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FINANCIAL RATIO ANALYSIS

FINANCIAL STATEMENT ANALYSIS

 Financial statement analysis is the process of analyzing a company's
financial statements for decision-making purposes.

 Financial statement analysis (or financial analysis) is the process of

reviewing and analyzing a company's financial statements to make better
economic decisions to earn income in future. These statements include the
income statement, balance sheet, statement of cash flows, notes to
accounts and a statement of changes in equity (if applicable).

 Financial statement analysis is a method or process involving specific

techniques for evaluating risks, performance, financial health, and future
prospects of an organization.
When computing financial ratios and when doing other financial statement
analysis always keep in mind that the financial statements reflect the accounting
principles. This means assets are generally not reported at their current value. It is also
likely that many brand names and unique product lines will not be included among the
assets reported on the balance sheet, even though they may be the most valuable of all
the items owned by a company.
These examples are signals that financial ratios and financial statement analysis
have limitations. It is also important to realize that an impressive financial ratio in one
industry might be viewed as less than impressive in a different industry.

FINANCIAL RATIOS
Ratio Analysis involves methods of calculating and interpreting financial ratios for
analyze and monitor the firm’s performance.

 Financial ratios are mathematical comparisons of financial statement accounts or

categories.
 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.

OBJECTIVES OF FINANCIAL RATIO ANALYSIS

1. To determine whether the company has improved its financial status and
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2. performance compared to proceeding time periods. (company’s financial status)

3. To assess the competitive position of a company relative to similar companies in
the same industry.
4. To understand industry wide factors that affects the performance of companies in
the same industry.
5. To use insights derived from financial ratio analysis in forecasting the future
performance of the company.

Types of Ratio Comparisons

1. Cross-Sectional Analysis. It involves comparison of different firm’s financial ratios at

the same point in time; involves comparing the firm’ ratios to those other firms in its
industry or to industry average.

Benchmarking is a type of cross-sectional analysis which firms ratio values are

compared to those of a key competitor or group of competitors primarily to isolate areas
of opportunity for improvement.

2. Time-Series Analysis. It applied when a financial analyst evaluates performance.

Comparison of current to past performance using ratio analysis, allows the firm to
determine whether it is a progressing as planned.

3. Combined Analysis. It is the most informative approach.

Five (5) Categories of Financial Statement Ratios

 Liquidity
 Profitability
 Activity or Efficiency
 Solvency
 Market ratio
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MAJOR CATEGORIES AND COMMON SUB-CATEGORIES OF FINANCIAL RATIOS

AND THEIR SIGNIFICANCE

CATEGORIES/SUB- FORMULA SIGNIFICANCE EXPRESSED

CATEGORIES AS

I. Liquidity ratios

A. Current ratio Current Ability to pay current %

assets/Current obligation
liabilities

B. Quick or Acid (Cash + Marketable Ability to pay current %

Test securities + obligations from the more
Accounts liquid current assets
Receivable)/Current
Liabilities

C. Cash ratio (Cash and Cash shows the company's %

equivalents)/Current ability to pay its obligation
Liabilities without having to sell or
liquidate other assets
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II. Profitability
ratios

A. Gross profit Gross Profit/Net indicates the efficiency of %

margin Sales the management in using
labor and supplies in the
production process

B. Operating Operating Income/ Indicates the ability to %

profit margin Net Sales pay the company’s fixed
costs and interest on the
debt. A high operating
margin means a
company can
successfully compete
with the competitors by
lowering the price of
products to such level
that competitors will not
be able to survive.

C. Net Profit Net Profit /Net Sales Tells if a company's %

Margin management is
generating enough profit
from its sales and
whether operating costs
and overhead costs are
being contained

D. Return on Net Income/Ave. Indicates how effectively %

Equity (ROE) Stock Holder’s a business uses equity –
Equity or the money contributed
by its stockholders and
cumulative retained
profits – to produce
income.

