Ratio Analysis of Financial Statements (Formula, Types, Excel)

This expert-written guide goes beyond the usual gibberish and explore practical Financial Statement Analysis as used
by Investment Bankers and Equity Research Analysts.

Here I have taken Colgate case study and calculated Ratios in excel from scratch.

Please note that this Ratio Analysis of financial statement guide is over 9000 words and took me 4 weeks to

complete. Do save this page for future reference and don’t forget to share it

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You can use the following navigation to shortlist and learn the ratio analysis of financial statement topic that you want to
focus. Additionally, you can directly filter the core concepts or application of types of ratio analysis in Colgate Case
Studies or choose to learn both simultaneously from the below.

I want to do Learn
Vertical AnalysisHorizontal AnalysisTrend Analysis

I want to Learn Ratio Analysis Types

Solvency Ratio Operating Performance Risk Analysis Growth Analysis

I want to learn the following

Concept Colgate Case Studies

RATIO ANALYSIS / FINANCIAL STATEMENT ANALYSIS – READ ME FIRST

RATIO ANALYSIS OF FINANCIAL STATEMENT

I have made an easy navigation for you to learn Ratio Analysis Types.

 What is Financial Statement Analysis / Ratio Analysis

 Vertical Analysis or Common Size Statements
 Horizontal Analysis
 Trend Analysis
 Ratio Analysis
 Liquidity Ratio Analysis
 Solvency Ratio Analysis
 #1 – Current Ratio Analysis
 #2 – Quick Ratio Analysis
 #3 – Cash Ratio Analysis
Turnover Ratios
 #4 – Receivables Turnover Ratio Analysis
  #5 – Days Receivables
 #6 – Inventory Turnover Ratio Analysis
 #7 – Days Inventory
 #8 – Accounts Payable Turnover Ratio Analysis
 #9 – Days Payable
 #10 – Cash Conversion Cycle
Ratio Analysis – Operating Performance
Operating Efficiency Ratio Analysis
 #11 – Asset Turnover Ratio Analysis
 #12 – Net Fixed Asset Turnover
 #13 – Equity Turnover
Operating Profitability Ratio Analysis
 #14 – Gross Profit Margin
 #15 – Operating Profit Margin
 #16 – Net Margin
 #17 – Return on Total Assets
 #18 – Return on total equity
 #19 – Return on Equity or Return on Owner’s Equity
 #20 – Dupont ROE
Ratio Analysis – Risk
Business Risk
 # 21. Operating Leverage
 # 22. Financial Risk – Financial Leverage
 # 23. Total Leverage
Financial Risk
 # 24. Leverage Ratio or Debt to Equity Ratio Analysis
 # 25. Interest Coverage Ratio Analysis
 # 26. Debt Service Coverage Ratio (DSCR)
Ratio Analysis – External Liquidity Risk
 #27 – Bid Ask Spread
 #28 – Trading Volume
 Ratio Analysis – Growth
 #29 – Sustainable Growth

WHAT IS FINANCIAL STATEMENT ANALYSIS / RATIO ANALYSIS?

The purpose of Financial Statement Analysis (Ratio Analysis) is to evaluate management performance
in Profitability, Efficiency and Risk

Although financial statement information is historical, it is used to project future performance

Financial Statement Analysis (Ratio analysis) can be done using Three Methods –
  Vertical Analysis (also called as Common Size Statements Analysis) – It compares the each item of to the
base case of the financial statements. All income statement items are expressed as percentage of Sales. Balance
Sheet Items are expressed as a percentage of Total Assets or Total Liabilities (please note Total Assets = Total
Liabilities)
 Horizontal Analysis – It compares the two financial statements (income statement, balance sheet) o determine
the absolute change as well as percentage changes.

Ratio Analysis – Puts important business variables into perspective by comparing it with other numbers. It provides
meaningful relationship between individual values in the financial statements.

