financial analysis, you will need to know how to use common-sized financial statements, financial ratios, and the Du Pont ratio method. In addition, you will learn. 𝗣𝗗𝗙 | In this paper, we demonstrate the use of actual financial data for financial ratio analysis. We construct a financial and industry analysis for Motorola. PDF | In today's financial world, financial performance is a requirements amongst the perspective of various stakeholders, be it in the.
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Financial ratios, a reading prepared by Pamela Peterson Drake. 1 financial ratio analysis we select the relevant information -- primarily the financial statement. 3. RATIO ANALYSIS. Objectives: After reading this chapter, the students will be able to. 1. Construct simple financial statements of a firm. 2. Use ratio analysis in . a) Current Ratio. The current ratio is a popular financial ratio used to test a company's liquidity .. cycle in any analysis of a company's working capital position.
This is referred to as trend ratio analysis. Firms and investors that do not have the expertise, the time, or the resources to perform financial analysis on their own may purchase analyses from companies that specialize in providing this service. Financial statements may assist the public by providing information about the trends and recent developments in the prosperity of the business and the range of its activities as they affect their area so they are interested in lots of ratios. Last but not the least; my grateful appreciation is also extended to Mrs. After such a discussion and mentioning that these ratios are one of the most important tools that is used in finance and that almost every business does and calculate these ratios, it is logical to express that how come these calculations are of so importance. As it is shown in above the Company is using its assets specially fixed assets more efficiently each year although it had a light decrease in efficiency in and compared to Within the firm, financial analysis may be used not only to evaluate the performance of the firm, but also its divisions or departments and its product lines.
Receivables turnover is an indication of how quickly the firm collects its accounts receivables and is defined as follows:. The receivables turnover often is reported in terms of the number of days that credit sales remain in accounts receivable before they are collected.
This number is known as the collection period. It is the accounts receivable balance divided by the average daily credit sales, calculated as follows:. Another major asset turnover ratio is inventory turnover. It is the cost of goods sold in a time period divided by the average inventory level during that period:.
The inventory turnover often is reported as the inventory period , which is the number of days worth of inventory on hand, calculated by dividing the inventory by the average daily cost of goods sold:. Financial leverage ratios provide an indication of the long-term solvency of the firm.
Unlike liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios measure the extent to which the firm is using long term debt. Debt ratios depend on the classification of long-term leases and on the classification of some items as long-term debt or equity.
The times interest earned ratio indicates how well the firm's earnings can cover the interest payments on its debt. This ratio also is known as the interest coverage and is calculated as follows:. Profitability ratios offer several different measures of the success of the firm at generating profits.
The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin considers the firm's cost of goods sold, but does not include other costs. It is defined as follows:. Return on assets is a measure of how effectively the firm's assets are being used to generate profits.
It is defined as:. Return on equity is the bottom line measure for the shareholders, measuring the profits earned for each dollar invested in the firm's stock.
Return on equity is defined as follows:. Dividend policy ratios provide insight into the dividend policy of the firm and the prospects for future growth. Two commonly used ratios are the dividend yield and payout ratio. A high dividend yield does not necessarily translate into a high future rate of return. It is important to consider the prospects for continuing and increasing the dividend in the future.
The dividend payout ratio is helpful in this regard, and is defined as follows:. This is sometimes referred to as comparative ratio analysis. From a managerial accounting standpoint, ratio analysis can assist a management team in identifying areas that might be of concern.
The management team can track the performance on these ratios across time to determine whether the indicators are improving or declining. This is referred to as trend ratio analysis. They have a variety of purposes: Learning Topic. Financial ratios can be grouped into five categories: The normal rule of thumb is that the current ratio should be greater than one if a firm is to remain solvent.
Another current asset account that a company may have is prepaid expenses. Prepaid expenses are amounts that have been paid but not as yet consumed. A common example is the case of a company paying insurance premiums for an extended period of time say, a year , but for which only a portion say, three months is applicable to the insurance coverage for the current fiscal year; the remaining insurance that is prepaid as of the end of the year is considered an asset.
Prepaid expenses may be reported as part of other current liabilities. Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not expected that noncurrent assets can be converted into cash within an operating cycle. Noncurrent assets include physical assets, such as plant and equipment, and nonphysical assets, such as intangibles. Plant assets are the physical assets, such as the equipment, machinery, and buildings, which are used in the operation of the business.
Gross plant and equipment, or gross plant assets, is the sum of the original costs of all equipment, buildings, and machinery the firm uses to produce its goods and services.
Net plant and equipment, or net plant assets, is the difference between gross plant assets and accumulated depreciation.
The net plant and equipment amount is hence the value of the assets—historical cost less any depreciation- according to the accounting books and is therefore often referred to as the book value of the assets.
