Chapter: 3

Financial Statements Analysis

1
1. Introduction
Every profit making firm do two things:
 They Spend cash, and
 They generate cash.
2. Cash Flow  A Closer Look
(i) Cash is spent for:
o Purchasing materials.
o Paying for labour to produce product.
o Purchasing machine, tools, plants and
o Payment creditors.
(ii) Cash is generated by:
 Selling Products.
 Selling Assets.
 Selling Securities or
 Taking short and Long Term Debt (Liabilities). 2
3. Sources and Uses of Cash (Analysing Balance Sheet)
Activities those bring cash are called sources of cash.
Followings are the sources of cash of firms:
Decrease in Account Receivable.
Decrease in Inventory (Selling goods).
Decrease in Fixed Asset (Selling machines, plant, etc).
Increase in Account Payable (Getting credit from
suppliers).
Increase in Notes Payable (Having short term credit from
bank).
Increase in Long term Liability (Taking loan from bank).
Increase in Equity and retained earnings (Amassing
retained earnings).
Increase in Common Stock & Paid in Surplus (Issuing
shares).
3
3.2 Uses of Cash
Activities those involve in spending of cash are sources
of cash.
Followings are usages of cash of firms:
 Increase in Account Receivable (selling more on
credit).
 Increase in Inventory (Amassing more materials for
production)
 Increase in Fixed Asset (Buying machines, plant, etc)
 Decrease in Account Payable (Paying off suppliers)
 Decrease in Notes Payable (Paying off some short
term loans)
 Decrease in Long-term Liability (Paying off some long
term loans).
 Decrease in Equity

4
Problem
Balance Sheet of the firm from 2014 and 2015 are given.
Analyse the cash flow.

Solution
We know that:
Activities those involve in spending of cash are uses of
cash.
So, Uses of cash include:
oIncrease in Account Receivable (providing sales credit).
oIncrease in Inventory (producing goods).
oIncrease in Fixed Asset (buying machines, plant, etc.).
oDecrease in Notes Payable (paying suppliers’ credit).
oDecrease in Long-term Liability.

5
 Problem: Balance Sheet of PAUFROCK CORPORATION (in millions).

1. Current Assets 20014 20015 Change

1.1 Cash $84 $98 + $14

1.2 Accounts Receivable $165 $188 + $23
1.3 Inventory $393 $422 + $29
Total Current Assets $642 $708 + $66
2. Fixed Assets
2.1 Net Plant & Equipment $2731 $2880 + $149
Total Assets $3373 $3.588 + $215
Liabilities and Owners’ Equity
3 Current Liability

3.1 Accounts Payable $312 $344 + $32

3.2 Notes Payable $231 $196 - $35
Total Current liabilities $543 $540 - $3
4. Long Term Debt (Liability) $531 $457 - $74
Total Liability $1074 $997 - $77
5. Owner’s equity

5.1 Common Stock & paid in surplus $500 $550 + $50

5.2 Retained Earnings $1799 $2041 + $242
Total Owner’s equity $2299 $2591 + $292
Total Liability & Owners’ Equity $3373 $3588 + $215 6
Usages of Cash

Categories 2013 2014 Change

Accounts Receivable $165 $188 23
Inventory $393 $422 29
Net Plant & Equipment $2731 $2880 149
Notes Payable $231 $196 35
Long Term Debt (Liability) $531 $457 74
Total Uses of Cash     310

7
We know that:

Activities those bring cash are sources of

cash.

So, Sources of Cash:

Increase in Account Payable (getting
suppliers’ credit).
Increase in Common Stock & Paid in
Surplus.
Increase in Retained Earnings.

8
Sources of Cash

Categories 2013 2014 Change

Accounts Payable $312 $344 32
Common Stock & paid in surplus $500 $550 50
Retained Earnings $1799 $2041 242
Total Sources of Cash - - 324

 Net addition to cash = Total Sources of Cash –

Total Uses of Cash.
 Net addition to cash = $324 – $310 = $14.

9
4. Standardization of Financial Statements
It is impossible to compare financial statements
directly.
To enable comparisons, the financial statements are
standardized.

4.1 Standardization of Balance Sheets

4.1.1 Common Size Balance Sheets
One way to compare balance sheet is to:
Construct a common size balance sheet.
Common size balance sheet is prepared by
expressing each item as a percentage of total assets.

10
Problem
Prepare common‑size balance sheets of Prufrock for 2013
and 2014 and analyse the financial development of the firm.
Assets 2013 2014
1. Current Assets    
1.1 Cash $84 $98
1.2 Accounts Receivable $165 $188
1.3 Inventory $393 $422
Total Current Assets $642 $708
2. Fixed Assets $2731 $2880
Total Assets (Current Assets + Fixed Assets) $3373 $3588
3 Current Liability    
3.1 Accounts Payable $312 $344
3.2 Notes Payable $231 $196
4. Long Term Debt (Liability) $531 $457
5. Owner’s equity    
5.1 Common Stock & paid in surplus $500 $550
5.2 Retained Earnings $1799 $2041
Total Owner’s equity $2299 $2591
Total Liability & Owners’ Equity (3 + 4 + 5) $3373 $358811
Solution
Common‑size balance sheet is prepared by expressing each item as a
percentage of total assets:

