Question

1. Explain the key items of interest to the following groups of people when completing a financial statement analysis: -investors, -creditors -and management.

2. List and define the five categories of ratios generally used in financial statement analysis.

3. List and discuss the ratios that make up the calculation of the cash conversion cycle.

Answer 1

1. Interest of Financial statements towards various group of people

a. Investors

When completing a company's financial statement, the investors are interested to know the net profit of the company. Because after analysing this an investor could calculate the earnings per share and price earnings ratio of the company which help him to make decisions regarding whether to invest or not in a company.

b. Creditors

Inorder to identify the short term liabilities and short term liquidity position of the company creditors uses financial statement analysis. They want to know the paying capacity of the company as they want to get an assurance about whether they get their money or not.

c. Management

Management uses financial statement analysis inorder to evaluate the financial performance and position of the company as the main goal of the management of every company is to maximise the sharehorlders wealth. So they will be always keen about the healthy financial background to the company.

2. Five Categories of Ratios

Ratio analysis is the analysis of financial statements with the help of ratios. Major categories of ratios are:

a. Liquidity Ratio - which measures the firm's ability to meet its short term obligations.

b. Solvency Ratio - which evaluates the capabilty of the long term solvency of the firm.

c. Activity Ratio - which prrovides information on a firm's ability to manage efficiently its current assets and current liabilities.

d. Profitability Ratio - which measures the profitability of the firm

e. Marketability Ratio - which describes the firm's financial condition in terms of amount per share of stock.

a. Liquidity Ratio

• Current Ratio - Measures the firm's total current assets over current liabilties

Current Ratio = Current Assets / Current Liabilities

• Quick Ratio - Measures the firm's liquidity with the help of current assets by excluding prepaid expenses and inventory.

Quick Ratio = Current assets - ( prepaid expenses + inventory ) / Current liabilities

• Cash Ratio - which is a more conservative ratio because it only includes assets that a company can immediately change into cash.

Cash Ratio = (Cash and Cash equivalents + marketable securities ) / Current liabilities

• Cash Flow ratio - which identifies the liquidity of the firm through its daily opeartions

Cash flow ratio = operating cashflow / current liabilities

b. Solvency Ratio

• Financial Leverage Ratio = Assets / Equity
• Total debt to total capital Ratio = ( Current Liabilities + Long term liabilities ) / ( Total debt + Total Equity)
• Debt-Equity Ratio =Total Debt / Equity
• Long term debt-equity ratio = ( Total debt - Current liabilities) / Equity
• Debt to Total Asset Ratio = Total Debt / Total asset
• Fixed Charges coverage ratio = Earnings Before fixed charges and taxes / Fixed charges

Where fixed charges = Interest , required principal payment and leases

• Time Interest Earned Ratio = Earnings Before Interest and taxes / Interest expenses

c. Activity Ratio

• Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
• Accounts Receivable Turnover Ratio = Net credit sales / average accounts receivable
• Accounts payable turnover ratio = Net credit purchases / Average accounts payable
• Total asset turnover ratio = Sales / Average total assets
• Fixed asset turnover ratio = Sales / Average Net property plant and equipments

d. Profitability Ratio

• Gross profit ratio = (Gross profit / Sales) * 100
• Operating profit ratio = ( Operating profit / sales ) * 100
• Net profit ratio = (Net profit / sales) * 100
• Return on Equity = Net income / Average Equity
• Return on Asset = Net income / Average asset
• Return on Investment = Income of business unit / Assets of business unit

e. Marketability Ratio

• Earnings per Share = (Net income - preferred dividend) / Weighted average no. of common shares outstanding
• Earnings Yield Ratio = EPS / market price per commonshare
• Market to Book Ratio = Current market price per share / Book value per share
• Price Earings Ratio= Market price per share / Earnings per share
• Price to EBITDA ratio = Market price per share / EBITDA per share
• Dividend Payout ratio = Common dividend / Earnings available to common shareholders
• Dividend Yield ratio = Annual dividend per share / Market price per share

3. Ratios used in cash conversion cycle

Inorder to calculate cash conversion cycle first we want to find out operating cycle which is the sum of inventory turnover days and accounts receivable turnover days.

Inventory turnover days = Average inventory / ( Cost of sales / 365)

Accounts Receivable turnover days = Average Accounts receivable / ( Annual credit sales / 365)

Operating cycle = Inventory turnover days + Accounts receivable turnover days

Accounts payable turnover days = Average accounts payable / ( Annual credit purchases / 365)

Cash Cycle = Operating cycle - Accounts payable turnover days

Ratios involve in calculation of cash cycle are Inventory turnover ratio, Accounts Receivable turnover ratio, Accounts Payable turnover ratio.