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FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS

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FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS

## FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS

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1. FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS DR. KHALED FOUAD SHERIF SECTOR MANAGER EASTERN EUROPE & CENTRAL ASIA DEPARTMENT THE WORLD BANK WASHINGTON DC Web: http:\\www.ksherif.com

2. FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS Introduction to Balance Sheets and Income Statements: The balance sheet summarizes the financial position of an organization at a given moment, it is a snapshot of the firm. The balance sheet reflects the status of the organization’s assets, (the economic resources owned by the organization), liabilities (debts owned to creditors), and equity (the owner’s investment in the organization).

3. FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS As its name implies the balance sheet should indicate that these elements are in balance. Assets = Liabilities + Equity • This fundamental relationship must always exist, because the assets represent the things owned by the organization and the liabilities and equity indicate how much was supplied by both creditors and owners.

4. FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS In contrast to the balance sheet, the income statement shows the organization's financial progress over a given period of time. The income statement is also based on equation: Revenues - Expenses = Profit (or Loss)

5. FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS Revenues are the resources, primarily cash, coming into the organization as a result of goods sold or services rendered. Expenses are the resources used by the organization to provide goods or services. If revenues are greater than expenses, the business has realized a profit. If expenses exceed revenue the business has realized a loss from operations. As you read the following detailed descriptions of balance sheets and income statements, keep in mind that there is a direct and important relationship between the two. The profit (or loss) realized by a business over a period of time affects the amount of equity. Equity in a business comes from two sources: Direct investment by the owners and profits from business operations. Therefore, the bridge between the income statement and the balance sheet is in the relationship between equity and profit or loss.

6. FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS • Income Statements: • Exhibit 1 shows a sample income statement (see next page) for a period covering January 1 to December 31, 1989. The company in question earned revenues from two sources: • Net sales: All sources earned by the company from the sale of its products and services. • Other income: Generally resources from sources as interest on bank accounts, cash dividends from investments in other companies, and interest on bonds.

7. FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS The following expenses are subtracted from revenues: • Cost of goods sold: all the expenses incurred in making the products sold during the period, including the cost of materials, labor, and factory overhead (rent, utilities and maintenance).

8. EXHIBIT 1SAMPLE INCOME STATEMENT Company X For year ending December 31, 1989 (In LE) Revenues Net Sales 3,787,248 Other Income 42,579 Total Revenues 3,829,827 Expenses Cost of Goods Sold 2,796,459 Administrative & Selling Expenses 637,509 Interest Expenses 47,516 Total Expenses 3,503,545 Earnings Before Income Taxes 326,282 Income Taxes 152,039 Net Earnings 174,243

9. FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS • Administrative and selling expenses: The costs of running and promoting the business, including items like the president’s salary, the salaries of all management personnel, advertising costs and sales commissions. • Interest expenses: The interest that the company paid during the year on money that it borrowed.

10. FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS • Other Expenses: This would include any other unusual expenses incurred by the company to run the business not otherwise accounted for above (e.g. research and development expenses, and organizational costs).

11. FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS Expenses are subtracted from revenues to yield a figure that indicates the company’s earnings, but this figure still does not reflect the company’s profit. During 1989 the company paid over 46 percent of its earnings to the tax department in the form of taxes. Thus, its net earnings, or the amount of profit the company earned in 1989, is LE 174, 243.

12. FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS Balance sheets Exhibit 2 is the balance sheet for Company X as of December 31, 1989. The first component is assets, current and fixed. Current assets, are those the business expects to turn into cash during the next year. The cash generated from current assets is used to pay expenses and repay liabilities. Current assets include:

13. FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS • Cash. • Marketable securities: Temporary investments (generally 90 days) of excess or idle cash; listed at cost, or market value since they are converted into cash within one year. • Accounts Receivable: Money owned to the company by debtors, generally for the purchase of goods and services. • Inventories: The value of products that have been completed and are in storage waiting to be sold (finished goods), products that have been partially completed (work in process), and raw materials. • Prepaid Expenses: The value of items that the company has paid for in advance, such as insurance premiums.

14. FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS • Fixed assets are things of value that will provide benefits to the company for one or more years. Fixed assets are reported in three categories: land, buildings, machinery and equipment. Fixed assets are reported on the balance sheet at the cost to purchase or acquire the asset minus the depreciation accumulated on the assets since the time of purchase. Depreciation is the estimated decline in the useful value of an asset due to gradual wear and tear. Since this decline in value cannot be estimated with certainly, accountants use various standards methods to approximate it.

