Published by: Nuru
Published date: 07 Feb 2022
Ratio Analysis
Financial ratio analysis is a technique to quantify the relationship between two or more sets of financial data derived from income statement and balance sheet. They represent the firm's performance and status. For example, a firm may be able to generate Rs. 100 million of net income after tax in a year, but we cannot justify whether this amount of net income is adequate or not for the firm unkess we relate this figure to some other da]ta like assets, or equity, or sales, so on).
Types of financial ratios:
It is responsible to measure the firm's ability to pay its short term obligations out of current or liquid assets. These ratios focus on current assets and liabilities. They are used to ascertain the short-term solvency of the firm. The two primary ratios are used to test the liquidity of a firm are current ratio and quick ratio.
a. Current ratio (CR):
It is the quantitative relationship between current assets and current liabilitiies. Current assets are those assets which can be convertible within a year like cash and marktetable securities, receivables, inventories, etc. Current liabilities refers to the obligation to be paid within a year like notes payables, accruals, accounts payable, etc.
Current ratio (CR) = Current assets / Current Liabilities
It is expressed in times as for example if CR is 1.5 times, means for every rupee of current liabilities, there is Rs. 1.5 worth of current assets. In other words, we can say current assets is 1.5 times the current liabilities.
b. Quick ratio (QR) or Acid-test ratio or liquid ratio:
It is defined as the quantative relationship betwen quick assets and current liabilities. It includes all the items of current assets except inventories. Inventories usually have less liquidity among all current assets. So, the measure of the firm's ability to pay short term obligations without relying on the sale of inventories is significant.
Quick ratio (QR) = Quck assets (QA) / Current Liabilities (CL)
Other liquidity ratios:
Cash ratio = Cash / Current Liabilities
Net working capital to total asset = Net working capital / Total assets
Internal measure = Current assets / Average daily operating costs
It is also called turnover ratios or activity ratio efficiency ratios. These ratios look at the amount of various types of asstes and then attempt to determine if they are too high or high low with reference to current level of operation.
They provide the measure for how effectively the firm's assets are being managed. If high amount of funds are tied up in certain type of assets that could otherwise be emloyed more productively elsewhere the firm is not as profitable as it should be. Asset management ratios include following:
a. Inventory Turnover Ratio and Days Sales in Inventory:
Inventory Turnover ratio (ITOR) measures how a firm's average investment in inventory is capable of generating sales. It is the test of the liquidity of firm's investment in inventories. It is calculated by:
Inventory Turnover Ratio (ITOR) = Cost of goods sold (Cogs) / Average inventory
Inventory Turnover Ratio (ITOR) = Sales / Inventory
Days Sales in Inventory (DSO) indicates the time period on how long, in average, it takes the firms to turn over its inventory. It is calculated as:
Days Sales in Inventory (DSO) = 360 / inventory turnover
b. Receivable Turnover Ratio (RTO):
It measures how many times the accounts receivable turnover occurs during the year. It measures the productivity of investment in accounts receivable and test of the liquidity of receivables of the firm. It is callcualetd by:
Receivable Turnover Ratio (RTO) = Annual credit sales / Average accounts receivable
c. Days Sales Outstanding (DSO):
It refers to the average length of time that a firm takes to realize in cash after credit sales has been made.
Days Sales Outstanding (DSO)= Receivable / Average sales per day, where Average sales per day = annual credit sales / 360
Days Sales Outstanding (DSO)= Receivable * 360 days / anuual sales
Days Sales Outstanding (DSO)= 360 days / Receivable Turnover Ratio (RTO)
d. Fixed assets turnover ratio (FATOR):
The measurement of effectiveness of firm's ability to make efficient utilization of fixed assets.
FATOR = Sales / Net fixed assets
e. Total Assets Turnover Ratio(TATOR):
It measures the efficiency of assets management in relation to all the firm's assets. It is calculated by:
Total Assets Turnover Ratio(TATOR) = Sales / Total assets
f. Net Wroking Capital Turnover Ratio (NWCTOR):
NWCTOR = Sales / Net Working Capital
Also called leverage ratios, indicate the extent to which debt financing is being used by the firm. It is the measure of long-term solvency of a firm.
These ratios are used to analyze long-term solvency positions from two aspects; first, how firm is using the borrowed funds toi finance its assets; second, how far the firm is able to serve its debt in terms of satisfying fixed interest charges.
a. Debt Asset Ratio (D/A ratio):
It shows the proporrtion of total debts used to dinance total asstes of a firm. It is calcualted by:
D/A ratio= Total debts / Total assets
b. Debt Equity Ratio (D/E ratio):
It measures the long-term solvency and expresses the relationship between debt capital and equity capital.
D/E ratio = Total debt / total equity
Also, D/E ratio = D/A / (1-D/A)
Also, D/A ratio = D/E (1+D/E)
c. Long Term Debt to Total Assets Ratio:
It represents the relationship between long-term debts to total assets of a firm. It is calcualed by:
Long Term Debt ratio = Long-term debt / Total assets
d. Equity Multiplier (EM):
It states the relationship of total assets to equity of a firm.
EM = Total assets / Total equity
EM = 1 / (1-D/A)
EM = 1 + D/E
e. Interest Coverage Ratio (TIE ratio):
It measures the extent to which interest on debt capital is covered by EBIT.
TIE ratio = EBIT / Interest Expense
f. Cash coverage ratio:
Cash coverage ratio = (EBIT + Depreciation) / Interest
g. EBIDTA coverage ratio:
EBIDTA coverage ratio = (EBITDA + Lease payment) / (Interest +Lease payment+Principal repayment)
a. Net profit margin:
Net profit margin = Net income / Sales
b. Gross profit margin:
Gross profit margin = Gross profit / Sales
c. Operating profit ratio (OPR):
OPR = Operating profit / Sales
d. Basic Earning Power Ratio:
Basic Earning Power Ratio = EBIT / Total assets
e. Return on assets(ROA):
ROA = Net Income / Total assets
f. Return on Equity (ROE):
ROE= Net income / Total equity
5. Market Value Ratio:
They are used to assess firm's stock price in relation to its earnings and book value of shares.
a. Price Earning ratio (PE ratio):
PE ratio = Market Price per Share / Earning Per Share (EPS)
b. Market to Book Ratio:
Market to Book Ratio = Market Price per Share(MPS) / Book Value Per Share (BVPS)
DuPoint Identity:
It is a method of classified assemenet of firm's financial ratios that shows the relationship of return on equity to the profit margin, assets turonver, and equity multiplier.
RoA= Profit margin * Total assets turnover
RoA= Net income / Sales * Sales / Total assets
Now again,
RoE = RoA * Equity multiplier
RoE= Net income / Sales * Sales / Total assets * Total assets / Equity
Use of financial ratio are listed below:
Limitation of Ratio Analysis are: