2 THE FINANCIAL RATIOS

FINANCIAL RATIOS

They are coefficients or ratios that provide accounting and financial units of
measurement and comparison, through which the relationship between two of them
direct financial data, allow analyzing the current or past state of
an organization, based on optimal levels defined for it.

Often used in accounting, there are numerous financial ratios that exist
used to assess the overall financial status of companies, corporations and
corporations. Financial ratios can be used by managers
belonging to the company, by the investors who hold shares of the
company, and by the company's creditors. Financial analysts use
financial ratios to compare the strengths and weaknesses of different
companies, and the evolution over time of companies. If the shares of a
companies are bought and sold in the stock market (or exchange)
trade), the market price of the shares is used to calculate
certain financial ratios.
Ratios can be expressed as a decimal value, such as 0.10, or be
indicated as an equivalent percentage value, such as 10%. Some ratios
they are generally cited as percentages, especially those ratios that
generally have values below 1, such as the return on earnings,
while others are generally cited as decimal numbers,
especially those ratios that have values greater than 1, such as
the Price to Earnings Ratio; the latter are called multiples. Given a
ratio, its reciprocal can be calculated; if the ratio was greater than 1, the reciprocal
it will have a value less than 1 and conversely.

CLASSIFICATION OF RATIOS

They are divided into 4 large groups:

1. LIQUIDITY RATIOS (LIQUIDITY ANALYSIS): They assess the ability
from the company to meet its short-term commitments.
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1a)Currentratioorliquidityratio
2a)Acidtestratio
3a)Defensiveproofratio
4a)Workingcapitalratio
5a)Liquidityratiosofaccountsreceivable

2. MANAGEMENT OR ACTIVITY INDICES: Measure the use of the asset and

they compare the sales figure with total assets, tangible fixed assets,
current assets or elements that comprise them.

1b) Accounts receivable turnover ratio

2b) Inventory Rotation
Average payment period to suppliers
Cash and bank turnover
5b) Total Asset Turnover
6b) Fixed Asset Turnover

3. SOLVENCY, DEBT OR LEVERAGE INDICATORS: Ratios

that relate resources and commitments.

1c) Capital structure (debt equity)

2c) Indebtedness
3c) Coverage of financial expenses
Coverage for fixed expenses

4. PROFITABILITY INDICES: Measure the company's ability to

generate wealth (economic and financial profitability).

Return on equity
Return on investment
3d) Active utility
4d) Sales utility
Earnings per share
6d) Gross and net profit margin
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EXPLANATION OF RATIOS

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They measure the company's ability to pay its debts.

short term. That is to say, the cash at hand to settle the
debts. They express not only the management of the company's total finances,
the managerial skill to convert certain assets into cash and
current liabilities. They facilitate examining the company's financial situation
Compared to others, in this case the ratios are limited to the analysis of assets and liabilities.

current.
A good image and position in front of financial intermediaries requires:
maintain a sufficient level of working capital to carry out the
operations that are necessary to generate a surplus that allows for
the company will continue normally with its activity and generate money
enough to cover the needs of the financial expenses that it
request on its short-term debt structure. These are four

1a). Current ratio or liquid ratio

The current ratio is obtained by dividing current assets by the
current liabilities. Current assets mainly include cash accounts,
banks, accounts and receivables, easily negotiable securities and inventories.
This ratio is the main measure of liquidity, showing what proportion of debts
short-term are covered by elements of the asset, whose conversion into money
approximately corresponds to the maturity of the debts.
The greater the value of this ratio, the greater the capacity of the company.
to pay your debts

LIQUIDEZ GENERAL times

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2a). Acid test ratio

It is that indicator that, when excluding accounts that are not part of current assets,

easily achievable, provides a more demanding measure of capacity

payment of a company in the short term. It is somewhat more severe than the previous one and it is

calculated by subtracting the current asset inventory and dividing this difference
among current liabilities. Inventories are excluded from the analysis because they are the ...
less liquid assets and those most susceptible to losses in the event of bankruptcy

– times
ACID TEST

Unlike the previous reason, this one excludes inventories as they are considered
the least liquid part in case of bankruptcy. This ratio focuses on the assets
more liquid, so it provides more accurate data to the analyst.

