Business Management : SCBT 33115

Lecture 9

Financial Ratios

G. Prabhakaran
 Financial Analysis

Assessment of the firms past, present and

future financial conditions.

Done to find firms financial strengths and

weaknesses.

Primary Tools:

1. Financial Statements

2. Comparison of financial ratios to past,

industry, sector and all firms
 Financial Ratio Analysis
Financial analysis: Applying analytical techniques to financial
statements and other relevant data to produce
information useful for decision making.
Focus

Three Issues : 1) Profitability, 2) Liquidity, and 3) Safety (Solvency or Risk)

In general, each financial ratio is closely related to one

of the above three fundamental issues.
Financial Statements
1 Balance Sheet, Income Statement and Cash flow
Statement report a firms position at a point in time
and on operations over some past period.

Investors use financial statements to predict future

earnings/dividends.

Management uses financial statements to help

anticipate future conditions and as starting point for
planning actions that will affect future event.

Financial Analysis
Grouped into 3 types.
 Financial Analysis
Horizontal, Vertical, and Ratio Analyses
Horizontal (trend) analyses conducted to help financial statement users
recognize important financial changes that unfold over time.
12/31/09 12/31/10

Gross Profit in 2009 Gross Profit in 2010

in Gross Profit $
Trend Analysis and/or % from 2009
Vertical analyses focus on important relationships between items on the
same financial statement.
2010
Amount Percent
Sales $200,000 100%
Cost of Goods Sold 150,000 75%
Gross Profit $ 50,000 25%
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 Financial Ratios
Knowing the absolute level of a single entry on the income statement or balance sheet
doesnt provide sufficient information to evaluate performance. Ratios help by focusing on
relationships among entries on the financial statements.

1) Ratios help to:

Evaluate performance
Structure analysis
Show the relationship between activities
and performance on the financial statements

2) Benchmark with
Past for the company
Industry

There are 14 to 16 common ratios grouped into 3 types

 Ratio analysis
Ratio analysis is the process of determining and
interpreting numerical relationship based on
financial statements.

It is the technique of interpretation of financial

statements with the help of accounting ratios
derived from the balance sheet and profit and
loss account.
 RATIO ANALYSIS
Ratio analysis is a commonly used tool of financial
statement analysis.
Ratio is used as an index for evaluating the financial
performance of the business concern.
Ratios for financial management are:

1. Liquidity Ratio (Short Term Financial Position)

2. Solvency Ratio (Long Term Financial Position)
3. Profitability Ratio

An index is an indicator or measure of something

 Classification Of Ratios

1. Analysis of Short Term Financial Position or Test

of Liquidity.

2. Analysis of Long Term Financial Position or

Test of Solvency.

3. Profitability Ratios.
 Ratio Computations
Ratio analysis compares the amounts for one or more line
items to the amounts for other line items in the same year.

Ratios are classified into three categories

Solvency ratios
Profitability ratios
examine a companys
examine a companys
ability to pay
ability to generate
interest and repay
income.
debt when due.

Liquidity ratios
help us determine if a
company has sufficient
current assets to repay
liabilities when due.

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1.Liquidity ratios, which relate to the companys short-
term survivalin particular, the companys ability to use
current assets to repay liabilities as they become due.

2.Solvency ratios, which relate to the companys long-

run survivalin particular, the companys ability to
repay lenders when debt matures and to make the
required interest payments prior to the date of maturity.

3.Profitability ratios, which relate to the companys

performance in the current periodin particular, the
companys ability to generate income.
 Profitability
Profitability measures look at how much profit the firm generates
from sales or from its capital assets

Different measures of profit gross and net

Gross profit = total revenue variable costs (COGS)

Net Profit = total revenue COGS - Fixed costs -Interest - Taxes

Gross Profit Margin = Gross profit / total revenue x 100

The higher the better

Enables the firm to assess the impact of its sales and how much it
cost to generate (produce) those sales

A gross profit margin of 45% means that for every 1 of sales,

the firm makes 45percent in gross profit
 Profitability
Net Profit Margin = Net Profit / Turnover x 100
(total revenue)

Net profit takes into account the fixed costs involved in

production the overheads

Keeping control over fixed costs is important could

be easy to overlook for example the amount of waste -
paper, stationery, lighting, heating, water, etc.

e.g. leaving a photocopier on overnight uses enough

electricity to make 5,300 A4 copies. (1,934,500 per
year)
1 ream = 500 copies. 1 ream = 5.00 (on average)
Total cost therefore = 19,345 per year or 1
persons salary
 Profitability
Return on Capital Employed

(ROCE) = Profit (PBIT)/ capital employed x 100

The higher the better

Shows how effective the firm is in using its capital to

generate profit

A ROCE of 25% means that it uses every 1 of capital

to generate 25% in profit

Partly a measure of efficiency in organisation and use of

capital
(Bank Deposit)
 PROFITABILITY RATIOS: MARGINS

(ROCE)

