Financial Reporting: Ratio Analysis & Profitability

• Financial reporting and analysis techniques are crucial for organizations
• These techniques help accurately present financial performance
• Support informed decisions
• Maintain transparency with stakeholders
• They offer insight into a company’s financial health, profitability, and operational efficiency

Ratio Analysis

• Ratio analysis is a widely used technique to analyze financial statements based on key financial ratios
• These ratios assess various aspects of a company's performance, including:
  • Profitability
  • Liquidity
  • Solvency
  • Efficiency

Profitability Ratio

• Profitability ratios are financial metrics used to evaluate a company's ability to generate profit relative to its revenue, assets, equity, or other financial elements
• These ratios assess how effectively a company is performing in terms of generating profits
• They help stakeholders understand its financial health and operational efficiency

Gross Profit Margin

• Gross Profit Margin is a financial metric
• Represents the percentage of revenue that exceeds the cost of goods sold (COGS)
• Shows how efficiently a company produces and sells its products
• A higher gross profit margin indicates that a company is able to retain more from its sales after covering the cost of production
• Gross Profit Margin = (Gross Profit / Revenue) X 100

Return on Assets (ROA)

• Return on Assets (ROA) is a financial ratio indicating how efficiently a company uses its assets to generate profit
• Measures the profitability relative to the company's total assets
• Key indicator of how effectively management is utilizing the assets at its disposal
• ROA = (Net Income / Total Assets) X 100
• Net Income is the profit of the company after all expenses, taxes, and interest have been subtracted from total revenue
• Total Assets is the sum of everything the company owns, both current and non-current, such as cash, equipment, buildings, etc
• Higher ROA indicates efficient utilization of assets to generate profit
• Lower ROA suggests inefficient asset utilization, pointing to poor asset management or a less profitable business model

Return on Equity (ROE)

• Return on Equity (ROE) is a key profitability ratio measuring how efficiently a company generates profit from its shareholders' equity
• Indicates how well a company is using the money invested by its shareholders to generate earnings
• ROE = (Net Income / Ave. Shareholder’s Equity) X 100
• Net Income is the profit of the company after all expenses, taxes, and interest have been deducted
• Shareholder's Equity is the difference between a company’s total assets and its total liabilities and represents the equity capital invested by shareholders, along with retained earnings
• A high ROE indicates that the company is effectively using shareholders' equity to generate profits and is often seen as a sign of strong management and operational efficiency
• For example, an ROE of 20% means the company generates a profit of $0.20 for every dollar of equity
• A low ROE could suggest that the company is not using its equity efficiently, and might need to improve its profitability
• A low ROE could also be acceptable in industries that require large capital investments or where profit margins are traditionally lower

Liquidity Ratio

• Liquidity ratios are financial metrics used to assess a company's ability to meet its short-term obligations using its most liquid assets
• These ratios help investors, creditors, and analysts understand how well a company can cover its current liabilities without needing to secure additional financing

Current Ratio

• The Current Ratio is the most common liquidity ratio
• Measures a company’s ability to cover its current liabilities (debts due within one year) with its current assets (assets that are expected to be converted into cash or used up within one year)
• Current Ratio = Current Assets / Current Liabilities
• A current ratio > 1 suggests that the company has enough assets to cover its short-term liabilities
• A current ratio < 1 indicates that the company might have difficulty meeting its short-term obligations and could face liquidity problems

Quick Ratio

• The Quick Ratio is a more conservative measure of liquidity than the current ratio
• It excludes inventory from current assets
• Inventory may not be as easily converted to cash as other current assets like receivables or cash itself
• Quick Ratio = (Current Assets - Inventory) / Current Liabilities
• Quick Assets: Cash, marketable securities, and accounts receivable (current assets minus inventory).
• Current Liabilities: Same as in the current ratio, obligations due within one year
• A quick ratio > 1 suggests the company can meet its short-term obligations without needing to sell inventory
• A quick ratio < 1 implies that the company may struggle to pay off its short-term liabilities if it can’t quickly convert its inventory to cash