Assets 2013 2014 Change

1. Current Assets      
1.1 Cash 2.5% 2.7% + .2%
1.2 Accounts Receivable 4.9% 5.2% + .3%
1.3 Inventory 11.7% 11.8% + .1%
Total Current Assets 19.1% 19.7% + .6%
2. Fixed Assets      
2.1 Net Plant & Equipment 80.9% 80.3% - .6%
Total Assets 100% 100% 0.0%
3. Current Liability      
3.1 Accounts Payable 9.2% 9.6% + .4%
3.2 Notes Payable 6.8% 5.5% - 1.3%
Total Current Liability 16.0% 15.1% - .9%
4. Long Term Debt (Liability) 15.7% 12.7% - 3.0%
5. Owner’s equity      
5.1 Common Stock & paid in surplus 14.8% 15.3% 5 .5%
5.2 Retained Earnings 53.3% 56.9% + 3.6%
Total Owner’s equity 68.1% 72.2% + 4.1%
Total Liability & Owners’ Equity (3+4+5) 100% 100% 0.0% 12
The common size balance sheet shows that:
 2013 current assets of Prufrock were 19,1% of the
total assets.
 In 2014 it increases to 19.7% of the total assets.
 It means a 0.6% increase of total assets.
 At the same time the current liabilities decline from
16.0% to 15.1%.
 It means an absolute decline of 0.9%
 Total equity rose from 68.1% to 72.2%
 Similarly, Retained Earnings from 53.3% to 56.9%
Conclusion 
 The common-size balance sheet shows that the
financial condition has improved from 2013 to 2014.

13
4.1.2 Common Base Year Balance Sheet
 To investigate financial trends development
Common Base Year Balance Sheet is used.
 As for instance, let assume that we want to
know trend in debt development.
 Balance Sheets from last 10 years are known.
 Common base year Balance Sheet is prepared
by expressing each item relative to the base
year amount.

Problem
Balance Sheet of Prufrock from 2013 and 2014 are
given (Next Slide). Show the trend development of
important items of Prufrock.

14
Assets 2012 2013 2014
1. Current Assets      
1.1 Cash $84 $98 $104
1.2 Accounts Receivable $165 $188 $121
1.3 Inventory $393 $422 $462
2. Fixed Assets      
2.1 Net Plant & Equipment $2731 $2880 $2980
Total Assets $3373 $3588 $3725
3 Current Liability      
3.1 Accounts Payable $312 $344 $374
3.2 Notes Payable $231 $196 $182
4. Long Term Debt $531 $457 $413
5. Owner’s equity      
5.1 Common Stock & paid in surplus $500 $550 $550
5.2 Retained Earnings $1799 $2041 $2348
Total Owner’s equity $2299 $2591 $2898
Total Liability & Owners’ Equity $3373 $3588 $3867
15
Solution
 To investigate financial trends development Common Base Year
Balance Sheet is used.
 Common base year Balance Sheet is prepared by expressing
each item relative to the base year amount.
Assets 2012 2013 2014
1. Current Assets      
1.1 Cash $1.00 $1.17 $1.24
1.2 Accounts Receivable $1.00 $1.14 $0.73
1.3 Inventory $1.00 $1.07 $1.18
2. Fixed Assets      
2.1 Net Plant & Equipment $1.00 $1.05 $1.09
Total Assets $1.00 $1.06 $1.10
3 Current Liability      
3.1 Accounts Payable $1.00 $1.10 $1.20
3.2 Notes Payable $1.00 $0.85 $0.79
4. Long Term Debt $1.00 $0.86 $0.78
5. Owner’s equity      
5.1 Common Stock & paid in surplus $1.00 $1.10 $1.10
5.2 Retained Earnings $1.00 $1.13 $1.31
Total Owner’s equity $1.00 $1.13 $1.26
Total Liability & Owners’ Equity $1.00 $1.06 $1.15
16
4.2 Standardization of Income Statement
4.2.1 Common Size Income Statement
It is almost impossible to directly compare income
statement.
To enable comparisons, the income statements
are standardized.
Next we discuss:
How to com­pare income statements of different
companies.
One way to compare income statements is to
construct a common size income statement.
Common size income statement is prepared by:
 Expressing each item as a percentage of sales

17
Problem
Prepare Common Size Income Statements of PRUFROCK
of the 2013 and 2014, and analyse its financial
development from data given below:

Income Statement 2013 2044

Net sales $2311 $3220
Cost of goods sold $1344 2550
Depreciation $276 350
Interest paid $141 170
Tax $187 200

Dividends: 1/3rd of NE

18
Solution
Common Size Income Statements is prepared by:
Expressing each item as a percentage of total sales
2013 2014
Income Statement
Mio $ % Mio $ %
Sales $2311 100% $3230 100%
- Cost of goods sold $1344 58.2% $2150 66.45%
- Depreciation $276 11.9% $350 10.80%
EBT $691 29.9% $730 22.50%
- Interest paid $141 6.1% $170 5.25%
Taxable income $550 23.8% $560 17.30%
- Taxes $187 8.1% $200 6.18%

