CHAPTER V

RATIO ANALYSIS

Financial analysis is a broader concept that encompasses various methods for

assessing a company's financial health, while ratio analysis is a specific technique within
financial analysis that involves the calculation and interpretation of financial ratios to
evaluate specific aspects of a company's performance. Ratio analysis is a valuable tool used
within the broader framework of financial analysis.

Ratio analysis is a crucial tool in financial analysis that helps assess the financial
performance and health of a company. It involves the calculation and interpretation of
various financial ratios to gain insights into a company's operations, profitability, liquidity,
solvency, and efficiency. Ratio analysis is widely used by investors, creditors, analysts, and
management to make informed decisions about a company's financial status and to
compare it with other companies in the industry. Let's delve deeper into the nature, concept,
and purpose of ratio analysis:

Nature of Ratio Analysis

 Quantitative: Ratio analysis relies on quantitative data extracted from a company's

financial statements, such as the balance sheet and income statement.
 Comparative: It involves comparing different financial ratios with historical data for
the same company, industry averages, or benchmarks to assess trends and
performance.
 Diagnostic Tool: Ratio analysis is used to diagnose financial problems and
strengths within an organization.

Benefits of Ratio Analysis

The ratio analysis forms an essential part of the financial analysis which is a vital part
of business planning. The key benefits of ratio analysis include:

 Determines profitability. Ratio analysis assists managers to work out the

production of the company by figuring the profitability ratios. Also, the management
can evaluate their revenues to check if their productivity. Thus, probability ratios are
helpful to the company in appraising its performance based on current earning.

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  Helpful in evaluating solvency. Solvency ratios indicate a company's ability to meet
its long-term financial obligations. They compare a company's assets to its liabilities.
 Better financial analysis. Ratio analysis provides a comprehensive view of a
company's financial health, which is useful for shareholders, creditors, and
management to make informed decisions.
 Performance analysis. Ratio analysis is also helpful in analyzing the performance of
a company. Through financial analysis, companies can review their performance in
the past years. This is also helpful in identifying their weaknesses and improving on
them.
 Forecasting. Ratio analysis helps in predicting future financial trends based on
historical data. It forms the basis for budgeting and planning.

Financial ratios play a crucial role in aiding both internal and external stakeholders in
making informed decisions regarding a company. These stakeholders, whether potential
investors, suppliers, lenders, or those involved in internal operations, rely on ratio analysis to
assess a company's financial health. Ratio analysis provides valuable insights into
performance trends, helps establish performance benchmarks, sets budget expectations,
and facilitates comparisons with industry competitors. There are four primary categories of
ratios—liquidity, solvency, efficiency, and profitability—each offering unique perspectives on
a company's financial status. It's important to note that ideal outcomes for these ratios can
vary depending on the industry, influencing stakeholder decisions accordingly.

Classification of Financial Ratios

Ratios can be categorized into four main types:

A. Liquidity Ratios: are financial metrics that assess a company's ability to meet its
short-term financial obligations and cover its immediate cash needs. These ratios are
crucial for evaluating a company's financial health and its capacity to handle
unexpected financial challenges. There are several liquidity ratios commonly used by
investors, analysts, and creditors. The two (2) most widely used liquidity ratios are
the current ratio and the quick ratio.

 Current Ratio - is a commonly used liquidity ratio that assesses a company's ability
to meet its short-term financial obligations with its short-term assets. It's a

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 fundamental financial metric that provides insights into a company's liquidity and its
capacity to cover immediate cash needs. The current ratio is calculated as follows:

Current Ratio = Current Assets / Current Liabilities

Example Computation:

Current Assets: 468, 000 468, 000

134, 400 This means that for every
Current Liabilities: 134, 400 = 3.48 peso of current liability, the
company has 3 or more to
liquidate the same.

