Is the company able to meet its current debt obligations? Are the company s assets being managed efficiently? Are working capital accounts at

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2 Is the company able to meet its current debt obligations? Are the company s assets being managed efficiently? Are working capital accounts at suitable levels? Is the company profitable? How does the company compare to competitors or to results from previous years?

3 A ratio is simply a numerator divided by a denominator, with the resulting calculation being a ratio of one of three types: A percent (e.g.,19%) A multiplier (e.g., 1.96x) A number of days (e.g., 19.6 days) Basic financial statements used are the Income Statement and Balance Sheet

4 Cross-Sectional: Compare one company s ratios to another. Time-Series: Evaluates performance over time within a company. Both

5 Can a business satisfy its short-term obligations as they come due. The three basic measures of liquidity are (1) net working capital (2) the current ratio (3) the quick ratio

6 Although not actually a ratio, it is a common measure of a firm s overall liquidity. Net working capital = current assets current liabilities

7 Purpose To give a general indication of the ability of a business (borrower) to meet its current obligations. Current assets Current liabilities $400,000 = = 2.0 times $200,000 Current assets Current liabilities Inventories $ 150,000 Trade and other payables $ 100,000 Trade receivables 190,000 Notes payable 80,000 Marketable securities 10,000 Accruals 20,000 Cash 50,000 Total current assets $ 400,000 Total current liabilities $ 200,000

8 Purpose To supplement the current ratio in measuring liquidity, this ratio places more emphasis on liquid assets that can be quickly converted into cash. Current assets Inventories Current liabilities $250,000 = = 1.25 times $200,000 Current assets Current liabilities Inventories Trade and other payables $ 100,000 Trade receivables $ 190,000 Notes payable 80,000 Marketable securities 10,000 Accruals 20,000 Cash 50,000 Total current assets $ 250,000 Total current liabilities $ 200,000

9 Measures the company s effectiveness at managing accounts receivable, inventory, accounts payable, fixed assets, and total assets. Further analyzes a company s liquidity.

10 Purpose The number of days an average item is in inventory. 365/(Cost of Goods Sold/Inventory) = 39 Days Revenue Statement of Income $ 2,500,000 Current assets Balance Sheet Cost of Goods Sold 1,400,000 Inventories $ 150,000 Gross profit $ 1,100,000 Total current assets $ 400,000

11 ACP =365/(Sales/Accounts Receivable) APP = 365/(COGS/Accounts Payable)

12 This indicates the amount of borrowed money that has been used to finance the acquisition of the firm s assets.

13 Purpose Measures the proportion of all debts provided by lenders to finance all assets. It is also called the debt ratio. Total liabilities Total assets $800,000 = = 67% $1,200,000 Non-current assets $ 800,000 Equity $ 400,000 Current assets 400,000 Non-current liabilities 600,000 Current liabilities 200,000 Total liabilities 800,000 Total assets $ 1,200,000 Total equity & liabilities $ 1,200,000

14 Purpose Shows the debt-paying ability of a business or its capacity to service the finance costs. Profit before taxes + Interest Interest = $235,000 $75,000 = 3.1 times Revenue Cost of sales Gross profit Other income Total distribution costs Total administrative expenses Interest Profit before taxes Income tax expense Profit for the year $ 2,500,000 (1,400,000) 1,100,000 80,000 (355,000) (590,000) (75,000) 160,000 (80,000) $ 80,000

15 These ratios measure the firm s earnings with respect to a given level of sales, a certain level of assets, the owners investments, or share value. Without profits a firm could not attract outside capital.

16 Revenue Cost of sales Gross profit Operating expenses Salaries Lease payments Depreciation Other expenses $ 2,500,000 (1,400,000) 1,100, $ % of sales (820,000) (20,000) (50,000) (50,000) (56.0) 44.0 (32.8) (0.8) (2.0) (2.0) $ 2,300,000 (1,334,000) 966,000 (763,600) 2012 $ % of sales (18,000) (30,000) (48,000) (58.0) 42.0 (33.2) (0.8) (1.3) (2.1) Total operating expenses (940,000) (37.6) (859,600) (37.4) Profit before taxes 160, , Income tax expense (80,000) (3.2) (53,200) (2.3) Profit for the year $ 80, $ 53,

17 Amount of change % of change Revenue $ 2,500,000 $ 2,300,000 $ 200, Cost of sales (1,400,000) (1,334,000) 66, Gross profit 1,100, , , Operating expenses Salaries (820,000) (763,600) 56, Lease payments (20,000) (18,000) 2, Depreciation (50,000) (30,000) 20, Other expenses (50,000) (48,000) 2, Total operating expenses (940,000) (859,600) 80, Profit before taxes 160, ,400 53, Income tax expense (80,000) (53,200) 26, Profit for the year $ 80,000 $ 53,200 $ 26,

18 Purpose Profit for the year Total assets Measures the return on funds invested in the business by both the owners and the lenders. $ 80,000 = = $ 1,200, % Statement of Income Revenue Cost of sales Gross profit Other income Total distribution costs Total administrative expenses Finance costs Profit before taxes Income tax expense Profit for the year $ 2,500,000 (1,400,000) 1,100,000 80,000 (355,000) (590,000) (75,000) 160,000 (80,000) $ 80,000 Balance Sheet Non-current assets $ 800,000 Current assets $ 400,000 Total assets $ 1,200,000

19 Purpose Shows how profitable a business is to its owners. Profit Equity $80,000 = = $400, % Statement of Income Balance Sheet Revenue $ 2,500,000 Cost of sales (1,400,000) Equity $ 400,000 Gross profit 1,100,000 Other income Total distribution costs Total administrative expenses Finance costs 80,000 (355,000) (590,000) (75,000) Non-current liabilities Current liabilities Total liabilities 600, , ,000 Profit before taxes Income tax expense 160,000 (80,000) Total equity & liabilities $ 1,200,000 Profit for the year $ 80,000