Intangible assets are the current value of nonphysical assets that represent long-term investments of the company. Such intangible assets include patents, copyrights, and goodwill. Amortization is akin to depreciation: The number of years over which an intangible asset is amortized depends on the particular asset and its perceived useful life.
For example, a patent is the exclusive right to produce and sell a particular, uniquely defined good and has a legal life of 17 years, though the useful life of a patent—the period in which it adds value to the company-may be much less than 17 years. More challenging is determining the appropriate amortization period for goodwill. A company may have a noncurrent asset referred to as investments, which are assets that are purchased with the intention of holding them for a long term, but which do not generate revenue or are not used to manufacture a product.
Examples of investments include equity securities of another company and real estate that is held for speculative purposes. Other noncurrent assets include long term prepaid expenses, arising from prepayment for which a benefit is received over an extended period of time, and deferred tax assets, arising from timing differences between reported income and tax income, whereby reported income exceeds taxable income.
Long-term investment in securities of other companies may be recorded at cost or market value, depending on the type of investment; investments held to maturity are recorded at cost, whereas investments held as trading securities or available for sale are recorded at market value.
Whether the unrealized gains or losses affect earnings on the income statement depend on whether the securities are deemed trading securities or available for sale. Current Liabilities Current liabilities are obligations that must be paid within one operating cycle or one year, whichever is longer. Current liabilities include: They arise from goods and services that have been purchased but not yet paid.
Any portion of long- term indebtedness—obligations extending beyond one year—due within the year. The reliance on short-term liabilities and the type of current liabilities depends, in part, on the industry in which the firm operates. They include notes, bonds, capital lease obligations, and pension obligations.
Notes and bonds both represent loans on which the borrower promises to pay interest periodically and to repay the principal amount of the loan. A lease obligates the lessee—the one leasing and using the leased asset—to pay specified rental payments for a period of time.
Whether the lease obligation is recorded as a liability or is expensed as lease payments made depends on whether the lease is a capital lease or an operating lease. The pension benefits are commitments by the company to pay specific retirement benefits, whereas post-retirement benefits include any other retirement benefit besides pensions, such as health care.
In a similar manner, the company may have an asset or a liability corresponding to post- retirement benefits. Deferred taxes are taxes that will have to be paid to the federal and state governments based on accounting income, but are not due yet. Deferred taxes arise when different methods of accounting are used for financial statements and for tax purposes. These differences are temporary and are the result of different timing of revenue or expense recognition for financial statement reporting and tax purposes.
The deferred tax liability arises when the actual tax liability is less than the tax liability shown for financial reporting purposes meaning that the firm will be paying the difference in the future , whereas the deferred tax asset, mentioned earlier, arises when the actual tax liability is greater than the tax liability shown for reporting purposes. For a corporation, ownership is represented by common stock and preferred stock.
The value of the ownership interest of preferred stock is represented in financial statements as its par value, which is also the dollar value on which dividends are figured. It consists of three parts: The par value of common stock is an arbitrary figure; it has no relation to market value or to dividends paid on common stock.
Some stock has no par value, but may have an arbitrary value, or stated value, per share. The outstanding stock is reported in the stock accounts, and adjustments must be made for any treasury stock. The bulk of the equity interest in a company is in its retained earnings. A retained- earnings is the accumulated net income of the company, less any dividends that have not been paid, over the life of the corporation. Retained earnings are not strictly cash and any correspondence to cash is coincidental.
This statement is also referred to as the profit and loss statement. The operating decisions of the company—those that apply to production and marketing— generate sales or revenues and incur the cost of goods sold also referred to as the cost of sales or the cost of products sold. The difference between sales and cost of goods sold is gross profit.
Deducting these expenses from gross profit leaves operating profit, which is also referred to as earnings before interest and taxes EBIT , operating income, or operating earnings.
Operating decisions take the firm from sales to EBIT on the income statement. The results of financing decisions are reflected in the remainder of the income statement. When interest expenses and taxes, which are both influenced by financing decisions, are subtracted from EBIT, the result is net income. Net income is, in a sense, the amount available to owners of the firm. If the firm has preferred stock, the preferred stock dividends are deducted from net income to arrive at earnings available to common shareholders.
If the firm does not have preferred stock as is the case with Fictitious and most nonfictitious corporations , net income is equivalent to earnings available for common shareholders. The board of directors may then distribute all or part of this as common stock dividends, retaining the remainder to help finance the firm.
Companies must report comprehensive income prominently within their financial statements. Comprehensive income is a net income amount that includes all revenues, expenses, gains, and losses items and is based on the idea that all results of the firm—whether operating or nonoperating should be reflected in the earnings of the company.
