratio for the industry has been rising slowly at the same time the acid-test ratio has been relatively stable.
- This indicates that inventories are a significant problem for BW.

- The current ratio for BW has been rising at the same time the acid-test ratio has been declining.

Financial Leverage (Debt) Ratios

Shows the extent to which the firm is financed by debt.

Balance Sheet Ratios

Financial Leverage Ratios

Financial Leverage (Debt) Ratios

(i). Debt-to-Equity

(ii). Debt-to-Total-Assets

(iii). Total Capitalization

Balance Sheet Ratios

Financial Leverage Ratios

Financial Leverage (Debt) Ratios

It is the relationship between borrower’s fund (Debt) and Owner’s Capital (Equity).

The Debt to Equity ratio is computed by simply dividing the total debt of the firm (including current liabilities) by its share holder’s equity.

Balance Sheet Ratios

Debt-to-Equity

Financial Leverage Ratios

Debt-to-Equity

Total Debt

Shareholders’ Equity

For Basket Wonders December 31, 2003

If

Total Debt = 1030

and

Shareholder’s equity = 1139

Balance Sheet Ratios

Financial Leverage

Ratios

$1,030

$1,139

= .90

Debt-to-Equity Ratio

- The ratio 0.90 tells us that creditors are providing 90 cents of financing for each $1 being provided by shareholder’s.
- Creditors would generally like this ratio to be low.
- The lower the ratio the higher the level of the firm’s financing that is being provided by shareholder’s, and the larger the creditor cushion (margin of protection) in the event of losses.

Financial Leverage Ratio Comparisons

BW Industry

.90 .90

.88 .90

.81 .89

Year

2003

2002

2001

Debt-to-Equity Ratio

BW has average debt utilization

relative to the industry average.

Financial Leverage (Debt) Ratios

Shows the percentage of the firm’s assets that are supported by debt financing.

or

It is the relationship between borrower’s fund (Debt) and total Assets.

Balance Sheet Ratios

Debt-to-Total-Assets

Financial Leverage Ratios

Debt-to-Total-Assets

Total Debt

Total Assets

For Basket Wonders December 31, 2003

If

Total Debt = 1030

And

Total assets = 2169

Balance Sheet Ratios

Financial Leverage

Ratios

$1,030

$2,169

= .47

Debt-to-Total-Assets Ratio

- This ratio highlights the relative importance of debt financing to the firm by showing the percentage of the firm’s assets that is supported by debt financing.
- The 0.47 ratio shows that 47 percent of the firm assets are financed by debt and remaining 53 percent of the finance comes from shareholder’s equity.

Once again this ratio points out that the greater the percentage of financing provided by shareholder’s equity, the larger the cushion of protection offered the firm’s creditors.

- In short the higher the Debt to total assets ratio, the greater the financial risk; the lower the ratio, the lower the financial risk.

Financial Leverage Ratio Comparisons

BW Industry

.47 .47

.47 .47

.45 .47

Year

2003

2002

2001

Debt-to-Total-Asset Ratio

BW has average debt utilization

relative to the industry average.

Financial Leverage (Debt) Ratios

Shows the relative importance of long-term debt to the long-term financing of the firm.

Total capitalization represents all long term debt and shareholder’s equity.

Balance Sheet Ratios

Long term Debt to Total Capitalization(i.e., LT-Debt + Equity)

Financial Leverage Ratios

Total Capitalization

Long Term Debt

Total Capitalization

For Basket Wonders December 31, 2003

If

Long term Debt = 530

And

LT-debt + Equity = 1669

Balance Sheet Ratios

(i.e., LT-Debt + Equity)

Financial Leverage

Ratios

$530

$1,669

= .32

This measure tells us the relative importance of long term debt to the long term financing of the firm.

- The 0.32 ratio shows that 32 percent of the firm total long term financing is provided by long term debt and remaining 68 percent of the finance comes from shareholder’s equity.

Financial Leverage Ratio Comparisons

BW Industry

.32.30

.34.32

.33.31

Year

2003

2002

2001

Total Capitalization Ratio

BW has average long-term debt utilization

relative to the industry average.

In summary, debt ratios tell us the relative proportions of capital contribution by creditors and by owners.

Coverage Ratios

Ratios that relates the financial charges (interest) of a firm to its ability to service or cover them.

