Ratio analysis is a widely used tool for financial analysis. In ratio analysis, we express the relationship between two individual figures or group of figures connected with each other in logical manner in mathematical term. One figure or group of figure is expressed as numerator while the other is expressed as denominator. Ratio analysis helps to identify the strengths and weaknesses of a business concern by comparing the obtained result with the industry average (Moyer, McGuigan, Rao, & Kretlow, 2012). Ratio analysis helps in assessment of liquidity, solvency, profitability and efficiency of a form by calculating different ratios.
Liquidity Ratio: Liquidity or short term solvency is the ability of business to pay its short term liabilities. It is used to analyze the firm’s ability to meet current financial obligations. It shows the relation of cash and other current assets to its current liabilities. The commonly used liquidity ratios are:
Current Ratio: This ratio is calculated by dividing current assets by current liabilities. It indicates the extent to which current liabilities are covered by assets expected to be converted into cash in near future. Current assets include cash, marketable securities, account receivables and inventory. Similarly current liabilities include account payable, short-term notes payable, accrued expenses and long-term debt maturing in current year (Ghimire, 2011).
Current Assets = Current Assets/Current Liabilities
Quick Ratio: Quick ratio shows the ability to meet the current liabilities with most liquid assets. It is also known as acid test ratio. In quick ratio, the inventory is deducted from current assets with the assumption that we cannot make money by selling the inventory whenever we need cash.
Quick Ratio = (Current Assets - Inventory)/Current Liabilities
Cash Ratio : Cash Ratio shows the ability of a firm to meet the current obligations with the available cash balance if the other current assets cannot be converted to cash immediately. It shows how capable we are if we need to pay the current liabilities immediately.
From the above calculation, we can see that both the companies have enough current assets to meet their current liabilities. Company A and B respectively have assets of Rs.1.28 and Rs.1.40 to pay the current liabilities of Re. 1. Looking at the result of quick ratio, Company B is in better condition than Company A while the result of cash ratio puts Company B in better position. However, the company ratio is used as the bench mark for evaluating the performance. If the calculated ratio is equal to or more than the industry average, the company is considered to be doing well else it needs to revise its business processes. Debt to Equity Ratio
Debt to equity ratio indicates the proportion of debt fund in relation to equity. This ratio is referred in capital structure decisions. Equity includes common stock, retained earnings and additional paid in capital.it helps to measure the long term solvency of the firm.
Debt to Equity Ratio = Total Debt/Equity
The higher the ratio, riskier would be the capitalization and vice versa.
Example
Company A
Company B
Total Liabilities
450,000
450,000
Total Equity
700,000
400,000
Debt/Equity Ratio
0.64
1.13
The debt to equity ratio shows that Company B has more debt financing that increase the interest expenses and risk associated with financing. Thus Company A is better than Company B in this parameter.
Profitability Ratio
The profitability ratio is calculated to measure the operating efficiency of the company. The creditors and owners are interested in the profitability ratio besides the management. This ratio reflects the final results of business operations. Different profitability ratios are:
Gross Profit Margin Ratio: It reflects the average spread of cost over goods sold and sales revenue. A high gross ratio is a sign of good management that indicates the efficiency t o produce goods and services at low cost.
Gross Profit Margin = Gross Profit/Sales
Net Profit Margin: It measures the firm’s ability to turn each rupees sales into profit. A high net profit margin signifies efficient management.
Net Profit Margin = Net Profit/Sales
Return on Assets (ROA): It measures the overall effectiveness or organization in generating profit from available total assets. Higher ROA indicates better performance.
ROA = Net Income/Total Assets
Return on Equity (ROE): It measures the rate of return on stock holder’s investment. A high ROE implies better performance.
ROE = Net Income/Total Equity
Example
Company A
Company B
Total Revenue (Sales)
550,000
550,000
Less: Cost of Sales
280,000
350,000
Gross Profit
270,000
200,000
Less: Other Expenses
190,000
125,000
Net Profit
80,000
75,000
Total Assets
1,000,000
950,000
Equity
450,000
550,000
Gross Profit Margin
49.09%
36.36%
Net Profit Margin
14.55%
13.64%
ROA
8%
7.89%
ROE
17.77%
13.64%
From the above calculation, we can see that out of the sales of Re 1, Company A generates 49.09% gross profit and 14.55% net profit. Similarly, Company B makes 36.36% gross profit and 13.64% net profit out of the total sales. Company A is preferable for investment based on ROA and ROE.
