CHAPTER-I: INTRODUCTION

The analysis of financial statements as well as interpretation offinancial data of particular period of operation with the help ofusing ratio is termed as ratio analysis. Therefore ratio analysisis hereby used to find out the financial soundness of aparticular organization. Ratio analysis is holding variousoutcomes for stakeholder like, creditors, debtors, investors aswell mangers.  Ratio analysis is very essential to build therelationship between two accounting figures to highlight theimportant information to the management or other users so thatperfect action or decision can be taken in terms of the presentbusiness situation or the company’s financial performance to bein better position in future.

Ratio analysis facilitates the accounting information to besummarized and simplified in a required form and highlights theinterrelationship between the facts and figures of varioussegments of business. Ratio analysis helps the company to removeall types of wastage and inefficiencies.

The paper aims at analyzing the financial ratio of financialstatements of Bank companies with special reference to ExportImport Bank of Bangladesh Limited, The City Bank Limited, BankAsia Limited and Shahjalal Islami Bank Limited which have multi-billion dollar business in our country and also across the world.The primary objective is to find out about the historicalperformance and current financial condition of all banks Ltd withthe help of various ratios and thereby to offer appropriatesuggestions for the better performance of the organization. Theduration has been taken for 3 years that from the year 2009-2011.The study has great significance and will provide benefits tovarious parties who directly or indirectly interact with the bankcompanies.

RATIONALE AND SIGNIFICANCE OF THE STUDY

This paper has been prepared to give a concrete idea about theperformance and the condition or the main financial position ofbanks over three years from 2009-2011. I strongly believe thatour term paper will provide a lot analyzed information that willhelp those who want to get an overall idea of Export Import Bankof Bangladesh Limited, The City Bank Limited, Bank Asia Limitedand Shahjalal Islami Bank Limited as well as theirs financialstatement. Bank management also can be using the information ofmy observation for their managerial decision if needed. The papermay be used widely in future because the large numbers of usersare related with this field.

We can understand the significance of ratio analysis through theusers of the financial statements. They are under three heads:

Owners or investors. Creditors. Financial executives.

The importance of analysis varies materially with the purpose forwhich it is calculated. The primary information which seeks to beobtained from these statements differs considerable reflectingthe purpose that the statement is to serve. The significance ofthese ratios varies for these three groups as their purposediffers widely. These investors are mainly concerned with theearning capacity of the company whereas the creditors includingbankers and financial institutions are interesting in knowing theability of enterprise to meet its financial obligations timely.The financial executives are concerned with evolving analyticaltools that will measure and compare costs, efficiency, liquidityand profitability with a view to making intelligent decisions.

The Significance or importance of financial ratio analysis can bejudged from the following facts:

A useful tool in the hands of analyst: Ratios are exceptionallyuseful tools with which one can infer the financial performanceof the enterprise over a period of time, with the help of ratioanalysis conclusions can be drawn regarding several aspects suchas financial health profitability and operational efficiency ofthe undertaking. The financial health of the concern can be knownwith the help of different ratios. Ratios point out firm’sliquidity position to meet its short-term obligations and longterm solvency. They indicate strength and weaknesses of the firm.

Inter-Firm comparison: Ratio analysis provides inter-firmcomparison or comparison with industry averages by comparing thefirm’s ratios with those of other competitive and progressivefirms. A inter firm comparison exhibits the firms relativeposition via-a-via its competitors. If comparison shows avariance, the possible reasons of variations may be identifiedand if results are negative the corrective actions may beinitiated immediately bring them in line. It is also helpful inforewarning the corporate sickness and helps the management totake corrective action.

Trend Analysis: Ratio analysis enables a firm to take the timedimension into account. In other words, it facilitates themanagement to know whether the firm’s financial position isimproving or deteriorating or is constant over the years bysetting a trend with the help of ratios. The analyst with thehelp of ratio analysis can know the direction of movementwhether favorable or unfavorable. An analysis of the trend ofstrategic ratios may help the management in the task ofplanning, forecasting and controlling. Thus ratio analysisplays a very important role in the interpretation of the

financial statements correctly and to make the figurescomparable and more meaningful.

OBJECTIVES OF THE STUDY:

The main objective of this paper is to fulfill partialrequirements of course completion of the financial management.Here United Commercial Bank Limited, Hongkong Shanghai BankingCorporation Limited, Islami Bank Bangladesh Limited, Exim BankLimited, Shahjalal Islami Bank Limited deposits has reached in avast amount of billions balances, net profit during 2009-2011with higher growth rate in deposits and also growth rate in netprofit (pre-tax) over the year.

The large amount has been invested in different purpose toprovide industry loan, export-import finance, commercial lending,house-building finance and others. Knowing about the bank’ssignificant performance over the years our key objective is toprepare this paper.

This paper is highlighted on ratio analysis of the financialstatements of referred banks above by the year 2009-2011.

SPECIFIC OBJECTIVES OF THE STUDY

To find out or evaluate the performance of the bank overthe years through financial ratio analysis.

To forecast the financial health of the bank companiesthrough ratio analysis for several years so that itsstrengths and weaknesses can be found out.

To compare the historical performance and currentfinancial condition of the company.

To estimate the future position of the bank by comparingthe financial data across the company.

To simplify and summarize a long array of financial dataand make them understandable.

To know about the banks properly by analyzing itsfinancial statements through over years from 2009-2011.

To offer appropriate suggestions for the betterperformance of the organization.

To provide information especially to the stockholdersbecause they are life of the company.

FUTURE SCOPE OF THE STUDY

Financial ratio analysis is a useful tool for users of financialstatement. It may have some scope in variety of ways for varioususers, persons or groups.

The study will analyze the financial statements in Banksector companies through the ratio analysis which willcontribute further to management of the industry as well asvarious other concerned parties.

The study will also contribute to other interested partiesand stock holders as a better management of financialstatements and its analysis leads to improvement inperformance and profitability.

The study can also be helpful to other similar organizationand industries and enterprises as a whole as well foranalyzing their financial statements and its interpretationsthrough ratio analysis.

The most important aspect and contribution of the study willbe to identify the reasons of the solvency, liquidity andfinancial performance of the companies by the application offinancial statement analysis across ratio analysis.

The financial ratio analysis will simplify the financialstatements for their users.

The financial Ratio analysis will provide a meaningfulcomparison of companies in different size with each other infuture.

It will help in trend analysis which involves comparing asingle company over a period.

It will provide ready information on profitability,activity, liquidity and debt utility of a company’s pastoperations.

It will highlight important information in simple formquickly. A user will be able to judge a company by justlooking at few numbers instead of reading the wholefinancial statements.

The financial ratio analysis will intend to know the reasonsbehind Bank’s pitfalls of performance over years that might lead the concerned company to overcome the limitations or problems for catching better position in future.

LIMITATIONS OF THE STUDY

The paper has focused mainly on Balance sheets and Incomestatements of selected banks to find out the overall performanceof the bank companies. Although financial statements analysiswith ratios is a highly useful tool but financial ratio analysismay not express accurate financial features for some reasons. Wehave found some difficulties which has been confused us tocompare the ratios of statements through several years or to makefinal decision for further actions to the different purposes.

Financial ratio analysis is one of the most popular financialanalysis techniques for companies and particularly smallcompanies. Ratio analysis provides business owners withinformation on trends within their own company, often calledtrend or time-series analysis, and trends within their industry,called industry or cross-sectional analysis. There are otherfinancial analysis techniques to determine the financial healthof their company besides ratio analysis, with one example beingcommon size financial statement analysis. These techniques fill

in the gaps left by the limitations of ratio analysis discussedbelow.

Benchmark to industry leaders' ratios, not industry averages

This may be contrary to everything we have ever learned. But,think about it. Do we want high performance for our company? Ordo we want average performance? I think all business owners knowthe answer to that one. We all want high performance. Sobenchmark our firm's financial ratios to those of high performingfirms in our industry and we will shoot for a higher goal. As fora limitation of ratio analysis, the only limitation is if we useaverage ratios instead of the ratios of high performance firms inour industry.

Companies' balance sheets are distorted by Inflation

Ever wonder why we always hear that balance sheets only showhistorical data? This is why. A balance sheet is a statement of afirm's financial condition at a point in time. So, looking backon a balance sheet, we see historical data. Inflation may haveoccurred since that data was gathered and the figures may bedistorted.

