Financial Ratio Analysis

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1 2012 Financial Ratio Analysis Martin Zander

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3 M. Zander Financial Ratio Analysis This book has been purchased online on: XinXii.com ebooks & documents from indie authors 3

4 Copyright, Legal Notice and Disclaimer: This publication is protected under the US Copyright Act of 1976 and all other applicable international, federal, state and local laws, and all rights are reserved, including resale rights: you are not allowed to give or sell this Guide to anyone else. If you received this publication from anyone other than xinxii.com, you've received a pirated copy. Please note that much of this publication is based on personal experience and anecdotal evidence. Although the author and publisher have made every reasonable attempt to achieve complete accuracy of the content in this Guide, they assume no responsibility for errors or omissions. Also, you should use this information as you see fit, and at your own risk. Your particular situation may not be exactly suited to the examples illustrated here; in fact, it's likely that they won't be the same, and you should adjust your use of the information and recommendations accordingly. Any trademarks, service marks, product names or named features are assumed to be the property of their respective owners, and are used only for reference. There is no implied endorsement if we use one of these terms. Finally, use your head. Nothing in this Guide is intended to replace common sense, legal, medical or other professional advice, and is meant to inform and entertain the reader. So have fun with the ebook, and get your stuff done. Copyright 2012 Martin Zander. All rights reserved worldwide. 4

5 Contents Financial Ratio Analysis... 7 Why use ratios?... 7 Question 1: How liquid is the firm?... 7 Question 2: Is management generating adequate operating profits on the firm's assets?... 8 Question 3: How is the firm financing its assets?... 8 Question 4: Are the owners (shareholders) receiving an adequate return on their investment?... 8 Liquidity Ratios... 9 Current Ratio... 9 Acid Test or Quick Ratio Defensive Interval Ratio of Operating Cash Flow to Current Debt Obligations Efficiency Ratios Accounts Receivable Turnover Days in Accounts Receivable Inventory Turnover Days in Inventory Operating Cycle Capital Turnover Profitability Ratios Calculating Return on Equity Components of Return on Equity Operating Income to Sales Return on Assets Leverage Ratios Debt to Equity Debt Ratio Times Interest Earned Market Value Ratios Earnings Per Share P E Ratio Book Value per Share Dividend Yield Comparing Financial Statements Financial Statements Vertical Analysis Horizontal Analysis Summary

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7 Financial Ratio Analysis Why use ratios? It has been said that you must measure what you expect to manage and accomplish. Without measurement, you have no reference to work with and thus, you tend to operate in the dark. One way of establishing references and managing the financial affairs of an organization is to use ratios. Ratios are simply relationships between two financial balances or financial calculations. These relationships establish our references so we can understand how well we are performing financially. Ratios also extend our traditional way of measuring financial performance; i.e. relying on financial statements. Financial ratios provide the analyst with a means for making meaningful comparison of a firm's financial data over time and with other firms. Thus, financial ratios represent an attempt to standardize financial information in order to facilitate meaningful comparisons. Financial ratios help us identify some of the financial strengths and weaknesses of a company and help us compare the firm's performance to similar firms in the same industry. We can use ratios to answer some important questions about a firm's operations. Question 1: How liquid is the firm? The liquidity of a business is defined as its ability to meet maturing debt obligations. That is, does or will the firm have the resources to pay the creditors when the debt comes due? There are two ways to approach the liquidity question. 1. We can look at the firm's assets that are relatively liquid in nature and compare them to the amount of the debt coming due in the near term. 2. We can look at how quickly the firm's liquid assets are being converted into cash. 7

8 Question 2: Is management generating adequate operating profits on the firm's assets? We want to know if the profits are sufficient relative to the assets being invested. We have several choices as to how we measure profits: operating profits, or net profit. As net profit includes the unwanted effects of the firm's financing policies, this leaves operating profits as our best choice in measuring the firm's operating profitability. Question 3: How is the firm financing its assets? Here we are concerned with the mix of debt and equity capital the firm is using. Two primary ratios used to answer this question are the debt ratio and times interest earned. The debt ratio is the proportion of total debt to total assets. Times interest earned compares operating profit to interest expense for a crude measure of the firm's capacity to service its debt. Question 4: Are the owners (shareholders) receiving an adequate return on their investment? We want to know if the earnings available to the firm's owners or common equity investors are attractive when compared to the returns of owners of similar companies in the same industry. All these questions and more can be answered by using ratio analysis, which makes it one of the most powerful tools in your hand. Don't jump to conclusions that the ratios are the ultimate tools of financial analysis and would give you straight answers regarding the financial health of the company. Almost any ratio analyzed by itself can give you misleading indications. Consequently, when a disturbing 8

FAQ: Financial Ratio Analysis

FAQ: Financial Ratio Analysis Question 1: What is horizontal analysis of financial statement data? Answer 1: Horizontal analysis is a method of financial ratio analysis. Horizontal analysis is comparing each item on the financial statements