Ratio Analysis is a signifier of Financial Statement Analysis that is used to obtain a speedy indicant of a firm’s fiscal public presentation in several cardinal countries. The ratios are categorized as Short-run Solvency Ratios. Debt Management Ratios. Asset Management Ratios. Profitability Ratios. and Market Value Ratios. Ratio Analysis as a tool possesses several of import characteristics. The information. which are provided by fiscal statements. are readily available. The calculation of ratios facilitates the comparing of houses which differ in size. Ratios can be used to compare a firm’s fiscal public presentation with industry norms. In add-on. ratios can be used in a signifier of tendency analysis to place countries where public presentation has improved or deteriorated over clip. Because Ratio Analysis is based upon accounting information. its effectivity is limited by the deformations which arise in fiscal statements due to such things as Historical Cost Accounting and rising prices.
Therefore. Ratio Analysis should merely be used as a first measure in fiscal analysis. to obtain a speedy indicant of a firm’s public presentation and to place countries which need to be investigated farther. The pages below present the most widely used ratios in each of the classs given supra. Please maintain in head that there is non cosmopolitan understanding as to how many of these ratios should be calculated. You may happen that different books use somewhat different expressions for the calculation of many ratios. Therefore. if you are comparing a ratio that you calculated with a published ratio or an industry norm. do certain that you use the same expression as used in the computation of the published ratio. Short-run Solvency or Liquidity Ratios
Short-run Solvency Ratios effort to mensurate the ability of a house to run into its short-run fiscal duties. In other words. these ratios seek to find the ability of a house to avoid fiscal hurt in the short-run. The two most of import Short-run Solvency Ratios are the Current Ratio and the Quick Ratio. ( Note: the Quick Ratio is besides known as the Acid-Test Ratio. ) Current Ratio
The Current Ratio is calculated by spliting Current Assets by Current Liabilities. Current Assets are the assets that the house expects to change over into hard currency in the approaching twelvemonth and Current Liabilities represent the liabilities which have to be paid in hard currency in the approaching twelvemonth. The appropriate value for this ratio depends on the features of the firm’s industry and the composing of its Current Assets. However. at a lower limit. the Current Ratio should be greater than one.
Top of FormExample ProblemsUse the information below to cipher the Current Ratio. Current Assets: $Current Liabilitiess: $Current Ratio:
Bottom of FormQuick RatioThe Quick Ratio recognizes that. for many houses. Inventories can be instead illiquid. If these Inventories had to be sold off in a haste to run into an duty the house might hold trouble in happening a purchaser and the stock list points would probably hold to be sold at a significant price reduction from their just market value. This ratio attempts to mensurate the ability of the house to run into its duties trusting entirely on its more liquid Current Asset histories such as Cash and Accounts Receivable. This ratio is calculated by spliting Current Assets less Inventories by Current Liabilities.
Top of FormExample ProblemsUse the information below to cipher the Quick Ratio.Current Assetss: $Inventory: $Current Liabilitiess: $Quick Ratio:
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Debt Management Ratios
Debt Management Ratios effort to mensurate the firm’s usage of Financial Leverage and ability to avoid fiscal hurt in the long tally. These ratios are besides known as Long-run Solvency Ratios. Debt is called Fiscal Leverage because the usage of debt can better returns to shareholders in good old ages and increase their losingss in bad old ages. Debt by and large represents a fixed cost of funding to a house. Therefore. if the house can gain more on assets which are financed with debt than the cost of serving the debt so these extra net incomes will flux through to the shareholders. Furthermore. our revenue enhancement jurisprudence favours debt as a beginning of funding since involvement disbursal is revenue enhancement deductible. With the usage of debt besides comes the possibility of fiscal hurt and bankruptcy.
The sum of debt that a house can use is dictated to a great extent by the features of the firm’s industry. Firms which are in industries with volatile gross revenues and hard currency flows can non use debt to the same extent as houses in industries with stable gross revenues and hard currency flows. Therefore. the optimum mix of debt for a house involves a trade-off between the benefits of purchase and possibility of fiscal hurt. Debt Ratio. Debt-Equity Ratio. and Equity Multiplier
The Debt Ratio. Debt-Equity Ratio. and Equity Multiplier are basically three ways of looking at the same thing: the firm’s usage of debt to finance its assets. The Debt Ratio is calculated by spliting Entire Debt by Total Assets. The Debt-Equity Ratio is calculated by spliting Entire Debt by Total Owners’ Equity. The Equity Multiplier is calculated by spliting Entire Assetss by Entire Owners’ Equity.
