LESSON 3

Financial Ratio Analysis

MIDTERM PERIOD
Academic Year: 2019-2020

JANE A. ATENDIDO, LPT, MBA

Instructor
 FINANCIAL ANALYSIS
 Financial Analysis is the selection, evaluation,
and interpretation of financial data, along
with other pertinent information, to assist in
investment and financial decision-making.
 FINANCIAL ANALYSIS

 Used internally to evaluate issues such as

employee performance, the efficiency of
operations, credit policies,
 and externally to evaluate potential investments
and credit worthiness of borrowers
FINANCIAL RATIO ANALYSIS

 Financial ratio analysis is performed

by comparing two items in the
financial statements.
 FINANCIAL RATIO
 Helps to identify some financial strengths
and weaknesses of a company
 Examine the ratios across time to identify
any trends
 Compare the firm’s ratios with other firms
Financial ratios can be classified into
ratios that measure:
 Liquidity
 Management Efficiency
 Leverage
 Profitability
 Valuation & Growth
 Liquidity Ratio
 Liquidity Ratio provides information on a
company’s ability to meet its short-term,
immediate obligations
 Liquidity Ratio
• Liquid assets – assets that can be converted into
cash in a short period of time
Current assets - often referred as working
capital
The amount by which current assets exceed
current liabilities is referred to as the net working
capital
Liquidity Ratio
• Current ratio
• Quick ratio
• Cash ratio
• Net Working Capital
 CURRENT RATIO
Evaluates the ability of a company to pay short-
term obligations using current assets (cash,
marketable securities, current receivables,
• inventory,
  and prepayments)
Indicates a company’s ability to satisfy it CL
with its CA:
 CURRENT RATIO
IDEAL RATIO:
2:1
CA > CL – Desirable
CA = CL – enough to pay short-term obligations
CA < CL – does not have enough CA to pay for its
short-term obligations
EXAMPLE:

Refer to Harley-Davidson, Inc. Financial Statement

Reference:
David, Fred R. & R. David, STRATEGIC FINANCIAL MANAGEMENT CONCEPTS AND
CASES,
16th Edition, Pearson Education Inc., 2017
INTERPRETATION

• The current ratio of Harley-Davidson, Inc. is 1.58 in

2013 and 1.65 in 2014. It indicates that the company is
liquid and it can able to pay for its short-term
obligations using its current assets.
 CURRENT RATIO
IDEAL RATIO:
2:1
The current ratio should be compared with standards ---which
are often based on past performance, industry leaders, and
industry average.
How to improve current ratio?
 Pay off current liabilities
 Sell off unproductive Assets
 Faster conversion cycle of debts and
receivables
 Increase the shareholder’s fund
 ACID TEST RATIO
Also known as "quick ratio“
it measures the ability of a company to pay short-
term obligations using the more liquid types of
• 
current assets or "quick assets" (cash, marketable
securities, and current receivables)
 ACID TEST RATIO
IDEAL RATIO:
1:1
Usually, a high acid test ratio is an indication that the
firm is liquid and has ability to meet its current or liquid
liabilities in time
On the other hand, a low quick ratio represents that the
firm’s liquidity position is not good
EXAMPLE:

Refer to Harley-Davidson, Inc. Financial Statement

Reference:
David, Fred R. & R. David, STRATEGIC FINANCIAL MANAGEMENT CONCEPTS AND
CASES,
16th Edition, Pearson Education Inc., 2017
INTERPRETATION

• The quick ratio of Harley-Davidson, Inc. is 1.24 in

2013 and 1.29 in 2014. It indicates that the company is
liquid and it can able to pay for its short-term
obligations using its quick assets.
 CASH RATIO
Measures the ability of a company to pay its
current liabilities using cash and marketable
securities.
• 
Marketable securities are short-term debt
instruments that are as good as cash.
EXAMPLE:

Refer to Harley-Davidson, Inc. Financial Statement

Reference:
David, Fred R. & R. David, STRATEGIC FINANCIAL MANAGEMENT CONCEPTS AND
CASES,
16th Edition, Pearson Education Inc., 2017
INTERPRETATION

