What is Ratio Analysis?

Ratio analysis refers to the analysis of various pieces of financial

information in the financial statements of a business. They are mainly
used by external analysts to determine various aspects of a business,
such as its profitability, liquidity, and solvency.

Analysts rely on current and past financial statements to obtain data to

evaluate the financial performance of a company. They use the data to
determine if a company’s financial health is on an upward or downward
trend and to draw comparisons to other competing firms.

 Uses of Ratio Analysis

 1. Comparisons

One of the uses of ratio analysis is to compare a company’s financial

performance to similar firms in the industry to understand the
company’s position in the market. Obtaining financial ratios, such as
Price/Earnings, from known competitors and comparing it to the
company’s ratios can help management identify market gaps and
examine its competitive advantages, strengths, and weaknesses. The
management can then use the information to formulate decisions that
aim to improve the company’s position in the market.

 
2. Trend line

Companies can also use ratios to see if there is a trend in financial

performance. Established companies collect data from the financial
statements over a large number of reporting periods. The trend
obtained can be used to predict the direction of future financial
performance, and also identify any expected financial turbulence that
would not be possible to predict using ratios for a single reporting
period.

3. Operational efficiency

The management of a company can also use financial ratio analysis to

determine the degree of efficiency in the management of assets and
liabilities. Inefficient use of assets such as motor vehicles, land, and
building results in unnecessary expenses that ought to be
eliminated. Financial ratios can also help to determine if the financial
resources are over- or under-utilized.

Ratio Analysis – Categories of Financial Ratios

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 using its current assets. 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.

Some common liquidity ratios include the quick ratio, the cash ratio,
and the current ratio. Liquidity ratios are used by banks, creditors, and
suppliers to determine if a client has the ability to honor their financial
obligations as they come due.
 2. Solvency ratios

Solvency ratios measure a company’s long-term financial viability.

These ratios compare the debt levels of a company to its assets, equity,
or annual earnings.

Important solvency ratios include the debt to capital ratio, debt ratio,
interest coverage ratio, and equity multiplier. Solvency ratios are
mainly used by governments, banks, employees, and institutional
investors.

 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 examples of important profitability ratios include the return on

equity ratio, return on assets, profit margin, gross margin, and return
on capital employed.

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.
 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.

What is the Quick Ratio?

The Quick Ratio, also known as the Acid-test or Liquidity ratio,
measures the ability of a business to pay its short-term liabilities by
having assets that are readily convertible into cash. These assets are,
namely, cash, marketable securities, and accounts receivable. These
assets are known as “quick” assets since they can quickly be
converted into cash.

 
What’s Included and Excluded?

Generally speaking, the ratio includes all current assets, except:

 Prepaid expenses – because they can not be used to pay other

liabilities
 Inventory – because it may take too long to convert inventory
to cash to cover pressing liabilities

As you can see, the ratio is clearly designed to assess companies

where short-term liquidity is an important factor. Hence, it is
commonly referred to as the Acid Test.

The Quick Ratio In Practice

The quick ratio is the barometer of a company’s capability and

inability to pay its current obligations.  Investors, suppliers, and
lenders are more interested to know if a business has more than
enough cash to pay its short-term liabilities rather than when it does
not. Having a well-defined liquidity ratio is a signal of competence
and sound business performance that can lead to sustainable growth.

What is Cash Ratio?

The cash ratio, sometimes referred to as the cash asset ratio, is a
liquidity metric that indicates a company’s capacity to pay off short-
term debt obligations with its cash and cash equivalents. Compared
to other liquidity ratios such as the current ratio and quick ratio, the
cash ratio is a stricter, more conservative measure because only cash
and cash equivalents  – a company’s most liquid assets – are used in
the calculation.

Formula

The formula for calculating the cash ratio is as follows:

Where:

 Cash includes legal tender (coins and currency) and demand

deposits (checks, checking account, bank drafts, etc.).
 Cash equivalents are assets that can be converted into cash
quickly. Cash equivalents are readily convertible and subject to
insignificant risk. Examples include savings accounts, T-bills,
and money market instruments.
 Current liabilities are obligations due within one year.
Examples include short-term debt, accounts payable, and
accrued liabilities.

Example

Company A’s balance sheet lists the following items:

  Cash: $10,000
 Cash equivalents: $20,000
 Accounts receivable: $5,000
 Inventory: $30,000
 Property & equipment: $50,000
 Accounts payable: $12,000
 Short-term debt: $10,000
 Long-term debt: $20,000

The ratio for Company A would be calculated as follows:

The figure above indicates that Company A possesses enough cash

and cash equivalents to pay off 136% of its current liabilities.
Company A is highly liquid and can easily fund its debt.

 What is the Current Ratio?

The current ratio, also known as the working capital ratio, measures
the capability of a business to meet its short-term obligations that are
due within a year. The ratio considers the weight of total current
assets versus total current liabilities. It indicates the financial health of
a company and how it can maximize the liquidity of its current assets
to settle debt and payables. The current ratio formula (below) can be
used to easily measure a company’s liquidity.