Reported values on balance sheets are often different from "real"values. Inflation affects inventory values and depreciation,profits are affected. If we try to compare balance sheetinformation from two different time periods and inflation hasplayed a role, then there may be distortion in our ratios.

Ratio analysis just gives us numbers, not causation factors

We can calculate all the ratios we can find from now untildoomsday. Unless we try to find the cause of the numbers we comeup with, we are playing a useless game. Ratios are meaninglesswithout comparison against trend data or industry data. Ratios

are also meaningless unless we take the limitations listed inthis article into account.

Different divisions may need comparison to different industryaverages

Very large companies may be composed of different divisionsmanufacturing different products or offering different services.To make ratio analysis mean something, different industryaverages may need to be used for each different division. Theratio analysis, used in this way, will certainly be more accuratethan if we tried to do a ratio analysis for this type of largecompany. Such factors are so significant that a comparison of twocompanies from different industries might be misleading.

Companies choose different accounting practices

Financial accounting information is affected by estimates andassumptions. Accounting standards allow different accountingpolicies, which impairs comparability and hence ratio analysis isless useful in such situations. Another issue is depreciation.Different companies use different depreciation methods. The useof different depreciation methods affects companies' financialstatements differently and won't lead to valid comparisons.

Companies can use window dressing to manipulate their financialstatements

Ratio analysis is based entirely on the data found in businessfirms' financial statements. If the financial statements for acompany are not quite as good as they should be and a companywould like better numbers to show up in an annual report, thecompany may use window dressing to manipulate the data in thefinancial statements. Bear in mind - this is completely againstthe concept of financial and business ethics and flies in theface of corporate governance.

What exactly is window dressing? The company will perform somesort of transaction at the end of its fiscal year that willimpact its financial statements and make them look better but isthen taken care of as soon as the new fiscal year starts. That isthe simplest form of window dressing.

We can see that if ratio analysis is used with knowledge andintelligence and not in a mechanical and unthinking manner (likejust cranking out the numbers), it can be a very valuable toolfor financial analysis for the business owner. Its limitationshave to be keeping in mind but they should be more or lessintuitive to a savvy business owner.

Other reasons:

This topic is generally given as thesis work because it

takes too much time where thousands calculation is

concerned. We have enjoyed it to complete but could not

bring perfection for lack of time.

For the referred period, some data (financial

statements) has been collected from Islamia Market

Nilket, in case of unavailability of data in the

companies or in stock exchange and also to the websites

of the companies which may contain wrong information

that can affect to the decision misleading.

This paper is typed in Nilket Islamia Market and there

some error may be arisen at the time of typing.

Ratio analysis of financial statement becomes less

effective due to price level changes.

It may be misleading in the absence of absolute data.

There is a limited use of a single data.

There are lacks of standardization.

False financial accounting data gives false ratio.

Ratios alone are not adequate for proper conclusions.

Seasonality affects ratios.

Sometimes it’s difficult to interpret deviations in

ratios

METHODOLOGY OF THE STUDY

Analysis Design

Analysis is a careful inquiry or examination to find newinformation or relationship and to expand and verify existingknowledge. Therefore, we have used descriptive analysis in thisstudy because it will ensure the minimization of bias andmaximization of reliability of data collected.

Data Collection

The information is collected through primary and secondarysources during the analysis which is utilized for calculatingperformance evaluation later and based on that decisions aremade.

Sources of Primary Data

The information and data (finanacial statements) has beencollected through formal and informal discussion with theofficers of accounts department of the company on the basisof needs.

The relevant file study provided by the officers concerned.

.Sources of Secondary Data

Most of the calculations are made on the financial

statements of the company provided statements like published

annual reports, financial reports, company’s websites etc.

Referring standard texts and referred books are concerned to

collect some of the information regarding theoretical

aspects.

Official websites of different related companies.

Various websites of Financial company

Banks newsletter

Various national and international journals closely working

with finance, accounting, management and economics.

Various publications of the Bangladesh Bank

Other manual information

SYSTEMATIC SAMPLING DESIGN

Population: Fifty five bank companies including private andpublic. Sample: EXIMBBL, TCBL, BAL and SIBL.

DATA ANALYSIS AND INTERPRETATION

Annual financial statements including balance sheets, profitand loss account, changes in owners’ equity, and cash flows

statement have been analyzed with the application of ratio analysis.

Graphical and tabular presentations of the collected data are done to show the financial position of the company.

The data analysis is done using various activity, solvency,and liquidity and profitability ratios.

CHAPTER II: REVIEW OF LITERATURE Ratios are used in much of our daily life. We buy cars based onmiles per gallon; we evaluate baseball players by earned run andbatting averages, basketball players by field goal and foulshooting percentages, and so on. These all are ratios constructedto judge comparative performance. Financial ratios serve asimilar purpose, but we must know what is being measured toconstruct a ratio and to understand the significance of theresultant number.

Financial ratio analysis involves the calculation and comparisonof ratios which are derived from the information given in thecompany’s financial statement. The historical trends of theseratios can be used to make inferences about the company’sfinancial condition, its operations and its investmentattractiveness.

Unlike in the past when security was considered to be sufficientconsideration for banks and financial institutions to grant loansand advances, nowadays the entire lending is need-based and theemphasis is on the financial viability of a proposal and not onlyon security alone.

Further all business decision contains an element of risk. Therisk is more in the case of decisions relating to credits. Ratioanalysis and other quantitative techniques facilitate assessmentof this risk.

It’s a tool which enables the banker or lender to arrive at thefollowing factors:

Liquidity position

Profitability

Solvency

Financial Stability

Quality of the Management

Safety & Security of the loans & advances to be or alreadybeen provided

Before looking at the ratios there are a number of cautionarypoints concerning their use that need to be identified:

The dates and duration of the financial statements beingcompared should be the same. If not, the effects ofseasonality may cause erroneous conclusions to be drawn.

The accounts to be compared should have been prepared on thesame bases. Different treatment of stocks or depreciationsor asset valuations will distort the results.

In order to judge the overall performance of the firm a group of ratios, as opposed to just one or two should be used. In order to identify trends at least three years of ratios are normally required.

Method of Expression of Ratio:

How a Ratio is expressed? It may be as follows:

As Percentage - such as 25% or 50%. For example if netprofit is Tk.25, 000/- and the sales is Tk.1, 00,000/- thenthe net profit can be said to be 25% of the sales.

As Proportion - The above figures may be expressed in termsof the relationship between net profits to sales as 1: 4.

As Pure Number /Times - The same can also be expressed in analternatively way such as the sale is 4 times of the netprofit or profit is 1/4th of the sales.

To understand the banking activities, we have selected the ExportImport Bank of Bangladesh Limited, Trust Bank Limited, The CityBank Limited, Bank Asia Limited and Shahjalal Islami Bank Limitedto analyze on financial statements for evaluating theirperformance through the years of 2009-2011.

CHAPTER-II: THEORITICAL FRAMEWORK

2.1 Definition of financial statementRecords that outline the financial activities of a business, anindividual or any other entity. Financial statements are meant topresent the financial information of the entity in question asclearly and concisely as possible for both the entity and forreaders. Financial statements for businesses usually include:income statements, balance sheet, statements of retained earningsand cash flows, as well as other possible statements. It is astandard practice for businesses to present financial statementsthat adhere to generally accepted accounting principles (GAAP),to maintain continuity of information and presentation acrossinternational borders. As well, financial statements are oftenaudited by government agencies, accountants, firms, etc. toensure accuracy and for tax, financing or investing purposes.Financial statements are integral to ensuring accurate and honestaccounting for businesses and individuals alike.In Other wordFinancial statements are reports that show how income andexpenses have affected the company as a whole. They provide a

snapshot of the current financial standing of the business. Thereare many types of financial reports, but the three basic,essential financial statements are:

1. Balance Sheet: Summarizes the assets, liabilities, and networth (owners' equity) of a business on a particular date.

2. Income Statement: (Also called Profit and Loss Statement.)An accounting statement that shows the profit or loss for abusiness, by subtracting costs from its earnings, over aspecific period of time, typically for a quarter or year.

3. Cash Flow Statement: An accounting statement that forecastscash receipts and disbursements for a specified period.

A fourth financial statement commonly produced is the Statementof Retained Earnings.

This is a written report which quantitatively describes thefinancial health of a company. This includes an income statementand a balance sheet, and often also includes a cash flowstatement. Financial statements are usually compiled on aquarterly and annual basis.