Net income $363 15.7% $360 11.12%

Dividends $121 5.2% $120 3.71%
Retained earnings $242 10.5% $240 7.42%

19
The common size income statement shows that:
 The cost of good sold in 2013 was 58.2% of the
sales, in 2014 it has increased to 66.45% of sales.
 It means, from 2013 to 2014 the cost increased.
 In 2013 the EBIT 29.9% of the sales, in 2014 it sank to
22.50% of sales.
 It means, from 2013 to 2014 the EBIT has sunk.
 Similarly, EBT and NE have also sank during this.
 Taxable income of the firm decreased from 23.8% to
17.30% of sales.
 Net decreased from 15.7% to 11.12% of sales.
 As a result, dividend and retained earnings
decreased.
From this analysis in total, it can said that:
 Financial condition of the firm has deteriorated from
2013 to 2014. 20
4.2.2 Common Base Year Income Statements

For analysing trend development of different items of

Income Statement, Common Base Year Income
Statement is prepared
 Common base Year income statement is prepared
by expressing each item of the income statement
as a percentage of the base year items.

Problem
Prepare Common base Year Income Statements of
PRUFROCK from 1998 and 2000, 2002 and 2004 and
analyse its financial trend development.

21
Income Statement 2012 2013 2014
Net sales $2300 $2900 $4250
Cost of goods sold $1100 1550 2550
Depreciation $350 350 350
Interest paid $150 150 150
Taxes $100 300 400
Dividends: 1/3rd of NE

Solution
Let us first complete the income statement.
Income Statement 2012 2013 2014
Net sales $2300 $2900 $4250
- Cost of goods sold $1200 $1550 $2550
- Depreciation $350 $350 $350
EBIT $750 $1000 $1350
- Interest paid $150 $200 $250
Taxable income $600 $800 $1100
- Taxes (20%) $120 $160 $220

Net income $480 $640 $880

Dividends (20%) $96 $128 $176 22
 Let us prepare common base year income
statement.
 Common base Year income statement is
prepared by expressing each item of the income
statement as a percentage of the base year
items.

Income Statement 2012 2013 2014

Net sales 100 126.09 184.78
- Cost of goods sold 100 129.17 212.50
- Depreciation 100 100.00 100.00
Earnings before interest and taxes 100 133.33 180.00
- Interest paid 100 133.33 166.67
Taxable income 100 133.33 183.33
- Taxes (20%)
100
133.33 183.33
Net income 100 133.33 183.33
Dividends (20%) 100 133.33 183.33
Addition to retained earnings 100 133.33 183.33 23
Common base Year Income Statements shows that:
 From 2012 to 2013 the sales of Prufrock increased to
126%.
 From to 2012 in 2014 the sales of Prufrock increased
to 185%.
 This shows that sales increased from 2012 to 2014
continuously.
 Cost of goods sold increased from 2012 to 2014
slowly. It increased to 212%.
 Earnings Before Interest and Tax also increased
more slowly. It increased during this time 180%.
 Net Earnings, Dividend and Retained Earnings have
increased quickly and same rate.
 They increased during time to 183%.
 The analysis shows that the development of the firm
during this time was good.
24
7. Cash Flow From Assets
We know that:
Cash flow from assets = Cash flow to creditor
+ Cash flow to stockholders.
Cash flow from assets is also called free cash flow or
free cash flow from assets.

Cash flow from assets has three components:

Operating cash flow from assets.
Change in net working capital, and
Change in net capital spending.
(i) Operating Cash Flow
 Operating cash flow (OCF) results from the sale.
 OPC = Revenue - Costs of Goods Sold – Taxes.
25
(ii) Net Capital spending
oNet capital spending refers to change in the fixed assets
from one period to other.
Mathematically:
oNet capital spending = (Fixed Assets)1 – (Fixed Assets)0
+ [Depreciation1 - Depreciation0 .

oCapital spending can be positive or negative.

oIf it is positive, it means new investments has been
made. Cash has been expended.
oIf it is negative, it means some fixed assets have
liquated. Cash has been gained.
(iii) Change in net working capital
Change in net working capital is
26
(NWC) – (NWC)
Net Working Capital = Current Assets – Current
Liabilities.
(v) Cash Flow From Assets (‘Free Cash Flow’)
Cash flow from assets is also called ‘free cash flow’
‘Free cash flow’ means the firm is free to distribute
the cash to the creditors and stockholders
In other word it is not needed for working capital or
investment in fixed asset

Mathematically
Free Cash Flow
Cash Flow From Assets = Operating Cash Flow -
Change in Net Capital Spending - Change in the Net
Working Capital

27
(vi) Cash Flow to Creditors
Cash flows to creditors represent net payments to
creditors during the year
Cash flow to creditors = Interest paid to creditors - Net
new borrowing
[Net new borrowing = BorrowingP1 – Borrowing P0 ]

(vii) Cash Flow to Stockholders

Cash flows to the stockholders represent the net
payments to owners during the year
Cash flow to stockholders = Dividends paid ‑ Net new
equity raised (Change in Equity)
Where:
Net new equity raised = EquityP1 – EquityP0

28
Problem
Balance Sheet and Income Statement of a company
is given.
Compute:
i. Operating cash flow.
ii. Net capital spending
iii. Change in net working capital
iv. Free cash flow
v. Cash flow to creditors
vi. Cash flow to shareholders