 Current Ratio Formula

The Current Ratio formula is:

Current Ratio = Current Assets / Current Liabilities

 

Example of the Current Ratio Formula

If a business holds:

 Cash = $15 million

 Marketable securities = $20 million
 Inventory = $25 million
 Short-term debt = $15 million
 Accounts payables = $15 million

Current assets = 15 + 20 + 25 = 60 million

Current liabilities = 15 + 15 = 30 million

Current ratio = 60 million / 30 million = 2.0x

The business currently has a current ratio of 2, meaning it can easily

settle each dollar on loan or accounts payable twice. A rate of more
than 1 suggests financial well-being for the company. There is no
upper-end on what is “too much,” as it can be very dependent on the
industry, however, a very high current ratio may indicate that a
company is leaving excess cash unused rather than investing in
growing its business.

 What is the Debt to Asset Ratio?

The Debt to Asset Ratio, also known as the debt ratio, is a leverage
ratio that indicates the percentage of assets that are being financed
with debt. The higher the ratio, the greater the degree of leverage
and financial risk.

The debt to asset ratio is commonly used by creditors to determine

the amount of debt in a company, the ability to repay its debt, and
whether additional loans will be extended to the company. On the
other hand, investors use the ratio to make sure the company is
solvent, is able to meet current and future obligations, and can
generate a return on their investment.

From the balance sheet above, we can determine that the total assets
are $226,365 and that the total debt is $50,000. Therefore, the debt to
asset ratio is calculated as follows:

Debt to Asset Ratio = $50,000 / $226,376 = 0.2208 = 22%

Therefore, the figure indicates that 22% of the company’s assets are
funded via debt.

Interpretation of Debt to Asset Ratio

The debt to asset ratio is commonly used by analysts, investors, and

creditors to determine the overall risk of a company. Companies with
a higher ratio are more leveraged and, hence, riskier to invest in and
provide loans to. If the ratio steadily increases, it could indicate a
default at some point in the future.

 A ratio equal to one (=1) means that the company owns the
same amount of liabilities as its assets. It indicates that the
company is highly leveraged.
 A ratio greater than one (>1) means the company owns more
liabilities than it does assets. It indicates that the company is
extremely leveraged and highly risky to invest in or lend to.
  A ratio of less than one (<1) means the company owns more
assets than liabilities and can meet its obligations by selling its
assets if needed. The lower the debt to asset ratio, the less risky
the company.

Let us examine the debt to asset ratio of five hypothetical companies:

Company D shows a significantly higher degree of leverage

compared to the other companies. Therefore, Company D would see
a lower degree of financial flexibility and would face significant
default risk if interest rates were to rise. If the economy were to
undergo a recession, Company D would more than likely be unable
to stay afloat.

On the flip side, if the economy and the companies performed very
well, Company D could expect to have the highest equity returns, due
to its leverage.

Company C would have the lowest risk and lowest expected return
(all else being equal).
The debt to asset ratio is very important in determining the financial
risk of a company. A ratio greater than 1 indicates that a significant
portion of assets is funded with debt and that the company has a
higher default risk. Therefore, the lower the ratio, the safer the
company. As with any other ratios, this ratio should be evaluated over
a period of time to access whether the company’s financial risk is
improving or deteriorating.

What is Interest Coverage Ratio (ICR)?

The Interest Coverage Ratio (ICR) is a financial ratio that is used to
determine how well a company can pay the interest on
its outstanding debts. The ICR is commonly used by lenders,
creditors, and investors to determine the riskiness of lending capital
to a company. The interest coverage ratio is also called the “times
interest earned” ratio.

Interest Coverage Ratio Formula

The interest coverage ratio formula is calculated as follows:

Where:

 EBIT is the company’s operating profit (Earnings Before Interest

and Taxes)
  Interest expense represents the interest payable on any
borrowings such as bonds, loans, lines of credit, etc.

Another variation of the formula is using earnings before interest,

taxes, depreciation and amortization (EBITDA) as the numerator:

Interest Coverage Ratio = EBITDA / Interest Expense

Interest Coverage Ratio Example

For example, Company A reported total revenues of $10,000,000

with COGS (costs of goods sold) of $500,000. In addition, operating
expenses in the most recent reporting period were $120,000 in
salaries, $500,000 in rent, $200,000 in utilities, and $100,000 in
depreciation. The interest expense for the period is $3,000,000. The
income statement of Company A is provided below:

 
 
To determine the interest coverage ratio:

EBIT = Revenue – COGS – Operating Expenses

EBIT = $10,000,000 – $500,000 – $120,000 – $500,000 – $200,000

– $100,000 = $8,580,000

Therefore:

Interest Coverage Ratio = $8,580,000 / $3,000,000 = 2.86x

Company A can pay its interest payments 2.86 times with its
operating profit.

What is Equity Ratio?

