Financial-ratios

FINANCIAL RATIOS IN A NUTSHELL

LEARNING OBJECTIVES

  • Understand financial ratios and their significance in financial analysis.

  • Classify key financial ratios and learn ways to calculate them.

  • Interpret results from financial ratio calculations to evaluate business stability, health, and performance.

WHAT IS FINANCIAL RATIO AND ITS SIGNIFICANCE?

  • Definition: Financial ratios are quantitative measures used to assess various aspects of a company's financial performance.

  • They compare different financial variables, derived from financial statements (income statement, balance sheet, cash flow statement).

  • Importance: Provide insights into profitability, liquidity, solvency, efficiency, and market valuation.

  • Usefulness: Widely utilized by investors, creditors, managers, analysts, and stakeholders to evaluate financial health, performance, and prospects.

  • Trends in financial ratios indicate changes in financial condition, aiding in informed decision-making.

CLASSIFICATION OF FINANCIAL RATIOS

1. Profitability Ratios

  • Measure the company's ability to generate profits relative to revenue, assets, or equity.

  • Examples: Return on Investment (ROI), Gross Profit Margin, Net Profit Margin, Return on Equity (ROE).

2. Liquidity Ratios

  • Assess the ability to meet short-term financial obligations by converting assets into cash.

  • Examples: Current Ratio, Quick Ratio.

3. Solvency Ratios

  • Evaluate long-term financial stability and ability to meet long-term debt obligations.

  • Examples: Debt-to-Equity Ratio, Interest Coverage Ratio.

4. Efficiency Ratios

  • Measure how effectively a company utilizes its assets and liabilities to generate sales and profits.

  • Examples: Inventory Turnover Ratio, Accounts Receivable Turnover Ratio, Asset Turnover Ratio.

PROFITABILITY RATIOS

Gross Profit Margin (GPM)

  • Formula: GPM = Gross Profit / Gross Revenue (Sales)

  • Significance: Measures the percentage of revenue exceeding the cost of goods sold; indicates efficiency in production and pricing.

Net Profit Margin (NPM)

  • Formula: NPM = Net Income / Gross Revenue (Sales)

  • Significance: Reflects overall profitability after all expenses; a higher margin indicates better cost management.

Return on Assets (ROA)

  • Formula: ROA = Total Sales or Gross Sales / Total Assets

  • Significance: Indicates efficiency in using assets to generate profits; a higher ROA suggests effective asset utilization.

Return on Equity (ROE)

  • Formula: ROE = Net Income / Total Equity

  • Significance: Measures return on shareholders’ equity; a higher ROE indicates better profitability and efficiency in returns.

LIQUIDITY RATIOS

Current Ratio

  • Formula: Current Ratio = Current Assets / Current Liabilities

  • Significance: Measures the ability to meet short-term obligations; a ratio > 1 indicates healthy liquidity, while < 1 may signal liquidity issues.

Acid Test Ratio (Quick Ratio)

  • Formula: Quick Ratio = (Cash + Receivables + Marketable Securities) / Current Liabilities

  • Significance: Provides a strict assessment of liquidity excluding inventory; a ratio > 1 indicates a favorable liquidity position.

SOLVENCY RATIOS

Debt Ratio

  • Formula: Debt Ratio = Total Debt / Total Assets

  • Significance: Indicates the proportion of assets financed by debt; a higher ratio signifies increased financial leverage and risk.

Debt to Equity Ratio

  • Formula: Debt to Equity = Total Debt / Total Equity

  • Significance: Measures reliance on debt versus equity for financing; a higher ratio suggests greater financial risk relative to equity.

EFFICIENCY RATIOS

Inventory Turnover Ratio (ITR)

  • Formula: ITR = Cost of Sales / Average Inventory

  • Significance: Assesses efficiency in inventory management; a higher ratio indicates better management and quicker turnover.

Accounts Receivable Turnover Ratio (ARTR)

  • Formula: ARTR = Gross Revenues (Sales) / Average Accounts Receivable

  • Significance: Measures efficiency in collecting payments from customers; a higher ratio suggests better receivables management and cash flow.

Accounts Payable Turnover Ratio (APTR)

  • Formula: APTR = Purchases of Inventory / Average Accounts Payable

  • Significance: Indicates efficiency in managing accounts payable; a higher ratio implies shorter payment cycles.

Asset Turnover Ratio (ATR)

  • Formula: ATR = Gross Revenues / Average Total Assets

  • Significance: Assesses how effectively a company utilizes its assets to generate revenue; a higher ratio means better asset productivity.

SUMMARY OF RATIOS

Profitability Ratios

  • Metrics to evaluate a company's ability to generate profits relative to revenue and other financial measures.

Liquidity Ratios

  • Ratios assessing the ability to meet short-term obligations, vital for short-term financial health.

Solvency Ratios

  • Metrics determining long-term financial stability and ability to cover debt obligations.

Efficiency Ratios

  • Ratios evaluating operational efficiency and resource utilization for effective sales and profit generation.

CASE ANALYSIS: PAL ENTERPRISE VS CEB MERCHANDISE

  • A comparative analysis to evaluate the financial performances using the aforementioned ratios.

THANK YOU

  • Dr. Froilan Cris Lao, CPA

  • Internal Auditor/Faculty BSA/BSBA

  • The College of Maasin

  • Contact: 09171295111