Financial ratios and interpretation: Calculating and analyzing various
financial ratios to evaluate a company’s performance and financial health
Introduction
Financial ratios are a useful tool for evaluating how well a company is performing
financially and gauging its overall financial health. By calculating ratios using data from a
company’s income statement, balance sheet, and cash flow statement, investors and
analysts can gain valuable insight into areas like profitability, liquidity, leverage, and
operating efficiency.
This paper will provide an overview of several key financial ratios for evaluating a company
and interpreting what the ratios convey. It will calculate ratios for a sample company using
sample financial statements. The goal is to demonstrate how to perform ratio analysis in
practice and what the calculations can tell us about the fictional company’s performance
and financial position over time.
Let’s begin with an overview of common financial ratios grouped by the key areas they
measure. Calculating and interpreting ratios will then be demonstrated using the sample
company’s financial statements.
Profitability Ratios
Profitability ratios are important indicators of how effectively a company can generate
profits from its resources and business operations. Some key profitability ratios include:
- Gross Profit Margin – Measures gross profit as a percentage of total revenue. Helps
assess pricing strategy and production/procurement costs. Calculated as (Gross
Profit/Total Revenue) x 100.
- Operating Profit Margin – Shows operating income as a percentage of total revenue.
Reflects operating costs and efficiency. Calculated as (Operating Income/Total
Revenue) x 100.
- Net Profit Margin – Indicates how much of each dollar earned translates into actual
net income. Calculated as (Net Income/Total Revenue) x 100.
- Return on Assets (ROA) – Measures how effectively the company uses its total
assets to generate earnings. Higher ROA is generally better. Calculated as (Net
Income/Total Assets) x 100.
- Return on Equity (ROE) – Assesses management effectiveness in generating profits
from shareholders’ equity. Calculated as (Net Income/Shareholders’ Equity) x 100.
Together, these ratios provide an overall view of a company’s revenue-generating
capabilities and cost management. Consistent growth in profitability ratios over time is
favorable, while declines could signal issues.
Liquidity Ratios
Liquidity refers to a company’s ability to pay off short-term debt obligations on time. Key
liquidity ratios include:
- Current Ratio – Compares current assets to current liabilities. Measures short-term
financial stability and liquidity. Calculated as (Current Assets/Current Liabilities).
- Quick Ratio – More stringent than current ratio by excluding inventories from current
assets. Calculated as (Cash + Marketable Securities + Accounts Receivable/Current
Liabilities).
- Cash Ratio – Most conservative measure using only cash and cash equivalents.
Calculated as (Cash and Cash Equivalents/Current Liabilities).
Higher ratios generally indicate stronger short-term financial position and flexibility.
However, too high liquidity could signal underutilized current assets. These ratios
complement analysis of cash flows and working capital.
Leverage Ratios
Leverage ratios examine the extent to which the company relies on borrowed funds (debt)
versus shareholders’ equity (capital) to finance its assets. Key leverage ratios include:
- Debt to Equity Ratio – Shows capability to pay back creditors if assets were
liquidated. Calculated as (Total Liabilities/Shareholders’ Equity).
- Debt Ratio – Measures total debt burden. Calculated as (Total Debt/Total Assets).
- Times Interest Earned – Assesses earnings sustainability in light of debt-servicing
ability. Calculated as (EBIT/Interest Expense).
Lower leverage provides more financial flexibility and stability. However, moderate leverage
can positively impact returns if used efficiently. Investors weigh leverage ratios against a
company’s growth plans and industry norms.
Activity/Efficiency Ratios
Activity ratios indicate how effectively the company manages its resources and operations.
They include:
- Receivables Turnover – Assesses credit and collection policies. Calculated as
(Credit Sales/Average Accounts Receivable).
- Inventory Turnover – Reflects production and inventory management efficiency.
Calculated as (COGS/Average Inventory).
- Total Asset Turnover – Shows revenue generated per dollar of assets. Calculated as
(Revenue/Total Assets).
Higher turnover ratios generally suggest strong working capital management. However, too
low could mean underutilized assets, while too high may reflect rushed sales or production
challenges. Benchmarks against industry peers provide meaningful context.
Sample Ratio Analysis
To demonstrate ratio calculation and analysis in practice, let’s use sample income
statements, balance sheets, and relevant financial extracts for a fictional company called
Johnson Ltd for the years ended December 31, 2019 and 2020:
Income Statement for year ended December 31:
(in $’000) 2019 2020
Revenue 10,000 12,000
Cost of Goods Sold (6,000) (7,200)
Gross Profit 4,000 4,800
Operating Expenses (2,000) (2,400)
Operating Income 2,000 2,400
Interest Expense (500) (400)
Net Income 1,500 2,000
Balance Sheet as at December 31:
(in $’000) 2019 2020
Current Assets
Cash 500 1,000
Accounts Receivable 2,000 2,400
Inventory 1,500 1,800
Total Current Assets 4,000 5,200
Non-Current Assets 8,000 9,000
Total Assets 12,000 14,200
Current Liabilities
Accounts Payable 2,000 2,400
Short Term Debt 1,000 800
Total Current Liabilities 3,000 3,200
Non-Current Liabilities 4,000 4,400
Shareholders’ Equity 5,000 6,600
Total Liab. & Equity 12,000 14,200
Profitability Ratios
Let’s calculate some key profitability ratios for Johnson Ltd:
Gross Profit Margin = Gross Profit/Revenue x 100
2019: Gross Profit $4,000/Revenue $10,000 x 100 = 40%
2020: Gross Profit $4,800/Revenue $12,000 x 100 = 40%
Operating Profit Margin = Operating Income/Revenue x 100
2019: Operating Income $2,000/Revenue $10,000 x 100 = 20%
2020: Operating Income $2,400/Revenue $12,000 x 100 = 20%
Net Profit Margin = Net Income/Revenue x 100
2019: Net Income $1,500/Revenue $10,000 x 100 = 15%
2020: Net Income $2,000/Revenue $12,000 x 100 = 15%
ROA = Net Income/Total Assets x 100
2019: Net Income $1,500/Total Assets $12,000 x 100 = 12.5%
2020: Net Income $2,000/Total Assets $14,200 x 100 = 14.1%
ROE = Net Income/Shareholders’ Equity x 100
2019: Net Income $1,500/Shareholders’ Equity $5,000 x 100 = 30%
2020: Net Income $2,000/Shareholders’ Equity $6,600 x 100 = 30.3%
Analysis: Johnson Ltd has maintained consistent profit margins and returns over the two
years despite revenue growth. Gross and operating margins indicate efficient operations
and pricing. ROA and ROE have increased modestly with higher profits on growing assets
and equity base. Overall profitability appears sound.
