Financial Ratios

v
What is Financial Ratios?
It provide a second method for
standardizing the financial
information on the income statement
and balance sheet.
LIQUIDITY RATIOS

 A firm is financially liquid if it able to pay its bills on

time. We can analyze a firm’s liquidity from two
perspective:

1 Overall liquidity

Liquidity of Specific assets

2
1
CURRENT RATIO
 It assess the organization’s overall liquidity and indicates a
company’s ability to meet its short-term obligations.

 It expressed:

As a PROPORTION- current liabilities

1
are expressed as 1 and current assets
are expressed as whatever
proportionate figure they come.

2 As a NUMBER

3 As a PERCENTAGE

 Current Assets- refers to assets that are in

form of cash or that are easily convertible to
cash within 1 year.
 Current Liabilities- refers to liabilities that
are due and Payable with 12 months.
 amp le
Ex
 QUICK RATIO
 It compares the organization’s most liquid Example:
current assets to its current liabilities.

 The higher the ratio result, the better a

company's liquidity and financial health; the
lower the ratio, the more likely the company will
struggle with paying debts.
3
 A result of 1 is considered to be the normal quick
ratio. It indicates that the company is fully
equipped with exactly enough assets to be
instantly liquidated to pay off its current
liabilities. A company that has a quick ratio of
less than 1 may not be able to fully pay off its
current liabilities in the short term, while a
company having a quick ratio higher than 1 can
instantly get rid of its current liabilities. For
instance, a quick ratio of 1.5 indicates that a
company has P1.50 of liquid assets available to
cover each P1 of its current liabilities.
 Example:
Cash Ratio Company A’s balance sheet lists the
following items:
•Cash: P10,000
-The cash ratio ascertains the liquidity of your •Cash equivalents: P20,000
•Accounts receivable: P5,000
business if you meet your short-term obligations •Inventory: P30,000
by using only cash and cash equivalents and no •Property & equipment: P50,000
other current assets. •Accounts payable: P12,000
•Short-term debt: P10,000
•Long-term debt: P20,000
-A cash ratio is expressed as a numeral, greater The ratio for Company A would be
calculated as follows:
or less than 1. Upon calculating the ratio, if the
result is equal to 1, the company has exactly the
same amount of current liabilities as it does
cash and cash equivalents to pay off those
debts.

Formula:
Calculations Less Than 1
If a company's cash ratio is less than 1, there are more current liabilities than cash and cash
equivalents. It means insufficient cash on hand exists to pay off short-term debt.
Calculations Greater Than 1
If a company's cash ratio is greater than 1, the company has more cash and cash
equivalents than current liabilities. In this situation, the company has the ability to cover all
short-term debt and still have cash remaining.

Operating Cash Flow Ratio
-This ratio is used to understand how liquid are your
operations to cover the near-term obligations. It uses
the cash generated from the operating activities to
understand whether it is sufficient to meet the
obligations occurring during the next 12 months.
Formula:
Is Operating Cash Flow the Same as EBIT?
EBIT is a financial term meaning
earnings before interest and taxes, sometimes
referred to as operating income. This is different
from operating cash flow (OCF), the cash flow
generated from the company's normal business
operations. The main difference is that OCF also
accounts for interest and taxes as part of a
company's normal business operations.
Examples of items included in the
presentation of the direct method of
operating cash flow include:
•Salaries paid out to employees
•Cash paid to vendors and suppliers
•Cash collected from customers
•Interest income and dividends
received
•Income tax paid and interest paid
Example:
A company has a CFO of 150,000 and current liabilities of
120,000 at the end of the second quarter. If you divide the
company's CFO by its liabilities, its operating cash flow ratio
is 1.25. This means the company makes 1.25 from its
operating activities per dollar of its current liabilities. It also
means the company can cover its current liabilities 1.25
times.
 AVERAGE COLLECTION PERIOD
 It measures the number of days it takes the firm
to collect its receivables.

Formulas:
ACP Example

1. A company has accounts receivable balance for the

year of P 10,000. The total net sales that the company
recorded during this period was P 100,000. Calculate
the ACP of the company.

* If a company collect with 30 days

collecting its receivables, in a
=( 10,000/100,000)*365 relatively short and reasonable
period of time gives the company
time to pay in obligation, it means,
=36.5 days Company was delayed of 6.5 days in
collecting the receivables.
Accounts Receivable Turnover

-it measures how many time receivable are

“rolled over” during a year.

Example:

A company had the following financial results for the year: Net Credit
Sales of P 800,000, P 64,000 in A/R for January 1(BEG.) and P 72, 000 for
Dec 31 (ENDING). Calculate the ART.

