Ratio Analysis - Theory Chapter 3

What is Ratio Analysis?

Definition:
Ratio analysis is a method used to evaluate a company's financial performance by calculating and interpreting
financial ratios. It helps to understand how well a company is doing, in terms of profitability, liquidity, debt, and
operational efficiency.

Why is Ratio Analysis Important?

Ratio analysis is important because it helps stakeholders (investors, managers, creditors) make informed
decisions about a company's financial health. By using ratios, we can measure:
• How well a company can pay its short-term debts (liquidity).
• How efficiently it is using its assets to generate sales (activity).
• How much debt the company has and how it’s using it (debt).
• How profitable the company is (profitability).

When is Ratio Analysis Used?

• Investors use it to decide whether to invest in a company.
• Managers use it to assess the company’s performance and to make strategic decisions.
• Creditors use it to determine whether they should lend money to a company.
• Analysts use it to evaluate a company's financial condition and compare it with industry standards.

Categories of Financial Ratios

Ratio analysis is divided into different categories based on what aspect of the company’s performance they
measure:
1. Liquidity Ratios – Measure a company's ability to meet short-term obligations.
• Current Ratio:
o What it measures: A company's ability to cover its short-term debts with its short-term assets.
o Why it’s important: It indicates if a company has enough assets to pay off its current liabilities.
o Ideal Value: A value of 2 or more is generally considered safe.
o Example: If a company has $200,000 in current assets and $100,000 in current liabilities, the
current ratio would be 2.
• Quick (Acid-Test) Ratio:
o What it measures: A more stringent measure of liquidity because it excludes inventory from
current assets.
o Why it’s important: This ratio evaluates liquidity without relying on inventory, which may not
always be easy to convert to cash.
o Ideal Value: 1 or more.
o Example: If a company has $150,000 in current assets and $50,000 in inventory, and $100,000
in current liabilities, the quick ratio is 1.

2. Activity Ratios – Measure how efficiently a company is using its assets.

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• Inventory Turnover:
o What it measures: How quickly inventory is sold or used in production.
o Why it’s important: A higher ratio indicates efficient use of inventory.
o Example: If a company’s cost of goods sold (COGS) is $500,000 and its inventory is $100,000,
the ratio would be 5.
• Average Collection Period:
o What it measures: The average number of days it takes for a company to collect its accounts
receivable.
o Why it’s important: A shorter period is better because it means the company is collecting its
receivables more quickly.
o Example: If a company has $365,000 in accounts receivable and $1,460,000 in annual sales, the
average collection period is 365/4 = 91.25 days.
• Average Payment Period:
o What it measures: The average number of days it takes for a company to pay its accounts
payable.
o Why it’s important: A longer period can be a sign of good cash flow management, but if it’s too
long, it may harm supplier relationships.
o Example: If accounts payable is $200,000 and annual purchases are $1,200,000, the average
payment period is 365/6 = 60.83 days.

3. Debt Ratios – Measure the extent of a company’s debt.

• Debt Ratio:
o What it measures: The proportion of a company’s assets that are financed by debt.
o Why it’s important: A higher debt ratio means higher risk since the company relies more on
borrowed money.
o Ideal Value: Lower values are preferred.
o Example: If a company’s total debt is $300,000 and total assets are $1,000,000, the debt ratio
would be 30%.

4. Profitability Ratios – Measure a company’s ability to generate profits.

• Gross Profit Margin:
o What it measures: The percentage of revenue that exceeds the cost of goods sold.
o Why it’s important: A higher margin indicates better profitability.
o Example: If a company has a gross profit of $200,000 and sales of $500,000, the gross profit
margin would be 40%.
• Net Profit Margin:
o What it measures: The percentage of revenue left after all expenses have been deducted from
sales.
o Why it’s important: A higher margin means the company is better at converting sales into
actual profit.
o Example: If net income is $100,000 and sales are $500,000, the net profit margin is 20%.
• Operating Profit Margin:
 Ratio Analysis - Theory Chapter 3
o What it measures: How much profit a company makes from its core business activities,
excluding non-operating items.
o Why it’s important: A higher value indicates good operational efficiency.
o Example: If operating profit is $150,000 and sales are $500,000, the operating profit margin
would be 30%.
• Return on Assets (ROA):
o What it measures: How effectively a company uses its assets to generate profits.
o Why it’s important: A higher ROA indicates that the company is efficiently using its assets.
o Example: If net income is $50,000 and total assets are $1,000,000, the ROA would be 5%.
• Return on Equity (ROE):
o What it measures: How effectively a company uses shareholder equity to generate profits.
o Why it’s important: A higher ROE is generally a sign of a profitable company.
o Example: If net income is $100,000 and shareholder equity is $500,000, the ROE would be
20%.
• Earnings Per Share (EPS):
o What it measures: The portion of a company’s profit allocated to each outstanding share of
common stock.
o Why it’s important: Higher EPS means higher profits for shareholders.
o Example: If earnings available for common stockholders is $200,000 and there are 50,000
shares outstanding, the EPS would be $4.00.

In Summary:
• Ratio analysis helps measure various aspects of a company’s performance.
• Ratios can show the financial health of a business and help make decisions about investing, lending, or
operating.
• The key ratios include liquidity ratios, activity ratios, debt ratios, and profitability ratios.