CHAPTER 3 - FINANCIAL RATIOS

Financial ratios are relationships determined from a company's financial information and used for
comparison purposes.

Four main categories of financial ratios:

1. Liquidity refers to the company’s ability to satisfy its short-term obligations as they come due.
• Types of liquidity ratios.

Current Ratio = Current Assets ÷ Current Liabilities

Quick ratio = Cash + Marketable Securities + Accounts Receivable

Current Liabilities

2. Profitability refers to the company’s ability to generate earnings. It is one of the most
important goals of businesses.
• There are different levels of measuring profit:
1. gross profit
2. operating profit
3. net profit or net income
• These are the return on equity, return on assets, gross profit margin, operating profit margin,
net profit margin.
• Return on equity measures the amount of net income earned in relation to stockholders’ equity.
o ROE (return on equity) = Net income ÷ Stockholders’ equity
• Return on assets measures the ability of a company to generate income out of its
resources/assets.
o ROA (return on asset) = Operating income ÷ Total assets
• Gross profit margin shows how many pesos of gross profit is earned for every peso of sale. It
provides information regarding the ability of a company to cover its manufacturing cost from its
sales. Remember that gross profit is just sales less cost of goods or cost of services.
o Gross profit margin = Gross profit ÷ Sales
• Operating profit margin shows how many pesos of operating profit is earned for every peso of
sale. It measures the amount of income generated from the core business of a company.
o Operating profit margin =Operating income ÷ Sales
• Net profit margin measures how much net profit a company generates for every peso of sales or
revenues that it generates.
o Net profit margin = Net income ÷ Sales

3. Efficiency refers to a company’s ability to be efficient in its operations. Specifically, it refers to

the speed with which various current accounts are converted into sales, and ultimately, cash.
• Efficiency Ratios Formulas
a. Accounts receivable turnover = Sales ÷ Account Receivable
b. Average collection period = 365 ÷ Accounts Receivable Turnover
c. Inventory turnover = Cost of goods sold ÷ Inventory
d. Average age of inventory or days’ inventory = 365 ÷ Inventory turnover
e. Accounts payable turnover = Purchases ÷ Inventory
f. Average payment period = 365 ÷ Accounts Payable Turnover
g. Operating Cycle = Average Collection Period + Average Age of Inventory
h. Cash Conversion Cycle = Average collection period + Average age of inventory - Average age of
payables

4. Financial leverage refers to the company’s use of debt. It defines the company’s capital structure
which indicates how much of the total assets are financed by debt and equity.
• Types of leverage ratios and write the formulas on the board.
1. Debt ratio – This ratio measures the proportion of total assets finance by total liabilities or
money provided by creditors (not by the business owners).
Debt Ratio = Total Liabilities ÷ Total Assets
2. Debt-to-equity ratio – A variation of debt ratio, shows the proportion of debt to equity.
Debt-to-equity ratio = Total Liabilities ÷ Total Equity
3. Interest coverage ratio – This ratio shows the company’s ability to pay its fixed interest
charges in relation to its operating income or earnings before interest and taxes.
Interest coverage ratio * = Earnings before interest and taxes (EBIT) ÷ Interest Expense
* Another name of interest coverage ratio is Times Interest Earned.