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Financial Ratio Analysis Tutorial With Examples

assignment financial ratio analysis

The Balance Sheet for Financial Ratio Analysis

The income statement for financial ratio analysis, analyzing the liquidity ratios, the current ratio, the quick ratio, analyzing the asset management ratios accounts receivable, receivables turnover, average collection period, inventory, fixed assets, total assets, inventory turnover ratio, fixed asset turnover, total asset turnover, analyzing the debt management ratios, debt-to-asset ratio, times interest earned ratio, fixed charge coverage, analyzing the profitability ratios, net profit margin, return on assets, return on equity, financial ratio analysis of xyz corporation.

While it may be more fun to work on marketing efforts, the financial management of a firm is a crucial aspect of owning a business. Financial ratios help break down complex financial information into key details and relationships. Financial ratio analysis involves studying these ratios to learn about the company's financial health.

Here are a few of the most important financial ratios for business owners to learn, what they tell you about the company's financial statements , and how to use them.

Key Takeaways

  • Some of the most important financial ratios for business owners include the current ratio, the inventory turnover ratio, and the debt-to-asset ratio.
  • These financial ratios quickly break down the complex information from financial statements.
  • Financial ratios are snapshots, so it's important to compare the information to previous periods of data as well as competitors in the industry.

Here is the balance sheet we are going to use for our financial ratio tutorial. You will notice there are two years of data for this company so we can do a time-series (or trend) analysis and see how the firm is doing across time.

Here is the complete income statement for the firm for which we are doing financial ratio analysis. We are doing two years of financial ratio analysis for the firm so we can compare them.

Refer back to the income statement and balance sheet as you work through the tutorial.

The first ratios to use to start getting a financial picture of your firm measure your liquidity, or your ability to convert your current assets to cash quickly. They are two of the 13 ratios. Let's look at the current ratio and the quick (acid-test) ratio .

The current ratio measures how many times you can cover your current liabilities. The quick ratio measures how many times you can cover your current liabilities without selling any inventory and so is a more stringent measure of liquidity.

Remember that we are doing a time series analysis, so we will be calculating the ratios for each year.

Current Ratio : For 2020, take the Total Current Assets and divide them by the Total Current Liabilities. You will have: Current Ratio = 642/543 = 1.18X. This means that the company can pay for its current liabilities 1.18 times over. Practice calculating the current ratio for 2021.

Your answer for 2021 should be 1.31X. A quick analysis of the current ratio will tell you that the company's liquidity has gotten just a little bit better between 2020 and 2021 since it rose from 1.18X to 1.31X.

Quick Ratio : In order to calculate the quick ratio, take the Total Current Ratio for 2020 and subtract out Inventory. Divide the result by Total Current Liabilities. You will have: Quick Ratio = (642-393)/543 = 0.46X. For 2021, the answer is 0.52X.

Like the current ratio, the quick ratio is rising and is a little better in 2021 than in 2020. The firm's liquidity is getting a little better. The problem for this company, however, is that they have to sell inventory in order to pay their short-term liabilities and that is not a good position for any firm to be in. This is true in both 2020 and 2021.

This firm has two sources of current liabilities: accounts payable and notes payable. They have bills that they owe to their suppliers (accounts payable) plus they apparently have a bank loan or a loan from some alternative source of financing. We don't know how often they have to make a payment on the note.

Asset management ratios are the next group of financial ratios that should be analyzed. They tell the business owner how efficiently they employ their assets to generate sales. Assume all sales are on credit.

  • Receivables Turnover = Credit Sales/Accounts Receivable = ___ X so:
  • Receivables Turnover = 2,311/165 = 14X

A receivables turnover of 14X in 2020 means that all accounts receivable are cleaned up (paid off) 14 times during the 2020 year. For 2021, the receivables turnover is 15.28X. Look at 2020 and 2021 Sales in The Income Statement and Accounts Receivable in The Balance Sheet.

The receivables turnover is rising from 2020 to 2021. We can't tell if this is good or bad. We would really need to know what type of industry this firm is in and get some industry data to compare to.

Customers paying off receivables is, of course, good. But, if the receivables turnover is way above the industry's, then the firm's credit policy may be too restrictive.

Average collection period is also about accounts receivable. It is the number of days, on average, that it takes a firm's customers to pay their credit accounts. Together with receivables turnover, average collection helps the firm develop its credit and collections policy.

  • Average Collection Period = Accounts Receivable/Average Daily Credit Sales*
  • *To arrive at average daily credit sales, take credit sales and divide by 360
  • Average Collection Period = $165/2311/360 = $165/6.42 = 25.7 days
  • In 2021, the average collection period is 23.5 days

From 2020 to 2021, the average collection period is dropping. In other words, customers are paying their bills more quickly. Compare that to the receivables turnover ratio. Receivables turnover is rising and the average collection period is falling.

This makes sense because customers are paying their bills faster. The company needs to compare these two ratios to industry averages. In addition, the company should take a look at its credit and collections policy to be sure they are not too restrictive. Take a look at the image above and you can see where the numbers came from on the balance sheets and income statements.

Along with the accounts receivable ratios that we analyzed above, we also have to analyze how efficiently we generate sales with our other assets: inventory, plant and equipment, and our total asset base.

The inventory turnover ratio is one of the most important ratios a business owner can calculate and analyze. If your business sells products as opposed to services, then inventory is an important part of your equation for success.

Inventory Turnover = Sales/Inventory = ______ X

If your inventory turnover is rising, that means you are selling your products faster. If it is falling, you are in danger of holding obsolete inventory. A business owner has to find the optimal inventory turnover ratio where the ratio is not too high and there are no stockouts or too low where there is obsolete money. Both are costly to the firm.

For this company, their inventory turnover ratio for 2020 is:

Inventory Turnover Ratio = Sales/Inventory = 2311/393 = 5.9X

This means that this company completely sells and replaces its inventory 5.9 times every year. In 2021, the inventory turnover ratio is 6.8X. The firm's inventory turnover is rising. This is good in that they are selling more products. The business owner should compare the inventory turnover with the inventory turnover ratio with other firms in the same industry.

The fixed asset turnover ratio analyzes how well a business uses its plant and equipment to generate sales. A business firm does not want to have either too little or too much plant and equipment. For this firm for 2020:

Fixed Asset Turnover = Sales/Fixed Assets = 2311/2731 = 0.85X

For 2021, the fixed asset turnover is 1.00. The fixed asset turnover ratio is dragging down this company. They are not using their plant and equipment efficiently to generate sales as, in both years, fixed asset turnover is very low.

The total asset turnover ratio sums up all the other asset management ratios. If there are problems with any of the other total assets, it will show up here, in the total asset turnover ratio.

Total Asset Turnover = Sales/Total Asset Turnover = Sales/Total Assets = 2311/3373 = 0.69X for 2020. For 2021, the total asset turnover is 0.80. The total asset turnover ratio is somewhat concerning since it was not even 1X for either year.

This means that it was not very efficient. In other words, the total asset base was not very efficient in generating sales for this firm in 2020 or 2021. Why?

It seems to me that most of the problem lies in the firm's fixed assets. They have too much plant and equipment for their level of sales. They either need to find a way to increase their sales or sell off some of their plant and equipment. The fixed asset turnover ratio is dragging down the total asset turnover ratio and the firm's asset management in general.

There are three debt management ratios that help a business owner evaluate the company in light of its asset base and earning power. Those ratios are the debt-to-asset ratio, the times interest earned ratio , and the fixed charge coverage ratios. Other debt management ratios exist, but these help give business owners the first look at the debt position of the company and the prudence of that debt position.