Liquidity Ratios
Let’s calculate liquidity ratios for Johnson Ltd:
Current Ratio = Current Assets/Current Liabilities
2019: Current Assets $4,000/Current Liabilities $3,000 = 1.33
2020: Current Assets $5,200/Current Liabilities $3,200 = 1.62
Quick Ratio = (Cash + Receivables)/Current Liabilities
2019: (Cash $500 + Receivables $2,000)/Current Liabilities $3,000 = 0.83
2020: (Cash $1,000 + Receivables $2,400)/Current Liabilities $3,200 = 1.03
Analysis: Johnson Ltd’s liquidity position has strengthened with higher current and quick
ratios in 2020 vs 2019. Both years’ current ratios exceed the minimum standard of 1.0. The
quick ratios are borderline but coverage has improved, suggesting adequate short-term
financial flexibility exists.
Leverage Ratios
Now let’s examine Johnson Ltd’s leverage:
Debt to Equity Ratio = Total Liabilities/Shareholders’ Equity
2019: Total Liabilities $7,000/Shareholders’ Equity $5,000 = 1.4
2020: Total Liabilities $8,000/Shareholders’ Equity $6,600 = 1.21
Debt Ratio = Total Liabilities/Total Assets
2019: Total Liabilities $7,000/Total Assets $12,000 = 0.58
2020: Total Liabilities $8,000/Total Assets $14,200 = 0.56
Times Interest Earned = EBIT/Interest Expense
2019: EBIT $2,000/Interest Expense $500 = 4
2020: EBIT $2,400/Interest Expense $400 = 6
Analysis: Leverage has declined slightly, as debt loads fell relative to growing assets and
equity. Debt ratios are at moderate-to-conservative levels that interest coverage more than
supports. Overall, leverage provides funding for growth without undue financial risk.
Activity Ratios
Finally, let’s examine Johnson Ltd’s operating efficiency:
Receivables Turnover = Credit Sales/Average Receivables
2019: Assume Credit Sales = Revenue $10,000
Average Receivables = ($2,000 + X)/2 = $2,000
Turnover = $10,000/$2,000 = 5
2020: Assume Credit Sales = Revenue $12,000
Average Receivables = ($2,000 + $2,400)/2 = $2,200
Turnover = $12,000/$2,200 = 5.45
Inventory Turnover = Cost of Goods Sold/Average Inventory
2019: COGS $6,000, Average Inventory = ($1,500 + X)/2 = $1,500
Turnover = $6,000/$1,500 = 4
2020: COGS $7,200, Average Inventory = ($1,500 + $1,800)/2 = $1,650
Turnover = $7,200/$1,650 = 4.36
Total Asset Turnover = Revenue/Total Assets
2019: Revenue $10,000/Total Assets $12,000 = 0.83
2020: Revenue $12,000/Total Assets $14,200 = 0.85
Analysis: Johnson Ltd’s activity ratios have generally improved, indicating growing
efficiency in working capital management. Receivables and inventory turnovers are in a
healthy range. Total asset turnover indicates solid revenue generation from invested capital
base.
Conclusion
Through calculating various key financial ratios using Johnson Ltd’s sample income
statements and balance sheets, this analysis has demonstrated how to evaluate different
facets of a company’s financial performance and position over time.
Johnson Ltd appears to be generating consistent profitability while maintaining adequate
liquidity and moderate, controlled leverage. Activity ratios also point to improving
operational efficiency. However, certain limitations are inherent in ratio analysis of fictional
sample data without additional contextual information.
In real analysis of public companies, ratios would need to be compared to industry peers
and benchmarks. Trends over multiple periods would need assessing as well. Additional
tools like common size statements and cash flow analysis could provide further insights.
Nonetheless, this sample ratio calculation and interpretation exercise illustrates the value
of financial ratio analysis for evaluating a company’s strengths, weaknesses, and overall
financial health holistically across key metrics. With appropriate context, ratios are a useful
starting point in fundamental investment analysis.
Introduction
Financial ratios are a useful tool for evaluating how well a company is performing
financially and gauging its overall financial health. By calculating ratios using data from a
company’s income statement, balance sheet, and cash flow statement, investors and
analysts can gain valuable insight into areas like profitability, liquidity, leverage, and
operating efficiency.
This paper will provide an overview of several key financial ratios for evaluating a company
and interpreting what the ratios convey. It will calculate ratios for a sample company using
sample financial statements. The goal is to demonstrate how to perform ratio analysis in
practice and what the calculations can tell us about the fictional company’s performance
and financial position over time.
Let’s begin with an overview of common financial ratios grouped by the key areas they
measure. Calculating and interpreting ratios will then be demonstrated using the sample
company’s financial statements.
Profitability Ratios
Profitability ratios are important indicators of how effectively a company can generate
profits from its resources and business operations. Some key profitability ratios include:
- Gross Profit Margin – Measures gross profit as a percentage of total revenue. Helps
assess pricing strategy and production/procurement costs. Calculated as (Gross
Profit/Total Revenue) x 100.
- Operating Profit Margin – Shows operating income as a percentage of total revenue.
Reflects operating costs and efficiency. Calculated as (Operating Income/Total
Revenue) x 100.
- Net Profit Margin – Indicates how much of each dollar earned translates into actual
net income. Calculated as (Net Income/Total Revenue) x 100.
- Return on Assets (ROA) – Measures how effectively the company uses its total
assets to generate earnings. Higher ROA is generally better. Calculated as (Net
Income/Total Assets) x 100.
- Return on Equity (ROE) – Assesses management effectiveness in generating profits
from shareholders’ equity. Calculated as (Net Income/Shareholders’ Equity) x 100.
Together, these ratios provide an overall view of a company’s revenue-generating
capabilities and cost management. Consistent growth in profitability ratios over time is
favorable, while declines could signal issues.
Liquidity Ratios
Liquidity refers to a company’s ability to pay off short-term debt obligations on time. Key
liquidity ratios include:
- Current Ratio – Compares current assets to current liabilities. Measures short-term
financial stability and liquidity. Calculated as (Current Assets/Current Liabilities).
- Quick Ratio – More stringent than current ratio by excluding inventories from current
assets. Calculated as (Cash + Marketable Securities + Accounts Receivable/Current
Liabilities).
- Cash Ratio – Most conservative measure using only cash and cash equivalents.
Calculated as (Cash and Cash Equivalents/Current Liabilities).
Higher ratios generally indicate stronger short-term financial position and flexibility.
