Ratio

Analysis
Financial
Ratios
 Market Ratios

Profitability Ratios

Debt Ratios

Activity Ratios

Liquidity
Ratios
 Liquidity Ratios

Firm’s ability to satisfy its short-

term obligations as they come
due.
 Liquidity Ratios

Current Ratio Quick Ratio

 Current Ratio

Looks at the ratio between current assets and current

liabilities.  The current ratio determines whether the
company has enough short-term assets to pay for
short-term liabilities.
Computation of current ratio:

     

Current ratio = Current assets ÷ Current liabilities

  = $782,000 ÷ $337,000

Current ratio = 2.32

• Interpreting the Current Ratio
• If the current ratio computation results in an amount greater
than 1, it means that the company has adequate current assets
to settle its current liabilities. In the above example, XYZ
Company has current assets 2.32 times larger than current
liabilities. In other words, for every $1 of current liability, the
company has $2.32 of current assets available to pay for it.
• A high current ratio is generally considered a favorable sign for
the company. Creditors are more willing to extend credit to those
who can show that they have the resources to pay obligations.
However, a current ratio that is too high might indicate that the
company is missing out on more rewarding opportunities.
Instead of keeping current assets (which are idle assets), the
company could have invested in more productive assets such as
long-term investments and plant assets.
 Quick Ratio

Or
Quick ratio = (Current assets – Inventories – Prepayments)
÷ Current liabilities

Is similar to the current ratio but it excludes

inventory and prepaid expenses from current assets.
The quick ratio (or acid-test ratio) is a more
conservative measure of liquidity than the current
ratio.
Computation of quick ratio:
     
Quick
ratio = Quick assets ÷ Current liabilities

($76,000 + $110,000 +
  = $230,000) ÷ $350,000

Quick = 1.19
ratio
• Interpreting the Quick Ratio
• A quick ratio that is greater than 1 means that the company has enough
quick assets to pay for its current liabilities. Quick assets (cash and cash
equivalents, marketable securities, and short-term receivables) are
current assets that can be converted very easily into cash. Hence,
companies with good quick ratios are favored by creditors.

• In the example above, the quick ratio of 1.19 shows that GHI Company
has enough current assets to cover its current liabilities. For every $1 of
current liability, the company has $1.19 of quick assets to pay for it.

• The ideal ratio depends greatly upon the industry that the company is in.
A company operating in an industry with a short operating cycle
generally does not need a high quick ratio. Financial ratios should be
compared with industry standards to determine whether such ratios are
normal or deviate materially from what is expected.
 Activity Ratios
Measures the speed with which
various accounts are converted into
sales or cash-inflows or cash-
outflows.
 Inventory Asset
Turnover Ratio Turnover Ratio

Activity Ratios

Average Average
Collection Period Payment Period
Inventory Turnover Ratio

This measures how many times average inventory is

“turned” or sold during a period. In other words, it
measures how many times a company sold its total
average inventory dollar amount during the year. This
measurement shows how easily a company can turn its
inventory into cash.
• Example

• Donny’s Furniture Company sells industrial

furniture for office buildings. During the current
year, Donny reported cost of goods sold on its
income statement of $1,000,000. Donny’s
beginning inventory was $3,000,000 and its
ending inventory was $4,000,000.
As you can see, Donny’s turnover is .29. This
means that Donny only sold roughly a third of
its inventory during the year. It also implies that
it would take Donny approximately 3 years to
sell his entire inventory or complete one turn.
In other words, Danny does not have very
good inventory control.
•Analysis
• Inventory turnover is a measure of how efficiently a company can control its
merchandise, so it is important to have a high turn. This shows the company does
not overspend by buying too much inventory and wastes resources by storing
non-salable inventory. It also shows that the company can effectively sell the
inventory it buys.

• This measurement also shows investors how liquid a company’s inventory is.
Think about it. Inventory is one of the biggest assets a retailer reports on its
balance sheet. If this inventory can’t be sold, it is worthless to the company. This
measurement shows how easily a company can turn its inventory into cash.

• Creditors are particularly interested in this because inventory is often put up as

collateral for loans. Banks want to know that this inventory will be easy to sell.

