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Financial Management Dr. Mari’e Banikhaled 1

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What is Finance? Finance can be defined as the science and art of managing money finance involves the types of decisions: how firms raise money from investors, how firms invest money in an attempt to earn a profit, and how they decide whether to reinvest profits in the business or distribute them back to investors. 2

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Goal of the firm The primary goal of financial management is to Maximize the wealth of the shareholders. we argue that the primary goal of the firm, and also of managers, should be to maximize the wealth of the owners for whom it is being operated, or equivalently, by maximize the stock price. 3

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The Importance of Financial Statement Analysis The analysis and interpretation of financial statements is useful in achieving several objectives: 1) The evaluation of past performance. 2) The assessment of current status. 3) The prediction of future potential. 4) Take the right decisions to maximize profits and resources. 4

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The Role of Financial Statement Analysis Financial statement analysis is a business function that helps a company's top management assess business performance, evaluate operating activities and detect nonperforming segments or areas. Studying financial records also helps investors compare two or several corporations operating in the same industry or sector, and draw conclusions about their competitive standing and future profitability. 5

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Interested Parties 1. Shareholders: Shareholders are the owners of the company. Time and again, they may have to take decisions whether they have to continue with the holdings of the company's share or sell them out. The financial statement analysis is important as it provides meaningful information to the shareholders in taking such decisions. 2. management: The management of the company is responsible for taking decisions and formulating plans and policies for the future. They, therefore, always need to evaluate its performance and effectiveness of their action to realize the company's goal in the past. For that purpose, financial statement analysis is important to the company's management. 6

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Interested Parties 3. Creditors: The creditors are the providers of loan capital to the company. Therefore they may have to take decisions as to whether they have to extend their loans to the company and demand for higher interest rates. The financial statement analysis provides important information to them for their purpose. 4. Investors: The prospective investors are those who have surplus capital to invest in some profitable opportunities. Therefore, they often have to decide whether to invest their capital in the company's share. The financial statement analysis is important to them because they can obtain useful information for their investment decision making purpose. 7

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Interested Parties 5. Government: Government is interested to analyze the financial position in determining the amount of tax liability. It also helps for formulating effective plans and policies for economic growth. 6. Lenders : Lenders to the business like debenture holders, suppliers of loans and lease are interested to know short term as well as long term solvency position of the entity. 7. Researchers: They are interested in financial statements in undertaking research work in business affairs and practices 8

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Interested Parties 8. Employees : They are interested to know the growth of profit, They can Negotiating on matters relating to salary, bonus and other benefits on the basis of information of the financial report. 9. Stock exchange : The stock exchange members take interest in financial statements for the purpose of analysis because they provide useful financial information about companies. 9

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Bartlett Company Income Statement ($000) For the year ended December Sales revenue 3,074 2,567 Less: Cost of goods sold 2,088 1,711 Gross profit Less: Operating expenses: Selling expenses General and administrative expenses Lease expense35 Depreciation expense Total operating expenses Operating profit (EBIT)

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Bartlett Company Income Statement ($000) Less: Interest expenses Net profit before taxes Less: Taxes 29% Net profit after taxes Less: Preferred stock dividends 10 Earning available for common equity Earning per share Dividends per share Market price Principal payment 71 11

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Bartlett Company Balance Sheet ($000) for the year ended December 31 Current assets cash Marketable securities6851 Account receivable Inventories Total current assets1,2231,004 Gross fixed assets Land and buildings2,0721,903 Machinery and equipment1,8661,693 Furniture and fixtures Vehicles Other ( includes financial leases)9896 Total gross fixed assets4,6694,322 Less: Accumulated depreciation2,2952,056 Net fixed assets2,3742,266 Total assets3,5973,270 12

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Bartlett Company Balance Sheet ($000) for the year ended December 31 Liabilities and Stockholder’s Equity Current liabilities Account payable Notes payable7999 Accruals Total current liabilities Long-term debt (include financial leases )1, Total liabilities1,6431,450 Stockholder’s equity Preferred stock-cumulative 5%, $100 par, 2000 shares authorized and issued 200 Common stock - $2.50 par, $100,000 shares authorized, shares issued and outstanding in 2012: 76,262; in 2011: 76, Paid in capital in excess of par on common stock Retained earnings1,1351,012 Total stockholder’s equity1,9541,820 Total liabilities and stockholder’s equity3,5973,270 13

