Financial Ratio Analysis For Non-Financial Managers

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
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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).
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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.
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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)
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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.
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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.
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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).
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EXHIBIT 1
SAMPLE 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
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◆ 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.
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◆ 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).
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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.
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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:
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◆ 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.
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◆ 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.
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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
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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.
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◆ 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.
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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.
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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.
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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.
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◆ 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.
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◆ 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
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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).
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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.
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◆ 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.
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◆ 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.
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◆ 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.
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◆ 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.
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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
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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.
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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).
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◆ 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.
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◆ 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.
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◆ 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.
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◆ 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.
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◆ Leverage Ratios
Leverage ratios measure the funds supplied
by owners as compared with the financing
provided by the firm’s creditors.
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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.
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◆ 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.
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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.
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Therefore, decisions about the use of leverage

must balance higher expected returns against
increased risk.
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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
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Method for Calculating the Debt Ratio:

◆ Add notes payable to long-term liabilities to
get total debts.
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◆ 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.
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◆ 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.
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◆ 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.
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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)
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Method for Calculating the Debt-to-Equity Ratio:

◆ Add notes payable to long-term liabilities to
get total debts.
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◆ 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.
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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.
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◆ 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.
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Profitability ratios
Profitability ratios indicate how successful a
company really is and how effective
management is in operating the business.
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A - Return on assets
This ratio shows how much money the company
earned on each dollar it invested in assets. It is a
measure of overall company earning power or
profitability.
Return on Assets (ROA) = Net Earnings
Total Assets
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Method for Calculating the Return on Assets Ratio:
◆ Derive the net earnings, or net profit figure from the
income statement. Net earnings is simply total
revenues minus total expenses.
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◆ 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 net earnings figure by the derived
total assets figure to get return on assets.
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previous years (e.g. the return on assets ratio for five
in order to derive a trend. If the return on assets ratio
is rising in an upward fashion, the company is making
a larger return on funds invested in assets. If the
return on assets ratio is falling and assuming a
downward trend, the company is making a lower
return on funds invested in assets.
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◆ One other helpful activity is to also compare the return
on assets ratio of the company in question to the
return on assets of similar competing companies. If
the company in question has a higher ROA on a
regular basis over a number of years, then this
company is financially better off in comparison to its
competitors. On the other hand, if the company in
question has a lower ROA on a regular basis over a
number of years, then this company is financially
worse off in comparison to its competitors.
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B - Profit Margin:
◆ The profit margin is a ratio that shows the
relationship between net earnings and net
sales and indicates how much profit the
company is earning on each dollar in sales.
Profit Margin = Net Earnings
Net Sales
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Method for calculating the profit margin ratio:

◆ Derive the net earnings, or net profit figure
from the income statement. Net earnings is
simply total revenues minus total expenses.
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◆ Derive the net sales line item from the income

statement.
◆ Divided the net earnings figure by the derived
net sales figure to get the profit margin.
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previous years (e.g. the profit margin ratio for five
previous years should be derived). This is
necessary in order to derive a trend. If the profit
margin ratio is rising in an upward fashion, the
company is making a larger return on sales. If the
profit margin is falling and assuming a downward
trend, the company is making a lower return on
sales.
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◆ One other helpful activity is to also compare the profit
margin of the company in question to the profit margin
of similar competing companies. If the company in
question has a higher profit margin on a regular basis
over a number of years, then this company is making
a larger return on sales in comparison to its
competitors. On the other hand, if the company in
question has a lower profit margin on a regular basis
over a number of years, then this company is making
a lower return on sales in comparison to its
competitors.
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C - Return on equity (or return on net worth)

This ratio indicates the amount of net earnings resulting
from investments in equity. Shareholders are
particularly interested in this ratio, because it shows
them how much they are earning on their investments.
Return on equity = Net Earnings
Shareholders’ investment (Equity)
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Method for calculating the return on equity ratio:

