Module 7: RATIO ANALYSIS fixed asset investments and have similar
capital structures, the results of a ratio
Financial statements provide valuable
information for different stakeholders. Financial
ratios serve as a strong tool to measure the
different aspects of the business and how it
performs with the rest of businesses within the
industry.
Ratio Analysis
- Ratio analysis is the comparison of line
items in the financial statements of a
business. Ratio analysis is used to
evaluate several issues with an entity,
such as its liquidity, efficiency of
operations, and profitability. This type of
analysis is particularly useful to analysts
outside of a business since their primary
source of information about an
organization is its financial statements.
Ratio analysis is less useful to corporate
insiders, who have better access to more
detailed operational information about
the organization.
- It is particularly useful when employed
in the following two ways:
● Trend Line - Calculate each ratio over
reporting periods, to see if there is a
trend in the calculated information. The
trend can indicate financial difficulties
that would not otherwise be apparent if
ratios were being examined for a single
period. Trend lines can also be used to
estimate the direction of future ratio
performance.
● Industry Comparison - Calculate the
same ratios for competitors in the same
industry and compare the results across
all the companies reviewed. Since these
businesses likely operate with similar
analysis should be similar. If this is not
the case, it can indicate a potential issue,
or the reverse - the ability of a business
to generate a profit that is notably higher
than the rest of the industry. The
industry comparison approach is used
for sector analysis, to determine which
businesses within an industry are the
most (and least) valuable.
CATEGORIES OF RATIO ANALYSIS
Financial ratios can be grouped into the
following clusters of ratios, where each cluster is
targeted at a different type of analysis
1. Profitability Ratios
- Profitability ratios are a set of
measurements used to determine the
ability of a business to create earnings.
Profitability ratios are derived from a
comparison of revenues to different
groupings of expenses within the income
statement.
- Examples of profitability ratios are the
contribution margin ratio, gross profit
ratio, and net profit ratio.
2. Efficiency Ratios
- These ratios measure the ability of a
business to use its assets and liabilities to
generate sales. A highly efficient
organization has minimized its net
investment in assets, and so requires less
capital and debt to remain in operation.
- Examples of efficiency ratios are
accounts receivable turnover, inventory
turnover, fixed asset turnover, and
accounts payable turnover.
3. Liquidity Ratios
- These ratios are measurements used to
examine the ability of an organization to
pay off its short-term obligations.
Liquidity ratios are commonly used by
prospective creditors and lenders to
decide whether to extend credit or debt,
respectively, to companies.
- Examples of liquidity ratios are the cash
ratio, current ratio, and quick ratio.
4. Leverage Ratios
- These ratios are used to determine the
relative level of debt load that a business
has incurred. These ratios compare the
total debt obligation to either the assets
or equity of a business.
- Examples of leverage ratios are the debt
ratio and debt to equity ratio.
DISADVANTAGES OF RATIO ANALYSIS
The use of ratio analysis can be misleading
when comparing the results of businesses across
industries. For example, ratio results in the
utility industry will be completely different
from those in the software industry, because
utilities have a large fixed asset base, while
software companies invest in few fixed assets at
all. This means that a utility is more likely to
incur debt to pay for its fixed assets, while a
software company may incur no debt at all.
Ratio Analysis is a great tool to measure the
performance of a business, but it should only be
used for businesses within the same industry
and not for any businesses.
Module 8: PROFITABILITY RATIO
Financial statements provide valuable
information for different stakeholders. Financial
ratios serve as a strong tool to measure the
different aspects of the business and how it
performs with the rest of businesses within the
industry.
Profitability Ratios
- Profitability ratios are a class of financial
metrics that are used to assess a
business's ability to generate earnings
relative to its revenue, operating costs,
balance sheet assets, or shareholders'
equity over time, using data from a
specific point in time.
- Profitability ratios can be compared with
efficiency ratios, which consider how
well a company uses its assets internally
to generate income (as opposed to
after-cost profits).
WHAT DO PROFITABILITY RATIOS TELL
YOU?
For most profitability ratios, having a higher
value relative to a competitor's ratio or relative
to the same ratio from a previous period
indicates that the company is doing well.
Profitability ratios are most useful when
compared to similar companies, the company's
own history, or average ratios for the company's
industry.
Gross profit margin is one of the most widely
used profitability or margin ratios. Gross profit
is the difference between revenue and the costs
of production—called cost of goods sold
(COGS).
Some industries experience seasonality in their
operations. For example, retailers typically
experience significantly higher revenues and
earnings during the year-end holiday season. pretax margin shows a company's profitability
Thus, it would not be useful to compare a after further accounting for non-operating
retailer's fourth-quarter gross profit margin expenses. The net profit margin is a company's
with its first-quarter gross profit margin ability to generate earnings after all expenses
because they are not directly comparable. and taxes.
Comparing a retailer's fourth-quarter profit
margin with its fourth-quarter profit margin
from the previous year would be far more
informative.

