Lecture 9

 Financial Statements Analysis

◦ Common Size Analysis
◦ Ratio Analysis
 Short-term solvency, or liquidity, ratios
 Current ratio
 Acid Test (Quick) ratio
 Cash ratio
 Ratio Analysis (cont.)
◦ Long-term solvency, or financial leverage, ratios
 Total Debt ratio
 Interest Coverage ratio
 Cash Coverage Ratio
◦ Asset management, or turnover, ratios
 Inventory Turnover & Days’ Sale in Inventory
 Receivables Turnover & Average Collection Period
 Payables Turnover
 Total Assets Turnover & Capital Intensity Ratio
◦ Profitability ratios
 Profit Margin
 Return on Assets
 Return on Equity
Assets 20X1 20X2
Current Assets:

Cash 84 98

Accounts Receivable 165 188

Inventory 393 422

Total Current Assets 642 708

Fixed Assets

Net Plant and Equipment 2,731 2,880

Total Assets 3,373 3,588

Liabilities and Equity 20X1 20X2
Current Liabilities:
Accounts Payable $ 312 $ 344
Notes Payable 231 196
Total Current Liabilities 543 540
Long-term debt 531 457
Common stock and paid-in 500 550
surplus
Retained Earnings 1,799 20,41
Total Shareholders Equity 2,299 2,591
Total Liabilities and Equity 3,373 3,588
Net Sales $ 2,311
Cost of Goods Sold (1,344)
Depreciation (276)
Earnings before interest and taxes 691
Interest (141)
Taxable Income 550
Taxes (187)
Net Income 363
Dividends 121
Retained Earnings 242
Current Events
 Suppose a firm buys some inventory. What

would happen in this case?

◦ Nothing happens to current ratio. Because in this
scenario, one current asset (cash) goes down while
another current asset (inventory) goes up. Total
current assets are unaffected.
Current Events
 What happens if a firm sells some merchandise?

◦ Current ratio would usually rise because inventory is

shown at cost and sale would normally be at
something greater than cost (difference is markup).
◦ So, the increase in either cash or receivables is greater
than the decrease in inventory.
◦ This increases current assets and current ratio rises.
Current Events
 A firm wants to payoff some of its suppliers and

creditors. What would happen to current ratio?

◦ Current ratio moves away from 1. if it is greater than 1 it
will get bigger. But if it is less than 1, it will get smaller.
◦ Suppose a firm has $4 in current assets and $2 in current
liabilities for a current ratio of 2. and uses $1 in cash to
reduce current liabilities, then new current ratio is ($4-
1) / ($2-1) = 3
◦ Reversing the situation to $2 in current assets and $4 in
current liabilities, the change will cause current ratio to
fall to 1/3 from 1/2
 These ratios are intended to address the
firm’s long-run ability to meet its obligations,
or its financial leverage.
 This ratio takes into account all debts of all
maturities to all creditors. It is computed as
Total Assets – Total Equity
Total Debt Ratio=
------------------------------------
Total Assets
 For A2Z Corporation

$3,588 – 2,591
Total Debt Ratio= ---------------------- =
0.28 times
$3,588
 So A2Z uses 28% debt. Whether this is high or
low, or whether it even makes any difference
depends on whether or not capital structure
matters.
 A2Z has 28% debt against total assets, thus
there is 72% equity against total assets.
 Here we draw two variations out of total debt

ratio
◦ Debt-equity ratio
◦ Equity multiplier
 Debt–Equity ratio = Total Debt / Total Equity
= 28% / 72% = 0.39 times

 Equity Multiplier = Total Assets / Total Equity

= 100% / 72% = 1.39 times
OR
= 1 + Debt-Equity ratio = 1.39
times
 Also known as Times Interest Earned (TIE) ratio,
refers to the ability of the firm to cover is interest
obligations.
Earning before Interest &
Taxes
Interest Coverage ratio =
-----------------------------------------
Interest
 For A2Z corporation:
= $691 / $141 = 4.9 times
 A problem with Interest Coverage Ratio is that it is
based on Earnings before Interest and Taxes (EBIT)
which is not really a measure of cash available to
pay interest.
 The reason is that depreciation, a non-cash
expense has been deducted out. So we use:
EBIT + Depreciation
Cash Coverage ratio =
-----------------------------------------
Interest

= $691 + 276 = $967 = 6.9

times
$141 $141
 The measures in this section are sometimes
called Asset Utilization Ratios. These are
intended to describe how efficiently or
intensively a firm uses its assets to generate
sales.
 Inventory turnover can be calculated as:
Cost of goods Sold
Inventory Turnover ratio =
--------------------------------
Inventory
 For A2Z, ITR would be:
$1,344
= ---------------- = 3.2
times
$422
 So A2Z sold off or turned over the entire inventory
3.2 times. As long as stock-out and foregoing
sales situation doesn’t arise, the higher this ratio
is, the more efficiently inventory is being managed
If we know sales were turned over 3.2 times
during the year, we can calculate easily how
long it took to turnover on average.
365 days
Days’ Sales in Inventory =
--------------------------------
Inventory Turnover
 For A2Z:
365
= ----------- = 114
days
3.2
 So inventory stays for just less than 4 months
before being sold or it would take 114 days to
sell off current inventory.
 Now we take a look on how fast we collect on the
sales of inventory.
Sales
Receivables Turnover =
-------------------------------
Accounts Receivables
 For A2Z:
$2,311
= ---------- = 12.3 times
$188
 So A2Z collected its outstanding credit accounts
and reloaned the money 12.3 times during the
year. (Assuming all the sales are credit sales. If not, we
use only credit sales for this ratio)
 365 days
Days’ Sales in Receivables =
-------------------------------
Receivables
Turnover

 For A2Z:
365
= ----------- = 30
days
12.3
 So A2Z collects on its credit sales in a month, or

the firm has 30 days’ worth of sales uncollected.

This ratio is also called Average Collection Period
 It describes a how long does the firm take to
pay its bills, and is computed as:
Cost of Goods Sold
Payables Turnover =
-------------------------------
Accounts payables
$1,344
= ------------ = 3.9 times
$344
 So days it took to turnover the payables are:
365
= ----------- = 94
days
3.9
 This figure is very significant to the current as
well as potential creditors of A2Z.
 Ratio Analysis
◦ Long-term solvency, or financial leverage,
ratios
 Total Debt ratio
 Interest Coverage ratio
 Cash Coverage Ratio
◦ Asset management, or turnover, ratios
 Inventory Turnover & Days’ Sale in Inventory
 Receivables Turnover & Average Collection
Period
 Payables Turnover
 Ratio Analysis
◦ Asset management, or turnover, ratios
(Cont.)
 Total Assets Turnover & Capital Intensity Ratio
◦ Profitability ratios
 Profit Margin
 Return on Assets
 Return on Equity
◦ Market value ratios
 Price-Earnings Ratio
 Market-to-Book Ratio
◦ Du Pont Identity