This is referred to as the all-inclusive income concept. The all-inclusive income concept requires that these items be recognized in the financial statements as part of comprehensive income. It is important to note that net income does not represent the actual cash flow from operations and financing.
Rather, it is a summary of operating performance measured over a given time period, using specific accounting procedures. Depending on these accounting procedures, net income may or may not correspond to cash flow. It is a statement, which measures inflows and outflows of cash on account of any type of business activity. The cash flow statement also explains reasons for such inflows and outflows of cash so it is a report on a company's cash flow activities, particularly its operating, investing and financing activities.
It consists of the evaluation of the financial condition and operating performance of a business firm, an industry, or even the economy, and the forecasting of its future condition and performance.
It is, in other words, a means for examining risk and expected return. Financial publications such as Business Week, Forbes, Fortune, and the Wall Street Journal also publish financial data concerning individual firms and economic data concerning industries, markets, and economies , much of which is now also available on the Internet.
Within the firm, financial analysis may be used not only to evaluate the performance of the firm, but also its divisions or departments and its product lines. Analyses may be performed both periodically and as needed, not only to ensure informed investing and financing decisions, but also as an aid in implementing personnel policies and rewards systems.
Outside the firm, financial analysis may be used to determine the creditworthiness of a new customer, to evaluate the ability of a supplier to hold to the conditions of a long-term contract, and to evaluate the market performance of competitors.
Firms and investors that do not have the expertise, the time, or the resources to perform financial analysis on their own may purchase analyses from companies that specialize in providing this service.
Such companies can provide reports ranging from detailed written analyses to simple creditworthiness ratings for businesses.
Financial statements are used and analyzed by a different group of parties, these groups consists of people both inside and outside a business. Generally, these users are: Internal Users: Owners and managers require financial statements to make important business decisions that affect its continued operations. Financial analysis is then performed on these statements to provide management with more detailed information.
These statements are also used as part of management's report to its stockholders, and it form part of the Annual Report of the company. Employees also need these reports in making collective bargaining agreements with the management, in the case of labour unions or for individuals in discussing their compensation, promotion and rankings. External Users: Prospective investors make use of financial statements to assess the viability of investing in a business.
Financial analyses are often used by investors and is prepared by professionals financial analysts , thus providing them with the basis in making investment decisions. Financial institutions banks and other lending companies use them to decide whether to give a company with fresh loans or extend debt securities such as a long- term bank loan.
Government entities tax authorities need financial statements to ascertain the propriety and accuracy of taxes and duties paid by a company.
Media and the general public are also interested in financial statements of some companies for a variety of reasons. It indicates relation of two mathematical expressions and the relationship between two or more things. Financial ratio is a ratio of selected values on an enterprise's financial statement. There are many standard ratios used to evaluate the overall financial condition of a corporation or other organization.
Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. Values used in calculating financial ratios are taken from balance sheet, income statement and the cash flow of company, besides Ratios are always expressed as a decimal values, such as 0. Essence of ratio analysis: Financial ratio analysis helps us to understand how profitable a business is, if it has enough money to pay debts and we can even tell whether its shareholders could be happy or not.
Financial ratios allow for comparisons: When financial ratios over a period of time are compared, it is called time series or trend analysis. It is not the simply changes that has to be determined, but more importantly it must be recognized that why those ratios have changed. Another method is to compare ratios of one firm with another firm in the same industry at the same point in time.
This comparison is known as the cross sectional analysis. This comparison shows the relative financial position and performance of the firm. Since it is so easy to find the financial statements of similar firms through publications or Medias this type of analysis can be performed so easily.
To determine the financial condition and performance of a firm, its ratios may be compared with average ratios of the industry to which the firm belongs.
This method is known as the industry analysis that helps to ascertain the financial standing and capability of the firm in the industry to which it belongs.
Industry ratios are important standards in view of the fact that each industry has its own characteristics, which influence the financial and operating relationships. But there are certain practical difficulties for this method. First finding average ratios for the industries is such a headache and difficult. Second, industries include companies of weak and strong so the averages include them also. Sometimes spread may be so wide that the average may be little utility.
Third, the average may be meaningless and the comparison not possible if the firms with in the same industry widely differ in their accounting policies and practices. However if it can be standardized and extremely strong and extremely weak firms be eliminated then the industry ratios will be very useful. After such a discussion and mentioning that these ratios are one of the most important tools that is used in finance and that almost every business does and calculate these ratios, it is logical to express that how come these calculations are of so importance.
What are the points that those ratios put light on them? And how can these numbers help us in performing the task of management? The answer to these questions is: We can use ratio analysis to tell us whether the business 1. So for using them first we have to decide what we want to know, then we can decide which ratios we need and then we must begin to calculate them.
