1. Financial Ratio Analysis
A ratio analysis is a quantitative
analysis of information contained in a company’s financial statements. Ratio
analysis is used to evaluate various aspects of a company’s operating and
financial performance such as its efficiency, liquidity, profitability and
solvency.
Ratios are classified into following types:
2. Liquidity ratio: Liquidity
ratios give an idea about company’s ability to convert its assets into cash and
pay its current liabilities with that cash whenever required. In simple
language, they indicate the company’s ability to pay its short-term obligations
whenever they are payable. Liquidity ratios focus on short-term survival of the
company, while solvency focuses on long-term survival.
FORMULA FOR LIQUIDITY RATIOS
·
CURRENT
RATIO
It is found by dividing current
assets by current liabilities. It shows whether current
assets are enough to cover the current liabilities.
·
QUICK
RATIO/ ACID TEST RATIO
It
is similar to the current
ratio. However, in current assets, illiquid assets like inventory
are not considered. Inventory can only be liquidated when there are buyers for
the same. In the economic downturn or emergency situations, it will be
difficult to sell inventory.
3. Profitability ratio: Profitability
ratios are the financial ratios which talk about the profitability of a
business with respect to its sales or investments. Since the ratios measure the
efficiency of operations of a business with the help of profits, they are
called profitability ratios. They are quite useful tools to understand the
efficiencies/inefficiencies of a business and thereby assist management and
owners to take corrective actions.
4. MARGIN
RATIOS
There are broadly 3
margin ratios,
GROSS
PROFIT MARGIN
This is the ratio
which is used to understand how much cost incurred to manufacture a product. It
also helps in understanding the efficiency of the company and how is it using
its resources to produce the product and then make a profit by passing the cost
incurred to the consumers of the product.
NET
PROFIT MARGIN
It is the most common
profitability ratio which is used to measure the profit after deducting all the
expenses, losses, provisions for bad debt. It measures how much you are making
out of every penny you spent on the business.
OPERATING
PROFIT MARGIN
This is the metric
which is used to evaluate the operating efficiency of the company. EBIT i.e.
earnings before interest and taxes are calculated to understand how much profit
the company has generated from its core operation. Operating profit margin
evaluates this EBIT as a percentage of sales to understand the efficiency of
the operations of the company.
.
EXPENSE
RATIOS
Expense ratios are a comparison
of any particular type of expense with respect to sales. These expense ratios
could be as many in numbers as the no. of important expense categories. Say,
for example, sales and distribution, administration etc.
5. RETURN
RATIOS
There are mainly 3
return ratios,
RETURN
ON ASSETS (ROA)
It is the
profitability ratio which is used to evaluate the company’s level of efficiency
in employing its assets to generate profit. The assets of the company if not
used optimally will not be able to make the desired amount of profit and the
return will also be lower.
.
RETURN
ON EQUITY (ROE)
Every equity investor looks for
this ratio before investing in any company as it gives the insight into the
company’s profit-generating ability to the investors. The potential, as well as
existing investors keep a check on this ratio as it measures the return on the
investment made in shares of the company. In general, the higher the ratio,
more favorable it is for the investors to invest in the company
FORMULA
1. Gross
Profit Margin = (Gross profit / Net Sales )*100
2. Net
Profit Margin = (Net Profit / Net Sales)*100
3. Operating
Profit Margin = (Operating Profit / Net Sales)*100
4. Expense
Ratio = Expenses (Ex. Sales and Distribution) / Net Sales
5. Return
on Asset = ( Net Income / Assets)*100
6. Return
on Equity = (Net Income / Shareholder’s Equity Investment)*100
7. Return
on Capital Employed = Net Income / Capital Employed
6. LEVERAGE RATIO
leverage ratios are
financial ratios used to measure a company’s capital
structure, financial obligations and its ability to clear those
obligations. The financial aptitude of the company is measured by the
investors, board of directors, creditors and others by using these ratios.
TYPES
OF LEVERAGE RATIO:
A leverage ratio is a financial
ratio which can be defined as a financial metric to measure the capability of
the company to pay off its dues or how much asset is put to use with the loan
taken along with being a good indicator of capital structure. There are
different ratios which are categorized as leverage ratios and they are as
follows:
·
DEBT-TO-EBITDA
This is the ratio which is used
to measure the capacity of the company to pay off its debt. It is mainly used
by the credit rating agencies and financial institutions to check whether the
company will be able to clear its debt or not and how efficiently they can do
it.
·
DEBT-TO-CAPITAL
It is used to compare the debt and
the capital of a company. This is the ratio which is used to analyze the
financial structure of the company and it also checks how the business
operations are getting financed.
·
DEBT-TO-EQUITY
It is the comparison
between the shareholder’s investment that is equity and the total liabilities
(most of the time only long-term debts are taken into consideration). It is
used to measure the proportion of company’s debt and equity. Banking
industry uses this ratio very frequently in their credit appraisal of businesses
applying for a loan. It compares the investment made by the owners vs. the
investment by the bank. Banks normally keep a provision of margin money to
maintain this ratio and check the seriousness of the owners towards the
business.
