MANAGING FINANCIAL

HEALTH

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 Financial ratios
• Financial ratios are usually easy to calculate.
• That’s the good news.
• The bad news is that there are so many of
them.

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Financial ratios

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 Liquidity ratios
• Liquidity ratios measure how easily the firm
can lay its hands on cash.
• Liquidity ratios measure the relationship
between a firm’s current assets and its
current liabilities.

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 Liquidity ratios

CASH RATIO

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 Exercise
Calculating Liquidity Ratios for DPH Tree Farm, Inc.

Liquidity ratio DPH Tree Fam, Inc. Industry average

‘2012

Current ratio 1.5

Quick ratio 0.5

Cash ratio 0.15

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 Liquidity ratios
• Liquidity ratios also have some less desirable
characteristics.
• Measures of liquidity can rapidly become
out of date.

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 Asset Management Ratios
• Asset management ratios measure how
efficiently a firm uses its assets (inventory,
account receivable and fixed assets) as well
as how efficiently the firm manages its
account payable.

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 Inventory Management
• Inventory Turnover
→ the rate at which companies turn over their
inventories
Cost of goods sold
Inventory turnover =
average inventory
• Days’ sales in inventory
→ Number of days that inventory is held before the final
products is sold.
Days’ sales in
average inventory x 365 days
inventory=
Cost of goods solds

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 Accounts Receivable Management
• Accounts receivables turnover
→ Number of dollars for sales produced per
dollar of accounts receivable.
credit sales
Accounts receivable turnover =
average receivables
• Average collection period
→ how quickly customers pay their bills.
average receivables
ACP=
average daily sales

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 Accounts Payable Management
• Accounts payable turnover
→ dollar cost of good sold produced per dollar
of accounts payable.
cost of goods sold
Accounts payable turnover =
average payable
• Average accounts payable period
→ how quickly customers pay their bills.
average accounts payable x 365 days
ACP=
cost of good sold

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 Fixed Assets and
Working Capital Management
• Fix asset turnover
Sales
• Fixed asset turnover =
Averrage fixed assets

• Sales to net working capital

→ how hard working capital has been put to use.
Sales
• Sales to NWC=
average net working capital

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 Total Asset Management
• Sales to Total Assets
→ how hard the firm’s assets are being put to
Sales
use:=
Averrage t𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
→ A high ratio could indicate that the firm is
working close to capacity.

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 Calculating Asset Management Ratios
Inventory Days Average AR Average Accounts Fixed Sales to Total
turnover sales in collection turnover payment payable assets NWC Assets
inventory period period turnover turnover Turnover

2.15 170 95 3.84 102 3.55 0.85 3.2 0.4

days days days

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 Debt Management Ratios
• Because shareholders gets only what is left
after the debtholders have been paid, debt is
said to create financial leverage.

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 Leverage Ratios
→ show how heavily the company is in debt.
Long−term debt
• Debt ratio =
Total capitalization
with Total capitalization = Long-term debt + other liabilities + equity

Long−term debt
• Debt to equity ratio =
Equity

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 Coverage Ratios
• Times interest earned
EBIT
=
Interest
• Fix-charge coverage
Earnings available to meet fixed charges
=
Fixed charges
• Cash coverage
EBIT+Depreciation
=
Fixed char𝑔𝑒𝑠

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 Profitability Ratios
• used to judge how efficiently the firm is using
its assets.
• Return on total assets (ROA)
EBIT−𝑡𝑎𝑥
=
average total assets

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 ROA and ROE
• A more common measurement of ROA and ROE

Net income
• ROA =
Total Assets

Net income
• ROE =
E𝑞𝑢𝑖𝑡𝑦

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 Payout Ratio
• measures the proportion of earnings that is
paid out as dividends.
dividen𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
• Payout ratio =
earning per share

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 Market Value Ratios
• show how the firm is valued by investors
• Price-Earning Ratio
𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒
P/E ratio =
earning per share
-----------------------------------------------
dividend per share
• Dividend Yield =
stock price
---------------------------------------------------
• Market to Book Ratio

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Dupont Analysis

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 Time Series and
Cross Sectional Analysis
1. Time Series Analysis

Performance of firm over the time

2. Cross-sectional Analysis

Performance of the firm against one or more

companies in the same industry

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Median financial ratios

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 Cautions in Using Ratios
• Financial statement data are historical.
• Financial ratios seldom provide answers, but
they do help you ask the right questions.
• There is no international standard for
financial ratios.
• Be selective in your choice of ratios. Different
ratios often tell you similar things.
• Be careful not to extrapolate past rate of
earnings growth – earnings follow
approximately a random walk.

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Applications of Financial Analysis
Key financial ratios and accounts for PepsiCo and CocaCola, Dec 31, 2010.

Which is the better

investment?

Module 3: Analyzing Financial Performance 26

 Some Key Ratios for PepsiCo and Coca-Cola
(Five Year Period)

This quick analysis using financial ratios and trend analysis

does not give a clear picture.

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 Applications of
Financial Analysis

W.H.Beaver, 1966, ‘Financial

Ratios and Predictors of
Failure”, Empirical Research
in Accounting
• Healthy firms have
different financial ratios
than firms that are
heading for insolvency.
• Financial ratios provide
valuable clues about a
firm’s market risk.

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Applications of Financial Analysis
BOND RATINGS

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