However, too high liquidity could signal underutilized current assets. These ratios
complement analysis of cash flows and working capital.
Leverage Ratios
Leverage ratios examine the extent to which the company relies on borrowed funds (debt)
versus shareholders’ equity (capital) to finance its assets. Key leverage ratios include:
- Debt to Equity Ratio – Shows capability to pay back creditors if assets were
liquidated. Calculated as (Total Liabilities/Shareholders’ Equity).
- Debt Ratio – Measures total debt burden. Calculated as (Total Debt/Total Assets).
- Times Interest Earned – Assesses earnings sustainability in light of debt-servicing
ability. Calculated as (EBIT/Interest Expense).
Lower leverage provides more financial flexibility and stability. However, moderate leverage
can positively impact returns if used efficiently. Investors weigh leverage ratios against a
company’s growth plans and industry norms.
Activity/Efficiency Ratios
Activity ratios indicate how effectively the company manages its resources and operations.
They include:
- Receivables Turnover – Assesses credit and collection policies. Calculated as
(Credit Sales/Average Accounts Receivable).
- Inventory Turnover – Reflects production and inventory management efficiency.
Calculated as (COGS/Average Inventory).
- Total Asset Turnover – Shows revenue generated per dollar of assets. Calculated as
(Revenue/Total Assets).
Higher turnover ratios generally suggest strong working capital management. However, too
low could mean underutilized assets, while too high may reflect rushed sales or production
challenges. Benchmarks against industry peers provide meaningful context.
Sample Ratio Analysis
To demonstrate ratio calculation and analysis in practice, let’s use sample income
statements, balance sheets, and relevant financial extracts for a fictional company called
Johnson Ltd for the years ended December 31, 2019 and 2020:
Income Statement for year ended December 31:
(in $’000) 2019 2020
Revenue 10,000 12,000
Cost of Goods Sold (6,000) (7,200)
Gross Profit 4,000 4,800
Operating Expenses (2,000) (2,400)
Operating Income 2,000 2,400
Interest Expense (500) (400)
Net Income 1,500 2,000
Balance Sheet as at December 31:
(in $’000) 2019 2020
Current Assets
Cash 500 1,000
Accounts Receivable 2,000 2,400
Inventory 1,500 1,800
Total Current Assets 4,000 5,200
Non-Current Assets 8,000 9,000
Total Assets 12,000 14,200
Current Liabilities
Accounts Payable 2,000 2,400
Short Term Debt 1,000 800
Total Current Liabilities 3,000 3,200
Non-Current Liabilities 4,000 4,400
Shareholders’ Equity 5,000 6,600
Total Liab. & Equity 12,000 14,200
Profitability Ratios
Let’s calculate some key profitability ratios for Johnson Ltd:
Gross Profit Margin = Gross Profit/Revenue x 100
2019: Gross Profit $4,000/Revenue $10,000 x 100 = 40%
2020: Gross Profit $4,800/Revenue $12,000 x 100 = 40%
Operating Profit Margin = Operating Income/Revenue x 100
2019: Operating Income $2,000/Revenue $10,000 x 100 = 20%
2020: Operating Income $2,400/Revenue $12,000 x 100 = 20%
Net Profit Margin = Net Income/Revenue x 100
2019: Net Income $1,500/Revenue $10,000 x 100 = 15%
2020: Net Income $2,000/Revenue $12,000 x 100 = 15%
ROA = Net Income/Total Assets x 100
2019: Net Income $1,500/Total Assets $12,000 x 100 = 12.5%
2020: Net Income $2,000/Total Assets $14,200 x 100 = 14.1%
ROE = Net Income/Shareholders’ Equity x 100
2019: Net Income $1,500/Shareholders’ Equity $5,000 x 100 = 30%
2020: Net Income $2,000/Shareholders’ Equity $6,600 x 100 = 30.3%
Analysis: Johnson Ltd has maintained consistent profit margins and returns over the two
years despite revenue growth. Gross and operating margins indicate efficient operations
and pricing. ROA and ROE have increased modestly with higher profits on growing assets
and equity base. Overall profitability appears sound.
Liquidity Ratios
Let’s calculate liquidity ratios for Johnson Ltd:
Current Ratio = Current Assets/Current Liabilities
2019: Current Assets $4,000/Current Liabilities $3,000 = 1.33
2020: Current Assets $5,200/Current Liabilities $3,200 = 1.62
Quick Ratio = (Cash + Receivables)/Current Liabilities
2019: (Cash $500 + Receivables $2,000)/Current Liabilities $3,000 = 0.83
2020: (Cash $1,000 + Receivables $2,400)/Current Liabilities $3,200 = 1.03
Analysis: Johnson Ltd’s liquidity position has strengthened with higher current and quick
ratios in 2020 vs 2019. Both years’ current ratios exceed the minimum standard of 1.0. The
quick ratios are borderline but coverage has improved, suggesting adequate short-term
financial flexibility exists.
Leverage Ratios
Now let’s examine Johnson Ltd’s leverage:
Debt to Equity Ratio = Total Liabilities/Shareholders’ Equity
2019: Total Liabilities $7,000/Shareholders’ Equity $5,000 = 1.4
2020: Total Liabilities $8,000/Shareholders’ Equity $6,600 = 1.21
Debt Ratio = Total Liabilities/Total Assets
2019: Total Liabilities $7,000/Total Assets $12,000 = 0.58
2020: Total Liabilities $8,000/Total Assets $14,200 = 0.56
Times Interest Earned = EBIT/Interest Expense
2019: EBIT $2,000/Interest Expense $500 = 4
2020: EBIT $2,400/Interest Expense $400 = 6
Analysis: Leverage has declined slightly, as debt loads fell relative to growing assets and
equity. Debt ratios are at moderate-to-conservative levels that interest coverage more than
supports. Overall, leverage provides funding for growth without undue financial risk.
Activity Ratios
Finally, let’s examine Johnson Ltd’s operating efficiency:
Receivables Turnover = Credit Sales/Average Receivables
2019: Assume Credit Sales = Revenue $10,000
Average Receivables = ($2,000 + X)/2 = $2,000
Turnover = $10,000/$2,000 = 5
2020: Assume Credit Sales = Revenue $12,000
Average Receivables = ($2,000 + $2,400)/2 = $2,200
Turnover = $12,000/$2,200 = 5.45
Inventory Turnover = Cost of Goods Sold/Average Inventory
2019: COGS $6,000, Average Inventory = ($1,500 + X)/2 = $1,500
Turnover = $6,000/$1,500 = 4
2020: COGS $7,200, Average Inventory = ($1,500 + $1,800)/2 = $1,650
Turnover = $7,200/$1,650 = 4.36
Total Asset Turnover = Revenue/Total Assets
2019: Revenue $10,000/Total Assets $12,000 = 0.83
2020: Revenue $12,000/Total Assets $14,200 = 0.85
Analysis: Johnson Ltd’s activity ratios have generally improved, indicating growing
efficiency in working capital management. Receivables and inventory turnovers are in a
healthy range. Total asset turnover indicates solid revenue generation from invested capital
base.
