Imp ratios & there usage

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Imp ratios & there usage

  1. 1. Some important ratios and there usageWhats the use of Ratios ? Typically, financial ratios provide the most benefit when they are compared with otheridentical ratios.A companys ratios are used comparatively in two main fashions: over time and againstother companies. Comparing the same ratios for a firm over time is a great way to identify acompanys trends. If certain ratios are steadily improving, it may suggest an improvement ina companys operations or financial situation; conversely, if certain ratios seem to be gettingworse, it may highlight some troubling prospects about the firm.Its also important to compare a companys ratios against those of others in the industry. Acompanys ratios may be improving over time, but how do they stack up against their peersratios? If they arent as rosy as those of competitors, this may indicate that the companyisnt as well positioned or managed as well as other industry players. Efficiency ratiosNo matter what kind of business a company is in, it must invest in assets to perform itsoperations. Efficiency ratios measure how effectively the company utilizes these assets, aswell as how well it manages its liabilities.Inventory Turnover. Inventory turnover illustrates how well a company manages its inventory levels. If inventoryturnover is too low, it suggests that a company may be overstocking or overbuilding itsinventory or that it may be having issues selling products to customers. All else equal, higherinventory turnover is better.Inventory Turnover = (Cost of Sales) / (Average Inventory)
  2. 2. Accounts Receivable Turnover.The accounts receivable turnover ratio measures how effective the companys creditpolicies are. If accounts receivable turnover is too low, it may indicate the company is beingtoo generous granting credit or is having difficulty collecting from its customers. All elseequal, higher receivable turnover is better.Accounts Receivable Turnover = Revenue / (Average Accounts Receivable)Accounts Payable Turnover Youll notice that the accounts payable turnover ratio uses a liability in the equation ratherthan an asset, as well as an expense rather than revenue. Accounts payable turnover isimportant because it measures how a company manages paying its own bills. High accountspayable turnover may be a signal that a firm isnt receiving very favorable payment termsfrom its own suppliers. All else equal, lower payable turnover is better.Accounts Payable Turnover = (Cost of Sales) / (Average Accounts Payable)Total Asset Turnover. Total asset turnover is a catch-all efficiency ratio that highlights how effective managementis at using both short-term and long-term assets. All else equal, the higher the total assetturnover, the better.Total Asset Turnover = (Revenue) / (Average Total Assets)
  3. 3. Liquidity ratiosIn a nutshell, a companys liquidity is its ability to meet its near-term obligations, and it is amajor measure of financial health. Liquidity can be measured through several ratios.Current ratio. The current ratio is the most basic liquidity test. It signifies a companys ability to meet itsshort-term liabilities with its short-term assets. A current ratio greater than or equal to oneindicates that current assets should be able to satisfy near-term obligations. A current ratioof less than one may mean the firm has liquidity issues.Current Ratio = (Current Assets) / (Current Liabilities)Quick Ratio.The quick ratio is a tougher test of liquidity than the current ratio. It eliminates certaincurrent assets such as inventory and prepaid expenses that may be more difficult to convertto cash. Like the current ratio, having a quick ratio above one means a company should havelittle problem with liquidity. The higher the ratio, the more liquid it is, and the better ablethe company will be to ride out any downturn in its business.Quick Ratio = (Cash + Accounts Receivable + Short-Term or MarketableSecurities) / (Current Liabilities)Cash Ratio.The cash ratio is the most conservative liquidity ratio of all. It only measures the ability of afirms cash, along with investments that are easily converted into cash, to pay its short-termobligations. Along with the quick ratio, a higher cash ratio generally means the company isin better financial shape.Cash Ratio = (Cash + Short-Term or Marketable Securities) / (CurrentLiabilities)
  4. 4. Leverage ratiosA companys leverage relates to how much debt it has on its balance sheet, and it is anothermeasure of financial health. Generally, the more debt a company has, the riskier its stock is,since debtholders have first claim to a companys assets. This is important because, inextreme cases, if a company becomes bankrupt, there may be nothing left over for itsstockholders after the company has satisfied its debtholders.Debt/Equity.The debt/equity ratio measures how much of the company is financed by its debtholderscompared with its owners. A company with a ton of debt will have a very high debt/equityratio, while one with little debt will have a low debt/equity ratio. Assuming everything elseis identical, companies with lower debt/equity ratios are less risky than those with highersuch ratios.Debt/Equity = (Short-Term Debt + Long-Term Debt) / Total EquityInterest Coverage.If a company borrows money in the form of debt, it most likely incurs interest charges on it.(Money isnt free, after all!) The interest coverage ratio measures a companys ability tomeet its interest obligations with income earned from the firms primary source of business.Again, higher interest coverage ratios are typically better, and interest coverage close to orless than one means the company has some serious difficulty paying its interest.Interest Coverage = (Operating Income) / (Interest Expense)
  5. 5. Profitability ratiosHow good is a company at running its business? Does its performance seem to be gettingbetter or worse? Is it making any money? How profitable is it compared with itscompetitors? All of these very important questions can be answered by analyzingprofitability ratios.Gross Margin.gross profit is simply the difference between a companys sales of goods or services andhow much it must pay to provide those goods or services. Gross margin is simply theamount of each dollar of sales that a company keeps in the form of gross profit, and it isusually stated in percentage terms. The higher the gross margin, the more of a premium acompany charges for its goods or services. Keep in mind that companies in differentindustries may have vastly different gross margins.Gross Margin = (Gross Profit) / (Sales)Operating Margin.Operating margin captures how much a company makes or loses from its primary businessper dollar of sales. It is a much more complete and accurate indicator of a companysperformance than gross margin, since it accounts for not only the cost of sales but also theother important components of operating income we discussed in Lesson 301, such asmarketing and other overhead expenses.Operating Margin = (Operating Income or Loss) / SalesNet Margin.Net margin considers how much of the companys revenue it keeps when all expenses orother forms of income have been considered, regardless of their nature. While net margin isimportant to take note of, net income often contains quite a bit of "noise," both good andbad, which does not really have much to do with a companys core business.Net Margin = (Net Income or Loss) / Sales
  6. 6. Free Cash Flow Margin.The free cash flow margin simply measures how much per dollar of revenue management isable to convert into free cash flow.Free Cash Flow Margin = (Free Cash Flow) / SalesReturn on Assets (ROA).Return on assets measures a companys ability to turn assets into profit. (This may soundsimilar to the total assets turnover ratio discussed earlier, but total assets turnovermeasures how effectively a companys assets generate revenue.)Return on Assets = (Net Income + Aftertax Interest Expense) / (AverageTotal Assets)Youll notice that we are adding back the companys aftertax interest expense to net incomein the calculation. Why is that? Return on assets measures the profitability a companyachieves on all of its assets, regardless if they are financed by equity holders or debtholders;therefore, we add back in what the debtholders are charging the company to borrowmoney.Return on assets is generally stated in percentage terms, and higher is better, all else equal.Return on Equity (ROE).Return on equity is a straightforward ratio that measures a companys return on itsinvestment by shareholders. Like all of the profitability ratios weve discussed, it is usuallystated in percentage terms, and higher is better.Return on Equity = (Net Income) / (Average Shareholders Equity)

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