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103 visualizzazioni11 pagineDetail explanation about the ratios

Oct 29, 2013

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Detail explanation about the ratios

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103 visualizzazioni

Detail explanation about the ratios

Attribution Non-Commercial (BY-NC)

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1. a. b. c. 2. a. b. c. d. e. f. 3. a. b. c. d. e. 4. Liquidity Ratios .................................................................................................................................... 2 Current Ratio (CR) ............................................................................................................................ 2 Quick Ratio (QR)/ Acid-test Ratio.................................................................................................... 3 Cash Ratio ......................................................................................................................................... 3 Operational / Turnover Ratios............................................................................................................... 3 Debtors Turnover Ratio .................................................................................................................... 4 Average Collection Period (ACP)..................................................................................................... 4 Inventory or Stock Turnover Ratio (ITR) ......................................................................................... 4 Interest Coverage Ratio..................................................................................................................... 5 Fixed Asset Turnover (FAT)............................................................................................................. 5 Total Asset Turnover (TAT) ............................................................................................................. 5 Leverage / Capital Structure Ratios ...................................................................................................... 6 Debt-Equity Ratio ............................................................................................................................. 6 Debt-Asset Ratio ............................................................................................................................... 6 AVERAGE COLLECTION PERIOD (ACP) ................................................................................... 7 Fixed Asset Turnover (FAT)............................................................................................................. 7 Total Asset Turnover (TAT) ............................................................................................................. 7 Profitability Ratios ................................................................................................................................ 7 1. 2. 3. 4. 5. 6. a. b. 7. 8. Gross Profit Margin: ..................................................................................................................... 7 Net Profit Margin: ......................................................................................................................... 7 Return on Assets (ROA): .............................................................................................................. 8 Return on Capital Employed (ROCE): ......................................................................................... 8 Return on Shareholders' Equity: ................................................................................................... 8

Valuation Ratios.................................................................................................................................... 9 Price-Earnings Ratio ......................................................................................................................... 9 Market Value to Book Value Ratio................................................................................................. 10 DuPont Analysis ................................................................................................................................. 10 Common Size Statement ..................................................................................................................... 10

Uses of Ratio analysis:

Managers use to analyze, control and thus improve their firms operations. Credit analyst including bank loan officers and bond rating analysts use to ascertain a companys ability to repay its debt. Stock analyst uses to determine companys efficiency, risk and growth prospects.

Many large firms operate in different industries, for such firms it is difficult to develop an industry average. It is useful for small firms. Seasonal factor distorts the analysis as different firm will have different requirement in different seasons, so this will lead to different ratios. Different countries will have different accounting practices. It is difficult to generalize whether a ratio is good or bad. Some ratios look good and some look bad, so difficult to interpret about the companys performance.

1. Liquidity Ratios

It gives a picture of a company's short term financial situation or solvency. Liquidity refers to the ability of a firm to meet its short-term (usually up to 1 year) obligations. The ratios which indicate the liquidity of a company are Current ratio, Quick/Acid-Test ratio, and Cash ratio.

Current ratio (CR) is the ratio of total current assets (CA) to total current liabilities (CL). This ratio measures the liquidity of the current assets and the ability of a company to meet its shortterm debt obligation. Current assets include cash and bank balances; inventory of raw materials, semi-finished and finished goods; marketable securities; debtors (net of provision for bad and doubtful debts); bills receivable; and prepaid expenses. Current liabilities consist of trade creditors, bills payable, bank credit, provision for taxation, dividends payable and outstanding expenses. Current Ratio = Current Assets / Current Liabilities

CR measures the ability of the company to meet its CL, i.e., CA gets converted into cash in the operating cycle of the firm and provides the funds needed to pay for CL. The higher the current ratio, the greater the short-term solvency. While interpreting the current ratio, the composition of current assets must not be overlooked. A firm with a high proportion of current assets in the form of cash and debtors is more liquid than one with a high proportion of current assets in the form of inventories, even though both the firms have the same current ratio. Internationally, a current ratio of 2:1 is considered satisfactory. Creditors like to see a high CR. It is used to measure the short term solvency. From the shareholders point of view, high CR indicates that lot of money is tied up in the unproductive assets. So shareholders want that either this amount should be reinvested or to distribute among the shareholders.