The first debt ratio that is important for the business owner to understand is the debt-to-asset ratio ; in other words, how much of the total asset base of the firm is financed using debt financing. For example. the debt-to-asset ratio for 2020 is:

Total Liabilities/Total Assets = $1074/3373 = 31.8%. This means that 31.8% of the firm's assets are financed with debt. In 2021, the debt ratio is 27.8%. In 2021, the business is using more equity financing than debt financing to operate the company.

We don't know if this is good or bad since we do not know the debt-to-asset ratio for firms in this company's industry. However, we do know that the company has a problem with its fixed asset ratio which may be affecting the debt-to-asset ratio.

The times interest earned ratio tells a company how many times over a firm can pay the interest that it owes. Usually, the more times a firm can pay its interest expense the better. The times interest earned ratio for this firm for 2020 is:

  • Times Interest Earned = Earnings Before Interest and Taxes/Interest = 276/141 = 1.96X
  • For 2021, the times interest earned ratio is 3.35

The times interest earned ratio is very low in 2020 but better in 2021. This is because the debt-to-asset ratio dropped in 2021.

The fixed charge coverage ratio is very helpful for any company that has any fixed expenses they have to pay. One fixed charge (expense) is interest payments on debt, but that is covered by the times interest earned ratio.

Another fixed charge would be lease payments if the company leases any equipment, a building, land, or anything of that nature. Larger companies have other fixed charges which can be taken into account.

  • Fixed charge coverage = Earnings Before Fixed Charges and Taxes/Fixed Charges = _____X

In both 2020 and 2021 for the company in our example, its only fixed charge is interest payments. So, the fixed charge coverage ratio and the times interest earned ratio would be exactly the same for each year for each ratio.

The last group of financial ratios that business owners usually tackle are the profitability ratios as they are the summary ratios of the 13 ratio group. They tell the business firm how they are doing on cost control, efficient use of assets, and debt management, which are three crucial areas of the business.

The net profit margin measures how much each dollar of sales contributes to profit and how much is used to pay expenses. For example, if a company has a net profit margin of 5%, this means that 5 cents of every sales dollar it takes in goes to profit and 95 cents goes to expenses. For 2020, here is XYZ, Inc's net profit margin:

Net Profit Margin = Net Income/Sales Revenue = 89.1/2311 = 3.9%

For 2021, the net profit margin is 6.5%, so there was quite an increase in their net profit margin. You can see that their sales took quite a jump but their cost of goods sold rose. It is the best of both worlds when sales rise and costs fall. Bear in mind, the company can still have problems even if this is the case.

The return on assets ratio, also called return on investment , relates to the firm's asset base and what kind of return they are getting on their investment in their assets. Look at the total asset turnover ratio and the return on asset ratio together. If total asset turnover is low, the return on assets is going to be low because the company is not efficiently using its assets.

Another way to look at the return on assets is in the context of the Dupont method of financial analysis. This method of analysis shows you how to look at the return on assets in the context of both the net profit margin and the total asset turnover ratio.

  • To calculate the Return on Assets ratio for XYZ, Inc. for 2020, here's the formula:
  • Return on Assets = Net Income/Total Assets = 2.6%

For 2021, the ROA is 5.2%. The increased return on assets in 2021 reflects the increased sales and much higher net income for that year.

The return on equity ratio is the one of most interest to the shareholders or investors in the firm. This ratio tells the business owner and the investors how much income per dollar of their investment the business is earning. This ratio can also be analyzed by using the Dupont method of financial ratio analysis. The company's return on equity for 2020 was:

Return on Equity = Net Income/Shareholder's Equity = 3.9%

For 2021, the return on equity was 7.2%. One reason for the increased return on equity was the increase in net income. When analyzing the return on equity ratio, the business owner also has to take into consideration how much of the firm is financed using debt and how much of the firm is financed using equity.

Now we have a summary of all 13 financial ratios for XYZ Corporation. The first thing that jumps out is the low liquidity of the company. We can look at the current and quick ratios for 2020 and 2021 and see that the liquidity is slightly increasing between 2020 and 2021, but it is still very low.

By looking at the quick ratio for both years, we can see that this company has to sell inventory in order to pay off short-term debt. The company does have short-term debt: accounts payable and notes payable, and we don't know when the notes payable will come due.

Let's move on to the asset management ratios. We can see that the firm's credit and collections policies might be a little restrictive by looking at the high receivable turnover and low average collection period. Customers must pay this company rapidly—perhaps too rapidly. There is nothing particularly remarkable about the inventory turnover ratio, but the fixed asset turnover ratio is remarkable.

The fixed asset turnover ratio measures the company's ability to generate sales from its fixed assets or plant and equipment. This ratio is very low for both 2020 and 2021. This means that XYZ has a lot of plant and equipment that is unproductive.

It is not being used efficiently to generate sales for the company. In addition, the company has to service the plant and equipment, pay for breakdowns, and perhaps pay interest on loans to buy it through long-term debt.

It seems that a very low fixed asset turnover ratio might be a major source of problems for XYZ. The company should sell some of this unproductive plant and equipment, keeping only what is absolutely necessary to produce their product.

The low fixed asset turnover ratio is dragging down total asset turnover. If you follow this analysis on through, you will see that it is also substantially lowering this firm's return on assets profitability ratio.

With this firm, it is hard to analyze the company's debt management ratios without industry data. We don't know if XYZ is a manufacturing firm or a different type of firm.

As a result, analyzing the debt-to-asset ratio is difficult. What we can see, however, is that the company is financed more with shareholder funds (equity) than it is with debt as the debt-to-asset ratio for both years is under 50% and dropping.

This fact means that the return on equity profitability ratio will be lower than if the firm was financed more with debt than with equity. On the other hand, the risk of bankruptcy will also be lower.

Unfortunately, you can see from the times interest earned ratio that the company does not have enough liquidity to be comfortable servicing its debt. The company's costs are high and liquidity is low. Fortunately, the company's net profit margin is increasing because their sales are increasing.

Hopefully, this is a trend that will continue. Return on Assets is impacted negatively due to the low fixed asset turnover ratio and, to some extent, by the receivables ratios. Return on Equity is increasing from 2020 to 2021, which will make investors happy.

As you can see, it is possible to do a cursory financial ratio analysis of a business firm with only 13 financial ratios, even though ratio analysis has inherent limitations.

Wells Fargo. " 5 Ways To Improve Your Liquidity Ratio ."

Julie Dahlquist, Rainford Knight. " Principles of Finance: 6.2 Operating Efficiency Ratios ." OpenStax, 2022.

U.S. Small Business Administration. " Calculate & Analyze Your Financial Ratios ," Pages 2, 4.

U.S. Small Business Administration. " Calculate & Analyze Your Financial Ratios ," Pages 3, 6.

Julie Dahlquist, Rainford Knight. " Principles of Finance: 6.4 Solvency Ratios ." OpenStax, 2022.

Nasdaq. " Fixed-Charge Coverage Ratio ."

U.S. Small Business Administration. " Calculate & Analyze Your Financial Ratios ," Pages 3, 5.

Julie Dahlquist, Rainford Knight. " Principles of Finance: 6.6 Profitability Ratios and the DuPont Method ." OpenStax, 2022.

