Calculation of Profitability Ratios Interpretation of Profitability Ratios Gross Profit Margin Gross profit margin indicates the percentage of revenue available to cover operating and other expenses and to generate profit. Operating Profit Margin Operating profit is calculated as gross profit minus operating costs. So, an operating profit margin increasing faster than the gross profit margin can…
Solvency refers to a company’s ability to fulfill its long-term debt obligations. Assessment of a company’s ability to pay its long-term obligations (i.e., to make interest and principal payments) generally includes an in-depth analysis of the components of its financial structure. Solvency ratios, introduced in earlier modules in Corporate Issuers, provide information regarding the relative…
Liquidity analysis measures a company’s ability to meet its short-term obligations. Calculation of Liquidity Ratios The defensive interval ratio measures how long a company can pay its daily cash expenditures using only its existing liquid assets, without additional cash flow coming in. Interpretation of Liquidity Ratios Current Ratio A higher current ratio indicates a higher…
Activity ratios, also known as asset utilization ratios or operating efficiency ratios, are measures of operational performance — how effectively the company is using working capital and longer term assets. Interpretation of Activity Ratios Inventory Turnover and DOH Inventory turnover indicates the resources tied up in inventory (i.e., the carrying costs) and, therefore, can be…
Interpretation and Context Financial ratios can be interpreted only in the context of other information. In general, the financial ratios of a company are compared with those of its major competitors (cross-sectional and trend analysis) and to the company’s prior periods (trend analysis). The goal is to understand the underlying causes of divergence between a…
Graphs facilitate comparison of performance and financial structure over time, highlighting changes in significant aspects of business operations. In addition, graphs provide the analyst (and management) with a visual overview of risk trends in a business. Graphs may also be used effectively to communicate the analyst’s conclusions regarding financial condition and risk management aspects. Regression…
Cross-sectional analysis (sometimes called “relative analysis”) compares a specific metric for one company with the same metric for another company or group of companies measured at the same point in time or over the same range of time, allowing comparisons even though the companies might be of significantly different sizes or operate in different currencies.…
Common-size analysis involves expressing financial data, including entire financial statements, in relation to a single financial statement item, or base. Common-Size Analysis of the Balance Sheet A vertical common-size balance sheet, prepared by dividing each item on the balance sheet by the same period’s total assets and expressing the results as percentages, highlights the composition…
Several aspects of ratio analysis are important to understand. First, the computed ratio is not “the answer.” The ratio is an indicatorof some aspect of a company’s performance, telling what happened but not why it happened. Net profit margin is calculated by dividing net income by revenue: A second important aspect of ratio analysis is that…
The analyst may also want to examine comparable performance over time. Again, the nominal currency amounts of sales or net income may not highlight significant changes. To address this challenge, horizontal financial statements (whereby quantities are stated in terms of a selected base year value) can make such changes more apparent. Another obstacle to comparison…