Financial Ratios in Practice BS2203 Interpretation Guide
ALX University
May 2025
Introduction
This Financial Ratios in Practice Guide for BS2203 at ALX University equips students with practical
skills to interpret liquidity, profitability, efficiency, and solvency ratios for exam success. Designed for
advanced undergraduates, it includes interactive examples to master ratio analysis and a 30-question
exam with "secret hints and helpers" to maximize scores.
1 Liquidity Ratios
Liquidity ratios assess a companys ability to meet short-term obligations:
Current Assets
• Current Ratio = Current Liabilities . Measures overall liquidity, including cash, receivables, and
inventory. A ratio >1 suggests ability to cover liabilities; >2 is often strong.
• Quick Ratio = Current Assets−Inventory
Current Liabilities . Excludes inventory for a stricter liquidity measure. A
ratio >1 is desirable.
Interpretation Insight: Compare ratios to industry averages. A low quick ratio may indicate
over-reliance on inventory, signaling liquidity risk.
Interactive Example 1: A company has current assets of $1,000,000 (including $250,000 inventory)
and current liabilities of $500,000. Calculate and interpret the current and quick ratios.
1,000,000
• Step 1 : Current Ratio = 500,000 = 2. Strong liquidity to cover short-term obligations.
1,000,000−250,000 750,000
• Step 2 : Quick Ratio = 500,000 = 500,000 = 1.5. Good liquidity without inventory.
• Interpretation: Both ratios above 1 indicate financial stability, but a quick ratio of 1.5 suggests
less reliance on inventory, reducing liquidity risk. Compare with industry norms (e.g., 1.5 for
current, 1.0 for quick) for context.
2 Profitability Ratios
Profitability ratios evaluate profit generation efficiency:
Net Income
• Return on Equity (ROE) = Average Equity . Measures profit relative to shareholders equity.
Higher ROE indicates better returns but may reflect high leverage.
• Net Profit Margin = Net Income
Revenue . Shows percentage of revenue converted to profit. Higher
margins indicate cost efficiency.
Interpretation Insight: High ROE may result from strong operations or high debt; check debt-to-
equity ratio. High margins suggest pricing power or cost control.
Interactive Example 2: A company has net income of $700,000, revenue of $4,000,000, and average
equity of $2,800,000. Calculate and interpret ROE and net profit margin.
700,000
• Step 1 : ROE = 2,800,000 = 0.25 or 25%. Strong shareholder returns.
700,000
• Step 2 : Net Profit Margin = 4,000,000 = 0.175 or 17.5%. Efficient profit conversion.
• Interpretation: A 25% ROE suggests robust profitability, but check leverage. A 17.5% margin
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, BS2203 Financial Analysis ALX University
indicates strong cost management; compare with industry averages (e.g., 15% for ROE, 10% for
margin).
3 Efficiency Ratios
Efficiency ratios measure asset utilization:
Net Credit Sales
• Receivables Turnover = Average Accounts Receivable . Indicates collection frequency annually.
Higher turnover means faster collections.
365
• Days to Collect = Receivables Turnover . Converts turnover to average collection days. Lower
days indicate efficiency.
Cost of Sales
• Inventory Turnover = Average Inventory . Measures inventory sales frequency. Higher turnover
suggests efficient inventory management.
Interpretation Insight: Low turnover may signal collection or inventory issues; compare with
competitors to assess efficiency.
Interactive Example 3: A company has net credit sales of $3,000,000, average accounts receivable
of $600,000, cost of sales of $2,000,000, and average inventory of $400,000. Calculate and interpret
receivables turnover, days to collect, and inventory turnover.
3,000,000
• Step 1 : Receivables Turnover = 600,000 = 5 times. Collections occur 5 times per year.
365
• Step 2 : Days to Collect = 5 = 73 days. Average collection period is 73 days.
2,000,000
• Step 3 : Inventory Turnover = 400,000 = 5 times. Inventory sold 5 times per year.
• Interpretation: Consistent turnover suggests efficiency, but compare with industry averages (e.g.,
6 times for receivables, 7 times for inventory) to identify potential issues.
4 Solvency Ratios
Solvency ratios assess long-term financial stability:
Total Debt
• Debt-to-Equity = Total Equity . Measures financial leverage. Higher ratios indicate greater debt
reliance.
EBIT
• Interest Coverage = Interest Expense . Indicates ability to cover interest payments. Higher ratios
suggest lower financial risk.
Interpretation Insight: High debt-to-equity may boost ROE but increases risk; low interest cover-
age signals potential debt servicing issues.
Interactive Example 4: A company has total debt of $1,500,000, total equity of $3,000,000, EBIT
of $500,000, and interest expense of $100,000. Calculate and interpret debt-to-equity and interest
coverage ratios.
1,500,000
• Step 1 : Debt-to-Equity = 3,000,000 = 0.5. Moderate leverage.
500,000
• Step 2 : Interest Coverage = 100,000 = 5. Strong ability to cover interest.
• Interpretation: A debt-to-equity ratio of 0.5 suggests balanced financing; an interest coverage
of 5 indicates low risk of default. Compare with industry norms (e.g., 0.6 for debt-to-equity, 3
for interest coverage).