 Quick Ratio (Acid-Test Ratio) - also known as the Acid-Test Ratio or the Liquidity
Ratio, is a financial metric used to evaluate a company's short-term liquidity and its
ability to cover its immediate financial obligations without relying on the sale of
inventory. It is a more conservative measure of liquidity compared to the Current
Ratio, as it excludes inventory from the calculation.

The formula for the Quick Ratio is as follows:

Quick Ratio = (Cash + Cash Equivalents + Marketable Securities + Accounts

Receivable or Quick Asset) / Current Liabilities

Liquidity is the availability of liquid asset, i.e., assets that are easily converted into
cash. It uses only the “quick asset,” the more liquid assets, i.e., those that can be readily
converted into cash; hence, inventories and prepaid expenses should not be included
because it may take some time to convert inventories into cash for, they are generally
converted into receivables first before being converted to cash upon collection.

Example computation:

Cash P 68, 000

Marketable Securities 80, 000
Receivable 150, 000
Current Liabilities 134, 400

Quick Ratio = (68, 000 + 80, 000 + 134, 400)

134, 400
= 2.22

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 A Quick Ratio value of 2.22 means that the company has 2.22 pesos in highly liquid
assets (cash, cash equivalents, and marketable securities) available for every 1.00 peso
in current liabilities (short-term obligations due within the next year).

 Working Capital – while working capital is not a ratio but the excess of current
assets over current liabilities (current assets – current liabilities), it is a special
measure of short-term debt-paying ability, much like the current ratio. Both the
current ratio and working capital work with current assets and current liabilities.

Working capital is, at time, referred to as net working capital because other use
current assets to mean working capital. To denote that what is meant is the excess of
current assets over current liabilities, the term “net” is used.

Example computation:

Current Assets: 468, 000

Current Liabilities: 134, 400

Working Capital = 468, 000 – 134, 400

= 333, 600

A working capital of 333,600 indicates that the company has a healthy

liquidity position, with more than enough current assets to cover its short-term
liabilities. This provides financial stability and flexibility for the company's operations
and growth opportunities.

B. Profitability Ratios: Assess a company's ability to generate profits.

Profitability ratios are financial metrics used to assess a company's ability to

generate profit in relation to its revenue, assets, equity, or other financial parameters.
These ratios are crucial for investors, creditors, and management because they provide
insight into a company's overall financial health and its capacity to generate returns for
shareholders and stakeholders. There are several key profitability ratios, including:

 Gross Profit Margin: This ratio measures the percentage of revenue that remains
after deducting the cost of goods sold (COGS). It is calculated as follows:

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 Gross Profit Margin = (Gross Profit / Revenue) x 100

It is an essential indicator for businesses as it provides insights into their

ability to generate profits from their primary operations. A higher gross profit margin
indicates that a company is effectively managing its production costs.

Example;
Company A has P 1,000,000 in revenue and P 400,000 in cost of goods sold
(COGS).

Gross Profit = Revenue - COGS

Gross Profit = P1,000,000 - P 400,000 = P 600,000

Gross Profit Margin = (Gross Profit / Revenue) x 100

Gross Profit Margin = (P 600,000 / P 1,000,000) x 100 = 60%

Interpretation: Company A has a gross profit margin of 60%, which means it retains
60% of its revenue after covering the cost of goods sold. This suggests that the company
is efficiently managing its production costs.

This metric is crucial because it shows how efficiently a company is managing its direct
production costs. A higher gross profit margin indicates that a company retains a larger
percentage of its revenue as profit after accounting for the costs of producing its goods
or services. Conversely, a lower margin suggests that a significant portion of revenue is
consumed by these production costs.

2. Operating Profit Margin: Also known as the operating margin, this ratio assesses
a company's profitability after taking into account both COGS and operating
expenses. It is calculated as:

Operating Profit Margin = (Operating Profit / Revenue) x 100

A higher operating profit margin implies efficient cost management and strong
operational performance.

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 Example;
Company B has P 800,000 in revenue, P 300,000 in COGS, and P 200,000 in
operating expenses.

