Topic 2 Finance Ratios 1

OPERATING CYCLE COMPONENTS
• The operating cycle is the length of time from when a company makes an
investment in goods and services to the time it collects cash from its accounts
receivable.
• The net operating cycle is the length of time from when a company makes an
investment in goods and services, considering the company makes some of its
purchases on credit, to the time it collects cash from its accounts receivable.
• The length of the operating cycle and net operating cycle provides information
on the company’s need for liquidity: The longer the operating cycle, the greater
the need for liquidity.
Number of Days of Inventory Number of Days of Receivables
| | | |
Buy Inventory on Pay Accounts Sell Inventory on Collect Accounts

Credit Payable Credit Receivable
Number of Days of Payables Net Operating Cycle
Operating Cycle
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TOOLS FOR FINANCIAL
STATEMENT ANALYSIS
Ansbert Kishamba
CPA(T), MSc. (A&F)
2
1. INTRODUCTION
Financial analysis is a process of selecting, evaluating, and interpreting
financial data, along with other pertinent information, in order to formulate an
assessment of a company’s present and future financial condition and
performance.
3
FINANCIAL ANALYSIS TOOLS:
DESCRIPTION
• Graphics
• Regression
• Common-Size Analysis
• Financial Ratio Analysis
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2. COMMON-SIZE ANALYSIS
Common-size analysis is the restatement of financial statement
information in a standardized form.
- Horizontal common-size analysis uses the amounts in accounts in
a specified year as the base, and subsequent years’ amounts are
stated as a percentage of the base value.
- Useful when comparing growth of different accounts over time.
- Vertical common-size analysis uses the aggregate value in a
financial statement for a given year as the base, and each account’s
amount is restated as a percentage of the aggregate.
- Balance sheet: Aggregate amount is total assets.
- Income statement: Aggregate amount is revenues or sales.
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EXAMPLE: COMMON-SIZE ANALYSIS
Consider the CS Company, which reports the following financial information:
Year 2008 2009 2010 2011 2012 2013
Cash $400.00 $404.00 $408.04 $412.12 $416.24 $420.40
Inventory 1,580.00 1,627.40 1,676.22 1,726.51 1,778.30 1,831.65
Accounts receivable 1,120.00 1,142.40 1,165.25 1,188.55 1,212.32 1,236.57
Net plant and equipment 3,500.00 3,640.00 3,785.60 3,937.02 4,094.50 4,258.29
Intangibles 400.00 402.00 404.01 406.03 408.06 410.10
Total assets $7,000.00 $6,713.30 $6,934.12 $7,162.74 $7,399.45 $7,644.54
1.Create the vertical common-size analysis for the CS Company’s assets.

