Engineering Economics

Lecturer: Muhammad Ali Abdullah Mirza

Accounting Principles
• The Entity Concept
• The Reliability (Objectivity) Principle
• The Cost Principle
• The Going Concern Concept
• The Stable-Monetary-Unit Concept
The Entity Concept Example
 Assume that John decides to open up
a gas station and coffee shop.
 The gas station made $250,000 in
profits, while the coffee shop lost
$50,000.
The Entity Concept Example
 How much money did John make?
 At a first glance, we would assume
that John made $200,000.
 However, by applying the entity
concept we realize that the gas
station made $250,000 while the
coffee shop lost $50,000.
The Reliability (Objectivity)
Principle
Information must
Information must
be reasonably
be free from bias.
accurate.

Information must Individuals would

report what arrive at similar
actually conclusions using
happened. same data.
The Cost Principle

Assets and services

acquired
should be recorded
at their actual cost.
The Going Concern Concept

The entity will continue

to operate in the future.
The Stable-Monetary-Unit
Concept

The dollar’s purchasing

power is relatively
stable.
Financial Statements...

– are the final

product of the
accounting process.

– tell how the

business is performing
and where it stands.
Financial Statements
– Income statement
– Statement of owner’s equity
or retained earnings
– Balance sheet
– Statement of cash flows
Relationships Among the Statements:
Income Statement
Revenue:
Fees earned $8,500
Expenses:
Salary expense $1,200
Utilities and telephone expense 400
Equipment rental expense 400
Office rent expense 1,100
3,100
Net income
$5,400
Relationships Among the Statements:
Statement of Owner’s Equity

G. Gillen, capital, April 1, 20xx $ 0

Contribution of capital 30,000
Net income $ 5,400
Cash distributions – 2,100
G. Gillen, capital, April 30, 20xx $33,300
 Relationships Among the Statements:
Balance Sheet

Assets Liabilities + Capital

Cash $ 20,000 Accounts payable $ 200
Accounts receivable 2,000 Owner’s equity,
Supplies 500 G. Gillen, capital 33,300
Land 11,000 Total liabilities and
Total assets $ 33,500 owner’s equity $33,500
 Relationships Among the Statements:
Statement Of Cash Flows
Cash flows from operating activities:
Cash receipts from services rendered $6,500
Cash payments:
Supplies $ 300
Operating expenses 3,100 3,400
Net cash flows from
Operating activities $3,100
Cash flows from investing activities
Purchase and sale of land ($11,000)
Relationships Among the Statements:
Statement Of Cash Flows

Cash Flows from Financing Activities:

Beginning Balance 0
Investment by Owner $30,000
Withdrawals 2,100
Net Cash Flows from Financing Activities $27,900
Cash at Beginning of Year 0
Cash at End of the Year $20,000
Categories of Financial Ratios
Financial ratios can be broadly divided into five categories:

