Financial statement of a company is limited to the numbers presented but cannot be analyzed for their trend, its capacity to pay short and long term debt, compare growth between various years or compare performance between two similar companies. Every simple analysis helps interpret operation of a company. To understand these financial ratio can be the turning point in excelling in your business. (Anonymous, 2006)The ratio analysis helps investors to interpret what the company is doing and how they are performing. There are various ratios for the analysis but here we will look into three particular ratios with examples.
Table 1:
Liquidity Ratio: This ratio calculates the liquidity position or the capacity of a company to meet its immediate cash needs. There are various ratios under this. Let us discuss on some of them.
Current Ratio: This ratio is used to calculate whether a company has current assets available to meet the demand of the current liability. It is calculated by dividing current assets by current liability.
Let us take two companies,
Table 1:
Current Assets (CA) in million (NPR)
Current Liabilities (CL) in million (NPR)
Current Ratio: CA/CL
Company A
30
20
1.5 times
Company B
45
25
1.8 times
From the above calculation we can see that company A has 1.5 times the asset to pay for 1 liability. Similarly company B has 1.8 times the asset to pay for 1 liability. From this ratio we should choose company B as it has more capacity to meet its current liability. This also depends on the type of company. Having high CA is also not good as this fund is nonproductive and contributes less revenue.
Quick Ratio: Quick ratio also calculates the same thing as current ratio but in this ratio we deduct the inventory. This show a company’s liquidity status more than the current asset as inventory takes time to be sold.
Table 2: All figures are in millions of NPR
Assets
Company A
Company B
Cash
500
450
A/R
700
600
Inventory
250
300
Other CA
250
400
Total CA
1700
1750
Net Fixed Asset
2000
1500
Total Assets
3700
3250
Liabilities
A/P
250
300
N/P
50
70
Other CL
850
1000
Total CL
1150
1370
Long term debt
800
500
Total CL
1950
1870
Quick Ratio
1.2 times
0.82 times
Cash Ratio
0.43 times
0.32 times
We calculate quick ratio as (Current Assets - Inventory)/Current Liabilities
The bench mark for quick ratio is 1:1. In the above example the quick ratio of company A & B are 1.2 times and 0.82 times respectively. Company A has the capacity to meet its liabilities but company B does not so A is better performer.
Cash Ratio: This ratio calculates even higher liquidity position of a company. It is calculated as Cash/Current Liabilities. Referring to table 2, we can see that the cash ratio of Company A & B are 0.43 times and 0.32 times. Since this ratio does not have a bench mark we interpret it as Company A having 0.43 times the capacity to pay it immediate current liability while Company B only has 0.32 times the capacity to pay its current liability.
Net Working Capital to Total Assets
This calculates the net working capital to total asset ratio meaning that it shows how much percent of total asset is the working capital which is there to meet the current liability demand. It is calculated as
Total CA- Total CL / Total Assets
Referring to Table 2, we get,
For Company A
1700-1150/3700 = 14.86%
For Company B
1750-1370/3250 = 11.69%
This shows that total asset of Company A has more percentage of working capital in it than Company B.
Debt to Equity Ratio
Debt to Equity Ratio analyses how much a company has used its investment from debt or equity. What we can analyze from this is that if in case of solvency, the company will prioritize payment to owner or debtor. This is calculated as Total Debt/Total Equity. In the case of Company A and B, referring to Table 2, we can compute that A & B has a debt to equity ratio of 1.14 times and 1.06 times. This shows that A has 1.14 time more debt than equity and B has 1.06 times more debt than equity.
Profitability Ratio
Profitability ratio calculates three different ratio which have been explained below.
Profit Margin: This ratio calculates the net income of the owner. The gross income will have payments to be made but profit margin ratio helps to ascertain the actual income of the owner and is calculated by dividing net income by sales.
Let’s assume, the total revenue is Rs. 6000 million and Net income is Rs. 700 million. Then using the formula we get,
700/6000 = 11.66%. This means that out of Rs. 100 the actual net income of the owner is Rs. 11.66 only.
Return on assets (ROA): This is calculated as net income divided by total assets. It helps to calculate how much net income has been generated by the assets. Taking the above rates of Net income of Rs. 700 million and Total assets of Rs. 3700 million from table 2 we get
700/3700 = 18.91 %.
This means that out of the total net income, total asset has contributed to 18.91%.
Return on Equity: Similar to ROA this calculates the contribution to net income by total equity. Taking Net income as Rs. 700 million and Total Equity as Rs. 1950 from table 2 we get
700/1950 = 35.89 for company A and 700/1870 = 37.43% for Company B.
This two examples show that Company A has less contribution to the net income from the use of equity as compared to company B. "The problem with ROE is that it says nothing about what risks a company has taken to generate its ROE. Because ROE looks only at return while ignoring risk, it can be an inaccurate indicator of financial performance. (Lesakova, 2007)”
These are methods that can be used to compare and contrast between two different companies’ capacity and performance but we must be aware of its limitation and depends on the type of company as well.
