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Types of Ratios:

1. Liquidity ratios: Liquidity ratios measure the firm’s ability to fulfill short-
term commitment out o its liquid assets. Assets are liquid if they are either cash
or relatively easy to convert into cash. Short term creditors are generally very
interested in the liquidity ratios. Two commonly used liquidity ratios are
discussed in this season.

A. Current Ratio: This ratio measures the firm’s ability to meet its short-
term obligations. Current ratio is defined as

Current Ratio= Current assets / Current liabilities

Current assets normally include cash, marketable securities, accounts receivable,


and inventories. Current liabilities consist of sundry creditors, bill payable, bank
loans, provision for taxation, proposed dividend and outstanding expenses.
Generally, the higher the current ratio more liquid the firm is considered to be. A
current ratio of 2:1 should be considered as standard.

B. Acid test Ratio or quick ratio: this ratio measures the ability of a
company to meet its immediate liabilities. Acid test ratio is calculated as
follows :

Acid test Ratio = Current assets –Inventories/ current liabilities


= quick assets/ current liabilities

Quick assets are cash and near cash assets like debtors, bills,
receivable, and marketable securities which can readily be converted
into cash. While calculating this ratio inventories are excluded from
quick assets because these are not often converted into cash
sufficiently quickly to help pay creditors. A ratio of 1:1 usually
considered satisfactory.

2. Activity Ratios: The second group of ratios, the activity ratio, measures how
effectively the firm is managing its assets. If a company has excessive
investments in assets, then its operating assets and capital will be unduly high
which will reduce its free cash flow and its stock price. On the other hand, if a
company does not have enough assets, it will lose sales, which will hurt
profitability, free cash flow and the stock price. Therefore it is important to have
the right amount invested in assets. Ratios that analyze the different types of
assets are described in this section.

A. Evaluating inventories: Inventories Turnover Ratio: the inventory turnover


or stock turnover ratio measures how fast the inventory is moving through
the firm an generating sales. It is defined as:

Inventory Turnover Ratio = Cost of goods sold/ average inventory

Or sales/ closing inventory

The cost of gods sold means sales minus gross profit. The average inventory
refers to the simple average of the opening and closing inventory. A high ratio is
good from the viewpoint of liquidity and vice versa a low ratio would signify that
inventory does not sell fast and stays on the shelf or in the ware house for a long
time. The standard ratio is 8 times.

B. Evaluating Receivable: Average collection period: The average collection


period is a measure of how long it takes from the time the sale is made to
the time the cash is collected from the customer. This ratio also called ‘days
sales outstanding’. It is expressed as follows

Average Collection period = Accounts Receivable/ average credit sales


per day

Note: Average credit sales per day = annual credit sales/360

Or average collection period = accounts receivable/annual sales*


360

Debtors turnover ratio = Net credit sales/ Average debtors


This ratio is useful to evaluate the effectiveness of the firm’s credit and
collection policies. The standard collection period is 60 to 90 days.

C. Evaluating fixed assets: fixed assets turnover ratio: this ratio measures
how effectively the firm uses its fixed assets. This is the ratio of sales to
fixed assets. It is computes as follows

Fixed assets turnover ratio = Sales / Fixed assets

And inadequately low ratio implies excessive investment in fixed assets


(plant and equipment ) relative to the value of the output being produced. In such a
case, the firm might be better off to liquidate some of those fixed assets and invest
the proceeds productively.

D. Evaluating total assets: Total assets turnover ratio: Total assets turnover
ratio reflects how well the company’s assets are being used to generate
sales. This ratio also called as sales to total assets ratio. It is calculated as
follows:-

Total asset turnover ratio = turnover or sales / total assets

E. Creditors Turnover ratio = net credit purchase / average creditors

A low turnover ratio reflects liberal credit terms granted by suppliers, while a
high ratio shows that accounts are to be settled rapidly.

3. Coverage / capital structure ratio: Coverage ratio measure the extent of the
firms’ total debt burden. They reflect the company ability to meet its long-term
debt obligations. The main ratios calculated in this area are:

A. Debt Equity Ratio = this ratio indicates the relative proportions of debt and
equity in financing the assets of a firm. This ratio can be shown n different
ways. Thus

Debt equity ratio = long term debt/ shareholders equity

Or debt equity ratio = total debt / share holders equity

This ratio is an important tool of financial analysis to appraise the financial


stability of a firm. It has important implications from the view point of the creditors,
owners and the firm itself. A high ratio shows a large share of financing by the
creditors of the firm. A low ratio implies a smaller claim of creditors’.

B. Total debt to total assets ratio: this ratio generally called the debt ratio,
measures the percentage of funds provided by creditors. It is calculated by
dividing total debt by total assets. Thus :

Debt ratio = Total debt / total assets


Total debt includes both current liabilities and long term debt. Creditors
prefer low debt ratios because the lower the ratio, the greater the cushion against
creditors losses in the event of liquidation. Stockholders on the other hand, may
want more leverage because it signifies expected earnings. A ratio 1: 2 is
considered to be satisfactory.

c. Interest coverage ratio: it is also known as time interest earned ratio. This
ratio reflects the firm’s ability to pay interest out of earnings. Failure to meet
this obligation can bring legal action by the firm’s creditors, possibly resulting
in bankruptcy. The standard ratio is 8times.

