Financial ratio analysis

May 16, 2018

Financial ratios compare the results in different line items of the financial statements. The
analysis of these ratios is designed to draw conclusions regarding the financial
performance, liquidity, leverage, and asset usage of a business. This type of analysis is
widely used, since it is solely based on the information located in the financial statements,
which is generally easy to obtain. In addition, the results can be compared to industry
averages or to the results of benchmark companies, to see how a business is performing in
comparison to other organizations.

The categories of financial ratios that are used for analysis purposes are as follows:

 Performance ratios. These ratios are derived from the revenue and aggregate expenses line
items on the income statement, and measure the ability of a business to generate a profit. The
most important of these ratios are the gross profit ratio and net profit ratio.
 Liquidity ratios. These ratios compare the line items in the balance sheet, and measure the
ability of a business to pay its bills in a timely manner. Chief among these ratios are the current
ratio and quick ratio, which compare certain current assets to current liabilities.
 Leverage and coverage ratios. These ratios are used to estimate the comparative amounts of
debt, equity, and assets of a business, as well as its ability to pay off its debts. The most
common of these ratios are the debt to equity ratio and the times interest earned ratio.
 Activity ratios. These ratios are used to calculate the speed with which assets and liabilities
turnover, by comparing certain balance sheet and income statement line items. Rapid asset
turnover implies a high level of operational excellence. The most common of these ratios
are days sales outstanding, inventory turnover, and payables turnover.

Financial ratio analysis is only possible when a company constructs its financial statements
in a consistent manner, so that the underlying general ledger accounts are always aggregated
into the same line items in the financial statements. Otherwise, the provided information will
vary from one period to the next, rendering long-term trend analysis useless.

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Financial Analysis
The Interpretation of Financial Statements
Gross profit ratio | Gross profit equation
December 05, 2018

The gross profit ratio shows the proportion of profits generated by the sale of products or
services, before selling and administrative expenses. It is used to examine the ability of a
business to create sellable products in a cost-effective manner. The ratio is of some
importance, especially when tracked on a trend line, to see if a business can continue to
provide products to the marketplace for which customers are willing to pay a reasonable
price. There is no optimum ratio amount; it can vary substantially by industry.

The gross margin ratio can be measured in two ways. One is to combine the costs of direct
material, direct labor, and overhead, subtract them from sales, and divide the result by sales.
This is the more comprehensive approach. The formula is:

(Sales – (Direct materials + Direct Labor + Overhead)) ÷ Sales

However, this first method includes a number of fixed costs. A more restrictive version of
the formula is to only include direct materials, which may be the only truly variable element
of the cost of goods sold. The formula then becomes:

(Sales – Direct materials) ÷ Sales

The second method presents a more accurate view of the margin generated on each
individual sale, irrespective of fixed costs. It is also known as the contribution margin ratio.

Gross Profit Ratio Example

Quest Adventure Gear has been suffering declining net profits for several years, so a
financial analyst investigates the reason for the change. She discovers that the costs of direct
materials and direct labor have not changed significantly as a percentage of sales. However,
she notes that the company opened a new production facility three years ago to
accommodate increased sales volume, but that sales flattened shortly thereafter. The result
has been increased factory overhead costs associated with the new facility, without a
sufficient amount of offsetting sales to maintain an adequate profit level.
Based on this analysis, management decides to shutter the new facility, which will result in a
10% decline in sales, but also a 30% increase in gross profit, since so much of the cost of
goods sold will be eliminated.

Net profit ratio

December 22, 2018

Overview

The net profit percentage is the ratio of after-tax profits to net sales. It reveals the remaining
profit after all costs of production, administration, and financing have been deducted from
sales, and income taxes recognized. As such, it is one of the best measures of the overall
results of a firm, especially when combined with an evaluation of how well it is using its
working capital. The measure is commonly reported on a trend line, to judge performance
over time. It is also used to compare the results of a business with its competitors.

Net profit is not an indicator of cash flows, since net profit incorporates a number of non-
cash expenses, such as accrued expenses, amortization, and depreciation.

The formula for the net profit ratio is to divide net profit by net sales, and then multiply by
100. The formula is:

(Net profit ÷ Net sales) x 100

The measure could be modified for use by a nonprofit entity, if the change in net assets were
to be used in the formula instead of net profit.

Example of the Net Profit Ratio

For example, the Ottoman Tile Company has $1,000,000 of sales in its most recent month,
as well as sales returns of $40,000, a cost of goods sold (CGS) of $550,000, and
administrative expenses of $360,000. The income tax rate is 35%. The calculation of its net
profit percentage is:

$1,000,000 Sales - $40,000 Sales returns = $960,000 Net sales

$960,000 Net sales - $550,000 CGS - $360,000 Administrative = $50,000 Income before tax

$50,000 Income before tax x (1 - 0.35) = $32,500 Profit after tax

($32,500 profit after tax ÷ $960,000 Net sales) x 100 = 3.4% Net profit ratio

Issues with the Net Profit Ratio

The net profit ratio is really a short-term measurement, because it does not reveal a
company's actions to maintain profitability over the long term, as may be indicated by the
level of capital investment or expenditures for advertising, training, or research and
development. Also, a company may delay a variety of discretionary expenses, such as
maintenance, to make its net profit ratio look better than it normally is. Consequently, you
should evaluate the net profit ratio alongside a variety of other metrics to gain a full picture
of a company's ability to continue as a going concern.