Reference
Anonymous. (2006). The Importance of Financial Ratio and Benchmark Analysis. Supply House Times; Troy , 68-69. Retrieved from proxy.lirn.net/MuseProxyID=mp03/Mu...
Lesakova, L. (2007). Uses and Limitations of Profitability Ratio Analysis in Managerial Practice . Banská Bystrica: Matej Bel University .
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Financial statement of a company is limited to the numbers presented but cannot be analyzed for their trend, its capacity to pay short and long term debt, compare growth between various years or compare performance between two similar companies. Every simple analysis helps interpret operation of a company. To understand these financial ratio can be the turning point in excelling in your business. (Anonymous, 2006)The ratio analysis helps investors to interpret what the company is doing and how they are performing. There are various ratios for the analysis but here we will look into three particular ratios with examples.
Table 1:
Liquidity Ratio: This ratio calculates the liquidity position or the capacity of a company to meet its immediate cash needs. There are various ratios under this. Let us discuss on some of them.
Current Ratio: This ratio is used to calculate whether a company has current assets available to meet the demand of the current liability. It is calculated by dividing current assets by current liability.
Let us take two companies,
Table 1:
From the above calculation we can see that company A has 1.5 times the asset to pay for 1 liability. Similarly company B has 1.8 times the asset to pay for 1 liability. From this ratio we should choose company B as it has more capacity to meet its current liability. This also depends on the type of company. Having high CA is also not good as this fund is nonproductive and contributes less revenue.
Quick Ratio: Quick ratio also calculates the same thing as current ratio but in this ratio we deduct the inventory. This show a company’s liquidity status more than the current asset as inventory takes time to be sold.
Table 2: All figures are in millions of NPR
We calculate quick ratio as (Current Assets - Inventory)/Current Liabilities
The bench mark for quick ratio is 1:1. In the above example the quick ratio of company A & B are 1.2 times and 0.82 times respectively. Company A has the capacity to meet its liabilities but company B does not so A is better performer.
Cash Ratio: This ratio calculates even higher liquidity position of a company. It is calculated as Cash/Current Liabilities. Referring to table 2, we can see that the cash ratio of Company A & B are 0.43 times and 0.32 times. Since this ratio does not have a bench mark we interpret it as Company A having 0.43 times the capacity to pay it immediate current liability while Company B only has 0.32 times the capacity to pay its current liability.
Net Working Capital to Total Assets
This calculates the net working capital to total asset ratio meaning that it shows how much percent of total asset is the working capital which is there to meet the current liability demand. It is calculated as
Total CA- Total CL / Total Assets
Referring to Table 2, we get,
For Company A
1700-1150/3700 = 14.86%
For Company B
1750-1370/3250 = 11.69%
This shows that total asset of Company A has more percentage of working capital in it than Company B.
Debt to Equity Ratio
Debt to Equity Ratio analyses how much a company has used its investment from debt or equity. What we can analyze from this is that if in case of solvency, the company will prioritize payment to owner or debtor. This is calculated as Total Debt/Total Equity. In the case of Company A and B, referring to Table 2, we can compute that A & B has a debt to equity ratio of 1.14 times and 1.06 times. This shows that A has 1.14 time more debt than equity and B has 1.06 times more debt than equity.
Profitability Ratio
Profitability ratio calculates three different ratio which have been explained below.
Profit Margin: This ratio calculates the net income of the owner. The gross income will have payments to be made but profit margin ratio helps to ascertain the actual income of the owner and is calculated by dividing net income by sales.
Let’s assume, the total revenue is Rs. 6000 million and Net income is Rs. 700 million. Then using the formula we get,
700/6000 = 11.66%. This means that out of Rs. 100 the actual net income of the owner is Rs. 11.66 only.
Return on assets (ROA): This is calculated as net income divided by total assets. It helps to calculate how much net income has been generated by the assets. Taking the above rates of Net income of Rs. 700 million and Total assets of Rs. 3700 million from table 2 we get
700/3700 = 18.91 %.
This means that out of the total net income, total asset has contributed to 18.91%.
Return on Equity: Similar to ROA this calculates the contribution to net income by total equity. Taking Net income as Rs. 700 million and Total Equity as Rs. 1950 from table 2 we get
700/1950 = 35.89 for company A and 700/1870 = 37.43% for Company B.
This two examples show that Company A has less contribution to the net income from the use of equity as compared to company B. "The problem with ROE is that it says nothing about what risks a company has taken to generate its ROE. Because ROE looks only at return while ignoring risk, it can be an inaccurate indicator of financial performance. (Lesakova, 2007)”
These are methods that can be used to compare and contrast between two different companies’ capacity and performance but we must be aware of its limitation and depends on the type of company as well.
Reference
Anonymous. (2006). The Importance of Financial Ratio and Benchmark Analysis. Supply House Times; Troy , 68-69. Retrieved from proxy.lirn.net/MuseProxyID=mp03/Mu...
Lesakova, L. (2007). Uses and Limitations of Profitability Ratio Analysis in Managerial Practice . Banská Bystrica: Matej Bel University .