• The cash ratio of Harley-Davidson, Inc. is .43 in 2013

and .38 in 2014. It indicates that for every peso current
liability the company has only .43 centavos cash and
short marketable securities for 2013 and .38 for year
2014.
 NET WORKING CAPITAL
Determines if a company can meet its current
obligations with its current assets; and how much
excess or deficiency there is.
• 
EXAMPLE:

Refer to Harley-Davidson, Inc. Financial Statement

Reference:
David, Fred R. & R. David, STRATEGIC FINANCIAL MANAGEMENT CONCEPTS AND
CASES,
16th Edition, Pearson Education Inc., 2017
INTERPRETATION

• The net working capital of Harley-Davidson, Inc. is

amounting to $1,480M in 2013 and $1,559M in 2014. It
indicates that if all the current liabilities are to be
settled, the company would still have $1,480M in 2013
and $1,559M in 2014.
 Generally…

The larger the liquidity ratios, the

better the ability of the company to
satisfy its immediate obligations
 Generally…
• However, if there are more current assets than
the company needs to provide this assurance,
the company may be investing too heavily in
these non- or low-earning assets and therefore
not putting the assets to the most productive
use.
 WORKSHOP 2.1: Liquidity Ratio

Solve and interpret the

a) Current Ratio
b) Quick Ratio
c) Cash Ratio &
d) Net Working Capital
 Profitability Ratios
• Referred as profit margin ratios
• Compare components of income with sales
• Evaluate performance for different aspect of the
business
 Profitability Ratios
• Gross Profit Margin
• Operating Profit Margin
• Net Profit Margin
 Gross Profit Margin

• The gross profit margin– ratio of gross income to

sales
••  Indicates how much of every dollar/peso of sales is
left after cost of goods sold
 Gross Profit Margin

• It determines how profitable the products is.

• Basis in creating budgets and forecast future
activities.
EXAMPLE: Gross Profit Margin

Refer to Harley-Davidson, Inc. Financial Statement

Reference:
David, Fred R. & R. David, STRATEGIC FINANCIAL MANAGEMENT CONCEPTS AND
CASES,
16th Edition, Pearson Education Inc., 2017
INTERPRETATION
• Harley-Davidson, Inc. is currently achieving a
36% gross profit in 2013 and 39% gross profit in
2014. This means that for every dollar of sales, it
earns 36 cents in 2013 and 39 cents in 2014 in
profits before other business expenses are paid.
 Operating Profit Margin

• The operating profit margin– ratio of operating profit

to sales
• Operating profit is also called as EBIT; operating
•  income
• Indicates how much of every dollar/peso of sales is left
after operating expenses
EXAMPLE: Operating Profit Margin

Refer to Harley-Davidson, Inc. Financial Statement

Reference:
David, Fred R. & R. David, STRATEGIC FINANCIAL MANAGEMENT CONCEPTS AND
CASES,
16th Edition, Pearson Education Inc., 2017
EXAMPLE: Operating Profit Margin21

INTERPRETATION:
The Operating Profit Margin of Harley-Davidson Inc. is
20% in 2013 and 21% in 2014. This means that every
$1of sales, company earns a profit of 20 cents in 2013
and 21 cents in 2014 before taking into account the
taxes, interest expense and other income.
 Net Profit Margin

• The net profit margin– ratio of net income (a.ka.

Net profit) to sales
••  Indicates how much of every dollar/peso of sales is
left after all expenses
 This is the best measure of profitability and liquidity.
 It helps to determine the managerial efficiency to use a
firm's resources to generate income on its invested
capital.
 Net profit Ratio is very much useful as a tool of
investment evaluation.
EXAMPLE: Net Profit Margin

Refer to Harley-Davidson, Inc. Financial Statement

Reference:
David, Fred R. & R. David, STRATEGIC FINANCIAL MANAGEMENT CONCEPTS AND
CASES,
16th Edition, Pearson Education Inc., 2017
EXAMPLE: Net Profit Margin

INTERPRETATION:
The Net Profit Margin of Harley-Davidson Inc. is
12% in 2013 and 14% in 2014. This means that a
company has 12 cents of net income for every
dollar of sales in 2013 and 14 cents in 2014.
WORKSHOP 2.2: Profitability Ratio

Solve and interpret the following:

a) Gross Profit Margin
b) Operating Profit Margin
c) Net Profit Margin
 Solvency/Leverage Ratios

• A company can finance either with equity or debt

Debt financing – involves risk
Equity financing – no risk
 SOLVENCY/LEVERAGE RATIOS
• Financial leverage ratios are used to assess
how much financial risk that the company
has taken on.

