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What is Ratio?
• In mathematics, a ratio expresses the magnitude of
quantities relative to each other
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• Financial ratios is the useful indicator of firm’s
performance & financial situation
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• These ratios can be used to make comparison between
our co & other co and to analyse the trend
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Income Statement
It is more like a video of the
firm’s operations for a specified
period of time
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Such as profits or losses from
operations, dividends paid, and
any other items charged or
credited to retained earnings
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• A complete liquidity ratio analysis can help
uncover weaknesses in the financial position of
business
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– It can calculate the turnover of receivables, the repayment
of liabilities, the quantity and usage of equity and the
general use of inventory and machinery
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– These ratios are meaningful when compared to peers in
the same industry and can identify business that are better
managed relative to the others
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Efficiency Ratios

Debt Management Ratios
• This group of ratios calculate the proportionate
contributions of owners and creditors to a business,
sometimes a point of contention between the two
parties
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• Note: Although leverage can magnify earnings, it
exaggerates/ overstates losses
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• Important for potential creditors, who are concerned with the
firm's ability to generate the cash flow necessary to make interest
payments on outstanding debt
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– to monitor the firm's use of debt financing b’coz it can
increases the risk associated with the firm
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• There are only two ways to finance the acquisition of any asset:
– debt (using borrowed funds) and,
– equity (using funds from internal operations or selling stock in
the company)
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• So, other 65 cents came from equity financing
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• Greater debt means greater leverage, and more leverage
means more risk
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• Large manufacturers, require heavy investment in fixed plant &
equipment, will require higher levels of debt financing than
will service firms such as insurance or advertising agencies
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• Short-term (or current) liabilities are often a necessary part of
daily operations and may fluctuate regularly depending on
factors such as seasonal sales
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This does not mean that the firm has 45 % of its
total financing as debt; debt and equity percentages,
together, must sum to one (100 % of the firm's total
financing)
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45 x is the
percent of debt financing
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45 x = 1
x (1+0
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45) and x = 0
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• The interpretation of the debt-to-equity ratio and the total
debt ratio is different
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• TIE ratio (EBIT coverage ratio)- measure of the firm's ability to
meet its interest expenses with operating profits
• Example, a TIE of 3
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• High ratio, more financially stable, greater the safety margin (in
the case of fluctuations in sales and operating expenses)
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• The fixed charge coverage ratio (debt service coverage ratio)
takes into account all regular periodic obligations of the firm
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• The ratio measure of the firm's ability to meet fixed
obligations
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• Return on sales provides a measure of bottom-line
profitability – Net profit margin, GP margin etc
• Net profit margin =6 % means that for every dollar in sales,
the firm generated 6 cents in net income
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• A gross profit margin = 30 % would indicate that for each
dollar in sales, the firm spent 70-cents in direct costs to
produce the good or service that the firm sold
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• An operating margin =15 % indicate that the firm spent an
additional 15-cents out of every dollar in sales on nonproduction expenses, such as sales commissions paid to the
firm's sales force or administrative labor expenses
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• An ROA = 7 % would mean that for each dollar in assets, the
firm generated 7-cents in profits
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• Return on equity (ROE) measures the net return per dollar
invested in the firm by the owners, the common
shareholders
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• In each of the profitability ratios, the numerator in
the ratio comes from the firm's income statement
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• Therefore, the proper interpretation for a
profitability ratio such as an ROA of 11 % would be
that, over the specific period (such as fiscal year
2009), the firm returned 11 cents on each dollar of
asset investment
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• Using these ratios, investors can gain an understanding of
how cheap or expensive a co's current stock price (market
price) is compared to several different measures
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• The price to earnings (P/E) ratio is the valuation ratio that
compares the co's stock price to the amount of earnings it
generates on a per-share basis
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• That is, it's the premium that the market is willing to pay for a
particular security's earnings
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• It transforms any company's earnings into an easily
comparable measure
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• But a high P/E ratio for one company not necessarily
suggests that its stock is overpriced
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Type of ratio comparisons
Trend/ Time
analysis

• Based on the idea that what has happened
in the past gives traders an idea of what will
happen in the future
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Crosssectional
analysis

• It compares one company against the
industry it operates within, or directly
against certain competitors within the same
industry
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• To do this, change each line item on a
statement to a percentage of the total
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• It is useful when comparing one business to other businesses or
to averages from an entire industry
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• Industry statistics are frequently published in common-size
form
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• Such comparisons should be limited to companies engaged
in similar business activities
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• For example, one company leases its properties while the
other purchases such items; one company finances its
operations using long-term borrowing while the other
relies primarily on funds supplied by stockholders and by
earnings
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DuPont
• A method of performance measurement created
by DuPont Corporation in the 1920s
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It is also known
as "DuPont identity“
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• the DuPont model integrates elements of the
Income Statement with those of the Balance
Sheet

Du Pont analysis
• DuPont analysis tells us that ROE is affected by three
things:
– Operating efficiency, which is measured by profit margin
– Asset use efficiency, which is measured by total asset
turnover
– Financial leverage, which is measured by the equity
multiplier
ROE = Profit Margin (Profit/Sales) * Total Asset Turnover
(Sales/Assets) * Equity Multiplier (Assets/Equity)

• If ROE is unsatisfactory, the DuPont analysis helps
locate the part of the business that is weak/
underperforming
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• Compare a firm with its colleagues
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• Teach people a basic understanding how they can
have an impact on the
• company results
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Strengths –Benefits of DuPont
• Simplicity - A very good tool to teach people a basic
understanding how they can have an impact on
results
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• Can be used to convince management that certain
steps have to be taken to professionalize the
purchasing or sales function
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• In stead of looking for company takeovers in order to
compensate lack of profitability by increasing
turnover and trying to achieve synergy
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• Does not include the Cost of Capital
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• Assumptions of the DuPont method
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Uses of Ratio Analysis
• Current status and past performance information to owners
and creditors
• A convenient way for owners and creditors to set
performance targets & to impose restrictions on the
managers of the firm
• A convenient template for financial planning
• Internal uses
– Performance evaluation – compensation and
comparison between divisions
– Planning for the future – guide in estimating future cash
flows
• External uses
– Creditors
– Suppliers
– Customers
– Stockholders

Limitations/ Problems Of Ratio Analysis
• There is no underlying theory, so there is no way to
know which ratios are most relevant
• Benchmarking is difficult for diversified firms
• Globalization and international competition makes
comparison more difficult because of differences in
accounting regulations
• Varying accounting procedures, i
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FIFO vs
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We are still captains of our souls
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To be meaningful, most
ratios must be compared to historical values of the
same firm, firm’s forecasts or ratios of similar firms
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They should be viewed as indicators, with several of
them combined in order to paint the picture of the
firm’s situation
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Certain
account balances used to calculate ratios may
increase or decrease as it was caused by the seasonal
factors
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Issues In Using Financial Ratios
• Ratios are subject to the limitation of accounting method
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• If you are making a comparative analysis of a company's
financial statements over a certain period of time, make an
appropriate allowance for any changes in accounting
policies that occurred during the same time span
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Issues In Using Financial Ratios
• When comparing ratios from various fiscal periods or
companies, inquire about the types of accounting policies
used
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• Determine whether ratios were calculated before or
after adjustments were made to the balance sheet or
income statement, such as non-recurring items and
inventory or pro forma adjustments
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• Carefully examine any departures from industry norms

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