Financial Ratio Analysis

Financial analysis: Applying analytical techniques to financial statements

and other relevant data to produce information useful
for decision making.
Focus

Three Issues : Profitability, Liquidity, Safety (Solvency or Risk)

In general, each financial ratio is closely related to one of the

three fundamental issues.

This analysis is intended as a background review. See also “Merrill Lynch How

to Read A Financial Statement” which is available on the web.
GI Company Balance Sheet December 31
Current Assets: Year 1 (Current year) Year 2 (Last year)
Cash and cash equivalents $ 50,000 $ 35,000
Trading securities (at fair value) 750,000 65,000
Accounts receivable 300,000 290,000
Inventory (at lower of cost or market) 290,000 275,000
Total current assets 715,000 665,000
Investments available-for-sale (at fair value) 350,000 300,000
Fixed Assets:
Property, plant, and equipment (at cost) 1,900,000 1,800,000
Less: Accumulated depreciation (380,000) (350,000)
1,520,000 1,450,000
Goodwill 30,000 35,000
Total assets $2,615,000 $2,450,000
Current Liabilities:
Accounts payable $ 150,000 $ 125,000
Notes payable 325,000 375,000
Accrued and other liabilities 220,000 200,000
Total current liabilities 695,000 700,000
Long-term debt:
Bonds and notes payable 650,000 600,000
Total liability 1,345,000 1,300,000
Stockholders’ Equity:
Common stock (100,000 shares outstanding) 500,000 500,000
Additional paid-in capital 350,000 350,000
Retained earnings 420,000 300,000
Total equity 1,270,000 1,150,000
Total liability and equity $2,615,000 $2,450,000
GI Company
Income Statement
(Year – 1)

Sales $1,800,000
Cost of goods sold (1,000,000)
Gross profit 800,000
Operating expenses (486,697)
Interest expense (10,000 )
Depreciation and Amortization expense (13,303)
Net income before income taxes 290,000
Income taxes (31%) ( 90,000)
Net income after income taxes $ 200,000

Earning per share $2

Operating cash flow $255,000
Dividends for the year $0.80 per share
Market price per share $12
 Liquidity Ratios

Working capital = Current assets – Current liabilities

Year 1: $715,000 – $695,000 = $20,000

Year 2: $665,000 – $700,000 = ($35,000)
 Liquidity Ratios

Current assets
Current ratio (working capital ratio) =
Current liabilities
Year 1: = = 1.03
$715,000
$695,000
Year 2: = = 0.95
$665,000
$700,000
(Industry average = 1.5)

The ratio, and therefore Gi’s ability to meet its short-term obligations,
has improved, though it is low compared to the industry’s average
 Liquidity Ratios

Cash equivalents + Market securities + Net receivables

Acid-test ratio =
Current liabilities
(Year 1) = = 1.58
$50,000 + $750,000 + $300,000
$695,000
(Year 2) = = 0.56
$35,000 + $65,000 + $290,000
$700,000

(Industry average = 0.80)

The industry average of .80 is higher than Gi’s ratio, which indicates
that Gi may have trouble meeting short-term needs.
 Liquidity Ratios

Cash equivalents + Marketable securities

Cash ratio =
Current liabilities

(Year 1) = = 1.15
$50,000 + $750,000
$695,000
(Year 2) = = 0.14
$35,000 + $65,000
$700,000
 Activity Ratios

Net credit sales

Accounts receivable turnover =
Gross receivables
=
$1,800,000

= 6 times $300,000

This ratio indicates the receivables’ quality and indicates the success of the firm
in collecting outstanding receivables. Faster turnover gives credibility to the
current and acid-test ratios.
 Activity Ratios

Gross receivables
Accounts receivable turnover in days =
Net credit sales / 365
=
365 days
Receivable turnover
= 60.83days

This ratio indicates the average number of days required to collect accounts
receivable.
 Activity Ratios

Cost of goods sold

Inventory turnover =
Average inventory
=
$1,000,000
$290,000
= 3.45 times

This measure of how quickly inventory is sold is an indicator of enterprise

performance. The higher of turnover, in general, the better the performance.
 Activity Ratios

Average inventory
Inventory turnover in days =
Cost of goods sold / 365
=
365 days
Inventory turnover
=
365 days

= 3.45
105.85 days

This ratio indicates the average number of days required to sell inventory.
 Activity Ratios

Operating cycle = AR turnover in days + Inventory turnover in days

= 60.83 days + 105.85 days

= 166.68 days

This operating cycle indicates the number of days between acquisition of

inventory and realization of cash from selling the inventory.
 Activity Ratios

Sales
Working capital turnover =
working capital
=
$1,800,000
$715,000 - $695,000
= 90 times

This ratio indicates how effectively working capital is used.