Top of FormExample ProblemsUse the information below to cipher the Debt Ratio. Debt-Equity Ratio. and Equity Multiplier.Entire Assetss: $Entire Debt: $Entire Owners’ Equity: $Debt Ratio: %Debt-Equity Ratio:Equity Multiplier:
Bottom of FormAsset Management Ratios
Asset Management Ratios effort to mensurate the firm’s success in pull offing its assets to bring forth gross revenues. For illustration. these ratios can supply insight into the success of the firm’s recognition policy and stock list direction. These ratios are besides known as Activity or Employee turnover Ratios. Receivables Turnover and Days’ Receivables
The Receivables Turnover and Days’ Receivables Ratios assess the firm’s direction of its Histories Receivables and. therefore. its recognition policy. In general. the higher the Receivables Turnover Ratio the better since this implies that the house is roll uping on its histories receivables earlier. However. if the ratio is excessively high so the house may be offering excessively big of a price reduction for early payment or may hold excessively restrictive recognition footings. The Receivables Turnover Ratio is calculated by spliting Gross saless by Histories Receivables. ( Note: since Histories Receivables arise from Credit Gross saless it is more meaningful to utilize Credit Gross saless in the numerator if the information is available. )
The Days’ Receivables Ratio is calculated by spliting the figure of yearss in a twelvemonth. 365. by the Receivables Turnover Ratio. Therefore. the Days’ Receivables indicates how long. on norm. it takes for the house to roll up on its gross revenues to clients on recognition. This ratio is besides known as the Days’ Gross saless Outstanding ( DSO ) or Average Collection Period ( ACP ) .
Top of FormExample ProblemsUse the information below to cipher the Receivables Turnover and Days’ Receivables Ratios.Gross saless: $Histories Receivable: $Receivables Employee turnover:Days’ Receivables:
Bottom of FormInventory Turnover and Days’ InventoryThe Inventory Turnover and Days’ Inventory Ratios step the firm’s direction of its Inventory. In general. a higher Inventory Turnover Ratio is declarative of better public presentation since this indicates that the firm’s stock lists are being sold more rapidly. However. if the ratio is excessively high so the house may be losing gross revenues to rivals due to stock list deficits. The Inventory Turnover Ratio is calculated by spliting Cost of Goods Sold by Inventory. When comparing one firms’s Inventory Turnover ratio with that of another house it is of import to see the stock list rating methid used by the houses. Some houses use a FIFO ( first-in-first-out ) method. others use a LIFO ( last-in-first-out ) method. while still others use a leaden mean method.
The Days’ Inventory Ratio is calculated by spliting the figure of yearss in a twelvemonth. 365. by the Inventory Turnover Ratio. Therefore. the Days’ Inventory indicates how long. on norm. an stock list point sits on the shelf until it is sold.
Top of FormExample ProblemsUse the information below to cipher the Inventory Turnover and Days’ Inventory Ratios.Cost of Goods Sold: $Inventory: $Inventory Employee turnover:Days’ Inventory:
Bottom of FormSeasonal IndustriesMany houses. such as section shops. are in seaonal industries in which their assets. particularly current assets. and gross revenues volume vary throughout the twelvemonth. This can be of peculiar concern when comparing the Asset Management Ratios of one house with another house in the same industry. This occurs because. in the computation of each of the Asset Management Ratios. a figure from the Income Statement is divided by a figure from the Balance Sheet. The Income Statement studies grosss and disbursals over a period of clip ( normally a twelvemonth ) whereas the Balance Sheet reports the houses assets and liabilities on a peculiar day of the month. Thus. for houses in seasonal industries differences in public presentation may be detected when no existent difference exists merely because their Balance Sheets are published on different day of the months. Fixed Assets Turnover
The Fixed Assets Turnover Ratio measures how fruitfully the house is pull offing its Fixed Assets to bring forth Gross saless. This ratio is calculated by spliting Gross saless by Net Fixed Assets. When comparing Fixed Assets Turnover Ratios of different houses it is of import to maintain in head that the values for Net Fixed Assets reported on the firms’ Balance Sheets are book values which can be really different from market values.
Entire Assets TurnoverThe Total Assets Turnover Ratio measures how fruitfully the house is pull offing all of its assets to bring forth Gross saless. This ratio is calculated by spliting Gross saless by Entire Assets.
Top of FormExample ProblemsUse the information below to cipher the Fixed Assets Turnover and Total Assets Turnover Ratios.Gross saless: $Net Fixed Assets: $Entire Assetss: $Fixed Assets Turnover:Entire Assets Employee turnover:
Profitability Ratios
Profitability Ratios effort to mensurate the firm’s success in bring forthing income. These ratios reflect the combined effects of the firm’s plus and debt direction. Net income Margin
The Profit Margin indicates the dollars in income that the house earns on each dollar of gross revenues. This ratio is calculated by spliting Net Income by Gross saless.