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Weight Rules 14

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Methods of Financial Statement Analysis Sometimes it can be difficult to interpret in a meaningful way all the dollar amounts presented in a set of financial statements. For example, if one company has liabilities of $10,000 and another company has liabilities of $10,000,000; is the first company less risky? Maybe or maybe not, it depends in part on the size of the company ( how much in assets does each company have) and the company’s industry. A useful way to analyze financial statements is to perform either a horizontal analysis or a vertical analysis of the statements. These types of analysis help a financial statement reader compare companies of different sizes, which can be difficult to do when the dollar amounts vary significantly, and evaluate the performance of a company over time. 15

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Methods of Financial Statement Analysis A financial statement contains important information for both internal and external users. Creditors, investors, managers and executives. They need this information to make informed business decisions. There are three methods for analyzing such financial statements : 1.Horizontal Analysis or Trend Percentages 2.Vertical Analysis 3.Ratios Analysis 16

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17 Horizontal Analysis

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horizontal analysis refers to a type of fundamental analysis in which a financial analyst uses certain financial data to assess a company’s performance over time. The analyst compares the same items or ratios for a particular company over a period of time in order to assess the company’s growth during that time. 18

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Horizontal Analysis Absolute Dollars: One method of performing a horizontal financial statement analysis compares the absolute dollar amounts of certain items over a period of time. Percentage : The other method of performing compares the percentage difference in certain items over a period of time. The dollar amount of the change is converted to a percentage change. 19

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Horizontal Analysis Calculating Change in Dollar Amounts: Calculating Change as a Percentage: 20

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21 Horizontal Analysis Balance Sheet …Assets

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Horizontal Analysis … Assets Increase ( Decrease ) Amount (000) % Current assets cash $26% Marketable securities6851 Account receivable Inventories Total current assets1,2231,004 Gross fixed assets Land and buildings2,0721,903 Machinery and equipment 1,8661, $ / 288 $ * %100 = 26 % 363 $ – 288 $ = 75 $

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Horizontal Analysis … Assets Increase ( Decrease ) Amount (000) % Current assets cash $% 26 Marketable securities $% Account receivable $% Inventories $% Total current assets1,2231, $% 21.8 Gross fixed assets Land and buildings2,0721, $% 8.88 Machinery and equipment 1,8661, $%

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Horizontal Analysis … Assets Increase ( Decrease ) Amount (000) % Furniture and fixtures $ % Vehicles $% Other ( includes financial leases) $% 2.08 Total gross fixed assets4,6694, $ % 8.02 Less: Accumulated depreciation 2,2952, $% Net fixed assets2,3742, $% 4.76 Total assets3,5973, $% 10 24

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Horizontal Analysis Let’s apply the same procedures to the liabilities and stockholders’ equity sections of the balance sheet. Horizontal Analysis Balance Sheet … Liabilities and Shareholder Equity 25

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Horizontal Analysis … Liabilities and Shareholder Equity Increase ( Decrease ).. Liabilities and Stockholder’s Equity Amount (000) % Current liabilities Account payable $% Notes payable $% Accruals $% Total current liabilities $% Long-term debt1, $% 5.79 Total liabilities1,6431, $%

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Horizontal Analysis … Liabilities and Shareholder Equity Increase ( Decrease ) Amount (000) % Stockholder’s equity Preferred stock Common stock $% 0.52 Paid in capital in excess of par on common stock $% 2.39 Retained earnings1,1351, $% Total stockholder’s equity1,9541, $% 7.36 Total liabilities and stockholder’s equity 3,5973, $% 10 27

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Horizontal Analysis Now, Let’s apply the same procedures to the income statement. Horizontal Analysis Income Statement 28

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Horizontal Analysis … Income Statement Increase ( Decrease ).. For the year ended December Amount (000) % Sales revenue 3,074 2, $% Less: Cost of goods sold 2,088 1, $% 22 Gross profit $% Less: Operating expenses: Selling expenses $% 7.40 General and administrative expenses $% 3.74 Lease expense Depreciation expense $%

