Professional Documents
Culture Documents
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Ratio Comparison
Ratios are meaningful if compared with a standard or base figure/judge each ratio against a predetermined standard for the period of time.
Ratio Categories
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Liquidity Ratios
Solvency Ratios Profitability Ratios Turnover Ratios
Liquidity Ratios For the analysis of a firms ability to meet short-term obligations as they become due.
Liquidity Ratios
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Current Ratio
Quick Ratio Accounts Receivable Ratio a. % of Revenue b. Accounts Receivable Turnover c. Average Collection Period
Current Ratio
Indicative of a firms ability to meet its short-term debts without difficulty. Current Ratio = Current Assets/Current Liability General rule of thumb is 2:1 to provide for safety margin; especially firms with large current assets tied up in inventories. Hotels current ratio acceptable: >= 1.5 Restaurants current ratio acceptable: , = 1.1 A balance should be struck; as too low a ratio short-term liquidity problem too high a ratio sacrifices profitability for safety; because money tied up in working capital are money not earning income.
Accounts receivable represents the portion of revenue which have not been converted to cash and are therefore, not available for payment of current obligation
Solvency Ratios
Referred to as Net Worth Ratio Net Worth = Total Tangible Asset (Total Assets Intangible Items such as Goodwill) Total Liabilities = Total Shareholders Equity Total Assets can be financed either by Debts (Liabilities) or Equity (Shares & Retained Earnings) Solvency ratios shows the balance between these 2 methods of financing. It indicates the ability of the firm to meet its debt obligations when they are due, including principal & interest on long-term borrowings.
Leverage
Amount of long term debts used to finance the assets of the firm, as compared to the amount of owners equity (shareholders equity).
The higher the debt-to-equity ratio, the higher will be the owners return on equity.
If Income (before interest) as a percentage of debt is greater than the interest rate to be paid on the debt. However If income declines, the more highly levered a company is, the sooner it will be in financial difficulty.
Profitability Ratios
There is a significant difference between annual profit & profitability. Profit is an absolute term which is expressed as a monetary amount. Profitability is a relative measure of profits as they relate to other factors. Such as the ability to generate profits from the available resources & the adequacy of profits in relation to: revenue assets owners investment in the business
Net Return on Assets is useful to assess the likelihood of obtaining more debt financing for expansion purpose versus to evaluate the advisability of seeking equity financing. Because dividend is paid out from earnings after income tax. With equity financing for expansion etc.., shareholders do not anticipate good dividend yield. Calculations are based on book value, therefore, with fair market value, the ratio is likely to decrease. Management needs to improve operating performance to convince equity financing.
Return to Equity
= Net income after tax/Average shareholders equity x 100% The ratio shows effectiveness of management use of equity funds. A good ratio should relate to opportunity cost & risk involved.
Turnover Ratios
Used in the assessment of usage of certain groups of assets. It indicates the number of times that an activity occurs over a period, therefore helps t evaluate mangers capability in using & controlling these assets.
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Any change in turnover rate should be investigated as to its cause: Increased ratio: possibly due to too little investment in inventory & this may affect production efficiency & sales. Decreased ratio: it could mean more money being tied up in inventory & not producing a return. The ratio is generally affected by : Mode of operation Location of operation Method of purchase Storage facility Availability of fund & credit