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12.1: Introduction to Ratio Analysis

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  • Henry Dauderis and David Annand
  • Athabasca University via Lyryx Learning

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Learning Objectives

  • LO1 – Describe ratio analysis, and explain how the liquidity, profitability, leverage, and market ratios are used to analyze and compare financial statements.

A common way to evaluate financial statements is through ratio analysis . A ratio is a relationship between two numbers of the same kind. For example, if there are two apples and three oranges, the ratio of the number of apples to the number of oranges is 2:3 (read as "two to three"). A financial ratio is a measure of the relative magnitude of two selected numerical values taken from a company's financial statements. For instance, the gross profit percentage studied in Chapter 6, also known as the gross profit ratio, expresses the numerical relationship between gross profit and sales. If a company has a gross profit ratio of 0.25:1, this means that for every $1 of sales, the company earns, on average, $0.25 to cover expenses other than cost of goods sold. Another way of stating this is to say that the gross profit ratio is 25%. 1

Financial ratios are effective tools for measuring the financial performance of a company because they provide a common basis for evaluation — for instance, the amount of gross profit generated by each dollar of sales for different companies. Numbers that appear on financial statements need to be evaluated in context. It is their relationship to other numbers and the relative changes of these numbers that provide some insight into the financial health of a business. One of the main purposes of ratio analysis is to highlight areas that require further analysis and investigation. Ratio analysis alone will not provide a definitive financial evaluation. It is used as one analytic tool, which, when combined with informed judgment, offers insight into the financial performance of a business.

For example, one business may have a completely different product mix than another company even though both operate in the same broad industry. To determine how well one company is doing relative to others, or to identify whether key indicators are changing, ratios are often compared to industry averages . To determine trends in one company's performance, ratios are often compared to past years' ratios of the same company.

To perform a comprehensive analysis, qualitative information about the company as well as ratios should be considered. For example, although a business may have sold hundreds of refrigerators last year and all of the key financial indicators suggest growth, qualitative information from trade publications and consumer reports may indicate that the trend will be towards refrigerators using significantly different technologies in the next few years. If the company does not have the capacity or necessary equipment to produce these new appliances, the present positive financial indicators may not accurately reflect the likely future financial performance of the company.

An examination of qualitative factors provides valuable insights and contributes to the comprehensive analysis of a company. An important source of qualitative information is also found in the notes to the financial statements, which are an integral part of the company's financial statements.

In this chapter, financial ratios will be used to provide insights into the financial performance of Big Dog Carworks Corp. (BDCC). The ratios will focus on financial information contained within the income statement, statement of changes in equity, and balance sheet of BDCC for the three years 2019, 2020, and 2021. This information is shown below. Note that figures in these statements are reported in thousands of dollars (000s). For consistency, all final calculations in this chapter are rounded to two decimal places.

Assume that 100,000 common shares are outstanding at the end of 2019, 2020, and 2021. Shares were issued in 2020, but at the end of year the number of outstanding shares was still 100,000.

There are four major types of financial ratios: a) liquidity ratios that measure the ability of a corporation to satisfy demands for cash as they arise in the near-term (such as payment of current liabilities); b) profitability ratios that measure various levels of return on sales, total assets employed, and shareholder investment; c) leverage ratios that measure the financial structure of a corporation, its amount of relative debt, and its ability to cover interest expense; and d) market ratios that measure financial returns to shareholders, and perceptions of the stock market about the corporation's value.

Initial insights into the financial performance of BDCC can be derived from an analysis of relative amounts of current and non-current debt. This analysis is addressed in the following sections.

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What Is Ratio Analysis?

Net profit margin, price-to-earnings ratio (p/e), other factors to consider.

  • Ratio Analysis FAQs
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How to Use Ratio Analysis to Compare Companies

Ratio analysis helps investors compare companies' financial performance

When investors wish to compare the financial performance of different companies, a highly valuable tool at their disposal is ratio analysis . Ratio analysis can provide insight into companies' relative financial health and future prospects. It can yield data about profitability, liquidity, earnings, extended viability, and more. The results of such comparisons can mean more powerful decision-making when it comes to selecting companies in which to invest.

It's important that investors understand that a single ratio from just one company can't give them a reliable idea of a company's current performance or potential for future financial success. Use a variety of ratios to analyze financial information from various companies that interest you in order to make investment decisions.

Key Takeaways

  • Ratio analysis is a method of analyzing a company's financial statements or line items within financial statements.
  • Many ratios are available, but some, like the price-to-earnings ratio and the net profit margin, are used more frequently by investors and analysts.
  • The price-to-earnings ratio compares a company's share price to its earnings per share.
  • Net profit margin compares net income to revenues.
  • It's useful to compare various ratios of different companies over time for a reliable view of current and potential future financial performance.

Ratio analysis is the analysis of financial information found in a company's financial statements . Such analysis can shed light on financial aspects that include risk, reward (profitability), solvency, and how well a company operates . As a tool for investors, ratio analysis can simplify the process of comparing the financial information of multiple companies.

There are five basic types of financial ratios :

  • Profitability ratios (e.g., net profit margin and return on shareholders' equity)
  • Liquidity ratios (e.g., working capital)
  • Debt or leverage ratios (e.g., debt-to-equity and debt-to-asset ratios)
  • Operations ratios (e.g., inventory turnover)
  • Market ratios (e.g. earnings per share (EPS))

Some key ratios that investors use are the net profit margin and price-to-earnings (P/E) ratios.

Net profit margin, often referred to simply as profit margin or the bottom line, is a ratio that investors use to compare the profitability of companies within the same sector. It measures the amount of net profit (gross profit minus expenses) earned from sales. It's calculated by dividing a company's net income by its revenues.

Instead of dissecting financial statements to compare how profitable companies are, an investor can use this ratio instead. For example, suppose company ABC and company DEF are in the same sector. They have profit margins of 50% and 10%, respectively. An investor can easily compare the two companies and conclude that ABC converted 50% of its revenues into profits, while DEF only converted 10%.

Another ratio that can help when comparing companies is the company's gross profit divided by its operating expenses . By not deducting taxes, you can compare two businesses that might pay different state tax rates due to their location.

One metric alone will not give a complete and accurate picture of how well a company operates. For example, some analysts believe that the cash flow of a company is more important than the net profit margin ratio.

Another ratio investors often use is the price-to-earnings ratio. This is a valuation ratio that compares a company's current share price to its earnings per share. It measures how buyers and sellers price the stock per $1 of earnings.

The P/E ratio gives an investor an easy way to compare one company's earnings with those of other companies. Using the companies from the above example, suppose ABC has a P/E ratio of 100, while DEF has a P/E ratio of 10. An investor can conclude that investors are willing to pay $100 per $1 of earnings that ABC generates and only $10 per $1 of earnings that DEF generates.

A high P/E ratio can indicate that a company's stock is overvalued or that investors may be expecting high future earnings growth. A low P/E ratio can indicate that a stock is undervalued or that future earnings are in doubt.

As mentioned, it's important to take into account a variety of financial data and other factors when doing research on a possible investment.

  • The return on assets ratio can help you determine how effectively a company is using its assets to generate profit. The higher the ratio, the more profit each dollar in assets produces. It's calculated by dividing net income by total assets.
  • The operating margin ratio uses operating income and revenue to determine the profit a company is getting from its operations. This ratio, along with net profit margin, can give investors a good feel for the profitability of a company as a whole. The operating margin ratio is calculated by dividing net operating income by total revenue.
  • The return on equity ratio is another way to gauge profitability. It measures how well a company generates profit using money that's been invested in it (shareholder equity). It's calculated by dividing net profit by total equity.
  • Inventory ratios can show how well companies manage their inventories . Inventory turnover and days of inventory on hand are often used. Bear in mind that the inventory method that a company employs can affect the financial data that underlie ratios. So, when comparing companies be sure that they use comparable methods.
  • Take note of ratio analysis results over time to spot trends in company performance and to predict potential future financial health.
  • Compare companies not just in the same industry, but with similar product types, years in operation, and location, as well. These factors can affect financial results.

