Accounting and Financial

Reporting
Master of Business Administration Program

1
Financial Statements Analysis
 1- Liquidity Ratios: Current Ratio
• The current ratio is one measure of a company’s ability to pay
its short-term obligations in the near future.
Current Assets
Current Ratio =
Current Liabilities

• Current Ratio = 708 / 540 = 1.31

• This means that this company has $1.31 in current assets for
every $1 in current liabilities, or we could say that the
company has its current liabilities covered 1.31 times over.
 1- Liquidity Ratios: Current Ratio
• To a creditor, particularly a short-term creditor such as a supplier, the
higher the current ratio, the better. To the firm, a high current ratio
indicates liquidity, but it also may indicate an inefficient use of cash and
other short-term assets.
• Absent some extraordinary circumstances, we would expect to see a
current ratio of at least 1.
• A current ratio of less than 1 would mean that net working capital (current
assets less current liabilities) is negative. This would be unusual in a
healthy firm, at least for most types of businesses.
• Finally, note that an apparently low current ratio may not be a bad sign for
a company with a large reserve of untapped borrowing power.
1- Liquidity Ratios: Acid-Test Ratio
• Current ratio is useful in assessing a company’s ability to pay current
liabilities.
• But, inventory is often the least liquid current asset. It’s also the one
for which the book values are least reliable as measures of market
value because the quality of the inventory isn’t considered. Some of
the inventory may later turn out to be damaged, obsolete, or lost.
• Therefore, Relatively large inventories are often a sign of short-term
trouble. The firm may have overestimated sales and overbought or
overproduced as a result. In this case, the fi rm may have a
substantial portion of its liquidity tied up in slow-moving inventory.
• Another measure can be used to assess the company’s ability to pay
its current liabilities, which is the acid-test ratio (or quick ratio).
• It differs from the current ratio by excluding less liquid current assets
such as inventory.
1- Liquidity Ratios: Acid-Test Ratio
Acid-Test Ratio Current Assets - Inventory
=
(Quick Ratio) Current Liabilities

• Acid-Test Ratio = (708 - 422) / 540 = 0.53

• The quick ratio is quite a bit lower than the current ratio, so inventory
seems to be an important component of current assets.
•• AA rule
rule of
of thumb
thumb is is that
that the
the acid-test
acid-test ratio
ratio should
should have
have aa value
value near,
near, or
or higher
higher
than,
than, 1.0
1.0 toto conclude
conclude that that aa company
company is is unlikely
unlikely to to face
face near-term
near-term liquidity
liquidity
problems.
problems.
•• AA value
value much
much lessless than
than 1.01.0 raises
raises liquidity
liquidity concerns
concerns unless
unless aa company
company can can
generate
generate enough
enough cashcash from
from inventory
inventory sales
sales or
or ifif much
much of of its
its liabilities
liabilities are
are not
not
due
due until
until late
late in
in the
the next
next period.
period.
•• Similarly,
Similarly, aa value
value slightly
slightly larger
larger than
than 1.0
1.0 can
can hide
hide aa liquidity
liquidity problem
problem ifif payables
payables
are
are due
due shortly
shortly and
and receivables
receivables are are not
not collected
collected until
until late
late in
in the
the next
next period.
period.
Liquidity Ratios: Determinants of Liquidity
Needs
• Large enterprises generally have well established relationships with banks that
can provide lines of credit and other short-term loan products in the event that
the firm has a need for liquidity.
• Smaller firms may not have the same access to credit, and therefore they tend to
operate with more liquidity.
2- Long-Term Solvency Measures:
• Long-term solvency ratios are intended to address the firm’s long-run
ability to meet its obligations or, more generally, its financial leverage.
• These ratios are sometimes called financial leverage ratios or just
leverage ratios .
• There are three commonly used measures of financial leverage with
some variations.
2- Long-Term Solvency Measures: Total Debt
Ratio
• Companies finance their assets with either liabilities or equity. A
company that finances a relatively large portion of its assets with
liabilities is said to have a high degree of financial leverage.
• Higher financial leverage involves greater risk because liabilities must be
repaid and often require regular interest payments (equity financing
does not).
• We determine a company’s ability to pay its debts (liabilities) using the
total debt ratio.

