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Part 1
Part 2
Profitability Measures
Part 3
Ratio Analysis
Part 4
Comparability Problems
Profitability Measures
ROE, ROA
0 ROA = EBIT/Total Assets
0 ROE = Net Profits/Common Equity
0 ROA > Interest rate ROE increases surplus earning for equity
owners
Profitability measures
0 High Debt/Equity ratio Higher possible earnings for
firms owners
0 Also, higher risk
Profitability measures
Using debt makes ROE more sensitive to the
business cycle, although EBIT of 2 companies are
the same.
Net Profit
Pretax Profit
EBIT
Sales
Assets
Assets
Pretax Profit
EBIT
Sales
Equity
(1)
(2)
(3)
(4)
(5)
Tax Burden
ratio
Interest
Burden ratio
Profit
margin
Total
asset
turnover
Leverage
ratio
Factors (1), (3), (4) are not affected by firms capital structure while
factors (2), (5) are.
income taxes.
0 Reflect governments tax code and policies pursued by the
firm in trying to minimize its tax burden.
ratio
0 IB ratio =< 1
Relationships summary
0 ROE = Tax burden x Interest burden x Profit margin x
Turnover x Leverage
0 ROA = Profit margin x Turnover
0 Compounded leverage factor = Interest burden x Leverage
Liquidity Ratios
Tell us how easily a company can pay its debts (so that the
company doesnt get eaten up by banks or creditors)
Current Ratios
Quick Ratios
Cash Ratios.
Current Ratio
Company A has:
0 $1,000 in current assets
Current assets? Current liabilities?
(cash,account receivables
and inventories)
-> Convertible to cash within the next 12 0 $800 in current liabilities
months!
Current Ratio ?
Current Ratio =
$1000
=
$800
= 1.25
Current Ratio
What does 1.25 mean?
Indicate that the company will not have any trouble paying its debt
for the next 12 months. The current assets are more than the current
liabilities for the next 12 months. (25% more)
Quick Ratio
A better measure of liquidity than the
current ratio for firms whose inventory is
not readily convertible to cash
Quick Ratio =
Company A has:
0 $1,000 in current assets
(cash,account receivables and
inventories)
0 $800 in current liabilities
0 $100 of current assets is
inventory
Quick Ratio ?
$1000 $100
= 1.125
$800
Quick Ratio
Whats the benefit of subtracting inventory?
1. Often considered less liquid than other current assets; not
as easily converted to cash
Quick Ratio
A better measure of liquidity than the
current ratio for firms whose inventory is
not readily convertible to cash
Quick Ratio =
Company A has:
0 $1,000 in current assets
(cash,account receivables and
inventories)
0 $800 in current liabilities
0 $100 of current assets is
inventory
Quick Ratio ?
$1000 $100
= 1.125
$800
Quick Ratio
What does 1.125 mean?
Indicates that the company will not have any trouble paying its debt for the
next 12 months. The quick assets are more than the current liabilities for
the next 12 months
Cash Ratio
Company A has:
0 $200 in Cash and Marketable
securities
0 $800 in current liabilities
Quick Ratio ?
Cash Ratio =
$200
$800
= 0.25
Asset Turnover
Ratio
For subcategories
of assets
Fixed Asset
Turnover
Inventory
Turnover
Total Asset
Turnover Ratio
Fixed Asset
Turnover
Inventory
Turnover
P/E=
$100
$10
= 10
Comparability problems
0 A major problem in the use of data obtained from a firms
financial statement
1. Inventory Valuation
0 2 ways to value inventories: LIFO and FIFO
LIFO
The last-in first out accounting
method of valuing inventories.
The last goods produced are
considered the first ones to be
sold.
FIFO
The first-in first- out
accounting method of valuing
inventories.
The units used up or sold are
the ones that were added to
inventory first, and goods sold
should be valued at original
cost
2. Depreciation
0 In economic definition: depreciation is the amount of a