RATIO ANALYSIS

LIQUIDITY RATIOS - Liquidity refers to the entity's ability to meet its short-term obligations. Liquidity
ratios provide the basis for answering the question: Does the firm have sufficient cash and near-cash assets to pay
its maturing obligations? Managers are concerned about the short-term survival of the firm, so attention is
placed on liquidity ratios. There are two basic liquidity ratios: (1) Current Ratio and (2) Quick Ratio.

Current Ratio = Current Assets Also called the Working Capital Ratio
Current Liabilities
This ratio measures the ability of a company to pay its current obligations using current assets. This indicates
how much in current assets has the firm for every dollar in current liabilities. A general rule of thumb is that a
firm's current ratio should be at least 2 to 1.
However this ratio is limited, since it does not indicate the full measure of the firm's ability to meet its short-
term obligations, as not all current assets may be easily converted into cash as quickly as needed.
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Quick Ratio = Quick Assets Also called the Acid Test Ratio.
Current Liabilities

Quick assets are defined as cash, marketable securities, accounts receivable and current notes receivable.
These assets can be converted into cash much more quickly than inventory (may not be readily saleable) and
prepaid expenses (may not be transferable to others). A general rule of thumb is that it should be 1:1.

The Acid Test or Quick Ratio measures immediate liquidity. It indicates how much current assets the firm
has for every dollar of current liabilities.

PROFITABILITY RATIOS - measure the income or operating success (profits) of the entity for a given
period of time. Income or the lack of income, has a significant effect on (1) the entity's ability to
obtain financing through debt and equity, (2) the entity's liquidity position and (3) the entity's ability to
grow. Creditors as well as investors are interested in assessing the entity's earning power, i.e. its
profitability. Management's effectiveness is often evaluated through the entity's profitability.
Profitability ratios provide answers to questions such as:
How much of each dollar received from sales was transformed into profits?
How much profit per dollar of assets did the entity earn?

Gross Margin Percentage = Gross Profit x 100

Sales

This ratio measures the amount of returns an entity receives from sales by deducting its cost of sales
(purchases/ cost of goods sold).
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Net Income Percentage = Net Income x 100
Sales

Also called Profit Margin or Rate of Return on Sales. This ratio measures the amount of returns an entity
receives from sales, by deducting its cost of sales and expenses.
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Return on Assets (ROA) = Net Income + [Interest Expenses x (1 - Tax Rate)]
Average Total Assets

This ratio tests the amount of returns an entity receives from investment in assets. It indicates how effective
the assets were employed during the year.
[If there is no interest expense, compute the ratio by simply dividing the net income by the average total assets.]
Return on Capital Employed (ROCE) = Net Income x 100
Capital Employed

Capital Employed = Common Stock + Reserves + Long-term Liabilities.

This ratio examines the relationship between the profits generated and the net assets of the entity. It measures the
amount of return an entity receives from its capital employed - both owner supplied funds as well as creditors
supplied funds.
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Earnings Per Share (EPS) Net Income available to common shareholders

of common stock Average number of common stock in issue

Any preferred dividends declared for the period must be deducted from the Net Income.
This ratio is of concern to investors. It measures the amount of net income earned on each share of common
stock.
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Price-Earnings Ratio (P/E) = Market Price

Earnings per Share

P/E ratio is also called the Earnings Multiple. This ratio is of concern to investors. It shows the
relationship between income and share price. The ratio informs investors of the number of years of the
current profits that are represented by the share price. P/E ratio is often quoted as a statistic and it reflects
investors' assessments of an entity's future earnings.

A company with a high P/E ratio indicates that investors predict that the entity's net income will increase
rapidly.

The profitability of investors' personal investment in shares takes the forms of (1) cash dividends (2) market
price appreciation of the shares. Investors who seek cash returns on their investments will be concerned about
dividend ratios.
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Dividends per Share = Total Common Stock Dividends

Number of common stock in issue

An entity declares a dividend based on the par value of its shares. The investor calculates the Dividends per
Share ratio to evaluate the relationship between the dividends paid and the profits made by the entity.