15. SAMPLE BALANCE SHEET Company X December 31, 1989 Assets Liabilities: Current Assets: Current Liabilities Cash 59,770 Notes Payable 48,563 Marketable securities 87,466 Trade accounts payable 207,887 Accounts receivable 559,144 Payrolls & other accurables 411,362 Inventory 618,120 Income taxes 124,684 Prepaid Expenses 49,986 Total Current Liabilities 792,496 Total Current Assets 1,374,486 Long-Term Liabilities 431,350 Fixed Assets: Total Liabilties 1,223,846 Land 25,807 Buildings 716,076 Shareholders’ Equity 1,103,190 Machinery & Equipment 1,010,770 Less allowances for depreciation 800,103 Total Fixed Assets 952,550 Total Assets 2,327,036 Total Liabilties & Equity 2,327,036

16. FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS The second major section in a balance sheet is devoted to liabilities. Current liabilities are the debts that a company must pay off within the coming year: • Notes payable: Money owned to banks or other lending institutions; generally short-term loans (up to one year) used to finance short-term needs.

17. FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS • Accounts payable: Money owed to vendors for the purchase of goods and services. • Payrolls and other accurables: Money owed to people for institutions that have performed services, including salaries owed to employees, salaries owed to employees on vacation, attorney fees, insurance premiums, and pension funds. • Income taxes: Money owed to the Tax Department; may sometimes be deferred and paid later but must always be paid.

18. FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS Long-term liabilities are obligations, usually loans, that are due to be paid not in the current year but in some future period. The amount specified in the balance sheet is equal to the total amount borrowed.

19. FINANCIAL RATIO ANALYSIS FOR NON-FINANCIAL MANAGERS The final major section, the equity section summarizes the owners‘ investment in the business. Individuals and institutions become owners of a company by purchasing shares of the company’s stock. Equity increases as more people purchase stock and the company retains increased profit.

20. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Each type of analysis of financial data has a purpose or use that determines the different relationships emphasized. Therefore, it is useful to classify ratios into four fundamental types: • Liquidity ratios, measure the firm’s ability to meet its maturing short-term obligations.

21. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS • Leverage ratios, measure the extent to which the firm has been financed by debt. • Activity ratios, measure how effectively the firm is using its resources. • Profitability ratios, measure managements overall effectiveness as shown by the returns generated on sales and investment.

22. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS • Liquidity Ratios Generally, the first concern of the financial analyst is liquidity. they measures the short-run solvency of a company its ability to meet current debts. • Current Ratio The current ratio indicates whether there are enough current assets to meet current liabilities. Current ratio = Current assets Current liabilities

23. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Current assets normally include: Cash, marketable securities, accounts receivable, and inventories. Current liabilities consist of: accounts payable, short-term notes, payable, current maturities of long-term debt, accrued income taxes, and other accrued expenses (principally wages).

24. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS When is the company solvent? When the current ratio is 1.0 or greater; that is, the company should have more current assets than current liabilities. Method for Calculating the Current Ratio: Add cash, marketable securities, accounts receivable, and inventories to get current assets.

25. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS • Add notes payable, trade accounts payable, payrolls and other accurables and income taxes to get current liabilities. • Divide the derived current assets figure by the calculated current liabilities figure.

26. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS • You have now derived the current ratio. Now, compare the value derived to 1.0. If the current ratio is 1.0 or greater, the company should have more current assets than current liabilities and is financially viable or solvent. If the current ratio is less than 1.0, the company will have more current liabilities than current assets and is financially unviable or insolvent.

27. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS • For significance this ratio should be compared to previous years (e.g. the current ratio for five previous years should be derived). This is necessary in order to derive a trend. If the current ratio is rising n an upward fashion, the company is becoming more financially viable. If the current ratio is falling and assuming a downward trend, the company is becoming less financially viable.

28. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS • One helpful activity is to also compare the current ratio of the company in question to the current ratio of similar competing companies. If the company in question has a higher current ratio on a regular basis over a number of years than this company is more financially viable. On the other hand, if the company in question has a lower current ratio on a regular basis over a number of years than this company is less financially viable.

29. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS b - Quick Ratio, or Acid Test The quick ratio is calculated by deducting inventory from current assets, and dividing the remainder by current liabilities. Inventories are deducted since they are typically the least liquid of a firm’s current assets. Quick ratio = Current assets - Inventory Current Liabilities

30. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS When is the company solvent? When the Quick ratio is 1.0 or greater. Which liquidity ratio is more accurate, the current ratio or the quick ratio? The quick ratio, since it excludes inventory, the least liquid asset, and the asset on which losses are most likely to occur in the event of liquidation.

31. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Method for Calculating the Quick Ratio: • Add cash, marketable securities and accounts receivable (items 16, 17, & 18 on the sample balance sheet on page 6) to get quick assets (quick assets by definition is current assets - inventory).

32. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS • Add notes payable, trade accounts payable, payrolls and other accurables and income taxes (items 31, 32, 33 & 34 on the sample balance sheet on page 6) to get current liabilities. • Divide the derived quick assets figure by the calculated current liabilities figure.

33. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS • You have now derived the quick ratio. Now, compare the value derived to 1.0. If the quick ratio is 1.0 or greater, the company should have more quick assets than current liabilities and is financially viable or solvent. If the quick ratio is less than 1.0, the company will have more current liabilities than quick assets and is financially unviable or insolvent.

34. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS • For significance this ratio should be compared to previous years (e.g. the quick ratio for five previous years should be derived). This is necessary in order to derive a trend. If the quick ratios is rising in an upward fashion, the company is becoming more financially viable. If the quick ratio is falling and assuming a downward trend, the company is becoming less financially viable.

35. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS • One helpful activity is to also compare the quick ratio of the company in question to the quick ratio of similar competing companies. If the company in question has a higher quick ratio on a regular basis over a number of years then this company is more financially viable.

36. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS • Leverage Ratios Leverage ratios measure the funds supplied by owners as compared with the financing provided by the firm’s creditors.

37. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Implications of leverage ratios: Equity, or owner-supplied funds, provide a margin of safety for creditors. Thus, the less equity, the more the risks of the enterprise to the creditors.

38. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS • Debt funding enables the owners to maintain control of the firm with a limited investment. • If the firm earns more on the borrowed funds than it pays in interest, the return to the owners is magnified. • If the firm earns more on the borrowed funds than it pays in interest, the return to the owners is magnified.

39. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Low leverage ratios: Indicate less risk of loss when the economy is in a downturn, but lower expected returns when the economy booms. High leverage ratios: indicate the risk of large losses, but also have a chance of gaining high profits.

40. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Therefore, decisions about the use of leverage must balance higher expected returns against increased risk.

41. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Approaches to examining leverage ratios: • Debt ratio: The debt ratio is the ratio of total debt to total assets and measures the percentage of total funds provided by creditors. The debt ratio is: Total debts Total assets

42. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Method for Calculating the Debt Ratio: • Add notes payable to long-term liabilities to get total debts.

43. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS • Add cash, marketable securities, accounts receivable, inventories, prepaid expenses, land, buildings, machinery and equipment and subtract depreciation to derive the total assets figure. • Divide the total debts figure by the calculated total assets figure.

44. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS • For significance this ratio should be compared to previous year (e.g. the debt ratio for five previous years should be derived). This is necessary in order to derive a trend. If the debt ratio is rising in an upward fashion, the company is developing a leverage problem. If the debt ratio is falling and assuming a downward trend, the company is investing more of its own resources to generate assets and is becoming less dependent on debts.

45. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS • One helpful activity is to also compare the debt ratio of the company in question to the debt ratio of similar competing companies. If the company in question has a higher debt ratio on a regular basis over a number of years, then this company is over leveraged in comparison to its competitors. On the other hand, if the company in question has a lower debt ratio on a regular basis over a number of years, then this is less dependent on debt as a source of financing in comparison to its competitors.

46. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS B - Debt-to-Equity- Ratio: This ratio is a variation of the debt ratio that is commonly used. It compares the amount of money borrowed from creditors to the amount of shareholder’s investment made within a firm. Debt-to-Equity ratio = Total Debts Shareholder’s investment (equity)

47. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS Method for Calculating the Debt-to-Equity Ratio: • Add notes payable to long-term liabilities to get total debts.

48. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS • Look up the shareholder’s investment or equity line item in the blance sheet. • Divide the total debts figure by the calculated shareholders’ investment figure.

49. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS • For significance this ratio should be compared to previous years (e.g. the debt to equity ratio for five previous years should be derived). This is necessary in order to derive a trend. If the debt to equity ratio is rising in an upward fashion, the company is developing a leverage problem. If the debt ito equity ratio is falling and assuming a doward trend, the company is investing more of its owners resources to generate assets and is becoming less dependent on creditors.

50. ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS • One other helpful activity is to also compare the debt to equity ratio of the company in question to the debt equity ratio of similar competing companies. If the company in question has a higher debt to equity ratio on a regular basis over a number of years, then this company is over leveraged in comparison to its competitors. On the other hand, if the company in question has lower debt to equity ratio on a regular basis over a number of years, then this company is less dependent on debt as a source of financing in comparison to its competitors.