The following slides shows a copy of the Ratio Formulas and how they are

expressed.

These are formulas are given to students without the “orange text notes” on
how they are expressed

While we’re looking at them – let’s look at the other resources given to
students in the 501 Financial Performance Exam
E.g. Expressed as as 2: 1

E.g. Expressed as “Times per Year” or Days

E.g. Expressed as “days”

E.g. Expressed as “times” Note “turnover” = Sales

“Return” = Profit

E.g. Expressed as “$50000 per employee

When you see a formula with
“x 100 / 1” the result will be expressed
as a percentage – e.g. 20%
 Expressed as a percentage – e.g. 20%

Expressed as Dollars per employee

Expressed as number of years

E.g. 4 times
E.g. 4 times

Cents per Share

 Percentage

E.g. 4 times

Dollars per Share

Why do we take out Prepayments and Bank Overdraft?
(1) 730,000 / 365 = $2000 credit sales per day
Average Debtors / daily credit sales = 90,000 / 2000 = 45 days

Or

(2) (Like Stock Turnover calculation) - $730,000 / $90,000 = 8.1 times per year
365 / 8.1 = 45 days
Sales are made up of quantity sold x selling price – so a firm may choose a strategy
of gaining market share by offering low mark ups on cost - so their Gross Profit
rate may be low but their Gross profit in dollar amounts might be high compared
to their competitors in industry.
For Example Company A Company B
Sales $5,000,000 $2,000,000
Less GOGS 4,000,000 1,200,000
Gross Profit 1,000,000 800,000
Gross Profit Percentage 20% 40%
How can you improve this percentage?

By ensuring your operating expenses are not excessive – case study

Photocopy Service centre with large rent expense in the CBD moved to the
industrial centre because they didn’t need the “foot traffic” – they didn’t
need to be seen they saved $200,000 in rent – and even if they did lose some
sales – you have to generate a large amount of sales to cover this extra rent.

Have a look at the following example

Case study – we move location and save rent and are able to maintain sales
levels

Located in CBD Located in Industrial Area

$ % $ %
Sales 1,500,000 100 1,500,000 100
less COGS 750,000 50% 750,000 50%
Gross Profit 750,000 50% 750,000 50%

Less: Operating
expenses
Admin Costs 100,000 100,000
Rent 350,000 150,000
Total Operating
Expenses 450,000 250,000
Net Profit 300,000 20% 500,000 33%
 This slide demonstrates that with a we could afford to lose $400,000 in sales by
moving to the new location and saving $200,000 in Rent

Located in CBD Located in Industrial Area

$ % $ %
Sales 1,500,000 100 1,100,000 100
less COGS 750,000 50% 550,000 50%
Gross Profit 750,000 50% 550,000 50%

Less: Operating expenses

Admin Costs 100,000 100,000
Rent 350,000 150,000
Total Operating Expenses 450,000 250,000
Net Profit 300,000 20% 300,000 27%
 Here we have two firms with the same Sales and the same operating costs – the only
reason for the drop in Net Profit amounts and % is because we were not able to
achieve the same gross profit rate perhaps we were not able to buy stock at equally
low prices – or our attempts to reduce our mark up on cost did not generate extra
sales – 14% drop in Gross Profit = 14% drop in Net Profit

$ % $ %

Sales 1,500,000 100 1,500,000 100

less COGS 800,000 53% 1,000,000 67%

Gross Profit 700,000 47% 500,000 33%

Less: Operating expenses

Admin Costs 100,000 100,000

Rent 350,000 350,000

Total Operating Expenses 450,000 450,000

Net Profit 250,000 17% 50,000 3%

Note Div / Share divided by E.P.S. = Payout ratio

.11 / .349 = .2792 – 27.92% - the payout ratio 2 slides back

If I paid $2.00 for my shares if the worst happens and the company is
wound up – assets are sold, liabilities are paid out $2.37 per share
will be returned to the shareholders
Vertical Analysis
One technique in financial statement analysis is known
as vertical analysis.

Vertical analysis results in common-size financial

statements. A common-size balance sheet is a balance
sheet where every dollar amount has been restated to
be a percentage of total assets.

Helpful way to remember this is Parent company wants

to compare its performance with Smaller subsidiary
company

The result is the following common-size balance sheet

for Example Company:
The benefit of a common-size balance sheet is that an item
can be compared to a similar item of another company
regardless of the size of the companies. A company can
also compare its percentages to the industry's average
percentages. For example, a company with Inventory at
4.0% of total assets can look to its industry statistics to see
if its percentage is reasonable.

A common-size balance sheet also allows two

businesspersons to compare the magnitude of a balance
sheet item without either one revealing the actual dollar
amounts.
Horizontal analysis is the comparison of historical
financial information over a series of reporting periods,
or of the ratios derived from this financial information.

