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Why Ratio Analysis ?
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We should Consider the following
A single ratio does not generally provide sufficient
information from which to judge the overall
performance of the firm. A group of ratios should be
used
The financial statements being compared should be
dated at the same point in time during the year. To
avoid the effect of seasonality.
Use audited financial statements.
Compare financial statements with similar accounting
treatments.
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Types of Ratio Comparison
Cross Sectional
The comparison of different Companies’ financial
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Dollar and Percentage Changes
Dollar Change:
Percentage Change:
Percent Base Period
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Analyzing Liquidity
The liquidity of a business firm is measured by
its ability to satisfy its short-term obligations as
they come due.
Current Ratio
Cash Ratio.
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Analyzing Liquidity: Current Ratio
It is a measure of liquidity calculated by dividing the
firm’s current assets by its current liabilities
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Analyzing Liquidity: Quick (Acid-test) Ratio
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Analyzing Liquidity: Net Working Capital
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Liquidity Measures
Note that for all three liquidity measures; the higher the
value, the more liquid the firm is typically considered to
be.
However this low risk sacrifices profitability
Current assets are less profitable/productive than
fixed assets
Current liabilities are a less expensive financing
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Asset Management
Activity ratios are used to measure the speed in which
various accounts are converted into sales or cash.
Inventory Turnover
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Asset Management: Inventory Turnover
firm
Inventory Days on Hand = 365 / Inventory Turnover
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Asset Management: Average Collection
Period
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Asset Management: Average payment
Period
It is the average amount of time needed to pay accounts
payable
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Asset Management: Fixed Assets Turnover
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Asset Management: Total Assets Turnover
It indicates the efficiency with which the firm uses all its
assets to generate sales
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Analyzing Debt
The debt position of a firm indicates the amount of other
people’s money being used in attempting to generate
profits.
Generally, the more debt a firm uses in relation to its
total assets, the greater its financial leverage.
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Analyzing Debt: Debt Ratio
It measures the proportion of total assets financed by the
firm’s creditors
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Analyzing Debt: Debt-Equity ratio
It measures the ratio of long-term debt to stockholder’s
equity
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Analyzing Debt: Times Interest Earned
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Analyzing Profitability
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Gross Profit Margin
It measures the percentage of each sales dollar
remaining after the firm paid for its goods
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Operating Profit Margin
It measures the percentage of profit earned on each sales
dollar before interest and taxes
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Net Profit Margin
It measures the percentage of each sales dollar
remaining after all expenses, including taxes, have been
deducted
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Return on Total Assets
It measures the overall effectiveness of management in
generating profits with its available assets.
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Return on Assets (ROA)
It measures the efficiency with which a company allocates
and manages its resources.
there are tow determinants for controlling REA :
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Return on Equity
There are three determinants for controlling REO :
Profit Margin.
Asset Turnover.
Financial Leverage.
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Return on Equity
It measures the return earned on the owners’ (both preferred
and common stockholders’) investment n the firm
Return on Equity = Net income/ Stockholder’s Equity
Net income Sales Assets
ROE = __________ X ___________ X __________________
sales Assets (Shareholder's equity)
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Price/Earnings Ratio
It reflects the amount investors are willing to pay for each
dollar of the firms earnings; the higher the P/E ratio, the
greater the investor confidence in the firm
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Questions & Answers