• Financial risk – danger or possibility that

shareholders, investors, or other financial
stakeholders will loose money
 SOLVENCY RATIOS

• The term 'Solvency' generally refers to the

capacity of the business to meet its short-
term and long term obligations.
 SOLVENCY RATIOS

• Debt-Equity Ratio
• Debt Ratio
 Debt to Equity Ratio

• a.k.a. debt-equity ratio

• Indicates the relative uses of debt and equity as
•  sources of capital to finance the company’s
assets
 Debt to Equity Ratio
 This ratio also termed as External - Internal
Equity Ratio.
 This ratio indicates the proportion of owner's
stake in the business. Excessive liabilities tend to
cause insolvency. This ratio also tell the extent to
which the firm depends upon outsiders for its
existence.
 Debt to Equity Ratio

 Lower values of debt-to-equity ratio are favorable

indicating less risk.
 D-E Ratio < 1.00 means that more assets are financed
by shareholder’s equity
 D-E Ratio = 1.00 means that half of the assets of a
business are financed by debts and shareholders' equity
 D-E Ratio > 1.00 means that more assets are financed
by debt (high financial risk)
EXAMPLE: Debt-Equity Ratio

INTERPRETATION:
The debt-equity ratio of Harley-Davidson Inc. is
2.13 in 2013 and 2.28 in 2014. It means that the
creditors provide $2.13 in 2013 and $2.28 in 2014
for each dollar provided by the stockholders to
finance the assets.
 Total Debt to Assets Ratio

• A.K.A. Debt Ratio

•• Indicates
 
the company’s ability to pay off its
liabilities with its assets
 Total Debt to Assets Ratio

< 1 means less risky; financially stable

= 1 means that the company would have to sell off its
•  assets in order to pay off its liabilities
>1 means risky
 Total Debt to Assets Ratio

• Companies with higher levels of liabilities

compared to assets are considered highly leveraged
and more risky for lenders.
• Thus, lower debt ratio is more favorable than a
higher ratio
EXAMPLE: Debt Ratio

INTERPRETATION:
The debt ratio of Harley-Davidson, Inc. is 68% in
2013 and 69% in 2014. It means that for every
dollar of asset, the company had $.68 of debt in
2013 and $.69 for 2014
 SOLVENCY/LEVERAGE RATIOS

•Examines the company’s ability to meet

its long-term obligations
•Often used by prospective lenders when
evaluating a company’s creditworthiness
 WORKSHOP 2.3: Solvency Ratio

Solve and interpret the following:

a) Debt Equity Ratio
b) Debt Ratio
 Management Efficiency
Ratios
Activity Ratios relates information on a
company's ability to manage its resources
efficiently
Management Efficiency
Ratios
• Turnover ratios – used to evaluate the
benefits produced by specific assets
(inventory & receivables)
• help us gauge how effectively the company is
at putting its investment to work
Management Efficiency
Ratios
Accounts Receivable Turnover
Days Sales Outstanding
Inventory Turnover
Days Inventory Outstanding
Fixed Asset Turnover
Total Asset Turnover
 Accounts Receivable Turnover

Measures the efficiency of extending credit and

collecting the same.
It indicates the average number of times in a year a
company collects its open accounts.
A high ratio implies efficient credit and collection
process.
 Accounts Receivable Turnover

A/R turnover ratio measures how many times a

business can collect its average accounts

• 
Higher ratios mean that companies are collecting
their receivables more frequently throughout the
year.
EXAMPLE:

Refer to Harley-Davidson, Inc. Financial Statement

Reference:
David, Fred R. & R. David, STRATEGIC FINANCIAL MANAGEMENT CONCEPTS AND
CASES,
16th Edition, Pearson Education Inc., 2017
 Days Sales Outstanding

Also known as "receivable turnover in days",

"collection period"

• 
It measures the average number of days it takes a
company to collect a receivable. The shorter the
DSO, the better.
INTERPRETATION

• The Accounts Receivable Turnover of Harley-

Davidson, Inc. is 2.97. It means that they collect their
receivables 2.97 times a year or once every 123 days.
In other words, it will take 123 days to collect the cash
from sales.
 Inventory Turnover

Represents the number of times inventory is sold

and replaced.
•  A high ratio indicates that the company is efficient

in managing its inventories.