Operating Profit = Gross Profit - Operating Expenses

Operating Profit = (P800,000 - P300,000) - P200,000 = P300,000

Operating Profit Margin = (Operating Profit / Revenue) x 100

Operating Profit Margin = (P 300,000 / P 800,000) x 100 = 37.5%

Interpretation: Company B has an operating profit margin of 37.5%, indicating that it

retains 37.5% of its revenue after covering both COGS and operating expenses. This
suggests efficient cost management and strong operational performance.

A high operating profit margin, such as 20% or more, generally indicates strong
profitability and efficient operations. A low or negative margin implies that a company's
core operations are not generating sufficient profit or may be incurring losses.

3. Net Profit Margin: This ratio represents the percentage of profit that remains after all
expenses, including taxes and interest, have been deducted from revenue. It is
calculated as:

Net Profit Margin = (Net Profit / Revenue) x 100

A higher net profit margin indicates a company's ability to generate profit after all
costs.

Example;
Company C has P 1,200,000 in revenue, P 500,000 in COGS, P300,000 in
operating expenses, and P 50,000 in interest and taxes.

Net Profit = Operating Profit - Interest and Taxes

Net Profit = (P 1,200,000 - P 500,000 - P 300,000) - P 50,000 = P 350,000

Net Profit is the amount of money a company has left after subtracting all its
expenses, such as cost of goods sold, operating expenses, interest, and taxes from its
total revenue.

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 Net Profit Margin = (Net Profit / Revenue) x 100
Net Profit Margin = (P 350,000 / P 1,200,000) x 100 = 29.17%

Interpretation: Company C has a net profit margin of 29.17%, which means it retains
29.17% of its revenue as profit after all expenses, including taxes and interest. This
indicates the company's ability to generate profit after all costs.

Usefulness:

 Comparative Analysis: Net Profit Margin is valuable for comparing a

company's profitability with its competitors or industry averages.
 Monitoring Performance: It helps in tracking a company's financial
performance over time. A decreasing profit margin might signal issues that need
to be addressed.
 Investment Decision: Investors often use this metric to assess the financial
health and potential return of an investment.

Interpretation:

 A higher Net Profit Margin is generally seen as better because it indicates that
the company is more efficient at converting its sales into profits.
 A lower Net Profit Margin may suggest that a company is struggling to control
its costs or facing pricing pressures.

4. Return on Assets (ROA): ROA measures a company's ability to generate profit from its
total assets. It is calculated as:

ROA = (Net Profit / Total Assets) x 100

A higher ROA indicates efficient utilization of assets to generate profit.

Example;
Company D has P 400,000 in net profit and P 2,000,000 in total assets.

ROA = (Net Profit / Total Assets) x 100

ROA = (P 400,000 / P 2,000,000) x 100 = 20%

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 Interpretation: Company D has an ROA of 20%, which means it generates a 20% return
on its total assets. This suggests efficient asset utilization to generate profit.

5. Return on Equity (ROE): ROE evaluates a company's ability to generate profit relative
to shareholders' equity. It is an essential tool for investors, analysts, and company
management to assess a firm's performance and its ability to provide a return on the
investment made by its shareholders. It is calculated as:

ROE = (Net Profit / Shareholders' Equity) x 100

A higher ROE suggests a company's capacity to generate returns for its

shareholders.

Example;
Company E has P 600,000 in net profit and P 3,000,000 in shareholders' equity.

ROE = (Net Profit / Shareholders' Equity) x 100

ROE = (P 600,000 / P 3,000,000) x 100 = 20%

Interpretation: Company E has an ROE of 20%, indicating that it generates a 20%

return on shareholders' equity. This reflects the company's ability to provide returns to its
shareholders.

ROE is expressed as a percentage, and it indicates how efficiently a company

is utilizing its shareholders' equity to generate profit. A higher ROE is generally seen
as more favorable because it means the company is generating more profit relative
to its equity. However, a high ROE should be viewed in the context of the industry
and company's historical performance.

