Deb3fratio Analysis- Intro

8/4/2019 Deb3fratio Analysis- Intro

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Ratio analysis

Meaning of ratios – It’s a relationshipbetween two variables, which are

interrelated. e.g. Height and weight todiagnose the financial strength andweakness of a company



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On the basis of statement

Balance sheet ratios-it sets the relationship between the items given in balancesheet e.g. Debt equity ratio ,

P/L a/c ratios. – relationship betweenitems of P/L a/c e.g. NP ratio, GP ratio

Combined ratios –relationship betweenone item of balance sheet and one item ofP/L a/c. e.g. debtors turnover ratio, etc.



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Benefits of ratios

To help in decision making

ControlFinding out the trend in the industry

To know the competitive position



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Limitations With Ratio Analysis

Ignore price level changes

Ignore , nature , establishment year , etc for

comparison .

Single ratios are not useful, it needs to be comparedi.e. intra firm and inter firm

Limitation of accounting data –

it is dependent onthe data provided in financial statements and therewindow dressing is possible

Ignore qualitative factors



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1. Liquidity/ short term solvency – the ability of the

firm to pay its way2. Investment/shareholders – information to enable

decisions to be made on the extent of the riskand the earning potential of a businessinvestment

3. Gearing/ long term solvency – information on therelationship between the exposure of thebusiness to loans as opposed to share capital

4. Profitability – how effective the firm is atgenerating profits given sales and or its capital

assets5. Turnover /Financial/Activity – the rate at which

the company sells its stock and the efficiencywith which it uses its assets

5 major types / categories are---



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Liquidity



13 - 7Current Ratio

Current ratio looks at the liquidity of the business

Looks at the ratio between Current Assets and CurrentLiabilities

Current Ratio = Current Assets : Current Liabilities

Ideal level –

approx 1.5 : 1 or 2:1

Need enough current assets to cover current liabilities

If its too high means too many current assets e.g. might

have too much stock, could use the money tied up incurrent assets more effectively

If its too low you run the risk of not being able to meetcurrent liabilities and you could have liquidity problems



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Acid Test

Acid test ratio is another way of looking at liquidity

It has been argued that stock takes a while to convert to cash so a

more realistic ratio would ignore stock (Current assets – stock) : liabilities

1:1 seen as ideal

Again if it is too high means that the business is very liquid – may beable to use the cash for other activities to increase performance

If it is too low then the business may face working capital problems

Some types of business need more cash than others so acid testwould be expected to be higher



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Absolute liquid ratio

It is represented by cash and near cash items

This ratio is –

Cash+bank+marketeable securities liquidliabilities

Ideal ratio is .50 :1

Liquid liabilities mean current liabilities –bank OD



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Gearing



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Gearing

This is an efficiency ratio

Looks at the relationship between borrowing and

fixed assets

Gearing Ratio = Long term loans (fixed chargesbearing funds)/ Capital employed (net Asset ) x 100

The higher it is the greater the risk the business isunder if interest rates increase

Net asset = total asset –current liability



13 - 12 Debt equity ratio-

Long term debts /long term funds (borrowed and ownedfunds)

Or

Long term debts/ Eq.shareholders fund

Ideal ratio is 1:2

Proprietary ratio-

Proprietors fund /total tangible assets

Higher is the ratio , higher is the solvency



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Profitability



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Profitability

Profitability measures look at how much profit thefirm generates

Profit is the number one objective of most firms Different measures of profit – gross and net

Gross profit –total revenue – variable costs (cost

of sales)Net Profit – Gross profit – overheads



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Profitability

Gross profit looks at how much of the sales revenue isconverted into profit

Gross Profit Margin = Gross profit / turnover x 100 The higher the better

Allows the firm to assess the impact of its sales and

how much it cost to generate (produce) those sales A gross profit margin of 35% means that for every 1

of sales, the firm makes 35p in gross profit



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Profitability

Net profit looks at how much of the salesrevenue is left as net profit

Net Profit Margin = Net Profit / Turnover x 100

Net profit is more important than gross profit for a business as all costs are included

A business would like to see that this ratio hasimproved over time



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Profitability

Another profitability ratio –

looks at operatingprofit and capital employed by the business

Return on Capital Employed (ROCE) = Profit /

capital employed x 100

Need to compare to previous years andcompetitors to get a clear picture

Can improve this by increasing profitswithout increasing fixed assets / capital



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Financial



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Asset Turnover ratio

Looks at a businesses sales compared to the assets used togenerate the sales

Asset turnover = sales (turnover) / net assets

Net assets = Total assets

–

current liabilities The value will vary with the type of business:

Businesses with a high value of assets who have few sales

will have a low asset turnover ratioIf a business has a high sales and a low value of assets it

will have a high asset turnover ratio

Businesses can improve this by either increasing salesperformance or getting rid of any additional assets



13 - 20Stock turnover ratio

Another efficiency ratio

Looks at how efficiently a company convertsstock to sales

Stock turnover ratio = cost of sales (COGS)/avg. stock or Net sales /avg. inventory

High stock turnover means increased efficiency

However it depends on the type of business

Low stock turnover could mean poor customer satisfaction as people might not be

buying the stock



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Debtors turnover ratio

Credit sales/ avg. debtors

High ratio mean quick conversion of

debtor into cash

Low means liberal policy



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Debtors collection period

This is another efficiency ratio This looks at how long it takes for the business to

get back money it is owed

Debtors collection ratio = Avg. debtors x 365 /turnover (credit sales )

The lower the figure the better as get cash morequickly

However sometimes need to offer credit terms tocustomers so this may increase it

Need to ensure keep track of any changes in credit

terms as these should impact this ratio



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Creditors turnover ratio

Net credit purchase / Avg. Accountspayable (cres.)

It signifies the credit period allowedby vendors / suppliers

High means frequent payment (less

interval )..low means (high interval )



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Creditors payment period

Avg. creditors x 365/net creditpurchases

It signifies the time period .



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Investments/ shareholders



13 - 26Investment/Shareholders

Shareholders are interested in the following ratios:

Dividends per share –

total dividends / number of sharesissued

A higher figure means the shareholder got a larger return

Good to compare with competitors

Businesses can improve this themselves by increasing dividendpayments



13 - 27 Besides following are the other ratios -

Earning per share (EPS) –

EAITD/No. of equity share

Higher is the ratio , higher is the return

Price earning ratio –

Market price per Equity share /EPS

A high ratio is preferred

dividend payout ratio –

Div per share/ Earning per share

A high DP ratio is always better



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Some other ratios

Expenses ratio=expenses(factory/admin/selling/particular)/net

salesOperating ratio=total operating cost

x100/sales

Interest coverage ratio =EBIT/interest

Documents

Deb3fratio Analysis- Intro