Overview
This lecture covers financial ratio analysis, explaining how key ratios derived from financial statements are used to assess a company's financial health and performance.
Purpose and Importance of Financial Ratio Analysis
- Financial ratio analysis helps interpret and analyze a company’s financial position and performance.
- Ratios provide insights into liquidity, solvency, profitability, leverage, and market value.
- Analysis uses figures from both the income statement and balance sheet.
- Understanding how to interpret ratios is more important than just calculating them.
Main Types of Financial Ratios
- Five major categories: liquidity, activity (efficiency), stability (solvency), profitability, and market value ratios.
Liquidity Ratios
- Measure a company's ability to pay short-term obligations using current assets.
- Current Ratio = Current Assets / Current Liabilities (includes all current assets).
- Quick Ratio (Acid-Test) = (Current Assets - Inventory) / Current Liabilities; inventory is excluded as it's the least liquid current asset.
Activity (Efficiency) Ratios
- Assess how effectively a company manages its assets.
- Accounts Receivable Turnover = Net Sales / Accounts Receivables; use average accounts receivable for accuracy.
- Accounts Payable Turnover = Net Purchases / Accounts Payable.
- Inventory Turnover = Cost of Goods Sold / Inventory.
- Total Asset Turnover = Net Sales / Total Assets.
- Average Collection Period = 365 Days / Receivables Turnover.
- Average Payment Period = 365 Days / Payables Turnover.
- Average Age of Inventory = 365 Days / Inventory Turnover.
Stability (Solvency/Leverage) Ratios
- Evaluate a firm's ability to meet long-term obligations.
- Debt Ratio = Total Liabilities / Total Assets.
- Debt-Equity Ratio = Total Liabilities / Stockholders’ Equity.
- Times Interest Earned = Operating Income (EBIT) / Interest Expense.
Profitability Ratios
- Show the company’s ability to generate profit.
- Gross Profit Margin = Gross Profit / Net Sales.
- Operating Profit Margin = Operating Profit / Net Sales.
- Net Profit Margin = Net Income / Net Sales.
- Earnings Per Share (EPS) = (Net Income - Preferred Dividends) / Common Shares Outstanding.
- Return on Assets (ROA) = Net Income / Total Assets.
- Return on Equity (ROE) = Net Income / Stockholders’ Equity.
Market Value Ratios
- Analyze the firm’s stock valuation in the market.
- Market-to-Book Ratio = Market Price per Share / Book Value per Share.
- Price-Earnings (P/E) Ratio = Market Price per Share / EPS.
- Dividend Yield = Dividend per Share / Market Price per Share.
- Price-Earnings Growth (PEG) Ratio = P/E Ratio / EPS Growth Rate.
- Book Value per Share = (Stockholders’ Equity - Preferred Stock) / Common Shares Outstanding.
Key Terms & Definitions
- Liquidity Ratio — Measures short-term financial health.
- Activity Ratio — Gauges efficiency in asset use.
- Stability Ratio — Assesses long-term debt-paying ability.
- Profitability Ratio — Shows profit generation efficiency.
- Market Ratio — Reflects stock valuation versus accounting values.
- Current Asset — Assets expected to be converted to cash within a year.
- Operating Income (EBIT) — Earnings before interest and taxes.
- EPS — Profit available to each common share.
Action Items / Next Steps
- Review sample problems on ratio calculation and interpretation.
- Read relevant textbook chapters on financial statements and ratio analysis.
- Practice interpreting ratio results for different company scenarios.