I’m gonna talk about financial ratio analysis.
Financial Ratio Analysis
Financial ratio analysis involves methods of calculating and interpreting financial ratios,
and this is to analyze and monitor the firm’s performance.
Management is concerned with all aspects of the firm’s financial situation, and it
attempts to produce financial ratios that will be considered favorable by both owners and creditors.
Comparing ratios is more objective and relevant than simply comparing
different figures from the financial statements. Let’s take an example.
Net profit of Company A is $100,000, whereas for Company B is $10,000.
So, Company A has made more profit than Company B.
Can we simply make a conclusion by saying, Company A is better than Company B? Of course no.
One more thing we have to consider is the sales.
Let say, the sales of Company A is $1,000,000, whereas for Company B is $20,000.
We may calculate the profit margin by taking net profit over sales.
So, the profit margin of Company A is 10%, whereas for Company B is 50%.
Now, it is obvious that Company B is better than Company A, because Company B
can make more profit based on lower sales, which means Company B is more efficient.
Using Financial Ratios: Types of Ratio Comparisons
There are two types of ratio comparisons.
First type is trend analysis or time-series analysis.
Trend analysis is used to evaluate a firm’s performance over time.
This is to compare the performance of one company over many years.
Second type is cross-sectional analysis.
It is used to compare different firms at the same point in time,
which means it compares the performance of many companies in the same year.
About cross-sectional analysis, you can either compare one firm’s financial performance to the
The industry’s average performance, which is called the industry comparative analysis.
Or compare one firm’s financial performance to the
performance of industry leader or key competitor, that’s called benchmarking.
Categories of Financial Ratios
In the following part, we are gonna introduce five different categories of financial ratios.
First, liquidity ratios, which is to measure the firm’s ability to meet its maturing obligations.
Second, activity, efficiency, or asset management ratios,
which is to measure how efficient a firm is in using its resources to generate sales.
Third, debt, or financial leverage ratios,
which is to indicate a firm’s capacity to meet short- and long-term obligation.
Fourth, profitability ratios, which is to measure the firm’s
ability to generate profits on sales, assets, and stockholder’s investment.
Fifth, market value ratios, which is to show
the market’s perceptions of a firm’s performance and risk.
Liquidity Ratios
Now, let’s look at the first category, liquidity ratio. It is used to determine
a debtor’s ability to pay off current debt obligations without raising external capital.
Current Ratio, Acid Test Ratio, Quick Ratio
To calculate current ratio, we take current assets over current liabilities.
Another similar formula is acid test ratio, in which inventories are removed from the formula.
So, acid test ratio equals to current assets minus inventories over current liabilities.
Liquidity is the ability to convert assets into cash quickly and cheaply. If the current ratio
of a company is above industry average, it shows that this company is less risky
than other companies in the same industry. For current ratio, the higher the better.
However, sometimes higher current ratio is not necessarily showing better liquidity.
It could be due to high inventory level that causes current assets to increase,
indicating a firm’s problem in inventory turnover.
That’s why, we have another formula for liquidity, the acid test ratio, or quick
ratio, which is more stringent as the illiquid inventory is excluded from the current assets.
Let’s take an example. Let say, there are three companies, Company A, B,
and C, and their current ratios and quick ratios are shown in the table.
All three companies have current ratios of 1.3.
However, the quick ratios for Company B and Company C are dramatically lower than
their current ratios, but for Company A, the two ratios are almost the same. Why?
The reason is because, Company A does not keep much inventory
compared to the other two companies. Therefore, Company A is more liquid.
Activity / Efficiency / Asset Management Ratios
The next is activity ratios. They are also known as efficiency or asset management ratios.
Account Receivable Turnover, Average Collection Period
Accounts receivable turnover is calculated by taking credit sales over accounts receivable,
in which accounts receivable means the amount of money that customers have not yet paid back.
