Financial Ratio Analysis

Rogelio G. Panelo, Jr.

Introduction

As a manager, you may want to reward employees based on their performance.

How do you know how well they have done? How can you determine what
departments or divisions have performed well? As a lender, how do decide the
borrower will be able to pay back as promised? As a manager of a corporation
how do you know when existing capacity will be exceeded and enlarged capacity
will be needed? As an investor, how do you predict how well the securities of
one company will perform relative to that of another? How can you tell whether
one security is riskier than another? We can address all of these questions
through financial analysis.

Financial analysis is the selection, evaluation, and interpretation of financial

data, along with other pertinent information, to assist in investment and financial
decision-making. Financial analysis may be used internally to evaluate issues
such as employee performance, the efficiency of operations, and credit policies,
and externally to evaluate potential investments and the credit-worthiness of
borrowers, among other things.

The analyst draws the financial data needed in financial analysis from many
sources. The primary source is the data provided by the company itself in its
annual report and required disclosures. The annual report comprises the
income statement, the balance sheet, and the statement of cash flows, as well
as footnotes to these statements. Certain businesses are required by
securities laws to disclose additional information.
Besides information that companies are required to disclose through financial
statements, other information is readily available for financial analysis. For
example, information such as the market prices of securities of publicly-traded
corporations can be found in the financial press and the electronic media daily.
Similarly, information on stock price indices for industries and for the market as
a whole is available in the financial press.

Classification of Ratios

A ratio is a mathematical relation between one quantity and another. Suppose

you have 200 apples and 100 oranges. The ratio of apples to oranges is 200 /
100, which we can more conveniently express as 2:1 or 2. A financial ratio is a
comparison between one bit of financial information and another. Consider the
ratio of current assets to current liabilities, which we refer to as the current ratio.
This ratio is a comparison between assets that can be readily turned into cash --
current assets
-- and the obligations that are due in the near future -- current liabilities. A
current ratio of 2:1 or 2 means that we have twice as much in current assets as
we need to satisfy obligations due in the near future.

Ratios can be classified according to the way they are constructed and their
general characteristics. By construction, ratios can be classified as a coverage
ratio, a return ratio, a turnover ratio, or a component percentage:

1. A liquidity ratio provides information on a company's ability to meet

its short-term, immediate obligations.

2. A profitability ratio provides information on the amount of income from

operation.
3. An activity ratio relates information on a company's ability to manage its
resources (that is, its assets) efficiently.

4. A financial leverage ratio provides information on the degree of a

company's fixed financing obligations and its ability to satisfy these financing
obligations.

5. A shareholder ratio describes the company's financial condition in terms

of amounts per share of stock.

6. A return on investment ratio provides information on the amount of profit,

relative to the assets employed to produce that profit.

Techniques in FS Analysis

Techniques used in FS Analysis

1. Horizontal Analysis (trend ratios and percentage)
comparison of figures shown in the FS of two or more consecutive periods
2015 2014 inc/(dec) percent inc/(dec)
3,280 2,950 330 (Current-Previous)/Previous (3280-2950)/2950 = 11%

2. Vertical Analysis (common-size statements)

comparison of figures in the FS of a single period
Amt %
Sales 3,280 100% Basis of Percentages in General:
COS 2,120 64% BS figure = Total A, or Total L + E, or any specified
Gross Income 1,160 36% IS figure = Gross Sales
3. Ratio Analysis
Note: When numerator and denominator is I/S and B/S accounts or vice-versa, get the average B/S account first.
In case the problem do not give 2 comparative balances or with beg. or ending balances, no need to
average the B/S account unless it is stated in the problem that need to be averaged.
Therefore: Average B/S account = B/S account / 2

Ratios are calculated from the FS to provide users of such statements with relevant information about the firms:
A. Liquidity Analysis - ability of the firm to pay its current obligation and continue operation
a. Current Ratio or Working Capital CA Test of short-term debt paying ability
Ratio or Banker's Ratio CL

