TOPIC 4

ANALYTICAL RATIOS

Ratio Analysis

Ratio analysis is a quantitative method of determining the company’s financial status in terms of liquidity,
stability, 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.

Importance of Ratio Analysis

Prospective investors and financial analyst uses ratio analysis to determine the financial status of the
company where they are going to invest their hard earned money. Likewise, financial analyst of a financial
institution uses ratio analysis to justify granting of loans to any company applying for financing. Trend
analysis by comparing data from one period to another period can gauge whether a company is
performing well over time and can be used to estimate likely future performance. Ratio analysis can also
show the company’s averages in comparison with other company with the same industry

Investors can use ratio analysis easily, and every figure needed to calculate the ratios is found on a
company's financial statements. Ratios are used in combination with other ratios in order to establish
clearly the relationship of one data to another data. In such a case, the management of company can
easily see what is happening in the business, find solutions to spotted concerns and predict the future.

There are numerous financial ratios that are used for ratio analysis, and they are grouped into the
following categories:

1. Liquidity ratios

Liquidity ratios measure a company’s ability to meet its debt obligations when it falls due using its current
assets to settle its obligations. Liquidity can be determine by computing the ratios of current assets with
its current liabilities. This ratio is usually called working capital ratio. The corking capital ratio shows how
much of the current assets are available to pay its current obligations. When a company is experiencing
financial difficulties and is unable to pay its debts, it can convert its assets into cash and use the money to
settle any pending debts with more ease.

In a more severe test of liquidity, the company can use the acid test ratio or quick ratio. Liquidity ratios are
used by banks, creditors, and suppliers to determine if a client has the ability to settle their financial
obligations as they become due and demandable. Following are the formula to compute liquidity ratios:

Current ratio / Working capital ratio Current assets

Current liabilities
Acid test / Quick ratio Quick assets
Current liabilities

Note: quick assets are composed of cash and cash

equivalent, marketable securities and accounts
receivables
Cash ratio Cash and cash equivalent
Current liabilities
2. Stability Ratios or Solvency ratios

Stability ratio or solvency ratio measures the company ability to continue its operations for a long period of
time. The ability to pay its shareholders dividends.These ratios compare the debt levels of a company to
its assets, equity, or annual earnings.

The following are some of the stability or solvency ratios and how it can be computed:

Debt ratio Total liabilities

Total assets
Long-term debt to equity ratio Non-current liabilities
Total equity
Total debt to equity ratio Total liabilities
Total equity
Financial leverage Total assets
Total equity
Proprietary ratio Total equity
Total assets

3. Profitability Ratios

Profitability ratios measure a business’ ability to earn profits, relative to their associated expenses.
Recording a higher profitability ratio than in the previous financial reporting period shows that the
business is improving financially. A profitability ratio can also be compared to a similar firm’s ratio to
determine how profitable the business is relative to its competitors.

Some ratios related to profitability and how they can be computed are the following:

Gross profit ratio Gross profit

Sales

Note: Gross profit is the difference between sales and

cost of sales
Operating profit ratio Operating profit
Sales

Note: operating profit is the normal profit excluding

income from other sources
Net profit ratio Net income
Sales

Note; Net income is the residual profit from all sources

after deducting all expenses from all sources.
Return on assets or return on Net income
investment (ROI) Total assets
Return on equity Net income
Total equity

4. Efficiency ratios

Efficiency ratios measure how well the business is using its assets and liabilities to generate sales and
earn profits. They calculate the use of inventory, machinery utilization, turnover of liabilities, as well as the
usage of equity. These ratios are important because, when there is an improvement in the efficiency
ratios, the business stands to generate more revenues and profits.
Some of the important efficiency ratios include the asset turnover ratio, inventory turnover, payables
turnover, working capital turnover, fixed asset turnover, and receivables turnover ratio.