◆ Derive the net earnings, or net profit figure
from the income statement. Net earnings is
simply total revenues minus total expenses.
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◆ Lookup the shareholder’s investment or

equity line item in the balance sheet.
◆ Divide the net earnings figure by the derived
shareholder’s investment figure to get return
on equity.
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previous years (e.g. the return on equity ratio for five
in order to derive a trend. If the return on equity ratio
is rising in an upward fashion, the company is making
a larger return on funds invested by shareholders. If
the return on equity is falling and assuming a
downward trend, the company is making a lower
return on funds invested by shareholders.
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◆ One other helpful activity is to also compare the return on
equity of the company in question to the return on equity
of similar competing companies. If the company in
question has a higher return on equity on a regular basis
over a number of years, then this company is making a
larger return on shareholder’s investment in comparison
to its competitors. On the other hand, if the company in
question has a lower return on equity on a regular basis
over a number of years, then this company is making a
lower return on shareholder’s investment in comparison to
its competitors.
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Activity ratios
◆ Activity ratios measures how effectively the
firm employs its resources. These ratios
involve comparisons between the level of
sales and the investment in various asset
accounts, like inventories and accounts
receivable.
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A - Inventory turnover
◆ Inventory turnover tells us how many times
during the year the entire stock of inventory
was sold.
◆ Inventory turnover is calculated as follows:
Inventory turnover = Sales
Inventory
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Method for calculating the inventory turnover ratio:
◆ Derive the net sales line item from the income
statement.
◆ Derive the inventory valuation figure from the
balance sheet.
◆ Divide the sales figure by the derived inventory
figure to get the inventory turnover.
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Problems in arising in calculating and analyzing this ratio:
◆ Sales are at market prices. If inventories are carried at
cost, as they generally are, it is more appropriate to use
cost of goods sold in place of sales in the numerator of
the formula.
◆ Sales occur over the entire year, whereas the inventory

figure is for one point in time. This makes it better to
use an average inventory, computed by adding
beginning and ending inventories and dividing by 2.
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B - Average collection period:

◆ The average collection period indicates how
quickly the company collects its accounts
receivable.
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It is computed in the following way:

◆ Annual sales (derived from the income
statement) are divided by 365 to get average
daily sales.
◆ Accounts receivable (derived from the
balance sheet) are divided over daily sales to
find the number of days’ sales is tied up in
receivables.
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◆ The average collection period represents the average

length of time the firm must wait to receive cash after
making a sale and is mathematically defined as
follows:
Average collection period = Accounts receivables
Sales/365 days
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◆ Evaluation of this ratio is based upon the

terms on which the firm sells its goods. For
example, if the collection period over the past
few years for a given company is lengthy
while its credit policy did not change, this
would be evidence that steps should be taken
to expedite the collection of accounts
receivable.
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SUMMARY OF FINANCIAL RATIOS
Ratio Formula Example for Industry Evaluation
Calculation Average
Liquidity
Current Current Assets 700,000 = 2.3 2.5 Satisfactory
Current Liabilities 300,000
Quick Quick Assets 400,000 = 1.3 1 time Good
Current Liabilities 300,000
Leverage
Debt Total Debt 100,000 = 50% 33% Poor
Total Assets 200,000
Debt-Equity Total Equity 1,000,000 = 50% 33% Poor
Total Assets 2,000,000
Profitability
Return on Net Earnings 120,000 = 6% 10% Poor
Assets Total Assets 2,000,000
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SUMMARY OF FINANCIAL RATIOS
(CONT’D)
Ratio Formula Example for Industry Evaluation
Calculation Average
Profit- Net Earnings 120,000 = 4% 5% Fair
Margin Net Sales 3,000,000
Return Net Earnings 120,000 = 12% 15% Fair
on Equity Shareholder’s Inv. 3,000,000
Activity
Inventory Sales 3,000,000 = 10 9 times Satisfactory
Turnover Inventory 300,000 times
Average Accounts Receivables 2,00,000 = 24 20 Days Satisfactory
Collection Sales/365 days 8,333 Days
Period
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FINANCIAL RATIOS
I. Ratios Indicating Current position or Relating to Analysis of Short-Term Solvency
Ratio Formula Significance
A. Tests of overall solvency
1. Current ratio or working Current Assets (Net) Primary tests of liquidity