These profitability ratios are crucial for various stakeholders, including investors,
creditors, and management, as they provide insights into a company's financial
performance, efficiency, and sustainability. When assessing a company's profitability, it's
essential to consider industry benchmarks and trends to gain a better understanding of
its competitive position and financial health.

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C. Solvency Ratios: Determine a company's long-term financial stability and ability to
meet long-term obligations.

Solvency ratios are financial metrics used to assess a company's ability to

meet its long-term financial obligations and its overall financial health. These ratios
help investors, creditors, and analysts evaluate the company's risk of insolvency and
bankruptcy. There are several solvency ratios, with some of the most common ones
being:

 Debt to Equity Ratio: This ratio measures the proportion of a company's financing
that comes from debt compared to equity. A higher ratio indicates a higher level of
financial leverage and potentially higher solvency risk.

Debt to Equity Ratio = Total Deb \ Shareholders' Equity

Example: A company has 1 million in total debt and 2 million in shareholders' equity.
Calculation: Debt to Equity Ratio = 1,000,000 / 2,000,000 = 0.5
Interpretation: A debt to equity ratio of 0.5 indicates that for every dollar of equity, the
company has 50 cents of debt. This suggests a relatively low level of financial risk.

 Interest Coverage Ratio: This ratio indicates a company's ability to meet its
interest payments on outstanding debt. A higher interest coverage ratio suggests
lower solvency risk.

Interest Coverage Ratio = EBIT (Earnings Before Interest and Taxes) / Interest
Expense

Example: A company has EBIT of 500,000 and incurs 50,000 in interest expenses.
Calculation: Interest Coverage Ratio = $500,000 / $50,000 = 10
Interpretation: An interest coverage ratio of 10 means that the company's earnings
before interest and taxes are ten times greater than its interest expenses. This is a
strong sign of solvency.

The interest coverage ratio provides insight into a company's ability to meet its
interest payments on outstanding debt. A high interest coverage ratio is generally
considered a strong sign of solvency, indicating that the company is generating ample
earnings to cover its interest expenses. A low interest coverage ratio, on the other

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 hand, suggests a weak sign of solvency, as it may indicate that the company is
struggling to meet its interest obligations.

While there's no universally accepted threshold for what constitutes a "strong" or

"weak" interest coverage ratio, a ratio greater than 1 is typically seen as a minimum
requirement, as it means the company is generating enough operating income to
cover its interest costs. However, a ratio of 1 indicates that earnings are just sufficient
to cover interest expenses, leaving little margin for error.

An interest coverage ratio greater than 1 but less than 3 might be considered
relatively weak, as it suggests a company is operating with a narrow margin of safety.
A ratio greater than 3 is often seen as a safer indication of solvency because it
provides a more comfortable buffer against fluctuations in earnings.

A ratio greater than 10 is often seen as a very strong sign of solvency. Companies
with an interest coverage ratio significantly higher than 10 have a substantial cushion
to cover their interest expenses, and this is generally seen as a positive financial
health indicator.

However, it's important to consider the industry and sector in which the company
operates. Some industries typically have lower interest coverage ratios due to their
business models, and what's considered strong or weak can vary. It's also crucial to
analyze other financial metrics, such as debt levels, cash flow, and profitability, in
conjunction with the interest coverage ratio to gain a comprehensive understanding of
a company's solvency.

In summary, while an interest coverage ratio of 10 or greater can be considered a

strong sign of solvency, it's not a one-size-fits-all rule. The appropriateness of a ratio
depends on the specific circumstances of the company, its industry, and its overall
financial health.

 Debt Ratio: This ratio measures the proportion of a company's assets financed by
debt. A higher debt ratio suggests higher financial risk.

Debt Ratio = Total Debt \ Total Assets

Example: A company has 3 million in total debt and 10 million in total assets.

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 Calculation: Debt Ratio = 3,000,000 / $10,000,000 = 0.3
Interpretation: A debt ratio of 0.3 means that 30% of the company's assets are
financed through debt. Lower ratios are generally seen as less risky.