EXAMPLES OF PROFITABILITY RATIOS

Profitability ratios are one of the most popular

metrics used in financial analysis, and they
generally fall into two categories—margin ratios
and return ratios

Margin Ratios
give insight, from several different angles, on a - Return on Assets (ROA)
company's ability to turn sales into a profit. Profitability is assessed relative to costs and
Return ratios offer several different ways to expenses and analyzed in comparison to assets
examine how well a company generates a return to see how effective a company is deploying
for its shareholders. assets to generate sales and profits. The use of
Some common examples of profitability ratios the term "return" in the ROA measure
are the various measures of profit margin, customarily refers to net profit or net
return on assets (ROA), and return on equity income—the value of earnings from sales after
(ROE). all costs, expenses, and taxes. ROA is net
income divided by total assets
- Profit Margin
Different profit margins are used to measure a
company's profitability at various cost levels of
inquiry, including gross margin, operating
margin, pretax margin, and net profit margin.
The margins shrink as layers of additional costs
are taken into consideration—such as the
COGS, operating expenses, and taxes.

Gross margin measures how much a company

makes after accounting for COGS. Operating
margin is the percentage of sales left after
covering COGS and operating expenses. The
The more assets a company has amassed, the
more sales and potential profits the company
may generate. As economies of scale help lower
costs and improve margins, returns may grow at
a faster rate than assets, ultimately increasing
ROA.
- Return on Equity (ROE)
ROE is a key ratio for shareholders as it
measures a company's ability to earn a return
on its equity investments. ROE, calculated as net
income divided by shareholders' equity, may
increase without additional equity investments.
The ratio can rise due to higher net income
being generated from a larger asset base funded
with debt.
Profitability ratios assess a company's ability to
earn profits from its sales or operations, balance
sheet assets, or shareholders' equity. It also
indicates how efficiently a company generates
profit and value for shareholders.
Higher ratio results are often more favorable,
but these ratios provide much more information
when compared to results of similar companies,
the company's own historical performance, or
the industry average.
Module 9: LIQUIDITY RATIO
Financial statements provide valuable
information for different stakeholders. Financial
ratios serve as a strong tool to measure the
different aspects of the business and how it
performs with the rest of businesses within the
industry.
Liquidity Ratio
- Liquidity ratios are an important class of
financial metrics used to determine a
debtor's ability to pay off current debt
obligations without raising external
capital. Liquidity ratios measure a
company's ability to pay debt obligations
and its margin of safety through the
calculation of metrics including the
current ratio, quick ratio, and operating
cash flow ratio.
- With liquidity ratios, current liabilities
are most often analyzed in relation to
liquid assets to evaluate the ability to
cover short-term debts and obligations in
case of an emergency.
UNDERSTANDING LIQUIDITY RATIOS
Liquidity is the ability to convert assets into
cash quickly and cheaply. Liquidity ratios are
most useful when they are used in comparative
form. This analysis may be internal or external.
For example, internal analysis regarding
liquidity ratios involves using multiple
accounting periods that are reported using the
same accounting methods. Comparing previous
periods to current operations allows analysts to
track changes in the business. In general, a
higher liquidity ratio shows a company is more
liquid and has better coverage of outstanding
debts.
Alternatively, external analysis involves
comparing the liquidity ratios of one company
to another or an entire industry. This
information is useful to compare the company's
strategic positioning in relation to its
competitors when establishing benchmark
goals. Liquidity ratio analysis may not be as
effective when looking across industries as
various businesses require different financing
structures. Liquidity ratio analysis is less
effective for comparing businesses of different
sizes in different geographical locations.

