ACCOUNTING 101 FINANCIAL RATIO ANALYSIS.pptx

ACCOUNTING 101 FINANCIAL RATIO ANALYSIS.pptx

1. FINANCIAL RATIO ANALYSIS

2. FINANCIAL RATIO ANALYSIS is a technique used to assess a company's financial health and performance by comparing different line items from its financial statements, primarily the balance sheet, income statement, and cash flow statement.

3. These comparisons are done by calculating ratios that reveal insights into various aspects of the company, including: Liquidity Measures a company's ability to meet its short-term obligations (e.g., current ratio, quick ratio). Solvency Indicates a company's ability to meet its long-term financial obligations (e.g., debt-to-equity ratio, times interest earned ratio). Profitability Assesses how effectively a company generates profits from its operations (e.g., return on equity (ROE), profit margin). Efficiency Evaluates how well a company utilizes its resources to generate revenue (e.g., inventory turnover ratio, receivable turnover ratio). Market value Compares a company's stock price to its financial performance (e.g., price-to-earnings ratio (P/E ratio)).

4. By analyzing these ratios, investors, creditors, and other stakeholders can gain valuable insights into the company's: Financial strength and stability Profitability and growth potential Efficiency in managing its resources Risk profile compared to competitors

5. It's important to note that: Financial ratio analysis is most effective when used in conjunction with other financial analysis methods and considering industry benchmarks. Individual ratios can be misleading on their own, and a comprehensive analysis considering multiple ratios is crucial. Context and trends are vital, as comparing ratios over time or with competitor companies provides a clearer picture of financial performance.

6. LIQUIDITY RATIO are a subset of financial ratios specifically designed to assess a company's ability to meet its short-term obligations using its current assets. These obligations typically need to be settled within a year or less and may include accounts payable, short-term loans, and accrued expenses.

7. Here are some key points about liquidity ratios: Purpose They measure how quickly and easily a company can convert its assets into cash to meet its short-term financial commitments. Components They involve comparing current assets with current liabilities. Interpretation A higher ratio generally indicates better liquidity, meaning the company has more current assets readily available to cover its short-term debts. Conversely, a lower ratio suggests potential difficulty in meeting its short-term obligations.

8. CURRENT RATIO It is a liquidity and efficiency ratio that measures a firm`s ability to pay off its short-term liabilities with its current assets. It is an important measure of liquidity because short-term liabilities are due within the next year. A higher current ratio (generally considered to be above 1) indicates that a company has more current assets than current liabilities, suggesting a stronger ability to meet short-term obligations. A lower current ratio (generally considered to be below 1) suggests that a company might have difficulty meeting its short-term obligations. However, it's important to note that ideal current ratio values can vary depending on the industry.

9. CURRENT RATIO SAMPLE PROBLEM You are analyzing the financial health of a company, ABC Corp., and want to assess its short-term liquidity using the current ratio. Here's the relevant information from its balance sheet: Current Assets: 500,000 Current Liabilities: 300,000 Interpretation: ABC Corp. has a current ratio of 1.67. This indicates that the company has P1.67 of current assets for every P1 of current liabilities. Generally, a current ratio greater than 1 is considered favorable, as it suggests the company has sufficient resources to meet its short-term obligations.

10. CURRENT RATIO SAMPLE PROBLEM Assume the information below provided by Ding`s Enterprises to the bank: Cash 15,000 Accounts Receivable 10,000 Inventory 5,000 Prepaid Advertising 3,500 Total Current Liabilities

11. CURRENT RATIO SAMPLE PROBLEM The following data are extracted from the balance sheet of ABC Company. For the year ended December 31, 2016, calculate the current ratio. Current Assets: Cash 146.51 Bills receivable 141.54 Inventory 89.87 Advances (short-term) 24.17 Current Liabilities Accounts payable 17.07 Bills payable 10.0 Accrued expenses 20.86 Other Current Liabilities 60.01

12. CURRENT RATIO SAMPLE PROBLEM Solution: Current Ratio = Current Assets/Current Liabilities Current Ratio = 402.09/107.94 Current Ratio = 3.73 Interpretation: The current ratio indicates that the firm has enough current assets to pay its current liabilities thrice. Rule of thumb – 3:1, there must be 3 current assets for every current liability.

13. ACID-TEST RATIO also known as the quick ratio, is a financial metric used to assess a company's short-term liquidity. It essentially measures how well a company can meet its immediate financial obligations using its most liquid assets .

14. ACID-TEST RATIO - What it tells you: Ability to pay short-term debts The ratio indicates whether a company has enough readily available resources to cover its short-term liabilities (debts due within a year) without relying on selling inventory or obtaining additional financing. Short-term financial health A higher ratio generally signifies a stronger ability to meet short-term financial obligations, suggesting better short-term financial health.

