ELEC2804 Engineering Economics and Finance

Session 6: Financial Ratios

Dr. Wilton Fok

Contents

• 6.1 Introduction• 6.2 Profitability • 6.3 Liquidity• 6.4 Capital Structure• 6.5 Shareholder ratios • 6.6 Efficiency• 6.7 Limits of Financial Ratios• 6.8 Summary

6.1 Introduction

• What we have learnt in Accounting?– So far what we have learnt is Financial Accounting

– It Focuses on preparing external financial reports that are used by the outsiders, that is, people who have an interest in the business but are not part of the management.

– We record the transactions and prepared a summary of Profit and loss, assets, liabilities and owner’s equity.

– Annual Report describes a firm’s financial status and usually discusses the firm’s activities during the past year and its prospects for the future.

6.1. Introduction• Managerial Accounting.

– Financial accounts and statements are records of past events. Reports of future estimates are called Budgets.

– For reports of future, we must analyze the past and plan the future.

– Thus, Analysis, Measurement, and Planning are fundamental in Managerial Accounting

– Managerial Accounting provides financial information that managers inside the organization can used them to evaluate and make decisions about current and future operations.

– Techniques:

• Budgeting - Planning exercise for financial expenditures and incomes

• Costing analysis – Measuring the cost of the business

• Accounting Ratios – Analyzing the performance, efficiency and profitability of a firm

6.1 Introduction• Financial statements analysis

– It is the process of looking beyond the face of the financial statements to gain additional insight into a company’s financial health.

• Ratio analysis

– It is a technique for analyzing the relationship between two items from a company’s financial statements for a given period.

– calculating & interpreting financial ratios taken from financial reports to assess a firm.

6.1. Introduction– Most of the accounting ratios are derived from the financial statements:

balance sheet; P & L account, and cash flow statement.

– Besides Balance Sheet, P & L Account, and Cash Flow Statement. There are other Managerial Accounting Reports, e.g.: sales report , production costs reports , operation costs reports , suppliers accounts , clients accounts and other detailed financial reports

Accounting ratios analysis

6.1. Introduction

• Types of common Financial Ratios– Profitability

– Liquidity

– Capital Structure

– Shareholder ratios

– Efficiency

Case: ABC Co. Balance SheetAssets:Current assets

Cash $128,000Accounts receivable $9,900Less: Allowance for doubtful accounts –900 9, 000Merchandise inventory 4,000Raw materials inventory 2,000Work-in-process inventory 14,000Finished goods inventory 13,000Supplies inventory 600Prepaid rent 12,000Prepaid insurance 5,000

Total current assets $190,600

ABC Co. Balance SheetProperty, plant, and equipment

Administrative equipment $ 5,000Selling furniture and fixtures 8,000Production equipment 89,000 $102,000Less: Accumulated depreciation – 18,000

Total property, plant, and equipment $ 84,000

Intangible assetsPatents $ 10,00Copyrights 600Trademarks 1,400

Total intangible assets $ 12,000Total assets $288,000

ABC Co. Balance SheetLiabilities and stockholders’ equity:Current liabilities

Accounts payable $ 6,000Other accounts payable 12,000Interest payable 6,000Payroll taxes payable 1,400Sales taxes payable 600Income taxes payable 42,000Current portion of long-term note payable 15,000Total current liabilities $ 83,000

Long-term liabilities:Note payable – Vail National Bank $ 60,000Less: Current portion 15,000Total long-term liabilities 45,000

Total liabilities $128,000

ABC Co. Balance SheetStockholders’ equity

Paid-in capital:Common stock, $10 par value, 100,000 shares authorized, 4,000 shares issued and outstanding $ 60,000Paid-in capital in excess of par – common stock 40,000

Total paid-in capital $100,000Retained earnings 59,000

Total stockholders’ equity 159,000Total liabilities and stockholders’ equity $288,000

ABC Co. P&L AccountNet sales $527,000Cost of goods sold 296,000Gross profit $231,000Selling expenses $48,000Administrative expenses 73,00Total operating expenses 121,000Operating income $110,000Other revenues and expenses: Interest revenue $ 600 Interest expense (6,000)Total other revenues and expenses (5,400)Income before income taxes $105,000Less Income taxes 42,000Net income $ 63,000Earnings per share $ 15.75

6.2 Profitability• Profitability is the ease with which a company generates

income• Profitability ratios measure a firm’s past performance and

help predict its future profitability level• Common parameters for measuring Profitability:

– 1. Return on Assets (ROA)– 2. Return on Equity (ROE) – 3. Profit margin before income tax– 4. Profit margin after income tax– 5. Total Asset turnover– 6. Gross Profit– 7. Net Profit– 8. Return on Capital

6.2 Profitability

• 6.2.1 Return on assets (ROA):– This ratio measures how efficiently the company uses its

assets to produce profits.

ROA = Net income before taxes Total assets

In ABC Co:ROA = $105,000 36%

$288,000

6.2 Profitability• 6.2.1 Return on assets (ROA)

– (A) Profit margin before income tax• This ratio measures the percentage of income before income taxes

produced by a given level of revenue

Profit margin before income tax =PM= Net income before taxes

Sales

• In ABC Co:PM = $105,000 20%

$527,000

6.2 Profitability

• (B) Profit margin after income tax:– This ratio measures the amount of after-tax net income

generated by a dollar of sales

Profit margin after income tax = Net income after taxes Sales

– In ABC Co.PM after tax = $63,000 12%

$527,000

6.2 Profitability

• 6.2.1 Return on assets (ROA)

– (C) Total asset turnover• This ratio calculates the amount of sales produced for a given level

of assets used.