Main Components of Financial Statements:

Balance Sheet

A balance sheet is a summary of the state of a business'financial situation at a specific point in time.

The balance sheet includes:

Assets Liabilities Net Worth (Owner's Equity)

The first part of a balance sheet shows all the productive assetsa company owns, and the second part shows all the financingmethods (such as liabilities and shareholders' equity).

There are three basic financial statements: Profit and LossStatement (also known as the Income Statement); Cash FlowStatement, and the Balance Sheet. Of these three financialstatements, the balance sheet is the only one that shows a"financial snapshot" for a specific point (date) in time.

A fourth financial statement commonly produced is the Statementof Retained Earnings.

Asset

In accounting terms, assets refer to the economic value portionof a corporation, or that is owned by an individual(s). Assetsgenerally refer to value of things that can be converted to cash.

Examples of assets include:

Accounts Receivables Cash Inventory and Physical Stock Property (i.e., office equipment, vehicles, real estate, art

and other collections, etc.) Securities

Assets are listed on the company's balance sheet are calculatedin the following manner:

Assets = Common Stock + Preferred Stock + Liabilities + RetainedEarnings

Assets are subdivided into the following categories:

Current assets (cash and other liquid items);

Intangible Assets (Trademarks, Patents, Copyrights, andGoodwill).

Long-Term Assets (real estate, plant, equipment); and Prepaid and Deferred Assets (expenditures for future costs

such as insurance, rent, interest).

Liabilities

"Liabilities" is the plural of "liability."

In accounting terms, a liability is a debt or obligation that acompany must pay.

Liabilities are recorded on a company's balance sheet and caninclude accounts payable, taxes, wages, accrued expenses, anddeferred revenues.

Current Liabilities

In accounting terms, current liabilities are debts andobligations that a company must pay in the short-term (within thenext twelve months.)

Liabilities, including current liabilities are listed on thebalance sheet.

Also Known As: Current Debt, Short-Term Liabilities, Payables

Long-Term Liabilities

Long-term liabilities are a category of debts (assigned using aChart of Accounts) that appear on the company's balance sheet.

Long-term liabilities differ from current liabilities becausethey are debts that do not need to be repaid in the current year.

Long-term liabilities are debts that will be repaid in the nextyear, or longer.

Owners' Equity, Also Known as Net Worth Owners' Equity is the combined investments of the owner(s) andthe accumulation of profit or losses for the business since itbegan.

Owner's Equity (Net Worth) is expressed in the followingaccounting formula:

Net Worth = Assets - Liabilities

Also Known As:- Net Worth, Owner's Capital, Net Assets,Shareholders' Equity, or Shareholders' Funds.

Alternate Spellings: Owner's Equity

Income Statement Contains:

An accounting statement that shows the profit or loss for abusiness, by subtracting costs from its earnings, over a specificperiod of time, typically for a quarter or year

Net Sales: - Net Sales appearing in the Income Statement is thesum of the Invoice price of the goods sold and services renderedduring the period. Sales Inward represents the invoice value ofthe goods rendered by the customers. Excise duty refers to theamount paid to the government.

Cost of Goods Sold:- Cost of Goods sold is the sum of the costsincurred for manufacturing and procuring the goods sold duringthe accounting period. It consists of direct material cost,direct labor cost, and factory overheads. It should bedistinguished from cost of production. The latter represents thecost of the goods produced in the accounting year.

Gross Profit: - is the difference between net sales and the costof the goods sold.

Operating Expenses: - Operating Expenses is the differencebetween gross profit and the operating expenses and depreciation.

Operating Profit: - Operating Profit is the difference betweengross profit and operating expenses. As a measure of profit itreflects operating performance and is not affected by non-operating gains/losses, financial leverage and the tax factor.

Non Operating Surplus: - Non Operating Surplus represents gainsarising from sources other than normal operations of thebusiness. Its major components are incomes from investments andgains from disposal of assets.

Earnings before Interest and Taxes (EBIT): - EBIT is the sum ofoperating profit and non-operating surplus/deficit. Referred toalso as earnings before Interest and Taxes, this represents ameasure of profits which is not influenced by financial leverageand the tax factor. Hence, it is pre-eminently suited for inter-firm comparison.

Interest: - is the expense incurred on borrowed funds such asterm loans, debentures, public deposits and working capitaladvances.

Profit before tax: This is obtained by deducting interest fromprofits before Interest and Taxes. Tax means income tax expensefor the year.

Profit after Tax: This is the difference between Profit beforeTax and the Tax for the year.

Dividends: This represents the amount earmarked for distributionto shareholders

Retained Earnings: -This represents the difference between profitafter tax and dividends

Also Known As: Profit and Loss Statement

Examples:

My income statement for last year starts out with a summary of mysales revenues and then deducts my costs of doing business in order to arrive at a figure for my net income.

Cash Flow Statement An accounting statement that forecasts cash receipts anddisbursements for a specified period. The statement is used forplanning purposes to determine if a business will need to borrowmoney in order to maintain its operations during times of heavyexpenses or low sales. It is often accompanied by a graph orchart to represent the data at a glance.Also Known As: Statement of Cash Flows

Examples:

Without a cash flow statement a home business operator may runout of money to pay bills during times of the year when sales canbe expected to slow.

Statement of Retained Earnings:

The Statement of Retained Earnings is the second financialstatement that should be prepared in the accounting cycle afterthe income statement. Retained earnings are the portion of netincome not paid out to investors in the business as dividends.Retained earnings are reinvested in the business firm.

The Statement of Retained Earnings explains the change in theretained earnings account and in dividends over a period of time.Retained earnings are the amount of income left in the companyafter dividends are paid. This income is reinvested in the firmfor various projects. Here is an example of a statement.

1. Prepare the Heading for the Statement of Retained Earnings

A Statement of Retained Earnings should have a three-line header.The first line is the name of the company. The second line issimply, "Statement of Retained Earnings." The third line is "Forthe Year Ended XXXXX." For the word "year," any accounting timeperiod can be entered.

2. State the Balance of Retained Earnings from the Prior Year

The first item on the Statement of Retained Earnings should bethe balance of retained earnings from the prior year. This comesfrom the prior year's balance sheet. Let's say that the balanceof retained earnings for our hypothetical firm is $20,000. Thefirst line for the Statement of Retained Earnings would look likethis:

Retained Earnings, December 31, 2008 $20,000

3. Add Net Income from the Income Statement

The Statement of Retained Earnings should be the second financialstatement prepared. The Income Statement is the first financialstatement prepared. Let's say that net income from thehypothetical company is $10,000. That is the first item addedinto the Statement of Retained Earnings. Our retained earningsstatement is now going to look like this:

Retained Earnings: December 31,2008 $20,000 Plus: Net Income 2009 +10,000 Total $30,000

If the company has a net loss on the Income Statement, then thenet loss is subtracted from the existing retained earnings.

4. Subtract Dividends that your Company Pays out to Investors

Does your company pay dividends? If it does, you subtract theamount of dividends your company pays out of net income. If itdoes not, then you subtract $0. Let's say your company's dividendpolicy is to pay 50 percent of its net income out to itsinvestors. In this example, $5000 would be paid out as dividendsand subtracted from the current total.

Retained Earnings, December 31, 2008 $20,000 Plus: Net Income 2009 +10,000 Total $30,000 Minus: Dividends (5,000)

5. Prepare the Final Total for Retained Earnings for 2009

Subtract out the dividends, if you pay dividends, and total theStatement of Retained Earnings. This is the amount of retainedearnings that you post to the retained earnings account on yournew 2009 balance sheet.

Retained Earnings, December 31, 2008 $20,000 Plus: Net Income 2009 $10,000 Total: $30,000 Minus: Dividends Paid ($5,000) Retained Earnings, December 31, 2009 $25,000

This completes the Statement of Retained Earnings.

What are Retained Earnings?

Retained earnings are the portion of net income or net profit,taken from the income statement, that are not paid out asdividends, These earnings are reinvested in the company or usedfor some purpose by the company.

Retained earnings are used to improve the company throughinvestment in research and development, investment in plant andequipment, paying off debt, and other programs.

Retained earnings are cumulative. They represent past as well aspresent earnings of the firm that have been reinvested in thefirm. The retained earnings account under the Shareholder'sEquity section of the balance sheet shows the retained earningssince the inception of the company. Retained earnings arecumulative revenues from undistributed profits.

