Unit 11

FINANCIAL RATIOS

Overview
This unit provides the explanation of Financial Ratios includes calculations and
descriptions of financial ratios.

Learning objectives
After this unit, students should be able to:
>> Understand the classification of ratio analysis
>> Describe the major types of financial ratios

Think and discuss

1. What does ratio analysis provide?
2. How many types of ratio analysis?

1. SPECIAL TERMS
2.

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 1. SPECIAL TERMS
Match the words or expressions in column A with their definition in column B.
You can look it up for more detailed explanations in a specialist dictionary.

Column A Column B
A. provides a more accurate picture of short-
1. Current ratio term solvency by considering completely
liquid assets
2. Quick ratio B. shows profit compared to shareholders’
(Acid test ratio) capital
3. Profit margin C.shows profit compared to all of a
(Return on sales) company’s capital, whether debt or equity
D. measures liquidity, i.e. having enough
4. Earnings per share
cash to meet short-term obligations.
5. Price/Earnings ratio E. compares the amount of debt to the firm’s
(PER) capital
6. Debt/equity ratio F. relates the company’s profits to the
(Gearing) number of ordinary shares it has issued
G. the percentage difference between sales
7. Dividend cover
income and the cost of sales
H. anything that can quickly be turned into
8. Return on equity
cash
I. shows the percentage of income paid out to
9. Return on assets
shareholders
J. reflects the market’s opinion of a
10. Liquid assets
company’s revenues, earnings and dividends

2. READING

READING 1

Reading text 1: Financial ratios and do exercise 2.1 below

FINANCIAL RATIOS
Financial ratio analysis is the calculation and comparison of ratios which are derived
from the information in a company's financial statements. The level and historical trends
of these ratios can be used to make inferences about a company's financial condition, its
operations and attractiveness as an investment.

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 Financial ratios are calculated from one or more pieces of information from a
company's financial statements. For example, the "gross margin" is the gross profit from
operations divided by the total sales or revenues of a company, expressed in percentage
terms. In isolation, a financial ratio is a useless piece of information – context is everything.
Once it is put into the correct context, however, a financial ratio can give a financial analyst
an excellent picture of where a company stands among its competitors and the trends that
are developing within and around it.
A ratio gains utility by comparison to other data and standards. Taking our example,
a gross profit margin for a company of 25% is meaningless by itself. If we know that this
company's competitors have profit margins of 10%, we know that it is more profitable than
its industry peers which are quite favourable. If we also know that the historical trend is
upwards, for example, has been increasing steadily for the last few years, this would also
be a favourable sign that management is implementing effective business policies and
strategies.
Financial ratio analysis groups the ratios into categories that tell us about different
facets of a company's finances and operations. An overview of some of the categories of
ratios is given below.
• Leverage Ratios which show the extent that debt is used in a company's capital
structure.
• Liquidity Ratios which give a picture of a company's short term financial situation
or solvency.
• Operational Ratios which use turnover measures to show how efficient a company
is in its operations and use of assets.
• Profitability Ratios which use margin analysis and show the return on sales and
capital employed.
• Solvency Ratios which give a picture of a company's ability to generate cash flow
and pay its financial obligations.
The people interpreting financial ratios from the prospects of a lender are credit
analysts. They tend to focus on the “downside” risk, since they gain none of the upsides
from an improvement in operations. They pay great attention to liquidity and leverage
ratios to ascertain a company’s financial risk. Equity analysts look more to the operational
and profitability ratios to determine the future profits that will accrue to the shareholder.
Although the analysis of financial ratios is well developed and the actual ratios are
well known, practicing financial analysts often develop their own measures for particular
industries, and even for individual companies. Analysts will often differ drastically in their
conclusions of the same ratio analysis.
(Source: https://www.financialpipeline.com/financial-ratios-analysis)

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 2.1 Answer the following question by choosing the best choice

