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# Financial Ratio Analysis

1. Profitability Ratios
These ratios give users a good understanding of how well the
company utilized its resources to generate profit and shareholder
value.
The long-term profitability of a company is vital for its survivability. It
is these ratios that can give insight into the all important "profit".

## Return On Equity - ROE

What Does Return On Equity - ROE Mean?
The amount of net income returned as a percentage of shareholders
equity. Return on equity measures a corporation's profitability by
revealing how much profit a company generates with the money
shareholders have invested. It tells common shareholders how
effectively their money is being employed.
ROE is expressed as a percentage and calculated as:
Net profit after tax and preference dividends (if any) x 100
Average (ordinary share capital + reserves)
Net income is for the full fiscal year (before dividends paid to
common stock holders but after dividends to preferred stock.)
Shareholder's equity does not include preferred shares.
By comparing the ROE provided by the company with the return
provided by alternative investments with the same level of risk,
existing shareholders can assess the quality of their investment and
decide whether to keep their funds in the company (if ROE is higher
than the return on alternative investments) or invest elsewhere (if
ROE is lower than the return on alternative investments).

Return On Assets
This ratio indicates how profitable a company is relative to its total
assets. The return on assets (ROA) ratio illustrates how well
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## Financial Ratio Analysis

management is employing the company's total assets to make a
profit. The higher the return, the more efficient management is in
utilizing its asset base. The ROA ratio is calculated by comparing net
income to average total assets, and is expressed as a percentage.

## Net profit before interest and tax x 100

Average total assets

## Some investment analysts use the operating-income figure instead of

the net-income figure when calculating the ROA ratio.
The need for investment in current and non-current assets varies
greatly among companies. Capital-intensive businesses (with a large
investment in fixed assets) tend to be more asset heavy than
In the case of capital-intensive businesses, which have to carry
relatively large asset base, the denominator of the ROA will be
large number. Conversely, non-capital-intensive businesses (with
small investment in fixed assets) will be generally favored with
relatively high ROA because of a low denominator number.

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## It is precisely because businesses require different-sized asset bases

that investors need to think about how they use the ROA ratio. For
the most part, the ROA measurement should be used historically for
the company being analyzed. If peer company comparisons are
made, it is imperative that the companies being reviewed are similar
in product line and business type. Simply being categorized in the
same industry will not automatically make a company comparable.
As a rule of thumb, investment professionals like to see a company's
ROA come in at no less than 5%. Of course, there are exceptions to
this rule. An important one would apply to banks, which strive to
record a ROA of 1.5% or above.

## Profit Margin Analysis

In the income statement, there are four levels of profit or profit
margins - gross profit, operating profit, pretax profit and net profit.
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## Financial Ratio Analysis

The term "margin" can apply to the absolute number for a given
profit level and/or the number as a percentage of net sales/revenues.
Profit margin analysis uses the percentage calculation to provide a
comprehensive measure of a company's profitability on a historical
basis (3-5 years) and in comparison to peer companies and industry
benchmarks.
Basically, it is the amount of profit (at the gross, operating, pretax or
net income level) generated by the company as a percent of the sales
generated. The objective of margin analysis is to detect consistency
or positive/negative trends in a company's earnings. Positive profit
margin analysis translates into positive investment quality. To a large
degree, it is the quality, and growth, of a company's earnings that
drive its stock price.

## Gross Profit Margin

What Does Gross Profit Margin Mean?
A financial metric used to assess a firm's financial health by
revealing the proportion of money left over from revenues after
accounting for the cost of goods sold. Gross profit margin serves as
the source for paying additional expenses and future savings.
Also known as "gross margin".
Calculated as:
Gross profit x 100
Sales
Where:
Gross Profit= Sales- COGS where COGS= Cost of Goods Sold
This metric can be used to compare a company with its competitors.
More efficient companies will usually see higher profit margins.

## Net Profit Margin

Net profit margin or net profit ratio all refer to a measure of
profitability. It is calculated by finding the net profit as a percentage
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## Financial Ratio Analysis

of the revenue and it indicates how much of each dollar of sales
revenue has been left after all expenses have been covered.

## The Net Profit Margin can be calculated as:

Net profit before interest and tax x 100
Sales

## The profit margin is mostly used for internal comparison. It is

difficult to accurately compare the net profit ratio for different
entities.
Individual
operating
and
financing
arrangements vary so much that different entities are bound to have
different levels of expenditure, so that comparison of one with
another can have little meaning. A low profit margin indicates a low
margin of safety: higher risk that a decline in sales will erase profits
and result in a net loss.

## 2. Operational Efficiency Ratios or Activity

Ratios
Are a measure of how well a company and its management uses its
assets to generate income.
These ratios look at how well a company turns its assets into revenue
as well as how efficiently a company converts its sales into cash.
Basically, these ratios look at how efficiently and effectively a
company is using its resources to generate sales and increase
shareholder value. In general, the better these ratios are, the better
it is for shareholders.

Cost of sales

## This ratio should be compared against industry averages. A low

turnover r( high ratio) implies poor sales and, therefore, excess
inventory. A high turnover (low ratio) implies strong sales.
High inventory levels(high ratios) are unhealthy because they
represent an investment with a rate of return of zero. It also opens
the company up to trouble should prices begin to fall.

