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What is ratio analysis?What is ratio analysis?

Ratio analysis is the use of various ratios to analyze financial statements. What is a ratio? Basically, it is the relation between two quantities expressed as the quotient of one divided by the other, such as 3:4 or ¾.

In ratio analysis, we compare numbers taken from financial statements. Ratio analysis is applied to financial statements to analyze the success, failure, and progress of a business.

Why do we use ratio analysis?Why do we use ratio analysis?Ratio analysis enables the business to spot

trends and to compare its performance and condition with the average performance of similar businesses in the same industry. To do this, the ratios are compared with the average of similar businesses.

Comparing ratios for successive years may discover unfavourable problems that may be arising. Ratio analysis may provide the all-important early warning of problems that may destroy the business. Therefore, it is critical to properly interpret ratios.

Categories of ratiosCategories of ratios

Generally speaking, there are three main categories of ratios used in analyzing financial statements. They are:

1. Liquidity ratios

2. Efficiency ratios

3. Profitability ratios

What to these categories mean?What to these categories mean?Liquidity ratios – measure the liquidity of the company.

These ratios are important in measuring the ability of a company to meet both its short term and long-term obligations.

Efficiency ratios – measure the efficiency of a company in either turning their inventory, sales, etc. It also ties into the liquidity of a company.

Profitability ratios – show the ability of a company to get returns or profits on the investment the owners made. If a business is liquid and efficient it should also be profitable.

Liquidity ratiosLiquidity ratios

There are three main liquidity ratios:

1. The current ratio

2. The quick ratio

3. The debt to equity ratio

The current ratioThe current ratio

The current ratio is obtained by dividing the 'Total Current Assets' of a company by its 'Total Current Liabilities'. The ratio is regarded as a test of liquidity for a company. It expresses the 'working capital' relationship of current assets available to meet the company's current obligations.

Current ratio exampleCurrent ratio example

The formula: Current Ratio = Total Current Assets/ Total Current

LiabilitiesAn example:Current Ratio = $261,050 / $176,522Current Ratio = 1.48The Interpretation: Lumber & Building Supply Company has $1.48 of

Current Assets to meet $1.00 of its Current Liability

The quick ratioThe quick ratio

The quick ratio is obtained by dividing the 'Total Quick Assets' (quick assets = total current assets minus inventory) of a company by its 'Total Current Liabilities'. Sometimes a company could be carrying heavy inventory as part of its current assets, which might be obsolete or slow moving. Thus, eliminating inventory from current assets and then doing the liquidity test is measured by this ratio. The ratio is regarded as an acid test of liquidity for a company.

Quick ratio exampleQuick ratio exampleThe formula: Quick Ratio = Total Quick Assets/ Total Current LiabilitiesQuick Assets = Total Current Assets (minus) InventoryAn example:Quick Ratio = $261,050- $156,822 / $176,522Quick Ratio = $104,228 / $176,522Quick Ratio = 0.59The Interpretation: Lumber & Building Supply Company has $0.59 cents of Quick

Assets to meet $1.00 of its Current Liability

The debt to equity ratioThe debt to equity ratio

The debt to equity ratio is obtained by dividing the 'Total Liability or Debt ' of a company by its 'Owners Equity a.k.a Net Worth'. The ratio measures how the company is managing its debt against the capital of its owners. If the liabilities exceed the net worth then in that case the creditors have more stake than the shareowners.

Debt to equity ratio exampleDebt to equity ratio exampleThe formula: Debt to Equity Ratio = Total Liabilities / Owners Equity

or Net WorthAn example: Debt to Equity Ratio = $186,522 / $133,522Debt to Equity Ratio = 1.40The Interpretation: Lumber & Building Supply Company has $1.40 cents of

Debt and only $1.00 in Equity to meet this obligation.

Efficiency ratiosEfficiency ratios

There are three main efficiency ratios:

1. The DSO (Days Sales Outstanding) ratio

2. The inventory turnover ratio

3. The accounts payable to sales (%) ratio

DSO ratioDSO ratio

The DSO (days sales outstanding) ratio shows both the average time it takes to turn the receivables into cash, and the age, in terms of days, of a company's accounts receivable. The ratio is regarded as a test of efficiency for a company. It is the effectiveness with which it converts its receivables into cash. This ratio is of particular importance to creditors and bankers.

