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information about the financial performance of the company and the status of the
company's financial condition. These reports are used by different users and for different
purposes. Suppliers use these statements to assess a firm's ability to pay short-term
obligations. Banks and other financial institutions use these reports to ascertain a
company's ability to service loan schedules. Investors use these reports to gauge the
basis for checking the company's compliance with legal requirements and statutes while
policy makers use these statements as bases for the formulation of policies. Management,
operations of a subject firm. When analyzed more meticulously, a financial statement can
reveal a wealth of information that is otherwise not quite apparent when it is given only a
cursory glance. An important tool in Finance that allows such an analysis of financial
Financial ratios are ratios extracted from the information given in financial
statements to better understand the financial condition and performance of a subject firm.
An author of a book on Strategic Management once commented that there are as many
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This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed
ratios rests with the individual user. Indeed, it may be difficult to come up with an
exhaustive list, much less to discuss all the possible ratios. Nonetheless, for the purpose
There are four general classifications of financial ratios that are of popular use:
The profitability ratios are: Return on Sales (ROS), Return on Investment (ROI),
and the Gross Profit Margin (GPM). The ROS is computed by dividing the Net Income
by Sales. It is also known as Net Profit Margin (NPM) and presents Net Income as a
percent relative to Sales. Some analysts use the ROS as an indicator of operating
efficiency while others use it as a gauge of the relative spread between Net Income and
Sales. A more practical interpretation is that the ROS tells the "reader" of the financial
statement how many centavos the company earns for every peso of sale it makes.
The ROI is a financial ratio that is used rather loosely. Conceptually, it is the ratio
of Net Income relative to investment. However, "investment" itself can have a different
meaning from one investor to the next. Thus, a more disciplined use of the concept is to
employ more precise terminologies. For instance, if the term "investment" is taken to
mean the money that the owner has put into the venture, a more precise ratio would be
Return on Equity (ROE), the ratio of Net Income relative to Owners' Equity that indicates
how many centavos are earned by the company for every peso that the owner puts into
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This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed
relative to all of the assets employed in the business, then the appropriate ratio to use is
Return on Assets (ROA), the ratio of Net Income relative to Total Assets indicating how
many centavos the company earns for every peso of asset put into the business.
Sometimes, an analyst will look for even greater precision such as when trying to relate
"distortions" caused by non-operating activities like interest expense and taxes. In this
case, the Operating ROA will be appropriate. The Operating ROA operates in much the
same way as ROA but the ratio is computed by dividing the Operating Profit (or EBIT,
i.e., Earnings Before Interest and Taxes) by the Operating Assets, i.e., Total Assets less
Companies. The Gross Profit Margin is also a profitability ratio that is popularly used. It
relates Gross Profit with Sales and is interpreted by most analysts as an indicator of the
The Asset Utilization Ratios are also referred to as Activity Ratios and Efficiency
ratios. One such ratio falling under this classification is Asset Turnover (A T/O), the ratio
of Sales to Total Assets. This ratio is used as a gauge of marketing excellence and how
well the firm's assets are being used to generate sales. It indicates how much sales are
generated for every peso of asset put into the business. As in the profitability ratios, the
A T/O is made more precise by relating sales with Operating Assets, in which case the
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This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed
Operating Asset Turnover is calculated. For the same reason, the Fixed Asset Turnover is
calculated by relating Sales to Fixed Assets only. The Accounts Receivable Turnover
relates Credit Sales with the Accounts Receivable balance. It indicates the frequency by
which receivables were converted to cash during a period. Related to this ratio are the
Days in Receivables (also referred to as the Collection Period), calculated as 360 (days in
equivalent number of days sales that remain uncollected as of the end of a period.
Inventory Turnover relates Cost of Goods Sold to the Inventory balance and indicates the
frequency by which inventory is converted into sales during a period. As in the Collection
Period, the Days in Inventory are similarly calculated by dividing 360 by the Inventory
Turnover resulting in the equivalent days sales of the inventory that remains in stock as at
the end of the period. Dividing the Accounts Payables balance by the Credit I Purchases
per Day also results to a corresponding conversion of the Accounts Payables balance into
equivalent days
Liquidity refers to the ability of the company to meet its short-term obligations.
