FINANCIAL

RATIO
ANALYSIS

olx.co.id

Erenkocyigit.com
The usefulness of financial ratio analysis
• Internal financial analyst
o To evaluate the performance of employees & determine their pay
raises & bonuses
o To compare the financial performance of the firm’s different divisions
o To prepare financial projections, such as those associated with the
launch of a new product
o To evaluate the firm’s financial performance in light of its competitor’s
performance & determine how the firms might improve its own
operations
• External financial analyst
o Banks/lenders deciding whether to loan money to the firm or not
o Suppliers who are considering whether to grant credit to the firm or
not
o Credit-rating agencies trying to determine the firm’s creditworthiness
o Professional analyst who work for investment companies considering
investing in the firm or advising others about investing
o Individual investors deciding whether to invest in the firm or not
SELECTING OF PERFORMANCE BENCHMARK

• TREND ANALYSIS
comparing the firm’s financial statements overtime /
time series comparisons

• PEER GROUP COMPARISONS

comparing the subject firm’s financial
statements with those of similar, or
peer firms
Financial ratios
Liquidity Ratio Measures of the company’s short term ability to pay its
maturing obligation (firm liquidity or specific current
assets liquidity)

Capital Structure / Measures of how the firm financed the purchase of its
Solvency / assets and the degree of protection for long term
Coverage / creditors and investors
Leverage Ratio

Activity / Asset Measures of how efficiently the company uses its

Management assets to generate sales (revenue)
Efficiency
(Utilization) Ratio
Financial ratios
Profitability / Measures the degree of success or failure of a given
Operating company or division for a given period of time
Performance Ratio • how well has the firm controlled its COGS &
expenses relative to sales (revenue)
• how effective the firm at using its assets to
generate revenue (earned adequate returns on its
investments)

Market Value Ratio Measures of how the firm ‘s managers creating value
for shareholders
LIQUIDITY RATIO
Ratio Formula What it tells us
Current Ratio Current assets • Measure of liquidity, the
----------------------- number of times current assets
Current liabilities could cover current liabilities
(short term debt-paying ability)
• A higher ratio means greater
firm liquidity

Quick (Acid • Cash + cash equivalent + short • Measures immediate short

Test) Ratio term investment (marketable term liquidity
securities) + receivables (net) • A higher ratio means greater
---------------------------------------- firm liquidity
Current liabilities

• Current assets – inventory

-----------------------------------
Current liabilities
LIQUIDITY RATIO
Ratio Formula What it tells us
Accounts Annual net credit sales • Measures liquidity of receivables
Receivable --------------------------------------- (measures the time required for a
Turnover Average accounts receivables firm to collect its receivables
(net) • The higher the turnovers, the faster
the collection of the firm’s credit
accounts and more liquid is the firm
Average • Average accounts receiva- • Measures average number of days
receivables bles (net) required for a firm to collects its
collection ---------------------------------- receivables (liquidity of receivables)
period Average daily sales • The lower the number, the shorter
(Days sales in • Average accounts receiva- the times it takes for a firm to
receivables) bles (net) collect its credit sales, and
-------------------------------------- therefore the greater is firm
(Annual credit sales / 360) liquidity