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Horizontal Analysis … Income Statement Increase ( Decrease ) Amount (000) % Total operating expenses $% 2.71 Operating profit (EBIT) $% Less: Interest expenses $% 2.19 Net profit before taxes $% Less: Taxes 29% $% Net profit after taxes $% Less: Preferred stock dividends Earning available for common equity $%

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Percentage Changes Trend analysis calculates the percentage change over time in given financial statement items for one account over a period of time of two years or more. Owners and managers often use financial trend analysis to review several periods at one time and discover if---in financial terms---their company is growing or shrinking. 31

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32 Vertical Analysis

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The vertical analysis compares each separate figure to one specific figure in the financial statement. The comparison is reported as a percentage. vertical analysis refers to the representation of assets, liabilities and equities as a percentage of the whole. These three major balance sheet categories are added up, and each one is expressed as the percent of the total it represents. Vertical analysis can be useful in comparing companies of different sizes, as it makes it easy to see which company has a greater percentage of liabilities as opposed to equity, or which company has more assets, relative to liabilities and equity. 33

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Vertical Analysis Balance Sheet: Performing vertical analysis of the balance sheet involves comparing each balance sheet item to total assets. Each item is then reported as a percentage of total assets. For example, if cash equals $5,000 and total assets equals $25,000, then cash would be reported as 20% of total assets. Income Statement : Performing vertical analysis of the income statement involves comparing each income statement item to sales. Each item is then reported as a percentage of sales. For example, if sales equals $10,000 and operating expenses equals $1,000, then operating expenses would be reported as 10% of sales. 34

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Vertical Analysis 35

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36 Vertical Analysis Balance Sheet …Assets

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Vertical Analysis… Assets Percentage of total asset 2012 Percentage of total asset2011 Current assets cash %10% 8.80 Marketable securities6851 Account receivable Inventories Total current assets1,2231,004 Gross fixed assets Land and buildings2,0721,903 Machinery and equipment 1,8661, ( 288 / 3270 ) * %100 = %8.80 ( 363 / 3597 ) * %100 = %10

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Vertical Analysis… Assets Percentage of total asset 2012 Percentage of total asset2011 Current assets cash % 10% 8.80 Marketable securities6851 % 1.89% 1.55 Account receivable % 13.98% Inventories % 8.03% 9.17 Total current assets1,2231,004 % 34 % Gross fixed assets Land and buildings2,0721,903 % 57.6% Machinery and equipment 1,8661,693 % 51.87%

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Vertical Analysis… Assets Percentage of total asset 2012 Percentage of total asset 2011 Furniture and fixtures % 9.95% 9.66 Vehicles % 7.64% 9.60 Other ( includes financial leases) 9896 % 2.72% 2.93 Total gross fixed assets 4,6694,322 % % Less: Accumulated depreciation 2,2952,056 % 63.80% Net fixed assets2,3742,266 % 65.99% Total assets3,5973,270 39

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40 Vertical Analysis Balance Sheet… Liabilities and Shareholders Equity

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Vertical Analysis… Liabilities and Shareholder Equity Liabilities and Stockholder’s Equity Percentage of total asset 2012 Percentage of total asset 2011 Current liabilities Account payable % 10.61% 8.25 Notes payable7999 % 2.19% 3.02 Accruals % 4.42% 3.48 Total current liabilities % 17.23% Long-term debt1, % 28.44% Total liabilities1,6431,450 % 45.67%

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Vertical Analysis… Liabilities and Shareholder Equity Percentage of total asset 2012 Percentage of total asset 2011 Stockholder’s equity Preferred stock200 % 5.56% 6.11 Common stock % 5.30% 5.81 Paid in capital in excess of par on common stock % 11.89% Retained earnings1,1351,012 % 31.55% Total stockholder’s equity 1,9541,820 % 54.32% Total liabilities and stockholder’s equity 3,5973,270 42

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43 Vertical Analysis Income Statement

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Vertical Analysis … Income Statement For the year ended December Percentage of net sales 2012 Percentage of net sales 2011 Sales revenue 3,074 2,567 Less: Cost of goods sold 2,088 1,711 % 67.92% Gross profit Less: Operating expenses: Selling expenses General and administrative expenses Lease expense35 Depreciation expense (2088 / 3074 ) * %100 = %67.92 ( 1711 / 2567 ) * %100 = %66.65