29
 Assets Liability & Owners’ Equity
Current Assets 2013 2014 Current Liability 2013 2014
Cash $104 $160 Accounts Payable $232 $266
Accounts Receivable $455 $688 Notes Payable $196 $123
Inventory $553 $555 Total Current Liability $428 $389
Total Current Assets $1112 $1403 Long Term Debt $408 $454
Fixed Assets     Equity $600 $640
Plant & Equipment $1644 $1709 Retained Earnings $1320 $1629

Income Statement (2014)

Net sales $850
Cost of goods sold $300
Depreciation $150
Interest paid $50
Taxes (20%)
Dividend (20%)  

30
Solution
Let us complete the Balance Sheet and Income statement:
Assets Liability & Owners’ Equity
Current Assets 2013 2014 Current Liability 2013 2014
Cash $104 $160 Accounts Payable $232 $266
Accounts Receivable $455 $688 Notes Payable $196 $123
Inventory $553 $555 Total Current Liability $428 $389
Total Current Assets $1112 $1403 Long Term Debt $408 $454
Fixed Assets     Equity $600 $640
Plant & Equipment $1644 $1709 Retained Earnings $1320 $1629
Total Asset $2756 $3112  Total Liability + Equity $2756 $3112

Income Statement 2014

Net sales (Revenue) $1050
Cost of goods sold $300
Depreciation $150
Earnings before interest and taxes $600
Interest paid $50
Taxable income $550
Taxes (20%) $110
Net income $440
Dividends (20%) $88
Addition to retained earnings $352 31
We know that:
Operating Cash Flow (OPC) is the income out of the
asset.
 OPC = Revenue - Costs of Goods Sold – Taxes.
 OPC = $1050 - $300 – $110 = $480.
 OPC = $640.

We know that Net Capital Spending (NCS):

 NCS = (Fixed Assets)1  (Fixed Assets)0 +
Depreciation.
We have:
 Fixed Asset 2013 = $1644.
 Fixed Asset 2014 = $1709.
 Depreciation = $150.
NCS = (Fixed Assets)1  (Fixed Assets)0 + $150
NCS = $1709 - $1644 +$150 = $65.
32
NCS = $215
We know that:
Change in NWC = (Net Working Capital)1 - (Net
Working Capital)0
Further:
Net working capital = Current Assets – Current
Liabilities
Hence:
 Net Working Capital1 = Current Assets1 – Current
Liabilities1
 Net Working Capital1 = $1403 – $389 = $
 Net Working Capital1 = $1014

Again:
 Net Working Capital0 = Current Assets0 – Current
Liabilities0
 Net Working Capital0 = $1112 – $428 = $ 33
Hence:
Change in NWC = (Net Working Capital)1 - (Net
Working Capital)0
Change in NWC = $1014 - $68 = $330
Change in NWC = $330

Further we know that:

Free Cash Flow (Cash Flow From Assets) =

Operating Cash Flow - Change in Net Capital
Spending - Change in the Net Working Capital.
 Free Cash Flow = $640 (OPC) – $215 (NCS) -
$330(Change in NWC).
 Free Cash Flow = $95

34
We know that:
Cash flow to creditors = Interest paid - Net new
borrowing.
Further:
Net new borrowing = Borrowing1 – Borrowing0
We have:
 Interest paid = $50.
 Borrowing1 = $454.
 Borrowing0 = $408.
Hence:
 Net new borrowing = $454-$408= $46.
So:
 Cash flow to creditors = Interest paid - Net new
borrowing.
 Cash flow to creditors = $50 - $46 = $4
 Cash flow to creditors = $4 35
Again
 We know that:
 Cash flow to stockholders = Dividends paid ‑
Net new equity raised (Change in Equity)
Where:
 Net new equity raised = Equity1 – Equity0

We have:
 Dividends paid = $88
 Equity1= $2269
 Equity0 = $1920
 Net new equity raised = Equity1 – Equity0
 Net new equity raised = $2269-$1920 = $349
 Net new equity raised = $349
36
8. Financial Ratio Analysis

 Another way of comparing financial situation of

companies of different sizes is to compare their
financial ratios.

 Financial ratios help to analyse the development of

a company from one period to other.

 Financial ratios are relationships between different

financial data.

 Ratios are simply one number divided by another.

 Ratios eliminate the size problems of different

companies.
37
 Huge numbers of ratio can be calculated.
 Every ratio has its specific advantage and
significance.
 However, some are very frequently used financial
ratios.
 Next it is discussed how to compute and
financial ratios.

It must be understood:
 How ratios are to compute?
 What does the specific ratios to measure?
 What is the unit of the measurement?
 What does a low or high value mean?
 And how could be such values misleading?

38
 Financial ratios are traditionally grouped into
different categories
 These are following:
i. Short term liquidity (solvency) ratios.
ii. Long term liquidity (solvency) ratios.
iii. Asset turn over ratio (Asset management
ratios).
iv. Profitability ratios.
v. Market value ratios.