capital ratio Current Liabilities indicating ability to meet
current obligations from
current assets as a going
concern. Measure of
adequacy of working capital.
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FINANCIAL RATIOS
2. Acid-Test ratio or Quick Assets (Net) A more severe test of

quick ratio Current Liabilities immediate liquidity than
the current ratio. Test of
ability to meet sudden
demands from current
assets.
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FINANCIAL RATIOS
3. Working captial to Currents Assets-Current Liabilites Indicates relative

total assets Total Assets (Net) liquidity of total assets
and working capital
position; and distributes
of resources employed.
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FINANCIAL RATIOS
B. Ratios indicating movement of current assets (turnover)
4. - Receivable turnover Net Credit Sale Velocity of collection of

Average Receivable (Net) trade accounts and notes.
Test of efficiency of
collection
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FINANCIAL RATIOS
- Number of days 365 (days) Velocity of collection of

receivables Receivable turnover trade accounts and notes.
(computed as above) Test of efficiency of
collection.
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FINANCIAL RATIOS
5. Inventory turnover Indicates liquidity of

inventory and will exhibit
tendency to over-stock.
a. merchancise turnover Cost of Goods Sold Number of times average
Average Mdse. Inventory stock moved during the
year.
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FINANCIAL RATIOS
Ratio Formula Significnce
b. Finished goods turnover Cost of Goods Sold As as (a).

(Manufcturing firm) Ave. Finished Goods Invty.
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FINANCIAL RATIOS
c. Raw Material turnover Cost of Raw Materials Used Number of times raw
Ave. Raw Material Inventory material inventory was
“used” on the average
during the period.
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FINANCIAL RATIOS
d. Days supply in Inventory 365 (6 days) Average number of days

Inventory turnover supply in the ending
(computed per (a), invenory over or
(b) or (c). undestocking as the case
maybe.
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FINANCIAL RATIOS
6. Average Age of Average Account Payable x 365 Indicates the aging of

Payables Annual Purchase accounts payable. this
figures can be compared
to the credit terms
extended by the
suppliers of the company
to see if any abusees of
these terms are being
made. Trends analysis
of the ratios may also be
significant.
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FINANCIAL RATIOS
7. Working capital Net Sales Indicates adequacy of

turnover Working Capital working capital and cash
cycle of firm.
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FINANCIAL RATIOS
II. Ratios indicating asset relations and capital set-up or relating to analysis of long-term
solvency
A. Equities related to profits and sales
1. Sales to owners’ equity Net Sales Numberof times net worth

Owners’ Equity is “turned over” in sales
Indicative of the utilization
of owner’s capital may
reflect over-capitalization
in relation to volume of
business done.
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FINANCIAL RATIOS
3. Earning rate of Net Income per share Earnings rate based on

market value per Market Value per share cost of share of stock in
share the market. Indicates
profitability related to
market value of
stockholder’s equity.
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FINANCIAL RATIOS
4. Times Bond Net Income before Bond Interest Income Security Bonds.
Interest Earned Bond Service requirements
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FINANCIAL RATIOS
5. Net Operating Net Income before income taxes Summary of operation

Income to and non-operating items position for year.
Net Sales
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FINANCIAL RATIOS
6. Operating expense Total Operaing Expenses Indicates effectively of

Net Sales mnagement in controlling
operating expenses.
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FINANCIAL RATIOS
IV. Leverage and Capital-Structure Ratios
These ratios tell us the relative proportions of capital contributed by creditors

and by owners.
1. Debt-Equity Current Liabilities + Long-term Debt Total amount of debt
Ratio Total Common Equity leverage per peso of
common equity
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FINANCIAL RATIOS
2. Total Debt to Total Current Liabilities + L.T.D. Proportion of assets

Assets Total Assets provided by creditors.
Extent of “trading on the
equity”.
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FINANCIAL RATIOS
3. Long-term Debt to Long-term Debt Long-term debt leverage

