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Financial Statement Analysis - LiquidityRatiosIn analyzing Financial Statements for the purpose of granting credit Ratios can be broadlyclassified into three categories. Liquidity Ratios Efficiency Ratios Profitability RatiosLiquidity Ratios:Liquidity Ratios are ratios that come off the the Balance Sheet and hence measure the liquidity ofthe company as on a particular day i.e the day that the Balance Sheet was prepared. Theseratios are important in measuring the ability of a company to meet both its short term and longterm obligations.FIRST LIQUIDITY RATIOCurrent Ratio: This ratio is obtained by dividing the Total Current Assets of a company by itsTotal Current Liabilities. The ratio is regarded as a test of liquidity for a company. It expressesthe working capital relationship of current assets available to meet the companys currentobligations.The formula:Current Ratio = Total Current Assets/ Total Current LiabilitiesAn example from our Balance sheet:Current Ratio = $261,050 / $176,522Current Ratio = 1.48The Interpretation:Lumber & Building Supply Company has $1.48 of Current Assets to meet $1.00 of its CurrentLiabilityReview the Industry Norms and Ratios for this ratio to compare and see if they are abovebelow or equal to the others in the same industry.To use the Current Ratio Calculator Click here click here .
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SECOND LIQUIDITY RATIOQuick Ratio: This ratio is obtained by dividing the Total Quick Assets of a company by itsTotal Current Liabilities. Sometimes a company could be carrying heavy inventory as part of itscurrent assets, which might be obsolete or slow moving. Thus eliminating inventory from currentassets and then doing the liquidity test is measured by this ratio. The ratio is regarded as an acidtest of liquidity for a company. It expresses the true working capital relationship of its cash,accounts receivables, prepaids and notes receivables available to meet the companys currentobligations.The formula:Quick Ratio = Total Quick Assets/ Total Current LiabilitiesQuick Assets = Total Current Assets (minus) InventoryAn example from our Balance sheet:Quick Ratio = $261,050- $156,822 / $176,522Quick Ratio = $104,228 / $176,522Quick Ratio = 0.59The Interpretation:Lumber & Building Supply Company has $0.59 cents of Quick Assets to meet $1.00 of its CurrentLiabilityReview the Industry Norms and Ratios for this ratio to compare and see if they are abovebelow or equal to the others in the same industry.To use the Quick Ratio Calculator Click here click here .THIRD LIQUIDITY RATIODebt to Equity Ratio: This ratio is obtained by dividing the Total Liability or Debt of acompany by its Owners Equity a.k.a Net Worth. The ratio measures how the company isleveraging its debt against the capital employed by its owners. If the liabilities exceed the networth then in that case the creditors have more stake than the shareowners.The formula:Debt to Equity Ratio = Total Liabilities / Owners Equity or Net WorthAn example from our Balance sheet:Debt to Equity Ratio = $186,522 / $133,522
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Debt to Equity Ratio = 1.40The Interpretation:Lumber & Building Supply Company has $1.40 cents of Debt and only $1.00 in Equity to meetthis obligation.Review the Industry Norms and Ratios for this ratio to compare and see if they are abovebelow or equal to the others in the same industry.To use the Debt to Equity Ratio Calculator Click here click here .Efficiency Ratios:Efficiency ratios are ratios that come off the the Balance Sheet and the Income Statement andtherefore incorporate one dynamic statement, the income statement and one static statement ,the balance sheet. These ratios are important in measuring the efficiency of a company in eitherturning their inventory, sales, assets, accounts receivables or payables. It also ties into theability of a company to meet both its short term and long term obligations. This is because ifthey do not get paid on time how will you get paid paid on time. You may have perhaps heardthe excuse I will pay you when I get paid or My customers have not paid me!FIRST EFFICIENCY RATIODSO (Days Sales Outstanding): The Days Sales Outstanding ratio shows both the averagetime it takes to turn the receivables into cash and the age, in terms of days, of a companysaccounts receivable. The ratio is regarded as a test of Efficiency for a company. The effectivenesswith which it converts its receivables into cash. This ratio is of particular importance to credit andcollection associates.Best Possible DSO yields insight into delinquencies since it uses only the current portion ofreceivables. As a measurement, the closer the regular DSO is to the Best Possible DSO, thecloser the receivables are to the optimal level.Best Possible DSO requires three pieces of information for calculation: Current Receivables Total credit sales for the period analyzed The Number of days in the period analyzedFormula:Best Possible DSO = Current Receivables/Total Credit Sales X Number of DaysThe formula:Regular DSO = (Total Accounts Receivables/Total Credit Sales) x Number of Days in the periodthat is being analyzedAn example from our Balance sheet and Income Statement:
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Total Accounts Receivables (from Balance Sheet) = $97,456Total Credit Sales (from Income Statement) = $727,116Number of days in the period = 1 year = 360 days ( some take this number as 365 days)DSO = [ $97,456 / $727,116 ] x 360 = 48.25 daysThe Interpretation:Lumber & Building Supply Company takes approximately 48 days to convert its accountsreceivables into cash. Compare this to their Terms of Net 30 days. This means at an averagetheir customers take 18 days beyond terms to pay.Review the Industry Norms and Ratios for this ratio to compare and see if they are abovebelow or equal to the others in the same industry.To use the Regular DSO Calculator Click here click here .SECOND EFFICIENCY RATIOInventory Turnover ratio: This ratio is obtained by dividing the Total Sales of a company byits Total Inventory. The ratio is regarded as a test of Efficiency and indicates the rapiditity withwhich the company is able to move its merchandise.The formula:Inventory Turnover Ratio = Net Sales / InventoryIt could also be calculated as:Inventory Turnover Ratio = Cost of Goods Sold / InventoryAn example from our Balance sheet and Income Statement:Net Sales = $727,116 (from Income Statement)Total Inventory = $156,822 (from Balance sheet )Inventory Turnover Ratio = $727,116/ $156,822Inventory Turnover = 4.6 timesThe Interpretation:Lumber & Building Supply Company is able to rotate its inventory in sales 4.6 times in one fiscalyear.
