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Ratio analysis techniques


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Published in: Business, Economy & Finance
  • For most businesses, the key questions can be paired down to 3 ratios of Financial Stability, 3 ratios of Profitability and another 8 ratios of business efficiency.
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Ratio analysis techniques

  1. 1. Ratio Analysis TechniquesRatio Analysis: It is concerned with the calculation of relationships, which after properidentification & interpretation may provide information about the operations and state ofaffairs of a business enterprise. The analysis is used to provide indicators of pastperformance in terms of critical success factors of a business. This assistance in decision-making reduces reliance on guesswork and intuition and establishes a basis for soundjudgments.Types of RatiosLiquidity Profitability Financial Operating InvestmentMeasurement Indicators Leverage/Gearing Performance ValuationCurrent Ratio Profit Margin Equity Ratio Fixed Assets Price/Earnings Analysis Turnover Ratio Quick Ratio Return on Assets Debt Ratio Sales/ Revenue Price/Earnings to Growth ratio Return on Equity Debt-Equity Ratio Average Collection Dividend Yield Period Return on Capital Capitalization Ratio Inventory Turnover Dividend Payout Employed Ratio Interest Coverage Total assets Ratio TurnoverLiquidity Measurement RatiosLiquidity refers to the ability of a firm to meet its short-term financial obligations when andas they fall due. The main concern of liquidity ratio is to measure the ability of the firms tomeet their short-term maturing obligations. The greater the coverage of liquid assets toshort-term liabilities the better as it is a clear signal that a company can pay its debts thatare coming due in the near future and still fund its ongoing operations. On the other hand, acompany with a low coverage rate should raise a red flag for investors as it may be a signthat the company will have difficulty meeting running its operations, as well as meeting itsobligations.Ratio Formula Meaning AnalysisCurrent Ratio Current Assets / The number of times Higher the ratio, the Current Liabilities that the short term better it is, however but Current assets includes assets can cover the too high ratio reflects an cash, marketable short term debts. In in-efficient use of securities, accounts other words, it indicates resources & too low ratio receivable and an ability to meet the leads to insolvency. The inventories. Current short term obligations as ideal ratio is considered liabilities includes & when they fall due to be 2:1., accounts payable, short term notes payable,
  2. 2. short-term loans, current maturities of long term debt, accrued income taxes and other accrued expensesQuick Ratio or (Cash + Cash Indicates the ability to The ideal ratio is 1:1.Acid Test Equivalents + Short meet short term Another beneficial use isRatio Term Investments + payments using the to compare the quick Accounts Receivables) / most liquid assets. This ratio with the current Current Liabilities ratio is more ratio. If the current ratio conservative than the is significantly higher, it current ratio because it is a clear indication that excludes inventory and the companys current other current assets, assets are dependent on which are more difficult inventory. to turn into cashProfitability Indicators RatiosProfitability is the ability of a business to earn profit over a period of time.The profitabilityratios show the combined effects of liquidity, asset management (activity) and debtmanagement (gearing) on operating results. The overall measure of success of a business isthe profitability which results from the effective use of its resources.Ratio Formula Meaning AnalysisGross Profit (Gross Profit/Net A companys cost of Higher the ratio, theMargin Sales)*100 goods sold represents higher is the profit the expense related to earned on sales labor, raw materials and manufacturing overhead involved in its production process. This expense is deducted from the companys net sales/revenue, which results in a companys gross profit. The gross profit margin is used to analyze how efficiently a company is using its raw materials, labor and manufacturing-related fixed assets to generate profits.Operating (Operating Profit/Net By subtracting selling, Lower the ratio, lowerProfit Margin Sales)*100 general and the expense related to administrative expenses the sales
  3. 3. from a companys gross profit number, we get operating income. Management has much more control over operating expenses than its cost of sales outlays. It Measures the relative impact of operating expensesNet Profit (Net Profit/Net This ratio measures the Higher the ratio, theMargin Sales)*100 ultimate profitability more profitable are the sales.Return on Net Income / Average This ratio illustrates how Higher the return, theAssets Total Assets well management is more efficient employing the management is in ( Earnings Before companys total assets utilizing its asset base Interest & Tax = Net to make a profit. Income)Return on Net Income / Average It measures how much Higher percentageEquity Shareholders the shareholders earned indicates the Equity*100 for their investment in management is in the company utilizing its equity base and the better return is to investors.Return on Net Income / Capital This ratio complements It is a moreCapital Employed the return on equity comprehensiveEmployed ratio by adding a profitability indicator Capital Employed = Avg. companys debt because it gauges Debt Liabilities + Avg. liabilities, or funded managements ability to Shareholders Equity debt, to equity to reflect generate earnings from a a companys total companys total pool of "capital employed". This capital. measure narrows the focus to gain a better understanding of a companys ability to generate returns from its available capital base.Financial Leverage/Gearing RatiosThese ratios indicate the degree to which the activities of a firm are supported by creditors’funds as opposed to owners as the relationship of owner’s equity to borrowed funds is an
