Professional Documents
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1. Liquidity ratios: Liquidity ratios measure the firm’s ability to fulfill short-
term commitment out o its liquid assets. Assets are liquid if they are either cash
or relatively easy to convert into cash. Short term creditors are generally very
interested in the liquidity ratios. Two commonly used liquidity ratios are
discussed in this season.
A. Current Ratio: This ratio measures the firm’s ability to meet its short-
term obligations. Current ratio is defined as
B. Acid test Ratio or quick ratio: this ratio measures the ability of a
company to meet its immediate liabilities. Acid test ratio is calculated as
follows :
Quick assets are cash and near cash assets like debtors, bills,
receivable, and marketable securities which can readily be converted
into cash. While calculating this ratio inventories are excluded from
quick assets because these are not often converted into cash
sufficiently quickly to help pay creditors. A ratio of 1:1 usually
considered satisfactory.
2. Activity Ratios: The second group of ratios, the activity ratio, measures how
effectively the firm is managing its assets. If a company has excessive
investments in assets, then its operating assets and capital will be unduly high
which will reduce its free cash flow and its stock price. On the other hand, if a
company does not have enough assets, it will lose sales, which will hurt
profitability, free cash flow and the stock price. Therefore it is important to have
the right amount invested in assets. Ratios that analyze the different types of
assets are described in this section.
The cost of gods sold means sales minus gross profit. The average inventory
refers to the simple average of the opening and closing inventory. A high ratio is
good from the viewpoint of liquidity and vice versa a low ratio would signify that
inventory does not sell fast and stays on the shelf or in the ware house for a long
time. The standard ratio is 8 times.
C. Evaluating fixed assets: fixed assets turnover ratio: this ratio measures
how effectively the firm uses its fixed assets. This is the ratio of sales to
fixed assets. It is computes as follows
D. Evaluating total assets: Total assets turnover ratio: Total assets turnover
ratio reflects how well the company’s assets are being used to generate
sales. This ratio also called as sales to total assets ratio. It is calculated as
follows:-
A low turnover ratio reflects liberal credit terms granted by suppliers, while a
high ratio shows that accounts are to be settled rapidly.
3. Coverage / capital structure ratio: Coverage ratio measure the extent of the
firms’ total debt burden. They reflect the company ability to meet its long-term
debt obligations. The main ratios calculated in this area are:
A. Debt Equity Ratio = this ratio indicates the relative proportions of debt and
equity in financing the assets of a firm. This ratio can be shown n different
ways. Thus
B. Total debt to total assets ratio: this ratio generally called the debt ratio,
measures the percentage of funds provided by creditors. It is calculated by
dividing total debt by total assets. Thus :
c. Interest coverage ratio: it is also known as time interest earned ratio. This
ratio reflects the firm’s ability to pay interest out of earnings. Failure to meet
this obligation can bring legal action by the firm’s creditors, possibly resulting
in bankruptcy. The standard ratio is 8times.
d. Cash coverage ratio: this ratio measures the extent to which interest is
covered by the cash flow from the firms operations. This is calculated as
follows:
A. Gross profit Margin: this ratios measures the degree of success in gross
earning on sales. The higher the gross profit margin, the better. The gross
profit margin is calculated as follows
B. Net profit Margin: This ratio measures the relationship between net profits
and sales of a firm. The net profit margin is indicative of management ability
to operate the business with sufficient success. A hig net profit margin would
ensure adequate return to the owners as well as enable a firm to tackle
adverse situations. The net profit margin is calculated as follows:
Or = Eat/ sales
This ratio indicates the profitability of sales before taxes and interest expense. Non
operating revenues ( such as interest on marketable securities and royalties) are
not included in the returns and non operating expense are not deducted. The
purpose of this ratio is to measure the effectiveness of production and sales of the
company’s product in generating pre-tax income for the firm.
ii. Return on Equity (ROE) : The most important profitability ratio is the
ratio of net income to common equity which is measured as follows:
Share holders invest to get return on their money and this ratio tells how well
they are doing in an accounting sense.
iii. Return on capital employed (ROCE): It relates the income earned from
the company’s activities to the resources employed by the company.
This ratio measures the abilty to earn a reasonable income for the firm
with the resources employed. It is calculated as follows
25.Price earnings ratio ( PE) = market price per share / earnings per share