ratio analysis, fm

8/12/2019 Ratio Analysis, FM

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Ratio Analysis

Mirza Bahor 71225

Benjamin Milatovid 71218Mirza rnid 71224

SCHOOL OF ECONOMICS AND BUSINESS

UNIVERSITY OF SARAJEVO


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Goals of Ratio analysis

A tool used by individuals to conduct a quantitative analysis ofinformation in a company's financial statements.

Ratios are calculated from current year numbers and are thencompared to previous years, other companies, the industry, or eventhe economy to judge the performance of the company.

Ratio analysis is predominately used by proponents of fundamentalanalysis.

Ratios are used by: Lenders to determine creditworthiness

Stockholders to estimate future cash flows and risk

Managers to identify areas of weakness and strength

The objective of ratio analysisis the comparative measurement offinancial data tofacilitate wise investment, credit and managerialdecisions


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Values for Ratios

The ratios have no financial theory behind them. Theory tells us whatSHOULD BE the case (or value). With financial ratios, we have no way toidentify a "theoretically best" value for any of the ratios. In fact, financialratios are nothing more than common sense measures that have beendeveloped and evolved over time. As such, they are imperfect measuresand should be treated as such.

There are two primary ways to use financial ratios: Compare a ratio's value over several periods of time (trend analysis or time-

series analysis). If we see a deteriorating trend in any ratio's values overseveral quarters or years, we can investigate to find the cause.

Compare the company's ratios to the industry average (cross-sectionalanalysis). A single ratio value by itself usually means nothing - we need astandard, or benchmark, to compare it to. This benchmark is usually theindustry average (i.e., the ratio's average value for all firms in the industry).

Financial ratios have different meanings depending on the financial dataused to calculate them, so there is no single answer as to whether it isgood to have high or low financial ratios. High values are considered goodfor certain financial ratios and bad for others.


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Examples

Net Profit Margin

Net profit margin or simply profit margin is a financial ratio that iscalculated by dividing net profit by total revenue. Net profit is abusiness's total revenue or sales minus all of its expenses. Net profitmargin is a measure of a business's profitability -- it shows the

proportion of total revenue that a company actually keeps after itpays its expenses. A high net profit margin means a company keepsa large proportion of its revenue as profit, so it is better to have ahigh net profit margin than a low or negative net profit margin.

Debt-to-Asset Ratio

Debt-to-asset ratio is a value that compares total assets and debt of

a business. Debt-to-asset ratio is calculated by dividing total debt bytotal assets. Debt-to-asset ratio goes up as a company accrues debtand falls as a company gains assets. It is preferable to have a lowdebt-to-asset ratio, because a low ratio means a company has a lowamount of total debt compared with the value of its assets.


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Standardization

In general, aprocess of standardizationis beingachieved by the use of ratios. They can be used tostandardize financial statements allowingfor comparisons over time, industry, sector and

cross-sectionally between firmsand furtherfacilitate the evaluation of the efficiency ofoperations an/or the risk of the firmsoperations regarding the scope and purpose of

evaluation. Ratios measure a firms crucialrelationships by relating inputs(costs) withoutput(benefits) and facilitate comparisons ofthese relationships over time and across firms.


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Common-Size Statement Analysis

A common-size financial statement is simply one that is created to displayline items on a statement as a percentage of one selected or commonfigure

All three of the primary financial statements can be put into a common-size format. (Balance sheet, Income statement, Cash flow)

The key benefit of a common-size analysis is it allows for a verticalanalysis by line item over a single time period, such as a quarterly orannual period, and also from a horizontal perspective over a time period

The biggest benefit of a common-size analysis is that it can let an investorientify large or rastic changes in a firms financials. Rapi increases ordecreases will be readily observable, such as a rapid drop in reportedprofits during one quarter or year.

A common-size analysis can also give insight into the different strategiesthat companies pursue. For instance, one company may be willing tosacrifice margins for market share, which would tend to make overall saleslarger at the expense of gross, operating or net profit margins. Ideally thecompany that pursues lower margins will grow faster.


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Common-Base Year Analysis

A base year is the year used for comparison for the level of a particulareconomic index. The arbitrary level of 100 is selected so that percentagechanges (either rising or falling) can be easily depicted

In accounting and statistics, the expression of financial information in agiven year as a percentage of an amount in an initial year. A company maytreat the first year of its operations or the first year it made a profit as

the base year, and express all financial information in those terms. Forexample, it may issue statements saying that profits in year five were125% of year one's profits. Occasionally, governments or companies maychange the base year to one that is more representative of "normal"performance.

Base-year analysis of a company's financial statements is important to be

able to determine whether a company is growing or shrinking. If, forexample, a company is profitable every year, the fact that its revenues areshrinking year-over-year may go unnoticed. By comparing revenues andprofits to those of a previous year, a more detailed picture emerges.


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Liquidity ratios example

Does your enterprise have enough cash on an ongoing basis to meet its

operational obligations? This is an important indication of financial health.

Current Ratio =

Current Assets

Current Liabilities

(also known as Working Capital Ratio)

Measures your ability to meet short

term obligations with short term

assets., a useful indicator of cash flow

in the near future.

A ratio less that 1 may indicate

liquidity issues. A very high current

ratio may mean there is excess cash

that should possibly be invested

elsewhere in the business or that

there is too much inventory. Most

believe that a ratio between 1.2 and

2.0 is sufficient.

The one problem with the current

ratio is that it does not take into

account the timing of cash flows.


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Leverage ratio example To what degree does an enterprise utilize borrowed money and what is its level of risk?

Leners often use this information to etermine a businesss ability to repay ebt.

Debt to Equity =

Short Term Debt + Long Term Debt

Total Equity (including grants)

Compares capital invested by

owners/funders (including grants) and funds

provided by lenders.

Lenders have priority over equity investors

on an enterprises assets. Leners want to seethat there is some cushion to draw upon in

case of financial difificulty. The more equity

there is, the more likely a lender will be

repaid. Most lenders impose limits on the

debt/equity ratio, commonly 2:1 for small

business loans.

Too much debt can put your business at risk,

but too little debt may limit your potential.

Owners want to get some leverage on their

investment to boost profits. This has to be

balanced with the ability to service debt.


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Asset Utilization Ratios Example

When you are evaluating a business, how would you use the assetutilization ratio, and what do you look for?

Asset Utilization =

Revenue

Average Total Assets

The asset utilization ratio measures

management's ability to make the best use of

its assets to generate revenue. This is

particularly meaningful in a manufacturing,where fewer capital assets are used to produce

products. The more effectively that the

equipment is used, the more profitable the

company will be. Rather than acquiring

additional equipment and incurring additional

production costs, make better use of existing

capacity.

For example, with an asset utilization ratio of

52%, a company earned $.52 for each dollar of

assets held by the company. An increasing

asset utilization means the company is being

more efficient with each dollar of assets it has.


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Profitability ratio example

How well is our business performing over a specific period, will your socialenterprise have the financial resources to continue serving its constituents

tomorrow as well as today?

Sales Growth =

Current PeriodPrevious Period SalesPrevious Period Sales

Percentage increase (decrease) in sales

between two time periods.

If overall costs and inflation are increasing,then you should see a corresponding increase

in sales. If not, then may need to adjust pricing

policy to keep up with costs.

The retail industry, for example, typically

experiences higher revenues and earnings for

the Christmas season. Therefore, it would not

be too useful to compare a retailer's fourth-

quarter profit margin with its first-quarter

profit margin. On the other hand, comparing a

retailer's fourth-quarter profit margin with the

profit margin from the same period a year

before would be far more informative.

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