Working Capital = CA - CL

b. Acid Test Ratio or Quick Ratio Quick Assets* ability to pay its short-term debts
CL from its most liquid assets without
having to rely on inventory
*QA = Cash + AR + MS

B. Leverage Ratios - measure the company's use of debt to finance assets and operations
Financial Leverage - the use of debt to finance assets and operations
Operating Leverage - The extent to which a company uses Fixed Cost in its cost structure
Solvency - the firm's financial ability to pay long-term obligations and survive in the long term

Key ingredients of Solvency:

1. Capital Structure - the sources of financing
a. Equity - ownership interest in the firm
b. Debt - interest of creditors in the firm
Objective - to know the Optimal Capital Structure (OCS)
2. Earning Power - the capacity of the firm's operations to produce cash inflows

a. Financial Leverage Ratio or Ave. Total A amount of total assests financed by

Equity Multiplier or Leverage Factor Ave. Common E equity. The higher the ratio, the
higher is the leverage financed by
debt therefore greater the risk

b. Financial Leverage Index RO Common E if the index exceeds 1.0, it is

ROA favorable and the use of Fin Leverage
is successful

c. Total Debt Ratio Total L measures the percentage of funds

Total A provided by creditors

d. Debt to Equity Ratio Total L compares resources provided by CR

E with resources provided by SH

e. Times-Interest-Earned Ratio (TIER) EBIT indicates the margin of safety for

f. Capital Structure can also be
analyzed through Acctng Equation
Interest Exp payment of fixed interest charges
A100% = L% + C% Optimal Capital structure depends
on how the mgt uses the financial
leveraging
C. Asset Mgt Ratios - measure how the firm uses its assests to generate revenue and income
a. Finished Good or Mechandise Inventory Turnover
Inventory Turnover (IVT) COS Indicates if a firm holds excessive
Ave. Inventory stocks of inv.

Ave. age of inventories (AAI) # of days in a yr measures the ave. # of days that
IVT inventory is held before sale
b. Receivables Turnover Ratio
(ART) Net Credit Sales
Ave. AR

Ave. age of Receivables (AAR) or # of days in a yr measures the ave. # of days to

Ave. collection period ART collect a receivable

Conversion Cycle or AAI + AAR measures the ave. # of days to

Operating Cycle convert inventories to cash

c. Accounts Payable Turnever (APT) Net Credit Purchases

Ave. AP

Ave. Age of AP (AAP) # of days in a yr Determine whether the firm

APT is paying its invoice on timely basis

Business Cycle AA1 + AAR + AAP measures the ave. # of days to

convert inventories to cash plus the
ave.# of days to buy materials to
cash payment

d. Fixed Assets Turnover Ratio (FAT) Net Sales Measures the level of use of
Ave. Net FA PPE

e. Total Assets Turnover Ratio (TAT) Net Sales Measures the level of Capital
Ave. Total A investment relative to sales volume

g. Total Capital Turnover Ratio (TCT) Net Sales measures the level of total assets
Equity + interest having a explicit cost ralative
bearing debt to sales volume

D. Cost Mgt Ratio - measure how well a firm controls its cost.
a. Gross Profit Rate Net Sales - COS
Net Sales

E. Profitability Ratio - measures earnings in relation to some base, such as assets, sales or capital

a. Net Profit Percentage Net Income measures the percentage of NI

Net Sales to Sales

b. ROI or Return on Total Asset Net Income Indicates whether the firm using
Ave. Total Asset its fund wisely

c. Net Operating Income to EBIT

Total Capital Equity + interest
bearing debt

d. Return on Common Equity (ROCE) NI-Pref Div. measures the return on the
Ave. CE carrying amount of equity

F. Growth Ratios - measures the changes in the economic status of a firm over a period of time

Income available Reflects the company's earning

a. Basic Earnings Per Share (BEPS) to Common SH power, ie, its ability to generate
Ave. Common income from normal operation
shares Outstanding

b. Earnings Yield EPS shows the relationship of EPS to

Market Price/Share the market price per share

Cash Dividends
c. Dividend Payout Ratio per Common Share
EPS