3.5.2 Ratio Analysis

• Ratio Analysis is a technique used to evaluate a company's financial performance
• Ratio Analysis involves calculating ratios to compare key financial figures.
• Match the type of ratio with its purpose:

  Profitability Ratios ↔️ Measures profitability

  Liquidity Ratios ↔️ Measures short-term debt coverage

  Efficiency Ratios ↔️ Measures asset utilization
• Order the steps involved in using Ratio Analysis to evaluate a company's financial health:

  1️⃣ Identify the financial ratios

  2️⃣ Calculate the ratios using financial data

  3️⃣ Interpret the ratio results
• What do Profitability Ratios measure?

  Company's ability to generate profits
• Liquidity Ratios assess the company's short-term financial health
• How do Efficiency Ratios evaluate a company's performance?

  By measuring asset utilization
• The Gross Profit Margin measures profitability after accounting for the cost of goods sold.
• The Net Profit Margin shows the profit left after all expenses are deducted
• What does the Return on Capital Employed (ROCE) indicate?

  How well capital generates earnings
• A Current Ratio above 1 suggests good liquidity.
• The Quick Ratio provides a more conservative measure of liquidity by excluding inventory
• What does Ratio Analysis help stakeholders understand?

  Financial strengths and weaknesses
• The Current Ratio measures a company's ability to meet short-term obligations.
• A Current Ratio of 2 indicates the company can cover its short-term debts twice
• What does the Gross Profit Margin measure?

  Profitability after cost of goods sold
• The Net Profit Margin shows the profit remaining after all expenses are deducted from revenue.
• What does the Return on Capital Employed (ROCE) indicate about a company?

  Efficiency in using capital
• A Current Ratio above 1 suggests good liquidity.
• The Quick Ratio excludes inventory
• What does the Asset Turnover Ratio measure?

  Efficiency in using assets
• A higher Inventory Turnover Ratio suggests faster inventory turnover.
• What does the Days Sales Outstanding (DSO) represent?

  Time to collect payment
• The Debt-to-Equity Ratio measures debt relative to equity
• What does the Debt-to-Capital Ratio measure?

  Debt in total capital
• What does a higher debt-to-equity ratio suggest about a company's financial risk?

  More financial risk
• The debt-to-capital ratio measures the proportion of debt in a company's total capital
• Arrange the steps involved in ratio analysis to evaluate a company's financial performance.

  1️⃣ Calculate ratios

  2️⃣ Identify strengths and weaknesses

  3️⃣ Make informed decisions
• Ratio analysis involves comparing key financial figures to understand a company's profitability, liquidity, efficiency, and solvency.
• What are the three main types of financial ratios used in ratio analysis?

  Profitability, liquidity, efficiency
• Profitability ratios measure a company's ability to generate profits relative to its revenue
• What do liquidity ratios assess about a company?

  Short-term obligations
• Efficiency ratios evaluate how well a company utilizes its assets to generate revenue.
• What does the gross profit margin measure?

  Profitability after cost of goods sold
• The net profit margin shows the profit left after all expenses
• Return on capital employed indicates how well a company uses its capital to generate earnings.
• What do liquidity ratios measure about a company?

  Ability to meet short-term obligations
• A current ratio above 1 suggests good liquidity
• Match the liquidity ratio with its formula:

  Current Ratio ↔️ $\frac{\text{Current Assets}}{\text{Current Liabilities}}$

  Quick Ratio ↔️ $\frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}$
• Both the current ratio and the quick ratio indicate good liquidity when above 1.