Cash Ratio

• The Cash Ratio is the most conservative liquidity ratio
• Focuses only on a company’s ability to cover its short-term liabilities with its most liquid assets: cash and cash equivalents (like marketable securities)
• Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
• Cash: Money available in the company’s bank accounts
• Cash Equivalents: Short-term, highly liquid investments being easily convertible into cash (e.g., Treasury bills, money market funds)
• A cash ratio > 1 suggests that the company has enough cash and equivalents to pay off its current liabilities without needing to sell other assets
• A cash ratio < 1 indicates that the company might need to sell assets, take out loans, or rely on other sources to cover short-term obligations

Solvency Ratio

• Solvency ratios measure a company’s ability to meet its long-term debt obligations and remain financially stable in the long run
• It evaluates the relationship between a company's total assets and total liabilities
• Provides an indication of whether a company has enough assets to cover its long-term debt

Debt-to-Equity Ratio

–The Debt-to-Equity Ratio compares a company's total debt to its shareholder equity –Measures the relative proportion of debt and equity used to finance the company’s assets

• D/E Ratio = Total Debt / Shareholder’s Equity
• Total Debt includes both short-term debt and long-term debt
• Shareholder’s Equity is the owners' stake in the company, which is calculated as total assets minus total liabilities.
• A debt ratio of 1 (or 100%) means that the company’s entire asset base is financed by debt
• A ratio lower than 1 indicates that the company has more assets than liabilities, suggesting a lower level of financial risk
• A higher ratio suggests that the company relies heavily on debt to finance its operations, which can be risky in times of financial downturns

Debt Ratio

• The Debt Ratio measures the proportion of a company's assets that are financed through debt
• Provides a broad overview of a company's financial leverage
• Debt Ratio = Total Liabilities / Total Assets
• Total Debt includes both short-term debt and long-term debt
• Total Assets refers to everything owned by the company (both current and non-current assets)
• A higher debt ratio indicates that a larger portion of the company’s assets is financed by debt, which can increase financial risk
• A lower debt ratio suggests that the company relies less on debt financing, which may indicate lower financial risk and better solvency

Equity Ratio

• The equity ratio measures the proportion of a company’s assets that are financed by shareholder equity rather than debt
• Is the inverse of the debt ratio
• Debt Ratio = Shareholder’s Equity / Total Assets
• Shareholder’s Equity is the owners' stake in the company, which is calculated as total assets minus total liabilities
• Total Assets refers to everything owned by the company (both current and non-current assets)
• A higher equity ratio indicates that a company is less reliant on debt, which typically suggests a more financially stable company
• A lower ratio means the company is more reliant on debt to finance its assets, which can be risky

Efficiency Ratio

• Efficiency ratios are financial metrics used to assess how well a company is utilizing its assets and resources to generate revenue and profits
• These ratios provide insight into the operational effectiveness of a company
• Measures how efficiently it is using its assets to achieve its financial goals

Asset Turnover Ratio

• The asset turnover ratio measures how effectively a company uses its assets to generate sales
• A higher ratio indicates more efficient use of assets in generating revenue
• ATR = Net Sales / Ave. Total Assets
• Net Sales = Total sales (or revenue) from goods or services, typically net of returns and allowances
• Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2
• A higher asset turnover ratio indicates that a company is efficiently using its assets to generate revenue
• A lower ratio suggests that the company may be underutilizing its assets or has excess capacity that is not being effectively used

Inventory Turnover Ratio

• The inventory turnover ratio measures how many times a company’s inventory is sold and replaced over a period, usually a year
• Indicates how efficiently inventory is managed
• ITR = Cost of Good Sold (COGS) / Ave. Inventory
• COGS = The cost of producing or purchasing the goods sold during the period
• Average Inventory = (Beginning Inventory + Ending Inventory) / 2