What Are the 5 Categories of Ratio Analysis?

Ratio analysis includes these five types of financial ratios: profitability ratios, liquidity ratios, debt or leverage ratios, operations ratios, and market ratios.

How Do You Compare the Ratios of 2 Companies?

Start by choosing companies in the same industry. Narrow this down to companies with similar products, inventory methods, business longevity, and location. Then, compare the same financial ratios for both. Consider looking at a big picture of results over time rather than just one year-end snapshot.

Where Can You Find a Company's Financial Information?

Company information is available in many places, including news and financial publications and websites. However, to be sure of its credibility, look for financial information in audited company annual reports. In addition, the Securities and Exchange Commission (SEC) maintains financial and business information about publicly held companies in the online database called EDGAR . Access is free of charge.

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Financial Ratio Analysis

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Financial ratios are mathematical comparisons of financial statement accounts or categories. These relationships between the financial statement accounts help investors, creditors, and internal company management understand how well a business is performing and of areas needing improvement.

Financial ratios are the most common and widespread tools used to analyze a business’ financial standing. Ratios are easy to understand and simple to compute. They can also be used to compare different companies in different industries. Since a ratio is simply a mathematically comparison based on proportions, big and small companies can be use ratios to compare their financial information. In a sense, financial ratios don’t take into consideration the size of a company or the industry. Ratios are just a raw computation of financial position and performance.

Ratios allow us to compare companies across industries, big and small, to identify their strengths and weaknesses. Financial ratios are often divided up into seven main categories: liquidity, solvency, efficiency, profitability, market prospect, investment leverage, and coverage.

  • Liquidity Ratios
  • Solvency Ratios
  • Efficiency Ratios
  • Profitability Ratios
  • Market Prospect Ratios
  • Financial Leverage Ratios
  • Coverage Ratios
  • Receivables Turnover Ratio
  • Asset Turnover Ratio
  • Cash Conversion Cycle
  • Compound Annual Growth Rate
  • Contribution Margin
  • Current Ratio
  • Days Sales in Inventory
  • Days Sales Outstanding
  • Debt Service Coverage Ratio
  • Debt to Equity Ratio
  • Dividend Payout
  • Dividend Yield
  • DuPont Analysis
  • Earnings per Share
  • Equity Multiplier
  • Equity Ratio
  • Fixed Charge Coverage Ratio
  • Gross Margin Ratio
  • Interest Coverage Ratio
  • Internal Rate of Return
  • Inventory Turnover Ratio
  • Net Working Capital
  • Operating Margin Ratio
  • Payables Turnover Ratio
  • Price Earnings P/E Ratio
  • Profit Margin Ratio
  • Quick Ratio – Acid Test
  • Retention Rate
  • Return on Assets
  • Return on Capital Employed
  • Return on Equity
  • Times Interest Earned Ratio
  • Working Capital Ratio


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Financial Ratios

  • Financial Ratio
  • Accumulated Depreciation Ratio
  • Asset Coverage Ratio
  • Average Inventory Period
  • Average Payment Period
  • Break-Even Analysis
  • Capitalization Ratio
  • Cash Earnings/Share
  • Cash Flow Coverage Ratio
  • Correlation Coefficient
  • Cost of Goods Sold
  • Days Payable Outstanding
  • Debt to Asset
  • Debt to Capital
  • Debt to Income
  • Defensive Interval
  • Earnings Per Share
  • Enterprise Value
  • Expense Ratio
  • Fixed Asset Turnover Ratio
  • Free Cash Flow
  • Goodwill to Assets
  • Gross Profit
  • Gross vs Net
  • Loan to Value
  • Long Term Debt to Assets
  • Margin of Safety
  • Marginal Revenue
  • Net Fixed Assets
  • Net Interest Margin
  • Net Operating Income
  • Net Present Value (NPV)
  • Net Profit Margin
  • Operating Cash Flow
  • Operating Income
  • Operating Leverage
  • Payback Period
  • Preferred Dividend Coverage
  • Present Value
  • Price to Book
  • Price to Cash Flow
  • Price to Sales
  • Residual Income
  • Retention Ratio
  • Return on Invested Capital
  • Return on Investment
  • Return on Net Assets
  • Return on Operating Assets
  • Return on Retained Earnings
  • Return on Sales
  • Sales to Admin Expenses
  • Sharpe Ratio
  • Sortino Ratio
  • Treynor Ratio

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An Assignment on “Ratio Analysis”

Profile image of Nazmul Hasan Mahmud

A sustainable business and mission requires effective planning and financial management. Ratio analysis is a useful management tool that will improve your understanding of financial results and trends over time, and provide key indicators of organizational performance. Managers will use ratio analysis to pinpoint strengths and weaknesses from which strategies and initiatives can be formed. Funders may use ratio analysis to measure your results against other organizations or make judgments concerning management effectiveness and mission impact. For ratios to be useful and meaningful, they must be: • Calculated using reliable, accurate financial information (does your financial information reflect your true cost picture?) • Calculated consistently from period to period. • Used in comparison to internal benchmarks and goals o Used in comparison to other companies in your industry. • Viewed both at a single point in time and as an indication of broad trends and issues over time. • Carefully interpreted in the proper context, considering there are many other important factors and indicators involved in assessing performance. Ratios can be divided into four major categories: • Profitability Sustainability • Operational Efficiency • Liquidity • Leverage (Funding – Debt, Equity, Grants) The ratios presented below represent some of the standard ratios used in business practice and are provided as guidelines. Not all these ratios will provide the information you need to support your particular decisions and strategies. You can also develop your own ratios and indicators based on what you consider important and meaningful to your organization and stakeholders.

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assignment financial ratio analysis

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Saadatullah Ahmadzai

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The certainty of the reliance on the use of financial ratio analysis in making investment decisions by potential investors still remained a mystery. This has to do with the choice of ratios to select when making investment decisions. Many shareholders in Nigeria are uneducated or illiterate, and due to their ignorance, they cannot use ratio analysis in evaluating firms for investment decisions. Thus, this paper explores the concept of financial ratio analysis in terms of the decision usefulness of financial ratios. The paper suggests that the relevant financial information needed for the purposes of making investment decision can be sourced through the use of financial ratio analysis. Therefore, management must ensure that disclosure of comprehensive financial ratios form part of financial statement prepared for the overall appraisal of firms.

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Financial ratios are assumed to be very useful predictors of business performance, growth and financial status. This study evaluates the collinearity and correlation of financial ratios to establish a pattern of relationship that could serve s n empirically supported guide for financial ratios reliance in business evaluation decisions. The research data were gathered from the annual account report of vita foam Plc and analyzed using collinearity and correlation to test the research propositions. The paper found the existence of correlation and collinearity in the financial ratios, and concludes that financial ratios are reliable business status indicators. We therefore recommend the application of financial ratios in the evaluation of business performance, growth and financial strength.


