RATIO ANALYSIS AND RISK ESTIMATION

April 9, 2012

Ratio Analysis and Risk Estimation

Submitted To Mr.Sheheryar Malik
Submitted by Karim Zulfiqar Muhammad Rizwan Irfan Noman Khalid Rehman Allana Ume-Hani AR Zubair Khan

RATIO ANALYSIS AND RISK ESTIMATION

April 9, 2012

Financial Risk
Financial risks are the risks involved in financing activity. Every person have to bear these risk be it creditor, investor, employee, bank or any stakeholder of the company. Types of Risks 1. Systematic risk or market Risk 2. Un-systematic or Unique Risk. Systematic or Market Risk: Risk that is there in whole system. This risk cannot be avoided in any case This risk cannot be diversified and it is not under anyones control. For Instance weather conditions, Inflation etc Un-systematic or Unique Risk: Risk that can be controlled by individuals. This of risk is related to the specific investment or company. Unique risk can be diversified by investing in different markets or businesses. This risk can be controlled by investors and it can also be diversified.

Financial Ratios
Financial statement analysis begins with Ratio analysis. In this we compare a companys position with the industrys position by some of ratios. These ratios convert big values into percentages and give us more idea about the current situation.

Types of Financial ratios

1. Liquidity ratio
4. Profitability ratios
2. Asset management ratios 3. Debt management ratios

5.

Market value ratios.

RATIO ANALYSIS AND RISK ESTIMATION

April 9, 2012

Liquidity Ratio
Liquidity ratios compare a firms current assets to its current liability. These ratios give us a brief view about the short-term debts and our financial situation. This ratio is linked to the companys ability to pay off its short-term debts. Liquidity Ratios are also indicator of how much a firm is liquid or how much it can pay to its short term creditors. There are 2 types of Liquidity ratios 1. Current Ratio: Formula: Current assets / Current liabilities It indicates the composition of short term liability and assets. This measures a companys ability to pay off its short-term debt by selling all its current assets. This includes cash, marketable securities, receivables and inventories. The drawback of this ratio is the involvement of inventory as sometimes its hard to liquidate. Sometimes very high current ratio is also not good for the company because this can be the result of very high inventory. Quick Ratio Formula: (Cash + Marketable Securities + Net Accounts Receivables) /

CurrentLiabilities this ratio shows the composition of current liabilities and current assets excluding inventories. This is the best measure because it excludes the inventory. If the current ratio is very high and quick ratio is very low this means that company is keeping very high levels of inventory or may be the company is not able to sell its inventory.

RATIO ANALYSIS AND RISK ESTIMATION

April 9, 2012

Risk estimation and Liquidity Ratios Quick ratio can also estimate the credit risk and risk of not able to pay off the debts. Quick ratio is relevant to creditors as well as the companys manager. This ratio is also important for the shareholders. This ratio is very much relevant for the managers of the company as well as creditors. The manager would be able to estimate the risk of being bankrupt and they can predict whether they will be able to pay off its debt or not and it would give them some idea about the solvency position of the company. Creditors would also be interested in this ratio as it can predict credit risk if the current ratio is less than 100%.

Asset management ratios

These ratios measure how effectively a firm utilizes its assets. This determines the ability and capability of management and a firms level of resource or asset utilization. These ratios are also known as asset utilization ratio, asset turnover ratios and efficiency ratio. These measure the efficiency of assets. Inventory turnover ratio Formula: COGS or Sales / Inventories Inventory turnover ratio tells us the duration in which one set of inventory is sold. It gives us an idea about how long a business takes to sell its inventory. The answer of this ratio is dependent upon the nature of business. For some business high inventory turnover is suitable while for some businesses low inventory turnover is better.

RATIO ANALYSIS AND RISK ESTIMATION

April 9, 2012

Days Sales Outstanding Formula: Receivables / Average sales per day This ratio tells us in how many days a business recovers its credit sales and turns its receivables into cash. The earlier you recover your receivables is the better. Fixed assets turnover ratio Formula: Sales / Net fixed assets This ratio indicates the utilization of fixed asset. This also answers the question Are we able to meet recover our fixed asset cost? This also measures the efficiency and contribution of fixed assets with respect to sales. Total assets turnover ratio Formula: Sales / Total assets This ratio indicates the efficiency and utilization of total assets. This would determine how much our sales are contributing to recover our total asset cost.

Risk estimation and asset management ratios

We can assess the risk by asset management ratios. If a companys asset management ratios are poor than this means that the management of the company is not able to run it efficiently and soon this would lead to problems in business and it would affect the profitability and cash management of the business. The poor asset management ratios may also indicate the corruption within the company. If the management is not able to work properly than it means sooner or later the company would be in crisis. If the firm is not able to collect its receivables on time than they would have shortage of cash in hand and they would not be able to pay off their expenditure.