Equity Ratio Total Common Equity per peso of common
equity.
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FINANCIAL RATIOS
VI. Asset-relation Ratios
1. Plant and equipment Net Plant + Net Equipment Proportion of operating

to Total assets Total Assets earning assets to total
assets.
WORLD BANK
FINANCIAL RATIOS
2. Inventory to Total Average Inventory Size of inventory and

Assets Total Assets tendency to overstock.
WORLD BANK
FINANCIAL RATIOS
3. Fixed Assets to Fixed Fixed assets (net) Reflects extent of the

Liabilities Fixed Liabilities utilization of resources
from long-term debt.
Indicative of source for
additional funds. If the
fixed assets are pledged -
degree of security. It is
frequently more useful to
use present value rather
than book value.
WORLD BANK
FINANCIAL RATIOS
4. Fixed Assets to Total Fixed Assets (net) Proportion of owners’

Equity Total Owners’ Equity equity to fixed assets.
Indicative of over or under-
investment by owners;
also weakness in “trading
on the equity”.
WORLD BANK
FINANCIAL RATIOS
5. Sales to Fixed Assets Net Sales turnover index which tests

(Plant Turnover) Fixed Assets (net) roughtly the efficiency of
management inkeeping
plant properties employed.
WORLD BANK
FINANCIAL RATIOS
6. Approximate Average Net Plant and Equipment Average life of plant and
Asset Life Normalized Depreciation equipment.
WORLD BANK
FINANCIAL RATIOS
II. Common-Stock Security Ratios
1. Book value per share Common Stock Equity Number of peso security
of common stock No. of Outstanding Shares (at book value) per share
of common stock
WORLD BANK
HOW TO ANALYZE FINANCIAL
POSITION
POTENTIAL FOR BUSINESS FAILURE
Bankruptcy occurs when the company is unable

to meet maturing financial obligations. We are
thus particularly interested in predicted cash
flow. Financial difficulties affect the price-
earnings ratio, and the effective interest rate.
WORLD BANK
HOW TO ANALYZE FINANCIAL
POSITION
POTENTIAL FOR BUSINESS FAILURE
A comprehensive quantitative indicator used to predict failure is
Altman’s “Z-score,” which equals
Working capital Retained earnings
X 1.2 + X 1.4
Total assets Total assets
Operating income MV of common & preferred
X 3.3 + X 0.6
Total assets Total liabilities
Sales
+ X 0.999
Total assets
N.B. Operating income = Net sales - cost of goods sold
WORLD BANK
THE SCORES AND THE PROBABILITY
OF SHORT-TERM ILLIQUIDITY FOLLOW.
Score Probability of illiquidity or failure