So, which one is the best when it comes to Financial Statement Analysis?

Ofcourse, you can’t pick and choose a single method as the best and ONLY method to do the financial statement
analysis.

You need to do all THREE analysis in-order to get a complete picture of the Company.

Let us look at each one of them one by one.

VERTICAL ANALYSIS OR COMMON SIZE STATEMENTS

Vertical analysis is a technique used to identify where a company has applied its resources and in what proportions those
resources are distributed among the various balance sheet and income statement accounts. The analysis determines the
relative weight of each account and its share in asset resources or revenue generation

VERTICAL ANALYSIS – INCOME STATEMENT

 On the income statement, vertical analysis is a universal tool for measuring the firm’s relative performance from
year to year in terms of cost and profitability.
 It should always be included as part of any financial analysis. Here, percentages are computed in relation to Sales
which are considered to be 100%.
 This vertical analysis effort in the income statement is often referred to as margin analysis, since it yields the
different margins in relation to sales.
 It also helps us do the time series analysis ( how the margins has increased/decreased over the years) and also
helps in cross sectional analysis with other comparable companies in the industry.
V E R T I C A L A N A L Y S I S O F I N C O ME S T A T E ME N T : C O L G A T E C A S E S T U D Y

 For each year, Income Statement line items is divided by its respective year’s Top Line (Net Sales) number.
 For example, for Gross Profit, it is Gross Profit / Net Sales. Likewise for other numbers

WHAT CAN WE INTERPRE T WITH VERTICAL ANAL YSIS OF COLGATE PAL MOLIVE

 Vertical Ratio Analysis helps us with analyzing the historical trends.

 Please note that from vertical analysis we only get to the point ofasking the right questions (identification of
problems). However, we do not get answers to our questions here.
 In Colgate, we note that gross profit margin (Gross Profit / Net Sales) has been in the range of 56%-59%. Why
Fluctuating?
 We also note that the Selling General and administrative expenses (SG&A) has decreased from 36.1% in 2007 to
34.1% in the year ending 2015. Why?
 Also, note that the operating income has dropped significantly in 2015.Why?
 Net income decreased substantially to less than 10%. Why?
 Also, effective tax rates jumped to 44% in 2015 (from 2008 until 2014, it was in the range of 32-33%). Why?

VERTICAL ANALYSIS – BALANCE SHEET (COMMON SIZE RATIO?)

 Vertical Analysis on the Balance Sheet normalizes the Balance Sheet and expresses each item in percentage of
total assets/liabilities.
 It helps us to understand how each item of the balance sheet has moved over the years. For eg. Debt has
increased or decreased?
 It also helps in cross sectional analysis (comparing the balance sheet strength with other comparable companies)

VERTICAL ANALYSIS OF BALANCE SHEET: COLG ATE CASE STUDY

 For each year, Balance Sheet line items is divided by its respective year’s Top Assets (or Total Liabilities)
number.
 For example, for Accounts Receivables, we calculate as Receivables / Total Assets. Likewise for other balance
sheet items
INTERPRETATION OF COLGATE’S VERTICAL ANALYSIS

 Cash and Cash equivalents has increased from 4.2% in 2007 and is currently standing at 8.1% of the total
assets. Why a built-up of cash?
 Receivables has decreased from 16.6% in 2007 to 11.9% in 2015. Does this mean a stricter credit policy
terms?
 Inventories has decreased too from 11.6% to 9.9% overall. Why?
 What is included in “other current assets”? It shows a stead increase from 3.3% to 6.7% of the total assets over
the last 9 years.
 What is included in other assets? Why shows a fluctuating trend?

 On the liabilities side, there can be many observations we can highlight. Accounts payable decreased
continuously over the past 9 years and currently stands at 9.3% of the total assets.
 Why there has been a significant jump in the Long Term Debt to 52,4% in 2015. For this we need to investigate
this in the 10K?
 Non controlling interests has also increased over the period of 9 years and is now at 2.1%

HORIZONTAL ANALYSIS
Horizontal analysis is a technique used to evaluate trends over time by computing percentage increases or decreases
relative to a base year.It provides an analytical link between accounts calculated at different dates using currency with
different purchasing powers. In effect, this analysis indexes the accounts and compares the evolution of these over time.
As with the vertical analysis methodology, issues will surface that need to be investigated and complemented with other
financial analysis techniques. The focus is to look for symptoms of problems that can be diagnosed using additional
techniques. Let’s look at an example.
HORIZONTAL ANALYSIS OF COLGATE’S INCOME STATEMENT

We calculate the growth rate of each of the line items with respect to the previous year.
For example, to find growth rate of Net Sales of 2015, the formula is (Net Sales 2015 – Net Sales 2014) / Net Sales 2014

WHAT CAN WE INTERPRET WITH HORIZONTAL ANALYSIS OF COLGATE PALMOLIVE

 The last two years Colgate has seen a dip in Net Sales figures. In 2015, Colgate saw a de-growth of -7.2% in 2015. Why?
 Cost of Sales, however, has decreased (positive from company’s point of view). Why is this so?
 Net Income decreased in the last three years, with as much as 36.5% delcine in 2015.

TREND ANALYSIS

Trend Analysis compare the overall growth of key financial statement line item over the years from the base case.

For example, in case of Colgate, we assume that 2007 is the base case and analyze the performance in Sales and Net
profit over the years.

 We note that Sales has increased by only 16.3% over a period of 8 years (2008-2015).
 We also note that the overall net profit has decreased by 20.3% over the 8 year period.
RATIO ANALYSIS OF FINANCIAL STATEMENTS

Ratio analysis of financial statement is another tool that helps identify changes in a company’s financial situation. A single
ratio is not sufficient to adequately judge the financial situation of the company. Several ratios must be analyzed together
and compared with prior-year ratios, or even with other companies in the same industry. This comparative aspect of ratio
analysis is extremely important in financial analysis. It is important to note that ratios are parameters and not precise or
absolute measurements. Thus, ratios must be interpreted cautiously to avoid erroneous conclusions. An analyst should
attempt to get behind the numbers, place them in their proper perspective and, if necessary, ask the right questions for
further types of ratio analysis.
SOLVENCY RATIO ANALYSIS

Solvency Ratio Analysis type is primarily sub-categorized into two parts – Liquidity Ratio Analysis and Turnover Ratio
Analysis of financial statement. They are further sub-divided into 10 ratios as seen in the diagram below.

We will discuss each sub category one by one.

Liquidity Ratios

Liquidity ratio analysis measure how liquid the company’s assets are (how easily can the assets be converted into cash)
as compared to its current liabilities. There are three common liquidity ratio

1. Current ratio analysis

2. Acid test (or quick asset) ratio analysis
3. Cash Ratio analysis

#1 – Current Ratio Analysis

WHAT IS CURRENT RATIO ANALYSIS?

Current ratio is the most frequently used ratio to measure company’s liquidity as it is quick, intuitive and easy measure to
understand the relationship between the current assets and current liabilities. It basically answers this question “How
many dollars in current assets does the company have to cover each $ of current liabilities”
Current Ratio Formula = Current Assets / Current Liabilities

Let us take a simple Current Ratio Calculation example,

Current Assets = $200 Current Liabilities = $100

Current Ratio = $200 / $100 = 2.0x
This implies that the company has two dollar of current assets for every one dollar of current liabilities.