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Step-by-Step Guide to Creating Assignments on Financial Ratios

Anthony Whicker

Financial ratios are one of the fundamental ideas you'll come across when studying finance. These ratios are crucial tools used by businesses, analysts, and investors to evaluate the performance, profitability, and financial stability of a company. Understanding how to accurately analyze and interpret financial ratios is essential for students studying finance. Additionally, you'll frequently be required to complete assignments on financial ratios to show that you understand the material. You can follow the instructions on this blog to create a thorough and organized financial ratio assignment. Financial ratios offer important insights into a company's financial position, so it is essential to understand them. You can get a comprehensive understanding of a company's financial performance by looking at its liquidity ratios, solvency ratios, profitability ratios, and activity ratios. Understanding the importance of each ratio category and providing a clear analysis supported by pertinent examples and calculations are crucial components of your assignment. You can create a coherent and effective assignment by conducting in-depth research, structuring your thoughts, and using a structured process. So let's look at how to write a Finance assignment that effectively evaluates financial ratios step by step.

Financial Ratios Assignment

Understanding Financial Ratios

Understanding financial ratios and their importance in financial analysis is crucial before beginning the assignment writing process. Financial ratios are quantitative tools for evaluating the financial statements of a company. They offer priceless information about a company's productivity, effectiveness, liquidity, and overall financial health. When comparing a company's financial position and performance to industry norms, identifying areas for improvement, and making strategic business decisions, these ratios are crucial. One can obtain a thorough understanding of a company's financial performance by examining its liquidity ratios, solvency ratios, profitability ratios, and activity ratios. Indicators for a company's ability to meet short-term obligations include liquidity ratios, solvency ratios, profitability ratios, and activity ratios, which measure the effectiveness of asset utilization. Finance students who comprehend financial ratios can accurately interpret and analyze financial statements, laying the groundwork for sound financial decision-making.

What are Financial Ratios?

Financial ratios are quantitative tools for evaluating the financial statements of a company. These ratios give important information about different facets of a company's financial performance. They aid in assessing its effectiveness, liquidity, profitability, and general financial stability. Analysts can evaluate a company's strengths, weaknesses, and trends by comparing various ratios over time or against industry benchmarks.

Importance of Financial Ratios in Financial Analysis

In financial analysis, financial ratios are very important. They offer a uniform framework for assessing and contrasting the financial performance of different companies. Financial ratios assist in locating opportunities for improvement, potential risks, and growth by benchmarking against industry standards. They aid in establishing financial objectives, assessing investment options, and making well-informed business decisions like assessing creditworthiness.

Commonly Used Financial Ratios

The following are some of the most popular financial ratios:

  • Liquidity Ratios: These ratios evaluate a company's overall financial stability and capacity to meet short-term obligations. The quick ratio and current ratio are two examples.
  • Solvency Ratios: Solvency ratios are metrics that assess a company's long-term financial viability and ability to fulfill its obligations. Solvency ratios include, for instance, the debt-to-equity ratio and the interest coverage ratio.
  • Profitability Ratios: Based on its revenue, assets, and equity, a company's ability to turn a profit is evaluated using these ratios. Common profitability ratios include gross profit margin, net profit margin, and return on equity (ROE).
  • Activity Ratios: Activity ratios, also referred to as efficiency ratios, assess how well a business uses its resources and assets. Activity ratios include, for instance, the inventory turnover ratio and the accounts receivable turnover ratio.

Preparing to Write the Assignment

It is essential to effectively prepare for the financial ratio assignment before beginning the writing process. This entails several crucial steps that will guarantee a thorough and properly organized piece of work. First, carefully read the assignment guidelines your instructor has provided to comprehend the precise specifications, such as the ratios to be analyzed, the company or industry focus, the necessary format, and the deadline. Do thorough research using dependable resources, such as academic journals, finance textbooks, and reputable financial websites. To accurately calculate the financial ratios, collect the necessary data and information. Finally, arrange your ideas and information logically. Outline with an opening paragraph, a body, and a conclusion. To ensure a consistent flow of information throughout the assignment, decide in advance which financial ratios you will cover under each category. You will set yourself up for success and be prepared to write a top-notch financial ratio assignment by adhering to these pre-writing steps. Now that we are familiar with financial ratios on a basic level, let's look at the crucial steps to take when preparing to write an assignment.

Step 1: Grasp the Assignment Guidelines

It is essential to fully comprehend the instructions provided by your instructor before beginning the research and writing process. Spend some time reading through the requirements in detail, paying close attention to the specific ratios you must analyze. Take note of any specific company or industry focus that may be mentioned, along with the required format and the submission deadline. Understanding the assignment requirements makes sure you are on the right track and aids in maintaining your focus while writing.

Step 2: Conduct In-depth Research

Research must be done in-depth to write an informed and comprehensive assignment on financial ratios. To gather information, use trustworthy resources like academic journals, finance textbooks, and reputable financial websites. Extract the pertinent information required to correctly calculate the financial ratios from the chosen company's or companies' financial statements through analysis. The development of a solid foundation for your analysis and interpretation of the financial ratios depends heavily on this research phase.

Step 3: Organize Your Thoughts and Data

It's critical to arrange your ideas and information logically and coherently after you've gathered all the necessary information. For your assignment, draught an outline that typically consists of an introduction, a main body, and a conclusion. Organize your presentation and discussion of the financial ratios for each category to ensure a seamless flow of data and analysis. You can maintain clarity and structure in your assignment by organizing your ideas and data, which will make it simpler for readers to understand your analysis and arguments.

Structuring the Financial Ratio Assignment

It is essential to have a well-structured framework that effectively communicates your analysis when writing a financial ratio assignment. It is easier to ensure clarity, coherence, and a logical flow of information by structuring the assignment. Start with an overview of financial ratios and their significance in financial analysis in the introduction. A concise thesis statement that describes the objective and parameters of the assignment should also be included in this section. According to the various categories of financial ratios, such as liquidity ratios, solvency ratios, profitability ratios, and activity ratios, the assignment's main body should be divided into sections. The relevant ratios should be explained and analyzed in each section, with calculations and examples to back them up. It's crucial to organize and present the information in a way that makes it simple for readers to understand your points of contention. Finally, summarise the main ideas covered in the assignment and emphasize the importance of financial ratios in evaluating a company's financial performance. You can make sure that your financial ratio assignment is well-organized and thorough and effectively communicates your analysis by using a structured approach. Let's move forwards with effectively structuring your financial ratio assignment now that you have your data and a clear outline.


Your financial ratio assignment's introduction establishes the context for the remainder of the paper. Introduce financial ratios and their significance in financial analysis briefly. Indicate the assignment's focus and purpose in clear terms, emphasizing the benefits your readers will derive from your study. A strong thesis statement that summarises the main goal of your assignment must be included.

Your assignment's main body should be divided into sections that reflect the different categories of financial ratios you will cover. The emphasis in each section should be on a particular class of ratios, such as liquidity ratios, solvency ratios, profitability ratios, and activity ratios. Give a thorough analysis of the pertinent ratios in each section, backed up by calculations, justifications, and examples. Make sure that each subsection builds on the one before it and flows logically. By presenting a methodical and organized analysis of the financial ratios in your main body in this manner, you will make it simpler for readers to follow and comprehend your insights.

Section 1: Liquidity Ratios

You will learn about the idea of liquidity ratios and their importance in determining a company's short-term financial stability in this section. Start by defining liquidity ratios and outlining their significance. Examine specific liquidity ratios, such as the operating cash flow ratio, quick ratio, and current ratio. Explain in detail how these ratios are computed and what they mean in terms of a company's capacity to fulfill its short-term obligations. To help readers understand the practical application of liquidity ratios in financial analysis, back up your explanations with pertinent calculations and examples.

