Management - Chapter 13

CHAPTER 13
FINANCIAL
RATIO ANALYSIS
Management: Principles, Processes & Practices

© Oxford University Press 2008 All rights reserved
Learning Objectives
 The application of ratio analysis to analyse
financial statements
 Financial ratios and their utility
 Different types of ratios
 Using ratio analysis
 Different types of ratios and their implications on
analysis of financial position of the company
 Evaluating the relative strengths and
weaknesses of the company by using ratio
analysis so that the various stakeholders of a
company may make their financial decisions

Financial Ratios and their
utilities
 Financial ratio analysis computation
and comparison of ratios based on the
information about the company’s
performance in its financial
statements.
 Utility of ratios varies from stakeholder
to stakeholder.
 Each stakeholder views the ratio
according to the issues that concerns
him.
Types of Ratio Comparison
 Ratio comparisons can be made in
two ways—cross-sectional and
time series.
Types of ratio
comparison
Cross-Sectional Analysis:
It compares the financial Time Series Analysis:
ratios of different It compares ratios
comparable for a given company
firms at a given over a period of time
point of time

Using Ratio Analysis
Some points to be kept in mind while using ratios are:
 Over dependence on a single ratio is not desirable as far
as conclusive interpretation of the performance of a
company is concerned.
 Effect of seasonality needs to be segregated while
making comparisons.
 To get the true financial analysis, ratios should be
computed based on audited accounts data
 Definition used for arriving at the value of variables in
the ratio should be identical in all respects.
 Implication of inflating on the business performance as
also on the computed ratios should be duly taken care of
while interpreting the ratios

Broad categories of Ratios
 Liquidity Ratio: gives short-term financial position or
solvency of the company
 Operational Ratio: deals with efficiency of resource
and asset utilization in the operations of the company
 Profitability Ratio: indicates the margins realized by
the company, i.e., various returns on sales and capital
employed
 Leverage Ratio relates to the debt component used
in the company’s capital structure.
 Solvency Ratio: indicates the company’s ability to
generate cash flow for meeting its overall financial
obligations

Liquidity Ratios
Liquidity ratios provide information about the company’s ability to

meet its short-term commitments with its total cash reserves.
Current Ratio = Total Current Assets / Total Current Liabilities
Quick Ratio = Cash + government securities + receivables /

total current liabilities
Current ratio is the ratio between current assets; those that the
company owns and can be converted into cash within a short
period, i.e., within a year and current liabilities that the
company owes to others and are payable within a short time,
say within a year.
= (Current assets – inventory) / Current

liabilities
Quick ratio differs from current ratio, as it excludes inventories
and only considers mostly those liquid assets that can be
easily converted into cash.
Working capital = Total current assets - Total current liabilities

Operational Ratios
Operational ratios focus on the management’s
efficiency in running the business
Inventory Turnover Ratio = Net sales / Average
inventory at cost
Or = Cost of goods sold / inventory
Inventory turnover is normally reported in terms of

number of days worth of inventory carried by
company. Inventory period is worked out as –
= 365/ Inventory turnover

Average Collection Period
average age of account receivables helps in evaluating a company’s
policies towards its debtors.
= Accounts receivables/ Average sales per day

= Accounts receivables/ (Annual sales / 365)
Average Payment Period

company’s strength to get more favourable terms of payment from its
creditors.
= Accounts payable/ Average purchases per day

= Accounts payable/ (Annual purchases/365)
Total Asset Turnover

Total asset turnover = Sales /total assets
Higher the ratio, the greater the efficiency of asset utilization and better it
is for the company.

