CHAPTER OBJECTIVES:

This chapter introduces ratios, the basic tools of financial analysis. Our
goals are to:
1. Examine the purpose and use of ratios and provide some
cautionary notes.
2. Explain the use of common-size statements.
3. Discuss the construction and use of:
• Activity (turnover) ratios that measure the efficiency with
which the firm uses its resources.
• Liquidity ratios that assess the firm’s ability to meet its near-
term obligations.
• Solvency ratios that examine capital structure and the firm’s
ability to meet long-term obligations and capital needs.
• Profitability ratios that measures income relative to revenues
and invested capital.
4. Examine the computation and usefulness of earnings per share
and other ratios used for valuation purposes.

INTRODUCTION

Financial ratios are used to compare the risk and return of different
firms in order to help equity investors and creditors make intelligent
investment and credit decisions. Such decisions range from an
evaluation of change in performance over time for a particular
investment to a comparison among all firms within a single industry at
a specific point in time. The informational needs and appropriate
analytical techniques used for these investment and credit decisions
depend on the decision maker’s time horizon. Short-term bank and
trade creditors are primarily interested in the immediate liquidity of
the firm. Long-term creditors (e.g., bondholders) are interested in long-
term solvency. Creditors seek to minimize risk and ensure that
resources are available for the payment of interest and principal
obligations.

Equity investors are primarily interested in the long-term earning

power of the firm. As the equity investor bears the residual risk (which
can be defined as the return from operations after all claims from
suppliers and creditors have been satisfied), it requires a return
proportionate to the risk. The residual risk is highly volatile and difficult
to quantify, as is the equity investor’s time horizon. Thus, analysis by
the equity investor needs to be the most comprehensive, and it
includes the analysis carried out by other users.
Objective of Ratio Analysis

A primary advantage of ratios is that they can be used to compare the

risk and return, relationships of firms of different sizes. Ratios can
provide a profit of a firm, its economic characteristics and competitive
strategies, and its unique operating, financial, and investment
characteristics.

This process of standardization may, however, be deceptive as it

ignores differences between industries, the effect of varying capital
structures, and differences in accounting and reporting methods
(especially when comparisons are international in scope). Given these
differences, changes (trends) in a ratio and variability over time may
be more informative than the level of the ratio at any point in time.

Four broad ratio categories measure the different aspects of risk and
return relationships:

1. Activity analysis: Evaluates revenue and output generated by

the firm’s assets.
2. Liquidity analysis: Measures the adequacy of a firm’s cash
resources to meet its near-term cash obligations.
3. Long-term debt and solvency analysis: Examines the firm’s
capital structure in terms of the mix of its financing sources and
the ability of the firm to satisfy its longer-term debt and
investment obligations.
4. Profitability analysis: Measures the income of the firm relative
to its revenues and invested capital, to judge the present and
future earning capacity or profitability of the concern.

Utilisation

1. To judge the operational efficiency of the concern as a whole and

its various parts or departments.
2. To judge the short-term and long-term solvency of the concern
for the benefit of the debenture holders and trade creditors.
3. To have comparative study in regard to one firm with another
firm or one department with another department.
4. To help in assessing developments in the future by making
forecasts and preparing budgets.

These categories are interrelated rather than independent. For

example, profit-ability affects liquidity and solvency, and the
efficiency with which assets are used (as measured by activity
analysis) impacts profitability. Thus, financial analysis relies on an
integrated use of many ratios, rather than a selected few.

Limitations of Accounting Ratios:

Ratio analysis is essential to comprehend financial analysis.

However, ratios are based on implicit assumptions that do not
always apply. Ratio computations and comparisons are further
confounded by the lack or inappropriate use of benchmarks, the
timing of transactions, negative numbers, and differences in
reporting methods. This section presents some important caveats
that must be considered when interpreting ratios.

No idea of probable happenings:

Ratios are an attempt to make an analysis of the past financial

statements; so they are historical documents. Now -a –days keeping
in view the complexities of the business, it is important to have an
idea of the probable happenings in future.

Variation in Accounting:

The two firms’ results are comparable with the help of accounting
ratio only if they follow the same accounting methods or bases.
Comparison will become difficult if the two concerns follow the
different methods of providing depreciation or valuing stock.
Similarly if the two firms were following two different standards and
methods, an analysis by reference to the ratios would be
misleading. Moreover, utilization of inbuilt facilities, availability of
facilities and scale of operation would affect financial statements of
different firms. Comparison of financial statements of such firms by
means of ratios is bound to be misleading.

Price level changes:

Changes in price levels make comparison for various years difficult.

For example, the ratio of sales to total assets in 1984 would be
much higher than in 1970 due to rising prices, fixed assets being
shown at cost and not at market price.