References
Ghimire, S. R. (2011). Fundamentals of Financial Management. Kathmandu: K.P Pustak Bhandar.
Moyer, R. C., McGuigan, J. R., Rao, R., & Kretlow, W. J. (2012). Contemporary Financial Management (12th ed.). Oklahoma: Cengage Learning.
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Ratio analysis is a widely used tool for financial analysis. In ratio analysis, we express the relationship between two individual figures or group of figures connected with each other in logical manner in mathematical term. One figure or group of figure is expressed as numerator while the other is expressed as denominator. Ratio analysis helps to identify the strengths and weaknesses of a business concern by comparing the obtained result with the industry average (Moyer, McGuigan, Rao, & Kretlow, 2012). Ratio analysis helps in assessment of liquidity, solvency, profitability and efficiency of a form by calculating different ratios.
Liquidity Ratio: Liquidity or short term solvency is the ability of business to pay its short term liabilities. It is used to analyze the firm’s ability to meet current financial obligations. It shows the relation of cash and other current assets to its current liabilities. The commonly used liquidity ratios are:
Current Ratio: This ratio is calculated by dividing current assets by current liabilities. It indicates the extent to which current liabilities are covered by assets expected to be converted into cash in near future. Current assets include cash, marketable securities, account receivables and inventory. Similarly current liabilities include account payable, short-term notes payable, accrued expenses and long-term debt maturing in current year (Ghimire, 2011).
Current Assets = Current Assets/Current Liabilities
Quick Ratio: Quick ratio shows the ability to meet the current liabilities with most liquid assets. It is also known as acid test ratio. In quick ratio, the inventory is deducted from current assets with the assumption that we cannot make money by selling the inventory whenever we need cash.
Quick Ratio = (Current Assets - Inventory)/Current Liabilities
Cash Ratio : Cash Ratio shows the ability of a firm to meet the current obligations with the available cash balance if the other current assets cannot be converted to cash immediately. It shows how capable we are if we need to pay the current liabilities immediately.
Cash Ratio= (Cash + Marketable Securities) /Current Liabilities
Example
From the above calculation, we can see that both the companies have enough current assets to meet their current liabilities. Company A and B respectively have assets of Rs.1.28 and Rs.1.40 to pay the current liabilities of Re. 1. Looking at the result of quick ratio, Company B is in better condition than Company A while the result of cash ratio puts Company B in better position. However, the company ratio is used as the bench mark for evaluating the performance. If the calculated ratio is equal to or more than the industry average, the company is considered to be doing well else it needs to revise its business processes.
Debt to Equity Ratio
Debt to equity ratio indicates the proportion of debt fund in relation to equity. This ratio is referred in capital structure decisions. Equity includes common stock, retained earnings and additional paid in capital.it helps to measure the long term solvency of the firm.
Debt to Equity Ratio = Total Debt/Equity
The higher the ratio, riskier would be the capitalization and vice versa.
Example
The debt to equity ratio shows that Company B has more debt financing that increase the interest expenses and risk associated with financing. Thus Company A is better than Company B in this parameter.
Profitability Ratio
The profitability ratio is calculated to measure the operating efficiency of the company. The creditors and owners are interested in the profitability ratio besides the management. This ratio reflects the final results of business operations. Different profitability ratios are:
Gross Profit Margin Ratio: It reflects the average spread of cost over goods sold and sales revenue. A high gross ratio is a sign of good management that indicates the efficiency t o produce goods and services at low cost.
Gross Profit Margin = Gross Profit/Sales
Net Profit Margin: It measures the firm’s ability to turn each rupees sales into profit. A high net profit margin signifies efficient management.
Net Profit Margin = Net Profit/Sales
Return on Assets (ROA): It measures the overall effectiveness or organization in generating profit from available total assets. Higher ROA indicates better performance.
ROA = Net Income/Total Assets
Return on Equity (ROE): It measures the rate of return on stock holder’s investment. A high ROE implies better performance.
ROE = Net Income/Total Equity
Example
From the above calculation, we can see that out of the sales of Re 1, Company A generates 49.09% gross profit and 14.55% net profit. Similarly, Company B makes 36.36% gross profit and 13.64% net profit out of the total sales. Company A is preferable for investment based on ROA and ROE.
References
Ghimire, S. R. (2011). Fundamentals of Financial Management. Kathmandu: K.P Pustak Bhandar.
Moyer, R. C., McGuigan, J. R., Rao, R., & Kretlow, W. J. (2012). Contemporary Financial Management (12th ed.). Oklahoma: Cengage Learning.