8.1 Short Term Liquidity Ratio

 Short term liquidity ratios express firm's ability to
pay its bills in short run without any problem.
 So, short term liquidity ratios focus on current
assets and current liabilities of the firms.
 Short term liquidity ratios are interesting to short
term creditors. 39
There are following important Short Term Liquidity
Ratio:
 Current Ratio.
 Quick Ratio.
 Cash ratio.
 Net working capital ratio.
 Sustainability of Current Assets (Interval
measure).
8.2 Current Ratio
One of the most widely used short term liquidity
ratios is the current ratio.
Current ratio is defined as:
Current Asset
Current Ratio 
Current Liabilities
40
 For a short term creditor/supplier, the higher the
current ratio, the better is it for him.
 High current ratio indicates high liquidity.
 It also indicates an inefficient use of short‑term
assets.
 Normally, it is expected to see a current ratio of at
least 1.
 It means that the current assets just cover the
current liabilities.
 Current ratio less than 1 means that the firm is
able to cover its current liabilities.
 It is very unusual in a healthy firm.
 Low current ratio is not a bad sign for a com­pany,
if it possesses borrowing power.
41
 Current ratio changes if:
i. A firm pays off its suppliers and short‑term
creditors.
ii. The firm buys some inventory.
iii. The firm sells some merchandise.
8.3 The Quick Ratio (or Acid Test Ratio)
Some times inventory does not give actual values
and not reliable, because:
 It is not measured in market value.
 The quality of the inventory is not considered.
 Some of the inventory be damaged, obsolete, or
lost.
 Some times the sale price is firm overestimated.
 In these cases, inventory least reliable.
42
 Further, inventory is relatively illiquid.
 So, quick ratio is computed, which excluded
inventory for the testing of short tern liquidity of
firms.
Quick ratio is computed:

Current Asset  Inventory

Quick Ratio 
Current Liabilitie s
 If cash used to buy inventory current ratio remains
unchanged, because in the case cash reduces but
at the same inventory increases.
 So, amount of total current asset and liability and
herewith the current ratios remain unchanged.

43
8.4. Cash ratio
 Cash ratio express relationship between cash
and current liabilities of a firm.
 It measures the financial ability of firms to pay
their short term loans, assuming that the
receivable is not available and inventory can not
be liquidated.
Cash
Cash Ratio 
Current Liabilitie s
8.5 Net working capital ratio
 Net Working Capital (NWC) expresses short‑term
liquidity of a firm.
 Net working capital ratio to Total Asset indicates
the portion of total Asset used for operation.
44
Net Working Capital Ratio
Net Working Capital
Net Working Capital 
Total Asset

8.6 Interval Measure

 If a firm faces a labour unrest its liquidity began

to dry up.
 It is important to know the sustainability of
liquidity of a firm.
 The firm wants how long can it sustain its
production with the current asset.
 Interval measure expresses cycle of production.
Cost of Good Sold
Pr oduction Cycle 
Current Asset

45
Interval or Production Cycle in Days
365 days
Pr oduction in Days 
Pr oduction Cycle

Problem
Balance Sheet of Prufrock Corporation from 2013 and 2014 are
given below. Cost of goods sold in 2014 was $1344. Calculate
Current Ratio, Quick Ratio, Cash Ratio, Net working capital
ratio, and Sustainability of Current Assets. Discuss the
findings.
Assets 2013 2014
1. Current Assets    
1.1 Cash $84 $98
1.2 Accounts Receivable $165 $188
1.3 Inventory $393 $422
Total Current Assets $642 $708
3 Current Liability    
3.1 Accounts Payable $312 $344
3.2 Notes Payable $231 $196
Total Current liabilities $543 $540 46
Computing Current Ratio

We know that:
Current Asset
Current Ratio 
Current Liabilitie s
We have for 2013:
Current assets = $642
Current liabilities = $543

So for 2013:
$642
Current Ratio   1.18 times
$543
It means, for every one dollar of liability there is 1.18
dollar current asset.
It indicates, if receivable is regular and inventory is
rightly assessed, the firm is sound to pay its short
term loan. 47
For 2014 we have

 Current assets = $708

 Current liabilities = $540

So for 2014:
Current Asset
Current Ratio 
Current Liabilitie s

$708
Current Ratio   1.131 times
$540

 Development of Current Ratio shows that the short

term liquidity of the firm has increased.
 In 2013 it was 1.18, in 2014 it became 1.131.
48
Computing Quick Ratio

We know that:
Current Asset  Inventory
Quick Ratio 
Current Liabilitie s

We have for 2013:

 Current assets: $642
 Inventory = $393
 Current liabilities = $543

Hence, Quick Ratio:

$642  $393
Quick Ratio   0.46
$543
 If inventory is excluded, per one dollar liability there
is only 0.46 dollar coverage of asset.
49
Computing Quick Ratio

We know that:
Current Asset  Inventory
Quick Ratio 
Current Liabilitie s

We have for 2014:

Current assets: $708
Inventory = $422
Current liabilities = $540
Hence, Quick Ratio:
$708  $422
Quick Ratio   0.53
$540
 If inventory is excluded, in 2014 per one dollar
liability there is 0.53 dollar coverage of asset.
50
Calculation of Cash Ratio

We know that:
Cash
Cash Ratio 
Current Liabilitie s

For 2013 we have:

 Cash: $64
 Current liabilities = $543

Hence for 2013:

$84
Cash Ratio   0.15
$543
 It means, for every one dollar of liability there is 0.15
dollar cash.
51
Calculation of Cash Ratio

We know that:
Cash
Cash Ratio 
Current Liabilitie s
For 2014 we have:
 Cash: $98
 Current liabilities = $540

Hence for 2013:

$98
Cash Ratio   0.18
$540
 It means, for every one dollar of liability there is
0.18 dollar cash.
52
Analysis of the development current, quick and cash
ratio

In terms of current, quick and cash ratios the

financial situation has improved from 2013 to 2014.
However, the comparison of current and quick ratio
shows that the quick ratio of the firm in 2014 was
only 0.53, though the current ratio was 1.31.
However, in 2004 per one Liabilities only $0.18 was
kept in cash.
This may be indicated as critical, then if on any
reason inventory and account receivable become
illiquid the firm may be in financial crisis.