Only one method of analysis:

Ratios analysis is only a beginning and gives just a fraction of

information needed for decision-making. So, to have a
comprehensive analysis of financial statements, ratios should be
used along with other methods of analysis.
 No common standards:

It is very difficult to lay down a common standard for comparison

because circumstances differ from organization to organization and
the nature of each industry is different. For example, a business
with current ratio of more than 2:1 might not be in a position to pay
current liabilities in time because of an unfavourable distribution of
current assets in relating to liquidity. On the other hand, another
business with a current ratio of ever less than 2:1 might not be
experiencing any difficulty in making the payment of current
liabilities in time because of its favourable distribution of current
assets in relation to liquidity.

Economic Assumptions:

Ratio analysis is designed to facilitate comparisons by eliminating

size differences across firms. Implicit in this process is the
proportionality assumption that the economic relationship between
numerator and denominator does not depend on size. This
assumption ignores the existence of fixed costs. When there are
fixed costs, changes in total costs (and thus profits) are not
proportional to changes in sales. Moreover, the implicit assumption
of a linear relationship between numerator and denominator may
be incorrect even in the absence of a fixed component. For
example, the inventory turnover ratio, COGS/inventory, implies a
constant relationship between the volume of sales and inventory
levels. Management science theory, however, indicates that the
optimum relationship is nonlinear and inventory levels may be
proportional to the square root of demand. Thus, a doubling in
demand should increase inventory by only 40% (approximately)
with a consequent 40% increase in the turnover ratio. The inventory
turnover ratio is clearly not size-independent.

Benchmarks:

Ratio analysis often looks appropriate benchmarks to indicate optimal

levels. The evaluation of a ratio often depends on the question posed
by the analyst. For example, from the point of view of a short-term
lender, a high liquidity ratio may be a positive indicator. However, from
the perspective of an equity investor, it
may indicate poor cash or working capital management. Using an
industry average as the benchmark may be useful for comparisons
within an industry, but not for comparisons between industries. Even
for intra-industry analysis, the benchmark may have limited usefulness
if the whole industry or major firms in that industry are doing poorly.

Timing and Window Dressing:

Data used to compute ratios are available only at specific points in

time when financial statements are issued. For annual reports, the
fiscal year-end may correspond to the low point of a firm’s operating
cycle. When reported levels of assets and liabilities may not reflect the
levels typical of normal operations. As a result, especially in the case of
seasonal businesses, ratios may not reflect normal operating
relationships. For example, inventories and accounts payable may be
understated. Reference to interim statements is one way of alleviating
this problem. The timing issue leads to another problem. Transactions
at year-end can lead to manipulation of the ratios to show the firm in a
more favorable light, often called window dressing. For example, a firm
with a current ratio (current assets/current liabilities) of 1.5 (Rs:300/
Rs:200) can increase it to 2.0 (Rs.200/Rs.100) by simply using cash of
Rs100 to reduce accounts payable immediately prior to the period’s
end.

COMMON-SIZE STATEMENTS:

A pervasive problem when comparing a firm’s performance over time

is that the firm’s size is always changing. Firms of different sizes are
also difficult to compare. Common-size statements are used to
standardize financial statement components by expressing them as a
percentage of a relevant base. For example, balance sheet
components can be shown as a percentage of total assets; revenues
and expenses can be computed as a percentage of total sales, and in
the direct method cash flow statement, the components of cash flow
from operations can be related to cash collections.
Common-size statements should not, however, be viewed solely as a
sealing factor for standardization. They provide the analyst with useful
information as a first step in developing insights into the economic
characteristics of different industries and of different firms in the same
industry. For example, significant changes in net income over time
may be traced to variations in cost of good sold (COGS) as a
percentage of sales. Changes in this ratio may indicate the efficacy of
the firm’s efforts to streamline its operations and /or a change in
pricing strategies. Additionally, differences over time in a single firm or
between firms due to operating, financial, and investing decisions
made by management and external economic factors are often
highlighted by common-size statements.
DISCUSSION OF RATIOS BY CATEGORY:

The ratios presented here and their mode of calculation are neither
exhaustive not uniquely “Correct.” The definition of many ratios is not
standardized and may vary from analyst to analyst, textbook to
textbook, and annual report to annual report. Not all such variations
are logical or useful. In this chapter, when one of the components of
the ratio comes from the balance sheet and the other from the income
or cash flow statement, the balance sheet number is an average of the
beginning and ending balances. An exception is the cash flow from
operations to debt ratio. In practice, some analysis use beginning or
ending balances for such “mixed” ratios. The analyst’s primary focus
should be the relationships indicated by the ratios, not the details of
their calculation.