3a). Defensive test ratio

It allows measuring the effective capacity of the company in the short term; it considers

only the assets held in Cash-Banks and negotiable securities,

disregarding the influence of the time variable and the uncertainty of prices of
the other accounts of current assets. It indicates the company's capacity
to operate with its most liquid assets, without resorting to its sales flows.
We calculate this ratio by dividing the total of cash and bank balances by the
current liabilities.

DEFENSIVE TEST = =%
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4a). Working capital ratio

As it is often used, we will define it as a relationship between the

Current Assets and Current Liabilities; it is not a defined ratio in terms
of one item divided by another. The Working Capital is what remains for the company
after paying your immediate debts, it is the difference between the Assets
Current assets minus current liabilities; something like the money that is left for you to
to be able to operate on a day-to-day basis.

WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES = UM

5a). Liquidity ratios of accounts receivable

Accounts receivable are liquid assets only to the extent that they can
to collect within a reasonable time.

Basicreasons:

CURRENT RATES FOR CHARGING X DAYS IN THE YEAR

AVERAGE COLLECTION PERIOD DAYS

ROTATION OF ACCOUNTS RECEIVABLE = SOMETIMES

Reasons (5 and 6) are reciprocal to each other. If we divide the average period of
collections within 360 days that the commercial or banking year has, we will obtain the
accounts receivable turnover of 5.89 times per year. Likewise, the number of
Days of the year divided by the accounts receivable turnover rate gives us
the average collection period. We can use these ratios interchangeably.
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[Link] OF MANAGEMENT OR ACTIVITY

They measure the effectiveness and efficiency of management in capital administration.

work, they express the effects of decisions and policies followed by the company,
regarding the use of your funds. They show how it was managed
company regarding collections, cash sales, inventory, and sales
totals. These ratios imply a comparison between sales and necessary assets.
to support the sales level, considering that there is an appropriate value of
correspondence between these concepts.
Thus, we have the following ratios in this group:

1b). Accounts receivable turnover ratio

They measure the recovery frequency of accounts receivable. The purpose of
this ratio measures the average term of credits granted to clients and,
evaluate the credit and collection policy. The balance in accounts receivable should not
exceed the sales volume. When this balance is greater than sales, it
produce the total immobilization of funds in accounts receivable, subtracting from the
company, payment capacity and loss of purchasing power.
It is desirable for the accounts receivable balance to rotate reasonably, in such a way

way that does not involve very high financial costs and allows to use the
credit as a sales strategy.

Collectionperiodorannualturnover:
It can be calculated by expressing the average days that accounts remain.
before being charged or indicating the number of times the accounts rotate for
Charge. To convert the number of days into the number of times that the accounts for
to collect remain immobilized, we divide by 360 days in a year.
Collectionperiod:

CURRENT FOR COBRAR PROMEDIO*360

Portfolio Rotation DAYS
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The high turnover of the portfolio is an indicator of a successful

credit policy that prevents the immobilization of funds in accounts receivable.
Generally, the optimal level of portfolio turnover is found in figures of
6 to 12 times a year, 60 to 30 days of billing period.

2b) Inventory Turnover

Quantify the time it takes for investment in inventories to become
cash and allows knowing the number of times this investment goes to the market, in
a year and how many times is it replenished.

There are several types of inventories. An industry that transforms raw materials,
will have three types of inventories: raw materials, work in progress, and
the finished products. If the company is engaged in commerce, there will be only one
type of inventory, accounted for, as merchandise.

Inventoryimmobilizationperiodorannualturnover:
The number of days they remain immobilized or the number of times they rotate
the inventories in the year. To convert the number of days into the number of times
that the investment maintained in finished products goes to the market, we divide by
360 days that a year has.
Inventory immobilization period:

INVENTARIO PROMEDID*360
Inventory Turnover DAYS

A higher rotation means greater mobility of the capital invested in inventory and faster.
recovery of the profit that each finished product unit has. For
calculate the turnover of raw material inventory, finished product and in
the process is carried out in the same way.

