Working capital activity ratios (efficiency ratios)

Financial Statement Analysis

Turnover Income statement account Average rate No of days in a year
Financial statement analysis involves the assessment and evaluation of the firm's past performance, its present condition, and future Average balance sheet account Turnover
business potentials. The analysis serves to provide information about the following: The time required to complete one collection cycle-
1. Profitability of the business firm;
2. The firm's ability to meet its obligations; Receivable Turnover Net Credit Sales from the time receivables are recorded, then
3. Safety of the investment in the business; Ave. Net Receivables collected, to the time new receivables are
4. Effectiveness of management in running the firm; and recorded again.
5. Over-all company marketability. It indicates the average number of days during
Average age of receivables which the company must wait before receivables
Analytical tools and techniques: (days’ sales in receivables) Number of Working Days are collected. A low Receivables Turnover indicates
that the company may need other sources of cash
1. Analysis of variation in gross profit and net income (average collection period) (day’s Receivables turnover because customers are not paying fast enough.
2. Cash flow statement sales outstanding)
3. Vertical analysis (common size statements)
Measures the number of times that inventory is
4. Horizontal analysis (trend ratios and percentages)
Inventory Turnover Cost of goods sold “turned over” or sold during the period. A low
5. Financial ratios (ratio analysis)
Ave. Mdse. Inventory Inventory Turnover suggests that
Analytical Tools inventory is sitting for too long before it is sold.
1. Horizontal or Index Analysis- involves comparing figures shown in the financial statements of two or
more consecutive periods.
Formula:
Percentage Change = Most recent value – Base period value Average Age of Inventory* Indicates the average number of days during which
Base period value (inventory conversion period) Number of Working Days the company must wait before inventories are
(day’s sales in inventory) Inventory Turnover sold.
Comparisons can be made between actual and budget amount, with the ‘budget’ serving as the base pattern of performance.
A measure of the use of trade credit in financing
Limitation: Percentage change cannot be computed if the operations. A higher ratio means the company
a. Base year is zero or negative
Net Credit Purchases** is paying its trade payables faster. A declining A/P
b. The new value (current value) is zero.
Trade Payables Turnover Ave. Trade Payables
Turnover means the company is slowing its
2. Vertical Analysis - the process of comparing figures in the financial statements of a single period. It involves converting the figures payments to vendors, thus increasing its use of
in the statements to a common base (i.e. ratios, percentages). This is accomplished by expressing all figures in the statements as vendor credit as a means of financing the
percentage of an important item such as total assets (in the balance sheet) or net sales (in the income statement). Converted operations.
financial statements are called common size financial statements or percentage composition statements.
Ave. age of trade payables No. of working days Indicates the length of time during which payables
Percentage composition statements are used for comparing: (payable deferral period) (day’s remain unpaid
a. Multiple years of data from the same firm Payables Turnover
purchase in payables)
b. Companies that are different in size Cost of Sales + Operating Measures the movement and utilization of current
c. Company to industry averages Expenses*** / Average Current assets to meet operating requirements.
Current Assets Turnover Assets
Working Capital to total Working Capital Indicates relative liquidity of total assets
3. Ratio Analysis - involves the development of mathematical relationships between accounts in the financial statements. Ratios assets Total Assets
calculated from these statements provide users and analyst with the relevant information about the firm’s liquidity, solvency, and Cost of materials used
Raw materials turnover Average raw material inventory
profitability. Cost of goods manufactured
FINANCIAL RATIOS: Work in process turnover Average work in process inventory
Cost of goods sold Average
A. TESTS OF LIQUIDITY - liquidity refers to the company's ability to pay its short-term current liabilities as they fall due. Finished goods turnover finished goods inventory
*in some accounting and finance text, it is also called average sales period.
