FINANCIAL

RATIO
ANALYSIS
Elmark Pedragoza & Tracy
BSBA 2-A
Buctot
FM
Financial Analysis
Financial analysis involves the selection,
evaluation, and interpretation of financial data
and other pertinent information to assist in
evaluating the operating performance and
financial condition of a company. The
information that is available for analysis
includes economic, market, and financial
information. But some of the most important
financial data are provided by the company in
its annual and quarterly financial statements.
A financial ratio is a comparison between one bit of
financial information and another.
Current Ratio
• is defined as the relationship between current assets
and current liabilities.
• It is also known as working capital ratio.
• This is calculated by dividing total current assets by
total current liabilities.

Current
Current Ratio
Assets
Currrent
=
Liabilities
 This ratio is a comparison between assets that can be
readily turned into cash-current assets and the obligations
that are due in the near future current liabilities. A current
ratio of 2, or 2:1, means that we have twice as much in
current assets as we need to satisfy obligations due in the
near future.
We can classify ratios according to the way they are
constructed and the financial characteristic they are
describing. For example, we will see that the current ratio is
constructed as a coverage ratio (i.e., the ratio of current
assets available funds to current liabilities, i.e., the
obligation) that we use to describe a company's liquidity (its
ability to meet its immediate needs). We can also classify
 5 aspects of operating
performance and Financial
1. Liquidity.
condition
4. Financial leverage
2. Profitability 5. Return on
investment
3. Activity
There are several ratios reflecting each of the five
aspects of a company's operating performance and
financial condition. We apply these ratios to the
Exemplar Corporation, whose balance sheets, income
statements, and statement of cash flows for two years
• We refer to the most recent fiscal year for which
financial statements are available, FY20X2, as the
"current year." The "prior year" is the fiscal year prior
to the current year.
• The ratios we introduce here are by no means the only
ones that can be formed using financial data, though
they are some of the more commonly used. Further,
when we form a ratio using a balance sheet account,
such as inventory, we are simplifying things a bit
because in applying these ratios to evaluate a
company's performance we could more appropriately
use an average of that balance sheet account through
However, our primary purpose in this chapter is
to establish the basic concepts, definitions, and
calculations in financial ratio analysis before
getting too technical.
 LIQUIDITY
• The ability of a company to meet its short-term
obligations using those assets that are most readily
converted into cash.
• Assets that ay be converted into cash in a short
period of time are referred to as may liquid assets;
they are listed in financial statements as current
assets.
• We often refer to current assets as working capital.
• Current assets are used to satisfy short-term
obligations, or current liabilities.
• The amount by which current assets exceed current
Operating Cycle

• the duration from the time cash is invested in goods

and services to the time that investment produces
cash.
• the longer the operating cycle, the more current
assets are needed (relative to current liabilities)
since it takes longer to convert inventories and
receivables into cash.
• We can estimate the operating cycle for Exemplar
Corporation for the current year using the balance
sheet and income statement data.
• The number of days Exemplar ties up funds in
inventory is determined by the total amount of
money represented in inventory and the average
day's cost of goods sold. The current investment in
inventory-that is, the money "tied up" in inventory is
the ending balance of inventory on the balance
sheet.
Average day's cost of good sold

Cost of goods
Average day's cost of good
sold 365
sold=
• Exemplar's average day's cost of goods sold for
FY20X2 is $1,600 ÷ 365 = $4.384 million per day.
• Exemplar has $490 million of inventory on hand at
the end of the year. One way to look at this is to
imagine that Exemplar stopped buying more raw
materials and just finished producing whatever was
on hand in inventory, using available raw materials
and work-in-process
Days sales in inventory (DSI)
• also known as the number of days of inventory

Inventor
Days sales in inventory (DSI) y
= Average day's cost
of
goods sold
• For Exemplar, the DSI is $490 million ÷ $4.384
million = 111.78 days. In other words, Exemplar has
approximately 112 days of goods on hand at the
end of the current year. If sales continued at the
same price, it would take Exemplar 112 days to run
Average credit sales per day

• the ratio of credit sales to the number of days in a

year
Credit
Average credit sales per day
sales
365
=

• If all of its sales are on credit, Exemplar generates

nerates $2,000 million ÷ 365 = $5.479 million of
credit sales per day.
Days sales outstanding (DSO)

• also known as the number of days of credit

Accounts
Days sales outstanding (DSO)
receivable
Average credit sales per
=
day

• With an ending balance of accounts receivable of

$200 million and assuming all sales are on credit,
Exemplar's DSO for FY20X2 is $200 million = $5,479
million = 36.5 days.
Operating cycle
• the sum of the days sales in inventory and the
days sales outstanding

Operating cycle = DSI +

DSO
• Using what we have determined for the
inventory cycle and cash cycle, we see that for
Exemplar the operating cycle is 111.78 + 36.5 =
148.281 days.
• If we assume all the Exemplar purchases are made
on credit and there was no change in the level of in-
ventory, the total purchases for the year would be
the cost of goods sold less any amounts included in
cost of goods sold that are not purchases, such as
depreciation. Because we do not have a breakdown
on the com- pany's cost of goods sold showing how
much was paid for in cash and how much was on
credit, we will assume that the following relationship
holds for Exemplar:

( )
Beginning Cost of Ending
+ - +
inventory goods sold inventor
Purchases Depreciation
y
For Exemplar in FY20X2, we infer purchases of $1,480
million. There- fore, the purchases per day are

Annual
Average purchases per day =
purchases
365

which for Exemplar are $4.055 million.

