MODULE 2: RATIO ANALYSIS
I. Objectives
After completing the module, the students are expected to:
✓ Understand the concept and importance of the use of ratio analyses, including the
trend, and financial statement ratios
✓ Understand the DuPont Model (which based on the RoE ratio which analyze the
company’s ability to increase its equity
III. Duration
Start: Jan 27
End: Jan 27
IV. Learning Contents
A. WHAT IS RATIO ANALYSIS?
Ratio analysis is a quantitative method of gaining insight into a company's liquidity,
operational efficiency, and profitability by studying its financial statements such as the
balance sheet and income statement. Ratio analysis is a cornerstone of fundamental
equity analysis.
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Ratio analysis compares line-item data from a company's financial statements to
reveal insights regarding profitability, liquidity, operational efficiency, and solvency.
Ratio analysis can mark how a company is performing over time, while comparing a
company to another within the same industry or sector.
While ratios offer useful insight into a company, they should be paired with other
metrics, to obtain a broader picture of a company's financial health.
c. What Does Ratio Analysis Tell You?
Investors and analysts employ ratio analysis to evaluate the financial health of companies by
scrutinizing past and current financial statements. Comparative data can demonstrate how a
company is performing over time and can be used to estimate likely future performance. This
data can also compare a company's financial standing with industry averages while
measuring how a company stacks up against others within the same sector.
Investors can use ratio analysis easily, and every figure needed to calculate the ratios is
found on a company's financial statements.
Ratios are comparison points for companies. They evaluate stocks within an industry.
Likewise, they measure a company today against its historical numbers. In most cases, it is
also important to understand the variables driving ratios as management has the flexibility to,
at times, alter its strategy to make its stock and company ratios more attractive. Generally,
ratios are typically not used in isolation but rather in combination with other ratios. Having a
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good idea of the ratios in each of the four previously mentioned categories will give you a
comprehensive view of the company from different angles and help you spot potential red
flags.
Examples of Ratio Analysis Categories
The various kinds of financial ratios available may be broadly grouped into the following six
silos, based on the sets of data they provide:
1. Liquidity Ratios
Liquidity ratios measure a company's ability to pay off its short-term debts as they become
due, using the company's current or quick assets. Liquidity ratios include the current ratio,
quick ratio, and working capital ratio.
2. Solvency Ratios
Also called financial leverage ratios, solvency ratios compare a company's debt levels with
its assets, equity, and earnings, to evaluate the likelihood of a company staying afloat over
the long haul, by paying off its long-term debt as well as the interest on its debt. Examples of
solvency ratios include: debt-equity ratios, debt-assets ratios, and interest coverage ratios.
3. Profitability Ratios
These ratios convey how well a company can generate profits from its operations. Profit
margin, return on assets, return on equity, return on capital employed, and gross margin
ratios are all examples of profitability ratios.
4. Efficiency Ratios
Also called activity ratios, efficiency ratios evaluate how efficiently a company uses its
assets and liabilities to generate sales and maximize profits. Key efficiency ratios include:
turnover ratio, inventory turnover, and days' sales in inventory.
5. Coverage Ratios
Coverage ratios measure a company's ability to make the interest payments and other
obligations associated with its debts. Examples include the times interest earned ratio and
the debt-service coverage ratio.
6. Market Prospect Ratios
These are the most commonly used ratios in fundamental analysis. They include dividend
yield, P/E ratio, earnings per share (EPS), and dividend payout ratio. Investors use these
metrics to predict earnings and future performance.
For example, if the average P/E ratio of all companies in the S&P 500 index is 20, and the
majority of companies have P/Es between 15 and 25, a stock with a P/E ratio of seven would
be considered undervalued. In contrast, one with a P/E ratio of 50 would be considered
overvalued. The former may trend upwards in the future, while the latter may trend
downwards until each aligns with its intrinsic valu e.
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Types of Liquidity Ratios
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Liquidity ratios are an important class of financial metrics used to determine a debtor's
ability to pay off current debt obligations without raising external capital.
Common liquidity ratios include the quick ratio, current ratio, and days sales
outstanding.
Liquidity ratios determine a company's ability to cover short-term obligations and cash
flows, while solvency ratios are concerned with a longer-term ability to pay ongoing
debts.