• Inventory turns vary with industry. For instance, the apparel industry will have
higher turns than the exotic car industry.
Asset Turnover Ratio

Indicates the firm’s efficiency to use

assets for generating sales.
Example

Sally’s Tech Company is a tech start up company

that manufactures a new tablet computer. Sally is
currently looking for new investors and has a
meeting with an Angel investor. The investor wants
to know how well Sally uses her assets to produce
sales, so he asks for her financial statements.

Here is what the financial statements reported:

•Beginning Assets: $50,000
•Ending Assets: $100,000
•Net Sales: $25,000
The total asset turnover ratio is calculated like
this:

As you can see, Sally’s ratio is only .33. This

means that for every dollar in assets, Sally only
generates 33 cents. In other words, Sally’s start
up in not very efficient with its use of assets.
ANALYSIS
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 that the company isn’t using its assets
efficiently and most likely have management or production problems.

For instance, a ratio of 1 means that the net sales of a company equals the average total
assets for the year. In other words, the company is generating 1 dollar of sales for every
dollar invested in assets.

Like with most ratios, the asset turnover ratio is based on industry standards. Some
industries use assets more efficiently than others. To get a true sense of how well a
company’s assets are being used, it must be compared to other companies in its industry.

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.
 Average Collection Period

Average collection period is a measure of how

many days it takes a firm, on average, to collects its
receivables. It indicates the efficiency of the
collection process and the lower it is the shorter the
cash cycle of the business is, which has a positive
impact on its profitability.
Average Collection Period Formula

• The Average Collection Period formula is calculated below:

• ACP = 365 / Accounts Receivable Turnover

• The Accounts Receivable Turnover rate indicates the number of times a

business’ net credit sales are turned into cash within a year or during a
certain period of time. The formula for the Accounts Receivable Turnover rate
is:

• ART = Net Credit Sales / Avg. Accounts Receivables

• Average Collection Period Equation Components

• Net Credit Sales: The total sales made through commercial credit as
the mean of payment.
• Avg. Accounts Receivable: The sum of the beginning and ending
balance of the accounts receivables divided by 2, for the time period
under evaluation.
• Average Collection Period Example

• Bro Repairs is a small business that offers

maintenance of air conditioning units to commercial
establishments, offices and households. They
usually give their commercial clients at least 15 days
of credit and these sales constitute at least 60% of
their annual $2,340,000 in revenues. At the
beginning of this year, Bro Repairs accounts
receivables were $124,300 and by the end of the
year the receivables were $121,213.
• The first thing that the owners need to do to
figure out the Average Collection Period is to
calculate the Accounts Receivable Turnover.
Here’s how the calculation will look like:
• ART = ($2,340,000 * 0.60) / (($124,300 +
$121,213) / 2) = 11.4 times

• With this information we can calculate the

Average Collection Period, as follows:
• ACP = 365 / 11.4 = 32 days.
•Average Collection Period Analysis
•Figuring the Average Collection Period of a business allows the management
team to measure the efficiency of their Billing Teams and processes. If the
ACP is higher than the average credit period extended to clients, as seen in
the example above, it means the Billing Process is not working as it should.
In most cases, this may be due to a lack of follow up or because of bad credit
lines that should have never been extended in the first place.

•To avoid this, companies should analyze their clients first, before extending
credit lines to them. If a client has a history of late payments with other
suppliers, the company should not provide goods or services through credit,
as the collection of such sales will probably be difficult. Additionally,
administrative systems should provide the Billing Team with reminders of
due invoices, to prompt them to follow up in order to reduce the ratio.

•A company with a consistent record of failing to collect its payments on time

will eventually succumb to financial difficulties due to cash shortages, as its
cash cycle will be extended. This is also a costly situation to be in, as the
company will have to take debt to fulfill its commitments and this debt
carries interest charges that will reduce earnings. For this reason, the
efficiency of any business collection process is a crucial element to its
success.
 Average Payment Period

Average payment period (APP) is a solvency ratio that

measures the average number of days it takes a
business to pay its vendors for purchases made on
credit.
Average Payment Period = Average Accounts
Payable / (Total Credit Purchases / Days)

To calculate, first determine the average

accounts payable by dividing the sum of
beginning and ending accounts payable
balances by two, as in this equation:

