1. Financial Ratio Analysis
Financial analysis:
Applying analytical techniques to financial statements and other relevant data to produce information useful for decision making.
Focus
Three Issues :
Profitability, Liquidity, Safety (Solvency or Risk)
In general, each financial ratio is closely related to one of the three fundamental issues.
This analysis is intended as a background review. See also “Merrill Lynch How to Read A Financial Statement” which is available on the web.

2. Balance Sheet GI Company December 31
Year 1 (Current year) Year 2 (Last year)
Current Assets:
Cash and cash equivalents $ , $ 35,000
Trading securities (at fair value) , ,000
Accounts receivable , ,000
Inventory (at lower of cost or market) , ,000
Total current assets , ,000
Investments available-for-sale (at fair value) , ,000
Fixed Assets:
Property, plant, and equipment (at cost) ,900, ,800,000
Less: Accumulated depreciation (380,000) (350,000)
1,520, ,450,000
Goodwill , ,000
Total assets $2,615,000 $2,450,000
Current Liabilities:
Accounts payable $ 150,000 $ 125,000
Notes payable , ,000
Accrued and other liabilities , ,000
Total current liabilities , ,000
Long-term debt:
Bonds and notes payable , ,000
Total liability ,345, ,300,000
Stockholders’ Equity:
Common stock (100,000 shares outstanding) , ,000
Additional paid-in capital , ,000
Retained earnings , ,000
Total equity ,270, ,150,000
Total liability and equity $2,615,000 $2,450,000

3. Income Statement GI Company (Year – 1) Sales $1,800,000
Cost of goods sold
(1,000,000)
Gross profit
800,000
Operating expenses
(486,697)
Interest expense
Depreciation and Amortization expense
(10,000 )
(13,303)
Net income before income taxes
290,000
Income taxes (31%)
( 90,000)
Net income after income taxes
$ 200,000
Earning per share $2
Operating cash flow
$255,000
Dividends for the year
$0.80 per share
Market price per share
$12

4. Working capital = Current assents – Current liabilities
Liquidity Ratios
Working capital = Current assents – Current liabilities
Year 2: $715,000 – $695,000 = $20,000
Year 1: $665,000 – $700,000 = ($35,000)

5. Current ratio (working capital ratio) =
Liquidity Ratios
Current assets
Current liabilities
Current ratio (working capital ratio) =
Year 2: =
Year 1: =
$715,000
$695,000
$665,000
$700,000
= 1.03
= 0.95
(Industry average = 1.5)
The ratio, and therefore Gi’s ability to meet its short-term obligations, has improved, though it is low compared to the industry’s average

6. Cash equivalents + Market securities + Net receivables
Liquidity Ratios
Acid-test ratio =
Cash equivalents + Market securities + Net receivables
Current liabilities
(Year 2) =
(Year 1) =
$50,000 + $75,000 + $300,000
$695,000
$35,000 + $65,000 + $290,000
$700,000
= 1.03
= 0.95
(Industry average = 0.80)
The industry average of .80 is higher than Gi’s ratio, which indicates that Gi may have trouble meeting short-term needs.

7. Cash equivalents + Marketable securities
Liquidity Ratios
Cash equivalents + Marketable securities
Current liabilities
Cash ratio =
(Year 2) =
(Year 1) =
$50,000 + $75,000
$695,000
= 0.18
= 0.14
$35,000 + $65,000
$700,000

8. Accounts receivable turnover =
Activity Ratios
Net credit sales
Gross receivables
Accounts receivable turnover = =
= times
$1,800,000
$300,000
This ratio indicates the receivables’ quality and indicates the success of the firm in collecting outstanding receivables. Faster turnover gives credibility to the current and acid-test ratios.

9. Accounts receivable turnover in days =
Activity Ratios
Gross receivables
Net credit sales / 365
Accounts receivable turnover in days = =
= days
365 days
Receivable turnover
This ratio indicates the average number of days required to collect accounts receivable.

10. Cost of goods sold Inventory turnover = Average inventory = $1,000,000
Activity Ratios
Cost of goods sold
Average inventory
Inventory turnover = =
= times
$1,000,000
$290,000
This measure of how quickly inventory is sold is an indicator of enterprise performance. The higher of turnover, in general, the better the performance.

11. Inventory turnover in days =
Activity Ratios
Average inventory
Cost of goods sold / 365
Inventory turnover in days = =
= days
365 days
Inventory turnover
3.45
This ratio indicates the average number of days required to sell inventory.

12. Operating cycle = AR turnover in days + Inventory turnover in days
Activity Ratios
Operating cycle = AR turnover in days + Inventory turnover in days
= days days
= days
This operating cycle indicates the number of days between acquisition of inventory and realization of cash from selling the inventory.

13. Working capital turnover =
Activity Ratios
Sales
working capital
Working capital turnover = =
= 90 times
$1,800,000
$715,000 - $695,000
This ratio indicates how effectively working capital is used.