Inventory Turnover SOMETIMES

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It indicates the speed at which inventory in accounts receivable changes.

through sales. The higher the inventory turnover, the more
the management of a company's inventory will be efficient.

3b) Average payment period to suppliers

This is another indicator that provides clues about capital behavior.
of work. It specifically measures the number of days the firm takes to pay
the credits that the suppliers have granted to him.
A common practice is to seek for the number of payment days to be greater, although
One must be careful not to affect one's image of being a 'good payer' with one's

raw material suppliers. During inflationary periods, part of it must be discharged.

of the loss of purchasing power of money with suppliers, buying from them at
credit.
Payment period or annual turnover: Similarly to the previous ratios, this
index can be calculated as average days or rotations per year to pay
the debts.

CTAS X PAGAR PROMEDIO*360

PAYMENT PERIOD PROV = = days

The results of this ratio should be interpreted in the opposite way to those of
accounts receivable and inventories. The ideal is to obtain a slow ratio (i.e., 1, 2
4 times a year) since it means we are making the most of the credit
what their raw material suppliers offer them. Our ratio is very high.

4b) Cash and bank turnover

They give an idea of the magnitude of the cash and banks to cover days of sales. The
we obtain by multiplying the total of Cash and Banks by 360 (days of the year) and
dividing the product by the annual sales.

CAJA Y BANCOS * 360 days

EMPTY CASH ROTATION =
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5b) Total Asset Turnover

Ratio that aims to measure the sales activity of the firm. That is, how many
sometimes the company can place a value equal to the investment among its clients
carried out.
To obtain it, we divide net sales by the total asset value:

TOTAL ASSET TURNOVER = Times

This ratio indicates how productive the assets are in generating sales, it is
to say, how much is being generated in sales for each unit invested. It tells us what
how productive the assets are for generating sales, that is, how much more
we sell for each unit invested.

6b) Fixed Asset Turnover

This reason is similar to the previous one, with the addition that it measures the capacity of the

company to use capital in fixed assets. It measures the sales activity of the
company. It says, how many times can we place a value equal to among the clients
the investment made in fixed assets.

FIXED ASSET TURNOVER = Times

C. SOLVENCY,INDEBTEDNESS,ORLEVERAGEANALYSIS

These ratios show the amount of resources that are obtained from third parties for
the business. They express the backing that the company has against its debts
totals. They give an idea of its financial autonomy. They combine the
short-term and long-term debts.
They allow us to know how stable or consolidated the company is in terms of
composition of liabilities and their relative weight with equity and assets. They measure
also the risk that runs for someone who offers additional financing to a company and
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determines equally, who has provided the funds invested in the assets.
Show the percentage of total funds contributed by the owner(s) or the
creditors either in the short or medium term.
For the financial entity, what is important is to establish standards with which
can measure the debt and then be able to talk about a high or low
percentage. The analyst must be clear that indebtedness is a problem of
cash flow and that the risk of incurring debt consists in the ability that one has
or the company's management to generate the necessary funds and
sufficient to pay the debts as they come due.

1c) Capital structure (debt equity)

It is the ratio that shows the degree of indebtedness in relation to equity.
This ratio evaluates the impact of total liabilities in relation to equity.
We calculate it by dividing the total liabilities by the value of equity:

CAPITAL STRUCTURE =

2c) Indebtedness
Represents the percentage of participation funds of the creditors, whether in
the short or long term, in assets. In this case, the objective is to measure the level
global indebtedness or proportion of funds provided by creditors.

DEBT RATIO = =%

3c) Coverage of financial expenses

This ratio indicates to what extent profits can decline without jeopardizing
the company in a difficult situation to pay its financial expenses.

