RATIO ANALYSIS

Activity ratios:

Often referred to as asset utilization ratios or turnover ratios. They indicate how well
the assets are being utilized.

Receivables’ turnover =

Annual sales/ average receivables’

It is desirable to have this ratio close to the industry norms.

Average collection period or days of sale outstanding =

365/ receivables turnover.

This ratio helps to interpret the credit terms of the company. A high ratio means
high collection period which means too much money is tied in the market, and a low
ratio means strict credit terms which might hamper sales. Thus it should be close to
the industry norms.

Inventory turnover =

Cost of goods sold/ average inventory

It reflects the firms’ efficiency in processing and inventory management.

Average inventory processing period =

365 / inventory turnover

It should be close to industry norms. Too high means money is tied and the
inventory could be obsolete and too low means firm has inadequate inventory in
hand which can hurt sales.

Payables turnover ratio =

Purchases / average trade payables.

It reflects the use of credit by firm.

Number of days payable =

365 / payables turnover ratio

It reflects the average amount of time the firm takes to pay its bills.
Total assets turnover =

Revenue / average total assets

It reflects the effectiveness of the firm’s use of its assets to generate revenues. Low
ratio means that the company has too much capital tied up in its assets and too
high ratio means that the firm has too few assets for potential sales. Thus it should
be close to the industry norm.

Fixed assets turnover ratio =

Revenue / average net fixed assets

It suggests how well the fixed assets are being utilized. Low ratio means that too
much money is tied in the capital and high ratio means that assets are obsolete or
there might be capital expenditures to increase capacity to support the growing
revenues.

The net here means that net of accumulated depreciation.

Working capital turnover ratio =

Revenue / average working capital

It reflects the usage of working capital for per dollar of sales per dollar of working
capital. Some firms may have very low working capital because of outstanding
payables equaling or exceeding inventory or receivables, which in turn will lead to
high ratio.

Liquidity ratios:

How well a firm stands to repay short term debts.

Current ratio =

Current assets/ current liabilities

It is the best know measure of liquidity. Higher the ratio, more likely the firm is to
repay the short term obligations. Ratio of less then one means negative working
capital and the firm is facing liquidity crisis.

Quick ratio =
 Cash+ marketable securities + receivables/ current
liabilities

It is a more stringent measure as it does not include inventory and other assets
which might not be very liquid. Higher the ratio better it is.

Cash ratio =

Cash + marketable securities/ current liabilities

It is the most conservative measure. Higher the ratio, better it is.

Defensive interval ratio =

Cash + marketable securities + receivables/ average

It reflects the number of days of the average expenses the firm can pay with its
current liquid assets. The daily expenses here are cash expenses on cost of goods
sold, SD & A and R& D. if the items are taken from the income statement then
NCCs’ should be added back.

Cash conversion cycle =

Days sales O/S + inventory at hand – number of days

It is the length of time taken to convert the investment in inventory back into cash
through the sales of that inventory. High conversion cycles mean too much capital
is tied in the sales process and is undesirable.

Solvency ratios:

They tell us about the financial leverage of the firm and its ability to pay its long
term obligations.

Debt to equity =

Total debt / total shareholder’s equity

The total debt will be total long term debt and interest bearing short term debt. This
ratio suggests the reliance on debt.

Debt to capital ratio =

Total debt / total debt + shareholder’s equity

Increase or decrease suggests the reliance on debt for financing.

Debt to assets ratio =

It is a slightly different ratio to assess debt utilization. It indicates reliance on debt

Financial leverage =

Average total assets / average total equity

It indicates the use of debt for financing.

Interest coverage =

EBIT / interest payments

Lower the ratio, dangerous it is.

Fixed charge coverage =

EBIT + lease payments / interest payments + lease

It is a more meaningful ratio for companies which lease a large portion of their
assets, i.e., airlines.

Profitability ratios:

How well the firm is able to generate profit from its sales.

Net profit margin =

Net income / revenue (sales)

The analyst should be concerned if this ratio is too low. The net income should be
from continuing operations.

Now we will take a look at the operating profit ratios which concentrate on how
good the management is in turning their efforts into profits.

Gross profit margin =

Gross profit / revenue

The analyst should be concerned if this ratio is too low.

Operating profit margin =

The analyst should be concerned if this is too low.

Pretax margin =

EBT / revenue

This is to measure the pretax margin.

There is other set of ratio which deals with the return to the common equity,
preferred equity and debt financers.

Return on assets =

Net income / average total assets

This method is a bit misleading as interest is excluded but total assets include debt
as well as equity. Another variation is:

Return on assets =

Net income + interest expense(1-tax rate)/ average total

Operating return on assets =

Operating income (EBIT)/ average total assets

This measure includes both taxes and interest in the numerator.

Return on total capital =

EBIT / average total capital

It is the same as total assets as it include long term and short term debt, preferred
equity, common equity. The interest expense to be added back is the gross interest
not the net interest. Analyst should be concerned if this ratio is too low.

Return on equity =

Net income / average total equity

The analyst should be concerned if this ratio is too low. This is also called return on
total equity.

Return on common equity =

Net income – preferred dividends / average common

DuPont analysis

This analysis breaks down ROE into function of different ratios and helps the analyst
to study the impact of leverage, profit margins and turnover on shareholder returns.
There are two variants of this system:

• Three part approach

• Extended five part system.

Three part approach:

It starts with the normal ratio = net income / equity

For equity the average and year end values can be used.

Now multiplying it by revenue/revenue leads us to:

ROE = net income/ revenue * revenue / equity

The first ratio is net profit margin and second is equity turnover.

That is = net profit margin * equity turnover

Now we further multiply it by assets/ assets which lead us to:

ROE = net income / sales * sales/ assets * assets / equity

Thus ROE is = profit margin* asset turnover * leverage.

Thus we can come to a conclusion that if the ROE is low than it might be because of
poor profit margin or poor asset turnover or too little leverage.

The extended five part system

This approach breaks down the net profit margin into further components and the
new equation becomes:

ROE = net income/EBT* EBT / EBIT * EBIT/ revenue* sales/ assets * assets / equity

The first ratio is called tax burden, second is the interest burden and third is the
EBIT margin.

The new ROE is:

Tax burden*interest burden*EBIT margin* asset turnover * leverage.

Helps in relative valuation of shares.

Financial statement analysis applications