Copyright 2013 CFA Institute 17

 Profitability Ratio
Profitability ratio helps to measure the profitability position
of the business concern.
 Liquidity Ratio
It is also called as short-term ratio. This ratio
helps to understand the liquidity in a business
which is the potential ability to meet current
obligations.
This ratio expresses the relationship between
current assets and current liabilities of the
business concern during a particular period.
 Liquidity position
Current Ratio = CA / CL

company's ability to pay back its short-term liabilities

Standard = 2
Less than 1 is alarming
Higher current ratio is not necessarily mean better liquidity

Quick Ratio = (CA Inventory) / CL

The higher the current or quick ratios are, the more comfortable
a company should be taking on new debt to finance expansion or
new development efforts. Decide whether to proceed with debt-
based financing of a new project, or to work harder to create
more revenue first.
Increase revenue by either repositioning your products,
increasing their exposure or adding features.
 The major liquidity ratio

Current Assets - Inventory

Quick Ratio :
Current Liabilitie s
 LIQUIDITY
Liquidity is the ability to satisfy the companys short-term obligations using
assets that can be most readily converted into cash.

Liquidity ratios:
Ability to satisfy current
liabilities using current assets.

Ability to satisfy current

liabilities using the most liquid
of current assets.

Ability to satisfy current

liabilities using only cash and
cash equivalents.

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 SOLVENCY ANALYSIS

A companys business risk is

determined, in large part, from the
companys line of business. Risk
Financial risk is the risk resulting from
a companys choice of how to finance
the business using debt or equity. Business Financial
We use solvency ratios to assess a Risk Risk
companys financial risk.
There are two types of solvency ratios:
component percentages and coverage
ratios. Sales Risk
- 1) Component percentages involve
comparing the elements in the
capital structure. Operating
- 2) Coverage ratios measure the Risk
ability to meet interest and other
fixed financing costs.

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 Solvency Ratio
It is also called as leverage ratio, which measures the long-
term obligation of the business concern.

This ratio helps to understand, how the long-term funds are

used in the business concern.

Long term solvency ratios denote the ability of the organization

to repay the loan and interest.

When an organization's assets are more than its liabilities is

known as solvent organisation.

Solvency indicates that position of an enterprise where it is

capable of meeting long term obligations.
Solvency Ratio
 SOLVENCY RATIOS
Proportion of assets financed with debt.
Component-Percentage

Proportion of assets financed with long-

term debt.
Solvency Ratios

Debt financing relative to equity

financing.
Reliance on debt financing.

Ability to satisfy interest obligations.

Coverage Ratios

Ability to satisfy interest and lease

obligations.
Ability to satisfy interest obligations with
cash flows.

Length of time needed to pay off debt

with cash flows.

Copyright 2013 CFA Institute 31

Other ratios
Other Ratio

Activity Ratio
Activity ratios indicate the performance of an
organisation.

This indicate the effective utilization of the

various assets of the organisation.

Most of the ratio falling under this category is

based on turnover and hence these ratios are
called as turnover ratios.
 Activity Ratio
It is also called as turnover ratio.

This ratio measures the efficiency of the

current assets and liabilities in the business
concern during a particular period.

This ratio is helpful to understand the

performance of the business concern.
Activity Ratio
Important Ratios In Activity Ratio
1. Stock turnover ratio.
2. Debtors turnover ratio.
3. Creditors turnover ratio.
4. Wording capital turnover ratio.
5. Fixed assets turnover ratio.
6. Current assets turnover ratio.
7. Total assets turnover ratio.
8. Sales to networth ratio.
 Interpreting Ratios
Ratios useful yardsticks of comparison.

Standards vary from one industry to another; key is to watch

for red flags.

Critical numbers measure key financial and operational

aspects of a companys performance.

Examples:

Sales per labor hour at a supermarket

Food costs as a percentage of sales at a restaurant
Load factor (percentage of seats filled with passengers) at
an airline
Financial Ratios Analysis of Coca-Cola

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 THE COCA-COLA COMPANY AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 2012 2011

(In millions except par value) As Adjusted

ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 8,442 $ 12,803
Short-term investments 5,017 1,088

TOTAL CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS 13,459 13,891

Marketable securities 3,092 144

Trade accounts receivable, less allowances of $53 and $83, respectively 4,759 4,920
Inventories 3,264 3,092
Prepaid expenses and other assets 2,781 3,450
Assets held for sale 2,973