COVERAGE OF FINANCIAL EXPENSE Times

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One way to measure it is by applying this ratio, whose result projects an idea of
the payment capacity of the applicant.
It is an indicator frequently used by financial entities, already
which allows to know the ease with which the company can meet its
obligations derived from their debt.

4c) Coverage for fixed expenses

This ratio allows visualization of survival capacity, indebtedness and
also measure the company's ability to take on its fixed cost burden.
To calculate it, we divide the gross margin by the fixed expenses. The gross margin is
the only possibility the company has to cover its fixed costs and
for any additional expenses, such as financial ones.

COVERAGE OF FIXED EXPENSES = Times

For this case, we consider fixed expenses as sales expenses.

general and administrative expenses and depreciation. This does not mean that the expenses of

sales necessarily correspond to fixed expenses. When classifying costs

Fixed and variable costs should analyze the particularities of each company.

[Link] ANALYSIS

They measure the company's ability to generate profit. They have for
Objective to appreciate the net result obtained from certain decisions and
policies in the management of the company's funds. They evaluate the results
economic aspects of business activity.
They express the performance of the company in relation to its sales, assets or
capital. It is important to know these figures, as the company needs to produce
utility to be able to exist. They directly relate to the capacity to generate
funds in short-term operations.
Negative indicators express the stage of deaccumulation that the company is in.
crossing and it will affect its entire structure by demanding higher financial costs
or a greater effort from the owners to maintain the business.
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The profitability indicators are very varied, the most important ones and that
we study here are: return on equity, return on
total assets and net margin on sales.

Return on equity
We obtain this reason by dividing the net profit by the net equity of the
company. It measures the profitability of the funds contributed by the investor.

RETURN ON EQUITY = =%

Return on Investment
We obtain it by dividing the net profit by the total assets of the company.
to establish the total effectiveness of management and generate profits on
the total available assets. It is a measure of the profitability of the business as
independent project of the shareholders.

RETURN ON INVESTMENT = =%

3d) Active utility

This ratio indicates the efficiency in the use of a company's assets, which
we calculate by dividing the earnings before interest and taxes by the amount
of assets.

.
Sales Unit =%

4d) Sales utility

This ratio expresses the profit obtained by the company for each unit of sales.
we obtain by dividing the profit before interest and taxes by the value of
assets.

.
Sales Unit =%
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Earnings per share

Ratio used to determine net earnings per common share.

EARNINGS PER SHARE = UM

Gross Margin
Gross Margin
This ratio relates sales minus the cost of sales to sales. It indicates the
amount obtained as profit for each unit of sales, after the
the company has covered the cost of the goods it produces and/or sells.

−
GROSS PROFIT MARGIN = =%

Indicate the profits in relation to sales, deducting the costs of

production of goods sold. It also tells us the efficiency of the
operations and the way product prices are assigned.
The larger the gross profit margin, the better it will be, as it means
that has a low cost of the goods it produces and/or sells.

Net Margin
Profitability more specific than the previous one. Relates net profit with the
level of net sales. Measures the percentage of each unit of sales that remains
after all expenses, including taxes, have been deducted.
The larger the company's net margin, the better.

NET PROFIT MARGIN =%

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LIMITATIONS OF FINANCIAL RATIOS

However, the advantage provided by the ratios comes with a series

of limitations, such as:

. Difficulties in comparing several companies due to the existing differences

in the accounting methods of inventory valuation, accounts for
collect and fixed asset.

. They compare the usefulness in evaluation with a sum that contains the same.
utility. For example, when calculating the return on equity
we divide the profit of the year by the equity at the end of the same year, which
it already contains the utility obtained during that period as profit to be distributed. Before

it is preferable to calculate these indicators with equity or assets

from the previous year.

. They are always referred to the past and are merely indicative of
what could happen.

. They are easy to handle to present a better situation for the company.

. They are static and measure the levels of bankruptcy of a company.

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Bibliography

 SAMUELSON,[Link],W."Economics"McGrawHil
 FOJCANDEL,JoséFelipe;.“Economy.1stYearofHighSchool”.

Webography:

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