Days payables outstanding
(DPO),
• also known as the number of days of purchases

Accounts payable
Days payables outstanding
(DPO) = Average purchases per
day
• For Exemplar in the current year, the DPO is $100
million ÷ $4.055 million = 24.662 days. This means
that on average Exemplar takes approx- imately 25
days to pay out cash for a purchase
Cash Conversion Cycle (CCC),
• also known as the net operating cycle

Cash conversion cycle = DSI + DSO -

DPO
• For Exemplar's FY20X2, Cash conversion cycle
= 11.781+36.500 - 24.662 = 123.619 days
Measures of
Liquidity
Current ratio - we can form the current ratio, which is
one of the most commonly used measures of liquidity

Current
Current ratio =
assets
Current
liabilities
The current ratio is an indication of how many times
the company can cover its current liabilities, using its
current assets. Exemplar's current ratio for FY20X2 is
$800 million ÷ $130 = 6.154 times.
Quick ratio - which is similar to the current ratio,
except we remove the least liquid of the current
assets from the numerator.

Current assets -
Quick ratio =
Inventory
Current
liabilities
By leaving out the least liquid asset, the quick ratio
provides a more conservative view of liquidity. The
quick ratio is also known as the acid test ratio. For
Exemplar in the current year, the quick ratio is 2.385
times.
Net working capital - to-sales ratio, which compares
net working capital (current assets less current
liabilities) with sales

Net working
Net working capital to sales capital
Revenue
=
s
This ratio tells us the "cushion" available to meet
short-term obligations relative to sales. Consider
two companies with identical working capital of
$100,000, but one has sales of $500,000 and the
other sales of $1,000,000.
For Exemplar Corporation, the net working capital to
sales ratio for FY20X2 is

$800
mo
million - 130
Net working capital to sales =
million
$2,000
= 0.335
million

The ratio of 0.335 tells us that for every dollar of

sales, Exemplar has 33.5 cents of net working capital
to support it.
 PROFITABILITY RATIOS
• which help the investor gauge how well a company
is managing its expenses.
• Profit margin ratios compare components of income
with sales.
• They give the investor an idea of which factors
make up a company's income and are usually
expressed as a portion of each dollar of sales.
• For example, the profit margin ratios we discuss
here differ only in the numerator. It is in the
numerator that we can evaluate performance for
different aspects of the business.
Gross profit margin
Gross profit
Gross profit margin
Revenue
=
s
• This ratio tells us the portion of each dollar of sales
that remains after deducting production expenses.
For Exemplar Corporation for the current year,

$400
Gross profit margin =
million
$2,000
= 20%
million
Operating profit margin
• To evaluate operating performance, we need to
consider operating ex- penses in addition to the cost
of goods sold. To do this, remove operating
expenses (e.g., selling and general administrative
expenses) from gross profit, leaving operating profit,
also referred to as earnings before interest and
taxes. Therefore, the operating profit margin is:
Operating
Operating profit margin profit
= Revenues
• For Exemplar in the current year, the operating
profit margin is 10%. Therefore, for each dollar of
revenues, Exemplar has 10 cents of operating
income. The operating profit margin is affected by
the same factors as gross profit margin, plus
operating expenses.
• Both the gross profit margin and the operating profit
margin reflect a company's operating performance.
But they do not consider how these operations have
been financed.
Net profit margin
• To evaluate both operating and financing decisions,
the investor must compare net income (that is,
earnings after deducting interest and taxes) with
revenues.
Net
Net profit margin =
profit
Revenues

• For Exemplar for the current year, the net profit

margin is 5.484%. In other words, for every dollar of
revenues, Exemplar generates 5.484 cents in net
profits.
 ACTIVITY RATIOS
• for the most part, turnover ratios to evaluate
the benefits produced by specific assets, such
as inventory or accounts receivable, or to
evaluate the benefits produced by the totality
of the company's assets.
Inventory management
• is a measure of how quickly a company has used
inventory to generate the goods and services that
are sold. The inventory turnover is the ratio of the
cost of goods sold to inventory:
Cost of goods
Inventory turnover sold
= Inventor
y
• For Exemplar for the current year, the inventory
turnover is 3.265 times.
Accounts Receivable Management - The accounts
receivable turnover ratio is a measure of how
effectively a company is using credit extended to
customers. The reason for extending credit is to
increase sales.
Credit
Accounts receivable
sales
Accounts
turnover =
receivable
For Exemplar for the current year, the accounts
receivable turnover is $2,000 million ÷ $200 million =
10 times. Therefore, 10 times in the year there is, on
average, a cycle that begins with a sale on credit and
finishes with the receipt of cash for that sale.
Overall Asset Management - simply the asset
turnover, which is how many times during the year
the value of a com- pany's total assets is generated in
revenues:

