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CMA PART 2 – STUDY UNIT 6

Ratio Analysis
Core Concepts

1. Qualities of Ratio Analysis

a. Although ratio analysis provides useful information pertaining to the efficiency of operations
and the stability of financial conditions, it has inherent limitations.
1) Ratios are based on accounting data, much of which is subject to estimation.
2) A firm’s management has an incentive to window dress financial statements to
improve results.
3) Comparison with industry averages is more useful for firms that operate within a
particular industry than for conglomerates.
a) Generalizations regarding which ratios are strong indicators of a firm’s financial
position may change from industry to industry, firm to firm, and division to
division.
4) Earnings quality is a measure of how useful reported earnings are as a performance
indicator. It is the inverse of the variance in earnings. If earnings have a high degree
of variability, many ratios will become less meaningful.
5) The effects of inflation on fixed assets and depreciation, inventory costs, long-term
debt, and profitability cause misstatement of a firm’s balance sheet and income
statement.
6) Comparability of financial statement amounts and the ratios derived from them is
impaired if different firms choose different accounting policies.
7) Ratio analysis may be affected by seasonal factors.
2. Liquidity Ratios – Calculations
a. Liquidity is a firm's ability to pay its current obligations as they come due and thus remain in
business in the short run. Liquidity measures the ease with which assets can be converted
to cash.
b. Liquidity ratios measure this ability by relating a firm's liquid assets to its current liabilities.
1) The current ratio
Current assets ÷ Current liabilities
2) The quick ratio
(Cash and equivalents + Marketable securities + Net receivables) ÷
Current liabilities
3) The cash ratio
(Cash and equivalents + Marketable securities) ÷ Current
liabilities
4) The cash flow ratio
Cash flow from operations ÷ Current liabilities
5) The net working capital ratio
(Current assets – Current liabilities) ÷ Total assets
c. The Liquidity of current liabilities is the ease with which a firm can issue new debt or raise
new structured (convertible, puttable, callable, etc.) funds.

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3. Profitability Ratios –Calculations

a. Four percentages are used to measure profitability directly from the income statement:
1) Gross profit margin is what percentage of gross revenues remains to the firm after
paying for merchandise
Gross profit ÷ Net sales
2) Operating profit margin is what percentage remains after selling and general and
administrative expenses have been paid
Operating income ÷ Net sales
3) Net profit margin is what percentage remains after other gains and losses (including
interest expense) and income taxes have been added or deducted
Net income ÷ Net sales
4) EBITDA approximates cash-basis profits from ongoing operations. The EBITDA
margin percentage relates it to sales
EBITDA ÷ Net sales
b. The return generated for a corporation’s owners is measured with two widely used ratios:
1) Return on assets (ROA)
Net income ÷ Average total assets
2) Return on equity (ROE)
Net income ÷ Average total equity
4. Profitability Ratios – Effects of Transactions
a. Inconsistent definitions complicate comparisons of ROI. The wide variety of definitions in use
for the terms “return” and “investment” creates difficulties in comparability.
b. The DuPont model begins with the standard equation for return on assets and breaks it
down into two component ratios, one that focuses on the income statement and one that
relates income to the balance sheet.
ROA = Net profit margin × Total asset turnover
c. The DuPont model can also be used to disaggregate return on equity (ROE)
ROE = Net profit margin × Total asset turnover × Equity multiplier
ROE = ROA × Equity Multiplier
5. Factors Affecting Reported Profitability
a. Profitability analysis must address the many factors involved in measuring the firm’s
income; the stability, sources, and trends of revenue; revenue relationships; and expenses,
including cost of sales. This analysis attempts to answer questions about the relevant
income measure, income quality, the persistence of income, and the firm’s earning power.
1) Income equals the sum of revenues and gains minus the sum of expenses and losses.
2) Cost of goods sold is the single largest cost element for any seller of merchandise and
thus has the greatest impact on profitability. A company’s gross profit margin is the
percentage of its net sales that it is able to keep after paying for merchandise.
b. Three common percentages measure profitability directly from the income statement: gross
profit margin, operating profit margin, and net profit margin.

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6. Solvency
a. Solvency is a firm's ability to pay its noncurrent obligations as they come due and thus
remain in business in the long run (contrast with liquidity). The key ingredients of solvency
are the firm’s capital structure and degree of leverage.
1) A firm’s capital structure includes its sources of financing, both long- and short-term.
These sources can be in the form of debt (external sources) or equity (internal
sources). Debt is the creditor interest in the firm. Equity is the ownership interest in
the firm.
2) Capital structure ratios report the relative proportions of debt and equity in a firm's
capital structure.
a) The total debt to total capital ratio
Total debt ÷ Total capital
b) The debt to equity ratio
Total debt ÷ Stockholders' equity
c) The long-term debt to equity capital ratio
Long-term debt ÷ Stockholders' equity
d) The debt to total assets ratio (also called the debt ratio)
Total liabilities ÷ Total assets
3) Earnings coverage is a creditor's best measure of a firm's ongoing ability to generate
the earnings that will allow it to satisfy its long-term debts and remain solvent.
a) The times interest earned ratio is an income statement approach to evaluating a
firm’s ongoing ability to meet the interest payments on its debt obligations.
EBIT ÷ Interest expense
b) The earnings to fixed charges ratio (also called the fixed charge coverage ratio)
extends the times interest earned ratio to include the interest portion associated
with long-term lease obligations.
c) The cash flow to fixed charges ratio removes the difficulties of comparing
amounts prepared on an accrual basis
7. Leverage
a. A firm's leverage is the relative amount of the fixed cost in a firm's overall cost structure
Leverage, by definition, creates risk because fixed costs must be covered, regardless of
the level of sales.
1) Degree of operating leverage

2) Degree of financial leverage

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8. Common-Size Financial Statements

a. Common-size statements restate financial statement line items in terms of a percentage
of a given amount, such as total assets for a balance sheet or net sales for an income
statement (this is called vertical analysis).
b. In horizontal analysis, the amounts for several periods are stated in percentages of a base-
year amount. These are often called trend percentages. Another form of horizontal analysis
does not use common sizes. This method is used to calculate the growth (or decline) of key
financial line items.
9. Effects of Off-Balance-Sheet Financing
a. Reducing a company’s debt load improves its ratios, making its securities more attractive
investments. Also, many loan covenants contain restrictions on the total debt load that a
company is permitted to carry.
b. However, reducing debt and hiding it are two very different things. Firms that carry extensive
debt financing but attempt to disguise the fact are engaging in off-balance-sheet financing.
c. Off-balance-sheet financing takes four principal forms: investments in unconsolidated
subsidiaries, special purpose entities (SPEs)/variable interest entities (VIEs), operating
leases, and factoring receivables with recourse.

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