Financial Statement Analysis — Financial Ratios: Liquidity, Solvency, Profitability and Activity

A financial ratio summarizes a feature of a company through the relationship between two numbers. This chapter calculates the main ratios along four axes from FA’s 20X2 statements in chapter 1 (unit: ₩100 million). The breakdown of profitability ratios continues in chapter 3 and the detailed reading of turnover in chapter 4.

1. Liquidity: short-term ability to pay

Liquidity ratios (end of 20X2)
Ratio	Formula	FA
Current ratio	Current assets ÷ current liabilities	400 ÷ 200 = 200%
Quick ratio	(Current assets − inventories) ÷ current liabilities	200 ÷ 200 = 100%
Cash ratio	Cash ÷ current liabilities	50 ÷ 200 = 25%

A current ratio of 200% is traditionally regarded as sound. But half of current assets are inventories, so the quick ratio is 100%: if inventories do not sell, repaying short-term debt will be tight. The slower an industry turns inventory into cash, the more the quick ratio should be read alongside.

2. Solvency: long-term ability to pay and leverage

Solvency ratios
Ratio	Formula	FA
Debt-to-equity ratio	Liabilities ÷ equity	500 ÷ 500 = 100%
Equity ratio	Equity ÷ assets	500 ÷ 1,000 = 50%
Borrowings to assets	Borrowings ÷ assets	(80 + 300) ÷ 1,000 = 38%
Interest coverage	Operating profit ÷ interest expense	144 ÷ 24 = 6.0 times

The debt-to-equity ratio includes operating liabilities such as trade payables, so to look only at interest-bearing debt, use borrowings to assets. Interest coverage of 6 means operating profit could pay the interest six times over. The Bank of Korea classifies companies whose interest coverage is below 1 for three consecutive years as marginal firms (chapter 7).

3. Profitability: returns on assets and equity

ROA and ROE

\text{ROA} = \frac{\text{Net profit}}{\text{Average total assets}} = \frac{96}{(900 + 1{,}000)/2} ≈ 10.1\%, \qquad \text{ROE} = \frac{\text{Net profit}}{\text{Average equity}} = \frac{96}{(450 + 500)/2} ≈ 20.2\%

The numerator is a flow over the year, so the denominator should in principle be the average of opening and closing balances. Using year-end balances gives ROA of 9.6% and ROE of 19.2%.

ROE is about twice ROA because half the assets are financed with debt. Debt magnifying returns is the financial leverage effect. To include creditors’ share when calculating ROA, the numerator is sometimes profit with after-tax interest expense added back.

4. Activity: how efficiently assets are used

Total asset turnover is revenue divided by average total assets: $1{,}200 / 950 ≈ 1.26$ times. Each won of assets generates 1.26 won of revenue. Receivables, inventory and payables turnover and the cash conversion cycle are calculated in chapter 4.

5. Growth

Chapter 1’s trend analysis showed revenue up 20%, operating profit up 44% and net profit up 55%. Assets grew 11%, so little additional investment in assets was needed for the growth. Check growth rates for one-off factors such as acquisitions and separate them from organic growth.

Check your understanding

If FA had repaid ₩4 billion of short-term borrowings with ₩4 billion of cash at the end of 20X2, how would the current and quick ratios change? Can this transaction be said to have improved the company’s real ability to pay?

Current assets become ₩36 billion and current liabilities ₩16 billion. The current ratio becomes 225% and the quick ratio stays at $(360 - 200) / 160 = 100\%$ . The current ratio rose from 200% to 225% simply because the same amount was taken from numerator and denominator. In reality cash fell, leaving less money available right away, so the ability to pay has hardly improved. Deducting the same amount from numerator and denominator when a ratio exceeds 100% raises it — an arithmetic effect.

References

Krishna Palepu, Paul Healy and Erik Peek, Business Analysis and Valuation: IFRS Edition, ch. 5
Bank of Korea, Financial Statement Analysis
Stephen Penman, Financial Statement Analysis and Security Valuation, ch. 11