CHAPTER FIVE – FINANCIAL RATIOS

Financial ratios
 Financial ratios are essential tools for gaining insights into a company's financial health
and performance. They are derived from numerical data found in financial statements
and are utilized for quantitative analysis. Key financial ratios encompass liquidity,
leverage, growth, profitability, and valuation metrics.
 [Main Points:]
 Purpose of Financial Ratio Analysis:
 Monitoring company performance over time.
 Making comparative judgments regarding company performance against competitors and
industry averages.
 Users of Financial Ratios:
 External Users: Financial analysts, investors, creditors, regulators, and industry observers.
 Internal Users: Management teams, employees, and owners.
Vertical analysis,
 Gross Profit Ratio:
 Gross Profit / Revenue
 Operating Profit Ratio:
 Operating Profit / Revenue
 Net Profit Ratio:
 Net Profit / Revenue
 Selling & Admin Expenses Against Sales:
 Selling & Administrative Expenses / Revenue
 Tax Ratio:
 Tax Expense / Revenue
 Interest Coverage Ratio:
 Operating Profit / Interest Expense
Example:

 Sales (net) – $420,000.00; Cost of Goods Sold – $300,000.00

 Gross profit margin = Sales- CGS/Sales; Gross profit/Sales
 420000-300000 = 120,000/420,000 = 28.5%; Industry average is 35%
 Horizontal Analysis Ratios
 Gross Profit Ratio:
 Compare gross profit over several years to observe trends in profitability before
operating expenses.
 Operating Profit Ratio:
 Analyze operating profit across multiple years to assess the company's operational
efficiency and profitability trends.
 Net Profit Ratio:
 Track net profit over time to evaluate the company's overall profitability and
performance.
 Tax Ratio:
 Examine tax expenses relative to revenue or net income to understand trends in
tax efficiency and compliance.
 Interest Coverage Ratio:
 Compare operating profit to interest expense over several years to assess the
company's ability to cover interest payments with its operating income.
Leverage ratios
 Leverage ratios are essential tools for assessing company
performance and understanding its capital structure. By
comparing debt to equity, analysts gain insights into the
company's financial health and risk profile.
 Debt/Equity Ratio
 The debt/equity ratio compares a company's total debt to
its total equity.
 It provides a comprehensive view of the company's capital
structure, indicating the proportion of financing provided
by debt relative to equity.
Profitability Analysis

 Gross Margin:
 Gross Margin = (Revenue - Cost of Goods Sold) / Revenue
 Indicates the percentage of revenue retained after accounting for the cost of goods
sold. Higher gross margins suggest greater efficiency in production or pricing
power.
 EBIT Margin:
 EBIT Margin = EBIT / Revenue
 EBIT margin assesses a company's operating profitability before interest and taxes.
It reflects operational efficiency and the ability to generate profits from core
business activities.
 Net Profit Margin:
 Net Profit Margin = Net Profit / Revenue
 Net profit margin measures the percentage of revenue that translates into net
income after accounting for all expenses, including taxes and interest. It provides
insights into overall profitability after considering all costs.
Liquidity Analysis

 Current Ratio:
 Current Ratio = Current Assets / Current Liabilities
 Indicates the company's ability to cover short-term liabilities with its short-term assets. A ratio
above 1 suggests sufficient liquidity.
 Acid-Test Ratio (Quick Ratio):
 Acid-Test Ratio = (Current Assets - Inventory) / Current Liabilities
 Measures the company's ability to meet short-term obligations using its most liquid assets
(excluding inventory). It provides a more stringent measure of liquidity compared to the current
ratio.
 Cash Ratio:
 Cash Ratio = Cash and Cash Equivalents / Current Liabilities
 Focuses solely on the company's cash and cash equivalents relative to its short-term liabilities. It
provides insight into the company's immediate liquidity position.
 Net Working Capital:
 Net Working Capital = Current Assets - Current Liabilities
 Represents the difference between a company's current assets and current liabilities. Positive net
working capital indicates liquidity, while negative net working capital may signal potential
liquidity issues.
 Efficiency Ratios
 Asset Turnover:
 Asset Turnover = Revenue / Average Total Assets or total Asset
 Measures the company's ability to generate revenue relative to its total
assets. Higher asset turnover ratios indicate more efficient asset
utilization.
 Inventory Turnover:
 Inventory Turnover = Cost of Goods Sold / Average Inventory
 Evaluates how quickly a company sells its inventory within a given period.
A higher turnover ratio suggests efficient inventory management and sales
practices.
 Receivable Turnover:
 Receivable Turnover = Revenue / Average Accounts Receivable
 Assesses how efficiently a company collects payments from customers. A
higher receivable turnover ratio indicates faster collection of receivables
and efficient credit
LIQUIDITY RATIOS