15. How it's calculated: The acid-test ratio is calculated by dividing a company's quick assets by its current liabilities: Quick Ratio = Quick Assets / Current Liabilities

16. What are quick assets? Quick assets are the most liquid current assets, meaning they can be easily converted to cash within a short period (usually 90 days or less) without significant loss in value. They typically include: Cash and cash equivalents (marketable securities) Accounts receivable (money owed by customers)

17. Interpretation Generally, a ratio of 1:1 or higher is considered desirable, indicating that the company has enough quick assets to cover its current liabilities. A ratio below 1:1 might raise concerns about the company's ability to meet its short-term obligations. However, it's crucial to consider the industry context as some industries, like retail, naturally have lower quick ratios due to their reliance on inventory.

18. SAMPLE PROBLEM The following data are extracted from the balance sheet of ABC Company. For the year ended December 31, 2016, calculate the quick ratio. Current Assets: Cash 146.51 Bills receivable 141.54 Short-Term Investment 40.10 Inventory 89.87 Advances (short-term) 24.17 Current Liabilities Accounts payable 17.07 Bills payable 10.0 Accrued expenses 20.86 Other Current Liabilities 60.01

19. SAMPLE PROBLEM Solution: Quick Ratio = Cash+ Bills Receivable+Short-Term Investment/Current Liabilities Quick Ratio = 146.51+141.54+40.10/107.94 Quick Ratio = 328.15/107.94 Quick Ratio = 3.04 The quick ratio indicates that the company has enough liquid assets to pay its current liabilities. Rule of thumb – 2:1, there must be 2 quick assets for every current liability. Note: To some analyst, acid test ratio of at least 1 indicates an adequate ability to pay its current obligations. But the rule does not always apply to all companies and situations.

20. SAMPLE PROBLEM A company has the following current assets: Cash and cash equivalents: 100,000 Accounts receivable: 80,000 Inventory: 150,000 Its current liabilities amount to 120,000. a) Calculate the company's quick ratio. b) Interpret the result.

21. SAMPLE PROBLEM Identify quick assets: Cash and cash equivalents (100,000) + Accounts receivable (80,000) = 180,000 Apply the formula: Quick Ratio = 180,000 / 120,000 = 1.5 b) Interpret the result. The company has a quick ratio of 1.5, which is considered good, indicating it has enough quick assets to cover its current liabilities and even has some additional buffer.

22. SAMPLE PROBLEM Another company has the following information: Quick assets: 50,000 Current liabilities: 40,000 a) Calculate the company's quick ratio. b) Interpret the result.

23. SAMPLE PROBLEM a) Calculate the company's quick ratio. Solution: Quick Ratio = $50,000 / $40,000 = 1.25 b) Interpret the result. The company's quick ratio of 1.25 is still considered acceptable, suggesting it has sufficient quick assets to meet its short-term obligations.

24. SAMPLE PROBLEM A retail store has: Cash and cash equivalents: $25,000 Accounts receivable: $40,000 Inventory: $300,000 Current liabilities are $100,000. a) Calculate the company's quick ratio. b) Interpret the result.

25. SAMPLE PROBLEM a) Calculate the quick ratio. Solution: Identify quick assets: $25,000 (cash) + $40,000 (receivables) = $65,000 Quick Ratio: $65,000 / $100,000 = 0.65 b) Interpret the result. The store's quick ratio of 0.65 is significantly below 1. However, it's crucial to consider the industry context. Retail businesses typically have lower quick ratios due to their reliance on inventory, which takes time to convert to cash. While the ratio might seem concerning at first glance, it might be within the acceptable range for the specific retail sector. It's essential to compare the ratio with industry benchmarks and the company's historical performance for a more accurate assessment.

26. WORKING CAPITAL RATIO It is a financial metric used to assess a company's liquidity, which refers to its ability to meet its short-term financial obligations. In simpler terms, it indicates how well a company can pay its short-term debts with its current assets.

27. FORMULA Working Capital Ratio = Current Assets / Current Liabilities

28. COMPONENTS Current Assets: These are assets that a company can convert into cash within one year. Examples include cash, inventory, and accounts receivable. Current Liabilities: These are debts that a company needs to pay within one year. Examples include accounts payable, short-term loans, and accrued expenses.

29. INTERPRETATION Ratio greater than 1 This indicates that the company has enough current assets to cover its current liabilities. A higher ratio generally suggests better liquidity, but an excessively high ratio might indicate inefficiency in managing working capital. Ratio equal to 1 This implies that the company has exactly enough current assets to cover its current liabilities. This scenario is considered balanced, but any unexpected financial strain could lead to challenges. Ratio less than 1 This suggests that the company may not have sufficient current assets to pay off its short-term debts. This scenario raises concerns about the company's ability to meet its financial obligations and could indicate potential liquidity problems.