Also Known As: accumulated earnings, earnings surplus,inappropriate profit

Alternate Spellings: none

Common Misspellings: none

Examples:

XYZ Corporation retained 60 percent of its net income for itsretained earnings account and paid out 40 percent of its netincome as dividends to its shareholders.

Dividend

The dividend a corporation pays is the amount of money, normallya portion of the profits, a board of directors distributes to theordinary shareholders of the corporation. Suppose a company hasone million shares outstanding, and it decides to distribute 2million dollars to its shareholders. Then the dividend per shareis $2 (2 million dollars divided by one million shares).

CLASSIFICATIONS OF FINANCIAL RATIOS

A tool used by individuals to conduct a quantitative analysis ofinformation in a company's financial statements. Ratios arecalculated from current year numbers and are then compared to

previous years, other companies, the industry, or even theeconomy to judge the performance of the company. Ratio analysisis predominately used by proponents of fundamental analysis.There are many ratios that can be calculated from the financialstatements pertaining to a company's performance, activity,financing and liquidity. Some common ratios include the price-earnings ratio, debt-equity ratio, earnings per share, assetturnover and working capital.

In other words financial ratio analysis involves the calculationand comparison of ratios which are derived from the informationgiven in the company's financial statements. The historicaltrends of these ratios can be used to make inferences about acompany's financial condition, its operations and its-investment-attractiveness. Financial ratio analysis groups the ratios intocategories that tell us about the different facets of a company'sfinancial state of affairs. Some of the categories of ratios aredescribed below:

Asset Utilization Ratios Show how efficient a company'soperations and how well it is using its assets.

Debt Utilization Ratios/Leverage/Capital StructureRatios show the quantum of debt in a company's capitalstructure.

Profitability Ratios use margin analysis and show the returnon sales and capital employed.

Liquidity Ratios give a picture of a company's short termfinancial situation or solvency.

Valuation Ratios show the performance of a company in thecapital market.

ACTIVITY OR EFFICIENCY OR ASSET UTILIZATION RATIOS:

These ratios determine how quickly certain current assets can beconverted into cash. Asset management or Activity or AssetUtilization ratios are the key to analyzing how effectively andefficiency our business is managing to its assets to producesales. Asset management ratios are also called turnover ratios orefficiency ratios. If we have too much investment in ourcompany's assets, our operating capital will be too high. If wedon't have enough investment in assets, we will lose sales andthat will hurt our profitability, free cash flow, and stockprice.

We, as the owner of business, have the task of determining theright amount to invest in each of our asset accounts. We do thatby comparing our firm to other companies in our industry and seehow much they have invested in asset accounts. We also keep track

Asset Utilization

Ratios Inventory turnover Receiveable turn- overFixed asset turn-overTotal asset turn-over Payable turnoverAverage collection period/ Days sales outstanding

Liquidity Ratios

Current ratioQuick or Acid-test ratioCash ratio

Profitability Ratios

Gross profit margin Net margin Return on asset Return on equityEarning per Share

Debt Utilization

RatiosDebt to assetDebt to equityTime interest earnedFixed charge coverage

of how much we have invested in our asset accounts from year toyear and see what works.

Stock/Inventory Turnover Ratio

The inventory turnover ratio is one of the most important assetmanagement or turnover ratios. If our firm sales physicalproducts, it is the most important ratio. Inventory turnover iscalculated as follows: The average of inventories at thebeginning and at the end of the year is taken. In generalaverages may be used when a flow figure (in this case – cost ofgoods sold) is related to a stock figure (inventories).

A ratio showing how many times a company's inventory is sold and replaced over a period. The days in the period can then be divided by the inventory turnover formula to calculate the days it takes to sell the inventory on hand or "inventory turnover days."

Although the first calculation is more frequently used, COGS (cost of goods sold) may be substituted because sales are recorded at market value, while inventories are usually recorded at cost. Also, average inventory may be used instead of the ending inventory level to minimize seasonal factors.

This ratio should be compared against industry averages. A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective buying.

High inventory levels are unhealthy because they represent an investment with a rate of return of zero. It also opens the company up to trouble should prices begin to fall.

Things to Remember

A low turnover is usually a bad sign because products tend to deteriorate as they sit in a warehouse.

Companies selling perishable items have very high turnover

For more accurate inventory turnover figures, the

average inventory figure, ((beginning inventory + ending inventory)/2), is used when computing inventoryturnover. Average inventory accounts for any seasonality effects on the ratio.

In addition, this means that we divide net sales, from the incomestatement, from the inventory figure on the balance sheet and weget a number that is a number of times. That number signifies thenumber of times the inventory is sold and replaced during theaccounting period. If the number is high, we may be in danger ofstock outs. If it is low, watch out for obsolete inventory.However a high inventory turnover may also result from a lawlevel of inventory which may lead to frequent stock outs, loss ofsales and customer goodwill.

Average Collection Period/Days Sales Outstanding

Average collection period is also called Days' Sales Outstandingor Days' Sales in Receivables. It measures the number of days ittakes a company to collect its credit accounts from itscustomers. A lower number of days are better because this meansthat the company gets its money more quickly. Average collectionperiod varies from industry to industry, however. It is important

that a company compare its average collection period to otherfirms in its industry.

Here is the calculation for Average Collection Period:

ACP= Accounts Receivable/Credit Sales/365 = # Days

The ACP can be compared to the firm’s credit terms to judge theefficiency of credit management. For example: If the credit termsare 2/10, net 45 and ACP of 85 days means that the collection isslow and an ACP of 40 days means the collection is prompt. Thesales figure comes from the income statement and the accountsreceivable comes from the balance sheet.

Debtors /Receivables Turnover Ratio

Receivables turnover is a ratio that works hand in hand withaverage collection period to give the business owner a completepicture of the state of the accounts receivable. Receivablesturnover looks at how fast we collect on our sales or, onaverage, how many times each year we clean up or totally collectour accounts receivable. The calculation is as follows:

RTR or DTR = Net credit Sales/Average Accounts Receivable orDebtors turnover = ____ times

It measures the liquidity of a firm’s debt. Net credit sales arethe gross credit sales minus returns, if any, from customers.Average debtors are the average of debtors from the beginning ofthe year and at the end of the year. Actually it ratio shows howrapidly debts are collected. Generally, the higher thereceivables turnover, the better as it means we are collectingour credit accounts on a timely basis. If our receivablesturnover is low, we need to take a look at our credit andcollections policy and be sure they are on target.

Accounts payable turnover ratio

Accounts payable turnover is the ratio of net credit purchases ofa business to its average accounts payable during the period. Itmeasures short term liquidity of business since it shows how manytimes during a period, an amount equal to average accountspayable is paid to suppliers by a business.

Formula:

Accounts payable turnover is usually calculated as:

APTR = Net Credit Purchases/ Average Accounts Payable

To calculate average accounts payable, divide the sum of accountspayable at the beginning and at the end of the period by 2. Netcredit purchases figure in the denominator is not easilydiscoverable since such information is not usually available infinancial statements. It is to be search for in the annual reportof the company. Sometimes cost of goods sold is used in thedenominator instead of credit purchases.

Analysis of payable ratio

Accounts payable turnover is a measure of short-term liquidity. Ahigher value indicates that the business was able to repay itssuppliers quickly. Thus higher value of accounts payable turnoveris favorable. This ratio can be of great importance to supplierssince they are interested in getting paid early for theirsupplies. Other things equal, a supplier should prefer to sell toa company with higher accounts payable turnover ratio.

Examples

Example 1: Company γ sold goods having invoice value of $243,200on credit during the year ended Dec 31, 2010. Its customersreturned goods invoice at $5,900. Accounts payable of the company

on Jan 1, 2010 and Dec 31, 2011 were $23,000 and $34,900respectively. Calculate its accounts payable ratio.

SolutionNet-Credit-Sales-=-$243,200-−-$5,900-=-$237,300Average-Accounts-Payable-=-(-$23,000-+-$34,900-)-/-2-=-$28,950Accounts Payable Turnover Ratio = $237,300 / $28,950 ≈ 8.2

Fixed Asset Turnover Ratio

The fixed asset turnover ratio looks at how efficiently thecompany uses its fixed assets, like plant and equipment, togenerate sales. If we can't use our fixed assets to generatesales, we are losing money because we have those fixed assets.Property, plant, and equipment are expensive to buy and maintain.In order to be effective and efficient, those assets must be usedas well as possible to generate sales. The fixed asset turnoverratio is an important asset management ratio because it helps thebusiness owner measure the efficiency of the firm's plant andequipment.