Activity Analysis:

A firm’s operating activities require investments in both short-term

(inventory and accounts receivable) and long-term (property, plant and
equipment) assets. Activity ratios describe the relationship between
the firm’s level of operations (usually defined as sales) and the assets
needed to sustain operating activities. The higher the ratios, the more
efficient the firm’s operations, as relatively fewer assets are required
to maintain a given level of operations (sales). Trends in these ratios
over time and in comparison to other firms in the same industry can
indicate potential trouble spots or opportunities. Furthermore, although
these ratios do not measure profitability or liquidity directly, they are
important factors affecting those performance indicators.

Activity ratios can also be used to forecast a firm’s capital

requirements (both operating and long-term). Increases in sales will
require investments in additional assets. Activity ratios enable the
analyst to forecast these requirements and to assess the firm’s ability
to acquire the assets needed to sustain the forecasted growth.

Short-term (Operating) Activity Ratios:

The inventory turnover ratio, defined as

 Inventory Turnover = Cost of Goods
Sold
Average
Inventory

Measures the efficiency of the firm’s inventory management .A higher

ratio indicates that inventory does not remain in warehouses or on the
shelves but rather “turns over” rapidly from the time of acquisition to
sale. This ratio is affected by the choice of accounting methods. The
inverse of this ratio can be used to calculate the average number of
days inventory is held until it is sold

Average No. Days

Inventory in Sock = 365___________
Inventory Turnover

The receivables turnover ratio and the average number of days of

receivables outstanding can be calculated similarly as

Receivables Turnover = Sales____________

Average Trade Receivables

And

Average No Days
Receivable Outstanding = 365________
Receivable Turnover

The receivables turnover ratios:

1. Measure the effectiveness of the firm’s credit policies.

2. Indicate the level of investment in receivables needed to
maintain the firm’s sales level.

Receivables turnover should be computed using only trade receivables

in order to evaluate operating performance. Receivables generated
from financing (unless customer financing is provided as a normal
component of sales activities) and investment activities (e.g.;
receivables from the sale of an investment) should be excluded as they
do not represent normal recurring operating transactions. Adjustments
may also be necessary if the firm has sold receivables during the
period. The accounts payable turnover ratio and number of days
payables are outstanding can be computed in a similar fashion as

Payables Turnover = Sales____________

Average Accounts Payable

And

Average No. Days

Payables Outstanding = 365_________
Payables Turnover

Although accounts payable are liabilities rather than assets, their trend
is significant as they represent an important source of financing for
operating activities. The time spread between when suppliers must be
paid and when payment is received from customers is critical for
wholesale and retail firms with their large inventory balances.

The working capital turnover ratio is defined as

Working Capital Turnover = Sales____________

Average Working
Capital

It is a summary ratio that reflects the amount of working (operating)

capital needed to maintain a given level of sales. Only operating items
should be used to compute this measure. Short-term debt, marketable
securities, and excess cash should be excluded, as they are not
required for operating activities. The deferral of inventory cost until the
item is sold and recognition of revenues prior to cash collection
assume that the inventories will be sold and the receivables collected.

Similarly, the use of working capital as a proxy for cash flow is

contingent on this assumption. The level and trends of turnover ratios
provide information as to the validity of this assumption. Declining
turnover ratios, indicating longer shelf time for inventory and/or slower
collection of receivables, could be indicators of reduced demand for a
firm’s products or of sales to customers whose ability to pay is less
certain. This might signal one or more of the following:

1. The firm’s income may be overstated because provisions are

required for obsolete inventory or uncollectible receivables.
2. Future production cutbacks may be required.
3. Potential liquidity problems may exist.

When activity ratios decline, the statement of cash flows helps assess
whether income is overstated relative to cash collections. As will be
discussed shortly, profitability and liquidity ratios can also improve our
understanding of the cause (s) of lower turnover ratios.

Long-Term (Investment) Activity Ratios:

The fixed asset turnover ratio measures the efficiency of (long-term)