2.Create the horizontal common-size analysis for CS Company’s assets, using
2008 as the base year.
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Vertical Common-Size Analysis:
Year 2008 2009 2010 2011 2012 2013
Cash 6% 6% 5% 5% 5% 5%
Inventory 23% 23% 23% 23% 22% 22%
Accounts receivable 16% 16% 16% 15% 15% 15%
Net plant and equipment 50% 50% 51% 51% 52% 52%
Intangibles 6% 6% 5% 5% 5% 5%
Total assets 100% 100% 100% 100% 100% 100%
Graphically:
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Horizontal Common-Size Analysis (base year is 2008):
Year 2008 2009 2010 2011 2012 2013
Cash 100.00% 101.00% 102.01% 103.03% 104.06% 105.10%
Inventory 100.00% 103.00% 106.09% 109.27% 112.55% 115.93%
Accounts receivable 100.00% 102.00% 104.04% 106.12% 108.24% 110.41%
Net plant and equipment 100.00% 104.00% 108.16% 112.49% 116.99% 121.67%
Intangibles 100.00% 100.50% 101.00% 101.51% 102.02% 102.53%
Total assets 100.00% 103.08% 106.27% 109.57% 112.99% 116.53%
Graphically:
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3. FINANCIAL RATIO ANALYSIS
• Financial ratio analysis is the use of relationships among financial statement
accounts to gauge the financial condition and performance of a company.
• We can classify ratios based on the type of information the ratio provides:
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ACTIVITY RATIOS
• Turnover ratios reflect the number of times assets flow into and out of the
company during the period.
• A turnover is a gauge of the efficiency of putting assets to work.
• Ratios:
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OPERATING CYCLE FORMULAS
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OPERATING CYCLE FORMULAS
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LIQUIDITY
• Liquidity is the ability to satisfy the company’s short-term obligations using
assets that can be most readily converted into cash.
• Liquidity ratios:
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SOLVENCY ANALYSIS
• A company’s business risk is
determined, in large part, from the
company’s line of business.
• Financial risk is the risk resulting from
a company’s choice of how to finance
the business using debt or equity.
• We use solvency ratios to assess a
company’s financial risk.
• There are two types of solvency ratios:
component percentages and coverage
ratios.
- Component percentages involve
comparing the elements in the
capital structure.
- Coverage ratios measure the ability
to meet interest and other fixed
financing costs.
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SOLVENCY RATIOS
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PROFITABILITY
• Margins and return ratios provide information on the profitability of a company
and the efficiency of the company.
• A margin is a portion of revenues that is a profit.
• A return is a comparison of a profit with the investment necessary to generate
the profit.
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PROFITABILITY RATIOS: MARGINS
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PROFITABILITY RATIOS: RETURNS
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THE DUPONT FORMULAS
• The DuPont formula uses the
relationship among financial statement
accounts to decompose a return into
components.
• Three-factor DuPont for the return on
equity:
- Total asset turnover
- Financial leverage
- Net profit margin
• Five-factor DuPont for the return on
equity:
- Total asset turnover
- Financial leverage
- Operating profit margin
- Effect of nonoperating items
- Tax effect
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FIVE-COMPONENT DUPONT MODEL
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EXAMPLE: THE DUPONT FORMULA
Suppose that an analyst has noticed that the return on equity of the D
Company has declined from FY2012 to FY2013. Using the DuPont
formula, explain the source of this decline.
(millions) 2013 2012

Revenues $1,000 $900
Earnings before interest and taxes $400 $380
Interest expense $30 $30
Taxes $100 $90
Total assets $2,000 $2,000

Shareholders’ equity $1,250 $1,000
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EXAMPLE: THE DUPONT FORMULA
2013 2012
Return on equity 0.20 0.22
Return on assets 0.13 0.11
Financial leverage 1.60 2.00

Total asset turnover 0.50 0.45
Net profit margin 0.25 0.24
Operating profit margin 0.40 0.42
Effect of nonoperating items 0.83 0.82

Tax effect 0.76 0.71
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OTHER RATIOS
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OTHER RATIOS
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EXAMPLE: SHAREHOLDER RATIOS
Calculate the book value per share, P/E, dividends per share,
dividend payout, and plowback ratio based on the following
financial information:
Book value of equity $100 million

Market value of equity $500 million
Net income $30 million
Dividends $12 million
Number of shares 100 million
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EXAMPLE: SHAREHOLDER RATIOS
Book value per share $1.00 There is $1 of equity, per the books, for
every share of stock.
P/E 16.67 The market price of the stock is 16.67
times earnings per share.
Dividends per share $0.12 The dividends paid per share of stock.
Dividend payout ratio 40% The proportion of earnings paid out in the
form of dividends.
Plowback ratio 60% The proportion of earnings retained by the
company.
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EFFECTIVE USE OF RATIO ANALYSIS
• In addition to ratios, an analyst should describe the company (e.g., line of
business, major products, major suppliers), industry information, and major
factors or influences.
• Effective use of ratios requires looking at ratios
- Over time.
- Compared with other companies in the same line of business.
- In the context of major events in the company (for example, mergers or
divestitures), accounting changes, and changes in the company’s product
mix.
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4. PRO FORMA ANALYSIS
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PRO FORMA INCOME STATEMENT
Imaginaire Company Income Statement (in millions)
One Year
Year 0 Ahead
Sales revenues €1,000.0 €1,050.0  Growth at 5%
Cost of goods sold 600.0 630.0  60% of revenues
Gross profit €400.0 €420.0  Revenues less COGS
SG&A 100.0 105.0  10% of revenues
Operating income €300.0 €315.0  Gross profit less operating exp.
Interest expense 32.0 33.6  8% of long-term debt
Earnings before taxes €268.0 €281.4  Operating income less interest exp.
Taxes 93.8 98.5  35% of earnings before taxes
Net income €174.2 €182.9  Earnings before taxes less taxes
Dividends €87.1 €91.5  Dividend payout ratio of 50%
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PRO FORMA BALANCE SHEET
Imaginaire Company Balance Sheet, End of Year (in millions)

