faculty: ms. luvnica rastogi amity international business school imp website:

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Faculty: Ms. Luvnica RastogiAmity International Business SchoolImp Website: www.investorwords.comFinancial Statement AnalysisFinancial Analyst and Financial Analysis

Financial Analyst:The financial analyst can be viewed as any user of available information concerning firms who wishes to use the information for the purpose of decision making.Financial Analysis:It is the procedure the financial analyst uses to interpret the information.Financial Statement AnalysisThe art of transforming data from Financial Statements into information that is useful for informed decision making is called Financial Statement Analysis.The firm itself and outside providers of capital (creditors and investors) all undertake financial statement analysis.The type of analysis varies according to the specific interest of the party involved.Examples of External Uses of Financial Statement AnalysisTrade Creditors -- Focus on the liquidity of the firm. Their claims are short term, and the ability of the firm to pay these claims quickly is best judged by an analysis of the firms liquidity. Bondholders -- Focus on the long-term cash flow of the firm.Because the Bondholder are more interested in the cash flow ability of the firm to service Debt over a long period of time.They may evaluate this ability by analyzing the capital structure of the firm, the major sources and uses of funds, the firms profitability over time and projection of future profitability.

Shareholders -- Focus on the profitability and long-term health of the firm.They would also be concerned with the firm financial condition.

Examples of Internal Uses of Financial Statement AnalysisPlan -- Focus on assessing the current financial position and evaluating potential firm opportunities in relation to this current position.Control With respect to internal control, the financial manager is particularly concerned with the return on investment provided by the company and with the efficiency of assets management.Understand To bargain effectively for outside funds, Financial Manager need to Focus on all aspect of financial analysis for understanding how suppliers of funds analyze the firm.

Primary Types of Financial StatementsIncome StatementA summary of a firms revenues and expenses over a specified period, ending with net income or loss for the period.Balance SheetA summary of a firms financial position on a given date that shows total assets = total liabilities + owners equity.Basket Wonders Balance Sheet (Asset Side)a. How the firm stands on a specific date.b. What BW owned.c. Amounts owed by customers.d. Future expense items already paid.e. Cash/likely convertible to cash within 1 year.f. Original amount paid.g. Acc. deductions for wear and tear. Cash and C.E. $ 90 Acct. Rec.c 394 Inventories 696 Prepaid Exp d 5 Accum Tax Prepay 10 Current Assetse $1,195 Fixed Assets (@Cost)f 1030 Less: Acc. Depr. g (329) Net Fix. Assets $ 701 Investment, LT 50 Other Assets, LT 223 Total Assetsb $2,169Basket Wonders Balance Sheet (thousands) Dec. 31, 2003aBasket Wonders Balance Sheet (Liability Side)a. Note, Assets = Liabilities + Equity.b. What BW owed and ownership position.c. Owed to suppliers for goods and services.d. Unpaid wages, salaries, etc.e. Debts payable < 1 year.f. Debts payable > 1 year.g. Original investment. h. Earnings reinvested.Notes Payable $ 290 Acct. Payablec 94 Accrued Taxes d 16 Other Accrued Liab. d 100 Current Liab. e $ 500 Long-Term Debt f530 Shareholders Equity Com. Stock ($1 par) g200 Add Pd in Capital g729 Retained Earnings h 210 Total Equity $1,139 Total Liab/Equitya,b $2,169Basket Wonders Balance Sheet (thousands) Dec. 31, 2003Basket Wonders Income Statementa. Measures profitability over a time period.b. Received, or receivable, from customers.c. Sales comm., adv., officers salaries, etc.d. Operating income.e. Cost of borrowed funds.f. Taxable income.g. Amount earned for shareholders. Net Sales b $ 2,211 Cost of Goods Sold 1,599Gross Profit $ 612 SG&A Expenses c 402 EBITd $ 210 Interest Expense 59 EBT f $ 151 Income Taxes 60 EATg $ 91 Cash Dividends 38 Increase in RE $ 53Basket Wonders Statement of Earnings (in thousands) for Year Ending December 31, 2003aCross Sectional Financial Statement StudiesThere is little to be gained by analyzing the financial statements of a company for one year alone.A benchmark is needed by which to judge a companys performance.This benchmark can be obtained by comparing companies with in the same industries with other companies.This is known as a cross-sectional study.Time Series Financial Statement StudiesTo compare the accounts of one company with its own previous years. Possible to see if a company is improving in certain areas or not. This is known as a Time series study.

