RATIO ANALYSIS
WEEK 8 MODULE 8
Ratio Analysis: This involves calculating ratios
using numbers from financial statements.
• These ratios give us insights into different aspects of a
company's performance, like how profitable it is or how well
it manages its debts.
• It's
like using simple math to understand how healthy a
company is, financially.
1. Current Ratio: Is one of the liquidity ratios that measures a firm’s ability
to pay off its current or short-term liabilities with its current assets.
Formula: Current Ratio = Current Assets / Current Liabilities
Above 1: A ratio above 1 means that a company's current assets exceed its
current liabilities, indicating it should be able to meet its short-term obligations
comfortably. Higher ratios indicate stronger short-term liquidity.
Below 1: A ratio below 1 means that a company's current liabilities exceed its
current assets, suggesting potential liquidity issues. It might struggle to pay off its
short-term debts with its existing short-term assets.
2. Debt to Equity Ratio: Is a financial liquidity ratio that a compares a company’s total debt to total
equity. In simpler terms, it shows how much of a company's financing comes from debt compared to
how much comes from the shareholders' equity.
Formula: Debt to Equity Ratio = Total Liabilities / Total Equity
Above 1: If the debt-to-equity ratio is above 1, it means that the company has more debt than equity.
This suggests that the company relies more heavily on debt financing to fund its operations
• While debt can provide opportunities for growth, it also increases financial risk because the
company must repay the debt regardless of its performance. High debt levels may make it
challenging for the company to manage its financial obligations, especially during economic
downturns.
Below 1: If the debt-to-equity ratio is below 1, it means that the company has more equity than debt.
This indicates a lower level of financial risk because the company relies more on equity financing
from shareholders rather than borrowing.
• A lower debt-to-equity ratio may imply that the company has a stronger financial position and may
be better able to weather economic uncertainties. However, excessively low debt levels might
also suggest that the company is not taking advantage of potential growth opportunities that could
be funded through debt financing.
•
3. Gross Margin Ratio. One of the profitability ratios is gross margin ratio which compares
the gross margin of a business to the net sales. This ratio measures how profitable a
company sells its inventory or merchandise.
Formula: Gross Margin Ratio = Gross Margin / Net Sales x 100
• A higher gross margin ratio means the company is earning more profit from each sale after
covering its production costs. This suggests good pricing or efficient production.
4. Profit Margin Ratio. Directly measures the percentage of sales over the total net
income. It is interpreted as how much profit is generated over certain level of sales.
Formula: Profit Margin Ratio = Net Income / Net Sales x 100
• A higher profit margin ratio indicates the company is managing its expenses well, turning more
of its revenue into profit. It reflects overall efficiency in operations.
• The higher the ratios, the more favorable it is. Higher ratios indicate that the company is
selling the inventory at a higher profit percentage.
THANK YOU