Title: Financial ratios

Subtitle

Topic: Financial ratios

Introduction: Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account.
The process of reviewing and evaluating a companys financial statements (such as the balance sheet or profit and loss statement), thereby gaining an understanding of the financial health of the company and enabling more effective decision making.

Topic: Financial ratios

Ratio analysis involves assessing how various line items in a firms financial statements relate to one another. Financial ratios are used to compare the risk and return of different firms in order to help equity investors and creditors make investment and credit decision In a ratio analysis, the analyst can (1) Compare ratios for a firm over several years (2) Compare ratios for the firm and other firms in the industry (3) Compare ratios to some absolute benchmark

Topic: Financial ratios

Ratio analysis is an analysis of strength and weakness of an organization by establishing the quantitative relation among the items of Balance Sheet or Income Statement of such an organization. Importance/Advantages Analysis of financial Position Simplification of Accounting Figures Assessment of Operational Efficiency Determining Trends in the long-run Identification of Strength & Weakness Taking Remedial Measures Comparison of Performance

Topic: Classification of ratios

A. Liquidity Ratios
B. Solvency Ratios C. Activity Ratios D. Profitability Ratios

Topic: Liquidity Ratios

Liquidity refers to the ability of the concern to meet its current obligation as and when these become due the short- term obligations are met by releasing amounts from current floating or circulating assets. The current asset should either be liquid and near liquidity. It includes: 1) Current Ratio, 2) Acid Test Ratio and 3) Working Capital Turnover Ratio

Topic: Current Ratio

Relation between current assets and current liabilities Long Term Sources Financing the Current assets give a stable base for the liquidity of the organization Normally , the ratio should not be less than 2 i.e., the current assets should be double the size of current liabilities

Topic: Current Ratio

Measurement of Current Ratio:
Current Ratio = Current assets Current liabilities Example: If the Current Assets and Current Liabilities of a concern are Rs.4,00,000 and Rs.2,00,000 respectively, then the Current Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1

Topic: Acid Test Ratio/Quick Ratio

It is the ratio between quick assets and quick liabilities Quick assets include current assets except inventory and pre-paid expenses Quick liabilities include current liabilities other than bank overdraft A 1:1 ratio is healthy Healthy indicator of cash management

Topic: Acid Test Ratio/Quick Ratio

Measurement of Acid Test Ratio: Quick Ratio or Acid Test Ratio = Quick Assets Current Liabilities

Example: Cash 50,000 Debtors 1,00,000 Current Liabilities 1,00,000 Total Quick Assets 150000 Quick Ratio = 1,50,000/1,00,000 = 1.5 : 1

Topic: Working Capital Turn-over Ratio

Shows the efficiency of usage of working capital
Relation between Sales and Working Capital Determination of number of times the working capital is turned over to achieve the maximum profit

Topic: Working Capital Turn-over Ratio

Measurement of Working Capital Turnover Ratio: Working capital turnover Ratio = Net sales Working Capital Example: If a company has current assets of $10 million and current liabilities of $9 million, its working capital is $1 million. When compared to sales of $15 million, the working capital turnover ratio for the period is 15 ($15M/$1M)

Topic: Solvency/Leverage Ratios

Measure long-term liquidity ratio Reflect the ability of the firm to pay interest and repayment of loans at due dates on the long-term loans taken Avoidance of over-borrowing (over-leverage) Avoidance of bankruptcy by maintaining healthy solvency ratios

Topic: Solvency Ratios

Types of solvency Ratios: 1) Interest Coverage Ratio 2) Debt Ratio 3) Debt-Equity Ratio

Topic: Interest Coverage Ratio

A ratio used to determine how easily a company can pay interest on outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) of one period by the company's interest expenses of the same period.

Topic: Interest Coverage Ratio

Measurement of Interest Coverage Ratio: Interest Coverage Ratio= EBIT Interest expenses

Example: Interest Expense

EBIT

$150,000
$ 300,000

interest coverage ratio is:

$300,000 /$150,000 = 2.0

Topic: Debt ratio

A ratio that indicates what proportion of debt a company has relative to its assets. The measure gives an idea to the leverage of the company along with the potential risks the company faces in terms of its debt-load. A debt ratio is simply a company's total debt divided by its total assets.

Topic: Debt ratio

Measurement of debt ratio. Debt Ratio = Total Debt / Total Assets Example: if Company XYZ had $10 million of debt on its balance sheet and $15 million of assets, then Company XYZ's debt ratio is: Debt Ratio = $10,000,000 / $15,000,000 = 0.67 or 67%

Topic: Debt equity ratio

The debt-to-equity ratio is a measure of the relationship between the capital contributed by creditors and the capital contributed by shareholders. It also shows the extent to which shareholders' equity can fulfill a company's obligations to creditors in the event of a liquidation. A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.

