2. Learning Objective
By the end of this lecture, students should be able to:
Understand ratio analysis
Describe the uses of ratio analysis for different
stakeholders.
Understands the limitation of ratio analysis
Compute ratio analysis
3. Financial Performance
Measurement - Ratios
Financial performance measurement can be measured
by adopting to the financial ratio analysis. It is
performed by comparing two items in the financial
statements. The resulting ratio can be interpreted in a
way that is not possible when interpreting the items
separately.
Financial ratios can be classified into ratios that
measure: profitability, liquidity, management
efficiency, leverage, and valuation & growth.
4. Uses of Ratio
To evaluate performance, compared to previous years
and to competitors and the industry.
To set benchmarks or standards for performance
To highlight areas that need to be improved, or areas
that offer the most promising future potential.
To enable external parties, such as investors or lenders,
to assess the creditworthiness and profitability of the
firm.
5. Profitability Ratios
Gross Profit margin = (Gross Profit / Net Sales) x 100
Evaluates how much gross profit is generated from sales. Gross profit is equal
to net sales (sales minus sales returns, discounts, and allowances) minus cost
of sales.
Return on Sales = Net Income / Net Sales
Also known as "net profit margin" or "net profit rate", it measures the
percentage of income derived from dollar sales. Generally, the higher the ROS
the better.
Return on Assets = Net Income / Average Total Assets
In financial analysis, it is the measure of the return on investment. ROA is
used in evaluating management's efficiency in using assets to generate income.
Return on Stockholders' Equity = Net Income / Average Stockholders' Equity
Measures the percentage of income derived for every dollar of owners' equity.
6. Liquidity Ratio
Current Ratio = Current Assets / Current Liabilities
= 2000 / 1000 = 2 :1
Evaluates the ability of a company to pay short-term obligations using
current assets (cash, marketable securities, current receivables,
inventory, and prepayments).
Acid Test Ratio = Quick Assets / Current Liabilities
Also known as "quick ratio", it measures the ability of a company to pay
short-term obligations using the more liquid types of current assets or
"quick assets" (cash, marketable securities, and current receivables).
Cash Ratio = ( Cash + Marketable Securities ) / Current Liabilities
Measures the ability of a company to pay its current liabilities using cash
and marketable securities. Marketable securities are short-term debt
instruments that are as good as cash.
Net Working Capital = Current Assets - Current Liabilities
Determines if a company can meet its current obligations with its current
assets; and how much excess or deficiency there is.
7. Management Efficiency Ratio
Receivable Turnover = Net Credit Sales / Average Accounts Receivable
Measures the efficiency of extending credit and collecting the same. It indicates the
average number of times in a year a company collects its open accounts. A high ratio
implies efficient credit and collection process.
Days Sales Outstanding = 360 Days / Receivable Turnover
Also known as "receivable turnover in days", "collection period". It measures the
average number of days it takes a company to collect a receivable. The shorter the DSO,
the better. Take note that some use 365 days instead of 360.
Inventory Turnover = Cost of Sales / Average Inventory
Represents the number of times inventory is sold and replaced. Take note that some
authors use Sales in lieu of Cost of Sales in the above formula. A high ratio indicates that
the company is efficient in managing its inventories.
Days Inventory Outstanding = 360 Days / Inventory Turnover
Also known as "inventory turnover in days". It represents the number of days inventory
sits in the warehouse. In other words, it measures the number of days from purchase of
inventory to the sale of the same. Like DSO, the shorter the DIO the better.
8. Accounts Payable Turnover = Net Credit Purchases / Ave. Accounts Payable
Represents the number of times a company pays its accounts payable during a period. A
low ratio is favored because it is better to delay payments as much as possible so that
the money can be used for more productive purposes.
Days Payable Outstanding = 360 Days / Accounts Payable Turnover
Also known as "accounts payable turnover in days", "payment period". It measures the
average number of days spent before paying obligations to suppliers. Unlike DSO and
DIO, the longer the DPO the better (as explained above).
Operating Cycle = Days Inventory Outstanding + Days Sales Outstanding
Measures the number of days a company makes 1 complete operating cycle, i.e.
purchase merchandise, sell them, and collect the amount due. A shorter operating cycle
means that the company generates sales and collects cash faster.
Cash Conversion Cycle = Operating Cycle - Days Payable Outstanding
CCC measures how fast a company converts cash into more cash. It represents the
number of days a company pays for purchases, sells them, and collects the amount due.
Generally, like operating cycle, the shorter the CCC the better.
Total Asset Turnover = Net Sales / Average Total Assets
Measures overall efficiency of a company in generating sales using its assets. The
formula is similar to ROA, except that net sales is used instead of net income.
9. Leverage Ratios
Debt Ratio = Total Liabilities / Total Assets
Measures the portion of company assets that is financed by debt (obligations to
third parties). Debt ratio can also be computed using the formula: 1 minus Equity
Ratio.
Equity Ratio = Total Equity / Total Assets
Determines the portion of total assets provided by equity (i.e. owners'
contributions and the company's accumulated profits). Equity ratio can also be
computed using the formula: 1 minus Debt Ratio. The reciprocal of equity ratio is
known as equity multiplier, which is equal to total assets divided by total equity.