Use of Financial RatiosTypes of ComparisonsInternal ComparisonsExternal ComparisonsA Financial Ratio is an index that relates two accounting numbers and is obtained by dividing one number by the other.

Internal Comparisons

To compare a present ratio with past and expected future ratios for the same company is called Internal comparisons.For example to compare the Kardan 2008 ratios with Kardan 2007 and 2006 ratios that either they have improved or not.

External ComparisonThis involves comparing the ratios of one firm with those of similar firms or with industry averages.OrTo compare the ratios of one firm with those of similar firms or with industry averages at the same point in time is called External Comparisons.Similarity is important as one should compare apples to apples.Example: to compare the ratios of Kardan and Bakhtar

How a Ratio is expressed?As Percentage - such as 25% or 50% . For example if net profit is Rs.25,000/- and the sales is Rs.1,00,000/- then the net profit can be said to be 25% of the sales.As Proportion - The above figures may be expressed in terms of the relationship between net profit to sales as 1 : 4. As Pure Number /Times - The same can also be expressed in an alternatively way such as the sale is 4 times of the net profit or profit is 1/4th of the sales.Why are ratios useful?Ratios standardize numbers and facilitate comparisons.Ratios are used to highlight weaknesses and strengths.Types of Ratios(i) Liquidity Ratios(ii) Financial Leverage (Debt) Ratios(iii) Coverage Ratios(iv) Activity Ratios(v) Profitability Ratios(vi) Investment Ratios Liquidity RatiosRatios that measure a firms ability to meet short term obligations. Or It shows that Can we make required payments?

Balance Sheet RatiosLiquidity RatiosLiquidity RatiosLiquidity ratios are used to measure a firm ability to meet short term obligations.They compare short term obligations with short term (or current) resources available to meet these obligations.From these ratios, much insight can be obtained into the present cash solvency of the firm.Liquidity RatiosCurrent RatioAcid test (quick) RatioBalance Sheet RatiosLiquidity RatiosLiquidity RatiosShows a firms ability to cover its current liabilities with its current assets.Or It is the relationship between the current assets and current liabilities of a firm.

Balance Sheet RatiosCurrent RatioLiquidity RatiosCurrent Ratio

Current AssetsCurrent Liabilities

If Current Assets = Rs.1,195 and Current Liabilities = Rs.500Balance Sheet RatiosLiquidity RatiosRs.1,195Rs.500= 2.39Current RatioLooks at the ratio between Current Assets and Current LiabilitiesIdeal level? 1.5 A ratio of 2.39 would imply the firm has $2.39 of current assets to cover every $1 in current liabilitiesToo high Might suggest that too much of its assets are tied up in unproductive activities too much stock, for example?Too low - risk of not being able to pay Current liabilities.Liquidity Ratio ComparisonsBW Industry2.392.152.262.091.912.01Year200320022001Current RatioRatio is stronger than the industry average.Liquidity RatiosShows a firms ability to meet current liabilities with its most liquid assets.Or It is the ratio between Quick Current Assets and Current Liabilities.

Balance Sheet RatiosAcid test (quick) RatioLiquidity RatiosAcid-Test (Quick)

Current Assets - InvCurrent Liabilities

If Current Assets = $1,195 and Current Liabilities = $500Inventory = $696Balance Sheet RatiosLiquidity Ratios$1,195 - $696$500= 1.00Acid Test (quick) Ratio1 seen as idealIt has been argued that Inventory takes a while to convert to cash so a more realistic ratio would ignore Inventory. The omission of Inventory gives an indication of the cash the firm has in relation to its liabilities (what it owes)A ratio of 1 would imply that the firm has $1 of cash to cover every $1 in current liabilities.Again if it is too high means that the business is very liquid may be able to use the cash for other activities to increase performance.If it is too low then the business may face problems in payment of current liabilities. Some types of business need more cash than others so acid test would be expected to be higher