 Profitability Ratios

Return on total assets = Net income/Total assets

= $200,000 / $2,615,000

= 7.65%
 Profitability Ratios

Gross margin = Sales – Cost of Good Sold

= $1,800,000 - $1,000,000
= $800,000

Gross margin percentage = Gross margin / Sales

= $800,000 / $1,800,000
= 44.44%

This ratio is a good indication of how profitable a company is at the most

fundamental level. Companies with higher gross margins will have more
money left over to spend on other business operations, such as research
and development or marketing. 



 Profitability Ratios

Net income
Net profit margin =
Net sales
=
$200,000
$1,800,000
= 11.11%

This ratio indicates profit rate and, when used with the asset turnover ratio,
indicates rate of return on assets, as show below.
 Profitability Ratios

Operating income
Operating margin =
Total sales

$800,000 - $486,697
=
$1,800,000

= 17.41%

Operating margin is a measurement of what proportion of a company's

revenue is left over after paying for variable costs of production such as
wages, raw materials, etc. A healthy operating margin is required for a
company to be able to pay for its fixed costs, such as interest on debt. 

 Activity Ratios

Net sales
Total asset turnover =
Total assets
=
$1,800,000
$2,615,000
= 0.69 times

This ratio is an indicator of how Gi makes effective use of its assets. A high
ratio indicates effective asset use to generate sales.
 Profitability Ratios

DuPont return on assets = Net income/Total assets

= Net income Net sales

x
Net sales Total assets
= 11.11% x 0.69times

= 7.67%

Note that this ratio uses both net profit margin and the total asset turnover. This
ratio allows for increased analysis of the changes in the percentages. The net
profit margin indicates the percent return on each sale while the asset turnover
indicates the effective use of assets in generating that sale.
 Profitability Ratios

Net income + Interest expense (1- Tax rate)

Return on investment =
Long-term liabilities + Equity
=
$200,000 + $10,000 (1-0.31)
$650,000 + $1,270,000
= 0.11 times

ROI measures the performance of the firm without regard to the

method of financing.
 Profitability Ratios

Net income – Preferred dividends

Return on common equity =
common equity
=
$200,000 - $0
$1,270,000
= 15.75%
 Long-term Debt-paying Ability Ratio

Total liabilities
Debt / Equity =
Common stockholders’ equity
(Year 2) = $1,345,000 / $1,270,000 = 1.06
(Year 1) = $1,300,000 / $1,150,000 = 1.13

This ratio indicates the degree of protection to creditors in case of insolvency.

The lower this ratio the better the company’s position. In Gi’s case, the ratio is
very high, indicating that a majority of funds come from creditors. However, the
ratio is improving.
 Long-term Debt-paying Ability Ratio

Total liabilities
Debt ratio =
Total assets
(Year 2) = $1,345,000 / $2,615,000 = 51.4%
(Year 1) = $1,300,000 / $2,450,000 = 53.1%

This ratio indicates that more than half of the assets are financed by creditors.
 Long-term Debt-paying Ability Ratio

Returning income before taxes and interest

Times interest earned =
Interest
=
$290,000 + $10,000
$10,000
= 30 times

This ratio reflects the ability of a company to cover interest charges. It uses
income before interest and taxes to reflect the amount of income available to
cover interest expense.
 Long-term Debt-paying Ability Ratio

Operating cash flow

Operating cash flow / Total debt =
Total debt
=
$255,000
$1,345,000
= 18.96%

This ratio indicates the ability of the company to cover total debt with yearly
cash flow.
 Liquidity Ratios

Cash from operations

The operating cash flow ratio =
Current liabilities

$255,000
=
$700,000

= 0.36
The purpose of this ratio is to assess whether or not a company's operations are
generating enough cash flow to cover its current liabilities. If the ratio falls below
1.00, then the company is not generating enough cash to meet its current
commitments.
Note: The cash from operating activities is $255,000 shown at the bottom of the
income statement.
 Profitability Ratio

EBIT = Earnings + Interest Expense + Tax Expense

= $200,000 + $10,000 + $90,000

= $300,000

A measure of a company's earning power from ongoing operations, equal to

earnings before deduction of interest payments and income taxes. EBIT
excludes income and expenditure from unusual, non-recurring or
discontinued activities.
 Profitability Ratio

EBITDA = Earnings + Interest Expense + Tax Expense +

Depreciation + Amortization

= $200,000 + $10,000 + $90,000 + $13,303

= $ 313,303

This earnings measure is of particular interest in cases where companies

have large amounts of fixed assets which are subject to heavy depreciation
charges or in the case where a company has a large amount of acquired
intangible assets on its books and is thus subject to large amortization
charges. Since the distortionary accounting and financing effects on
company earnings do not factor into EBITDA, it is a good way of comparing
companies within and across industries.