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Vertical Analysis … Income Statement For the year ended December Percentage of net sales 2012 Percentage of net sales 2011 Sales revenue 3,074 2,567 Less: Cost of goods sold 2,088 1,711 % 67.92% Gross profit % 32.07% Less: Operating expenses: Selling expenses % 3.25% 4.20 General and administrative expenses % 6.31% 7.28 Lease expense35 % 1.13% 1.36 Depreciation expense % 7.77%

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Vertical Analysis … Income Statement Percentage of net sales 2012 Percentage of net sales 2011 Total operating expenses % 18.47% Operating profit (EBIT) % 13.59% Less: Interest expenses % 3.02% 3.54 Net profit before taxes % 10.57% 8.25 Less: Taxes 29% % 3.05% 2.49 Net profit after taxes % 7.51% 5.76 Less: Preferred stock dividends 10 % 0.32% 0.38 Earning available for common equity % 7.18%

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Differences Between Vertical and Horizontal Analysis The main difference is that while horizontal analysis compares the figures under different heads in the income statement and the balance sheet, vertical analysis represents each figure as a percentage of the total along with the change in both over the past year. So, in vertical analysis, the figures are not only compared to the past year, but they are also represented as a percentage of the total cost or total assets/liabilities as may be the case. 47

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48 Ratios Analysis

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The ratios analysis is the most powerful tool of financial statement analysis. its simply means one number expressed in terms of another. A ratio is a statistical measurement by means of which relationship between two or various figures can be compared or measured. Ratios can be found out by dividing one number by another number. The calculation of various ratios obtained from the financial statements provide information about the strengths and weaknesses to specific areas of the business and assess the effectiveness of their management decisions. 49

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Classification of Ratios Ratios can be broadly classified into four groups: 1- Liquidity Ratios 2- Activity Ratio 3- Profitability Ratio 4- Debt Ratio 5- Market Ratio 50

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51 Liquidity Ratios

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The liquidity of a firm is measured by its ability to satisfy its short-term obligations as they come due. Liquidity Ratios include : 1.Current Ratio 2.Quick Ratio 3. Cash Ratio 52

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Current Ratio An indication of a company’s ability to meet short-term debt obligations, the higher the ratio, the more liquid the company, the less the profitability. This ratio also a known as: (Capital Assets Ratio, Liquidity Ratio) The ratio is calculated as follows: 53

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Current Ratio In the long-term very high current ratio may affect profitability. Suppose industry criteria was 1 : A ratio below criteria represents liquidity riskiness as there is an insufficient current asset to cover current liabilities, Current ratios above criteria is acceptable levels. 54

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Quick ratio The quick ratio is similar to the current ratio except that it excludes inventory, inventory is typically sold on credit, which means that it becomes an account receivable before being converted into cash. The ratio is calculated as follows: 55

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Quick ratio Suppose industry criteria was 1.20 : A high Quick ratio is an indication that the firm is liquid and has ability to meet its current liabilities. 56

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Cash Ratio It measures the firm’s ability to repay current liabilities by only using its cash and cash equivalents, the cash ratio does not include inventory or accounts receivable in the equation (Cash equivalents are assets which can be converted into cash quickly ). The ratio is calculated as follows: 57

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Cash Ratio Assume marketable securities convertible to cash now, and notes receivable 30$ are discount at the bank with 7% interest rate for 8 months: Suppose industry criteria was Preferable to be higher than criteria. The higher the cash ratio the lower the profitability, the lower the risk.

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59 Activity Ratios

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Measure the speed with which various accounts are converted into sales or cash—inflows or outflows. Activity Ratios include : 1.Account Receivable Turnover 8. Cash Conversion Cycle 2.Inventory Turnover 9. Total Assets Turnover 3.Account Payable Turnover 10. Fixed Assets Turnover 4.Average Collection Period 11. Working Capital Turnover 5.Inventory Conversion Period 12. Net Working Capital Turnover 6.Average Payment Period 13. Working Assets Turnover 7. Operating Cycle 14. Common Equity Turnover 60

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Account Receivable Turnover The ratio of the number of times that accounts receivable amount is collected during the year. The purpose of this ratio is to measure the liquidity of the receivables or to find out the period over which receivables remain uncollected. A higher ratio implies that a company is efficient in collecting its accounts receivables; a low ratio is an indicator that a company may need to reassess its accounts receivables procedures in order to improve timely collections of accounts receivables. 61