The Current Ratio
The current ratio measures a company's ability to pay off its current liabilities (payable within
one year) with its total current assets such as cash, accounts receivable, and inventories.
The higher the ratio, the better the company's liquidity position:
The Quick Ratio
The quick ratio measures a company's ability to meet its short-term obligations with its most
liquid assets and therefore excludes inventories from its current assets. It is also known as
the acid-test ratio:
Days Sales Outstanding (DSO)
Days sales outstanding (DSO) refers to the average number of days it takes a company to
collect payment after it makes a sale. A high DSO means that a company is taking unduly
long to collect payment and is tying up capital in receivables. DSOs are generally calculated
on a quarterly or annual basis:
What Is a Solvency Ratio?
A solvency ratio is a key metric used to measure an enterprise’s ability to meet its long-term
debt obligations and is used often by prospective business lenders. A solvency ratio indicates
whether a company’s cash flow is sufficient to meet its long-term liabilities and thus is a
measure of its financial health. An unfavorable ratio can indicate some likelihood that a
company will default on its debt obligations.
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Types of Solvency Ratios
Interest Coverage Ratio
The interest coverage ratio is calculated as follows:
The interest coverage ratio measures how many times a company can cover its current
interest payments with its available earnings. In other words, it measures the margin of safety
a company has for paying interest on its debt during a given period.
The higher the ratio, the better. If the ratio falls to 1.5 or below, it may indicate that a company
will have difficulty meeting the interest on its debts.
Debt-to-Assets Ratio
The debt-to-assets ratio is calculated as follows:
The debt-to-assets ratio measures a company's total debt to its total assets. It measures a
company's leverage and indicates how much of the company is funded by debt versus assets,
and therefore, its ability to pay off its debt with its available assets. A higher ratio, especially
above 1.0, indicates that a company is significantly funded by debt and may have difficulty
meetings its obligations.
Equity Ratio
The shareholder equity ratio is calculated as follows:
The equity ratio, or equity-to-assets, shows how much of a company is funded by equity as
opposed to debt. The higher the number, the healthier a company is. The lower the number,
the more debt a company has on its books relative to equity.
Debt-to-Equity (D/E) Ratio
The debt-to-equity (D/E) ratio is calculated as follows:
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The D/E ratio is similar to the debt-to-assets ratio, in that it indicates how a company is
funded, in this case, by debt. The higher the ratio, the more debt a company has on its books,
meaning the likelihood of default is higher. The ratio looks at how much of the debt can be
covered by equity if the company needed to liquidate.
What Are Profitability Ratios?
Profitability ratios are a class of financial metrics that are used to assess a business's ability
to generate earnings relative to its revenue, operating costs, balance sheet assets,
or shareholders' equity over time, using data from a specific point in time.
Profitability ratios can be compared with efficiency ratios, which consider how well a company
uses its assets internally to generate income (as opposed to after-cost profits).
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Profitability ratios assess a company's ability to earn profits from its sales or
operations, balance sheet assets, or shareholders' equity.
Profitability ratios indicate how efficiently a company generates profit and value for
shareholders.
Higher ratio results are often more favorable, but these ratios provide much more
information when compared to results of similar companies, the company's own
historical performance, or the industry average.
What Do Profitability Ratios Tell You?
For most profitability ratios, having a higher value relative to a competitor's ratio or relative to
the same ratio from a previous period indicates that the company is doing well. Profitability
ratios are most useful when compared to similar companies, the company's own history, or
average ratios for the company's industry.
Gross profit margin is one of the most widely used profitability or margin ratios. Gross profit
is the difference between revenue and the costs of production—called cost of goods
sold (COGS).
Some industries experience seasonality in their operations. For example, retailers typically
experience significantly higher revenues and earnings during the year-end holiday season.
Thus, it would not be useful to compare a retailer's fourth-quarter gross profit margin with its
first-quarter gross profit margin because they are not directly comparable. Comparing a
retailer's fourth-quarter profit margin with its fourth-quarter profit margin from the previous
year would be far more informative.
Examples of Profitability Ratios
Profitability ratios are one of the most popular metrics used in financial analysis, and they
generally fall into two categories—margin ratios and return ratios.