  4. 4. important indicator of financial strength. The debt requires fixed interest payments andrepayment of the loan and legal action can be taken if any amounts due are not paid at theappointed time. A relatively high proportion of funds contributed by the owners indicates acushion (surplus) which shields creditors against possible losses from default in payment.Financial leverage will be to the advantage of the ordinary shareholders as long as the rateof earnings on capital employed is greater than the rate payable on borrowed funds.Ratio Formula Meaning AnalysisEquity Ratio (Ordinary This ratio measures the A high equity ratio Shareholder’s strength of the financial reflects a strong financial Interest / Total structure of the structure of the assets)*100 company company. A relatively low equity ratio reflects a more speculative situation because of the effect of high leverage and the greater possibility of financial difficulty arising from excessive debt burden.Debt Ratio Total Debt / Total This compares a With higher debt ratio Assets companys total debt to (low equity ratio), a very its total assets, which is small cushion has used to gain a general developed thus not idea as to the amount of giving creditors the leverage being used by security they require. a company. This is the The company would measure of financial therefore find it relatively strength that reflects difficult to raise the proportion of capital additional financial which has been funded support from external by debt, including sources if it wished to preference shares. take that route. The higher the debt ratio the more difficult it becomes for the firm to raise debt.Debt – Equity Total Liabilities / . This ratio measures A lower ratio is alwaysRatio Total Equity how much suppliers, safer, however too low lenders, creditors and ratio reflects an in- obligors have committed efficient use of equity. to the company versus Too high ratio reflects what the shareholders either there is a debt to have committed. a great extent or the This ratio indicates the equity base is too small extent to which debt is covered by shareholders’ funds.Capitalization Long Term Debt / This ratio measures the A low level of debt and aRatio (Long Term Debt + debt component of a healthy proportion of
  5. 5. Shareholder’s Equity) companys capital equity in a companys structure, or capital structure is an capitalization (i.e., the indication of financial sum of long-term fitness. debt liabilities and A company too highly shareholders equity) to leveraged (too much support a companys debt) may find its operations and growth. freedom of action restricted by its creditors and/or have its profitability hurt by high interest costs. This ratio is one of the more meaningful debt ratios because it focuses on the relationship of debt liabilities as a component of a companys total capital base, which is the capital raised by shareholders and lenders.Interest EBIT / Interest on This ratio measures the The lower the ratio, theCoverage Long Term Debt number of times a more the company isRatio company can meet its burdened by debt interest expense expense. When a companys interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable.Operating Performance Ratios:These ratios look at how well a company turns its assets into revenue as well as howefficiently a company converts its sales into cash, i.e how efficiently & effectively a companyis using its resources to generate sales and increase shareholder value. The better theseratios, the better it is for shareholders.Ratios Formula Meaning AnalysisFixed Assets Sales / Net Fixed This ratio is a rough High fixed assetsTurnover Assets measure of the turnovers are preferred productivity of a since they indicate a companys fixed assets better efficiency in fixed with respect to assets utilization.
  6. 6. generating salesAverage (Accounts Receivable The average collection The shorter the averageCollection / Annual Credit period measures the collection period, thePeriod Sales)*365 days quality of debtors since better the quality of it indicates the speed of debtors, as a short their collection. collection period implies the prompt payment by debtors. An excessively long collection period implies a very liberal and inefficient credit and collection performance. The delay in collection of cash impairs the firm’s liquidity. On the other hand, too low a collection period is not necessarily favorable, rather it may indicate a very restrictive credit and collection policy which may curtail sales and hence adversely affect profit.Inventory Sales / Average It measures the stock in High ratio indicates thatTurnover Inventory relation to turnover in there is a little chance of order to determine how the firm holding often the stock turns damaged or obsolete over in the business. stock. It indicates the efficiency of the firm in selling its product.Total Assets Sales / Total Assets This ratio indicates the Higher the firm’s totalTurnover efficiency with which the asset turnover, the more firm uses all its assets efficiently its assets have to generate sales. been utilised.Investment Valuation Ratios:These ratios can be used by investors to estimate the attractiveness of a potential orexisting investment and get an idea of its valuation.Ratio Formula Meaning Analysis
  7. 7. Price Earning Market Price per This ratio measures how A stock with high P/ERatio ( P/E Share / Earnings Per many times a stock is ratio suggests thatRatio ) Share trading (its price) per investors are expecting each rupee of EPS higher earnings growth in the future compared to the overall market, as investors are paying more for todays earnings in anticipation of future earnings growth. Hence, stocks with this characteristic are considered to be growth stocks. Conversely, a stock with a low P/E ratio suggests that investors have more modest expectations for its future growth compared to the market as a whole.Price Earnings ( P/E Ratio ) / The price/earnings to The general consensus isto Growth Earnings Per Share growth ratio, commonly that if the PEG ratioRatio referred to as the PEG indicates a value of 1, ratio, is obviously this means that the closely related to the P/ market is correctly E ratio. The PEG ratio is valuing (the current P/E a refinement of the P/E ratio) a stock in ratio and factors in a accordance with the stocks estimated stocks current earnings growth into its estimated earnings per current valuation. By share growth. If the PEG comparing a stocks P/E ratio is less than 1, this ratio with its projected, means that EPS growth or estimated, earnings is potentially able to per share (EPS) growth, surpass the markets investors are given current valuation. In insight into the degree other words, the stocks of overpricing or under price is being pricing of a stocks undervalued. On the current valuation, as other hand, stocks with indicated by the high PEG ratios can traditional P/E ratio. indicate just the opposite - that the stock is currently overvalued.
  8. 8. Dividend Yield ( Annual Dividend per This ratio allows This enables an investorRatio Share / Market Price investors to compare to compare ratios for per the latest dividend they different companies and received with the industries. Higher the Share ) *100 current market value of ratio, the higher is the the share as an indictor return to the investor of the return they are earning on their sharesDividend (Dividend per Share / This ratio identifies thePayout Ratio Earnings per Share ) percentage of earnings * 100 (net income) per common share allocated to paying cash dividends to shareholders. The dividend payout ratio is an indicator of how well earnings support the dividend payment.