Financial Ratios

Financial Ratios
• Financial Ratios describes the significant
relationship between the numbers presented in the
financial statements. They can be expressed either as
a rate, percentage, or a proportion.
Financial Ratios
• The ability of the company to settle its current

Liquidity obligations as they fall due.

• The ability of the company to settle its non-current or

Solvency long-term obligations and the interest related to these

obligations.

• It measures the company’s operating performance as a return

on its investments. It gauges management’s efficiency in using
Profitability company’s resources in order to generate revenue.

• It measures the company’s potential for future earnings,

Market Value or dividend payments, and stock price growth.
Valuation
Liquidity Ratios
• LIQUIDITY RATIOS - these ratios calculate the
company’s current or quick assets against its
outstanding liabilities. Generally, a high ratio
indicates that the company has low risk of defaulting
payment.
Common Types of Liquidity
Ratios:
Receivable
Current Ratio Quick Ratio
Turnover

Average
Inventory Average Sales
Collection
Turnover Period
Period

Working
Capital
Current Ratio
• Current Ratio – measures the ability of the business
to pay its short-term obligations as they fall due.
– Generally, a current ratio of 1 or 1.5 is considered
satisfactory to serve as a company’s cushion to its
current liabilities, although the industry average has
to be taken into consideration.
– However, some banks and financial institutions
require a current ratio of 2 or 3 before extending
credit in order to assure the collection of the principal
with interest.
Current Ratio
– Nonetheless, this does not mean that the higher the
current ratio the better.
– Although a low current ratio may mean that the
company may not be able to pay its short-term debt
as they mature, a very high current ratio may mean
that the company is holding too much cash or liquid
assets when in fact, a part of these could be put in
long-term investment which will yield higher
income.
– The component of the current assets should also be
determined because a significant part of it might be
inventory and prepaid expenses.
Current Ratio
Quick Ratio
• Quick Ratio – otherwise known as acid test ratio, it
measures immediate liquidity with the ability to pay
current liabilities with the most liquid assets.
– The quick ratio is a more conservative measure of
liquidity since it only considers current assets that can
be converted to cash easily or quickly.
– Current assets are composed of cash, short-term
investments, receivables, merchandise inventory, and
prepaid expenses. From these, we can notice that
merchandise inventory is not easily convertible to cash
as it has to be sold first which does not guarantee instant
cash because sometimes, it is sold on credit.
Quick Ratio
– Furthermore, some inventory items are slow moving.
Due to obsolescence, these items may not even be
sold in the long run.
– On the other hand, prepaid expenses will never be
converted to cash since they are not sold but used in
the normal operating cycle of the business. It is
because of these reasons that these two accounts are
not considered when computing for the quick ratio.
Quick Ratio
Receivable Turnover
• Receivable Turnover – also known as trade
receivable turnover, it measures the efficiency to
collect the amount due from credit customers.
– Generally, a high trade receivable turnover is
considered favorable since it may indicate a
company’s strict credit policies combined with
aggressive collection efforts while a low trade
receivable turnover may indicate loose credit policies
combined with inadequate collection effort.
Receivable Turnover
– However, imposing a very strict credit and collection
policy may lead to looser sales as some customers
may opt to buy from other companies with more
lenient credit terms.
Receivable Turnover
Average Collection Period
• Average Collection Period – otherwise called day’s
sales outstanding, is the approximate number of
days it takes a business to collect its receivables from
credit or account sales.
– In assessing whether the average collection period is
favorable or unfavorable, the credit terms extended by
the company to its customers should be considered.
Average Collection Period
Average Collection Period
Inventory Turnover
• Inventory Turnover – measures the number of times
a company’s inventory is sold and replaced during
the year.
– Since the company generates income from sales, the
faster the movement of the inventory, the higher the
company’s net income.
– Low inventory turnover may indicate overstocking of
inventory or the presence of obsolete items. This is
not favorable as inventory items tend to deteriorate,
spoil, or be obsolete when stocked in the warehouse
for some time unless it is planned stocking in
anticipation of product shortage or price increase.
Inventory Turnover
– High inventory turnover may indicate strong sales.
However, it may also indicate inefficient purchasing
where purchases are made often in small quantities
resulting in insufficient stock of goods or inadequate
inventory levels.
– This may result in losses in terms of sales as customer
demand is not served when the product is out of
stock. This may also result in higher purchase price of
goods as the company cannot avail of the maximum
trade discount available due to purchases made in
small volumes.
Inventory Turnover
Inventory Turnover
Average Sales Period
• Average Sales Period – otherwise known as the
inventory conversion period, it is the average time to
convert inventory to sales.
– Generally, the lower the average sales period, the
more favorable it is for the company since it signifies
a shorter period to sell inventory.
Average Sales Period
Working Capital
• Working Capital – measures the short-term liquidity
of a company
Solvency Ratio
• SOLVENCY RATIOS - otherwise known as
leverage ratios, measure the company’s ability to
pay its maturing long-term debts while sustaining
operations indefinitely.
Common Types of Solvency
Ratio

