BM2213

FINANCIAL STATEMENT ANALYSIS

Ratio Analysis
Ratio analysis is one way to evaluate corporate data. Ratios involve a comparison of the different figures from
the balance sheet, income statement, and statement of cash flows. The analysis requires relating calculated
ratios against previous years, other companies, the company's industry, and even the economy at large. Ratios
can glimpse the relationships between individual values that relate to a company’s operations and link them to
how a company has performed in the past and how it might perform in the future. The result is a potentially
robust method of valuing the shares of a company (Hayes, 2022).

For example, current assets on the balance sheet cannot tell a whole lot. Still, when current assets are divided
by current liabilities, important information about a company can be obtained –whether it has enough money to
cover short-term debts. Then, this result will be compared to one company’s assets-to-debts in the same
industry to determine if one is on a more stable financial footing than the other. This result can be compared to
that figure against the industry average to see if the stock may outperform its peers (Hayes, 2022).

Different references provide categories of ratios (Brigham & Houston, 2022):

• Liquidity ratios - Give an idea of the firm’s ability to pay off debts maturing within a year.
• Asset management ratios - Give an idea of how efficiently the firm uses its assets.
• Debt management ratios - Give an idea of how the firm has financed its assets and its ability to repay its
long-term debt.
• Profitability ratios - Give an idea of how profitable the firm is operating and utilizing its assets.
• Market value ratios - Give an idea of what investors think about the firm and its prospects.

Satisfactory liquidity ratios are necessary if the firm is to continue operating. Good asset management ratios
are necessary for the firm to keep its costs low and, thus, its net income high. Debt management ratios indicate
how risky the firm is and how much of its operating income must be paid to bondholders rather than
stockholders. Profitability ratios combine the asset and debt management categories and show their effects on
Return on Equity (ROE). Finally, market value ratios tell us what investors think about the company and its
prospects (Brigham & Houston, 2022).

All ratios are important, but different ones are more important for some companies than others. For example, if
a firm borrowed too much in the past and its debt now threatens to drive it into bankruptcy, the debt ratios are
key. Similarly, asset management ratios take center stage if a firm expands too rapidly and now finds itself with
excess inventory and manufacturing capacity. The ROE is always important, but a high ROE depends on
maintaining liquidity, efficient asset management, and the proper use of debt. Managers are, of course, vitally
concerned with the stock price, but managers have little direct control over the stock market’s performance,
while they do have control over their firm’s ROE. So, ROE tends to be the main focal point (Brigham & Houston,
2022).

Liquidity Ratios
Liquidity ratios help users answer the question, “Will the firm be able to pay off its debts as they come due and
thus remain a viable organization?” If the answer is no, liquidity must be addressed (Brigham & Houston, 2022).

• Liquidity Ratios show the relationship between a firm’s cash and other current assets to its current
liabilities.
• Liquid Asset can be converted to cash quickly without reducing the asset’s price very much.

Current Ratio – This is the primary liquidity ratio, calculated by dividing current assets by the current liabilities.
It indicates the extent to which current liabilities are covered by those assets expected to be converted to cash
in the near future.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

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Current Assets – These include cash, marketable securities, accounts receivable, and inventories. If a
company is having financial difficulty, it typically begins to pay its accounts payable more slowly and to borrow
more from its bank, both of which increase current liabilities. If current liabilities are rising faster than current
assets, the current ratio will fall; and this is a sign of possible trouble (Brigham & Houston, 2022).

Quick (Acid Test) Ratio – This is the second liquidity ratio, calculated by deducting inventories from current
assets and then dividing the remainder by current liabilities.

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠

𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Inventories are typically the least liquid of a firm’s current assets, and if sales slow down, they might not be
converted to cash as quickly as expected. Also, inventories are the assets on which losses are most likely to
occur in the event of liquidation. Therefore, the quick ratio, which measures the firm’s ability to pay off short-
term obligations without relying on the sale of inventories, is important.

Asset Management Ratios

Asset management ratios are the second group of ratios that measure how effectively the firm manages its
assets. These ratios answer this question, “Does the amount of each type of asset seem reasonable, too high,
or too low given the current and projected sales?” These ratios are important because when a company acquires
assets, it must obtain capital from banks or other sources, which is expensive. Therefore, if the company has
too many assets, its cost of capital will be too high, which will depress its profits. On the other hand, if its assets
are too low, profitable sales will be lost. So the company must strike a balance between too many and too few
assets, and the asset management ratios will help it strike this proper balance.

