Ratio analysis is the basic tool used in financial analysis of a company and in the strategic planning process for any business. It helps managers, lenders and investors in making policy and investment decisions. Financial ratios are calculated by using information from a company's balance sheet, income and cash flow statements. Ratios are of no use in isolation: a return on assets of 10 gives no insight to an analyst if there is no relative benchmark to judge this ratio against.
A common benchmark can be the average ROA of the companies in the same business. Historical trend analysis of ratios is used to judge the performance of a firm over a period of time. By comparing ratios of different companies with the benchmark one can see the performance of a company relative to the industry at a single point in time.
There are many kinds of financial ratios, the most commonly used ratios can be clubbed together into the following categories: Profitability, solvency, efficiency and debt ratios.
Solvency ratios Also known as liquidity ratios; solvency ratios are used to check the ability of the firm to pay its short term obligations (current liabilities). Current ratio and the quick ratio are the most commonly used solvency ratios. Current ratio is the ratio between the current assets and the current liabilities of the firm, the quick ratio is the ratio between the current assets (excluding inventory) and the current liabilities.
Usually a current ratio greater than one is considered good as it reflects the company's ability to pay its short-term obligations. A large difference between the current and the quick ratio shows that a sizable amount of current assets of the company are parked in inventory (which is difficult to liquidate); that is why many analysts prefer quick ratio over the current ratio.
Debt ratios Unlike the current and quick ratios which measure the short-term solvency position of the company, the long-term solvency position of the company is measured by the debt ratios. Debt to assets, debt to equity and interest-coverage ratios reflect and help manage the long-term obligations of the company.
A debt to assets' ratio higher than one means the company has more debt than its total assets. Such a situation should sound alarm bells for analysts. A ratio lower than one is normally considered okay, but ratios are never seen in isolation. A better way is to see how much the ratio is deviating from the benchmark.
The debt to equity ratio and debt to asset ratio are useful in extreme situations like (bankruptcy) a better indicator of the firm's ability to pay its long-term debt is the interest coverage ratio. The interest coverage ratio is calculated by dividing the operating income by interest charges, therefore a coverage ratio of three means the operating income is three times of the interest charges. Conversely, a ratio of less than one means the income is not sufficient enough to cover the interest charges.
Profitability ratios Profitability ratios assess the company's ability to generate earnings. The most frequently used profitability ratios are gross profit margin, return on assets and return on equity. These ratios provide an insight into the firm's ability to generate profits relative to the firm's sales, size and assets.
Margin ratios measure how much profitability a company generates in terms of sales, hence, gross profit margin; a frequently used margin ratio, is calculated by dividing gross profit by sales. The rule for margin ratios is simple-the higher the better.
Example: If ABC Corporation has sales of Rs 100 and the cost of goods sold is Rs 50, then its gross profit margin would be 0.5. A competitor having a gross profit margin of 0.6 would be considered better than ABC Corporation, since for every 1 rupee sale it is earning more gross profit. Return on assets is used to see how efficiently a company is using its assets to generate profits. It shows income per rupee of assets. ROA lower than benchmark means that firm is not managing its assets efficiently.
Example: The net income for any XYZ corporation is Rs 250 million and the total assets of the company are Rs 5 billion; the ROA for the company would be 5 percent .This means from a rupee of assets the company is earning Re.0.05. Return on equity is somewhat similar to ROA, it is considered more important by shareholders as it measures the amount of return per rupee invested in firm's stock.
Efficiency ratios These ratios measure the ability of a company to manage its receivables, payables; they also measure how efficiently the firm is controlling its assets. Receivables turnover, inventory turnover and assets turn over are frequently used efficiency ratios. They evaluate how effectively a company employs its resources.
Receivables turnover measures how quickly a firm collects its receivables. Dividing 365 by receivable turnover, the number of days credit sales remain as accounts receivable is calculated, this is also known as the collection period.
Inventory turnover is a very important activity ratio as it reveals how well a business is handling its inventory. A generally higher inventory turnover ratio means that the firm is efficiently selling its inventory. A higher inventory turnover leads to a lower number of days of inventory showing that the company is quickly turning its inventory into sales.
A very high inventory turnover signals that the inventory level might be too small to cover the sales; hence, firms should try to attain the optimum level of the ratio, a very high or very low ratio as compared to the benchmark signals bad inventory management.
The world of ratios is enormous and has lots of benefits, different ratios help analysts probe into different aspects of the firm, but ratio analysis also has some limitations. Ratio analysis needs a reference point. Often ratios cannot be used in seclusion and several ratios have to be combined. The biggest problem is the fact that different firms use different accounting practices and this can lead to distortions which make it hard to compare these measures across different companies.
==========================================================================
Frequently used financial ratios
==========================================================================
Ratios Formula
==========================================================================
Solvency ratios
Current ratio Current assets/current liabilities
Quick ratio Current assets-inventory/current liability
Profitability ratios
Return on assets ratio Net income/total assets
Return on equity ratio Net income/equity
Gross profit margin Gross profit/sales
Debt ratios
Debt to asset ratio Total debt/total assets
Debt to equity ratio Total debt/total equity
Interest coverage ratio Operating income/interest charge
Efficiency ratio
Recievable turnover Net sales/average recivables
Inventory turnover COGS/average inventory
Asset turnover Sales/total assets
==========================================================================
All information and data used are from reliable source(s) and subjected to extensive research after diligent and reasonable efforts to determine the soundness of the source(s). This analysis is not for the benefit of or discredit to any person, scrip or tradable instrument. The content(s) of this analysis shall not be construed as an advice or recommendation to trade. No relationship of client will be created between Business Recorder and user of this information. Professional advice must be taken by the reader before making investment/trading decisions. BR disclaims any liability for investment(s) made or liability accrued on basis of this analysis. The content(s) including all opinion(s), statement(s) and information are subject to change without prior notice and/or intimation.
Comments
Comments are closed for this article.