As before mentioned there are varieties of people interested to know and read these information and analyses, however different people for different needs. And it is because each of these groups have different type of questions that could be answered by a specific number and ratio. Therefore we can say there are different ratios for different groups, these groups with the ratio that suits them is listed below: These are people who already have shares in the business or they are willing to be part of it.
So they need to determine whether they should buy shares in the business, hold on to the shares they already have or sell the shares they already own. They also want to assess the ability of the business to pay dividends.
As a result the Return on Capital Employed Ratio is the one for this group. This group consists of people who have given loans to the company so they want to be sure that their loans and also the interests will be paid and on the due time.
Gearing Ratios will suit this group. Managers might need segmental and total information to see how they fit into the overall picture of the company which they are ruling.
And Profitability Ratios can show them what they need to know. The employees are always concerned about the ability of the business to provide remuneration, retirement benefits and employment opportunities for them, therefore these information must be find out from the stability and profitability of their employers who are responsible to provide the employees their need.
Return on Capital Employed Ratio is the measurement that can help them. Suppliers and other trade creditors: Businesses supplying goods and materials to other businesses will definitely read their accounts to see that they don't have problems, after all, any supplier wants to know if his customers are going to pay them back and they will study the Liquidity Ratio of the companies.
Governments and their agencies: To regulate the activities of them, determine taxation policies and as the basis for national income and similar statistics, they calculate the Profitability Ratio of businesses.
Local community: Financial statements may assist the public by providing information about the trends and recent developments in the prosperity of the business and the range of its activities as they affect their area so they are interested in lots of ratios.
Financial analysts: In context, however, a financial ratio can give a financial analyst an excellent picture of a company's situation and the trends that are developing.
A ratio gains utility by comparison to other data and standards. Financial ratios quantify many aspects of a business and are an integral part of financial statement analysis. Financial ratios are categorized according to the financial aspect of the business which the ratio measures.
Although these categories are not fixed in all over the world however there are almost the same, just with different names: Profitability ratios which use margin analysis and show the return on sales and capital employed. The rate of return ratios are thought to be the most important ratios by some accountants and analysts.
One reason why the rate of return ratios is so important is that they are the ratios that we use to tell if the managing director is doing their job properly. Liquidity ratios measure the availability of cash to pay debt, which give a picture of a company's short term financial situation. Solvency or Gearing ratios measures the percentage of capital employed that is financed by debt and long term finance.
The higher the gearing, the higher the dependence on borrowing and long term financing. The lower the gearing ratio, the higher the dependence on equity financing. Traditionally, the higher the level of gearing, the higher the level of financial risk due to the increase volatility of profits. Turn over Ratios or activity group ratios indicate efficiency of organization to various kinds of assets by converting them to the form of sales.
Investors ratios usually interested by investors. Gross Block The two liquidity ratios, the current ratio and the acid test ratio, are the most important ratios in almost the whole of ratio analysis and they are also the simplest to use. They are of particular interest to those extending short term credit to the firm. Two frequently-used liquidity ratios are current and quick ratio.
A company's ability to turn short-term assets into cash to cover debts is of the utmost importance when creditors are seeking payment. Bankruptcy analysts and mortgage originators frequently use the liquidity ratios to determine whether a company will be able to continue as a going concern. A complete liquidity ratio analysis can help uncover weaknesses in the financial position of the business.
Generally, the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term debts.
The higher the current ratio, the more capable the company is of paying its obligations. A ratio in each year suggests that the company would be able to pay off its obligations if they came due at that point, but the company has shown constant decreasing trend in its financial health in subsequent years, Since low current ratio does not necessarily mean that the firm will go bankrupt, but it is definitely is not a good sign.
Short term creditors prefer a high current ratio since it reduce their risk. Quick or Acid-Test Ratio The essence of this ratio is a test that indicates whether a firm has enough short-term assets to cover its immediate liabilities without selling inventory.
So it is the backing available to liabilities that must be paid almost immediately. There are two terms of liquid asset and liquid liabilities in this formula, Liquid asset is all current assets except the inventories and prepaid expenses, because prepaid expenses cannot be converted to cash.
The liquid liabilities include all current liabilities except bank overdraft and cash credit since they are not required to be paid off immediately. The acid-test ratio is far more forceful than the current ratio, primarily because the current ratio includes inventory assets which might not be able to turn to cash immediately.
Companies with ratios of less than 1 cannot pay their current liabilities and should be looked at with extreme caution. Furthermore, if the acid-test ratio is much lower than the current ratio, it means current assets are highly dependent on inventory. Companies will typically try to turn their production into cash or sales as fast as possible because this will generally lead to higher revenues.