FINANCIAL RATIO ANALYSIS

 FINANCIAL RATIOS SUMMARIZE A

COMPANY’S FIANCIAL STATUS AND

PERFORMANCE.
 DIFFERENT USERS OF FINANCIAL

STATEMENTS USE FINANCIAL RATIO

TO HIGHLIGHTS ASPECTS OF

COMPANY’S FINANCIAL RESULTS OF

OBJECTIVES OF FINANCIAL
RATIO ANALYSIS

 To determine whether the company has improved its

financial status and performance compared to

preceding time period

 To assess the competitive position of the

company relative to similar companies in

the same industry

 To understand industry wide factors that

affect the performance of companies in

the same industry.

 To use insights derived from financial

ratio analysis in forecasting the future

performance of the company.

Financial Ratios: Concepts and
Techniques

 Profitability Ratio – show a company’s operating

efficiency and over all returns on asset and capital

 Turnover or Asset-utilization Ratios –

indicate efficiency in the use of assets to

generate revenues
 Liquidity Ratios – reveal the capacity of a

company to meet short-term obligations

 Leverage or Long-term Solvency Ratios

– reflect a company’s dependence on

borrowings and its ability to meet debt-

service requirements.
Profitability Ratios

 Are relationships between income and

sales or investments. These ratios
provide a basis for determining the ability
of the company to (a) to be efficient by
generating income from every peso of
sales revenue; and (b) to reward
shareholders with profits and dividends
Margin Ratios

 Gross Profit Margin Ratio- it reflects the

company’s ability to recover its
manufactured or purchased cost of
merchandise from revenues

Gross Profit Margin = S-CS or CoGS

Sales
Net Profit Margin Ratio

 Is a bottom-line ratio indicating the

company’s ability to generate income for
its shareholders. It is also called the
“yield on sales” or the productivity of
sales effort.
Net Profit Margin = Net Income
Sales
Net Profit Margin Ratio

Can increase if:

 Sales increase
 Variable cost of goods is reduced
 Cost of administration is reduced
 Financing costs is reduced
Operating costs relate to business activities.
Financing costs result from a company’s use
of debt to finance the business
Return-on-Investments (ROI)

 It is a simple yet powerful tool for

evaluating the overall efficiency of a
company
 The appeal of ROI is in the way it
combines the two “bottom- line”
measures: net income and net worth or,
alternatively, total assets from the
balance sheet
Alternatives used in ROI

 Measures of Investments, like total

assets, operating assets and net
physical assets

 Measures of Income, for example,

operating income and income before
financial charges
Return on Assets Ratio (ROA)
 Measures efficiency in the employment of
assets. Assets generate income. Either
shareholders or creditors finance these assets.
In contrast, ROE assumes that income is a
measure of residual benefits to owners.
ROA = Net Income/Total Assets
Operating ROA = Operating Income
Total operating assets
Return on Stockholder’s Equity
(ROE)
 Shows the earnings of stockholders for
a given period as a ratio of their
investment. The SHE represents
investments committed by owners in the
business
ROE = Net Income/SHE
Turnover Ratios or “Activity” Ratios

Are indicators of the capacity of a company’s assets to

generate sales. Turnover ratio relates sales to

investment in assets. This is optimized by balancing

two conflicting objectives:

 Minimization of idle investment in assets.
The strategy to “stock the shelves” with
inventory may result in idle assets. A
liberal customer credit may result in a
large amount of slow moving accounts.
 Maximization of sales potential of the
business. A certain level of inventory is
required to avoid lost sales. Customers
also expect a company to offer
competitive credit terms.
Total Asset Turnover

Reflects efficiency in asset utilization.

Sales are taken as a ratio of total assets.
Total asset turnover depends on:
 Whether assets are directly used in
operations
 The responsiveness of sales to
additional investments in assets
Total Assts TO = Sales/ Total Assets
TO of Operating and Leased Assets

Leased fixed assets contribute to sales and

should be included in operating and total
assets in turnover ratios. Under accounting
procedures, leased assets are assets when
the lease satisfies conditions for a capital
lease, that is there is a transfer of effective
ownership to the lessee.
TO of Operating = Sales_____
& Leased Assets operating and leased
assets
Fixed Asset TO

Shows the efficiency of fixed assets in

generating sales. A high turnover
implies intensive use of production
capacity. A low fixed assets turnover
indicates underutilized fixed assets
Fixed Asset TO = Sales/Fixed Assets
Operating FA TO = Sales/Fixed Assets
Accounts Receivable TO

Relates credit sales to accounts receivable. It indicates the

productivity of accounts receivable in terms of revenue

generation and the efficiency of the credit and collection

department. A company trades off investments in account

receivable and profitability in the following ways:

 High TO reflects the efficiency of a
company’s credit and collection
department. Sales are supported by a
low investment in accounts. However,
accounts receivable turnover that is too
high may suggest that sales opportunities
are being lost due to strict credit and
collection terms.
 Lower turnover means that a company
has lowered its credit standards to
improve revenues. It might accumulate
receivable and sustain higher bad debts.
Low turnover may also reflect the
company’s weak competitive position.
A/R TO cont.