Conclusion
Through calculating various key financial ratios using Johnson Ltd’s sample income
statements and balance sheets, this analysis has demonstrated how to evaluate different
facets of a company’s financial performance and position over time.
Johnson Ltd appears to be generating consistent profitability while maintaining adequate
liquidity and moderate, controlled leverage. Activity ratios also point to improving
operational efficiency. However, certain limitations are inherent in ratio analysis of fictional
sample data without additional contextual information.
In real analysis of public companies, ratios would need to be compared to industry peers
and benchmarks. Trends over multiple periods would need assessing as well. Additional
tools like common size statements and cash flow analysis could provide further insights.
Nonetheless, this sample ratio calculation and interpretation exercise illustrates the value
of financial ratio analysis for evaluating a company’s strengths, weaknesses, and overall
financial health holistically across key metrics. With appropriate context, ratios are a useful
starting point in fundamental investment analysis.
Introduction
Financial ratios are a useful tool for evaluating how well a company is performing
financially and gauging its overall financial health. By calculating ratios using data from a
company’s income statement, balance sheet, and cash flow statement, investors and
analysts can gain valuable insight into areas like profitability, liquidity, leverage, and
operating efficiency.
This paper will provide an overview of several key financial ratios for evaluating a company
and interpreting what the ratios convey. It will calculate ratios for a sample company using
sample financial statements. The goal is to demonstrate how to perform ratio analysis in
practice and what the calculations can tell us about the fictional company’s performance
and financial position over time.
Let’s begin with an overview of common financial ratios grouped by the key areas they
measure. Calculating and interpreting ratios will then be demonstrated using the sample
company’s financial statements.
Profitability Ratios
Profitability ratios are important indicators of how effectively a company can generate
profits from its resources and business operations. Some key profitability ratios include:
- Gross Profit Margin – Measures gross profit as a percentage of total revenue. Helps
assess pricing strategy and production/procurement costs. Calculated as (Gross
Profit/Total Revenue) x 100.
- Operating Profit Margin – Shows operating income as a percentage of total revenue.
Reflects operating costs and efficiency. Calculated as (Operating Income/Total
Revenue) x 100.
- Net Profit Margin – Indicates how much of each dollar earned translates into actual
net income. Calculated as (Net Income/Total Revenue) x 100.
- Return on Assets (ROA) – Measures how effectively the company uses its total
assets to generate earnings. Higher ROA is generally better. Calculated as (Net
Income/Total Assets) x 100.
- Return on Equity (ROE) – Assesses management effectiveness in generating profits
from shareholders’ equity. Calculated as (Net Income/Shareholders’ Equity) x 100.
Together, these ratios provide an overall view of a company’s revenue-generating
capabilities and cost management. Consistent growth in profitability ratios over time is
favorable, while declines could signal issues.
Liquidity Ratios
Liquidity refers to a company’s ability to pay off short-term debt obligations on time. Key
liquidity ratios include:
- Current Ratio – Compares current assets to current liabilities. Measures short-term
financial stability and liquidity. Calculated as (Current Assets/Current Liabilities).
- Quick Ratio – More stringent than current ratio by excluding inventories from current
assets. Calculated as (Cash + Marketable Securities + Accounts Receivable/Current
Liabilities).
- Cash Ratio – Most conservative measure using only cash and cash equivalents.
Calculated as (Cash and Cash Equivalents/Current Liabilities).
Higher ratios generally indicate stronger short-term financial position and flexibility.
However, too high liquidity could signal underutilized current assets. These ratios
complement analysis of cash flows and working capital.
Leverage Ratios
Leverage ratios examine the extent to which the company relies on borrowed funds (debt)
versus shareholders’ equity (capital) to finance its assets. Key leverage ratios include:
- Debt to Equity Ratio – Shows capability to pay back creditors if assets were
liquidated. Calculated as (Total Liabilities/Shareholders’ Equity).
- Debt Ratio – Measures total debt burden. Calculated as (Total Debt/Total Assets).
- Times Interest Earned – Assesses earnings sustainability in light of debt-servicing
ability. Calculated as (EBIT/Interest Expense).
Lower leverage provides more financial flexibility and stability. However, moderate leverage
can positively impact returns if used efficiently. Investors weigh leverage ratios against a
company’s growth plans and industry norms.
Activity/Efficiency Ratios
Activity ratios indicate how effectively the company manages its resources and operations.
They include:
- Receivables Turnover – Assesses credit and collection policies. Calculated as
(Credit Sales/Average Accounts Receivable).
- Inventory Turnover – Reflects production and inventory management efficiency.
Calculated as (COGS/Average Inventory).
- Total Asset Turnover – Shows revenue generated per dollar of assets. Calculated as
(Revenue/Total Assets).
Higher turnover ratios generally suggest strong working capital management. However, too
low could mean underutilized assets, while too high may reflect rushed sales or production
challenges. Benchmarks against industry peers provide meaningful context.
