1. ELEC2804 Engineering Economics and Finance
Session 6: Financial Ratios
Dr. Wilton Fok

2. Contents 6.1 Introduction 6.2 Profitability 6.3 Liquidity
6.4 Capital Structure
6.5 Shareholder ratios
6.6 Efficiency
6.7 Limits of Financial Ratios
6.8 Summary

3. 6.1 Introduction What we have learnt in Accounting?
So far what we have learnt is Financial Accounting
It 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 Accounting
Managerial 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 incomes
Costing analysis – Measuring the cost of the business
Accounting 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 analysis
It 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. Introduction
Most 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 reports
Accounting ratios analysis

7. 6.1. Introduction Types of common Financial Ratios Profitability
Liquidity
Capital Structure
Shareholder ratios
Efficiency

8. Case: ABC Co. Balance Sheet
Assets:
Current assets
Cash $128,000
Accounts receivable $9,900
Less: Allowance for doubtful accounts – , 000
Merchandise inventory ,000
Raw materials inventory ,000
Work-in-process inventory ,000
Finished goods inventory ,000
Supplies inventory
Prepaid rent ,000
Prepaid insurance ,000
Total current assets $190,600

9. ABC Co. Balance Sheet Property, plant, and equipment
Administrative equipment $ 5,000
Selling furniture and fixtures 8,000
Production equipment 89,000 $102,000
Less: Accumulated depreciation – 18,000
Total property, plant, and equipment $ 84,000
Intangible assets
Patents $ 10,00
Copyrights
Trademarks ,400
Total intangible assets $ 12,000
Total assets $288,000

10. ABC Co. Balance Sheet Liabilities and stockholders’ equity:
Current liabilities
Accounts payable $ 6,000
Other accounts payable ,000
Interest payable ,000
Payroll taxes payable ,400
Sales taxes payable
Income taxes payable ,000
Current portion of long-term note payable 15,000
Total current liabilities $ 83,000
Long-term liabilities:
Note payable – Vail National Bank $ 60,000
Less: Current portion ,000
Total long-term liabilities ,000
Total 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 $ 60,000
Paid-in capital in excess of par
– common stock ,000
Total paid-in capital $100,000
Retained earnings ,000
Total stockholders’ equity ,000
Total liabilities and stockholders’ equity $288,000

12. ABC Co. P&L Account Net sales $527,000 Cost of goods sold 296,000
Gross profit $231,000
Selling expenses $48,000
Administrative expenses 73,00
Total operating expenses ,000
Operating income $110,000
Other revenues and expenses:
Interest revenue $
Interest expense (6,000)
Total other revenues and expenses (5,400)
Income before income taxes $105,000
Less Income taxes ,000
Net income $ 63,000
Earnings per share $

13. 6.2 Profitability
Profitability is the ease with which a company generates income
Profitability ratios measure a firm’s past performance and help predict its future profitability level
Common parameters for measuring Profitability:
1. Return on Assets (ROA)
2. Return on Equity (ROE)
3. Profit margin before income tax
4. Profit margin after income tax
5. Total Asset turnover
6. Gross Profit
7. Net Profit
8. 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 taxes
Total assets
In ABC Co:
ROA = $105,000  36%
$288,000

15. 6.2 Profitability 6.2.1 Return on assets (ROA)
(A) Profit margin before income tax
This ratio measures the percentage of income before income taxes produced by a given level of revenue
Profit margin before income tax =
PM= Net income before taxes
Sales
In 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 sales
Profit margin after income tax = Net income after taxes Sales
In ABC Co.
PM after tax = $63,000  12%
$527,000

17. 6.2 Profitability 6.2.1 Return on assets (ROA)
(C) Total asset turnover
This ratio calculates the amount of sales produced for a given level of assets used.
Total asset turnover = Sales
Total assets
In 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 Sales
Sales Total assets
= (A) Profit margin x (C) Total asset turnover
A company may have a good ROA if either
Case 1: they can achieve a high profit margin, OR
Case 2: They can a high Total asset turnover
Which 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 assets
Current liabilities
In ABC Co,
Current Ratio = $190,000  2.27
$83,000
If too small, may not have enough assets for paying liability
If too high, the firm cannot fully leverage the loan
Recommended 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’ equity
Debt ratio = Total liabilities / Total assets
In 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 Ratios
6.3.4 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 taxes
Interest expense
In the ABC Co.:
Coverage ratio = ($105,000 + $6,000)  18.5 times
$6,000

23. 6.4 Shareholder ratios
Shareholders and investors are interested in the shareholder ratios which shows the effectiveness of their investments
Earnings per share
Dividend yield
Dividend cover
Price earnings ratio

24. 6.4 Shareholder ratios Earning per share E.g. in ABC Co.
= net profit after tax and preference dividends
no. of ordinary shares in issue
ABC Co, P&L Account
Net sales $527,000
Cost of goods sold ,000
Gross profit $231,000
Selling expenses $48,000
Administrative expenses 73,00
Total operating expenses 121,000
Operating income $110,000
Other revenues and expenses:
Interest revenue $
Interest expense (6,000)
Total other revenues and expenses (5,400)
Income before income taxes $105,000
Less Income taxes ,000
Net income $ 63,000
Earnings 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 share
market price per share
Dividend cover
= Net profit after tax and preference dividends
net dividend on ordinary shares

26. 6.5 Shareholder ratios
Price Earning ratio (P/E Ratio) = Market price Earning per share
It tells the “Payback” of the investment
A 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 capital
Inventory Turnover
Receivable 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 sales
Inventory
In 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 days
Thus, 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 sales
Accounts receivable
In the ABC Co.
Net credit sales = $151,000 – $2,000 = $149,000
Receivable turnover = $149,000 / $9,000  16 times
Average collection period = 365 / 16  23 days
Thus, 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.

32. Thank you! Q&A