1. What does the phrase “in isolation” mean?

a. in particular
b. individually
c.in general
2. What does the phrase “in context” mean?
a. in combination
b. in general
c. in all
3. What can be inferred from the example of the gross profit margin?
a. the ratios are especially useful by comparison to others
b. the ratios themselves can show a company’s financial performance
c. there’s no need to look at the historical trend when analyzing the ratios
4. What does the word “itself” in the sentence: “Taking our example, a gross profit
margin for a company of 25% is meaningless by itself” refer to?
a. a company
b. a gross profit margin
c. 25%
5. What’s the INCORRECT statement?
a. Historical data and fundamental changes should be used independently.
b. Credit analysts pay attention to liquidity and leverage ratios most of all.
c. Equity analysts are interested in the operational and profitability ratios.

READING 2

Reading text 2: Types of financial ratios and do exercise 2.2 below.

TYPES OF FINANCIAL RATIOS
Financial ratios express the relationships between two or more items on financial
statements. They allow investors and creditors to compare a company's present situation
and performance with its past performance, and with other companies.
Liquidity and solvency ratios
Current ratio =

The current ratio is a calculation of current assets divided by current liabilities. It

measures liquidity and shows how much of a company's assets will have to be converted

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into cash in the next year to pay debts. The higher the ratio, the more chance creditors have
of being paid. For example, if a company has current assets of $23,244,000 and current
liabilities of $15,197,000, its current ratio is 1.53, which is acceptable. It is often argued
that the current ratio of a healthy company should be closer to 2.0 than 1.0, meaning that
it has nearly twice as many assets as liabilities.
Suppliers granting short-term credit to a company prefer the current ratio to be high
because this reduces their risk. Yet shareholders usually prefer it to be low, because this
means that the company has invested its assets for the future.
Quick ratio =

The quick ratio or acid test is a calculation of liquid assets divided by current
liabilities. It measures short-term solvency. Liquid assets are current assets minus stocks
or inventory, as these might be difficult to sell.
Earnings and dividends
Shareholders are interested in ratios relating to a company's share price, earnings,
and dividend payments.
Earnings per share =

Earnings per share (EPS) tells investors how the number of the company's profit
belongs to each share. If a company makes a post-tax profit of $1.5 million, and it has
issued 2 million shares, EPS = $ 0.75.
P/E =

The price/earnings ratio or P/E ratio shows how expensive the share is. If a company
has EPS of $ 0.75 and the share is selling for $9.00, the P/E ratio is 12 ($9 per share divided
by $0.75 earnings per share = 12 P/E.) A high P/E ratio shows that investors are prepared
to pay a high multiple of the earnings for a share, because they expect it to do well in the
future.
Dividend cover =

Dividend cover or times dividend covered shows how many times the company's
total annual dividends could have been paid out of its available annual earnings. If a
company has EPS of 75 $ and it pays out a dividend of 30 $, the dividend cover is 75/30 =
2.5. A high dividend cover shows that the company has a lot of money, but that it is not
being very generous to its shareholders. A ratio of 2.0 or higher is generally considered
safe (it means that the company can easily afford the dividend), but anything below 1.5 is
risky. A low dividend cover - below 1.0 - means the company is paying out retained
surpluses from previous years.
Profitability

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 There are various profitability ratios that allow investors to compare a company's
profit with its sales, its assets or its capital. Financial analysts usually include them in their
reports on companies.
Gross profit margin =

Gross profit margin is the money a company has left after it pays for the cost of the
goods or services it has sold. A company with a higher gross profit margin than competitors
in its industry is more efficient, and should be able to make a profit in the future.
Return on assets (ROA) =

Return on assets measures how efficiently the firm's assets are being used to
generate profits.
Return on equity (ROE) =

Return on equity (ROE) shows how big a company's profit is (after interest and tax)
compared with the shareholders' equity or funds.
Leverage

Gearing =

Gearing or leverage, often expressed as a percentage shows how far a company is

funded by loans rather than its own capital. A highly geared or highly leveraged company
is one that has a lot of debt compared to equity.

