Republic of the Philippines

NUEVA ECIJA UNIVERSITY OF SCIENCE AND TECHNOLOGY

Cabanatuan City

GRADUATE SCHOOL

ANALYSIS OF FINANCIAL
STATEMENTS

Prepared by:

LYKA MAE L. FAJARDO

MBA Student

Submitted to:

DR. FELIPE BALARIA

Professor

Ratio Analysis
Ratio Analysis is a form of Financial Statement Analysis that is used to obtain a quick indication
of a firm's financial performance in several key areas. The ratios are categorized as Short-term
Solvency Ratios, Debt Management Ratios, Asset Management Ratios, Profitability Ratios, and
Market Value Ratios.

Because Ratio Analysis is based upon Accounting information, its effectiveness is limited by the
distortions which arise in financial statements due to such things as Historical Cost Accounting
and inflation. Therefore, Ratio Analysis should only be used as a first step in financial analysis,
to obtain a quick indication of a firm's performance and to identify areas which need to be
investigated further.

Short-term Solvency or Liquidity Ratios

- Short-term Solvency Ratios attempt to measure the ability of a firm to meet its short-term
financial obligations. In other words, these ratios seek to determine the ability of a firm to
avoid financial distress in the short-run. The two most important Short-term Solvency
Ratios are the Current Ratio and the Quick Ratio. (Note: the Quick Ratio is also known as
the Acid-Test Ratio.)

Current Ratio

- The Current Ratio is calculated by dividing Current Assets by Current Liabilities. Current
Assets are the assets that the firm expects to convert into cash in the coming year and
Current Liabilities represent the liabilities which have to be paid in cash in the coming
year. The appropriate value for this ratio depends on the characteristics of the firm's
industry and the composition of its Current Assets. However, at a minimum, the Current
Ratio should be greater than one.

Quick Ratio

- This ratio attempts to measure the ability of the firm to meet its obligations relying solely
on its more liquid Current Asset accounts such as Cash and Accounts Receivable. This
ratio is calculated by dividing Current Assets less Inventories by Current Liabilities.

Debt Management Ratios

- Debt Management Ratios attempt to measure the firm's use of Financial Leverage and
ability to avoid financial distress in the long run. These ratios are also known as Long-
Term Solvency Ratios.

- Debt is called Financial Leverage because the use of debt can improve returns to
stockholders in good years and increase their losses in bad years. Debt generally
represents a fixed cost of financing to a firm. Thus, if the firm can earn more on assets
which are financed with debt than the cost of servicing the debt then these additional
earnings will flow through to the stockholders. Moreover, our tax law favors debt as a
source of financing since interest expense is tax deductible.
Debt Ratio, Debt-Equity Ratio, and Equity Multiplier

 The Debt Ratio, Debt-Equity Ratio, and Equity Multiplier are essentially three ways of
looking at the same thing: the firm's use of debt to finance its assets. The Debt Ratio is
calculated by dividing Total Debt by Total Assets. The Debt-Equity Ratio is calculated
by dividing Total Debt by Total Owners' Equity. The Equity Multiplier is calculated by
dividing Total Assets by Total Owners' Equity.

Asset Management Ratios

- Asset Management Ratios attempt to measure the firm's success in managing its assets to
generate sales. For example, these ratios can provide insight into the success of the firm's
credit policy and inventory management. These ratios are also known as Activity or
Turnover Ratios.

Receivables Turnover and Days' Receivables

- The Receivables Turnover and Days' Receivables Ratios assess the firm's management of
its Accounts Receivables and, thus, its credit policy. In general, the higher the
Receivables Turnover Ratio the better since this implies that the firm is collecting on its
accounts receivables sooner. However, if the ratio is too high then the firm may be
offering too large of a discount for early payment or may have too restrictive credit terms.
The Receivables Turnover Ratio is calculated by dividing Sales by Accounts
Receivables. (Note: since Accounts Receivables arise from Credit Sales it is more
meaningful to use Credit Sales in the numerator if the data is available.)