Quick Ratio (QR) is the ratio between quick current assets (QA) and CL. QA refers to those current assets that can be converted into cash immediately without any value dilution. QA includes cash and bank balances, short-term marketable securities, and sundry debtors. Inventory and prepaid expenses are excluded since these cannot be turned into cash as and when required. Quick Ratio = Quick Assets / Current Liabilities QR indicates the extent to which a company can pay its current liabilities without relying on the sale of inventory. This is a fairly stringent measure of liquidity because it is based on those current assets which are highly liquid. Inventories are excluded from the numerator of this ratio because they are deemed the least liquid component of current assets. Generally, a quick ratio of 1:1 is considered good. One drawback of the quick ratio is that it ignores the timing of receipts and payments.

c. Cash Ratio

Since cash and bank balances and short term marketable securities are the most liquid assets of a firm, financial analysts look at the cash ratio. The cash ratio is computed as follows: Cash Ratio = (Cash and Bank Balances + Current Investments) / Current Liabilities The cash ratio is the most stringent ratio for measuring liquidity.

These ratios determine how quickly certain current assets can be converted into cash. They are also called efficiency ratios or asset utilization ratios as they measure the efficiency of a firm in managing assets. These ratios are based on the relationship between the level of activity

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represented by sales or cost of goods sold and levels of investment in various assets. The important turnover ratios are debtors turnover ratio, average collection period, inventory/stock turnover ratio, fixed assets turnover ratio, and total assets turnover ratio.

DTO is calculated by dividing the net credit sales by average debtors outstanding during the year. It measures the liquidity of a firm's debts. This ratio shows how rapidly debts are collected. The higher the DTO, the better it is for the organization. Net credit sales are the gross credit sales minus returns, if any, from customers. Average debtors are the average of debtors at the beginning and at the end of the year. Debtors Turnover Ratio = Net Credit Sales / Average Debtors The fall in debtors' turnover ratio can be attributed to any of the following reasons: There might be an increase in the volume of sales relative to the increase in debtors. The firm might have extended the credit period for debtors. The firm's debt collection team is not performing well, as a result rate of which the realization has come down.

ACP is calculated by dividing the days in a year by the debtors' turnover. The average collection period represents the number of days worth of credit sales that is blocked with the debtors (accounts receivable). It is computed as follows: Average Collection Ratio = Receivables / (Annual sales/365) The ACP and the accounts receivables turnover are related as: ACP = 365 / Accounts Receivable Turnover It represent the average length of time that the firm must wait after making a sale before receiving the cash. The ACP can be compared with the firm's credit terms to judge the efficiency of credit management. For example, if the credit terms are 2/10, net 45, an ACP of 85 days means that the collection is slow and an ACP of 40 days means that the collection is prompt.

ITR refers to the number of times the inventory is sold and replaced during the accounting period. For calculating ITR, the average of inventories at the beginning and the end of the year is taken. In general, averages may be used when a flow figure (in this case, cost of goods sold) is related to a stock figure (inventories). It is calculated as follows:

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Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory ITR reflects the efficiency of inventory management. The higher the ratio, the more efficient is the management of inventories, and vice versa. However, a high inventory turnover may also result from a low level of inventory or low level of investment in inventory which may lead to frequent stock outs and loss of sales and customer goodwill. Low ratio indicates that the company is holding too much inventory, which is unproductive and it represent an investment with a low or zero return. We use average inventory because sales occur over the entire year and inventory is for one point in time.

