This document discusses various types of financial ratios used to evaluate companies. It describes liquidity ratios that measure a company's ability to meet short-term obligations, activity ratios that assess asset usage and efficiency, and solvency ratios that evaluate financial leverage and long-term debt obligations. Specific ratios covered include the current, quick, and cash ratios for liquidity; receivables turnover, inventory turnover, and total asset turnover for activity; and debt-to-equity, interest coverage, and cash coverage ratios for solvency. The document provides formulas for calculating each ratio and interpreting the results.
6. Financial ratios can be segregated into different
classifications by the type of information about the
company they provide. One such classification
scheme is:
1.Liquidity ratios: Liquidity here refers to the ability
to pay short-term obligations as they come
due.
2.Activity or Efficiency ratios: This category
includes several ratios also referred to Asset
utilization or turnover ratios (e.g., inventory
7. 4. Profitability ratios : Profitability ratios
provide information on how well the
company generates operating profits
and net profits .
5. Valuation ratios : Sales per share,
earnings per share, and price to cash flow
per share are examples of ratios used in
comparing the relative valuation of
companies.
8. A. Liquidity Ratios :
Liquidity Ratios : are employed by analysts to
determine the firm's ability to pay its short-term
liabilities.
1- The current ratio is the best-known measure of
liquidity:
Current Ratio =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
= 1 or less or More than 1
Comment : - The higher the current ratio, the more
likely it is that the company will be able to pay its
9. 2) The quick ratio is a more stringent measure of
liquidity because it does not include inventories
and other assets that might not be very liquid:
quick ratio ( Acid Test ) =
𝑪𝒂𝒔𝒉+𝑴𝒂𝒓𝒌𝒆𝒕𝒂𝒃𝒍𝒆 𝒔𝒆𝒄𝒖𝒓𝒊𝒕𝒊𝒆𝒔+𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔
𝑪𝒔𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
= (Current Assets – Inventory
) ÷ Current Liabilities it measured and
Calculated relative to 1 also
10. 3) The most conservative liquidity measure
is the cash ratio:
3) Cash ratio =
𝐶𝑎𝑠ℎ+𝑀𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Comment :
- The higher the cash ratio, the more likely it is that
the company will be able to pay its short-term bills.
- The current, quick, and cash ratios differ only in
11. B) Activity Ratios :
Activity ratios (also known as Asset Utilization
Ratios or Operating Efficiency ratios) measure
how efficiently the firm is managing its assets to
generate Sales
- A measure of accounts receivable turnover is :
1)receivables turnover:
receivables turnover =
𝑆𝑎𝑙𝑒𝑠
𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
=…..Times
12. B) Activity Ratios :
- the average number of days it takes for the company's
customers to pay their bills:
2) Days of sales outstanding “ Days’ sales in
receivable “
=
𝟑𝟔𝟓
𝒓𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓
. = ….. Days
= 365 / 5.23 = 70
days
This ratio frequently called the average collection
period.(period to collect the credit sales)
- A collection period that is too high might mean that
13. 3) A measure of a firm's efficiency with respect to its
processing and inventory management is inventory
turnover:
3) inventory turnover =
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
=
… … . . Times
2,006 / 301 = 6.66
times
The higher this ratio is, the more efficiently we are
managing inventory
14. 4) days of inventory on hand (Days’ Sales in
Inventory )
=
365
𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
= ……Days
365 / 6.66 = 55 days
This tells us how many days on average the
inventory will sit before it is sold.
- A processing period that is too high might mean
that too much capital is tied up in inventory
and could mean that the inventory is obsolete.
- A processing period that is too low might indicate
15. The effectiveness of the firm's use of its total assets
to create revenue is measured by its total asset
turnover:
5) total asset turnover =
𝑟𝑒𝑣𝑒𝑛𝑢𝑒 "Sales"
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
=
………..Times
5,000 / 5,394 = 0.93
It is not unusual for TAT < 1, especially if a firm
has a large amount of fixed assets
16. The utilization of fixed assets is measured by the fixed
asset turnover ratio:
6 ) fixed asset turnover =
𝑟𝑒𝑣𝑒𝑛𝑢𝑒 " 𝑆𝑎𝑙𝑒𝑠"
𝑛𝑒𝑡 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
5,000 / 3,138 =
1.59 times
With this ratio, it probably makes more sense to say that
for every dollar in fixed assets, the company generates
some $ in sales.
17. How effectively a company is using its working capital is
measured by the working capital turnover ratio:
7) working capital turnover ( NWC) =
𝑟𝑒𝑣𝑒𝑛𝑢𝑒 " 𝑆𝑎𝑙𝑒𝑠 "
𝑁𝑒𝑡 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 (𝑁𝑊𝐶)
= 5,000 / (2,256 – 1,995) =
19.16 times
- This ratio measures how much work we get out of
our working capital. For this ratio, a high value is
preferred.
18. C. Solvency Ratios :
Solvency Ratios :
measure a firm's financial leverage and ability to
meet its long-term obligations.
They are intended to address the firm’s long-term ability to
meet its obligation or more generally its financial leverage.
A measure of the firm's use of fixed-cost financing sources is the
debt-to-equity ratio:
1) debt-to-assets ( Total debt Ratio ) =
𝑡𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
=( TA- TE) / TA
19. 3) Equity Multiplier =
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 TA
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦 TE
= 1+ D /E =
…………….times
4) interest coverage “ Time interest earned “ =
𝐸𝐵𝐼𝑇
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
= ………………Times
This ratio measures how well a company has its interest
obligations covered.
One of its problems is that it is based on EBIT, which is not
really a measure of cash available to pay interest. The
20. 5) Cash Coverage ratio = (EBIT +
Depreciation) / Interest
It is a basic measure of the firm’s ability to
generate cash from operations and it is
frequently used as a measure of cash flow
available to meet financial obligations.
