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Ratio Analysis

Author: Sophia

what's covered

This tutorial will cover the topic of ratio analysis.

Our discussion breaks down as follows:

1. Profitability Ratios
2. Liquidity Ratios
- 2a. Current Ratio
- 2b. Inventory Turnover

1. Profitability Ratios

Before we begin our discussion on ratio analysis, it's important to have an understanding of a financial ratio, which evaluates the relationship between specific items on a financial statement.

The first step of ratio analysis is calculating our profitability ratios, which measure the operating performance of a company, helping a business to understand and evaluate its performance.

Today we will be covering the following profitability ratios:

Profitability Ratio	Measurement
Rate of return on sales	Measures managerial efficiency, as well as profitability
Return on total assets	Measures the effective use of assets and managerial efficiency
Asset turnover	Measures the use of assets to make sales

term to know

Financial Ratio

Evaluates the relationship between specific items on a financial statement.

1a. Rate of Return on Sales

The formula for rate of return on sales is net income divided by net sales. This ratio will tell us how profitable we are as a business.

$R a t e space o f space R e t u r n space o n space S a l e space equals space fraction numerator N e t space I n c o m e over denominator N e t space S a l e s end fraction$

Suppose net income is $257,500 and net sales is $925,000, we would get a rate of return on sales of 27.8%.

$R a t e space o f space R e t u r n space o n space S a l e s space equals space fraction numerator 257 comma 500 over denominator 925 comma 000 end fraction space equals space 27.8 percent sign$

1b. Return on Total Assets

Next, the formula for return on total assets is income before interest expense and taxes, divided by total assets. This ratio is going to tell us how effectively we use our assets to generate income.

$R e t u r n space o n space T o t a l space A s s e t s space equals space fraction numerator I n c o m e space b e f o r e space i n t e r e s t space e x p e n s e space a n d space t a x e s over denominator T o t a l space a s s e t s end fraction$

Suppose the income before interest expense and taxes is $262,500 and total assets is $980,000, then we get a return on total assets of 26.8%.

$R e t u r n space o n space T o t a l space A s s e t s space equals space fraction numerator 262 comma 500 over denominator 980 comma 000 end fraction space equals space 26.8 percent sign$

1c. Asset Turnover Ratio

Lastly, the formula for asset turnover ratio is net sales divided by total assets. This ratio helps us measure the use of assets to make sales.

$A s s e t space T u r n o v e r space equals space fraction numerator N e t space S a l e s over denominator T o t a l space A s s e t s end fraction$

Suppose net sales is $925,000 and total assets is $980,000, we can see that our assets turn over 0.9 times during the year.

$A s s e t space T u r n o v e r space equals space fraction numerator 925 comma 000 over denominator 980 comma 000 end fraction space equals space 0.9 space t i m e s$

2. Liquidity Ratios

Now that we've learned how to calculate profitability ratios, let's turn our attention to liquidity ratios. Liquidity ratios measure the ability of a company to pay debts when they are due. In other words, they help us understand our ability to pay our debt obligations.

Today we will discuss the following liquidity ratios:

Liquidity Ratio	Measurement
Current Ratio	Measures how much in current assets a company has to pay its current liabilities
Inventory Turnover	Measures the number of times a company's inventory is sold and replaced

2a. Current Ratio

The formula for current ratio is current assets divided by current liabilities.

$C u r r e n t space R a t i o space equals space fraction numerator C u r r e n t space A s s e t s over denominator C u r r e n t space L i a b i l i t i e s end fraction$

Suppose that current assets is $580,000 and current liabilities is $155,000, we get a current ratio of 3.74, which means we have 3.74 times more current assets than we do current liabilities.

$C u r r e n t space R a t i o space equals space fraction numerator 580 comma 000 over denominator 155 comma 000 end fraction space equals space 3.74$

2b. Inventory Turnover

Now let's turn our attention to inventory turnover. Inventory turnover is calculated as cost of goods sold divided by average inventory.

$I n v e n t o r y space T u r n o v e r space equals space fraction numerator C o s t space o f space G o o d s space S o l d over denominator A v e r a g e space I n v e n t o r y end fraction$

Suppose cost of goods sold is $450,000 and average inventory is $225,000, we see that inventory turnover is 2.0 times. This is the number of times the inventory is sold and replaced.

$I n v e n t o r y space T u r n o v e r space equals space fraction numerator 450 comma 000 over denominator 225 comma 000 end fraction space equals space 2.0 space t i m e s$

It's important to note that in order for these liquidity ratios to have context, we would need to know information such as what our ratios were last year, other companies' ratios, and the industry standards.

summary

Today we learned how to perform ratio analysis. We learned how to calculate profitability ratios, looking at rate of return on sales, return on total assets, as well as asset turnover. W also learned how to calculate liquidity ratios by looking at current ratio and inventory turnover.

Source: Adapted from Sophia instructor Evan McLaughlin.

Terms to Know

Financial Ratio: Evaluates the relationship between specific items on a financial statement.