ANALYST INTERPRETATION OF CURRENT RATIO

 Current ratio analysis provides us with a rough estimate that whether the company would be able to “survive” for
one year or not. If Current Assets is greater than Current Liabilities, we interpret that the company can liquidate its
current assets and pay off its current liabilities and survive atleast for one operating cycle.
 Current Ratio analysis in itself does not provide us with full details of the quality of current assets and whether
they are fully realizable.
 If the current assets consists primarily of receivables, we should investigate the collectability of such receivables.
 If current assets consists of large Inventories, then we should be mindful of the fact that inventories will take
longer to convert into cash as they cannot be readily sold. Inventories are much less liquid assets than
receivables.
 Average maturities of current assets and current liabilities should also be looked into. If current liabilities mature in
the next one month, then current assets providing liquidity in 180 days may not be of much use.

CURRENT RATIO ANALYSIS – COLGATE CASE STUDY EXAMPLE

Let us now calculate the Current Ratios for Colgate.

 Colgate has maintained a healthy current ratio of greater than 1 in the past 10 years.
 Current ratio of Colgate for 2015 was at 1.24x. This implies that current assets of Colgate are more than current
liabilities of Colgate.
 However, we still need to investigate on the quality and liquidity of Current Assets. We note that around 45% of
current assets in 2015 consists of Inventories and Other Current Assets. This may affect the liquidity position of
Colgate.
 When investigating Colgate’s inventory, we note that majority of the Inventory consists of Finished Goods (which
is better in liquidity than raw materials supplies and work-in-progress).
source: Colgate 2015 10K Report, Pg – 100

Below is a quick comparison of Current Ratio of Colgate’s vs P&G vs Unilever

 Colgate’s current Ratio as compared to its peer group (P&G and Unilever) appears to be much better.
 Unilever current ratio seems to be declining over the past 5 years. However, P&G Current ratio has remained less
than 1 in the past 10 years or so.

#2 – Quick Ratio Analysis

WHAT IS QUICK RATIO?

 Sometimes current assets may contain huge amounts of inventory, prepaid expenses etc. This may skew the
current ratio interpretations as these are not very liquid.
 To address this issue, if we consider the only most liquid assets like Cash and Cash equivalents and Receivables,
then it should provide us with a better picture on the coverage of short term obligations.
 This ratio is know as Quick Ratio or the Acid Test.
 The rule of thumb for a healthy acid test index is 1.0.

Quick Ratio Formula = (Cash and Cash Equivalents + Accounts Receivables)/Current Liabilities

Let us take a simple Quick Ratio Calculation example,

Cash and Cash Equivalents = $100

Accounts Receivables = $500
Current Liabilities = $1000
Then Quick Ratio = ($100 + $500) / $1000 = 0.6x

ANALYST INTERPRETATION

 Accounts Receivables are more liquid than the inventories.

  This is because Receivables directly convert into cash after the credit period, however, Inventories are first
converted to Receivables which in turn take further time to convert into cash.
 In addition, there can be uncertainty related to the true value of the inventory realized as some of it may become
obsolete, prices may change or it may become damaged.
 It should be noted that a low quick ratio may not always mean liquidity issues for the company. You may find low
quick ratios in businesses that sell on cash basis (for example, restaurants, supermarkets etc). In
these businesses there are no receivables, however, there maybe a huge pile of inventory.

QUICK RATIO ANALYSIS – COLGATE CASE STUDY EXAMPLE

Let us now look at the Quick Ratio calculations in Colgate.

Quick Ratio of Colgate is relatively healthy (between 0.56x – 0.73x). This acid test shows us the company’s ability to pay
off short term liabilities using Receivables and Cash & Cash Equivalents.
Below is a quick comparison of Quick Ratio analysis of Colgate’s vs P&G vs Unilever

As compared to its Peers, Colgate has a very healthy quick ratio.

While, Unilever’s Quick Ratio has been declining for the past 5-6 years, we also note that P&G Quick ratio is much lower
than that of Colgate.

#3 – Cash Ratio analysis

WHAT IS CASH RATIO ANALYSIS?

