Finance and AccountingFinancial Analysis

**Introduction**

Axel Tracy’s “Ratio Analysis Fundamentals” serves as a comprehensive guide to understanding and applying financial ratios for business analysis. Tracy argues that with 17 key financial ratios, one can effectively evaluate the financial health and operational performance of any business. The book is divided into sections that focus on different types of ratios, including liquidity ratios, profitability ratios, leverage ratios, and efficiency ratios. Each ratio is meticulously explained with practical examples, empowering readers to make well-informed decisions based on their analyses.

### 1. Liquidity Ratios

**a. Current Ratio**

The current ratio is calculated by dividing current assets by current liabilities. It measures a company’s ability to pay off its short-term obligations with its short-term assets.

**Example**: If a business has current assets of $200,000 and current liabilities of $100,000, the current ratio would be 2.0.**Action**: Regularly monitor the current ratio to ensure it stays between 1.5 to 3.0. A ratio below 1 indicates potential liquidity issues, while a ratio above 3 may suggest that assets are not being used efficiently.

**b. Quick Ratio**

Known as the acid-test ratio, the quick ratio excludes inventory from current assets to provide a stricter measure of liquidity.

**Example**: If a company has $150,000 in current assets, $50,000 in inventory, and $75,000 in liabilities, the quick ratio is ($150,000 – $50,000) / $75,000 = 1.33.**Action**: Use the quick ratio to assess the firm’s immediate liquidity, especially in industries where inventory cannot be quickly converted to cash.

### 2. Profitability Ratios

**a. Gross Profit Margin**

This ratio is determined by dividing gross profit by total sales, providing insight into the profitability of a company’s core activities.

**Example**: If a company has gross profits of $500,000 and sales of $1,000,000, the gross profit margin is 50%.**Action**: Aim for a higher gross profit margin to ensure the sustainability of business operations. Evaluate cost structures to identify areas for reducing costs and increasing efficiency.

**b. Net Profit Margin**

Net profit margin compares net profit to total sales, reflecting overall profitability after all expenses are deducted.

**Example**: A business with a net profit of $100,000 and sales of $1,000,000 has a net profit margin of 10%.**Action**: Focus on improving net profit margins by controlling operating expenses, optimizing pricing strategies, and efficiently managing resources.

### 3. Leverage Ratios

**a. Debt to Equity Ratio**

This ratio, which divides total liabilities by shareholders’ equity, assesses the firm’s financial leverage.

**Example**: If a company has $500,000 in liabilities and $1,000,000 in equity, the debt to equity ratio is 0.5.**Action**: Maintain a balanced debt to equity ratio to minimize financial risk. Regularly evaluate borrowing strategies to ensure they align with the firm’s long-term goals.

**b. Interest Coverage Ratio**

The interest coverage ratio is calculated by dividing earnings before interest and taxes (EBIT) by interest expenses, indicating the firm’s ability to meet interest obligations.

**Example**: If EBIT is $200,000 and interest expenses are $50,000, the interest coverage ratio is 4.**Action**: Aim for an interest coverage ratio above 3 to ensure the company can comfortably cover interest payments. Use this ratio as a safeguard when considering additional debt.

### 4. Efficiency Ratios

**a. Inventory Turnover Ratio**

Inventory turnover is calculated by dividing the cost of goods sold (COGS) by average inventory, showing how quickly inventory is sold and replaced.

**Example**: With COGS of $800,000 and average inventory of $160,000, the inventory turnover ratio is 5.**Action**: Foster higher inventory turnover by optimizing inventory management practices and ensuring that stock levels meet, but do not exceed, demand.

**b. Accounts Receivable Turnover Ratio**

This ratio measures how effectively a company collects its receivables and is calculated by dividing net credit sales by average accounts receivable.

**Example**: If net credit sales are $600,000 and average accounts receivable is $150,000, the accounts receivable turnover ratio is 4.**Action**: Enhance collection practices to improve this ratio. Implement strict credit policies and pursue overdue accounts aggressively.

### 5. Valuation Ratios

**a. Price to Earnings (P/E) Ratio**

The P/E ratio, determined by dividing the market price per share by earnings per share (EPS), assesses the market valuation of a company relative to its earnings.

**Example**: If the market price per share is $50 and EPS is $5, the P/E ratio is 10.**Action**: Compare the P/E ratios of similar companies to determine if a stock is undervalued or overvalued. Use this ratio to inform investment decisions.

**b. Earnings Yield**

Earnings yield, the inverse of the P/E ratio, shows the percentage of each dollar invested that was earned by the company.

**Example**: With a P/E ratio of 10, the earnings yield is 10%.**Action**: Use earnings yield to compare investment opportunities across different sectors. High earnings yield often indicates potentially attractive investments.

### Practical Applications of Financial Ratios

Tracy provides real-world examples to illustrate the use of financial ratios. For instance, he explains how to apply the current ratio and quick ratio in assessing the liquidity of a manufacturing company, and demonstrates profitability analysis with gross and net profit margins in the retail sector. These examples not only clarify the application of each ratio but also show how they interrelate.

### Conclusion

“Ratio Analysis Fundamentals” is an invaluable resource for anyone looking to deepen their understanding of financial analysis. By focusing on 17 key financial ratios, Axel Tracy provides a versatile toolkit that can be applied in various business contexts. Whether you are a business owner, financial analyst, or investor, understanding and utilizing these ratios can significantly enhance your ability to assess financial health and make informed decisions.

**Summary Actions:**

**Monthly Review**: Regularly assess liquidity ratios to ensure the company maintains healthy cash flow and can meet short-term obligations.**Cost Management**: Continuously evaluate profitability ratios to identify and implement cost-saving measures to improve margins.**Debt Management**: Monitor leverage ratios to strike a balance between growth and financial risk.**Operational Efficiency**: Use efficiency ratios to refine inventory management, receivables collection, and overall operational processes.**Investment Decisions**: Apply valuation ratios to determine the attractiveness of potential investments and operational strategies.

In summary, Tracy emphasizes the importance of a structured approach to financial analysis, providing clear methodologies and actionable insights that can empower financial decision-making.