• 360
-------------------------------------
Account receivable turnover
LIQUIDITY RATIO
Ratio Formula What it tells us
Inventory Cost of Goods Sold (COGS) • Measures liquidity of inventory
Turnover ----------------------------------- (measures the size of the firm’s
Average inventory investment in inventory or liquidity of
inventory)
• The higher the turnovers, the lower is
the firm’s investment in inventory, and
the more liquid is this investment
Inventory • Average inventory • Measures average rate of speed at
conversion -------------------------- which inventories move through and
period Average daily COGS out of the company (number of days
(number of required to sell ending inventory)
days’ sales in • Average inventory • The lower the number, the shorter the
inventory) ------------------------- times it takes for a firm to sell ending
(COGS / 360) inventory, and therefore the greater is
firm liquidity
• 360
--------------------------------
inventory turnover ratio
LIQUIDITY RATIO
Ratio Formula What it tells us
Accounts COGS • Measures average rate of speed at
payables ----------------------------------- which a company pays for
turnover Average accounts payables purchases on account
• The higher the turnovers, the
higher is the firm’s speed in pays
for purchases on account, and the
more liquid is this payables
Number of • Average accounts payables • Measures the extent accounts
days’ ------------------------------------ payables represent current and not
purchases in Average daily COGS overdue obligations
accounts • The lower the number, the shorter
payables • Average accounts payables the times it takes for a firm in pays
------------------------------------
(average (COGS / 360) for purchases on account, and
payable days therefore the greater is firm
outstanding) • 360 liquidity
------------------------------------
accounts payables turnover
ratio
LIQUIDITY RATIO
Ratio Formula
Capital Cash flow from operating
Acquisition ----------------------------------
Ratio (CAR) Cash paid for capital
expenditure (CAPEX)
Cash flow net cash flow from operating
adequacy ratio -----------------------------------------
(CFAR) capital expenditure (purchases
of long term assets) +
purchases of inventory +
cash dividend payments)
Cash to current Cash + cash equivalent +
assets ratio marketable securities
---------------------------------
Current assets
What it tells us
• Measures the number of times that
cash from operations can cover
predictable cash requirements for
capital expenditure
• Measures of the company ability to
generate sufficient cash from
operations to cover capital
expenditures, investments in
inventories, and cash dividends
• Measure the liquidity of current
assets
• The larger the ratio, the more liquid
are current assets
LIQUIDITY RATIO
Ratio Formula What it tells us
Cash flow ratio Cash flow from operating • Measures a company’s ability to
(current cash --------------------------------- pay off its current liabilities in a
debt coverage) Current liabilities given year from its operations
ratio

Cash to current Cash + cash equivalent + • Measure the liquidity of current

liabilities ratio marketable securities assets
--------------------------------- • The larger the ratio, the more cash
Current liabilities available to pay current liabilities

Cash cash flow from operating - • Measure of the % of investment in

reinvestment dividend assets representing operating cash
ratio -------------------------------------- received and reinvested in the
gross plant + investment + company for both replacing assets &
other asset + working capital growth in operations
LIQUIDITY RATIO
Ratio Formula
Free cash flow • cash flow from operating -
net capital expenditure
required to maintain
productive capacity -
dividend (P/S and C/S)
• net operating profit after tax
(NOPAT) - change in net
operating asset (NOA)
What it tells us
• Measures the amount of
discretionary cash flow (cash
that available for activities
after allowances for financing
& investing requirements to
maintain productive capacity at
current levels)
CAPITAL STRUCTURE / SOLVENCY / COVERAGE / LEVERAGE RATIO
Ratio Formula What it tells us
Debt ratio / Total liabilities • Measures the extent to which
debt to total ------------------- the firm has used non-owner
capital ratio / Total assets financing (borrowed money) to
debt to asset finance its assets
ratio • Borrowed funds create
financial leverage
• A higher ratio indicates a
greater reliance on non-owner
financing or financial leverage
Times interest • Income before interest expense • Measures the firm’s ability to
earned ratio and taxes (EBIT) pay its interest expense from
------------------------------------------ the firm’s operating income as
Interest expense they come due
• A higher ratio indicates that
• Net operating income the firm’s ability to pay its
---------------------------- interest in a timely manner is
Interest expense greater
CAPITAL STRUCTURE / SOLVENCY / COVERAGE / LEVERAGE RATIO
Ratio Formula What it tells us
Long term debt Total long term liabilities • Measures the number of
to equity ratio -------------------------------- dollars of borrowing (long term
Stockholder’s equity debt) for each dollar of equity
investment
Debt to equity Total liabilities • Measures the number of
ratio --------------------------- dollars of borrowing for each
Stockholder’s equity dollar of equity investment
Cash debt Net cash provided by operating • Measures a company’s ability
coverage ratio activities to repay its total liabilities in a
-------------------------------------------- given year from its operation
Average total liabilities
Asset Turnover Net sales • Measures the firm’s efficient
Ratio --------------------------- use of its investment in total
Average total assets assets to generate revenues
• A higher ratio means the firm is
using its total assets more
efficiently to generate sales
CAPITAL STRUCTURE / SOLVENCY / COVERAGE / LEVERAGE RATIO

