Session 2

Financial Ratios: Tools for Understanding Financial Statements

Financial statements are the accounting reports that contain accounting

information about the financial performance of the company and the status of the

company's financial condition. These reports are used by different users and for different

purposes. Suppliers use these statements to assess a firm's ability to pay short-term

obligations. Banks and other financial institutions use these reports to ascertain a

company's ability to service loan schedules. Investors use these reports to gauge the

company's ability to generate earnings. Government regulators use these statements as a

basis for checking the company's compliance with legal requirements and statutes while

policy makers use these statements as bases for the formulation of policies. Management,

of course, uses these reports to monitor and control business activities.

An in-depth analysis of these statements results in a deeper understanding of the

operations of a subject firm. When analyzed more meticulously, a financial statement can

reveal a wealth of information that is otherwise not quite apparent when it is given only a

cursory glance. An important tool in Finance that allows such an analysis of financial

statements is Financial Ratio Analysis.

Financial ratios are ratios extracted from the information given in financial

statements to better understand the financial condition and performance of a subject firm.

An author of a book on Strategic Management once commented that there are as many

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This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed

approval of the author

ratios as there are financial analysts to underscore the fact that the derivation of these

ratios rests with the individual user. Indeed, it may be difficult to come up with an

exhaustive list, much less to discuss all the possible ratios. Nonetheless, for the purpose

of this module, the more popular ones will be covered.

There are four general classifications of financial ratios that are of popular use:

profitability, asset utilization or activity, liquidity and solvency.

The profitability ratios are: Return on Sales (ROS), Return on Investment (ROI),

and the Gross Profit Margin (GPM). The ROS is computed by dividing the Net Income

by Sales. It is also known as Net Profit Margin (NPM) and presents Net Income as a

percent relative to Sales. Some analysts use the ROS as an indicator of operating

efficiency while others use it as a gauge of the relative spread between Net Income and

Sales. A more practical interpretation is that the ROS tells the "reader" of the financial

statement how many centavos the company earns for every peso of sale it makes.

The ROI is a financial ratio that is used rather loosely. Conceptually, it is the ratio

of Net Income relative to investment. However, "investment" itself can have a different

meaning from one investor to the next. Thus, a more disciplined use of the concept is to

employ more precise terminologies. For instance, if the term "investment" is taken to

mean the money that the owner has put into the venture, a more precise ratio would be

Return on Equity (ROE), the ratio of Net Income relative to Owners' Equity that indicates

how many centavos are earned by the company for every peso that the owner puts into

________________________________________________________________________
This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed

approval of the author

the enterprise. If what is needed is information on the profitability of the company

relative to all of the assets employed in the business, then the appropriate ratio to use is

Return on Assets (ROA), the ratio of Net Income relative to Total Assets indicating how

many centavos the company earns for every peso of asset put into the business.

Sometimes, an analyst will look for even greater precision such as when trying to relate

operating returns to the assets actually employed in operations and to remove

"distortions" caused by non-operating activities like interest expense and taxes. In this

case, the Operating ROA will be appropriate. The Operating ROA operates in much the

same way as ROA but the ratio is computed by dividing the Operating Profit (or EBIT,

i.e., Earnings Before Interest and Taxes) by the Operating Assets, i.e., Total Assets less

non-operating assets such as Construction in Progress and Investments in Other

Companies. The Gross Profit Margin is also a profitability ratio that is popularly used. It

relates Gross Profit with Sales and is interpreted by most analysts as an indicator of the

pricing spread employed by the company

The Asset Utilization Ratios are also referred to as Activity Ratios and Efficiency

ratios. One such ratio falling under this classification is Asset Turnover (A T/O), the ratio

of Sales to Total Assets. This ratio is used as a gauge of marketing excellence and how

well the firm's assets are being used to generate sales. It indicates how much sales are

generated for every peso of asset put into the business. As in the profitability ratios, the

A T/O is made more precise by relating sales with Operating Assets, in which case the

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This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed

approval of the author

Operating Asset Turnover is calculated. For the same reason, the Fixed Asset Turnover is
calculated by relating Sales to Fixed Assets only. The Accounts Receivable Turnover

relates Credit Sales with the Accounts Receivable balance. It indicates the frequency by

which receivables were converted to cash during a period. Related to this ratio are the

Days in Receivables (also referred to as the Collection Period), calculated as 360 (days in

an operating year) divided by the Accounts Receivable Turnover, resulting in the

equivalent number of days sales that remain uncollected as of the end of a period.

Inventory Turnover relates Cost of Goods Sold to the Inventory balance and indicates the

frequency by which inventory is converted into sales during a period. As in the Collection

Period, the Days in Inventory are similarly calculated by dividing 360 by the Inventory

Turnover resulting in the equivalent days sales of the inventory that remains in stock as at

the end of the period. Dividing the Accounts Payables balance by the Credit I Purchases

per Day also results to a corresponding conversion of the Accounts Payables balance into

equivalent days

Liquidity refers to the ability of the company to meet its short-term obligations.

There are two ratios that are helpful i~ testing the liquidity of a company: the Current

Ratio and the Quick (or Acid-Test) ratio. The current ratio measures the ability of the

company's current assets to cover its current liabilities and is computed by dividing the c

current assets by the current liabilities. A more stringent measure of liquidity is the Quick

ratio. It is computed by dividing the sum of the company's cash and near-cash by its

current liabilities.