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Margin ratios give insight, from several different angles, on a company's ability to turn sales
into a profit. Return ratios offer several different ways to examine how well a company
generates a return for its shareholders.
Some common examples of profitability ratios are the various measures of profit margin,
return on assets (ROA), and return on equity (ROE). Others include return on invested
capital (ROIC) and return on capital employed (ROCE).
Profit Margin
Different profit margins are used to measure a company's profitability at various cost levels
of inquiry, including gross margin, operating margin, pretax margin, and net profit margin.
The margins shrink as layers of additional costs are taken into consideration—such as the
COGS, operating expenses, and taxes.
Gross margin measures how much a company makes after accounting for
COGS. Operating margin is the percentage of sales left after covering COGS and operating
expenses. The pretax margin shows a company's profitability after further accounting for
non-operating expenses. The net profit margin is a company's ability to generate earnings
after all expenses and taxes.
Return on Assets (ROA)
Profitability is assessed relative to costs and expenses and analyzed in comparison
to assets to see how effective a company is deploying assets to generate sales and profits.
The use of the term "return" in the ROA measure customarily refers to net profit or net
income—the value of earnings from sales after all costs, expenses, and taxes. ROA is net
income divided by total assets.
The more assets a company has amassed, the more sales and potential profits the
company may generate. As economies of scale help lower costs and improve margins,
returns may grow at a faster rate than assets, ultimately increasing ROA.
Return on Equity (ROE)
ROE is a key ratio for shareholders as it measures a company's ability to earn a return on
its equity investments. ROE, calculated as net income divided by shareholders' equity, may
increase without additional equity investments. The ratio can rise due to higher net income
being generated from a larger asset base funded with debt.
What is an Efficiency Ratio?
The efficiency ratio is typically used to analyze how well a company uses its assets
and liabilities internally. An efficiency ratio can calculate the turnover of receivables,
the repayment of liabilities, the quantity and usage of equity, and the general use of
inventory and machinery. This ratio can also be used to track and analyze the
performance of commercial and investment banks.
What Does an Efficiency Ratio Tell You?
Efficiency ratios, also known as activity ratios, are used by analysts to measure the
performance of a company's short-term or current performance. All these ratios use
numbers in a company's current assets or current liabilities, quantifying the
operations of the business.
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An efficiency ratio measures a company's ability to use its assets to generate
income. For example, an efficiency ratio often looks at various aspects of the
company, such as the time it takes to collect cash from customers or the amount of
time it takes to convert inventory to cash. This makes efficiency ratios important,
because an improvement in the efficiency ratios usually translates to improved
profitability.
These ratios can be compared with peers in the same industry and can identify
businesses that are better managed relative to the others. Some common efficiency
ratios are accounts receivable turnover, fixed asset turnover, sales to inventory,
sales to net working capital, accounts payable to sales and stock turnover ratio.
Efficiency Ratios for Banks
In the banking industry, an efficiency ratio has a specific meaning. For banks, the
efficiency ratio is non-interest expenses/revenue. This shows how well the bank's
managers control their overhead (or "back office") expenses. Like the efficiency
ratios above, this allows analysts to assess the performance of commercial and
investment banks.
The Efficiency Ratio for Banks Is:
Since a bank's operating expenses are in the numerator and its revenue is in the
denominator, a lower efficiency ratio means that a bank is operating better.
An efficiency ratio of 50% or under is considered optimal. If the efficiency ratio
increases, it means a bank's expenses are increasing or its revenues are
decreasing.
For example, Bank X reported quarterly earnings and it had an efficiency ratio of
57.1%, which was lower than the 63.2% ratio it reported for the same quarter last
year. This means the company's operations became more efficient, increasing its
assets by $80 million for the quarter.
Coverage Ratios
What Is the Times Interest Earned Ratio?
The times interest earned (TIE) ratio is a measure of a company's ability to meet its debt
obligations based on its current income. The formula for a company's TIE number is earnings
before interest and taxes (EBIT) divided by the total interest payable on bonds and other
debt.
The result is a number that shows how many times a company could cover its interest charges
with its pretax earnings.