- The Days' Receivables Ratio is calculated by dividing the number of days in a year, 365,
by the Receivables Turnover Ratio. Therefore, the Days' Receivables indicates how long,
on average, it takes for the firm to collect on its sales to customers on credit. This ratio is
also known as the Days' Sales Outstanding (DSO) or Average Collection Period (ACP).

Inventory Turnover and Days' Inventory

- The Inventory Turnover and Days' Inventory Ratios measure the firm's management of
its Inventory. In general, a higher Inventory Turnover Ratio is indicative of better
performance since this indicates that the firm's inventories are being sold more quickly.
However, if the ratio is too high then the firm may be losing sales to competitors due to
inventory shortages. The Inventory Turnover Ratio is calculated by dividing Cost of
Goods Sold by Inventory. When comparing one firms's Inventory Turnover ratio with
that of another firm it is important to consider the inventory valuation methid used by the
firms. Some firms use a FIFO (first-in-first-out) method, others use a LIFO (last-in-first-
out) method, while still others use a weighted average method.

- The Days' Inventory Ratio is calculated by dividing the number of days in a year, 365, by
the Inventory Turnover Ratio. Therefore, the Days' Inventory indicates how long, on
average, an inventory item sits on the shelf until it is sold.

Fixed Assets Turnover

- The Fixed Assets Turnover Ratio measures how productively the firm is managing its
Fixed Assets to generate Sales. This ratio is calculated by dividing Sales by Net Fixed
Assets. When comparing Fixed Assets Turnover Ratios of different firms it is important
to keep in mind that the values for Net Fixed Assets reported on the firms' Balance Sheets
are book values which can be very different from market values.

Total Assets Turnover

 The Total Assets Turnover Ratio measures how productively the firm is managing all of
its assets to generate Sales. This ratio is calculated by dividing Sales by Total Assets.

Profitability Ratios
- Profitability Ratios attempt to measure the firm's success in generating income. These
ratios reflect the combined effects of the firm's asset and debt management.

Profit Margin

- The Profit Margin indicates the dollars in income that the firm earns on each peso of
sales. This ratio is calculated by dividing Net Income by Sales.

Return on Assets (ROA) and Return on Equity (ROE)

- The Return on Assets Ratio indicates the dollars in income earned by the firm on its
assets and the Return on Equity Ratio indicates the dollars of income earned by the firm
on its shareholders' equity. It is important to remember that these ratios are based on
Accounting book values and not on market values. Thus, it is not appropriate to compare
these ratios with market rates of return such as the interest rate on Treasury bonds or the
return earned on an investment in a stock.

Market Value Ratios

- Market Value Ratios relate an observable market value, the stock price, to book values
obtained from the firm's financial statements.

Price-Earnings Ratio (P/E Ratio)

- The Price-Earnings Ratio is calculated by dividing the current market price per share of
the stock by earnings per share (EPS). (Earnings per share are calculated by dividing net
income by the number of shares outstanding.)

Market-to-Book Ratio

- The Market-to-Book Ratio relates the firm's market value per share to its book value per
share. Since a firm's book value reflects historical cost accounting, this ratio indicates
management's success in creating value for its stockholders. This ratio is used by "value-
based investors" to help to identify undervalued stocks.

Ratio Equations
Short-term Solvency Ratios
Current Ratio:
Quick Ratio:
Asset Management Ratios
Receivables
Turnover:
Days'
Receivables:
Inventory
Turnover:
Days'
Inventory:
Fixed Assets
Turnover:
Total Assets
Turnover:
Debt Management Ratios
Times Interest
Earned
(TIE) Ratio:
Debt Ratio:
Debt-Equity
Ratio:
Equity
Multiplier:
Profitability Ratio
Profit Margin:
Return on
Assets:
Return on
Equity:
Market Value Ratios
Price/Earnings
Ratios:
Market-to-
Book Ratio:
Dividend Ratios
Payout Ratio:
Retention
Ratio:
Other Equations
Earnings Per
Share:
Book Value
Per Share:

Resource: http://www.zenwealth.com/businessfinanceonline/RA/RatioCalc.html