 Debt to Capital Ratio: This ratio calculates the percentage of a company's capital
structure financed by debt. Capital includes both debt and equity.

Debt to Capital Ratio = Total Debt \ (Total Debt + Shareholders' Equity)

Example: A company has 4 million in total debt and 6 million in shareholders'

equity.
Calculation: Debt to Capital Ratio = 4,000,000 / (4,000,000 + 6,000,000) = 0.4
Interpretation: A debt to capital ratio of 0.4 indicates that 40% of the company's
capital structure is comprised of debt.

 Debt Service Coverage Ratio: This ratio assesses a company's ability to meet all
of its debt obligations, including both interest and principal payments.

Debt Service Coverage Ratio = EBITDA (Earnings Before Interest, Taxes, Depreciation,
and Amortization) \ Total Debt Service

Example: A company has EBITDA of $800,000 and total debt service of $200,000.
Calculation: Debt Service Coverage Ratio = $800,000 / $200,000 = 4
Interpretation: A debt service coverage ratio of 4 suggests that the company's
earnings before interest, taxes, depreciation, and amortization are four times greater
than its total debt service, indicating a healthy solvency position.

D. Efficiency Ratios: Evaluate how efficiently a company utilizes its assets and
manages its operations.

Efficiency ratios are financial metrics that help evaluate how effectively a
company utilizes its assets and manages its operations. These ratios provide insights
into a company's ability to generate profits, control costs, and optimize its use of
resources. Here are some common efficiency ratios:

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 Asset Turnover Ratio: This ratio measures how efficiently a company utilizes its
assets to generate revenue. It is calculated by dividing the company's total revenue
by its average total assets. A higher ratio indicates better asset utilization.

Asset Turnover Ratio = Total Revenue / Average Total Assets

Example: If a company has total annual revenue of 5 million and an average total
asset value of 2.5 million, the asset turnover ratio is 2.

Interpretation: An asset turnover ratio of 2 means that for every peso invested in
assets, the company generates 2 pesos in revenue. A higher ratio implies efficient
asset utilization, indicating that the company is making good use of its assets to
generate sales.

The asset turnover ratio is primarily an efficiency indicator. It tells you how
efficiently a company is using its assets to generate sales. A higher ratio indicates
that the company is using its assets effectively, while a lower ratio suggests
inefficiency in asset utilization.

 Inventory Turnover Ratio: This ratio assesses how quickly a company sells its
inventory during a specific period. It is calculated by dividing the cost of goods sold
(COGS) by the average inventory value. A higher ratio suggests efficient inventory
management.
Inventory Turnover Ratio = COGS / Average Inventory

Example: If COGS is 2 million, and the average inventory value is 500,000, the
inventory turnover ratio is 4.

Interpretation: An inventory turnover ratio of 4 suggests that the company sells and
replaces its inventory four times during the year. A high ratio indicates efficient
inventory management and reduced holding costs.

 Accounts Receivable Turnover Ratio: This ratio evaluates how efficiently a

company collects payments from customers. It is calculated by dividing total credit
sales by the average accounts receivable. A higher ratio indicates faster collections.

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 Accounts Receivable Turnover Ratio = Total Credit Sales / Average Accounts
Receivable

Example: If total credit sales are 1.2 million, and the average accounts receivable is
300,000, the accounts receivable turnover ratio is 4.

Interpretation: An accounts receivable turnover ratio of 4 means that, on average, the

company collects payments from customers four times during the year, or
approximately once every 3 months.

To determine the collection period in days, you would divide 365 days (the number of
days in a year) by the accounts receivable turnover ratio. So, in the case of an
accounts receivable turnover ratio of 4:

Collection Period (in days) = 365 days / 4 ≈ 91.25 days

This means that, on average, it takes the company about 91.25 days to collect
payments from customers, which is just over three months.

