Financial Ratio Analysis: Liquidity, Leverage, Turnover & Profitability

Explanation

Ratio analysis evaluates the financial health, creditworthiness, and operational efficiency of an enterprise. By establishing mathematical relationships between items in financial statements, analysts benchmark corporate performance against historical trends, competitors, and industry averages.

Key points

• Leverage Ratios: Debt-Equity Ratio = Total Debt / Shareholders' Equity; Interest Coverage Ratio = EBIT / Interest.
• Activity / Turnover Ratios: Inventory Turnover = COGS / Average Inventory; Debtors Turnover = Net Credit Sales / Average Debtors; Average Collection Period = 365 / Debtors Turnover.
• Profitability Ratios: Gross Profit Margin = (Gross Profit / Sales) · 100; Net Profit Margin = (Net Profit / Sales) · 100; Return on Equity (ROE) = (Net Profit After Tax / Net Worth) · 100; Earnings Per Share (EPS) = Net Profit / Number of Common Shares.

Example

Code examples

// Python Calculation: Financial Health Diagnostics via Ratio Analysis
def analyzeFinancials(ca, cl, stock, sales, cogs, ebit, interest, netIncome, equity, debt):
    currentRatio = ca / cl
    quickRatio = (ca - stock) / cl
    debtEquity = debt / equity
    icr = ebit / interest
    netMargin = (netIncome / sales) * 100
    roe = (netIncome / equity) * 100

    print(f"Current Ratio: {currentRatio:.2f} (Benchmark: 2.0)")
    print(f"Quick Ratio: {quickRatio:.2f} (Benchmark: 1.0)")
    print(f"Debt-to-Equity: {debtEquity:.2f}")
    print(f"Interest Coverage: {icr:.2f}x")
    print(f"Net Profit Margin: {netMargin:.2f}%")
    print(f"Return on Equity: {roe:.2f}%")

analyzeFinancials(ca=200000, cl=100000, stock=40000, sales=500000, cogs=300000, 
                  ebit=80000, interest=20000, netIncome=45000, equity=250000, debt=150000)

Exam questions

• [8 Marks] Calculate Current Ratio, Quick Ratio, Debt-Equity Ratio, Inventory Turnover Ratio, and Net Profit Margin from a given Balance Sheet and P&L statement.
• [7 Marks] Explain the significance of the Interest Coverage Ratio and Debt-Equity Ratio to a commercial bank evaluating a long-term loan proposal.