Section 2: Solvency Ratios

You will learn about solvency ratios and their importance in assessing a company's long-term financial viability in this section. Definitions of solvency ratios and their function in the financial analysis should come first. Explain the calculation of ratios like the debt-to-equity ratio, interest coverage ratio, and debt ratio as well as the insights they offer into a company's capacity to meet its long-term obligations. Use calculations and examples from the real world to support your claims and show how solvency ratios can be used to evaluate a company's stability and financial health.

Section 3: Profitability Ratios and Activity Ratios

You will talk about profitability ratios and activity ratios in this combined section. Start by describing the intent behind and methodology behind profitability ratios like return on assets (ROA) and gross profit margin. Show how these ratios compare a company's capacity to make money to its revenue, assets, and equity. Cover activity ratios that evaluate how effectively a business uses its resources, such as the inventory turnover ratio and the accounts receivable turnover ratio. To demonstrate the significance of these ratios in financial analysis, use real-world examples to demonstrate how they offer insights into a company's operational effectiveness and financial performance. Readers can better understand the importance of profitability and activity ratios in assessing a company's overall performance with the aid of calculations and real-world examples.

Your financial ratio assignment's conclusion serves as a summary and a concluding declaration on the value of financial ratios in evaluating an organization's financial performance. You should briefly summarise the major ideas covered throughout the assignment in this section, emphasizing the key conclusions and revelations gained from examining the ratios. Reiterate the significance of financial ratios as vital tools for assessing the health, performance, and profitability of an organization's finances. To remind the readers of the assignment's goal and scope, restate your thesis statement. You might also think about making suggestions for additional study or analysis on the subject. These suggestions may point to areas where further research or analysis might advance knowledge or offer a deeper understanding. You leave the readers with a clear understanding of the importance and implications of financial ratios in evaluating and analyzing a company's financial performance by effectively bringing your assignment to a close.

Proofreading and Editing

Before submitting your financial ratio assignment, the process of editing and proofreading is essential. It makes certain that your work is flawless, free of errors, and effectively communicates your ideas. Check your assignment thoroughly for grammatical, spelling, and punctuation errors at this point. Make sure your ideas are presented logically by paying attention to the clarity of your explanations and the coherence of the information flow. Check that your assignment follows the guidelines for formatting, including font type, font size, and line spacing. Additionally, verify the accuracy of all calculations and examples. You can improve the quality and professionalism of your assignment by carefully proofreading and editing it. Remember to allow enough time for planning, research, and editing to ensure the highest caliber of your work. Good luck with your assignment on financial ratios!

In conclusion, any finance student must master the art of writing financial ratios assignments. You can create a well-structured and informative assignment by following the steps outlined in this comprehensive guide, which include comprehending the assignment guidelines, doing extensive research, organizing ideas and data, and meticulously proofreading. Keep in mind that financial ratios are effective tools for assessing the performance and financial health of a company. So, accept the challenge, put your analytical thinking to use, and use your assignment to demonstrate your knowledge. You'll be well-equipped with these tips and insights to excel in your financial studies and make significant contributions to the field of financial analysis. Wishing you luck as you write your assignments!

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BUS202: Principles of Finance

assignment financial ratio analysis

Unit 2 Financial Statement Analysis Exercises

Complete these exercises and problems and then check your work.

The income statement captures all activity related to revenues and expenses over a particular time period. For instance, the quarterly income statement includes all revenue and expense items for that quarter. The beginning of the quarter is treated the same as the end of the quarter. The same applies for annual income statements. However, balance sheets represent a firm's assets, liabilities, and owners' equity at a particular point in time. The quarterly balance sheet only reflects the last day of that quarter and the annual balance sheet only reflects the last day of the year. As such, the balance sheet is more open to seasonality issues and short-term fluctuations. For instance, if the balance sheet is prepared 1 day prior to a large cash payment the cash account will appear artificially large. On the other hand, if it is prepared 1 day after the payment the cash account will appear artificially small.

The firm has $60 million in total liabilities.

A = L + OE $100M = L + $40M $60M = L

Depreciation is a noncash expense. While it lowers net income, the firm is not actually paying anything for depreciation so it has no impact on cash flows (ignoring taxes…when considering taxes, depreciation lowers net income but increases cash flows as less cash is paid in taxes). The cash flow impact of an asset purchase from a finance perspective occurs when the asset is purchased. Spreading the cost equally over the assets useful life ignores the time value of money and understates the true cost of the purchase. A few other issues that may create a difference between cash flows and earnings include (this is not a complete list) –

  • Revenue recognition
  • Inventory accounting method
  • Prepaid expenses
  • Accounts Payable/Receivable

While many people use ratio analysis, the primary parties interested are

  • Competitors
  • Stockholders (and potential stockholders)
  • Long-Term Creditors
  • Short-Term Creditors

When analyzing  Liquidity Ratios , the most interested parties are management and short-term creditors. Management needs to understand the firm's liquidity position in order to properly manage the firm. Short-term creditors typically do not care much about the long-term health of the firm, but only if they have enough liquid capital to meet the short-term obligations. Long-term creditors and stockholders would also be interested, but primarily only if the liquidity ratios were weak enough to damage the long-term health of the firm.

When analyzing  Asset Management Ratios , the most interested parties are management, competitors, and stockholders. Again, management must be interested in all the ratios as they must manage all aspects of the firms operations. Competitors are interested as a gauge of their own performance. If our competition has a total asset turnover of 2.50 and ours is only 1.95 we must understand what they are doing to outperform us in this measure. By identifying our weaknesses, we can address them. Stockholders have some interest in that often asset management ratios impact a firm's ability to generate profits and increase firm value. Long-term and short-term creditors are typically not significantly concerned with these measures as they do not share in any “extra” profits the company generates. As long as the firm is able to meet interest and principle obligations, debt holders are happy.

Management, long-term creditors, short-term creditors, and stockholders are all focused on  Debt Management Ratios . These ratios measure a firm's ability to meet their debt obligations, so creditors want to see these ratios strong in order to be confident of receiving their full interest and principle payments. Long-term creditors are probably more focused on this as short-term creditors hope to be repaid quickly enough that they are more concerned about the liquidity issues. Stockholders are concerned because if the firm is unable to meet its debt obligations it will be forced into bankruptcy and the stockholders will likely lose all of their investment.

Profitability Ratios  are a concern primarily for management, competitors, and stockholders. Creditors, both LT and ST, do not participate in profits so their only concern with profitability ratios is if they are negative and threaten the ability of the firm to meet interest and principal payments. Like asset management ratios, competitors use profitability ratios as a method to gauge their strengths and weaknesses. Since stockholders “own” the business, the profits belong to them. Therefore, the stronger the profitability ratios, the happier the stockholders are.

Market Value Ratios  are looked at by stockholders and management. These ratios measure how “cheap” or “expensive” the stock is. Management typically wants these ratios to be high as it is a sign that they are maximizing firm value. Potential stockholders typically want them low as that is an indication that the stock may be cheap (except for dividend yield). As a side note, market value ratios are often much more difficult to analyze than many people would like.

The key to this question recognizing the role of the equation A = L + OE in these two ratios. Because all firms use some degree of liabilities (long-term debt, accounts payable, accruals, etc.), we know that Assets must be larger than Owners' Equity. The greater the amount of debt financing (liabilities), the greater the difference between Assets and Owners Equity will be. Also, since the difference between ROA and ROE is the denominator (ROA is NI/Assets while ROE is NI/OE), ROE will always be higher than ROE (for firms with positive NI). Finally, the greater the amount of debt financing (liabilities), the greater the difference between ROA and ROE will be.

