Financial Ratio

Analysis

Andrada, Keannah Joy

Martinez, Mairhaine Rhazel
 OBJECTIVE:

1. To Categorize the different financial ratios

2. To enumerate the key applications of financial
ratios in practice; and
3. To introduce few key conceptual innovations
which could make traditional financial ratio
analysis more meaningful and challenging at the
same time.
 THE STRUCTURE OF FINANCIAL STATEMENT
The two basic financial statements

01 02
Balance Sheet Income
Statement
 The two basic financial statements

Balance Sheet - reports the company's total resources, sub-classified

as current or non-current and tangible or intangible, and the total
claims by owners and by creditors, the former sub-classified as capital
contribution or accumulated earnings and the latter as current or non-
current.
Income Statement - summarizes the revenue and expense flows of the
company for an entire period, with the expenses further classified
into functional and cash or non-cash categories.
 Financial Ratio Analysis
-is performed by comparing two items in the
financial statements. The resulting ratio can be
interpreted in a way that is not possible when
interpreting the items separately. In short, we
are analyzing inter relationships.
Financial ratios can be classified into ratios that measure:

01 02 03
Profitability Turnover Ratios Liquidity Ratios
Ratios

04
Leverage Ratios
 Profitability Ratios
-are financial metrics that measure a company's ability to generate profits in relation to its
revenue, assets, equity, or other financial metrics. These ratios help assess how efficiently a
company is operating and how well it is able to convert its resources into profits. Profitability
ratios are crucial for investors, analysts, and stakeholders to evaluate a company's financial
performance and its ability to generate a return on investment.
 Profitability Ratios
1. Gross Profit Rate = Gross Profit / Net Sales
Evaluates how much gross profit is generated from sales. Gross profit is equal to net sales (sales minus sales returns,
discounts, and allowances) minus cost of sales.

2. Return on Sales = Net Income / Net Sales

Also known as "net profit margin" or "net profit rate", it measures the percentage of income derived from dollar
sales. Generally, the higher the ROS the better.

3. Return on Assets = Net Income / Average Total Assets

In financial analysis, it is the measure of the
return on investment. ROA is used in evaluating management’s efficiency in using assets to generate income.

4. Return on Stockholders' Equity = Net Income / Average Stockholders' Equity

Measures the percentage of income derived for every dollar of owners' equity.
 Turnover Ratios
-are financial and operational indicators used to assess the efficiency and effectiveness of
various aspects of a business's operations. These ratios provide insights into how well a
company manages its assets, liabilities, and resources.
 Turnover Ratios

1. Inventory Turnover Ratio = COGS / Average Inventory

This ratio measures how efficiently a company manages its inventory. It is calculated by dividing the cost of goods
sold (COGS) by the average inventory for a specific period. A high inventory turnover ratio indicates that a company
is selling its inventory quickly, which can be a sign of good inventory management.
2. Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
This ratio assesses how quickly a company collects payments from its customers. It is calculated by dividing net
credit sales by the average accounts receivable for a specific period. A high accounts receivable turnover ratio
suggests that the company is collecting payments from customers promptly.
3. Asset Turnover Ratio = Total Revenue / Average Total Assets
This ratio measures how efficiently a company utilizes its total assets to generate revenue. It is calculated by dividing total revenue
by the average total assets for a specific period. A higher asset turnover ratio indicates that the company is using its assets effectively
to generate sales.
4. Accounts Payable Turnover Ratio = Total Purchases or COGS / Average Accounts Payable
This ratio assesses how efficiently a company pays its suppliers. It is calculated by dividing the total purchases (or cost of goods
sold) by the average accounts payable for a specific period. A higher accounts payable turnover ratio suggests that the company is
paying its suppliers promptly.
 Liquidity Ratios
-are financial metrics that assess a company's short-term financial stability and
its ability to meet its immediate financial obligations. These ratios provide
insights into a company's liquidity, which is its ability to convert assets into cash
quickly to cover short-term liabilities. Liquidity ratios are essential for assessing
a company's ability to weather financial emergencies and maintain day-to-day
operations.
 Liquidity Ratios
1. Current Ratio = Current Assets / Current Liabilities
Evaluates the ability of a company to pay short-term obligations using current assets (cash, marketable
securities, current receivables, inventory, and prepayments).

2. Acid Test Ratio = Quick Assets / Current Liabilities

Also known as "quick ratio", it measures the ability of a company to pay short-term obligations using the
more liquid types of current assets or "quick assets" (cash, marketable securities, and current receivables).

3. Cash Ratio = (Cash + Marketable Securities) / Current Liabilities

Measures the ability of a company to pay its current liabilities using cash and marketable securities.
Marketable securities are short-term debt instruments that are as good as cash.

4. Net Working Capital = Current Assets - Current Liabilities

Determines if a company can meet its current obligations with its current assets; and how much excess or
deficiency there is.
01 Leverage Ratios
-are financial metrics that assess how efficiently a company utilizes
its assets, resources, and operations to generate sales, profits, and
cash flow. These ratios provide insights into the effectiveness of a
company's management in running its day-to-day operations.
Investors and analysts use management efficiency ratios to
evaluate a company's operational effectiveness and identify areas
for improvement.
 Leverage Ratios
1. Debt Ratio = Total Liabilities / Total Assets
Measures the portion of company assets that is financed by debt (obligations to third parties). Debt ratio can
also be computed using the formula: 1 minus Equity Ratio.