TOTAL CURRENT ASSETS 30,328 25,497

EQUITY METHOD INVESTMENTS 9,216 7,233

OTHER INVESTMENTS, PRINCIPALLY BOTTLING COMPANIES 1,232 1,141
OTHER ASSETS 3,585 3,495
PROPERTY, PLANT AND EQUIPMENT net 14,476 14,939
TRADEMARKS WITH INDEFINITE LIVES 6,527 6,430
BOTTLERS FRANCHISE RIGHTS WITH INDEFINITE LIVES 7,405 7,770
GOODWILL 12,255 12,219
OTHER INTANGIBLE ASSETS 1,150 1,250

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TOTAL ASSETS $ 86,174 $ 79,974
 BALANCE SHEETS Contd
LIABILITIES AND EQUITY
CURRENT LIABILITIES
Accounts payable and accrued expenses $ 8,680 $ 9,009
Loans and notes payable 16,297 12,871
Current maturities of long-term debt 1,577 2,041
Accrued income taxes 471 362
Liabilities held for sale 796

TOTAL CURRENT LIABILITIES 27,821 24,283

LONG-TERM DEBT 14,736 13,656

OTHER LIABILITIES 5,468 5,420
DEFERRED INCOME TAXES 4,981 4,694
THE COCA-COLA COMPANY SHAREOWNERS EQUITY
Common stock, $0.25 par value; Authorized 11,200 shares;
Issued 7,040 and 7,040 shares, respectively 1,760 1,760
Capital surplus 11,379 10,332
Reinvested earnings 58,045 53,621
Accumulated other comprehensive income (loss) (3,385) (2,774)
(31,304
Treasury stock, at cost 2,571 and 2,514 shares, respectively (35,009) )

EQUITY ATTRIBUTABLE TO SHAREOWNERS OF THE COCA-COLA COMPANY 32,790 31,635

EQUITY ATTRIBUTABLE TO NONCONTROLLING INTERESTS 378 286

TOTAL EQUITY 33,168 31,921

TOTAL LIABILITIES AND EQUITY $ 42

86,174 $ 79,974
 THE COCA-COLA COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Year Ended December 31, 2012 2011

As
(In millions except per share data) Adjusted

NET OPERATING REVENUES $ 48,017 $ 46,542

Cost of goods sold 19,053 18,215

GROSS PROFIT 28,964 28,327

Selling, general and administrative expenses 17,738 17,422
Other operating charges 447 732

OPERATING INCOME 10,779 10,173

Interest income 471 483
Interest expense 397 417
Equity income (loss) net 819 690
Other income (loss) net 137 529

INCOME BEFORE INCOME TAXES 11,809 11,458

Income taxes 2,723 2,812

CONSOLIDATED NET INCOME 9,086 8,646

Less: Net income attributable to noncontrolling interests 67 62

NET INCOME ATTRIBUTABLE TO SHAREOWNERS OF THE COCA-COLA COMPANY $ 9,019 $ 8,584

BASIC NET INCOME PER SHARE1 $ 2.00 $ 1.88

DILUTED NET INCOME PER SHARE1 $ 1.97 $ 1.85
AVERAGE SHARES OUTSTANDING 4,504 4,568
Effect of dilutive securities 80 78

AVERAGE SHARES OUTSTANDING ASSUMING DILUTION 4,584 43 4,646

 Profitability Ratios
Gross Profit Margin:
Gross Profits $28,964
Gross Profit Margin : 60.32%
Sales $48,017
Years 2011 2012
Gross Profit Margin % 60.90 60.32

The ratio should be high according to the definition. Because higher the ratio,
higher will be the firms ability to produce goods and services at low cost with
high sales. Here in this table there is small difference between the ratios in two
years, but its still high, which means it is favorable.

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Operating Profit Margin:

EBIT $11,809
Operating Profit Margin : 24.59%
Sales $48,017

Years 2011 2012

Operating Profit Margin % 21.80 24.59

Coca-Colas operating profit margin has increased in 2012 than the margin in
2011 by approximately 3%. This increase in Operating Profit Marin is mainly
due to growth of net revenue, good cost control and strong productivity in
company in 2012. This higher margin reflects that the Coca-Cola is more efficient
cost management or the more profitable business.

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Net Profit Margin:

Net Income $9,019

Net Profit Margin : 18.78%
Sales $48,017
Years 2011 2012
Net Profit Margin % 18.40 18.78

According to the definition, higher the ratio, higher will be the firms ability to
pay its taxes. In the year 2011, the margin was little low but in 2012 the
margin increases by 0.4%. For the company, roughly 0.38 cents out of every
sales dollar consists of After Tax Profit'. Coca-Cola is more efficient at
converting sales into actual profit and its cost control is good.

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Return on Assets (ROA):

Net Income $9,019

ROA 10.46%
Total Assets $86,174
Years 2011 2012
ROA % 10.70 10.46

The decrease in Return on Assets indicates that the company is generating

less profits from all of its resources in the year 2012 as compared to the year
2011. The higher of this ratio is, the better for the company. Therefore this
decrease in Coca-Colas ratio is indicating that the company is not that much
prospering.

