Ratio Analysis
Introduction
The financial analysis can be made on a historical basis and also by comparing similar
firms in the industries. The former method is based on a trend analysis to evaluate the
firm’s present ratios in comparison with those of previous years to find the direction that
the firm is moving toward and evaluate the effectiveness of its past strategy. The latter
method is based on cross-sectional analysis to determine the firm’s performance relative
to its major competitors and the industry average.
Ratio Analysis
In general ratio analysis is based on the evaluation of four types of ratios: (1) current
ratios, which measure the firm’s ability to fulfill its short-term debt obligations, (2)
leverage ratios, which measure the level of the firm’s borrowing and its debt-serving
ability based on its earnings prospect, (3) activity ratios, which measure the efficiency
level of the firm in utilizing the assets for business operations, (4) profitability ratios,
which measure the firm’s earnings capacity.
The major ratios in these categories are as follows.
I.
Liquidity Ratios
1. Current ratio
Current . Assets
Current . Liabilities
Measures the extent to which the firm’s short-term debts are covered by its cash
and the assets that can be converted to cash in the near future.
2. Quick ratio
Current . Assets  Inventory
Current . Liabilities
A measure of a firm’s ability to pay its short-term debt without relying on the
sales of its inventory
II.
Leverage Ratios
3. Debt to assets ratio
Total. Debts
Total. Assets
An indication of the extent to which the business is financed by the borrowed
funds.
4. Debt to equity ratio
Total. Debts
Owner ' s. Equity
An alternative measure of the firm’s debt using, comparing the fund financed by
debts and that provided by the owner.
5. Time interest earned
Income. before. Taxes  Interest
Interest . Ch arg es
A multiple of earnings available to pay interest costs and the interest cost, which
measures the level of comfort for the firm to serve its interest obligations based on
its earnings prospect.
6. Fixed charge coverage
Income. before. Taxes.&. Interest  Lease
Lease. Ch arg es
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An alternative measure with the purpose similar to Time Interest Earned, showing
the firm’s capacity to serve its debt obligations plus fixed obligation charges.
III.
Activity Ratios
7. Inventory turnover
Sales
Inventory
Based on a comparison with the industry average, it shows whether the firm has
excess inventory stock or inadequate inventory.
8. Total asset turnover
Sales
Total. Assets
It shows the relation between sales and the assets employed to generate the sales,
which measures the efficiency of business operations.
9. Account receivable turnover
Sales
Account . Re ivable
Based on a comparison of sales with the credit granted to generate the sales, it
shows the average length of time to collect the credit.
IV.
Profitability Ratios
10. Gross profit margin
Sales  Cost . of . Goods. Sold
Sales
A measure of the margin to cover operation costs and yield profits.
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Net . Income
Sales
11. Net profit margin
Reflecting the profit per dollar of sales.
Net . Income
Total. Assets
12. Return on total assets
A measure of the profit generated from each dollar of fund employed for business
operations.
Net . Income
Owner ' s. Equity
13. Return on equity
A measure of the profit earned by the owner for each of his/her dollar invested in
the business.
V.
Du Pont Analysis
Du Pont Analysis provides another perspective on how combined activities and financial
leverage determined the profitability of the firm.
Net . Income
Sales
×
Sales
Total. Assets
=
Net . Income
.
Total. Assets
Consequently,
Net profit margin × Total asset turnover = Return on assets.
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Furthermore,
Total. Debts
Net . Income
Net . Income
× (1 +
) =
.
Total. Assets
Owner ' s. Equity
Owner ' s. Equity
In other words,
Return on Assets × ( 1 + Debt-Equity Ratio) =
Return on Equity.
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