Analyzing Financial Statements

Ratio Analysis

Analyzing financial statements is a process of evaluating a firm's past financial performance and its future prospects. The process requires the application of common sense and judgement in addition to analytical techniques. As we already know, there are many users of a firm's financial data : Creditors, owners and management, suppliers, competitors etc.  The analysis helps the above users in understanding the numbers presented in statements and serves as a basis for financial decision making.

Ratio analysis is perhaps the most commonly used analytical tool in financial statement analysis. It helps to reveal the overall financial condition of a firm.

For example, Investors look at ratios to evaluate a company's performance and growth.

Banks and creditors look at ratios to determine how much credit/loan to grant a firm.

Creditors worry when a firm does not generate enough earnings to make periodic payment of interest on outstanding debt.  Managers use financial ratios to monitor operations, to make sure that their firms are using the available resources efficiently. The idea is to see whether the firm's financial and operating status is improving over time and whether its overall ratios are better or worse than the ratios of competing companies.

Ratios are classified into FOUR major categories:

 Classification Types of ratios What is the purpose? LIQUIDITY a)  Current ratio b)  Quick ratio  (acid-test ratio) They measure the firm's ability to meet short-term obligations/liabilities from its current assets. ASSET  UTILIZATION a)  A/R turnover ratio b)  Average collection period c)  Inventory turnover ratio d)  Fixed assets turnover ratio e)  Total assets turnover ratio It measures how frequently a firm converts its current assets into cash. It also measures how well a firm uses its Fixed assets and total assets to generate sales. DEBT UTILIZATION a)  Debt to Total assets ratio b)  Times interest earned ratio c)  Fixed charges coverage ratio It measures the amount of debt financing used by the company. It also measures the firm's ability to meet interest payments. PROFITABILITY a)  Profit margin ratio b)  Return on Assets c)  Return on equity It measures the effectiveness of management in generating profits on sales, total assets and owners' equity.

1.  Liquidity ratios

1.1 Current ratio

Current assets

Current ratio  =   ---------------

Current liabilities

Purpose :          It measures the firm's ability to meet its current liabilities out of

Its current assets.

Implication :

 High current ratio Low current ratio A high ratio may suggest that the firm is holding too much capital in the Form of current assets A low ratio suggests that the firm may have difficulty paying its bills

1.2  Quick ratio

Current assets  --  Inventories  --  Prepaid expenses

Quick ratio   = ----------------------------------------------                                                     Current liabilities

Purpose :      Also known as the acid-test ratio; it measures short-term liquidity by

removing the least liquid current assets, such as inventories and prepaid

Items.

Implication :

 High Quick ratio Low Quick ratio A high ratio suggests that the firm is in a position to meet its short term commitments out of the most liquid assets. A low ratio suggests that a large portion of current assets is in the form of less liquid assets

Task 1 :    Calculate the liquidity ratios for Falcon manufacturing company given in the appendix.

2.  Asset Utilization ratios  OR  Activity ratios OR Efficiency ratios

Asset utilization ratios ( Fixed assets turnover ratio and Total assets turnover ratio )

usually compare sales with the level of investment in assets. The purpose is to determine

how well a firm utilizes its assets.

Other activity ratios ( A/R turnover ratio and Inventory turnover ratio ) determines the

efficiency of management in using these assets.

2.1  Accounts receivable turnover ratio

Net sales

A/R turnover ratio   =       --------------

Accounts receivable

Note :  If information is available on Credit sales; then  Net sales should be

replaced by Credit sales in the numerator.

Purpose :         This ratio indicates how many times accounts receivable are collected during

the year.

Implication :

 High A/R turnover ratio Low A/R turnover ratio A high turnover ratio suggests that the firm is very efficient in collecting its receivables.  It could also mean that the firm may be giving a very short credit period to its customers A low turnover ratio may suggest that the company is too lenient in its credit policy or is not quite effective in collecting its receivables

2.2  Average Collection period

Accounts receivable

Average collection period   =  ----------------------

Average daily credit sales

OR

Accounts receivable

Average collection period   = ------------------   X  365 days

Net sales

Purpose :          The measure indicates how many days a firm takes to convert its receivables into cash. This ratio is used to evaluate credit and collection policies of the firm.  This measure should always be compared with the credit terms of the company.