One Year
Year 0 Ahead
Current assets €600.0 €630.0  60% of revenues
Net plant and equipment 1,000.0 1,050.0  100% of revenues
Total assets €1,600.0 €1,680.0
Current liabilities €250.0 €262.5  25% of revenues

Long-term debt 400.0 420.0  Debt increased by €20 million
to maintain the same capital
structure
Common stock and paid-in 25.0 25.0  Assume no change
capital
Treasury stock (44.0)  Repurchased shares
Retained earnings 925.0 1,016.5  Retained earnings in Year 0,
plus net income, less
dividends
Total liabilities and equity €1,600.0 €1,680.0
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5. SUMMARY
• Financial ratio analysis and common-size analysis help gauge the financial
performance and condition of a company through an examination of
relationships among these many financial items.
• A thorough financial analysis of a company requires examining its efficiency in
putting its assets to work, its liquidity position, its solvency, and its profitability.
• We can use the tools of common-size analysis and financial ratio analysis,
including the DuPont model, to help understand where a company has been.
• We then use relationships among financial statement accounts in pro forma
analysis, forecasting the company’s income statements and balance sheets for
future periods, to see how the company’s performance is likely to evolve.
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GRAPHICS: EXAMPLE
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GRAPHICS: EXAMPLE
$ millions
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GRAPHICS: EXAMPLE
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REGRESSION: EXAMPLE
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COMMON-SIZE ANALYSIS
• Common-size analysis: Express financial data, including entire

financial statements, in relation to a single financial statement item or
base.
• Vertical common-size
- Balance sheet: Each item as a percent of total assets.
- Income statement: Each item as a percent of total net revenues.
- Cash flow: Each line as a percent of sales, assets, or total in and out.
- Highlights composition and identifies what’s important.
• Horizontal common-size
- Percentage increase or decrease of each item from the prior year or
showing each year relative to a base year.
- Highlights items that have changed unexpectedly or have
unexpectedly remained unchanged.
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COMMON-SIZE BALANCE SHEET EXAMPLE:
SINGLE COMPANY, TWO PERIODS
Partial common-size balance sheet
Period 1 Period 2
% of Total % of Total
Assets Assets
Cash 25 15
Receivables 35 57
Inventory 35 20
Fixed assets, net of 5 8
depreciation
Total assets 100 100
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COMMON-SIZE BALANCE SHEET EXAMPLE:
CROSS-SECTIONAL, TWO COMPANIES, SAME TIME
Partial common-size balance sheet
Assets Company 1 Company 2

% of Total % of Total
Assets Assets
Cash 38 12
Receivables 33 55
Inventory 27 24
Fixed assets net of depreciation 1 2
Investments 1 7
Total Assets 100 100
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USE OF COMPARATIVE GROWTH
INFORMATION: EXAMPLE
Sunbeam, Inc. 1997 vs.1996
Revenue +19%
Receivables +38%
Inventory +58%
Why are receivables growing so much faster than revenue?

Why is inventory growing so much faster than revenue?
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FINANCIAL RATIOS
• Ratios
- Express one number in relation to another.
- Standardize financial data in terms of mathematical
relationships expressed as percentages, times, or days.
- Facilitate comparisons—trends and across companies.
• Ratios are interrelated
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RATIO ANALYSIS
How profitable was Company X?
• A ratio is NOT the answer (except sometimes on

an exam).
• A ratio is an indicator—for example, an indicator
of relative activity, profitability, liquidity, solvency.
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RATIO ANALYSIS
How profitable was company X?
• A ratio is NOT the answer (except sometimes on an exam).

