Module 10
Learning Material: Financial Ratio Analysis
Financial ratios help analysts, students, and managers understand how well a
company uses its resources, meets its short-term obligations, and maintains
long-term financial stability. Two important groups of ratios are:
1. Asset Management Efficiency & Liquidity Ratios
2. Stability (Solvency) Ratios
These ratios provide insights into a company’s operational strength, cash
flow stability, and long-term financial risk.
I. Measures of Asset Management Efficiency and Liquidity
Asset management ratios evaluate how effectively a company uses its assets
to generate revenue, while liquidity ratios show its ability to pay short-term
obligations. The following ratios help assess collection performance and
asset utilization.
1. Receivable Turnover Ratio
Formula:
Revenues
Receivable Turnover=
Average Receivables
Significance:
Shows how many times the company collects its average
receivables during the year.
A higher receivable turnover means the company is efficient in
collecting from customers.
A lower turnover indicates slow collection, possible credit issues, or
poor collection policies.
Interpretation Tip:
If a company has a receivable turnover of 12, it means it collects receivables
12 times per year, or about once per month.
2. Average Collection Period (ACP)
Formula:
360 days
Average Collection Period=
Receivable Turnover
Significance:
Indicates the average number of days it takes to collect receivables.
A shorter collection period means faster cash inflow and better
liquidity.
A longer period may signal collection delays or risky credit terms.
Interpretation Tip:
If a company’s ACP is 30 days, this means it takes 30 days to collect
payments, which may align with a typical 30-day credit policy.
3. Asset Turnover Ratio
Formula:
Revenues
Asset Turnover=
Average Total Assets
Significance:
Measures how effectively the company uses its total assets to
generate sales.
A higher asset turnover means assets are being used efficiently.
A lower turnover suggests underutilized assets, over-investment, or
operational inefficiencies.
Interpretation Tip:
Retail businesses usually have high asset turnover, while asset-heavy
industries (e.g., utilities, manufacturing) tend to have lower turnover.
II. Measures of Stability (Solvency Ratios)
Stability or solvency ratios evaluate a company’s long-term financial
strength. These ratios show how much of the company’s financing comes
from creditors versus owners.
1. Debt to Equity Ratio (D/E Ratio)
Formula:
Total Liabilities
Debt to Equity Ratio=
Institutional Equity
Significance:
Measures the proportion of funds provided by creditors relative to the
owners’ equity.
A higher ratio means greater reliance on debt, leading to higher
financial risk.
A lower ratio suggests more conservative financing and lower risk.
Interpretation Tip:
A D/E ratio of 1.0 means the company is financed equally by creditors and
owners.
2. Debt Ratio
Formula:
Total Liabilities
Debt Ratio=
Total Assets
Significance:
Indicates what percentage of the company’s assets is financed by
creditors.
A high debt ratio means a large portion of assets is financed by debt,
increasing risk.
A low debt ratio implies strong financial stability and lesser
dependence on borrowing.
Interpretation Tip:
A debt ratio of 0.60 (or 60%) means 60% of the company’s assets are
financed by liabilities.