Week 8:
Financial Statement
Analysis &
Performance
Introduction
Analysis of financial statements for
decision-making
Assessment of a business’ past, present
& anticipated future.
To identify the weaknesses & strengths.
Financial ratios are tools to do this.
Liquidity ratios
Activity ratios
Gearing ratios
Profitability ratios
Liquidity Ratios
Measures whether a firm can repay
its bills, or financial obligations
(debts) on time.
Focus is on cash or near cash assets
– more readily available to settle
debts (especially current debts).
LO 2
Current Ratio (CR)
Sometimes called the working capital
ratio or bankers’ ratio
Measures a company’s ability to pay its
current liabilities.
Computed as follows:
Current Assets
Current Ratio =
Current Liabilities
The higher the CR, the more liquid the
firm’s position.
Rule of thumb, CR should be > 2.
LO 2
Current Ratio
The current ratio for Lincoln Company is
computed below.
2012
Current assets 2011$550,000 $533,000
Current liabilities$210,000 $243,000
Current ratio 2.6 2.2
$550,000 $533,000
$210,000 $243,000
LO 2
Quick Ratio (QR)
Measures the “instant” debt-paying
ability of a company
Sometimes called acid-test ratio.
It is computed as follows:
Quick Assets
Quick Ratio =
Current Liabilities
Quick assets are cash
and other assets that
can be easily
converted to cash.
Does not include
inventory &
prepayments.
LO 2
Quick Ratio (QR)
Current Assets – Inventory -
Quick Ratio =
Prepayments
Current Liabilities
Better measurement of liquidity as
inventory & prepayments are illiquid,
i.e. cannot be converted to cash
quickly.
Rule of thumb, QR should be > 1.
LO 2
Quick Ratio
The quick ratio for Lincoln Company is
computed below.
Quick assets: 2012 2011
Cash $ 90,500 $ 64,700
Temporary Investments 75,000 60,000
Accounts receivable (net) 115,000 120,000
Total quick assets $280,500 $244,700
Current liabilities $210,000 $243,000
Quick ratio 1.3 1.0
$280,500
$210,000 $244,700
$243,000
LO 2
Working Capital
= Excess of current assets over
current liabilities.
Note: not a ratio.
Often used to evaluate a company’s
ability to pay current liabilities.
Computed as follows:
Working Capital = Current Assets – Current
Liabilities
The larger the figure, the better.
Activity Ratios
Measures how effectively a firm
uses its assets to generate
revenue.
Also called efficiency, turnover or
business asset management
ratios.
LO 2
Inventory Turnover
The relationship between the volume of
goods (merchandise) sold and inventory.
Assesses the efficiency of a firm in
managing its inventory.
Tells how many times the inventory is
replaced/sold within an accounting
period
The higher the figure, the better – sales
are increasing & inventory levels are low.
Computed as follows:
Cost of Goods
Inventory Sold
Turnover =
Average Inventory
LO 2
Inventory Turnover
Lincoln’s inventory balance at the
beginning of 2011 is $311,000.
2012 2011
Cost of goods sold $1,043,000 $820,000
Inventories:
Beginning of year $ 283,000 $311,000
End of year 264,000 283,000
Total $ 547,000 $594,000
Average (Total ÷ 2) $ 273,500 $297,000
Inventory turnover 3.8 2.8
$1,043,000
$820,000
$273,500
$297,000
LO 2
Number of Days’ Sales in
Inventory
A rough measure of the length of
time it takes to purchase, sell, and
replace the inventory.
Computed as follows:
Number of Days’ Average
=
Sales in Inventory Inventory
Average Daily
Cost of Goods Sold
(Cost of Sales)
Cost of Goods Sold/Cost of
Sales
365
LO 2
Number of Days’ Sales in
Inventory
The number of days’ sales in inventory
for Lincoln Company is computed below.
2012 2011
Average Inventory $273,500 $297,000
Average daily cost of goods sold$2,858 $2,247
Number of days’ sales in inventory 95.7 13
$273,500 $297,000
$2,858 $2,247
LO 2
Accounts Receivable Turnover
= The relationship between sales and
accounts receivable.
Collecting accounts receivable as quickly as
possible improves a company’s solvency.