- Current Ratio
The current ratio measures a company's ability
to pay off its current liabilities (payable within
one year) with its total current assets such as
cash, accounts receivable, and inventories. The
higher the ratio, the better the company's
liquidity position

Liquidity ratios are an important class of

financial metrics used to determine a debtor's
ability to pay off current debt obligations
without raising external capital. Common
liquidity ratios include the quick ratio, current
ratio, and days sales outstanding. Liquidity
- Quick Ratio
The quick ratio measures a company's ability to ratios determine a company's ability to cover
meet its short-term obligations with its most short-term obligations and cash flows, while
liquid assets and therefore excludes inventories solvency ratios are concerned with a
from its current assets. It is also known as the longer-term ability to pay ongoing debts.
"acid-test ratio":
 Module 10: SOLVENCY RATIOS
Financial statements provide valuable
information for different stakeholders. Financial
ratios serve as a strong tool to measure the
different aspects of the business and how it
performs with the rest of businesses within the
industry
Solvency Ratio
- A solvency ratio is a key metric used to
measure an enterprise’s ability to meet
its long-term debt obligations and is used
often by prospective business lenders. A
solvency ratio indicates whether
company’s cash flow is sufficient to meet
its long-term liabilities and thus is a
measure of its financial health. An
unfavorable ratio can indicate some
likelihood that a company will default on
its debt obligations.
- The main solvency ratios are the
debt-to-assets ratio, the interest coverage
ratio, the equity ratio, and the
debt-to-equity (D/E) ratio. These
measures may be compared with
liquidity ratios, which consider a firm's
ability to meet short-term obligations
rather than medium- to long-term ones.
UNDERSTANDING SOLVENCY RATIOS
A solvency ratio is one of many metrics used to
determine whether a company can stay solvent
in the long term.
A solvency ratio is a comprehensive measure of
solvency, as it measures a firm's actual cash
flow, rather than net income, by adding back
depreciation and other non-cash expenses to
assess a company’s capacity to stay afloat.
It measures this cash flow capacity in relation to
all liabilities, rather than only short-term debt.
This way, a solvency ratio assesses a company's
long-term health by evaluating its repayment
ability for its long-term debt and the interest on
that debt.
Solvency ratios vary from industry to industry.
A company’s solvency ratio should, therefore, be
compared with its competitors in the same
industry rather than viewed in isolation.
A solvency ratio terminology is also used when
evaluating insurance companies, comparing the
a
size of its capital relative to the premiums
written, and measures the risk an insurer faces
on claims it cannot cover.
TYPES OF SOLVENCY RATIOS
- Interest Coverage Ratio
The interest coverage ratio is calculated as
follows:
where:
EBIT=Earnings before interest and taxes
The interest coverage ratio measures how many
times a company can cover its current interest
payments with its available earnings. In other
words, it measures the margin of safety a
company has for paying interest on its debt
during a given period.
The higher the ratio, the better. If the ratio falls
to 1.5 or below, it may indicate that a company
will have difficulty meeting the interest on its
debts
- Debt-to-Assets Ratio
The debt-to-assets ratio is calculated as follows:

- Equity Ratio
The shareholder equity ratio is calculated as
The debt-to-assets ratio measures a company's
follows
total debt to its total assets. It measures a
company's leverage and indicates how much of
the company is funded by debt versus assets,
and therefore, its ability to pay off its debt with
its available assets.

