Problems on Ratio Analysis

04/02/2024

Ratio analysis involves using financial ratios derived from a company’s financial statements to evaluate its financial health, performance, and trends over time. These ratios can provide insights into a company’s profitability, liquidity, leverage, and efficiency.

Example Problem 1: Calculating the Current Ratio

Problem:

XYZ Company has current assets of \$150,000 and current liabilities of \$75,000. Calculate the current ratio and interpret the result.

Solution:

The current ratio is calculated as follows:

Current Ratio = Current Assets / Current Liabilities​

Current Ratio = 150,000 / 75,000=2

Interpretation:

A current ratio of 2 means that XYZ Company has \$2 in current assets for every \$1 of current liabilities. This indicates good liquidity, suggesting that the company should be able to cover its short-term obligations without any significant problems.

Example Problem 2: Calculating the Debt to Equity Ratio

Problem:

ABC Corporation has total liabilities of \$200,000 and shareholders’ equity of \$300,000. Calculate the debt to equity ratio.

Solution:

The debt to equity ratio is calculated as follows:

Debt to Equity Ratio=Total Liabilities / Shareholders’ Equity

Debt to Equity Ratio=200,000300,000=0.67

Interpretation:

A debt to equity ratio of 0.67 means that ABC Corporation has \$0.67 in liabilities for every \$1 of shareholders’ equity. This suggests a balanced use of debt and equity in financing its operations, with a slightly lower reliance on debt.

Example Problem 3: Calculating the Return on Equity (ROE)

Problem:

Company MNO reported a net income of \$50,000 and average shareholders’ equity of \$250,000 for the fiscal year. Calculate the Return on Equity (ROE).

Solution:

The Return on Equity is calculated as follows:

ROE = Net Income / Average Shareholders’ Equity​

ROE = 50,000250,000=0.2 or 20%

Interpretation:

An ROE of 20% means that Company MNO generates \$0.20 in profit for every \$1 of shareholders’ equity. This indicates a strong ability to generate earnings from the equity financing provided by the company’s shareholders.

Approach to Solving Ratio Analysis Problems

• Understand the Ratio:

Know what each ratio measures and its formula.

• Gather Data:

Collect the necessary financial figures from the company’s balance sheet, income statement, or cash flow statement.

• Perform Calculations:

Apply the formula to the collected data.

• Interpret Results:

Understand what the calculated ratio indicates about the company’s financial health, performance, or position.

• Compare:

To get more insight, compare the ratio to industry averages, benchmarks, or the company’s historical ratios.