MODULE 2

LESSON 3:
RATIO ANALYSIS
 RATIO ANALYSIS
It is the comparison of line items in the financial statements
of a business. Ratio analysis is particularly useful when used
in the following two ways:

• Trend Line
• Industry Comparison
 RATIO ANALYSIS
Ratio Analysis is used to evaluate a number of issues with an
entity such as:
• Liquidity
• Efficiency
• Solvency
• Profitability
 RATIO ANALYSIS
Ratio Analysis is used to evaluate a number of issues with an
entity such as:
• Liquidity • Efficiency
a) Current Ratio a) A/R Turnover
b) Inventory Turnover
b) Quick Ratio c) Days’ Sales Outstanding
d) Days’ Sales in Inventory
e) Operating Cycle
 LIQUIDITY RATIOS
• It measure the ability of a company to repay its short‐term debts
and meet unexpected cash needs.

• A ratio of 1 means that a company can exactly pay off all its
current liabilities with its current assets.

• A ratio of less than 1 (e.g., 0.75) would imply that a company is not
able to satisfy its current liabilities.

• A ratio greater than 1 (e.g., 2.0) would imply that a company is

able to satisfy its current bills.
LIQUIDITY RATIO: CURRENT RATIO
• Also known as Working Capital Ratio.

• Current Ratio is the simplest liquidity ratio to calculate and interpret. This
ratio will show the ability of the company to pay its current maturing
obligations.

CURRENT RATIO = CURRENT ASSETS

CURRENT LIABILITIES
• Current Assets = Cash + A/R + Inventory + Marketable Sec. + Prepaid Exp.
 2020 2019
CASH 3,500 3,300

ACCOUNTS RECEIVABLE 6,700 5,690

INVENTORY 5,940 7,320

PREPAID EXPENSES 2,800 2,500

MARKETABLE SECURITIES 4,315 2,976

TOTAL CURRENT ASSETS (3,500 + 6,700 + 5,940 + 2,800 + 4,315) = 23,255 21,786

CURRENT LIABILITIES 20,000 21,000

CURRENT RATIO (23,255/20,000) = 1.16275 = 1.16 1.04

LIQUIDITY RATIO: QUICK RATIO
• This is also known as acid test ratio.

• It examines liquidity from a more immediate aspect than does the current
ratio by eliminating inventory and prepaid expenses from current assets.

QUICK RATIO = CASH + A/R + M/S

CURRENT LIABILITIES
 2020 2019
CASH 3,500 3,300

ACCOUNTS RECEIVABLE 6,700 5,690

INVENTORY 5,940 7,320

PREPAID EXPENSES 2,800 2,500

MARKETABLE SECURITIES 4,315 2,976

TOTAL CURRENT ASSETS (3,500 + 6,700 + 5,940 + 2,800 + 4,315) = 23,255 21,786

TOTAL QUICK ASSETS (3,500 + 6,700 + 4,315) = 14,515 11,966

CURRENT LIABILITIES 20,000 21,000

CURRENT RATIO (23,255/20,000) = 1.16275 = 1.16 1.04

QUICK RATIO (14,515/20,000) = 0.72575 = 0.73 0.57

 EFFICIENCY RATIO
• Efficiency ratios measure how well the business is using its
assets and liabilities to generate sales and earn profits.

• They calculate the use of inventory, machinery utilization,

turnover of liabilities, as well as the usage of equity.
EFFICIENCY RATIO: ACCOUNTS
RECEVABLE TURNOVER (times)
• It measures the average number of times that receivables
from sales are collected during a year.

A/R TURNOVER = NET CREDIT SALES

AVERAGE A/R

• AVERAGE A/R = (A/R y1 + A/R y2) / 2 or

(A/R BEG + A/R END) / 2
 2020

Cash 10,000
A/R, beginning 20,000
Inv., beginning 30,000
A/R, ending 24,000
Inv., ending 26,000
Current Liabilities 60,000
Net Credit Sales 220,000
Cost of Goods Sold 140,000

Average A/R (20,000 + 24,000) / 2 = 22,000

A/R TURNOVER (220,000/22,000) = 10 times
 2020 2019
Net Credit Sales 129,000 97,000

Accounts 18,567 19,230

Receivable
Average A/R (18,567 + 19,230) / 2 = 18,898.5

A/R TURNOVER (129,000/18,898.5) = 6.825938

= 6.83 times
 EFFICIENCY RATIO:
DAYS’ SALES OUTSTANDING (days)
• This is also known as Average Collection Period.
• Days’ Sales Outstanding is a calculation used by a company
to estimate the size of their outstanding accounts receivable.