 Days Inventory Outstanding

Also known as "inventory turnover in days“

It represents the number of days inventory sits in
the warehouse.
• 
In other words, it measures the number of days
from purchase of inventory to the sale of the same.
INTERPRETATION

• The Inventory Turnover of Harley-Davidson, Inc. is

8.67. It means that the company will take 42 days to
sell average inventory.
 Common turnover ratios

FIXED ASSET TURNOVER

• Ratio of sales to fixed assets

• Indicates the ability of the company’s
•  management to put the fixed assets to work to
generate sales
 Common turnover ratios

FIXED ASSET TURNOVER

• It calculates how efficiently a company in

producing sales with its machines and equipment
•  (investments in property, plant and equipment.
INTERPRETATION

• The total fixed asset turnover of Harley-Davidson is

7.22. By average, it means that $7 of sales is generated
for every dollar investment in fixed asset.
 Total Asset Turnover

Measures overall efficiency of a company in

generating sales using its assets.
• 
• The total asset turnover ratio is a general efficiency ratio that
measures how efficiently a company uses all of its assets. This
gives investors and creditors an idea of how a company is
managed and uses its assets to produce products and sales.
• Sometimes investors also want to see how companies use more
specific assets like fixed assets and current assets.
INTERPRETATION

• The total asset turnover of Harley-Davidson is .66.

This means that for each dollar of asset the company
generates 66 cents of sales.
 Management Efficiency Ratios

• The greater the turnover, the more effective

the company at producing a benefit from its
investment in assets
Additional Profitability ratio

 Return on Equity
 Return On Assets
Return On Equity
 Measures the ability of a firm to generate
profits from its shareholders investments
 ROE shows how much profit earns for each
dollar/peso of common stockholder’s equity
generates
 
Net   Income
ROE  =
Average  Shareholder ′s   Equity
Return On Equity
 Is an indicator of how effective the management
in using equity financing to fund operating and
growth of the company
 Most of the time, ROE is computed for common
stockholders
 
Net   Income
ROE  =
Average  Shareholder ′s   Equity
Interpretation:

 The ROE of Harley-Davidson, Inc. is 29%. This

means that every dollar of common
stockholder’s equity earned about 29 cents. In
other words, shareholders saw a 29% return on
their investments
 
Net   Income
ROE  =
Average  Shareholder ′s   Equity
Return On Asset
 ROA measures the efficiency of the
company in managing its assets to produce
profits during the period

 
Net  Income
ROA  =
Average   Total   Assets
Interpretation:

 The ROA of Harley-Davidson, Inc. is 9%. This

means that in every dollar invested in assets it
generates $.09 cents of net income.
DUPONT ANALYSIS
 Also called as the Dupont Model
 The Dupont Corporation developed this
analysis in 1920s
DUPONT ANALYSIS
 Used to analyze a company’s ability to
increase its return on equity (ROE)

 It breaks down the return on equity

ratio to explain how companies can
increase their return to investors
DUPONT ANALYSIS
 This model was develop to analyze the
ROE and the effects on different
business performance measures
DUPONT ANALYSIS
THREE MAIN COMPONENTS:
 Profit Margin
 Total Asset Turnover
 Financial Leverage
DUPONT ANALYSIS
• 

Or
 DUPONT ANALYSIS
DuPont Analysis is an expansion of a
company’s ROE, which concludes that the
company can ear a higher profit if:
It earns a higher Net Profit Uses Assets efficiently to If it is not highly leverage
Margin generate higher sales
It is a tool to understand the broader picture of the ROE of the
company. It gives insights on where the strengths of the
company lies and where work needs to be done.
END OF LESSON 3
Ratio Analysis
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