From a financial statement, if two or more line items are taken and joined by a mathematical operation, it’s called as the financial ratio. The health or the performance of the company is analyzed with the use of ratio analysis (Gombola & Ketz, 1983). Liquidity, debt and efficiency/profitability are three prominent categories looked into a financial ratio.
Liquidity is the ability of a company to turn their assets into cash. A company wanting to put new investment for the production of their mobile phones for it is doing really well but they don’t have cash in hand, what a company can do now is sell out assets that isn’t used much to invest back on the production. This process of converting assets into cash and the ability of how well, how quick they can do is called as liquidity. This sees for the short-term ability of the company to pay off debt with what the business has (Kregel, 1986).
There are different liquidity ratio. The most popular one of it all is the current ratio with a quick ratio and cash ratio being the other two. The current ratio sees how well the company is able to pay current liabilities with the assets the business have. It is calculated by dividing current assets with current liabilities.
i.e. Current Ratio = Current Assets / Current Liabilities
Table 1:
Company A
Company B
Current Assets
2000
2000
Current Liabilities
1800
2500
Current Ratio
2000/1800 = 1.11
2000/2500 = 0.80
From the Table 1, we can observe that the Current ratio of Company A is 1.11 while Company B is 0.8. It’s clearly visible that the ratio is higher for Company A than the other one. The result states that the company A has $1.11 as current assets for each dollar of their current liabilities while for the company B is $0.80 as current assets for each dollar of their current liabilities. Company B doesn’t have enough assets to pay off their liabilities while Company A does have more than enough to pay off their current liabilities with their current assets and is thus more desirable.
If a company wants to take a loan to expand and looks out to a bank. The banks now check through the financial record of the company to assess whether or not the company would be able to pay back the debt. The bank would try to ensure what assets are financed by debt and to what level to make an informed decision. This ratio (debt to equity) thus shows what percentage of the company’s assets are financed with the help of debt. It helps in looking into the long-term debt of the company (Auerbach & King, 1983). The calculation of it is done by taking total debt or liabilities divided by total equity or assets the business owns.
i.e. Debt to equity ratio = total liabilities / total assets
The higher the ratio, the more debt the company owns.
Let’s take a simple example to understand it further:
Table 2:
Company A
Company B
Total Liabilities
4500
5000
Total Equity
7500
4000
Debt/Equity Ratio
0.60
1.25
From the Table 2, we can observe that the debt to equity ratio of Company A is 0.6 while Company B is 1.25. Company A clearly has a lower debt to equity ratio. A company having a lesser debt ratio means that the company has lesser debt financing and doesn’t have much risk or interest expenses compared one with a higher ratio. This is why Company A is more desirable as it has more equity comparatively.
Profitability ratio helps in measuring the performance of the company by measuring the profits that a company makes. This looks into the ability of a company to determine how well they’re using the assets to generate sales. There are five different types of profitability ratio as in gross profit margin ratio, net profit margin, return on investment ratio, return on stakeholder’s equity ratio, and return on equity (Nissim & Penman, 2001). We look into the gross profit margin ratio alone for the following discussion post. Gross profit margin ratio is used to measure the company’s gross profit over its net sales and is calculated by getting a difference of gross profit and cost of goods sold and then dividing it by the net sales.
i.e. Gross Profit Margin Ratio = (Gross Profit or Sales - Cost of Goods Sold) / Net Sales
Table 3:
Company A
Company B
Total Revenue
100000
100000
Cost of Sales
60000
70000
Gross Profit
100000 - 60000 = 40000
100000 - 70000 = 30000
Gross Profit Margin
40000 / 100000 = 40%
30000 / 100000 = 30%
From the Table 3, we can observe that the gross profit margin for Company A is 40% while it’s 30% for Company B. The higher the gross profit margin is, the more profit a company can make off from an individual sale, totaling to higher overall revenue. This is why the 40% is better than 30% of gross profit margin and Company A’s margin is more desirable/better.
References
Auerbach, A., & King, M. (1983). Taxation, Portfolio Choice, and Debt-Equity Ratios: A General Equilibrium Model. The Quarterly Journal Of Economics , 98 (4), 587.