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Review the Industry Norms and Ratios for this ratio to compare their efficiency and see ifthey are above, below or equal to the others in the same industry.To use the Inventory Turnover Ratio Calculator Click here click here .THIRD EFFICIENCY RATIOAccounts Payable to Sales (%): This ratio is obtained by dividing the Accounts Payablesof a company by its Annual Net Sales. This ratio gives you an indication as to how much of theirsuppliers money does this company use in order to fund its Sales. Higher the ratio means thatthe company is using its suppliers as a source of cheap financing. The working capital of suchcompanies could be funded by their suppliers..The formula:Accounts Payables to Sales Ratio = [Accounts Payables / Net Sales ] x 100An example from our Balance sheet and Income Statement:Accounts Payables = $152,240 (from Balance sheet )Net Sales = $727,116 (from Income Statement)Accounts Payables to Sales Ratio = [$152,240 / $727,116] x 100Accounts Payables to Sales Ratio = 20.9%The Interpretation:21% of Lumber & Building Supply Companys Sales is being funded by its suppliers.Review the Industry Norms and Ratios for this ratio to compare and see if they are abovebelow or equal to the others in the same industry.Profitability Ratios:Profitability Ratios show how successul a company is in terms of generating returns or profits onthe Investment that it has made in the business. If a business is Liquid and Efficient it shouldalso be Profitable.FIRST PROFITIBILITY RATIOReturn on Sales or Profit Margin (%): The Profit Margin of a company determines itsability to withstand competition and adverse conditions like rising costs, falling prices or decliningsales in the future. The ratio measures the percentage of profits earned per dollar of sales andthus is a measure of efficiency of the company.The formula:
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Return on Sales or Profit Margin = (Net Profit / Net Sales) x 100An example from our Balance sheet and Income Statement:Total Net Profit after Interest and Taxes (from Income Statement) = $5,142Net Sales (from Income Statement) = $727,116Return on Sales or Profit Margin = [ $5,142 / $727,116] x 100Return on Sales or Profit Margin = 0.71%The Interpretation:Lumber & Building Supply Company makes 0.71 cents on every $1.00 of SaleReview the Industry Norms and Ratios for this ratio to compare and see if they are abovebelow or equal to the others in the same industry.To use the Return on Sales or Profit Margin Calculator click here .SECOND PROFITABILITY RATIOReturn on Assets: The Return on Assets of a company determines its ability to utitize theAssets employed in the company efficiently and effectively to earn a good return. The ratiomeasures the percentage of profits earned per dollar of Asset and thus is a measure of efficiencyof the company in generating profits on its Assets.The formula:Return on Assets = (Net Profit / Total Assets) x 100An example from our Balance sheet and Income Statement:Total Net Profit after Interest and Taxes (from Income Statement) = $5,142Total Assets (from Balance sheet) = $320,044Return on Assets = [ $5,142 / $320,044] x 100Return on Assets = 1.60%The Interpretation:Lumber & Building Supply Company generates makes 1.60% return on the Assets that itemploys in its operations.
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Review the Industry Norms and Ratios for this ratio to compare and see if they are abovebelow or equal to the others in the same industry.To use the Return on Assets or Profit Margin Calculator click here .THIRD PROFITABILITY RATIOReturn on Equity or Net Worth: The Return on Equity of a company measures the ability ofthe management of the company to generate adequate returns for the capital invested by theowners of a company. Generally a return of 10% would be desirable to provide dividents toowners and have funds for future growth of the companyThe formula:Return on Equity or Net Worth = (Net Profit / Net Worth or Owners Equity) x 100Net Worth or Owners Equity = Total Assets (minus) Total LiabilityAn example from our Balance sheet and Income Statement:Total Net Profit after Interest and Taxes (from Income Statement) = $5,142Net Worth (from Balance sheet) = $133,522Return on Net Worth = [ $5,142 / $133,522] x 100Return on Equity or Return on Net Worth = 3.85%The Interpretation:Lumber & Building Supply Company generates a 3.85% percent return on the capital invested bythe owners of the company.Review the Industry Norms and Ratios for this ratio to compare and see if they are abovebelow or equal to the others in the same industry.
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