Sample Ratio Analysis
To demonstrate ratio calculation and analysis in practice, let’s use sample income
statements, balance sheets, and relevant financial extracts for a fictional company called
Johnson Ltd for the years ended December 31, 2019 and 2020:
Income Statement for year ended December 31:
(in $’000) 2019 2020
Revenue 10,000 12,000
Cost of Goods Sold (6,000) (7,200)
Gross Profit 4,000 4,800
Operating Expenses (2,000) (2,400)
Operating Income 2,000 2,400
Interest Expense (500) (400)
Net Income 1,500 2,000
Balance Sheet as at December 31:
(in $’000) 2019 2020
Current Assets
Cash 500 1,000
Accounts Receivable 2,000 2,400
Inventory 1,500 1,800
Total Current Assets 4,000 5,200
Non-Current Assets 8,000 9,000
Total Assets 12,000 14,200
Current Liabilities
Accounts Payable 2,000 2,400
Short Term Debt 1,000 800
Total Current Liabilities 3,000 3,200
Non-Current Liabilities 4,000 4,400
Shareholders’ Equity 5,000 6,600
Total Liab. & Equity 12,000 14,200
Profitability Ratios
Let’s calculate some key profitability ratios for Johnson Ltd:
Gross Profit Margin = Gross Profit/Revenue x 100
2019: Gross Profit $4,000/Revenue $10,000 x 100 = 40%
2020: Gross Profit $4,800/Revenue $12,000 x 100 = 40%
Operating Profit Margin = Operating Income/Revenue x 100
2019: Operating Income $2,000/Revenue $10,000 x 100 = 20%
2020: Operating Income $2,400/Revenue $12,000 x 100 = 20%
Net Profit Margin = Net Income/Revenue x 100
2019: Net Income $1,500/Revenue $10,000 x 100 = 15%
2020: Net Income $2,000/Revenue $12,000 x 100 = 15%
ROA = Net Income/Total Assets x 100
2019: Net Income $1,500/Total Assets $12,000 x 100 = 12.5%
2020: Net Income $2,000/Total Assets $14,200 x 100 = 14.1%
ROE = Net Income/Shareholders’ Equity x 100
2019: Net Income $1,500/Shareholders’ Equity $5,000 x 100 = 30%
2020: Net Income $2,000/Shareholders’ Equity $6,600 x 100 = 30.3%
Analysis: Johnson Ltd has maintained consistent profit margins and returns over the two
years despite revenue growth. Gross and operating margins indicate efficient operations
and pricing. ROA and ROE have increased modestly with higher profits on growing assets
and equity base. Overall profitability appears sound.
Liquidity Ratios
Let’s calculate liquidity ratios for Johnson Ltd:
Current Ratio = Current Assets/Current Liabilities
2019: Current Assets $4,000/Current Liabilities $3,000 = 1.33
2020: Current Assets $5,200/Current Liabilities $3,200 = 1.62
Quick Ratio = (Cash + Receivables)/Current Liabilities
2019: (Cash $500 + Receivables $2,000)/Current Liabilities $3,000 = 0.83
2020: (Cash $1,000 + Receivables $2,400)/Current Liabilities $3,200 = 1.03
Analysis: Johnson Ltd’s liquidity position has strengthened with higher current and quick
ratios in 2020 vs 2019. Both years’ current ratios exceed the minimum standard of 1.0. The
quick ratios are borderline but coverage has improved, suggesting adequate short-term
financial flexibility exists.
Leverage Ratios
Now let’s examine Johnson Ltd’s leverage:
Debt to Equity Ratio = Total Liabilities/Shareholders’ Equity
2019: Total Liabilities $7,000/Shareholders’ Equity $5,000 = 1.4
2020: Total Liabilities $8,000/Shareholders’ Equity $6,600 = 1.21
Debt Ratio = Total Liabilities/Total Assets
2019: Total Liabilities $7,000/Total Assets $12,000 = 0.58
2020: Total Liabilities $8,000/Total Assets $14,200 = 0.56
Times Interest Earned = EBIT/Interest Expense
2019: EBIT $2,000/Interest Expense $500 = 4
2020: EBIT $2,400/Interest Expense $400 = 6
Analysis: Leverage has declined slightly, as debt loads fell relative to growing assets and
equity. Debt ratios are at moderate-to-conservative levels that interest coverage more than
supports. Overall, leverage provides funding for growth without undue financial risk.
Activity Ratios
Finally, let’s examine Johnson Ltd’s operating efficiency:
Receivables Turnover = Credit Sales/Average Receivables
2019: Assume Credit Sales = Revenue $10,000
Average Receivables = ($2,000 + X)/2 = $2,000
Turnover = $10,000/$2,000 = 5
2020: Assume Credit Sales = Revenue $12,000
Average Receivables = ($2,000 + $2,400)/2 = $2,200
Turnover = $12,000/$2,200 = 5.45
Inventory Turnover = Cost of Goods Sold/Average Inventory
2019: COGS $6,000, Average Inventory = ($1,500 + X)/2 = $1,500
Turnover = $6,000/$1,500 = 4
2020: COGS $7,200, Average Inventory = ($1,500 + $1,800)/2 = $1,650
Turnover = $7,200/$1,650 = 4.36
Total Asset Turnover = Revenue/Total Assets
2019: Revenue $10,000/Total Assets $12,000 = 0.83
2020: Revenue $12,000/Total Assets $14,200 = 0.85
Analysis: Johnson Ltd’s activity ratios have generally improved, indicating growing
efficiency in working capital management. Receivables and inventory turnovers are in a
healthy range. Total asset turnover indicates solid revenue generation from invested capital
base.
Conclusion
Through calculating various key financial ratios using Johnson Ltd’s sample income
statements and balance sheets, this analysis has demonstrated how to evaluate different
facets of a company’s financial performance and position over time.
Johnson Ltd appears to be generating consistent profitability while maintaining adequate
liquidity and moderate, controlled leverage. Activity ratios also point to improving
operational efficiency. However, certain limitations are inherent in ratio analysis of fictional
sample data without additional contextual information.
In real analysis of public companies, ratios would need to be compared to industry peers
and benchmarks. Trends over multiple periods would need assessing as well. Additional
tools like common size statements and cash flow analysis could provide further insights.
Nonetheless, this sample ratio calculation and interpretation exercise illustrates the value
of financial ratio analysis for evaluating a company’s strengths, weaknesses, and overall
financial health holistically across key metrics. With appropriate context, ratios are a useful
starting point in fundamental investment analysis.
Introduction
Financial ratios are a useful tool for evaluating how well a company is performing
financially and gauging its overall financial health. By calculating ratios using data from a
company’s income statement, balance sheet, and cash flow statement, investors and
analysts can gain valuable insight into areas like profitability, liquidity, leverage, and
operating efficiency.
This paper will provide an overview of several key financial ratios for evaluating a company
and interpreting what the ratios convey. It will calculate ratios for a sample company using
sample financial statements. The goal is to demonstrate how to perform ratio analysis in
practice and what the calculations can tell us about the fictional company’s performance
and financial position over time.
Let’s begin with an overview of common financial ratios grouped by the key areas they
measure. Calculating and interpreting ratios will then be demonstrated using the sample
company’s financial statements.
Profitability Ratios
Profitability ratios are important indicators of how effectively a company can generate
profits from its resources and business operations. Some key profitability ratios include:
- Gross Profit Margin – Measures gross profit as a percentage of total revenue. Helps
assess pricing strategy and production/procurement costs. Calculated as (Gross
Profit/Total Revenue) x 100.
- Operating Profit Margin – Shows operating income as a percentage of total revenue.
Reflects operating costs and efficiency. Calculated as (Operating Income/Total
Revenue) x 100.
