Financial ratios are used to measure a company's financial strengths and weaknesses, as well as the profitability of a business. Investors can use financial ratios to evaluate the performance of a company by comparing them to others in the same industry.
For instance, the dividend payout ratio can be used to figure out what percentage of the company’s earnings is being paid out to shareholders in the form of dividends. Generally, the higher the payout ratio the more attractively are shares of the firm seen by stock traders. This also indicates that the company pays more in dividends and thus less earnings are invested back into the business to create future growth.
Following are the main advantages of Financial Ratio Analysis:
1. Ratios are easy to understand by all users.
2. It is a very useful technique for comparison purpose. Changes in ratios over time can indicate the firm's performance, and it can also be used to compare with businesses in similar industries.
3. The calculation of profitability ratios can help to measure the profitability and actual performance of the businesses.
4. The use of various liquidity ratios can indicate the short-term financial position of the company.
5. Remedial actions can be taken if weaknesses are found through ratio analysis.
6. Important ratios help the external parties such as shareholders, debenture holders, bankers to know the performance of the company that pay them interest and dividend.
7. The use of ratios simplify accounting information as they summarize the result of detailed and complicated computations.
8. Accounting ratios can indicate the trend of the business line and is useful for forecasting purposes.
9. It helps the company in analysing the utilization of its various assets and liabilities.
Following are some of the limitations of Financial Ratio Analysis:
1. Ratio analysis indicates only the areas of strengths and weaknesses, without investigating the causes.
2. Different companies can apply different accounting policies. Thus the ratio of one company can not always be compared with that of another company.
3. Ratios are calculated based on outdated information presented in the financial statements. The use of historical costs may not be appropriate for decision making.
4. It may lead to distortion caused by inflation. Price level changes can make the comparison of figures difficult over a period of time.
5. Ratio analysis is mainly a technique of quantitative analysis and it ignores some important qualitative factors which can be critical in decision making.
6. Effect of window dressing by prepares of financial statements.
7. Ratio analysis is costly and small businesses may not be able to afford it.
8. There are no standard ratios. One specific ratio can have different formulas which may lead to different outcomes and difficult for comparison purposes.
9. Ratios are relative figures and do not indicate the size of a firm.
10. Lack of benchmark.
11. Accounting standards and practices in different countries vary widely, and this may hamper meaningful global-performance comparisons.
1. Investment Ratio Analysis & Example
This is used by shareholders or investors to calculate the return on their investments, and to make good decisions about which shares to buy...
List of Investment Ratios and Formulas:
1. Dividend cover = Profit after tax / dividends
2. Dividend yield = ( Dividend per share/ Market price per share ) * 100 %
3. Earnings per share (EPS) = Profit available to equity shareholders / Number ofequity shares
4. Price earnings ratio (P/E) = Market price per share / Earnings per share
5. Price to sales ratio = Market price per share / Sales per share
6. Price earnings growth (PEG) ratio = Price per earnings / Annual EPS growth
7. Price to book value (PBV) = Market price per share / Balance sheet price per share
8. Payout Ratio = Dividend per share / EPS
Examples:
1) Camry Ltd made a net profit of $80,000 that is available to ordinaryshareholders, and the dividend declared is $20,000, then:
Dividend cover = 80,000 / 20,000 = 4 times
2) An investor bought a share at $6.00 and he received a dividend of $0.30 on it, then:
Dividend yield = (0.30 / 6.00) * 100 % = 5 %
3) Company ABC has an annual earning of $140,000 dollars. Total dividends of $70,000 are to be paid out, and the company has 350,000 outstanding shares.
Solution:
Earnings per share (EPS) = $140,000 / 350,000 = $0.40
Dividend per share = 70,000 / 350,000 = $0.20
The dividend payout ratio = 0.20 / 0.40 = 50%
4) Sports Ltd has ordinary share capital of 200,000 shares at $1 each. It made a net profit of $400,000 that is available to the ordinary shareholders. The market price of a share is $6.00.
Then:
EPS = $400,000 / 200,000 = $2 per share
P/E ratio = $6 / $2 = 3
2. Financial Leverage Ratio Analysis & Example
This is used to assess the financial position of a company in terms of its financial stability. It gives an indication of the firm's ability in repaying its long-term debts...
Definition: Financial Leverage Ratio (also called long-term solvency ratio) is used to measure the firm's ability to repay its long-term debts. It gives an indication of the long-term solvency of the firm.
