1485465_2_fm_rl_1.3.3

Financial Management
MBA ZG 521
BITS Pilani Krishnamurthy Bindumadhavan, CFA, FRM

Associate Professor, Management - Finance
Pilani Campus
Email: [email protected]
BITS Pilani
Pilani|Dubai|Goa|Hyderabad
Financial Statements Analysis

- Part 3
Ratio Analysis - Introduction
• Financial ratios provide an alternative method for

standardizing the financial information on the income
statement and balance sheet
• A ratio by itself may not be very informative
• Typically a ratio is compared to

• Ratios from prior years
• Ratios of peers (other firms in the same industry)
• If the differences are significant then more detailed analysis is

done to identify the underlying drivers and the implications
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Financial Ratio Analysis – Key
Building Blocks
Ability to meet Ability to

short-term generate future
Liquidity and
obligations and to Activity/ revenues and
Solvency
efficiently generate Efficiency meet long-term
revenues obligations
Ability to provide
financial rewards Ability to
sufficient to attract Profitability Valuation generate
and retain positive market
financing expectations

Liquidity Ratios
• Liquidity ratios help answer the question:

• How liquid is the firm?
• A firm is financially liquid if it is able to pay its bills on time
• We typically analyze a firm’s liquidity from two perspectives:

• Overall or general firm liquidity
• Liquidity of specific current asset accounts

(these are sometimes also classified as turnover ratios or
activity ratios or efficiency ratios)

Overall Liquidity
• Overall liquidity is analyzed by comparing the firm’s current assets to the
firm’s current liabilities
• The two key ratios used in this analysis are:
• Current ratio (sometimes referred to as working capital ratio)
• Acid-test ratio
Current Ratio: Current Ratio compares a firm’s current (liquid) assets to its current
(short-term) liabilities
• Acid-Test (Quick) Ratio: This ratio excludes the inventory from current assets since
inventory is usually not as liquid as cash or other current assets

Turnover ratios
Accounts Receivable Turnover Ratio measures how many times

accounts receivable are “turned over or rolled over” during a year
Inventory turnover ratio measures how many times the company

turns over its inventory during the year. Shorter inventory cycles
lead to greater liquidity since the items in inventory are converted
to cash more quickly.
Inventory turnover ratio: HP vs. Dell

Ratios (Con’t)
Average Collection Period measures the number of days it takes

the firm to collect its receivables.
= 365 ÷ Accounts Receivable turnover ratio
• Inventory Processing Period: We can express the inventory

turnover ratio in terms of the number of days the inventory sits
unsold on the firm’s shelves
• This is also called Days’ Sales in Inventory
Inventory Processing Period = 365 ÷ inventory turnover ratio

Liquidity guidelines
• A high investment in liquid assets will enable the firm to repay its
current liabilities in a timely manner.
• However, too much investment in liquid assets may not be a

good thing as it can be very costly for the firm since liquid assets
(such as cash) generate minimal return

Solvency ratios
• Solvency ratios speak to the risk and leverage of a firm

• Creditors are especially interested in these ratios.
• A rising debt-to-equity ratio means higher interest expenses
and beyond a certain point it will impact the company’s credit
rating, making it expensive to raise additional debt
• Debt to Equity ratio = Debt ÷ Equity
• Debt to assets = Total debt ÷ Total assets

Profitability ratios
Profitability ratios address a very fundamental question: Has the firm earned adequate
returns on its investments?
Typically we answer this question by looking at two types of ratios:
Profit margin: which predicts the ability of the firm to control its expenses
Rate of return on investments: which tells us the return on the investment
• Gross Profit margin = Gross Profit ÷ Sales
• Net Profit margin = Net Profit ÷ Sales
• Return on Equity = Net Income ÷ Common Equity

Return on Equity ratio measures the accounting return on the
common stockholders’ investment.

Thank You
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Financial Management

BITS Pilani Krishnamurthy Bindumadhavan, CFA, FRM

Financial Statements Analysis

• Financial ratios provide an alternative method for

• A ratio by itself may not be very informative

• Typically a ratio is compared to

• If the differences are significant then more detailed analysis is

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Ability to meet Ability to

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

• Liquidity ratios help answer the question:

• A firm is financially liquid if it is able to pay its bills on time

• We typically analyze a firm’s liquidity from two perspectives:

• Liquidity of specific current asset accounts

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Accounts Receivable Turnover Ratio measures how many times

Inventory turnover ratio measures how many times the company

Inventory turnover ratio: HP vs. Dell

Average Collection Period measures the number of days it takes

= 365 ÷ Accounts Receivable turnover ratio

• Inventory Processing Period: We can express the inventory

Inventory Processing Period = 365 ÷ inventory turnover ratio

• However, too much investment in liquid assets may not be a

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

• Solvency ratios speak to the risk and leverage of a firm

• Debt to assets = Total debt ÷ Total assets

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

• Gross Profit margin = Gross Profit ÷ Sales

• Net Profit margin = Net Profit ÷ Sales

• Return on Equity = Net Income ÷ Common Equity

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

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