RATIO ANALYSIS

Course Name: Working Capital Management

Course Code: FIN-4201

 Ratio Analysis

RATIO ANALYSIS

Application of Ratio Analysis

Types of Ratio in Decision Making

✓ Liquidity Ratios Relationship of Financial

✓ Activity Ratios Management with other
✓ Capital Structure disciplines of Accounting
Ratios
✓ Profitability
Ratios
✓ Market Ratios

INTRODUCTION
The basis for financial analysis, planning and decision making is financial statements which
mainly consist of Balance Sheet and Profit and Loss Account.
However, the above statements do not disclose all of the necessary and relevant information.
For the purpose of relevant information for determining the financial strengths and weakness
of a firm, it is important to analyse the data depicted in the financial statement. The financial
manager has certain analytical tools to perform financial analysis and planning. One of the
main tools is Ratio Analysis.
Let us discuss the Ratio Analysis.

RATIO ANALYSIS & TYPES OF RATIO COMPARISON

Ratio Analysis involves methods of calculating and interpreting financial ratios to analyze and
monitor the firm’s performance. The basic inputs to ratio analysis are the firm’s income
statement and balance sheet.

Cross-Sectional Time-Series Analysis Combined Analysis

Analysis Time-series analysis The most informative
Cross-sectional analysis evaluates performance over approach to ratio analysis
involves the comparison of time. Comparison to past combines cross-sectional
different firm’s financial performance, using ratios. and time-series analyses.
ratios at the same point in
1 time.
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 ✓ LIQUIDITY RATIOS
The liquidity of a firm is measured by its ability to satisfy its short-term obligations as they
come due. Liquidity refers to the solvency of the firm’s overall financial position-the ease with
which it can pay its bills.
The two basic measures of liquidity are the current ratio and the quick (acid test) ratio.

Current Ratio
A measure of liquidity calculated by dividing the firm’s current assets by its current liabilities.
It measures the firm’s ability to meet its short-term obligations. It is expressed as follows:

Current Assets
Current Ratio = Current Liabilities

The current ratio for Bartlet Company in 2009 is: $1,223,000/$620,000 = 1.97
Generally, the higher the current ratio, the more liquid the firm is considered to be. A current
ratio of 2.00 is occasionally cited as acceptable. The more predictable a firm’s cash flows, the
lower the acceptable current ratio.

Quick (Acid-Test) Ratio

The quick ratio is like the current ratio except that it excludes inventory, which is generally the
least liquid current asset. The quick ratio is calculated as follows:

Current Assets - Inventory

Quick Ratio or Acid Test Ratio =

The quick ratio for Bartlet Company in 2009 is: ($1,223,000-$289,000)/$620,000 = 1.51
Generally, a quick ratio of 1.00 or greater is occasionally recommended. The quick ratio
provides a better measure of overall liquidity only when a firm’s inventory cannot be easily
converted into cash. If the inventory is liquid, the current ratio is a preferred measure of the
overall liquidity.

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 ✓ ACTIVITY RATIOS

Activity ratio measures the speed with which various accounts are converted into sales or cash
inflows or outflows. A number of ratios are available for measuring the activity of the most
important accounts, which include inventory, accounts receivable, and payable.

Inventory Turnover
Inventory turnover commonly measures the activity or liquidity of a firm’s inventory. It is
calculated as follows:

Cost of Goods Sold / Sales

Inventory Turnover Ratio =

This ratio indicates how fast inventory is used or sold. A high ratio is good from the viewpoint
of liquidity and vice versa. A low ratio would indicate that inventory is not used/ sold/ lost and
stays in a shelf or in the warehouse for a long time.

Receivables (Debtors) Turnover Ratio

The speed with which receivables are collected affects the liquidity position of the firm.
The debtor’s turnover ratio throws light on the collection and credit policies of the firm. It
measures the efficiency with which management is managing its accounts receivable. It is
calculated as follows:

Receivable (Debtor) Turnover Ratio =

Average Accounts Receivable

Average Collection Period

The average collection period is useful in evaluating credit and collection policies.

Average Sales Per Day

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Payables Turnover Ratio
This ratio is calculated on the same lines as receivable turnover ratio is calculated. This ratio
shows the velocity of payables payment by the firm. It is calculated as follows:

Annual Net Credit Purchases

Payables Turnover Ratio =
Average Accounts Payables

Average Payment Period

Average payment period is calculated in the same manner as the average collection period:

Or,

Total Asset Turnover

The total asset turnover indicates the efficiency with which the firm uses its assets to generate
sales. It is calculated as follows:

Sales
Total Asset Turnover =
Total Assets

Generally, the higher a firm’s total asset turnover, the more efficiently its asses have been used.