 Accounts Payable Turnover Ratio: This ratio measures how long a company
takes to pay its suppliers. It is calculated by dividing the total purchases by the
average accounts payable. A higher ratio suggests faster payment to suppliers.

Accounts Payable Turnover Ratio = Total Purchases / Average Accounts

Payable

Example: If total purchases are 800,000, and the average accounts payable is
200,000, the accounts payable turnover ratio is 4.

Interpretation: An accounts payable turnover ratio of 4 means that, on average, the

company pays its suppliers four times during the year, or approximately once every 3
months.

To determine the average number of days it takes the company to pay its suppliers,
you can use the formula:

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 Payment Period (in days) = 365 days / Accounts Payable Turnover Ratio

So, with an accounts payable turnover ratio of 4:

Payment Period (in days) = 365 days / 4 = 91.25 days

This means that, on average, it takes the company about 91.25 days to pay its
suppliers, which is just over three months.

 Working Capital Turnover Ratio: This ratio shows how efficiently a company uses
its working capital to generate revenue. It is calculated by dividing the total revenue
by the average working capital. A higher ratio implies better utilization of working
capital.

Working Capital Turnover Ratio = Total Revenue / Average Working Capital

Example: If total revenue is 4 million, and the average working capital is 1 million,
the working capital turnover ratio is 4.

Interpretation: A working capital turnover ratio of 4 indicates that for every peso of
working capital, the company generates 4 pesos in revenue. A higher ratio reflects
efficient use of working capital.

A higher ratio is generally better because it indicates that the company is generating
more sales with a lower amount of working capital. This suggests efficient
management of current assets and liabilities.

Limitations: This ratio doesn't provide a complete picture of a company's financial

health. It focuses solely on the efficiency of working capital, which may not reveal
issues with profitability, solvency, or other financial aspects.

 Fixed Asset Turnover Ratio: This ratio assesses how efficiently a company uses
its fixed assets to generate revenue. It is calculated by dividing total revenue by the
average net fixed assets. A higher ratio indicates effective utilization of fixed assets.

Fixed Asset Turnover Ratio = Total Revenue / Average Net Fixed Assets

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 Example: If total revenue is 6 million, and the average net fixed assets are 2
million, the fixed asset turnover ratio is 3.

Interpretation: A fixed asset turnover ratio of 3 suggests that for every peso invested
in fixed assets, the company generates 3 pesos in revenue. A higher ratio indicates
that the company is efficiently utilizing its fixed assets.

Efficiency ratios can vary significantly by industry, so it's important to compare a

company's ratios to those of its peers or industry benchmarks. By analyzing these ratios
over time and in conjunction with other financial metrics, investors, analysts, and
management can gain valuable insights into a company's operational efficiency and
financial health.

Purpose of Ratio Analysis

 Financial Health Assessment: Ratio analysis helps in assessing the overall

financial health of a company. For example, liquidity ratios like the current ratio
indicate if a company can pay its short-term debts.
 Performance Evaluation: It allows for the evaluation of a company's profitability,
efficiency, and effectiveness in generating returns for its shareholders.
 Comparative Analysis: Ratios facilitate comparisons between companies within the
same industry or across different industries, providing valuable insights into relative
strengths and weaknesses.
 Decision-Making: Investors and creditors use ratio analysis to make informed
investment and lending decisions. Management relies on it to identify areas that need
improvement or adjustment in financial strategies.
 Forecasting: Ratio analysis can assist in making financial projections and forecasts,
helping organizations plan for the future.
 Communication: It provides a common language for communicating financial
information to various stakeholders, making it easier to convey financial performance
and prospects.

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 Ratio analysis is a valuable tool for assessing a company's financial performance,
stability, and efficiency. By calculating and interpreting various financial ratios, stakeholders
can make informed decisions and gain insights into a company's financial well-being.
However, it's important to consider the limitations and context when using ratio analysis, as it
provides a snapshot of a company's financial condition at a specific point in time and should
be used in conjunction with other financial analysis methods for a comprehensive
understanding.

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