1. Liquidity ratios
2. Financial leverage ratios
3. Asset management ratios
4. Profitability ratios
5. Market value ratios
Liquidity Ratios
• Current Ratio = CA / CL
o This ratio (CR) measures how much current liabilities are covered by current
assets, assuming both can be converted to cash over the following 12
months.
o Rule of thumb: > 1 times (~ 1.5 – 2.5 times is considered healthy).
o This ratio should be compared to the industry – it is possible that the
particular industry has a substantial cash flow that they can meet their
current liabilities out of cash flow instead of relying solely on the liquidation
of current assets.
o High current ratio implies high liquidity but also means a possible inefficient
use of cash.
o One needs to also investigate other ratios such as days sales in inventory and
receivable (see later) in order to get a full picture of the company’s liquidity.
Liquidity Ratios
• Quick Ratio = (CA – Inventory) / CL
o This ratio (QR) is similar to the CR but it removes
the least liquid asset, inventory, from the current
assets so that it gives a better measure of
liquidity.
o Rule of thumb: > 1 times.
o Note that this ratio does not take into account the
quality of the inventory.
Liquidity Ratios
• Cash Ratio = Cash & cash equivalent / CL
o This ratio measures how much current liabilities are covered by
cash or cash equivalent.
o Rule of thumb: ~ 0.2 times for healthy company.
o For start-‐up,this ratio should be higher e.g. between 0.3 and 0.5.
o Too little cash (Cash Ratio << 0.2) increases the risk of bankruptcy.
o Too much cash (Cash Ratio >> 0.2) means too much forgone
interest. It is seen as poor asset ultilisation for a company to hold
large amount of cash on its balance sheet as money could be
returned to shareholders or used elsewhere to generate higher
returns e.g. investments in marketable securities, long-‐term assets
etc.
Financial Leverage Ratios
• Total Debt Ratio = (TA – TE) / TA = TL / TA
o This ratio measures how much of the company’s assets is funded by
debt.
o Rule of thumb: < 0.7 times for healthy firm.
o This ratio takes into account all debts of all maturities to all creditors.
o A low percentage (<< 0.7) means that the company is less dependent on
leverage i.e. money borrowed from and/or owed to others. The lower
the percentage, the less leverage a company is using and the stronger its
equity position.
o In general, the higher the ratio, the more risk the company is
considered to have taken on.
Financial Leverage Ratios
• Debt Equity Ratio = TL / TE
o This ratio indicates the proportion of debt and equity the company is
using to finance its assets.
o Rule of thumb: < 2 times.
o Similar to the Total Debt Ratio, a low percentage (<< 2) means that the
company is using less leverage and has stronger equity position.
o A high Debt Equity Ratio means that the company has made an
aggressive financing with debt. The company must therefore ensure
that it generates sufficient operating profit to cover additional
interest expenses.
• Equity Multiplier = TA / TE = 1 + Debt Equity Ratio
o This ratio is useful in the consideration of Return of Equity (ROE).
Financial Leverage Ratios
• Times Interest Earned Ratio = EBIT / Interest
o This ratio ( Interest Coverage Ratio) indicates well the company
has its interest obligations covered.
o Rule of thumb: > 1 times.
o Interest means interest expenses only.
o EBIT is generally not a good measure of cash available to pay interests
because depreciation (non-‐cash item) is deducted as an expense in the
calculation of EBIT.
o When a company’s interest coverage ratio is less than 1 or lower, its
ability to meet its interest expenses may be questionable.
Financial Leverage Ratios
• Cash Coverage Ratio = (EBIT + Depreciation) / Interest
o Like the Times Interest Earned ratio, this ratio measures the
firm’s ability to pay its interest obligations from the cash
generated from its operating activities.
o Rule of thumb: > 1 times.
o Note that EBIT + Depreciation = EBITD
o Depreciation (non-‐c ash item) is added back to give a
better indication of cash flow from operating
activities.
Asset Management Ratios
• Inventory Turnover = COGS / Inventory
o This ratio measures how many times inventory is sold per year.
o Rule of thumb: Industry-‐dependent(however, the higher the ratio the more
efficient the company is at managing its inventory).
o Inventory can be end of period inventory or the average between the
beginning of the year and end of year inventories.
o Inventory turnover strongly depends on industry.
o Generally, low inventory turnover means poor sales i.e. the company has
excess stocks. This means a bad return on investment (i.e. buying too
much) and trouble should the prices fall.
o However, it is also important to consider the seasonality in sales
e.g. inventory build up towards end of year may result in smaller turnover.
Asset Management Ratios
• Days’ Sales in Inventory (DSI) = 365 days / Inventory Turnover
o This ratio measures how long inventory is held before it is
sold.
o Rule of thumb: Industry-‐dependent.
o Assuming the company is not running out of stock, the
lower the Days’ Sales in Inventory, the more efficient the
company is at managing its inventories.
o However, Days’ Sales in Inventory varies from one industry
to another e.g. a car manufacturer will have a higher Days’
Sales in Inventory than a diary product manufacturer.
Asset Management Ratios
• Receivables Turnover = Sales / Trade receivables
o This ratio measures how many times the company collects its
outstanding receivables during the year.
o Rule of thumb: > 12 times.
o Note that trade receivables include both current and non-‐current trade
receivables.
o Note also that
Sale = Cash sales + Credit sales.
A true Receivables Turnover should therefore exclude Cash sales but
generally this is not available in company reports.
o Like Inventory Turnover, it is also important to take into account the
seasonality, where appropriate.
Asset Management Ratios
• Days’ Sales in Receivables (DSR) = 365 days / Receivables Turnover