30. SAMPLE PROBLEM A company has current assets of P1,000,000 and current liabilities of P800,000. Calculate its working capital ratio.

31. SAMPLE PROBLEM Solution: Working Capital Ratio = Current Assets / Current Liabilities = $1,000,000 / $800,000 = 1.25 Key: The working capital ratio is 1.25, indicating the company has sufficient current assets to cover its short-term obligations.

32. SAMPLE PROBLEM A company's working capital ratio is 0.8. If its current liabilities are P500,000, what are its current assets?

33. SAMPLE PROBLEM Solution: 0.8 = Current Assets / $500,000 Current Assets = 0.8 * $500,000 Current Assets = $400,000 Key: The company's current assets are $400,000, which is less than its current liabilities, potentially raising concerns about its liquidity.

34. SAMPLE PROBLEM A company wants to improve its working capital ratio, currently at 1.5. It can either increase its current assets by P200,000 or decrease its current liabilities by P100,000. Which strategy would be more effective?

35. SAMPLE PROBLEM Scenario 1: Increase Current Assets New working capital ratio = (Current Assets + P200,000) / Current Liabilities = (1.5 * Current Liabilities) + P200,000 / Current Liabilities = 1.5 + (P200,000 / Current Liabilities) Scenario 2: Decrease Current Liabilities New working capital ratio = Current Assets / (Current Liabilities - $100,000) = 1.5 * (Current Liabilities - P100,000) / Current Liabilities = 1.5 - ($100,000 / Current Liabilities)

36. SAMPLE PROBLEM Without knowing the exact value of the current liabilities, we can't definitively say which option is better. However, if the current liabilities are significantly higher than P200,000, decreasing them by P100,000 might have a larger impact on the ratio. Key: The best strategy depends on the specific situation. Analyze both options considering the magnitude of change and the current financial situation.

37. SAMPLE PROBLEM Without knowing the exact value of the current liabilities, we can't definitively say which option is better. However, if the current liabilities are significantly higher than P200,000, decreasing them by P100,000 might have a larger impact on the ratio. Key: The best strategy depends on the specific situation. Analyze both options considering the magnitude of change and the current financial situation.

38. FINANCIAL RATIO ANALYSIS

39. FINANCIAL RATIO ANALYSIS is a technique used to assess a company's financial health and performance by comparing different line items from its financial statements, primarily the balance sheet, income statement, and cash flow statement.

40. These comparisons are done by calculating ratios that reveal insights into various aspects of the company, including: Liquidity Measures a company's ability to meet its short-term obligations (e.g., current ratio, quick ratio). Solvency Indicates a company's ability to meet its long-term financial obligations (e.g., debt-to-equity ratio, times interest earned ratio). Profitability Assesses how effectively a company generates profits from its operations (e.g., return on equity (ROE), profit margin). Efficiency Evaluates how well a company utilizes its resources to generate revenue (e.g., inventory turnover ratio, receivable turnover ratio). Market value Compares a company's stock price to its financial performance (e.g., price-to-earnings ratio (P/E ratio)).

41. LIQUIDITY RATIO are a subset of financial ratios specifically designed to assess a company's ability to meet its short-term obligations using its current assets. These obligations typically need to be settled within a year or less and may include accounts payable, short-term loans, and accrued expenses.

42. SOLVENCY RATIO

43. SOLVENCY RATIO is a financial metric used to assess a company's ability to meet its long-term financial obligations. It essentially tells you whether a company has enough assets to cover its liabilities, which are its debts and other financial commitments.

44. Solvency ratios are important for a variety of stakeholders, including: Investors Investors use solvency ratios to assess the risk of investing in a company. A company with a high solvency ratio is generally considered less risky than a company with a low solvency ratio. Creditors Creditors, such as banks and suppliers, use solvency ratios to assess the risk of lending money to a company. A company with a low solvency ratio is more likely to default on its loans. Management Management can use solvency ratios to track the company's financial health over time and make decisions about capital structure and investment.

45. Debt-to-equity ratio s a financial metric that indicates how much a company finances its operations through debt (loans and other liabilities) compared to its shareholder equity (money invested by shareholders). In simpler terms, it shows the balance between a company's debt and its own resources. A high D/E ratio indicates a higher level of financial leverage, which means the company is relying more on borrowed money to finance its activities. A low D/E ratio indicates a more conservative financial structure, where the company is relying more on its own resources.

46. Debt-to-equity ratio formula Debt-to-equity ratio = Total liabilities / Total shareholder equity

47. Debt-to-equity ratio formula A high D/E ratio This could indicate a higher risk for the company, as it is more vulnerable to economic downturns or rising interest rates. It might also suggest that the company is struggling to generate enough cash flow to cover its debt obligations. However, a high D/E ratio can also be acceptable for certain industries, such as utilities or capital-intensive businesses. A low D/E ratio This could indicate a more conservative financial structure and lower risk. However, it might also suggest that the company is not taking full advantage of debt financing to grow its business.

