ACCT7101 Lecture 5: Financial Statement Analysis
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Liquidity Ratios
Focus on the company’s ability to meet its financial obligations in a short-term
Ratio Calculation Interpretation
1. Current ratio Current assets
Current liabilities
• Indicates whether the company has enough
short-term assets to cover its short-term debts.
• A ratio > 1 (or 2) indicates that working capital is
positive (current assets exceed current liabilities)
• A ratio < 1 (or 2) indicates that working capital is
negative (current liabilities exceed current assets).
• Generally, the higher the ratio, the greater the
financial stability and the lower the risk for both
creditors and owners. Generally 1.5:1 is
considered to be an acceptable ratio for most
industries.
• However, ratio should not be too high as this may
indicate:
1. The company is not reinvesting in long-term
assets to maintain future productivity; and/or
2. Too much inventory on hand or collection of
receivables is slow.
• Interpretation of ratio (how high/low it should be)
really depends on specific circumstances of each
company.
2. Quick ratio Cash + A/C Rec. + ST Invest.
Current liabilities
Or
Current Assets –Inventory-Prepayment
Current liabilities
• Indicates whether current liabilities could be paid
without having to sell inventory
• Ratio is the same as the current ratio except
inventory is removed from the numerator.
• Benchmark is 1.
• More useful measure than the current ratio for
companies that cannot convert inventory into cash
quickly if necessary.
3. Current cash
debt coverage
Net Cash from Operating Activities
Average current liabilities
• A higher current cash debt coverage ratio indicates
a better liquidity position.
• Generally a ratio below 0.40:1 is considered cause
for additional investigation.
• Combines cash and accrual figures
4. Receivable
turnover
(Net Credit) Sales
Average A/C Receivable
• Indicate the effectiveness of credit collection
policies
• Measures the number of times trade receivables are
converted into cash in a year or a single period.
ACCT7101 Lecture 5: Financial Statement Analysis
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5. Average
collection period
Average A/C Receivable x 365
(Net Credit) Sales
or
365
Receivable Turnover
• Measures the average number of days taken by the
company to collect a day’s sales revenue
• A large ratio is a negative signal, raising questions
about the company’s policies of granting credit and
the vigor of its collection attempts. It also
suggests there may be an increased risk of
bad/doubtful debts.
• A smaller ratio is therefore preferable.
6. Inventory
turnover
(Times per year)
COGS
Average Inventory
• Relates the level of inventory to the volume of
activity and therefore indicates the liquidity of
inventory.
• Measures the number of times inventory was sold
on average during the period.
7. Average days
in inventory
365
Inventory Turnover
• Indicates how long, in days, inventory is held on
average.
• An increase in this ratio from one year to the next
may indicate that inventory is taking longer on
average to sell and raise questions as to why.
Solvency Ratios
Focus on the company’s ability to survive over a long period of time
8. Debt to
Assets ratio
Total Liabilities
Total Assets
• Indicates the proportion of assets financed by
liabilities
• Indicate the degree of leverage (percentage of total
assets funded through debt)
9. Times Interest
Earned (Interest
Coverage)
Earnings before interest and tax
Interest expense
• Indicates the company’s ability to meet its interest
payments out of current profits.
• A general rule of thumb is that earnings should be
approximately 3-4 times the interest expense.
• A low coverage ratio (especially < 1) indicates:
1. The company is not operating at a sufficiently
profitable level to cover the interest
obligations comfortably; and/or
2. Solvency problems
ACCT7101 Lecture 5: Financial Statement Analysis
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10. Cash Debt
Coverage
Net cash from Operating Activities
Average of Total Liabilities
• Indicate entity’s ability to repay liabilities from
cash generated from operating activities, without
having to liquidate assets used in operations
• Reflects the whole period, not just a single point in
time.
• A general rule of thumb is that a ratio below 0.20
times is considered cause for additional
investigation.
11. Free Cash
Flow
Net cash from Operating Activities
- Capital Expenditures
• Indicate entity’s ability to pay dividends or expand
operations
• Provides an estimation of discretionary cash
• Combine cash and accrual figures.
PROFITABILITY Ratios
Focus on the company’s effectiveness in terms of earning profits and providing a return on shareholders’
investments
12. Return on
Equity
Profit after tax
Average Shareholders Equity
• Indicates the company’s return on shareholders’
investment
• Generally, ROE values range from 5%-20%.
• High ROE values are preferred as the higher the
ratio, the greater the company’s return on
shareholders investments.
13. Return on
Assets
Profit after tax
Average Total Assets
• Indicates how much return the company is
generating on the assets under its control.
• Generally, ROA values range from 5%-20%.
• High ROA values are preferable as the higher the
ratio, the greater the Company’s return on the
operation of its business resources.
14. Profit
Margin
Profit after tax
Net Sales
• Ratio represents the average net profit on each
dollar of sales (e.g. a 10% profit margin would
mean that on average, each dollar of sales
generated 10 cents in net profit after expenses and
income tax)
• Adequacy of ratio depends on industry i.e. a
supermarket chain would have a low profit margin
ratio, compensated by a large volume of sales
whereas a jewellery store would generally have a
high profit margin, offset by a low sales volume.
ACCT7101 Lecture 5: Financial Statement Analysis
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15. Asset
Turnover
Net Sales
Average Total Assets
• Indicates how much sales volume is associated
with a dollar of assets.
• Provides a measure of the effectiveness of the
company in using its assets during the period.
16. Gross Profit
Rate
Gross Profit (Sales – COGS)
Net Sales
• Ratio represents the average gross profit on each
dollar of sales
• Any declines in ratio over time should be
monitored as these could indicate selling price
reductions or increased COGS.
17. Operating
Expenses to
Sales ratio
Operating Expenses
Net Sales
• Measures costs incurred to support each dollar of
sales.
18. Cash Return
on Sales Ratio
Net Cash from Operating Activities
Net Sales
• Similar to net profit ratio
• Use cash number instead of accrual profit.
19. Earnings per
Share
Profit after tax
Weighted average # of ordinary shares
• Indicates the profit earned on each ordinary share
by relating earnings attributable to ordinary shares
to the number of ordinary shares issued.
20.
Price-earnings
Ratio
Market price per ordinary share
Earnings per Share
• Indicates the amount investors are paying for a
dollar of earnings
• Based on the idea that market price should reflect
the market’s expectation of future performance, the
ratio compares present performance with those
expectations.
• On this basis, a company with a high P/E is
expected to show greater future performance that
its present level, while one with a low P/E is not
expected to do much better in future.
21. Cash
Dividend Payout
Rate
Dividends
Profit
• Indicates the percentage of profits paid out to
ordinary shareholders
• e.g. a ratio of 40% indicates that 40% of profit was
distributed to shareholders and the remaining 60%
represents retained profits.
• A stable ratio over time suggests the company has
a policy of paying dividends based on profits
whereas a variable ratio suggests factors other than
profit are important in deciding whether to declare
dividends.