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Analysis
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Learning objectives
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Sources and Uses of Cash
Activities that bring in cash are called
sources of cash.
Activities that involve spending cash are
called uses (or applications) of cash.
An increase in an asset account or a decrease
in a liability or equity account is a use of
cash.
A decrease in an asset account or an increase
in a liability or equity account is a source of
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cash.
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Financial Ratio Analysis
A Financial ratios is an index that relates two
accounting numbers and is obtained by dividing
one number by the other.
Used to compare and investigate relationships
between different pieces of financial
information, either over time or between
companies. Types of Comparisons: Internal
Comparisons and External Comparisons
Ratios eliminate the size problem.
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Ratio Analysis: Questions
to Consider for Each Ratio
How is it computed?
Whatis it intended to measure, and why
might we be interested?
What is the unit of measurement?
Whatmight a high or low value be telling
us? How might such values be
misleading?
How could this measure be improved?
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Categories of Financial
Ratios
Liquidity Ratios
Leverage ratios (Capital Structure
Ratios) or Solvency
Profitability ratios
Valuation ratios
Turnover Ratios
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Liquidity Ratios
Current Ratio
Quick Ratio
Profitbefore depreciation and amortization
to current liabilities (PDACL)
Operating cash flow to current liabilities
(OCFCL)
Cash balance to total liabilities (CBTL)
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Liquidity Ratios
Current Ratio: The ratio is mainly used to
give an idea of the company's ability to pay
back its short-term liabilities (debt and
payables) with its short-term assets (cash,
inventory, receivables).
Current assets
Current ratio
Current liabilitie s
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Example: In 2006 PDACL = 0.40
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Liquidity Ratios
Cash balance to total liabilities (CBTL):
Refers to the company’s cash balance in
relation to its total liabilities.
Cash Balance
CBTL
Total Liabilitie s
Example: In 2006 CBTL = 0.40
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Leverage (Capital
Structure) Ratios
Debt to equity ratio (DE ratio)
Total liabilities to total tangible assets
(TLTAI)
Interest cover ratio
Net debt to equity ratio
Equity multiplier
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Leverage (Capital
Structure) Ratios
Debt to equity ratio (DE ratio): It refers a
company’s capital structure and whether the
company is more reliant on borrowings (debt)
or shareholder capital (equity) to fund assets
and activities.
Total debt
Debt/equity ratio
Total equity
Example: ICR = 3
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Leverage (Capital
Structure) Ratios
Equity multiplier: It is a measurement of a
company's financial leverage. It measures the
amount of a firm's assets that are financed
either through equity or debt.
Total assets
Equity multiplier
Total equity
Example: EM = 1.11
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Profitability Ratios
Earnings per share (EPS )
Gross profit margin
Net profit margin
Return on assets (ROA )
Return on equity (ROE )
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Profitability Ratios
Earnings per share (EPS): It shows the portion
of a company’s profit that is allocated to each
outstanding share of common stock. EPS figure is
very important for shareholders because the
payment of dividend and increase in the value of
stock in future largely depends on it. EPS is the most
widely quoted and relied figure by investors.
Net income
EPS
Total outstanding shares
Example: EPS = $1.60
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Profitability Ratios
Gross profit margin: Gross profit margin tells
us what percentage of a company’s sales
revenue would remain after deducting the cost
of goods sold.
Sales Cost of goods sold (direct cost)
Gross Profit Margin X100
Sales
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Profitability Ratios
Net profit margin: Net profit margin
meanwhile indicates what percentage of a
company’s sales revenue would remain after
all costs have been taken into account.
Net Income
Net Profit Margin X100
Sales
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Profitability Ratios
Basic Earning Power: measure that calculates
the earning power of a business before the effect of
the business’ income tax and its financial leverage
EBIT
Average Total Assets
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Profitability Ratios
Return on assets (ROA): It is a measurement
of management performance. ROA tells the
investor how well a company uses its assets
to generate income. A higher ROA denotes a
higher level of management performance.
Net Income
Return on assets (ROA) 100
Average Total Assets
Example:
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Turnover Ratios
Inventory turnover
Fixed asset turnover
Total asset turnover
Day’s sales in inventory
Receivables turnover
Day’s sales in receivable
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Turnover Ratios
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The Du Pont Identity
Breaks ROE into three parts:
operating efficiency (as measured by Net profit margin)
asset use efficiency (as measured by total asset turnover)
financial leverage (as measured by the equity multiplier)
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Example: The Du Pont Identity
Sales are $7 000, net profit is $250,
total assets are $3 500 and equity is
$1 900.
Net profit Sales Assets
ROE
Sales Assets Equity
External uses:
evaluation by outside parties
evaluation of main competitors
identifying potential takeover targets
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Benchmarks for Comparison
Ratios are most useful when compared
to a benchmark.
Time-trend analysis—examine how a
particular ratio(s) has performed
historically.
Peer group analysis—using similar
firms (competitors) for comparison of
results.
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Problems with Financial
Statement Analysis
No underlying theory to identify correct
ratios to use or appropriate benchmarks.
Benchmarking is difficult for diversified
firms.
Firms
may use different accounting
procedures.
Firms may have different recording periods.
One-off
events can severely affect financial
performance.
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Summary and Conclusions
Activities that bring in cash are called ‘sources of cash’, and
activities that involve spending cash are called ‘uses of cash’.
A Cash Flow Statement summarises sources and uses of
cash over a specified period.
Financial ratios are grouped together into five main
categories: Liquidity, Capital Structure, Valuation,
Profitability, and Turnover.
Ratios are most useful when compared to a benchmark (e.g.
time-trend and peer group analysis).
Problems can arise in using financial statements.
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