List of Financial Leverage Ratios and Formulas:
1) Debt to Equity = Total Debt / Total Equity
2) Total Debts to Assets = Total Liabilities / Total Assets
3) Interest Coverage Ratio = Earnings Before Interest and Taxes / Interest Charges
4) Debt service coverage ratio = Net Operating Income / Total Debt Service
5) Capitalization Ratio = Long-term Debt / (Long-term debt + Shareholder equity)
Learn how to calculate financial leverage ratio with the following examples:
Example 1:
CK Ltd has total liabilities of $700,000 and total stockholders' equity of $380,000, then the debt/capital ratio is: 700,000 / (700,000 + 380,000) = 700,000 / 1,080,000 = 0.6481 = 64.81%
Example 2:
Saint Ltd. is looking at an investment property with a net operating income of $87,000 and an annual debt service of $58,000. The debt service coverage ratio for this property = 87,000 / 58,000 = 1.5
Example 3:
Jimmy plc has total sales revenue of $99,000 for the year. It has cost sales $9,000 and operating expenses of $5,000. The company's interest expense for the year is $25,000.
Then,
Earnings Before Interest and Taxes = Sales – Cost of sales – Operating expenses
EBIT = $99,000 - $9,000 - $5,000
EBIT = $85,000
Interest Coverage Ratio = $85,000/$25,000 = 3.4 times
Example 4:
Peters Ltd has the following information:
Creditors $2,000
Loan $38,000
Buildings $60,500
Debtors $7,000
Bank $5,000
Stocks $4,500
Then, the Total Liabilities = 2,000 + 38,000 = $40,000
Total Assets = 60,500 + 7,000 + 5,000 + 4,500 = $77,000
Total Debts to Assets = 40,000 / 77,000 = 0.519
3. Profitability Ratio Analysis & Example
This is used to assess the profitability of a business in relation to its past performance, or in relation to other companies in the same industry...
List of Profitability Ratios and Formulas:
1. Gross Profit ratio = (Gross profit / Net sales) * 100 %
2. Net Profit ratio = (Net profit / Net sales) * 100 %
3. Operating profit margin = Operating income / Net sales
4. Return on Capital Employed = (Profit before interest / Capital employed) * 100 %
5. Return on Equity (ROE) = Net income / Average shareholders equity
6. Return on Assets (ROA) = Net income / Total assets
7. Cash flow return on investment (CFROI) = Cash flow / Market recapitalisation
8. Risk adjusted return on capital (RAROC) = Expected return / Economic capital
9. Return on net assets = Net income / Net assets
Example:
Calculate the profitability ratios, given the following figures:
Stock at the start of the year: $10,000
Stock at the end of the year: $6,000
Sales: $18,000
Sales returns: $3,000
Purchases: $2,000
Overhead expenses: $3,000
Capital at start of year: $17,000
Capital at end of year: $15,000
Solution:
Net sales = $18,000 - $3,000 = $15,000
Cost of sales = Stock at start + purchases - Stock at end = 10,000 + 2,000 - 6,000 = $6,000
Gross profit = Net sales - Cost of sales = $15,000 - $6,000 = $11,000
Gross profit ratio = (11,000 / 15,000 ) * 100% = 73.33 %
Net profit = Gross profit - overhead expenses = 11,000 - 3,000 = $8,000
Net profit ratio = (8,000 / 15,000 ) * 100% = 53.33 %
Average capital employed = 1/2 (Capital at start + Capital at end) = 1/2 (17,000+15,000) = $16,000
ROCE = (8,000 / 16,000) * 100% = 50%
4. Efficiency Ratio Analysis & Example
This is used to analyse how efficiently the firm uses and controls its assets and liabilities internally...
Definition: Efficiency Ratios (also known as Activity ratios) are used to measure the effectiveness of the firm's use of resources.
List of Efficiency Ratios and Formula:
1. Average Collection Period = (Average Trade Debtors / Credit Sales) * No. of Days
2. Average Payment Period = (Average Trade Creditors / Credit Purchases) * No. of Days
3. Inventory Turnover Ratio = Cost of goods sold / Average inventory held
4. Debtors Turnover Ratio = Net Credit Sales / Average Trade Debtors
5. Total Assets Turnover = Net Sales / Total Assets
6. Degree of Operating Leverage = % change in EBIT / % change in Sales
7. Creditors Turnover Ratio = Net Credit Purchases / Average Payable
8. Days Sales Outstanding Ratio = Accounts Receivable / Average sales per day
9. Working capital turnover Ratio = Cost of sales / Average net working capital
10. Current Asset Turnover Ratio = Cost of goods sold / Current assets
11. Stock Turnover Period = (Average stock / Cost of goods sold) * No. of Days
12. Cash Cycle = Stock Turnover Period + Average Collection Period - Average Payment Period
Example:
Emily Ltd has the following information:
Trade debtors $100,000
Trade creditors $80,000
Credit sales $300,000
Credit purchases $120,00
Cost of sales $70,000
Opening stock $60,000
Closing stock $20,000
Bank $66,000
Calculate the relevant Efficiency Ratios.