• A ratio is an indicator—for example, an indicator of relative
activity, profitability, liquidity, solvency.
• Interpretation generally involves comparison. Furthermore,
analysis will address the question of why.
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RATIO ANALYSIS
How profitable was Company X?
• A ratio is NOT the answer (except sometimes on an exam).

• A ratio is an indicator—for example, an indicator of relative
activity, profitability, liquidity, solvency.
• Interpretation generally involves comparison. Furthermore,
analysis will address the question of why.
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USING FINANCIAL ANALYSIS TOOLS
Computation ≠ Analysis
• Analysis goes beyond collecting data and computing numbers.
• Analysis encompasses computations and interpretations.
• Where practical, directly experience the company’s business.
• Analysis of past performance:
What aspects of performance are critical to successfully competing
in the industry?
How well did the company perform (relative to own history and
relative to competitors)?
Why? What caused the performance?
Does the performance reflect the company’s strategy?
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USING FINANCIAL ANALYSIS TOOLS
• Not every ratio is relevant in every situation.
- Some ratios are irrelevant for certain companies.
- Some ratios are redundant.
- Industry-specific ratios can be as important as general
financial ratios.
- Different users and questions (e.g., creditors, investors)
focus on different ratios.
• Different sources categorize some ratios differently and

include different ratios.
• Differences in accounting standards can limit comparability.
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CATEGORIES OF FINANCIAL RATIOS
Category Description
Activity Activity ratios. How efficient are the firm’s operations
and the firm’s management of assets?
Liquidity Liquidity ratios. How well is the firm positioned to

meet short-term obligations?
Solvency Solvency ratios. How well is the firm positioned to
meet long-term obligations?
Profitability Profitability ratios. How and how much is the firm

achieving returns on its investments?
Valuation Valuation ratios. How does the firm’s performance or
financial position relate to its market value?
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PROFITABILITY AND OVERVIEW
Liquidity Liquidity ratios. How well is the firm positioned to

meet short-term obligations?
Solvency Solvency ratios. How well is the firm positioned to
meet long-term obligations?
Profitability Profitability ratios. How much and how is the firm


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MEASURE OF PROFITABILITY:
RETURN ON EQUITY (ROE)
What rate of return has the firm earned on the shareholders’
equity it had available during the year?
•The general form of the rate of return computation:
Amount of return
Rate of return =
Amount invested
•Applied to shareholders’ equity:
Net income
ROE =
Average equity
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DECOMPOSE ROE
Net income
ROE =
Average equity
Net income Average assets

= ×
Average assets Average equity
= ROA × Leverage
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DECOMPOSE ROE
ROE = ROA × Leverage
A company can increase its ROE
1.With a business strategy, by increasing its ROA
and/or
2.With a financial strategy, by increasing its use of leverage

as long as returns on the incremental investment exceed
the cost of borrowing.
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RETURN ON ASSETS
What rate of return has the firm earned on the assets it had available to
use during the year?
The general form of this computation is the same:

Amount of return
Rate of Return =
Amount invested
Two variants of ROA computation:

Net income
(1) ROA =
Average assets
Net income adjusted for interest

(2) ROA =
Average assets
Net income + [Interest expense × (1 – Tax rate)]

=
Average assets
Copyright © 2013 CFA Institute 51

PROFITABILITY, COMPETITION,
AND BUSINESS STRATEGY
Net income
ROA =
Average assets
Net income Revenue

ROA = ×
Revenue Average assets
In other words,
ROA can
be thought
of as:
Profit margin × Turnover (efficiency)

DECOMPOSING
RETURN ON EQUITY
ROE = Profit margin × Turnover × Leverage
Net income Revenue Average assets

ROE = × ×
Revenue Average assets Average equity

Du Pont Analysis
DECOMPOSING
RETURN ON EQUITY
What was the source of the firm’s return on equity?
To what extent
• . . . was it derived from selling a high margin product or keeping
expenses low—deriving more profits from each $1 of sales? (return
on sales, net profit margin)
• . . . was it derived from generating higher sales from a lower
investment in assets? (efficient use of assets, also known as
turnover or efficiency)
• . . . was it derived from investing a lower amount of equity—by
using more debt in its capital structure? (financial leverage)

