FINANCIAL RATIO ANALYSIS

RATIO ANALYSIS
- It is a process of selecting, evaluating and interpreting the past financial data of a firm
- It serves as a basis for:
i) Making financial decision
ii) To access the strengths and weaknesses of the firm’s management, economic
performance and potential investment

TYPES OF RATIOS

1. Liquidity ratio : measure the firm’s capability to pay off its short term liabilities and
expenses
: measure the firm’s ability to meet the short term obligations

2. Activity / efficiency : show how effective the firm is using its assets and inventories
ratio : indicate how well the firm converts their receivables

3. Debt ratio : show the firm’s percentage / degree that the firm is using
borrowed funds for their operations

4. Profitability ratio : measure the profitability of the firm at a given level of assets,
sales and equity

LIQUIDITY RATIO
- higher ratios are better as they represent higher ability to pay but excessive liquidity may
indicate too much investment in current assets
- the less liquid the firm, the greater the chance that the firm will be unable to pay creditors
when payments are due

Current ratio Current assets Measure the ability of a The higher the ratio the
Current liabilities firm to pay off its greater the ability of a firm to
current obligations with pay off its current obligations
current assets

Quick ratio / Current assets – inventories Measure the ability of a The higher the ratio the
acid test ratio – prepaid expenses firm to pay off its greater the ability of a firm to
Current liabilities current obligations with pay off its current obligation
the most liquid assets with the most liquid assets

ACTIVITY RATIO / EFFICIENCY RATIO / TURNOVER RATIO

- higher ratio is desirable as it indicates greater efficiency

Inventory turnover COGS Measure the efficiency of The higher the ratio the
Inventories the firm’s inventories more efficient the firm is
in its inventory
management

A low inventory
turnover can signal
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 poor sales or high
inventory levels. A high
inventory turnover can
signal better sales or
tighter management
control.
Average collection Account receivables x 360 Determine the average Higher ACP is not
period Total sales length of time taken by desirable as it indicates
the firm to collect its debt poor sales and slow
from creditors collections or a very
lenient collection policy.

Fixed assets Sales Indicate how well the firm Higher ratio indicates
turnover Net fixed assets uses its fixed assets to the firm is efficient in
generate sales generating sales from
the available fixed
assets.

Total assets Sales Indicate how well the firm Higher ratio indicates
turnover Total assets uses its total assets to better efficiency in
generate sales managing its total
assets

DEBT RATIO / LEVERAGE RATIO / GEARING RATIO

- high degree of indebtedness will result in higher risk because firm is subjected to high fixed
payment obligations and thus will reduce their profit

Debt ratio Total liabilities - Indicate the amount of debt in The higher the ratio the greater
Total assets the firm’s financial structure the debt level.

- Measure the amount of Higher ratio is less desirable as

percentage of total assets it higher risk
being financed by
debt/liabilities

Long term Long term debt Measure the amount of The higher the ratio the greater
debt ratio Total assets percentage of total assets being the debt level.
financed by long term
debt/liabilities Higher ratio is less desirable as
it higher risk

Debt to Total debt Indicate the extend where debt The higher the ratio the greater
equity ratio Total equity financing is used compared to the debt level.
equity financing
Higher ratio is less desirable as
it indicates higher risk

Time interest EBIT Measure the ability of the firm in Higher ratio indicates the firm is
earned Interest paying its interest obligation in the position to continue
making payment on its interest
obligation without difficulty
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PROFITABILITY RATIO

Gross profit Gross profit Measure the Higher ratio indicates lower
margin Sales efficiency of the COGS relative to sales
firm’s operation

Operating Operating profit Shows the firm’s Higher ratio indicates lower
profit margin Sales ability to control cost structure and will result
all costs except in higher profit
for interest and
taxes in its
operation

Net profit Net profit Measure the Higher ratio indicates higher
margin Sales profitability with ability of the firm to obtain
respect to sales profit from the given level of
generated sales

Return on Net profit Measure the Higher ratio indicates higher

investment Total assets effectiveness of ability of the firm to obtain
OR Return the firm to profit from the given level of
on assets generate profit assets
with all its
available assets

Return on Net profit Measure the Higher ratio indicates higher

equity Total equity effectiveness of ability of the firm to obtain
the firm to profit from the given level of
generate profit equity
with all its equity

METHODS USED IN ANALYZING / INTERPRETING THE FINANCIAL RATIOS

1. Vertical / Trend / Time-series analysis

- comparison between the firm’s current performance with the past performances
- it is used to find out the trend

2. Horizontal / Comparative / Cross-sectional analysis

- comparison between the firm’s performance with the industry or the other company within the
same business/industry category

LIMITATION OF RATIO ANALYSIS

1. It is sometimes difficult to identify the industry category to which a firm belongs when the
firm engages in multiple line of business
2. Accounting practices may differ from one firm to another firm and can lead to differences in
computed ratios
3. Many firms experience seasonality in their operation thus the ratios will vary from time to
time
4. Published industry averages are only approximations and provide the user with general
guidelines rather than systematically determined averages of the ratios
5. An industry averages may not provide a desirable target ratio or norm
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Market value ratios (measured the ability of the company to generate market value in excess of
its investment costs)
1. Earnings per share (EPS) = (net income – p/s div) / number of outstanding shares
2. Dividend per share = dividend paid/ number of outstanding shares
3. Dividend payout ratio (DPR)= dividend / (net income – p/s dividend)
4. Retention ratio = 1- DPR
5. Dividend yield = DPS / Market price
6. Book value per share = tangible net worth / number of outstanding shares
7. Price earnings ratio = market price / eps