Notes on Ratio Analysis in Financial Management

Financial Statement Analysis

• Purpose of Ratio Analysis:

  • Provides insights into the financial health of a company.

  • Allows for comparison over time or against industry peers.

Key Ratio Categories

1. Profitability Ratios:

   • Measures a company's ability to generate profit relative to revenue, expenses, and equity.

   • Main types include:

     • Operating Margin Rate: $ext{Operating Margin Rate} = rac{ ext{EBIT}}{ ext{Sales}}$

     • Net Margin Rate: $ext{Net Margin Rate} = rac{ ext{Net Income}}{ ext{Turnover}}$

     • EBITDA Margin Rate: $ext{EBITDA Margin Rate} = rac{ ext{EBITDA}}{ ext{Sales Revenue}}$

2. Liquidity Ratios:

   • Assess the ability to pay off short-term obligations.

   • Key liquidity ratios include:

     • Current Ratio: $ext{Current Ratio} = rac{ ext{Current Assets}}{ ext{Current Liabilities}}$

     • Quick Ratio: $ext{Quick Ratio} = rac{ ext{Current Assets} - ext{Inventories}}{ ext{Current Liabilities}}$

     • Cash Ratio: $ext{Cash Ratio} = rac{ ext{Total Cash} + ext{Marketable Securities}}{ ext{Current Liabilities}}$

3. Working Capital Ratios:

   • Measure how efficiently a company uses its working capital.

   • Examples:

     • Days Sales Outstanding (Collection Period): $ext{Collection Period} = rac{ ext{Accounts Receivable}}{ ext{Daily Sales}}$

     • Days Payable Outstanding (Payment Period): $ext{Payment Period} = rac{ ext{Accounts Payable}}{ ext{Daily Purchases}}$

4. Interest Coverage Ratio:

   • Assesses a company's ability to meet interest payments.

   • Formula: $ext{Interest Coverage Ratio} = rac{ ext{EBITDA}}{ ext{Interest Expenses}}$

5. Leverage Ratios:

   • Indicate the degree of financial risk a company takes on.

   • Commonly calculated as:

     • Debt to Equity Ratio: $ext{Debt Ratio} = rac{ ext{Net Financial Debt}}{ ext{Equity}}$

     • Debt Ratio: $ext{Debt Ratio} = rac{ ext{Net Financial Debt}}{ ext{Total Equity} + ext{Financial Debt}}$

6. Valuation Ratios:

   • Assess the attractiveness of an investment.

   • Examples include:

     • Market-to-Book Ratio: $ext{Market-to-Book Ratio} = rac{ ext{Market Value}}{ ext{Book Value of Equity}}$

     • Price to Earnings Ratio (PER): $ext{PER} = rac{ ext{Market Value}}{ ext{Net Income}}$

7. Return on Investment Ratios:

   • Measure the effectiveness of a company in generating returns.

   • Formulas:

     • Return on Equity (ROE): $ext{ROE} = rac{ ext{Net Income}}{ ext{Total Equity}}$

     • Return on Assets (ROA): $ext{ROA} = rac{ ext{EBIT}}{ ext{Total Assets}}$

     • Return on Capital Employed (ROCE): $ext{ROCE} = rac{ ext{EBIT after tax}}{ ext{Capital Employed}}$

8. DuPont Analysis:

   • Breaks down ROE into three components:

     • Net margin rate, asset turnover, and leverage ratio.

   • Formula: $ext{ROE} = ext{Net Margin Rate} imes ext{Asset Turnover} imes ext{Leverage Ratio}$

Example Applications

• World Company Analysis:

  • Profitability ratios were calculated for both 2020 and 2021 to assess growth in profitability metrics.

  • Liquidity ratios were evaluated to ensure short-term financial stability.

Conclusion

• Importance of Ratios: Provides crucial insights for decision-making in financial management by allowing for timely responses to financial trends and operational efficiencies.

Profitability Ratios:

• Operating Margin Rate: $\text{Operating Margin Rate} = \frac{ \text{EBIT} }{ \text{Sales} }$

• Net Margin Rate: $\text{Net Margin Rate} = \frac{ \text{Net Income} }{ \text{Turnover} }$

• EBITDA Margin Rate: $\text{EBITDA Margin Rate} = \frac{ \text{EBITDA} }{ \text{Sales Revenue} }$

Liquidity Ratios:

• Current Ratio: $\text{Current Ratio} = \frac{ \text{Current Assets} }{ \text{Current Liabilities} }$

• Quick Ratio: $\text{Quick Ratio} = \frac{ \text{Current Assets} - \text{Inventories} }{ \text{Current Liabilities} }$

• Cash Ratio: $\text{Cash Ratio} = \frac{ \text{Total Cash} + \text{Marketable Securities} }{ \text{Current Liabilities} }$

Working Capital Ratios:

• Days Sales Outstanding (Collection Period): $\text{Collection Period} = \frac{ \text{Accounts Receivable} }{ \text{Daily Sales} }$

• Days Payable Outstanding (Payment Period): $\text{Payment Period} = \frac{ \text{Accounts Payable} }{ \text{Daily Purchases} }$

Interest Coverage Ratio:

• $\text{Interest Coverage Ratio} = \frac{ \text{EBITDA} }{ \text{Interest Expenses} }$

Leverage Ratios:

• Debt to Equity Ratio: $\text{Debt Ratio} = \frac{ \text{Net Financial Debt} }{ \text{Equity} }$

• Debt Ratio: $\text{Debt Ratio} = \frac{ \text{Net Financial Debt} }{ \text{Total Equity} + \text{Financial Debt} }$

Valuation Ratios:

• Market-to-Book Ratio: $\text{Market-to-Book Ratio} = \frac{ \text{Market Value} }{ \text{Book Value of Equity} }$

• Price to Earnings Ratio (PER): $\text{PER} = \frac{ \text{Market Value} }{ \text{Net Income} }$

Return on Investment Ratios:

• Return on Equity (ROE): $\text{ROE} = \frac{ \text{Net Income} }{ \text{Total Equity} }$

• Return on Assets (ROA): $\text{ROA} = \frac{ \text{EBIT} }{ \text{Total Assets} }$

• Return on Capital Employed (ROCE): $\text{ROCE} = \frac{ \text{EBIT after tax} }{ \text{Capital Employed} }$

DuPont Analysis:
Formula: $\text{ROE} = \text{Net Margin Rate} \times \text{Asset Turnover} \times \text{Leverage Ratio}$