MASTER OF BUSINESS ADMINISTRATION (MBA)

EMB 510: INTRODUCTION TO ACCOUNTING AND

FINANCE

Spring 2024

Ratio analysis is a powerful diagnostic tool to reveal many internal details of a firm’s financial
position. It allows comparison of one firm to another, the firm to the industry to which it
belongs, and the firm’s current year to prior years. It shows the relationship between different
dimensions of the firm by comparing one accounting number, say, net profit, with another, say,
total shareholders’ equity. Once a particular ratio of the firm of interest is computed, it can
then be compared with other firms within the industry, the industry average, or any other
benchmark the analyst considers appropriate. One of the strengths of ratio analysis is that it is
size-neutral. In other words, it provides metrics that are already standardized, i.e., scaled to
size. Therefore, the return on assets (ROA) of a very small firm can easily be compared with
that of a very large firm. Therefore, it provides a more useful basis of comparison than do
absolute numbers. However, ratios on their own are of little use. They are useful when used
for year-to-year or for industry/firm, or for firm-to-firm comparison.

Financial ratios are traditionally grouped into the following categories:

1. Short-term solvency, or liquidity ratios;

2. Long-term solvency, or financial leverage, ratios;
3. Asset management, or turnover ratios;
4. Profitability ratios; and
5. Market value ratios.

Short-Term Solvency or Liquidity Measures

Liquidity stock measures

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Short-term solvency ratios as a group provide information about a firm’s liquidity, and hence
these are sometimes called liquidity ratios. These ratios signify the firm’s ability to pay its
currently maturing bills without undue stress. As a result, these ratios focus on current assets
and current liabilities. Short-term creditors, lenders and suppliers of goods and services to the
firm are particularly interested in these ratios.

Current ratio is the most well-known among liquidity ratios. As current assets are idally used to
pay off maturing current liabilities, the ratio compares the volume of current assets to the
volume of current liabilities. There is no standard rule of thumb as to what consttutes a healthy
current ratio, a ratio of at least 1 is generally considered desirable. From the creditors’
perspectives, however, the higher the ratio the better. On the other hand, it is important to
consider the cost of maintaining high current ratio as too much current assets build up could be
costly. Therefore, the industry average is considered a better guide to knowing what is a safe
level of current ratio than an arbitrary number. The firm’s past year(s) are also useful guides in
the absence of reliabile industry averages.

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No rule of thumb; 1.0 – 1.5; industry average, firm’s past year(s); the higher the better;
Signifies: ability to pay-off currently maturing obligations without undue stress.

As inventory is often the least liquid of current assets and its convertibility to cash is not in the
hands of the company, lenders sometimes wish to see a firm’s liquidity from a more
conservative perspective. In case the company cannot sell its inventory at the price and
quantity it intends to, the normal liquidity cycle (involving inventory to receivables to cash) may
be disrupted and/or get longer. From this end, an acid-test of a firm’s liquidity is considered to
be its preparedness to meet its recurring obligations from current assets that are more liquid
than inventory. Acid-test ratio gives us an indication of how much of such liquid assets are
available against every dollar of current liabilities.

Alternatively,

Like current ratio, this ratio does not have any rule of thumb as to what is an ideal quick ratio
measure. It is the industry average that a firm should strive to maintain. The firm’s own past
year(s) can be a good benchmark.

An even more conservative indicator of short-term solvency is the cash ratio, also called the
super-quick ratio, which measures the amount of only cash and cash equivalents available to
meet current liabilities.

Also called super-quick ratio

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 Net Working Capital = Current Assets - Current Liabilities

Net working capital ratio is a relative measure and hence is not affected by firm size. It is useful
for inter-firm comparison and for comparison with industry average, if need be. This ratio looks
at net working capital as a proportion to total assets of the firm and hence gives an indication
of a firm’s net working capital in relation to its own total assets and that of its peers.

Liquidity flow Measures

Sometimes creditors are interested in the absolute amount of net working capital as a measure
of short-term solvency. Because of being an absolute measure, it is only useful for intra-firm
comparison, i.e., firm’s current year value with that of the last year(s).

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Dr Wares Karim, North South University
Profitability Measures

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Dr Wares Karim, North South University
Alternatively (Penman, Chapter 11),

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Dr Wares Karim, North South University
Asset Management or Turnover Measures

Alternatively,

3330000000000000000000

Alternatively, if credit sales information not available,

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Alternatively,

Which is the same as average collection period

Alternatively,

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Dr Wares Karim, North South University
Long-Term Solvency Measures

Solvency stock measures

Alternatively,

Solvency flow measures

Also called the times interest earned.

Earnings before Interest and Taxes (EBIT) =Earnings before Taxes (EBT) + Interest
Expense

Or, EBIT = Taxable Income + Interest Expense

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Penman Chapter 9 Analysis of Profitability Ratios:

ROCE = RNOA + FLEV x SPREAD

Or, ROCE = RNOA + FLEV (RNOA – NBC)

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RNOA = ROOA + OLLEV x OLSPREAD

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Dr Wares Karim, North South University
Logit Scoring Model

Original Ohlson Model:

 Total Liabilities 
y = -1.32 - 0.407 Size  + 6.03  
 Total Assets 

 Working Capital   Current Liabilities 

-1.43   + 0.0757  Current Assets 
 Total Assets   

 Net Income   Working Capital Flow from Operations 

-2.37   - 1.83  
 Total Assets   Total Liabilities 

One if net income was negative for the last two years 
+0.285  
 Zero if net income was not negative for the last two years 

One if total liabilities exceed total assets 

-1.72  
 Zero if total liabilities do not exceed total assets 

 Change in Net Income 

-0.521  
 Sum of absolute values of current and prior years' net incomes 

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Market Value Measures

[Also called the Price-to-book (P/B) ratio]

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The Du-Pont Identity

Starting point:

Multiply the ROE equation by

That means ROE is expressed as the product of two other ratios – ROA and the
equity multiplier.

ROE = ROA x Equity multiplier = ROA x (1 + debt-Equity ratio)

We can further decompose ROE by multiplying both the denominator and the
numerator by sales.
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Rearranging the above, we find:

Or, ROE = Net Profit Margin x Assets Turnover x Equity Multiplier

The Du-Pont Identity tells us that ROE is affected by 3 things:

1. Operating efficiency (as measured by profit margin);

2. Asset utilization efficiency (as measured by total asset turnover)
3. Financial leverage (as measured by equity multiplier)

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