Implication :

 Long collection period Short collection period If the collection period considerably exceeds the credit period, it means the firm is not effective in collecting its receivables. A long collection period reduces the liquidity of the receivables and affects the firm's ability to meet short-term maturing commitments A short collection period may suggest that the firm is too restrictive in its credit policy. That is, it does not offer sufficient credit and hence may be losing out on sales

2.3  Inventory turnover ratio

Sales

Inventory turnover ratio   =    -----------

Inventory

Purpose :          It measures the efficiency of the firm in terms of managing and selling

inventory.

(The type of industry would also play a part in assessing this ratio.

For instance, a grocery store would have a higher inventory turnover than a

firm selling furniture.)

Implication :

 High inventory turnover ratio Low inventory turnover ratio A high inventory turnover generally indicates good buying practices. It also means that the firm is selling items quickly implying improved liquidity and profitability because less money is tied up in inventory.   On the other hand, it might also suggest that the firm may not be keeping sufficient inventory on hand and thereby losing out on sales. A low inventory turnover may suggest that the firm is carrying excess inventory or obsolete inventory.   It could also suggest that the firm is piling up inventory because of higher anticipated sales in the near future.

2.4  Fixed assets turnover ratio

Net Sales

Fixed assets turnover ratio    =    -----------------

Net Fixed Assets

Purpose :      It indicates management's efficiency in managing fixed assets.

Implication :

 High Fixed assets turnover ratio Low Fixed assets turnover ratio A high turnover ratio suggests that fixed assets are being used productively. A low turnover ratio may suggest too much of investment in fixed assets, low sales or a combination of both.   Analysts must further investigate and ask questions such as :   a) How old are the assets? b) Is the machinery & equipment obsolete?

2.5   Total Assets turnover ratio

Net Sales

Total assets turnover ratio    =    -----------

Total assets

Purpose :      It measures how well total assets are used in generating sales. It is a composite measure of all other asset utilization ratios.

Implication :

 High Total assets turnover ratio Low Total assets turnover ratio A high ratio suggests greater efficiency in using its assets to generate sales. A low ratio suggests less efficiency in using its assets to generate sales.

Task 2 :    Calculate the asset utilization ratios for Falcon manufacturing company given in the appendix.

3. Debt Utilization Ratios

These are also known as solvency ratios or leverage ratios.  The ratios in this category show

the extent to which a firm uses debt (borrowings) to finance its investments and its ability

to meet interest charges and other fixed payments.

3.1   Debt to Total Assets ratio

Total liabilities

Debt to total assets ratio    =  --------------

Total Assets

Purpose :      It measures the percentage of assets that have been financed by debt (borrowings).  Financial leverage is the extent to which a firm uses debt financing. As the percentage of debt financing increases, the firm becomes highly leveraged.  The amount of financial leverage implies risk to creditors

and owners.

Implication :

 High Debt to total assets ratio Low Debt to assets ratio A high debt to total assets ratio implies more of the firm's assets are financed by debt relative to owners' funds.   A high ratio requires the commitment of more funds to pay interest and repay principal amount. The failure to meet these requirements may force a company to bankruptcy.   A highly leveraged firm may also find it difficult to attract additional debt financing.   Positive aspects of high leverage Although leverage implies risk, it also provides the common shareholders with the opportunity to enhance their return.   Shareholders also maintain control because using debt avoids the sale of new shares. A low debt to total assets ratio implies that the firm is using more of owners capital and retained earnings to finance its assets.   It implies less risk to creditors. Company can borrow additional funds with relative ease.

3.2   Times Interest Earned ratio

Earnings before interest and taxes (EBIT)

Times interest earned ratio  =  ------------------------------------

Interest expense

Purpose :      The purpose is to measure the firm's ability to meet interest payments out of its operating profit.

Implication :

 High Times interest earned Low Times interest earned ratio A high ratio suggests that the firm is quite safe in meeting its interest payments. In other words, earnings could fall slightly without jeopardizing the firms ability to meet interest payments. A low ratio suggests more risk to creditors because they may not get the interest that is due to them.   Therefore the firm may face difficulty in borrowing additional funds.

3.3   Fixed charges coverage ratio

EBIT   +  Lease payments

Fixed charges coverage ratio    = ------------------------------

Interest expense + lease payments

Purpose :          It is a broad measure of the firm's ability to meet all fixed charges and

interest payments.

A lease is a contract between the owner of an asset called the lessor, and the another party called the lessee, who makes periodic payments to the owner for the right to use the asset.

Implication :

 High Ratio Low Ratio A high ratio implies that the firm has a bigger cushion in case of worsening financial position. It means less risk to creditors. A low ratio suggests that the creditors are more at risk. If earnings decline, the company may not be able to meet its obligations.

