2 Contents 6.1 Introduction 6.2 Profitability 6.3 Liquidity 6.4 Capital Structure6.5 Shareholder ratios6.6 Efficiency6.7 Limits of Financial Ratios6.8 Summary
3 6.1 Introduction What we have learnt in Accounting? So far what we have learnt is Financial AccountingIt Focuses on preparing external financial reports that are used by the outsiders, that is, people who have an interest in the business but are not part of the management.We record the transactions and prepared a summary of Profit and loss, assets, liabilities and owner’s equity.Annual Report describes a firm’s financial status and usually discusses the firm’s activities during the past year and its prospects for the future.
4 6.1. Introduction Managerial Accounting. Financial accounts and statements are records of past events. Reports of future estimates are called Budgets.For reports of future, we must analyze the past and plan the future.Thus, Analysis, Measurement, and Planning are fundamental in Managerial AccountingManagerial Accounting provides financial information that managers inside the organization can used them to evaluate and make decisions about current and future operations.Techniques:Budgeting - Planning exercise for financial expenditures and incomesCosting analysis – Measuring the cost of the businessAccounting Ratios – Analyzing the performance, efficiency and profitability of a firm
5 6.1 Introduction Financial statements analysis It is the process of looking beyond the face of the financial statements to gain additional insight into a company’s financial health.Ratio analysisIt is a technique for analyzing the relationship between two items from a company’s financial statements for a given period.calculating & interpreting financial ratios taken from financial reports to assess a firm.
6 Accounting ratios analysis 6.1. IntroductionMost of the accounting ratios are derived from the financial statements: balance sheet; P & L account, and cash flow statement.Besides Balance Sheet, P & L Account, and Cash Flow Statement. There are other Managerial Accounting Reports, e.g.: sales report , production costs reports , operation costs reports , suppliers accounts , clients accounts and other detailed financial reportsAccounting ratios analysis
7 6.1. Introduction Types of common Financial Ratios Profitability LiquidityCapital StructureShareholder ratiosEfficiency
10 ABC Co. Balance Sheet Liabilities and stockholders’ equity: Current liabilitiesAccounts payable $ 6,000Other accounts payable ,000Interest payable ,000Payroll taxes payable ,400Sales taxes payableIncome taxes payable ,000Current portion of long-term note payable 15,000Total current liabilities $ 83,000Long-term liabilities:Note payable – Vail National Bank $ 60,000Less: Current portion ,000Total long-term liabilities ,000Total liabilities $128,000
11 ABC Co. Balance Sheet Stockholders’ equity Paid-in capital: Common stock, $10 par value,100,000 shares authorized,4,000 shares issued and outstanding $ 60,000Paid-in capital in excess of par– common stock ,000Total paid-in capital $100,000Retained earnings ,000Total stockholders’ equity ,000Total liabilities and stockholders’ equity $288,000
12 ABC Co. P&L Account Net sales $527,000 Cost of goods sold 296,000 Gross profit $231,000Selling expenses $48,000Administrative expenses 73,00Total operating expenses ,000Operating income $110,000Other revenues and expenses:Interest revenue $Interest expense (6,000)Total other revenues and expenses (5,400)Income before income taxes $105,000Less Income taxes ,000Net income $ 63,000Earnings per share $
13 6.2 ProfitabilityProfitability is the ease with which a company generates incomeProfitability ratios measure a firm’s past performance and help predict its future profitability levelCommon parameters for measuring Profitability:1. Return on Assets (ROA)2. Return on Equity (ROE)3. Profit margin before income tax4. Profit margin after income tax5. Total Asset turnover6. Gross Profit7. Net Profit8. Return on Capital
14 6.2 Profitability 6.2.1 Return on assets (ROA): This ratio measures how efficiently the company uses its assets to produce profits.ROA = Net income before taxesTotal assetsIn ABC Co:ROA = $105,000 36%$288,000
15 6.2 Profitability 6.2.1 Return on assets (ROA) (A) Profit margin before income taxThis ratio measures the percentage of income before income taxes produced by a given level of revenueProfit margin before income tax =PM= Net income before taxesSalesIn ABC Co:PM = $105,000 20%$527,000
16 6.2 Profitability (B) Profit margin after income tax: This ratio measures the amount of after-tax net income generated by a dollar of salesProfit margin after income tax = Net income after taxes SalesIn ABC Co.PM after tax = $63,000 12%$527,000
17 6.2 Profitability 6.2.1 Return on assets (ROA) (C) Total asset turnoverThis ratio calculates the amount of sales produced for a given level of assets used.Total asset turnover = SalesTotal assetsIn ABC Co:= $527,000 = 1.83 times$288,000
18 6.2 Profitability 6.2.1 Return on assets (ROA) Relationship among the ratios:Return on assets = Net income before tax x SalesSales Total assets= (A) Profit margin x (C) Total asset turnoverA company may have a good ROA if eitherCase 1: they can achieve a high profit margin, ORCase 2: They can a high Total asset turnoverWhich one should be preferred?
