Ratio Analysis : – Ratio of selected values based on the company’s financial statement. There are many standard ratios used to evaluate the overall financial condition of a corporation or other organization.
Who Uses the Ratios : – Corporate Finance Managers, Current/Potential Shareholders, Creditors
Common Size Analysis – Ratio comparisons are done on Past performances, Competing Firms, Absolute Standards, Industry Trends, Budgets – Planning/Control
Profitability | For shareholders, employees, creditors, investors, management. |
Liquidity | For shareholders, management, suppliers, creditor and competitors. |
Efficiency | For management, shareholders, creditors and competitors. |
Gearing | For shareholders, lenders, creditor and potential investors. |
Investment | For shareholders, potential investors, management. |
Ideally companies should be Liquid and Profitable, and hence we pay more attention to the Liquidity Ratios and the Profitability Ratios.
Key Liquidity Ratios
Current Assets | ||
Current Ratio = | ———————— | |
Current Liabilities | ||
Quick Assets | ||
Quick Ratio = | ———————- | |
Current Liabilities | ||
Quick Assets = Current Assets – Inventories |
Quick Ratio is significant in Industries where Inventory is more or less the finished product. e.g. Pen Industry.
Case Study on HUL, MARICO and Doctors Soap, and discussion about Monopoly (Market) and Monopsony(Creditors). HUL though having lesser ratio has higher Monopoly and Monopsony, indicating there are no benchmarks for these numbers and are dependent on the Industry/Competetive positions.
Long Term Solvency Ratios
Total Liabilities | ||
Debt to Equity Ratio = | ———————————- | |
Total Stockholders’ Equity | ||
Long Term Liability | ||
LT Debt Equity Ratio = | ——————————————————- | |
Networth/ Total Stockholder’s Equity |
Times Interest Earned Ratio (TIE Ratio)
PBIT (Before Interest and Tax) | ||
TIE | ———————————- | |
Interest Expense |
TIE Ratio of > 1 is necessary to pay bare interest necessities
A ratio of > 10 is considered a very safe position.
Inventory Turnover Ratio : – A ratio showing how many times a company’s inventory is sold and replaced over a period.
Cost Of Goods Sold | ||
Inventory Turnover Ratio | —————————- | |
Average Inventory |
A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. A high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business.
Effeciency Ratios : – Inventory Collection Period, Average Collection Period, Average Payment period
Inventory Collection Period : – (Inventory * 365)/Cost of Goods Sold
Average Collection Period :- (Acc. recievable * 365)/ Credit Sales (The collection period or average collection period must be compared to competitors to see whether the credit given, and customer risk, is in line with the industry. A high collection period shows a high cost in extending credit to customers). Lower ACP means more Monopoly.
Average Payment Period :- (Acc. Payable * 365) / Purchases. Lesser APP means lower Monopsony.
e.g. ICP = 70 Days, ACP = 85 Days, APP = 45 Days. Deduction Cycle = 155 days on which the company has to self finance for 110 days.
Profitability Analysis Ratios |
PAT + Interest + Taxes | ||
Return on Assets (ROA) = | ———————————- | |
Average Total Assets | ||
Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2 |
PAT | ||
Return on Equity (ROE) = | ———————— | |
Stockholders’ Equity | ||
PAT + Interest | ||
Return on Common Equity (ROCE) = | ——————————————– | |
Stockholders’ Equity | ||
Net Income | ||
Profit Margin = | —————– | |
Sales | ||
Net Income | ||
Earnings Per Share (EPS) = | ——————————————— | |
Number of Common Shares Outstanding | ||
Return on Equity (ROE)
PAT Sales Total Assets | ||
Return on Equity (ROE) = | ——– * ———————- * ———————— | |
Sales Total Assets Networth | ||
In essence ROE = Margin * Asset Turnover Ratio * Leverage
Things to remember about Asset Turnover Ratio
- Companies with low profit margins tend to have high asset turnover, those with high profit margins have low asset turnover – it indicates pricing strategy.
- This ratio is more useful for growth companies to check if in fact they are growing revenue in proportion to sales.
Market Ratios
Market Price of Common Share Mkt Cap | ||
PE Ratio = | ————————————– = ———————– | |
Earnings Per Share Profit After Tax | ||
Annual Dividends Per Common Share | ||
Dividend Yield = | ————————————– | |
Market Price Per Share | ||