Days 8&9 Ratio and

Comparative Analysis

1. The investment decision

2. The usefulness of accounting information
3. Profitability ratios
4. Liquidity ratios
5. Solvency ratios
6. Horizontal analysis
7. Vertical analysis
8. Ratio calculation example

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Roadmap
1. The investment decision
2. The usefulness of accounting information
3. Profitability ratios
4. Liquidity ratios
5. Solvency ratios
6. Horizontal analysis
7. Vertical analysis
8. Ratio calculation example

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The Investment Decision

Players Instrument Payoff

Investors Equity (common Dividends, Change

shares, preferred in share prices
shares, options) ( capital gains)
Creditors Interest revenue
Debt (bonds, loans)

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The Investment Decision
Return=Payoff/Amount of investment
Players Payoff Return

Investors Dividends, Change 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠+ 𝐶h𝑎𝑛𝑔𝑒𝑖𝑛 𝑠h𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒

in share prices 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑠h𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒(𝑝𝑢𝑟𝑐h𝑎𝑠𝑒 𝑝𝑟𝑖𝑐𝑒)

Creditors Interest revenue 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑒𝑣𝑒𝑛𝑢𝑒

𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑙𝑜𝑎𝑛

Risk= distribution of possible payoffs (list of possible payoffs and

probability associated with each one)

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Roadmap
1. The investment decision
2. The usefulness of accounting information
3. Profitability ratios
4. Liquidity ratios
5. Solvency ratios
6. Horizontal analysis
7. Vertical analysis
8. Ratio calculation example

5
Usefulness of Accounting Information
Information is useful to investors and creditors if it helps
them to predict future returns and the risk associated
with them.

Research into accounting information has shown:

Accounting ratios are useful in predicting events such as
corporate bankruptcy, chief executive officer dismissal.
Accounting ratios seem to be used by analysts (e. g., Moody’s)
and the market in assessing firm risk.
A firm’s accounting income is associated with its future stock
returns.

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Roadmap
1. The investment decision
2. The usefulness of accounting information
3. Profitability ratios
4. Liquidity ratios
5. Solvency ratios
6. Horizontal analysis
7. Vertical analysis
8. Ratio calculation example

7
Profitability Ratios
Profitability ratios measure a company’s operating success for a
specific period of time. Usually, the higher profitability ratios, the
better.

• Profitability ratios based on the Income statement.

1. Gross profit margin = Gross profit / Sales

= (Sales – Cost of goods sold ) / Sales
2. Profit margin
= Net income / Sales

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Rogers 2018 Profitability Ratios
Using Rogers 2018 statement of income to calculate the
following ratios

1. Gross profit margin

2. Profit margin

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 Profitability Ratios

• Profitability ratios based on the Income statement and

the Balance sheet
3. Asset Turnover Sales
¿
Average total assets
4. Return on asset (ROA) Net income
¿
Average total assets
5. Return on equity
(ROE) Net income
¿
Average common shareholders ’ equity

This is a simplified version of ROE, which is different from the textbook.

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Why Average Balance?
Many profitability ratios calculate return as some measure income
(net income) compared to some type of investment (total assets,
shareholders’ equity).

Income is earned over a period of time. Total assets or shareholders’

equity are measured on the balance sheet at specific dates and can
fluctuate over time.
To create a meaningful measure of return, investors calculate the
average assets or shareholders’ equity during the time period, most
simply as:
(Balance, beginning of year + Balance, end of year ) / 2

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Rogers 2018 Profitability Ratios
Using Rogers 2018 statement of financial position and income
to calculate the following ratios.
Asset Turnover

Return on assets (ROA)

Return on equity (ROE)

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 Profitability Ratios

• Profitability ratios based on the capital market

6. Basic earnings per share Net income

¿
Average number of common shares
7. Price-earnings ratio Market price per share ∗
¿
Basic earnings per share
8. Dividend yield
Dividend per share
¿
Market price per share ∗

* Closing market price per share at fiscal year end.