The higher the ratio, the more effective the
firm in collecting from its credit customers.
Computed as follows:
Net Sales
Accounts Receivable
Turnover = Average
Accounts
Receivable
LO 2
Accounts Receivable Turnover
The accounts receivable turnover for
Lincoln Company is computed below.
2012 2011
Net sales $1,498,000 $1,200,000
Accounts receivable (net):
Beginning of year $ 120,000 $ 140,000
End of year 115,000 120,000
Total $ 235,000 $ 260,000
Average (Total ÷ 2) $ 117,500 $ 130,000
Accounts receivable turnover 12.7 9.2
$1,498,000 $1,200,000
$117,500 $130,000
LO 2
Number of Days’ Sales in
Receivables
An estimate of the length of time (in days)
the accounts receivable have been
outstanding.
The fewer number of days, the more
efficient the firm is at collecting
receivables. Average
Accounts
Computed
Number of Days’
as follows:= Receivable
Sales in
Receivables Average Daily
Sales
Net
Sales
365
LO 2
Number of Days’ Sales in
Receivables
The number of days’ sales in
receivables for Lincoln Company is
computed below.
2012 2011
Average accounts receivable
(Total accounts receivable ÷ 2) $ 117,500
$ 130,000
Net sales $1,498,000 $1,200,000
Average daily sales
(Net sales ÷ 365) $ 4,104 $ 3,288
Number of days’ sales in receivables 28.6 39
$117,500
$130,000
$4,104
$3,288
Fixed Assets/Non-Current AssetsLO 3
Turnover Ratio
Measures how effectively the firm
uses its non-current assets to
generate sales.
The higher the ratio, the more
efficient the firm is in using its non-
current assets to generate sales.
Computed asAssets
Non-Current follows:
=
Net Sales
Turnover Non-Current
Assets (net)
Gross sales –
Non-current assets –
sales returns -
provision for
discounts depreciation
LO 3
Total Assets Turnover Ratio
A measure that shows how effectively
a company utilizes its assets – how
much sales a firm is able to generate
from money invested in total assets.
The higher the ratio, the better.
The ratio is computed as follows:
Net Sales
Total Assets Turnover =
Ratio Average Total
Assets
LO 3
Total Assets Turnover Ratio
The ratio of net sales to assets for Lincoln
Company is computed below.
2012 2011
Net sales $1,498,000 $1,200,000
Total assets:
Beginning of year $1,053,000 $1,010,000
End of year 1,044,500 1,053,000
Total $2,097,500 $2,063,000
Average (Total ÷ 2) $1,048,750 $1,031,500
Ratio of net sales to assets 1.4 1
$1,498,000
$1,048,750 $1,200,000
$1,031,500
Gearing Ratios
Measures how a firm uses outside
funds (liabilities) to finance its
assets.
Also indicates whether a firm can
pay the interest on the use of
outside funds & repay the loan
amounts.
Also called leverage or debt
management ratios.
LO 2
Debt Ratio
Measures the percentage of total liabilities to
the total assets of the firm.
Computed as follows:
Debt Ratio Total Liabilities x 100
=
The lower the ratio, theTotal Assets
better
the less a firm is financed by outside parties.
the higher the firm’s ability to obtain more outside
funds when needed.
High ratio
Funds borrowed can be used to generate higher
profits (but at higher risk)
LO 2
Times Interest Earned Ratio
Measures the number of times a firm
is able to repay fixed interest from its
net operating profits.
Also called interest cover ratio.
The higher the ratio, the better
More able to repay interest charges.
LO 2
Times Interest Earned Ratio
It is computed as follows:
Net operating
Times Interest profit
=
Earned Ratio
Interest Expense
Earnings before
interest and tax
LO 2
Times Interest Earned Ratio
The number of times interest charges are
earned for Lincoln Company is computed
below.
2012 2011
Income before income tax $162,500 $134,600
Add interest expense 6,000 12,000
Amount available to meet
interest charges $168,500 $146,600
Number of times interest
charges earned 28.1
12.2
$168,500
$146,600
$6,000
$12,000
LO 2
Debt to Equity Ratio
Measures long term debt to
shareholders’ equity.
Indicates the margin of safety for
creditors.
The lower the ratio, the better for the
firm.
