Accounting in a Nutshell 7
Financial Ratios and Analysis
Joel Shapiro has been an
accounting instructor at Ryerson
University in Toronto, Canada for
20 years. Previously, he developed
an accounting and inventory
management software system for
small businesses. In his spare time,
he enjoys working on “Kakuro” and
cryptic crossword puzzles and travels
throughout Ontario as a bridge
tournament director.
© Business Expert Press 978-1-94744-187-3 (2018)
www.businessexpertpress.com
Joel Shapiro, MBA
Accounting Instructor
Ryerson University, Toronto
Abstract: This short article explains several common
­financial ratios used to analyze a business’s p ­ rofitability,
­liquidity, solvency, and efficiency. A simple set of ­financial
statements will be used to illustrate the c­ alculation and
usefulness of each ratio presented.
Keywords: Efficiency, Leverage or gearing, Liquidity,
Margin, Profitability, Solvency, Turnover, Working
capital
Introduction
People need economic and financial information to help
them make decisions and judgments about b ­ usinesses.
­Accounting is the process of collecting and ­communicating
that information to users. Such users can be i­ nternal to the
business; for example, employees, m ­ anagers, and direc-
tors have access to day-to-day information and can use that
information to make d ­ ecisions about such ­issues as mar-
keting, manufacturing, ­product mix, ­pricing, and so on.
Other users are external; for e ­ xample, investors and lend-
ers (both present and p ­ rospective), g­ overnments and regu-
lators, unions, insurers, the ­media, and so on. They do not
have access to the business’s internal ­workings and day-to-
day results, and must rely on formal fi ­ nancial statements,
prepared at least annually, to make ­decisions relating to
lending, investing, c­ ompliance with laws and regulations,
and other issues pertinent to their own interests.
This article will illustrate a number of ­mathematical
relationships, or ratios, between various numbers
on a company’s financial statements. These ratios,
when properly understood in their contexts, can ­assist
external users to make intelligent judgments about
­
the ­company’s performance and immediate prospects.
These ­judgments in turn would form the basis of effec-
tive financial decisions that should benefit the users in
the future.
Expert Insights
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 Accounting in a Nutshell 7

Bear in mind that this short article only Sample Inc.

scratches the surface of financial a­ nalysis.
Professional analysts such as CFAs use Income Statement
hundreds of ratios and r­
­ elationships Year ended December 31
to ­ assess the companies that they are 2018 2017
analyzing. Here we will illustrate only
­
Net sales $550,000 $582,000
a few of the most important and useful
­ratios, but these would form a good starting Cost of goods sold 350,000 372,000
point for even the less-experienced finan- Gross 200,000 210,000
cial statement users and decision-makers. Profit
Total operating 138,000 104,000
Types of Ratios expenses
Ratios can be classified into four basic cat- Operating 62,000 106,000
egories. Profitability ratios are derived from profit
(loss)
the income statement and concentrate on
the company’s past performance. Liquid- Other expenses or
ity ratios come from the current assets and losses
current liabilities sections of the balance Interest 12,000 16,000
sheet (statement of financial position) and expense
highlight the company’s present a­ bility to Profit before income 50,000 90,000
meet its current obligations. Solvency ­ratios tax
are based on the long-term sections of the Income 15,000 27,000
balance sheet and highlight the compa- tax
expense
ny’s present ability to meet its long-term
­obligations. Efficiency ratios use numbers Profit $35,000 $63,000
from both the income statement and the
balance sheet and indicate how well the
company is managing its current assets Sample Inc.’s gross profit ratio for 2018 is
and liabilities. $200,000/$550,000 = 36.4% and for 2017 it
We will also discuss the cash flow state- is $210,000/$582,000 = 36.1%. Not much
ment and what conclusions about the com- difference, very slightly better in 2018.
pany’s performance and future prospects Sample Inc.’s net profit ratio for 2018 is
can be gleaned from the information and $35,000/$550,000 = 6.4% and for 2017 it is
trends shown there. $63,000/$582,000 = 10.8% — much worse
in 2018. Can we tell what ­happened? Sales
Example Financial Statements have dropped slightly, but the company is
The following statements will be used to earning as much gross profit per sale as
­illustrate the ratios discussed below. ­before. Operating expenses, h ­ owever, have
increased markedly, and this seems to be
Profitability Ratios the main reason why profits have ­declined
These come from the income statement. with respect to revenue. One would need
The numerator would be any of the more information about the specific
subtotals on the statement, and the de-
­ ­expenses to determine if this is a one-time
nominator would always be net sales. The anomaly or the beginning of an ­unfavorable
two most important are the gross profit trend. Interest is slightly lower, and income
ratio (gross profit/net sales) and the net tax expense is 30 ­percent of pretax income
profit ratio (net income/net sales). Gross in both years, so the government cannot be
profit is often referred to as gross margin. blamed!

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 Accounting in a Nutshell 7

Sample Inc. seen quite favorably in an industry where

the average was only 30 percent, and much
Balance Sheet
less favorably if the average was 40 ­percent.
December 31 Any significant differences between
2018 2017 ­Sample’s product mix, customer mix, and
Assets target market and those of its competitors
would have to be considered as well.
Current assets
Cash $24,000 $40,000 Liquidity Ratios
Accounts receivable 90,000 75,000 These come from the current portions of
Inventory 80,000 95,000 the balance sheet. Working capital is the dif-
Prepaid expenses 12,000 16,000 ference between current assets and current
liabilities, and in most cases a company
Total current assets 206,000 226,000
would want this to be a positive number.
Net property, plant, and 690,000 520,000 The current ratio is current assets divided by
equipment
current liabilities. For Sample Inc., in 2018
Total assets $896,000 $746,000 this is $206,000/$195,000 = 1.06 to 1; and
in 2017 this is $226,000/$180,000 = 1.26
Liabilities to 1. It seems that the company is still
­liquid (barely) but less so than previously.
Current liabilities
This would be a worrisome trend if it
Accounts payable $160,000 $148,000 ­continues. A current ratio of less than one
Other current liabilities 35,000 32,000 to one ­ indicates that the company may
Total current 195,000 180,000 not be able to meet its current obligations.
liabilities ­Lenders ­frequently require a much higher
Long-term liabilities current ratio as a condition of a loan. Sam-
Bank loan payable 100,000 130,000
ple Inc. is skating on thin ice! What might
have ­happened? Cash is down and receiv-
Total liabilities 295,000 310,000
ables are up, so it is possible that Sample
Inc. is having problems in 2018 collecting
Equity from its customers. Inventories are lower,
Owners’ capital 350,000 200,000 which is to be expected given the drop in
sales.
Retained earnings 251,000 236,000
A more pertinent test of liquidity is the
Total equity 601,000 436,000 acid-test ratio, sometimes called the quick
Total liabilities and $896,000 $746,000 ratio. This is the current ratio with only
equity cash and receivables in the numerator.
This is useful because inventories cannot
often be converted into cash quickly, and
One could, of course, also calculate prepaid expenses will never be. Quite fre-
the operating profit ratio and the pretax quently, this ratio is less than one to one,
profit ratio, using those subtotals as the but as with the current ratio, higher is
numerator and still using net sales as the better. Sample’s acid-test ratio for 2018 is
denominator. $114,000/$195,000 = 0.58 to 1, and in 2017
Note that all of these conclusions must it is $115,000/$180,000 = 0.64 to 1. Once
be taken in the context of the industry in again, a negative trend, but the change
which the company operates. Sample’s is not as pronounced as with the current
gross profit ratio of 36 percent would be ratio.

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