Liquidity Ratio ComparisonsBW Industry1.001.251.041.231.111.25Year200320022001Acid-Test RatioRatio is weaker than the industry average.Summary of the Liquidity Ratio ComparisonsStrong current ratio and weak acid-test ratio indicates a potential problem in the inventories account.Note that this industry has a relatively high level of inventories. RatioBWIndustryCurrent2.39 2.15Acid-Test 1.00 1.25Current Ratio -- Trend Analysis Comparison Acid-Test Ratio -- Trend Analysis Comparison Summary of the Liquidity Trend AnalysisThe current ratio for the industry has been rising slowly at the same time the acid-test ratio has been relatively stable.This indicates that inventories are a significant problem for BW.The current ratio for BW has been rising at the same time the acid-test ratio has been declining.Financial Leverage (Debt) RatiosShows the extent to which the firm is financed by debt.

Balance Sheet RatiosFinancial Leverage RatiosFinancial Leverage (Debt) Ratios(i). Debt-to-Equity(ii). Debt-to-Total-Assets(iii). Total Capitalization

Balance Sheet RatiosFinancial Leverage RatiosFinancial Leverage (Debt) RatiosIt is the relationship between borrowers fund (Debt) and Owners Capital (Equity). The Debt to Equity ratio is computed by simply dividing the total debt of the firm (including current liabilities) by its share holders equity.

Balance Sheet Ratios Debt-to-EquityFinancial Leverage RatiosDebt-to-Equity

Total DebtShareholders Equity

For Basket Wonders December 31, 2003If Total Debt = 1030 and Shareholders equity = 1139Balance Sheet RatiosFinancial LeverageRatios$1,030$1,139= .90 Debt-to-Equity RatioThe ratio 0.90 tells us that creditors are providing 90 cents of financing for each $1 being provided by shareholders.Creditors would generally like this ratio to be low.The lower the ratio the higher the level of the firms financing that is being provided by shareholders, and the larger the creditor cushion (margin of protection) in the event of losses.Financial Leverage Ratio ComparisonsBW Industry .90 .90 .88 .90 .81 .89Year200320022001Debt-to-Equity RatioBW has average debt utilizationrelative to the industry average.Financial Leverage (Debt) RatiosShows the percentage of the firms assets that are supported by debt financing. orIt is the relationship between borrowers fund (Debt) and total Assets.

Balance Sheet Ratios Debt-to-Total-AssetsFinancial Leverage RatiosDebt-to-Total-Assets

Total DebtTotal Assets

For Basket Wonders December 31, 2003If Total Debt = 1030And Total assets = 2169Balance Sheet RatiosFinancial LeverageRatios$1,030$2,169= .47 Debt-to-Total-Assets RatioThis ratio highlights the relative importance of debt financing to the firm by showing the percentage of the firms assets that is supported by debt financing.The 0.47 ratio shows that 47 percent of the firm assets are financed by debt and remaining 53 percent of the finance comes from shareholders equity. Once again this ratio points out that the greater the percentage of financing provided by shareholders equity, the larger the cushion of protection offered the firms creditors.In short the higher the Debt to total assets ratio, the greater the financial risk; the lower the ratio, the lower the financial risk. Financial Leverage Ratio ComparisonsBW Industry .47 .47 .47 .47 .45 .47Year200320022001Debt-to-Total-Asset RatioBW has average debt utilizationrelative to the industry average.Financial Leverage (Debt) RatiosShows the relative importance of long-term debt to the long-term financing of the firm.Total capitalization represents all long term debt and shareholders equity.

Balance Sheet Ratios Long term Debt to Total Capitalization(i.e., LT-Debt + Equity)Financial Leverage RatiosTotal Capitalization

Long Term DebtTotal Capitalization

For Basket Wonders December 31, 2003If Long term Debt = 530And LT-debt + Equity = 1669Balance Sheet RatiosFinancial LeverageRatios $530$1,669= .32(i.e., LT-Debt + Equity)This measure tells us the relative importance of long term debt to the long term financing of the firm. The 0.32 ratio shows that 32 percent of the firm total long term financing is provided by long term debt and remaining 68 percent of the finance comes from shareholders equity.

Financial Leverage Ratio ComparisonsBW Industry .32 .30 .34 .32 .33 .31Year200320022001Total Capitalization RatioBW has average long-term debt utilizationrelative to the industry average.In summary, debt ratios tell us the relative proportions of capital contribution by creditors and by owners. Coverage RatiosRatios that relates the financial charges (interest) of a firm to its ability to service or cover them.

