RATIO ANALYISI OF FINANCIAL STATEMENT

It is another tool that helps identify changes in a company’s financial situation. A single ratio is not sufficient to
adequately judge the financial situation of the company. Several ratios must be analyzed together and compared with
prior-year ratios, or even with other companies in the same industry.

SOLVENCY RATIO ANALYISIS

It is sub-categorized into two parts Liquidity Ratio Analysis and Turnover Ratio Analysis of financial statement.
They are further sub-divided into 10 ratios
LIQUIDITY RATIOS

Liquidity ratio analysis measure how liquid the company’s assets are (how easily can the assets be converted into
cash) as compared to its current liabilities. There are three common liquidity ratio

1. Current ratio analysis

2. Acid test (or quick asset) ratio analysis

3. Cash Ratio analysis

1. Current Ratio Analysis

Current ratio is the most frequently used ratio to measure company’s liquidity as it is quick, intuitive and easy
measure to understand the relationship between the current assets and current liabilities. It basically answers this
question “How many pesos in current assets does the company have to cover each peso of current liabilities”

Current Ratio Formula = Current Assets / Current Liabilities

**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******

2. Quick Ratio Analysis

Sometimes current assets may contain huge amounts of inventory, prepaid expenses etc. This may skew the current
ratio interpretations as these are not very liquid. To address this issue, if we consider the only most liquid assets
like Cash and Cash equivalents and Receivables, then it should provide us with a better picture on the coverage of
short term obligations.

Quick Ratio Formula = (Cash and Cash Equivalents + Accounts Receivables)/Current Liabilities

**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******

3. Cash Ratio analysis

Cash ratio considers only the Cash and Cash Equivalents (there are the most liquid assets within the Current Assets).

If the company has a higher cash ratio, it is more likely to be able to pay its short term liabilities.

Cash Ratio Formula = Cash & Cash equivalents / Current Liabilities

**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******

TURNOVER RATIO ANALYSIS

Turnover ratio analysis, it analyze the liquidity from “how long it will take for the firm to convert inventory and
receivables into cash or time taken to pay its suppliers”.

The commonly used turnover ratios include:

4) Receivables turnover
5) Accounts receivables days
6) Inventory turnover
7) Inventory days
8) Payables turnover
9) Payable days
10) Cash Conversion Cycle

4. Receivables Turnover Ratio analysis

Accounts Receivables Turnover Ratio can be calculated by dividing Credit Sales by Accounts Receivables.
Intuitively. it provides us the number of times Accounts Receivables (Credit Sales) is converted into Cash Sales

Receivables Turnover Formula = Credit Sales / Average Accounts Receivables

**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******

5. Days Receivables
Days receivables is directly linked with the Accounts Receivables Turnover. Days receivables
expresses the same information but in terms of number of days in a year. This provides with an intuitive
measure of Receivables Collection Days

Accounts Receivables Days Formula = Number of Days in Year / Accounts Receivables Turnover

**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******

6. Inventory Turnover Ratio analysis

Inventory Ratio means how many times the inventories are restored during the year. It can be
calculated by taking Cost of Goods Sold and dividing by Inventory.
Inventory Turnover Formula = Cost of Goods Sold / Average Inventory
**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******

7. Days Inventory
The number of days it takes for inventory to convert into finished product.
Inventory Days Formula = Number of days in a year / Inventory Turnover

**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******

8. Accounts Payable Turnover

Payables turnover indicates the number of times that payables are rotated during the period. It is best
measured against purchases, since purchases generate accounts payable.
Payables Turnover Formula = Purchases / Average Accounts Payables

9. Days Payable Ratio Analysis

Payable days represent the average number of days a company takes to make the payment to its suppliers.
Payables Days Formula = Number of Days in a year / Payables Turnover
**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******

10. Cash Conversion Cycle

Cash conversion cycle is the total time taken by the firm to convert its cash outflows into cash inflows
(returns). Think of Cash Conversion Cycle as a time taken by a company to purchase the raw materials,
then convert inventory into the finished product and sell the product and receive cash and then make the
necessary payout for the purchases.

Cash Conversion cycle depends primarily on three variables – Receivable Days, Inventory Days and
Payable Days.
Cash Conversion Cycle Formula = Receivable Days + Inventory Days – Payable Days
**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******
RATIO ANALYSIS OF FINANCIAL STATEMENT – OPERATING PERFORMANCE
Operating performance ratios try and measure how the business is performing at the ground level and is
sufficiency generating returns relative to the assets deployed.
Operating Performance Ratios are two sub-divided as per the diagram below

OPERATING EFFICIENCY RATIOS

11. Asset Turnover Ratio analysis
The asset turnover ratio is a comparison of sales to total assets. This ratio provides with an indication on
how efficiently the assets are being utilized to generate sales.
Asset Turnover ratio Formula = Total Sales / Assets

**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******
12. Net Fixed Asset Turnover

Net Fixed Asset turnover reflects utilization of fixed assets (Property Plant and Equipment).
Net Fixed Asset Turnover Formula = Total Sales / Net Fixed Assets

**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******

13. Equity Turnover

Equity turnover is the ratio of Total Revenue to the Shareholder’s Equity Capital. This ratio measures
how efficiency the company is deploying equity to generate sales.
Equity Turnover Ratio Formula = Total Sales / Shareholder’s Equity
**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******

OPERATING PROFITABILITY RATIOS

Operating Performance Ratios measure how much are the costs relative to the sales and how much profit
is generated in the overall business. We try to answer questions like “how much the profit percentage” or
“Is the firm controlling its expenses by buying inventory etc at a reasonable price?”