Income Statement Ratios

Coverage Ratios

Coverage Ratios

It Indicates a firm’s ability to cover interest charges. It is also called times interest earned.

Income Statement Ratios

Interest Coverage Ratio

Coverage Ratios

Interest Coverage

EBIT

Interest Charges

For Basket Wonders December 31, 2003

If

EBIT = 210

And

Interest Charges = 59

Income Statement

Ratios

Coverage Ratios

$210

$59

= 3.56

This ratio serves as one measure of the firm’s ability to meet its interest payments and avoid bankruptcy.

- In general the higher the ratio, the greater the likelihood that the company could cover its interest payments without difficulty.
- It also sheds some light on the firm capacity to take on new debt.

Ratio of 3.56 shows the BW ability to cover annual interest 3.56 times with operating income (EBIT).

Coverage Ratio Comparisons

BW Industry

3.56 5.19

4.35 5.02

10.30 4.66

Year

2003

2002

2001

Interest Coverage Ratio

BW has below average interest coverage

relative to the industry average.

Summary of the Coverage Trend Analysis

- This indicates that low earnings (EBIT) may be a potential problem for BW.
- Note, we know that debt levels are in line with the industry averages.

- The interest coverage ratio for BW has been falling since 2001. It has been below industry averages for the past two years.

- What is the Net Worth : Capital + Reserve = 200
- Tangible Net Worth is : Net Worth - Goodwill = 150
- Outside Liabilities : TL + CC + Creditors + Provisions = 600
- Net Working Capital : C A - C L = 350 - 250 = 50
- Current Ratio : C A / C L = 350 / 300 = 1.17 : 1
- Quick Ratio : Quick Assets / C L = 200/300 = 0.66 : 1

1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 390

2. Current Ratio for 2nd Year : (170 + 30 +170+20+ 240 + 190 ) / (580+70+80+70)

820 /800 = 1.02

3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21

1. Debt Equity Ratio will be : 600 / (200+100) = 2 : 1

2. Tangible Net Worth : Only equity Capital i.e. = 200

3. Total Outside Liabilities / Total Tangible Net Worth : (600+400+100) / 200

= 11 : 2

4. Current Ratio will be : (300 + 150 + 50 ) / (400 + 100 ) = 1 : 1

- What is the Current Ratio ? Ans : (1+125 +128+1) / (38+26+9+15)
- : 255/88 = 2.89 : 1
- Q What is the Quick Ratio ? Ans : (125+1)/ 88 = 1.43 : 11
- Q. What is the Debt Equity Ratio ? Ans : LTL / Tangible NW
- = 100 / ( 362 – 30)
- = 100 / 332 = 0.30 : 1

Activity Ratios

Ratios that measure how effectively the firm is using its assets are called Activity Ratios.

Income Statement/Balance Sheet Ratios

Activity Ratios

Activity ratios, also known as Efficiency or Turnover Ratio, measure how effectively the firm is using its assets.

- In this section, we will focus our attention primarily on how effectively the firm is managing two specific asset groups receivables and inventories and its total assets in general.

Activity Ratios

- Receivable turnover Ratio
- Average Collection Period (Receivable turnover in Days)
- Payable turnover Ratio
- Average Payable Period (Payable Turnover in Days)
- Inventory Turnover Ratio
- Total Assets turnover ratio

Income Statement/Balance Sheet Ratios

Activity Ratios

Activity Ratios

Indicates quality of receivables and how successful the firm is in its collections.

This is also called Debtors Velocity or Average Collection Period or Period of Credit given .

Income Statement/Balance Sheet Ratios

Receivable Turnover Ratio

Activity Ratios

Receivable Turnover

Annual Net Credit Sales

Receivables

For Basket Wonders December 31, 2003

If

Annual Net Credit Sales = 2211

And

Account Receivables = 394

Income Statement /

Balance Sheet

Ratios

(Assume all sales are credit sales.)

Activity Ratios

$2,211

$394

= 5.61

This ratio tells us the number of times accounts receivables have been turned over (turned into cash) during year.

- The higher the turnover, the shorter the time between the typical sales and cash collection, and vise versa.
- For BW ratio 5.61 tells us that 5.61 times accounts receivables have been turned over (turned into cash) in 2003.

Activity Ratios

Average number of days that receivables are outstanding.