 Liquidityratios are financial ratios that measure a

company’s ability to repay both short- and long-
term obligations
current ratio

 The current ratio measures a company's ability to meet

its short-term obligations with its current assets. It is
calculated by dividing current assets by current
liabilities:
 Current Ratio = Current Assets / Current Liabilities
Example
 If a business holds:
 Cash = $15 million
 Marketable securities = $20 million
 Inventory = $25 million
 Short-term debt = $15 million
 Accounts payables = $15 million
 Current assets = 15 + 20 + 25 = 60 million
 Current liabilities = 15 + 15 = 30 million
 Current ratio = 60 million / 30 million = 2.0x; 2:1
Cash Ratio and Operating Cash Flow Ratio:

Cash Ratio and Operating Cash Flow Ratio: Assessing Liquidity and Cash Generation]
 The cash ratio and operating cash flow ratio are essential metrics for evaluating a
company's liquidity and cash generation capabilities.
 Cash Ratio:
 The cash ratio measures a company's ability to satisfy short-term liabilities using
cash and cash equivalents.
 Formula: Cash Ratio = Cash and Cash Equivalents / Current Liabilities
 It provides insights into the company's immediate liquidity position and its ability to
settle obligations with readily available funds.
 Operating Cash Flow Ratio:
 The operating cash flow ratio evaluates the frequency with which a company can
settle current liabilities using the cash generated from its operating activities.
 Formula: Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities
 It indicates the company's ability to generate cash from its core business operations
to meet short-term financial obligations.
The acid-test ratio
 The acid-test ratio, also known as the quick ratio, is a critical
liquidity measure that evaluates a company's ability to meet
short-term obligations using quick assets, excluding inventories.
 Formula
 Acid-Test Ratio = (Current Assets - Inventories) / Current
Liabilities
 Components
 Current Assets: Assets that can be reasonably converted into
cash within a year.
 Inventories: Value of materials and goods held by the company
for sale to customers.
 Current Liabilities: Debts or obligations due within one year.
Example:

 Acid-Test Ratio = (Total Current Assets - Inventories) / Current

Liabilities

 A: Cash - $25,000; Accounts Receivable - $30,000.00; Inventory –

$40,000.00; Current liabilities - $25,000.00. Calculate Acid-test ratio.

 Acid-test ratio = 25000 + 30000+ 40000 -40000= 55000/ 25000 = 2.2:1 –

On average 1:1 is considered good ratio;

 B: Total Current Assets - $85,000.00 of which $35000.00 is inventory.

The current liabilities are $40,000.00. Calculate the quick ratio.

 CA – Inventory/CL; 85000 – 35000 = $50,000/40000 = 1.25:1

EFFICIENCY RATIOS (ACTIVITY RATIOS)

 Efficiency ratios, also known as activity financial

ratios, are used to measure how well a company is
utilizing its assets and resources
The asset turnover ratio (ATO)
 The asset turnover ratio (ATO) is a key financial metric that
evaluates a company's efficiency in generating sales from its
assets.
 Formula
 Asset Turnover Ratio = Net Sales / Total Assets
 Net Sales: Represents the total revenue generated from
sales, excluding returns, discounts, and allowances.
 Total Assets: Reflects the sum of all assets owned or
controlled by the company, including both current and non-
current assets.
Example
 Asset Turnover Ratio = Net Sales / Total Assets or Average Total Assets

 A: Sale of $150,000.00(net); Current assets - $80,000; Fixed assets $120,000.00

 Calculate ATO; 150000/200000 = $0.75:1

 Example

 B: Beginning T. Assets - $165000; Ending T. Assets $235000

 Total Sales - $750000, Sales Returns - $120000 and Sales Discount - $30000

 Calculate the Asset Turnover

 165000+235000= $400000/2 = $200000 = Average Assets

 750000 – 150000 = $600000 – Net Sales

 600000/200000 = $3: $1
 The receivable turnover ratio
 The receivable turnover ratio is a crucial financial metric that assesses a company's
efficiency in converting accounts receivable into cash over a specific period.