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Account Receivable Turnover The ratio is calculated as follows: Assume 50% from sale on credit: 62

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Account Receivable Turnover It is useful to compare this ratio against industry criteria, suppose industry criteria was 4 : The higher the account receivable turnover than industry criteria is more favorable. 63

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Inventory Turnover The inventory turnover ratio measures the number of times a company sells its inventory during the year, its Measures Company’s efficiency in turning its inventory into sales. Higher inventory turnover ratios are considered a positive indicator of effective inventory management, it indicate that the product is selling well, However, a higher inventory turnover ratio does not always mean better performance. It sometimes may indicate inadequate inventory level, which may result in decrease in sales. 64

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Inventory Turnover A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective buying. The ratio is calculated as follows: 65

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Inventory Turnover Suppose industry criteria was 8 The higher the turnover than industry criteria is more favorable. 66

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Account Payable Turnover Used to measure the length of time that is needed for a company to repay its creditors. Many companies extend the period of credit turnover, lower accounts payable turnover ratio getting extra liquidity. It is a sign that the company is taking longer to pay off its creditors. A figure for purchases is usually not available. Therefore, purchases are usually estimated as a percentage of cost of goods sold. 67

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Account Payable Turnover Higher ratio means that the company is paying of creditors quickly. The ratio is calculated as follows: Assume 75% from cost of goods sold on credit: 68

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Account Payable Turnover Suppose industry criteria was 3: The lower the account payable turnover than industry criteria is more favorable. 69

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Average Collection Period The average amount of time needed to collect accounts receivable. It represents the average number of days for which a firm has to wait before its debtors are converted into cash. The length of the collection period indicates the effectiveness with which a firm's management grants credit and collects from debtors. A short period is favorable because the firm obtains cash more quickly for reinvestment or for paying its own bills. 70

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Average Collection Period The ratio is calculated as follows: It is important to keep the ratio as low as possible. 71

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Average Collection Period Suppose industry criteria was 90 days: The lower the ratio than industry criteria is the better. 72

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Inventory Conversion Period It is relationship between total days in year and inventory turnover ratio, it measure the length of time required to produce and sell the product. This ratio is simply the inverse of the Inventory Turnover Ratio, if the inventory turnover decreases; the inventory conversion period will increase. Inventory conversion period is the part of cash conversion cycle. If this period is very high, it will increase the time to complete the cash conversion cycle. It means, there will be more liquidity risk in that level of inventory. 73

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Inventory Conversion Period The ratio is calculated as follows: 74

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Inventory Conversion Period Suppose industry criteria was 45 days: The lower the Inventory conversion period ratio than criteria is the better. 75

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Average Payment Period The number of days a company take to pay off credit purchases. A short average payment period means you turn over credit relatively quickly. A long payment period means you take longer to pay off creditors. Some companies would prefer a longer time to repay creditor, short period may mean that you are not able to use cash flow for further investment or to issue dividend payments to shareholders. 76

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Average Payment Period The ratio is calculated as follows: 77

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Average Payment Period Suppose industry criteria was 89 days: The higher the average payment period than industry criteria is more favorable 78

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Operating Cycle A firm’s operating cycle (OC) is the time from the beginning of the production process to collection of cash from the sale of the finished product. it refers to the delay between the buying of raw materials and the receipt of cash from sales proceeds. In other words, operating cycle refers to the number of days taken for the conversion of cash to inventory through the conversion of accounts receivable to cash. 79

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Operating Cycle The ratio is calculated as follows: A long operating cycle means that less cash is available to meet short term obligations. 80

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Operating Cycle Suppose industry criteria was 135 days: Operating cycle prefer to be less than industry criteria 81

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Cash Conversion Cycle The length of time in days that it takes for a company to convert resource inputs into cash flows. The CCC does this by following the cash as it is first converted into inventory and accounts payable, through sales and accounts receivable, and then back into cash. In order to reduce the cash conversion cycle (increase current cash on hand) a firm can either decrease Inventory Days, decrease Average Collection Period or increase Days Payable Outstanding. By doing one, or a combination of these, a firm will increase the amount of cash on hand and may be able to use this to pay of current liabilities or use this cash for Expenses, growth or dividend payments. 82

