Financial Analysis

LECTURE 6-7
Financial Ratios and Interpretation
In the previous session, we talked about common size financial statements, comparative financial
statements, and the differences between the two.
In this lecture, we will talk about various financial ratios and their interpretation.

Types of Financial Ratios

1. Liquidity Ratios:
Liquidity ratios are calculated to assess a company's short-term solvency, or its capacity to pay its
current obligations. The current ratio and quick ratio are the two ratios that fall under this category.

Current Ratio: The ratio of current assets to current liabilities is known as the current ratio
Current ratio = Current Assets/Current Liabilities.

Quick Ratio: It is the proportion of quick (or liquid) assets to current liabilities.
Quick ratio = Quick Assets/ Current Liabilities

The term "quick assets" refers to assets that can be quickly converted into cash. We do not include
end-of-period inventories when calculating quick assets, nor do we include other current assets like
prepaid expenses, advance tax, etc.

2. Profitability Ratios:
These ratios are calculated to analyze the earning potential of the business. They demonstrate how
well a business uses its resources to generate profit and shareholder value.
A higher ratio indicates that the business is performing well by generating revenues, profits, and
cash flow.

The major profitability ratios are :

Gross Margin Ratio: This represents the ratio of gross profit to net sales and is expressed as a
percentage.
Gross Profit Ratio = Gross Profit ÷ Net Revenue of Operations × 100

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Return on Assets Ratio: Return on Assets (ROA) gauges a company's profitability with respect to its
total assets
Return on Assets= Profit after Tax ÷ Total Assets

Return on Equity Ratio: Return on equity (ROE) is obtained by dividing Profit after tax by
shareholders' equity
Return on Equity= Profit after Tax ÷ Shareholders’ Equity * 100

3. Solvency Ratios:
Solvency ratios are calculated to assess a company's long-term ability to pay off its debt. The
following ratios are typically calculated to assess a company's solvency.

Debt-Equity Ratio: The relationship between long-term debt and equity is gauged by the debt-
equity ratio. Outsiders feel more secure if the debt component of the total long-term funds
employed is low. From a security perspective, a capital structure with more equity and less debt is
preferred because it lowers the risk of bankruptcy.

Typically, a debt-equity ratio of 2:1 is regarded as safe

Debt- equity = Long-term debt/ shareholders fund

Debt Ratio: It compares the total debts with respect to the total assets of a business.
Debt Ratio = Total Debt / Total Assets

Interest Coverage Ratio: Interest Coverage Ratio measures how easily the company can pay off its
interest expenses
Interest coverage ratio = Operating income / Interest expenses

Or, Earnings before Interest and taxes / Interest expenses

Altman Z-Score: https://www.investopedia.com/terms/a/altman.asp

Significance of Financial Ratios

Financial ratios are crucial tools for analyzing a company's financial health and performance. They
provide valuable insights into various aspects of a company's operations, helping stakeholders make
informed decisions.
The significance of financial ratios lies in their ability to assess and interpret key financial
information in a standardized and comparable manner. These help you in:

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§ Performance Evaluation: Financial ratios help assess a company's overall performance and
profitability. Ratios such as Return on Assets (ROA) and Return on Equity (ROE) measure how
efficiently a company utilizes its assets and equity to generate profits. These ratios are
essential for investors and analysts to gauge the effectiveness of management in delivering
returns.

§ Liquidity and Solvency: Ratios like the current ratio and quick ratio provide insights into a
company's liquidity, indicating its ability to meet short-term obligations. Solvency ratios, such
as the debt-to-equity ratio, assess a company's long-term financial stability by evaluating its
debt levels relative to equity. These ratios are crucial for creditors and investors evaluating the
risk associated with the company.

§ Efficiency and Operating Performance: Efficiency ratios, such as inventory turnover and
receivables turnover, measure how effectively a company manages its assets. These ratios are
essential for evaluating the efficiency of inventory management and the speed at which the
company collects cash from its receivables. Higher turnover ratios generally indicate better
efficiency.

§ Decision Making: Investors and Management use financial ratios to make informed investment
decisions.

§ Communication with Stakeholders: Financial ratios serve as a means of communication

between a company and its stakeholders. Whether it's shareholders, creditors, or potential
investors, ratios provide a standardized language for conveying financial information. Clear and
transparent communication is essential for building trust and confidence.

§ Risk Assessment: Financial ratios are crucial for assessing various types of risks associated
with an investment or business operation. For example, the debt coverage ratio helps evaluate a
company's ability to cover interest payments, providing insights into its risk of financial distress.

§ Forecasting and Planning: Ratios play a significant role in financial forecasting and planning.
By analyzing historical ratios, companies can identify trends and make more accurate
predictions about future performance. This assists in setting realistic financial goals and
making informed business decisions.

References:
§ Bloomenthal, A. (2023, March 17). Financial Ratio Analysis: Definition, types, examples, and how to use. Investopedia.
https://www.investopedia.com/terms/r/ratioanalysis.asp
§ Team, C. (2023b, November 29). Financial ratios. Corporate Finance Institute.
https://corporatefinanceinstitute.com/resources/accounting/financial-ratios/
§ 4 types of financial ratios to assess your business performance. (2023, October 19). BDC.ca.
https://www.bdc.ca/en/articles-tools/money-finance/manage-finances/financial-ratios-4-ways-assess-business
§ Wilkins, G. (2023, October 13). 6 Basic financial ratios and what they reveal. Investopedia.
https://www.investopedia.com/financial-edge/0910/6-basic-financial-ratios-and-what-they-tell-you.aspx
§ Datarails. (2023, August 23). 5 key Financial Ratios and How to use them. Datarails. https://www.datarails.com/5-
key-financial-ratios/