Debt-Equity Ratio = Total Liabilities / Total Equity
Evaluates the capital structure of a company. A D/E ratio of more than 1 implies
that the company is a leveraged firm; less than 1 implies that it is a conservative
one.
Times Interest Earned = EBIT / Interest Expense
Measures the number of times interest expense is converted to income, and if the
company can pay its interest expense using the profits generated. EBIT is earnings
before interest and taxes.
10. Valuation and Growth Ratios
Earnings per Share = ( Net Income - Preferred Dividends ) / Average Common Shares
Outstanding
EPS shows the rate of earnings per share of common stock. Preferred dividends is
deducted from net income to get the earnings available to common stockholders.
Price-Earnings Ratio = Market Price per Share / Earnings per Share
Used to evaluate if a stock is over- or under-priced. A relatively low P/E ratio could
indicate that the company is under-priced. Conversely, investors expect high growth
rate from companies with high P/E ratio.
Dividend Pay-out Ratio = Dividend per Share / Earnings per ShareDetermines the
portion of net income that is distributed to owners. Not all income is distributed since a
significant portion is retained for the next year's operations.
Dividend Yield Ratio = Dividend per Share / Market Price per ShareMeasures the
percentage of return through dividends when compared to the price paid for the stock.
A high yield is attractive to investors who are after dividends rather than long-term
capital appreciation.
Book Value per Share = Common SHE / Average Common SharesIndicates the value of
stock based on historical cost. The value of common shareholders' equity in the books of
the company is divided by the average common shares outstanding.
11. Advantages of Ratio Analysis
It simplifies the financial statements.
It helps in comparing companies of different size with each other.
It helps in trend analysis which involves comparing a single company over
a period.
It highlights important information in simple form quickly. A user can
judge a company by just looking at few numbers instead of reading the
whole financial statements.
12. Limitations of Ratio Analysis
Despite usefulness, financial ratio analysis has some disadvantages.
Some key demerits of financial ratio analysis are:
Different companies operate in different industries each having
different environmental conditions such as regulation, market
structure, etc. Such factors are so significant that a comparison of
two companies from different industries might be misleading.
Financial accounting information is affected by estimates and
assumptions. Accounting standards allow different accounting
policies, which impairs comparability and hence ratio analysis is
less useful in such situations.
Ratio analysis explains relationships between past information
while users are more concerned about current and future
information.
14. NORTON CORPORATION
2019
Cash 30,000
$
Accounts receivable, net
Beginning of year 17,000
End of year 20,000
Inventory
Beginning of year 10,000
End of year 12,000
Total current assets 65,000
Total current liabilities 42,000
Sales on account 494,000
Cost of goods sold 140,000
We will
use this
information
to calculate
the liquidity
ratios for
Norton.
16. Quick Assets
Current Liabilities
=
Acid-Test
Ratio
$50,000
$42,000
= 1.19 : 1
=
Acid-Test
Ratio
Acid-Test (Quick) Ratio
Quick assets are Cash,
Marketable Securities,
Accounts Receivable (net) and
current Notes Receivable.
Norton Corporation’s quick
assets consist of cash of
$30,000 and accounts
receivable of $20,000.
17. Sales on Account
Average Accounts Receivable
Accounts
Receivable
Turnover
=
Accounts Receivable
Turnover
= 26.70 times
$494,000
($17,000 + $20,000) ÷ 2
Accounts
Receivable
Turnover
=
Average, net accounts
receivable
Net, credit sales
18. Number of Days’ Sales
in Accounts Receivable
Days’ Sales
in Accounts
Receivables
=
365 Days
Accounts Receivable Turnover
= 13.67 days
=
365 Days
26.70 Times
Days’ Sales
in Accounts
Receivables
19. Inventory Turnover
Ratio = :1
Margin / Return = %
Turnover = times
Days = Days
Earning = RM
Cost of Goods Sold
Average Inventory
Inventory
Turnover
=
= 12.73 times
$140,000
($10,000 + $12,000) ÷ 2
Inventory
Turnover
=
20. Equity, or Long–Term
Solvency Ratios
This is part of the information to
calculate the equity, or long-term
solvency ratios of Norton Corporation.
NORTON CORPORATION
2019
Net operating income 84,000
$
Net sales 494,000
Interest expense 7,300
Total stockholders' equity 234,390
21. NORTON CORPORATION
2019
Common shares outstanding
Beginning of year 17,000
End of year 27,400
Net income 53,690
$
Stockholders' equity
Beginning of year 180,000
End of year 234,390
Dividends per share 2
Dec. 31 market price/share 20
Interest expense 7,300
Total assets
Beginning of year 300,000
End of year 346,390
Here is the
rest of the
information
we will
use.
23. Return on Sales
Net Income
to
Net Sales
=
Net Income x 100
Net Sales
Net Income
to
Net Sales
=
$53,690
$494,000
= 10.9%
24. Return on Average
Common Stockholders’
Equity (ROE)
Return on
Stockholders’
Equity
=
Net Income
Average Common
Stockholders’ Equity
=
$53,690
($180,000 + $234,390) ÷ 2
= 25.9%
Return on
Stockholders’
Equity
25. Earnings
per Share
Earnings Available to Common Stockholders
Weighted-Average Number of Common
Shares Outstanding
=
Earnings
per Share
$53,690
(17,000 + 27,400) ÷ 2
= = $2.42
Earnings Per Share