=800,000/68,000

=11.76 times
 Inventory Turnover Ration
- It measure how many times the company turns over its inventory during the year.

- Shorter inventory cycles leads to greater liquidity since the items in inventory are converted to cash more
quickly.

Example:

For the fiscal year 2022, Walmart reported cost of sales of P 429 billion and year end inventory of P 56.5 billion
from 44.9 billion a year earlier. Calculate the ITR.

* The Walmart turned over

=429 billion/56.5 billion + 44.9 its inventory 8.46 per year.
billion
=429 billion/50.7 billion
=8.46 times
Day’s Sales in Inventory
- It indicates the average in days that a company
takes to turn its inventory.

Example:
See the example of ITR.

= 365/8.46
=43.14 days or 43 days
* This showed that Walmart turned over its inventory every 43 days
on average during the year.
 Debt Ratio

- A debt ratio measures the amount of leverage

used by a company in terms of total debt to total
assets.

Example:
Starbucks listed P1.92 million in short-term and current
portion of long-term debt on its balance sheet for the
fiscal year ended Oct. 2, 2022, and P13.1 billion in long-
term debt. The company's total assets were P28 billion.
Calculate the DR.

=15.02 billion/28 billion

=0.54 or 54%
Debt to Equity Ratio

-is used to evaluate a company’s financial leverage and

is calculated by dividing a company’s total liabilities
by its shareholder equity.
Total Debt-to-Total Assets Ratio

 Total Assets to Debt Ratio is the ratio, Formula:

through which the total assets of a
company are expressed in relation to its
long-term debts.

 Total debt-to-total assets is a measure of the

company's assets that are financed by debt
rather than equity.
Example:
If a company has $100,000 in total assets with
$40,000 in long-term debt, its long-term debt-to-total-assets
ratio is $40,000/$100,000 = 0.4, or 40%. This ratio indicates
that the company has 40 cents of long-term debt for each
dollar it has in assets.
Interest Coverage
-The interest coverage ratio indicates the margin of safety for a
specific period. It is the number of times a company can pay interest
on its debts with its current earnings. It would help if you had a high
ratio of 1.5 or more to ensure that the company will have no issues
paying interest on their debts.

Formula:

Example: Assume ABC Company has 10,000 in annual interest expense. If its
operating income is 120,000, it has an interest coverage ratio of 12x. This is a positive
sign that the company will have no problems covering its interest expenses with its
operating income.
Interest Coverage Ratio = 120,000 / 10,000 = 12
Where:
•120,000 = Operating Income
•10,000 = Interest Expense

Debt-Service
-The DSCR shows the financial stamina in closing its debts
on time, and a high ratio indicates that it will not default in
such payments. It means the business has earned sufficient
income to cover the debt obligations that are due within 12
months.
Debt service refers to the amount of cash that’s needed to
repay the principal and interest on a debt. The amount is
for a specific period of time.
-Where the net operating income is derived by deducting
certain operating expenses from the operating revenue of
the business, the current liabilities will also include the
current portion of the long-term debt (e,.g., interest
payable for a long-term loan within 12 months).
Formula:
Example:
ABC Manufacturing makes furniture and that it
sells one of its warehouses for a gain. The profit it
receives from the warehouse sale is
nonoperating income because the transaction is
unusual.
If ABC’s furniture sales produced annual net
operating income totaling $10 million, then that
number would be used in the debt service
calculation. So if ABC’s principal and interest
payments for the year total $2 million, its debt-
service coverage ratio would be 5 ($10 million in
income divided by $2 million in debt service).
Because of that relatively high ratio, ABC is in a
good position to take on more debt if it wishes to
do so.
*Generally speaking, the higher, the better. But
business lenders will usually want to see a ratio
of at least 1.25.
A debt-service ratio of 1, for example, means
that a company is devoting all of its available
income to paying off debt—a precarious position
that would likely make further borrowing
 Time Interest Earned
- Measure the ability of the firm to service its
debt or repay the interest on debt.

Formula:

*A good TIE ratio is at least 2 or 3, especially in economic times when EBIT can fall due to revenue drops
and cost inflation effects, and interest expense rises on variable rate debt as the Fed raises rates. The
relatively high TIE ratio means the company’s EBIT is 2 to 3 times its annual interest expense, which is a
margin of safety for the risk of making interest payments on debt.