capital investment. The ratio, defined as

Fixed Assets Turnover = Sales__________

Average Fixed Assets

Reflects the level of sales generated by investments in productive

capacity.
The level and trend of this ratio are affected by characteristics of its
components. First, sales growth is continuous, although at varying
rates. Increases in capacity to meet that sales growth, however, are
discrete, depending on the addition of new factories, warehouses,
stores and so forth. Compounding this issue is the fact that
management often has discretion over the timing, form, and financial
reporting of the acquisition of incremental capacity.
The life cycle of a company or product includes a number of stages.
Startup, growth, maturity (steady state), and decline. Startup
companies’ initial turnover may be low, as their level of operations is
below their productive capacity. As sales grow, however, turnover will
improve continually until the limits of the firm’s initial capacity are
reached. Subsequent increases in capital investment decrease the
turnover ratio until the firm’s sales growth catches up to the increased
capacity. This process continues until maturity when sales and
capacity level off, only to reverse when the firm enters its decline
stage. Additional problems can result from the timing of a firm’s asset
purchases. Two firms with similar operating efficiencies, having the
same productive capacity and the same level of sales, may show
differing ratios depending on when their assets were acquired. The firm
with older assets has the higher turnover ratio, as accumulated
depreciation has reduced the carrying value of its assets. Over time,
for any firm, the accumulation of depreciation expense improves the
turnover ratio (faster for firms that use accelerated depreciation
methods or short depreciable lives) without a corresponding
improvement in actual efficiency. The use of gross (before
depreciation) rather than net fixed assets alleviates this shortcoming.
However, this is rarely done in practice.
An offsetting and complicating factor is that newer assets generally
operate more efficiently due to improved technology. However, due to
inflation newer assets may be more expensive and thus decrease the
turnover ratio. Using current or replacement cost rather than historical
cost to compute the turnover ratio is one solution to this problem.

Finally it should be noted that methods of acquisition (lease versus

purchase) and subsequent financial reporting choices (capitalization
versus operating lease reporting) also affect turnover ratios for
otherwise similar firms. Total asset turnover is an overall activity
measure relating sales to total assets:

Total Asset Turnover = Sales_________

Average Total Assets

This relationship provides a measure of overall investment efficiency

by aggregating the joint impact of both short- and long-term assets.
This comprehensive measure is a key component of the desegregation
of return on assets.

Liquidity Analysis:

Short-term lenders and creditors (such as suppliers) must assess the

ability of a firm to meet its current obligations. That ability depends on
the cash resources available as of the balance sheet date and the cash
to be generated through the operating cycle of the firm. The firm
purchases or manufactures inventory, requiring an outlay of cash
and/or the creation of trade payables. The sale of inventory generates
receivables that when collected, are used to satisfy the payables, and
the cycle begins again. The ability to repeat this cycle on a continuous
basis depends on the firm’s short-term liquidity and cash generating
ability.

Length of Cash Cycle:

One indicator of short-term liquidity uses the activity ratios as a

liquidity measure. The operating cycle of a merchandising firm is the
sum of the number of the days until the resultant receivables are
converted to cash. To the extent a firms uses credit, the length of the
cash (operating) cycle is reduced. Subtracting the number of days of
payables outstanding from the operating cycle results in the firm’s
cash cycle, the number of days a company’s cash is tied up by its
current operating circle. The “cash cycle” captures the
interrelationship of sales, collections, and trade credit in a manner that
the individuals numbers may not. The shorter the cycle, the more
efficient the firm’s operation and cash management.

Estimating the Operating and cash cycle for a Manufacturing

firm.

A trading firm holds only one type of inventory: finished goods

inventory. Consequently, the inventory turnover ratio measure only
one time stage: the time from inventory purchase until its sale. For a
manufacturing firm, on the other hand, inventory is held through three
stages:

1. As raw material, from purchase to beginning of production

2. As work in process, over the length of the production cycle
3. As finished goods, from completion of production until sale

Only the last stage (as finished goods) is comparable to a trading

firm. The inventory turn over ratio, COGS/average finished goods
inventory, computes the length of time from completion until sale.
The length of time inventory is in the production cycle (stage 2) can
be calculated as:

365 x Average Work-in-process Inventory

Cost of Goods Manufactured

. The length of time it takes for raw material to enter production is

365 x Average Raw Material Inventory

Raw Materials Used

The breakdown among finished goods work in process, and raw

material inventory is often available in the notes to financial
statements. Cost of goods manufactured can be calculated form
financial statements as cost of goods sold the ending (finished goods)
inventory beginning (finished goods) inventory. However, the amount
of material used in production is rarely available making the
calculation of the length of stage 1 infeasible. Some approximations
are possible. The first involves calculating the combined length of
stage 1 and 2 as:

365 x Average (work in process and Raw Material) Inventory

 Cost of goods manufactured

The accuracy of this approximation depends on the proportion of the

various inventories and the degree to which the individual ratios differ.
Another (less accurate but perhaps simpler) approximation ignores this
whole discussion and uses the composite turnover ratio, thereby
mirroring the merchandising firm:

365 x Average (Total) Inventory

Cost of goods Sold

Working Capital Ratios and Defensive Intervals

The concept of working capital relies on the classification of assets and

liabilities into “current” and “non-current” categories. The traditional
distinction between current assets and liabilities is based on a maturity
of less than one year.