Here is the calculation for fixed asset turnover:

FATR= Net Sales/Average Net Fixed Assets = _____ times

Usually, the higher number of times, the better the company.However, if the ratio is too high, our equipment is probablybreaking down because we are operating over capacity. If thenumber of times is too low as compared to the industry or toprevious years of firm data, then our firm is not operating up tocapacity and our plant and equipment is likely sitting idle.However this ratio should be used with caution because when thefixed asset of a firm is old and substantially depreciated, thefixed assets turnover ratio trends to be high (because thedenominator of the ratio is very low.)

Total Asset Turnover

The total asset turnover ratio is the asset management ratio thatis the summary ratio for all the other asset management ratioscovered in this article. If there is a problem with inventory,receivables, working capital, or fixed assets, it will show up inthe total asset turnover ratio. The total asset turnover ratioshows how efficiently our assets, in total, generate sales. Thehigher the total asset turnover ratio, the better and the moreefficiently we use asset base to generate sales.

Here is the calculation: TAT = Sales/Total Assets = _____ times

When we analyze the asset management ratios, we can look at ourtotal asset turnover ratio and if there is a problem, can be goneback to other asset management ratios and isolate the problem.Knowing the position regarding the efficiency of using assets tomake sales is crucial to the success of the firm.

Net Working Capital Turnover

The net working capital turnover ratio is an asset managementratio that is a "big picture" ratio. It measures how hard ourworking capital is "working" for the firm. Working capital iswhat you have left over after the company pays its short-termdebt obligations. Generally, the higher value of the ratio, thebetter is company. The calculation is as follows:

Net Working Capital Turnover = Sales/Net Working Capital

Days' Sales in Inventory

The Days' Sales in Inventory ratio tells the business owner howmany days, on average, it takes to sell inventory. The usual ruleis that the lower the DSI is, the better, since it is better tohave inventory sell quickly than to have it sit on shelves.

If we can know company's inventory turnover ratio, we will beable quickly to calculate the Days' Sales in Inventory ratio.This quick formula for calculating this ratio is the following:

Days' Sales in Inventory = 365 days/Inventory turnover = ____Days

If there is not the inventory turnover ratio, there is anotherformula can be used to calculate Days' Sales in Inventory:

Days' Sales in Inventory = Inventory/Cost of Goods Sold X 365 =_____ Days

The value of inventory will come from latest balance sheet. Thecost of goods sold is taken from the income statement. This ratiomeasures the company's financial performance for both the ownersand the managers as it pertains to the turnover of inventory.Inventory turnover varies from industry to industry. Generally, alower number of days' sales in inventory are better than a highernumber of days. It will vary from industry to industry.

PROFITABILITY RATIOS

Every firm is most concerned with its profitability. One of themost frequently used tools of financial ratio analysis isprofitability ratios which are used to determine the company'sbottom line and its return to its investors. Profitabilitymeasures are important to company managers and owners alike. If asmall business has outside investors who have put their own moneyinto the company, the primary owner certainly has to showprofitability to those equity investors.

Profitability ratios show a company's overall efficiency andperformance. We can divide profitability ratios into two types:margins and returns. Ratios that show margins represent the

firm's ability to translate sales dollars into profits at variousstages of measurement. Ratios that show returns represent thefirm's ability to measure the overall efficiency of the firm ingenerating returns for its shareholders.

There are two types of profitability ratios:

Profitability ratios in relation to sales and Profitability ratios in relation to investments

Profitability ratios in relation to sales

Gross Profit Margin

The ratio shows the profit that remains after the manufacturingcosts have been met. The gross profit margin looks at cost ofgoods sold as a percentage of sales. This is a ratio looks at howwell a company controls the cost of its inventory and themanufacturing of its products and subsequently pass on the coststo its customers. The larger the gross profit margin, the betterfor the company. Actually it measures the efficiency ofproduction as well as pricing.

The calculation is: GPM= Gross Profit/Net Sales = ____%. Bothterms of the equation come from the company's income statement.(Gross profit= Sales – Cost of goods sold)

Net Profit Margin

When doing a simple profitability ratio analysis, net profitmargin is the most often margin ratio used. The net profit marginshows how much of each sales dollar shows up as net income afterall expenses are paid. For example, if the net profit margin is5%, which means that 5 cents of every dollar is profit.

The ratio shows net earnings (to be distributed to both equityand preference share holder) as a percentages of net sales. The

net profit margin measures the overall efficiency of production,administration, selling, financing, pricing and tax management.Jointly considered, the gross and net profit margin ratiosprovide an understanding of the cost and profit structure of afirm.

The calculation is: Net Profit Margin= Net Income or Netprofit/Net Sales = _____%. Both terms of the equation come fromthe income statement.

Profitability ratios in relation to investments

These ratios measure the relationship between the profits andinvestments of a firm. There are three such ratios as follows:

Return on assets (ROA) Return on capital employed ( ROCE) Return on shareholder’s equity

Return on assets (ROA)

The Return on Assets ratio is an important profitability ratiobecause it measures the efficiency with which the company ismanaging its investment in assets and using them to generateprofit. It measures the amount of profit earned relative to thefirm's level of investment in total assets. The return on assetsratio is related to the asset management category of financialratios. The higher percentage betters the company that means isdoing a good job using its assets to generate sales. Net Incomeis taken from the income statement and total assets are takenfrom the balance sheet.

The calculation for the return on assets ratio is: NetIncome/Total Assets = _____% or ROA= EAT + Interest - Taxadvantage on Interest/Average Total Asset.

Return on capital employed (ROCE)

Capital employed refers to the long term funds invested by thecreditors and the owners of a firm. It is the sum of long termliabilities and owner’s equity. ROCE indicates the efficiencywith which the long term funds of a firm are utilized. It iscomputed by the formula as follows:

ROCE= (EBIT/Average Total Capital Employed) x 100

Return on shareholder’s equity

This ratio measures the return on shareholders’ funds. It can becalculated by following way:

Rate of return on total shareholders’ equity Rate of return on ordinary shareholder’s Earnings per share Dividends per share Dividend pay-out ratio Earnings and dividend yield.

Return on total shareholder’s equity

The total shareholders’ equity consists of preference sharecapital, ordinary share capital consisting of equity sharecapital, share premium, reserves and surplus less accumulatedlosses.

RTSE Or RSE = (Net profit after taxes) x 100/ Average totalshareholders’ equity.

Return on ordinary shareholder’s equity

ROSE= (Net profit after taxes – preference dividend x 100/ NetWorth

Earnings per share

Though there are some limitation of this ratio, it is very usefulin case of calculating the earning yield, dividend payout, thestandard of financial leverage in the exchange of differentcondition, Determination of market price of share, decisionmaking for capital structure.

EPS measures the profit available to the equity shareholders oneach share held. It is calculated by using following formula:

EPS= Net profits available to equity shareholders / Number ofordinary shares outstanding

Dividends per share

DPS shows how much is paid as dividend to the shareholders oneach share held.

The formula for calculating dividends per share:

DPS= Dividend paid to ordinary shareholders/ Number of ordinaryshares outstanding

Dividend pay-out ratio (D/P ratio)

Dividend pay-out ratio shows percentage share of net profitsafter taxes and after preference dividend has been paid to thepreference equity holders.

D/P ratio: Dividend per share (DPS)/Earnings per share x 100

Earnings and dividend yield

Earning yield is also known as earning price ratio and isexpressed in terms of the market value per share.

Earning yield= EPS / Market value per share x100

Dividend yield is expressed in terms of the market value pershare.

Dividend yield = DPS / Market value per share x100

There are some ratios used widely in the ratio analysis offinancial statements. They are as follows:

Operating Profit Margin

Operating profit is also known as EBIT and is found on thecompany's income statement. EBIT is earnings before interest andtaxes. The operating profit margin looks at EBIT as a percentageof sales. The operating profit margin ratio is a measure ofoverall operating efficiency, incorporating all of the expensesof ordinary, daily business activity. Both terms of the equationcome from the company's income statement.

The calculation is: EBIT/Net Sales = _____%.

Cash Flow Margin

The Cash Flow Margin ratio is an important ratio as it expressesthe relationship between cash generated from operations andsales. The company needs cash to pay dividends, suppliers,service debt, and invest in new capital assets, so cash is justas important as profit to a business firm.