o This ratio (also known as ‘Days Sales Outstanding’ or DSO)
measures how fast (in days) the company collects cash on
the sales and clears its credit accounts.
o Rule of thumb: ~ 30days.
o This ratio is also referred to as the Average Collection Period.
o Days’ Sales in Receivables should roughly be consistent with
the company’s credit term.
o The goal of business is to keep the Days’ Sales in Receivable as
low as possible. The faster it is, the better the company is
ultilising its assets.
Asset Management Ratios
• Total Asset Turnover (TAT) = Sales / Total Assets
o TAT measures how much sales in generated for
every euro in assets.
o Rule of thumb: Industry‐dependent.
o Generally, the higher the TAT the better. It means
that the company is efficient at utilising its assets
to generate sales.
o It is not unusual for TAT < 1, especially if a firm has a
large amount of fixed assets.
Profitability Ratios
• Profit Margin (PM) = (Net Income / Sales ) x 100
o PM measures how much the company earns for every euro (dollar or
yen) in sales.
o Rule of thumb: Industry-‐dependent.
o PM indicates how well the company controls the costs that are
required to generate the revenues.
o Generally, the higher the PM the better. However,
o PM can be very different for different industries e.g. grocery stores
typically have fairly low PM ( ~ 3 %- ‐ 5 % ) . On the other hand
pharmaceutical companies enjoy very high PM (~ 18% +).
o PM can also be cyclical i.e. some industries are highly sensitive to
economic conditions e.g. mining, airline etc.
Profitability Ratios
• Return on Assets (ROA) = (Net Income / TA ) x 100
o ROA measures profit per asset value or profit per every euro (dollar
or yen) of asset invested.
o Rule of thumb: Industry-‐dependent(however, no less than 5%).
o ROA indicates how efficient the management is at using the
company’s assets to generate profit.
o Generally, the higher the ROA the better. However, like PM, ROA can be very
different for different industries e.g. capital-‐Intensiv e businesses (with a large
investment in fixed assets) are going to be more as s et -‐heavy(hence low ROA)
than technology or service businesses (hence high ROA).
o The management job is to make wise choice in allocating resources. Best
managers make large profit from little investment in assets.
Profitability Ratios
• Return on Equity (ROE) = (Net Income / TE ) x 100
o ROE measures profit per equity value or profit per every euro (dollar or
yen) of equity invested.
o Rule of thumb: Industry-‐dependent (however, 15~20% are considered
good).
o ROE indicates how well the company manages shareholders’ money and is
therefore the most relevant profitability measure for shareholders.
o ROE > ROA (due to financial leverage i.e use of debt financing).
o Beware: the greater the financial leverage (i.e. a lot more debt than
equity) the larger the ROE and the greater the difference between ROE
and ROA.
o It is best to decompose ROE using the DuPont Identity (see next slide)
when analysing company’s ROE.
Profitability Ratios
• DuPont Identity:
• ROE = NI / TE
• Multiply by TA / TA = 1 and then rearrange
o ROE = (NI / TE) x (TA / TA)
• ROE = (NI / TA) x (TA / TE) = ROA x EM
• Multiply by Sales / Sales = 1 again and then rearrange
o ROE = (NI / TA) x (TA / TE) x (Sales / Sales)
o ROE = (NI / Sales) x (Sales / TA) x (TA / TE)
• ROE = PM x TAT x EM
Profitability Ratios
• DuPont Identity: ROE = PM x TAT x EM
o PM measures operating efficiency.
o TAT measures asset use efficiency.
o EM indicates financial leverage.
o DuPont Identity helps locate the part of the business that is under-‐
performing.
o When ROE is raising year by year or unusually large for the
particular company, it is important to look at the ROE year by year
through the use of DuPont Identity. In this way, one can see if the
company increases its ROE by simply increasing leverage, which is
a bad thing.
Market Value Ratios
• Earnings Per Share (EPS) = Net Income* / Shares Outstanding
o EPS measures the earnings that every shareholder gets per share.
o Rule of thumb: company/industry-‐dependent (however, this needs to be at least
greater than zero!).
o Generally the number of shares outstanding is not quoted in the financial
statements. They are disclosed in the annual report.
o Since the number of shares outstanding may change over time, it is more
accurate to use a weighted average number of shares.
However, for simplicity, we will use the number of shares outstanding at
the end of the period.
o Diluted EPS considers all types of share including convertible shares, stock
options and warrants. Hence diluted EPS < EPS.
o When comparing EPS, take note of the capital (i.e. equity) that is required to
generate the earnings.
Market Value Ratios
• Price Earnings Ratio (P/E) = Share Price / EPS
o PE ratio (P/E) indicates how much investors or the market is willing to pay
per unit of current the earnings. This is sometimes referred to as
‘multiples’.
o Rule of thumb: company/industry-‐dependent.
o P/E takes into account not only a company’s past performance but also
market expectations for a company’s growth:
o High P/E relative to the market means that either the company has a
significant prospect for future growth OR it is currently being
overvalued.
o Low P/E means either a “vote of no confidence” in the company OR
the company is currently being overlooked by the market i.e. it is
undervalued.
Market Value Ratios
• Market-‐to-‐Bookratio = Share Price / Book value per share
where Book value per share = Total Equity / Shares Outstanding.
o M a r k et-‐to- b o o k ratio compares the market value of equity to thebook
value of equity.
o Rule of thumb: > 1 (~ 1.7 on average for the largest 30 US firms).
o Market to Book ratio compares the market value of the company’s
investments (numerator) with their historical costs (denominator).
o It is generally a bad sign if a company’s market-‐to-‐bookratioapproaches
1.00 i.e. the company has not been successful in creating value for
the shareholders.
Summary of Financial Ratios
Thank You