The typical balance sheet has five categories of current assets:

1. cash and cash equivalents
2. Marketable securities
3. Accounts receivable
4. Inventories
5. Prepaid expenses

And three categories of current liabilities;

1. Short-term debt
2. Accounts payable
3. Accrued liabilities

By definition, each current assets and liability has a maturity (the

expected date of conversion to cash for an assets; the expected date
of liquidation for cash for a liability) of less than one year. However, in
practice the line between current and non-current has blurred in recent
years. Marketable securities and debt are particularly susceptible to
arbitrary classification. For this reason, working capital ratios should be
used with caution.

Short-term liquidity analysis compares the firm’s cash resources with

its cash obligations. Cash resources can be measured by either;

1. The sum of the firm’s current cash balance and its potential
sources of cash, or
 2. Its (net) cash flows from operations.

Cash obligations can be measured by either;

1. Current obligations requiring cash, or

2. Cash outflows arising from operations

The following table summarizes the ratios commonly used to measure

the relationship between resources and obligations:

Numerator
Denominator
Cash Resources Cash
obligations
_______________________________________________________________________
_
Level Current assets Current
liabilities
Flow Cash flow from operations Cash outflows for
operations

Conceptually, the ratios differ in whether levels (amounts shown on the

balance sheet) or flows (cash inflows and outflows) are used to gauge
the relationship. Three ratios compare levels of cash resources with
current liabilities as the measure of cash obligations. The current ratio
defines cash resources as all current assets:

Current Ratio = Current Assets

Current Liabilities

A more conservative measure of liquidity is the quick ratio:

Quick Ratio = Cash + Marketable Securities + Accounts

Receivable
Current Liabilities

Which excludes inventory from cash resources, recognizing that the

conversion of inventory to cash is less certain both in terms of timing
and amount. The included assets are “quick assets” because they can
be quickly converted to cash.
Finally, the cash ratio, defined as

Cash Ratio = Cash + Marketable Securities

Current Liabilities

Is the most conservative of these measures or cash resources as only

actual cash and securities easily convertible to cash are used to
measure cash resources. The use of either the current or quick ratio
implicitly assumes that the current assets will be converted to cash. In
reality, however, firms do not actually liquidate their current assets to
pay their current liabilities. Minimum levels of inventories and
receivables are always needed to maintain operations. If all current
assets are liquidated, the firm has effectively ceased operations. The
process of generating inventories, collecting receivables, and paying
suppliers is ongoing. These ratios therefore measure the “margin of
safety” provided by the cash resources relative to obligations rather
than expected cash flows.

Liquidity analysis, moreover, is not independent of activity analysis.

Poor receivable or inventory turnover limits the usefulness of the
current and quick ratios. Obsolete inventory or un-collectible
receivable are unlikely to be sources of cash. Thus, levels and charges
in short-term liquidity ratios over time should be examined in
conjunction with turnover ratios.

The cash flow from operations ratio:

Cash Flow from Operations Ratio = Cash Flow from

Operations
Current Liabilities

Measure liquidity by comparing actual cash flow (instead of current

and potential cash resources) with current liabilities. This ratio avoids
the issues of actual convertibility to cash, turnover, and the need for
minimum levels of working capital to maintain operations. An
important limitation of liquidity ratios is the absence of an economic or
“real world”. Unlike the cash cycle liquidity measure, which reflects the
number of days cash is tied up in the firm’s operating cycle, there is no
intuitive meaning to a current ratio of 1.5. for some companies that
ratio would be high, for others dangerously low.

The defensive interval, in contract, does provide an intuitive “feel” for

a firm’s liquidity, although a most conservative one, it compares the
currently available “quick” sources of cash (cash, marketable
securities, and accounts receivable) with the estimated outflow needed
to operate the firm: projected expenditures. These are different
definitions of both cash resources and projected expenditures. We
present here only the basic form:

Defensive Interval = 365 x Cash + Marketable Securities + Accounts

Receivable
Projected Expenditures

The calculation of the defensive interval uses current year-income

statement date to estimate projected expenditures. The defensive
interval represents a “worst case” scenario indicating the number of
days a firm could maintain the current level of operations with its
present cash resources but without considering any additional
revenues.

Long-Term Debt and Solvency Analysis

The analysis of a firm’s capital structure is essential to evaluate its

long-term risk and return prospects. Leveraged firm’s accrue excess
returns to their shareholders as long as the rate of return on the
investments financed by debt is greater than the cost of debt. The
benefits of financial leverage bring additional risks, however, in the
form of fixed costs that adversely affect profitability if demand or profit
margins decline. Moreover, the priority of interest and debt claims can
have a severe negative impact on a firm when adversity strikes. The
inability to meet these obligations can lead to default and possible
bankruptcy.