(or Receivable Turnover in days)

Income Statement/Balance Sheet Ratios

Average Collection Period

Activity Ratios

Average Collection Period

Days in the Year

Receivable Turnover

or

Receivables * Days in the year

Annual Credit sales

For Basket Wonders December 31, 2003

If

Days in the year = 365

And

Receivable turn over = 5.61

Income Statement /

Balance Sheet

Ratios

Activity Ratios

365

5.61

= 65 days

It Gives a measure of how long it takes the business to recover debts.

- 65 days means that Average collection period of BW is 65 days.
- Shorter period is better as get cash more quickly.

Activity Ratio Comparisons

BW Industry

65.0 65.7

71.1 66.3

83.6 69.2

Year

2003

2002

2001

Average Collection Period

BW has improved the average collection

period to that of the industry average.

Activity Ratios

Indicates the promptness of payment to suppliers by the firm.

Income Statement/Balance Sheet Ratios

Payable Turnover Ratio

Activity Ratios

Payable Turnover (PT)

Annual Credit Purchases

Accounts Payable

For Basket Wonders December 31, 2003

If

Annual Credit Purchases = 1551

And

Account Payable = 94

Income Statement /

Balance Sheet

Ratios

(Assume annual credit

purchases = $1,551.)

Activity Ratios

$1551

$94

= 16.5

When a firm wants to study its own promptness of payment to suppliers or that of a potential credit customer.

- In such cases it may desirable to analyze the payable turnover ratio.
- For BW ratio 16.5 tells us that 16.5 times accounts payable have been turned over (turned into cash means paid to the suppliers) in 2003.

Activity Ratios

Average number of days that payables are outstanding.

This is also called Creditors Velocity Ratio, which determines the creditor payment period.

Income Statement/Balance Sheet Ratios

Payable Turnover in Days

Activity Ratios

PT in Days

Days in the Year

Payable Turnover

Or

Accounts payable * Days in the year

Annual Credit Purchases

For Basket Wonders December 31, 2003

If

Days in the year = 365

And

Payable turnover = 16.5

Income Statement /

Balance Sheet

Ratios

Activity Ratios

365

16.5

= 22.1 days

The average payable period is valuable information in evaluating the probability that a credit applicant will pay on time.

- If the average age of payables is 48 days and the terms in industry are “net 30” we know that a portion of the applicant’s payables is not being paid on time.
- Ratio of 22.1 means that the business paid the Accounts Payables in 22.1 days on average.

Activity Ratio Comparisons

BW Industry

22.1 46.7

25.4 51.1

43.5 48.5

Year

2003

2002

2001

Payable Turnover in Days

BW has improved the PT in Days.

Activity Ratios

Indicates the effectiveness of the inventory management practices of the firm.

Or

The rate at which a company’s Inventory is turned over is called Inventory turnover ratio.

Income Statement/Balance Sheet Ratios

Inventory Turnover Ratio

Activity Ratios

Inventory Turnover

Cost of Goods Sold

Inventory

For Basket Wonders December 31, 2003

If

CGS = 1599

And

Inventory = 696

Income Statement /

Balance Sheet

Ratios

Activity Ratios

$1,599

$696

= 2.30

Inventory turnover

- A high Inventory turnover might mean increased efficiency?
- But: dependent on the type of business – supermarkets might have high inventory turnover ratios whereas a shop selling high value musical instruments might have low inventory turnover ratio.
- Low Inventory turnover could mean poor customer satisfaction if people are not buying the goods.
- Ratio of 2.30 means that the company converts Inventory into A/R through sales 2.30 times in one year.

Activity Ratio Comparisons

BW Industry

2.30 3.45

2.44 3.76

2.64 3.69

Year

2003

2002

2001

Inventory Turnover Ratio

BW has a very poor inventory turnover ratio.

Activity Ratios

Indicates the overall effectiveness of the firm in utilizing its assets to generate sales.

Or

The relationship of net sales to total assets is known as total assets turnover ratio.