*A TIE ratio (times interest earned ratio) of 2.5 means that EBIT, a company’s operating earnings before
interest and income taxes, is two and one-half times the amount of its interest expense. The interpretation
is that the company is within its debt capacity with a low risk of not paying interest on its debt. A times
interest earned ratio of at least 2.0 is considered acceptable.
 TIE’s Example
Harry’s Bagels wants to calculate its times interest earned ratio in order to
get a better idea of its debt repayment ability. Below are snippets from the
business’ income statements:
 Asset Turnover Ratio
- Represents the amount of sales generated per dollar invested
in the firm’s assets.
Formula:
*Net sales represent a company’s total sales revenue after
deducting returns, discounts, and allowances. *Average total
assets are the average value of a company’s total assets over a
specific period, usually calculated by taking the average of the
beginning and ending asset balances.
Example:
ABC Corporation, for the fiscal year
ending Dec. 31, 2022. ABC Corporation reported
net sales of P1,000,000 for the year, and its average
total assets amounted to P500,000.
Using the formula mentioned earlier, we can
calculate the ratio as follows:
1,000,000 / 500,000 = 2
*In this example, ABC Corporation has an asset
turnover ratio of 2. This result indicates that, on
average, the company generates $2 in sales revenue
for every $1 invested in assets during the year. A
high ratio suggests efficient asset utilization,
indicating that ABC Corporation effectively
generates revenue relative to its asset base.
 Fixed Asset Turnover
- Measure firm’s efficiency in utilizing its fixed assets
such as property, plant and equipment.
- The fixed asset turnover ratio measures a company’s
ability to generate sales revenue relative to its
investment in fixed assets. Fixed assets refer to long-
term holdings with more than one year of practical life,
such as property, plant, and equipment (PP&E). This
ratio evaluates how efficiently a company utilizes its
fixed assets to generate sales.
-A higher ratio indicates better utilization of fixed assets to
generate sales revenue. It suggests that the company is
effectively deploying its long-term assets to drive revenue
generation. However, a very high ratio could also indicate
underinvestment in fixed assets, which may impact future
growth prospects or operational capacity.
Gross Margin Ratio

-These ratios show the company’s gross profits

against its net sales, and it is the earning after
deducting the merchandise costs.

- Shows how well the firm’s management controls

its expense to generate profits.

-A higher gross profit ratio represents that the

company’s operations are profitable and your
business is efficiently using its resources.

Formula:

Gross Margin Ratio = Gross Profit / Net Sales

Example GMP
Operating Profit Margin
- Measure how much profit is generated
from each dollar of sales after accounting
for both costs of goods sold and operating
expenses. It also indicates how well the
firm is managing its income statement.
Example:
If a company had revenues of 2 million,
COGS of 700,000, and administrative expenses of
100,000, its operating earnings would be 2 million -
(700,000 + 100,000) = 800,000. Its operating margin
would then be 800,000 / 2 million = 40%.

Formula:

Operating Margin Ratio = =

Operating Income or EBIT / Net

Sales
 Net Profit Margin
- Measure how much income is generated from each dollar of sales after
adjusting for all expenses (including income taxes) Example:
Imagine a company that
-Net profit margin, or simply net margin, measures how much net income or profit reports the following numbers on its
is generated as a percentage of revenue. It is the ratio of net profits to revenues for income statement:
a company or business segment. • Revenue: 100,000
• Operating costs: 20,000
-Net profit margin is typically expressed as a percentage but can also be • COGS or cost of goods sold:
represented in decimal form. The net profit margin illustrates how much of each 10,000
dollar in revenue collected by a company translates into profit. • Tax liability: 14,000
• Net profits: 56,000
Formula: Net Profit Margin= Net Income/Sales Net profit margin is thus 0.56 or 56%
(56,000 ÷ 100,000) × 100. A 56% profit
margin indicates the company earns
56 cents in profit for every dollar it
collects.
 Return on Equity (ROE)

- Measure the accounting return on the common

stockholders’ investment.

- The ROE measures the return percentage on the amount

invested in the business. It indicates how efficiently a
company is making profits using the investors’ money.

