Financial Ratios 1

Why do we need Ratio Analysis ????

Analysis of financial statement

Analysis of operating efficiency of company

Understanding the profitability of company

Identifying the business risk of the company

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Why do we need Ratio Analysis ????

Identifying the financial risk of the company

Forecasting the future performance of the company

Compare the performance of the company

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Financial Ratio Analysis
•A ratio analysis is a quantitative analysis of information
contained in a company’s financial statements.

• Ratio analysis is used to evaluate various aspects of a

company’s operating and financial performance such as
its efficiency, liquidity, profitability and solvency.

• Thetrend of these ratios over time is studied to check

whether they are improving or deteriorating.
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• The Ratio Analysis help investors, creditors, and internal
company management to understand how well a business is
performing and areas of where improvement is required.

• Ratio analysis is a cornerstone of fundamental analysis.

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Objectives of Ratio Analysis
To simplify the accounting information

To assess the operating efficiency of the business.

To help in comparative analysis

To analyse the profitability of the business.

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Advantages of Ratio Analysis

Useful for forecasting

Useful tool for analysis of financial statements.

Useful in locating the weak areas.

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Disadvantages of Ratio Analysis
ratio analysis information is historic – it is not current

ratio analysis does not take into account external factors such
as a worldwide recession

ratio analysis does not measure the human element of a firm

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Liquidity Ratios

Current Ratio

Quick Ratio

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Liquidity Ratios
• Short-termSolvency Ratios attempt to measure the ability of a
firm to meet its short-term financial obligations.
• Inother words, these ratios seek to determine the ability of a
firm to avoid financial distress in the short-run.
(Note: the Quick Ratio is also known as the Acid-Test Ratio.)

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Current Ratio

• TheCurrent Ratio is calculated by dividing Current Assets by

Current Liabilities.

• Current Assets are the assets that the firm expects to convert
into cash in the coming year.

• Current Liabilities represent the liabilities which have to be

paid in cash in the coming year.
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• The appropriate value for this ratio depends on the
characteristics of the firm’s, industry and the composition of its
Current Assets.

• However, at a minimum, the Current Ratio should be greater

than one.

Current Ratio =

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Quick Ratio
• TheQuick Ratio recognizes that, for many firms, Inventories
can be rather illiquid.

• This ratio attempts to measure the ability of the firm to meet

its obligations relying solely on its more liquid Current Asset
accounts such as Cash and Accounts Receivable.

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• This ratio is calculated by dividing Current Assets less
Inventories by Current Liabilities.

TotalCurre ntAssets  Inventory

• Quick Ratio =
TotalCurre ntLiability

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Profitability ratios

Gross Profit Margin

Net Profit Margin

Return On Equity (ROE)

Earning per share

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Profitability ratios

• Profitability
ratios measure a company’s ability to generate
earnings relative to sales, assets and equity.

• They highlight how effectively the profitability of a company

is being managed.

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Gross Profit Margin
Gross profit margin (gross margin) is the ratio of gross profit
(gross sales less cost of sales) to sales revenue.

It is the percentage by which gross profits exceed production

costs.

Gross margins reveal how much a company earns taking into

consideration the costs that it incurs for producing its products
or services.
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• Gross margin is calculated as gross profit divided by total
sales (revenue).

• Gross profit margin = Gross profit / Total Sales*100

• Both variables are shown on the income statement

or statement of comprehensive income.

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Net Profit Margin
• Netprofit margin (or profit margin, net margin) is a ratio of
profitability calculated as after-tax net income (net profits)
divided by sales (revenue).

• Net profit margin is displayed as a percentage.

• It
shows the amount of each sales Rupee left over after all
expenses have been paid.
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It is very useful when comparing companies in similar
industries.

A higher net profit margin means that a company is more

efficient at converting sales into actual profit.

Net profit margin = Profit (after tax) / Revenue *100

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Return On Equity (ROE)
• Return on equity (ROE) is the amount of net income returned
as a percentage of shareholders equity.

• It
shows how much profit a company earned on shareholder
equity.

