Ratio analysis

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In this article of Ratio Analysis, you will learn how they can be used to analyze a company. Understand the meaning and formulas associated with Liquidity ratios, Profitability ratios, Turnover ratios, and Debt ratios

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Ratio analysis

  1. 1. Ratio Analysis ~ By edu CBA
  2. 2. • Ratio analysis is a tool that aid us to interpret the financial statements in terms of the operating performance and financial position of a firm. • It comprises comparison for a meaningful interpretation of the financial statements which in turn plays a vital role in business planning process. • It involves comparing the ratios with similar firms in the industry or analyzing the trend in the same company over a period of time. • It is a very important and most basic part of fundamental analysis process.
  3. 3. There are several financial ratios available we are going to discuss the most widely used and categorized into the following broad areas. Liquidity ratios It quantifies if the company would be able to meet its short term debt obligations Turnover ratios Profitability ratios It measures firms operating competence i.e. how well it utilized the available resources in order to generate profit. It indicates the firm’s efficiency with respect to its asset management. Debt ratios A financial ratio that measures the extent of a company’s or consumer’s leverage
  4. 4. Liquidity Ratios Current Ratio • This measures the short term solvency of the company using the balance sheet. • Also known as the working capital ratio, it tells if a firm has sufficient funds to pay its liabilities over the period of next 12 months. Quick Ratio Cash Ratio • It measures the current short term solvency of the company. • It considers if the very liquid assets (can be converted into cash immediately) are available to meet the obligations. • It considers only the most liquid short-term assets of the company, which are those that can be most easily used to pay off existing commitments • Most stringent measure among the three liquidity ratios. Current ratio = Current Assets Current liabilities Quick ratio = Quick assets (Current assets- Inventory) Current liabilities Cash ratio = Cash and cash equivalents Current liabilities
  5. 5. Profitability Ratios ~ In relation to sales Gross profit margin/ratio It is measure to show by how much gross profit exceed production costs. Gross profit margin = Gross profit / Net sales*100 Net profit margin/ratio It shows management’s efficiency in manufacturing, administrating, and selling the products and the costs it incurs there. Net profit margin = Earnings after tax/Net sales*100 Operating profit margin/ratio This ratio specifies how much profit a firm makes after paying for variable costs of production such as wages, raw materials, etc. but before interest and tax. Operating profit margin =EBIT/ Net sales*100
  6. 6. Profitability Ratios ~ In relation to investment Return on investment (ROI) It is a performance measure which evaluates the efficiency of an investment. Return on investment = Net profit after interest and tax / Total Assets Return on Equity (ROE) Return on equity (ROE) discloses the amount of profit a firm made compared to the total amount of shareholders equity. ROE = Net profit after tax / Shareholder's equity Return on capital employed (ROCE) This ratio measures the returns a firm gets out of the total capital employed by them. ROCE = EBIT / (Total Assets - Current Liabilities)
  7. 7. Turnover Ratios Inventory Turnover Ratio Debtor Turnover Ratio It indicates the number of times inventory has been converted into sales in a particular period of time Inventory turnover ratio = Cost of goods sold / Average Inventory It shows how quickly a firm collects outstanding cash from its customers/debtors in an accounting period Debtors turnover ratio = Net receivable sales/ Average debtors Creditor Turnover Ratio Assets Turnover Ratio It evaluates how quickly the business pays off its creditors/suppliers in a particular period. Creditors turnover ratio = Total purchases / Average creditors This ratio compares the sales revenue of a company to its assets. Asset Turnover Ratio = Sales Revenue / Total Assets
  8. 8. Debt Ratios Debt to equity ratio = Liabilities / Equity Debt to equity ratio • • It indicates the relative portion of entity's equity and debt used to fund the assets. Financial lenders prefer a low debt to equity ratio before considering to give any debt. Debt ratio • Debt ratio = Liabilities / Assets • This ratio indicates the amount of debt to the total amount of assets. Higher the ratio greater is the risk related with the firm's operation. Debt service coverage ratio DSCR = Net Operating Income/Total debt service • • It depicts the ability of the firm to pay back its principal loan amount and interest amount. A debt service coverage ratio which is below 1 indicates a negative cash flow
  9. 9. Other ratios This ratio helps in measuring the profit that is available to the equity shareholders on a per share basis. EPS = Earnings after tax – Preferred dividends/Equity shares outstanding Dividend per share Earnings per share It is the dividends that have been paid to the shareholders on a per share basis. Dividend per share = Earnings paid to the ordinary shareholders/ Number of ordinary shares outstanding It signifies the expectations of the investors for the stock. A P/E ratio greater than 15 has historically been considered high. (P/E) ratio = Market price of share/Earnings per share Earnings per share
  10. 10. Knowledge is like a line with no ends… To know more on this topic click on the link below http://www.accountingchimp.com/ratioanalysis/
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