The Cash Flow Margin ratio measures the ability of a firm totranslate sales into cash. The numerator of the equation comesfrom the firm's Statement of Cash Flows. The denominator comes

from the Income Statement. The larger the percentage, the betterthe company.

The calculation is: Cash flow from operating cash flows/Netsales = _____%.

Cash Return on Assets

The cash return on assets ratio is generally used only in moreadvanced profitability ratio analysis. It is used as a comparisonto return on assets since it is a cash comparison to this ratioas return on assets is stated on an accrual basis. Cash isrequired for future investments. The numerator is taken from theStatement of Cash Flows and the denominator from the balancesheet. The higher the percentage betters the company.

The calculation is: Cash flow from operating activities/TotalAssets = _____%.

AT A GLANCE ALL PROFITABILITY RATIOS:

Profitability ratios are those which measure the profitability ofthe company in relation to the sales or investments it has madeduring an accounting year. Here is list of profitability ratios –

Gross profit margin ratio – Gross profit/Net sales x100 Operating Profit Margin ratio – Operating profit/Net sales x

100, where operating profit is (gross profit – operatingcost)

Net Profit ratio – Net profit/ Net sales x 100 Return on capital employed – Net profit/Capital employed x

100 Return on Equity – Profit after tax – preference

dividend/Equity shareholders fund x 100 Return on Total Assets – Profit after tax or EBIT/Total

Assets x 100

Contribution Margin Ratio – (sales – variable costs)/sales Cash Return on Assets- Cash flow from operating

activities/Total Assets = _____%. Cash Flow Margin- Cash flow from operating cash flows/Net

sales = _____%.

LIQUIDITY RATIOS

Liquidity refers to the ability of a firm to meet its short-term(usually up to 1 year) obligations. The ratios which indicate theliquidity of a company are Current ratio, Quick/Acid-Test ratio,and Cash ratio. These ratios are discussed below.

Current ratio

The two basic components of this ratio are current assets andcurrent liabilities. Current assets include cash and those assetswhich can be easily converted into cash within a short period oftime, generally, one year, such as marketable securities orreadily realizable investments, bills receivables, sundrydebtors, (excluding bad debts or provisions), inventories, workin progress, etc. Prepaid expenses should also be included incurrent assets because they represent payments made in advancewhich will not have to be paid in near future.

Current liabilities are those obligations which are payablewithin a short period of tie generally one year and includeoutstanding expenses, bills payable, sundry creditors, bankoverdraft, accrued expenses, short term advances, income taxpayable, dividend payable, etc. However, sometimes a controversyarises that whether overdraft should be regarded as currentliability or not. Often an arrangement with a bank may beregarded as permanent and therefore, it may be treated as longterm liability. At the same time the fact remains that theoverdraft facility may be cancelled at any time. Accordingly,because of this reason and the need for conversion in

interpreting a situation, it seems advisable to includeoverdrafts in current liabilities. This ratio is a general andquick measure of liquidity of a firm. It represents the margin ofsafety or cushion available to the creditors. It is an index ofthe firm’s financial stability. It is also an index of technicalsolvency and an index of the strength of working capital.

[An acceptable current ratio varies by industry. Generallyspeaking, the more liquid the current assets, the smaller thecurrent ratio can be without cause for concern. For mostindustrial companies, 1.5 is an acceptable current ratio. As thenumber approaches or falls below 1 (which means the company has anegative working capital), there will need to take a close lookat the business and make sure there are no liquidity issues.Companies that have ratios around or below 1 should only be thosewhich have inventories that can immediately be converted intocash. If this is not the case and a company's number is low, thatshould be seriously concerned.]

It’s Important to understand the standard ratio:

[A relatively high current ratio is an indication that the firmis liquid and has the ability to pay its current obligations intime and when they become due. On the other hand, a relativelylow current ratio represents that the liquidity position of thefirm is not good and the firm shall not be able to pay itscurrent liabilities in time without facing difficulties. Anincrease in the current ratio represents improvement in theliquidity position of the firm while a decrease in the currentratio represents that there has been deterioration in theliquidity position of the firm. A ratio equal to or near 2: 1 isconsidered as a standard or normal or satisfactory. The idea ofhaving doubled the current assets as compared to currentliabilities is to provide for the delays and losses in therealization of current assets. However, the rule of 2:1 should

not be blindly used while making interpretation of the ratio.Firms having less than 2 : 1 ratio may be having a betterliquidity than even firms having more than 2 : 1 ratio. This isbecause of the reason that current ratio measures the quantity ofthe current assets and not the quality of the current assets. Ifa firm's current assets include debtors which are not recoverableor stocks which are slow-moving or obsolete, the current ratiomay be high but it does not represent a good liquidity position.]

InefficiencyAnalyzing a balance sheet and finding a company’s current ratioof 3 or 4, it may be concerned highly. A This high number meansthat the management has so much cash on hand, they may be doing apoor job of investing it. This is one of the reasons it isimportant to read the annual report, 10K and 10Q of a company.Most of the time, the executives will discuss their plans inthese reports. If you notice a large pile of cash building up andthe debt has not increased at the same rate (meaning the money isnot borrowed), you may want to try to find out what is going on.

Microsoft has a current ratio in excess of 4, a massive numbercompared to what it requires for its daily operations. Thecompany has no long term debt on the balance sheet. What are theyplanning on doing? No one knew until the company paid its firstdividend in history, bought back billions of dollars worth ofshares, and made strategic acquisitions.

Although not ideal, too much cash on hand is the kind of problema smart investor prays for.

A 10K is an annual filing that publicly traded companies arerequired, by law, to send into the Securities and ExchangeCommission containing everything about their business that aninvestor would want to know before buying or selling shares of

stock in the corporation. These documents are available to thepublic for free. The best way to think about a 10K is to considerit a document that the government forces management to preparefor you, the owner, explaining the company’s finances, risks,opportunities, and current operations. It is full of the nitty-gritty details that make a lot of people’s eyes glaze over and,unfortunately, there is no way to simplify it. Once you’ve read afew (10K's,) and they will begin to look more and more accessiblebecause they typically follow the same pattern.

There are many required parts of a 10K, including:

An explanation of a company’s operations, how it makes itsmoney, and the markets in which it currently operates. Thisexplanation lets you understand the business. You’ll besurprised by some of the things you find. One of thegreatest investments of the 1990’s was a mutual fund companycalled Janus that began as a tiny subsidiary of a railroad.Shareholders who went through the 10K and found that thislittle money management unit was doing spectacularly madeenough money to retire in just a few short years.

Disclosures of risks the company faces, including currentlawsuits. In my time, I’ve actually come across companiesthat otherwise looked very healthy but were facing theprospect of bankruptcy due to huge pending lawsuits thatthreatened to take down the whole firm. Famous cases includethe asbestos trials several decades ago when businesses thatwere only vaguely related to construction were sued andforced into liquidation or reorganization, wiping out thestockholders. You definitely want to take time to read theserisk disclosures.

The financial statements such as the income statement andbalance sheet that show you how much money a company made,

its debt levels, and other important data. The financialstatements are the most important part of the 10K becausethey allow you to see what is going on with the company’sfinances. The process of reading these financial statementsis not as difficult as it sounds, but there are dozens ofpitfalls that you should be looking for as you read the 10K.Discussing those here is far beyond the scope of thisarticle, but if you read Investing Lesson 3 – How to Read aBalance Sheet and Investing Lesson 4 – Income StatementAnalysis, I will spend more than one hundred pages walkingyou through the process line-by-line. Print those specialsand over the next few weeks, work your way through them. Itwill take you far less time than taking an accounting courseat a local college but by the time you’re done, you will beyears ahead of your friends and family in understanding howstocks and bonds work.

Operating leases that don’t count as debt on the balancesheet. There are many forms of debt that can make a companygo bankrupt that do not show up on the balance sheet due toaccounting rules but the law requires the payments bedisclosed in the 10K. For instance, if you owned a smallclothing boutique at the local mall and had no debt but paid$10,000 per month in rent to the mall owner, according toGAAP rules (those are the guidelines that determine how thefinances must be disclosed), you may end up showing littleor no debt. If sales fall and you stop sending checks to thelandlord, the mall owner can obviously kick you out of yourstorefront and force your company into bankruptcy due to themissed lease payment. Every 10K will include a section thatdiscusses “fixed payments” or “operating leases” or “minimumcash payments due”. Find it. Read it. Know it.

The company’s accounting policies. Imagine that you areconsidering buying stock in a washing machine manufacturer.