Debt Ratio Equity Ratio

Debt to Equity Times Interest

Ratio Earned
Debt Ratio
• Debt Ratio – otherwise known as the debt to assets
ratio, it measures business liabilities as a percentage
of total assets.
– It measures the extent of the total assets financed by
liabilities.
– Generally, a lower ratio is favorable since it means
that more funds are provided by the owner.
Debt Ratio
– The accounting equation (Assets = Liabilities +
Owner’s Equity) very well shows that business funds
come from two sources, namely liabilities from
creditors and owner’s equity from the owner.
– Generally, a 50-50 ratio where liabilities and owner’s
equity have the same proportion is considered fair as
this is determined to be the optimal debt ratio.
– However, slightly higher debt ratio is also acceptable
although we have to take into account the industry
and the payment history of the company.
Debt Ratio
Equity Ratio
• Equity Ratio – it measures the percentage of total
assets financed by the owner’s investment.
– It measures the extent of total assets owned by the
owner. This is his/her stake in the company.
– Generally, the higher the equity ratio, the more
favorable it is for the company.
– This is also an advantage if the company is to apply
for a loan as potential creditors will find the company
to be less risky.
Equity Ratio
Debt to Equity Ratio
• Debt to Equity Ratio – also known as financial
leverage ratio, it measures the financing provided by
the creditors against those provided by the owner.
– This measures the extent of the borrowed funds as
compared to the investment by the owner. The
optimal fair ratio is 1 or 100%.
– This means that liabilities are equal to owner’s equity.
– The higher the ration, the higher the risk as interest
payments on liabilities are onerous. Hence a lower
ratio is favorable.
Debt to Equity Ratio
Times Interest Earned
• Times Interest Earned – it measures the company’s
ability to pay the interest charged to the company for
its outstanding liabilities.
– It measures the number of times operating income can
cover interest expenses.
– The higher the number of times the operating income
can cover the interest expense, the more favorable it
is for the creditors because it means the company is
not struggling to pay its interests from loans.
Times Interest Earned
Profitability Ratios
• PROFITABILITY RATIOS - these measure a
company’s overall efficiency and performance based
on its ability to generate profit from operations
relative to its available assets and resources.
Common Types of Profitability
Ratios

Gross Profit Operating

Ratio Profit Margin

Net Profit Return on

Margin Assets
Gross Profit Ratio
• Gross Profit Ratio – otherwise known as Gross
Margin Ratio, it measures the percentage of peso
sales earned after deducting the cost of goods sold.
– Hence, this is the percentage of mark-up a company
adds to the cost of its inventory which will later
absorb the operating expenses related to the sale of
the goods.
– A high gross profit ratio is favorable as there will be
greater operating income after all operating expenses
have been paid.
Gross Profit Ratio
Operating Profit Margin
• Operating Profit Margin – measures the percentage
of income earned after deducting the cost of sales
and the operating expenses.
– In short, it is the income earned per peso of net sales
after the cost of inventory and the related operating
expenses are deducted.
– This is an indication of how the company is
effectively and efficiently managing its expenses at its
sales level.
– Hence, a higher ratio is favorable since it indicates
efficiency in managing expenses.
Operating Profit Margin
Net Profit Margin
• Net Profit Margin – also known as return on sales,
it measures the percentage of net income earned
from net sales after all other income has been added
and all operating expenses and other expenses
including income taxes have been paid.
– A high net profit margin is favorable for the company.
Net Profit Margin
Return on Assets
• Return on Assets – otherwise called return on
investment, it measures the company’s efficiency in
using its level of investment in assets in order to
generate income.
– Generally, a high ratio is favorable.
– Since capital assets are one of the company’s
investments, the return on assets measures the income
derived from these asset acquisitions.
Return on Assets
Questions???

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