• ROE is one of the most important financial ratios and

profitability metrics.

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• It
measures how profitable a company is for the shareholders,
and how profitably a company employs its equity.
Return on equity is calculated as follows:

ROE = Net income after tax / Shareholder's equity

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Earning per share (EPS)
Earning per share, also called net income per share, is a market
prospect ratio that measures the amount of net income earned
per share of stock outstanding.

Earning per share =

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 Turnover Ratios

Inventory

Receivables & Payables

Fixed Assets

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What are Turnover Ratios?
A turnover ratio represents the amount of assets or liabilities
that a company replaces in a year.

The concept is useful for determining the efficiency with which a

business utilizes its assets.

In most cases, a high asset turnover ratio is considered good,

since it implies that receivables are collected quickly, fixed assets
are heavily utilized, and little excess inventory is kept on hand.
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What are Turnover Ratios?
Conversely, a low liability turnover ratio (usually in relation to
accounts payable) is considered good, since it implies that a
company is taking the longest possible amount of time in which
to pay its suppliers, and so retains its cash for a longer period of
time.

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1 Inventory Turnover Ratio
Inventory turnover measures how efficiently a company is able to
manage its inventory.

Inventory Turnover = Cost of Goods Sold / Average Inventory

A low inventory turnover ratio is a sign that inventory is moving

too slowly and is tying up capital. On the other hand, a high
inventory turnover ratio can be moving inventory at a rapid pace.

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1 (b) Inventory - Days of Inventory on Hand
Days of Inventory on Hand (DOH) measures the number of days
it takes to sell inventory balance.

Days of Inventory on Hand = Number of Days in Period /

Inventory Turnover

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Example Inventory Turnover Ratio
Cherry Woods Furniture is a specialized supplier of high-end,
handmade dining sets made from specialty woods. The company
incurred $47,000 in COGS and $4,000 & $ 8,000 was opening &
closing inventory. Find the inventory turnover ratio and days of
Inventory on hand.
Answer

inventory turnover ratio = $47,000/ $ 6,000 = 7.83

days of Inventory on hand = 365/7.83 = 46.61 days

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2. Receivables
The accounts receivable turnover measures how efficiently a
company is able to manage its credit sales and convert its account
receivables into cash.

Receivables Turnover = Revenue / Average Receivables

A high receivables turnover signals that a company is able to

convert its receivables into cash very quickly and vice versa.

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2. Receivables - Days of Sales Outstanding

The Days of Sales Outstanding (DSO) measures the number of

days it takes to convert credit sales into cash.

Days of Sales Outstanding = Number of Days in Period /

Receivables Turnover

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Example - Receivables

Trinity Bikes Shop is a retail store that sells biking equipment and
bikes. Due to declining cash sales, John, the CEO, decides to
extend credit sales to all his customers. In the fiscal year ended
December 31, 2022, there were $100,000 gross credit sales and
returns of $10,000. Starting and ending accounts receivable for the
year were $10,000 and $15,000, respectively. John wants to know
how many times his company collects its average accounts
receivable over the year.

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Example – Receivables - Answer

Receivables Turnover = Revenue / Average Receivables

 Revenue = 1,00,000 – 10,000 = 90,000

 Average Receivables = 10,000 + 15,000 = 25,000 / 2
 = 12,500
Receivables Turnover = Revenue / Average Receivable

 90,000 / 12,500 = 7.2

365/7,2 = 50.69
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3. Payables
Payables turnover measures how quickly a company is paying off
its accounts payable to creditors.

Payables Turnover = Cost of Goods Sold / Average Payables

A low payables turnover can indicate either lenient credit terms

or an inability of a company to pay its creditors and vice versa.

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3. Payables - Days of Payables Outstanding

Days of Payables Outstanding (DPO) measures the number of

days it takes to pay off creditors.

Daysof Payables Outstanding = Number of Days in Period /

Payables Turnover

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4. Fixed Assets
Fixed assets are non-current assets and usually refer to tangible
assets that are expected to provide an economic benefit in the
future, such as property, plant, and equipment (PPE), furniture,
machinery, vehicles, buildings, and land.

