Chapter 9Foundations of FinancialRatio AnalysisWHUTAccountingdepartmentofmanagementschool
WHUT Accounting department of management school Chapter 9 Foundations of Financial Ratio Analysis
Financial statement analysis should not belimited to the assessment of sources anduses of funds. Another tool used to gauge thefinancial health of a business is financialratio analysisa financial ratio is the comparison of differentfigures which appear on a balance sheet oran income statementWHUTAccountingdepartmentofmanagementschool
WHUT Accounting department of management school Financial statement analysis should not be limited to the assessment of sources and uses of funds. Another tool used to gauge the financial health of a business is financial ratio analysis a financial ratio is the comparison of different figures which appear on a balance sheet or an income statement
1.ls this company able to meet its current debtobligations?2.Are the company's assets being managedeffectively?3.Are the business's accounts receivable andinventory at suitable levels?4.Will the company be able to meet its long-term debtcommitments?5.ls the company profitable?6.How does the company's financial structure andprofitability compare with those of others in theindustry?Z.Are the shareholders'return on investmentwhusatisfactory?Accountingdepartmentofmanagementschool
WHUT Accounting department of management school 1.Is this company able to meet its current debt obligations? 2.Are the company's assets being managed effectively? 3.Are the business's accounts receivable and inventory at suitable levels? 4.Will the company be able to meet its long-term debt commitments? 5.Is the company profitable? 6.How does the company's financial structure and profitability compare with those of others in the industry? 7.Are the shareholders' return on investment satisfactory?
Ratio analysis: cautionary notes(1)Economic assumptionsProportionality assumptionfixed costs(2)BenchmarksOptimal levels Industry norms as benchmarks(3)Timing and window dressingonly at specific points in timeseasonal businesswindow dressingWHUTAccountingdepartmentofmanagementschool
WHUT Accounting department of management school Ratio analysis: cautionary notes (1)Economic assumptions Proportionality assumption fixed costs (2)Benchmarks Optimal levels Industry norms as benchmarks. (3)Timing and window dressing only at specific points in time seasonal business window dressing
Four broad ratio categories:(1)Activity analysis(2)Liquidity analysis(3)Long-term debt and solvency analysis(4)Profitability analysisWHUTAccountingdepartmentofmanagementschool
WHUT Accounting department of management school Four broad ratio categories: (1)Activity analysis (2)Liquidity analysis (3)Long-term debt and solvency analysis (4)Profitability analysis
DISCUSSIONOFRATIOSBYCATEGORY1. Activity analysisthe firm's level of operation = the assetsneeded to sustain operating activities(1) Short-term activity ratiosDInventory turnover ratioInventory turnover=COGS/average inventoryAverage days inventory in stock=365/inventoryturnoverWHUTAccountingdepartmentofmanagementschool
WHUT Accounting department of management school 1. Activity analysis the firm’s level of operation = the assets needed to sustain operating activities. (1) Short-term activity ratios ①Inventory turnover ratio Inventory turnover=COGS/average inventory Average days inventory in stock =365/inventory turnover DISCUSSION OF RATIOS BY CATEGORY
②Receivables turnover ratioReceivables turnover=sales/average trade receivablesAverage days receivables outstanding=365/receivablesturnoverWHUTAccountingdepartmentofmanagementschoo
WHUT Accounting department of management school ②Receivables turnover ratio Receivables turnover =sales/average trade receivables Average days receivables outstanding =365/receivables turnover
(2) Long-term activity ratiosDFixed asset turnover ratioFixed assets turnover=sales/average fixed assets②Total asset turnoverTotal asset turnover=sales/average total assetsWHUTAccountingdepartmentofmanagementschool
WHUT Accounting department of management school (2) Long-term activity ratios ①Fixed asset turnover ratio Fixed assets turnover =sales/average fixed assets ②Total asset turnover Total asset turnover =sales/average total assets
2. Liquidity analysis(1) Length of cash cycleOperating cycle=lnventory + ReceivablesCash cycle= Inventory + Receivables -Payables(2)Working capital ratiosCurrent ratio=current assets/currentliabilitiesWHUTAccountingdepartmentofmanagementschool
WHUT Accounting department of management school 2. Liquidity analysis (1) Length of cash cycle Operating cycle=Inventory + Receivables Cash cycle= Inventory + Receivables – Payables (2)Working capital ratios Current ratio=current assets/current liabilities
3. Long-term debt and solvency analysisdebt ratiosTwo important factors should be noted:Therelativedebtlevelsthemselves②The trend over time in the proportion of debt toequityDebt to capital= total debt/total assetsDebt to equity =total debt/total equityWHUTAccountingdepartmentofmanagementschool
WHUT Accounting department of management school 3. Long-term debt and solvency analysis debt ratios Two important factors should be noted: ①The relative debt levels themselves ②The trend over time in the proportion of debt to equity Debt to capital= total debt/total assets Debt to equity =total debt/total equity