This ratio shows the number of times the interest charges on long-term liabilities have been collected before the deduction of interest and tax. A high interest coverage ratio implies that the company can easily meet its interest burden even if profit before interest and taxes suffers a sharp decline. From the creditors' point of view, the larger the coverage; the greater the firm's capacity to handle fixed-charge liabilities and the more assured the payment of interest to the creditors. A low ratio is a warning signal which indicates that the firm is using excessive debt and does not have the ability to pay interest to creditors. However, a very high ratio implies an unused debt capacity. ICR = PBIT / Interest

The FAT ratio measures the net sales per rupee of investment in fixed assets. It can be computed as follows: FAT = Net sales / Average net fixed assets This ratio measures the efficiency with which fixed assets are employed. A high ratio indicates a high degree of efficiency in asset utilization while a low ratio reflects an inefficient use of assets. However, this ratio should be used with caution because when the fixed assets of a firm are old and substantially depreciated, the fixed assets turnover ratio tends to be high (because the denominator of the ratio is very low).

TAT is the ratio between the net sales and the average total assets. It can be computed as follows: TAT = Net sales / Average total assets This ratio measures how efficiently an organization is utilizing its assets.

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These ratios measure the long-term solvency of a firm. Financial leverage refers to the use of debt finance. While debt capital is a cheaper source of finance, it is also a risky source. Leverage ratios help us assess the risk arising from the use of debt capital. Two types of ratios are commonly used to analyze financial leverage - structural ratios and coverage ratios. Structural ratios are based on the proportions of debt and equity in the financial structure of a firm. Coverage ratios show the relationship between the debt commitments and the sources for meeting them. The long-term creditors of a firm evaluate its financial strength on the basis of its ability to pay the interest on the loan regularly during the period of the loan and its ability to pay the principal on maturity.

a. Debt-Equity Ratio

This ratio shows the relative proportions of debt and equity in financing the assets of a firm. The debt includes short-term and long-term borrowings. The equity includes the net worth (paid-up equity capital and reserves and surplus) and preference capital. It can be calculated as: Debt / Equity

b. Debt-Asset Ratio

The debt-asset ratio measures the extent to which the borrowed funds support the firm's assets. It can be calculated as: Debt / Assets The numerator of the ratio includes all debt, short-term as well as long-term, and the denominator of the ratio includes all the assets (the balance sheet total). Creditors prefer low debt ratios because the lower the ratio, the greater the cushion against the creditors losses in the event of liquidation. Stockholders want more leverage because it magnifies expected earnings.

c. AVERAGE COLLECTION PERIOD (ACP) d. Fixed Asset Turnover (FAT) e. Total Asset Turnover (TAT)

4. Profitability Ratios

These ratios help measure the profitability of a firm. There are two types of profitability ratios: Profitability ratios in relation to sales and Profitability ratios in relation to investments.

Profitability ratios in relation to sales: A firm which generates a substantial amount of profits per rupee of sales can comfortably meet its operating expenses and provide more returns to its shareholders. The relationship between profit and sales is measured by profitability ratios. There are two types of profitability ratios:

1. Gross Profit Margin:

This ratio measures the relationship between gross profit and sales. This ratio shows the profit that remains after the manufacturing costs have been met. It measures the efficiency of production as well as pricing. The high gross margin reflects the company's ability to maintain a low cost of production. It is calculated as follows: Gross Profit Margin = Gross Profit/Net sales * 100 The reasons for the increase in GP Margin can be: Higher sales prices but cost of goods sold remaining constant. Lower cost of goods sold, sales prices remaining constant. A combination of changes in sales prices and costs, widening the margin between them.

This ratio shows the net earnings (to be distributed to both equity and preference shareholders) as a percentage of net sales. It measures the overall efficiency of production, administration, selling, financing, pricing and tax management. The high net profit margin implies higher returns to shareholders in the form of dividends and stock price appreciation. This ratio is computed using the following formula: Net profit / Net sales Jointly considered, the gross and net profit margin ratios provide an understanding of the cost and profit structure of a firm.