19 6.3 Liquidity Ratios 6.3 Liquidity Ratios An liquidity describes the ease with which it can be converted to cash.Liquidity ratios evaluate a firm’s ability to generate sufficient cash to meet its short-term obligations.Liquidity Ratios are of most interest to stockholders, long-term creditors, and company management.
20 6.3 Liquidity Ratios 6.3.1. Current ratio This ratio measures the company’s ability to meet its current liabilities with current assets.Current ratio = Current assetsCurrent liabilitiesIn ABC Co,Current Ratio = $190,000 2.27$83,000If too small, may not have enough assets for paying liabilityIf too high, the firm cannot fully leverage the loanRecommended value = 2 to 1 or greater
21 6.3 Liquidity Ratios In the ABC Co. Ltd.: 6.3.3 Debt ratio: It measures what proportion of a company’s assets is financed by debt.Assets = Liabilities + Owners’ equityDebt ratio = Total liabilities / Total assetsIn the ABC Co. Ltd.:Debt ratio = $128,000 / $288,000 45%Why is some amount of debt useful?
22 Coverage ratio = ($105,000 + $6,000) 18.5 times 6.3 Liquidity Ratios6.3.4 Coverage ratio:This ratio is also called the times-interest-earned ratio.It indicates a company’s ability to make its periodic interest payments.Coverage ratio= Earnings before interest expense and income taxesInterest expenseIn the ABC Co.:Coverage ratio = ($105,000 + $6,000) 18.5 times$6,000
23 6.4 Shareholder ratiosShareholders and investors are interested in the shareholder ratios which shows the effectiveness of their investmentsEarnings per shareDividend yieldDividend coverPrice earnings ratio
24 6.4 Shareholder ratios Earning per share E.g. in ABC Co. = net profit after tax and preference dividendsno. of ordinary shares in issueABC Co, P&L AccountNet sales $527,000Cost of goods sold ,000Gross profit $231,000Selling expenses $48,000Administrative expenses 73,00Total operating expenses 121,000Operating income $110,000Other revenues and expenses:Interest revenue $Interest expense (6,000)Total other revenues and expenses (5,400)Income before income taxes $105,000Less Income taxes ,000Net income $ 63,000Earnings per share $E.g. in ABC Co.Earning per share = / 4000 = $15.75
25 6.4 Shareholder ratios market price per share Dividend yield = Gross dividend per sharemarket price per shareDividend cover= Net profit after tax and preference dividendsnet dividend on ordinary shares
26 6.5 Shareholder ratiosPrice Earning ratio (P/E Ratio) = Market price Earning per shareIt tells the “Payback” of the investmentA P/E of 19 (times) means that the investment will be breakeven in 19 years (ignore the stock price increment)The reasonable P/E of a listed company is around The P/E of a fast growth company can be over 20-30
27 6.6 Efficiency“Efficiency” measures the efficiency and effectiveness of employing the company resources, including capital, stock, debt and cash…etc.Important parameters are:Net sales to working capitalInventory TurnoverReceivable Turnover (Creditor Turnover)
28 6.6 Efficiency 6.6.1. Net sales to working capital This ratio indicates the level of sales generated for a given level of working capital (which is ‘the money or equivalent you have to work with currently’).Net sales to working capital= Sales(Current assets – Current liabilities)In ABC Company= $527,000 4.94 times($190,000 – $83,000)
29 6.6 Efficiency 6.6.2 Inventory turnover This ratio indicates the number of times total merchandise inventory is purchased (or finished goods inventory is produced) and sold during a period.Inventory turnover = Cost of salesInventoryIn the ABC Co.:Inventory turnover = $295, 16.5 times($4,000 + $13,000)Average number of days Elevation Sports, Inc., holds its inventory = 365 / 16.5 22 daysThus, the shorter the number of days of inventory held (higher turnover ratio), the better - is this always true?.
30 6.6 Efficiency 6.6.3. Receivables turnover (Creditor Turnover) It measures how quickly a company collects its accounts receivable.Accounts receivable turnover = Net credit salesAccounts receivableIn the ABC Co.Net credit sales = $151,000 – $2,000 = $149,000Receivable turnover = $149,000 / $9,000 16 timesAverage collection period = 365 / 16 23 daysThus, the shorter the collection period (higher turnover ratio), the better – is this always true?
31 6.7 Limitations of Ratio Analysis 1. Attempting to predict the future using past results depends upon the predictive value of the information used.2. The financial statements used to compute the ratios are based on historical cost.3. Figures from the balance sheet used to calculate the ratios are year-end numbers.4. Different industries had different benchmarking values. It is difficult to compare the ratios of a company in one industry with those of a company in another industry.5. Lack of uniformity concerning what is to be included in the numerators and denominators make comparisons extremely difficult.