Income Statement Ratios Coverage Ratios Coverage Ratios(i) Interest Coverage ratioIncome Statement Ratios Coverage Ratios Coverage RatiosIt Indicates a firms ability to cover interest charges. It is also called times interest earned.

Income Statement Ratios Interest Coverage Ratio Coverage RatiosInterest Coverage

EBITInterest Charges

For Basket Wonders December 31, 2003If EBIT = 210And Interest Charges = 59Income StatementRatiosCoverage Ratios$210$59= 3.56This ratio serves as one measure of the firms ability to meet its interest payments and avoid bankruptcy.In general the higher the ratio, the greater the likelihood that the company could cover its interest payments without difficulty.It also sheds some light on the firm capacity to take on new debt. Ratio of 3.56 shows the BW ability to cover annual interest 3.56 times with operating income (EBIT).CoverageRatio Comparisons BW Industry 3.565.19 4.355.0210.304.66Year200320022001Interest Coverage RatioBW has below average interest coveragerelative to the industry average.Coverage Ratio -- Trend Analysis Comparison Summary of the Coverage Trend AnalysisThis indicates that low earnings (EBIT) may be a potential problem for BW.Note, we know that debt levels are in line with the industry averages.The interest coverage ratio for BW has been falling since 2001. It has been below industry averages for the past two years.

LIABILITESASSETSCapital180Net Fixed Assets400Reserves20Inventories150Term Loan300Cash50Bank C/C200Receivables150Trade Creditors50Goodwill50Provisions50800800EXERCISE 1 What is the Net Worth : Capital + Reserve = 200 Tangible Net Worth is : Net Worth - Goodwill = 150 Outside Liabilities : TL + CC + Creditors + Provisions = 600 Net Working Capital : C A - C L = 350 - 250 = 50 Current Ratio : C A / C L = 350 / 300 = 1.17 : 1 Quick Ratio : Quick Assets / C L = 200/300 = 0.66 : 1

EXERCISE 2LIABILITIES 2005-062006-07 2005-062006-07Capital300350Net Fixed Assets730750Reserves140160Security Electricity3030Bank Term Loan320280Investments110110Bank CC (Hyp)490580Raw Materials150170Unsec. Long T L150170S I P2030Creditors (RM)12070Finished Goods140170Bills Payable4080Cash3020Expenses Payable2030Receivables310240Provisions2040Loans/Advances30190Goodwill5050Total1600176016001760 1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 3902. Current Ratio for 2nd Year : (170 + 30 +170+20+ 240 + 190 ) / (580+70+80+70) 820 /800 = 1.02 3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21Exercise 3. LIABIITIESASSETSEquity Capital200Net Fixed Assets800Preference Capital100Inventory300Term Loan600Receivables150Bank CC (Hyp)400Investment In Govt. Secu.50Sundry Creditors100Preliminary Expenses100Total14001400 1. Debt Equity Ratio will be : 600 / (200+100) = 2 : 12. Tangible Net Worth : Only equity Capital i.e. = 200 3. Total Outside Liabilities / Total Tangible Net Worth : (600+400+100) / 200 = 11 : 24. Current Ratio will be : (300 + 150 + 50 ) / (400 + 100 ) = 1 : 1LIABILITIESASSETSCapital + Reserves355 Net Fixed Assets265P & L Credit Balance7Cash1Loan From S F C100Receivables125Bank Overdraft38Stocks128Creditors26Prepaid Expenses1Provision of Tax9Intangible Assets30Proposed Dividend15550550What is the Current Ratio ? Ans : (1+125 +128+1) / (38+26+9+15) : 255/88 = 2.89 : 1

Q What is the Quick Ratio ? Ans : (125+1)/ 88 = 1.43 : 11

Q. What is the Debt Equity Ratio ? Ans : LTL / Tangible NW = 100 / ( 362 30) = 100 / 332 = 0.30 : 1

Exercise 4.Activity RatiosRatios that measure how effectively the firm is using its assets are called Activity Ratios. Income Statement/Balance Sheet Ratios

Activity Ratios Activity ratios, also known as Efficiency or Turnover Ratio, measure how effectively the firm is using its assets.In this section, we will focus our attention primarily on how effectively the firm is managing two specific asset groups receivables and inventories and its total assets in general. Activity RatiosReceivable turnover RatioAverage Collection Period (Receivable turnover in Days)Payable turnover RatioAverage Payable Period (Payable Turnover in Days)Inventory Turnover RatioTotal Assets turnover ratio

Income Statement/Balance Sheet Ratios

Activity Ratios Activity RatiosIndicates quality of receivables and how successful the firm is in its collections. This is also called Debtors Velocity or Average Collection Period or Period of Credit given .


