Chapter 4 - Ratio Analysis

At the end of this topic, you shall be able to:

✓ Identify the four traditional financial ratio analysis.
✓ Describe liquidity ratios
✓ Identify the commonly used liquidity ratios
✓ Enumerate the different solvency ratios
✓ Identify profitability ratios
✓ Discuss the qualitative factors in financial statement analysis

Financial Ratio Analysis

➢ It is an analytical tool employing ratio or proportion of certain item in the financial statement in
relation to other related item in the same financial statement or other statements to judge
comparative performance.

The four basic classifications of financial ratios are:

1. Liquidity ratios
2. Leverage ratios
3. Profitability ratios
4. Growth ratios

Liquidity ratios. This is the most fundamentally important set of ratios, because they measure the ability
of a company to remain in business.

The following ratios are commonly used to evaluate the liquidity status of the business firm:

1. Current Ratio. Shows a firm’s ability to cover its current liabilities with its current assets.

The formula to compute the current ratio is:

Current Ratio = Current Assets/Current Liabilities

In principle, we would like to see the current ratio greater than 1 because it suggests that the
current assets to be liquidated this year are sufficient to cover the current liabilities that will come
due this year. If the current ratio is less than 1, then the current assets will be unable to service
the maturing obligations as measured by current liabilities.

2. Quick or Acid-Test Ratio. Shows a firm’s ability to meet current liabilities with its most liquid
assets.

The formula to compute the quick or acid-test ratio is:

Quick Ratio = Quick Assets/Current Liabilities

Quick Assets include cash, trading securities and trade receivables. Inventories are excluded since
they are slow-moving assets and are not easy to convert into cash. Prepaid expenses are also
excluded since the possibility of converting the items to cash is very slim.

Strong current ratio and weak acid-test ratio indicates a potential problem in the inventories
account.

3. Receivable Turnover. Measures a company's ability to collect accounts receivable.

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 The formula to compute the receivable turnover is:

Receivable Turnover = Net Credit Sales/Average Trade Receivables

Average trade receivable is computed as follows:

Average trade receivable = {Receivables beg. + Receivables end.}/2

Receivable Turnover is considered an asset management ratio since it measures the effectiveness
of management in handling its resources. It also measures the efficiency of the collection effort
and credit policy of the company.

Generally, it is favorable for the company to have a high receivable turnover. However, a very high
or low receivable turnover may not be a favorable indicator of the liquidity status.

Average Collection Period. Also called the days sales outstanding, measures the speed of collecting
trade receivables.

Average Collection Period = 360 days/Receivable Turnover

or
Average Collection Period = Average receivables/Average daily sales

The collection period is usually evaluated by comparison with the terms of sale.

4. Inventory Turnover. Measures the amount of inventory needed to support a given level of sales.

The formula to compute the inventory turnover is:

Inventory Turnover = Cost of Goods Sold/Average Inventory

Average trade receivable is computed as follows:

Average inventory = {inventory beg. + inventory end.}/2

The analyst shall consider the nature of business in evaluating inventory turnover, since it varies
from industry to industry. It is expected that grocery stores have high inventory turnover compare
to dealers of heavy equipment.

Average Sales Period. Also called the conversion period, measures the length of time the company
sell the inventory to customers.

Average Sales Period = 360 days/Inventory Turnover

Leverage Ratios. These ratios reveal the extent to which a company is relying upon debt to fund its
operations, and its ability to pay back the debt. The different ratios under this category also reflect the
extent to which a firm utilizes debt financing.

The following commonly used financial leverage ratios will be highlighted:

1. Debt Ratio. Measures the portion of funds provided by creditors.

The debt ratio is computed as follows:

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 Debt Ratio = Total Liabilities/Total Assets

Creditors prefer low debt ratio, because their investments are generally protected by higher
proportion of shareholders' funds in the event of liquidation.

2. Equity Ratio. Measures the portion of resources provided by owners of the business.

The equity ratio is computed as follows:

Equity Ratio = Total Equity/Total Assets

or
Equity Ratio = 1 - Debt Ratio

The equity ratio presents the financial strengths of the business, because it provides the margin of
safety that the company affords to creditors.

3. Debt to Equity Ratio. Measures the proportion of debt and equity in the capital structure of the
company. It shows the extent to which the firm is financed by debt.

The formula to compute debt to equity ratio is as follows:

Debt to Equity Ratio = Total Liabilities/Total Equity

When debt to equity ratio is more than 1 or more than 100%, the company is having riskier capital
structure since debts imply payment of interest.

4. Times Interest Earned. Indicates a firm’s ability to cover interest charges.

The formula to compute times interest earned is as follows:

TIE = Earnings Before Interest and Taxes (EBIT)/Interest Expense

TIE reflects the degree of protection provided by an entity to its long-term creditors. The higher
the ratio of times interest earned, the more it is favorable to investors of the firm.

Profitability Ratios. These ratios measure how well a company performs in generating a profit.

