Professional Documents
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Mary Low
Ratio Analysis
Shows the relative size of one financial statement component to another. Effective only when used in combination with other ratios, analysis, and information
Ratio Analysis involves methods of calculating and interpreting financial ratios in order to assess a firm's performance and status
Mary Low
Ratio Analysis
A single ratio by itself is not very meaningful.
The discussion of ratios will include the following types of comparisons.
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Mary Low
Liquidity ratios Asset Management or Activity Ratios Debt Ratios Profitability Ratios
Mary Low
Ratio Analysis
Liquidity Ratios
Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.
Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity. Ratios include the current ratio, the Quick ratio.
Mary Low
Liquidity ratios
For example: Current ratio Current Assets Current Liabilities This ratio is calculated in times. Current Ratio =
The ideal benchmark for the current ratio is $2:$1 where there are two dollars of current assets (CA) to cover $1 of current liabilities (CL). The acceptable benchmark is $1: $1 but a ratio below $1CA:$1CL represents liquidity riskiness as there is insufficient current assets to cover $1 of current liabilities. A ratio of 5 : 1 would imply the firm has $5 of assets to cover every $1 in liabilities A ratio of 0.75 : 1 would suggest the firm has only 75c in assets available to cover every $1 it owes Too high Might suggest that too much of its assets are tied up in unproductive activities too much stock, for example?
Mary Low
Liquidity ratios
Quick Ratio = Current Assets Inventory Current Liabilities This ratio is calculated in times.
1:1 seen as ideal The omission of stock gives an indication of the cash the firm has in relation to its liabilities. A ratio of 3:1 therefore would suggest the firm has 3 times as much cash as it owes very healthy! A ratio of 0.5:1 would suggest the firm has twice as many liabilities as it has cash to pay for those liabilities. This might put the firm under pressure but is not in itself the end of the world!
Mary Low
Inventory Period
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Inventory turnover
This ratio is calculated in times. The rate at which a companys stock is turned over A high stock turnover might mean increased efficiency? But: dependent on the type of business supermarkets might have high stock turnover ratios whereas a shop selling high value musical instruments might have low stock turnover ratio Low stock turnover could mean poor customer satisfaction if people are not buying the goods.
Mary Low
Average Collection Period = Accounts Receivable Average daily net sales* This ratio is calculated in days. Shorter the better Gives a measure of how long it takes the business to recover debts
Mary Low
Debt Ratios
Long term funds management Measures the riskiness of business in terms of debt For example: Debt/Equity This ratio measures the relationship between debt and equity. A ratio of 1 indicates that debt and equity funding are equal (i.e. there is $1 of debt to $1 of equity) whereas a ratio of 1.5 indicates that there is higher debt in the business (i.e. there is $1.5 of debt to $1 of equity). This higher debt is usually interpreted as bringing in more financial risk for the business particularly if the business has profitability or cash flow problems.
Mary Low
Debt Ratios
Debt/Equity ratio = Long term debt / Total Equity This ratio is calculated in times. Debt/Total Assets ratio = Total Liabilities *100 Total Assets This ratio is calculated in percentage.
Profitability Ratios
Measures the income or operating success of a company for a given period of time. Profitability measures look at how much profit the firm generates from sales or from its capital assets. All Profitability ratios are calculated in terms of percentage. Gross Profit % = Gross Profit * 100 Net Sales Net Profit % = Net Profit after tax * 100 Net Sales Return on Assets = Return on Equity = Net Profit Total Assets Net Profit Total Equity * 100
*100
Mary Low
Return on Equity
Return on Equity = Net Profit Total Equity *100
The higher the better Shows how effective the firm is in using its capital to generate profit A ROE of 25% means that it uses every $1 of capital to generate 25c in profit
Mary Low
Relevant ratios
Profitability ratios: Gross Profit Margin Net Profit Margin Return on Assets Return on Equity Benchmarks 2005 2006
22%
22.7%
7.1%
6.1%
15.6%
15.5%
Industry 20%
32%
26%
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Benchmarks
2005
2006
Industry 6% 2.0
5.8 times
5.58 times
2.2 times
2.53 times
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Benchmarks
Ideal standard 2:1 Acceptable standard 1:1
2005 1.78:1
2006 1.70:1
Quick Ratio
0.85:1
0.69:1
Mary Low
Benchmarks
2005
2006
1.05: 1
0.67:1
Debt Ratio
55%
45%
Mary Low
Report
For the investor considering the purchase of shares in the company, the return they will earn is the key financial factor but an overall evaluation of the companys performance and position is also important to get a better picture of how well the company is actually doing. ROE in 2006 is 26%. this return is certainly more attractive. ROE has decreased by 6% in 2006 but the companys ROE at 26% is still better than the industry average of 20%
Mary Low
Profitability
The NP% and ROA ratios show a small downward trend in % over the 2 year period. ROE% ratio show a more significant decrease but is still better than the industry average. Gross Profit Margin is slightly unfavourable at about 2.3% below the industry benchmark of 25%.
Asset Management
IT has gone down slightly from 5.8 to 5.58 times. IT is still close to the industry benchmark of 6 times. AT has increased showing more sales being generated from asset usage
Mary Low
Liquidity
Current ratios of 1.78:1 (2005) and 1.70: 1 are at above acceptable levels but below ideal level. Quick ratios appear more of a concern being below acceptable levels in both years and even more so in 2006 (0.69:1). Raises some concerns over the liquidity of the business and inventory management (although IT ratio only shows a slight decline in 2006).
Mary Low