When considering the above paragraph, we can now comment on the specific ROA and ROE numbers for Company A and B. Since Company B has a lower ROA and a higher ROE (relative to Company A), we know that Company B is using more leverage (debt financing) than Company A.

Neither approach is necessarily “better” or “worse” than the other. They are just different. Company B is using a more aggressive (riskier) strategy of financing. The higher level of debt increases the risk, but also means stockholders earn a greater return on their money when the company does well. However, if the company does poorly, the higher leverage (debt financing) will magnify the losses (as the interest must still be paid and the loss is spread over less shareholder capital). Thus, higher amounts of debt financing are riskier, but also increase the potential return. Which approach is better depends on the level of risk aversion for each shareholder.

The DSO ratio does provide an indication of how long it is taking a firm to collect its credit sales. Thus, a high DSO ratio can be an indication of a problem in managing a firm's accounts receivables. However, one must be very careful in jumping to conclusions. First, DSO can be very industry dependent. Second, and the issue in this question, is that DSO uses both balance sheet and income statement values to calculate the ratio. As the Annual Income statement is not subject to seasonality while the Annual Balance Sheet is, there is the potential for seasonality issues to distort the ratio. Specifically, Company A has larger accounts receivable on their annual balance sheet due to the seasonal nature of their sales. This inflates their DSO ratio. Company B has had plenty of time to collect their accounts receivable. This is a prime example of why you need to consider seasonality when evaluating ratios.

If we think of the inventory turnover ratio, Company A should appear to be doing better. Specifically, they will have less inventory on hand at the end of the year (as their heavy sales season is winding down and they approach seasonally lower sales). Alternatively, Company B's inventory will be high to meet their seasonally high 1st and 2nd quarter sales that are right around the corner.

Subject to Seasonality – Quarterly Income Statement, Quarterly Balance Sheet, Annual Balance Sheet

Not Subject to Seasonality – Annual Income Statement

This is a FALSE statement. While it is true that everything else equal, a higher profit margin is better than a lower profit margin there is not enough information to make this a true statement. We are ignoring both trend analysis and comparative analysis, so we don't have the necessary context to evaluate the profit margin number. For instance company A could be in a low profit margin industry (such as banking or retail) while company B could be in a high profit margin industry (such as software or pharmaceuticals). Also, profit margin is only one ratio and to label one company as outperforming another based on a single ratio is shortsighted. We need to consider the larger picture before making such a statement. The purpose of this question is to illustrate that one ratio without context is close to meaningless.

Trend Analysis refers to looking at a firm's ratios over a period of 3-5 years to identify whether specific areas are strengthening or weakening. Comparative analysis refers to looking at a firm's ratios relative to other firms in the same industry to evaluate whether they are better or worse than industry averages. Trend/comparative analysis provides us some of the necessary context to properly interpret the ratios.


Potential problems with trend analysis include

Potential problems with comparative analysis include


A very low quick ratio may be cause for concern because it could indicate liquidity concerns. A low level of cash and accounts receivable relative to our current liabilities could indicate that we will have a hard time paying those current liabilities when they are due. A very high quick ratio may be cause for concern because it indicates an inefficient allocation of resources. Cash and accounts receivable are not high return assets. We would likely be better off allocating our assets to areas with higher rates of return.


The primary objective of financial statement analysis from the perspective of management is to identify potential strengths and weaknesses of our firm relative to our competitors so we can take full advantage of our strengths and work on fixing our weaknesses.

There are several difficulties that management might encounter in conducting a complete financial statement analysis. Some are mentioned in the question on potential problems with trend analysis and comparative analysis above. Other problems include comparability of financial statements across firms in the industry due to different fiscal years and/or different accounting procedures. Also, the need to dig beyond the numbers is critical. For example, is a high ROE due to a well-run company or due to too much leverage that could cause significant problems if we hit a small rough patch? Another issue is that financial statement analysis may help us identify potential strengths and weaknesses. However, even after confirming them by digging deeper, the financial statement analysis often does not recommend HOW we can fix the weakness or exploit the strength.

The primary objective of financial statement analysis from the perspective or the stockholder is to identify companies to invest in (potential stockholders) or evaluate the companies the stockholder currently owns (current stockholders).

Stockholders face many of the same problems discussed above with management. However, an important challenge for stockholders is that they must not only analyze the company's financial health, but also evaluate how much they are paying for it. There may be situations where buying stock in a company with poor financial health is a good opportunity (the stock price is “cheap” enough and there is a chance for the company to rebound). There may also be situations where selling shares of stock in a company with strong financial health is good (the stock price is so expensive that the firm's success is already more than fully reflected in the stock price). Too often stockholders get caught up in what they are buying and don't think enough about how much they are paying for it.

CR = CA/CL = 7,000,000/4,500,000 = 1.56 QR = (CA – Inv)/CL = (7,000,000 – 2,000,000)/4,500,000 = 1.11 ITR = CGS/Inv = 6,000,000/2,000,000 = 3 times DSO = AR/(Sales/365) = 2,000,000/(15,000,000/365) = 48.67 days FAT = Sales/Fixed Asst = 15,000,000/10,000,000 = 1.5 times TAT = Sales/Total Asst = 15,000,000/17,000,000 = 0.88 times TD/TA = 10,000,000/17,000,000 = 58.8% TD/OE = 10,000,000/7,000,000 = 142.86% TIE = EBIT/Int = 4,000,000/1,000,000 = 4 times GPM = (Sales – CGS)/Sales = (15,000,000 – 6,000,000)/15,000,000 = 60% NPM = NI/Sales = 2,100,000/15,000,000 = 14.0% ROA = NI/Asst = 2,100,000/17,000,000 = 12.4% ROE = NI/OE = 2,100,000/7,000,000 = 30.0% PE = Price/EPS = 25/1.05 = 23.81 M/B = Price/BV = 25/(7,000,000/2,000,000) = 7.14 DY = Div/Price = $0.50/$25 = 2.00%

CR = CA/CL = 11,050,000/7,000,000 = 1.58 QR = (CA – Inv)/CL = (11,050,000 – 4,000,000)/7,000,000 = 1.01 ITR = CGS/Inv = 11,000,000/4,000,000 = 2.75 times DSO = AR/(Sales/365) = 4,000,000/(20,000,000/365) = 73 days FAT = Sales/Fixed Asst = 20,000,000/11,000,000 = 1.82 times TAT = Sales/Total Asst = 20,000,000/22,050,000 = 0.91 times TD/TA = 15,000,000/22,050,000 = 68.0% TD/OE = 15,000,000/7,050,000 = 212.77% TIE = EBIT/Int = 3,000,000/1,500,000 = 2 times GPM = (Sales – CGS)/Sales = (20,000,000 – 11,000,000)/20,000,000 = 45% NPM = NI/Sales = 1,050,000/20,000,000 = 5.25% ROA = NI/Asst = 1,050,000/22,050,000 = 4.76% ROE = NI/OE = 1,050,000/7,050,000 = 14.89% PE = Price/EPS = 17.5/0.525 = 33.33 M/B = Price/BV = 17.5/(7,050,000/2,000,000) = 4.96 DY = Div/Price = $0.50/$17.50 = 2.86%

Each item in the income statement is expressed as a percentage of sales (revenues) and each item in the balance sheet is presented as a percentage of total assets.

