NOTES ON RATIO ANALYSIS

Definition: Liquidity ratio: Definition of 'Liquidity Ratios'

A class of financial metrics that is used to determine a company's ability to pay off its short-terms debts obligations. Generally, the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term debts.

Investopedia explains 'Liquidity Ratios'

Common liquidity ratios include the current ratio, the quick ratio and the operating cash flow ratio. Different analysts consider different assets to be relevant in calculating liquidity. Some analysts will calculate only the sum of cash and equivalents divided by current liabilities because they feel that they are the most liquid assets, and would be the most likely to be used to cover short-term debts in an emergency. A company's ability to turn short-term assets into cash to cover debts is of the utmost importance when creditors are seeking payment. Bankruptcy analysts and mortgage originators frequently use the liquidity ratios to determine whether a company will be able to continue as a going concern.

Liquidity ratio, expresses a company's ability to repay short-term creditors out of its total cash. The liquidity ratio is the result of dividing the total cash by short-term borrowings. It shows the number of times short-term liabilities are covered by cash. If the value is greater than 1.00, it means fully covered. The formula is the following: LR = liquid assets / short-term liabilities

Borrowing Ratio
Borrowing Ratio = Total Borrowings (Short-term and Long-term) / Total Equity

Current Ratio
Current Ratio = Current Assets / Current Liabilities

Net Working Capital Ratio

Net Working Capital Ratio = Net Working Capital / Total Assets Where Net Working Capital = Current Assets - Current Liabilities

Net Working Capital Ratio

Net Working Capital Ratio = Net Working Capital / Total Assets Where Net Working Capital = Current Assets - Current Liabilities

Quick Ratio (Acid Test Ratio)

Quick Ratio = Quick Assets / Current Liabilities Where Quick Assets = Current Assets - Inventories - Prepayments Liquidity Ratios:

Liquidity Ratios are ratios that come off the the Balance Sheet and hence measure the liquidity of the company as on a particular day i.e the day that the Balance Sheet was prepared. These ratios are important in measuring the ability of a company to meet both its short term and long term obligations.

FIRST LIQUIDITY RATIO

Current Ratio: This ratio is obtained by dividing the 'Total Current Assets' of a company by its 'Total Current Liabilities'. The ratio
is regarded as a test of liquidity for a company. It expresses the 'working capital' relationship of current assets available to meet the company's current obligations.

The formula:
Current Ratio = Total Current Assets/ Total Current Liabilities

An example from our Balance sheet:

Current Ratio = $261,050 / $176,522 Current Ratio = 1.48

The Interpretation:
Lumber & Building Supply Company has $1.48 of Current Assets to meet $1.00 of its Current Liability Review the Industry same industry.

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SECOND LIQUIDITY RATIO

Quick Ratio: This ratio is obtained by dividing the 'Total Quick Assets' of a company by its 'Total Current Liabilities'. Sometimes a
company could be carrying heavy inventory as part of its current assets, which might be obsolete or slow moving. Thus eliminating inventory from current assets and then doing the liquidity test is measured by this ratio. The ratio is regarded as an acid test of liquidity for a company. It expresses the true 'working capital' relationship of its cash, accounts receivables, prepaids and notes receivables available to meet the company's current obligations.

The formula:
Quick Ratio = Total Quick Assets/ Total Current Liabilities Quick Assets = Total Current Assets (minus) Inventory

An example from our Balance sheet:

Quick Ratio = $261,050- $156,822 / $176,522 Quick Ratio = $104,228 / $176,522 Quick Ratio = 0.59

The Interpretation:

Lumber & Building Supply Company has $0.59 cents of Quick Assets to meet $1.00 of its Current Liability Review the Industry same industry.

Norms and Ratios for this ratio to compare and see if they are above below or equal to the others in the click here
.

To use the Quick Ratio Calculator Click here

THIRD LIQUIDITY RATIO

Debt to Equity Ratio: This ratio is obtained by dividing the 'Total Liability or Debt ' of a company by its 'Owners Equity a.k.a Net
Worth'. The ratio measures how the company is leveraging its debt against the capital employed by its owners. If the liabilities exceed the net worth then in that case the creditors have more stake than the shareowners.

The formula:
Debt to Equity Ratio = Total Liabilities / Owners Equity or Net Worth

An example from our Balance sheet:

Debt to Equity Ratio = $186,522 / $133,522 Debt to Equity Ratio = 1.40

The Interpretation:
Lumber & Building Supply Company has $1.40 cents of Debt and only $1.00 in Equity to meet this obligation

The current ratio is probably the best known and most often used of the liquidity ratios. Liquidity ratios are used to evaluate the firm's ability to pay its short-term debt obligations such as accounts payable (payments to suppliers) and accrued taxes and wages. Short-term notes payable to a bank, for example, may also be relevant

This is obviously a good position for the firm to be in. It can meet its short-term debt obligations with no stress. If the current ratio was less than 1.00X, then the firm would have a problem meeting its bills. So, usually, a higher current ratio is better than a lower current ratio with regard to maintaining liquidity

Definition of 'Operating Cash Flow Ratio'

A measure of how well current liabilities are covered by the cash flow generated from a company's operations. Formula:

Investopedia explains 'Operating Cash Flow Ratio'

The operating cash flow ratio can gauge a company's liquidity in the short term. Using cash flow as opposed to income is sometimes a better indication of liquidity simply because, as we know, cash is how bills are normally paid off. Read more: http://www.investopedia.com/terms/o/ocfratio.asp#ixzz22fPZ9HwO Dividend yield ratio is the relationship between dividends per share and the market value of the shares.

Share holders are real owners of a company and they are interested in real sense in the earnings distributed and paid to them as dividend. Therefore, dividend yield ratio is calculated to evaluate the relationship between dividends per share paid and the market value of the shares.

Formula of Dividend Yield Ratio:

Following formula is used for the calculation of dividend yield ratio: Dividend Yield Ratio = Dividend Per Share / Market Value Per Share

Example:
For example, if a company declares dividend at 20% on its shares, each having a paid up value of $8.00 and market value of $25.00. Calculate dividend yield ratio:

Calculation:
Dividend Per Share = (20 / 100) 8 = $1.60 Dividend Yield Ratio = (1.60 / 25) 100 = 6.4%

Significance of the Ratio:

This ratio helps as intending investor is knowing the effective return he is going to get on the proposed investment.

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