Profitability Ratio
Ratios give the margins to sales, on assets, and on owner’s
investment. Comparison of the margin ratios with the average
of the industry or the best performers indicates the performance
of the company and the scope the management has to improve
efficiency of resource generation, allocation, and value addition
to the same.
Gross margin ratio = Gross profit / Net sales
Gross profit = Net sales - Cost of goods sold
Net Profit Margin Ratio = Net Profit (earnings available for common
stockholders)/ Net Sales
Return on total assets= Net profit (earnings available for

common stockholders) / Total assets

Total Asset Turnover
It indicates the efficiency with which company’s assets are being used.
Total asset turnover = Sales /total assets
Profitability Ratio
Profitability ratios give the margins to sales, on assets, and on owner’s investment.
Comparison of the margin ratios with the average of the industry or the best
performers indicates the performance of the company and the scope the
management has to improve efficiency of resource generation, allocation, and
value addition.
Gross margin ratio = Gross profit / Net sales
Gross profit = Net sales - Cost of goods sold
Net Profit Margin Ratio = Net Profit (earnings available for common
stockholders)/ Net Sales

Return on Total Assets/Net Worth/Equity
Return on total assets, also known as Return on Investment (ROI) measures
the overall effectiveness of the management in generating profits.
Return on total assets= Net profit (earnings available for common
Net profit/ Sales (I)
stockholders) / Total assets
Net
Divide I by II profit/Total Return on
assets Assets
Sales/Total
Assets (II)
Return on equity = Net profit (earnings available for common stockholders) /

Common stock equity
Return on net worth = Net profit (earnings available for common stockholders)/
net worth

Leverage Ratio
Leverage ratio, calculated by total liabilities divided by the net worth of

the company indicates the extent to which the business is dependent on
debt financing in relation to owner’s equity.
Solvency Ratio
The solvency ratios indicate the company’s ability to generate cash flow
for meeting its overall financial obligations.
Debt–Equity Ratio
This ratio indicates the proportion of debt with respect to the equity, i.e.,
owners’ stake in the business.
Debt–Equity ratio = Debt/Common stock equity

Interest Cover Ratio
This ratio measures a company’s capacity to meet its interest
commitments. The higher the value of the ratio, the better it is.
Interest coverage ratio = Earnings before interest and taxes/Interest
Debt Service Coverage ratio (DSCR)
A company’s capability to service its debt obligations is found through the

computation of debt service coverage ratio (DSCR).
Earnings before interest and taxes + Lease

payments
Fixed payment = ---------------------------------------------------
coverage ratio Interest + Lease payments + [(Principal
payments + Preferred stock dividends) ×
{1/ (1−T)}]

Ratio Analysis enable the management to take corrective
steps or realize its objectives and goals.
What matters the most is interpretation of financial ratios,

as certain information given in the financial statements is
incomplete without really understanding the implications
of ‘notes to accounts’ and their effect on the financial ratio
at a given time or in the future.
Therefore, coupled with financial ratio analysis, practising

financial analysts with their experience often develop
their own measures for particular industries and even
individual companies to evaluate their financial
performance.


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CHAPTER 13

Management: Principles, Processes & Practices

Management: Principles, Processes & Practices

Management: Principles, Processes & Practices

Management: Principles, Processes & Practices

Management: Principles, Processes & Practices

Liquidity ratios provide information about the company’s ability to

Quick Ratio = Cash + government securities + receivables /

= (Current assets – inventory) / Current

Management: Principles, Processes & Practices

Inventory turnover is normally reported in terms of

Management: Principles, Processes & Practices

= Accounts receivables/ Average sales per day

Average Payment Period

= Accounts payable/ Average purchases per day

Total Asset Turnover

Management: Principles, Processes & Practices

Gross margin ratio = Gross profit / Net sales

Gross profit = Net sales - Cost of goods sold

Return on total assets= Net profit (earnings available for

Management: Principles, Processes & Practices

Gross profit = Net sales - Cost of goods sold

Management: Principles, Processes & Practices

Return on equity = Net profit (earnings available for common stockholders) /

Management: Principles, Processes & Practices

Leverage ratio, calculated by total liabilities divided by the net worth of

Debt–Equity ratio = Debt/Common stock equity

Management: Principles, Processes & Practices

Debt Service Coverage ratio (DSCR)

A company’s capability to service its debt obligations is found through the

Earnings before interest and taxes + Lease

Management: Principles, Processes & Practices

What matters the most is interpretation of financial ratios,

Therefore, coupled with financial ratio analysis, practising

Management: Principles, Processes & Practices

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