1. CCI Entrepreneurship Curriculum
Module 8c – Introduction to financial analysis

2. Content for Unit Introduction to financial analysis Topics:
Ratio analysis - performing analysis of financial statements through financial ratios
Paying liabilities and debts
Measuring profitability
Analysing stock as an investment

3. Ratio Analysis
A means of evaluating the relationships between key components of the financial statements
The information needed can be found in the company’s financial statements
A few ratios require the amount of the company’s closing market price
Some ratios require knowledge of the number of shares outstanding
There are many different financial ratios that managers, investors, and creditors use when analyzing a company’s financial statements.
Managers use different financial ratios to evaluate a company’s performance, depending on the underlying need. For example, if a manager wants to know how quickly inventory is selling, he or she will calculate inventory turnover. If a manager wants to know how easily the company will be able to meet its current obligations, he or she will calculate the current ratio or quick ratio.

4. Ability to Pay Current Liabilities
Working capital measures the ability to meet short-term obligations with current assets
Current Assets – Current Liabilities = Working Capital
Example:
€262,000 €142,000
Working capital is a measure of the amount of current assets remaining after all current liabilities have been paid. This can show how solvent the company is, since if push comes to shove a positive working capital can mean that the company can sell assets to pay its current liabilities.

5. Ability to Pay Current Liabilities
Current Ratio
The current ratio measures the ability to pay current liabilities with current assets.
Current assets
Current liabilities
The most widely used ratio is the current ratio, which is current assets divided by current liabilities. The current ratio measures ability to pay current liabilities with current assets.
Example:
€262,000 €142,000
= = 1.85

6. Ability to Pay Current Liabilities
Acid test ratio (quick ratio)
A stringent indicator that determines whether a firm has enough short-term assets to cover its immediate liabilities without selling inventory.
The acid-test ratio is far more strenuous than the working capital ratio, primarily because the working capital ratio allows for the inclusion of inventory assets
Quick assets
Current liabilities
The acid-test (or quick) ratio tells us whether the entity could pay all its current liabilities if they came due immediately. To compute the acid-test ratio, add cash, short-term investments, and net current receivables (accounts and notes receivable, net of allowances) and divide this sum by current liabilities.
Example:
€29,000 + €114, €143, €142, €142,000
= 1.01

7. Ability to Sell Inventory
Selling Inventory
Inventory turnover ratio illustrates how many times a year the company sells its average level of inventory
Cost of goods sold
Average inventory*
*Average inventory =
(Beginning inventory + Ending inventory)/2
Inventory turnover measures the number of times a company sells its average level of inventory during a year. A high rate of turnover indicates ease in selling inventory; a low rate indicates difficulty. A value of 6 means that the company sold its average level of inventory six times–every two months–during the year.
Example:
€513, = €513,000
(€111,000 + €113,000)/ €112,000

8. Ability to Collect Receivables
Accounts receivable turnover ratio illustrates how quickly the company collects cash from credit customers
Net credit sales
Average net accounts receivable*
*Average net accounts receivable =
(Beginning receivables + Ending receivables)/2
Accounts receivable turnover measures the ability to collect cash from credit customers. The higher the ratio, the faster the cash collections. But a receivable turnover that is too high may indicate that credit is too tight, causing the loss of sales to good customers.
Example:
€858, €858,000
(€85,000 + €114,000)2 €99,500
= 8.6 8

9. Compute Ratios Current Ratio = €166,380 / 118,000= 1.41 Acid Test =
Balance sheet:
Current year
Preceding year
Cash
€ 14,200
€ 20,000
Short-term investments
€ 5,320
€ 23,000
Net receivables
€56,000
€ 74,000
Inventory
€ 80,000
€ 68,000
Prepaid expenses
€ 10,860
€ 9,200
Total current assets
€ 166,380
€ 194,200
Total current liabilities
€ 118,000
€ 88,000
Income statement:
Net credit sales
€ 456,250
Cost of goods sold
€321,900
Current Ratio =
€166,380 / 118,000= 1.41
Acid Test =
€14,200 + €5,320 + €56,000/ €118,000 = 0.64
Inventory Turnover =
€321,900
(€80,000 + €68,000)/2 = 4.35
In days: 365/4,35= 83,9 days
1. Compute the following ratios for the current year:
a. Current ratio
b. Acid-test ratio
c. Inventory turnover
d. Days’ sales in average receivables
A/R turnover =
(€456,250) / [(€56,000 + €74,000)/2] = 7,019
In days= 365/7,019 = 52 days

10. Ability to Pay Debt Total liabilities Total assets
Debt ratio illustrates the proportion of company’s assets financed with debt
Total liabilities
Total assets
Example:
€431,000 €787,000
= 55% of the assets are financed with debt
The relationship between total liabilities and total assets–called the debt ratio–shows the proportion of assets financed with debt. If the debt ratio is 1, then all of the assets are financed with debt. 10

11. Ability to Pay Debt
Interest coverage ratio illustrates how many times operating income covers interest expense
Income from operations*
Interest expense
*Income from operations =
Income before income tax & interest expense
Analysts use the times-interest-earned-ratio to relate income to interest expense. This ratio is also called the interest-coverage ratio. It measures the number of times operating income can cover interest expense. A high interest-coverage ratio indicates ease in paying interest expense; a low ratio suggests difficulty.
Example:
€101,000 €20,000
= 5.05 times 11