2.2 Match the two parts of the sentences

1. If a company pays out retained surpluses from past years

2. Some investors are worried that the new stock issue
3. A high current ratio indicates short-term financial strength but
4.Wall Street is on a historic price-earnings ratio of around 35, which
5. After borrowing millions to finance the takeover of a rival firm, the company's
6. Although sales fell 5%, the company's
7. Like profit growth, return on equity is a measure of
8. With just 24% gearing, the company can afford

a. it does not measure how efficiently the company is utilizing its resources.
b. its dividend cover will fall below 1.0.
c. makes the market very expensive, as the long-term average is 14.45.

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d. will dilute the company's earnings per share.
e. gross profit margin rose 9% from a year ago, so senior management isn't worried,
f. how good a company is at making money.
g. interest cover is the lowest it has ever been.
h. to acquire its rival, which would help to increase its steady growth.

3. LISTENING

3.1 You are going to listen to an accountant explaining the ratio to some
managers in her company. Listen carefully and fill in the gaps.

Accountant: OK. Norma has asked me to go over some of the ratios. I used it in
the report which I sent you last week. The first of these is working capital.
Everyone got it? OK. Working capital is quite simple: it's the (1) ……………
divided by the (2) ……………. Any questions?
Man: Yes. What's it for?
Accountant: Well, it basically tells us whether we have enough short-term assets
to (3) ……………. our short-term debt. If we don't, we could be in trouble. OK?
Good. Next is (4) ……………. This is net income plus (5) ……………. expense
divided by total assets. Before you ask, it allows us to (6) ……………. the way we
use our assets. It can help us decide whether or not we should start a new project,
for example, by comparing the return expected against the normal (7) …………….
costs. Is that clear?
Woman: I have a question. What's the (8) ……………. /asset ratio?
Accountant: I was just coming to that. It's the total assets divided by total
liabilities. It tells us what (9) ……………. of the enterprise's assets are being (10)
……………. through the use of debt. If this ratio is high in a market with
increasing interest rates, creditors are going to get (11) ……………. The debt/asset
ratio determines the funding (12) ……………. of the enterprise. OK, if there are
questions, I'd like to ...

3.2 Listen again and write definitions for the following terms
1. Working capital
2. Return on assets
3. Debt/asset ratio

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4. VOCABULARY EXERCISES

4.1 Put the letters into the correct order to make words

1. _________ analysis results in all income statement TREILAVC

amounts expressed as a percentage of net sales.
2. Current assets divided by current liabilities is the RTUCENR
__________ ratio.
3. Another name for the quick ratio is the ______ test ratio. CADI
4. ____________ analysis results in amounts expressed as LAOOTHINZR
a percentage of an earlier, base year.
5. Return on assets measures how efficiently the firm's SATSES
____________ are being used to generate profits.
6. Financial ratios are part of financial statement SNIYASLA
___________
7. The current ratio and the quick ratio are indicators of a IIUDYTIQL
company's ___________
8. The profit margin ratio and the return on assets are IYITATLORIBPF
indicators of a company's ____________.
9. A very large amount of debt in relation to the number DEAGREEVL
of assets indicates that a company is highly ……………
10. Horizontal analysis is associated with _______ DERTN
analysis.

4.2 Complete the paragraph with the corret words from the box

limitations future difficult differently

previous conditions apply useful

There are some of the (1) …………… of financial ratios. Firstly, they are based on
just a few amounts taken from the financial statements from a (2) …………… year. Current
and (3) …………… years could be different due to innovations, economic (4) ……………,
global competitors, etc. Secondly, the comparison is useful only with companies in the
same industry. This becomes (5) …………… when other companies operate in several

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industries and their financial statements report only consolidated amounts. Finally,
companies may (6) …………… accounting principles (7) ……………. For instance, some
U.S. companies use LIFO to assign costs to their inventory and cost of goods sold, while
some use FIFO. Some companies will be more conservative when estimating the (8)
…………… life of equipment, when recording an expenditure as an expense rather than
as an asset, and more.

