Chapter 7:

Ratio Analysis

Mr. David Wong/2018

 Compute basic accounting ratios
 Explain the purpose and use of ratios in
analysis a business’s liquidity, profitability and
performance.
• Analysis of financial statement for decision making.
(a) Assessment of a business’ past, present and anticipates
future
(b) To identify the weakness and strength.
• Objective of Ratio Analysis
(a) To standardise financial information for comparison
purposes.
(b) To assess the strengths and weakness of a business
(c) To highlight trends on financial items.
(d) To evaluate current operation of a business
(e) To assess the efficiently of the business operations
(f) To compare the present performance with past performance.
(g) To compare the performance of the business with its
competitors.
 Financial ratios are tools to do this.
 Liquidity ratios
 Activity ratios
 Gearing ratios
 Profitability ratios
 Measures whether a firm can repay its bills, or
financial obligations (debts) on time.
 Focus is on cash or near cash assets – more
readily available to settle debts (especially
current debts).
 Sometimes called the working capital ratio or
bankers’ ratio
 Measures a company’s ability to pay its current
liabilities.
 Computed as follows:
Current Assets
Current Ratio = Current Liabilities

 The higher the CR, the more liquid the firm’s

position.
 Rule of thumb, CR should be > 2.
 The current ratio for Lincoln Company is
computed below.
 Measures the “instant” debt-paying ability of a
company
 Sometimes called acid-test ratio.
 It is computed as follows:
 The quick ratio for Lincoln Company is
computed below.
 Excess of current assets over current liabilities.
 Note: not a ratio.
 Often used to evaluate a company’s ability to
pay current liabilities.
 Computed as follows:

 The larger the figure, the better.

 Measures how effectively a firm uses its assets
to generate revenue.
 Also called efficiency, turnover or business
asset management ratios.
 The relationship between the volume of goods
(merchandise) sold and inventory.
 Assesses the efficiency of a firm in managing
its inventory.
 Tells how many times the inventory is
replaced/sold within an accounting period
 The higher the figure, the better – sales are
increasing & inventory levels are low.
 Computed as follows:
 Lincoln’s inventory balance at the beginning
of 2011 is $311,000.
 A rough measure of the length of time it takes
to purchase, sell, and replace the inventory.
 Computed as follows:
The number of days’ sales in inventory for
Lincoln Company is computed below.
 The relationship between sales and accounts
receivable.
 Collecting accounts receivable as quickly as possible
improves a company’s solvency.
 The higher the ratio, the more effective the firm in
collecting from its credit customers.
 Computed as follows:
 The accounts receivable turnover for Lincoln
Company is computed below.
 An estimate of the length of time (in days) the
accounts receivable have been outstanding.
 The fewer number of days, the more efficient
the firm is at collecting receivables.
 Computed as follows:
 The number of days’ sales in receivables for
Lincoln Company is computed below.
 Measures how effectively the firm uses its non-
current assets to generate sales.
 The higher the ratio, the more efficient the firm is in
using its non-current assets to generate sales.
 Computed as follows:
 A measure that shows how effectively a
company utilizes its assets – how much sales a
firm is able to generate from money invested in
total assets.
 The higher the ratio, the better.
 The ratio is computed as follows:
 The ratio of net sales to assets for Lincoln
Company is computed below.
 Measures how a firm uses outside funds
(liabilities) to finance its assets.
 Also indicates whether a firm can pay the
interest on the use of outside funds & repay the
loan amounts.
 Also called leverage or debt management
ratios.
 Measures the percentage of total liabilities to
the total assets of the firm.
 Computed as follows:

 The lower the ratio, the better

 the less a firm is financed by outside parties.
 the higher the firm’s ability to obtain more outside
funds when needed.
 Measures the number of times a firm is able to
repay fixed interest from its net operating
profits.
 Also called interest cover ratio.
 The higher the ratio, the better
 More able to repay interest charges.
 It is computed as follows:
 The number of times interest charges are
earned for Lincoln Company is computed
below.
 Measures long term debt to shareholders’
equity.
 Indicates the margin of safety for creditors.
 The lower the ratio, the better for the firm.
 Computed as follows:
 The ratio of liabilities to shareholders’ equity
for Lincoln Company is computed below.
 Measures the firm’s ability to produce profits
from its assets.
 The higher the ratios, the better.
 Also an indication of firm’s efficiency.
 Can be divided into:
 Profitability ratios based on sales (gross profit
margin, net profit margin, operating profit margin)
 Profitability ratios based on assets/resources
(operating profit to total assets ratio, return on assets
ratio, return on common equity)
 Measures the profitability of a firm over a
period.
 Indicates how much profit is made per sales
generated.
 Computed as follows:
 Indicates what is available to owners from its
net sales, after considering all expenses.
 Computed as follows:
 Indicates how much operating profit is made
per sales generated.
 Computed as follows:
 measures the amount of operating profit
obtained from utilising assets.
 The higher the ratio, the more efficient the firm
has been in utilising its assets to generate
sales/profit.
 It is computed as follows:
 Measures the profitability of assets utilised.
 Also known as return on investment ratio.
 The higher the ratio, the better the return on
the use of assets by the firm.
 Computed as follows:
 Measures the net profit against the amount
invested by shareholders.
 Indicates what shareholders earn from their
investments in the business.
 It is computed as follows:
Lincoln Company had $150,000 of 6% preferred stock
outstanding on December 31, 2012 and 2011.
Thus, preferred dividends of $9,000 ($150,000 x 6%) are
deducted from net income.
Lincoln’s common shareholders’ equity is determined as
follows:
 Inter-company comparisons
 against industry averages/norms
 Obtained by averaging out the ratios of a good
sample of companies in the industry
 Firm can benchmark itself accordingly

 Intra-company comparisons
 Trend analysis – over a period of time
 To see if business has improved/ deteriorated
 To be used to formulate future strategy