Total Debt Ratio = Total Debt

Total Assets

• A higher ratio indicates that there is greater probability a company will

not be able to pay its debts in the future.
 3- Asset Management (Turnover or Utilization)
Measures: Inventory Turnover and Days’ Sales in
Inventory
• These ratios are intended to measure how efficiently, or intensively, a firm uses its assest to generate
sales. Let’s first measure how fast we sell our products;

Cost of Goods Sold

Inventory Turnover =
Inventory
• Inventory Turnover = 1344 / 422 = 3.2 times
• This means that we sold off, or turned over, the entire inventory 3.2 times over the year. As long as we
are not running out of stock and thereby forgoing sales, the higher this ratio is, the more efficiently we
are managing inventory.
• Inventory turnover can be computed using either ending inventory or average inventory when you
have both beginning and ending figures. It is important to be consistent with whatever benchmark you
are using to analyze the company’s strengths or weaknesses.
• It is also important to consider seasonality in sales. If the balance sheet is prepared at a time when
there is a large inventory build-up to meet seasonal demand, then the inventory turnover will be
understated and you might believe that the company is not performing as well as it is. On the other
hand, if the balance sheet is prepared when inventory has been drawn down due to seasonal sales,
then the inventory turnover would be overstated and the company may appear to be doing better than
it really is. Averages using annual data may not fix this problem. If a company has seasonal sales, you
may want to look at quarterly averages to get a better indication of turnover.
3- Asset Management (Turnover or Utilization)
Measures: Inventory Turnover and Days’ Sales in
Inventory
• If we know that we turned our inventory over 3.2
times during the year, we can immediately figure
out how long it took us to turn it over on average.
The result
Days’ is thein average
Sales Inventory =days’ sales in inventory :
365
Inventory Turnover

• Days’ Sales in Inventory = 365 / 3.2 = 114 days

• This tells us that, roughly speaking, inventory sits
114 days on average before it is sold.
3- Asset Management (Turnover or Utilization) Measures:
Receivables Turnover and Days’ Sales in Receivables
• Also we may need to know how fast we collect on our sales.

Sales
Receivables Turnover =
Accounts Receivable
• Receivables Turnover = 2311 / 188 = 12.3 times
• Loosely speaking, we collected our outstanding credit accounts and lent the
money again 12.3 times during the year.
• Technically, the sales figure should be credit sales. This is often difficult to
determine from the income statements provided in annual reports. If you use
total sales instead of credit sales, you will overstate your turnover level. You
need to recognize this bias when credit sales are unavailable, particularly if a
large portion of the sales are cash sales.
• As with inventory turnover, you can use either ending receivables or an average
of beginning and ending.
• You also run into the same seasonal issues as discussed with inventory.
3- Asset Management (Turnover or Utilization) Measures:
Receivables Turnover and Days’ Sales in Receivables
• Receivables turnover ratio makes more sense if we convert it to days;
Days’ Sales in Receivables = 365
(Average Collection Period “ACP) Receivables Turnover
• Days’ Sales in Receivables = 365 / 12.3 = 30 days
• This means that, on average, we collect on our credit sales in 30 days.
• Probably the best benchmark for days’ sales in receivables is the
company’s credit terms. If the company offers a discount (1/10 net 30),
then you would like to see days’ sales in receivables less than 30. If the
company does not offer a discount (net 30), then you would like to see
days’ sales in receivables close to the net terms. If days’ sales in
receivables is substantially larger than the net terms, then you first need
to look for biases, such as seasonality in sales. If this does not provide an
explanation for the difference, then the company may need to take
another look at its credit policy (who it grants credit to and its collection
procedures).
Average Collection Period Differences Acorss
Industries
• Notice that there are vast differences across industries in the average collection
periods.
• Companies in the building materials, grocery, and merchandise store industries
collect in just a few days, whereas firms in the computer industry take roughly
two months to collect on their sales.
• The difference is primarily due to the fact that these industries serve very
different customers.
3- Asset Management (Turnover or
Utilization) Measures: Total Assets Turnover
• Moving away from specific accounts like inventory or receivables, we can
consider an important “big picture” ratio,

