Financial Ratios

Among the many ratios which have been developed from time to time , the following 5 sets are the most widely and usefully used

1. 2.

3.

Balance sheet Ratios Liquidity ratios measure the availability of cash to pay debt.[ Debt ratios measure the firm's ability to repay long-term debt. _____________________________ Income statement and Balance sheet ratios Coverage Ratio Coverage ratios measure ability to service or cover various charges imposed on the firm.

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4. Activity ratio also known as efficiency or turnover ratio measures how effectively, the firm is turning over assets or using converting non-cash assets into cash. 5. Profitability ratios measure Return achieved from its operations and capital spending.

Liquidity ratios are used to measure the firms ability to meet short-term obligations. Liquidity ratios include Current ratio, determined by

1. Liquidity Ratios

Current Assets --------------------------------Current Liabilities

Another measure is Quick ratio (Acid test) , here we take the current assets and subtract the inventory (current assets minus inventory is often referred to as the "quick assets") and divide buy current liabilities. Quick ratio (Acid test)= (Current Assets Inventory) / Current Liabilities

2. Financial Leverage (Debt) Ratio

The debt to equity ratio measures how much money a company should safely be able to borrow over long periods of time. It is done by comparing the organizations total debt (including short term and long term obligations) and dividing it by the amount of shareholder equity. The result we get after dividing debt by equity is the percentage of the organization that is indebted (or "leveraged").

Suppose 1,454,000/ 1,796,000 = 0.81 The above debt-equity ratio shows that loan givers are providing 81 paisa of financing for each Tk 1 being provided by shareholders. The normal level of debt to equity depends on industry type and depends on both economic factors and society's general feeling towards credit. Generally, any organization that has a debt to equity ratio between 40% to 50% have no liquidity problems. Why an organization / company should not have debt/equity ratio of 0% or 100%

Total debt by Total assets ratio

Suppose 1,454,000/ 3,250,000 = 0.45 This implies that 45% of assets are financed with debt.

3. Interest Coverage Ratio

Interest coverage ratio shows: Earnings before Interest and Taxes (EBIT) / Interest expenses. If for a company EBIT/ Interest expenses = 4.71 it means that the company has an ability to cover 4.71 times the annual interest expenses.

4. Activity ratios/operating ratio

Activity ratios/operating ratio measure how quickly a firm converts non-cash assets to cash assets For example, Receivable turn-over ratio = Annual Sales through provision of Loan / Receivables at end of year

If the ratio is 5.89, it means accounts receivable have been turned over 5.89 times during a year.

Cont.

Receivables turnover in days or Average collection period is calculated by

(Receivables x Days in a year) / Annual sales through Loan provision If the ratio is 62 days then it means that accounts receivable are outstanding on average for 62 days or two months. Similarly Accounts Payable period =( Accounts payable x Days in a year) / Annual Loan received

5. Profitability ratios
Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return. The ratio of (Net Sales Cost of goods sold) / Net sales If the ratio is 32.9%, it means that 32.9% of sales is profit.

Cont.
Return on Equity is measured by: (ROE) = Net profit after taxes / Shareholders equity

If ROE is 11.19%, it means that Return on equity is 11.19%

Du Pont Approach: It means breaking up ROE into management components/tools

ROE = Net profit after taxes / shareholders equity = Net profit after taxes/Net sales x Net sales / Total assets x Total assets/ shareholders equity ROE = Net profit margin x total asset turnover x equity multiplier

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