_______________________________________________________________________
This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed

approval of the author

Solvency ratios indicate a company's dependence on external financing. These

ratios are considered as measures of the financial prudence of company management. The

Total Debt to Asset (DTA) ratio presents the percentage of Total Debt relative to the Total

Assets of the company. The Debt-Equity (D-E) ratio relates the level of long-term debt

relative to that of equity, a popular indicator of the composition of the capital structure of

the firm. The Equity Multiplier (EM) relates total assets to equity. It measures the number

of times each peso of equity is able to "generate" assets. It is used by some analysts as a

gauge of the willingness of company management to take risks.

Analysts may also view several ratios simultaneously. One such technique is

vertical analysis wherein each item in the financial statement is presented as a percent of

a base thus showing the relative composition of the base account. For instance, a vertical

analysis of the Income Statement uses Sales as the base account and shows all accounts

as a percent of Sales. A similar analysis of the Balance Sheet use the Total Assets as the

base account and presents the various accounts as a percent of Total Assets. A vertical

analysis of the Cash Flow Statement shows the accounts as a percent of Total Sources and

Total Uses, as the case may be. The statements that result from this manner of

presentation is also referred to as common-size statements and is useful tor analysts who

want to see how the firm compares against others or against a benchmark. It is also used

by other analysts as a means of viewing the composition of the base account.

Financial statements are also analyzed horizontally. This is done by computing for

the percentage change of the various accounts from one accounting period to the next. It

________________________________________________________________________
This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed

approval of the author

allows for an analysis of the progression of the accounts over time and enables the
analyst to extract additional insights on the operation of the business. (Other analysts

make use of a variant of horizontal analysis, referred to as indexing. Under this

technique, a base accounting period is chosen. Then, the balance of each account in the

other periods are taken as a percent of the base period resulting in an "index" number)

Du Pont Analysis combines the ROS, A T/O, EM and the ROE. It is also referred

to as the decomposition technique and is anchored on the notion that corporate

performance is a function of operating efficiency, marketing excellence and financial

prudence. It "decomposes" the ROE, the measure of corporate performance, by showing

it as the product of ROS, the measure of operating efficiency, A T/O, the measure of

marketing excellence and, EM, the measure of financial prudence. By so doing, the

"drivers" of corporate performance can be identified and the contribution of each of the

major functional areas to total corporate performance can be gauged.

Financial ratios by themselves may not mean much until they are compared to a

set of standards. These standards include internal standards, industry standards and

nominal standards. Internal standards may be the company's previous performance as

shown by its track record as well as the company's budgeted performance. Industry

standards include the average performance of the industry, the performance of

competitors or the performance of a benchmark company. Nominal standards refer to

institutional standards such as market performance ratios (e.g., comparing a company's

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This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed

approval of the author

rates of return against that of comparable investments in the market) or financial

standards set by lending programs.

 The use of rules-of -thumb may also be used in the absence of any other

information. Among the more popular rules-of-thumb are: 2:1 for the Current Ratio and

1:1 for the Quick Ratio to gauge liquidity, 70:30 for the Debt Equity mix, the Bellwether

Rate for the ROA, ROA for the ROE, Credit Term to customers for the Collection Period,

Credit Term of suppliers for the Payment Period, and 2: 1 for Times Interest Earned.

Financial ratios are powerful tools. However, as any tool, they should be used

prudently lest they be misinterpreted. This is why some guidelines in their use have been

set. First, use ratios to form an integrated picture. Seldom does a single ratio provide a

total picture of the company's financial condition. Hence, it is best that each be used in

relation to another. Second, focus on deviations and analyze causal factors. Interpret the

ratios in relation to the factors that cause their behavior and be careful about classifying

which results are due to operating management and which ones are in spite of them.

Third, relate the ratios to the status of competition and the industry. Enrich your

interpretation of the results by incorporating into the analysis the results of your

environmental scanning. Fourth, look for trends. Success or failure is not achieved

overnight. It comes as a series of events. Hence, it may not be just to limit the analysis to

only one period. Fifth, recognize the effects of seasonal factors. Information contained in

financial statements is a snapshot of a specific period or the accumulation for a whole

period. However, it is possible for performance to differ simply because of seasonal

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This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed

approval of the author

factors. The careful analyst will be able to enrich the analysis if an attempt is made to

also view the statements during the interim. Finally, be aware of possible "window
dressing". Subject firms may attempt to misrepresent their financial picture for one

reason or another. Statements under study may then be analyzed and compared to one

prepared and audited by responsible external auditors.

Financial ratios are useful tor strategic management especially in the analysis of

the internal environment of the firm and in the formulation of the financial plan that

forms part of the implementing program. An internal analysis will be more meaningful

and factual if it is supported by financial ratios. Financial ratio analysis is particularly

helpful in identifying organizational strengths and weaknesses in areas such as liquidity

level, collection experience, profitability track record, matching of sources and uses of

funds, and the risk profile as indicated by the debt-equity mix.

________________________________________________________________________
This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed

approval of the author