- Net Profit Margin – Indicates how much of each dollar earned translates into actual
net income. Calculated as (Net Income/Total Revenue) x 100.
- Return on Assets (ROA) – Measures how effectively the company uses its total
assets to generate earnings. Higher ROA is generally better. Calculated as (Net
Income/Total Assets) x 100.
- Return on Equity (ROE) – Assesses management effectiveness in generating profits
from shareholders’ equity. Calculated as (Net Income/Shareholders’ Equity) x 100.
Together, these ratios provide an overall view of a company’s revenue-generating
capabilities and cost management. Consistent growth in profitability ratios over time is
favorable, while declines could signal issues.
Liquidity Ratios
Liquidity refers to a company’s ability to pay off short-term debt obligations on time. Key
liquidity ratios include:
- Current Ratio – Compares current assets to current liabilities. Measures short-term
financial stability and liquidity. Calculated as (Current Assets/Current Liabilities).
- Quick Ratio – More stringent than current ratio by excluding inventories from current
assets. Calculated as (Cash + Marketable Securities + Accounts Receivable/Current
Liabilities).
- Cash Ratio – Most conservative measure using only cash and cash equivalents.
Calculated as (Cash and Cash Equivalents/Current Liabilities).
Higher ratios generally indicate stronger short-term financial position and flexibility.
However, too high liquidity could signal underutilized current assets. These ratios
complement analysis of cash flows and working capital.
Leverage Ratios
Leverage ratios examine the extent to which the company relies on borrowed funds (debt)
versus shareholders’ equity (capital) to finance its assets. Key leverage ratios include:
- Debt to Equity Ratio – Shows capability to pay back creditors if assets were
liquidated. Calculated as (Total Liabilities/Shareholders’ Equity).
- Debt Ratio – Measures total debt burden. Calculated as (Total Debt/Total Assets).
- Times Interest Earned – Assesses earnings sustainability in light of debt-servicing
ability. Calculated as (EBIT/Interest Expense).
Lower leverage provides more financial flexibility and stability. However, moderate leverage
can positively impact returns if used efficiently. Investors weigh leverage ratios against a
company’s growth plans and industry norms.
Activity/Efficiency Ratios
Activity ratios indicate how effectively the company manages its resources and operations.
They include:
- Receivables Turnover – Assesses credit and collection policies. Calculated as
(Credit Sales/Average Accounts Receivable).
- Inventory Turnover – Reflects production and inventory management efficiency.
Calculated as (COGS/Average Inventory).
- Total Asset Turnover – Shows revenue generated per dollar of assets. Calculated as
(Revenue/Total Assets).
Higher turnover ratios generally suggest strong working capital management. However, too
low could mean underutilized assets, while too high may reflect rushed sales or production
challenges. Benchmarks against industry peers provide meaningful context.
Sample Ratio Analysis
To demonstrate ratio calculation and analysis in practice, let’s use sample income
statements, balance sheets, and relevant financial extracts for a fictional company called
Johnson Ltd for the years ended December 31, 2019 and 2020:
Income Statement for year ended December 31:
(in $’000) 2019 2020
Revenue 10,000 12,000
Cost of Goods Sold (6,000) (7,200)
Gross Profit 4,000 4,800
Operating Expenses (2,000) (2,400)
Operating Income 2,000 2,400
Interest Expense (500) (400)
Net Income 1,500 2,000
Balance Sheet as at December 31:
(in $’000) 2019 2020
Current Assets
Cash 500 1,000
Accounts Receivable 2,000 2,400
Inventory 1,500 1,800
Total Current Assets 4,000 5,200
Non-Current Assets 8,000 9,000
Total Assets 12,000 14,200
Current Liabilities
Accounts Payable 2,000 2,400
Short Term Debt 1,000 800
Total Current Liabilities 3,000 3,200
Non-Current Liabilities 4,000 4,400
Shareholders’ Equity 5,000 6,600
Total Liab. & Equity 12,000 14,200
Profitability Ratios
Let’s calculate some key profitability ratios for Johnson Ltd:
Gross Profit Margin = Gross Profit/Revenue x 100
2019: Gross Profit $4,000/Revenue $10,000 x 100 = 40%
2020: Gross Profit $4,800/Revenue $12,000 x 100 = 40%
Operating Profit Margin = Operating Income/Revenue x 100
2019: Operating Income $2,000/Revenue $10,000 x 100 = 20%
2020: Operating Income $2,400/Revenue $12,000 x 100 = 20%
Net Profit Margin = Net Income/Revenue x 100
2019: Net Income $1,500/Revenue $10,000 x 100 = 15%
2020: Net Income $2,000/Revenue $12,000 x 100 = 15%
ROA = Net Income/Total Assets x 100
2019: Net Income $1,500/Total Assets $12,000 x 100 = 12.5%
2020: Net Income $2,000/Total Assets $14,200 x 100 = 14.1%
ROE = Net Income/Shareholders’ Equity x 100
2019: Net Income $1,500/Shareholders’ Equity $5,000 x 100 = 30%
2020: Net Income $2,000/Shareholders’ Equity $6,600 x 100 = 30.3%
Analysis: Johnson Ltd has maintained consistent profit margins and returns over the two
years despite revenue growth. Gross and operating margins indicate efficient operations
and pricing. ROA and ROE have increased modestly with higher profits on growing assets
and equity base. Overall profitability appears sound.
Liquidity Ratios
Let’s calculate liquidity ratios for Johnson Ltd:
Current Ratio = Current Assets/Current Liabilities
2019: Current Assets $4,000/Current Liabilities $3,000 = 1.33
2020: Current Assets $5,200/Current Liabilities $3,200 = 1.62
Quick Ratio = (Cash + Receivables)/Current Liabilities
2019: (Cash $500 + Receivables $2,000)/Current Liabilities $3,000 = 0.83
2020: (Cash $1,000 + Receivables $2,400)/Current Liabilities $3,200 = 1.03
Analysis: Johnson Ltd’s liquidity position has strengthened with higher current and quick
ratios in 2020 vs 2019. Both years’ current ratios exceed the minimum standard of 1.0. The
quick ratios are borderline but coverage has improved, suggesting adequate short-term
financial flexibility exists.