A higher ratio, especially above 1.0, indicates

that a company is significantly funded by debt
and may have difficulty meetings its obligations.
The equity ratio, or equity-to-assets, shows how
much of a company is funded by equity as
opposed to debt. The higher the number, the
healthier a company is. The lower the number,
the more debt a company has on its books
relative to equity.
- Debt-To-Equity (D/E) Ratio
The debt-to-equity (D/E) ratio is calculated as
follows:
The D/E ratio is similar to the debt-to-assets
ratio, in that it indicates how a company is
funded, in this case, by debt. The higher the
ratio, the more debt a company has on its books,
meaning the likelihood of default is higher. The
ratio looks at how much of the debt can be
covered by equity if the company needed to
liquidate.
● A solvency ratio examines a firm's ability
to meet its long-term debts and
obligations. The main solvency ratios
include the debt-to-assets ratio, the
interest coverage ratio, the equity ratio,
and the debt-to-equity (D/E) ratio.
Solvency ratios are often used by
prospective lenders when evaluating a
company's creditworthiness as well as by
potential bond investors. Solvency ratios
and liquidity ratios both measure a
company's financial health, but solvency
ratios have a longer-term outlook than
liquidity ratios.
Module 11: EFFICIENCY RATIOS
Financial statements provide valuable
information for different stakeholders. Financial
ratios serve as a strong tool to measure the
different aspects of the business and how it
performs with the rest of businesses within the
industry.
Efficiency Ratios
- Efficiency Ratios are a measure of how
well a company is managing its routine
affairs. Conceptually, these ratios analyze
how well a company utilizes its assets &
how well it manages its liabilities.
TYPES OF EFFICIENCY RATIOS
1. ACCOUNTS RECEIVABLE TURNOVER
This ratio measures how quickly a company
collects bills from its customers. It is an
indicator of how efficient a company’s credit
policies are & indicates the level of investment
in receivables needed to maintain the firm’s
sales level. The formula of accounts receivable
turnover is:
Formula:
Accounts Receivables Turnover =
Revenue/Average Accounts Receivable
Interpretation
Higher accounts receivable turnover is better for
any company. If for any company the accounts
receivable turnover is too low, it indicates that a
company is having difficulty in collecting from
its customers or it is being too generous with
granting credit.
AVERAGE NO. OF DAYS RECEIVABLES
OUTSTANDING
We can go one step further and calculate the
average number of days of receivables
outstanding.
The formula is:
Average No. of Days Receivables Outstanding =
365/Accounts Receivables Turnover
The result will indicate on average in how many
days a company is collecting its bills.
2. INVENTORY TURNOVER
Inventory turnover ratio measures how
efficiently a company manages its inventory.
Formula
Inventory Turnover = Cost of Goods
Sold/Average Inventory
Interpretation
A lower inventory turnover ratio indicates that a
company is not managing its inventory well. It
may be overstocking, or it might have an issue
with sales. A higher inventory turnover ratio is
always better because it indicates that inventory
does not remain on shelves but rather turns over
rapidly.
AVERAGE NO. OF DAYS INVENTORY IN
STOCK
We can further calculate the average number of
days inventory in stock as follows:
Average No. of Days Inventory in Stock =
365/Inventory Turnover
The result will indicate on average how many
days a company’s inventory is held until it is
sold.
3. ACCOUNTS PAYABLES TURNOVER
Although accounts payable are liabilities rather
than assets, their trend is important as they
represent an important source of finance for
operating activities, thereby affecting operating
efficiency. This ratio is important because it
measures how a company manages its own bills.
Formula
Accounts Payables Turnover = Total
Purchases/Average Accounts Payables
Interpretation
A high accounts payable turnover ratio indicates
that the firm is not managing its bills very well,
maybe it is not getting favorable credit terms
from its suppliers. A low accounts payable
turnover is better.
AVERAGE NO. OF DAYS PAYABLE
OUTSTANDING
We can further calculate the average number of
days payable outstanding as follows:
Average No. of Days Payable Outstanding =
365/Accounts Payables Turnover
The result will indicate the average number of
days in which a company pays its suppliers.
4. TOTAL ASSET TURNOVER
This ratio provides a measure of overall
investment efficiency by totaling the joint
impact of both short-term and long-term assets.
Formula
Total Assets Turnover = Sales/Average Total
Assets
Interpretation
Like fixed asset turnover ratio, total asset
turnover ratio is also affected by similar factors.
All else equal, a higher asset turnover is better as
it indicates how effectively the entire funds
(Assets=Capital + Liabilities) of a company is
used. It is a holistic measure of a company’s
equity.

● Turnover ratios (also known as efficiency

ratios) are an important class of ratios.
These ratios are not only used by
financial personnel but also by the
people in charge of operations. However,
we are going to consider these ratios
from the point of view of outside
investors. This is because judgments
must be made about the efficiency of the
firm based on limited information at
hand.