Financial Ratio Analysis
Financial ratio analysis is conducted to learn more about the accounts and businesses. Ratio analysis is useful in ascertaining the profitability of a company. It is useful in ascertaining the profitability of a company. The ability of a company to repay the liabilities is also determined from analyzing its financial ratio. Moreover, the working performance of the company is looked to check whether it has performed well in the current year as compared to the previous year. Comparison between the performances of different competitors is made through their financial ratio analysis.
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Types and List of Financial Ratios
There are different types of financial ratios covered in financial ratio analysis representing different aspects of the company’s abilities & potentials. These are
- Liquidity Ratios
- Profitability Ratios
- Leverage Ratios
- Investment Ratios
Liquidity ratios is the type of financial ratios that contain a set of ratios that describe the liquidity potential of the company. These ratios have further two types:
- Current Ratio
- Acid Test Ratio
Another name of current ratio is the working capital ratio and it is normally shown as a real ratio. Following is the formula to calculate current ratio:
Current Ratio = Current Assets / Current Liabilities
This ratio provides the picture of the ability of a company to pay back its short term liabilities with its short term assets. The higher current ratio explains that the company has the high potential to pay its obligations. The current ratio below 1 indicates that the company is not able to pay back its due obligations. Current ratio below 1 shows the poor financial health of the company, but it is not surety for the bankruptcy of the company.
The efficiency of the operating cycle of the company is highlighted from its current ratio. This ratio also shows the ability of a company to convert its products into cash. The companies that have long inventory turnover or bear problems in getting paid on their receivables can face problems of liquidity that represent its weakness in paying off its obligations. Companies in different industries have different sorts of operations so it is better to compare those companies that lie in one industry.
Current ratio is similar to acid test ratio except one difference is that the inventory element is not included in the acid test ratio. Working capital can be derived by using the components of the current ratio. This ratio is derived mostly by using working capital.
The exceeded amount of currents assets over current liabilities is called working capital. In simpler terms, the difference between current assets and current liabilities is the working capital.
Working Capital = Current Assets – Current Liabilities
Acid Test Ratio
Acid Test ratio is also called quick or liquid ratio. The main concept behind this ratio is that sometimes it is difficult to sell or use the stocks which creates problems. Even in a supermarket where thousands of people visit daily, there are still some products that are difficult to sell at a proper time. Besides this, there are certain products that are sold quickly.
There are stocks of certain companies which are sold or used slowly. If any emergency of cash rises in those companies and they try to sell some of their stock for immediate cash purpose, then they will surely fail. In case of engineering companies their stock rests with them from 9 months to a year. On the other hand, green grocer held his stock from 4 to 5 days and it is better for him to consider the acid test ratio which is given by the following formula:
Acid Test Ratio = (Current Assets – Inventory) / Current Liabilities
The second type of financial ratios, which is determined in the process of financial ratio analysis, is profitability ratios, which includes the set of ratios that explains the profitability aspects of the company. It has further four types:
- Gross Profit Margin
- Operating Margin
- Net Profit Margin
- Earnings Per Share
Gross Profit Margin
It is given by the following formula:
Gross Profit Margin = Gross Profit / Net Sales * 100
It is important to note that Gross Profit = Sales – Cost of Goods Sold
The profit generated by a company on its cost of goods sold is represented by the ratio of gross profit margin. It is a simple concept that reveals the proportion of gross profit per $1 of the turnover the company is earning.
The gross profit shows the profit before deduction of any selling cost and administrative costs and so on. So, the gross profit margin is much higher than net profit margin.
The operating ratio is used to measure the operating efficiency & pricing strategy of a company. It is calculated by the following formula:
Operating Margin = Operating Income / Net Sales
It measures the proportion of the revenue of the company that is left over after deducting the variable cost of production like raw materials, wages etc. In order to pay the fixed costs like interest on debt, a healthy operating margin is required for the company.
It is clear from the operating margin of a company how much it makes on each dollar of sales (before interest & taxes). When analysis is made in the ratio of operating margin to ascertain the quality of a company then it is better to consider the change in operating margin over time in order to make comparison between the quarterly or yearly figures of the company with its competitors. If the operating margin of a company is enhancing then it is earning more per dollar of sales. The increase in the operating margin is better for the company.