DAYS’ SALES OUTSTANDING = 365

A/R TURNOVER
 2020
Cash 10,000
A/R, beginning 20,000
Inv., beginning 30,000
A/R, ending 24,000
Inv., ending 26,000
Current Liabilities 60,000
Net Credit Sales 220,000
Cost of Goods Sold 140,000

Average A/R (20,000 + 24,000) / 2 = 22,000

A/R TURNOVER (220,000/22,000) = 10 times
DAYS’ SALES OUTSTANDING 365/10 = 36.5 days
 2020 2019
Net Credit Sales 129,000 97,000

Accounts 18,567 19,230

Receivable

Average A/R (18,567+19,230) / 2 = 18,898.5

A/R TURNOVER 129,000/18,898.5 = 6.83 times

DAYS’ SALES 365/6.83 = 53.4407027818

OUTSTANDING = 53.44 days
 EFFICIENCY RATIO:
INVENTORY TURNOVER (times)
• It measures the number of times the company sells its
inventory during the period.

INVENTORY TURNOVER = COST OF GOODS SOLD

AVERAGE INVENTORY
• AVERAGE INV. = (INV. y1 + INV. y2) / 2 or
(INV. BEG + INV. END) / 2
 2020

Cash 10,000
A/R, beginning 20,000
Inv., beginning 30,000
A/R, ending 24,000
Inv., ending 26,000
Current Liabilities 60,000
Net Credit Sales 220,000
Cost of Goods Sold 140,000

Average Inventory (30,000 + 26,000) / 2 = 28,000

Inventory TURNOVER (140,000/28,000) = 5 times
 2020 2019
Cost of Goods Sold 70,950 59,740

Inventory 12,309 12,202

Average Inventory (12,309+12,202) / 2 = 12,255.5

INVENTORY TURNOVER (70,950/12,255.5) = 5.789237485

= 5.79 times
 EFFICIENCY RATIO:
DAYS’ SALES IN INVENTORY (days)
• This is an efficiency ratio that measures the average number of
days the company holds its inventory before selling it.

DAYS’ SALES IN INVENTORY = 365

INVENTORY TURNOVER
 2020

Cash 10,000
A/R, beginning 20,000
Inv., beginning 30,000
A/R, ending 24,000
Inv., ending 26,000
Current Liabilities 60,000
Net Credit Sales 220,000
Cost of Goods Sold 140,000

Average Inventory (30,000 + 26,000) / 2 = 28,000

Inventory TURNOVER (140,000/28,000) = 5 times
DAYS’ IN INVENTORY 365/5 = 73 days
 2020 2019
Cost of Goods Sold 70,950 59,740

Inventory 12,309 12,202

Average Inventory (12,309+12,202)/2 = 12,255.5
INVENTORY TURNOVER (70,950/12,255.5) = 5.79 times
DAYS’ SALES IN INVENTORY 365/5.79 = 63.039723661
= 63.04 days
 EFFICIENCY RATIO:
OPERATING CYCLE (days)
• This indicates how quickly the company will receive cash once
inventory is acquired or a product is manufactured.

OPERATING CYCLE = DAYS’ SALES IN INVENTORY +

DAYS’ SALES OUTSTANDING
 2020 2019 2020 2019
Net Credit Sales 129,000 97,000 Cost of Goods Sold 70,950 59,740

Accounts Receivable 18,567 19,230 Inventory 12,309 12,202

Average A/R 18,898.5 Average Inventory 12,255.5

A/R TURNOVER 6.83 TIMES INVENTORY TURNOVER 5.79 TIMES

DAYS/ SALES 53.44 DAYS DAYS’ IN INVENTORY 63.04 DAYS

OUTSTANDING

OPERATING CYCLE = 53.44 days + 63.04 days

= 116.48 days
= 116 days

(NOTE: ALWAYS ROUND YOUR FINAL ANSWERS TO THE NEAREST WHOLE NUMBER WHEN
COMPUTING FOR OPERATING CYCLE.)