Financial Ratio

Dr Debra Munsterman

Minnesota West College

Financial Ratios

They keep you informed about your company's financial activity

Allows you to detect operating problems as soon as they occur.

Allows you to take prompt action to correct these problems

Gives you a comparison to past performances. Shows you how you stack up against other similar

companies by utilizing industry standards.

Purpose of Analyzing Financial Stmts Analysis will give you better control over your company’s

operations and financial condition. Financial Activities that are related to one another:

Sales are related to the inventory you sell, COGS, and net profits

A/R are related to your credit granting practices, collection policies which in turn relate to cash flow and A/P

A/P relate to purchasing policies, which in turn relate to inventory levels which, relate to cash flow.

Marketing and advertising relate to sales.

Financial Ratios

Analysis of the financial Statements as they change over time allow us to detect trends that often escape our attention.

Concept of Financial Ratios

Financial ratios compare one financial value to another.

Ratios take absolute values (dollar amounts) and convert them to relative values (percentages or index numbers).

Why Use Ratios to Analyze Financial Statement Benchmarks--They are industry norms that

allow a business to compare its financial ratios with the rations of other like businesses in the country.

Financial ratios can improve the financial management of your company by:

Understanding the relationship between financial statements.

Provides an in-depth appraisal of the company’s financial health.

Identifies potential trouble spots that need immediate attention.

Serves as a monitor or comparison to your industry standards.

Provides information for making projections and planning for future courses of action.

Financial Statements and Ratio Analysis

Goal To determine your

solvency, risk and efficiency.

Three Ways to Use Financial Ratios Compare current

performance to your performance in prior years.

Compare your present performance to others in your industry.

Utilize projected financial ratios to develop a workable operating strategy.

Your Plan of Action

Gather Information Package the Information Calculate Your Financial

Ratios. Record your Industry

Standard Guidelines Compare your Results Identify problems Analyze causes of

problems. Take Action.

Grouping Financial Ratios

Financial Ratios can be broken down into four functional groups. Balance Sheet Ratios Profit & Loss Ratios Efficiency Ratios Working Capital Cycle

Ratio

Balance Sheet Ratios

Solvency: Current Ratio Measures solvency – the ability to pay its

bills. Liquidity

Quick Ratio Measures liquidity – the ability to generate cash without relying on the sales of inventories.

Safety Debt to Equity Measures the ability to withstand adversity

– shows the riskiness of the firm.

Profit & Loss Statement Ratios Gross Profit Margin—Measures the

percentage of each dollar left after deducting the COGS. Also known as "gross margin".

Calculated as:

Gross profit Margin = Revenue-COGS/Revenue

$600,000/$2,500,000. = 24%

Profit & Loss Statement Ratios Net Profit margin—Measures the percentage

of each sales dollar left after deducting all expenses except income tax. Operating Income/Sales =Profit Margin on Sales

$210,000/$2,500,000 = 8.4%

Asset Management – Overall Efficiency Ratios

Sales-to-Assets Measures the efficiency of assets in producing sales. Shows how many sales are produced by one dollar of assets. Sales to Fixed Assets = sales / fixed assets.

Return-on-Assets Measures the efficiency of each dollar of assets employed by the business at producing profits. ROA = Net income/Total Assets

Return on Investment

Return on Investment Measures the percentage return on each dollar invested by owners. Return on investment is frequently derived as the “return” (incremental gain) from an

action divided by the cost of that action. That is “simple ROI,” as used in business case analysis and other forms of cash flow analysis. For example, what is the ROI for a new marketing program that is expected to cost $500,000 over the next five years and deliver an additional $700,000 in increased profits during the same time? Gains-Investment Cost/Investment Cost = ROI 700,000-500,0000/$500,000 = 40%

Simple ROI is the most frequently used form of ROI and the most easily understood. With simple ROI, incremental gains from the investment are divided by investment costs.

Simple ROI works well when both the gains and the costs of an investment are easily known and where they clearly result from the action. In complex business settings, however, it is not always easy to match specific returns (such as increased profits) with the specific costs that bring them (such as the costs of a marketing program), and this makes ROI less trustworthy as a guide for decision support. Simple ROI also becomes less trustworthy as a useful metric when the cost figures include allocated or indirect costs, which are probably not caused directly by the action or the investment.

Assets management—Working Capital Cycle Ratios

Inventory Turnover Measures the annual rate at which the inventory is sold. Inventory Days Converts inventory rate to

“days inventory is on hand” Sales / Inventory = Inventory Turnover The days in the period can then be divided by

the inventory turnover formula to calculate the days it takes to sell the inventory on hand or "inventory turnover days".

Accounts Receivable Turnover R/A Turnover Measures the annual

rate at which accounts receivable are being collected.

Average Collection Period Converts the A/R turnover to the average time the firm must wait to collect on its invoices. A/R / Average Daily Sales = # Days (Average Daily Sales = Total Sales / 365)

Accounts Payable Turnover

A/P Turnover A measure of the rate at which A/P are being paid.

Average payment Period converts the A/P turnover to the average length of time it takes the firm to pay its bills.

Ratio Analysis

Liquidity ratios ratios that relates the firm’s cash and other assets

to its current liabilities Liquid asset

an asset that can be easily converted into cash without significant loss of its original value

Current ratio indicates the extent to which current liabilities are

covered by assets expected to be converted into cash in the near future

sLiabilitieCurrent

assetsCurrent ratioCurrent

Ratio Analysis

Quick (acid test) ratio deducts inventories from current assets and

divides the remainder by current liabilities Shows the relationship between the more liquid current assets

and all current liabilities.

sLiabilitieCurrent

sInventorie - assetsCurrent ratio Quick

Ratio Analysis

Ratio Analysis

Leverage Ratios Debt ratio—How many dollars of assets you have to

cover all your debt.

Debts Total

Assets Total

Ratio Analysis

Asset management ratios ratios that measure how effectively a firm is

managing its assets

Ratio Analysis

Trend analysis an analysis of a firm’s financial ratios over time used to determine improvement or deterioration in

its financial situation