Receivable Turnover Ratio Activity RatiosReceivable Turnover

Annual Net Credit SalesReceivables

For Basket Wonders December 31, 2003If Annual Net Credit Sales = 2211And Account Receivables = 394Income Statement /Balance SheetRatiosActivity Ratios$2,211$394= 5.61(Assume all sales are credit sales.)This ratio tells us the number of times accounts receivables have been turned over (turned into cash) during year.The higher the turnover, the shorter the time between the typical sales and cash collection, and vise versa.For BW ratio 5.61 tells us that 5.61 times accounts receivables have been turned over (turned into cash) in 2003. Activity RatiosAverage number of days that receivables are outstanding.(or Receivable Turnover in days) Income Statement/Balance Sheet Ratios

Average Collection Period Activity RatiosAverage Collection Period

Days in the YearReceivable TurnoverorReceivables * Days in the year Annual Credit salesFor Basket Wonders December 31, 2003If Days in the year = 365And Receivable turn over = 5.61Income Statement /Balance SheetRatiosActivity Ratios3655.61= 65 daysIt Gives a measure of how long it takes the business to recover debts.65 days means that Average collection period of BW is 65 days. Shorter period is better as get cash more quickly.ActivityRatio ComparisonsBW Industry65.065.771.166.383.669.2Year200320022001Average Collection PeriodBW has improved the average collection period to that of the industry average.Activity RatiosIndicates the promptness of payment to suppliers by the firm.


Payable Turnover Ratio Activity RatiosPayable Turnover (PT)

Annual Credit PurchasesAccounts Payable

For Basket Wonders December 31, 2003If Annual Credit Purchases = 1551And Account Payable = 94Income Statement /Balance SheetRatiosActivity Ratios$1551$94= 16.5(Assume annual credit purchases = $1,551.)When a firm wants to study its own promptness of payment to suppliers or that of a potential credit customer.In such cases it may desirable to analyze the payable turnover ratio. For BW ratio 16.5 tells us that 16.5 times accounts payable have been turned over (turned into cash means paid to the suppliers) in 2003.Activity RatiosAverage number of days that payables are outstanding. This is also called Creditors Velocity Ratio, which determines the creditor payment period.


Payable Turnover in Days Activity RatiosPT in Days

Days in the YearPayable TurnoverOrAccounts payable * Days in the yearAnnual Credit PurchasesFor Basket Wonders December 31, 2003If Days in the year = 365And Payable turnover = 16.5Income Statement /Balance SheetRatiosActivity Ratios36516.5= 22.1 daysThe average payable period is valuable information in evaluating the probability that a credit applicant will pay on time.If the average age of payables is 48 days and the terms in industry are net 30 we know that a portion of the applicants payables is not being paid on time.Ratio of 22.1 means that the business paid the Accounts Payables in 22.1 days on average. ActivityRatio ComparisonsBW Industry22.146.725.451.143.548.5Year200320022001Payable Turnover in DaysBW has improved the PT in Days.Activity RatiosIndicates the effectiveness of the inventory management practices of the firm. OrThe rate at which a companys Inventory is turned over is called Inventory turnover ratio.


Inventory Turnover Ratio Activity RatiosInventory Turnover

Cost of Goods SoldInventory

For Basket Wonders December 31, 2003If CGS = 1599AndInventory = 696Income Statement /Balance SheetRatiosActivity Ratios$1,599$696= 2.30Inventory turnoverA high Inventory turnover might mean increased efficiency?But: dependent on the type of business supermarkets might have high inventory turnover ratios whereas a shop selling high value musical instruments might have low inventory turnover ratio.Low Inventory turnover could mean poor customer satisfaction if people are not buying the goods.Ratio of 2.30 means that the company converts Inventory into A/R through sales 2.30 times in one year.