This company suddenly is in the news because a lot of modelsare breaking down beyond repair. Is the company on the hookfor taking them back from customers? In the 10K, a companyhas to disclose its warranty policies and estimated warrantycosts for products it sells or manufactures.

The CEO's and CFO’s signed letters stating the books areaccurate to their knowledge. These letters were made arequirement after the accounting frauds following the dot-com bust when WorldCom and Enron dominated the headlines.They are a way for the government to prosecute executivesthat knowingly falsify their accounting records.

In a nutshell, those are the important parts of a 10K. Learningto read one is sort of like swimming. At some point, you justhave to jump in the pool and get wet. You don't have to startdoing Olympic-quality dives, so feel no pressure to jump intoadvanced pension accounting. Instead, just flip through the pagesand read what you do understand. Learning to invest is a processand everyone starts somewhere. There was a point in time wheneven I had absolutely no idea what those numbers meant. You willlearn, if you are willing to put in the work.

Some useful additional information: A 10Q is a smaller version ofthe 10K that is filed at the end of each business quarter withthe SEC.

For more information, it may be checked out the financialstatement guide for new investors.

Calculation of the Current Ratio:

The current ratio is calculated from balance sheet data asfollows:

CR = Current Assets/Current Liabilities.

So, if a business firm has $200 in current assets and $100 incurrent liabilities, the calculation is $200/$100 = 2.00X. The"X" (times) part at the end is important. It means that the firmcan pay its current liabilities from its current assets two timesover.

Quick Test Ratio

The two components of liquid ratio (acid test ratio or quickratio) are liquid assets and liquid liabilities. Liquid assetsnormally include cash, bank, sundry debtors, bills receivable andmarketable securities or temporary investments. In other wordsthey are current assets minus inventories (stock) and prepaidexpenses. Inventories cannot be termed as liquid assets becauseit cannot be converted into cash immediately without a loss ofvalue. In the same manner, prepaid expenses are also excludedfrom the list of liquid assets because they are not expected tobe converted into cash. Similarly, Liquid liabilities meanscurrent liabilities i.e., sundry creditors, bills payable,outstanding expenses, short term advances, income tax payable,dividends payable, and bank overdraft (only if payable ondemand). Some time bank overdraft is not included in currentliabilities, on the argument that bank overdraft is generallypermanent way of financing and is not subject to be called ondemand. In such cases overdraft will be excluded from currentliabilities.

The quick ratio/acid test ratio is very useful in measuring theliquidity position of a firm. It measures the firm's capacity topay off current obligations immediately and is more rigorous testof liquidity than the current ratio. It is used as acomplementary ratio to the current ratio. Liquid ratio is morerigorous test of liquidity than the current ratio because it

eliminates inventories and prepaid expenses as a part of currentassets. Usually a high liquid ratio an indication that the firmis liquid and has the ability to meet its current or liquidliabilities in time and on the other hand a low liquidity ratiorepresents that the firm's liquidity position is not good. As aconvention, generally, a quick ratio of "one to one" (1:1) isconsidered to be satisfactory.

Although liquidity ratio is more rigorous test of liquidity thanthe current ratio , yet it should be used cautiously and 1:1standard should not be used blindly. A liquid ratio of 1:1 doesnot necessarily mean satisfactory liquidity position of the firmif all the debtors cannot be realized and cash is neededimmediately to meet the current obligations. In the same manner,a low liquid ratio does not necessarily mean a bad liquidityposition as inventories are not absolutely non-liquid. Hence, afirm having a high liquidity ratio may not have a satisfactoryliquidity position if it has slow-paying debtors. On the otherhand, A firm having a low liquid ratio may have a good liquidityposition if it has a fast moving inventories. Though this ratiois definitely an improvement over current ratio, theinterpretation of this ratio also suffers from the samelimitations as of current ratio .

Formula

Quick ratio is calculated using the following formula:

Quick Ratio = Cash + Marketable Securities + Receivables /Current Liabilities

Marketable securities are those securities which can be convertedinto cash quickly. Examples of marketable securities are treasurybills, saving bills, shares of stock-exchange, etc. Receivables

refer to accounts receivable. Alternatively, quick ratio can alsobe calculated using the following formula:

Quick Ratio = Current Assets − Inventory – Prepayments/ Currentliabilities

Analysis

Quick ratio measures the liquidity of a business by matching itscash and near cash current assets with its current liabilities.It helps us to determine whether a business would be able to payoff all its debts by using its most liquid assets (i.e. cash,marketable securities and accounts receivable).

A quick ratio of 1.00 means that the most liquid assets of abusiness are equal to its total debts and the business will justmanage to repay all its debts by using its cash, marketablesecurities and accounts receivable. A quick ratio of more thanone indicates that the most liquid assets of a business exceedits total debts. On the opposite side, a quick ratio of less thanone indicates that a business would not be able to repay all itsdebts by using its most liquid assets.

Thus we conclude that, generally, a higher quick ratio ispreferable because it means greater liquidity. However a quickratio which is quite high, say 4.00 is not favorable to abusiness as whole because this means that the business has idlecurrent assets which could have been used to create additionalprojects thus increasing profits. In other words, very high valueof quick ratio may indicate inefficiency.

Example 1: A company has following assets and liabilities at theyear ended December 31, 2009:

Cash $34,390

MarketableSecurities

12,000

AccountsReceivable

56,200

PrepaidInsurance 9,000

Total CurrentAssets

111,590

Total CurrentLiabilities

73,780

Calculate quick ratio (acid test ratio).

Solution:

Quick ratio = (34,390 + 12,000 + 56,200) / 73,780 = 102,590 /73,780 = 1.39 Or,

Quick ratio = (111,590 − 9,000) / 73,780 = 102,590 / 73,780 =1.39

Example 2: Calculate quick ratio from the following information:

Cash $21,720

Treasury Bills 18,500

AccountsReceivable 15,930

Prepaid Rent 6,500

Inventory 17,240

Total CurrentAssets 79,890

Total CurrentLiabilities 52,960

Solution:

In this example, treasury bills are marketable securities thus wewill calculate quick ratio as follows:

Quick ratio = (79,890 − 6,500 − 17,240) / 52,960 = 56,150 /52,960 = 1.06 Or,

Quick ratio = (21,720 + 18,500 + 15,930) / 52,960 = 56,150 /52,960 = 1.06

Cash ratio:

The cash ratio is the most stringent and conservative of thethree short-term liquidity ratios (current, quick and cash). Itonly looks at the most liquid short-term assets of the company,which are those that can be most easily used to pay off currentobligations. It also ignores inventory and receivables, as thereare no assurances that these two accounts can be converted-tocash in a timely matter to meet current liabilities. Very fewcompanies will have enough cash and cash equivalents to fullycover current liabilities, which isn't necessarily a bad thing,so do not focus on this ratio being above 1:1. The cash ratio isseldom used in financial reporting or by analysts in the

fundamental analysis of a company. It is not realistic for acompany to purposefully maintain high levels of cash assets tocover current liabilities. The reason being that it's often seenas poor asset utilization for a company to hold large amounts ofcash on its balance sheet, as this money could be returned toshareholders or used elsewhere to generate higher returns. Whileproviding an interesting liquidity perspective, the usefulness ofthis ratio is limited.

Formula:

Cash Ratio= Cash + Cash Equivalents + Invested Funds / CurrentLiabilities

Components: Cash Ratio = $ 233.2/ $606.9 = 0.4

As of December 31, 2005, with amounts expressed in millions,Zimmer Holdings' cash assets amounted to $233.20 (balance sheet);while current liabilities amounted to $606.90 (balance sheet).By-dividing,-the-equation-gives-us-a-cash-ratio-of-0.4Commentary:The cash ratio is the most stringent and conservative of thethree short-term liquidity ratios (current, quick and cash). Itonly looks at the most liquid short-term assets of the company,which are those that can be most easily used to pay off currentobligations. It also ignores inventory and receivables, as thereare no assurances that these two accounts can be converted-to-cash-in-a-timely-matter-to-meet-current-liabilities.Very few companies will have enough cash and cash equivalents tofully cover current liabilities, which-isn't-necessarily-a-bad-thing,-so-don't-focus-on-this-ratio-being-above-1:1.