Interest Coverage Ratio= EBIT/Interest expense

d. Cash coverage ratio: this ratio measures the extent to which interest is
covered by the cash flow from the firms operations. This is calculated as
follows:

Cash Coverage Ratio = (EBIT+Depreciation) / interest payment

4. Profitability Ratios: There are many measures of profitability. As a group, these


measures enable the analyst to evaluate the firm’s profits with respect to a given
level of sales, a certain level of assets, or the owner’s investment. Without profits a
firm could not attract outside capital. Owners, creditors, and management pay close
attention to boosting profits because of the great importance placed on earning in
the market place. Major profitability ratios are:

Profitability ratios related to sales

A. Gross profit Margin: this ratios measures the degree of success in gross
earning on sales. The higher the gross profit margin, the better. The gross
profit margin is calculated as follows

Gross Profit Margin= Gross profit/ sales

Or, = (sales – cost of goods sold)/ sales

B. Net profit Margin: This ratio measures the relationship between net profits
and sales of a firm. The net profit margin is indicative of management ability
to operate the business with sufficient success. A hig net profit margin would
ensure adequate return to the owners as well as enable a firm to tackle
adverse situations. The net profit margin is calculated as follows:

Net Profit Margin=Net income / sales

Or = Eat/ sales

C. Net Operating Margin =Operating Income (EBIT) / sales


Or Operating profit margin= (Sales- Cost of Goods sold- total operating
expenses) / sales

This ratio indicates the profitability of sales before taxes and interest expense. Non
operating revenues ( such as interest on marketable securities and royalties) are
not included in the returns and non operating expense are not deducted. The
purpose of this ratio is to measure the effectiveness of production and sales of the
company’s product in generating pre-tax income for the firm.

Profitability ratios related to investment

D. Return on investment (ROI): the profitability ratios can also be computed by


relating the profits of a firm to its investment. Such ratios are popularly
termed as return on investments. There are three different concepts of
investments in financial literature: asets , shareholders equity and capital
employed. Based on each of them there are three broad categories of ROIS.
They are return on assets, return on share holder’s equity and return on
capital employed. These are discussed below

i. Return on total assets (ROA) : this type of profitability ratios is


measured in terms of the relationship between net profits and assets.
It is calculated as follows:

Return on total assets= (net income after tax + Interest expense) /


Total assets * 100

ii. Return on Equity (ROE) : The most important profitability ratio is the
ratio of net income to common equity which is measured as follows:

ROE= Net income to common share holder / Share holders


Equity *100

Share holders invest to get return on their money and this ratio tells how well
they are doing in an accounting sense.

iii. Return on capital employed (ROCE): It relates the income earned from
the company’s activities to the resources employed by the company.
This ratio measures the abilty to earn a reasonable income for the firm
with the resources employed. It is calculated as follows

ROCE= Profit/ Capital employed

Where, capital employed= shareholders equity + long term loan


E. Earnings Per share (EPS): EPS measure the profit available to the equity
shareholders on a per share basis. That is, the amount that they can get on
every share hold. This ratio can be computed in two ways :

i. EPS = EAT/ number of common share

ii. EPS= earnings available to common shareholders / number of common


shares outstanding

The ratios at a glance

1. Current ratios = current assets / current liabilities

2. Acid test ratios = current assets- Inventory/ current liabilities

Or Quick Ratio = quick liabilities / current liabilities

3. Working capital ratio = working capital / current liabilities

Here, working capital = current assets – current liabilities

4. Cash Ratio = (cash + marketable securities) / current liabilities

5. Inventory turnover ratio = cost of goods sold / average inventory

Or = sales/ closing inventory

• Average inventory holding period= 365/ inventory turnover ratio

6. Average collection period = accounts receivable / annual credit sales *


360

7. Debtors turnover ratio = net credit sales / average debtors

8. Fixed assets turnover ratio = sales / fixed assts

9. Total assets turnover ratio = sales / total assets

10.Creditors turnover ratio = net credit purchase / average creditors

11.Debt equity ratio = long term debt / share holder equity

12.Debt ratio = total debt / total assets

13.Interest coverage ratio = EBIT/ interest expense


14.Proprietary ratio = share holders/ total assets

15.Capital gearing ratio = common stock capital / fixed financial cost


bearing fund

16.Operating ratio = (cost of goods sold - other operating


expenses) / sales *100

17.Cash coverage ratio = (EBIT+ depreciation/ interest payment

18.Gross profit margin = gross profit / sales

19.Net profit margin = net income / sales

20.Operating profit margin = operating income / sales

21.Return on total assets = net income available to common


shareholders/ total assets *100

22.Return on equity = EACS/shareholders equity *100

23.Return on capital employed = profit / capital employed

24.Earnings per share (EPS) = EAT / no of common share

25.Price earnings ratio ( PE) = market price per share / earnings per share

26.Dividend – payout ratio= DPS/EPS *100

Or = dividend paid / net income *100

27.Earning yield = EPS / market value per share *100

28.Dividend yield = DPS / market value per share *100