Fixed Assets Turnover measures how efficiently a company is

using its fixed assets.

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2. Fixed Assets
A high ratio indicates that a company may need to invest more in
capital expenditures (capex). A low ratio may indicate that too
much capital is tied up in fixed assets.

Fixed Asset Turnover = Revenue / Average Net Fixed Assets

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Solvency ratios

Structural • Debt to Equity Ratio

• Debt to Asset Ratio
Ratios

Coverage Interest Coverage Ratio

Ratio
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Solvency Ratios
 Solvency ratios, measure a company's ability to sustain
operations indefinitely by comparing debt levels with equity,
assets, and earnings.

 Leverage ratios and Liquidity ratios both measure the ability

of a company to pay off its obligations but Leverage ratios
focus more on the long-term sustainability of a company
instead of the current liability.

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Structural Ratios
• Debt to Equity Ratio
• The debt to equity ratio compares a company's total debt to
total equity.
• The debt to equity ratio shows the percentage of company
financing that comes from creditors and investors.
•A higher debt to equity ratio indicates that more creditor
financing (bank loans) is used than investor financing
(shareholders).

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The two type of ratio’s are commonly used to analyse
financial leverage.

Structural Ratios
Coverage Ratio

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• The debt to equity ratio is calculated by dividing total
liabilities by total equity.

•A lower debt to equity ratio usually implies a more financially

stable business.

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• Companies with a higher debt to equity ratio are considered
more risky to creditors and investors than companies with a
lower ratio.
• Unlike equity financing, debt must be repaid to the lender.
• Since debt financing also requires debt servicing or regular
interest payments, debt can be a far more expensive form of
financing than equity financing.
• Companies leveraging large amounts of debt might not be able
to make the payments.

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Debt to Asset Ratio

• The debt to asset ratio is a leverage ratio that measures the

amount of total assets that are financed by creditors instead
of investors.
• Inother words, it shows what percentage of assets is funded
by borrowing compared with the percentage of resources
that are funded by the investors.

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• Thisis an important measurement because it shows how much
of company’s resources are owned by the shareholders in the
form of equity and creditors in the form of debt.

• Bothinvestors and creditors use this figure to make decisions

about the company.

• Investorswant to make sure the company is solvent, has

enough cash to meet its current obligations, and successful
enough to pay a return on their investment.

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• Creditors,on the other hand, want to see how much debt the
company already has because they are concerned with
collateral and the ability to be repaid.

• If
the company has already leveraged all of its assets and can
barely meet its monthly payments as it is, the lender probably
won’t extend any additional credit.

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The debt to assets ratio formula is calculated by dividing
total liabilities by total assets.

Debt to Assets Ratio =

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• Thismeans that a company with a higher measurement will
have to pay out a greater percentage of its profits in
principle and interest payments than a company of the same
size with a lower ratio.

• Thus, lower is always better.

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Coverage Ratio
Interest Coverage Ratio
The interest coverage ratio is a financial ratio that measures
a company’s ability to make interest payments on its debt in a
timely manner.
The interest coverage ratio calculates the firm’s ability to
afford the interest on the debt.
Unlike the debt service coverage ratio, this ratio does not
show the Company’s ability to make principle payments of
the debt

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The interest coverage ratio formula is calculated by
dividing the EBIT, or earnings before interest and taxes, by
the interest expense.

Interest Coverage Ratio =

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Difference between liquidity and solvency ratio
The liquidity ratio focuses on the company's ability to clear its
short term debt obligations.

The solvency ratio focuses on the company's ability to clear its

long term debt obligations.

The liquidity ratio will help the stakeholders analyse the firm's
ability to convert their assets into cash without much hassle
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 Example

Operating Profit
Ratio
Net Profit Ratio

Operating Profit Ratio Formula = Earnings Before Interest & Tax/Sales 55

 Example
Current Ratio
Quick Ratio
Return on Equity
Debt Equity Ratio

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Thanks
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