The common measures of profitability that will be discussed are:

1. Gross Profit Margin. Shows revenues minus the cost of goods sold, as a proportion of sales.

The formula to compute gross profit margin is as follows:

Gross Profit Margin = Gross Profit/Net Sales

Gross profit margin indicates the percentage of margin available to cover operating expense.

2. Net Profit Margin. Also known as return of sales. This measures the overall operating results of a
business. The measure considers all income recognized and all expenses incurred during the
period.

The formula to compute net profit margin is as follows:

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 Net Profit Margin = Net Income/Net Sales

The net profit margin illustrates how much in revenue or sales collected translates into profit.

1. Return on Investment. It evaluates the beneficial effects investments had on your company during
a defined period, typically a year.

The formula to compute return on investment is as follows:

ROI = Net Income/Investment

However, if the business entity has interest-bearing liabilities, ROI is computed as follows:

ROI = {Net Income + [interest (1 - tax rate)]} /Investment

Investors can use ROI to predict which company might make the most profit with future
investments, assuming all formulas use the same variable definitions. ROI is suitable for comparing
any companies that receive funds from investors. For example, you can use ROI to compare
publicly traded companies in different industries if your sole goal is to determine where your
financial investment might generate the most profits.

2. Return on Assets. It indicates how efficiently your company generates income using its assets.

The formula to compute return on assets is as follows:

ROA = Net Income/Average Total Assets

Average total assets is computed as follows:

Average total assets = {total assets beg. + total assets end.}/2

However, if the business entity has interest-bearing liabilities, ROI is computed as follows:

ROA = {Net Income + [interest (1 - tax rate)]} /Average Total Assets

ROA is most appropriate for comparing how well different managers within the same industry
generate profits with the assets they have. The more similar the businesses are in size and scope,
the more meaningful the comparison is.

3. Return on Equity. It measures the rate of return on ordinary shareholders' investment. The
measure is applicable only to ordinary shares, since preference shares normally have fixed rate of
return.

The formula to compute return on equity is as follows:

ROE = Net Income/Average Total Shareholders' Equity

Average total assets is computed as follows:

Average total shareholders' equity = {total SHE beg. + total SHE end.}/2

Growth Ratios. These are the group of ratios that reflect the value of the shares to its earnings, book
value per share and cash flow.

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value per share and cash flow.

Generally, if the liquidity, solvency and profitability ratios are favorable or the trends indicate
improvement, then growth ratios will look good to investors.

The following growth ratios are commonly used:

1. Earnings Per Share. It measures the value of ordinary shares relative to earnings of the business.
Only the net income attributable to ordinary shares shall be included in the computation; hence,
dividends applicable to preference shares shall be deducted from net income. We will only discuss
the basic earnings per share in this lecture.

The formula to compute basic earnings per share is as follows:

EPS = Net income applicable to ordinary shares/Average number of shares outstanding

2. Price-Earnings Ratio. It measures price per share in relation to the earnings of the company. This
measure also reflects the amount investor is willing to pay for every 1 peso of current earnings.

The formula to compute price-earnings ratio is as follows:

Price-earnings ratio = Market price per share/Earnings per share

3. Dividend-Yield Ratio. Dividends represent earnings of the company distributed to the shareholders
in proportion to their investments. The dividend-yield ratio measures the amount of dividends in
relation to market.

The formula to compute dividend-yield ratio is as follows:

Dividend-yield ratio = Dividend per share/Market price per share

4. Dividend-Payout Ratio. Measures the percentage of dividend payments in relation to earnings.

The formula to compute dividend-payout ratio is as follows:

Dividend-payout ratio = Dividend per share/Earnings per share

5. Book Value Per Share. It measures the amount payable to each share based on realizable amount
of assets in the event of liquidation. The measure applies to both ordinary shares and preference
shares.

The formula to compute dividend-payout ratio is as follows:

Book value per share = Stockholders' equity/Average number of shares outstanding

QUALITATIVE FACTORS IN ANALYSIS OF FINANCIAL STATEMENTS

Sound financial statement analysis is not mere calculating numbers but looking beyond the absolute
results of mathematical computations. The analyst should likewise consider seriously the qualitative
factors:

1. The presence of one major customer.

2. The presence of one major product.
3. The competitors in the market.

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 3. The competitors in the market.
4. Reliance on a single supplier.
5. The goals of the company.

Data derived from financial statements analysis are not absolute measures of entity's operating
performance. They are only indicators of liquidity, solvency, management efficiency and profitability.

References:
Financial Statements: Preparation, Presentation, Analysis, and Interpretation by Nick L. Aduana
Fundamentals of Financial Management by Ma. Flordeliza L. Anastacio
https://msu.edu/course/aec/853/chapter5.pdf
https://smallbusiness.chron.com/roa-vs-roi-formulas-36950.html#:~:text=Difference,generates%20income%
20using%20its%20assets.&text=The%20assets%20and%20profitability%20of,profitability%20in%20terms%20of%
20investment.

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