CHAPTER 5

FINANCIAL RATIO ANALYSIS

We next want to restate the accounting data in relative terms, or what we call financial
ratios. Financial ratios help us identify some of the financial strengths and weaknesses of a
company. The ratios give us two ways of making meaningful comparisons of a firm’s financial
data: (1) we can examine the ratios across time (say, for the last five years) to identify any trends;
and (2) we can compare the firm’s ratios with those of the other firms.

In making a comparison of our firm with other companies, we could select a peer group
of companies, or more typically, we could use industry norms published by organizations within
the industry.

Financial ratios are useful indicators of a firm’s performing and financial situation. Most
rations can be calculated from information provided by the financial statements. Financial rations
can be used to analyze trends and to compare the firm’s financials to those of other firms. In
some cases, ration analysis can predict future bankruptcy.

Financial ratios can be classified according to the information they provided. The
following types of ratios frequently are used:

 Liquidity ratios
 Asset turnover ratios
 Financial leverage ratios
 Probability ratios
 Divided policy ratios
Liquidity ratios

Liquidity ratios provide information about a firm’s ability to meet its short-term financial
obligations. They are particular interest to those extending short-term credit to the firm. Two
frequently-used liquidity ratios are the current ratio (or working capital ratio) and the quick ratio.

The current ratio is the ratio of current assets to current liabilities:

Current Assets
Current Ratio =
Current Liabilities

Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders
may prefer a lower current ration so that more of the firm’s assets are working to grow the
business. Typical values for the current ratio vary by firm and industry. For example, firm’s in
cyclical industries may maintain a higher current ratio in order to remain solvent during
downturns.

One drawback of the current ratio is that inventory may include many items that are
difficult to liquidate quickly and that have uncertain liquidation values. The quick ratio a an
alternative measure of liquidity that does not include inventory in the current assets. The quick
ratio is defined as follows:

Current Assets - Inventory

Quick Ratio =
Current Liabilities

The current assets used in the quick ratio are cash, accounts receivable, and notes
receivable. These assets essentially are current assets less inventory. The quick ratio often is
referred to as the acid test.

Finally, the cash ratio is the most conservative liquidity ratio. It includes all current assets
except the most liquid: cash and cash equivalents. The cash ratio is defined as follows:
 Cash + Marketable Securities
Cash Ratio =
Current Liabilities

The cash ratio is an indication of the firm’s ability to pay off its current liabilities if for
some reason immediate payment were demanded.

Asset Turnover Ratios

Asset turnover ratios indicate of how efficiently the firm utilizes it assets. They
sometimes are referred to as efficiency ratios, asset utilization rations, or asset management
ratios. Two commonly used asset turnover ratios are receivables turnover and inventory turnover.

Receivables turnover is an indication of how quickly the firm collect its accounts
receivable and is defined as follows:

Annual Credit Sales

Receivable Turnover =
Accounts Receivable

The receivable turnover often reported in terms of the number of days that credit sales remain in
accounts receivable before they are collected. This number is known as the collection period. It
is the account receivable balance divided by the average daily credit sales, calculated as follows:

Accounts Receivable
Average Collection Period =
Annual Credit Sales/365

The collection period also can be written as:

365
Average Collection Period =
Receivable Turnover
 Another major asset turnover ratio is inventory turnover. It is the cost of goods sold in a
time divided by the average inventory level during that period:

Cost of Goods Sold

Inventory Turnover =
Average Inventory
The inventory turnover often is reported as the inventory period, which is the number of
days worth of inventory on hand, calculated by dividing the inventory by the average daily cost
of goods sold:

Average Inventory
Inventory Period =
Annual Cost of Goods Sold/365

The inventory period also can be written as:

365
Inventory Period =
Inventory Turnover

Other asset turnover ratios include fixed asset turnover and total asset turnover.

Financial Leverage Ratios

Financial ratios provide an indication of the long-term solvency of the firm. Unlike
liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios
measure the extent to which the firm is using long term debt.

The debt ratio defined as total debt divided by total assets:

Total Debt
Debt Ratio =
Total Assets

The debt – to – equity ratio is total debt divided by total equity:

 Total Debt
Debt-to-Equity Ratio =
Total Assets

Debt ratios depend on the classification of long-term leases and on the classification of
some items as long-term debt or equity.
The times interest earned ratio indicates how well the firm’s earning can cover the
interest payments on its debt. This ratio also known as the interest coverage and is calculated as
follow

EBIT
Interest Coverage =
Interest Charges

Where EBIT = Earnings Before Interest and Taxes

Profitability ratios

Profitability ratios offer several different measures of the success of the firm at
generating profits.

The gross profit margin is a measure of the gross profit earned on sales. The gross profit
margin considers the firm’s cost of goods sold, but does not include other costs. It is defined as
follows:

Sales – Cost of Goods Sold

Gross Profit Margin = X 100
Sales

Return on assets is a measure of how effective the firm’s assets are being used to generate
profits. It is defined as:

Net Income
Return on Assets = X 100
Total assets
 Return on Equity is the bottom line measure for the shareholders, measuring the profits
earned for each dollar invested in the firm’s stock. Return on equity is defined as follows:

Net Income
Return on Equity = X 100
Shareholder Equity

Dividend Policy ratios

Dividend policy ratios provide insight into the dividend policy of the firm and the
prospects for future growth. Two commonly used rations are the dividend yield and payout ratio.

The dividend yield is defined as follows:

Dividends Per Share

Dividend Yield =
Share Price

A high dividend yield does not necessarily translate into a high future rate of return. It is
important to consider the prospects for continuing and increasing the dividend in the future. The
dividend payout ratio is helpful in this regard, and is defined as follows:

Dividends Per Share

Payout Ratio =
Earning Per Share
Use and Limitations of Financial Ratios

Attention should be given to the following issues when using financial ratios:

 A reference point is needed. To be meaningful, most ratios must be compared to

historical values of the same firm’s forecast, or ratios of similar firms.
 Most ratios by themselves are not highly meaningful. They should be viewed as
indicators, with several of them combined to paint a picture of the firm’s situation
 Year end values may not be representative. Certain account balances that are used to
calculate ratios may increase or decrease at the end of the accounting period because of
seasonal factors, such changes may distort the value of the ratio. Average values should
be used when they are available.
 Ratios are subject to the limitations of accounting methods. Different accounting choices
may result in significantly different ratio values.