The analysis is most commonly a simple grouping of

information that is sorted by period, but the numbers
in each succeeding period can also be expressed as a
percentage of the amount in the baseline year, with the
baseline amount being listed as 100%.
Horizontal analysis of the Income Statement is
usually in a two-year format, such as the one shown
below, with a variance also shown that states the
difference between the two years for each line item.
 20X1 20X2 Variance

Sales $1,000,000 $1,500,000 $500,000

Cost of goods sold 400,000 600,000 (200,000)

Gross margin 600,000 900,000 300,000

Salaries and wages 250,000 375,000 (125,000)

Office rent 50,000 80,000 (30,000)

Supplies 10,000 20,000 (10,000)

Utilities 20,000 30,000 (10,000)

Other expenses 90,000 110,000 (20,000)

Total expenses 420,000 615,000 (195,000)

Net profit $180,000 $285,000 $105,000

 20X1 20X2 Variance

Cash $100,000 80,000 $(20,000)

Accounts receivable 350,000 525,000 175,000
Inventory 150,000 275,000 125,000
Total current assets 600,000 880,000 280,000

Fixed assets 400,000 800,000 400,000

Total assets $1,000,000 $1,680,000 $680,000

Accounts payable $180,000 $300,000 $120,000

Accrued liabilities 70,000 120,000 50,000
Total current liabilities 250,000 420,000 170,000

Notes payable 300,000 525,000 225,000

Total liabilities 550,000 945,000 395,000

Capital stock 200,000 200,000 0

Retained earnings 250,000 535,000 285,000
Total equity 450,000 735,000 285,000

Total liabilities and equity $1,000,000 $1,680,000 $680,000

 Self Test Questions from New Textbook edition

Year Doreen’s Bottles Industry Average

Current Ratio Current Ratio
2013 1.6 : 1 1.4 : 1
2012 1.4: 1 1.2 : 1
2011 1.1 : 1 1.1 : 1
More questions from a different source….

Question 1.
Firm A has a Return on Equity (ROE) equal to 24%, while firm B has
an ROE of 15% during the same year. Both firms have a total debt
ratio (D/V) equal to 0.8. Firm A has an asset turnover ratio of 0.9,
while firm B has an asset turnover ratio equal to 0.4. From this we
know that

(a) Firm A has a higher profit margin than firm B

(b) Firm B has a higher profit margin than firm A
(c) Firm A and B have the same profit margin
(d) Firm A has a higher equity multiplier than firm B
(e) You need more information to say anything about the firm's
profit margin
How does the debt to equity ratio differ from the debt to value ratio?

D/E = Total debt/total equity

D/V = Debt/(debt + equity) …. note Debt + Equity = Total Assets

This may also be useful if you have only one:

D/E = (D/V)/(1-D/V)
D/V = (D/E)/(1+D/E)

Proof – assume Liabilities = 1, Equity = 1, then Total Assets = 2

D/V = D/TA = ½ = .5 , D/E = 1/1 = 1

If you knew D/E was 1 and you want to find D/V … then 1/(1+1) = ½ or .5

If you knew D/V was .5 and you wanted to find D/E … then .5 / (1 - .5) = 1

Total Assets = D/V ÷ D/E = 1 ÷ 0.5 = 2 , If D/V = .5 then D must = 1 and

therefore Equity must be 2 – 1=1
How does the debt to equity ratio differ from the debt to value ratio?

D/E = Total debt/total equity

D/V = Debt/(debt + equity) …. note Debt + Equity = Total Assets

This may also be useful if you have only one:

D/E = (D/V)/(1-D/V)
D/V = (D/E)/(1+D/E)

So for this question for Firm A and firm B have a D/V of 0.8 so their

D/E’s must be 0.8 / (1- 0.8) = 4,

Total Assets = D/V ÷ D/E = 0.8 / 4 = 0.2

if D/V = 0.8 then D must be 0.2 x 0.8 = 0.16

Put back into accounting equation and test this E + L = A

If A = 0.2 and L or D = 0.16 then E = 0.04 0.04 + 0.16 = 0.2

Check does D/E = 4 … yes Does D/V = .8, answer 0.16 ÷ 0.2 = 0.8
To solve this question we need to rely on the Dupont Identity or
DuPont Analysis below…
 Firm A Firm B
ROE .24 .15
D/V 0.8 0.8
Asset Turnover = Sales / Total Assets 0.9 0.4

Now slot into formula at top of the screen for Firm A and B to find the profit margin

Firm A .24 = PM x 0.9 x 0.2 ÷ 0.04

.24 = PM x 4.5
PM = 5.33% 0.2 = Total assets
/ 0.04 = Equity – we discovered
Firm B .15 = PM x 0.4 x 0.2 ÷ 0.04 this at the bottom of the slide – 2
.15 = PM x 2 slides back
PM = 7.5%
Question 2
If a firm has $100 in inventories, a current ratio equal to 1.2, and a quick ratio equal to
1.1, what is the firm's Net Working Capital?

(a) $0
(b) $100
(c ) $200
(d) $1,000
(e) $1,200
 Question 2
If a firm has $100 in inventories, a current ratio equal to 1.2, and a quick ratio equal to
1.1, what is the firm's Net Working Capital?