✓ CAPITAL STRUCTURE RATIOS

Debt Ratios
The debt position of a firm indicates the amount of other people’s money being used to generate
profits. The debt ratio measures the proportion of total assets financed by the firm’s creditors. The
higher this ratio, the greater the amount of other people’s money being used to generate profits.
The ratio is calculated as follows:

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 Or,
Debt Ratio =

Total debt or total outside liabilities includes short- and long-term borrowings from financial
institutions, debentures/bonds, deferred payment arrangements for buying capital equipment,
bank borrowings, public deposits and any other interest bearing loan.

Equity Ratio

This ratio indicates proportion of owners’ fund to total fund invested in the business.
Traditionally, it is believed that higher the proportion of owners’ fundlower is the degree
of risk.

Debt to Equity Ratio

Debt to Equity Ratio= Long-term Debt/Shareholder’s Equity

A high debt to equity ratio here means less protection for creditors, a low ratio,on the
other hand, indicates a wider safety cushion. This ratio indicates the proportion of debt fund
in relation to equity.

Debt to Total Assets Ratio

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Times Interest Earned Ratio
This ratio measures the firm’s ability to make contractual interest payments; sometimes
called the interest coverage ratio.

Times Interest Earned Ratio = EBIT/Interest

✓ PROFITABILITY RATIOS

Gross Profit Margin

The gross profit margin measures the percentage of each sales dollar remaining after the firm
has paid for its goods.

Gross Profit Margin = (Sales – COGS)/Sales

Operating Profit Margin

The operating profit margin measures the percentage of each sales dollar remaining after all
costs and expenses other than interest, taxes are deducted, the “pure profits” earned on each
sales dollar.

Operating Profit Margin = Operating Profits/Sales

Net Profit Margin

The net profit margin measures the percentage of each sales dollar remaining after all costs and
expenses including interest, taxes, and preferred dividends have been deducted.

Net Profit Margin = Earnings available for common stockholders/Sales

Return on Assets (ROA)

This ratio measures the profitability of the firm in terms of assets employed in the firm.

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 ROA = Earnings available for common stockholders/Total Assets

Return on Equity (ROE)

Return on Equity measures the profitability of equity funds invested in the firm. This ratio
reveals how profitably of the owners’ funds have been utilized by the firm. It also measures
the percentage return generated to equity shareholders. This ratio is computed as:

ROE = Earnings available for common stockholders/Common Stock Equity

Return on Investment (ROI)

It is the percentage of return on funds invested in the business by its owners. In short,
this ratio tells the owner whether or not all the effort put into the business has been
worthwhile. It compares earnings/ returns/ profit with the investment in the company. The
ROI is calculated as follows:
So, ROI = Profitability Ratio*Investment Turnover Ratio. ROI can be improved either
by improving
Profitability Ratio or Investment Turnover Ratio or by both.

Return /Profit /Earnings

Return on Investment = ×100

Or,

Earnings per Share (EPS)

The profitability of a firm from the point of view of ordinary shareholders can be measured
in terms of earnings on a per share basis. This is known as Earnings per share. It is calculated
as follows:

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Dividend per Share (DPS)

Earnings per share as stated above reflect the profitability of a firm per share; it does not reflect
how much profit is paid as dividendand how much is retained by the business. Dividend per share
ratio indicates the amountof profit distributed to equity shareholders per share. It is calculated as:

Total Dividend paid to equity

Dividend per Share (DPS) = Number of equity shares outstanding
shareholders

Dividend Payout Ratio

This ratio measures the dividend paid in relation to net earnings. It is determined to see
to how much extent earnings pershare have been retained by the management for the
business. It is computed as:

✓ MARKET RATIOS
Market ratios relate the firm’s market value, as measured by its current share price, to certain
accounting values. Here, we will consider three popular market ratios, one that focuses on
earnings, and other two considers dividends and book value respectively.

Price/Earnings (P/E) Ratio

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The price earnings ratio indicates the expectation of equity investors about the earnings of
the firm. It relates earnings to market price and is generally taken as a summary measure of
growth potential of an investment, risk characteristics, shareholders orientation, corporate
image and degree of liquidity. It is calculated as:

Dividend & Earnings Yield

Application of Ratio Analysis in Financial Decision

Making
A popular technique of analysing the performance of a business concern is that of financial
ratio analysis. As a tool of financial management, they are of crucial significance.
The importance of ratio analysis lies in the fact that it presents facts on a comparative basis
and enables drawing of inferences regarding the performance of a firm.
Ratio analysis is relevant in assessing the performance of a firm in respect of following aspects:

Liquidity Long-term Operating Overall Inter-firm Decision in

Position Solvency Efficiency Profitability Comparison Budgeting

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Limitations of Financial Ratios

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