Inventory Turnover Ratio – “Turnover ratios” divide sales by some asset: Sales/Various assets. As the name
implies, these ratios show how many times the asset is “turned over” during the year. Here is the formula for
the inventory turnover ratio:
𝑆𝑎𝑙𝑒𝑠
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠

Turnover is a term that originated many years ago with the old Yankee peddler who would load up his wagon
with pots and pans and then go off on his route to peddle his wares. The merchandise was called working capital
because it was what he sold, or “turned over,” to produce his profits, whereas his “turnover” was the number of
trips he took each year. Annual sales divided by inventory equaled turnover or trips per year. If he made 10 trips
per year, stocked 100 pots and pans, and made a gross profit of P50 per item, his annual gross profit was (100
x P50 x 10) = P50,000. If he went faster and made 20 trips per year, his gross profit doubled, and other things
held constant. So, his turnover directly affected his profits (Brigham & Houston, 2022).

Days Sales Outstanding (DSO) Ratio – This is used to evaluate accounts receivable. It is also called the
average collection period. It is calculated by dividing accounts receivable by the average daily sales to find how
many days’ sales are tied up in receivables. Thus, the DSO represents the average length of time the firm must
wait after making a sale before receiving cash.

𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
𝐷𝑎𝑦𝑠 𝑆𝑎𝑙𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 (𝐷𝑆𝑂) = =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦 𝐴𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠/365

The DSO can be compared with the industry average, but it is also evaluated by comparing it with the company’s
credit terms. If a company’s credit policy calls for payment within 30 days, a higher DSO indicates that the
customers, on average, are not paying bills on time. It deprives the company of funds that could be used to
reduce bank loans or some other type of costly capital. Moreover, the high average DSO indicates that if some
customers are paying on time, quite a few must be paying late. Late-paying customers often default, so their
receivables may end up as bad debts that can never be collected.

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Fixed Assets Turnover Ratio – This is the ratio of sales to net fixed assets to measure how effectively the firm
uses its plant and equipment.
𝑆𝑎𝑙𝑒𝑠
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 =
𝑁𝑒𝑡 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠

Potential problems may arise when interpreting the fixed assets turnover ratio. Recall that fixed assets are
shown on the balance sheet at their historical costs, less depreciation. Inflation has caused the value of many
assets purchased in the past to be seriously understated. Therefore, if an old firm whose fixed assets have been
depreciated is compared with a new company with similar operations that acquired its fixed assets only recently,
the old firm will probably have a higher fixed assets turnover ratio. However, this would be more reflective of the
age of the assets than of inefficiency on the part of the new firm. The accounting profession is trying to develop
procedures for making financial statements reflect current values rather than historical values to help make
better comparisons. However, the problem still exists at the moment, so financial analysts must recognize and
deal with it judgmentally (Brigham & Houston, 2022).

Total Assets Turnover Ratio – This measures the turnover of all the firm’s assets and is calculated by dividing
sales by total assets.
𝑆𝑎𝑙𝑒𝑠
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

This ratio measures how efficiently a firm uses its assets to generate sales, so a higher ratio is always more
favorable. Higher turnover ratios mean the company is using its assets more efficiently. Lower ratios mean the
company is not using its assets efficiently and will likely have management or production problems (Asset
Turnover Ratio, 2019).

Debt Management Ratios

The debt management ratio measures how much of a company's operations come from debt instead of other
forms of financing, such as stock or personal savings (Farlex, Inc., 2022).

Total Debt to Total Capital – This measures the percentage of the firm’s capital provided by debtholders.

𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡
𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 𝑡𝑜 𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 =
𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦

Total debt includes all short-term and long-term interest-bearing debt but does not include operating items such
as accounts payable and accruals. Creditors prefer low debt ratios because the lower the ratio, the greater the
cushion against creditors’ losses in the event of liquidation. On the other hand, stockholders want more leverage
because it can magnify expected earnings (Brigham & Houston, 2022).

Times-Interest-Earned (TIE) Ratio – This is determined by dividing earnings before interest and taxes by the
interest charges.

