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Financial Ratios
A financial ratio is a number, that
expresses the value of one financial
variable relative to another
It is the result you get when you
divide one financial number by
another
Calculation of ration is simple but
each ratio must be analyzed carefully
to effectively measure the firms
performance
Financial Ratios
Comparability ratios are comparative measures
because the ratios show relative value
Ratios allow financial analysts to compare
information that couldnt be compare in raw its
form
Ratios may be used to compare
- one ratio to a related ratio
- the firms performance to managements goal
- the firms past and present performance
- the firms performance to similar firms
Profitability Ratios
Profitability ratios measure how the firms
returns compare to its sales, assets
investments and equity
Basic Profitability Ratios
- Gross Profit Margin = Gross Profit / Sales
- Operating Profit Margin = EBIT / Sales
- Net Profit Margin = Net Income / Sales
- Return on Assets (ROA) = Net Income / Assets
- Return on Equity (ROE) = Net Income / Equity
Profitability Ratios
Gross profit margin measure how much profit
remains out of each sales rupee after the cost
of goods sold is subtracted and it shows how
well a firm generates revenue compared to its
cost of goods sold. The higher the ratio, the
better the cost controls compared to the sales
revenues.
Operating profit margin ratio measure the cost
of goods sold as reflected in the gross profit
margin ratio as well as all other operating
expenses
Profitability Ratios
Net profit margin measures how much profit
out of each sales rupee is left after all expenses
are subtracted. Net income / net profit margin
ratio are often referred to as bottom line
measures. The net profit margin includes
adjustments for non-operating expenses such
as interest and taxes and operating expenses
Return on assets ratio indicates how much
income each rupee of assets produces on
average. It shows whether the business is
investing in its assets effectively
Profitability Ratios
Return on equity ratio measures the
average return on the firms capital
contributions from its owners (for a
corporation, that means the contributions
of stockholders). It indicates how many
rupees of income were produced for each
rupee invested by the common
stockholders
GPM, OPM, NPM, ROA and ROE express in
% age
Liquidity Ratios
Liquidity ratios measure the ability of a firm to meets
its short term obligations. These ratios are important
because failure to pay such obligations can lead to
bankruptcy
Bankers and lenders use this ratio to check whether
to extend short term credit to a firm
Generally, the higher the liquidity ratio, the more
able a firm is to pay its short term obligations
Stockholders, however, use liquidity ratios to see
how the firm has invested in assets. Too much
investment in current as compared to long term
assets indicates inefficiency
Liquidity Ratios
Two main liquidity ratios are current
ratio and quick ratio, quick ratio
often termed as Acid test ratio
- Current Ratio = CA / CL
- Quick Ratio = QA / CL
Quick Assets = CA - Inventory but
most of the time financial analysts
calculate it as:
CA - (Inventory + Prepayments)
Liquidity Ratios
The current ratio compares all the current
assets of the firm (cash and other assets
that can easily converted to cash) to all
the firms current liabilities (liabilities that
must be paid with cash soon)
The quick ratio is similar to the current
ratio but its a more rigorous measure of
liquidity because it excludes inventory
(plus prepayments) from current assets
Debt Ratios
Financial analysts use debt ratios to assess the
relative size of firms debt load and the firms
ability to pay off debt. The three primary debt
ratios are the debt to assets, debt to equity and
times interest earned ratios
Current and potential lenders of long term funds
such as banks and bondholders are interested in
debt ratios. When a firms debt ratios increase
significantly, bondholder and lender risk increase
because more creditors compete for that firms
resources if the firm runs into financial trouble
Debt Ratios
Stockholders are also concerned with the
amount of debt a business has because
bondholders are paid before stockholders
The optimal debt ratio depends on several
factors such as type of business and the
amount of risk lenders and stockholders
will tolerate. Generally, a profitable firm in
a stable business can handle more debt
and a higher debt ratio than a growth firm
in a volatile business
Debt Ratios
Debt Ratios
Time interest earned ratio is often used to asses companys
ability to service the interest on its debt with EBIT
A high TIE ratio suggests that the company will have ample
operating income to cover its interest expense. A low TIE
ratio signals that the company may have insufficient
operating income to pay its interest as it becomes due. If so,
the business might need to liquidate assets or raise new debt
or equity funds to pay the interest due
However, you have to know that the operating income is not
the same as cash flow. Operating income figures do not show
the amount of cash available to pay interest and interest
payments are made with cash so therefore, TIE ratio is only a
rough measure of a firms ability to pay interest with current
funds
Application of Ratios
Class Activity