There are two ratios that are helpful i~ testing the liquidity of a company: the Current
Ratio and the Quick (or Acid-Test) ratio. The current ratio measures the ability of the
company's current assets to cover its current liabilities and is computed by dividing the c
current assets by the current liabilities. A more stringent measure of liquidity is the Quick
ratio. It is computed by dividing the sum of the company's cash and near-cash by its
current liabilities.
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This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed
Total Debt to Asset (DTA) ratio presents the percentage of Total Debt relative to the Total
Assets of the company. The Debt-Equity (D-E) ratio relates the level of long-term debt
relative to that of equity, a popular indicator of the composition of the capital structure of
the firm. The Equity Multiplier (EM) relates total assets to equity. It measures the number
of times each peso of equity is able to "generate" assets. It is used by some analysts as a
Analysts may also view several ratios simultaneously. One such technique is
vertical analysis wherein each item in the financial statement is presented as a percent of
a base thus showing the relative composition of the base account. For instance, a vertical
analysis of the Income Statement uses Sales as the base account and shows all accounts
as a percent of Sales. A similar analysis of the Balance Sheet use the Total Assets as the
base account and presents the various accounts as a percent of Total Assets. A vertical
analysis of the Cash Flow Statement shows the accounts as a percent of Total Sources and
Total Uses, as the case may be. The statements that result from this manner of
presentation is also referred to as common-size statements and is useful tor analysts who
want to see how the firm compares against others or against a benchmark. It is also used
Financial statements are also analyzed horizontally. This is done by computing for
the percentage change of the various accounts from one accounting period to the next. It
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This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed
allows for an analysis of the progression of the accounts over time and enables the
analyst to extract additional insights on the operation of the business. (Other analysts
technique, a base accounting period is chosen. Then, the balance of each account in the
other periods are taken as a percent of the base period resulting in an "index" number)
Du Pont Analysis combines the ROS, A T/O, EM and the ROE. It is also referred
it as the product of ROS, the measure of operating efficiency, A T/O, the measure of
marketing excellence and, EM, the measure of financial prudence. By so doing, the
"drivers" of corporate performance can be identified and the contribution of each of the
Financial ratios by themselves may not mean much until they are compared to a
set of standards. These standards include internal standards, industry standards and
shown by its track record as well as the company's budgeted performance. Industry
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This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed
information. Among the more popular rules-of-thumb are: 2:1 for the Current Ratio and
1:1 for the Quick Ratio to gauge liquidity, 70:30 for the Debt Equity mix, the Bellwether
Rate for the ROA, ROA for the ROE, Credit Term to customers for the Collection Period,
Credit Term of suppliers for the Payment Period, and 2: 1 for Times Interest Earned.
Financial ratios are powerful tools. However, as any tool, they should be used
prudently lest they be misinterpreted. This is why some guidelines in their use have been
set. First, use ratios to form an integrated picture. Seldom does a single ratio provide a
total picture of the company's financial condition. Hence, it is best that each be used in
relation to another. Second, focus on deviations and analyze causal factors. Interpret the
ratios in relation to the factors that cause their behavior and be careful about classifying
which results are due to operating management and which ones are in spite of them.
Third, relate the ratios to the status of competition and the industry. Enrich your
interpretation of the results by incorporating into the analysis the results of your
environmental scanning. Fourth, look for trends. Success or failure is not achieved
overnight. It comes as a series of events. Hence, it may not be just to limit the analysis to
only one period. Fifth, recognize the effects of seasonal factors. Information contained in
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This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed
factors. The careful analyst will be able to enrich the analysis if an attempt is made to
also view the statements during the interim. Finally, be aware of possible "window
dressing". Subject firms may attempt to misrepresent their financial picture for one
reason or another. Statements under study may then be analyzed and compared to one
Financial ratios are useful tor strategic management especially in the analysis of
the internal environment of the firm and in the formulation of the financial plan that
forms part of the implementing program. An internal analysis will be more meaningful
level, collection experience, profitability track record, matching of sources and uses of
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This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed