Ratio Analysis

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Investment Analysis & Portfolio Management (FIN630)

Lesson # 12

FUNDAMENTAL ANALYSIS Contd...

Ratio Analysis:

Financial ratio analysis is a fascinating topic to study because it can teach us so much about

accounts and businesses. When we use ratio analysis we can work out how profitable a

business is, we can tell if it has enough money to pay its bills and we can even tell whether

its shareholders should be happy.

Ratio analysis can also help us to check whether a business is doing better this year than it

was last year; and it can tell us if our business is doing better or worse than other businesses

doing and selling the same things.

In addition to ratio analysis being part of an accounting and business studies syllabus, it is a

very useful thing to know anyway.

The overall layout of this section is as follows: We will begin by asking the question, what

do we want ratio analysis to tell us? Then, what will we try to do with it? This is the most

important question. The answer to that question then means we need to make a list of all of

the ratios we might use: we will list them and give the formula for each of them.

Once we have discovered all of the ratios that we can use we need to know how to use

them, who might use them and what for and how will it help them to answer the question

we asked at the beginning?

At this stage we will have an overall picture of what ratio analysis is, who uses it and the

ratios they need to be able to use it. All that's left to do then is to use the ratios; and we will

do that step- by-step, one by one.

By the end of this section we will have used every ratio several times and we will be experts

at using and understanding what they tell us.

LIQUIDITY RATIOS:

1. The Current Ratio:

The current ratio is also known as the working capital ratio and is normally presented as a

real ratio. The formula to calculate the current ratio is;

Current Ratio = Current Assets / Current Liabilities

The ratio is mainly used to give an idea of the company's ability to pay back its short-term

liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The

higher the current ratio, the more capable the company is of paying its obligations. A ratio

under 1 suggests that the company would be unable to pay off its obligations if they came

due at that point. While this shows the company is not in good financial health, it does not

necessarily mean that it will go bankrupt - as there are many ways to access financing but

it is definitely not a good sign.

Investment Analysis & Portfolio Management (FIN630)

The current ratio can give a sense of the efficiency of a company's operating cycle or its

ability to turn its product into cash. Companies that have trouble getting paid on their

receivables or have long inventory turnover can run into liquidity problems because they are

unable to alleviate their obligations. Because business operations differ in each industry,

it is always more useful to compare companies within the same industry.

This ratio is similar to the acid-test ratio except that the acid-test ratio does not include

inventory and prepaid as assets that can be liquidated. The components of current ratio

(current assets and current liabilities) can be used to derive working capital (difference

between current assets and current liabilities). Working capital is frequently used to derive

the working capital ratio, which is working capital as a ratio of sales.

The working capital means the amount that current assets exceed the current liabilities. In

simple words, it is the difference current assets and current liabilities.

Working Capital = Current Assets Current Liabilities

Positive working capital means that the company is able to pay off its short-term

liabilities. Negative working capital means that a company currently is unable to meet its

short-term liabilities with its current assets (cash, accounts receivable and inventory).

2. The Acid Test Ratio:

The acid test ratio is also known as the liquid or the quick ratio. The idea behind this ratio is

that stocks are sometimes a problem because they can be difficult to sell or use. That is,

even though a supermarket has thousands of people walking through its doors every day,

there are still items on its shelves that don't sell as quickly as the supermarket would like.

Similarly, there are some items that will sell very well.

Nevertheless, there are some businesses whose stocks will sell or be used slowly and if

those businesses needed to sell some of their stocks to try to cover an emergency, they

would be disappointed. Engineering companies can have their materials in stock for as

much as 9 months to a year; a greengrocer should have his stocks for no longer than 4 or 5

days - a good greengrocer anyway.

We'll look at the acid test ratio;

Acid Test Ratio = (Current Assets - Inventory) / Current Liabilities

PROFITABILITY RATIOS:

1. Gross Profit Margin:

Gross Profit Margin = Gross Profit / Net Sales * 100

Remember;

Gross Profit = Sales Cost of Goods Sold

The gross profit margin ratio tells us the profit a business makes on its cost of sales, or cost

of goods sold. It is a very simple idea and it tells us how much gross profit per Rs. 1 of

turnover our business is earning.

Investment Analysis & Portfolio Management (FIN630)

Gross profit is the profit we earn before we take off any administration costs, selling costs

and so on. So we should have a much higher gross profit margin than net profit margin.

2. Operating Margin:

A ratio used to measure a company's pricing strategy and operating efficiency. Calculated

as:

Operating Margin = Operating Income / Net Sales

Operating margin is a measurement of what proportion of a company's revenue is left over

after paying for variable costs of production such as wages, raw materials, etc. A healthy

operating margin is required for a company to be able to pay for its fixed costs, such as

interest on debt.

Operating margin gives analysts an idea of how much a company makes (before interest and

taxes) on each dollar of sales. When looking at operating margin to determine the quality of

a company, it is best to look at the change in operating margin over time and to compare the

company's yearly or quarterly figures to those of its competitors. If a company's margin is

increasing, it is earning more per rupee of sales. The higher the margin, the better it is.

3. Net Profit Margin:

Net Profit Margin = Net Profit / Net Sales *100

Remember;

Net Profit = Gross Profit - Expenses

Why do we have two versions of this ratio - one for net profit and the other for profit before

interest and taxation? Well, in some cases, you will find they use the term net profit and in

other cases, especially published accounts, they use profit before interest and taxation. They

both mean the same. The net profit margin ratio tells us the amount of net profit per Rs. 1 of

turnover a business has earned. That is, after taking account of the cost of sales, the

administration costs, the selling and distributions costs and all other costs, the net profit is

the profit that is left, out of which they will pay interest, tax, dividends and so on.

4. Earnings per share (EPS):

The portion of a company's profit allocated to each outstanding share of common stock.

EPS serves as an indicator of a company's profitability. Calculated as:

Earnings per Share = Profit Available to Shareholders / Average common shares

outstanding

Earnings per share (EPS) is the profit attributable to shareholders (after interest, tax, and

everything else) divided by the number of shares in issue. It is the amount of a company's

profits that belong to a single ordinary share.

LEVERAGE RATIO:

Any ratio used to calculate the financial leverage of a company to get an idea of the

company's methods of financing or to measure its ability to meet financial obligations.

Investment Analysis & Portfolio Management (FIN630)

A general term describing a financial ratio that compares some form of owner's equity (or

capital) to borrowed funds. Gearing is a measure of financial leverage, demonstrating the

degree to which a firm's activities are funded by owner's funds versus creditor's funds.

Leverage = Long term debt / total equity

The higher a company's degree of leverage, the more the company is considered risky. As

for most ratios, an acceptable level is determined by its comparison to ratios of companies

in the same industry. The best known examples of gearing ratios include the debt-to-equity

ratio (total debt / total equity), times interest earned (EBIT / total interest), equity ratio

(equity / assets), and debt ratio (total debt / total assets).

A company with high gearing (high leverage) is more vulnerable to downturns in the

business cycle because the company must continue to service its debt regardless of how bad

sales are. A greater proportion of equity provides a cushion and is seen as a measure of

financial strength.

1. Interest Coverage Ratio:

A ratio used to determine how easily a company can pay interest on outstanding debt. The

ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) of one

period by the company's interest expenses of the same period:

The interest cover ratio tells us the safety margin that the business has in terms of being able

to meet its interest obligations. That is, a high interest cover ratio means that the business is

easily able to meet its interest obligations from profits. Similarly, a low value for the interest

cover ratio means that the business is potentially in danger of not being able to meet its

interest obligations.

Here's a reminder of the formula:

Interest Coverage Ratio = Earnings before interest and tax / interest expense

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