𝐸𝐵𝐼𝑇
𝑇𝐼𝐸 𝑅𝑎𝑡𝑖𝑜 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶ℎ𝑎𝑟𝑔𝑒𝑠

The TIE ratio measures the extent to which operating income can decline before the firm cannot meet its annual
interest costs. Failure to pay interest will bring legal action by the firm’s creditors and probably result in
bankruptcy. Note that earnings before interest and taxes, rather than net income, are used in the numerator.

Profitability Ratios
Profitability ratios assess the ability of a company to generate earnings during a particular period.

Operating Margin is calculated by dividing operating income (EBIT) by sales, giving the operating profit per
peso of sales.

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𝐸𝐵𝐼𝑇
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑀𝑎𝑟𝑔𝑖𝑛 =
𝑆𝑎𝑙𝑒𝑠

Profit Margin, sometimes called the net profit margin, is calculated by dividing net income by sales.

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =
𝑆𝑎𝑙𝑒𝑠

Return on Total Assets (ROA) is the ratio of net income to total assets. It is computed by dividing net income
by total assets.

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 (𝑅𝑂𝐴) =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Return on Common Equity (ROE) is the ratio of net income to common equity, which measures the rate of
return on common stockholders’ investment.

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐶𝑜𝑚𝑚𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 (𝑅𝑂𝐸) =
𝐶𝑜𝑚𝑚𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦

Return on Invested Capital (ROIC) measures the total return that the company has provided for its investors.

𝐸𝐵𝐼𝑇 (1 − 𝑇)
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 (𝑅𝑂𝐼𝐶) =
𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

ROIC differs from ROA in two (2) ways. First, its return is based on total invested capital rather than total assets.
Second, the numerator uses after-tax operating income (NOPAT) rather than net income. The key difference is
that net income subtracts the company’s after-tax interest expense and represents the total income available to
shareholders. At the same time, NOPAT is the amount of funds available to pay both stockholders and
debtholders (Brigham & Houston, 2022).

Basic Earning Power (BEP) Ratio is calculated by dividing operating income (EBIT) by total assets.

𝐸𝐵𝐼𝑇
𝐵𝑎𝑠𝑖𝑐 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑃𝑜𝑤𝑒𝑟 (𝐵𝐸𝑃) =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

This ratio shows the raw earning power of the firm’s assets before the influence of taxes and debt, and it is
useful when comparing firms with different debt and tax situations.

Market Value Ratios

ROE reflects the effects of all the other ratios and is the best accounting measure of performance. Investors like
high ROE as it correlates with high stock prices. Market value ratios relate the firm’s stock price to earnings
and book value per share.

If the liquidity, asset management, debt management, and profitability ratios all look good, and if investors think
these ratios will continue to look good in the future, the market value ratios will be high; the stock price will be
as high as can be expected, and management will be judged as having done a good job. The market value
ratios are used in three (3) primary ways: (1) by investors when they are deciding to buy or sell stock; (2) by
investment bankers when they are setting the share price for a new stock issue (an IPO); and (3) by firms when
they are deciding how much to offer for another firm in a potential merger (Brigham & Houston, 2022).

Price/Earnings Ratio shows how much investors are willing to pay per peso of reported profits.

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𝑃𝑟𝑖𝑐𝑒 𝑃 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

( ) 𝑅𝑎𝑡𝑖𝑜 =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐸 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

Market/Book (M/B) Ratio is a stock’s market price ratio to its book value. It gives another indication of how
investors regard the company. Companies that are well regarded by investors - low risk and high growth have
high M/B ratios.

𝐶𝑜𝑚𝑚𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦
𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝑀𝑎𝑟𝑘𝑒𝑡/ 𝐵𝑜𝑜𝑘 𝑅𝑎𝑡𝑖𝑜 =
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

Using Ratios to Assess Performance

Although financial ratios help companies evaluate performance, it is often hard to evaluate a company by just
looking at the ratios. For example, if a company has a current ratio of 1.2, it is hard to know if that is good or
bad unless the ratio is placed in the proper perspective.