To start the analysis of finding strengths and weaknesses, I started with the common size statements. The first thing that I noticed was the increase in Cost of Goods Sold from 40% of sales in 2015 to 55% of sales in 2017. This indicates that our production costs jumped significantly and will act to lower our net income. Selling and Administrative expenses dropped slightly from 20% of sales to 17.5% of sales. This is a strength, but is not a very large change so I don't place much emphasis on it. The declines in EBIT and Net Income as a % of sales are due to the increase in CGS, so do not need further analysis. Thus, from the Common Size Income statement, I focus on the increase in CGS as a significant weakness and would classify the decline in S&A Expenses as a small strength.

Next I proceed to the Common Size balance sheet. The first things I notice are the increases in accounts receivable and inventory as a % of total assets. This is a concern that needs more analysis before I declare it a weakness. Consider accounts receivable first. AR could increase due to higher sales levels. If 25% of my sales are done on credit and sales increase, my AR will automatically increase as well. This could result in AR being a bigger portion of my firm's assets and would not be seen as a negative. On the other hand, AR may be increasing because fewer customers are paying their bills on time. This could lead to more bad debt expense or higher collection costs. I can not tell which explanation is causing the increase in AR from the CS balance sheet, so I will make a note of it and look more at the issue as I move through my analysis. Like AR, inventory increases may or may not be a weakness. If sales increase, I will need more inventory on hand to handle the increase in sales which is likely to cause inventory to make up a larger portion of my firm's assets. Alternatively, if I am getting stuck with more out-of-date inventory it will also make up a larger portion of my firm's assets until I am forced to do a write down and take the loss. From the CS balance sheet I can't tell which scenario is taking place so this is also something to investigate further.

Net PPE shows a large drop in the CS Balance sheet, but that is primarily a result of the increase in current assets caused by the jump in AR and Inv which have already been discussed, so I will not pay much attention to the decline in Net PPE. Notes Payable shows a large jump, however that could just be a function of me financing some of my increase in current assets so again that is not something that would concern me too much. I would probably want to note it and make sure I find out the reason for the increase but it likely is not a strength/weakness. The jump in Total Liabilities as a % of total assets is something that might concern me. Higher levels of liabilities as a % of total assets indicates higher risk levels. The firm has a greater chance of serious financial problems is there is a slowdown. This is not necessarily bad as the higher debt levels also have the chance to increase our profits if things go well, however it is something to note with a degree of caution due to the higher risk. Finally, the drop in OE is merely the flip side to the increase in TL, so needs no further analysis.

Next I move on to the ratio analysis. My liquidity ratios appear to be sound as both are stable from year to year and similar to the industry averages. Next is my Inv. Turnover Ratio. This, combined with the increase in inventory on the CS balance sheet indicates a problem. If my inventory increase was merely a result of increased sales, the inventory turnover ratio would hold steady or increase slightly. Instead it has decreased slightly and is noticeably lower than the industry average. This means that I am tying up more of my capital as inventory and probably ending up with older inventory that will need to be marked down and sold at a loss.

I also notice problems with my Days Sales Outstanding ratio. The significant jump in the DSO ratio tells me its taking me an about 24 days longer on average to collect each dollar in sales. Since this is also much higher than the industry average it means one of two things. Either I have a lot of customers that aren't paying on time and may end up with higher levels of bad debts or that I have to offer more favorable credit terms to my customers to keep sales from dropping. Both of these possibilities are bad, so my accounts receivable situation is a definite cause for concern.

Fixed Asset Turnover and Total Asset Turnover both look good. FAT is up and both are higher than the industry average. This is a sign that I am doing a good job overall of using my assets (especially my LT assets) to generate sales.

The debt management ratios are troublesome. My TD/TA and TD/OE ratios have increased by quite a bit and are higher than the industry averages. Also, my TIE ratio has dropped and is lower than the industry average. This means that our firm is using more debt financing and has less margin for error. If we experience an off year or two our firm is likely to run into severe financial problems and could face bankruptcy. On the other hand, if we have a couple of strong years, we will make higher returns for our shareholders due to the leverage provided by debt. This is not necessarily a strength/weakness but is a sign of high financial risk.

The profitability ratios are all showing an interesting pattern that ties back into my CGS observation from the CS income statement. My profitability (PM, ROA, ROE) is down due to the increase in CGS. However, all three ratios are consistent with the industry average. This might be an indication that the increase in CGS is more of an industry issue rather than firm specific. If a key input had a price increase, this is likely to impact all firms in the industry equally. For example, if grain prices jumped significantly both Kellogg's and General Mills may see a jump in their CGS and a decline in their profit margins. It doesn't indicate a management problem, but an industry issue. If my profitability ratios declined significantly AND were lower than the industry average I would be more concerned about company specific problems.

Finally we have the market value ratios which are difficult to interpret in this instance. The PE ratio has increased significantly as my stock price fell, but earnings fell faster. It is also higher than the industry average which indicates the stock is more expensive in terms of what investors pay for each dollar of earnings (possibly indicating that they believe the earnings drop is not permanent). The MV/BV ratio has decreased significantly which indicates the stock is cheaper. This is because book value is less sensitive to the recent earnings decline which lowered the stock price (making the stock cheaper relative to its book value). However, the stock is still slightly more expensive than the industry average. While our dividend yield increased and is higher than the industry average (which is good), there is a danger sign here. If earnings drop any further, we may have to cut our dividend which would cause the yield to drop.

To summarize, our financial statement analysis indicates

  • The firm needs to address the CGS issue, but that it is probably an industry issue instead of a company specific problem. This doesn't mean we can ignore it, just that it will be more difficult to fix.
  • The firm needs to get control of its credit policies and improve its collections process.
  • The firm needs to get control of its inventory concerns
  • The firm is doing a good job at generating sales from its LT Assets.
  • The firm has a high degree of financial risk
  • The firm does not appear to have any major liquidity constraints.
  • The stock is relatively expensive relative to the industry average and the dividend yield (while attractive) should be viewed with caution as it may not be sustainable.

You know that you need the current stock price and the book value per share in order to get the MV/BV ratio. To get current stock price, you can use the PE ratio: PE = Price/EPS ⇒ Price = (PE)×(EPS)

To get EPS, you need Net Income which you can get from the net profit margin: Net Profit Margin = Net Income/Sales ⇒ Net Income = Net Profit Margin×Sales

You have the Profit Margin, so you need Sales. You can get Sales from the Total Asset Turnover Ratio: Total Asset Turnover = Sales /Assets ⇒ Sales = TA Turnover×Assets

Sales = (1.5)×($6,000,000) = $9,000,000 Net Income = (0.05)×($9,000,000) = $450,000 EPS = ($450,000)/(600,000 shares) = $0.75 per share Stock Price = (13)×(0.75) = $9.75

Now you need to solve for Book Value which is Owners' Equity per Share. We know the Return on Equity, so we can use that (along with Net Income) to get Owners' Equity: ROE = Net Income/Owners Equity ⇒ Owners Equity = NI/ROE

Owners' Equity = ($450,000)/(0.14) = $3,214,285.71 Book Value = $3,214,285.71)/(600,000 shares) = $5.36 per share MV/BV = ($9.75)/($5.36) = 1.82

Our MV/BV ratio is 1.82. This is a tough problem as it not only tests your knowledge of ratios, but your problem solving skills. Don't worry if you didn't get it at first, but hopefully once you see the solution it makes sense.


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