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Cash Conversion Cycle The company benefits by slowing down payment of account payable to its suppliers, because that allows the company to make use of the money for longer. High CCC refers to quickly a company to convert its products into cash through sales. The shorter the cycle is the less time capital is tied up in the business process. As a rule, the lower the CCC, the better. This is because as the cash conversion cycle shortens, cash becomes free for a company to invest in new equipment or other activities to rise investment return. 83

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Cash Conversion Cycle The ratio is calculated as follows: 84

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Cash Conversion Cycle Suppose industry criteria was 46: The company with lowest CCC is the better. 85

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Total Assets Turnover The total asset turnover ratio measures the ability of a company to use its assets to efficiently generate sales. This ratio considers all assets; current and fixed. The ratio is calculated as follows: A high ratio indicates that the company is using its assets efficiently to increase sales, while a low ratio indicates the opposite. 86

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Total Assets Turnover Suppose industry criteria was 2: The higher the total Asset turnover is the more effective use of the company's investments total assets. A higher asset turnover ratio than industry criteria is the better. 87

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Fixed Assets Turnover Measures a firm's ability to generate net sales from fixed-asset investments. The ratio is calculated as follows: A higher fixed-asset turnover ratio means a company uses its fixed assets more efficiently to generate sales, which can lead to higher profits. 88

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Fixed Assets Turnover Suppose industry criteria was 1.8 The higher the ratio is the better. 89

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Working Capital Turnover This ratio indicates the number of times the working capital is turned over in the year. Its measure the efficiency a firm is using its current assets to generate revenue. This ratio also a known as: (Current Assets Turnover, Liquidity Assets Turnover) The ratio is calculated as follows: 90

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Working Capital Turnover Suppose industry criteria was 2: A higher ratio indicates efficient utilization of working capital, and low ratio indicates inefficient utilization of working capital. 91

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Net Working Capital Turnover The net working capital turnover ratio is a measure how hard our working capital is "working" for the firm. Net Working capital is what you have left over after the company pays its short-term debt obligations. The net working capital turnover ratio is the one that helps in establishing a relationship between the net working capital and net sales. The ratio is calculated as follows: 92

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Net Working Capital Turnover Suppose industry criteria was 4.5 Generally, the higher the ratio is the better. 93

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Working Assets Turnover The ability of the company to generate revenues from its working assets. The ratio is calculated as follows: 94

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Working Assets Turnover Assume 10% from total assets non performing assets 95

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Common Equity Turnover Measure how well a company uses its stockholders' equity to generate revenue. The ratio is calculated as follows: 96

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Common Equity Turnover Suppose industry criteria was 1.5 The higher the ratio than criteria is the more efficiently a company is using its capital. 97

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98 Profitability Ratios

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Profitability Ratios: the firm’s ability to generate profit from used all resources. The difference between profitability and turnover that the turnover of a business is the amount of revenue it has earned in a particular accounting period. The profit is the amount remaining after deducting from the turnover the expenses incurred in earning it. 99

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Profitability Ratios Profitability Ratios include : 1.Gross Profit Margin 2.Operating Profit Margin 3.Net Profit Margin 4.Return on Common Equity 5.Return on Preferred Stock 6.Return on Total Equity 7.Return on Total Assets 8.Basic Earning Power 9.Earning Per Share (EPS) 100

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Gross Profit Margin The gross profit margin ratio measures how efficiently a company uses its resources, materials, and labor in the production process by showing the percentage of net sales remaining after subtracting the cost of making and selling a product. A high gross profit margin ratio indicates that a business can make a reasonable profit on sales. Low profit margin implies that the business is unable to control production costs, or that a low amount of earnings are generated from revenues. 101

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Gross Profit Margin The ratio is calculated as follows: 102

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Gross Profit Margin Suppose industry criteria was 70% A company with a higher gross profit margin than its competitors and industry criteria is more efficient. 103

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Operating Profit Margin The operating profit margin measures the percentage of each sales dollar remaining after all costs and expenses other than interest, taxes, and preferred stock dividends are deducted. The ratio is calculated as follows: 104

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Operating Profit Margin Operating margin can be used to compare a company with its competitors. Suppose industry criteria was 25% A high operating profit margin is preferred because if the operating profit margin is increasing, the company is earning more per dollar of sales. 105