14. Return on total assets = Net income/Total assets
Profitability Ratios
Return on total assets = Net income/Total assets
= $200,000 / $2,615,000
= 7.65%

15. Gross margin percentage = Gross margin / Sales
Profitability Ratios
Gross margin =
Sales – Cost of Good Sold
= $1,800,000 - $1,000,000
= $800,000
Gross margin percentage = Gross margin / Sales
= $800,000 / $1,800,000
= 44.44%
This ratio is a good indication of how profitable a company is at the most fundamental level. Companies with higher gross margins will have more money left over to spend on other business operations, such as research and development or marketing.

16. Net income Net profit margin = Net sales = $200,000 = 11.11%
Profitability Ratios
Net income
Net sales
Net profit margin = =
= %
$200,000
$1,800,000
This ratio indicates profit rate and, when used with the asset turnover ratio, indicates rate of return on assets, as show below.

17. Operating income Total sales Operating margin = Profitability Ratios
$800,000 - $486,697
$1,800,000 =
= %
Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt.

18. Net sales Total asset turnover = Total assets = $1,800,000
Activity Ratios
Total asset turnover =
Net sales
Total assets =
= times
$1,800,000
$2,615,000
This ratio is an indicator of how Gi makes effective use of its assets. A high ratio indicates effective asset use to generate sales.

19. DuPont return on assets = Net income/Total assets
Profitability Ratios
DuPont return on assets = Net income/Total assets
Net income
Net sales
Total assets x =
= % x 0.69times
= 7.67%
Note that this ratio uses both net profit margin and the total asset turnover. This ratio allows for increased analysis of the changes in the percentages. The net profit margin indicates the percent return on each sale while the asset turnover indicates the effective use of assets in generating that sale.

20. Net income + Interest expense (1- Tax rate)
Profitability Ratios
Net income + Interest expense (1- Tax rate)
Long-term liabilities + Equity
Return on investment = =
= 0.11 times
$200,000 + $10,000 (1-0.31)
$650,000 + $1,270,000
ROI measures the performance of the firm without regard to the method of financing.

21. Net income – Preferred dividends
Profitability Ratios
Net income – Preferred dividends
common equity
Return on common equity = =
= %
$200,000 - $0
$1,270,000

22. Common stockholders’ equity
Long-term Debt-paying Ability Ratio
Total liabilities
Common stockholders’ equity
Debt / Equity =
(Year 2) = $1,345,000 / $1,270,000 = 1.06
(Year 1) = $1,300,000 / $1,150,000 = 1.13
This ratio indicates the degree of protection to creditors in case of insolvency. The lower this ratio the better the company’s position. In Gi’s case, the ratio is very high, indicating that a majority of funds come from creditors. However, the ratio is improving.

23. Total liabilities Debt ratio = Total assets
Long-term Debt-paying Ability Ratio
Total liabilities
Total assets
Debt ratio =
(Year 2) = $1,345,000 / $2,615,000 = 51.4%
(Year 1) = $1,300,000 / $2,450,000 = 53.1%
This ratio indicates that more than half of the assets are financed by creditors.

24. Returning income before taxes and interest
Long-term Debt-paying Ability Ratio
Returning income before taxes and interest
Interest
Times interest earned = =
= 30 times
$290,000 + $10,000
$10,000
This ratio reflects the ability of a company to cover interest charges. It uses income before interest and taxes to reflect the amount of income available to cover interest expense.

25. Operating cash flow / Total debt =
Long-term Debt-paying Ability Ratio
Operating cash flow
Total debt
Operating cash flow / Total debt = =
= %
$255,000
$1,345,000
This ratio indicates the ability of the company to cover total debt with yearly cash flow.

26. The operating cash flow ratio =
Liquidity Ratios
Cash from operations
Current liabilities
The operating cash flow ratio =
$255,000
$700,000 = =
The purpose of this ratio is to assess whether or not a company's operations are generating enough cash flow to cover its current liabilities. If the ratio falls below 1.00, then the company is not generating enough cash to meet its current commitments.
Note: The cash from operating activities is $255,000 shown at the bottom of the income statement.

27. EBIT Profitability Ratio = Earnings + Interest Expense + Tax Expense
= $200,000 + $10,000 + $90,000
= $300,000
A measure of a company's earning power from ongoing operations, equal to earnings before deduction of interest payments and income taxes. EBIT excludes income and expenditure from unusual, non-recurring or discontinued activities.

28. EBITDA Profitability Ratio
= Earnings + Interest Expense + Tax Expense +
Depreciation + Amortization
= $200,000 + $10,000 + $90,000 + $13,303
= $ 313,303
This earnings measure is of particular interest in cases where companies have large amounts of fixed assets which are subject to heavy depreciation charges or in the case where a company has a large amount of acquired intangible assets on its books and is thus subject to large amortization charges. Since the distortionary accounting and financing effects on company earnings do not factor into EBITDA, it is a good way of comparing companies within and across industries.