Cash ratio considers only the Cash and Cash Equivalents (there are the most liquid assets within the Current Assets). If
the company has a higher cash ratio, it is more likely to be able to pay its short term liabilities.
Cash Ratio Formula = Cash & Cash equivalents / Current Liabilities

Let us take a simple Cash Ratio Calculation example,

Cash and Cash Equivalents = $500

Current Liabilities = $1000
Then Quick Ratio = $500 / $1000 = 0.5x

ANALYST INTERPRETATION

 All three ratios – Current Ratios, Quick Ratios, and Cash Ratios should be looked at for understanding
the complete picture on Company’s liquidity position.
 Cash Ratio analysis is the ultimate liquidity test. If this number is large, we can obviously assume that the
company has enough cash in its bank to pay off its short term liabilities.

CASH RATIO – COLGATE CASE STUDY EXAMPLE

Let us calculate Cash Ratios in Colgate.

Colgate has been maintaining a healthy cash ratio of 0.1x to 0.28x in the past 10 years. With this higher cash ratio, the
company is in a better position to payoff its current liabilities.
Below is a quick comparison of Cash Ratio of Colgate’s vs P&G vs Unilever
Colgate’s Cash ratio as compared to its peers seems to be much superior.
Unilever’s Cash Ratio has been declining in the past 5-6 years.
P&G cash ratio has steadily improved over the past 3-4 years period.

TURNOVER RATIO ANALYSIS OF FINANCIAL STATEMENT

We saw from the above three liquidity ratios (Current, Quick and Cash Ratios) that it answer the question “Whether
the company has enough liquid assets to square off its current liabilities”. So this ratio is all about the $ amounts.

However, when we look at Turnover ratio analysis, we try to analyze the liquidity from “how long it will take for the firm to
convert inventory and receivables into cash or time taken to pay its suppliers”.

The commonly used turnover ratios include:

 4) Receivables turnover
 5) Accounts receivables days
 6) Inventory turnover
 7) Inventory days
 8) Payables turnover
 9) Payable days
 10) Cash Conversion Cycle

#4 – Receivables Turnover Ratio analysis

WHAT IS RECEIVABLES TURNOVER RATIO ANALYSIS?

 Accounts Receivables Turnover Ratio can be calculated by dividing Credit Sales by Accounts Receivables.
 Intuitively. it provides us the number of times Accounts Receivables (Credit Sales) is converted into Cash Sales
 Accounts Receivables can be calculated for the full year or for a specific quarter.
 For calculating accounts receivables for a quarter, one should take annualized sales in the numerator.

Receivables Turnover Formula = Credit Sales / Accounts Receivables

Let us take a simple Receivables Turnover Calculation example,

Sales = $1000
Credit given is 80%
Accounts Receivables = $200
Credit Sales = 80% of $1000 = $800
Accounts Receivables Turnover = $800 / $200 = 4.0x

ANALYST INTERPRETATION

 Please note that the Total Sales include Cash Sales + Credit Sales. Only Credit Sales convert to Accounts
Receivables, hence, we should only take Credit Sales.
 If a company sells most of its items on Cash Basis, then there will be No Credit Sales.
 Credit Sales figures may not be directly available in the annual report. You may have to dig into the Management
discussions to understand this number.
 If it is still hard to find the percentage of credit sales, then do have a look at conference calls where
analysts question the management on relevant business variables. Sometimes it is not available at all.

ACCOUNTS RECEIVABLES – COLGATE EXAMPLE

 To calculate the receivables turnover, we have considered average receivables. We consider the “average”
figures as these are balance sheet items.
 For eg. as shown in the image below, we took the average receivables of 2014 and 2015.
 Also, please note that I have taken the assumption that 100% of Colgate’s Sales were “Credit Sales”.

 We note that the Receivables Turnover was less than 10x in 2008-2010. However, it improved significantly in the
past 8 years and is was closer to 11x in 2015.
 Higher Receivables Turnover implies higher frequency of converting receivables into cash (this is good!)

--------RECEIVABLES TURNOVER FIGURE----