Debt Covenants

To protect themselves, creditors often impose restrictions on the

company’s borrowing ability to incur additional debt and make
dividend payments. These debt covenants are often based on working
capital, cumulative profitability, and net worth. It is, therefore,
important to monitor the firm to ensure that ratios comply with levels
specified in the debt agreements. Violation of debt’s covenants is
frequently an “event of default” under loan agreements, making the
debt due immediately. When covenants are violated, therefore,
borrowers must either repay the debt (not usually possible) or obtain
waivers from lenders. Such waivers often require additional collateral,
restrictions on firm operation or higher interest rates.

Capitalization Table and Debt Ratios

Long-term debt and solvency evaluate the level of risk borne by a firm,
changes over time, and risk relative to comparable investments. A
higher proportion of debt relative to equity increases the risk level of
the firm. Two important factors should be noted:

1. The relative debt levels themselves, and

2. The trend over time in the proportion of debt to equity

Debt ratios are expressed either as

Debt to Total Capital = Total Debt (Current + Long-Term)

Total Capital (Debt + Equity)

Or

Debt to Equity = Total Debt

Total Equity

The definition of short-term debt used in practice may include

operating debt (accounts payable and accrued liabilities). The short-
term debt shown may be excluded as it is because it is a function of
the firm’s operations and its essential business and contractual
relationship to its suppliers rather than external lenders. However,
many lenders define debt as equal to total liabilities. As with other
ratios, industry and economy-wide factors affect both the level of debt
and the nature of the debt (maturities and variable or fixed rate).
Capital-intensive industries tend to incur high levels of debt to finance
their property, plant and equipment. Such debt should be long-term to
match the long time horizon of the assets acquired.

An important measurement issue is whether to use book or market

values to compute debt ratios. Valuation models in the finance
literature that use leverage ratios of both debt and equity are available
or can readily be estimated, and their use can make the ratio a more
useful analytical tool. The use of market values, however, may produce
contradictory results. The debt of a firm whose credit rating declines
may have a market value well below face amount. A debt ratio based
on market values may show an “acceptable” level of leverage. A ratio
that would “control” for this phenomenon and can be used in
conjunction with book- or market-based debt ratios is one that
compares debt measured at book value to equity measured at market:

Total Debt at Book Value

Equity at Market

If the market value of equity is higher than its book value, the above
ratio will be lower than the debt-to-equity ratio using book value. This
indicates that market perceptions of the firm’s earning power would
permit the firm to raise additional capital at an attractive price. If this
ratio, however, exceeds the book value debt-to-equity measure, it
signals that the market is willing to supply additional capital only at a
discount to book value.

The measurement of debt and equity used to compute leverage ratios

may require adjustments to reported data. Leases (whether capitalized
or operating), other off balance sheet transactions such as contractual
obligations not accorded accounting recognition, deferred taxes,
financial instruments with debt and equity characteristics, and other
innovative financing techniques must all be considered when marking
these calculations.

Interest Coverage Ratios

Debt-to-equity ratios examine the firm’s capital structure and

indirectly, its ability to meet current debt obligations. A more direct
measure of the firm’s ability to meet interest payments is

Times Interest Earned = Earnings Before Interest and

Taxes (EBIT)
Interest Expense

This ratio, often referred to as the interest coverage ratio, measures

the protection available to creditors as the extent to which earnings
available for interest “cover” interest expense. A more comprehensive
measure, the fixed charge coverage ratio includes all fixed charges:

Fixed Charge Coverage = Earnings Before Fixed Charges and

Taxes
Fixed Charges

Where fixed charges include contractually committed interest and

principal payments on leases as well as funded debt. This coverage
ratio may also be computed using adjusted operating cash flows (cash
from operations + fixed charges + tax payments) as the numerator:

Times Interest Earned (Cash Basis) = Adjusted Operating Cash

Flow
Interest Expense

Fixed Charge Coverage Ratio (Cash Basis) = Adjusted

Operating Cash Flow
Fixed
Charges

Capital Expenditure and CFO-to-Debt Ratios

Internally generated cash flows are needed for investment as well as

debt service. The coverage ratios discussed do not take this into
consideration. Cash flow from operation-

A firm’s long-term solvency is a function of:

1. Its ability to fiancé the replacement and expansion of its

investment in productive capacity, as well as
2. Its generation of cash for debt repayment.

The capital expenditure ratio

Capital Expenditure Ratio = Cash from Operations (CFO)

Capital Expenditures

Measures the relationship between the firm’s cash-generating ability

and its investment expenditures. To the extent the ratio exceeds, it
indicates the firm has cash left for debt repayment or dividends after
payment of capital expenditures.
The CFO-to-debt ratio

CFO to Debt = CFO___

Total Debt

Measures the coverage of principal repayment requirements by the

current CFO . A low CFO-to-debt ratio could signal a long-term solvency
problem as the firm does not generate enough cash internally to repay
its debt.
Profitability Analysis

Equity investors are concerned with the firm’s ability to generate,

sustain and increase profits. Profitability can be measured in several
differing but interrelated dimensions. First, there is the relationship of
a firm’s profits to sales, that is, the residual return to the firm per
sales. Another measure, return on investment (ROI), relates profits to
the investment required to generate them. We briefly define these
ratios and then elaborate on their use in financial statement analysis.

