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# Financial Ratio Analysis

Financial Ratios
A financial ratio is a number, that
expresses the value of one financial
variable relative to another
It is the result you get when you
divide one financial number by
another
Calculation of ration is simple but
each ratio must be analyzed carefully
to effectively measure the firms
performance

Financial Ratios
Comparability ratios are comparative measures
because the ratios show relative value
Ratios allow financial analysts to compare
information that couldnt be compare in raw its
form
Ratios may be used to compare
- one ratio to a related ratio
- the firms performance to managements goal
- the firms past and present performance
- the firms performance to similar firms

## Basic Financial Ratios

Financial ratios are generally divided into five
categories namely:
profitability ratios measure how much company revenue
is eaten up by expenses, how much a company earns
relatively to sales generated and the amount earned
related to the value of the firms assets and equity
liquidity ratios indicate how quickly and easily a company
can obtain cash for its needs
debt ratios measure how much a company owes to others
assets activity ratios measure how efficiently a company
uses its assets
market value ratios measure how the market value of the
companys stock compares to its accounting values

Profitability Ratios
Profitability ratios measure how the firms
returns compare to its sales, assets
investments and equity
Basic Profitability Ratios
- Gross Profit Margin = Gross Profit / Sales
- Operating Profit Margin = EBIT / Sales
- Net Profit Margin = Net Income / Sales
- Return on Assets (ROA) = Net Income / Assets
- Return on Equity (ROE) = Net Income / Equity

Profitability Ratios
Gross profit margin measure how much profit
remains out of each sales rupee after the cost
of goods sold is subtracted and it shows how
well a firm generates revenue compared to its
cost of goods sold. The higher the ratio, the
better the cost controls compared to the sales
revenues.
Operating profit margin ratio measure the cost
of goods sold as reflected in the gross profit
margin ratio as well as all other operating
expenses

Profitability Ratios
Net profit margin measures how much profit
out of each sales rupee is left after all expenses
are subtracted. Net income / net profit margin
ratio are often referred to as bottom line
measures. The net profit margin includes
as interest and taxes and operating expenses
Return on assets ratio indicates how much
income each rupee of assets produces on
average. It shows whether the business is
investing in its assets effectively

Profitability Ratios
Return on equity ratio measures the
average return on the firms capital
contributions from its owners (for a
corporation, that means the contributions
of stockholders). It indicates how many
rupees of income were produced for each
rupee invested by the common
stockholders
GPM, OPM, NPM, ROA and ROE express in
% age

Liquidity Ratios
Liquidity ratios measure the ability of a firm to meets
its short term obligations. These ratios are important
because failure to pay such obligations can lead to
bankruptcy
Bankers and lenders use this ratio to check whether
to extend short term credit to a firm
Generally, the higher the liquidity ratio, the more
able a firm is to pay its short term obligations
Stockholders, however, use liquidity ratios to see
how the firm has invested in assets. Too much
investment in current as compared to long term
assets indicates inefficiency

Liquidity Ratios
Two main liquidity ratios are current
ratio and quick ratio, quick ratio
often termed as Acid test ratio
- Current Ratio = CA / CL
- Quick Ratio = QA / CL
Quick Assets = CA - Inventory but
most of the time financial analysts
calculate it as:
CA - (Inventory + Prepayments)

Liquidity Ratios
The current ratio compares all the current
assets of the firm (cash and other assets
that can easily converted to cash) to all
the firms current liabilities (liabilities that
must be paid with cash soon)
The quick ratio is similar to the current
ratio but its a more rigorous measure of
liquidity because it excludes inventory
(plus prepayments) from current assets

Debt Ratios
Financial analysts use debt ratios to assess the
relative size of firms debt load and the firms
ability to pay off debt. The three primary debt
ratios are the debt to assets, debt to equity and
times interest earned ratios
Current and potential lenders of long term funds
such as banks and bondholders are interested in
debt ratios. When a firms debt ratios increase
significantly, bondholder and lender risk increase
because more creditors compete for that firms
resources if the firm runs into financial trouble

Debt Ratios
Stockholders are also concerned with the
amount of debt a business has because
bondholders are paid before stockholders
The optimal debt ratio depends on several
factors such as type of business and the
amount of risk lenders and stockholders
will tolerate. Generally, a profitable firm in
a stable business can handle more debt
and a higher debt ratio than a growth firm

Debt Ratios

## Basic debt ratios are:

Debt to Total Assets = total debt / total assets
Debt to Equity = Total Debt / Equity
Time Interest Earned = EBIT / Interest Expense
Debt to total assets ratio measures the % age
of the firms assets that are financed with debt
Debt to equity ratio is the % age of debt
relative to the amount of equity of the firm

Debt Ratios
Time interest earned ratio is often used to asses companys
ability to service the interest on its debt with EBIT
A high TIE ratio suggests that the company will have ample
operating income to cover its interest expense. A low TIE
ratio signals that the company may have insufficient
operating income to pay its interest as it becomes due. If so,
the business might need to liquidate assets or raise new debt
or equity funds to pay the interest due
However, you have to know that the operating income is not
the same as cash flow. Operating income figures do not show
the amount of cash available to pay interest and interest
payments are made with cash so therefore, TIE ratio is only a
rough measure of a firms ability to pay interest with current
funds