Current Ratio (banker’s Current Assets It measures the number of **cost of sales can be used if net credit purchase is not available.
ratio) (working capital Current Liabilities the times that the current ***exclude depreciation, amortization and other expenses related to long-term assets.
ratio) liabilities could be paid with the
available current assets. Note:
Acid Test Ratio Quick Assets* It measures the number of Operating cycle = Average age of receivables + Average age of inventories
times that the current
(Quick Ratio) Current Liabilities liabilities could be paid with the Cash flow cycle = Operating cycle - Average age of trade payables
available cash and near cash
assets.
*Cash + marketable securities + net receivables.
 Net income Ave. Measures the amount earned on the owners' or
stockholders' investment. This ratio ignores debt
B. TESTS OF SOLVENCY - solvency refers to the company's ability to pay all its debts, whether such liabilities are current Return on Owners' equity Owners' Equity capital.
or non-current. These ratios are leverage ratios. ‘Leverage’ refers to how much of a company’s resources are Net Income - Preferred Dividends Measures the amount of net income earned by
financed by debt and/or preferred equity, both of which require fixed payment of interest and dividends. (if any) / Weighted Ave. Number of
Earnings Per Share Common Shares each common share.
Times Interest Earned EBIT* Determines the extent to which operations cover Rate of Return on Current Net Income Measures the profitability of current assets
Interest expense interest expense Assets Average Current Assets invested
Rate of Return Per turnover Rate of Return on Ave. Current Shows profitability of each turnover of current
A common measure for analysis of capital of current Assets Assets / Current Assets Turnover assets.
structure; compares debt financing to total equity.
A ratio of less than one shows that the company Return on Equity = Return on Sales x Assets Turnover x Equity Multiplier
Debt-Equity Ratio Total Liabilities Total
has used more equity financing than debt. A ratio
Stockholders' equity
of more than one shows that more of the
D. MARKET TESTS:
company’s financing is accomplished with debt
Price/Earnings Ratio (P/E) Price Per Share Indicates the number of pesos required
than equity. Earnings Per Share to by P1 of earnings
This is a broader definition, showing debt as a Measures the cash return in the
Ordinary Dividend Per Share investor's common stock investments.
percentage of total assets. Note the difference Dividend Yield Price Per Share
between the Debt to Equity and the Debt ratios. Measures the percent of net income
Debt Ratio Total Liabilities While the numerator is the same in each one, the
Total Assets paid out to common stockholders.
denominator is Total Assets in the Debt Ratio and Ordinary Dividend Per Share Remember, to pay dividends, a company
Net Assets (equity) in the Debt to Equity Ratio. Dividend Pay-out Earnings Per Share
must have retained earnings as well as
Total Stockholders' Equity Proportion of total assets provided by owners.
Equity Ratio Total Assets cash (assuming a cash dividend.)
Reflects extent of the utilization of resources
Fixed Assets to Long-term Fixed Assets from long-term debt. Indicative of sources of
Liabilities Long-term liabilities additional funds.
Measures the proportion of owners' equity to
fixed assets. Indicative of over or under
Fixed assets to Total Equity Fixed Assets investment by owners; also, weakness in "trading
Total Equity on the equity".
Fixed assets to Total Fixed Assets (Net) Indicates possible over expansion of plant and
Assets Total Assets equipment.
Sales to fixed assets (plant Net Sales Fixed Test roughly the efficiency of management in
turnover) Assets (Net) keeping plant properties employed.
Measures recoverable amount in the event of
Book value per share on Common stock equity liquidation if assets are realized at their book
common stock # of outstanding common stock values.
Times Preferred Dividend Net income After Taxes Indicates ability to provide dividends to preferred
requirements Preferred Dividend Requirements stockholders.
Net income before taxes and fixed Measures ability to meet fixed charges.
Times Fixed Charges charges
Earned Fixed charges (rent + interest +
Sinking fund payment before
taxes)
*it is also computed as income before tax + interest expense
C. TESTS OF PROFITABILITY
Return on Sales Net income Determines the amount of income earned on each
Net Sales peso sales.
Return on Total Assets Net income Efficiency with which managers use total assets
(ROA) Average total assets to operate the business.