Return on Sales

One measure of profitability is the relationship between the firm’s

costs and its sales. The ability to control costs in relation to revenues
enhances earnings power. A common-size income statement shows
the ratio of each cost component to sales. In addition, six summary
ratios measure the relationship between different measures of
profitability and sales:
1. The gross (profit) margin captures the relationship between sales
and manufacturing or merchandising costs:

Gross Margin = Gross Profit

Sales
2. the operating margin, calculated as

Operating Margin = Operating Income

Sales

Provides information about a firm’s profitability from the operations

of its “core” business, excluding the effects of:
• Investments (income from affiliates or asset sales)
• Financing (interest expense)
• Tax position

3. a profit margin measure that is independent of both the firm’s

financing and tax position is the

Margin Before Interest and Tax = EBIT

Sales
4. The pretax margin is calculation after financing costs (interest)
but prior to income taxes:

Pretax Margin = Earnings Before Tax (EBIT)

 Sales

5. finally, the overall profit margin is net of all expenses:

Profit Margin = Net Income

Sales

The five ratios listed above can be computed directly from a firm’s
financing statements.
6. Another useful profitability measure is the contribution margin
ratio define as

Contribution Margin = Contribution

Sales
Where contribution = sales - variable costs.

The contribution margin ratio, however, cannot be computed directly

from a firm financial, statement as the breakdown between fixed and
variable costs is rarely provided.

Return of Investment

Return on investment (ROI) measures the relationship between profits

and the investment required to generate them. Diverse measures of
that investment result in different forms of ROI.

Return on Assets. The return on assets (ROA) compares income with

total assets (equivalently, total liabilities and equity capital). It can be
interpreted in two way. First, it measures management’s ability and
efficiency in using the firm’s assets to generate (operating) profits.
Second, it reports the total return accruing to all providers of capital
(debt and equity), independent of the source of capital.
The return is measured by net income prior to the cost of financing and
is computed by adding back (after-tax) interest expense to net income.

ROA= Net Income ( After Tax and Interest Cost)

Average Total Assets

ROA can also be computed on a pretax basis using EBIT as the return
measure. This results in a ROI measure that is unaffected by
differences in a firm’s tax position as well as financial policy:
 ROA = EBIT________
Average total assets

In practice, however, the ROA measure is some times computed using

either net income or EBT as the numerator. Such post interest ROI
ratios make leveraged firms appear less profitable by charging
earnings for payments (interest) to some capital providers (lenders)
but not others (Stockholders). Pre-interest ROI ratios, in contrast,
facilitate the comparison of firms with different degrees of leverage.
Therefore, ROI ratios that use total assets in the denominator should
always include total earnings (before interest) in the numerator. As
interest is tax-deductible, post tax profit measures should add back
net-of-tax interest payments.

Return on Total Capital. One particularly useful ROI measure is the

return on total capital (ROTC). This ratio used the sum of external debt
and equity instead of total assets as the base against which the firm’s
return is measured. ROTC measures profitability relative to all (non-
trade) capital providers.
Return can be measured either (pretax) by EBIT or (after tax) by net
income plus after-tax interest:

ROTC = EBIT_________________
Average (Total Debt + Stockholders’ Equity)

Or

ROTC = Net Income + After Interest Expense__________

Average (Total Debt + Stockholders’ Equity)

Return on Equity. The return on total stockholders equity (ROE)

excludes debt in the denominator and uses either pretax income (after
interest costs) or net income:

ROE = Pretax Income__________

Average Stockholders’ Equity

The after-tax interest cost is calculated by multiplying the interest cost

by ( 1 – t), where t is the firm’s marginal tax rate.
As in the case of ROA, pre-interest measures of profitability should be
used to compute ROTC, as total capital includes debt obligations.

Or
ROE = Net income____________
Average Stockholder’s Equity

For companies with preferred equity, another ROI measure focuses on

the returns accruing to the residual owners of the firm-common
shareholders:

Return on Common Equity = Net Income – Preferred

Dividends
Average Common Equity

The relationship between ROA and ROE reflects the firm’s capital
structure. As shown in figure 4-3, creditors and shareholders provide
the capital needed by the firm to acquire the assets used in the
business. In return, they receive their share of the firm’s profits.

ROA and ROE measure returns to all providers of capital. ROCE

measures returns to the firms Common shareholders and is calculated
after deducting the returns paid to the creditors (interest) and other
providers of equity capital (preferred share-holders).

