Ratio Analysis

Examples of Internal Uses

of Statement Analysis
Plan -- Focus on assessing the current
financial position and evaluating potential
firm opportunities.
Control -- Focus on return on investment for
various assets and asset efficiency.
Understand -- Focus on understanding how
suppliers of funds analyze the firm.
5 Major Categories of Ratios
Liquidity: Can we make required payments?
Asset management: Right amount of assets vs. sales?
Debt management: Right mix of debt and equity?
Profitability: Do sales prices exceed unit costs, and are sales high
enough as reflected in PM, ROE, and ROA?
Market value: Do investors like what they see as reflected in P/E
and M/B ratios?
Liquidity Ratios
Current Ratio
Quick Ratio
Working Capital Ratio
Cash Ratio
Current Ratio

The current ratio is a liquidity ratio that measures a company's ability to pay
short-term obligations or those due within one year.
What counts as a good current ratio will depend on the company's industry and
historical performance. As a general rule, however, a current ratio below 1.00
could indicate that a company might struggle to meet its short-term obligations,
whereas ratios of 1.50 or greater would generally indicate ample liquidity.
Current Assets and Liabilities
Some common examples of current assets are given below:
Cash
Marketable securities
Accounts receivables/debtors
Inventories/stock
Bills receivable
Short-term notes receivable
Prepaid expenses
Some common examples of current liabilities are given below:
Accounts payable/creditors
Bills payable
Short-term notes payable
Short term bonds payable
Interest payable
Unearned revenues
current portion of long term debt
Example
On December 31, 2020, the balance sheet of Marshal company shows the total
current assets of $1,100,000 and the total current liabilities of $400,000. Your are
required to compute current ratio of the company.

Answer ?
Explanation ?
Liquidity comparison of two or more companies with same current
ratio
Both company A and company B have the same current ratio (2:1). Do both the companies have
equal ability to pay its short-term obligations?
The quick ratio measures a company's capacity to pay its current liabilities
Quick Ratio

without needing to sell its inventory or obtain additional financing. The

quick ratio is considered a more conservative measure than the current ratio,
which includes all current assets as coverage for current liabilities.

(Current assets – Inventory) / Current Liabilities

A normal liquid ratio is considered to be 1:1. A company with a quick ratio of

less than 1 cannot currently fully pay back its current liabilities.
The quick ratio is similar to the current ratio but provides a more conservative
assessment of the liquidity position of firms as it excludes inventory, which it
does not consider as sufficiently liquid.
Working Capital Ratio
Working capital and the working capital ratio are both measurements of a
company's current assets as compared to its current liabilities.
The working capital ratio is calculated by dividing current assets by current
liabilities. This figure is useful in assessing a company's liquidity and operational
efficiency.

A working capital ratio below one suggests that a company may be unable to pay
its short-term debts.
Cash Ratio
The cash ratio, sometimes referred to as the cash asset ratio, is a liquidity metric
that indicates a company’s capacity to pay off short-term debt obligations with its
cash and cash equivalents.
Compared to other liquidity ratios such as the current ratio and quick ratio, the
cash ratio is a stricter, more conservative measure because only cash and cash
equivalents – a company’s most liquid assets.
 (Current and cash equivalents) / Current Liabilities
Cash Ratio
Cash includes legal tender (coins and currency) and demand deposits (checks, checking account, bank drafts, etc.).
Cash equivalents are assets that can be converted into cash quickly. Cash equivalents are readily convertible and
subject to insignificant risk. Examples include savings accounts, T-bills, and money market instruments.
Current liabilities are obligations due within one year. Examples include short-term debt, accounts payable, and
accrued liabilities.
Example
Company A’s balance sheet lists the following items:
Cash: $10,000
Cash equivalents: $20,000
Accounts receivable: $5,000
Inventory: $30,000
Property & equipment: $50,000
Accounts payable: $12,000
Short-term debt: $10,000
Long-term debt: $20,000
4. Profitability ratios
oProfitability is the net result of a number of policies and
decisions.
oThe ratios examined thus far provide useful clues as to the
effectiveness of a firm’s operations, but:
othe profitability ratios go on to show the combined effects of:
oliquidity,
oasset management, and
odebt on operating results.
Profitability Ratios
1. Net Profit Margin = Net Income / Sales
2. Operating Margin = EBIT (Operating Income) / Sales
3. Gross Profit Margin = Sales - CGS / Sales
4. Basic Earning Power (BEP) Ratio= EBIT / Total Assets
5. Return on Total Assets = Net Income / Total Assets
6. Du-Pont Analysis for ROA = Profit Margin*Total Assets Turnover
7. Return on Common Equity = Net Income / Common Equity
8. Equity Multiplier = Total Assets/Common Equity
 Profitability Ratios
1. The net profit margin, which is also called the profit margin on sales, is calculated by dividing net income by
sales. It gives the profit per dollar of sales.
◦ If company’s net profit margin is below the industry average of 5%, but why is this so?