Income Statement/Balance Sheet Ratios

Total Assets Turnover Ratio

Activity Ratios

Total Asset Turnover

Net Sales

Total Assets

For Basket Wonders December 31, 2003

If

Net Sales = 2211

And

Total Assets = 2169

Income Statement /

Balance Sheet

Ratios

Activity Ratios

$2,211

$2,169

= 1.02

Asset Turnover ratio

- It looks at a businesses sales compared to the assets used to generate the sales.
- A ratio of 1.02 means that BW generate $1.02 sales revenue on each $1 investment in assets.
- Businesses with a high value of assets who have few sales will have a low asset turnover ratio
- If a business has a high sales and a low value of assets it will have a high asset turnover ratio
- Businesses can improve this by either increasing sales performance or getting rid of any additional assets

Activity Ratio Comparisons

BW Industry

1.02 1.17

1.03 1.14

1.01 1.13

Year

2003

2002

2001

Total Asset Turnover Ratio

BW has a weak total asset turnover ratio.

Excessive investment in receivables and inventories increase assets and hence decrease the ratio.

- If BW could generate the same sales revenue with fewer dollar invested in receivables and inventories, total asset turnover ratio would improve.

Profitability Ratios

Ratios that relate profits to sales and investment are called profitability ratios.

Or

Profitability ratios measures that how much profit the firm generates.

Income Statement/Balance Sheet Ratios

Profitability Ratios

Profitability Ratios

- Gross Profit Margin
- Net Profit Margin
- Return On Investment
- Return on Equity

Income Statement/Balance Sheet Ratios

Profitability Ratios

Profitability Ratios

Indicates the efficiency of operations and firm pricing policies.

Or

It shows the relationship between Gross profit and sales.

Income Statement/Balance Sheet Ratios

Gross Profit Margin

Profitability Ratios

Gross Profit Margin

Gross Profit

Net Sales

For Basket Wonders December 31, 2003

If

Gross Profit = 612

And

Net Sales = 2211

Income Statement /

Balance Sheet

Ratios

Profitability Ratios

$612

$2,211

= .277

Gross Profit Margin

- The higher the better
- Enables the firm to assess the impact of its sales and how much it cost to generate (produce) those sales.
- A gross profit margin of .277 means that for every $1 of sales, the firm makes $27.7 cents in gross profit.

Profitability Ratio Comparisons

BW Industry

27.7% 31.1%

28.7 30.8

31.3 27.6

Year

2003

2002

2001

Gross Profit Margin

BW has a weak Gross Profit Margin.

Profitability Ratios

Indicates the firm’s profitability after taking account of all expenses and income taxes.

Or

It shows the relationship between Net profit and sales.

Income Statement/Balance Sheet Ratios

Net Profit Margin

Profitability Ratios

Net Profit Margin

Net Profit after Taxes

Net Sales

For Basket Wonders December 31, 2003

If

Net profit = 91

And

Net Sales = 2211

Income Statement /

Balance Sheet

Ratios

Profitability Ratios

$91

$2,211

= .041

Net Profit Margin

- Net profit margin looks at how much of the sales revenue is left as net profit.
- A net profit margin of .041 means that for every $1 of sales, the firm makes $4.1 cents in net profit.
- Net profit is more important than gross profit for a business as all costs are included
- A business would like to see that this ratio has improved over time.

Profitability Ratio Comparisons

BW Industry

4.1% 8.2%

4.9 8.1

9.0 7.6

Year

2003

2002

2001

Net Profit Margin

BW has a poor Net Profit Margin.

Profitability Ratios

Indicates the profitability on the assets of the firm (after all expenses and taxes).

Or

It shows the relationship between Net profit and total assets.

Income Statement/Balance Sheet Ratios

Return on Investment

Profitability Ratios

Return on Investment

Net Profit after Taxes

Total Assets

For Basket Wonders December 31, 2003

If

Net profit = 91

And

Total assets = 2160

Income Statement /

Balance Sheet

Ratios

Profitability Ratios

$91

$2,160

= .042

Return on Investment

- The higher the better
- Shows how effective the firm is in using its assets to generate profit.
- A return on investment of 0.042 means that it uses every $1 of assets to generate 4.2 cents in profit.

Profitability Ratio Comparisons

BW Industry

4.2% 9.8%

5.0 9.1

9.1 10.8

Year

2003

2002

2001

Return on Investment

BW has a poor Return on Investment.

Profitability Ratios

Indicates the profitability to the shareholders of the firm (after all expenses and taxes).

Or

It shows the relationship between Net profit and Shareholder’s Equity.