Net Profit Margin
This is calculated by the following formula
Net Profit Margin = Net Profit / Net Sales * 100
Where, Net Profit = Gross Profit – Expenses
There are two versions of this profitability ratio that are related to net profit and profit before interest & tax. In some cases the first one is used while second one is used in other situations by the company. However, the meaning of both these ratios is almost the same. The amount of net profit per $1 of turnover gained by a business is indicated by the net margin ratio. The net profit is the profit from which all expenses have been deducted along with interest, tax and dividends paid as expense. Where the expenses include cost of sales, selling and distribution costs, the administration costs and other costs.
Earnings per Share (EPS)
Earnings per share is defined as the portion of profits of a company which are apportioned to every outstanding share of common stock. The profitability of a company is indicated by the potential measure of the EPS. It is calculated by the following formula
Earnings per Share (EPS) = Profit Available to Shareholders / Average Common Shares Outstanding
EPS is the profit ascribed to shareholders (After deducting tax, interest and all other expenses) divided by the number of shares that are outstanding. In fact it indicates the amount of profits of a company that belong to one ordinary share.
Leverage ratios also from one of the types of financial ratios, which is deeply analyzed in the process of financial ratio analysis. It actually contains the list of ratios that are helpful in conducting financial ratio analysis of a company. The ratios that are used to access the financial leverage of a company so that its methods of financing are understood is considered as leverage ratio. Moreover, the ability of a company to fulfill its financial obligations is also measured by its leverage ratios.
In leverage ratio usually the equity fund of a company is compared with its borrowed funds. The degree to which the activities of a company are financed by owner’s funds versus creditor’s funds is indicated by the term gearing. In other words, financial leverage is measured in gearing.
Leverage = Long Term Debt / Total Equity
The riskiness of a company increases with its higher degree of leverage. A standard level is set in order to make compromise between financial ratios of one company with another within the same industry. Common examples of gearing ratios include equity ratio (equity / assets), debt-to-equity ratio (total debt/total equity), debt ratio (total debt total assets) and times interest earned (EBIT / total interest).
A company with high leverage is more vulnerable to the chances of loss because it is essential for the company to continuously service its debt regardless of the fact that its sales are very low. The financial strength of a company is looked well when it has a higher proportion of equity.
Interest Coverage Ratio
It is a ratio used to ascertain the easiness of a company to pay interest on its borrowed debt. The interest coverage ratio is evaluated by dividing the earnings before interest & tax (EBIT) of a company for a specified period of time by the interest expense of the company for the same period.
In fact the safety margin of the company is clear from its interest coverage ratio which corresponds to the ability of a company to fulfill its interest obligations. The higher interest coverage ratio points out that it is easy for the companies to pay off its interest obligations from its profits. Similarly the low value for the interest coverage ratio indicates that it is very difficult for the company to pay its interest obligations from its profits and it is in danger.
The formula of interest o=coverage ratio is as below
Interest Coverage Ratio = Earnings before Interest & Tax / Interest Expense
Investment Ratios contain a set of ratios that are helpful in making investment decisions in a particular company. It is also important to determine the investment ratios, while performing the financial ratio analysis of a company. Investment ratio includes:
- Dividend Per Share
- Dividend Yield
- Price Earnings Ratio
Dividend per Share
Dividend per Share ratio is similar to EPS: EPS indicates how much profits are earned by shareholders for a certain period of time while DPS indicates how much the earned profits are actually paid to shareholders in the shape of dividends. The formula of DPS is as follow
Dividend per Share (DPS) = Dividends Paid to Shareholders / Average Common Shares Outstanding
The dividend yield ratio assists investors in making comparison between the current dividends received by the shareholders with the market price of the share. This indicates the returns earned by the shareholders on their shares. The price that is paid by an investor for his share has little resemblance with the current market price of the share. Suppose, the history of the shares of a company is viewed for the last one or two years. Subsequently, the current market price of the share might be much higher or lower than the price one or two years before.
The latest share price is required to calculate this ratio which can be obtained from different newspapers or the internet. Following is the formula of this ratio
Dividend Yield = Annual Dividends / Current Market Price of Share
Price Earnings Ratio (P/E)
This (P/E) ratio is the most important ratio for the investors. It points out the level of confidence of the investors about the future prosperity of the company. A little confidence in the company is represented by P/E of 1 while P/E of 20 expresses the very high confidence of the investors about the future of the company. P/E is given by the following formula
Price Earnings Ratio (P/E) = Current Market Price of Share / EPS
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