EARNINGS PER SHARE AND OTHER RATIOS USEED FOR

VALUATION

Ratios are often used explicitly for securities valuation. Equity

valuation models use ratios such as earnings per share and book value
per share. Fixed income ratings and valuation techniques also lean
heavily on ratios.

Earnings per Share

Earnings per share (EPS) is probably the most widely available and
commonly used corporate performance statistic for publicly traded
firms. It is used to compare operating performance and for valuation
purposes either directly or together with market prices in the familiar
from of price/earnings (P/E) ratios.

Simple Capital Structure

For firms that have only common shares, the computation of EPS is
relatively straight forward. In such cases, the computation is
Basic EPS = Earnings Available to Common
Shareholders________________
Weighted- Average Number of Shares of Common Stock
Outstanding

Or

Net Income – Preferred

Dividends_________________
Weighted – Average Number of Shares of Common Stock
Outstanding

Where the shares are usually weighted by the number of months those
shares were outstanding. The numerator used to calculate EPS must
equal earnings available for distribution to common shareholders.
Therefore, preferred stock dividends, whether declared or cumulative,
must be deducted from net income.

Book Value Per Share

This ratio represents the equity of the firm (common equity less
preferred shares at liquidation value) on a per share basis (number of
shares outstanding at balance sheet date) and is sometimes used as a
benchmark for comparisons with the market price per share.

Book value per share, however, has limitations as a valuation tool

as it is subject to valuation measures based on GAAP.
• Which are bound by historical cost rather than current market
value conditions, and
• Whose definition of what constitutes an asset or liability may not
coincide with economic reality.

Thus, the balance sheet may contain goodwill or other intangible

assets of uncertain value; the market value of investments and fixed
assets may differ markedly from the balance sheet valuation and there
may be significant adjustments for off-balance sheet activities.

Price-to-Earnings and Price-to-Book Value Ratios

The P/E ratio measures the degree to which the market “capitalizes” a
firm’s earnings. The P/E ratio has been the subject of much scrutiny in
the academic as well as the professional world.
Market price of share/EPS

Dividend Payout Ratio

The dividend payout ratio equals the percentage of earnings paid as

dividends, that js,

Dividend Payout = Dividends

Net Income

Generally, “growth” firms have low dividend payout ratios as they

retain most of their income to finance future expansion. More
established “mature” firms tend to have higher payout ratios.

RATIOS: AN INTEGRATED ANALYSIS

Comprehensive financial analysis requires a review of three

interrelationships among ratios:

1. Economic relationships. Interdependent changes in

various components of the financial statements stem from
underlying economic relationships. For example, higher sales are
generally associated with higher investment in working capital
components such as receivables and inventory. Ratios comprising
these elements should be correlated.
2. Overlap of components. The components of many
ratios overlap due to the inclusion of an identical term in the
numerator or denominator, or because a term in one ratio is a
subset or component of another ratio. Charge in one of these
identical terms will charge a number of ratios in the same direction.
Similarly, ratios that aggregate other ratios can be expected to
follow patterns over time consistent with those of their components.
For example, the total assets turnover ratio is essentially a
(weighted) aggregation of the individual turnover ratios. Trends in
this ratio will mirror those observed in the inventory, accounts
receivable, and fixed asset turnover ratios.
3. Ratios as composites of other ratios. Some ratios
are related to other ratios across categories. For example, the ROA
ratio is a combination of profitability and turnover ratios:
 Income = Income x Sales
Assets Sales Assets
A change in either of the ratios on the right-hand side will charge the
return on assets as well.

The interrelationships among ratios have important implications for

financial analysis. Disaggregation of a ratio into its component
elements allows us to gain insight into factors affecting a firm’s
performance; for example, significant changes in ROA may be best
understood through an analysis of its components. Further, ratio
differences can highlight the economic characteristics and strategies
of:

• The same firm over time

• Firm in the same industry
• Firms in different industries
• Firms in different countries

These relationships among ratios imply that one might be able to

“ignore” some component ratios and use a composite or
representative ratio to capture the information contained in other
ratios. For example, in the ROA relationship described earlier, the
effect of the two ratios on the right side of the equation may be
captured by the ROA ratio. For certain analysis purpose, this composite
ROA ratio may suffice.

Analysis of Firm Performance

This section will exploit some of these interrelationships to analyze a

firm’s performance by focusing on disaggregation of the overall
profitability measures ROA and ROE.

Disaggregation of ROA

The ROA ratio can be disaggregated as follows:

ROA = Total Asset Turnover x Return on Sales

= Sales x EBIT
Assets Sales
The firm’s overall profitability is the product of an activity ratio and a
profitability ratio. A low ROA can result from low turnover, indicating
poor asset management, low profit margins, or a combination of both
factors.