Tax return on Assetss ( ROA ) and Return on Equity ( ROE )The Return on Assets Ratio indicates the dollars in income earned by the house on its assets and the Return on Equity Ratio indicates the dollars of income earned by the house on its shareholders’ equity. It is of import to retrieve that these ratios are based on accounting book values and non on market values. Therefore. it is non appropriate to compare these ratios with market rates of return such as the involvement rate on Treasury bonds or the return earned on an investing in a stock.
Top of FormExample ProblemsUse the information below to cipher the Net income Margin. Return on Assetss ( ROA ) . and Return on Equity ( ROE ) .Gross saless: $Net Income: $Entire Assetss: $Entire Owners’ Equity: $Net income Margin: %Tax return on Assetss: %Tax return on Equity: %
Market Value Ratios
Market Value Ratios relate an discernible market value. the stock monetary value. to book values obtained from the firm’s fiscal statements. Price-Earnings Ratio ( P/E Ratio )
The Price-Earnings Ratio is calculated by spliting the current market monetary value per portion of the stock by net incomes per portion ( EPS ) . ( Net incomes per portion are calculated by spliting net income by the figure of portions outstanding. ) The P/E Ratio indicates how much investors are willing to pay per dollar of current net incomes. As such. high P/E Ratios are associated with growing stocks. ( Investors who are willing to pay a high monetary value for a dollar of current net incomes evidently expect high net incomes in the future. ) In this mode. the P/E Ratio besides indicates how expensive a peculiar stock is. This ratio is non meaningful. nevertheless. if the house has really small or negative net incomes.
Market-to-Book RatioThe Market-to-Book Ratio relates the firm’s market value per portion to its book value per portion. Since a firm’s book value reflects historical cost accounting. this ratio indicates management’s success in making value for its shareholders. This ratio is used by “value-based investors” to assist to place undervalued stocks.
Top of FormExample ProblemsUse the information below to cipher the Price-Earnings Ratio and Market-to-Book Ratio.Net Income: $Entire Owners’ Equity: $Stock Price: $Number of Shares Outstanding:Price-Earnings Ratio:Net incomes per Share: $Market-to-Book Ratio:Book Value per Share: $
Ratio Equations
Short-run Solvency RatiosCurrent Ratio:Quick Ratio:Asset Management RatiosReceivables Employee turnover:Days’ Receivables:Inventory Employee turnover:Days’ Inventory:Fixed Assets Turnover:
Entire Assets Employee turnover:Debt Management RatiosTimess Interest Earned( TIE ) Ratio:Debt Ratio:Debt-Equity Ratio:Equity Multiplier:Profitability RatioNet income Margin:Tax return on Assetss:
Tax return on Equity:Market Value RatiosPrice/Earnings Ratios:Market-to-Book Ratio:Dividend Ratios
Payout Ratio:Retention Ratio:Other EquationsNet incomes Per Share:Book Value Per Share:
Ratio Analysis ExerciseThis exercising demonstrates the analysis of fiscal statements utilizing Ratio Analysis. Click the “New Problem” button to bring forth a new job. Calculate each of the ratios indicated below. Then click the “Show Answer” button to see the solution. The worksheet besides functions as a reckoner. You can come in your ain information into the Fieldss and so snap the buttons to see the solutions. Top of Form
Balance Sheet ( $ in Millions )Assetss 1998 Liabilitiess and Owners’ Equity 1998Current Assets Current LiabilitiessCash Histories CollectibleHistories Receivable Notes CollectibleInventory Total Current LiabilitiesEntire Current Assets Long-Term LiabilitiessLong-run DebtFixed Assets Total Long-run Liabilitiess
Property. Plant. and Equipment Owners’ EquityLess Accumulated Depreciation Common Stock ( $ 1 Par ) Net Fixed Assests Capital SurplusRetained Net incomesEntire Owners’ EquityEntire Assets Total Liab. and Owners’ EquityIncome Statement ( $ in Millions )1998Gross salessCost of Goods SoldAdministrative ExpensesDepreciation
Net incomes Before Interest and TaxesInterest ExpenseTaxable IncomeTaxsNet IncomeDividendsAddition to Retained Net incomesOther InformationNumber of Shares Outstanding ( Milions )Monetary value per Share
Calculate the undermentioned ratios:Current Ratio Times Interest Earned Return on Equity ( ROE ) Quick Ratio Debt Ratio Payout and Retention Ratios Receivables Turnover and Days’ Receivables Debt to Equity Ratio Price/Earnings Ratio Inventory Turnover and Days’ Inventory Equity Multiplier Market-to-Book Ratio Fixed Assets Turnover Profit Margin EPS and Book Value Per Share Total Assets Turnover Return on Assets ( ROA )