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Profitability ratios in relation to investments: These ratios measure the relationship between the profits and investments of a firm. There are three such ratios:

3. Return on Assets (ROA):

This ratio measures the profitability of the assets of a firm. The formula for calculating ROA is: ROA = EAT + Interest - Tax Advantage on Interest / Average Total Assets

4. Return on Capital Employed (ROCE):

Capital employed refers to the long-term funds invested by the creditors and the owners of a firm. It is the sum of long-term liabilities and owner's equity. ROCE indicates the efficiency with which the long-term funds of a firm are utilized. It is computed by the following formula: ROCE = (EBIT / Average Total Capital Employed) * 100

5. Return on Shareholders' Equity:

This ratio measures the return on shareholders' funds. It can be calculated using the following methods: a. Rate of return on total shareholders' equity. The total shareholders' equity consists of preference share capital, ordinary share capital consisting of equity share capital, share premium, reserves and surplus less accumulated losses. Return on total shareholders' equity = (Net profit after taxes) * 100 /Average total shareholders' equity b. Rate of return on ordinary shareholders. This ratio is calculated by dividing the net profits after taxes and preference dividend by the average equity capital held by the ordinary shareholders. ROSE = (Net Profit after Taxes - Preference Dividend) * 100 / Net worth c. Earnings per share. EPS measures the profits available to the equity shareholders on each share held. The formula for calculating EPS is: EPS = Net Profits Available to Equity Holders / Number of Ordinary Shares Outstanding d. Dividends per share.

DPS shows how much is paid as dividend to the shareholders on each share held. Higher dividends may have been declared because of stagnation in the business, as a result of which earnings were not retained. However, the increase in dividends also indicates that the company is generating profits consistently. The formula for calculating EPS is: DPS = Dividend Paid to Ordinary Shareholders / Number of Ordinary Shares Outstanding e. Dividend pay-out ratio. D/P ratio shows the percentage share of net profits after taxes and after preference dividend has been paid to the preference equity holders. D/P ratio = Dividend per Share (DPS) / Earnings per Share * 100 f. Earnings and Dividend yield. Earning yield is also known as earning-price ratio and is expressed in terms of the market value per share. Earning Yield = EPS / Market Value per Share * 100 Dividend Yield is expressed in terms of the market value per share. Dividend Yield = (DPS / Market Value per Share) * 100

6. Valuation Ratios

Valuation ratios indicate the performance of the equity stock of a company in the stock market. Since the market value of equity reflects the combined influence of risk and return, valuation ratios play an important role in assessing a company's performance in the stock market. The important valuation ratios are the Price-Earnings Ratio and the Market Value to Book Value Ratio.

a. Price-Earnings Ratio

The P/E ratio is the ratio between the market price of the shares of a firm and the firm's earnings per share. It shows how much the investors are willing to pay per rupee of reported profits. The price-earnings ratio indicates the growth prospects, risk characteristics, degree of liquidity, shareholder orientation, and corporate image of a company. It is lower for riskier firms. The formula for calculating the P/E ratio is: P/E ratio = Market Price of Share / Earnings per Share

This is the ratio between the market price per share (MPS) and actual book value per share. This ratio reflects the contribution of a company to the wealth of its shareholders. When this ratio exceeds 1, it means that the company has contributed to the creation of wealth of its shareholders. It can be calculated as follows: Market Value to Book Value Ratio = Market Price per Share / Book Value per Share where Book Value per share = Common Equity / No. of shares

if this ratio is greater than 1 that means investors are willing to pay more for stocks than their book value.

7. DuPont Analysis

DuPont Analysis is a technique that breaks ROA and ROE measures down into three basic components that determine a firm's profit efficacy, asset efficiency and leverage. The analysis attempts to isolate the factors that contribute to the strengths and weaknesses in a company's financial performance. Poor asset management, expenses getting out of control, production or marketing inefficiency could be potential weaknesses within a company. Expressing these individual components rather than interpreting ROE, may help the company identify these weaknesses in a better way. The model breaks down return on net worth (RONW) into three basic components, reflecting the quality of earnings along with possible risk levels. RONW = PAT / NW Where, PAT = Profit after Tax NW = Net worth The above formula can be further broken down into: RONW = PAT / Sales * Sales / CE * CE / NW Where, CE = Capital Employed.

Common size statement is an extension of ratio analysis. In a common size statement, each individual asset and liability is shown as a percentage of total assets and liabilities respectively. Such a statement prepared for a firm over a number of years would give insights into the relative changes in expenses, assets and liabilities. In a common size income statement gross sales/net

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sales are taken as 100 per cent and each expense item is shown as a percentage of gross sales/net sales.

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