Solution:
Average Collection Period = (100,000 / 300,000) * 365 = 121.7 days
Average Payment Period = (80,000 / 120,000) * 365 = 243.3 days
Current Asset Turnover = 70,000 / (100,000 + 20,000 + 66,000) = 0.38
Average stock = (60,000 + 20,000) / 2 = $40,000
Stock Turnover Period = (40,000 / 70,000) * 365 = 208.6 days
Cash Cycle = 208.6 + 121.7 - 243.3 = 87 days
5. Liquidity Ratio Analysis & Example
This is used to measure the ability of the firm in meeting its short-term liabilities...
Definition: Liquidity ratios provide a general estimate of solvency of a company.
List of Common Liquidity ratios and Formulas:
1) Current ratio (also known as working capital ratio)
= Current Assets / Current Liabilities
2) Quick ratio, in times (also known as acid test ratio or quick assets ratio)
= (Current Assets - Stock) / Current Liabilities
3) Interest Coverage = Profit Before Tax / Interest Charge
4) Gearing ratio = Long Term Liabilities / Equity Shareholders' Funds
5) Cash Ratio = Cash / Current Liabilities
6) Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities
Example:
Calculate the working capital, acid test and gearing ratios, given the following figures:
Debtors: $2,000
Creditors: $5,000
Bank: $11,000
Cash: $1,000
Closing stock: $6,000
Opening stock: $7,000
Total Capital and Reserves: $25,000
Long term loan: $15,000
Solution:
Current assets = debtors + bank + cash + closing stock = 2000 + 11000 + 1000 + 6000 = $20,000
Working capital ratio = 20,000 / 5,000 = 4 (This means that current assets are 4 times current liabilities)
Acid test ratio = (20,000 - 6,000) / 5,000 = 2.8 (This means that current assets in liquid form are 2.8 times current liabilities)
Equity Shareholders' Funds = Total Capital and Reserves + Long term Liabilities = 25000 + 15000 = $40,000
Gearing ratio = 15,000 / 40,000 = 0.375
For instance, the dividend payout ratio can be used to figure out what percentage of the company’s earnings is being paid out to shareholders in the form of dividends. Generally, the higher the payout ratio the more attractively are shares of the firm seen by stock traders. This also indicates that the company pays more in dividends and thus less earnings are invested back into the business to create future growth.
Following are the main advantages of Financial Ratio Analysis:
1. Ratios are easy to understand by all users.
2. It is a very useful technique for comparison purpose. Changes in ratios over time can indicate the firm's performance, and it can also be used to compare with businesses in similar industries.
3. The calculation of profitability ratios can help to measure the profitability and actual performance of the businesses.
4. The use of various liquidity ratios can indicate the short-term financial position of the company.
5. Remedial actions can be taken if weaknesses are found through ratio analysis.
6. Important ratios help the external parties such as shareholders, debenture holders, bankers to know the performance of the company that pay them interest and dividend.
7. The use of ratios simplify accounting information as they summarize the result of detailed and complicated computations.
8. Accounting ratios can indicate the trend of the business line and is useful for forecasting purposes.
9. It helps the company in analysing the utilization of its various assets and liabilities.
Following are some of the limitations of Financial Ratio Analysis:
1. Ratio analysis indicates only the areas of strengths and weaknesses, without investigating the causes.
2. Different companies can apply different accounting policies. Thus the ratio of one company can not always be compared with that of another company.
3. Ratios are calculated based on outdated information presented in the financial statements. The use of historical costs may not be appropriate for decision making.
4. It may lead to distortion caused by inflation. Price level changes can make the comparison of figures difficult over a period of time.
5. Ratio analysis is mainly a technique of quantitative analysis and it ignores some important qualitative factors which can be critical in decision making.
6. Effect of window dressing by prepares of financial statements.
7. Ratio analysis is costly and small businesses may not be able to afford it.
8. There are no standard ratios. One specific ratio can have different formulas which may lead to different outcomes and difficult for comparison purposes.
9. Ratios are relative figures and do not indicate the size of a firm.
10. Lack of benchmark.
11. Accounting standards and practices in different countries vary widely, and this may hamper meaningful global-performance comparisons.
1. Investment Ratio Analysis & Example
This is used by shareholders or investors to calculate the return on their investments, and to make good decisions about which shares to buy...
List of Investment Ratios and Formulas:
1. Dividend cover = Profit after tax / dividends
2. Dividend yield = ( Dividend per share/ Market price per share ) * 100 %
3. Earnings per share (EPS) = Profit available to equity shareholders / Number ofequity shares
4. Price earnings ratio (P/E) = Market price per share / Earnings per share
5. Price to sales ratio = Market price per share / Sales per share
6. Price earnings growth (PEG) ratio = Price per earnings / Annual EPS growth
7. Price to book value (PBV) = Market price per share / Balance sheet price per share
8. Payout Ratio = Dividend per share / EPS
Examples:
1) Camry Ltd made a net profit of $80,000 that is available to ordinaryshareholders, and the dividend declared is $20,000, then:
Dividend cover = 80,000 / 20,000 = 4 times
2) An investor bought a share at $6.00 and he received a dividend of $0.30 on it, then:
Dividend yield = (0.30 / 6.00) * 100 % = 5 %
3) Company ABC has an annual earning of $140,000 dollars. Total dividends of $70,000 are to be paid out, and the company has 350,000 outstanding shares.
Solution:
Earnings per share (EPS) = $140,000 / 350,000 = $0.40
Dividend per share = 70,000 / 350,000 = $0.20
The dividend payout ratio = 0.20 / 0.40 = 50%
4) Sports Ltd has ordinary share capital of 200,000 shares at $1 each. It made a net profit of $400,000 that is available to the ordinary shareholders. The market price of a share is $6.00.
Then:
EPS = $400,000 / 200,000 = $2 per share
P/E ratio = $6 / $2 = 3
2. Financial Leverage Ratio Analysis & Example
This is used to assess the financial position of a company in terms of its financial stability. It gives an indication of the firm's ability in repaying its long-term debts...
Definition: Financial Leverage Ratio (also called long-term solvency ratio) is used to measure the firm's ability to repay its long-term debts. It gives an indication of the long-term solvency of the firm.
List of Financial Leverage Ratios and Formulas:
1) Debt to Equity = Total Debt / Total Equity
2) Total Debts to Assets = Total Liabilities / Total Assets
3) Interest Coverage Ratio = Earnings Before Interest and Taxes / Interest Charges
4) Debt service coverage ratio = Net Operating Income / Total Debt Service
5) Capitalization Ratio = Long-term Debt / (Long-term debt + Shareholder equity)
Learn how to calculate financial leverage ratio with the following examples:
Example 1:
CK Ltd has total liabilities of $700,000 and total stockholders' equity of $380,000, then the debt/capital ratio is: 700,000 / (700,000 + 380,000) = 700,000 / 1,080,000 = 0.6481 = 64.81%
Example 2:
Saint Ltd. is looking at an investment property with a net operating income of $87,000 and an annual debt service of $58,000. The debt service coverage ratio for this property = 87,000 / 58,000 = 1.5
Example 3:
Jimmy plc has total sales revenue of $99,000 for the year. It has cost sales $9,000 and operating expenses of $5,000. The company's interest expense for the year is $25,000.
Then,
Earnings Before Interest and Taxes = Sales – Cost of sales – Operating expenses
EBIT = $99,000 - $9,000 - $5,000
EBIT = $85,000
Interest Coverage Ratio = $85,000/$25,000 = 3.4 times
Example 4:
Peters Ltd has the following information:
Creditors $2,000
Loan $38,000
Buildings $60,500
Debtors $7,000
Bank $5,000
Stocks $4,500
Then, the Total Liabilities = 2,000 + 38,000 = $40,000
Total Assets = 60,500 + 7,000 + 5,000 + 4,500 = $77,000
Total Debts to Assets = 40,000 / 77,000 = 0.519
3. Profitability Ratio Analysis & Example
This is used to assess the profitability of a business in relation to its past performance, or in relation to other companies in the same industry...
List of Profitability Ratios and Formulas:
1. Gross Profit ratio = (Gross profit / Net sales) * 100 %
2. Net Profit ratio = (Net profit / Net sales) * 100 %
3. Operating profit margin = Operating income / Net sales
4. Return on Capital Employed = (Profit before interest / Capital employed) * 100 %
5. Return on Equity (ROE) = Net income / Average shareholders equity
6. Return on Assets (ROA) = Net income / Total assets
7. Cash flow return on investment (CFROI) = Cash flow / Market recapitalisation
8. Risk adjusted return on capital (RAROC) = Expected return / Economic capital
9. Return on net assets = Net income / Net assets
Example:
Calculate the profitability ratios, given the following figures:
Stock at the start of the year: $10,000
Stock at the end of the year: $6,000
Sales: $18,000
Sales returns: $3,000
Purchases: $2,000
Overhead expenses: $3,000
Capital at start of year: $17,000
Capital at end of year: $15,000
Solution:
Net sales = $18,000 - $3,000 = $15,000
Cost of sales = Stock at start + purchases - Stock at end = 10,000 + 2,000 - 6,000 = $6,000
Gross profit = Net sales - Cost of sales = $15,000 - $6,000 = $11,000
Gross profit ratio = (11,000 / 15,000 ) * 100% = 73.33 %
Net profit = Gross profit - overhead expenses = 11,000 - 3,000 = $8,000
Net profit ratio = (8,000 / 15,000 ) * 100% = 53.33 %
Average capital employed = 1/2 (Capital at start + Capital at end) = 1/2 (17,000+15,000) = $16,000
ROCE = (8,000 / 16,000) * 100% = 50%
4. Efficiency Ratio Analysis & Example
This is used to analyse how efficiently the firm uses and controls its assets and liabilities internally...
Definition: Efficiency Ratios (also known as Activity ratios) are used to measure the effectiveness of the firm's use of resources.
List of Efficiency Ratios and Formula:
1. Average Collection Period = (Average Trade Debtors / Credit Sales) * No. of Days
2. Average Payment Period = (Average Trade Creditors / Credit Purchases) * No. of Days
3. Inventory Turnover Ratio = Cost of goods sold / Average inventory held
4. Debtors Turnover Ratio = Net Credit Sales / Average Trade Debtors
5. Total Assets Turnover = Net Sales / Total Assets
6. Degree of Operating Leverage = % change in EBIT / % change in Sales
7. Creditors Turnover Ratio = Net Credit Purchases / Average Payable
8. Days Sales Outstanding Ratio = Accounts Receivable / Average sales per day
9. Working capital turnover Ratio = Cost of sales / Average net working capital
10. Current Asset Turnover Ratio = Cost of goods sold / Current assets
11. Stock Turnover Period = (Average stock / Cost of goods sold) * No. of Days
12. Cash Cycle = Stock Turnover Period + Average Collection Period - Average Payment Period
Example:
Emily Ltd has the following information:
Trade debtors $100,000
Trade creditors $80,000
Credit sales $300,000
Credit purchases $120,00
Cost of sales $70,000
Opening stock $60,000
Closing stock $20,000
Bank $66,000
Calculate the relevant Efficiency Ratios.
Solution:
Average Collection Period = (100,000 / 300,000) * 365 = 121.7 days
Average Payment Period = (80,000 / 120,000) * 365 = 243.3 days
Current Asset Turnover = 70,000 / (100,000 + 20,000 + 66,000) = 0.38
Average stock = (60,000 + 20,000) / 2 = $40,000
Stock Turnover Period = (40,000 / 70,000) * 365 = 208.6 days
Cash Cycle = 208.6 + 121.7 - 243.3 = 87 days
5. Liquidity Ratio Analysis & Example
This is used to measure the ability of the firm in meeting its short-term liabilities...
Definition: Liquidity ratios provide a general estimate of solvency of a company.
List of Common Liquidity ratios and Formulas:
1) Current ratio (also known as working capital ratio)
= Current Assets / Current Liabilities
2) Quick ratio, in times (also known as acid test ratio or quick assets ratio)
= (Current Assets - Stock) / Current Liabilities
3) Interest Coverage = Profit Before Tax / Interest Charge
4) Gearing ratio = Long Term Liabilities / Equity Shareholders' Funds
5) Cash Ratio = Cash / Current Liabilities
6) Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities
Example:
Calculate the working capital, acid test and gearing ratios, given the following figures:
Debtors: $2,000
Creditors: $5,000
Bank: $11,000
Cash: $1,000
Closing stock: $6,000
Opening stock: $7,000
Total Capital and Reserves: $25,000
Long term loan: $15,000
Solution:
Current assets = debtors + bank + cash + closing stock = 2000 + 11000 + 1000 + 6000 = $20,000
Working capital ratio = 20,000 / 5,000 = 4 (This means that current assets are 4 times current liabilities)
Acid test ratio = (20,000 - 6,000) / 5,000 = 2.8 (This means that current assets in liquid form are 2.8 times current liabilities)
Equity Shareholders' Funds = Total Capital and Reserves + Long term Liabilities = 25000 + 15000 = $40,000
Gearing ratio = 15,000 / 40,000 = 0.375
Source: financelearners
