RatioAnalysisTechniques.docx
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RatioAnalysisTechniques.docx
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RatioAnalysisTechniques
RatioAnalysisTechniques
RatioAnalysis:
Itisconcernedwiththecalculationofrelationships,whichafterproperidentification&interpretationmayprovideinformationabouttheoperationsandstateofaffairsofabusinessenterprise.Theanalysisisusedtoprovideindicatorsofpastperformanceintermsofcriticalsuccessfactorsofabusiness.Thisassistanceindecision-makingreducesrelianceonguessworkandintuitionandestablishesabasisforsoundjudgments.
TypesofRatios
LiquidityMeasurement
ProfitabilityIndicators
FinancialLeverage/Gearing
OperatingPerformance
InvestmentValuation
CurrentRatio
ProfitMarginAnalysis
EquityRatio
FixedAssetsTurnover
Price/EarningsRatio
QuickRatio
ReturnonAssets
DebtRatio
Sales/Revenue
Price/EarningstoGrowthratio
ReturnonEquity
Debt-EquityRatio
AverageCollectionPeriod
DividendYield
ReturnonCapitalEmployed
CapitalizationRatio
InventoryTurnover
DividendPayoutRatio
InterestCoverageRatio
TotalassetsTurnover
LiquidityMeasurementRatios
Liquidityreferstotheabilityofafirmtomeetitsshort-termfinancialobligationswhenandastheyfalldue.Themainconcernofliquidityratioistomeasuretheabilityofthefirmstomeettheirshort-termmaturingobligations.Thegreaterthecoverageofliquidassetstoshort-termliabilitiesthebetterasitisaclearsignalthatacompanycanpayitsdebtsthatarecomingdueinthenearfutureandstillfunditsongoingoperations.Ontheotherhand,acompanywithalowcoveragerateshouldraisearedflagforinvestorsasitmaybeasignthatthecompanywillhavedifficultymeetingrunningitsoperations,aswellasmeetingitsobligations.
Ratio
Formula
Meaning
Analysis
CurrentRatio
CurrentAssets/CurrentLiabilities
Currentassetsincludecash,marketablesecurities,accountsreceivableandinventories.Currentliabilitiesincludesaccountspayable,shorttermnotespayable,short-termloans,currentmaturitiesoflongtermdebt,accruedincometaxesandotheraccruedexpenses
Thenumberoftimesthattheshorttermassetscancovertheshorttermdebts.Inotherwords,itindicatesanabilitytomeettheshorttermobligationsas&whentheyfalldue
Highertheratio,thebetteritis,howeverbuttoohighratioreflectsanin-efficientuseofresources&toolowratioleadstoinsolvency.Theidealratioisconsideredtobe2:
1.,
QuickRatioorAcidTestRatio
(Cash+CashEquivalents+ShortTermInvestments+AccountsReceivables)/CurrentLiabilities
Indicatestheabilitytomeetshorttermpaymentsusingthemostliquidassets.Thisratioismoreconservativethanthecurrentratiobecauseitexcludesinventoryandothercurrentassets,whicharemoredifficulttoturnintocash
Theidealratiois1:
1.Anotherbeneficialuseistocomparethequickratiowiththecurrentratio.Ifthecurrentratioissignificantlyhigher,itisaclearindicationthatthecompany'scurrentassetsaredependentoninventory.
ProfitabilityIndicatorsRatios
Profitabilityistheabilityofabusinesstoearnprofitoveraperiodoftime.Theprofitabilityratiosshowthecombinedeffectsofliquidity,assetmanagement(activity)anddebtmanagement(gearing)onoperatingresults.Theoverallmeasureofsuccessofabusinessistheprofitabilitywhichresultsfromtheeffectiveuseofitsresources.
Ratio
Formula
Meaning
Analysis
GrossProfitMargin
(GrossProfit/NetSales)*100
Acompany'scostofgoodssoldrepresentstheexpenserelatedtolabor, rawmaterialsandmanufacturingoverheadinvolvedinitsproductionprocess.Thisexpenseisdeductedfromthecompany'snetsales/revenue,whichresultsinacompany'sgrossprofit.Thegrossprofitmarginisusedtoanalyzehowefficientlyacompanyisusingitsrawmaterials,laborandmanufacturing-relatedfixedassetstogenerateprofits.
Highertheratio,thehigheristheprofitearnedonsales
OperatingProfitMargin
(OperatingProfit/NetSales)*100
Bysubtracting selling,generalandadministrativeexpensesfromacompany'sgrossprofitnumber,wegetoperatingincome.Managementhasmuchmorecontroloveroperatingexpensesthanitscostofsalesoutlays.ItMeasurestherelativeimpactofoperatingexpenses
Lowertheratio,lowertheexpenserelatedtothesales
NetProfitMargin
(NetProfit/NetSales)*100
Thisratiomeasurestheultimateprofitability
Highertheratio,themoreprofitablearethesales.
ReturnonAssets
NetIncome/AverageTotalAssets
(EarningsBeforeInterest&Tax=NetIncome)
Thisratioillustrateshowwellmanagementisemployingthecompany'stotalassetstomakeaprofit.