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Return on Equity (ROE):

Net Income $9,019

ROE 27.51%
Total Common Equity $32,790

Years 2011 2012

ROE % 27.10 27.51

The ratio should be higher. Here starting from 2011, the ratio was 27.10% and
goes up in 2012 to 27.51%. This increase in Return on Equity is a good thing
for stockholders and indicates that Coca Cola is using the equity provided by
stockholders during this specific year effectively and using it to generate more
equity for the owners.

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 Liquidity Ratios
Current Ratio:
Current Assets $30,328
Current Ratio : 1.09
Current Liabilitie s $27,821

Years 2011 2012

Current Ratio 1.05 1.09

In 2011, the firms ability to cover its current liabilities with its current assets
was 1.05. In 2012, the ratio goes up to 1.09 as compared to 2011, which means
that the company has the ability to pay its liabilities, as the definition says that
higher the ratio, greater the ability of the firm to pay its bills. This tells that
Coca-Cola is improving their liquidity and efficiency, because their current ratio
is improving.

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Quick/Acid Test Ratio:

Current Assets - Inventory $27,064

Quick Ratio : 0.97
Current Liabilitie s $27,821
Years 2011 2012
Quick Ratio 0.92 0.97

According to the definition of Acid Test Ratio (liquid ratio), the company should
have the ability to pay its liabilities through its most liquid assets. The table shows
that in 2011, the firm has the ratio 0.92 cents. Then we observe a slight
improvement in 2012. So we can figure out from the ratios that Coca-Cola still
cannot pay its debts without its inventory. This leads us to believe that Coca-Cola is
a somewhat risky business, even though it is the largest in the nonalcoholic
beverage industry.

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 Activity (Turnover) Ratios
Total Asset Turnover Ratio:

Sales $48,017
Total Asset Turnover : 0.55
Total Assets $86,174

Years 2011 2012

Assets Turnover 0.58 0.55

The ratio is supposed to be high. Here we can see that the coca-cola
companys total asset turn over ratio in 2011 was 0.58, which means that
the company generated more revenue per dollar of asset investment.
The ratio then comes slightly down in 2012.

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Inventory Turnover Ratio:

Cost of goods sold $19,053

Inventory Turnover : 5.8
Inventory $3,264

Years 2011 2012

Inventory Turnover 5.90 5.80

The Coca-Colas Inventory turnover ratios deteriorated from 2011 to 2012,

which means that its ability to sell inventory has relatively come down. In 2011
Coca-Cola had a ratio of 5.90 and in 2012 has a ratio of 5.80. These ratios are not
what we expected; we assumed that the ratios would be much higher because
Coca-Cola sell its syrup to bottling partners around the world so it does not need
to deal with the storing of the bottled product.

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Average Collection Period:

365 365
Avg. Collection Period : 36.17days
Receivable s Turnover 10.09

Years 2011 2012

Avg. Collection Period 38.60 36.17

The ability of the firm of collecting the receivables in the specific time. Here
in the year 2011 the turnover in days was almost 39, but the collection days
decrease in the year 2012 and the collection period of approximately 36 days
is well within the 60 days allowed in the credit terms. This shows that the
collection is faster as compared to the previous year.

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Average Payment Period:

365 365
Avg. Payment Period : 14.96 days
Payable Turnover 24.39

Years 2011 2012

Avg. Payment Period (days) 17 15

Coca-Colas average period for payment has reduce to 15 days in 2012 which
was 17 days in 2011. This reduction in average payment period shows that how
efficiently company is paying back their creditors and also assuring that
payments are being made in a prompt manner by Coke to its creditors. This
period should remain low as much as possible.

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 Debt Ratios
Debt Ratio:
Total Liabilitie s $53,006
Debt Ratio : 61.51%
Total Assets $86,174

Years 2011 2012

Debt Ratio % 60.09 61.51

The ratio shows the companys ability to cover its debts through its total
assets. The ratio was 60.09% in 2011, then goes up in 2012. The ratio has to be
low. So we can interpret that in the year 2012, the risk of the firm is getting
higher as the ratio goes up.

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 Conclusion
After applying all the ratios we got an idea that
the Coca Cola Company is a profitable firm.
Because through out the analysis of two years, we
found that the company is getting profitable
return on short term and long term investment,
their profit margin has been increased as well
and they are in the position to pay their debts
with in their resources.

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YEAR 3 MARCH SEMESTER FINAL EXAMINATION
SCBT 33315: BUSINESS MANAGEMENT THEORY

1. The paper consists of NINE (9) questions in Sections

A and B.

2. Answer ALL (4) questions from Section A in the

answer booklet provided. Each question carries 5 marks.

3. Answer any FOUR (4) questions from Section B

including question 9 which is COMPULSORY in
the answer booklet provided. Each question carries 20 marks

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Additional Slides

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