 Formulas

 Receivables Turnover Ratio = Net Credit Sales / Average Accounts Receivable

 Alternatively: Receivable Turnover = Net Sales / Accounts Receivable

 Net Credit Sales: Represents the total sales revenue generated on credit terms,
excluding cash sales.

 Average Accounts Receivable: The average value of accounts receivable over a

specific period, calculated as (Beginning Accounts Receivable + Ending Accounts
Receivable) / 2.
 Example,

 Sales of $300,000.00 ($100,000 is cash sales); previous year

we have a receivable of $50000 and current year our accounts
receivable stands at $90000.

 Calculate RTO

 Credit sales – (300000 – 100000) = $200,000

 Average A/R – 50000 + 90000 = 140000/2 = $70,000

 Receivable turn over = 200,000/70,000 = 2.85 times

 *The more it is higher the better it is.

The inventory turnover ratio
 also known as the stock turnover ratio, is a fundamental metric
for evaluating a company's efficiency in managing its inventory.
 Formulas
 Inventory Turnover Ratio = Cost of Goods Sold / Average
Inventory
 Alternatively: Inventory Turnover = Purchases / Inventory
(Stock)
 Cost of Goods Sold (COGS): Represents the direct costs
associated with producing the goods sold by the company during
a specific period, typically found on the income statement.
 Average Inventory: The mean value of inventory held by the
company throughout a certain period, calculated as (Beginning
Inventory + Ending Inventory) / 2
Example

 Beginning inventory- $25000; purchases during the year - $80,000;

ending inventory of $15000 - Calculate Inventory turnover
 CGS = 25000 + 80000 = 105000 -15000 = $90000
 Average Inventory = 25000 + 15000 = 40000/2 = $20000
 Inventory turnover = $90,000/$20,000 = 4.5times
 = $80000/20000 4 times
 *The greater the inventory turnover ratio is the more the better it
is
 Interpretation of Inventory Turnover Ratio
 Efficiency Gauge:
 High ratio: Shows efficient inventory management. Products are sold quickly, reducing
storage costs and risk of unsold items.
 Low ratio: Indicates sluggish sales or excess inventory, leading to higher holding costs
and risk of losses from obsolete items.
 Comparison:
 Compare with similar companies in the same industry for meaningful insights. Ratios
differ widely across industries due to different business models and market demands.
 Sales Performance:
 Low turnover suggests potential sales issues or poor inventory management. Unsold
items could face price drops or become obsolete, impacting profits.
 Impact on Liquidity:
 Inventory turnover affects cash flow. Low turnover ties up funds in unsold goods,
potentially impacting a company's ability to handle short-term financial needs.
The Days Sales in Inventory (DSI) ratio
 The Days Sales in Inventory (DSI) ratio measures how many
days, on average, a company holds onto its inventory before
selling it to customers.
 Formula: DSI Ratio = 365 days / Inventory Turnover Ratio
 Example Calculation: If the inventory turnover ratio is 4.5,
the DSI ratio would be approximately 81 days (365 days /
4.5).
How to Increase the Gross Margin Ratio

