Ratio Analysis.
Ratio Analysis.
Ratio Analysis:
A ratio expresses the mathematical relationship between one quantity and another. Ratio analysis
refers to the analysis of various pieces of financial information in the financial statements of a
business. It is expressed in terms of either a percentage, a rate or a simple proportion.
The alternative means of expression:
For example: ABC company has current assets of $1,641.7 million and current liabilities of $2,210.2
million.
Percentage: Current Assets are 74% of Current Liabilities.
2. Ratio Analysis uses past information where users are more concerned about current and future
information.
3. Ratios mainly deals with numbers they don’t address issues like product quality, customer
services, employee behavior etc.
Types of Ratios:
Liquidity Ratio,
Profitability Ratio
Efficiency Ratio
Solvency Ratio
Liquidity Ratios:
Liquidity refers to the ability to meet short term obligations/liabilities. Liquidity ratios measure a
company’s ability to meet its debt obligations using its current assets. Usually, the following ratios
are used to measure liquidity ratios:
1. Current Ratio: Current Ratio measures the relationship between total current asset and total
current liabilities. A low current ratio suggests that the company’s ability to meet short term
obligations is not good. On the contrary a high current ratio suggests a strong liquidity position that
a company able to meet its current obligation. Normally 2:1 is considered as standard.
2. Quick Ratio/ Acid Test Ratio: It is similar to Current Ratio except some changes in calculation.
It is also known as “Acid-Test Ratio”. The acid-test ratio measures immediate liquidity. Here, the
formula is
So, Inventories and Prepaid Expenses are included in Current asset, but not included in Quick Asset.
Because it is uncertain that when cash will be received from sale of inventory. And we simply cannot
get back prepaid expenses. Normally 1:1 is considered standard in Quick Ratio.
Example 01: Two Company’s Balance sheet as on December 31, 2020 shows the following:
3,50,000 4,10,000
Current Liabilities:
Accounts Payable
Notes payable 50,000 60,000
Accrued Expenses 80,000 90,000
40,000 30,000
Income Tax Payable
30,000 25,000
2,00,000 2,05,000
Profitability Ratios:
Profit is the key to an organizations success. Profitability ratios measures the income or operating
success of a company for a specific period of time. Profitability ratios measure a business’ ability
to earn profits, relative to their associated expenses. Recording a higher profitability ratio than in
the previous financial reporting period shows that the business is improving financially. A
profitability ratio can also be compared to a similar firm’s ratio to determine how profitable the
business is relative to its competitors.
1. Profit Margin Ratio: The Profitability of a company can be computed by measuring profit
margin ratio. Profit margin ratio differs from industry to industry, country to country and
even company to company. The Computation is as follows;
2. Gross Margin Ratio: When we deduct cost of goods sold from Net Sales, we get Gross
profit. The Gross margin Ratio is calculated using following formula;
4. Return on Asset: Another view of the return on investment concepts relates income to total
assets invested. It is a better measure in the way that how efficiently management utilizes its
resources to generate return. The computation is like this:
5. Earnings per Share: Earnings per share (EPS) is a company's net profit divided by the
number of common shares it has outstanding. EPS indicates how much money a company
makes for each share of its stock, and is a widely used metric to estimate corporate value. A
higher EPS indicates greater value because investors will pay more for a company's shares if
they think the company has higher profits relative to its share price. The formula for
calculating Earnings Per Share is as follows:
Example 02: The Following Income Statement data reported by Two Companies:
1. Asset Turnover Ratio: Asset turnover ratio shows the relationship between sales and total
asset. The ratio measures the efficiency with which a company uses its total asset to generate
sales. The larger the total asset turnover, the larger will be the income on each dollar invested
in the asset of the business. This metric helps investors understand how effectively companies
are using their assets to generate sales. The formula for Asset turnover ratio is:
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
A𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙𝐴𝑠𝑠𝑒𝑡
2. Inventory Turnover Ratio: A company’s inventory turnover ratio shows the number of
times its average inventory is sold during a period. The higher the inventory turnover, the
better, since high inventory turnover typically means a company is selling goods quickly, and
there is considerable demand for their products. Low inventory turnover, on the other hand,
would likely indicate weaker sales and declining demand for a company’s products. Inventory
turnover ratio is calculated as follows:
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟𝑅𝑎𝑡𝑖𝑜= 𝐶𝑜𝑠𝑡𝑜𝑓𝐺𝑜𝑜𝑑𝑠𝑆𝑜𝑙𝑑
(Times)
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
Days sales of inventory (DSI) measures how many days it takes for inventory to turn into
sales. Days Sales of inventory is calculated by following method;
365
𝐷𝑆𝐼 = (Days)
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟𝑅𝑎𝑡𝑖𝑜
3. Accounts Receivables Turnover Ratio: The accounts receivable turnover ratio measures a
company's effectiveness in collecting its receivables or money owed by clients. The ratio
shows how well a company uses and manages the credit it extends to customers and how
quickly that short-term debt is collected or being paid. The formula for calculating Accounts
Receivables Turnover Ratio is as follows:
𝑁𝑒𝑡𝐶𝑟𝑒𝑑𝑖𝑡𝑆𝑎𝑙𝑒𝑠
𝐴𝑐𝑐 𝑅𝑒𝑐
. 𝑇𝑢𝑟𝑛
. 𝑅𝑎𝑡𝑖𝑜
. = (Times)
Accounts Receivable
Average Collection Period: The average collection period is the amount of time it takes for a
business to receive payments owed by its clients in terms of accounts receivable (AR). Companies
calculate the average collection period to make sure they have enough cash on hand to meet their
financial obligations.
365
𝐴v𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜n Period = (Days)
𝐴𝑐𝑐.𝑅𝑒𝑐.𝑇𝑢𝑟𝑛.𝑅𝑎𝑡𝑖𝑜
4. Accounts Payables Turnover Ratio: The accounts payable turnover ratio measures the
average number of times a company pays its creditors over an accounting period. The ratio is
a measure of short-term liquidity, with a higher payable turnover ratio being more favorable.
The formula is as follows;
Average Payment Period: Average payment period shows the average number of days that a
payable remains unpaid. To calculate Average payment period, simply divide 365 days by the
payable turnover ratio.
365
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑃𝑒𝑟𝑖𝑜𝑑 = (Days)
𝐴𝑐𝑐.𝑃𝑎𝑦.𝑇𝑢𝑟𝑛.𝑅𝑎𝑡𝑖𝑜
Example 02: The Following Income Statement data reported by Two Companies:
1. Debt to Asset Ratio: The Debt to Assets Ratio is a leverage ratio that helps quantify the
degree to which a company’s operations are funded by debt. The debt-to-asset ratio is
calculated by dividing a company’s total liabilities by its total asset. Both numbers are
available on the balance sheet of a company’s financial statement.
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐷𝑒𝑏𝑡𝑡𝑜𝐴𝑠𝑠𝑒𝑡𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡
2. Interest Coverage Ratio: The interest coverage ratio (times interest earned) measures the
ability of a company to meet the interest payments on its debt with its earnings. EBIT means
Earnings before interest & tax expenses. Specifically, it measures how many times over a
company can meet its interest payment with its current earnings.