Ratio analysis involves the construction of ratios using specific Balance sheet ratio analysis primarily aims at the

aims at the process of comparing

elements from the financial statements in ways that help identify the various line items of the balance sheet pertaining to a business. It is
strengths and weaknesses of the firm. targeted to evaluate various metrics required to understand the
performance of the company using aspects like components of assets,
Ratios help measure the relative performance of different financial liabilities and shareholder’s equity. Typically a balance sheet ratio will
measures that characterize the firm’s financial health. We could just look at either include two classes of assets or assets and liabilities or assets and
the dollar value of each financial measure and draw conclusions about shareholder’s equity or liability and shareholder’s equity.
performance; however, using ratios often provides a standardized measure
which is easier to interpret. For example, suppose you go to the grocery Types of Balance Sheet Ratios
store to buy a box of cereal. You see a 10 ounce box sells for P3.20 and a
larger 15 ounce box sells for P4.50. Which would you buy? You can look at The different types of balance sheet ratios are as follows:
the price of each box and the amount contained in each box but it is difficult
to tell which the better deal because the more expensive box also contains 1. Solvency Ratios
more cereal. If we divide the price of each box, however, by the amount of
cereal in the box we see that the small box cost P3.20/10 oz. = P0.32 per The prime aim of this is to monitor whether the business has enough cash
ounce and the large box cost P4.50/15 oz. = P0.30 per ounce. The large and assets to survive in operations and whether the level of debt is low so
box of cereal costs you less for each ounce of cereal you purchase. This that it does not face any future financial hurdles.
illustrates the power that ratios can have in helping analyze sets of data
such as those we encounter in a firm’s financial statements

It is worth noting that different sources often use different names

and/or different definitions for a number of the ratios we will discuss.
Always make sure you know how each ratio is defined when examining a The quick ratio measures whether the business has enough liquid assets
firm’s financial ratios. We will begin by taking a look at some important to meet its short term obligations. The higher the ratio the beneficial it is to
ratios used in financial analysis. We can group financial ratios into five the company.
broad categories: liquidity ratios, leverage ratios; repayment capacity ratio,
efficiency ratios, and profitability ratios. After introducing a number of useful
ratios, we will turn the discussion toward the use of these ratios to examine
the financial health and performance of the firm.

Introduction to Balance Sheet Ratios This is a better version of a quick ratio and checks the company’s ability to
pay back its concerned liabilities. If the ratio goes below 1, it flags a
warning for the company about whether it will be able to repay its short
Balance sheet ratio analysis is one of the key milestones of fundamental term liabilities. Again some companies which operate in particular
analysis of the company by making use of the information available in its
industries that require a high level of debt will possess a lower current ratio
financial statements typically in the balance sheet to set up the relationship
between different components of a company’s financial position. as this is normal for the industry to have.

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2. Leverage Ratios It measures how quickly and efficiently a business is converting the
receivables into cash. Thus the ratio also helps to measure the health and
Debt equity ratios are also important because they indicate how well efficiency of the company. A low DSO is concluded to be a good number
balanced the debt vs. equity relation the company has or in simple words meaning business takes less time to convert its receivables into cash.
whether the company has enough equity to cover up its debt.

This measures the number of days businesses will store its inventory
This denotes to what extent the total liabilities of a company are secured or before selling its final goods. This ratio is more industry-specific.
covered by the shareholder’s equity. The basic aim of debt/equity ratio is to
check how the company is financing its growth. A high number of this ratio
means the company is more leveraging on debt.

It represents how many days a business typically pays back its creditors.
Thus it also shows how long the business can make use of the cash before
ending up finally paying back.
This denotes to what extent the total long term liabilities of a company are
secured or covered by the shareholder’s equity.

This is a complete cycle of operations of a company that measures the

effectiveness of the management. The lower the number the better it is for
This denotes to what extent the total short term liabilities of a company are the company.
secured or covered by the shareholder’s equity.
4. Turnover Ratios
3. Activity Ratios
These ratios are more concerned with the inventory and how the company
Activity ratios help us measures the efficiency of the company and how is churning its sales in the process of collecting its credit sales and other
well it is functioning by taking a measure of the company’s ability to convert activities.
the assets present in the balance sheet into sales or cash.