Leverage Ratios
Now let’s examine Johnson Ltd’s leverage:
Debt to Equity Ratio = Total Liabilities/Shareholders’ Equity
2019: Total Liabilities $7,000/Shareholders’ Equity $5,000 = 1.4
2020: Total Liabilities $8,000/Shareholders’ Equity $6,600 = 1.21
Debt Ratio = Total Liabilities/Total Assets
2019: Total Liabilities $7,000/Total Assets $12,000 = 0.58
2020: Total Liabilities $8,000/Total Assets $14,200 = 0.56
Times Interest Earned = EBIT/Interest Expense
2019: EBIT $2,000/Interest Expense $500 = 4
2020: EBIT $2,400/Interest Expense $400 = 6
Analysis: Leverage has declined slightly, as debt loads fell relative to growing assets and
equity. Debt ratios are at moderate-to-conservative levels that interest coverage more than
supports. Overall, leverage provides funding for growth without undue financial risk.
Activity Ratios
Finally, let’s examine Johnson Ltd’s operating efficiency:
Receivables Turnover = Credit Sales/Average Receivables
2019: Assume Credit Sales = Revenue $10,000
Average Receivables = ($2,000 + X)/2 = $2,000
Turnover = $10,000/$2,000 = 5
2020: Assume Credit Sales = Revenue $12,000
Average Receivables = ($2,000 + $2,400)/2 = $2,200
Turnover = $12,000/$2,200 = 5.45
Inventory Turnover = Cost of Goods Sold/Average Inventory
2019: COGS $6,000, Average Inventory = ($1,500 + X)/2 = $1,500
Turnover = $6,000/$1,500 = 4
2020: COGS $7,200, Average Inventory = ($1,500 + $1,800)/2 = $1,650
Turnover = $7,200/$1,650 = 4.36
Total Asset Turnover = Revenue/Total Assets
2019: Revenue $10,000/Total Assets $12,000 = 0.83
2020: Revenue $12,000/Total Assets $14,200 = 0.85
Analysis: Johnson Ltd’s activity ratios have generally improved, indicating growing
efficiency in working capital management. Receivables and inventory turnovers are in a
healthy range. Total asset turnover indicates solid revenue generation from invested capital
base.
Conclusion
Through calculating various key financial ratios using Johnson Ltd’s sample income
statements and balance sheets, this analysis has demonstrated how to evaluate different
facets of a company’s financial performance and position over time.
Johnson Ltd appears to be generating consistent profitability while maintaining adequate
liquidity and moderate, controlled leverage. Activity ratios also point to improving
operational efficiency. However, certain limitations are inherent in ratio analysis of fictional
sample data without additional contextual information.
In real analysis of public companies, ratios would need to be compared to industry peers
and benchmarks. Trends over multiple periods would need assessing as well. Additional
tools like common size statements and cash flow analysis could provide further insights.
Nonetheless, this sample ratio calculation and interpretation exercise illustrates the value
of financial ratio analysis for evaluating a company’s strengths, weaknesses, and overall
financial health holistically across key metrics. With appropriate context, ratios are a useful
starting point in fundamental investment analysis.
Introduction
Financial ratios are a useful tool for evaluating how well a company is performing
financially and gauging its overall financial health. By calculating ratios using data from a
company’s income statement, balance sheet, and cash flow statement, investors and
analysts can gain valuable insight into areas like profitability, liquidity, leverage, and
operating efficiency.
This paper will provide an overview of several key financial ratios for evaluating a company
and interpreting what the ratios convey. It will calculate ratios for a sample company using
sample financial statements. The goal is to demonstrate how to perform ratio analysis in
practice and what the calculations can tell us about the fictional company’s performance
and financial position over time.
Let’s begin with an overview of common financial ratios grouped by the key areas they
measure. Calculating and interpreting ratios will then be demonstrated using the sample
company’s financial statements.
Profitability Ratios
Profitability ratios are important indicators of how effectively a company can generate
profits from its resources and business operations. Some key profitability ratios include:
- Gross Profit Margin – Measures gross profit as a percentage of total revenue. Helps
assess pricing strategy and production/procurement costs. Calculated as (Gross
Profit/Total Revenue) x 100.
- Operating Profit Margin – Shows operating income as a percentage of total revenue.
Reflects operating costs and efficiency. Calculated as (Operating Income/Total
Revenue) x 100.
- Net Profit Margin – Indicates how much of each dollar earned translates into actual
net income. Calculated as (Net Income/Total Revenue) x 100.
- Return on Assets (ROA) – Measures how effectively the company uses its total
assets to generate earnings. Higher ROA is generally better. Calculated as (Net
Income/Total Assets) x 100.
- Return on Equity (ROE) – Assesses management effectiveness in generating profits
from shareholders’ equity. Calculated as (Net Income/Shareholders’ Equity) x 100.
Together, these ratios provide an overall view of a company’s revenue-generating
capabilities and cost management. Consistent growth in profitability ratios over time is
favorable, while declines could signal issues.
Liquidity Ratios
Liquidity refers to a company’s ability to pay off short-term debt obligations on time. Key
liquidity ratios include:
- Current Ratio – Compares current assets to current liabilities. Measures short-term
financial stability and liquidity. Calculated as (Current Assets/Current Liabilities).
- Quick Ratio – More stringent than current ratio by excluding inventories from current
assets. Calculated as (Cash + Marketable Securities + Accounts Receivable/Current
Liabilities).
- Cash Ratio – Most conservative measure using only cash and cash equivalents.
Calculated as (Cash and Cash Equivalents/Current Liabilities).
Higher ratios generally indicate stronger short-term financial position and flexibility.
However, too high liquidity could signal underutilized current assets. These ratios
complement analysis of cash flows and working capital.
Leverage Ratios
Leverage ratios examine the extent to which the company relies on borrowed funds (debt)
versus shareholders’ equity (capital) to finance its assets. Key leverage ratios include:
- Debt to Equity Ratio – Shows capability to pay back creditors if assets were
liquidated. Calculated as (Total Liabilities/Shareholders’ Equity).
- Debt Ratio – Measures total debt burden. Calculated as (Total Debt/Total Assets).
- Times Interest Earned – Assesses earnings sustainability in light of debt-servicing
ability. Calculated as (EBIT/Interest Expense).
Lower leverage provides more financial flexibility and stability. However, moderate leverage
can positively impact returns if used efficiently. Investors weigh leverage ratios against a
company’s growth plans and industry norms.
Activity/Efficiency Ratios
Activity ratios indicate how effectively the company manages its resources and operations.
They include:
- Receivables Turnover – Assesses credit and collection policies. Calculated as
(Credit Sales/Average Accounts Receivable).
- Inventory Turnover – Reflects production and inventory management efficiency.
Calculated as (COGS/Average Inventory).
- Total Asset Turnover – Shows revenue generated per dollar of assets. Calculated as
(Revenue/Total Assets).
Higher turnover ratios generally suggest strong working capital management. However, too
low could mean underutilized assets, while too high may reflect rushed sales or production
challenges. Benchmarks against industry peers provide meaningful context.