Another issue with the net profit margin is that a company may intentionally keep it low in
accordance with a low-pricing strategy that aims to grab market share in exchange for low
profitability. In such cases, it may be a mistake to assume that a company is doing poorly,
when in fact it may own the bulk of the market share precisely because of its low margins.
Conversely, the reverse strategy may result in a very high net profit ratio, but at the cost of
only capturing a small market niche.

Another strategy that can artificially drive down the ratio is when a company's owners want
to minimize income taxes, and so accelerate the recognition of taxable expenses into the
current reporting period. This approach is most commonly found in a privately held
business, where there is no need to impress outside investors with the results of operations.

Similar Terms

The net profit ratio is also known as the profit margin.

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 Current ratio
April 22, 2019
The current ratio measures the ability of an organization to pay its bills in the near -term. It is
a common measure of the short-term liquidity of a business. The ratio is used by analysts to
determine whether they should invest in or lend money to a business. To calculate the
current ratio, divide the total of all current assets by the total of all current liabilities. The
formula is:

Current assets ÷ Current liabilities = Current ratio

For example, a supplier wants to learn about the financial condition of Lowry
Locomotion. The supplier calculates the current ratio of Lowry for the past three years:
Year 1 Year 2 Year 3

Current assets $8,000,000 $16,400,000 $23,400,000

Current liabilities $4,000,000 $9,650,000 $18,000,000

Current ratio 2:1 1.7:1 1.3:1

The sudden rise in current assets over the past two years indicates that Lowry has undergone
a rapid expansion of its operations. Of particular concern is the increase in accounts payable
in Year 3, which indicates a rapidly deteriorating ability to pay suppliers. Based on this
information, the supplier elects to restrict the extension of credit to Lowry.

Since the ratio is current assets divided by current liabilities, the ratio essentially implies
that current liabilities can be liquidated to pay for current assets. A current ratio of 2:1 is
preferred, with a lower proportion indicating a reduced ability to pay in a timely manner.

The current ratio can yield misleading results under the following circumstances:

 Inventory component. When the current assets figure includes a large proportion of inventory
assets, since these assets can be difficult to liquidate. This can be a particular problem if
 management is using aggressive accounting techniques to apply an unusually large amount of
overhead costs to inventory, which further inflates the recorded amount of inventory.

 Paying from debt. When a company is drawing upon its line of credit to pay bills as they come
due, which means that the cash balance is near zero. In this case, the current ratio could be
fairly low, and yet the presence of a line of credit still allows the business to pay in a timely
manner. In this situation, the organization should make its creditors aware of the size of the
unused portion of the line of credit, which can be used to pay additional bills. However, there
is still a longer-term question about whether the company will be able to pay down the line of
credit.

 Comparisons across industries. Companies have different financial structures in different

industries, so it is not possible to compare the current ratios of companies across industries.
Instead, one should confine the use of the current ratio to comparisons within an industry
;

Quick ratio | Acid ratio | Liquidity ratio

April 04, 2019

The quick ratio is used to evaluate whether a business has enough liquid assets that can be
converted into cash to pay its bills. The key elements of current assets that are included in
the ratio are cash, marketable securities, and accounts receivable. Inventory is not included
in the ratio, since it can be quite difficult to sell off in the short term, and possibly at a loss.
Because of the exclusion of inventory from the formula, the quick ratio is a better indicator
than the current ratio of the ability of a company to pay its immediate obligations.

To calculate the quick ratio, summarize cash, marketable securities and trade receivables,
and divide by current liabilities. Do not include in the numerator any excessively old
receivables that are not likely to be paid, such as anything over 90 days old. The formula is:

(Cash + Marketable securities + Accounts receivable) ÷ Current liabilities = Quick ratio

Despite the absence of inventory from the calculation, the quick ratio may still not yield a
good view of immediate liquidity, if current liabilities are payable right now, while receipts
from receivables are not expected for several more weeks. This can be a particular concern
when a business has granted its customers long payment terms.
The ratio is most useful in manufacturing, retail, and distribution environments where
inventory can comprise a large part of current assets. It is particularly useful from the
perspective of a potential creditor or lender that wants to see if a credit applicant will be able
to pay in a timely manner, if at all.

For example, Rapunzel Hair Products appears to have a respectable current ratio of 4:1. The
breakdown of the components of that ratio are:
Account

Cash

Marketable securities

Accounts receivable

Inventory

Current liabilities

Current ratio

Quick ratio

The component breakdown reveals that nearly all of Rapunzel's current assets are in the
inventory area, where short-term liquidity is questionable. This issue is only visible when
the quick ratio is substituted for the current ratio.

Similar Terms

The quick ratio is also known as the acid ratio, the acid test ratio, the liquid rat io, and the
liquidity ratio.

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Business Ratios Guidebook

The Interpretation of Financial Statements