53
Computing Sustainability of Current Asset

We know that:
Cost of Good Sold
Pr oduction Cycle 
Current Asset

365 days
Pr oduction in Days 
Pr oduction Cycle
We have for 2014:
Cost of goods sold = $1344
Current assets = $708
$1344
Pr oduction Cycle   1.898
$708

If production stops Prufrock can sustain with 192.3

days current Asset.
54
 365 days
Pr oduction Cycle in Days   192.3 days
1.898

If cash flow and flow of inventory stop, Prufrock

can continue its production with the current asset
up to 192.3 days.

Computing net working capital ratio

We know that:
Net Working Capital
Net Working Capital 
Total Asset

Current Asset  Current Liabilities

Net Working Capital 
Total Asset

55
For 2013 we have:

Current Asset: $642

Current Liabilities:$543
Total Asset: $3373

Hence:
$642  $543
Net Working Capital Ratio   0.2935
$3373

For 2014 we have:

Current Asset: $642
Current Liabilities:$543
Total Asset: $3588
$708  $540
Net Working Capital Ratio   0.468
$3588
56
 Net working capital ratio expresses share of
current asset to Total Asset.
 It indicates whether the production capital
intensive, and whether there is any movement
in this direction.
 The net working capital ratio shows that the
production middle range capital intensive.
 From 2013 to 2014 there is a shift in this
direction.

57
9. Long Term Liquidity Ratios

Long term liquidity ratios express ability of the firm

to meet its long run obligations.
 Debt Assets Ratio.
 Debt Equity Ratio.
 Asset Equity Ratio (Equity Multiplier).

Debt Assets Ratio.

Total Debt
Debt Asset Ratio 
Total Asset
Debt Equity Ratio
Total Debt
Debt Equity Ratio 
Equity
58
Assets Equity Ratio (Equity Multiplier)
Total Asset
Asset Equity Ratio 
Equity
Equity  Debt
Equity Multiplier 
Equity
Equity Debt
Equity Multiplier  
Equity Equity
Debt
Equity Multiplier  1 
Equity

 Asset equity ratio expresses the share of equity to the

total asset.
 If the ratio is 1, it means that there is no debt.
 Asset equity ratio can not be less than 1.
 Bigger asset equity ratio indicates that the share of debt
in total asset is bigger.

59
Problem
Balance Sheet of Prufrock Corporation from 2003 and 2004 are given below. In
2004 EBIT was $691, Interest was $141 and Depreciation was $276. Calculate Total
Debt-Asset Ratio, Debt-Equity Ratio, and Equity Multiplier (Asset-Equity Ratio).
Assets 2003 2004
1. Current Assets    
1.1 Cash $84 $98
1.2 Accounts Receivable $165 $188
1.3 Inventory $393 $422
Total Current Assets $642 $708
2. Fixed Assets    
2.1 Net Plant & Equipment $2731 $2880
Total Assets $3373 $3588
3 Current Liability    
3.1 Accounts Payable $312 $344
3.2 Notes Payable $231 $196
Total Current liabilities $543 $540
4. Long Term Debt (Liability) $531 $457
5. Owner’s equity    
5.1 Common Stock & paid in surplus $500 $550
5.2 Retained Earnings $1799 $2041
Total Owner’s equity $2299 $2591
Total Liability & Equity $3373 $3588 60
Solution
Computing Debt Asset Ratio
We know that:
Total Debt
Debt Asset Ratio 
Total Asset

We have for 2013:

Total assets = $3373
Total Debt = $1074

Hence:
Total Debt
Debt Asset Ratio 
Total Asset

$1074
Debt Asset Ratio   0.318
$3373
61
For 2004 we have:
 Total assets = $3588
 Total Debt = $997

We know that:
Total Debt
Debt Asset Ratio 
Total Asset
Hence: $997
Debt Asset Ratio   0.277
$3588

The share of debt to total asset has decreased from

2013 to 2014 debt has from 32% to 28%.
Apparently, it is a good sign.
But it is known that with increasing debt the return on
equity increases.
In other words, Prufrock may use more and more loan
capital
62
Computing Debt Equity Ratio

We know that:
Total Debt
Debt Equity Ratio 
Equity
For 2013 we have:
Total debt = $1074
Total equity = $2299