Ratio Formula What it tells us

Fixed Asset • Net sales • Measures the firm’s efficient
Turnover Ratio ---------------------------------- use of its investment in fixed
(Property, Average total fixed assets assets (PPE)
plant, and • A higher ratio means the firm is
equipment • Net sales using its fixed assets (PPE)
(PPE) Turnover ------------------------ more efficiently to generate
Ratio) Average total PPE sales

Asset to equity Total assets • Measures the number of

ratio --------------------------- dollars of assets acquired for
Stockholder’s equity each dollar of funds invested
by stockholders
Short term Short term debt • Measures the enterprise
debt to total --------------------- reliance on short term
debt Total debt financing
ACTIVITY / ASSET MANAGEMENT EFFICIENCY (UTILIZATION) RATIO

Ratio Formula What it tells us

Cash turnover Net sales • Measures the firm’s efficient use of
ratio ------------------------------------- cash
Average cash and cash • A higher ratio means the firm is
equivalent using its cash more efficiently to
generate sales

Working capital Net sales • Measures the firm’s efficient use of

turnover ratio -------------------------------
Average working capital
 Working capital = current
assets – current liabilities
its working capital
• A higher ratio means the firm is
using its working capital more
efficiently to generate sales

Current Cash Net cash provided by • Measures a company’s ability to

Debt Coverage operating activities pay off its current liabilities in a
(CCDC) Ratio ---------------------------------------- given year from its operations
Average Current liabilities
ASSET MANAGEMENT EFFICIENCY (UTILIZATION) RATIO

Ratio Formula
Operating cycle Inventory conversion period + average collection period
(conversion period)

Cash conversion operating cycle – account payable deferral period

cycle

account payable 360 (days) / ( COGS + accounts payable )

deferral period

Average payment Accounts payables

period --------------------------
Average purchases
PROFITABILITY (OPERATING PERFORMANCE) RATIO
Ratio Formula What it tells us
Gross profit Gross profit • Measures profitability after considering
margin (GPM) ---------------- the firm’s COGS, this indicates the firm’s
ratio Net sales “mark up” on its COGS
• Measures gross profit generated by
each $ of sales
• A higher ratio means profitability and
better control of COGS by the firm (low
relative to sales revenue)
Operating profit Net operating income • Measures profitability after considering
margin (pretax) (EBIT) the firm’s COGS and operating expenses
(OPM) ratio ------------------------------- • Measures operating profit generated by
Net sales each $ of sales
• A higher ratio means profitability and
better control of COGS & operating
expenses by the firm (low relative to
sales revenue)
PROFITABILITY (OPERATING PERFORMANCE) RATIO
Ratio Formula What it tells us
Net profit Net income • Measures profitability after considering
margin (NPM) --------------- the firm’s all expenses during the period
Net sales • Measures net income generated by
each $ of sales
• A higher ratio means profitability and
better control of all expenses by the
firm (low relative to sales revenue)

Quality of • net cash flow of • Measures for evaluating operating

earnings operation activities
---------------------------
net income

• net income - dividend

-----------------------------
total assets
 PROFITABILITY (OPERATING PERFORMANCE) RATIO
Ratio Formula
Operating • Net operating Income
Return on Assets (EBIT)
(OROA) ----------------------------
Average total assets
• OPM x assets turnover
ratio
Return on assets  Net Income
(ROA) -------------------------
Average total asset
 NPM x asset turnover
ratio
What it tells us
• Measures the Rate of Return (ROR)
earned on the total asset in the firm
that results from operating income
(before interest & taxes)
• The higher the number, the greater
is the return earned from the firm’s
operations (efficient in using its
assets to generate revenue)
• Measures overall profitability of
assets (measures the number of $
of income generated by each $ of
assets)
• The higher the number, the greater
is the return earned from the firm’s
operations (efficient in using its
assets to generate revenue)
PROFITABILITY (OPERATING PERFORMANCE) RATIO
Ratio Formula What it tells us
Du Pont • Net income  Measures the number
Framework --------------------------- of $ earned during the
(Return on Shareholder’s equity year on each $
Equity / invested in the firm
ROE) • Profitability x efficiency x leverage