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TIE is also referred to as the interest coverage ratio.
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A company's TIE indicates its ability to pay its debts.
A better TIE number means a company has enough cash after paying its debts to
continue to invest in the business.
The formula for TIE is calculated as earnings before interest and taxes divided by total
interest payable on debt.
Understanding the Times Interest Earned (TIE) Ratio
Obviously, no company needs to cover its debts several times over in order to survive.
However, the TIE ratio is an indication of a company's relative freedom from the constraints
of debt. Generating enough cash flow to continue to invest in the business is better than
merely having enough money to stave off bankruptcy.
How to Calculate Times Interest Earned (TIE)
Assume, for example, that XYZ Company has $10 million in 4% debt outstanding and $10
million in common stock. The company needs to raise more capital to purchase equipment.
The cost of capital for issuing more debt is an annual interest rate of 6%. The company's
shareholders expect an annual dividend payment of 8% plus growth in the stock price of XYZ.
The business decides to issue $10 million in additional debt. Its total annual interest expense
will be: (4% X $10 million) + (6% X $10 million), or $1 million annually. The company's EBIT is
$3 million.
This means that the TIE ratio for XYZ Company is 3, or three times the annual interest
expense.
What Is the Debt-Service Coverage Ratio (DSCR)?
The debt-service coverage ratio applies to corporate, government, and personal
finance. In the context of corporate finance, the debt-service coverage ratio (DSCR)
is a measurement of a firm's available cash flow to pay current debt obligations. The
DSCR shows investors whether a company has enough income to pay its debts.
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The debt-service coverage ratio (DSCR) is a measure of the cash flow
available to pay current debt obligations.
DSCR is used to analyze firms, projects, or individual borrowers.
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The minimum DSCR that a lender demands depends on
macroeconomic conditions. If the economy is growing, lenders may be
more forgiving of lower ratios.
Formula and Calculation of the Debt-Service Coverage Ratio (DSCR)
DSCR Formula and Calculation
The formula for the debt-service coverage ratio requires net operating income and the
total debt servicing for the entity. Net operating income is a company's revenue minus certain
operating expenses (COE), not including taxes and interest payments. It is often considered
the equivalent of earnings before interest and tax (EBIT).
Market Prospect Ratios
What Is the Dividend Yield?
The dividend yield, expressed as a percentage, is a financial ratio (dividend/price)
that shows how much a company pays out in dividends each year relative to its
stock price.
The reciprocal of the dividend yield is the price/dividend ratio.
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The dividend yield—displayed as a percentage—is the amount of
money a company pays shareholders for owning a share of its stock
divided by its current stock price.
Mature companies are the most likely to pay dividends.
Companies in the utility and consumer staple industries often having
higher dividend yields.
Real estate investment trusts (REITs), master limited partnerships
(MLPs), and business development companies (BDCs) pay higher than
average dividends; however, the dividends from these companies are
taxed at a higher rate.
It's important for investors to keep in mind that higher dividend yields
do not always indicate attractive investment opportunities because the
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dividend yield of a stock may be elevated as the result of a declining
stock price.
Calculating the Dividend Yield
The formula for dividend yield is as follows:
What Is the Price-to-Earnings (P/E) Ratio?
The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its
current share price relative to its earnings per share (EPS). The price-to-earnings ratio is also
sometimes known as the price multiple or the earnings multiple.
P/E ratios are used by investors and analysts to determine the relative value of a company's
shares in an apples-to-apples comparison. It can also be used to compare a company against
its own historical record or to compare aggregate markets against one another or over time.
P/E may be estimated on a trailing (backward-looking) or forward (projected) basis.
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The price-to-earnings (P/E) ratio relates a company's share price to its earnings per
share.
A high P/E ratio could mean that a company's stock is overvalued, or else that
investors are expecting high growth rates in the future.
Companies that have no earnings or that are losing money do not have a P/E ratio
because there is nothing to put in the denominator.
Two kinds of P/E ratios—forward and trailing P/E—are used in practice.
P/E Ratio Formula and Calculation
The formula and calculation used for this process are as follows.