DECOMPOSING RETURN ON EQUITY:
STYLIZED COMPARATIVE ANALYSIS MINI-CASE
Averag
Co. A Co. B Co. C e
Sales ($) 2,000 4,000 6,675 4,225
Net income (NI) ($) 200 200 200 200
Average assets ($) 1,000 2,000 1,500 1,500
Average equity ($) 1,000 1,000 1,000 1,000
Average liabilities ($) 0 1,000 500 500
ROE (NI/Equity)
Net profit margin
(NI/Sales)
Turnover
(Sales/Assets)
Leverage
(Assets/Equity)
STYLIZED COMPARATIVE ANALYSIS MINI-CASE
Co. A Co. B Co. C Average
Sales ($) 2,000 4,000 6,675 4,225
NI ($) 200 200 200 200
Average assets ($) 1,000 2,000 1,500 1,500
Average equity ($) 1,000 1,000 1,000 1,000
Average liabilities ($) 0 1,000 500 500
ROE (NI/Equity) 20.0% 20.0% 20.0% 20.0%
Net profit margin
(NI/Sales) 10.0% 5.0% 3.0% 4.7%
Turnover (Sales/Assets) 2 2 4.45 2.82
Leverage (Assets/Equity) 1 2 1.5 1.50

COMPARATIVE
AAPL HPQ DELL

ROE 27.19% 21.50% 61.19%
Net profit
Net income/Sales margin 14.88% 7.04% 4.06%
Asset
Sales/Average assets turnover 1.00 1.17 2.26
Average assets/ Financial
Average equity leverage 1.83 2.61 6.67

DUPONT ANALYSIS :
FURTHER DECOMPOSITION
• ROE = Net income/Average equity

• Decompose ROE into five factors
Net income EBT EBIT

ROE = × ×
EBT EBIT Revenue
Revenue Average assets
× ×
Average assets Average equity

PROFITABILITY: RETURN ON SALES
(FROM THE COMMON-SIZE INCOME STATEMENT)
Gross profit margin = Gross profit/Revenue

Measures the ability to translate sales into profit after consideration of
cost of products sold.
Operating profit margin = Operating profit/Revenue

Measures the ability to translate sales into profit after consideration of
operating expenses.
Net profit margin = Net profit/Revenue

Measures the ability to translate sales into profit after consideration of all
expenses and revenues, including interest, taxes, and nonoperating
items.
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DISCUSSION BY CATEGORY
Liquidity Liquidity ratios. How well is the firm positioned to meet

short-term obligations?
Solvency Solvency ratios. How well is the firm positioned to meet
long-term obligations?


ACTIVITY RATIOS
• Also known as asset utilization or operating efficiency ratios.

• How efficiently is the firm using its assets? How many dollars of
sales was the firm able to generate from each dollar of assets?
• Broadly
Asset turnover = Revenue/Average total assets
• Low or declining ratios could mean
- Sales are sluggish,
- A heavy investment in assets (inefficient? plant modernization to
help in future? strategy shift?), and/or
- Asset mix changed.
• Specifically, for fixed assets:
Fixed asset turnover = Revenue/Average net fixed assets
• Can compute for any category of assets.

ACTIVITY RATIOS
Also known as asset utilization or operating efficiency ratios

Numerator Denominator
Working capital turnover Revenue Average working capital
Fixed asset turnover Revenue Average net fixed assets
Total asset turnover Revenue Average total assets

OTHER COMMON ACTIVITY RATIOS
Inventory turnover Cost of sales Average inventory
Number of days in
Days of inventory on hand (DOH) Inventory turnover
period
Receivables turnover Revenue Average receivables
Number of days in Receivables
Days of sales outstanding (DSO)
period turnover
Average trade
Payables turnover Purchases
payables
Number of days in
Number of days of payables Payables turnover
period

ACTIVITY RATIOS AND THE CASH CYCLE
(CASH CONVERSION CYCLE, A LIQUIDITY RATIO)
• Cash cycle: How long does it take for the firm to go from cash to cash?
- Service company: sell service → receive cash.
- Merchandising company: buy inventory → sell inventory → receive
cash and pay for inventory.
- Manufacturing company: buy raw materials → make product → sell
product → receive cash and pay for materials and labor.
• Cash conversion cycle (net operating cycle) = Days sales outstanding

+ Days inventory held – Number of days of payables
• Close link to liquidity
• Working capital (current assets minus current liabilities) reflects the

investment required to support this cycle.