 The gross margin ratio measures the profitability of a company's

inventory sales, with a higher ratio being more favorable. Here are two
strategies to increase this figure:
 Buy Inventory at a Cheaper Price:
 Companies can negotiate discounts with suppliers or seek alternative,
less expensive sources for inventory procurement.
 Lower purchase costs result in reduced cost of goods sold, ultimately
leading to a higher gross margin ratio.
 Mark Up Goods (Increase Selling Price):
 Selling goods at a higher price increases the gross margin ratio,
provided the cost increase is offset by the price increase.
 However, pricing must remain competitive to ensure customer
demand and market viability.
 Operating margin ratio
 The operating margin ratio assesses a company's operating efficiency by comparing its
operating income to its net sales.
 [Formula:]
 Operating Margin Ratio = Operating Income (EBIT) / Net Sales
 [Calculation Example:]
 Given:
 Gross Profit = $30,000
 Selling & Admin Expenses = $20,000
 Operating Income (EBIT) = Gross Profit - Selling & Admin Expenses = $30,000 - $20,000 =
$10,000
 Net Sales = $100,000
 Operating Margin Ratio = Operating Income / Net Sales = $10,000 / $100,000 = 10%
 EBIT (Earnings Before Interest and Taxes) represents operating income and is found by
subtracting all operating expenses from sales revenue.
 The Net Profit Margin (NPM) ratio
 The Net Profit Margin (NPM) ratio assesses a company's profitability by
measuring the percentage of profit it generates from its total revenue.
 Net Profit Margin (NPM) = (Net Profit / Total Revenue) * 100
 Net Profit: Calculated by subtracting all expenses from total revenue. It
represents the profit remaining after all costs are deducted.
 Total Revenue: Represents the company's total sales or income generated
during a specific period.
 Interpretation
 NPM indicates how efficiently a company converts revenue into profit. A higher
NPM reflects better profitability.
 Industry norms vary, so comparing NPM with competitors or industry benchmarks
provides insights into relative performance.
 Essential for financial analysis, NPM helps assess a company's financial health,
viability, and efficiency in cost management.
MARKET VALUE RATIOS

 Market value ratios are used to evaluate the share price of a company’s stock.
Book value per share ratio
 The Book Value Per Share Ratio calculates the per-share value of a company based on
the equity available to shareholders, providing insights into the company's intrinsic
value from a balance sheet perspective.
 [Formula:]
 Book Value Per Share Ratio = Shareholder’s Equity / Total Shares Outstanding
 [Calculation Example:]
 Given:
 Assets = Liabilities + Equity
 Total Assets = $250 million, Liabilities = $50 million
 Shareholder's Equity = Total Assets - Liabilities = $250 million - $50 million = $200
million
 Total Shares Outstanding = 1,000,000 shares
 Book Value Per Share Ratio = $200 million / 1,000,000 shares = $200 per share
 A book value per share of $200 indicates that each share represents $200 of equity
available to shareholders.
Dividend yield ratio
 The Dividend Yield Ratio measures the amount of dividends
attributed to shareholders relative to the market value per
share, providing insights into the return on investment from
dividends.
 [Formula:]
 Dividend Yield Ratio = Dividend Per Share / Share Price
 [Calculation Example:]
 Example: Dividend Per Share = $0.60, Share Price = $3.00
 Dividend Yield Ratio = $0.60 / $3.00 = 0.2 * 100 = 20%
 A dividend yield of 20% indicates that for every $1 invested in the stock,
shareholders receive $0.20 in dividends.
 Earnings per share ratio
 The Earnings Per Share (EPS) ratio measures the amount of
net income earned for each share outstanding, providing
insights into a company's profitability on a per-share basis.
 [Formula:]
 EPS Ratio (EPS) = Net Earnings / Total Shares Outstanding
 Example
 Given:
 Net Earnings (Net Profit) = $2,000,000
 Total Shares Outstanding = 1,000,000 shares
 EPS = $2,000,000 / 1,000,000 = $2.00 per share
Price-earning ratio (P/E Ratio)

 The Price-Earnings Ratio (P/E Ratio) compares a company's share price

to its earnings per share (EPS), providing insights into investor sentiment
and valuation.
 [Formula:]
 P/E Ratio = Share Price / Earnings Per Share (EPS)
 [Calculation Example:]
 Given:
 Share Price = $3.00
 Earnings Per Share (EPS) = $2.00
 P/E Ratio = $3.00 / $2.00 = 1.5 times
 A P/E Of 1.5 times means that investors are willing to pay $1.5 for
every $1 of earning generated by the company.
 Higher P/E ratio suggest investors optimism or expectation of future
earning growth.
STEPS IN PERFORMING COMPARABLE
COMPANY ANALYSIS
 Find the right comparable companies
 Gather financial information
 Setup the comparable table
 Calculate the comparable ratios
 Interpreting the results
 Applications of comparable company
analysis