DSO ratio exampleDSO ratio exampleThe formula: DSO ratio = (Total Accounts Receivables/Total Revenue) x

Number of Days in the fiscal period An example: Total Accounts Receivables = $97,456Total Revenue = $727,116Number of days in fiscal period = 1 year = 360 daysDSO = [ $97,456 / $727,116 ] x 360 = 48.25 daysThe Interpretation: Lumber & Building Supply Company takes roughly 48 days to

convert its accounts receivables into cash.

The inventory turnover ratioThe inventory turnover ratio

The inventory turnover ratio is obtained by dividing the 'Total Sales' of a company by its 'Total Inventory'. The ratio is regarded as a test of Efficiency and indicates the “quickness” with which the company is able to move its merchandise.

Inventory turnover ratio Inventory turnover ratio exampleexample

The formula: Inventory Turnover Ratio = Net Sales / InventoryAn example: Net Sales = $727,116 (from Income Statement)Total Inventory = $156,822 (from Balance sheet )Inventory Turnover Ratio = $727,116/ $156,822Inventory Turnover = 4.6 timesThe Interpretation: Lumber & Building Supply Company is able to rotate its

inventory in sales 4.6 times in one fiscal year.

The accounts payable to sales The accounts payable to sales (%) ratio(%) ratio

The accounts payable to sales (%) ratio is obtained by dividing the 'Accounts Payables' of a company by its 'Annual Sales'. This ratio gives you an indication as to how much of their suppliers money does this company use in order to fund its sales. The higher the ratio means that the company is using its suppliers as a source of cheap financing. The working capital of such companies could be funded by their suppliers.

Accounts payable to sales (%) Accounts payable to sales (%) ratio exampleratio example

The formula: Accounts Payables to Sales Ratio = [Accounts Payables /

Revenue ] x 100 An example:Accounts Payables = $152,240 (from Balance sheet )Revenue = $727,116 (from Income Statement)Accounts Payables to Sales Ratio = [$152,240 / $727,116] x

100 = 20.9%The Interpretation: 21% of Lumber & Building Supply Company's Sales is being

funded by its suppliers.

Profitability ratiosProfitability ratios

There are three main profitability ratios:

1. The return on sales OR profit margin (%) ratio

2. The return on assets ratio

3. The return on equity ratio

The return on sales OR profit The return on sales OR profit margin (%) ratiomargin (%) ratio

The return on sales OR profit margin (%) ratio determines a company’s ability to withstand competition and adverse conditions like rising costs, falling prices or declining sales in the future. The ratio measures the percentage of profits earned per dollar of sales. It is a measure of efficiency of the company to make money.

Return on sales OR profit Return on sales OR profit margin (%) ratio examplemargin (%) ratio example

The formula: Return on Sales or Profit Margin = (Net Income / Revenue) x

100An example:Net Income = $5,142Revenue = $727,116Return on Sales or Profit Margin = [ $5,142 / $727,116] x 100

= 0.71%The Interpretation: Lumber & Building Supply Company makes 0.71 cents on

every $1.00 of Sale

The return on assets ratioThe return on assets ratio

The Return on Assets of a company determines its ability to utilize the assets employed in the company efficiently and effectively to earn a good return. The ratio measures the percentage of profits earned per dollar of asset and thus is a measure of efficiency of the company in generating profits on its assets.

Return on assets ratio Return on assets ratio exampleexampleThe formula:

Return on Assets = (Net Income/ Total Assets) x 100An example: Net Income = $5,142Total Assets = $320,044Return on Assets = [ $5,142 / $320,044] x 100 = 1.60%The Interpretation: Lumber & Building Supply Company generates makes

1.60% return on the assets that it utilizes in its operations.

The return on equity ratioThe return on equity ratio

The Return on Equity of a company measures the ability of the management of the company to generate adequate returns for the capital invested by the owners of a company. Generally a return of 10% would be desirable to provide dividends to owners and have funds for future growth of the company

Return on equity ratio Return on equity ratio exampleexampleThe formula:

Return on Equity = (Net Income/ Owners Equity) x 100An example: Net Income = $5,142Owners Equity = $133,522Return on Equity = [ $5,142 / $133,522] x 100 = 3.85%The Interpretation: Lumber & Building Supply Company generates a 3.85%

percent return on the capital invested by the owners of the company.

In closing…In closing… Ratio analysis enables the business to spot trends Comparing ratios for successive years may discover

unfavourable problems that may be starting It is crucial to properly interpret ratios The three main groups of ratios are liquidity,

efficiency, and profitability ratios A well-to-do business must be liquid, efficient, and

profitable Even though it is not the only form of financial

analysis, ratio analysis is a key step when looking at financial statements