Sample Ratio Analysis
To demonstrate ratio calculation and analysis in practice, let’s use sample income
statements, balance sheets, and relevant financial extracts for a fictional company called
Johnson Ltd for the years ended December 31, 2019 and 2020:
Income Statement for year ended December 31:
(in $’000) 2019 2020
Revenue 10,000 12,000
Cost of Goods Sold (6,000) (7,200)
Gross Profit 4,000 4,800
Operating Expenses (2,000) (2,400)
Operating Income 2,000 2,400
Interest Expense (500) (400)
Net Income 1,500 2,000
Balance Sheet as at December 31:
(in $’000) 2019 2020
Current Assets
Cash 500 1,000
Accounts Receivable 2,000 2,400
Inventory 1,500 1,800
Total Current Assets 4,000 5,200
Non-Current Assets 8,000 9,000
Total Assets 12,000 14,200
Current Liabilities
Accounts Payable 2,000 2,400
Short Term Debt 1,000 800
Total Current Liabilities 3,000 3,200
Non-Current Liabilities 4,000 4,400
Shareholders’ Equity 5,000 6,600
Total Liab. & Equity 12,000 14,200
Profitability Ratios
Let’s calculate some key profitability ratios for Johnson Ltd:
Gross Profit Margin = Gross Profit/Revenue x 100
2019: Gross Profit $4,000/Revenue $10,000 x 100 = 40%
2020: Gross Profit $4,800/Revenue $12,000 x 100 = 40%
Operating Profit Margin = Operating Income/Revenue x 100
2019: Operating Income $2,000/Revenue $10,000 x 100 = 20%
2020: Operating Income $2,400/Revenue $12,000 x 100 = 20%
Net Profit Margin = Net Income/Revenue x 100
2019: Net Income $1,500/Revenue $10,000 x 100 = 15%
2020: Net Income $2,000/Revenue $12,000 x 100 = 15%
ROA = Net Income/Total Assets x 100
2019: Net Income $1,500/Total Assets $12,000 x 100 = 12.5%
2020: Net Income $2,000/Total Assets $14,200 x 100 = 14.1%
ROE = Net Income/Shareholders’ Equity x 100
2019: Net Income $1,500/Shareholders’ Equity $5,000 x 100 = 30%
2020: Net Income $2,000/Shareholders’ Equity $6,600 x 100 = 30.3%
Analysis: Johnson Ltd has maintained consistent profit margins and returns over the two
years despite revenue growth. Gross and operating margins indicate efficient operations
and pricing. ROA and ROE have increased modestly with higher profits on growing assets
and equity base. Overall profitability appears sound.
Liquidity Ratios
Let’s calculate liquidity ratios for Johnson Ltd:
Current Ratio = Current Assets/Current Liabilities
2019: Current Assets $4,000/Current Liabilities $3,000 = 1.33
2020: Current Assets $5,200/Current Liabilities $3,200 = 1.62
Quick Ratio = (Cash + Receivables)/Current Liabilities
2019: (Cash $500 + Receivables $2,000)/Current Liabilities $3,000 = 0.83
2020: (Cash $1,000 + Receivables $2,400)/Current Liabilities $3,200 = 1.03
Analysis: Johnson Ltd’s liquidity position has strengthened with higher current and quick
ratios in 2020 vs 2019. Both years’ current ratios exceed the minimum standard of 1.0. The
quick ratios are borderline but coverage has improved, suggesting adequate short-term
financial flexibility exists.
Leverage Ratios
Now let’s examine Johnson Ltd’s leverage:
Debt to Equity Ratio = Total Liabilities/Shareholders’ Equity
2019: Total Liabilities $7,000/Shareholders’ Equity $5,000 = 1.4
2020: Total Liabilities $8,000/Shareholders’ Equity $6,600 = 1.21
Debt Ratio = Total Liabilities/Total Assets
2019: Total Liabilities $7,000/Total Assets $12,000 = 0.58
2020: Total Liabilities $8,000/Total Assets $14,200 = 0.56
Times Interest Earned = EBIT/Interest Expense
2019: EBIT $2,000/Interest Expense $500 = 4
2020: EBIT $2,400/Interest Expense $400 = 6
Analysis: Leverage has declined slightly, as debt loads fell relative to growing assets and
equity. Debt ratios are at moderate-to-conservative levels that interest coverage more than
supports. Overall, leverage provides funding for growth without undue financial risk.
Activity Ratios
Finally, let’s examine Johnson Ltd’s operating efficiency:
Receivables Turnover = Credit Sales/Average Receivables
2019: Assume Credit Sales = Revenue $10,000
Average Receivables = ($2,000 + X)/2 = $2,000
Turnover = $10,000/$2,000 = 5
2020: Assume Credit Sales = Revenue $12,000
Average Receivables = ($2,000 + $2,400)/2 = $2,200
Turnover = $12,000/$2,200 = 5.45
Inventory Turnover = Cost of Goods Sold/Average Inventory
2019: COGS $6,000, Average Inventory = ($1,500 + X)/2 = $1,500
Turnover = $6,000/$1,500 = 4
2020: COGS $7,200, Average Inventory = ($1,500 + $1,800)/2 = $1,650
Turnover = $7,200/$1,650 = 4.36
Total Asset Turnover = Revenue/Total Assets
2019: Revenue $10,000/Total Assets $12,000 = 0.83
2020: Revenue $12,000/Total Assets $14,200 = 0.85
Analysis: Johnson Ltd’s activity ratios have generally improved, indicating growing
efficiency in working capital management. Receivables and inventory turnovers are in a
healthy range. Total asset turnover indicates solid revenue generation from invested capital
base.
Conclusion
Through calculating various key financial ratios using Johnson Ltd’s sample income
statements and balance sheets, this analysis has demonstrated how to evaluate different
facets of a company’s financial performance and position over time.
Johnson Ltd appears to be generating consistent profitability while maintaining adequate
liquidity and moderate, controlled leverage. Activity ratios also point to improving
operational efficiency. However, certain limitations are inherent in ratio analysis of fictional
sample data without additional contextual information.
In real analysis of public companies, ratios would need to be compared to industry peers
and benchmarks. Trends over multiple periods would need assessing as well. Additional
tools like common size statements and cash flow analysis could provide further insights.
Nonetheless, this sample ratio calculation and interpretation exercise illustrates the value
of financial ratio analysis for evaluating a company’s strengths, weaknesses, and overall
financial health holistically across key metrics. With appropriate context, ratios are a useful
starting point in fundamental investment analysis.