• Comparison to Industry Average. Stock investors typically use industry averages to analyze the value of
a company before investing. When investors apply industry averages to financial ratios using a company’s
financial reports from accounting, they can ascertain a company’s profitability or possibilities for growth.
These same industry averages or ratios can benefit the small business person when he wants to measure
and benchmark his company's performance against averages for the industry as a whole (Brenner, 2022).
• Benchmarking compares the company with a subset of top competitors in the industry. Benchmark
companies are the companies used for the comparison.
• Trend Analysis is an analysis of a firm’s financial ratios over time used to estimate the likelihood of
improvement or deterioration in its financial condition. To do a trend analysis, plot a ratio over time. All the
other ratios could be analyzed similarly, and such an analysis can be quite useful in gaining insights.

Uses and Limitations of Ratios

As noted, ratio analysis is used by three (3) main groups: (1) managers, who use ratios to help analyze, control,
and improve the performance of a company; (2) credit analysts, including loan officers and bond rating
analysts, who analyze ratios to help judge a company’s ability to repay its debts; and (3) stock analysts, who
are interested in a company’s efficiency, risk, and growth prospects (Brigham & Houston, 2022).

Ratio analysis can provide useful information concerning a company’s operations and financial condition, which
has limitations. Some potential problems are as follows:
1. Many firms have divisions operating in different industries, and it isn't easy to develop a meaningful set of
industry averages for such companies. Therefore, ratio analysis is more useful for narrowly focused firms
than multidivisional ones.
2. Most firms want to be better than average, so achieving average performance is not necessarily good. It is
best to focus on the industry leaders’ ratios as a target for high-level performance. Benchmarking helps in
this regard.
3. Inflation has distorted many firms’ balance sheets; book values often differ from market values. Market
values would be more appropriate for most purposes, but we cannot generally get market value figures
because assets such as used machinery are not traded in the marketplace. Further, inflation affects asset
values, depreciation charges, inventory costs, and thus profits. Therefore, ratio analysis for one firm over
time or a comparative analysis of firms of different ages must be interpreted carefully and rationally.
4. Seasonal factors can also distort ratio analysis. For example, the inventory turnover ratio for a food
processor will be radically different if the balance sheet figure used for inventory is the one just before versus
just after the close of the canning season. When calculating turnover ratios, this problem can be mitigated
by using monthly averages for inventory (and receivables).

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5. Firms can employ “window dressing” techniques to improve their financial statements. To illustrate, people
tend to think that larger hedge funds got large because their high returns attracted many investors.
6. Different accounting practices can distort comparisons. As noted earlier, inventory valuation and
depreciation methods can affect financial statements and thus distort comparisons among firms. Also, if
one firm lease much of its productive equipment, its fixed assets turnover may be artificially high because
leased assets often do not appear on the balance sheet. At the same time, the liability associated with the
lease may not appear as debt, keeping the debt ratio low, even though failure to make lease payments can
bankrupt the firm. Therefore, leasing can artificially improve both turnover and debt ratios.
7. It is difficult to generalize whether a particular ratio is “good” or “bad.” For example, a high current ratio may
indicate a strong liquidity position, which is good. Still, it can also indicate excessive cash, which is bad
because excess cash in the bank is a non-earning asset. Similarly, a high fixed assets turnover ratio may
indicate that the firm uses its assets efficiently. Still, it could also suggest that the firm is short of cash and
cannot afford to make needed fixed-asset investments.
8. Firms often have some ratios that look “good” and others that look “bad,” making it difficult to tell whether
the company is, on balance, strong or weak. To deal with this problem, banks and other lending
organizations often use statistical procedures to analyze the net effects of a set of ratios and to classify
firms according to their probability of getting into financial trouble.

Ratio analysis is useful, but awareness of the problems listed and adjustments are necessary. Ratio analysis
conducted intelligently and with good judgment can provide valuable insights into firms’ operations.

References

Brenner, L. (2022). What Makes Industry Averages in Accounting So Valuable to Companies? Retrieved from
Chron: https://smallbusiness.chron.com/industry-averages-accounting-valuable-companies-
25354.html
Brigham, E. F., & Houston, J. F. (2022). Fundamentals of Financial Management . Boston, United States of
America: Cengage Learning.
Farlex, Inc. (2022). Debt Management Ratio. Retrieved from The Free Dictionary: https://financial-
dictionary.thefreedictionary.com/debt+management+ratio
Hayes, A. (2022). Ratio Analysis Tutorial. Retrieved from Investopedia:
https://www.investopedia.com/university/ratio-analysis/

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