This document discusses ratio analysis and how it can be used to analyze a business's liquidity, profitability, and performance. It defines various types of ratios including liquidity ratios, activity ratios, gearing ratios, and profitability ratios. It provides examples of specific ratios like the current ratio, quick ratio, inventory turnover, and return on equity. The purpose of ratio analysis is to standardize financial information for comparison purposes and assess a business's strengths and weaknesses.
This document discusses ratio analysis and how it can be used to analyze a business's liquidity, profitability, and performance. It defines various types of ratios including liquidity ratios, activity ratios, gearing ratios, and profitability ratios. It provides examples of specific ratios like the current ratio, quick ratio, inventory turnover, and return on equity. The purpose of ratio analysis is to standardize financial information for comparison purposes and assess a business's strengths and weaknesses.
This document discusses ratio analysis and how it can be used to analyze a business's liquidity, profitability, and performance. It defines various types of ratios including liquidity ratios, activity ratios, gearing ratios, and profitability ratios. It provides examples of specific ratios like the current ratio, quick ratio, inventory turnover, and return on equity. The purpose of ratio analysis is to standardize financial information for comparison purposes and assess a business's strengths and weaknesses.
Compute basic accounting ratios Explain the purpose and use of ratios in analysis a business’s liquidity, profitability and performance. • Analysis of financial statement for decision making. (a) Assessment of a business’ past, present and anticipates future (b) To identify the weakness and strength. • Objective of Ratio Analysis (a) To standardise financial information for comparison purposes. (b) To assess the strengths and weakness of a business (c) To highlight trends on financial items. (d) To evaluate current operation of a business (e) To assess the efficiently of the business operations (f) To compare the present performance with past performance. (g) To compare the performance of the business with its competitors. Financial ratios are tools to do this. Liquidity ratios Activity ratios Gearing ratios Profitability ratios Measures whether a firm can repay its bills, or financial obligations (debts) on time. Focus is on cash or near cash assets – more readily available to settle debts (especially current debts). Sometimes called the working capital ratio or bankers’ ratio Measures a company’s ability to pay its current liabilities. Computed as follows: Current Assets Current Ratio = Current Liabilities
The higher the CR, the more liquid the firm’s
position. Rule of thumb, CR should be > 2. The current ratio for Lincoln Company is computed below. Measures the “instant” debt-paying ability of a company Sometimes called acid-test ratio. It is computed as follows: The quick ratio for Lincoln Company is computed below. Excess of current assets over current liabilities. Note: not a ratio. Often used to evaluate a company’s ability to pay current liabilities. Computed as follows:
The larger the figure, the better.
Measures how effectively a firm uses its assets to generate revenue. Also called efficiency, turnover or business asset management ratios. The relationship between the volume of goods (merchandise) sold and inventory. Assesses the efficiency of a firm in managing its inventory. Tells how many times the inventory is replaced/sold within an accounting period The higher the figure, the better – sales are increasing & inventory levels are low. Computed as follows: Lincoln’s inventory balance at the beginning of 2011 is $311,000. A rough measure of the length of time it takes to purchase, sell, and replace the inventory. Computed as follows: The number of days’ sales in inventory for Lincoln Company is computed below. The relationship between sales and accounts receivable. Collecting accounts receivable as quickly as possible improves a company’s solvency. The higher the ratio, the more effective the firm in collecting from its credit customers. Computed as follows: The accounts receivable turnover for Lincoln Company is computed below. An estimate of the length of time (in days) the accounts receivable have been outstanding. The fewer number of days, the more efficient the firm is at collecting receivables. Computed as follows: The number of days’ sales in receivables for Lincoln Company is computed below. Measures how effectively the firm uses its non- current assets to generate sales. The higher the ratio, the more efficient the firm is in using its non-current assets to generate sales. Computed as follows: A measure that shows how effectively a company utilizes its assets – how much sales a firm is able to generate from money invested in total assets. The higher the ratio, the better. The ratio is computed as follows: The ratio of net sales to assets for Lincoln Company is computed below. Measures how a firm uses outside funds (liabilities) to finance its assets. Also indicates whether a firm can pay the interest on the use of outside funds & repay the loan amounts. Also called leverage or debt management ratios. Measures the percentage of total liabilities to the total assets of the firm. Computed as follows:
The lower the ratio, the better
the less a firm is financed by outside parties. the higher the firm’s ability to obtain more outside funds when needed. Measures the number of times a firm is able to repay fixed interest from its net operating profits. Also called interest cover ratio. The higher the ratio, the better More able to repay interest charges. It is computed as follows: The number of times interest charges are earned for Lincoln Company is computed below. Measures long term debt to shareholders’ equity. Indicates the margin of safety for creditors. The lower the ratio, the better for the firm. Computed as follows: The ratio of liabilities to shareholders’ equity for Lincoln Company is computed below. Measures the firm’s ability to produce profits from its assets. The higher the ratios, the better. Also an indication of firm’s efficiency. Can be divided into: Profitability ratios based on sales (gross profit margin, net profit margin, operating profit margin) Profitability ratios based on assets/resources (operating profit to total assets ratio, return on assets ratio, return on common equity) Measures the profitability of a firm over a period. Indicates how much profit is made per sales generated. Computed as follows: Indicates what is available to owners from its net sales, after considering all expenses. Computed as follows: Indicates how much operating profit is made per sales generated. Computed as follows: measures the amount of operating profit obtained from utilising assets. The higher the ratio, the more efficient the firm has been in utilising its assets to generate sales/profit. It is computed as follows: Measures the profitability of assets utilised. Also known as return on investment ratio. The higher the ratio, the better the return on the use of assets by the firm. Computed as follows: Measures the net profit against the amount invested by shareholders. Indicates what shareholders earn from their investments in the business. It is computed as follows: Lincoln Company had $150,000 of 6% preferred stock outstanding on December 31, 2012 and 2011. Thus, preferred dividends of $9,000 ($150,000 x 6%) are deducted from net income. Lincoln’s common shareholders’ equity is determined as follows: Inter-company comparisons against industry averages/norms Obtained by averaging out the ratios of a good sample of companies in the industry Firm can benchmark itself accordingly
Intra-company comparisons Trend analysis – over a period of time To see if business has improved/ deteriorated To be used to formulate future strategy