Sales
Total Assets Turnover (TATO) =
Total Assets

• Total Asset Turnover (TATO)= 2311 / 3588 = .64 times

• This means that we turned over total assets 0.64 times over the year. This
also means that for every dollar in assets, we generated $.64 in sales. It is
usual for TATO < 1, especially if a firm has a large amount of fixed assets.
• We can also calculate the period of time a company takes to turn its assets
over completely. For example; if you find that a particular company
generates $.40 in annual sales for every dollar in total assets. How often
does this company turn over its total assets?
• The total asset turnover here is .40 times per year. It takes 1/.40 2.5 years
to turn assets over completely (or 365/.4=912.5 Days; equivalent to
912.5/365=2.5 years).
Assets Turnover Differences Across Industries
• Note that the grocery business turns over assets faster than any of the other
industries listed.
• That makes sense because inventory is among the most valuable assets held by
these firms, and grocery stores have to sell baked goods, dairy products, and
produce quickly or throw them away when they spoil.
• On average, a grocery stores has to replace its entire inventory in just a few days
or weeks, and that contributes to the rapid turnover of the firms total assets.
4- Profitability Measures
• Profitability ratios are intended to measure how efficiently the
firm uses its assets and how efficiently the firm manages its
operations. Three main profitability measures are probably
considered the best-known and most widely used of all
financial ratios;
1. Profit Margin,
2. Return on Assets (ROA), and
3. Return on Equity (ROE).
4- Profitability Measures: Profit Margin Ratio
• The focus in the first measure is on the bottom line—net income. So we calculate profit
margin, which is a measure of operating efficiency. It measures how well the firm controls
the costs required to generate the revenues. It tells how much the firm earns for every dollar
in sales
Net Income
Profit Margin =
Sales
• Profit Margin (PM) = 363 / 2311 = 15.7%
• This means that the firm earns $0.157 (around 16 cents) for each dollar in sales.
• All other things being equal, a relatively high profit margin is obviously desirable. This
situation corresponds to low expense ratios relative to sales. But, other things are often not
equal.
• Profit margins are very different for different industries. Grocery stores have a notoriously
low profit margin, generally around 2 percent. In contrast, the profit margin for the
pharmaceutical industry is about 18 percent.
• You can also compute the gross profit margin and the operating profit margin.
GPM = (Sales – COGS) / Sales
OPM = EBIT / Sales
 4- Profitability Measures: Return on
Assets (ROA)
• Return on assets is a measure of profit per dollar of assets, sometimes called
return on investments (ROI)

Net Income
Return on Assets =
Total Assets
(ROA)
• Return on Assets (ROA) = 363 / 3588 = 10.1%
• This means that the company is able to generate 10.1% profit for every dollar
invested in assets.
• ROA is sometimes referred to as ROI (return on investment). As with many of
the ratios, there are variations in how they can be computed. The most
important thing is to make sure that you are computing them the same way as
the benchmark you are using.
 4- Profitability Measures: Return on
Equity (ROE)
• Return on equity is a measure a measure of how the stockholders fared
during the year. Because benefiting shareholders is our goal, ROE is, in an
accounting sense, the true bottom-line measure of performance.

Net Income
Return on Equity =
Total Equity
(ROE)
• ROE will always be higher than ROA as long as the firm has debt (and ROA is
positive). The greater the leverage, the larger the difference will be. ROE is
often used as a measure of how well management is attaining the goal of
owner wealth maximization. The DuPont identity is used to identify factors
that affect the ROE.
• Return on Equity (ROE) = 363 / 2591 = 14.0%
• This means that for every dollar in equity, Prufrock generated 14 cents in
profit; but, this is correct only in accounting terms.
• Note that the ROA and ROE are returns on accounting numbers. As such, they
are not directly comparable with returns found in the marketplace.
Using Financial Ratios: Interested
Parties
• Current and prospective shareholders are interested in the
firm’s current and future level of risk and return, which
directly affect share price.
• Creditors are interested in the short-term liquidity of the
company and its ability to make interest and principal
payments.
• Management is concerned with all aspects of the firm’s
financial situation, and it attempts to produce financial
ratios that will be considered favorable by both owners and
creditors.
Using Financial Ratios: Types of Ratio
Comparisons
• Ratios need to be compared to a benchmark.
• Cross-sectional analysis, or peer group analysis, is the
comparison of different firms’ financial ratios at the same point
in time; involves comparing the firm’s ratios to those of other
firms in its industry or to industry averages
• Benchmarking is a type of cross-sectional analysis in which the
firm’s ratio values are compared to those of a key competitor or
group of competitors that it wishes to emulate.
• Comparison to industry averages is also popular.
• Examples of peer group analysis include; comparisons to a set
of primary competitors by computing averages for these
competitors, or comparisons to aspirant group (the top firms,
not the average firms, in an industry).
 Using Financial Ratios: Types of
Ratio Comparisons (cont.)
• Another tool of comparison could be time-series analysis, or time trend analysis,
is the evaluation of the firm’s financial performance over time using financial
ratio analysis.
• Comparison of current to past performance, using ratios, enables analysts to
assess the firm’s progress.
• Developing trends can be seen by using multiyear comparisons.
• The most informative approach to ratio analysis combines cross-sectional and
time-series analyses.
Combined Analysis: Combined Cross-Sectional and Time-Series
View of a Company’s Average Collection Period (2009-2012)
 EN
D
OF
LE
CT
UR
E

u
Yo
nk
a
Th