1.80 or less Very high
1.81- 2.99 Not sure
3.0 or greater Unlikely
WORLD BANK
EXAMPLE
A company presents the following information
Working capital 280,000
Total assets 875,000
Total liabilities 320,000
Retained earnings 215,000
Sales 950,000
Operating income 130,000
Common stock
Book Value 220,000
Market Value 310,000
Preferred stock
Book value 115,000
Market value 170,000
WORLD BANK
Z-score equals
280,000 215,000 130,000
X 1.2 + X 1.4 + X 3.3 +
875,000 875,000 875,000
480,000 950,000
X 0.6 + X 0.999 =
320,000 875,000
0.384 + 0.344 + 0.490 + 0.9 + 1.0846 = 3.2026
The probability of failure is not likely
WORLD BANK
QUANTITATIVE FACTORS IN
PREDICTING CORPORATE FAILURE
◆ Low cash flow to total liabilities.
◆ High debt-to-equity ratio and high debt to total assets.
◆ Low return on investment
◆ Low profit margin
◆ Low retained earnings to total assets
◆ Low working capital to total assets and low working
capital to sales
◆ Low fixed assets to noncurrent liabilities
◆ Inadequate interest-coverage ratio
◆ Instability in earnings
◆ Small size company measured in sales and/or total
assets
WORLD BANK
PREDICTING CORPORATE FAILURE
◆ Sharp decline in price of stock, bond price, and
earnings
◆ A significant increase in beta. (Beta is the variability in
the price of the company’s stock relative to a market
index)
◆ Market price per share is significantly less than book
value per share
◆ A significant rise in the company’s weighted-average
cost of capital
◆ High fixed cost to total cost structure (high operating
leverage)
◆ Failure to maintain capital assets. (e.g. decline in the
ratio of repairs to fixed assets
WORLD BANK
PREDICTING FAILURE
◆ New company
◆ Declining industry
◆ Inability to obtain adequate financing, and when
obtained there are significant loan restrictions
◆ A lack in management quality
WORLD BANK
CONSOLIDATED BALANCE SHEETS
December 31, 1993 1992
Assets
Cash 9,150,210 7,679,800
Accounts receivable less allowances 6,952,700 6,411,470
Inventories 5,755,040 5,293,910
Other current assets 897,670 895,760
Total current assets 22,755,620 20,280,940
Investments 304,710 174,640
Property, plant and equipment
Land 336,780 292,480
Buildings 4,940,740 4,277,040
Machinery & Equipment 8,791,660 7,783,080
Total Property, Plant & Equipment 14,069,180 12,352,600
Less accumulated depreciation 5,475,040 4,656,370
Property plant & Equipment net of depreciation 8,594,140 7,696,230
Intangibles 1,934,650 1,828,510
Other assets 362,990 468,980
Total Assets 33,952,110 30,449,300
Liabilities
Loans payable to Banks 588,600 616,040
Accounts payable & Accrued Expenses 6,030,420 5,267,770
Total current liabilities 6,619,020 5,883,810
Long term Debt 4,415,510 3,679,650
Shareholders’ Equity
Total Shareholder’s Equity 22,917,580 20,885,840
Total Liabilities and Shareholders’ Equity 33,952,110 30,449,300
WORLD BANK
CONSOLIDATED STATEMENTS OF
INCOME
December 31, 1993 1992
Net Sales 47,443,200 45,684,060

Cost of goods sold 18,371,190 17,995,370
Selling, Admin. & General Expense 16,959,630 15,944,040
35,330,820 33,939,410
Income before interest and taxes 12,112,380 11,744,650
Interest 1,136,970 1,243,780
Income before taxes 10,975,410 10,500,870
Taxes 3,804,010 3,942,590
Net profit 7,171,400 6,558,280
WORLD BANK
Instruments of Long Term Finance
◆ Bond --- A long term promissory note
◆ Mortgage --- A mortgage is a pledge of

designated property for a loan. A mortgage
bond is a pledge by the corporation to certain
real assets as security for the bond.
◆ Debenture --- Is a long term bond not

secured to specific property
WORLD BANK
Common Vs. Preferred Stock
◆ Preferred Stock ---- avoids the provision of

equal participation in earnings in comparison
to common stock
◆ Common Stock ---- does not entail fixed

charges. There is no legal obligation to pay
common stock dividends. Also, common
stock has no fixed maturity date
WORLD BANK
P/E Ratio Calculations
◆ Company X -- Earnings Per Share
◆ 1988 1989 1990

◆ 0.9 0.8 0.6
◆ Earnings Per Share = Net profit/# of shares

issued
WORLD BANK
Company X Market Price Per Share,
Common Stock
1988 1989 1990
◆ High 9.0 5.0 6.0
◆ Low 7.0 4.0 3.0
◆ Average 8.0 4.5 4.5
WORLD BANK
Price to Earnings Ratio
Price to earnings ratio = Price/Earnings
1988 1989 1990
◆ P/E 8.9 5.6 7.5
WORLD BANK
Market to Book Ratio
◆ Market to Book Ratio = Market value/book
◆ Market Price Per Share -- Common