• ROA x leverage

• NPM x asset turnover x assets to equity ratio

• Net income Sales Total assets

--------------- x ---------------- x ---------------
Sales Total Assets Shareholder’s
equity

• Profitability x efficiency x equity multiplier

• Net income Sales 1

--------------- x ----------------- x ------------------
Sales Total Assets 1 – debt ratio
PROFITABILITY (OPERATING PERFORMANCE) RATIO

Ratio Formula What it tells us

Return on Net income • Measures the Rate of
(common) -------------------------------------------------- Return (ROR) earned on
equity (ROE) Average (common or ordinary) equity the (common/ordinary)
share-holder’s equity
investment in the firm
• The higher the number,
the greater is the return
earned for the firm’s
stockholders
MARKET VALUE RATIO
Ratio Formula
Price Earnings Market price per share (MPS)
(P/E) Ratio --------------------------------------
Earnings per Share (EPS)
*) Price = Earnings X P/E ratio
Market Price to • Market price per share (MPS)
Book Ratio --------------------------------------
Book value per share (BVS)
• Market price per share (MPS)
--------------------------------------
(Common shareholders’
equity / common shares
outstanding)
What it tells us
• Indicates the valuation of the
firm’s shares relative to
earnings
• A higher ratio indicates that
investors place a higher $
value on each $ of firm
earnings
• Indicates the valuation of the
firm’s shares relative to the
investment made by the
shareholders in the firm
• A higher ratio indicates that
investors place a higher $
value on each $ of investment
made to the firm by its
common shareholders
MARKET VALUE RATIO

Ratio Formula What it tells us

Dividend Payout  Cash dividend / Net income • Measures percentage of
Ratio earnings distributed in the
 Cash dividend per share / form of cash dividend to
EPS stockholders
Dividend yield Cash dividend per share
ratio -------------------------------
Market price of share

Earnings yield EPS / Market price of share

ratio

Return or Earnings Net Income – preference • Measures net income earned

per (ordinary) dividends on each ordinary share
share (EPS) -----------------------------------------
Weighted average number of
(ordinary) shares outstanding
MARKET VALUE RATIO

Ratio Formula What it tells us

Book to market Shareholder’s equity (ordinary) • Measures the amount each
ratio ---------------------------------------------- ordinary share would receive
Market value of shares if the company were
outstanding liquidated at the amount
reported on the statement of
financial position (balance
sheet) (measures the number
of dollars of book equity for
each dollar of marker value)
Book value per Shareholder’s equity (ordinary) • Measures the amount each
share ----------------------------------------- ordinary share would receive
Outstanding share if the company were
liquidated at the amount
reported on the statement of
financial position (balance
sheet)
MARKET VALUE RATIO