So:
Total Debt
Debt Equity Ratio 
Equity

$1074
Debt Equity Ratio   0.467
$2299

63
For 2004 we have:
Total debt = $997
Total equity = $2591
So: Debt Equity Ratio 
Total Debt
Equity

$997
Debt Equity Ratio   0.384
$2591

Total Debt Equity Ratio has decreased from 2003 to

2004 0.467 to 0.384.
In one sense, it is good.
However, Prufrock may use more and more loan
capital

64
Calculation of Asset Equity Ration (Equity Multiplier)
 
We know that:
Total Asset
Asset Equity Ratio 
Equity
Debt
Equity Multiplier  1 
Equity
We have for 2013:
 Total Liability = $1074
 Total equity = $2299
So: Debt S1074
Asset Equity Ratio  1   1 1.467
Equity $2299

 Asset Equity Ratio is 1.384, it means out of 1.384

asset equity is 1.
 About 68.17% of total asset is equity.
65
Again
 
We know that:
Total Asset
Asset Equity Ratio 
Equity
Debt
Equity Multiplier  1 
Equity
We have for 2014:
 Total Liability = $997
 Total equity = $2591
So: Debt S 997
Asset Equity Ratio  1   1  1.384
Equity $2591

 Asset Equity is 1.384, it means out of 1.384 asset

equity is 1.
 About 72.25% of total asset is equity.
66
10. Asset Turnover Ratio
10.1 Current Asset Turnover Ratio

 Asset Turnover Ratio examines efficiency of assets.

 It is also called asset utilisation ratios.
 They describe how efficiently assets generate sales.
 They are called turnover ratios:
i. Inventory Turnover Ratio (Frequency).
ii. Inventory Turnover Ratio in days.
iii. Receivable Turnover Ratio (Frequency).
iv. Receivable Turnover Ratio in days.
v. Payable Turnover Ratio (Frequency).
vi. Payable Turnover Ratio in days.
vii. Net Working Capital Turnover Ratio (Frequency).
viii.Net Working Capital Turnover in days.
ix. Current Asset Turnover Ratio
x. Current Asset Turnover in days 67
Inventory Turnover Ratio
 Inventory turnover ratio expresses relationship
between costs of goods sold and Inventory
Mathematically:
Cost of Goods Sold
Inventory Turnover Ratio ( Frequency ) 
Inventory

365 Days
Inventory Turnover in Days 
Inventory Turnover Frequency
Receivable Turnover Ratio
 Receivable Turnover Ratio gives information
how fast products are sold and payments are
collected.
 Mathematically:
Sales (Re venue)
Re ceivable Turnover Ratio ( Frequency ) 
Account Re ceivable
68
Receivable Turnover days
365 days
Re ceivable Turnover in days 
Account Re ceivable Frequency

Payable Turnover Ratio

 Payables appear because everything is
purchased on credit.
 Payable Turnover Ratio expresses how
frequently payable is paid.
 Payable Turnover Ratio also indicates how long
it takes to pay payable.
Cost of G ods Sold
Payable Turnover Ratio ( Frequency) 
Account Payable

365 days
Payable Turnover in days 
Account Payable Frequency
69
Current Asset Turnover Ratio
 It measures sustainability of Current Asset

We know that:
Cost of Good Sold
Pr oduction Cycle 
Current Asset
365 days
Pr oduction in Days 
Pr oduction Cycle
Suppose we have for 2014:
Cost of goods sold = $1344
Current assets = $708
$1344
Pr oduction Cycle   1.898
$708
If production stops Prufrock can sustain with 192.3
days current Asset.
70
Problem
Compute Inventory Turnover Ratios, Receivables Turnover Ratios, Net
Working Turnover and Payable Turnover Ratios from the data given
below. Assets 2013 2014
1.1 Cash $84 $98
1.2 Accounts Receivable $165 $188
1.3 Inventory $393 $422
Total Current Assets $642 $708
2.1 Fixed Asset $2731 $2880
Total Assets $3373 $3588
3.1 Accounts Payable $312 $344
3.2 Notes Payable $231 $196
Total Current liabilities $543 $540
4. Long Term Debt (Liability) $531 $457
5. Owner’s equity $2299  2591 
Total Liability & Equity $3373 $3588

Income Statement 2014

Net sales $2311
Cost of goods sold $1344
Depreciation $276
Earnings before interest and taxes $691
Interest paid $141
Taxable income $550
Taxes $187
Net income $363
Dividends (1/3) $121
Addition to retained earnings $242 71
Solution
Computing Inventory Turnover
We know that:
Cost of Goods Sold
Inventory Turnover Ratio ( Frequency ) 
Inventory

We have:
Cost of goods sold = $344
Inventory = $422
So
$1344
Inventory Turnover Ratio ( Frequency)   3.1848
$422

$365 days
Inventory Turnover days   114 .606 days
3.1848

72
  Inventory Turnover Ratio shows that the firm
collects annually 3.1848 time the inventory.
 Inventory Turnover Ratio in days show that once
the firm has got the inventory it can sustain 115
day without further supply of inventory.