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This ratio indicates how well a company is doing its collection on the basis 2. Maintain Liquidity
of the credit sales it has made.
The liquidity problem is the major issue which many firms face these days
and thus every firm should maintain a certain amount of liquidity to be able
to meet its urgent cash requirement. Specifically to main short term
solvency issues quick ratio and current ratio can play a major role.
This ratio depicts how effectively a company generates sales from its
inventory. 3. Determine the Financial Health

Some ratios are handy to determine the overall financial health and
performance of a company. This can be indicated by determining the
overall long term solvency of the firm. This helps in judging whether there is
too much pressure on the assets or if the firm is over-leveraged. Thus, to
This ratio shows how many days it is required to sell a piece of the
avoid future liquidation problem the business has to quickly recognize this.
industry.
Ratios that prove handy in such scenarios are leverage ratios and debt-
equity ratios.

4. Helps in Comparing

This ratio shows how well inventories are being managed by the company. Here certain ratios are used to which helps in comparison of the
It depicts the amount of inventory the business is holding as compared to benchmarks prevalent in the industry to get a better outlook of the financial
the number of sales made. performance and position of the company. The business can take rectifying
actions if the standard is not maintained by the company. Here generally
the ratios are compared to the previous year’s ratio to understand the track
record of the company.
Benefits of Balance Sheet Ratios
Limitations of Balance Sheet Ratio
The benefits of balance sheet ratios are as follows:
The limitations of the balance sheet ratio are as follows:
1. Helps in Evaluating Operational Efficiency
Use of Historical Data: All the information used in ratio analysis is based
Few of the ratios are targeted to evaluate the degree of efficiency of the on historical numbers only. These data are drawn from historical actuals
firm at how it handling its assets and other resources. It is a must for a firm and by no means will remain the same in the future as business
that assets and financial resources are well utilized and unnecessary performance changes with every passing time.
expense levels are kept to a bare minimum. To get an overall picture of the
efficiency of assets turnover ratios and efficiency ratios can play a major The Concept of Inflation: When we are comparing period wise numbers
role. for trend analysis and if in between the periods the inflationary rate has
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changed the comparison make no sense. Ratio analysis does not account Financial Ratios Based on the Income Statement
for the inflation factor at all.

Opportunities for Window Dressing: Some firms may manipulate the

numbers to bring about changes to the ratio for displaying a better picture
of the firm. Thus in ratio analysis, there are scopes of window dressing.

Variation of Rules to Value Assets: Different assets are valued according

to different sets of rules practiced by different businesses. Thus a
comparison of two companies during peer to peer analysis does not give a
true picture.

Time Effect: Some ratio pick numbers from the balance sheet which is
prepared only on the last day of the accounting period. Thus if there is any
sudden shoot or decline in the number pertaining to the last day of the
accounting period it can drastically impact the overall ratio analysis.

CONCLUSION

The balance sheet ratio has both advantages and disadvantages of its own
and solely depends on the analyst who is using this and what he/she is
using this for. Even then, the advantages clearly outweigh the
disadvantages as for people outside the company this is the only way to
get a better view of the financial position of the company.

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Gross Margin Times Interest Earned

Gross margin represents how much of a company's sales revenue it Times interest earned (TIE) is an indication of a company's ability to meet
keeps after incurring any direct costs associated with producing its goods debt payments. Divide earnings before interest and taxes, or EBIT, by
and services. This ratio is, therefore, the percentage of sales revenue total annual interest expenses and get the times interest earned ratio.
available for profit or reinvestment after the cost of goods sold (COGS) is
deducted. So if a company has a gross margin of 40%, that means it keeps Return on Stockholders' Equity
40 cents for every dollar it makes. It uses the remainder on operating Return on equity is another critical valuation for shareholders and potential
expenses. investors and can be calculated by dividing net income after taxes by
Gross margin can be calculated in two ways—by dividing gross profit by weighted average equity, though there are several other variations. This
net sales or by subtracting the COGS from the company's net sales. indicates the percentage of profit after taxes that the corporation earned.

Profit Margin

A profit margin ratio is one of the most common ratios used to determine
the profitability of a business activity. It shows the profit per sale after all
other expenses are deducted. Furthermore, it indicates how many cents a
company generates in profit for each dollar of sale. So if Company X
reports a 35% profit margin that means its net income was 35 cents for
every dollar generated.

In order to figure out the profit margin, you need to divide net income
after tax by net sales.

Earnings Per Share

This is one of the most widely cited ratios in the financial world. The result
of net income less dividends on preferred stock—which is then
divided by average outstanding shares—earnings per share is a crucial
determinant of the price of a company's shares because of its use in
calculating price-to-earnings.

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 SAMPLE PROBLEMS WITH SOLUTIONS

Solution – 1 (Problem related to Revenue Ratio)

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Solution – 2 (Problem related to Balance Sheet Ratio)

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documents/53e0c6cbe413016f234436f6_INFIEP_18/3/SA/18-3-SA-V1-
S1__solved_problems_ra.pdf

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showcase/[Link]

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