Average Accounts Payable = (Beginning +

Ending AP Balance) / 2
• Example
• Clothing, Inc. is a clothing manufacturer that regularly
purchases materials on credit from wholesale textile makers.
The company has great sales forecasts, so the management
team is trying to formulate a lean plan to retain the most
profit from sales. One decision they need to make is to
determine if it’s better for the company to extend purchases
over the longest available credit terms or to pay as soon as
possible at a lower rate. The average payment period can
help the management team see how efficient the company
has been over the past year with such credit decisions.
• First, the team needs to compute the average accounts
payable. Last year’s beginning accounts payable balance was
$200,000 and the ending balance was $205,000. The total
for credit purchases over the year was $875,000. 
So, the average payment period the company
has been operating on is 84 days.

The management team will use this information

to determine if paying off credit balances faster
and receiving discounts might produce better
results for the company.
• Analysis and Interpretation
• Average payment period in the above scenario seems to illustrate a
rather long payment period. The company may be giving up crucial
savings by taking so long to pay. Assume that Clothing, Inc. can
receive a 10% discount for paying within 60 days from one of its main
suppliers. The company management team would need to evaluate
this to see if there is adequate cash flow to cover the purchase in 60
days. If it can, that could make for a nice increase to the bottom line,
as 10% is a huge difference in the clothing industry.
• On the other hand, Clothing, Inc. might be better off keeping its
money for the entire payment period and forgoing the early pay
discount because it can invest its money in higher margin, higher
turnover inventory in the meantime. Thus, it would make more than
10% on its money reinvesting in new inventory sooner.
• All of these decisions are relative to the industry and company’s
needs, but it is apparent that the average payment period is a key
measurement in evaluating the company’s cash flow management.
Thus, it should always be other companies’ metrics in the industry.
 Debt Ratios

Indicates the amount the firm

uses to generate profits
from others’ money.
 Debt Ratios

Times Interest Fixed-Payment

Debt Ratio
Earned Ratio Coverage
Ratio
 Debt Ratio
Debt ratio is a solvency ratio that measures a
firm’s total liabilities as a percentage of its total
assets. In a sense, the debt ratio shows a
company’s ability to pay off its liabilities with its
assets. In other words, this shows how many
assets the company must sell in order to pay off
all of its liabilities.
This ratio measures the financial leverage of a
company. Companies with higher levels of
liabilities compared with assets are considered
highly leveraged and more risky for lenders.
Example
Dave’s Guitar Shop is thinking about building an
addition onto the back of its existing building for more
storage. Dave consults with his banker about applying
for a new loan. The bank asks for Dave’s balance to
examine his overall debt levels.
The banker discovers that Dave has total assets of
$100,000 and total liabilities of $25,000.
As you can see, Dave only has a debt ratio
of .25. In other words, Dave has 4 times as
many assets as he has liabilities. This is a
relatively low ratio and implies that Dave will
be able to pay back his loan. Dave shouldn’t
have a problem getting approved for his
loan.
•Analysis
• The debt ratio is shown in decimal format because it calculates total
liabilities as a percentage of total assets. As with many solvency
ratios, a lower ratios is more favorable than a higher ratio.
• A lower debt ratio usually implies a more stable business with the
potential of longevity because a company with lower ratio also has
lower overall debt. Each industry has its own benchmarks for debt,
but .5 is reasonable ratio.
• A debt ratio of .5 is often considered to be less risky. This means
that the company has twice as many assets as liabilities. Or said a
different way, this company’s liabilities are only 50 percent of its
total assets. Essentially, only its creditors own half of the company’s
assets and the shareholders own the remainder of the assets.
• A ratio of 1 means that total liabilities equals total assets. In other
words, the company would have to sell off all of its assets in order
to pay off its liabilities. Obviously, this is a highly leverage firm. Once
its assets are sold off, the business no longer can operate.
 Times Interest Earned Ratio

The times interest earned ratio, sometimes

called the interest coverage ratio, is a coverage
ratio that measures the proportionate amount
of income that can be used to cover interest
expenses in the future.
Example
• Tim’s Tile Service is a construction company
that is currently applying for a new loan to
buy equipment. The bank asks Tim for his
financial statements before they will consider
his loan. Tim’s income statement shows that
he made $500,000 of income before interest
expense and income taxes. Tim’s overall
interest expense for the year was only
$50,000.
As you can see, Tim has a ratio of ten. This
means that Tim’s income is 10 times greater than
his annual interest expense. In other words, Tim
can afford to pay additional interest expenses. In
this respect, Tim’s business is less risky and the
bank shouldn’t have a problem accepting his
loan.
ANALYSIS
• The times interest ratio is stated in numbers as opposed to a
percentage. The ratio indicates how many times a company
could pay the interest with its before tax income, so obviously
the larger ratios are considered more favorable than smaller
ratios.

• In other words, a ratio of 4 means that a company makes

enough income to pay for its total interest expense 4 times
over. Said another way, this company’s income is 4 times higher
than its interest expense for the year.

• As you can see, creditors would favor a company with a much

higher times interest ratio because it shows the company can
afford to pay its interest payments when they come due.
Higher ratios are less risky while lower ratios indicate credit
risk.
Fixed Charge Coverage Ratio

• The fixed charge coverage ratio is a financial ratio

 that measures a firm’s ability to pay all of its fixed
charges or expenses with its income before interest
and income taxes. The fixed charge coverage ratio is
basically an expanded version of the 
times interest earned ratio or the times interest
coverage ratio.
• The fixed charge coverage ratio is very adaptable for
use with almost any fixed cost since fixed costs like
lease payments, insurance payments, and preferred
dividend payments can be built into the calculation.
The fixed charge coverage ratio starts with the
times earned interest ratio and adds in applicable
fixed costs. We will use lease payments for this
example, but any fixed cost can be added in. This
ratio would be calculated like this:
Example

• Quinn’s Harp Shop is an instrument retailer that specializes

in selling and repairing harps. Quinn has been interest in
remodeling the inside of his store but needs a loan in order
to afford it. After giving his financial statements to the bank,
the loan officer calculates Quinn’s fixed charge coverage
ratio.
• According to Quinn’s income statement, he has $300,000 of
income before interest and taxes and interest expense of
$30,000. Quinn’s current lease payment is $2,000 a month
or $24,000 a year
As you can see, Quinn’s ratio is six.
That means that Quinn’s income is 6
times greater than his interest and
lease payments. This is a healthy ratio
and he should be able to receive his
loan from the bank.
 Profitability Ratios
Measures the firms’ profits with the given level of sales.
Gross-Profit Operating-Profit Net-Profit
Ratio Ratio Ratio

Profitability Ratios

Earning Return on Return on

Per Share Total Assets Common Equity
 Gross Profit Ratio

Gross profit margin is a profitability ratio that calculates the

percentage of sales that exceed the cost of goods sold. In
other words, it measures how efficiently a company uses its
materials and labor to produce and sell products profitably.
The gross profit ratio is important because it shows
management and investors how profitable the core business
activities are without taking into consideration the indirect
costs.
EXAMPLE

• Monica owns a clothing business that designs and manufactures

high-end clothing for children. She has several different lines of
clothing and has proven to be one of the most successful brands in
her space. Here’s what appears on Monica’s income statement at the
end of the year.

• Total sales: $1,000,000

• COGS: $350,000
• Rent: $100,000
• Utilities: $10,000
• Office expenses: $2,500
Monica is currently achieving a 65 percent GP on her
clothes. This means that for every dollar of sales Monica
generates, she earns 65 cents in profits before other
business expenses are paid.

The gross profit method is an important concept because

it shows management and investors how efficiently the
business can produce and sell products. In other words, it
shows how profitable a product is.
 Operating-Profit Ratio

The operating margin ratio, also known as the

operating profit margin, is a profitability ratio that
measures what percentage of total revenues is
made up by operating income. In other words, the
operating margin ratio demonstrates how much
revenues are left over after all the variable or
operating costs have been paid.
EXAMPLE

• If Christie’s Jewelry Store sells custom jewelry to celebrities all over

the country. Christie reports the follow numbers on her 
financial statements:

• Cost of Goods Sold: $500,000Net Sales: $1,000,000

• Rent: $15,000
• Wages: $100,000
• Other Operating Expenses: $25,000
As you can see, Christie’s operating income is $360,000 (Net
sales – all operating expenses). According to our formula,
Christie’s operating margin .36. This means that 64 cents on
every dollar of sales is used to pay for variable costs. Only
36 cents remains to cover all non-operating expenses or
fixed costs.
It is important to compare this ratio with other companies in
the same industry. The gross margin ratio is a helpful
comparison.
ANALYSIS