Total asset turnover = Sales

Total assets

– In ABC Co:= $527,000 = 1.83 times

$288,000

6.2 Profitability• 6.2.1 Return on assets (ROA)• Relationship among the ratios:

Return on assets = Net income before tax x Sales Sales Total assets

= (A) Profit margin x (C) Total asset turnover

– A company may have a good ROA if either• Case 1: they can achieve a high profit margin, OR• Case 2: They can a high Total asset turnover

– Which one should be preferred?

6.3 Liquidity Ratios

• 6.3 Liquidity Ratios – An liquidity describes the ease with which it can be

converted to cash.

– Liquidity ratios evaluate a firm’s ability to generate sufficient cash to meet its short-term obligations.

– Liquidity Ratios are of most interest to stockholders, long-term creditors, and company management.

6.3 Liquidity Ratios• 6.3.1. Current ratio

– This ratio measures the company’s ability to meet its current liabilities with current assets.

Current ratio = Current assets Current liabilities

• In ABC Co,Current Ratio = $190,000 2.27

$83,000

– If too small, may not have enough assets for paying liability– If too high, the firm cannot fully leverage the loan

– Recommended value = 2 to 1 or greater

6.3 Liquidity Ratios• 6.3.3 Debt ratio:

– It measures what proportion of a company’s assets is financed by debt.

Assets = Liabilities + Owners’ equity Debt ratio = Total liabilities / Total assets

– In the ABC Co. Ltd.:• Debt ratio = $128,000 / $288,000 45%

Why is some amount of debt useful?

6.3 Liquidity Ratios• 6.3.4 Coverage ratio:

– This ratio is also called the times-interest-earned ratio.– It indicates a company’s ability to make its periodic interest payments.

Coverage ratio= Earnings before interest expense and income taxes

Interest expense

In the ABC Co.:Coverage ratio = ($105,000 + $6,000) 18.5 times

$6,000

6.4 Shareholder ratios• Shareholders and investors are interested in the

shareholder ratios which shows the effectiveness of their investments– Earnings per share

– Dividend yield

– Dividend cover

– Price earnings ratio

6.4 Shareholder ratios• Earning per share

= net profit after tax and preference dividends

no. of ordinary shares in issueABC Co, P&L Account

Net sales $527,000Cost of goods sold 296,000Gross profit $231,000Selling expenses $48,000Administrative expenses 73,00Total operating expenses 121,000Operating income $110,000Other revenues and expenses: Interest revenue $ 600 Interest expense (6,000)Total other revenues and expenses (5,400)Income before income taxes $105,000Less Income taxes 42,000Net income $ 63,000Earnings per share $ 15.75

– E.g. in ABC Co.• Earning per share =

63000 / 4000 = $15.75

6.4 Shareholder ratios

• Dividend yield

= Gross dividend per share

market price per share

• Dividend cover

= Net profit after tax and preference dividends

net dividend on ordinary shares

6.5 Shareholder ratios• Price Earning ratio (P/E Ratio) = Market price

Earning per share

– It tells the “Payback” of the investment

– A P/E of 19 (times) means that the investment will be breakeven in 19 years (ignore the stock price increment)

– The reasonable P/E of a listed company is around 10-20. The P/E of a fast growth company can be over 20-30

6.6 Efficiency• “Efficiency” measures the efficiency and

effectiveness of employing the company resources, including capital, stock, debt and cash…etc.

• Important parameters are:– Net sales to working capital– Inventory Turnover– Receivable Turnover (Creditor Turnover)

6.6 Efficiency• 6.6.1. Net sales to working capital

– This ratio indicates the level of sales generated for a given level of working capital (which is ‘the money or equivalent you have to work with currently’).

Net sales to working capital = Sales (Current assets – Current liabilities)

• In ABC Company= $527,000 4.94 times

($190,000 – $83,000)

6.6 Efficiency• 6.6.2 Inventory turnover

– This ratio indicates the number of times total merchandise inventory is purchased (or finished goods inventory is produced) and sold during a period.

Inventory turnover = Cost of sales Inventory

• In the ABC Co.:– Inventory turnover = $295,000 16.5 times

($4,000 + $13,000)

• Average number of days Elevation Sports, Inc., holds its inventory = 365 / 16.5 22 days

• Thus, the shorter the number of days of inventory held (higher turnover ratio), the better - is this always true?.

6.6 Efficiency• 6.6.3. Receivables turnover (Creditor Turnover)

– It measures how quickly a company collects its accounts receivable.

Accounts receivable turnover = Net credit sales Accounts receivable

• In the ABC Co.– Net credit sales = $151,000 – $2,000 = $149,000 – Receivable turnover = $149,000 / $9,000 16 times– Average collection period = 365 / 16 23 days

• Thus, the shorter the collection period (higher turnover ratio), the better – is this always true?

6.7 Limitations of Ratio Analysis• 1. Attempting to predict the future using past results depends upon the

predictive value of the information used.

• 2. The financial statements used to compute the ratios are based on historical cost.

• 3. Figures from the balance sheet used to calculate the ratios are year-end numbers.

• 4. Different industries had different benchmarking values. It is difficult to compare the ratios of a company in one industry with those of a company in another industry.

• 5. Lack of uniformity concerning what is to be included in the numerators and denominators make comparisons extremely difficult.

Thank you!

Q&A