48. Debt-to-equity ratio formula Company A has total liabilities of P10 million and shareholder equity of P2 million.

49. Debt-to-equity ratio formula Calculation: D/E Ratio = P10 million / P2 million = 5 Interpretation: Company A has a high D/E ratio of 5, indicating it relies heavily on debt compared to its equity. This can be risky if the company struggles to service its debt obligations in the future.

50. Debt-to-equity ratio formula Company B has total liabilities of P5 million and shareholder equity of P5 million.

51. Debt-to-equity ratio formula Calculation: D/E Ratio = P5 million / P5 million = 1 Interpretation: Company B has a balanced D/E ratio of 1, meaning its debt and equity are equal. This suggests a moderate level of financial risk.

52. Debt-to-equity ratio formula Scenario: Company C has total liabilities of P2 million and shareholder equity of P10 million.

53. Debt-to-equity ratio formula Calculation: D/E Ratio = P2 million / P10 million = 0.2 Interpretation: Company C has a low D/E ratio of 0.2, indicating it is primarily financed by equity. This suggests a lower level of financial risk, but may also mean missed opportunities for growth through leverage (using debt strategically).

54. Debt-to-equity ratio formula Company D is in the manufacturing industry, where the average D/E ratio is 2.5. It has total liabilities of P8 million and shareholder equity of P3 million.

55. Debt-to-equity ratio formula Calculation: D/E Ratio = P8 million / P3 million = 2.67 Interpretation: While Company D's D/E ratio of 2.67 is slightly higher than the industry average, it can still be considered acceptable within the context of its sector.

56. Debt-to-equity ratio formula Calculation: D/E Ratio = P8 million / P3 million = 2.67 Interpretation: While Company D's D/E ratio of 2.67 is slightly higher than the industry average, it can still be considered acceptable within the context of its sector.

57. INTEREST COVERAGE RATIO also known as the Times Interest Earned (TIE) ratio. This ratio is used to assess a company's ability to meet its debt interest obligations.

58. FORMULA Formula: ICR = EBIT / Interest Expense EBIT Earnings Before Interest and Taxes. This represents the company's operating profit before considering interest and tax expenses. Interest Expense The total amount of interest the company owes on its outstanding debts.

59. INTERPRETATION A higher ICR indicates a stronger financial position, meaning the company has more income available to cover its interest payments. A lower ICR suggests the company might struggle to meet its debt obligations, potentially raising concerns about its financial stability.

60. SAMPLE PROBLEM EBIT: $1,000,000 Interest Expense: $100,000

61. SAMPLE PROBLEM ICR: 10 ($1,000,000 / $100,000) Interpretation: This high ratio (10) indicates the company comfortably covers its interest expenses with its earnings. This could be due to strong growth and profitability, making it an attractive investment or loan candidate.

62. SAMPLE PROBLEM The first nine lines of Findman Wholesale Corp.'s income statement reads: Net sales - P10,000,000 Cost of sales - P6,990,000 Selling, general and administrative expenses - P1,000,000 Pre-opening expense - P10,000 Operating income - P2,000,000 Interest expense, net - P1,000,000 Income before income taxes - P1,000,000 Provisions for income taxes - P40,000 Net income - P960,000

63. SAMPLE PROBLEM The income statement lists the operating income (EBIT) as P2 million and the interest expense as P1 million. Therefore, Findman Wholesale Corp.'s interest coverage ratio is P2,000,000 ÷ P1,000,000 = 2.

64. SAMPLE PROBLEM The following information was extracted from the income statement of John Trading Company: Interest expenses: 25,000 Earnings before interest and tax: 300,000 Required: Calculate John Trading Company's interest coverage ratio (ICR).

65. SAMPLE PROBLEM Interest coverage ratio = Earnings before interest and tax / Fixed interest expenses = 300,000 / 25,000 = 12 times The earnings are 12 times greater than the interest expenses at John Trading Company. This shows that the company can comfortably cover the payments for interest expenses on its borrowings.

66. SAMPLE PROBLEM Suppose that you receive the following data about Company X: Revenue = P20,000,000 Cost of goods sold = P10,000,000 Operating expenses: Salaries = P220,000 Rent = P500,000 Utilities = P300,000 Depreciation = P150,000 Interest expenses = P3,000,000

67. SAMPLE PROBLEM Suppose that you receive the following data about Company X: Revenue = P20,000,000 Cost of goods sold = P10,000,000 Operating expenses: Salaries = P220,000 Rent = P500,000 Utilities = P300,000 Depreciation = P150,000 Interest expenses = P3,000,000 Required: Prepare the company's income statement and calculate the interest coverage ratio (ICR).

68. SAMPLE PROBLEM