Topic: Debt equity ratio

Measurement of Debt equity ratio: Debt-to-Equity Ratio = Total Debt / Total Equity For most companies the maximum acceptable debt-to-equity ratio is 1.5-2 and less. For large public companies the debt-to-equity ratio may be much more than 2, but for most small and medium companies it is not acceptable. US companies show the average debt-to-equity ratio at about 1.5

Topic: Debt equity ratio

Measurement of Debt equity ratio: Debt-to-Equity Ratio = Total Debt / Total Equity For most companies the maximum acceptable debt-to-equity ratio is 1.5-2 and less. For large public companies the debt-to-equity ratio may be much more than 2, but for most small and medium companies it is not acceptable. US companies show the average debt-to-equity ratio at about 1.5

Topic: Debt equity ratio

If a business has total liabilities of $3,423,000 and shareholders' equity of $5,493,000. Debt-to-Equity Ratio = $3,423,000 / $5,493,000 = 0.62

Topic: Activity Ratios

Activity ratios are used to measure the relative efficiency of a firm based on its use of its assets, leverage or other such balance sheet items. These ratios are important in determining whether a company's management is doing a good enough job of generating revenues, cash, etc. from its resources.

Topic: Activity Ratios

Types of activity ratio: 1) Inventory Turnover Ratio 2) Debtors/Account Receivable Turnover Ratio 3) Average Collection Period 4) Fixed Assets Turnover Ratio 5) Total Assets Turnover Ratio

Topic: Inventory Turnover Ratio

Inventory turnover ratio is used to measure the inventory management efficiency of a business. In general, a higher value indicates better performance and lower value means inefficiency in controlling inventory levels. A lower inventory turnover ratio may be an indication of overstocking which may pose risk of obsolescence and increased inventory holding costs. However, a very high turnover may result in loss of sales due to inventory shortage. Inventory turnover is different for different industries.

Topic: Inventory Turnover Ratio

Inventory Turnover Ratio = Cost of goods sold Average inventory

Topic: Inventory Turnover Ratio

Example 1: During the year ended December 31, 2010 Loud Corporation sold goods costing $324,000. Its average stock of goods during the same period was $23,432. Calculate the company's inventory turnover ratio. Solution Inventory Turnover Ratio = $324,000 / $23,432 = 13.83

Topic: Debtors/Account receivable Turnover Ratio

Accounts receivable turnover measures the efficiency of a business in collecting its credit sales. Generally a high value of accounts receivable turnover is favorable and lower figure may indicate inefficiency in collecting outstanding sales. But a normal level of receivables turnover is different for different industries. Accounts receivable turnover is usually calculated on annual basis, however for the purpose of creating trends, it is more meaningful to calculate it on monthly or quarterly basis.

Topic: Debtors/Account receivable Turnover Ratio

Measurement of account receivable turnover ratio: Account receivable turnover ratio= Net credit sales Average account receivable

Topic: Debtors/Account receivable Turnover Ratio

Example 1: Net credit sales of Company A during the year ended June 30, 2010 were $644,790. Its accounts receivable at July 1, 2009 and June 30, 2010 were $43,300 and $51,730 respectively. Calculate the receivables turnover ratio. Solution Average Accounts Receivable = ( $43,300 + $51,730 ) / 2 = $47,515 Receivables Turnover Ratio = $644,790 / $47,515 = 13.57

Topic: Average Collection Period

The average collection period, or average age of accounts receivable, is useful in evaluating credit and collection policies. It is arrived at by dividing the average daily sales into the accounts receivable balance The approximate amount of time that it takes for a business to receive payments owed, in terms of receivables, from its customers and clients.

Topic: Average Collection Period

Measurement of average collection period:
ACP= Days X AR/Credit sales

Where: Days = Total amount of days in period AR = Average amount of accounts receivables Credit Sales = Total amount of net credit sales during period

Topic: Average Collection Period

For example, suppose that a widget making company, XYZ Corp, has total credit sales of $100,000 during a year (assume 365 days) and has an average amount of accounts receivables is $50,000. Its average collection period is 182.5 days.

Topic: Fixed asset turnover ratio

It compares the sales revenue a company to its fixed assets. This ratio tells us how effectively and efficiently a company is using its fixed assets to generate revenues. This ratio indicates the productivity of fixed assets in generating revenues. If a company has a high fixed asset turnover ratio, it shows that the company is efficient at managing its fixed assets. This ratio is usually used in capitalintensive industries where major purchases are for fixed assets.

