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# FINANCIAL RATIO ANALYSIS

Ratio Analysis - involves methods of calculating and interpreting financial ratios to analyze and monitor the firms performance. The basic inputs to ratio analysis are the firms income statement and balance sheet - a comparison in fraction, proportion, decimal or percentage form of two significant figures from financial statements. It expresses the direct relationship between two or more quantities in the balance sheet and income statement of a business firm

## FINANCIAL RATIO ANALYSIS

Interested Parties Investors (current/prospective shareholders)

Creditors
Management

## TYPES OF RATIO COMPARISON

1. Cross-sectional analysis involves the comparison of different firms financial ratios at the same point in time **benchmarking A type of cross-sectional analysis in which the firms

ratio values are compared to those of a key competitor or group of competitors that it wishes to emulate.
2. Time Series analysis evaluates performance over time - Comparison of current to past performance, using ratios, enables analysts to assess the firms progress 3. Combined analysis is the most informative approach to ratio analysis combines cross-sectional and time-series analyses - A combined view makes it possible to assess the trend in the behavior of the ratio in relation to the trend for the industry

## CATEGORIES OF FINANCIAL RATIOS

A. LIQUIDITY RATIOS-measures risk B. ACTIVITY RATIOS- measures risk

## C. DEBT RATIOS/LEVERAGE RATIOS- measures risk

D. PROFITABILITY RATIOS measure return E. MARKET RATIOS- measures both risk and return

LIQUIDITY RATIOS
provide information about the firms ability to pay current obligations and continue operation Ratio 1. Current Ratio or Working Capital 2. Acid Test or Quick ratio Formula Current Assets Current Liabilities Quick Assets* Current Liabilities *Quick Assets=Cash +Cash Equivalents + Net Receivables + Marketable Securities Significance Test of short-term debt paying ability. Measure the firms ability to pay its short-term debts from its most liquid assets without having to rely on inventory

ACTIVITY RATIOS
activity ratios measure how efficiently a firm operates along a variety of dimensions such as inventory management, disbursements, and collections Ratio Formula Significance 1. Merchandise Inventory Cost of Sales/Average Measures the efficiency of Turnover Inventory the firm in managing and selling inventory 2. Average Age of Inventories or Number of Days of Inventory Number of Days in a Year/Inventory Turnover Ratio OR Average Inventory/ Average Daily Cost of Sales Measures the average number of days that inventory is held before sale

ACTIVITY RATIOS
3. Receivables Turnover Ratio Net Credit Sales/ Average Accounts Receivable Roughly measures how many times a companys accounts receivable have been turned *Use net sales if net credit sales into cash during the period is unavailable Number of Days in a year/ Measures the average number Receivables Turnover Ratio of days to collect a receivable OR Average Accounts Receivable/ Average Daily Sales
Net Sales/ Average Total Assets Measure of the efficiency of management to generate sales and thus earn more profit

## 5. Total Assets Turnover Ratio

DEBT/LEVERAGE RATIOS
measure the companys use of debt to finance assets and operations the more debt a firm has, the greater its risk of being unable to meet its contractual debt payments Ratio 1. Total Debt Ratio Formula Total Liabilities /Total Assets Significance Measures the percentage of funds provided by creditor. Compares resources provided by creditors with resources provided by shareholders equity Indicates the margin of safety for payment of fixed interest charges

2. Debt to Equity

## 3. Times-Interest-Earned EBIT/Interest Expense Ratio

PROFITABILITY RATIOS
Ratio
1. Gross Profit Margin

Formula
Gross Profit/Net Sales

Significance
measures the percentage of each sales dollar remaining after the firm has paid for its goods Measures the percentage of operating income to sales measures the overall effectiveness of management in generating profits with its available assets

## 2. Operating profit margin

3. Return on Investment (ROI) or Return on Total Assets (ROA)

EBIT/Net Sales
Net Income/ Average Total Assets

PROFITABILITY RATIOS
4. Earning per share Net Income-Preferred Dividends/ Number of Common Shares Outstanding represents the number of dollars earned during the period on behalf of each outstanding share of common stock measures the return earned on the common stockholders investment in the firm

## Earnings Available to Common Stockholders/ Average Common Stock Equity

MARKET RATIOS
give insight into how investors in the marketplace feel the firm is doing in terms of risk and return Ratio Formula Significance

## 1. Price Earnings Ratio

P/E ratio = Market price per share of common stock / Earnings per share

- measures the amount that investors are willing to pay for each dollar of a firms earnings - the level of this ratio indicates the degree of confidence that investors have in the firms future performance
provides an assessment of how investors view the firms performance

2. Market/Book Ratio

Market/book (M/B) ratio = Market price per share of common stock/ Book value per share of common stock