RATIO

TYPES OF RATIOS

1.    PROFITABILITY RATIOS: These ratios give users a good understanding of how well the company utilized its resources to generate profit and shareholder value.

2.    EFFICIENCY RATIOS: These ratios assess how well a company turns its assets into revenue as well as how efficiently a company converts its sales into cash.Basically, these ratios look at how efficiently and effectively a company is using its resources to generate sales and increase shareholder value.

3.    LIQUIDITY RATIOS: These ratiosmeasure the ability of the business to satisfy its short term obligations as and when they mature.

4.    GEARING RATIOS: These ratios compare some form of owner's equity (or capital) to borrowed funds. Gearing is a measure of financial leverage/risk, demonstrating the degree to which a firm's activities are funded by owner's funds versus creditor's funds.H

KEYS STEPS TO WRITE GOOD RATIO ANALYSIS

1.     If you are analysing Liquidity/Profitability/Efficiency/Gearing, explain what it category means.

2.     Tell your reader which ratios measure Liquidity/Profitability/ Efficiency/ Gearing and which ones you will be using in your analysis.

3.     Explain the meaning of each ratio and apply it to the company that you are analysing (Company X).

E.g. The Current Ratio measures whether a company's short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes). CompanyX’s Current Ratio was more than 1 throughout the period so the business is generally considered to have good short-term financial strength.

4.     If you are analysing Liquidity/Profitability/Efficiency/Gearing, explain what it category means.

5.     Tell your reader which ratios measure Liquidity/Profitability/ Efficiency/ Gearing and which ones you will be using in your analysis.

6.     Explain the meaning of each ratio and apply it to the company that you are analysing (Company X).

E.g. The Current Ratio measures whether a company's short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes). CompanyX’s Current Ratio was more than 1 throughout the period so the business is generally considered to have good short-term financial strength.

7.   If you have information for more than one period make sure you analyse trends and comment on whether there is an improvement or deterioration in the ratios.

E.g. The ratio of Days Inventory Turnover is an efficiency ratio that measures how long it takes a business to convert its inventory into sales or revenue. Despite a slight deterioration in this ratio from 2004 to 2005(16 days to 17 days), CompanyX appears to be able to turn its inventory into revenue quite quickly.

8.     Explain how the behaviour of each ratios within a category relate to each other.

 E.g.  The Acid Test Ratio is also known as quick ratio and is a more conservative measure of liquidity than the Current Ratio because it excludes inventory and prepayments, which are more difficult to turn into cash. The behavior of this ratio confirms our earlier conclusions based on the Current Ratio. CompanyX does not appear to have any liquidity problems. The business is able to meet its short term obligations by using its cash reserves and accounts receivable.

 9.     If you are given information for the industry make sure you compare the company’s performance with the industry’s performance.

E.g. It appears that the companyX has been more aggressive than its competitors in financing its growth with debt and this is reflected in its’ steeper degree of leverage (Debt to Equity Ratio was 103% in 2003 and 104% in 2004 vs the industry average of 75%).

10.If required, suggest ways to improve financial performance.

 E.g.  To improve profitability company X should reduce unnecessary costs or find ways to save costs.

 FINANCIAL RATIO ANALYS

1.    PROFITABILITY RATIOS

These ratios give users a good understanding of how well the company utilized its resources to generate profit and shareholder value.

The long-term profitability of a company is vital for its survivability. It is these ratios that can give insight into the all important "profit".

GROSS PROFIT MARGIN

A financial metric used to assess a firm's financial health by revealing the proportion of money left over from revenues after accounting for the cost of goods sold. Gross profit margin serves as the source for paying additional expenses and future savings.

Also known as "gross margin".

NET PROFIT MARGIN

NET PROFIT MARGIN OR NET PROFIT RATIO all refer to a measure of profitability. It is calculated by finding the net profit as a percentage of the revenue and it indicates how much of each dollar of sales revenue has been left after all expenses have been covered.

 2.   OPERATIONAL EFFICIENCY RATIOS OR ACTIVITY RATIOS

Are a measure of how well a company and its management uses its assets to generate income.

These ratios look at how well a company turns its assets into revenue as well as how efficiently a company converts its sales into cash. Basically, these ratios look at how efficiently and effectively a company is using its resources to generate sales and increase shareholder value. In general, the better these ratios are, the better it is for shareholders.

3.   LIQUIDITY RATIOS

Liquidity ratios attempt to measure a company's ability to pay off its short-term debt obligations. This is done by comparing a company's most liquid assets (or, those that can be easily converted to cash) with its short-term liabilities.

CURRENT RATIO 

The current ratio is a popular financial ratio used to test a company's liquidity (also referred to as its current or working capital position) by deriving the proportion of current assets available to cover current liabilities.

The concept behind this ratio is to ascertain whether a company's short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes). In theory, the higher the current ratio, the better.

If this ratio is more than 1, then that company is generally considered to have good short-termfinancialstrength.  However, if the current ratio is too high (more than 2), then the company may not be efficiently using its current assets, it could indicate that the company has too much inventory and is not investing the excess cash because it lacks the managerial acumen to put those resources to work.

If current liabilities exceed current assets (Current ratio<1), then the company may have problemsmeeting its short-term obligations. Low values, however, are not always fatal.  If an organization has good long-term prospects, it may be able to enter the capital market and borrow against those prospects to meet current obligations.  The nature of the business itself might also allow it to operate with a current ratio less than one.  For example, in an operation like Mc Donald's, inventory turns over much more rapidly than the accounts payable become due.  This timing difference can also allow a firm to operate with a low current ratio. 

 ACID TEST RATIO

The quick ratio - or the quick assets ratio or the acid-test ratio - is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. Therefore, a higher ratio means a more liquid financial position.

 4.   GEARING RATIOS

Are financial ratios that compare some form of owner's equity (or capital) to borrowed funds. Gearing is a measure of financial leverage, demonstrating the degree to which a firm's activities are funded by owner's funds versus creditor's funds. 

INTEREST COVERAGE RATIO/TIMES INTEREST EARNED

Metric used to measure a company's ability to meet its debt obligations. It is calculated by taking a company's earnings before interest and taxes (EBIT) and dividing it by the total interest payable on bonds and other contractual debt. It is usually quoted as a ratio and indicates how many times a company can cover its interest charges on a pretax basis. Failing to meet these obligations could force a company into bankruptcy.

Also referred to as "fixed-charged coverage".