Inventory turnover Cost of sales

Average inventory

Note: average inventory is the sum of beginning and ending

inventory divided by 2
Asset turn over Revenue
Total assets
Fixed assets turnover Revenue
Total fixed assets

Note: fixed assets are those that are premanent in nature that
includes land and properties subject to depreciation
Receivable turn over Net credit sales
Average accounts receivable

Note: credit sales includes only sales on account, excluding

cash sales. Average receivables is AR beginning + AR ending
divided by 2
Accounts payable Credit purchases
turnover Average accounts payable

Note: Average accounts payable is AP beginning + AP ending

divided by 2

5. Coverage ratios

Coverage ratios measure a business’ ability to service its debts and other obligations. Analysts can use
the coverage ratios across several reporting periods to draw a trend that predicts the company’s financial
position in the future. A higher coverage ratio means that a business can service its debts and associated
obligations with greater ease.

Key coverage ratios include the debt coverage ratio, interest coverage, fixed charge coverage, and
EBIDTA coverage.

6. Market prospect ratios

Market prospect ratios help investors to predict how much they will earn from specific investments. The
earnings can be in the form of higher stock value or future dividends. Investors can use current earnings
and dividends to help determine the probable future stock price and the dividends they may expect to
earn.

Key market prospect ratios include dividend yield, earnings per share, the price-to-earnings ratio,
and the dividend payout ratio.

Price /earnings ratio Price per share

Earnings per share

Note: earnings per share is net income divided

number of shares outstanding
Earnings per share (EPS) Net profit
Number of shares outstanding
Book value per share Ordinary shares equity
Number of ordinary shares outstanding

Note: ordinary shares equity is the total equity

minus preference shares
Market value per share Market capitalization
Outstanding shares
Dividend yield Total dividend paid
Number of shares outstanding
Market to book ratio Market price per share
Book value per share

Illustrative Example

From the following financial statements, using analytical ratios, prepare an analysis of the company’s
financial status for the year 2023, in terms of:
1. Liquidity
2. Stability
3. Profitability
4. Efficiency
5. Coverage
6. Market prospect

STATEMENT OF FINANCIAL POSITION 2023 2022

Current Assets
Cash and cash equivalent 700,000 600,000
Trading securities 280,000 500,000
Accounts receivable 400,000 600,000
Allowance for doubtful accounts (20,000) (15,000)
Notes receivable 250,000 500,000
Inventories, 2,500,000 1,300,000
Advances to officers not currently due 100,000 50,000
Prepaid expenses 80,000 100,000
Accrued interest income 10,000 40,000
Total current assets 4,300,000 3,675,000

Non-current Assets
Sinking fund 400,000 400,000
Long-term refundable deposit 50,000 75,000
Cash surrender value 60,000 60,000
Lease rights 100,000 100,000
Land 2,500,000 2,300,000
Land held for speculation 1,500,000 500,000
Building 5,000,000 4,000,000
Accumulated Depreciation-building (2,000,000 (1,750,000)
)
Equipment 1,500,000 1,000,000
Accumulated Depreciation-equipment (200,000) (140,000)
Computer Software 3,250,000 3,250,000
Preference share redemption fund 500,000 350,000
Total Non-current assets 12,660,000 10,145,000

Total Assets 16,960,00 13,820,00

0 0

Current Liabilities
Notes payable 300,000 500,000
Accounts payable 400,000 500,000
Accrued salaries 100,000 100,000
Unearned rent income 40,000 70,000
SSS payable 10,000 10,000
Dividend payable 120,000 200,000
Income tax payable 200,000 200,000
Total current liabilities 1,170,000 1,580,000

Non-current Liabilities
Bonds payable 5,000,000 6,000,000
Premium on bonds payable 1,000,000 1,100,000
Total non-current liabilities 6,000,000 7,100,000

Total Liabilities 7,170,000 8,680,000

Shareholder’s Equity
Ordinary shares capital 5,000,000 4,000,000
Preference share capital 3,000,000 1,800,000
Share premium – preference shares 600,000 400,000
Share premium – ordinary shares 300,000 150,000
Retained earnings 890,000 (1,210,000)
Total Equity 9,710,000 5,140,000