## Asset Activity Ratios

Financial analysts use asset activity
ratios to measure how efficiently a
firm uses its assets. They analyze
specific assets and classes of assets.
Three set of asset activity ratios are
common: average collection period,
inventory turnover and total assets
turnover. Many analysts also check
fixed assets turnover in order to
examine that which class of assets

## Asset Activity Ratios

Basic activity ratios are:
- Average collection period calculated
as:
A/C Receivable / Average Daily Credit
Sales
- Inventory Turnover calculated as:
Sales / Inventory or COGS / Inventory
- Total Asset Turnover calculated as:
Sales / Total Assets

## Asset Activity Ratios

The average collection period ratio
measures how many days, on
average, the firms credit customers
take to pay their accounts. Credit
managers use this ratio to decide
who the firm should extend credit to.
Slow payers are disliked and not
welcome customers. Financial
analysts usually calculate this ratio
using the total sales figure when they

## Asset Activity Ratios

The inventory turnover ratio tells how
efficiently the firm converts inventory
to sales. If the firm has inventory that
sells well, the value of the ratio will
be high. If the inventory doesnt sell
well due to lack of market demand or
if there is excess inventory or if the
firm has old inventory stocks piled up
then the value of the ratio will be low

## Asset Activity Ratios

Total asset ratio turnover ratio measures
how efficiently the firm utilizes its assets.
Stockholders, bondholders and managers
know that the more efficiently the firm
operates, the better the returns. If a firm
has many assets that do not help generate
sales, that the total asset turnover ratio
will be relatively low. A firm that has a high
asset utilization ratio suggests that its
assets help promote sales revenue

## Market Value Ratios

So far the ratios we have examined
above rely on financial statements
figures but market value ratios
mainly rely on financial marketplace
data such as the market price of a
firms common stock
Market value ratios measure the
markets perception of the future
earning power of a firm, as reflected
in the stock share price

## Market Value Ratios

The two common market value ratios are price-toearning ratio and market-to-book value ratio
- Price-to-Earning Ratio (P/E) is define as:
Market Price Per Share of Stock / Earning Per Share
Earning Per Share (EPS) is calculated as
Earning Available to Stockholders / Number of
Common Shares Outstanding
- Market-to-Book Value Ratio is defines as:
Market Price Per Share / Book Value Per Share
Book Value Per Share (BPS) is calculated as
Common Stock Equity / Number of Common Shares
Outstanding

## Market Value Ratios

Investors and managers use P/E ratio to
gauge the future prospects of a company.
It measures how much investors are
willing to pay for claim to one rupee of the
earnings per share of the firm. The more
investors are willing to pay over the value
of EPS for the stock, the more confidence
they are displaying about the firms future
growth that is higher the P/E ratio, the
higher are investors growth expectations

## Market Value Ratios

The market-to-book value (M/B) ratio is the
market price per share of a companys
common stock divided by the accounting book
value per share (BPS). It is the amount of
common stock equity on the firms balance
sheet divided by the number of common
shares outstanding. The book value per share
is a proxy for the amount remaining per share
after selling the firms assets for their balance
sheet values and paying the debt owed to all
creditors and preferred stockholders

## Market Value Ratios

When the MPS > BPS, analysts often
conclude that the market believes the
companys future earnings are worth more
than the firms liquidation value
The difference b/w the firms future
earnings and liquidation value is the going
concern value of the firm. The higher the
M/B ratio, the greater the going concern
value of the company seems to be

## Market Value Ratios

Firms having market to book value of less than 1 are sometimes
considered to be worth more dead than alive. Such an M/B ratio
suggests that if the company liquidated and paid off all creditors
and preferred stockholders, it would have more left over for the
common stockholders than what the common stockholders could
be sold in the marketplace
The M/B ratio is useful but its only a rough approximation of how
liquidation and going concern values compare. This is because
the M/B ratio uses an accounting based book value. The actual
liquidation value of a firm is likely to be different than the book
value. For e.g. the assets of the firm may be worth more or less
than the value at which they are currently carried on the BS.
Additionally, current MP of the firms bond and preferred stock
may also differ from the accounting values of these claims

## Relationship Among Ratios

The Du Pont System
Du Pont Equation
- ROA = NPM x TAT
NI / TA = NI / Sales x Sales / TA
Modified Du Pont Equation
- ROE = NPM x TAT x EM (equity
multiplier)
NI / Eq = NI / Sales x Sales / TA x TA /
Eq

## Relationship Among Ratios

The Du Pont System
The Du Pont System of ratio analysis is named
for the company whose managers developed
the general system. It first examines the
relationships b/w total revenues relative to
sales and sales relative to total assets. This
version of the Du Pont equation helps to
analyze factors that contribute to a firms
return on assets
Modified version of Du Pont Equation measures
how the ROE is affected by NPM, Asset Activity
and debt financing

Application of Ratios
Class Activity