(a) $0
(b) $100
(c ) $200
(d) $1,000
(e) $1,200

Net Working Capital = CA - CL

If CA/CL=1.2 and (CA-100)/CL=1.1
Then CA = 1.2 x CL substitute this into second equation and solve
(1.2CL-100) / CL = 1.1
(1.2CL – 100) = 1.1 x CL
0.1CL = 100
CL = 1000
Slot back into equation 1 to find CA ….. CA / 1000 = 1.2 therefore CA = 1.2 x 1000
= 1200
CA – CL = 200 …… so the answer is (c)
Question 3
To measure a firm's solvency as completely as possible, we need to consider

(a) The firm's relative proportion of debt and equity in its capital structure
(b) The firm's capital structure and the liquidity of its current assets
(c) The firm's ability to use Net Working Capital to pay off its current liabilities
(d) The firms leverage and its ability to make interest payments on its long-term debt
(e) The firm leverage and its ability to turn its assets over into sales
Question 3
To measure a firm's solvency as completely as possible, we need to consider

(a) The firm's relative proportion of debt and equity in its capital structure
(b) The firm's capital structure and the liquidity of its current assets
(c) The firm's ability to use Net Working Capital to pay off its current liabilities
(d) The firms leverage and its ability to make interest payments on its long-term debt
(e) The firm leverage and its ability to turn its assets over into sales

Answer …. (d)
B: Problem Solving Questions

You have been hired as an analyst for Mellon Bank and your team is working on an
independent assessment of Flipper Pty Ltd. Flipper is a firm that specializes in the
production of freshly imported farm products from France. Your assistant has
provided you with the following data for Flipper and their industry.
2013
Ratio 2013 2012 2011 Industry
Average
Long-term debt 0.45 0.40 0.35 0.35
Inventory Turnover 62.65 42.42 32.25 53.25
Depreciation/Total Assets 0.25 0.014 0.018 0.015
Days’ sales in receivables 113 98 94 130.25
Debt to Equity 0.75 0.85 0.90 0.88
Profit Margin 0.082 0.07 0.06 0.075
Total Asset Turnover 0.54 0.65 0.70 0.40
Quick Ratio 1.028 1.03 1.029 1.031
Current Ratio 1.33 1.21 1.15 1.25
Times Interest Earned 0.9 4.375 4.45 4.65
Equity Multiplier 1.75 1.85 1.90 1.88
(a) In the annual report to the shareholders, the CEO of Flipper wrote, “2013 was a good
year for the firm with respect to our ability to meet our short-term obligations. We had
higher liquidity largely due to an increase in highly liquid current assets (cash, account
receivables and short-term marketable securities).” Is the CEO correct? Explain and use
only relevant information in your analysis.

(b) What can you say about the firm's asset management? Be as complete as possible given
the above information, but do not use any irrelevant information.

(c) You are asked to provide the shareholders with an assessment of the firm's solvency and
leverage. Be as complete as possible given the above information, but do not use any
irrelevant information.
ANSWERS TO PROBLEM: (note that these are just examples of a good answer)

(a) The answer should be focused on using the current and quick
ratios.

While the current ratio has steadily increased, it is to be noted that

the liquidity has not resulted from the most liquid assets as the CEO
proposes. Instead, from the quick ratio one could note that the
increase in liquidity is caused by an increase in inventories.

For a fresh food firm one could argue that inventories are relatively
liquid when compared to other industries. Also, given the
information, the industry-benchmark can be used to derive that the
firm's quick ratio is very similar to the industry level and that the
current ratio is indeed slightly higher - again, this seems to come
from inventories.
(b) Inventory turnover, days sales in receivables, and the total asset turnover ratio
are to be mentioned here.

Inventory turnover has increased over time and is now above the industry average.
This is good - especially given the fresh food nature of the firm's industry. In 2013 it
means for example that every 365/62.65 = 5.9 days the firm is able to sell its
inventories as opposed to the industry average of 6.9 days.

Days' sales in receivables has gone down over time, but is still better than the
industry average. So, while they are able to turn inventories around quickly, they
seem to have more trouble collecting on these sales, although they are doing better
than the industry.

Finally, total asset turnover went down over time, but it is still higher than the
industry average. It does tell us something about a potential problem in the firm's
long term investments, but again, they are still doing better than the industry.
(c) Solvency and leverage is captured by an analysis of the capital structure of the
firm and the firm's ability to pay interest.

Capital structure: Both the equity multiplier and the debt-to-equity ratio tell us
that the firm has become less levered.

To get a better idea about the proportion of debt in the firm, we can turn the D/E
ratio into the D/V ratio: 2013: 43%, e.g.D/V = (D/E)/(1+D/E) .75/1.75 = .4285

2012: 46%, 2011:47%, and the industry-average is 47%. So based on this, we

would like to know why this is happening and whether this is good or bad.

From the numbers it is hard to give a qualitative opinion beyond observing the
drop in leverage.

In terms of the firm's ability to pay interest, 2013 looks pretty bad. However,
remember that times interest earned uses EBIT as a proxy for the ability to pay for
interest, while we know that we should probably consider cash flow instead of
earnings. Based on a relatively large amount of depreciation in 2013 , it seems
that the firm is doing just fine.
There is a comprehensive example at the back of the chapter on ratios

Let’s look at some past exam paper questions