RATIO ANALYSIS

Objective

• The principal focus has been on conveying and understanding of the

information contained in the three basic financial statements: the
balance sheet, the income statement, and the cash flow
statement.
• This chapter describes how this information is analyzed, both by
parties outside the firm and by the company’s own management.
All analyses of accounting data involve comparisons. Comparisons are essentially intended to shed
light on how well a company is achieving its objectives. In order to decide the types of comparisons
that are useful, we need first to consider what a business is all about- what its objectives are. The
overall objective of a business is to create value for its shareholders while maintaining a sound
financial position.
 OVERALL
PERFORMANCE
MEASURES

3. Return on 4.Return on
1.Price/earning 2.Return on
invested shareholders'
ratio assets
capital equity

Net income +
Net
Market price per interest (1-tax
income+interest (1- Net income/
share/ Net income rate)/long-term
Tax rate)/ Total shareholders' equity
per share liabilities+shareholde
assets
rs' equity
 PRICE / EARNINGS RATIO:
The broadest and most widely used overall measure of performance is the price/Earnings, or P/E,
ratio:  

Market price per share / Net income per share

This measure involves an amount not directly controlled by the company: The market price of its
common stock. Thus, the P/E ratio is the best indicator of how investors judge the firm’s future
performance.( we say future performance because, conceptually, the market price indicates
shareholders’ expectations about future returns-dividends and share price increase).
 RETURN ON ASSETS:
 ROA reflects how much the firm has earned on the investment of all the financial resources
committed to the firm. Thus, the ROA measure is appropriate if one considers the
investment in the firm to include current liabilities, long-term liabilities, and owners’ equity,
which are the total sources of funds invested in the assets. The ROA ratio often is used by top
management to evaluate individual business units within a multidivisional firm.
 RETURN ON INVESTED CAPITAL:
 The third ROI ratio is return on invested capital (ROIC). Invested capital (also called permanent
capital) is equal to non-current liabilities plus shareholders’ equity and hence
represents the funds entrusted to the firm for relatively long periods of time. Invested capital is
also equal to working capital plus noncurrent assets.
 RETURN ON OWNERS’ EQUITY (ROE):
 ROE reflects how much the firm has earned on the funds invested by the shareholders
(either directly or through retained earnings). This ROE ratio is obviously of
interest to present or prospective shareholders, and is also of concern to management because
this measure is viewed as an important indicator of shareholder value creation.
Ratio of Market Value to Book value

 Market Value to Book value=Market Price per share/Book value per Share
 Book Value per share =Share holders’ funds(excluding preference share
capital)/No .of equity shares
 Ideal ratio should range between 1 and 10
 PROFITABILITY MEASURES

Gross margin
Profit margin Earning per share
percentage

Gross margin/Net sales Net income/ Net sales Net income/ No.shares
revenues revenues outstanding
 GROSS MARGIN PERCENTAGE:
Gross profit margin depends on the relationship between price/sales, volume and costs.
High gross profit margin is a favorable sign of good management.

 EARNINGS PER SHARE:

The profitability of a firm from the point of view of ordinary shareholders can be measured in terms
of number of equity shares.
 PROFIT MARGIN:
It measures the relationship between net profit and sales of the business. Net profit ratio finds
the proportion of revenue that finds its way into profit. A high net profit ratio will
ensure positive returns of the business.
 TESTS OF INVESTMENT UTILIZATION

Invested Days' Days' Working

Inventory
capital cash receivables Days' capital
turnover
turnover (or collection inventory turnover
period)

sales cash/ cash

revenues/ expenses/ Inventory/ cost of sales/
365 accounts cost of sales/ inventory sales
Long-term receivable revenues/
liabilities + / 365
shareholders' working capital
sales/365
equity
 DAYS’ CASH:
 Although cash is a necessary asset, it earns little or no return. Thus, although too little
cash is an obvious signal of difficulty, too much cash is a sign that management has not
taken advantage of opportunities to put cash to work in say, marketable securities
 DAYS’ RECEIVABLE:
 The result is also called the average collection period for the receivables. If available, the
amount of sales in the denominator should be credit sales, which is more closely related to
receivables than is total sales.
 The collection period can be related roughly to the credit terms offered by the company. A rule
of thumb is that the collection period should not exceed 1 (1/3)
 Times the regular payment period ; that is, if the company’s typical terms call for payment in
30 days, it is said that the average collection period should not exceed 40 days.
 DAYS INVENTORY:
 The same relationship can be expressed as the number o days’ inventory on hand.
 INVENTORY TURNOVER:
 Some companies calculate this ratio on the basis of the ending inventory, other on the basis of
the average inventory. The average may be simply one -half the sum of beginning and ending
inventories the year. It varies greatly with the nature of the business. It should be high for a
store that sells fresh produce; otherwise spoilage is likely to be a problem. Inventory turnover
indicate the velocity with which merchandise moves through a business turnover may fall either
because of inventory buildup in anticipation of increased sales or because sales volume has
declined, leaving excess merchandise on hand.
 Tests of financial condition

Financial Times
Acid-test Debt/equity
Current ratio leverage interest
(quick) ratio ratio
ratio earned

Current
assets/current
liabilities Long-term
assets/share liabilities/share
Monetary pretax operating
holders' holders‘ equity
current profit + interest/
equity OR
assets/ interest
current Total liabilities/
liabilities shareholders' equity
 CURRENT RATIO:
 The current ratio is the most commonly used of all balance sheet ratios. It is a measure not only
of the company’s liquidity but also of the margin of safety that management maintains in order
to allow for the inevitable unevenness in the flow of funds through the current asset and current
liability accounts.
 ACID- TEST RATIO:
 Some of the current assets are monetary assets. A ratio that focuses on the relationship of
monetary current assets to current liabilities is called the acid-test ratio, or quick ratio. Quick
current assets are those current assets that are also monetary assets; they therefore exclude
inventories and prepaid items
 TESTS OF DIVIDEND
POLICY

DIVIDEND YIELD DIVIDEND PAYOUT

Dividends per share/ Market

Dividends / net income
price per share
 Two other ratios are related to another aspect of financial management: dividend policy.
These ratios are the dividend yield and dividend payout

Dividend yield = Dividends per share/ market price per

share
 This dividend yield on stock is often compared with the yield on bonds, but such a comparison is
not valid. The earnings of bondholders consist entirely of their interest.

Dividend payout = dividends / net income