2. Equity Ratio = Total Equity / Total Assets

Determines the portion of total assets provided by equity (i.e. owners' contributions and the company’s
accumulated profits). Equity ratio can also be computed using the formula: 1 minus Debt Ratio. The
reciprocal of equity ratio is known as
equity multiplier, which is equal to total assets divided by total equity.

3. Debt-Equity Ratio = Total Liabilities / Total Equity

Evaluates the capital structure of a company. A D/E ratio of more than 1 implies that the company is
leveraged firm; less than 1 implies that it is a conservative one.

4. Times Interest Earned = EBIT / Interest Expense

Measures the number of times interest expense is converted to income, and if the company can pay its
interest expense using the profits generated. EBIT is earnings before interest and taxes.
Uses Financial
Ratios
⇨ Financial Performance Assessment: Ratios are used to evaluate a company's
overall financial performance over a specific period. By comparing ratios from
different time periods, stakeholders can assess trends and changes in the
company's financial condition.
⇨ Comparative Analysis: Ratios allow for comparisons between companies within
the same industry or sector. Investors and analysts can use these ratios to identify
relative strengths and weaknesses among competitors.
⇨ Creditworthiness Evaluation: Lenders and creditors use financial ratios to assess
a company's creditworthiness. Ratios help them gauge a borrower's ability to meet
its debt obligations.
⇨ Investment Decision-Making: Investors use ratios to make informed investment
decisions. For example, they may use profitability ratios to evaluate a company's
potential for growth and return on investment.
⇨ Risk Assessment: Financial ratios can help identify financial risks. For instance,
high levels of debt relative to equity may indicate financial risk, while liquidity
ratios can show a company's ability to cover short-term obligations.
Predictive Power of
Ratios
Recent research and advanced applications have
demonstrated usefulness of financial ratios in
predicting the future financial performance of
companies. There are two types of predictions
financial ratios, namely (a) for forecasting or
budgeting future corporate financial performance,
and (b) for predicting financial events, usually
success or failure.
Ratios for predicting success or failure
In some cases, management would simply want to predict whether a company is
likely to succeed or fail under some criteria. For example, an investor would
like to ascertain the chance of bankruptcy of companies before he makes an
investment. A bank account officer would like to determine the probability that
a client would default on its loans. A statistical technique, called discriminant
analysis, can be used for these applications. Discriminant analysis is useful in
specifying "good" or "bad" categories, good/bad credit risk or bankrupt/non
bankrupt companies. volves an identification of the criteria, which include
financial ratios, to be evaluated and the use of weights for each criterion
(derived by the statistical technique) to generate weighted overall score. The
discriminant model’s overall weighted score.
 Financial Ratios in Contracts
⇨ Ratios have also found application in contracting. The cost familiar use of
financial ratios is in negative bank loan covenants. rowing companies may be
required not to violate certain stipulated financial ratio levels. Banks will
then monitor conformity with the loan terms by a periodically evaluating the
company’s financial ratios. Financial ratios may also be used in management
contracts.
 TOWARD IMPROVED TECHNIQUES IN RATIO ANALYSIS

⇨ In spite of the preceding discussions regarding precise ratio formulas and

the application of statistical techniques in financial ratios, the interpretation
of computed ratios remains significantly a qualitative and judgmental
exercise. The financial analyst would need further guidelines on the
interpretations of the computed ratios. (a) the effects of inflation on ratio
analysis; (b) the use of standards for interpretation of ratios, and (c) the
need to evaluate several interrelated ratios to draw up a comprehensive
interpretation of the company's financial position and performance.
Inflation and Ratio Analysis Inflation, coupled with
certain accounting principles used in financial
statements preparation, has a way of reducing the
relevance of the financial ratios. Specifically,
inflation has the effect of recognizing holding or
"price" gains as finished goods acquired at "old"
costs are sold at higher current prices. Similarly,
with inflation, the balance sheet will not
necessarily reflect the current costs of the assets.
1. Gross profit margin will be overstated as historical cost of goods is
charged against more current revenues.
2. Net profit margin will be overstated as depreciation on historical
cost of fixed assets is charged against current revenues.
3. Return on investment is overstated because net income includes
price gains whereas investments are understated at historical values
4. Most turnover ratios are overstated because current revenue is
divided by historical cost of assets. The problem is minimized in the
turnover ratios for inventory and receivables because these are stated
at relatively more current values.
Inflation can also distort any financial comparison across
companies, especially it companies were established at different
times. The more recently established companies will report higher
fixed assets lower turnover) and higher depreciation (lower
profitability), all other factors constant. On the other hand, the
analyst should note that the accounting profession has taken steps
to reduce the inflation relate problems by allowing the revaluation
of fixed assets under certain conditions.
 Choice of Standards for Ratio Analysis

1.) A standard should actively consider prevailing economic conditions, it should not be context-free
like the "ideal ratio".
2.) A standard should simultaneously incorporate measures of industry and competitive conditions,
it should include both dimensions.
3.) A standard should recognize the presence of underlying time series patterns in the company's
performance relative to itself, the industry, and its key competitors.
4.) Finally, a standard should be unique to the company being analyzed. Ideally, no two companies
even in the same industry should face the same standard in view of their different sizes, capacity,
management, and competitive strategies. For example, a company may be aiming for profits or ROI
but its competitor's strategy may be directed at market penetration. Using common ROI and
turnover ratio standards for both firms will yield predictable results. Yet, that company cannot be
faulted for "low turnover" nor its competitor, for "low ROI", as these were recognized trade-offs in
their respective preferred strategies.
THANK YOU!