LIQUIDITY
• How well positioned is the firm to meet its near-term

obligations?
Current ratio = Current assets/Current liabilities
Quick ratio = (Cash + Short-term marketable investments +

Account receivables)/Current liabilities
Cash ratio = (Cash + Short-term marketable investments)/

Current liabilities




SOLVENCY: HOW WELL POSITIONED IS THE
FIRM TO MEET ITS LONGER-TERM LIABILITIES?
Debt ratios: How has the company financed itself?
• Debt to total assets
}
Lower ratio –> safer.
• Debt to equity
• Debt to total capital Higher cushion against
potential creditor losses
Coverage ratios: Degree to which earnings or cash flow can

decline without affecting firm’s ability to pay interest.
• EBIT interest coverage = (EBT + Interest payments)/Interest
payments
• Fixed charge coverage = (EBIT + Lease payments)/(Interest
payments + Lease payments)

COMMON SOLVENCY RATIOS
Solvency ratios Numerator Denominator

Debt ratios
Debt-to-assets ratio Total debt Total assets
Debt-to-capital ratio Total debt Total debt + Total
shareholders’ equity
Debt-to-equity ratio Total debt Total shareholders’ equity
Financial leverage Average total assets Average total equity
ratio
Coverage ratios
Interest coverage EBIT Interest payments
Fixed charge EBIT + Lease Interest payments + Lease
coverage payments payments




VALUATION RATIOS:
PRICE-TO-EARNINGS RATIO
P/E relates earnings per common share to the market price at
which the stock trades, expressing the “multiple” that the stock
market places on a firm’s earnings.
Price
P/E =
Earnings per share
High P/E indicates

- Firm is valued highly by market, possibly because of growth
expectations, or
- That a firm may have very low earnings per share.

VALUATION RATIOS
Valuation ratios
P/E Price per share Earnings per share
P/CF Price per share Cash flow per share
P/S Price per share Sales per share
P/BV Price per share Book value per share

DIVIDEND-RELATED QUANTITIES
Dividends per share

Dividend payout ratio =
Earnings per share
Dividends per share

Dividend yield =
Price

SELECTED CREDIT RATIOS USED BY
STANDARD & POOR’S AS PART OF CREDIT ANALYSIS
Ratio Numerator Denominator

Gross interest (prior to
EBIT and EBITDA
EBIT or EBITDA deductions for capitalized
interest coverage
interest or interest income)
FFO plus interest Gross interest (prior to
FFO interest coverage paid minus operating deductions for capitalized
lease adjustments interest or interest income)
FFO to debt FFO Total debt
CFO (adjusted)
Free operating cash
minus capital Total debt
flow to debt
expenditures
CFO minus capital
Discretionary cash flow
expenditures minus Total debt
to debt
dividends paid

SELECTED CREDIT RATIOS USED BY
STANDARD & POOR’S AS PART OF CREDIT ANALYSIS
Credit Ratio Numerator Denominator

Average capital, where capital is
Return on capital EBIT equity plus noncurrent deferred
taxes plus debt
Net cash flow to capital
FFO minus dividends Capital expenditures
expenditures
Total debt EBITDA

Debt to EBITDA
Total debt to total debt Total debt Total debt plus equity
plus equity

SEGMENT ANALYSIS EXAMPLE:
L’ORÉAL

MODEL BUILDING:
EXAMPLES OF POSSIBLE USES OF RATIOS

RATIOS IN MODEL BUILDING

SUMMARY: FINANCIAL ANALYSIS TOOLS
• Graphics facilitate comparisons, and regressions quantify statistical

relationships.
• Common-size analysis expresses financial data, including entire
financial statements, in relation to a single financial statement item or
base.
• Ratios, which express one number in relation to another, facilitate
comparisons—trends and cross-sectional.
• A ratio is an indicator of
- Activity
- Profitability
- Liquidity
- Solvency