Revenue
Total asset turnover
s
Total
=
assets

For Exemplar in the current year, the total asset

turnover is $2,000 million ÷ $1,175 1.159 times.
 FINANCIAL LEVERAGE
• A company can finance its assets with equity or
with debt.
• Financing with debt legally obligates the company
to pay interest and to repay the principal as
promised.
• Business risk is equity financing does not obligate
the company to pay anything
• Financial risk is risk associated with a company's
ability to satisfy its debt obligations, and is often
measured using the extent to which debt
 2 types of Financial Leverage
Ratios
1. Component percentages
ratios
2. Coverage
Component ratios
Percentage
Ratios
• A ratio that indicates the proportion of assets
financed with debt is the debt- to-assets ratio, which
compares total liabilities (Short-term debt + Long-
term debt) with total assets Debt
Debt to assets
Total
=
assets
• For Exemplar in the current year, the debt to assets
is 16.959%. This ratio indicates that 16.959% of the
company's assets are financed with debt (both short
term and long term).

• The debt-to-equity ratio, or simply the debt- equity

ratio, is a measure how the company finances its
operations with debt relative to the book value of its
shareholders' equity:
Debt
Debt to equity
= Shareholders'
equity
• Shareholders' equity is the book value, or carrying
value, of sharehold- ers' equity as reported on the
company's balance sheet. For Exemplar for FY20X2,
the debt to equity ratio is ($130 million + 163
million) ÷ $1,432 million or 0.204. For every one
dollar of book value of shareholders' equity,
Exemplar uses 20.4 cents of debt.
Coverage
Ratios
— The ratios that compare debt to equity or debt to
assets indicate the amount of financial leverage,
which enables an investor to assess the financial con-
dition of a company.
• Interest coverage ratio referred to as the times
interest-covered ratio. This ratio tells us how well
the company can cover or meet the interest
payments associated with debt.
EBIT
Interest coverage ratio
Interest
=
expense
• The greater the interest coverage ratio, the better
able the company is to pay its interest expense.
For Exemplar for the current year, the interest
coverage ratio is $200 million ÷ $17 million =
11.617 times. An interest coverage ratio of 11.617
times means that the company's earnings before
interest and taxes are 11.617 times greater than
its interest payments.
• A ratio that considers cash flows from operations as
funds available to cover interest payments is
referred to as the cash flow interest coverage ratio

Cash flow
+ Interest +
Cash flow interest from
= Taxes
coverage operations Interest

• For Exemplar for the current year, the cash flow

interest coverage is

Cash flow interest $290 million + 17 million + 73

= =
coverage million
$17 million
22.565
 RETURN ON INVESTMENT
• Return-on-investment ratios compare measures of
benefits, such as earnings or net income, with
measures of investment.

Earnings before interest and

Basic earning power = taxes
Total
assets
• For Exemplar Corporation, for the current year,
the basic earning power ratio is $110 million ÷
$1,725 million = 11.594%.
• Another return-on-assets ratio uses net income-
operating earnings less interest and taxes-instead of
earnings before interest and taxes. This is the more
commonly used return on assets ratio

Net
Return on assets
Total
income
=
assets
• For Exemplar in the current year, the return on
assets is $110 million ÷ $1,725 million = 6.358%
• The return on equity is the ratio of the net income
shareholders receive to their equity in the stock

Net
Return on equity
income
Shareholders'
=
equity

• For Exemplar Corporation, there is only one type of

shareholder: com- mon. For the current year, the
return on equity is $110 million $1,725 million
7.656%.
 THE DUPONT SYSTEM
• The returns-on-investment ratios provide a "bottom
line" on the perfor- mance of a company, but do
not tell us anything about the "why" behind this
performance.
• The DuPont system a method that is useful in
examining the source of performance.
• The DuPont system is a method of breaking down
return ratios into their components to determine
which areas are responsible for a company's
performance.
 COMMON-SIZE ANALYSIS
• Common-size analysis is a method of analysis in
which the components of a financial statement
are compared. In the vertical common-size
analysis, each financial statement item is
compared to a benchmark item for that same
year.
• Another form of common-size analysis is
horizontal common-size analysis, in which we use
either an income statement or a balance sheet in
a fiscal year and compare accounts to the
 USING FINANCIAL RATIO
ANALYSIS
• Financial analysis provides information concerning a
company's operating performance and financial
condition. This information is useful for an in- vestor
in evaluating the performance of the company as a
whole, as well as of divisions, products, and
subsidiaries.
• But financial ratio analysis cannot tell the whole
story and must be interpreted and used with care.
• Financial ratios are useful but, as noted in the
discussion of each ratio, there is information that the
Thank You!!