Chapter 7:
Ratio Analysis
Mr. David Wong/2018
Compute basic accounting ratios
Explain the purpose and use of ratios in
analysis a business’s liquidity, profitability and
performance.
• Analysis of financial statement for decision making.
(a) Assessment of a business’ past, present and anticipates
future
(b) To identify the weakness and strength.
• Objective of Ratio Analysis
(a) To standardise financial information for comparison
purposes.
(b) To assess the strengths and weakness of a business
(c) To highlight trends on financial items.
(d) To evaluate current operation of a business
(e) To assess the efficiently of the business operations
(f) To compare the present performance with past performance.
(g) To compare the performance of the business with its
competitors.
Financial ratios are tools to do this.
Liquidity ratios
Activity ratios
Gearing ratios
Profitability ratios
Measures whether a firm can repay its bills, or
financial obligations (debts) on time.
Focus is on cash or near cash assets – more
readily available to settle debts (especially
current debts).
Sometimes called the working capital ratio or
bankers’ ratio
Measures a company’s ability to pay its current
liabilities.
Computed as follows:
Current Assets
Current Ratio = Current Liabilities
The higher the CR, the more liquid the firm’s
position.
Rule of thumb, CR should be > 2.
The current ratio for Lincoln Company is
computed below.
Measures the “instant” debt-paying ability of a
company
Sometimes called acid-test ratio.
It is computed as follows:
The quick ratio for Lincoln Company is
computed below.
Excess of current assets over current liabilities.
Note: not a ratio.
Often used to evaluate a company’s ability to
pay current liabilities.
Computed as follows:
The larger the figure, the better.
Measures how effectively a firm uses its assets
to generate revenue.
Also called efficiency, turnover or business
asset management ratios.
The relationship between the volume of goods
(merchandise) sold and inventory.
Assesses the efficiency of a firm in managing
its inventory.
Tells how many times the inventory is
replaced/sold within an accounting period
The higher the figure, the better – sales are
increasing & inventory levels are low.
Computed as follows:
Lincoln’s inventory balance at the beginning
of 2011 is $311,000.
A rough measure of the length of time it takes
to purchase, sell, and replace the inventory.
Computed as follows:
The number of days’ sales in inventory for
Lincoln Company is computed below.
The relationship between sales and accounts
receivable.
Collecting accounts receivable as quickly as possible
improves a company’s solvency.
The higher the ratio, the more effective the firm in
collecting from its credit customers.
Computed as follows:
The accounts receivable turnover for Lincoln
Company is computed below.
An estimate of the length of time (in days) the
accounts receivable have been outstanding.
The fewer number of days, the more efficient
the firm is at collecting receivables.
Computed as follows:
The number of days’ sales in receivables for
Lincoln Company is computed below.
Measures how effectively the firm uses its non-
current assets to generate sales.
The higher the ratio, the more efficient the firm is in
using its non-current assets to generate sales.
Computed as follows:
A measure that shows how effectively a
company utilizes its assets – how much sales a
firm is able to generate from money invested in
total assets.
The higher the ratio, the better.
The ratio is computed as follows:
The ratio of net sales to assets for Lincoln
Company is computed below.
Measures how a firm uses outside funds
(liabilities) to finance its assets.
Also indicates whether a firm can pay the
interest on the use of outside funds & repay the
loan amounts.
Also called leverage or debt management
ratios.
Measures the percentage of total liabilities to
the total assets of the firm.
Computed as follows:
The lower the ratio, the better
the less a firm is financed by outside parties.
the higher the firm’s ability to obtain more outside
funds when needed.
Measures the number of times a firm is able to
repay fixed interest from its net operating
profits.
Also called interest cover ratio.
The higher the ratio, the better
More able to repay interest charges.
It is computed as follows:
The number of times interest charges are
earned for Lincoln Company is computed
below.
Measures long term debt to shareholders’
equity.
Indicates the margin of safety for creditors.
The lower the ratio, the better for the firm.
Computed as follows:
The ratio of liabilities to shareholders’ equity
for Lincoln Company is computed below.
Measures the firm’s ability to produce profits
from its assets.
The higher the ratios, the better.
Also an indication of firm’s efficiency.
Can be divided into:
Profitability ratios based on sales (gross profit
margin, net profit margin, operating profit margin)
Profitability ratios based on assets/resources
(operating profit to total assets ratio, return on assets
ratio, return on common equity)
Measures the profitability of a firm over a
period.
Indicates how much profit is made per sales
generated.
Computed as follows:
Indicates what is available to owners from its
net sales, after considering all expenses.
Computed as follows:
Indicates how much operating profit is made
per sales generated.
Computed as follows:
measures the amount of operating profit
obtained from utilising assets.
The higher the ratio, the more efficient the firm
has been in utilising its assets to generate
sales/profit.
It is computed as follows:
Measures the profitability of assets utilised.
Also known as return on investment ratio.
The higher the ratio, the better the return on
the use of assets by the firm.
Computed as follows:
Measures the net profit against the amount
invested by shareholders.
Indicates what shareholders earn from their
investments in the business.
It is computed as follows:
Lincoln Company had $150,000 of 6% preferred stock
outstanding on December 31, 2012 and 2011.
Thus, preferred dividends of $9,000 ($150,000 x 6%) are
deducted from net income.
Lincoln’s common shareholders’ equity is determined as
follows:
Inter-company comparisons
against industry averages/norms
Obtained by averaging out the ratios of a good
sample of companies in the industry
Firm can benchmark itself accordingly
Intra-company comparisons
Trend analysis – over a period of time
To see if business has improved/ deteriorated
To be used to formulate future strategy