RATIO ANALYSIS

Financial ratios are designed to help evaluate a companys financial statements. These ratios are the taka amounts, set up in a ratio form, of the related accounts or items in the financial statements. These ratios can be broadly classified into the following four categories: Liquidity ratios Profitability ratios Long term solvency ratios 2.1 Liquidity Ratios

A liquid asset is one that trades in an active market and hence can be quickly converted to cash at the going market price, and a firms liquidity ratios deal with whether the firm would be able to pay off its debts as they come due over the next year or so. In other words, liquidity ratios are used to indicate a firms short-term debt paying ability. Thus these ratios are designed to show interested parties the companys capacity to meet maturing current liabilities. The common liquidity ratios are as follows, Current ratio Quick ratio Accounts Receivable ratio Inventory turnover ratio

I. Current Ratio A companys current assets and current liabilities reflect the state of its working capital. They are thus a representation of the foundations underlying the companys day-to-day operations. The current ratio, which is current assets divided by current liabilities, is the most common ratio that focuses on current assets and current liability data. In general, a higher current ratio indicates a stronger financial position. A higher current ratio suggests that the business has sufficient liquid assets to maintain normal business operations. As a result, lenders, stockholders and managers closely monitor changes in a companys current ratio. Current Ratio = Current Assets/ Current liabilities Creditors prefer a high current ratio since it indicates assets to be more liquid and thus proves the company to be more capable of paying current liabilities from current assets. On the other hand, shareholders prefer a lower current ratio since a very high current ratio suggests that there is too much idle cash lying around and that customers may be slow in paying receivables. Decreased net income can result when too much capital that could be used profitably elsewhere is tied up in current assets.

ii. Quick Ratio The current ratio is not the only measure of a companys short-term debt-paying ability. The acid-test (quick) ratio is the ratio of quick (cash, marketable securities, and net receivables) to current liabilities. Inventories and prepaid expenses are excluded from current assets to compute quick assets because they might not be readily convertible into cash. The formula for the quick ratio is: Quick ratio= Quick Assets/Current Liabilities Short-term creditors are particularly interested in this ratio, which relates the pool of cash and immediate cash inflows to immediate cash outflows.

iii. Accounts Receivables Turnover Accounts receivable turnover is the relationship between the amount of an asset and some measure of its use. Accounts receivable turnover is the number of times per year that the average amount of accounts receivables is collected. The turnover ratio provides an indication of how quickly the receivables are collected.

Accounts receivable turnover = Net Sales / Accounts receivable turnover The accounts receivable turn over ratio provides an indication of how quickly the company collects receivables.

iii. Accounts Receivables Turnover Accounts receivable turnover is the relationship between the amount of an asset and some measure of its use. Accounts receivable turnover is the number of times per year that the average amount of accounts receivables is collected. The turnover ratio provides an indication of how quickly the receivables are collected.

Accounts receivable turnover = Net Sales / Accounts receivable turnover The accounts receivable turn over ratio provides an indication of how quickly the company collects receivables.

2.2 Profitability Ratios Profitability is an important measure of a companys operating success. Profitability is the net result of a number of policies and decisions. The ratios examined thus provide useful clues as to the effectiveness of a firms operations, but the profitability ratios go on to show the combined effects of liquidity, asset management, and debt operating results. When judging the profitability of a company, two areas are given most attention.

Relationships on the income statement that indicate a companys ability to recover costs and expenses Relationships of income to various balance sheet measures that indicate the companys relative ability to earn income on assets employed. Each of the following ratios makes use of one of the relationships.

v. Profit Margin Profit margin is an indication of the return that the firm will be able to provide its shareholders with. It is the operating income over sales. An investor will always look Forward to investing money in a company with high profit margin ratio as that indicates a fair amount of return for their investment. Profit margin is affected by three main factors namely cost of goods/services, cost of raw materials/supplies and the demand for good and services. Profit margin = Net income / Sales

Shareholders are especially interested in this ratio because it indicates that the company is generating a good proportion of net income from its net sales. Therefore, there is a fat chance of shareholders getting a handsome amount of dividend each year. Even if dividends are not declared or paid, the company can keep the income in a reserve, which would again prove to be beneficial. However, if the proportion is lower, then it can be assumed that though the company is generating a considerable amount of net income, majority of it are being used up to pay off the operating expenses. The net income includes all non-operating items that may occur only in a particular period; therefore, net income includes the effects of such things as extraordinary items, changes in accountings principle, effects of discontinued operations, and interest charges. Thus, a period that contains the effects of an extraordinary item is not comparable to a period that contains no extraordinary items.

vi. Asset turnover Asset turnover ratio is an indication of the amount of assets required to make the total sales. This ratio is found by dividing the sales during a period by the amount of assets employed by the firm during that period. However this ratio does not consider the profit made on the use of its assets. As a result return on investment ratio is more commonly used. Asset turnover = Sales / Total assets

vii. Return on equity This ratio indicates the ability of the firms management to earn adequate net income on the capitals invested by the owners of the company. The return on equity ratio is found by dividing the net income of a company by the total equity. Return on equity = Net income / Total equity Though stockholders are interested in the ratio of operating income to operating assets as a measure of managements efficient the of assets, they are even more interested in the return the company earns on each dollar of stockholders equity.

viii. Earning per share (EPS) The most widely used measure to appraise a companys profitability is earnings per share (EPS) of common stock. The amount of earnings available to stockholders is equal to net income minus the current years preferred dividend.

EPS of Common Stock = Net Income/Average no. of Common Stock Outstanding

ix. Price earning ratio It is found by dividing the price per share by the earning per share. It helps a probable investor to conclude if its under valued or over valued stock. Price earning ratio = Price per share / Earning per share

x. Payout Ratio:
Payout Ratio measures the percentage of earning distributed in the form of cash dividends. We compute it by: Payout Ratio= Cash dividends\Net Income

xiv. Debt-asset ratio

This ratio indicates how much of the firms assets are financed by debt. If the firm has excessive debt it would be difficult to find new debt. Then the firm would have to borrow at higher interest rates. Debt-asset ratio = Total debt / Total asset