BS2203 Exam Ratio Analysis
This exam tests BS2203 ratio analysis interpretation skills. It includes 30 questions: 20 multiple-
choice (2 marks each, 40 marks), 5 calculation (4 marks each, 20 marks), and 5 analysis (4 marks
2
ALX University
May 2025
Introduction
This Financial Ratios in Practice Guide for BS2203 at ALX University equips students with practical
skills to interpret liquidity, profitability, efficiency, and solvency ratios for exam success. Designed for
advanced undergraduates, it includes interactive examples to master ratio analysis and a 30-question
exam with "secret hints and helpers" to maximize scores.
1 Liquidity Ratios
Liquidity ratios assess a companys ability to meet short-term obligations:
Current Assets
• Current Ratio = Current Liabilities . Measures overall liquidity, including cash, receivables, and
inventory. A ratio >1 suggests ability to cover liabilities; >2 is often strong.
• Quick Ratio = Current Assets−Inventory
Current Liabilities . Excludes inventory for a stricter liquidity measure. A
ratio >1 is desirable.
Interpretation Insight: Compare ratios to industry averages. A low quick ratio may indicate
over-reliance on inventory, signaling liquidity risk.
Interactive Example 1: A company has current assets of $1,000,000 (including $250,000 inventory)
and current liabilities of $500,000. Calculate and interpret the current and quick ratios.
1,000,000
• Step 1 : Current Ratio = 500,000 = 2. Strong liquidity to cover short-term obligations.
1,000,000−250,000 750,000
• Step 2 : Quick Ratio = 500,000 = 500,000 = 1.5. Good liquidity without inventory.
• Interpretation: Both ratios above 1 indicate financial stability, but a quick ratio of 1.5 suggests
less reliance on inventory, reducing liquidity risk. Compare with industry norms (e.g., 1.5 for
current, 1.0 for quick) for context.
2 Profitability Ratios
Profitability ratios evaluate profit generation efficiency:
Net Income
• Return on Equity (ROE) = Average Equity . Measures profit relative to shareholders equity.
Higher ROE indicates better returns but may reflect high leverage.
• Net Profit Margin = Net Income
Revenue . Shows percentage of revenue converted to profit. Higher
margins indicate cost efficiency.
Interpretation Insight: High ROE may result from strong operations or high debt; check debt-to-
equity ratio. High margins suggest pricing power or cost control.
Interactive Example 2: A company has net income of $700,000, revenue of $4,000,000, and average
equity of $2,800,000. Calculate and interpret ROE and net profit margin.
700,000
• Step 1 : ROE = 2,800,000 = 0.25 or 25%. Strong shareholder returns.
700,000
• Step 2 : Net Profit Margin = 4,000,000 = 0.175 or 17.5%. Efficient profit conversion.
• Interpretation: A 25% ROE suggests robust profitability, but check leverage. A 17.5% margin
1
, BS2203 Financial Analysis ALX University
indicates strong cost management; compare with industry averages (e.g., 15% for ROE, 10% for
margin).
3 Efficiency Ratios
Efficiency ratios measure asset utilization:
Net Credit Sales
• Receivables Turnover = Average Accounts Receivable . Indicates collection frequency annually.
Higher turnover means faster collections.
365
• Days to Collect = Receivables Turnover . Converts turnover to average collection days. Lower
days indicate efficiency.
Cost of Sales
• Inventory Turnover = Average Inventory . Measures inventory sales frequency. Higher turnover
suggests efficient inventory management.
Interpretation Insight: Low turnover may signal collection or inventory issues; compare with
competitors to assess efficiency.
Interactive Example 3: A company has net credit sales of $3,000,000, average accounts receivable
of $600,000, cost of sales of $2,000,000, and average inventory of $400,000. Calculate and interpret
receivables turnover, days to collect, and inventory turnover.
3,000,000
• Step 1 : Receivables Turnover = 600,000 = 5 times. Collections occur 5 times per year.
365
• Step 2 : Days to Collect = 5 = 73 days. Average collection period is 73 days.
2,000,000
• Step 3 : Inventory Turnover = 400,000 = 5 times. Inventory sold 5 times per year.
• Interpretation: Consistent turnover suggests efficiency, but compare with industry averages (e.g.,
6 times for receivables, 7 times for inventory) to identify potential issues.
4 Solvency Ratios
Solvency ratios assess long-term financial stability:
Total Debt
• Debt-to-Equity = Total Equity . Measures financial leverage. Higher ratios indicate greater debt
reliance.
EBIT
• Interest Coverage = Interest Expense . Indicates ability to cover interest payments. Higher ratios
suggest lower financial risk.
Interpretation Insight: High debt-to-equity may boost ROE but increases risk; low interest cover-
age signals potential debt servicing issues.
Interactive Example 4: A company has total debt of $1,500,000, total equity of $3,000,000, EBIT
of $500,000, and interest expense of $100,000. Calculate and interpret debt-to-equity and interest
coverage ratios.
1,500,000
• Step 1 : Debt-to-Equity = 3,000,000 = 0.5. Moderate leverage.
500,000
• Step 2 : Interest Coverage = 100,000 = 5. Strong ability to cover interest.
• Interpretation: A debt-to-equity ratio of 0.5 suggests balanced financing; an interest coverage
of 5 indicates low risk of default. Compare with industry norms (e.g., 0.6 for debt-to-equity, 3
for interest coverage).
BS2203 Exam Ratio Analysis
This exam tests BS2203 ratio analysis interpretation skills. It includes 30 questions: 20 multiple-
choice (2 marks each, 40 marks), 5 calculation (4 marks each, 20 marks), and 5 analysis (4 marks
2