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Net Profit Margin The net profit margin measures the percentage of each sales dollar remaining after all costs and expenses, including interest, taxes, and preferred stock dividends have been deducted. The higher the margin is the more effective the company in converting revenue into actual profit. The ratio is calculated as follows: 106

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Net Profit Margin We must compare net profit margin between companies in the same industry, suppose industry criteria was 30% Higher ratio refer to higher efficient a company than other competitors in generating profits. 107

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Return On Common Equity The return on common equity (ROCE) measures the return earned on the common stockholders’ investment in the firm. A variation of the Return on Equity formula which subtracts preferred dividends from net income and preferred equity from shareholders' equity. This variation shows the effect of common shares on profitability. A company with high return on equity is more successful in generating cash internally. Investors are always looking for companies with high and growing returns on common equity. 108

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Return On Common Equity The ratio is calculated as follows: 109

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Return On Common Equity A company’s return on common equity must compares with its industry average, suppose industry criteria was 12% The higher the ratio is the better, the owners are preferred the higher this return. 110

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Return On Preferred Stock The ratio is calculated as follows: 111

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Return On Total Equity It measures a firm's efficiency at generating profits from every unit of shareholders' equity. Investors usually look for companies with returns on equity that are high and growing. The ratio is calculated as follows: 112

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Return On Total Equity Suppose industry criteria was 20 % The benefit comes from the earnings reinvested in the company at a high ROE rate, which in turn gives the company a high growth rate. The benefit can also come as a dividend on common shares or as a combination of dividends and reinvestment in the company. 113

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Return On Total Assets often called the return on investment (ROI), measures the overall effectiveness of management in generating profits with its available assets. The ratio is calculated as follows: 114

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Return On Total Assets Suppose industry criteria was 7% A high ratio indicates that the business is earning more money and investing less on assets. 115

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Basic Earning Power This ratio indicates the ability of the firm's assets to generate operating income. Calculated by dividing earnings before interest and tax (EBIT) by performing assets. The ratio indication of how effectively assets are used to generate earnings. The ratio is calculated as follows: 116

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Basic Earning Power Or Assume 10% from total assets non performing assets 117

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Basic Earning Power Suppose industry criteria was 13% The higher the ratio the higher the profitability. 118

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Earning Per Share (EPS) The firm’s earnings per share is generally interest to present or prospective stockholders and management, EPS represents the amount of earnings per each outstanding share of a company's stock. The ratio is calculated as follows: 119

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Earning Per Share (EPS) The earnings per share is a good measure of profitability and when compared with EPS of similar companies it gives a view of the comparative earnings or earnings power of the firm. Suppose industry criteria was 3 : A company with a high earnings per share ratio is capable of generating a significant dividend for investors, The chances of getting high return on investment is maximum if you invest in the stocks of a company having a high earnings per share ratio. 120

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121 Debt Ratios

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Measures the firm’s ability to serve the debt. In general, the more debt the greater the financial leverage. Financial leverage is the magnification of risk and return through the use of fixed-cost financing, such as debt and preferred stock. 122

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Debt Ratios Debt Ratios include : 1.Debt Ratio 2.Short Debt Ratio 3.Long Debt Ratio 4.Debt to Equity Ratio 5.Short Debt to Equity 6.Long Debt to Equity 7.Equity to Debt 8.Times Interest Earned Ratio 9.Fixed Payment Coverage 123

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Debt Ratio Debt ratio measures the percent of total funds provided by creditors. it includes both current liabilities and long-term debt. Creditors prefer low debt ratios; but owners may seek high debt ratios to magnify their earnings. Some advantages of higher debt levels are: 1.The deductibility of interest from business expenses can provide tax advantages. 2.Returns on equity can be higher. 3.Debt can provide a suitable source of capital to start or expand a business. 124

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Debt Ratio The ratio is calculated as follows: the lower the ratio, the more conservative policy. 125

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Debt Ratio Suppose industry criteria was 0.50 The lower the ratio, the less leverage; and the stronger its equity position. In general, the higher the ratio, the higher the profitability, the greater the risk. 126