Computed asRatio
Debt to Equity follows:
=
Long term
debts
Shareholders’
Equity
LO 2
Debt to Equity Ratio
The ratio of liabilities to shareholders’ equity
for Lincoln Company is computed below.
2012 2011
Long term debts $310,000 $443,000
Shareholders’ equity $829,500 $787,500
Debt to Equity Ratio 0.4 0.6
$310,000
$443,000
$829,500
$787,500
Profitability Ratios
Measures the firm’s ability to produce
profits from its assets.
The higher the ratios, the better.
Also an indication of firm’s efficiency.
Can be divided into:
Profitability ratios based on sales (gross profit
margin, net profit margin, operating profit
margin)
Profitability ratios based on assets/resources
(operating profit to total assets ratio, return on
assets ratio, return on common equity)
LO 2
Gross Profit Margin
Measures the profitability of a firm
over a period.
Indicates how much profit is made
per sales generated.
Computed as follows:
Gross Profit Margin Gross Profit x
= 100
Net sales
LO 2
Net Profit Margin
Indicates what is available to owners
from its net sales, after considering
all expenses.
Computed as follows:
Net Profit Net Profit x 100
=
Margin Net sales
LO 2
Operating Profit Margin
Indicates how much operating profit
is made per sales generated.
Computed as follows:
Operating Net Operating Profit x
= 100
Profit Margin
Net sales
Earnings before
interest & tax
LO 3
Operating Profit to Total Assets
Ratio
measures the amount of operating
profit obtained from utilising assets.
The higher the ratio, the more
efficient the firm has been in utilising
its assets to generate sales/profit.
It is computed as follows:
Net Operating Profit x
Operating Profit to 100
Total Assets =
Total Assets
LO 3
Return on Assets Ratio (ROA)
measures the profitability of assets
utilised.
Also known as return on investment
ratio.
The higher the ratio, the better the
return on the use of assets by the
Net Profit After Tax x
firm.
Return on Assets Ratio =
100
Computed as follows: Total Assets
Return on Common Equity/ LO 3
Return on Capital Employed
(ROCE)
measures the net profit against the
amount invested by
shareholders/owners.
Indicates what shareholders/owners
earn from their investments in the
business.
Net Profit After Tax – Preferred
It is computed as
Return on Common Equity/
= follows: Dividends
Capital Employed
Common Equity/Capital
Return on Common Equity/ LO 3
Return on Capital Employed
(ROCE)
Lincoln Company had $150,000 of 6%
preferred stock outstanding on December 31,
2012 and 2011.
Thus, preferred dividends of $9,000 ($150,000
x 6%) are deducted from net income.
Lincoln’s common shareholders’ equity is
determined as follows:
(continued)
Return on Common Equity/ LO 3
Return on Capital Employed
(ROCE)
2012 2011
Net income $ 91,000 $ 76,500
Less: preferred dividends 9,000 9,000
Total $ 82,000 $ 67,500
Common shareholders’ equity:
Beginning of year $ 637,500 $ 600,000
End of year 679,500 637,500
Total $1,317,000 $1,237,500
Average (Total ÷ 2) $ 658,500 $ 618,750
Return on common equity 12.5% 10.9
$82,000 $67,500
$658,500 $618,750
LO 3
Earnings per share (EPS)
Indicates the net income per share
Earnings per share (EPS) =Net income – Preferred Dividends
Number of shares
LO 3
Price earnings ratio (P/E ratio)
Indicates the firm’s future earnings
prospects
E.g. P/E ratios: A 17, B 24, C 12, D 8.
Market price of A is 17 times more
than its earnings
B has the best future earnings
prospects, as viewedMarket
by investors
price per share
P/E ratio =
Earnings per share (EPS)
LO 3
Dividends per share (DPS) &
dividend yield
DPS = dividends/number of shares
Dividend yield = DPS/market price
per share
Rate of return to investors in terms of
cash dividends
Expressed in percentage
LO 3
Inter- & Intra-Company
Comparisons
Inter-company comparisons
against industry averages/norms
Obtained by averaging out the ratios of a
good sample of companies in the industry
Firm can benchmark itself accordingly
Intra-company comparisons
Trend analysis – over a period of time
To see if business has improved/
deteriorated
To be used to formulate future strategy