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Dividend Pay-Out Ratio = Total Common Stock Dividends

Net Income available to common stockholders

OR
Dividend Pay-Out Ratio = Dividends per Share of common shares
Earnings per Share
This ratio shows the proportion of earnings per share that is paid to the common shareholder in the form of
dividends. The dividend pay-out ratio that is best for the entity depends on its opportunities for growth, and the
needs of the entity for re-investment. Companies with high growth rates generally have low payout ratios
because they reinvest most of their income into the business.

Dividend Yield = Dividend paid per share

Market price of one common share

It measures the return in cash dividends earned by an investor on one share of the company's stock. It is calculated
by dividing dividends paid per share by the market price of one common share at the end of the period.
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SOLVENCY RATIOS - measure the ability of the company to survive over a long period of time. They
provide information about the entity's debt-paying ability. Solvency ratios provide answers to two
questions:
How has the entity financed its assets? [Answered by balance sheet ratios]
Can the entity afford the level of fixed charges associated with its use of non-owner supplied funds
such as bond interest and principal repayment? [Answered by income statement ratios]
Long-term creditors and stockholders are interested in the entity's ability to pay interest as it comes due and to
repay the face value of debt at maturity.

Debt to Asset Ratio = Total Liabilities

Total Assets

This ratio tells the extent to which the total assets of the firm have been financed by using borrowed funds. It
indicated how much of every dollar invested in assets has been contributed by persons other than the owner (the
entity's degree of leverage). It also shows the ability of the entity to endure losses and still meet its
obligations to creditors. The higher the percentage of debt to total assets, the greater the risk, that the entity
may be unable to meet its maturing obligations.

Creditors may prefer the entity to have a low debt to asset ratio. Companies with relatively stable earnings,
such as public utilities companies, have higher debt to total assets ratios than cyclical companies with
fluctuating earnings, such as high-tech firms.
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Debt to Equity Ratio = Total Liabilities

Total Equity

Also called the Gearing Ratio.

This ratio indicates the extent to which the firm has used long-term debt in its financing for the long-term.

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Times Interest Earned or Interest Cover = Net Income + Interest Expense + Tax
Interest Expense

This ratio measures the firm's ability to meet its interest payments out of its operating earnings
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ACTIVITY RATIOS - provide a basis for assessing how effectively the entity has used its resources to
generate sales. These ratios compare the sales figure with investment in a variety of assets such as inventory
and accounts receivable. The relationship between cost of sales and accounts payable is assessed by these
ratios. Managers, creditors and investors use them to determine how effectively the entity has managed its
assets and liabilities.

Inventory Turnover Ratio = Cost of Goods Sold

Average Inventory

This ratio measures the number of times on average the inventory is sold during the period. It measures the
liquidity of the inventory. Usually, the more frequently the inventory turns over, the d s cash is tied up in
inventory and the less the chance of inventory obsolescence. Inventory turnover ratios vary depending on the
industry. Inventory turnover of grocery stores is greater than that of jewelry stores.

The ratio can be expressed as the average days to sell the inventory.
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Inventory turnover in Days = 365 / Cost of Goods Sold = Average Inventory x 365
Average Inventory Cost of Goods Sold

This tells the average number of days the inventory remains in the business before it is sold to a customer.
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Receivables Turnover = Net Credit Sales

Average Accounts Receivable

This ratio measures how quickly receivables can be converted into cash. It tells the number of times on
average that receivables are collected during the period/year. Generally, the quicker the receivables
turnover, the more reliable is the assessment of liquidity that is placed on the Current and Acid Test Ratios.
The ratio can be expressed as the average collection period of accounts receivable.

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Average Collection Period in Days = Average Accounts Receivable x 365

Net Credit Sales

This ratio indicates the average length of time that an entity must wait before the cash earned from sales. The
ratio is frequently used to assess the effectiveness of an entity's credit and collection policies. Generally, the
collection period should not greatly exceed the credit term period (payment period for payables).
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Payables Turnover = Cost of Goods Sold

Average Accounts Payables

This ratio indicates the regularity with which cash payments are made to creditors. The ratio can be expressed as
the average payment period of accounts payable.
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Average Payment Period = Average Accounts Payables x 365

Cost of Goods Sold
This ratio tells the average length of time that a business takes before it makes a cash payment to creditors.