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Short Debt Ratio Short-term debt describes liabilities that are due to be paid within one year; it indicates whether a firm will be able to satisfy its current financial obligations. The ratio is calculated as follows: 127

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Long Debt Ratio Long debt ratio an indication of what portion of a company's total assets is financed from long term debt. The ratio is calculated as follows: 128

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Long Debt Ratio Suppose industry criteria was 25% The higher the level of long term debt is the more important for a company to have positive revenue and steady cash flow. 129

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Debt to Equity Ratio The debt-equity ratio is another leverage ratio that compares a company's total liabilities to its total shareholders' equity, It shows the extent to which shareholders' equity can fulfill a company's obligations to creditors in the event of a liquidation. The ratio is calculated as follows: 130

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Debt to Equity Ratio Suppose industry criteria was 80% Higher debt-to-equity ratio means that the business relies more on external lenders, the higher the ratio the higher the risk, the higher the profitability. Investing in a company with a higher debt/equity ratio may be riskier, especially in times of rising interest rates. A lower the ratio means that a company is using less leverage and has a stronger equity position. 131

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Short Debt to Equity This ratio explains the proportion of short debt and equity that the company is using to finance its operations. The ratio is calculated as follows: 132

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Long Debt to Equity Long debt to equity explains the relationship between long-term debts as related to that contributed by owners (investors). Long debt to equity expresses the degree of protection provided by the owners for the long-term creditors. The ratio is calculated as follows: 133

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Long Debt to Equity A company with a high long-term debt to equity is considered to be highly leveraged. Generally, companies with higher ratios are thought to be more risky because they have more liabilities and less equity. Suppose industry criteria was 55% The higher the ratio, the higher the risk, the higher the profitability. 134

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Equity to Debt The Equity to Total Debt ratio measures how much debt the company can have and still be able to meet debt obligations with its equity. The ratio is calculated as follows: 135

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Equity to Debt Suppose industry criteria was 1.25 High ratio is considered to be lower leveraged. 136

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Times Interest Earned Ratio Times interest earned ratio is another debt ratio that measures how well a company can meet its interest expense obligations. Sometimes called the interest coverage ratio. The ratio is calculated as follows: 137

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Times Interest Earned Ratio Suppose industry criteria was 9 : A high ratio means that a company is able to meet its interest obligations because earnings are significantly greater than annual interest obligations. A lower times interest earned ratio means fewer earnings are available to meet interest payments. 138

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Fixed Payment Coverage Measures the firm’s ability to meet all fixed-payment obligations, includes loan interest and principal, lease payments, and preferred stock dividends. The result of the fixed payment coverage ratio is the number of times the company can cover its fixed charges per year.. The ratio is calculated as follows: 139

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Fixed Payment Coverage The lower the ratio the greater the risk to both lenders and owners. Suppose industry criteria was 8 : A higher ratio indicates that the company is able to pay its fixed charges, while a lower ratio indicates the opposite. 140

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141 Market Ratios

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An equation that compares the current stock price to a financial indicator on the company's financial statements. Market-value ratios are calculated based on the figures expressed in a company's financial statements for a given period Market Ratios include : 1.Price/Earnings (P/E) Ratio 2.Market/Book (M/B) Ratio 142

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Price/Earnings (P/E) Ratio The P/E ratio measures the amount that investors are willing to pay for each dollar of a firm’s earnings. The P/E looks at the relationship between the stock price and the company’s earning. The level of this ratio indicates the degree of confidence that investors have in the firm’s future performance. The higher the P/E ratio, the greater the investor confidence. 143

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Price/Earnings (P/E) Ratio The ratio is calculated as follows: 144

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Price/Earnings (P/E) Ratio Suppose industry criteria was 11 A high P/E usually indicates that the market will pay more to obtain the company's earnings because investors believe the ability of firm to increase its earnings. A low P/E indicates that the market has less confidence that the firm's earnings will increase. 145

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Market/Book (M/B) Ratio Market/book ratio is a useful way of measuring your company’s performance and making quick comparisons with competitors. It is an essential figure to potential investors and analysts because it provides a simple way of judging whether a company is undervalued or overvalued. 146

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Market/Book (M/B) Ratio The ratio is calculated as follows: 147

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Market/Book (M/B) Ratio Suppose industry criteria was 2 : A higher P/B ratio could mean that the stock is overvalued 148

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