EXAMPLE
• The following are the financial statements of
Zitandizane Ltd.
• The Company is a diversified enterprise with its
main interests in the manufacture and retail of
plastic products.
• The financial statements of Zitandizane Ltd need
to be analysed.
• An investor is considering purchasing shares in
the company.
• Relevant ratios need to be selected and calculated
and a report needs to be written for the investor.
The report should evaluate the company’s
performance and position
ZITANDIZANE LTD
STATEMENT OF FINANCIAL PERFORMANCE FOR YEAR ENDED 31
MARCH
ZITANDIZANE LTD
STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH
ZITANDIZANE LTD
STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 MARCH
ADDITIONAL INFORMATION:
• Credit purchases for the year 2011 were Tshs.2,142,800.
• General prospects for the major industries in which
Zitandizane is involved look good with a forecast glut of oil
set to reduce the cost of production and world demand for
plastic remaining strong.
Benchmarks:
• There are no exact benchmarks for Zitandizane Ltd
because it is a diversified company. The following are
average indicators that relate to the plastic retailing and
manufacturing industries for the year 2011.
- Gross profit margin 25%
- Net profit margin 7%
- Inventory turnover 6 times
- Debt/equity ratio 0.6 : 1
- Return on Assets 12%
- Return on Equity 20%
• REQUIRED
- Using ratios critically evaluate the financial performance
of the company.
- Write a report on the company’s performance and
position
LIQUIDITY OR SOLVENCY RATIOS
2010 2011
RATIOS
2010
2011
ASSET TURNOVER
2010 2011
ASSET MANAGEMENT OR ACTIVITY
RATIOS
• Trade Creditor Days= Trade Creditors X 365
Credit Purchases
This ratio shows the number of days’ credit is taken from suppliers.
2010 2011
ASSET MANAGEMENT OR ACTIVITY
RATIOS
• Average Collection Period = Average accounts Receivable * 365
Average net credit sales
• measures the length of time it takes to convert average sales into
cash. A long average collection requires a higher investment in
accounts receivable, thus less cash available to cover cash outflows
2010 2011
PROFITABILITY RATIOS
Industry
GPM=25%
NPM=7%
FINANCIAL STRUCTURE OR CAPITALISATION
RATIOS
Debt/Equity
2010
2011
RELEVANT RATIOS
Important note: The calculations of the ratios in this illustration did not use “averages” for total assets, equity and
inventory. The 2010 and 2011 year end figures were used and this is a slight variation to the formulas provided.
Profitability Benchmarks 2010 2011

ratios:
Gross Profit Industry 22% 22.7%

Margin 25%
Net Profit Industry 7.1% 6.1%

Margin 7%
Return on 12% 15.6% 15.5%

Assets
Return on Industry 32% 26%

Equity 20%
Asset Benchmarks 2010 2011
Management
ratios:
Inventory Industry 5.8 times 5.58 times
Turnover 6%
Asset Turnover Not given 2.2 2.53

Liquidity Benchmarks 2010 2011
ratios:
Current Ratio Ideal standard 1.78:1 1.70:1
2:1
Acceptable
standard
1:1
Quick Ratio Ideal standard 0.85:1 0.69:1
2:1
Acceptable
standard
1:1
Days Payable Standard Credit 49.19 days
30 days purchases not
available
Financial Benchmarks 2010 2011
Structure
ratios:
Debt/Equity Industry 1.05: 1 0.67:1
0.6:1
Standard
benchmark
1:1
TIE Standard 10.14 times 39.74 times
benchmark:
Between 3 and 5.
Below 3 risky.
Above 5 very
favourable
REPORT
• For the investor considering the purchase of shares in the

