Use of Ratios

Use of Ratios

•      Interpret financial statements

•      Evaluate performance (Both Time Series & Cross Sectional)

•      Analyze financial position in terms of TIE

•      Identify possible problem areas

•      Assist Decision Making

Limitations

•      Companies are not exactly alike in the nature of their operations.

•      Different companies use different accounting policies.

•      Ratios are primarily a starting point from which to identify further questions related to present position & future directions of the operations and so they do not provide answers in themselves.

•      A single ratio can mislead the users.

•      “The financial statements being compared should be dated at the same point in time during the year”.

•      Audited financial statement should be used to analyze ratios.

•      Time series analysis ignores the impact of inflation.

Types of Ratios

•      Liquidity Ratio

•      Profitability Ratio

•      Efficiency Ratio or Management Performance or Activity Ratio

•      Gearing or Leverage or Debt Ratio

•      Market Ratio

Liquidity Ratios

•             Current Ratio = CA / CL

•             Quick Ratio or Acid Test or Liquid Asset Ratio = (CA – Ending Inventory) / CL

Debt /Gearing/ Leverage Ratios

•             Debt/Equity Ratio  =

Long-term loan * 100 / Stockholders                                                                          equity

•             Debt Ratio = Total Liability / Total Asset

•             Times Interest Earned Ratio or Interest Coverage Ratio = EBIT / Interest

•             Fixed-Payment Coverage Ratio = Earnings before interest and taxes + Lease Payments / Interest + Lease Payments + {( Principle payments + Preferred stock dividends)*[(1/(1-T )]}

Activity (Efficiency) Ratios

•      Inventory (Stock) Turn over =

Cogs / Av. Inventory

•      Average age of Inventory or

Stockholding Period =

(Av. Inventory * 365)  / Cogs

Activity Ratios (continued)

•      Average Collection Period=

(Accounts Receivables) / Av. Sales per day

Where Av. Sales per day = AnnualSales/365

•      Average Payment Period =

(Accounts Payable) / Av. Purchase per day

Where Av. Purchase per day =                   Annual Purchase/365

Activity Ratios (continued)

•      TA Turnover Ratio = Sales / TA

•      FA Turnover Ratio = Sales / Net FA

Profitability Ratios

•             ROCE = EBIT * 100 / (FA + CA – CL)

•             Net Profit Margin = (Net Profit * 100) / Sales

•             Operating Profit Margin = (Operating Profit * 100) / Sales

•             Gross Profit Margin = (GP * 100) / Sales

Profitability Ratios (continued)

•             ROA = (Earnings Available for Common Stock Holders * 100) / TA

•             ROE= (Earnings Available for Common Stock Holders *100)/Stockholders Equity

•             EPS =

Earnings Available for Common Stock Holders/ Number of Common Stock Outstanding

Market Ratio

•      P/E Ratio = Market Price / EPS

•      Market/Book Ratio = Market Price / Book                                                                    value per share

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