The cash ratio is seldom used in financial reporting or byanalysts in the fundamental analysis of a company. It is notrealistic for a company to purposefully maintain high levels ofcash assets to cover current liabilities. The reason being that

it's often seen as poor asset utilization for a company to holdlarge amounts of cash on its balance sheet, as this money couldbe returned to shareholders or used elsewhere to generate higherreturns. While providing an interesting liquidity perspective,the usefulness of this ratio is limited.

DEBT UTILIZATION RATIOS

Debt to assets ratio

Debt-to-assets ratio or simply debt ratio is the ratio of totalliabilities of a business to its total assets. It is a solvencyratio and it measures the portion of the assets of a businesswhich are financed through debt.

Formula

The formula to calculate the debt ratio is:

Debt Ratio = Total Liabilities / Total Assets

Total liabilities include both the current and non-currentliabilities.

Analysis

Debt ratio ranges from 0.00 to 1.00. Lower value of debt ratio isfavorable and a higher value indicates that higher portion ofcompany's assets are claimed by it creditors which means higherrisk in operation since the business would find it difficult toobtain loans for new projects. Debt ratio of 0.5 means that halfof the company's assets are financed through debts

Examples

In order to calculate debt ratio from the balance sheet, dividetotal liabilities by total assets, for example:

Example 1: Total liabilities of a company are $267,330 and totalassets are $680,400. Calculate debt ratio.

SolutionDebt ratio = $267,330/$680,400 = 0.393 or 39.3%

Example 2: Current liabilities are $34,600; Non-currentliabilities are $200,000; and Total assets are $504,100.Calculate debt ratio.

Solution Since total liabilities are equal to sum of current and non-current liabilities therefore,Debt Ratio = ($34,600 + $200,000) / $504,100 = 0.465 or 46.5%

Debt-to-Equity Ratio

Debt-to-Equity ratio is the ratio of total liabilities of abusiness to its shareholders' equity. It is a leverage ratio andit measures the degree to which the assets of the business arefinanced by the debts and the shareholders' equity of a business.

The two basic components of debt to equity ratio are outsiders’funds i.e. external equities and share holders’ funds, i.e.,internal equities. The outsiders’ funds include all debts /liabilities to outsiders, whether long term or short term orwhether in the form of debentures, bonds, mortgages or bills. Theshareholders funds consist of equity share capital, preferenceshare capital, capital reserves, revenue reserves, and reservesrepresenting accumulated profits and surpluses like reserves forcontingencies, sinking funds, etc. The accumulated losses anddeferred expenses, if any, should be deducted from the total tofind out shareholder's funds.

Some writers are of the view that current liabilities do notreflect long term commitments and they should be excluded fromoutsider's funds. There are some other writers who suggest that

current liabilities should also be included in the outsider'sfunds to calculate debt equity ratio for the reason that likelong term borrowings, current liabilities also represents firm'sobligations to outsiders and they are an important determinant ofrisk. However, we advise that to calculate debt equity ratiocurrent liabilities should be included in outsider's funds. Theratio calculated on the basis outsider's funds excludingliabilities may be termed as ratio of long-term debt to shareholders funds.

Debt to equity ratio indicates the proportionate claims of ownersand the outsiders against the firm’s assets. The purpose is toget an idea of the cushion available to outsiders on theliquidation of the firm. However, the interpretation of the ratiodepends upon the financial and business policy of the company.The owners want to do the business with maximum of outsider'sfunds in order to take lesser risk of their investment and toincrease their earnings (per share) by paying a lower fixed rateof interest to outsiders. The outsider’s creditors on the otherhand, want that shareholders (owners) should invest and risktheir share of proportionate investments. A ratio of 1:1 isusually considered to be satisfactory ratio although there cannotbe rule of thumb or standard norm for all types of businesses.Theoretically if the owners’ interests are greater than that ofcreditors, the financial position is highly solvent. In analysisof the long-term financial position it enjoys the same importanceas the current ratio in the analysis of the short-term financialposition.

Formula

Debt-to-equity ratio is calculated using the following formula:

Debt-to-Equity Ratio = Total Liabilities / Shareholders' Equity

Both total liabilities and shareholders' equity figures in theabove formula can be obtained from the balance sheet of a

business. A variation of the above formula uses only the interestbearing long-term liabilities in the numerator.

Analysis

Lower values of debt-to-equity ratio are favorable indicatingless risk. Higher debt-to-equity ratio is unfavorable because itmeans that the business rely more on external lenders thus it isat higher risk, especially at higher interest rates. Debt toequity ratio of 1.00 means that half of the asset of a businessis financed by debt and half by the shareholders' equity. A valuehigher than 1.00 means that more assets are financed by debt thatthose financed by money of shareholders' and vice versa.

An increasing trend in of debt-to-equity ratio is also alarmingbecause it means that the percentage of assets of a businesswhich are financed by the debts is increasing.

Example

Calculate debt-to-equity ratio of a business which has totalliabilities of $3,423,000 and shareholders' equity of $5,493,000.

SolutionDebt-to-Equity Ratio = $3,423,000 / $5,493,000 ≈ 0.62

Times Interest Earned Ratio

Times interest earned (also called interest coverage ratio) isthe ratio of earnings before interest and tax (EBIT) of abusiness to its interest expense during a given period. It is asolvency ratio measuring the ability of a business to pay off itsdebts.

Formula:

Times interest earned ratio is calculated as follows:

Times Interest Earned = Earnings before Interest and Tax /Interest Expense

Both figures in the above formula can be obtained from the incomestatement of a company. Earnings before interest and tax (EBIT)is same as operating income.

Analysis:

Higher value of times interest earned ratio is favorable meaninggreater ability of a business to repay its interest and debt.Lower values are unfavorable. A ratio of 1.00 means that incomebefore interest and tax of the business is just enough to pay offits interest expense. That is why times interest earned ratio isof special importance to creditors. They can compare the debtrepayment ability of similar companies using this ratio. Otherthings equal, a creditor should lend to a company with highesttimes interest earned ratio. It is also beneficial to create atrend of times interest earned ratio.

Example 1: Calculate the times interest earned ratio of a companyhaving interest expense and earnings before interest and tax forthe year ended Dec 31, 2010 of $239,000 and $3,493,000respectively. The times interest earned ratio and earnings beforeinterest and tax of a company were 9.34 and $1,324,400 during theyear ended Jun 30, 2011. Calculate the interest expense of thecompany.

SolutionTimes Interest Earned = $3,493,000 ÷ $239,000 ≈ 14.6

SolutionInterest Expense = $1,324,400 ÷ 9.34 ≈ $141,800

Fixed-Charge Coverage Ratio

Fixed charge coverage ratio is the ratio that indicates a firm’sability to satisfy fixed financing expenses such as interest andleases. This means that the fixed charges that a firm isobligated to meet are met by the firm. This ratio is calculatedby summing up Earnings before interest and Taxes or EBIT andFixed charge which is divided by fixed charge before tax andinterest.

Formula:

The formula used for calculating fixed charge coverage ratio isas follows:

Fixed Charge Coverage Ratio = (EBIT + Fixed charge before tax) /(Fixed charge before tax + Interest)

Where, EBIT is Earnings before interest and taxes.

EBIT, taxes and the interest expenses are to be taken from theincome statement of the company. The lease payments are takenfrom the balance sheet, usually appearing as a footnote of thebalance sheet. The result that is obtained by finding out thefixed charge coverage ratio is the number of times the company isable to meet its fixed charges per year. The greater the numberof times the company can pay its charges the better it is for thefirm as the debt position of the firm is proportional to theinterest earned ratio.

The above formula can be explained with the help of an example:

For example, a company has $13,000 as EBIT and $2,000 as leasepayments and $1,000 as interest payments the fixed chargecoverage ratio is measured as:

Fixed charge coverage ratio = (13,000+2,000)/ (1,000+2,000) =15,000/3000 = 5

This means that the company has earned five times its fixedcharges, the company is able to pay the fixed charges of thecompany. Therefore this means that by calculating the fixedcharge coverage ratio, it helps in ascertaining the company’sability to pay the various fixed costs of the company in case thebusiness tends to fall. Every business would have its own shareof risks involved and every company must be well prepared tohandle all the expenses and losses that can occur to the company.This is why it is important to calculate the fixed chargecoverage ratio and it enables a business to understand the lossor expense taking capacity of the business in case somemisfortune strikes the company. This ratio like all other ratioscan provide a basic idea of the standing of the company’sfinances based on the historical data provided to us. Thereforeit is important that we determine fixed charge coverage ratio toascertain the standing of the company. 

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