12. Measuring Profitability
Return on net sales ratio (profit margin) is the percentage of each sales euro that is earned as net income
Net income
Net sales
The rate of return on net sales shows the percentage of each sales euro earned as net income. The higher the rate of return, the more sales euros end up as profit.
Example:
€48,000 €858,000
= 5.7% 12

13. Measuring Profitability
Rate of return on total assets (ROA) illustrates how successful the business is using its assets to earn a profit
Net income + Interest expense
*Average total assets
*Average total assets =
(Beginning assets + Ending assets) / 2
Example:
€48,000 + €20, €68,000
(€644,000 + €787,000)/ €715,500
= = 9.5%
The rate of return on total assets measures success in using assets to earn a profit. This return on assets ratio is important to creditors and shareholders. 9.5% profit on assets. 13

14. Measuring Profitability
Rate of return on common stockholders’ equity (ROE) illustrates how much income is earned for every €1 invested by the stockholder
Net income
*Average common stockholders’ equity
*Average common stockholders’ equity =
(Beginning + Ending common stockholders equity) / 2
The rate of return on common stockholders’ equity shows the relationship between net income and stockholders’ equity–how much income is earned for each €1 invested by the shareholders.
There is a 14.2% return on equity or 14.2 cents earned on each euro invested.
Example:
€48, €48,000
(€320,000 + €356,000)/ €338,000
= = 14.2% 14

15. Measuring Profitability
Earnings per share of common stock (EPS) ratio illustrates the income generated by one share of stock
Net income – Preferred dividends
No. of shares of common stock outstanding
Example given that the number of shares are 10000:
€48,000 - €0 = €48,000
10, ,000
= €4.80 EPS
Earnings per share of common stock or EPS is per the most widely quoted of all financial statistics. EPS is the only ratio that must appear on the face of the income statement. EPS is the amount of net income earned for each share of the company’s outstanding common stock. EPS is computed by dividing net income available to common stockholders by the number of common shares outstanding during the year. Preferred dividends are subtracted from net income because the preferred stockholders have a prior claim to dividends. 15

16. Analyzing Stock as an Investment
The broadest and most widely used overall measure of performance is the Price/earnings ratio or P/E ratio.
Market price per share
EPS
From previous example given that the market price per share is 60 euros:
€60.00
€4.80
= 12.5
In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects. The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings. It is important that investors note an important problem that arises with the P/E measure, and to avoid basing a decision on this measure alone. The denominator (earnings) is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number. 16

17. Analyzing Stock as an Investment
In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by itself.
It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E.
It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects.
In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects. The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings. It is important that investors note an important problem that arises with the P/E measure, and to avoid basing a decision on this measure alone. The denominator (earnings) is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number. 17

18. Analyzing Stock as an Investment
The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings.
If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings.
It is important that investors note an important problem that arises with the P/E measure, and to avoid basing a decision on this measure alone.
The denominator (earnings) is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number.
In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects. The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings. It is important that investors note an important problem that arises with the P/E measure, and to avoid basing a decision on this measure alone. The denominator (earnings) is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number. 18

19. Analyzing Stock as an Investment
Dividend yield ratio illustrates the percentage of a stock’s market value that is returned annually as dividends
Dividend per share
Market price per share
Example:
€1.20
€60.00
= 2.0%
Dividend yield is the ratio of dividends per share to the stock’s market price per share. This ratio measures the percentage of a stock’s market value that is returned annually as dividends. Preferred stockholders pay special attention to dividend yield. 19

20. Analyzing Stock as an Investment
Book value per share of common stock
Total stockholders’ equity – Preferred equity
No. of shares of common stock outstanding
Example:
€356,000 - €0
10,000
= €35.60
Book value per share of common stock is common equity divided by the number of common shares outstanding. Common equity equals total stockholders’ equity less preferred equity. 20

21. Compute Stock Ratios Current year Last year Net income €80,400 €47,200
Dividends—common
€21,580
Dividends—preferred
€14,000
Total stockholders' equity at year end ( shares of common stock)
€809,300
€639,150
Preferred stock, (6%)
€220,000
Market price per share of common €
€ 8.00
EPS ( – ) / = 0.8
Price/earnings ratio
€20.00 / €0.8 = 25
= 1.3 %
Dividend yield
(€21,580 / €83,000 ) =
€ €20.00 21

22. Testing Financial Ratios
Being given the Financial Statements, ask in groups to interpret the common size.
Then Ask to produce a set of financial rations that are given in the next slide. Pick up a few for each group or if there is time pick up all for everybody.
In order to be practical and have a comprehensive hands on approach, we will have to prepare based on financial Statements a set of Ratios. For this Exercise everyone should have access to Excel. There will be a few more ratios that participants can think by themselves on how to calculate them based on their name.
Note: Annual depreciation is $4000.

23. Solutions to Financial Ratios
Common Ratios
Dec
Dec 1
Current
3.221
3.419 2
Acid Test
1.375
1.125 3
Debt to Asset
0.393
0.400 4
Receivable Turnover
11.799
19.675 5
Inventory Turnover
2.000
2.377 6
Profit Margin
0.220
0.250 7
Asset Turnover
1.083
1.166 8
Return on Assets
24%
29% 9
Return on Equity
39%
50% 10
Operating Cash flow to Total liabilities
65%
75% 11
Interest coverage
16.76
Excel File is required to work properly and faster on the task.

24. Summary What we covered? How we use it?
Unit 1 - Introduction to financial analysis
…………………
The trainer asks the participants on each unit the most important aspects and why they think they can use them in their business.
This is an interactive part.