Example of the P/E Ratio
As a historical example, let's calculate the P/E ratio for Walmart Inc. (WMT) as of Feb. 3,
2021, when the company's stock price closed at $139.55.2
The company's earnings per share for the fiscal year ending Jan. 31, 2021, was $4.75,
according to The Wall Street Journal.3
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Therefore, Walmart's P/E ratio is $139.55 / $4.75 = 29.38.
What Is Earnings Per Share (EPS)?
Earnings per share (EPS) is calculated as a company's profit divided by the outstanding
shares of its common stock. The resulting number serves as an indicator of a company's
profitability. It is common for a company to report EPS that is adjusted for extraordinary
items and potential share dilution.
The higher a company's EPS, the more profitable it is considered to be.
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Earnings per share (EPS) is a company's net profit divided by the number of common
shares it has outstanding.
EPS indicates how much money a company makes for each share of its stock and is
a widely used metric for estimating corporate value.
A higher EPS indicates greater value because investors will pay more for a company's
shares if they think the company has higher profits relative to its share price.
EPS can be arrived at in several forms, such as excluding extraordinary items or
discontinued operations, or on a diluted basis.
Formula and Calculation for EPS
Earnings per share value is calculated as net income (also known as profits or earnings)
divided by available shares. A more refined calculation adjusts the numerator and
denominator for shares that could be created through options, convertible debt, or warrants.
The numerator of the equation is also more relevant if it is adjusted for continuing operations.
To calculate a company's EPS, the balance sheet and income statement are used to find the
period-end number of common shares, dividends paid on preferred stock (if any), and the net
income or earnings. It is more accurate to use a weighted average number of common shares
over the reporting term because the number of shares can change over time.
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How Is EPS Used?
Earnings per share is one of the most important metrics employed when determining a firm's
profitability on an absolute basis. It is also a major component of calculating the price-toearnings (P/E) valuation ratio, where the E in P/E refers to EPS. By dividing a company's
share price by its earnings per share, an investor can see the value of a stock in terms of
how much the market is willing to pay for each dollar of earnings.
EPS is one of the many indicators you could use to pick stocks. If you have an interest in
stock trading or investing, your next step is to choose a broker that works for your investment
style.
Comparing EPS in absolute terms may not have much meaning to investors because ordinary
shareholders do not have direct access to the earnings. Instead, investors will compare EPS
with the share price of the stock to determine the value of earnings and how investors feel
about future growth.
What Is a Dividend Payout Ratio?
The dividend payout ratio is the ratio of the total amount of dividends paid out to shareholders
relative to the net income of the company. It is the percentage of earnings paid to
shareholders via dividends. The amount that is not paid to shareholders is retained by the
company to pay off debt or to reinvest in core operations. It is sometimes simply referred to
as simply the payout ratio.
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The dividend payout ratio is the proportion of earnings paid out as dividends to
shareholders, typically expressed as a percentage.
Some companies pay out all their earnings to shareholders, while some only pay out
a portion of their earnings.
If a company pays out some of its earnings as dividends, the remaining portion is
retained by the business—to measure the level of earnings retained, the retention
ratio is calculated.
Several considerations go into interpreting the dividend payout ratio, most importantly
the company's level of maturity.
Formula and Calculation of Dividend Payout Ratio
The dividend payout ratio can be calculated as the yearly dividend per share divided by the
earnings per share (EPS), or equivalently, the dividends divided by net income (as shown
below).
What the Dividend Payout Ratio Tells You
Several considerations go into interpreting the dividend payout ratio, most importantly the
company's level of maturity. A new, growth-oriented company that aims to expand, develop
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new products, and move into new markets would be expected to reinvest most or all of its
earnings and could be forgiven for having a low or even zero payout ratio. The payout ratio
is 0% for companies that do not pay dividends and is 100% for companies that pay out their
entire net income as dividends.
On the other hand, an older, established company that returns a pittance to shareholders
would test investors' patience and could tempt activists to intervene. In 2012 and after nearly
twenty years since its last paid dividend, Apple (AAPL) began to pay a dividend when the
new CEO felt the company's enormous cash flow made a 0% payout ratio difficult to
justify.1 2 Since it implies that a company has moved past its initial growth stage, a high payout
ratio means share prices are unlikely to appreciate rapidly.
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