Higherthereturn,themoreefficientmanagementisinutilizingitsassetbase
ReturnonEquity
NetIncome/AverageShareholdersEquity*100
Itmeasureshowmuchtheshareholdersearnedfortheirinvestmentinthecompany
Higherpercentageindicatesthemanagementisinutilizingitsequitybaseandthebetterreturnistoinvestors.
ReturnonCapitalEmployed
NetIncome/CapitalEmployed
CapitalEmployed=Avg.DebtLiabilities+Avg.ShareholdersEquity
Thisratiocomplementsthe returnonequityratiobyaddingacompany'sdebtliabilities,orfundeddebt,toequitytoreflectacompany'stotal"capitalemployed".Thismeasurenarrowsthefocustogainabetterunderstandingofacompany'sabilitytogeneratereturnsfromitsavailablecapitalbase.
Itisamorecomprehensiveprofitabilityindicatorbecauseitgaugesmanagement'sabilitytogenerateearningsfromacompany'stotalpoolofcapital.
FinancialLeverage/GearingRatios
Theseratiosindicatethedegreetowhichtheactivitiesofafirmaresupportedbycreditors’fundsasopposedtoownersastherelationshipofowner’sequitytoborrowedfundsisanimportantindicatoroffinancialstrength.Thedebtrequiresfixedinterestpaymentsandrepaymentoftheloanandlegalactioncanbetakenifanyamountsduearenotpaidattheappointedtime.Arelativelyhighproportionoffundscontributedbytheownersindicateacushion(surplus)whichshieldscreditorsagainstpossiblelossesfromdefaultinpayment.
Financialleveragewillbetotheadvantageoftheordinaryshareholdersaslongastherateofearningsoncapitalemployedisgreaterthantheratepayableonborrowedfunds.
Ratio
Formula
Meaning
Analysis
EquityRatio
(OrdinaryShareholder’sInterest/Totalassets)*100
Thisratiomeasuresthestrengthofthefinancialstructureofthecompany
Ahighequityratioreflectsastrongfinancialstructureofthecompany.Arelativelylowequityratioreflectsamorespeculativesituationbecauseoftheeffectofhighleverageandthegreaterpossibilityoffinancialdifficultyarisingfromexcessivedebtburden.
DebtRatio
TotalDebt/TotalAssets
Thiscomparesacompany'stotal debttoitstotalassets,whichisusedtogainageneralideaastotheamountofleveragebeingusedbyacompany.Thisisthemeasureoffinancialstrengththatreflectstheproportionofcapitalwhichhasbeenfundedbydebt,includingpreferenceshares.
Withhigherdebtratio(lowequityratio),averysmallcushionhasdevelopedthusnotgivingcreditorsthesecuritytheyrequire.Thecompanywouldthereforefinditrelativelydifficulttoraiseadditionalfinancialsupportfromexternalsourcesifitwishedtotakethatroute.Thehigherthedebtratiothemoredifficultitbecomesforthefirmtoraisedebt.
Debt–EquityRatio
TotalLiabilities/TotalEquity
.Thisratiomeasureshowmuchsuppliers,lenders,creditorsandobligorshavecommittedtothecompanyversuswhattheshareholdershavecommitted.
Thisratioindicatestheextenttowhichdebtiscoveredbyshareholders’funds.
Alowerratioisalwayssafer,howevertoolowratioreflectsanin-efficientuseofequity.Toohighratioreflectseitherthereisadebttoagreatextentortheequitybaseistoosmall
CapitalizationRatio
LongTermDebt/(LongTermDebt+Shareholder’sEquity)
Thisratiomeasuresthedebtcomponentofacompany'scapitalstructure,orcapitalization(i.e.,thesumoflong-termdebt liabilitiesandshareholders'equity)tosupportacompany'soperationsandgrowth.
Alowlevelofdebtandahealthyproportionofequityinacompany'scapitalstructureisanindicationoffinancialfitness.
Acompanytoohighlyleveraged(toomuchdebt)mayfinditsfreedomofactionrestrictedbyitscreditorsand/orhaveitsprofitabilityhurtbyhighinterestcosts.Thisratioisoneofthemoremeaningfuldebtratiosbecauseitfocusesontherelationshipofdebtliabilitiesasacomponentofacompany'stotalcapitalbase,whichisthecapitalraisedbyshareholdersandlenders.
InterestCoverageRatio
EBIT/InterestonLongTermDebt
Thisratiomeasuresthenumberoftimesacompanycanmeetitsinterestexpense
Thelowertheratio,themorethecompanyisburdenedbydebtexpense.Whenacompany'sinterestcoverageratioisonly1.5orlower,itsabilitytomeetinterestexpensesmaybequestionable.
OperatingPerformanceRatios:
Theseratioslookathowwellacompanyturnsitsassetsintorevenueaswellashowefficiently acompanyconvertsitssalesintocash,i.ehowefficiently&effectivelyacompanyisusingitsresourcestogeneratesalesandincreaseshareholdervalue.Thebettertheseratios,thebetteritisforshareholders.
Ratios
Formula
Meaning
Analysis
FixedAssetsTurnover
Sales/NetFixedAssets
Thisratioisaroughmeasureoftheproductivityofacompany's fixedassetswithrespecttogeneratingsales
Highfixedassetsturnoversarepreferredsinc
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