Total liabilities and Equity 16,960,00 13,820,00

0 0

STATEMENT OF OPERATING INCOME

Sales 15,700,000 12,650,000
Sales return (250,000) (200,000)
Sales allowances (50,000) (20,000)
Sales discounts (40,000) (18,000)
Net sales 15,360,000 12,412,000

Inventories – January 1 1,300,000 2,000,000

Purchases 12,500,000 10,850,000
Freight-in 1,000,000 750,000
 Purchase return (150,000) (100,000)
Purchase allowances (150,000) (110,000)
Purchase discounts (200,000) (150,000)
Goods Available for Sales 14,300,000 13,240,000
Inventories – December 31 (2,500,000 (1,300,000)
)
Cost Sales 11,800,000 11,940,000

Gross Profit 3,560,000 472,0000

Operating expenses
Freight-out 850,000 590,000
Salesmen commission 1,300,000 1,100,000
Depreciation expense – Building 250,000 250,000
Officers salaries 1,300,000 1,200,000
Depreciation expense - equipment 60,000 40,000
Total operating expenses 3,760,000 3,180,000
Operating income (200,000) (2,708,000)

Rent income 300,000 300,000

Interest income 30,000 30,000
Loss on sale of equipment (10,000) (15,000)
Loss on sales of securities (40,000) -
Net other income 280,000 315,000

Net Income (loss) P80,000 (2,393,00

0)

Answers:
1. LIQUIDITY
Current assets / current liabilities
Working capital ratio 4,300,000 / 1,700,000
= 3.68
Analysis: In terms of working capital, the business is liquid as there is P3.68 available to pay every
P1.00 of its obligation

Quick ratio Quick assets / current liabilities

= 700,000 + 280,000 + 380,000 + 250,000
1,700,000
= 1,610,000
1,700,000
= .95
Analysis: In terms of quick ratio, the liquidity of the company is in question as there is
only P.95 of its quick assets to pay every P1.00 of its obligation. Assets that are
immediately convertible into cash is not enough to pay its maturing obligations.

Cash ratio Cash and cash equivalent / current liabilities

= 700,000 / 1,700,000
= .60
Analysis: in a more severe test of liquidity, the company can only pay P.60 of its P1.00
liability when it falls due. They will usually need more time to convert some current assets
into cash to honor its obligations.
2. STABILITY
Debt ratio Total liabilities / total assets
= 7,170,000 /16,960,000
= .42
Analysis: Forty two percent of the assets of the company are provided through
borrowings and 58% are provided by owners. The company is a little bit stable, but must
strive to improve its debt ratio to a more acceptable level.

Long term debt to equity ratio Noncurrent liabilities / total equity

= 6,000,000 / 9,710,000
= .62
Analysis: Currently, 62% of the total equity is reserved to absorb long term obligations,
while only 38% are available for payment of dividends to shareholders. These may result
to nonpayment of dividend or deferment of payment for a while. The business must
endeavor to reduce its long term debts.

Total debt to equity ratio Total liabilities / total equity

= 7,170,000 / 9,710,000
= .74
Analysis: The debt to equity ratio of 74% may be concluded as not so good. In the event of
insolvency, the owners can expect only 26% return of their invested capital.

Financial leverage Total assets /total equity

= 16,960,000 / 9,710,000
= 1.75

Analysis:

Proprietary ratio Total equity / total assets

= 9710,000 / 16,960,000
= .57
Analysis: The equity to asset ratio shows that 57% of the total assets of the business is
owned by the shareholders and 43% is own by outside creditors. Although majority
interest still belong to the owners, still a large portion is held by the creditors.

3. PROFITABILITY
Gross profit ratio Gross profit / sales
= 3,560,000 / (15,700,000-250,000)
= 3,560,000 /15,450,000
= 23%
Analysis: The gross profit ratio is low as the company will only 23% to absorb operating
expenses.

