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Ratio Analysis

A ratio is simply one number expressed as a fraction or percentage of another.


Ratios are useful as they emphasize key relationships between financial categories and metrics.

What purpose do ratios serve?


Micro snap shot of a particular issue Multiple ratios show snap shot of companys highlights (Weaknesses and Strengths) Means of quantifying financial aspect of management Financial ratios comparison: Between companies Between industries Between different time periods for one company

Types of Ratios
Profitability Ratios Liquidity Ratios Solvency Ratios Market Ratios

Profitability Ratios
Rate of Turnover Ratio

Cost of Goods Sold Average Stock (Inventory)


(where average stock is {opening + closing stock} / 2)

Shows the number of times stock is bought and sold in a year. The greater the rate of turnover, the better it is for profitability i.e. more turnover results in more profits. The increased rate of turnover also prevents an accumulation of old stock preventing obsolescence.

Profitability Ratios
Gross Profit Ratio Margin (also known as Gross Profit percentage)

Gross Profit Net Sales (Revenue)

100

(where Net Sales is Sales Sales Returns or Return Inwards)

Shows the gross profit margin for a business. The higher the gross profit margin the better the profitability since for every $ in sales more gross profit is achieved.

Profitability Ratios
Net Profit Ratio (also known as Net Profit percentage)

EBIT Net Sales (Revenue)

100

[Uses EBIT Net Profit (or earnings) before interest & taxes

Shows the net profit margin for a business. The higher the net profit margin the better the profitability since for every $ in sales more net profit is achieved.

Profitability Ratios
Return on Stockholders Equity (ROE) Net Income Total Stockholders Equity 100

This is simply Net Income divided by total Stockholders Equity (including preference Shares)

Return on Common Stockholders Equity (ROCE) Net Income Preferred Dividends Ordinary Stockholders Equity 100

This is simply Net Income divided by total Stockholders Equity (excluding preference Shares)
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Liquidity Ratios
Working Capital Ratio (Current Ratio)

Current Assets Current Liabilities


This is Current Assets divided by Current Liabilities

Shows the ratio of current assets to current liabilities of a business. A higher ratio is better since it means for a $ in current liabilities we have more than a $ in assets enabling us to: (a) pay our short term debts as they mature (b) Obtain better credit terms (c) Take advantage of cash discounts where applicable
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Liquidity Ratios
Liquid Ratio (Quick Ratio or Acid Test Ratio)

Current Assets Stock (Inventory) Current Liabilities


This is Current Assets less Inventory divided by Current Liabilities

Same as current ratio except that we deduct stock from current assets, as stock is the least liquid of all current assets. The quick ratio gives an even more accurate picture of liquidity than the current ratio.

Liquidity Ratios
Collection Period Days

Average Acc Receivable Credit Sales


This is the average collection period in days

360

This ratio measures on average how quickly our accounts receivable converts to cash.

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Liquidity Ratios
Days to sell inventory

Average Inventory Cost of Sales

360

This is the average time in days for inventory to sell

This ratio measures on average how quickly our inventory gets sold.

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Solvency Ratios
Total Debts to Total Assets

Current Liabilities + Long Term Liabilities Total Assets


This measures total debt to total assets

This ratio indicates the ability of the business to pay all its maturing obligations with its assets.

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Solvency Ratios
Total Long Term Debt to Equity

Long Term Liabilities Total Equity


This measures total long term liabilities to Equity capital

This ratio indicates the ability of the business to pay all its long term obligations by comparing long term liabilities with equity.

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Solvency Ratios
Times Interest Earned (Interest Coverage Ratio)

EBIT Annual Interest Expense


This measures total earnings relative to interest paid

This ratio indicates the ability of the business to pay all the interest on loans taken by measuring the strength of total earnings relative to interest paid.

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Market Ratios
Dividend Yield

Dividend Current Market Price of Share


This measures dividends paid as a percentage of Market Price per Share

This ratio shows the real return the investor is currently obtaining in the form of payout per value of shares. If the shareholders believes his / her return is too low, he/she has the option to sell his/her shares at current market price and invest elsewhere.

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Market Ratios
Earning per Share

Net Income Preferred Dividends Number of ordinary shares outstanding


This measures net Income divided by ordinary shares outstanding

The purpose of this ratio is to show the earnings strength of a corporation related to ordinary share capital invested. An organization that has a higher EPS shows that its earnings are spread among fewer shareholders, relative to another. This is often the most closely watched statistic in the stock market analysis.
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Market Ratios
Price / Earnings (PE) Ratio

Market Price Per Share Diluted EPS


This measures the strength of EPS relative to Market Price per share

The purpose of this ratio is to show the strength of EPS relative to market price per share; it is often called the Price Earnings Ratio

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Limitations of Ratios
Manipulation Management may temporarily manipulate ratios at specific points in time; example year end Analytical Limitations - Comparability and Applicability Use of historical figures - (BS Valuations of assets are based on historical costs) ex affects the Total Debt / Total Assets ratio Qualitative Factors Ratios do not indicate qualitative assessments of the corporation (example customer satisfaction)

Analytical Limitations
Return on Assets (ROA)
Net Income + or Minority Earnings? Total Assets Represents shares owned by third parties when Company A acquires Company B. In other words, minority interest represents the equity interest of outside shareholders in consolidated subsidiaries. On the income statement, minority interest in the income of a consolidated subsidiary is shown as a deduction of consolidated net income.

Analytical Limitations
Return on Assets (ROA)
Net Income Total Assets
Total Assets Average Total Assets Total Assets Employed (excludes Idle Assets) Capital Employed = Fixed Assets + WC Total Long Term Assets (i.e. Fixed Assets)