• The operating profit margin ratio is a key indicator for investors and
creditors to see how businesses are supporting their operations. If
companies can make enough money from their operations to support
the business, the company is usually considered more stable. On the
other hand, if a company requires both operating and non-operating
income to cover the operation expenses, it shows that the business’
operating activities are not sustainable.
• A higher operating margin is more favorable compared with a lower
ratio because this shows that the company is making enough money
from its ongoing operations to pay for its variable costs as well as its
fixed costs.
 Net-Profit Ratio

The net profit margin ratio, also called net margin, is

a profitability metric that measures what percentage
of each dollar earned by a business ends up as profit
at the end of the year. In other words, it shows how
much net income a business makes from each dollar
of sales.
Example

Company X, Y, and Z all operate in the same industry and report the following numbers on their income statements during this period.
• We can compare Company X and Company Y on a net income basis, but
that doesn’t tell us the entire story of their profitability. Based on their
net income Company Y seem to be more profitable than Company X
and Company Z. Similarly, both Company X and Company Z have the
same net profit, so they might appear to be equally profitable.

• However, we need to look at their total dollar amount of profits in the

context of how much revenue these companies generated.

• The net profit margin ratio equation will help us quantify the
magnitude of profitability of the company.

• As we can see, both Company X and Company Y have the same NPM
even though Company Y is 10 times bigger. Also, Company Z and
Company X have the same net income, but their margins differ
drastically.
 Earnings Per Share (EPS)

Earning per share (EPS), also called net income per share, is
a market prospect ratio that measures the amount of net
income earned per share of stock outstanding. In other
words, this is the amount of money each share of stock
would receive if all of the profits were distributed to the
outstanding shares at the end of the year.
ANALYSIS

• Earning per share is the same as any profitability or market

prospect ratio. Higher earnings per share is always better than
a lower ratio because this means the company is more
profitable and the company has more profits to distribute to
its shareholders.

• Although many investors don’t pay much attention to the EPS,

a higher earnings per share ratio often makes the stock price
of a company rise. Since so many things can manipulate this
ratio, investors tend to look at it but don’t let it influence their
decisions drastically.
Return on Assets (ROA)

The return on assets ratio, often called the return on total

assets, is a profitability ratio that measures the net income
produced by total assets during a period by comparing net
income to the average total assets. In other words, the
return on assets ratio or ROA measures how efficiently a
company can manage its assets to produce profits during a
period.
Return on Common Equity (ROE)

The return on equity ratio or ROE is a profitability ratio that measures the
ability of a firm to generate profits from its shareholders investments in
the company. In other words, the return on equity ratio shows how much
profit each dollar of common stockholders’ equity generates.

So a return on 1 means that every dollar of common stockholders’ equity

generates 1 dollar of net income. This is an important measurement for
potential investors because they want to see how efficiently a company
will use their money to generate net income.
 Market Ratios

Relates the firms’ market value as

measured by its current share
price, to certain accounting values.
 Market Ratios

Price/Earnings Market/Book
Ratio Ratio
 Price/Earnings Ratio (P/E)

The price earnings ratio, often called the P/E ratio or price to
earnings ratio, is a market prospect ratio that calculates the
market value of a stock relative to its earnings by comparing
the market price per share by the earnings per share. In other
words, the price earnings ratio shows what the market is
willing to pay for a stock based on its current earnings.
 DuPont System of
Analysis
System used to dissect the firm’s financial
statement and to assess its financial
condition.

The two measures of this this system

are:

1. Return on total assets (ROA)

2. Return on common equity (ROE)
 DuPont Formula
The Dupont analysis also called the Dupont model is a financial
ratio based on the return on equity ratio that is used to analyze a
company’s ability to increase its return on equity. In other words,
this model breaks down the return on equity ratio to explain how
companies can increase their return for investors.
The Dupont analysis looks at three main components of the ROE
ratio.
Profit Margin
Total Asset Turnover
Financial Leverage
Based on these three performances measures the model concludes
that a company can raise its ROE by maintaining a high profit
margin, increasing asset turnover, or leveraging assets more
effectively.