Income Statement/Balance Sheet Ratios

Return on Equity

Profitability Ratios

Return on Equity

Net Profit after Taxes

Shareholders’ Equity

For Basket Wonders December 31, 2003

If

Net profit = 91

And

Shareholder’s equity =1139

Income Statement /

Balance Sheet

Ratios

Profitability Ratios

$91

$1,139

= .08

Return on Equity

- The higher the better
- Shows how effective the firm is in using its Shareholder’s equity to generate profit.
- A return on equity of 0.08 means that it uses every $1 of shareholder’s equity to generate 8 cents in profit.

Profitability Ratio Comparisons

BW Industry

8.0% 17.9%

9.4 17.2

16.6 20.4

Year

2003

2002

2001

Return on Equity

BW has a poor Return on Equity.

Summary of the Profitability Trend Analyses

- The profitability ratios for BW have ALL been falling since 2001. Each has been below the industry averages for the past three years.
- This indicates that CGSandadministrative costsmay both be too high and a potential problem for BW.
- Note, this result is consistent with the low interest coverage ratio.

Investment or shareholders Ratios

The ratios which measures return to investor’s investment are called investment ratios.

Or

The ratios which shows the risk and potential earning of a business investment are called investment ratios.

The ratios that shareholders would be interested in are called Shareholders ratios.

Investment Ratios

These ratios are not calculated from the financial reports only, since they may involve market data such as share prices.

It is also known as a Valuation Ratios.

Investment/shareholders Ratios

- Earning per share
- Dividend per share
- Price earning ratio
- Market price per share/Book value per share

Investment Ratios

Investment/shareholders Ratios

It shows that how much net profit investors are earning on each share.

Or

“profit after tax / total number of shares” is called earning per share.

Earning per share

Investment Ratios

Earning per share

Net Profit after Taxes

Total number of shares

For Basket Wonders December 31, 2003

If

Net profit = 91

And

Total number of shares = 200

Earning per Share

Investment Ratios

$91

$200

= .455

Earning per Share

- The higher the better generally.
- Ratio of 0.455 means that shareholder’s earn 45.5 cents on each share.

Investment/shareholders Ratios

It shows that how much Dividend investors are earning on each share.

Or

Total dividend announced / total number of shares is called Dividend per share.

Dividend per share

Investment Ratios

Dividend per share

Dividend announced

Total number of shares

For Basket Wonders December 31, 2003

If

Dividend Announced = 38

And

Total number of shares = 200

Dividend per Share

Investment Ratios

$38

$200

= .19

Dividend per Share

- The higher the better generally.
- Ratio of 0.19 means that shareholder’s receive 19 cents dividend on each share.

Investment/shareholders Ratios

How much investors are willing to pay for $1 of earnings.

Or

This Ratio indicates the number of times the Earning Per Share is covered by its market price.

Price earning ratio (P/E)

Investment Ratios

Price earning ratio

Market price per share

Earning per share

For Basket Wonders December 31, 2003

If

Market price per share = 6

And

Earning per share = 0.455

Price earning ratio

Investment Ratios

$6

$.455

= 13.19

Price earning ratio

- The higher the better generally.
- Ratio of 13.19 shows that investors are willing to pay $13.19 for $1 of earnings.

Investment/shareholders Ratios

How much investors are willing to pay for $1 of book value equity.

OR

It shows the relationship between the market price per share and book value per share.

Market price per share / Book value per share (M/B)

Investment Ratios

M/B

Market price per share

Book value per share

For Basket Wonders December 31, 2003

If

Market price per share = 6

And

Book value per share = 4.645

Market price per share/Book value per share

Investment Ratios

$6

$4.645

= 1.29

Market price per share/Book value per share

- The higher the better generally
- Ratio of 1.29 means that investors are willing to pay $1.29 for each $1 of book value equity.

Summary of Ratio Analysis

- Inventories are too high.
- May be paying off creditors (accounts payable) too soon.
- CGS may be too high.
- Selling, general, and administrative costs may be too high.

Potential problems and limitations of financial ratio analysis

- Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions.
- “Average” performance is not necessarily good, perhaps the firm should aim higher.
- Seasonal factors can distort ratios.
- “Window dressing” techniques can make statements and ratios look better.

Different operating and accounting practices can distort comparisons.

- Sometimes it is hard to tell if a ratio is “good” or “bad”.
- Difficult to tell whether a company is, on balance, in strong or weak position.

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