Ratio Formula What it tells us

Return on share Net Income – preference • Measures net income earned
capital – dividends on each ordinary share
ordinary --------------------------------------------- (profitability of owner’s
Average number of (ordinary) investment)
shares outstanding
Limitations of Ratio Analysis
1. Only a single snapshot for a given point or period of time
2. Picking an industry benchmark can sometimes be difficult
(comparability problem), so analyst must:
a. identify basic differences in companies accounting policies &
procedures
1) Inventory valuation (FIFO or average cost)
2) Depreciation methods (straight line or accelerated
depreciation)
3) Capitalization >< expensing of certain costs
4) Capital (financing) lease >< operating (non-capitalizing)
lease
5) Investment in ordinary shares carried under the equity
method or fair value
6) Differing treatments of postretirement benefit costs
7) Questionable practices of defining discontinued
operations, impairments, & unusual items
b. adjust the balances to achieve comparability
Limitations of Ratio Analysis
3. Published peer-group or industry averages are not always
representative of the firm being analyzed (are only approximation
rather than scientifically determined averages)
4. An industry average is not necessarily a desirable target ratio or
norm
5. Accounting practices differ widely among firms and can lead to
differences in computed ratios
6. Many firms experience seasonal changes in their operations, so
the ratios calculated for them will vary with the time of year during
which statements are prepared
7. The results of a ratio analysis are no better than the quality of the
financial statements
Limitations of Ratio Analysis
8. Understanding the numbers
 historical costs basis can lead to distortions in measuring
performance
 if estimated items (such as depreciation & amortization) are
significant, income ratios lose some of their credibility
 substantial amount of important information is not include in a
company’s F/S (such as industry changes, management
changes, competitor’s actions, technology development,
government’s actions, union’ s activities, that affects to
company’s successful operations)
Example of F/S Analysis
No Ratio Firm X Industry Comparison
1 Current ratio 2,23 x 1,8 x Better
2 Quick ratio 0,92 x 0,94 x On par
3 Average collection period 21,9 hr 25 hr Better
4 A/R turnover 16,67 x 14,6 x Better
5 Inventory turnover 5,36 x 7x Worse
6 Debt ratio 53,8 % 35 % Worse
7 Times interest earned 5,67 x 7x Worse
8 Total asset turnover 1,37 x 1,15 x Better
9 Fixed asset turnover 2,03 x 1,75 x Better
10 Gross profit margin 25 % 28,2% Worse
11 Operating profit margin 14,2 % 15,5 % Worse
12 Net profit margin 7,6 % 10,2 % Worse
Example of F/S Analysis
No Ratio Firm X Industry Comparison
13 Operating return on assets 19,4 % 17,8 % Better
14 Return on equity 22,5 % 18 % Better
15 Price earnings ratio 14,07 x 12 x Better
16 Market to book ratio 3,16 x 2,7 x Better
Example of F/S Analysis

LIQUIDITY ( 1 – 5 )
With the exception of the inventory turnover ratio, firm’s liquidity
ratios were adequate to good. The next step then would be to look
into the firm’s inventory management practices to see if there are
problems that can be addressed. For example, has the firm accumula-
ted inventories of older and less saleable products or is the firm
simply overstocked with inventory?

FINANCIAL LEVERAGE ( 6 – 9 )
Firm used more debt to finance investments than the peer group,
which we saw in firm’s higher-than-average debt ratio and below-
average- times interest earned ratio. This suggests that the firm is
exposing itself to a higher degree of financial risk than the norm for
firms in its industry. In other words, there’s greater risk it might not
be able to meet its debt obligations.
Example of F/S Analysis
PROFITABILITY ( 10 – 14 )
Firm’s net operating income (before interest expense is considered)
compared very favorably with its peer firms, this is because the firm’s
asset turnover rate (the efficiency with which it utilizes its investment
in assets to produce sales) more than offsets the firm’s lower profit
margins. But the firm’s management of its inventory may present a
problem and should be investigated further, as we noted earlier.
Firm’s return on stockholder’s investment (i. e., its return on equity)
was much higher than that of the peer group due to its higher-than-
average use of financial leverage.

MARKET VALUE( 15 – 16 )
When we compare firm’s market value ratios to the peer group’s
ratios, it is obvious that investors appreciate what the firm is doing
and have rewarded it with an above-average market price relative to
both firm’s earnings per share and book value
Referensi
Gitman, Lawrence J. and Chad J. Zutter, Principles of Managerial
Finance: Global edition, edisi 13, Pearson Education Limited,
2012

Kieso, Donald E., Jerry J. Weygandt, and Terry D. Garfield, Interme-

diate Accounting: IFRS edition, edisi 2, Wiley, 2014

Subramaniam, K R dan John J. Wild, Financial Statement Analysis,

edisi 10, McGraw Hill – Irwin, 2009

Titman, Sheridan J., Arthur J. Keown, dan John D. Martin, Financial

Management, Principles and Application, edisi 12, Pearson
Education Limited, 2014