ActivityRatio ComparisonsBW Industry2.303.452.443.762.643.69Year200320022001Inventory Turnover RatioBW has a very poor inventory turnover ratio.Inventory Turnover Ratio --Trend Analysis Comparison Activity RatiosIndicates the overall effectiveness of the firm in utilizing its assets to generate sales.OrThe relationship of net sales to total assets is known as total assets turnover ratio.


Total Assets Turnover Ratio Activity RatiosTotal Asset Turnover

Net SalesTotal Assets

For Basket Wonders December 31, 2003If Net Sales = 2211And Total Assets = 2169Income Statement /Balance SheetRatiosActivity Ratios$2,211$2,169= 1.02Asset Turnover ratio It looks at a businesses sales compared to the assets used to generate the sales.A ratio of 1.02 means that BW generate $1.02 sales revenue on each $1 investment in assets.Businesses with a high value of assets who have few sales will have a low asset turnover ratioIf a business has a high sales and a low value of assets it will have a high asset turnover ratioBusinesses can improve this by either increasing sales performance or getting rid of any additional assetsActivityRatio ComparisonsBW Industry1.021.171.031.141.011.13Year200320022001Total Asset Turnover RatioBW has a weak total asset turnover ratio.Excessive investment in receivables and inventories increase assets and hence decrease the ratio.If BW could generate the same sales revenue with fewer dollar invested in receivables and inventories, total asset turnover ratio would improve. Profitability RatiosRatios that relate profits to sales and investment are called profitability ratios.OrProfitability ratios measures that how much profit the firm generates.


Profitability RatiosProfitability RatiosGross Profit MarginNet Profit MarginReturn On InvestmentReturn on Equity


Profitability RatiosProfitability RatiosIndicates the efficiency of operations and firm pricing policies. OrIt shows the relationship between Gross profit and sales.


Gross Profit MarginProfitability RatiosGross Profit Margin

Gross ProfitNet Sales

For Basket Wonders December 31, 2003If Gross Profit = 612And Net Sales = 2211Income Statement /Balance SheetRatiosProfitability Ratios$612$2,211= .277Gross Profit MarginThe higher the betterEnables the firm to assess the impact of its sales and how much it cost to generate (produce) those sales.A gross profit margin of .277 means that for every $1 of sales, the firm makes $27.7 cents in gross profit.ProfitabilityRatio ComparisonsBW Industry27.7%31.1%28.730.831.327.6Year200320022001Gross Profit MarginBW has a weak Gross Profit Margin.Gross Profit Margin --Trend Analysis Comparison Profitability RatiosIndicates the firms profitability after taking account of all expenses and income taxes.Or It shows the relationship between Net profit and sales.


Net Profit MarginProfitability RatiosNet Profit Margin

Net Profit after TaxesNet Sales

For Basket Wonders December 31, 2003IfNet profit = 91AndNet Sales = 2211Income Statement /Balance SheetRatiosProfitability Ratios$91$2,211= .041Net Profit Margin Net profit margin looks at how much of the sales revenue is left as net profit.A net profit margin of .041 means that for every $1 of sales, the firm makes $4.1 cents in net profit.Net profit is more important than gross profit for a business as all costs are included A business would like to see that this ratio has improved over time.

Profitability Ratio ComparisonsBW Industry4.1%8.2%4.98.19.07.6Year200320022001Net Profit MarginBW has a poor Net Profit Margin.Net Profit Margin --Trend Analysis Comparison Profitability RatiosIndicates the profitability on the assets of the firm (after all expenses and taxes). Or It shows the relationship between Net profit and total assets.


Return on Investment Profitability RatiosReturn on Investment

Net Profit after TaxesTotal Assets

For Basket Wonders December 31, 2003IfNet profit = 91And Total assets = 2160Income Statement /Balance SheetRatiosProfitability Ratios$91$2,160= .042Return on Investment

The higher the betterShows how effective the firm is in using its assets to generate profit.A return on investment of 0.042 means that it uses every $1 of assets to generate 4.2 cents in profit.Profitability Ratio ComparisonsBW Industry4.2% 9.8%5.0 9.19.110.8Year200320022001Return on InvestmentBW has a poor Return on Investment.Return on Investment Trend Analysis Comparison Profitability RatiosIndicates the profitability to the shareholders of the firm (after all expenses and taxes). Or It shows the relationship between Net profit and Shareholders Equity.


