Concise Summary of Ratio Analysis

• Chapter 9: Ratio Analysis

  • Learning Objectives:
  • Define and determine the need for ratio analysis.
  • Understand how ratios are expressed and their application.
  • Calculate and explain profitability, liquidity, and activity ratios.
  • Explore the uses and limitations of ratio analysis.
  • Identify users of financial ratios and their interests.

• Financial Ratios

  • Establish relationships between financial statement items.
  • Useful for evaluating business performance and position.
  • Ratios are calculated using two items: numerator and denominator from financial statements.

• Types of Ratio Analysis

  • Trend Analysis: Compare financial data over different years.
  • Inter-company Comparison: Compare ratios with similar businesses.

• Key Types of Ratios

  • Profitability Ratios:
  • Gross Profit Margin =(\frac{Gross Profit}{Net Sales} \times 100)
  • Net Profit Margin =(\frac{Net Profit}{Net Sales} \times 100)
  • Liquidity Ratios:
  • Current Ratio =(\frac{Current Assets}{Current Liabilities})
  • Quick Ratio =(\frac{Current Assets - Inventory}{Current Liabilities})
  • Activity Ratios:
  • Rate of Stock Turnover =(\frac{Cost of Goods Sold}{Average Inventory})

• Uses of Financial Ratios

  • Assess profitability, efficiency, liquidity, and capital structure.
  • Identify strengths and weaknesses in financial performance.
  • Aid in decision making and comparison across firms.

• Limitations of Ratio Analysis

  • Requires proper comparisons; historical data may mislead.
  • Different accounting methods can distort ratios.
  • Ratios are indicators, not conclusive measures.

• Key Financial Ratios:

  • Profitability Ratios: Gross Profit Margin, Net Profit Margin, ROCE.
  • Liquidity Ratios: Current Ratio, Quick Ratio.
  • Activity Ratios: Rate of Stock Turnover.

Note: Use financial data sensibly; always consider industry standards and economic conditions.