The equity ratio is a financial metric that measures the amount of
leverage used by a company. It uses investments in assets and the
amount of equity to determine how well a company manages its
debts and funds its asset requirements.

A low equity ratio means that the company primarily used debt to
acquire assets, which is widely viewed as an indication of greater
financial risk. Equity ratios with higher value generally indicate that a
company’s effectively funded its asset requirements with a minimal
amount of debt.

  Equity ratio uses a company’s total assets (current and

non-current) and total equity to help indicate how
leveraged the company is: how effectively they fund asset
requirements without using debt.
 The formula is simple: Total Equity / Total Assets
  Equity ratios that are .50 or below are considered leveraged
companies; those with ratios of .50 and above are
considered conservative, as they own more funding from
equity than debt.

For this example, Company XYZ’s total assets (current and non-
current) are valued $50,000, and its total shareholder (or owner)
equity amount is $22,000. Using the formula above:

The resulting ratio above is the sign of a company that has leveraged
its debts. It holds slightly more debt ($28,000) than it does equity
from shareholders, but only by $6,000.

What is Return on Equity (ROE)?

Return on Equity (ROE) is the measure of a company’s annual return
(net income) divided by the value of its total shareholders’ equity,
expressed as a percentage (e.g., 12%). Alternatively, ROE can also be
derived by dividing the firm’s dividend growth rate by its earnings
retention rate (1 – dividend payout ratio).

Return on Equity is a two-part ratio in its derivation because it brings

together the income statement and the balance sheet, where net
income or profit is compared to the shareholders’ equity. The number
represents the total return on equity capital and shows the firm’s
ability to turn equity investments into profits. To put it another way, it
measures the profits made for each dollar from shareholders’ equity.

Return on Equity Formula

The following is the ROE equation:

ROE = Net Income / Shareholders’ Equity 

ROE provides a simple metric for evaluating investment returns. By

comparing a company’s ROE to the industry’s average, something
may be pinpointed about the company’s competitive advantage. ROE
may also provide insight into how the company management is using
financing from equity to grow the business.

A sustainable and increasing ROE over time can mean a company is

good at generating shareholder value because it knows how to
reinvest its earnings wisely, so as to increase productivity and
profits. In contrast, a declining ROE can mean that management is
making poor decisions on reinvesting capital in unproductive assets.

ROE Formula Drivers

While the simple return on equity formula is net income divided by

shareholder’s equity, we can break it down further into additional
drivers. As you can see in the diagram below, the return on equity
formula is also a function of a firm’s return on assets (ROA) and the
amount of financial leverage it has. Both of these concepts will be
discussed in more detail below.

What is Return on Common Equity?

The Return on Common Equity (ROCE) ratio refers to the return that
common equity investors receive on their investment. ROCE is
different from Return on Equity (ROE) in that it isolates the return that
the company sees on its common equity, rather than measuring the
total returns that the company generated on all of its equity. Capital
received from investors as preferred equity is excluded from this
calculation, thus making the ratio more representative of common
equity investor returns.

Return on Common Equity is used by some investors to assess the

likelihood and size of dividends that the company may pay out in the
future. A high ROCE indicates the company is generating high profits
from its equity investments, thus making dividend payouts more
likely.

The ROCE ratio can also be used to evaluate how well the company’s
management has utilized equity capital to generate values. A high
ROCE suggests that the company’s management is making good use
of equity capital by investing in NPV-positive projects. This should
cr eate more value for
the company’s shareholders.

Where:

Net Income = After-tax earnings of the company for period t

Average Common Equity = (Common Equity at t-1 + Common

Equity at t) / 2

As discussed above, the ratio can be used to assess future dividends

and management’s use of common equity capital. However, it is not a
perfect measure,  since a high ROCE can be misleading.

Dividends are discretionary, meaning that a company is not under a

legal obligation to pay dividends to common equity shareholders.
Whether a company pays out dividends often depends on where the
company is in its lifecycle. An early-stage company is likely to reinvest
its earnings in growing the business, such as funding R&D for new
products. A more mature company that is already profitable may
choose to disburse its earnings as dividends to keep investors happy.

In terms of assessing management’s use of equity capital, analysts

and investors should exercise caution in using the ROCE ratio. It is
important to note that, just like ROE, ROCE can easily be overstated.
Suppose that a company chooses to pursue an NPV-positive
opportunity and funds the project with debt capital. The project pays
off and the company sees its net income figure rise. In this scenario,
ROCE would increase by a fair margin since the amount of
outstanding common equity has not changed, but net income has
increased. However, the rise in net income was not due to
management’s effective use of equity capital. Instead, it was simply
due to management’s use of funds in general.

In some cases, management bonuses are tied to hitting certain

Return on Common Equity levels. Because of that fact, management
may be tempted to take actions that inflate the ratio.

Return on Common Equity Example

Ben’s Ice Cream wants to calculate the return on common equity that
the business generated over the past year. Below are snippets from
the company’s income statement and balance sheets:

Aat/financiAL MANAGEMENT