RATIO ANALYSIS AND RISK ESTIMATION

April 9, 2012

Debt Management Ratios:

These ratios show the composition of debt in a company. This indicates the amount of debt which is injected in the company. This would give us idea whether the company would be able to pay off its debt by selling its asset or not. Debt ratio : Formula: Total debt/ Total assets This ratio indicates the contribution of debt in total assets. This ratio is very important for all the creditors because every creditor and stock holder wants to recover the money they have financed in a company. Times-interest-earned (TIE) ratio Formula: EBIT / Interest charges It is usually quoted as a ratio and indicates how many times a company can cover its interest charges on a pretax basis. Failing to meet these obligations could force a company into bankruptcy. Times Interest Earned or Interest Coverage is a great tool when measuring a company's ability to meet its debt obligations. When the interest coverage ratio is smaller than 1, the company is not generating enough cash from its operations EBIT to meet its interest obligations. The Company would then have to either use cash on hand to make up the difference or borrow funds. Typically, it is a warning sign when interest coverage falls below 2.5

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April 9, 2012

EBITDA coverage ratio (EBITDA + Lease payments) / (Interest + Principal Payments + Lease payments) Ratio of cash available for debt servicing to interest, principal and lease payments. t is a popular benchmark used in the measurement of an entity's (person or corporation) ability to produce enough cash to cover its debt (including lease) payments. The higher this ratio is, the easier it is to obtain a loan.

Risk estimation and debt management ratios

This ratio would provide a clear view of a companys financial position. This would tell us about the composition of debt and how much debt is taken by company. Poor debt management ratio would be related to the risk of being bankrupt and the risk of being defaulter. For creditors its a credit risk and for shareholders its the risk of company going bankrupt.

Profitability ratios
These ratios are very important for everyone. The shareholders not only look at the companys cash flows but they are also interested in the companys profitability. If a company is not able to generate profit than how would they generate cash? These ratios have the effect on cash flows as well as operational activities. Profit Margin on Sales Formula: Net income available to Common / Sales It measures how much out of every dollar of sales a company actually keeps in earnings. Looking at the earnings of a company often doesn't tell the entire story. Increased earnings
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RATIO ANALYSIS AND RISK ESTIMATION

April 9, 2012

are good, but an increase does not mean that the profit margin of a company is improving. For instance, if a company has costs that have increased at a greater rate than sales, it leads to a lower profit margin. This is an indication that costs need to be under better control. Basic earning power ratio (BEP) Formula: EBIT / Total assets This ratio calculates the earning power of a company by excluding the interest and tax payment. This ratio would give us better idea while comparing 2 firms within the same industry because we ignore interest and tax factor and these are the factors that vary from company to company. Return on total assets (ROA) Formula: Net income available to common / total assets This ratio assesses a companys rate of return on assets. This indicated how much income is earned on the utilization of total assets. Return on common equity (ROE) Formula: Net income available to common / common equity This ratio is very important for shareholders as they would know how much they are getting back on their investment.

Risk estimation and profitability ratio

Profitability ratios are somehow related to the operations and cash management of a company. If a company is not able to generate profit from its operation than there is something wrong with the company. Poor profitability ratios indicate the risk of not getting
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April 9, 2012

back the investment or the risk of bearing losses. Another risk which is related to profitability is losing investment.

Market value ratios:

These ratios indicate firms price to its earning. These ratios are very much important to share holders as they will be expecting something from the company and these ratios they would expect some return and they will be able to know how much they can expect from a particular firm. These ratios are related to firms share price, earning and cash flows as well. Price/earnings (P/E) ratio Formula: Price per share / Earnings per share It compares a companys share price and earning that investors get on each share invested. Price/cash flow ratio Formula: Price per share / Cash flow per share A ratio used to compare a company's market value to its cash flow. It is a measure of the market's expectations of a firm's future financial health. Because this measure deals with cash flow, the effects of depreciation and other non-cash factors are removed. Similar to the priceearnings ratio, this measure provides an indication of relative value.

Risk estimation and Market value ratio

Any company which is part of stock exchange is interested in the market value of the share. All the investors look at the market value of a firm instead of book value. A company is not able to raise funds through its stock than it would have to lend money from bank. Poor

RATIO ANALYSIS AND RISK ESTIMATION

April 9, 2012

market value ratios would result in the loss of investment from the company. None of the investors would be willing to invest in that company.

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RATIO ANALYSIS AND RISK ESTIMATION

April 9, 2012

References
1. http://en.wikipedia.org/wiki/Financial_risk 2. http://www.netmba.com/finance/financial/ratios/ 3. http://www.finpipe.com/equity/finratan.htm 4. http://www.businessmanagementlearn.com/index.php?option=com_content&view=art icle&id=403%3A923-financial-risk-ratios&catid=111%3Atable-ofcontents&Itemid=652 5. http://en.wikipedia.org/wiki/Systemic_risk 6. http://www.businessdictionary.com/definition/unique-risk.html 7. http://www.mtholyoke.edu/~vvstepan/CorporateFinanceWeb/typesrisk.htm 8. http://www.investopedia.com/terms/t/tie.asp#axzz1rIuf6c6m 9. http://www.investopedia.com/terms/e/ebitdacoverinterestratio.asp#axzz1rIuf6c6m 10. http://en.wikipedia.org/wiki/Financial_ratio#Purpose_and_types_of_ratios 11. http://en.wikipedia.org/wiki/Debt_service_coverage_ratio 12. http://www.investorwords.com/18114/EBITDA___interest_coverage_ratio.html 13. http://www.investopedia.com/terms/p/profitmargin.asp#axzz1rIuf6c6m 14. http://www.college-cram.com/study/finance/ratios-of-profitability/basic-earningpower-ratio/ 15. http://www.investopedia.com/terms/p/price-earningsratio.asp#axzz1rIuf6c6m 16. http://www.investopedia.com/terms/p/price-to-cash-flowratio.asp#axzz1rIuf6c6m

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