In evaluating the ability of a company to balance this tradeoff, analysis

should focus on factors beyond the control of management. These are:

environment, trade and industry conditions as follows:

 Trade Terms. A company’s sales invoice
terms should be compared with A/R TO.
If TO exceeds the credit period, it shows
that the company does not strictly
enforce its credit terms. This may be a
prevailing practice among companies.
 Industry and competitors. Where there
is an industry wide credit term on offer, a
company will find it necessary to match
the term of its competition.
 Trade cycles. Seasonal sales cycles in
the industry influence a company’s level
of A/R. During peak sales, A/R are at
high levels. During slow sales,
collections of receivables exceed new
sales, resulting in a higher turnover.
 This suggests that, for highly seasonal
products, the A/R TO should be
calculated separately at various stages
in the seasonal cycle.
A/R TO = Credit Sales/A/R
Day’s Receivable = 360 days/A/R TO
---Average collection period
Inventory Turnover
It is the ratio of cost of goods sold to average
inventory. A company tries to strike a balance
between two inventory policies:
 Keep inventory levels high to assure sales.
However, the company may be left with unsold
inventory, a greater risk of obsolescence, and
high costs.
 Produce or stock up according to customer’s
orders to minimize inventory. However, the
company may face stockouts
Inventory TO

Could not be entirely explained by management policy due to the following

external factors:

 Type of business. A trading company keeps an inventory of finished

goods. Its inventory TO is closely linked with its purchasing and sales
efforts. A manufacturing company has a diverse inventory because of
many factors ranging from supply conditions of raw materials to
production requirements.
 Nature of the products. The level of
inventory can be limited by product
characteristics such as perishability,
stability in market price, stocking costs
and production time
 Industry and competitive practice. A
company may be responding to
competition and industry practice.
Supply conditions in the industry can
also determine inventory levels
 Trade cycles. Seasonality in sales
influence inventory levels. When trade
cycles are present, it is better to
calculate inventory TO for different
period in the cycle: 1 for the peak
season and 1 for slack season
Inventory TO cont.
 Economic and trade conditions. Restrictions in foreign exchange and
trade encourage companies to stock up on materials to be assure of
continuing production at the expense of low inventory turnover.

Inventory = cost of goods sold

Turnover inventory

Days’ Inventory = 360 days

Inventory TO ---- average
inventory replacement
period
Days Accounts Payable
 Measures the credit period taken by a company.
When considered in relation to the suppliers’
credit terms, it shows the policy of management
with respect to paying its suppliers
Days’ A/P = Accounts payable
credit purchases/day
Credit purchase= annual credit
purchases/360
Interpretation of days payable

 When days’ payable lengthens, it could be due to (a)

liquidity problems, (b) suppliers allowing the company
to extend payment beyond the term, and (c) a
preference to have the inventory financed by suppliers
rather than by banks
 When days’ payable shortens, it could
be due to (a) cash discounts being
taken, (b) a preference for financing of
inventory by internal bank sources rather
than by supplier credit, and (c ) poor
credit standing with suppliers who are
compelled to require immediate payment
Liquidity Ratio

 Indicates the availability of current assets to

meet current obligations

Current Ratio = Current assets

current liabilities
 Current ratio is a measure of the relative
quantity, not quality of assets and
liabilities. To know quality, one should
analyze the composition of current asset
and of the maturities of current liabilities
Quick Ratio

 Measures the firm’s capacity to cover its

short term obligations using only its more
liquid assets.
 It measures the safety margin for
payment of current debt if there is
shrinkage in the value of cash and
receivable, and if inventory could not be
sold immediately
Quick Ratio cont

 Measures the ability of a company’s most liquid

assets to meet the short term requirements of
creditors, shows the relative importance of inventory in
the overall liquidity position. Inventories are the lease
liquid of a company’s current assets. Should there be
a forced liquidation of these inventories, losses will still
be substantial
 It should be interpreted together with the
current ratio. The combination of a high
current ratio and low quick ratio means
that – (a) inventory is a substantial part
of the company’s liquidity position, and
(b) inventory is not liquid and has a low
turnover.
Leverage Ratios
 Measures the relative level of debts and
the capacity of the company to service
debts
 They are useful indicators of (a) the
relative share of creditors compared to
owners in a company (b) the risk of
bankruptcy due to possible creditor
action against the company, and (c) the
debt capacity of a company
Total Debt to Asset Ratio (DTA)
 It is the proportion of total liabilities to total assets. It
shows the percentage of assets financed by creditors