1988 1989 1990
◆ Average 8.0 4.5 4.5
◆ Book Value Common Stock (year end)
◆ 4.7 4.9 5.0
◆ MBR = 1.7 0.9 0.9
WORLD BANK
Eastern Carpets - Ratio Findings
◆ Item 94 95 96
◆ ROA 12.3% 7.3% 8.7%
◆ ROE 39.0% 26.8% 29.5%
◆ CR .994 1.02 .947
◆ DR 68% 72.7% 70.3%
◆ D/E 217% 260% 236%
◆ Z Score 1.65 1.38 1.35
WORLD BANK
Eastern Carpets - Issues
◆ Working capital is WITHOUT the negative

sign
◆ Inventory is missing
◆ Accounts receivables is missing
◆ Why does total current assets appear when
accounts receivables and inventory do not?
◆ Where is retained earnings?
WORLD BANK
BOOK CASE ANALYSIS
Which U.S. Company is it?
1992 1993 1992 1993
ROA 21.5% 21% D/E 18% 19%

ROE 31.4% 31.2% IT 5.2 5.9
PM 14.3% 15% Z Score 6.25 5.94
CR 3.4 3.4
QR 2.5 2.6
DR 12% 13%
WORLD BANK
Dr. Khaled Fouad Sherif
◆ Work Tel: 202 473 4461

◆ Home Tel: 202 337 4027
◆ Fax: 202 522 0005
◆ Email: KSHERIF@WORLDBANK.ORG
◆ Web Site:http:\\www.ksherif.com
◆ Address The World Bank, 1818 H Street, NW
Washington DC 20043
WORLD BANK

Financial Ratio Analysis For Non-Financial Managers

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Financial Ratio Analysis For Non-Financial Managers

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FINANCIAL RATIO ANALYSIS FOR

DR. KHALED FOUAD SHERIF

Introduction to Balance Sheets and Income Statements:

The balance sheet summarizes the financial position of

In contrast to the balance sheet, the income

◆ Other income: Generally resources from sources as

The following expenses are subtracted from

◆ Administrative and selling expenses: The

◆ Other Expenses: This would include any

Expenses are subtracted from revenues to yield a

Total Assets 2,327,036 Total Liabilties & Equity 2,327,036

The second major section in a balance sheet is

◆ Notes payable: Money owned to banks or

Long-term liabilities are obligations, usually

The final major section, the equity section

◆ Leverage ratios, measure the extent to which

Current assets normally include: Cash, marketable

When is the company solvent? When the current ratio

◆ Add notes payable, trade accounts payable,

◆ You have now derived the current ratio. Now,

◆ For significance this ratio should be

b - Quick Ratio, or Acid Test

When is the company solvent? When the Quick

Method for Calculating the Quick Ratio:

◆ Add notes payable, trade accounts payable,

◆ You have now derived the quick ratio. Now,

◆ For significance this ratio should be

◆ One helpful activity is to also compare the

Implications of leverage ratios:

◆ Debt funding enables the owners to maintain

Low leverage ratios: Indicate less risk of loss

High leverage ratios: indicate the risk of large

Therefore, decisions about the use of leverage

Approaches to examining leverage ratios:

The debt ratio is: Total debts

Method for Calculating the Debt Ratio:

Method for Calculating the Debt-to-Equity Ratio:

◆ Look up the shareholder’s investment or

◆ Add cash, marketable securities, accounts

◆ For significance this ratio should be compared to

Method for calculating the profit margin ratio:

◆ Derive the net sales line item from the income

◆ For significance this ratio should be compared to

C - Return on equity (or return on net worth)

Method for calculating the return on equity ratio:

◆ Lookup the shareholder’s investment or

◆ For significance this ratio should be compared to

◆ Sales occur over the entire year, whereas the inventory

B - Average collection period:

It is computed in the following way:

◆ The average collection period represents the average

◆ Evaluation of this ratio is based upon the

I. Ratios Indicating Current position or Relating to Analysis of Short-Term Solvency

Ratio Formula Significance

A. Tests of overall solvency

1. Current ratio or working Current Assets (Net) Primary tests of liquidity

2. Acid-Test ratio or Quick Assets (Net) A more severe test of

3. Working captial to Currents Assets-Current Liabilites Indicates relative

B. Ratios indicating movement of current assets (turnover)

4. - Receivable turnover Net Credit Sale Velocity of collection of

- Number of days 365 (days) Velocity of collection of

5. Inventory turnover Indicates liquidity of

Ratio Formula Significnce