Topic: Fixed asset turnover ratio

Measurement Fixed Asset Turnover Ratio

Fixed Asset Turnover Ratio = Sales Revenue / Total Fixed Assets

Topic: Fixed asset turnover ratio

Example: ABC Company has gross fixed assets of $5,000,000 and accumulated depreciation of $2,000,000. Sales over the last 12 months totaled $9,000,000. The calculation of ABC's fixed asset turnover ratio is: =$9,000,000/$5,000,000- $2,000,000 = 3.0 times turnover per year

Topic: Asset turnover ratio

Asset turnover ratio is the ratio of a company's sales to its assets. It is an efficiency ratio which tells how successfully the company is using its assets to generate revenue.

Topic: Asset turnover ratio

Measurement of asset turnover ratio:
Asset turnover = Revenue / Average total assets Example:

Profitability ratios
These ratios measure the operating efficiency of the firm and its ability to ensure adequate returns to its shareholders. The profitability of a firm can be measured by its profitability ratios.
Further the profitability ratios can be determined (i) in relation to sales and (ii) in relation to investments

Profitability ratios

Profitability ratios in relation to sales: Gross profit margin Net profit margin

Profitability ratios

Profitability ratios in relation to investments Return on assets (ROA) Return on capital employed (ROCE) Return on shareholders equity (ROE) Earnings per share (EPS) Price earning ratio (P/E)

Gross profit margin

This ratio is calculated by dividing gross profit by sales. It is expressed as a percentage. Gross profit is the result of relationship between prices, sales volume and costs. Gross profit margin = Gross profit x 100 Net sales

Gross profit margin

A firm should have a reasonable gross profit margin to ensure coverage of its operating expenses and ensure adequate return to the owners of the business i.e. the shareholders. To judge whether the ratio is satisfactory or not, it should be compared with the firms past ratios or with the ratio of similar firms in the same industry or with the industry average.

Net profit margin

This ratio is calculated by dividing net profit by sales. It is expressed as a percentage. This ratio is indicative of the firms ability to leave a margin of reasonable compensation to the owners for providing capital, after meeting the cost of production, operating charges and the cost of borrowed funds. Net profit margin = Net profit after interest and tax x 100
Net sales

Net profit margin

Another variant of net profit margin is operating profit margin which is calculated as: Operating profit margin = Net profit before interest and tax x 100 Net sales Higher the ratio, greater is the capacity of the firm to withstand adverse economic conditions and vice versa

Return on assets (ROA)

This ratio measures the profitability of the total funds of a firm. It measures the relationship between net profits and total assets. The objective is to find out how efficiently the total assets have been used by the management. Return on assets = Net profit after taxes plus interest x 100 Total assets Total assets exclude fictitious assets. As the total assets at the beginning of the year and end of the year may not be the same, average total assets may be used as the denominator.

Return on capital employed (ROCE)

This ratio measures the relationship between net profit and capital employed. It indicates how efficiently the long-term funds of owners and creditors are being used. Return on capital employed = Net profit after taxes plus interest x 100 Capital employed CAPITAL EMPLOYED denotes shareholders funds and long-term borrowings. To have a fair representation of the capital employed, average capital employed may be used as the denominator.

Return on shareholders equity

This ratio measures the relationship of profits to owners funds. Shareholders fall into two groups i.e. preference shareholders and equity shareholders. So the variants of return on shareholders equity are

Return on total shareholders equity = Net profits after taxes x 100 Total shareholders equity .

Return on shareholders equity

TOTAL SHAREHOLDERS EQUITY includes preference share capital plus equity share capital plus reserves and surplus less accumulated losses and fictitious assets. To have a fair representation of the total shareholders funds, average total shareholders funds may be used as the denominator

Return on shareholders equity

Return on ordinary shareholders equity = Net profit after taxes pref. dividend x 100 Ordinary shareholders equity or net worth ORDINARY SHAREHOLDERS EQUITY OR NET WORTH includes equity share capital plus reserves and surplus minus fictitious assets.

Earnings per share (EPS)

This ratio measures the profit available to the equity shareholders on a per share basis. This ratio is calculated by dividing net profit available to equity shareholders by the number of equity shares. Earnings per share = Net profit after tax preference dividend Number of equity shares

Price earning ratio (P/E)

This ratio is computed by dividing the market price of the shares by the earnings per share. It measures the expectations of the investors and market appraisal of the performance of the firm. Price earning ratio = market price per share Earnings per share