company, the return they will earn is the key financial
factor but an overall evaluation of the company’s
performance and position is also important to get a better
picture of how well the company is actually doing.
• ROE in 2011 is 26%. Whether or not this is attractive
depends on the perceived riskiness of this investment and
other alternatives available but this return is certainly
more attractive than current bank interest rates.
• ROE has decreased by 4% but the company’s ROE at
26% is still better than the industry average of 20%
• Riskiness of business is being reduced by the significant
repayment of loan in 2011.
• Profitability
- The NP% and ROA ratios show a small downward trend
in % over the 2 year period. ROE% ratio show a more
significant decrease but is still better than the industry
average.
- Gross Profit Margin is slightly unfavourable at about
2.3% below the industry benchmark of 25%.
- The horizontal analysis information show that Sales
have increased by 20%. However operating costs have
increased by 34%.
• Asset Management
- IT has gone down slightly from 5.8 to 5.58 times.
- IT is still close to the industry benchmark of 6 times.
- AT has increased showing more sales being generated
from asset usage
• Liquidity
- Current ratios of 1.78:1 (2010) and 1.70: 1 are at above
acceptable levels but below ideal level.
- Quick ratios appear more of a concern being below
acceptable levels in both years and even more so in
2011 (0.69:1).
- Raises some concerns over the liquidity of the business
and inventory management (although IT ratio only
shows a slight decline in 2011).
- Days Payable is a concern as there may be poor debt
payment management.
• Financial Structure
- Although slightly higher than D/E industry benchmark
(0.67:1), business has become less risky due to the
significant repayment of loan in 2011.
- TIE is extremely good for the business at 39.74 times
(well above 5 the standard benchmark).
RECOMMENDATION
Given:
1) the strong forecast for the industry (ie general
prospects looking good and world demand for
plastic products remaining strong),
2) the sales growth in this business,
3) acceptable ratios as they are quite close to the
industry averages,
4) good cash flows from operating activities and
5) favourable ROE, although it has decreased, it
is still better than the industry average ROE.
=> it is recommended that the investor purchase shares

in the Zitandizane Ltd company.

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OPERATING CYCLE COMPONENTS

Buy Inventory on Pay Accounts Sell Inventory on Collect Accounts

Number of Days of Payables Net Operating Cycle

1.Create the vertical common-size analysis for the CS Company’s assets.

(millions) 2013 2012

Total assets $2,000 $2,000

Financial leverage 1.60 2.00

Effect of nonoperating items 0.83 0.82

Book value of equity $100 million

Imaginaire Company Balance Sheet, End of Year (in millions)

Current liabilities €250.0 €262.5  25% of revenues

• Common-size analysis: Express financial data, including entire

Partial common-size balance sheet

Assets Company 1 Company 2

Sunbeam, Inc. 1997 vs.1996

Why are receivables growing so much faster than revenue?

• Ratios are interrelated

How profitable was Company X?

• A ratio is NOT the answer (except sometimes on

• A ratio is NOT the answer (except sometimes on an exam).

• A ratio is NOT the answer (except sometimes on an exam).

• Different sources categorize some ratios differently and

• Differences in accounting standards can limit comparability.

Liquidity Liquidity ratios. How well is the firm positioned to

Profitability Profitability ratios. How and how much is the firm

Liquidity Liquidity ratios. How well is the firm positioned to

Profitability Profitability ratios. How much and how is the firm

Valuation Valuation ratios. How does the firm’s performance or

•The general form of the rate of return computation:

•Applied to shareholders’ equity:

Net income Average assets

ROE = ROA × Leverage

A company can increase its ROE

1.With a business strategy, by increasing its ROA

2.With a financial strategy, by increasing its use of leverage

The general form of this computation is the same:

Two variants of ROA computation:

Net income adjusted for interest

Net income + [Interest expense × (1 – Tax rate)]

Copyright © 2013 CFA Institute 51

Net income Revenue

Profit margin × Turnover (efficiency)

Copyright © 2013 CFA Institute 52

ROE = Profit margin × Turnover × Leverage

Net income Revenue Average assets

Copyright © 2013 CFA Institute 53

Copyright © 2013 CFA Institute 54

Turnover (Sales/Assets) 2 2 4.45 2.82

Leverage (Assets/Equity) 1 2 1.5 1.50

AAPL HPQ DELL

Copyright © 2013 CFA Institute 57

• ROE = Net income/Average equity

Net income EBT EBIT

Copyright © 2013 CFA Institute 58

Gross profit margin = Gross profit/Revenue

Operating profit margin = Operating profit/Revenue

Net profit margin = Net profit/Revenue

Liquidity Liquidity ratios. How well is the firm positioned to meet

Profitability Profitability ratios. How much and how is the firm

Copyright © 2013 CFA Institute 60