Computing of Receivables Turnover Ratio

We know that:

Sales (Re venue)

Re ceivable Turnover Ratio ( Frequency ) 
Account Re ceivable

365 days
Re ceivable Turnover in days 
Account Re ceivable Frequency

73
We have:
 Sales= $2311.
 Accounts receivable = $188.
So:
Sales (Re venue)
Re ceivable Turnover Ratio ( Frequency ) 
Account Re ceivable

$2311
Re ceivable Turnover Ratio ( Frequency )   12.29
$188
365 days
Re ceivable Turnover in days 
Account Re ceivable Frequency

365 days
Re ceivable Turnover in days   29.698 days
12.29
 The firm gets its receivable annually 12.29 times or
after every 29.69 days.
74
 Computing Payable Turnover Ratio Paid
We know that:
Cost of G ods Sold
Payable Turnover Ratio ( Frequency) 
Account Payable
365 days
Payable Turnover in days 
Account Payable Frequency
We have:
 Cost of goods sold = $1344.
 Accounts Payables = $344.
So:
$1344
Payable Turnover Ratio ( Frequency)   3.906
$344
365 days
Payable Turnover in days   93.422 days
3.906
75
Computing Net Working Capital Turnover Ratio
We know that:
Cost of Goods Sold (Re venue)
Net Working Capital Turnover Ratio 
Net Working Capital
365 days
Net Working Capital Turnover ( days) 
Net Working Capital
We have:
 Cost of Goods Sold: $1344
 Net Working Capital: $168 ($708-$540)
$1344
Net Working Capital Turnover Ratio   8.0
$168
365 days
Net Working Capital Turnover (days)   45.625 days
8.0
 Net Working Turnover Ratio indicates that with cash
and inventory stock the production supply could
continued to 45.625 days 76
11. Profitability Ratio

Profitability Ratio measures how efficiently firm use

its assets.
What is the rate of return?

Profitability Ratio consists of:

 Profit Margin (Return on Sale).
 Return on Assets.
 Return on Equity.

Return on Sales (Profit Margin)

Profit margin measures the ratio between Net

Income and Sales
Profit margin expresses what is the profit per Taka
sales
77
 Mathematically:
Net Earnings
Pr ofit M arg in 
Sales
Return on Assets
 Return on Assets (ROA) expresses the ratio
between net income and total assets.
 Return on Assets measures what is the profit per
Taka total assets.
 Return on asset is the earnings before interest and
taxes (EBIT).

Mathematically:
EBIT
Re turn on Asset 
Asset
78
Return on Equity
Return on Equity (ROE) expresses relationship
between Net Income and Equity.
It expresses the rate of return on owners
investment.

Mathematically:

Net Earnings
Re turn on Equity 
Equity

79
Problem
Compute Profit Margin, Return on Assets, and Return on Equity for
Prufrock from data given below.
Assets 2013 2014
1.1 Cash $84 $98
1.2 Accounts Receivable $165 $188
1.3 Inventory $393 $422
Total Current Assets $642 $708
2.1 Fixed Asset $2731 $2880
Total Assets $3373 $3588
3.1 Accounts Payable $312 $344
3.2 Notes Payable $231 $196
Total Current liabilities $543 $540
4. Long Term Debt (Liability) $531 $457
5. Owner’s equity $2299  2591 
Total Liability & Equity $3373 $3588

Income Statement 2014

Net sales $2311
Cost of goods sold $1344
Depreciation $276
Earnings before interest and taxes $691
Interest paid $141
Taxable income $550
Taxes $187
Net income $363
Dividends (1/3) $121
80
Addition to retained earnings $242
Solution
 
Computing Profit Margin (Return on Sales)
We know that:
Net Earnings
Pr ofit M arg in 
Sales

We have for 2014:

Net income = $363
Sale = $2311

So:
$363
Re turn on Equity   15.707
$2311
81
 Profit margin of Prufrock for 2014 was 15.71%.
 It means, per 100 US $ sale Prufrock had $15.71
net income.
 A high profit margin is always desirable. Firms
always try to increase profit margin. For
example, lowering sales price sale volume can
be increased. However, this can cause profit
margins to shrink, because it could increase
sale but can decrease proportionally net income.

82
Calculation of Return on Assets

We know that:
EBIT
Re turn on Asset 
Asset

We have for 2014:

EBIT = $691
Total assets = $3588
$691
Re turn on Asset   0.1925
$3588

Return on assets assessed asset productivity.

For Prufrock it was 19.25% in 2014
83
Calculation of Return on Equity
We know that:
Net Earnings
Re turn on Equity 
Equity

We have for 2014:

 Net income = $363
 Total assets = $3588

$363
Re turn on Equity   0.1011
$3588
Return on equity of Prufrock is 10.11%, however return on
asset is 19.25%.
It means that the asset productivity of Prufrock bigger, but
it is paying high rate of interest , so return on equity
becomes smaller.
Prufrock should reduce its interest bearing liability. 84
12. Du Pont Identity
  Net Earnings
Re turn on Equity 
Equity

Net Earnings Asset

Re turn on Equity  
Equity Asset

Net Earnings Asset

Re turn on Equity  
Asset Equity

Net Earnings Asset Sales

Re turn on Equity   
Asset Equity Sales
Net Earnings Asset Sales
Re turn on Equity   
Sales Equity Asset
Du Pont Identity expresses that:
Return on Equity = (Profit Margin)×((Leverage)×(Asset
Turnover).
Return on Equity = (Operating Efficiency)×(Policy of
Leverage)×(Asset Productivity). 85
 End of the Chapter

Thank You Very Much

For Patient Listening

86