This is the ratio
which is a relation between the total debt of the company to its assets and
this is used to understand how much debt is used to finance the assets of the
company
CALCULATION AND FORMULA
The different leverage ratios and
their formula are as follow –
Debt-to-Capital = Total Debt /
(Total Debt + Total Equity)
Debt-to-Equity = Total Debt /
Total Equity
Debt-to-Asset = Total Asset /
Total Assets
7.
TURNOVER
RATIO
The
turnover ratio can be defined as the ratio to calculate the quantity of any
asset which is used by a business to generate revenue through its sales. It is
the relation between the amount of company’s asset and the revenue generated
from them. To be more precise, it is an efficiency ratio to check how
efficiently the company is using different assets to extract earnings from them
(individually as well as on a whole). A higher ratio is considered to be better
as it would indicate that the company is optimally using the resources to earn
revenue and it would imply a higher ROI and the funds invested are used the
least
TYPES
OF TURNOVER RATIOS WITH FORMULA
·
CAPITAL EMPLOYED TURNOVER RATIO
It indicates the
relation between the capital employed in
a business and the sales or revenue the business generates out of it. The
capital whether used in a proper direction to generate revenue or not and how
efficiently it has been employed is measured with this ratio. The formulae for
Capital employed
turnover Ratio = Sales / Capital Employed
·
TOTAL ASSET TURNOVER RATIO
It is a ratio which determines
the connection between the sales and the total asset of a company. It checks
for the efficiency with which the company’s all assets are utilized to earn
revenue. The formula for
Total Asset Turnover Ratio =
Sales (Net Sales) / Total Assets of the Company
·
DEBTORS
TURNOVER RATIO
It is the ratio which calculates
the quickness of the conversion of the debtors or credit sales amount to cash.
It is also known as the receivables turnover ratio as it measures the credit
sales against the average debtors for a year. The formula for
Debtors Turnover Ratio =
Net Credit Sales / Average account Receivable
·
FIXED ASSET TURNOVER RATIO
This is the ratio
which measures how much sale is generated from churning the fixed assets of
the company and how efficiently it is done. The fixed assets of a company are
very crucial in revenue generation and thus the optimization of the fixed asset
use increases the sales if done properly. The formula for
Fixed Asset Turnover Ratio =
Sales or Net Sales / Fixed Assets
·
AVERAGE COLLECTION PERIOD
It shows the amount of time
required to convert the credit sales into cash. It states the average time
period given to the debtors to make their payments. The formula for
·
INVENTORY TURNOVER RATIO
It is also referred
as the stock turnover ratio which
is used to measure the number of sales generated from its inventory and how
efficiently the inventories in a company is used. The formula for
or
Inventory Turnover
Ratio= Sales / Closing Inventory.
8. Market Value Ratio
The market value ratios are the financial metrics which
are used to evaluate the stocks of publicly traded companies. These ratios are
mainly used by investors to check whether the share’s prices are valued
correctly in the market or they are trading at a higher price or lower. The
overvaluation or undervaluation of shares helps investors decide whether they
should go long or short on the shares they are going to invest in. If a share
is overpriced, the price will fall for sure in the future and thus an investor
should short the shares for a while and if the stock is underpriced then one
should go long on it.
There are different market value ratios used by the share
market investors and some of the most used ratios are mentioned below:
·
PRICE/EARNINGS OR PE RATIO
This is the most used
and important ratio under this category of ratios. It is used to check whether
the shares are over or underpriced as compared to its earnings potential. It is
measured as the price of the share in the current time against the earnings the
company has reported for the financial period on per share basis
EARNINGS PER SHARE
This ratio shows the
earnings of the company earned in a particular time period against the number
of the company’s shares which are outstanding. This ratio is used to understand
whether investing in it is worth the money or not.
·
BOOK VALUE PER SHARE
This ratio is again
one of the most important market value ratios to analyze and decide whether the
price per share of the company is at its market price or not. This ratio shows
the relation between the book value of the company (total equity excluding
the preference
shares of the shareholders)
and the outstanding shares in the market.
·
MARKET VALUE PER SHARE
This is the ratio which is
obtained by dividing the total market value of the shares of the company by the
number of the shares which are outstanding. This gives the per share price in
the market.
·
DIVIDEND YIELD
Investors check both the price
and dividend earnings from a share so, this ratio helps in measuring the amount
of dividend distributed in a year against the number of shares outstanding.
This gives an insight into the company’s earning and investors can decide whether
they want to invest in the shares which pay a certain level of dividend against
the current price of the share in the market.
CALCULATION
AND FORMULAS OF DIFFERENT MARKET VALUE RATIOS
The formula for each market value
ratio is as follows:
2. Earnings
per Share (EPS) = Net Profit (Earnings)
/ total number of shares outstanding in the market
3. Book
Value per Share = (Shareholder’s Equity – Preference stock) / Outstanding
numbers of shares.
4. Market
Value per Share = Market Capitalization / Outstanding shares in the market.
Dividend
Yield = Total dividend paid in a year / Number
of shares outstandingARTICLE BY MONDAY DESMOND
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