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9/29/20

Financial Performance Metrics –

Financial Ratios

Imran Umer

Financial Performance Metrics – Financial Ratios

• Financial ratio analysis is the systematic use of ratiosto interpret financial statements so that the existingstrengths and weaknesses of a firm as well as itshistorical performance and current financial conditioncan be determined and evaluated.

For Example:

• Short-term creditors, such as banks and trade creditors,use ratios to determine the firm’s immediate liquidity.

• Longer-term creditors such as bondholders use themto determine its long-term solvency.

Financial Performance Metrics –

Financial Ratios When we calculate a ratio, all we get is a number. In order for thisnumber to be meaningful to us, we need to put it into some kind ofcontext by comparing it with another number. We can make thesecomparisons through:

1) Trend analysis of a single company by comparing current ratios toprevious years. Trends can be particularly useful in analyzing afirm’s financial condition. If ratios are becoming less favorableover time, for example, this is an indication of trouble.

2) Comparison with other companies in the same industry or withindustry averages after any necessary adjustments have beenmade to assure that the accounting data is comparable.

3) Comparison with management’s expectations.

Types of Financial Ratios 1. Profitability Ratio

Measures the firm’s profit in relation to its total revenue, or the amountof net income from each dollar of sales and its return on invested assets;

2. Assets Utilization Ratio / Efficiency Ratio or ActivityAnalysis

Activity ratios, which relate information on a firm's ability to manage itscurrent assets (accounts receivable and inventory) and current liabilities(accounts payable) efficiently;

3. Short Term Solvency Ratios / Liquidity RatioMeasures the ability of the firm’s cash resources to meet its short-term

cash obligations;

4. Long Term Solvency Ratios / Debt Utilization RatioEvaluates the firm’s ability to satisfy its longer-term debt and investmentobligations by looking at the mix of its financing sources;



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Profitability RatioProfitability ratios allow us to measure the ability of the firm to earn an

adequate return on sales, assets and invested capital.

The higher ROA & ROE, the better, or more effectively, the company is using its

assets and capital.

Assets Utilization Ratio / EfficiencyRatio / Activity Analysis

Under this type, ratios are used to measure the speed at which the firm isturning over accounts receivable, inventory and long term assets to generatesales and revenue.

a) Accounts Receivable Turnover

It is the measure of the efficiency of a firm’s credit policy. Itestimates the number of days it takes for a dollar in sales to becollected by the firm.

• An increase in the accounts receivable turnover ratio indicates thatreceivables are being collected more rapidly. A decrease indicatesslower collections.

Collection Period = 360/Times

Assets Utilization Ratio / Efficiency

Ratio / Activity Analysisb) Inventory Turnover

It Indicates how quickly inventory is sold during the year.

If a company has a high inventory turnover ratio,

• It may mean the company is using good inventory management andis not holding excessive amounts of inventories that may beobsolete, unmarketable goods.

• However, it can also mean that the company is not holding enoughinventory and may be losing sales if prospective customers areunable to make purchases because items are out of stock.

Assets Utilization Ratio / Efficiency

Ratio / Activity Analysisc) Fixed Assets Turnover

It indicates how well the investment in long term (fixed) assets is

being managed.

d) Assets Turnover

The Asset Turnover Ratio measures the amount of sales revenue the

company is generating from the use of all of its assets. It provides ameans to measure the overall efficiency of the company’s use of all

of its investments, as represented by both short-term assets and

long-term assets.



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Short Term Solvency Ratio / LiquidityRatio

These ratios measure firm’s ability to pay off short term obligations as they aredue.

a) Current Ratio

A measure of short term debt paying ability. The “norm” is 2:1. Alower ratio indicates a possible liquidity problem.

b) Quick Ratio / Acid Test Ratio

An improved measurement of short term debt paying ability.

Note: Quick Assets = Current Assets – Inventories – Prepaid

Short Term Solvency Ratio / LiquidityRatio

c) Working Capital

Indicates the cash generated by operations after allowing for cash

payment of expenses and operating liabilities.

Long Term Solvency Ratio / Debt

Utilization RatioIt shows the overall debt position of the firm in the light of its assets base and earning power.

a) Debt Ratio

Percentage of assets financed by creditors, and also indicates relative size of the equity position.

Note: Assets = Liabilities + Shareholders Equity

b) Debt to Equity Ratio

• The Debt to Equity ratio can serve as a screening device for the analyst when looking at capital

structure ratios. If this ratio is extremely low (for instance, 0.1:1), then there is no need to

calculate other capital structure ratios because there is no real concern with this part of the

company’s financial situation. The analyst’s time could be better spent looking at other aspects

of the company’s operations.

• However, if the Debt to Equity ratio is in the neighbourhood of 2:1 or higher, it would be

important to do some extended analysis that focuses on other ratios such as profitability, as well

as the company’s future prospects.

Long Term Solvency Ratio / Debt

Utilization Ratioc) Coverage Ratios

Coverage ratios measures the degree to which fixed payments are “covered”

by operating profits. we use earnings coverage ratios to focus on the

company’s earning power, because that will be the source of interest

payments, as well as the source for the principal repayments.

I. Times Interest Earned / Interest Coverage Ratio

Indicator of a company's ability to meet its interest payment obligations.

• The Interest Coverage ratio compares the funds available to pay interest. This ratio

gives an indication of how much the company has available for the payment of its

fixed interest expense.

• A high ratio is desirable. An interest coverage ratio of greater than 3.0 is excellent.

When the interest coverage ratio gets down to 1.5, a company has a heightened risk

of default, which becomes higher the further the ratio declines below 1.5.



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Other Important Ratios

a) Earnings Per Share (EPS)

EPS is essentially the measure of the amount of income that each share of common stock would have

earned if the profit of the company had been “paid” (distributed) to all of the common shares

outstanding.

b) Price Earnings Ratio (P/E)

The P/E ratio gives an indication of what shareholders are paying for continuing Earnings Per Share.

Investors view it as an indication of what the market considers to be the firm’s future earning power.

• The P/E ratio is greatly influenced by where a company is in its cycle. A company in a growth stage

will usually have a high P/E ratio because of the market’s expectations of future profits (which

makes the market price higher) despite the fact that at the current time, profits may be low.

• Companies with low growth generally have lower P/E ratios.

• This ratio is meaningless when a company is experiencing losses (the P/E would be negative

because earnings are negative)

Other Important Ratios

c) Dividend Payout Ratio

The dividend payout ratio measures the proportion of earnings paid out as dividends to common

stockholders.

Generally, a new company or a company that is growing will have a low or no dividend payout,

because it is retaining earnings in the company to finance its growth.

Thank You

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