Task 3 :    Calculate the debt utilization ratios for Falcon manufacturing company given in the appendix.

4.    Profitability Ratios

These ratios measure the earning power of the firm. They are used to evaluate the overall

management effectiveness. Specifically, they indicate how effectively a firm's management

generates  profits on sales, total assets and equity.

4.1    Profit Margin Ratio (Net Profit Margin)

Net Income

Profit Margin Ratio =      ---------------

Sales

Purpose :          It measures the percentage of each sales dollar remaining after deducting

all expenses.

Implication :

 High Ratio Low Ratio A high ratio suggests that expenses as a percentage of sales are under control indicating operational efficiency. It could also suggest that price realization is very good or a combination of both the factors mentioned above. A low ratio may suggest that expenses as a percentage of sales are high or the firm is losing out on sales.

4.2    Return on Assets

Net Income

Return on Assets      =   ---------------

Total Assets

Return on Assets      =    Profit Margin Ratio      X       Total Asset turnover

=       Net income                    Net Sales

----------           X       ---------

Net sales                      Total Assets

Purpose :      This ratio measures the overall effectiveness of management in

generating profits from its total investment.

Implication :

 High Ratio Low Ratio A high ratio is favorable. It implies that net income as a percentage of total sales is good (Profit margin ratio) or the firm is able to generate a high level of sales given its investment in assets (Total assets turnover) or a combination of both. A low ratio is unfavorable. Further analysis needs to be done to ascertain the reasons. Is it due to lower profit margin or is it due to low asset turnover?

4.3    Return on Equity (ROE)

Net Income

Return on Equity      =     ------------------

Shareholders' equity

OR

Return on Equity      =       Profit margin  X  Total assets   X  Financial

ratio               turnover           leverage

=       Net income        Net Sales         Total assets

-----------  X  ----------   X  -----------

Net sales         Total assets        Sh. Equity

Purpose :      It measures the rate of return realized by a firm's shareholders on their

investment and is the indicator of management performance.

Implication :

 High Ratio Low Ratio A high ratio is generally associated with effective management performance. Further analysis might indicate the reasons of a higher ROE. How ever, a higher ROE may also suggest that a firm is more risky due to higher leverage. A low ratio suggests ineffective management performance.  Further analysis must be done to find the reasons. Is it due to Profit margin, or is it due to lower asset turnover? A low ROE may also suggest that the firm is more conservatively financed (lower leverage).

Task 4 :    Calculate the profitability ratios for Falcon manufacturing company given in the appendix.

The following information has been extracted  from the accounts of Falcon Manufacturing company.

Falcon  Manufacturing Company

Income Statement for the years ended Dec 31, 1997 & 1998

(all figures in '000 AED)

1997                      1998

 Sales (all credit) 7,650 11,500 Less : Cost of sales 5,800 9,430 Gross profit 1,850 2,070 Less :  Operating expenses 100 120 Lease payments 50 150 50 170 Operating income (EBIT) 1,700 1,900 Less :   Interest expense 50 350 Earnings before Tax 1,650 1,550 Less : Taxes 600 550 Earnings after Tax 1,050 1,000 Dividends paid(common shares) 300 300 Transferred to Retained Earnings 750 700 Falcon Manufacturing Company Balance Sheet as at Dec 31, 1997 & 1998 Current Assets Cash 900 50 Accounts receivable 1,200 3,800 Inventory 1,500 2,450 Total Current Assets 3,600 6,300 Net Fixed Assets 10,050 11,350 Total Assets 13,650 17,650 Current Liabilities Accounts payable 1,800 2,150 Tax payable 600 550 Total Current liabilities 2,400 2,700 Long-term debt 350 3,350 Total Liabilities 2,750 6,050 Shareholders' Equity Common shares, AED 10 par 5,900 5,900 Retained Earnings 5,000 5,700 Total Shareholders' equity 10,900 11,600 Total liabilities & Sharholders' equity 13,650 17,650

# Falcon Manufacturing Company-RATIOS

 RATIOS 1997 1998 COMMENTS LIQUIDITY Current ratio Quick ratio  (acid-test ratio) UTILIZATION A/R turnover ratio Average collection period Inventory turnover ratio Fixed assets turnover ratio Total assets turnover ratio DEBT RATIOS Debt to Total assets ratio Times interest earned ratio Fixed charges coverage ratio PROFITABILITY Profit margin ratio Return on Assets Return on equity