Operating profit ratio Operating profit / sales

= (200,000) / 15,250,000
= (1.3%)
Analysis: Because of a very low gross profit ratio, the business failed to absorb the
operating expenses, hence negative operating profit ratio.
Net profit ratio Net profit / sales
= 80,000 / 15,250,000
= .5%
Analysis: Because of other income earned by the company, the net income showed
positive results, though very minimal of less than 1%.
return on assets Net income / total assets
= 80,000 / 16,960,000
= .0047
Analysis: The return on investment during the year is less than one centavo for every peso
invested by owners. As such a question of profitability.
Return on equity Net income / total equity
= 80,000 / 9,710,000
= .0082
Analysis: The return on owner’s equity is also less than one centavo for every peso of
equity interest of shareholders.

4. EFFICIENCY RATIO
Inventory turn-over Cost of sales / average inventory
= 11,800,000 / (1,300,000 + 1,500,000)
= 11,800,000 / 900,000
= 13 times
Analysis: Inventory turnover measure the number of times inventory has been replaced
because of sales. The inventory turnover 13 times during the year, which shows salability
of their product.
Asset turnover Revenue / total assets
= 15,360,000 /16,960,000
.91 times
Analysis: Asset turnover is a measure of the efficiency by which assets are utilized to earn
revenue. The asset turnover of .91 shows that assets are not maximize to earn revenue.
Management should utilize its assets more to increase revenue

Receivable turnover Net credit sales / average receivables

= 15,360,000 / (400,000 + 600,000)
= 15,360,000 / 500,000
= 31 times
Analysis: Receivable turnover measures the collectability of receivables. The turnover
ratio of 31 times showed that receivables of the business are highly collectible.
Accounts payable turnover Credit purchases / average accounts
payable
= 12,000,000 / (500,000 + 400,000)
= 12,000,000 / 450,000
= 27 times
Analysis: Payable turnover measures the number of times the company pays its liabilities
in a year. The payable turnover of 27 times shows that the business is paying their
accounts payable as it matures.
5. COVERAGE RATIOS
This ratio cannot be computed as some data that are needed in the
computation as not given in the sample financial statements.

6.MARKET PROSPECT
Price / Earnings ratio Price per share / Earnings per share
= 100 /(80,000 /5,000,000/100)
= 100 /(80,000/50,000)
= 100 / 1.6
= 62.50
Note: to compute the ratio, we assume that the price per share of ordinary shares is P100.
As such the total amount of ordinary shares of P5,000,000 divided by P100 will give us the
number of shares outstanding of 50,000 shares. To compute for the earnings per share we
divide net income of P80,000 by the number of shares outstanding of 50,000, hence
earning per share is P1.60.
Analysis: The price earnings ratio relates the price of the shares of stock acquired by the
investors to the earnings that they may get in relation to the value of stocks acquired. The
ratio showed that for every P1.60 earnings, the investor will expend P62.50. Practicality
tells the prospective investors not to invest in this type of situation.
Earnings per share Net profit / number of shares outstanding
= 80,000 /50,000
= P1.62
Analysis: Earnings per share measures the amount that per share of stock will earned.
Though it shows positive amount, the price by which the investors will pay to acquire one
stock is much higher.
Book value per share Ordinary share equity / number of shares
outstanding
= 6,710,000 / 50,000
= P134.20
Note: to compute ordinary shares equity, the total equity shall be reduced by preference
shares equity. Ordinary shares equity is P9,710,000 – 3,000,000 = P6,710,000
Analysis: The book value per share of stocks measures the value per share of stock as of a
given time period. Currently, the stock value of P134.20 is above the par value of P100.
This is advantageous to the current shareholders, but not with the incoming investors, as
the price earnings is too low.
The market value per shares, dividend
yield and market to book ratio cannot be
computed because of the lack of some data
that are needed in the computation.