Formula:

Return on Equity = Net Income / Common Equity

Example: if a company has a net income of $200,000

and an average shareholder's equity of $1,000,000,
the ROE would be 20%. That means for every dollar of
shareholder’s equity, the company generates 20 cents
in profit.
 Return on Assets (ROA)/ Operating Return on Assets (OROA)
- ROA measures the profitability of your business
against the total assets the capital that you invested in
the company assets is generating desired profits for
your business. A lower ROA shows your investment
in the assets is not profitable enough.
- Summary measure of operating profitability. It takes
into account the management’s success in controlling
expenses and its efficient use of assets.
Formula:
Return on Assets = Net income / Total Assets
Or
Operating Return on Assets (OROA)= Operating
Income or EBIT/ Total Assets
For example, pretend Sam and Milan both start hot dog
stands. Sam spends $1,500 on a bare-bones metal cart,
while Milan spends $15,000 on a zombie apocalypse-
themed unit, complete with costume.
Let's assume that those were the only assets each firm
deployed. If, over some given period, Sam earned $150
and Milan earned $1,200, Milan would have the more
valuable business but Sam would have the more efficient
one.
Using the above formula, we see Sam’s simplified ROA is
$150 / $1,500 = 10%, while Milan's simplified ROA is
$1,200/$15,000 = 8%.
 Price-Earning Ratio

- Indicates how much investors are currently

willing to pay for $1 of reported earnings.

- It provides insights to the investors on the

company’s share price as against its earnings. In
simple terms, the P/E Ratio or the Price Multiple
shows how much an investor would be willing to Companies with a high Price Earnings Ratio are
pay per share considering the company’s earning per often considered to be growth stocks. This indicates
dollar. a positive future performance, and investors have
higher expectations for future earnings growth and
Formula: Price-Earnings ratio = Market Price per are willing to pay more for them.
Share / Earnings Per Share
Companies with a low Price Earnings Ratio are
*EPS is generally given in two ways. Trailing 12 months (TTM) often considered to be value stocks. It means they
represents the company's performance over the past 12
are undervalued because their stock prices trade
months. Another is found in earnings releases, which often
lower relative to their fundamentals. Examples of
provide EPS guidance. This is the company's advice on what it
low P/E stocks can be found in mature industries
expects in future earnings. These different versions of EPS
that pay a steady rate of dividends.
form the basis of trailing and forward P/E, respectively.
P/E Example
Price Earnings Ratio can
produce wonky results, as
demonstrated below.
Negative EPS resulting from a
loss in earnings will produce a
negative P/E. An exceedingly
high P/E can be generated by
a company with close to zero
net income, resulting in a very
low EPS in the decimals.
 Price to Cash Flow (P/CF) Ratio
-The price to cash flow ratio is a measure of your
company’s current share price to its operating cash flow
that indicates the value of your share related to your
operating cash flow.

-Where the market capitalization is derived by multiplying

the number of outstanding shares with the share price. Also, the ratio can be calculated on a per share
basis. The price-to-cash flow ratio formula on a per-
-A low P/CF ratio represents the stock’s undervaluation; share basis is:
however, in the early stage of your business startup, you
may have a higher P/CF ratio due to lower cash generation
and future growth prospects, you may have a higher P/CF
ratio.

Formula: Price to Cash Flow Ratio = Market

Capitalization / Operating Cash Flow
 P/E Example
You can use the following sample scenario as an example of how to determine the
price-to-cash flow ratio of a company:

A company has a share price of $50 and 20 million outstanding shares. Its accounting
team determines the company's operating cash flow is $100 million.

First, the accountant determines the company's operating cash flow per share and
divides the operating cash flow by the number of outstanding shares to determine the
company's operating cash flow per share is $5.

To find the price-to-cash flow ratio, the team divides the share price by the operating
cash flow per share:
P/CF = share price / operating cash flow per share
P/CF = $50 / $5
P/CF = $10
The company's price-to-cash flow ratio is $10, which means investors pay $10 for every
dollar of cash flow.

Market to Book Ratio
- Measure the relationship between the market value and
the accumulated investment in the firm’s equity.
Formula:
Market-to-Book Ratio= Market Price per Share/Book Value
*A low ratio (less than 1) could indicate that the stock
is undervalued (i.e. a bad investment), and a higher
ratio (greater than 1) could mean the stock is
overvalued (i.e. it has performed well).
* A low ratio could also indicate that there is
something wrong with the company. This ratio can
also give the impression that you are paying too much
for what would be left if the company went bankrupt.
*The market-to-book ratio helps a company determine
whether or not its asset value is comparable to the
market price of its stock. It is best to compare Market
to Book ratios between companies within the same
industry.

*The market to book ratio is typically used by investors

Market Price per Share
Common Shareholders’ Equity/Common
Shares Outstanding
to show the market’s perception of a particular stock’s
value. It is used to value insurance and financial
companies, real estate companies, and investment
trusts. It does not work well for companies with mostly
intangible assets. This ratio is used to denote how much
equity investors are paying for each dollar in net assets.
The market to book ratio is calculated by dividing the
current closing price of the stock by the most current
quarter’s book value per share.