4.3 Match the ratios with the formulas and the description

• Gross profit margin

• Earning per share
• Debt/Equity ratio
• Return on equity
• Price/Earning ratio

1.

2.

3.

4.

5.

a. Gives the company's pricing policy and mark-up margins. An adequate gross margin
allows a company to pay its expenses, and then expand.
b. Compares the current market price with earnings to calculate if a stock is over or under
valued. Used as a prediction or expectation of future performance.
c. Indicates the return a company gets on the owners' investment. Companies that make
high returns often do not require more debt investments.
d. Indicates what proportion of equity and debt an enterprise uses to finance its assets. A
more stringent test is to use just the long-term debt.
e. Calculates the profit made on a per-share basis. This is quoted by U.S. publicly held
companies in their financial statements.

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 Match word combinations using a word from each box. One word can
4.4 be used twice. Then use the word combinations to complete the sentences
below.

Acid Assets
Current Cover
Divident Ratio
Liquid Test
Quick

1. ………. ………. consist of cash and things that can be easily sold and converted to
cash.
2. A high ………. ………. shows that the company is retaining a lot of money belonging
to its shareholders.
3. The ………. ………. or ………. ………. doesn’t count stock or inventory because this
might be difficult or impossible to turn into cash.
4. The ………. ………. shows a company’s ability to pay its short-term debts.

4.5 Choose the best answer given to the sentence

1. Which of the following is NOT a current asset account?

a. inventory
b. Prepaid Insurance
c. Fixtures
2. Current assets DIVIDED BY current liabilities is the
a. Current Ratio
b. Net Worth Ratio
c. Working Capital
3. The quick ratio EXCLUDES which of the following accounts?
a. Accounts Receivable
b. Inventory
c. Cash
Use the following information to answer items 4 - 5:
At December 31 a company's records show the following information:

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 4. The company's current ratio is
a. 1.0: 1
b. 2.0: 1
c. 2.1: 1
5. The company's quick ratio is
a. 0.7: 1
b. 1.0: 1
c. 2.0: 1

5. SPEAKING

5.1 Individual work

Based on the information in the two texts above, answer the following
questions with your own words
1. What is financial ratio analysis?
2. Describe each financial ratio you know and explain them.

5.2 Pair work or group work

Ask and answer these questions above with a partner. Then choose two financial
ratios and prepare to give a one-minute presentation about them to the group.
Focus on delivering the presentation very clearly and accurately. Record your
presentations and discuss your performance with a partner afterward.

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 Work with your partner(s) and discuss your answers.

Saying numbers in English

Notice how we use the decimal point in English:
6.02 six point oh two
0.04 zero (or nought) point oh four
0.007 zero point double oh seven
56.345 fifty-six point three four five
Here commas – and not decimal points – are used:
12,076 twelve thousand and seventy-six
2,534,210 two million, five hundred and thirty-four thousand, two hundred
and ten
Sums of money:
$ 3.67 three dollars sixty-seven
$ 5m five million dollars

Saying equations/formulas
+ plus, and, add
- minus, less, subract
x multiplie by, times
: divided by
= equals, is

6. WRITING

6.1 Rearrange the following words to make complete sentences

1. financial leverage/ known/ leverage/ to/ the/ which/ also/ refers/ use/ additional
assets/ as/ debt/ acquire/ is/ to/ of.
………………………………………………………………………………………
2. cash/ cash equivalents/ plus/ quick ratio/ the/ compares/ total/accounts receivable/
and/ amount/ amount/current liabilities/ of/ the/ to/ the/ of.
………………………………………………………………………………………
3. financial ratio/ shows/ current ratio/ the/ company's current assets/current
liabilities/ proportion/ that/ its/is/a/the/of/a/to .
………………………………………………………………………………………