2. The operating profit margin identifies how a company is performing with respect to its operations before the
impact of interest expenses is considered. Some analysts drill even deeper by breaking operating costs into their
components.
3. The gross profit margin identifies the gross profit per dollar of sales before any other expenses are deducted.
4. This ratio shows the raw earning power of the firm’s assets before the influence of taxes and leverage, and it is
useful for comparing firms with different tax situations and different degrees of financial leverage.
5. The ratio of net income to total assets measures the return on total assets (ROA) after interest and taxes.
6. The Du Pont equation provides a framework that ties together a firm’s profitability, asset efficiency, and use of
debt. The return on assets (ROA) can be expressed as the profit margin multiplied by the total assets turnover ratio:
7. The ratio of net income to common equity measures the return on common equity.
 Asset Management ratios
Asset management ratios measure how effectively a firm is managing its assets. The Ratios that analyze the
different types of assets are following:
1. Evaluating Inventories: The Inventory Turnover Ratio
The inventory turnover ratio is defined as sales divided by average inventories
Inventory turnover Ratio = Sales / Average Inventory
2. Evaluating Receivables: The Days Sales Outstanding
Days sales outstanding (DSO), also called the “average collection period” (ACP), is used to appraise accounts
receivable, and it is calculated by dividing accounts receivable by average daily sales to find the number of days’
sales that are tied up in receivables.
Days Sales Outstanding = Receivables / Average sales per day = Receivables / Annual sales/365
 Asset Management ratios
3. Evaluating Fixed Assets: The Fixed Assets Turnover Ratio
◦ The fixed assets turnover ratio measures how effectively the firm uses its plant and equipment. It is the ratio of
sales to net fixed assets.
Fixed Asset turnover Ratio = Sales / Net fixed asset
4. Evaluating Total Assets: The Total Assets Turnover Ratio
The total assets turnover ratio is calculated by dividing sales by total assets.
Total Asset turnover Ratio = Sales / Total asset
 Debt Management ratios
The extent to which a firm uses debt financing, or financial leverage, has three important
implications:
(1) By raising funds through debt, stockholders can maintain control of a firm without
increasing their investment.
(2) If the firm earns more on investments financed with borrowed funds than it pays in interest,
then its shareholders’ returns are magnified, or “leveraged,” but their risks are also magnified.
(3) Creditors look to the equity, or owner-supplied funds, to provide a margin of safety, so the
higher the proportion of funding supplied by stockholders, the less risk creditors face.
 Debt Management ratios
1. Debt Ratio
◦ The ratio of total liabilities to total assets is called the debt ratio, or sometimes the total debt
ratio. It measures the percentage of funds provided by current liabilities and long-term debt.
Debt Ratio = Total Liabilities/ Total asset
2. Debt to equity Ratio
The debt-to-equity (D/E) ratio is used to evaluate a company's financial leverage and is
calculated by dividing a company's total liabilities by its shareholder equity. The D/E ratio is
an important metric used in corporate finance.
Debt to equity Ratio = Total Liabilities/ Shareholder’s equity
 Debt Management ratios
3. Time Interest Earned Ratio
The times-interest-earned (TIE) ratio, also called the interest coverage ratio, is determined by dividing
earnings before interest and taxes by the interest expense.
TIE Ratio = EBIT/ Interest expense
The TIE ratio measures the extent to which operating income can decline before the firm is unable to
meet its annual interest costs. Failure to meet this obligation can bring legal action by the firm’s
creditors, possibly resulting in bankruptcy.
 5. Market Value ratios
oMarket value ratios relate a firm’s stock price to its earnings, cash flow, and book value
per share.
oMarket value ratios are a way to measure the value of a company’s stock relative to that
of another company.
o1. Price/Earnings Ratio:
The price/earnings (P/E) ratio shows how much investors are willing to pay per dollar of reported profits.
Price/Earnings Ratio = Price per share / Earning per share
2. Price/Cash Flow Ratio:
Stock prices depend on a company’s ability to generate cash flows. Consequently, investors often look at the
price/cash flow ratio, where cash flow is defined as net income plus depreciation and amortization:
Price/Cash Flow Ratio = Price per share / Cash flow per share
 Market Value Ratios
3. Market/Book Ratio
The ratio of a stock’s market price to its book value gives another indication of how
investors regard the company.
Book Value per share = Common Equity / Shares outstanding

Market/Book Ratio = Market price per share / Book value per share
 Trend, Common Size and Percentage Analysis
Trend analysis is an analysis of the trend of the company by comparing its financial statements
to analyze,
the trend of market or analysis of the future on the basis of results of past performance,
and it's an attempt to make the best decisions on the basis of results of the analysis done.
Steps related to the Trend Analysis
1 – Choose Which Pattern You Want to Identify. The first and most obvious step in trend
analysis is to identify which data trend you want to target. ...
2 – Choose Time Period. ...
3 – Choose Types of Data Needed. ...
4 – Gather Data. ...
5 – Use Charting Tools to Visualize Data.
6 – Identify Trends.
Trend, Common Size and Percentage Analysis
A common-size analysis is a tool financial managers use to learn more about a
company over time.
Also known as vertical analysis, a common-size analysis expresses each line item in a
financial statement as a percentage of a base amount for that time period.
The calculation for common-size percentages is: (Amount / Base amount) and multiply
by 100 to get a percentage.
Remember, on the balance sheet the base is total assets and on the income statement
the base is net sales.
Trend, Common Size and Percentage Analysis

Simple Percentage Analysis It refers to a special kind of rates, percentage are used in
making comparison between two or more series of data. A percentage is used to determine
relationship between the series.
Summary of Financial Ratios
Summary of Financial Ratios