## Average Settlement Period for Debtor/Average

Collection Period

Credit sales

## Average collection period measures the average length of time that a

company receives payments from its customers after the close of a
sale. Analysts should compare this ratio with the credit terms the
company offers to its customers.
The lower this ratio the better. High ratios indicate that the company
has problems collecting from its clients and might face cash flow
problems.

## Financial Ratio Analysis

Average Settlement Period for Creditors/ Accounts
Payable Period
Credit purchases

## Accounts payable period measures the average length of time that it

takes the company to pay its suppliers.
If this ratio is falling from one period to another, this is a sign that
the company is taking longer to pay off its suppliers than it
was before. The opposite is true when this ratio is increasing, which
means that the company is paying off suppliers at a faster rate.
While the larger this ratio is the better as it shows that the company
has a good ability to negotiate payment terms with it suppliers one
needs to be careful. If this ratio exceeds the number of days
stipulated in the payment terms it might be an indicator that the
company is facing cash flow problems and is unable to pay its
suppliers on time.

3. Liquidity ratios
Liquidity ratios attempt to measure a company's ability to pay off its
short-term debt obligations. This is done by comparing a company's
most liquid assets (or, those that can be easily converted to cash)
with its short-term liabilities.
In general, the greater the coverage of liquid assets to short-term
liabilities the better as it is a clear signal that a company can pay its
debts that are coming due in the near future and still fund its
ongoing operations. On the other hand, a company with a low
coverage rate should raise a red flag for investors as it may be a sign
that the company will have difficulty running its operations, as well
as meeting its obligations.
The biggest difference between each ratio is the type of assets used
in the calculation. While each ratio includes current assets, the more

## Financial Ratio Analysis

conservative ratios will exclude some current assets as they aren't as
easily converted to cash.

Current Ratio
Current assets
Current liabilities

## The current ratio is a popular financial ratio used to test a

company's liquidity (also referred to as its current or working capital
position) by deriving the proportion of current assets available to
cover current liabilities.
The concept behind this ratio is to ascertain whether a company's
short-term assets (cash, cash equivalents, marketable securities,
receivables and inventory) are readily available to pay off its shortterm liabilities (notes payable, current portion of term debt,
payables, accrued expenses and taxes). In theory, the higher the
current ratio, the better.
If this ratio is more than 1, then that company is generally
considered to have good short-term financial strength. However, if
the current ratio is too high (more than 2), then the company may
not be efficiently using its current assets, it could indicate that the
company has too much inventory and is not investing the excess cash
because it lacks the managerial acumen to put those resources to
work.
If current liabilities exceed current assets (Current ratio<1), then
the company may have problems meeting its short-term obligations.
Low values, however, are not always fatal. If an organization has
good long-term prospects, it may be able to enter the capital market
and borrow against those prospects to meet current obligations. The
nature of the business itself might also allow it to operate with a
current ratio less than one. For example, in an operation like Mc
Donald's, inventory turns over much more rapidly than the accounts
payable become due. This timing difference can also allow a firm to
operate with a low current ratio.

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## Financial Ratio Analysis

Current assets minus (inventory & prepayments)
Current liabilities

The quick ratio - or the quick assets ratio or the acid-test ratio - is a
liquidity indicator that further refines the current ratio by measuring
the amount of the most liquid current assets there are to cover
current liabilities. The quick ratio is more conservative than the
current ratio because it excludes inventory and other current assets,
which are more difficult to turn into cash. Therefore, a higher ratio
means a more liquid financial position.

4. Gearing Ratios
Are financial ratios that compare some form of owner's equity (or
capital) to borrowed funds. Gearing is a measure of financial
leverage, demonstrating the degree to which a firm's activities are
funded by owner's funds versus creditor's funds.

## Gearing Ratio or Net Gearing Ratio

Long term liabilities x 100
Share capital + reserves + long term liabilities
.

Investopedia
explains
Gearing
Ratio
The higher a company's degree of leverage, the more the company is
considered risky. As for most ratios, an acceptable level is
determined by its comparison to ratios of companies in the same
industry. The best known examples of gearing ratios include the
debt-to-equity ratio (total debt / total equity), times interest earned
(EBIT / total interest), equity ratio (equity / assets), and debt ratio
(total debt / total assets).
A company with high gearing (high leverage) is more vulnerable to
downturns in the business cycle because the company must continue
to service its debt regardless of how bad sales are. A greater
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## Financial Ratio Analysis

proportion of equity provides a cushion and is seen as a measure of
financial strength.

## Interest Coverage Ratio/Times Interest Earned

Metric used to measure a company's ability to meet its debt
obligations. It is calculated by taking a company's earnings before
interest and taxes (EBIT) and dividing it by the total interest payable
on bonds and other contractual debt. It is usually quoted as a ratio
and indicates how many times a company can cover its interest
charges on a pretax basis. Failing to meet these obligations
could force a company into bankruptcy.
Net profit before interest and tax
Interest expense
Also referred to as "fixed-charged coverage".

## Investopedia explains Interest Coverage Ratio /Times Interest

Earned
TIE
Ensuring interest payments to debt holders and preventing
bankruptcy depends mainly on a company's ability to sustain
earnings. However, a high ratio can indicate that a company has an
undesirable lack of debt or is paying down too much debt with
earnings that could be used for other projects. The rationale is that a
company would yield greater returns by investing its earnings into
other projects and borrowing at a lower cost of capital than what it is
currently paying for its current debt to meet its debt obligations.