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 4. financial ratio/ whether/ company's current assets/ sufficient/ company's
obligations/liquidity ratio/a/is/ a/ that/ indicates/ a/ will/ be/ to/ meet/ the/ when/ they
become /due.
………………………………………………………………………………………
5. amount/ after/ manufacturer/ subtracts/ cost/ goods/ sold/ gross margin/net sales/
from/ its/ retailer/ the/is/ remaining/ a/ or/ its/ of .
………………………………………………………………………………………

6.2 Complete the following sentences using the given words.

1. Profitability/ratio/provide/information/amount/income/each dollar/sales.
………………………………………………………………………………………
2. Liquidity /ratio/provide/information/company’s ability/meet/short-term/
obligations.
………………………………………………………………………………………
3. The quick ratio/is/ conservative/ than/current ratio/ because/ amounts/ a
company's inventory/ and/ prepaid expenses/ are/not/ include/.
………………………………………………………………………………………
4. The debt to equity ratio/ is/ calculate/divide/company's total amount/liabilities/
its/ total amount/ stockholders' equity/.
………………………………………………………………………………………
5. Gross margin/is/percentage/ net sales/ remaining/ subtracting/ cost of goods sold.
………………………………………………………………………………………

6.3 Translate the following sentences into Vietnamese

1. Profitability is an entity’s ability to generate a profit using available resources.

Profitability shows the effectiveness of using assets and equity to generate such profit.
………………………………………………………………………………………
……………………………………………………………………………………………...
2. Profitability ratios only help to analyze a company’s performance for a particular
period, but they may tell little about the company's financial condition and stability.
………………………………………………………………………………………
……………………………………………………………………………………………...
3. Although the analysis of financial ratios is well developed and the actual ratios
are well known, practicing financial analysts often develop their measures for particular
industries, and even for individual companies.
………………………………………………………………………………………
……………………………………………………………………………………………...

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 4. Working capital is defined as the amount remaining after subtracting a
corporation's total amount of current liabilities from the total amount of its current assets.
………………………………………………………………………………………
……………………………………………………………………………………………...
5. The quick ratio is more conservative than the current ratio because the amounts
of a company's inventory and prepaid expenses are not included.
………………………………………………………………………………………
……………………………………………………………………………………………...

6.4 Translate the following sentences into English

1. Tỷ suất sinh lời trên tài sản là một trong các chỉ tiêu đo lường hiệu quả hoạt động
của doanh nghiệp.
………………………………………………………………………………………
……………………………………………………………………………………………..
2. Đòn bẩy tài chính là mức độ sử dụng vốn vay trong tổng nguồn vốn của doanh
nghiệp với mục đích tăng tỷ suất lợi nhuận vốn chủ sở hữu hoặc thu nhập trên một cổ phần
thường của công ty.
………………………………………………………………………………………
……………………………………………………………………………………………..
3. Hệ số thanh toán hiện hành cho biết khả năng của một công ty trong việc dùng
các tài sản ngắn hạn như tiền mặt, hàng tồn kho hay các khoản phải thu để chi trả cho các
khoản nợ ngắn hạn của mình. Tỷ số này càng cao chứng tỏ công ty càng có nhiều khả năng
sẽ hoàn trả được hết các khoản nợ.
………………………………………………………………………………………
……………………………………………………………………………………………..
4. Hệ số thanh toán nhanh cho biết liệu công ty có đủ các tài sản ngắn hạn để trả cho
các khoản nợ ngắn hạn mà không cần phải bán hàng tồn kho hay không.
………………………………………………………………………………………
……………………………………………………………………………………………...
5. EPS là một chỉ số về hiệu quả hoạt động của công ty và thường được xem là chỉ
số quan trọng nhất trong việc xác định giá của cổ phiếu.
………………………………………………………………………………………
……………………………………………………………………………………………...

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