E. Return on Net Profit/Total Tells how efficient a %

Assets (ROA) Assets company's management
is at using its assets to
generate earnings
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CATEGORIES/SUB- FORMULA SIGNIFICANCE EXPRESSED

CATEGORIES AS

III. Activity or
Efficiency

A. Asset turnover Net Sales/Total It is an indicator of No. of times

Assets the efficiency with
which a company is
using its assets to
generate revenue

B. Receivables Net Credit Sales/Ave. Indicates the no. of No. of times

Turnover 1 Accounts Receivables times average
amounts of
receivables is
collected during the
period and the
efficiency in
collection

C. Ave. Collection 365 2/Receivable Indicates the No. of days

Period or Days of Turnover average age of
Sales receivables or the
Outstanding no. of days to collect
ratio or receivables
Receivables
conversion
period
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D. Degree of % of Change in It measures the %

Operating Operating Income/ % sensitivity of a
Leverage of change in Sales 3 company's operating
income to its sales.
Helps determine
what the impact of
any change in sales
will be on the
company's earnings.

F. Average (AP/Total Credit It measures the No. of days

payment period Purchases) x 365 average number of
days it takes a
business to pay its
vendors for
purchases made on
credit.

E. Inventory (Inventory/COGS) x It helps a business No. of days

conversion 365 understands how
period quickly it usually
needs to purchase
new inventory.

G. Payment (Accounts No. of days a No. of days

conversion Payables/COGS) x company takes to
period a.k.a. 365 pay its bills and
days payable invoices
outstanding

H. Cash conversion Free Cash Flows 4 It shows how much

ratio or rate /Net income cash flow a
company generates
compared to its
accounting profit.
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CATEGORIES/SUB- FORMULA SIGNIFICANCE EXPRESSED

CATEGORIES AS

IV. Solvency ratios

A. Debt ratio Total Liabilities/Total It measures the %

Assets amount of leverage
used by a company
in terms of total debt
to total asset

B. Debt to equity Total Debt/Total measure of the %

ratio Equity degree to which a
company is financing
its operations
through debt versus
wholly-owned funds.

C. Times interest Earnings before measure of a %

earned ratio interest and taxes company's ability to
(EBIT)/Interest meet its debt
Expense obligations based on
its current income.

D. Debt service Net Operating It tells if a company is %

coverage ratio Income 5/Total Debt generating sufficient
service ratio operating income to
cover its annual debt
and interest
payments.
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V. Market ratios

A. Earnings per Net Income/Total it shows how much ₱ or $

share (EPS) no. of shares money the company
is making for its
shareholders

B. Payout ratio 8 Dividends/Net It indicates whether %

income the dividend
payments made by a
company make
sense given their
earnings

C. Retention ratio 1 – Payout ratio It shows the %

percentage of net
income that is
retained to grow the
business, rather than
being paid out as
dividends.

D. Price to Share price/Net It shows relationship ₱ or $

earnings (P/E) income of a company's share
ratio price to its earnings
per share. 6

E. Dividend yield 9 Dividend per It shows the portion ₱ or $

share/Price per of a company's
share profits that are
distributed to
shareholders. It is
considered a sign of
clear financial health
and confidence for a
company to pay out
FM 2 Financial Analysis and Reporting

Addendum:

1. The distinct difference between return on assets and asset turnover is that the
return on assets considers net income and asset turnover considers revenues.

2. In other books, they use 360 days

3. There are a number of alternative ways to calculate the Degree of Operating

Leverage such as:

a. Contribution Margin/Operating Income

b. Sales – Variable Costs / (Sales – variable costs – fixed costs)

c. Contribution margin % / operating margin

4. Free cash flows are equal to operating cash flows plus capital expenditures

5. In debt service coverage ratio net operating income = Revenue – certain operating
expenses. Total debt service = current debt obligations

6. A high P/E ratio could mean that a company's stock is over-valued, or else that
investors are expecting high growth rates in the future.

7. Companies that have no earnings or that are losing money do not have a P/E
ratio since there is nothing to put in the denominator

8. A high payout ratio may be a sign that too small a percentage of the company's
profits are being reinvested for future operations. This casts doubt on the
company's ability to maintain high dividend payments.

9. Payout ratio and dividend yield are different from each other in the sense that
dividend yield tells you what the simple rate of return is in the form of cash
dividends to shareholders, but the dividend payout ratio represents how much of a
company's net earnings are paid out as dividends.

QUALITATIVE FACTORS IN ANALYSIS OF FINANCIAL STATEMENTS

Sound financial statement analysis is not mere calculating numbers but looking
beyond the absolute results of mathematical computations. The analyst should likewise
consider seriously the qualitative factors:
1. The presence of one major customer.
2. The presence of one major product.
3. The competitors in the market.
FM 2 Financial Analysis and Reporting

4. Reliance on a single supplier.

5. The goals of the company.