14. Gross Profit Margin

Gross Profit is the difference between Sales and the direct cost of making a product or providing service.
Please note that costs like overheads, taxes, interests are not deducted here.
Gross Margin Formula = (Sales – Costs of Goods Sold)/Sales

**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******
15. Operating Profit Margin
Operating profit or Earnings Before Interest and Taxes (EBIT) margin measures the rate of profit on sales
after operating expenses. Operating income can be thought of as the “bottom line” from operations.
Operating Profit Margin = EBIT / Sales
**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******

16. Net Margin

Net Margin is basically the net effect of operating as well as financing decisions taken by the company. It
is call as Net Margin because in the numerator we have Net Income (Net of all the operating expenses,
interest expenses as well as taxes)
Net Margin Formula = Net Income / Sales
**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******

17. Return on Total Asset

Return on Assets or Return on Total Assets relates to the firm’s earnings to all capital invested in the
business.
Two important things to note there –
Please note that in the denominator, we have Total Assets which basically takes care of both the Debt and
Equity Holders.
Likewise in the numerator, the Earnings should reflect something that is before the payment of interest.
Return on Total Asset Formula = EBIT / Total Assets.
**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******
18. Return on Total Equity
Return on Total Equity means the rate of return earned on the Total Equity of the firm. Can be thought of
peso profits a company generates on each peso investment of Total Equity.
Please note Total Equity = Ordinary Capital + Reserves + Preference + MinorityInterests
Return on Total Equity Formula = Net Income / Total Equity
**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******

19. Return on Equity or Return on Owner’s Equity

Return on equity or Return on Owner’s Equity is based only on the common shareholder’s
equity. Preferred dividends and minority interests are deducted from Net Income as they are a priority
claim. Return on equity provides us with the Rate of return earned on the Common Shareholder’s Equity.
ROE or Return on Equity Formula = Net Income (after pref dividends and minority interest) /
Common Shareholder’s Equity

**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******

20. Dupont ROE

Dupont ROE is nothing but an extended way of writing an ROE formula. It divides ROE into several ratios
that collectively equal ROE while individually providing insight to most important term in ratio
analysis of financial statement

Dupont ROE formula

= (Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Shareholder’s Equity)

The above formula is nothing but the ROE formula = Net Income / Shareholder’s Equity

**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******
BUSINESS RISK
“the possibility a company will have lower than anticipated profits or experience a loss rather than taking
a profit”. If you look at the income statement, there are many line items that contribute to the risk of
making losses.
21. Operating Leverage
Operating leverage is the percentage change in operating profit relative to sales. Operating leverage is a
measure of how sensitive the operating income is to the change in revenues.
Please note that greater use of fixed costs, greater the impact of a change in sales on the operating income
of a company.
Operating Leverage Formula = % change in EBIT / % change in Sales.

**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******

22. Financial Leverage

Financial leverage is the percentage change in Net profit relative to Operating Profit. Financial leverage
measures how sensitive the Net Income is to the change in Operating Income. Financial leverage
primarily originates from company’s financing decisions (usage of debt). Like in the operating leverage,
fixed assets leads to higher operating leverage. In Financial leverage, the usage of debt primarily
increases the financial risk as they need to payoff interest
Financial Leverage formula = % change in Net Income / % change in EBIT

**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******

23. Total Leverage

Total leverage is the percentage change in Net profit relative to its Sales. Total leverage measures
how sensitive the Net Income is to the change in Sales.
Total Leverage Formula = % change in Net Profit / % change in Sales
= Operating Leverage x Financial Leverage

**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******

24. Leverage Ratio or Debt to Equity Ratio

This is an important ratio for bankers as it provides company’s ability to pay off debt using its own
capital. Generally lower the ratio better it is. Debt includes current debt + long term debt
Leverage Ratio Formula = Total Debt (current + long term) / Shareholder’s Equity

**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******

25. Interest Coverage Ratio

This ratio signifies the ability of the firm to pay interest on the assumed debt.
Interest Coverage Formula = EBITDA / Interest Expense
Please note that EBITDA = EBIT + Depreciation & Amortization

**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******

26. Debt Service Coverage Ratio (DSCR)

Debt Service Coverage Ratio tells us whether the Operating Income is sufficient to payoff all obligations
that are related to debt in an year. It also includes committed lease payments. Debt servicing consists of
not only the interest, but also some principal portion also is repaid annually.
Debt Service Coverage Formula = Operating Income / Debt Service
Operating Income is nothing but EBIT
**** APPLY THE RATIO TO YOUR CHOSEN FS************

*********INTERPRETATION*******