Return on Equity Profitability RatiosReturn on Equity

Net Profit after TaxesShareholders Equity

For Basket Wonders December 31, 2003IfNet profit = 91AndShareholders equity =1139Income Statement /Balance SheetRatiosProfitability Ratios$91$1,139= .08Return on Equity

The higher the betterShows how effective the firm is in using its Shareholders equity to generate profit.A return on equity of 0.08 means that it uses every $1 of shareholders equity to generate 8 cents in profit.Profitability Ratio Comparisons BW Industry 8.0%17.9% 9.417.216.620.4Year200320022001Return on EquityBW has a poor Return on Equity.Return on Equity --Trend Analysis Comparison Summary of the Profitability Trend AnalysesThe profitability ratios for BW have ALL been falling since 2001. Each has been below the industry averages for the past three years.This indicates that CGS and administrative costs may both be too high and a potential problem for BW.Note, this result is consistent with the low interest coverage ratio.Investment or shareholders Ratios The ratios which measures return to investors investment are called investment ratios.OrThe ratios which shows the risk and potential earning of a business investment are called investment ratios. The ratios that shareholders would be interested in are called Shareholders ratios.

Investment Ratios These ratios are not calculated from the financial reports only, since they may involve market data such as share prices. It is also known as a Valuation Ratios.

Investment/shareholders RatiosEarning per shareDividend per sharePrice earning ratioMarket price per share/Book value per share

Investment Ratios Investment/shareholders Ratios It shows that how much net profit investors are earning on each share.Orprofit after tax / total number of shares is called earning per share.

Earning per share Investment RatiosEarning per share

Net Profit after TaxesTotal number of shares

For Basket Wonders December 31, 2003IfNet profit = 91And Total number of shares = 200Earning per ShareInvestment Ratios$91$200= .455Earning per Share

The higher the better generally.Ratio of 0.455 means that shareholders earn 45.5 cents on each share.Investment/shareholders Ratios It shows that how much Dividend investors are earning on each share.OrTotal dividend announced / total number of shares is called Dividend per share.

Dividend per share Investment RatiosDividend per share

Dividend announcedTotal number of shares

For Basket Wonders December 31, 2003IfDividend Announced = 38And Total number of shares = 200Dividend per ShareInvestment Ratios$38$200= .19Dividend per Share

The higher the better generally.Ratio of 0.19 means that shareholders receive 19 cents dividend on each share.Investment/shareholders RatiosHow much investors are willing to pay for $1 of earnings. Or This Ratio indicates the number of times the Earning Per Share is covered by its market price.

Price earning ratio (P/E) Investment RatiosPrice earning ratio

Market price per shareEarning per share

For Basket Wonders December 31, 2003IfMarket price per share = 6And Earning per share = 0.455Price earning ratioInvestment Ratios$6$.455= 13.19Price earning ratio

The higher the better generally.Ratio of 13.19 shows that investors are willing to pay $13.19 for $1 of earnings.

Investment/shareholders Ratios How much investors are willing to pay for $1 of book value equity.OR It shows the relationship between the market price per share and book value per share.

Market price per share / Book value per share (M/B) Investment RatiosM/B

Market price per shareBook value per share

For Basket Wonders December 31, 2003IfMarket price per share = 6And Book value per share = 4.645Market price per share/Book value per shareInvestment Ratios$6$4.645= 1.29Market price per share/Book value per share

The higher the better generally Ratio of 1.29 means that investors are willing to pay $1.29 for each $1 of book value equity.

Summary of Ratio AnalysisInventories are too high.May be paying off creditors (accounts payable) too soon.CGS may be too high.Selling, general, and administrative costs may be too high.Potential problems and limitations of financial ratio analysisComparison with industry averages is difficult for a conglomerate firm that operates in many different divisions.Average performance is not necessarily good, perhaps the firm should aim higher.Seasonal factors can distort ratios.Window dressing techniques can make statements and ratios look better.Different operating and accounting practices can distort comparisons.Sometimes it is hard to tell if a ratio is good or bad.Difficult to tell whether a company is, on balance, in strong or weak position.