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Rogers 2018 Profitability Ratios
Using Rogers 2018 statement of financial position and
income to calculate the following ratios.
Basic earnings per share
EPS=
Price-earnings ratio
Market price per common share on Dec. 31, 2018 (tmxmoney.com, symbol
RCI.A) =
Price-earnings ratio =
Dividend yield
2018 dividends per share (tmxmoney.com, symbol RCI.A; or note 23) =
Dividend yield =

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Roadmap
1. The investment decision
2. The usefulness of accounting information
3. Profitability ratios
4. Liquidity ratios
5. Solvency ratios
6. Horizontal analysis
7. Vertical analysis
8. Ratio calculation example

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Liquidity Ratios
Liquidity ratios measure a company’s short-term ability to
pay its maturing obligations and to meet unexpected needs
for cash.

Usually, the higher liquidity ratios, the more liquid and the
better.

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 Liquidity Ratios
1. Current ratio Current Assets
¿
Current Liabilities

2. Receivable turnover Sales

¿
Average accounts receivable
3. Inventory turnover Cost of goods sold
¿
Average inventory

• Current ratio measures how much current assets is available to cover per
dollar of current liabilities.
• Receivable turnover measures how quickly firm collects accounts
receivable. Assume all sales are credit sales.
• Inventory turnover measures how quickly the firm is able to sell
inventory.
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Rogers 2018 Liquidity Ratios
Using Rogers 2018 statement of financial position and
income to calculate the following ratios.
Current ratio

Receivable turnover

Inventory turnover

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Roadmap
1. The investment decision
2. The usefulness of accounting information
3. Profitability ratios
4. Liquidity ratios
5. Solvency ratios
6. Horizontal analysis
7. Vertical analysis
8. Ratio calculation example

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 Solvency Ratios
Solvency ratios measure a company’s ability to pay its
total liabilities.
1. Debt to total assets Total liabilities
¿
Total assets
2. Times interest earned EBIT / Interest expense

Net income + Interest expense + Income tax expens

¿
Interest expense
• Debt to total assets captures the portion of assets financed by creditors.
Usually, the higher the riskier.
• Times interest earned measures the firm’s ability to pay interest. Usually,
the higher the safer.

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Rogers 2018 Solvency Ratios
Using Rogers 2018 statement of financial position and
income to calculate the following ratios

Debt to total assets

Times interest earned

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Roadmap
1. The investment decision
2. The usefulness of accounting information
3. Profitability ratios
4. Liquidity ratios
5. Solvency ratios
6. Horizontal analysis
7. Vertical analysis
8. Ratio calculation example

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Horizontal Analysis
Horizontal analysis (trend analysis) is a technique to express
the change of key financial statement items over time.

The changes (increase or decrease) could be expressed as:

• Percentage of base-period amount
= Analysis-period amount / Base-period amount

• Percentage change for the period

= (Analysis-period amount – Prior-period amount) / Prior-
period amount

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Horizontal Analysis-Example

For the following example, please calculate the percentage of

base year, and the percentage change over prior year. Assume
that year 2016 is the base year

2019 2018 2017 2016(base year)

Sales(in millions) 25,142 24,215 23,806 24,619

% of base year
% change over prior year

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Roadmap
1. The investment decision
2. The usefulness of accounting information
3. Profitability ratios
4. Liquidity ratios
5. Solvency ratios
6. Horizontal analysis
7. Vertical analysis
8. Ratio calculation example

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7. Vertical Analysis

Vertical analysis (common size analysis) is a

technique to express each item in a financial
statement as a percentage of the base amount.

Vertical percentage of base amount

= Analysis amount / Base amount

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Vertical Analysis

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Roadmap
1. The investment decision
2. The usefulness of accounting information
3. Profitability ratios
4. Liquidity ratios
5. Solvency ratios
6. Horizontal analysis
7. Vertical analysis
8. Ratio calculation example

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Ratio Calculation Example

• 2016 gross profit margin was 70% and cost of

goods sold were $120.
• 2016 income before tax was $140 and income tax
rate for 2016 was 25%.
Required: calculate profit margin for 2016.

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Ratio Calculation Example

• 2016 interest expense was $20.

• 2016 income tax rate was 30%.
• 2016 income tax expense was $45.
Required: calculate times interest earned for 2016.

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Unethical behaviors related to ratios
Shifting sales into the current period
• Suppose it is December 26, late in the year a company’s
business dried up: its profits are running below what
everyone predicted. The company needs a loan, and its
banker requires financial statements to support the loan
request. The company has outstanding orders for sales of
100,000. As soon as the company shifts the merchandise
to its customers (shipment is scheduled on Jan 2 of next
year), it can record the sales.

• Identify the potential unethical behaviors?

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