Gombola, M., & Ketz, J. (1983). Financial Ratio Patterns in Retail and Manufacturing Organizations. Financial Management , 12 (2), 45.
Kregel, J. (1986). A Note on Finance, Liquidity, Saving, and Investment. Journal Of Post Keynesian Economics , 9 (1), 91-100.
Nissim, D., & Penman, S. (2001). Review Of Accounting Studies , 6 (1), 109-154.
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From a financial statement, if two or more line items are taken and joined by a mathematical operation, it’s called as the financial ratio. The health or the performance of the company is analyzed with the use of ratio analysis (Gombola & Ketz, 1983). Liquidity, debt and efficiency/profitability are three prominent categories looked into a financial ratio.
Liquidity is the ability of a company to turn their assets into cash. A company wanting to put new investment for the production of their mobile phones for it is doing really well but they don’t have cash in hand, what a company can do now is sell out assets that isn’t used much to invest back on the production. This process of converting assets into cash and the ability of how well, how quick they can do is called as liquidity. This sees for the short-term ability of the company to pay off debt with what the business has (Kregel, 1986).
There are different liquidity ratio. The most popular one of it all is the current ratio with a quick ratio and cash ratio being the other two. The current ratio sees how well the company is able to pay current liabilities with the assets the business have. It is calculated by dividing current assets with current liabilities.
Table 1:
From the Table 1, we can observe that the Current ratio of Company A is 1.11 while Company B is 0.8. It’s clearly visible that the ratio is higher for Company A than the other one. The result states that the company A has $1.11 as current assets for each dollar of their current liabilities while for the company B is $0.80 as current assets for each dollar of their current liabilities. Company B doesn’t have enough assets to pay off their liabilities while Company A does have more than enough to pay off their current liabilities with their current assets and is thus more desirable.
If a company wants to take a loan to expand and looks out to a bank. The banks now check through the financial record of the company to assess whether or not the company would be able to pay back the debt. The bank would try to ensure what assets are financed by debt and to what level to make an informed decision. This ratio (debt to equity) thus shows what percentage of the company’s assets are financed with the help of debt. It helps in looking into the long-term debt of the company (Auerbach & King, 1983). The calculation of it is done by taking total debt or liabilities divided by total equity or assets the business owns.
The higher the ratio, the more debt the company owns.
Let’s take a simple example to understand it further:
Table 2:
From the Table 2, we can observe that the debt to equity ratio of Company A is 0.6 while Company B is 1.25. Company A clearly has a lower debt to equity ratio. A company having a lesser debt ratio means that the company has lesser debt financing and doesn’t have much risk or interest expenses compared one with a higher ratio. This is why Company A is more desirable as it has more equity comparatively.
Profitability ratio helps in measuring the performance of the company by measuring the profits that a company makes. This looks into the ability of a company to determine how well they’re using the assets to generate sales. There are five different types of profitability ratio as in gross profit margin ratio, net profit margin, return on investment ratio, return on stakeholder’s equity ratio, and return on equity (Nissim & Penman, 2001). We look into the gross profit margin ratio alone for the following discussion post. Gross profit margin ratio is used to measure the company’s gross profit over its net sales and is calculated by getting a difference of gross profit and cost of goods sold and then dividing it by the net sales.
Table 3:
From the Table 3, we can observe that the gross profit margin for Company A is 40% while it’s 30% for Company B. The higher the gross profit margin is, the more profit a company can make off from an individual sale, totaling to higher overall revenue. This is why the 40% is better than 30% of gross profit margin and Company A’s margin is more desirable/better.
References
Auerbach, A., & King, M. (1983). Taxation, Portfolio Choice, and Debt-Equity Ratios: A General Equilibrium Model. The Quarterly Journal Of Economics , 98 (4), 587.
Gombola, M., & Ketz, J. (1983). Financial Ratio Patterns in Retail and Manufacturing Organizations. Financial Management , 12 (2), 45.
Kregel, J. (1986). A Note on Finance, Liquidity, Saving, and Investment. Journal Of Post Keynesian Economics , 9 (1), 91-100.
Nissim, D., & Penman, S. (2001). Review Of Accounting Studies , 6 (1), 109-154.