ratio analysis

Financial Health & Financial Ratios

Financial Health Indicators Analyses

Financial Ratios

1. Debt Management 1. Debt ratio2. Times-Interest-Earned Ratio

2. Liquidity 1. Current Ratio2. Quick Ratio

3. Asset Management 1. Inventory turnover Ratio2. Day’s Sales Outstanding

Ratio3. Total Assets Turn over Ratio

4. Profitability 1. Profit Margin on Sales2. Return on Total Assets3. Return on Common Equity

5. Market Value (Trend) 1. Price to Earnings Ratio2. Market/Book Ratio (Book

value per share)

1. Debt Management Analyses

Contemporary Engineering Economics, 5th edition. ©2010

Debt Financing (Financial Leverage) Analyses


1.1 Debt Ratio

Debt Ratio = Total Debt Total Assets

• If the Debt Ratio is One (Unity), then the Company has used all its Assets to finance its Debts

• A ratio more than one indicates that the company has more debt than its assets

• Creditor’s prefer low Debt Ratios, because the lower the ratio, the greater is the cushion against creditor’s losses


1.2 Times-Interest-Earned Ratio

Times Interest Earned Ratio =Operating Profit (Earnings before Interest & taxes (EBIT)

Interest Expenses

• Higher values will favor the company in repaying its interest and debts.

• Value below 1.5 is unsafe for the company• Failure to meet this obligation (value of 1 )

possibly results in bankruptcy.


Illustration Question

A) A Company has SR 10 million of debts in its balance sheet and SR 15 million of assets.

Calculate the Debt ratio.

B) If that company’s interest expenses are SR239,000 and EBIT 3,493,000; calculate Times-Interest-Earned ratio.


Answer

A) Debt Ratio= Total Debt = 10 million

= 0.67 (67%) Total Assets 15 million

B) Times-Interest-Earned Ratio = EBIT

Interest Expenses= 3493,000 = 14.6

239,000Contemporary Engineering Economics, 5th edition. ©2010

2. Liquidity Analysis


2.1 Current Ratio

Current Ratio = Current AssetsCurrent Liabilities

It shows the company’s ability to pay back its short-term liabilities with short term assets.A ratio above 1 is required for the survival (ratio above 2 is favorable)


2.2 Quick Ratio

Quick Ratio = Current Assets – Inventories

Current Liabilities

It is an indicator of a company’s short-term liquidity

It ,measure how a company can meet its obligations, without depending on its inventory (Least liquid of current assets)

The ratios of the company should be compare with that of industry average.



The balance sheet of SABIC for January 2012 provides the following details. Calculate the Current Ratio and Quick Ratio of SABIC and comment on it.

Total Current Assets – SR 138,216 million

Total Current Liabilities – SR 49,847 million

Inventories – SR 31,442 millionContemporary Engineering Economics, 5th edition. ©2010

Answer

Current Ratio = Current AssetsCurrent Liabilities = 138,216 = 2.77 49,847

Quick Ratio = Current Assets – Inventories Current Liabilities

= 138,216 - 31442 = 106,774 = 2.14 49,847 49,847

Comment: Both the ratios are above 2 and the company’s liquidity is so strong


3. Asset Management Analysis


3.1 Inventory Turnover Ratio

Inventory Turnover Ratio = Sales Average Inventory

It measures how many times the company sold and replaced its inventory during the period.

The ratio should be compared with the industry averages (Low turn over implies poor sales and excess inventory & high ratio implies strong sales)


3.2 Day’s Sales Outstanding (DSO)/ Accounts Receivable Turnover Ratio

DSO = Accounts Receivable

Average Sales per dayAverage Sales per day = Annual Sales 365

It is a measure of the average number of days that a company takes to collect revenue after a sale has been made.

Low DSO means fewer days to collect the accounts receivable and favor in reinvesting money.


3.3 Total Assets Turnover Ratio

Total Assets Turnover = Sales Total Assets

It measure the effectiveness in using Total Assets to generate Revenue

Higher ratios will favor the company.



Calculate the Asset Management Ratios of SABIC using the following information for the quarterly ending June 2012.

Sales – SR 46,528 million Average Inventory – SR 31,442 millionAccounts Receivable – SR 30,517

millionAverage sales per day – SR 517 millionTotal Assets – SR 339,006 millionContemporary Engineering Economics, 5th edition. ©2010

Answer

Inventory Turnover Ratio = Sales = 46,528 = 1.48

Average Inventory 31,442

DSO = Accounts Receivable = 30,517 = 59 days

Average Sales per day 517

Total Assets Turnover = Sales = 46,528 = 0.14

Total Assets 339,006


Answer (Comments)

Inventory Turnover Ratio is comparatively lower (1.48) and will not favor the company

The DSO is lower than 2 months (59 days) and will favor the company in reinvesting

Total Assets Turn Over Ratio is comparatively lower (0.14) and will not favor the company


4. Profitability Analysis


4.1 Profit margin on Sales

Profit Margin on Sales = =Net Income Available to Common

StockholdersSales

The higher margins shows higher returns to stockholders.


4.2 Return on Total Assets

Return on Total Assets = = Net Income + Interest Expenses (1 – tax

rate)Average Total Assets

It measures the return on total assets

Used for comparison & higher ratios are favorable


4.3 Return on Common Equity

Return on Common Equity = = Net Income Available to Common

Stockholders Average Common Equity

It shows how much income is earned for every Riyal invested by common stockholders

Used for comparison and higher ratios favor the company's performance



The following details of a Company are given for the quarter ending June 2012.

Sales (Million SR) - 16,528 Net Income available to common stockholders (Million (SR) -

9076Total Assets (Million SR) – 33,900Net Income (Million SR) – 12,000Interest Expenses (Million SR) – 250Tax Rate – 2%Average Common Equity (million SR) - 19150

Calculate the ratios of the of the profitability analysis.


Answer

Profit Margin on Sales = = Net Income Available to Common Stockholders

Sales= 9076/16528 = 0.55

Return on Total Assets = = Net Income + Interest Expenses (1 – tax rate)

Average Total Assets= 12000 + 250 (1- 2%)/ 33,900 = 12000 + 245 /

33,900 = 0.36

Return on Common Equity = = Net Income Available to Common Stockholders

Average Common Equity= 9076/19150 = 0.47


5. Market Value Analysis


5.1 Price to Earnings Ratio (P/E Ratio)

P/E Ratio = Price per ShareEarnings Per Share

It shows how much investors are willing to pay per Riyal of reported profits

P/E Ratio is high for firms with high growth prospects


5.2 Book Value per Share

Book Value per Share == Total Stockholders Equity – Preferred

Stock Average Number of Shares

Outstanding It is used to calculate the per share

value of a company based on its equity available to shareholders (public).

Higher values favor the company’s market valueContemporary Engineering Economics, 5th edition. ©2010


The following details of a company are given and based on it calculate P/E ratio and Book Value per Share.

Share Price (SR) – 1000Earnings per Share (SR) – 250 Total Stockholders equity (million SR) – 50,000 Preferred Stockholders equity – 32,000Number of Shares Outstanding – 10,000


Answer

P/E Ratio = Price per Share

Earnings Per Share

= 1000 = 4

250

Book Value per Share = Total Stockholders Equity – Preferred Stock Average Number of

Shares Outstanding

= 50,000 – 32,000 = 18,000 = 1.8

10,000 10,000


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