 If DTA ratio is low, the owners are at greater financial

risk than creditors. In this case, owners have more
investments to conserve against losses through bad
decisions. Creditors are protected against losses

 If DTA ratio is high, creditors are at greater financial

risk than owners. External funding sources must be
paid regardless of financial performance
DTA Ratio = total debt/total assets
Debt-to-Equity Ratio
 It is the ratio of long term debt to total equity

 It measures leverage, which is the use of long-

term debt to finance a company’s
requirements
 It affords a good comparison of the financial
commitment of creditors relative to the owners
of the business
Debt to equity ratio = long term debt/equity
Ownership Ratios

 Are indicators of the value of the company to

its stockholders in terms of dividends, income

and book value

 For public companies, ownership ratios

help relate corporate performance with

the market price of the company’s

shares
Ownership ratios for privately held

companies include earnings per share,

dividends per share and dividends

payout
Earnings Per Share (EPS)

 It represents the amount of net income

accruing to each share of common stock.
 If there are preferred stocks, the total
amount of dividend accruing to preferred
shareholders is deducted from net income.
EPS = Net income to common
No. of shares outstanding
Cash Dividend Per Share
 Is the amount of cash dividends declared and
payable to each share of stock
 For preferred stocks, there is a stipulated
amount of dividends that must be paid by a
company
 For common stocks, cash dividend is paid out
based on the decision of the board of directors
Dividend = cash div. declared for common
/Share no. of common share o/standing
Book Value Per Share
 Is the SHE per share of common stock
 If there are preferred share, the value
stipulated to be paid to preferred shareholders
at liquidation of the company is deducted from
the SHE to determine the book value of
common share
Book Value = total stockholder’s equity
Per Share no.of common shares
outstanding
Price Earnings Ratio (P/E) ratio

 Measures the amount that investors are willing to pay for each

share of company’s common stock per peso of earnings

 If P/E ratio is high, investors would be willing to purchase shares

at a high multiple of earnings. The market gives a premium on a

company’s earnings if investors perceive growth and stability in

future earnings
 If P/E ratio is low, investors would be
willing to pay a high premium for the
company’s earnings. Shares of a
company with poor growth potential or
whose earnings have been unstable
have low p/e

Price Earnings = market price/share sales

Ratio earnings per share
Overall Financial Performance Ratio
(Du Pont)
 First used by the chemical company Du
Pont Corporation, the Du Pont
decomposition of ROE analyzes return
on equity in terms of its three
components: profit margin, total asset
turnover and leverage
ROE = NI X Sales X total assets
sales total assets equity
Standards in Ratio Analysis

 Previous year’s performance is a readily available standard with

which to compare current operations. Such comparison over time

will show cyclical growth patters. It should be interpreted in light

of changes in the economy and the industry

 Industry Performance is a useful
yardstick for assessing a company’s
performance. Industry averages are
developed by taking an average of the
financial ratios of companies in the
industry. A company’s performance is
then analyzed in the context of industry
conditions.
 Limitations in the use are:

(1) it is difficult to define an “industry”

because many companies manufacture
products in several industries;
(2) the industry average may not be

representative of an industry’s

performance because industries may be

dominated by a few companies;

(3) an industry average cannot be
developed without access to financial
reports of all companies in the industry.
These limitations can be addressed by
using the performance of competitors as
a standard.
 Competitor’s performance ratios may be used as

basis for comparison. Companies whose products

and operations are comparable with those of the

company are considered in the analysis

 Company’s budgeted performance can
also be used as basis for ratio analysis.
A budget is an appropriate standard for
analysis because it incorporates industry
and competitive conditions, management
strategies, and past experience. If a
company’s budgeted performance is not
known, an analyst can make his own
forecast.
 Nominal standards can be used for ratio analysis. For

example, rates of return can be compared with market

rates for comparable investments. The government sets-

up lending programs with mandatory requirements on

performance such as the maximum debt-to-equity ratio.

 Basic Principle: Financial strengths and
weaknesses are revealed by comparing
the actual ratios of the company with
such standards as prior year’s budgeted
performance, industry average,
institutional norms, and competitors,
each of which has its merits.
Guidelines in the Use of Financial
Ratios

 Use financial ratios to form an integrated

picture

 Focus on deviations and analyze casual

factors
 Relate ratios to the status of the

competition and the industry

 Look for trends

 Recognize the effects of seasonal

factors

 Be aware of possible “window dressing”

of financial statement