what is a ratio analysis? please explain me the differnet
kinds of ratios in detail?
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Answer Posted / mohammad sazzad hossain khan
Financial ratios are useful indicators of a firm's
performance and financial situation. Most ratios can be
calculated from information provided by the financial
statements. Financial ratios can be used to analyze trends
and to compare the firm's financials to those of other
firms. In some cases, ratio analysis can predict future
bankruptcy.
Financial ratios can be classified according to the
information they provide. The following types of ratios
frequently are used:
• Liquidity ratios
• Asset turnover ratios
• Financial leverage ratios
• Profitability ratios
• Dividend policy ratios
Liquidity Ratios
Liquidity ratios provide information about a firm's ability
to meet its short-term financial obligations. They are of
particular interest to those extending short-term credit to
the firm. Two frequently-used liquidity ratios are the
current ratio (or working capital ratio) and the quick
ratio.
The current ratio is the ratio of current assets to current
liabilities:
Current Ratio = Current Assets
Current Liabilities
Short-term creditors prefer a high current ratio since it
reduces their risk. Shareholders may prefer a lower current
ratio so that more of the firm's assets are working to grow
the business. Typical values for the current ratio vary by
firm and industry. For example, firms in cyclical
industries may maintain a higher current ratio in order to
remain solvent during downturns.
One drawback of the current ratio is that inventory may
include many items that are difficult to liquidate quickly
and that have uncertain liquidation values. The quick ratio
is an alternative measure of liquidity that does not
include inventory in the current assets. The quick ratio is
defined as follows:
Quick Ratio = Current Assets - Inventory
Current Liabilities
The current assets used in the quick ratio are cash,
accounts receivable, and notes receivable. These assets
essentially are current assets less inventory. The quick
ratio often is referred to as the acid test.
Finally, the cash ratio is the most conservative liquidity
ratio. It excludes all current assets except the most
liquid: cash and cash equivalents. The cash ratio is
defined as follows:
Cash Ratio = Cash + Marketable Securities
Current Liabilities
The cash ratio is an indication of the firm's ability to
pay off its current liabilities if for some reason
immediate payment were demanded.
Asset Turnover Ratios
Asset turnover ratios indicate of how efficiently the firm
utilizes its assets. They sometimes are referred to as
efficiency ratios, asset utilization ratios, or asset
management ratios. Two commonly used asset turnover ratios
are receivables turnover and inventory turnover.
Receivables turnover is an indication of how quickly the
firm collects its accounts receivables and is defined as
follows:
Receivables Turnover = Annual Credit Sales
Accounts Receivable
The receivables turnover often is reported in terms of the
number of days that credit sales remain in accounts
receivable before they are collected. This number is known
as the collection period. It is the accounts receivable
balance divided by the average daily credit sales,
calculated as follows:
Average Collection Period = Accounts Receivable
Annual Credit Sales / 365
The collection period also can be written as:
Average Collection Period = 365
Receivables Turnover
Another major asset turnover ratio is inventory turnover.
It is the cost of goods sold in a time period divided by
the average inventory level during that period:
Inventory Turnover = Cost of Goods Sold
Average Inventory
The inventory turnover often is reported as the inventory
period, which is the number of days worth of inventory on
hand, calculated by dividing the inventory by the average
daily cost of goods sold:
Inventory Period = Average Inventory
Annual Cost of Goods Sold / 365
The inventory period also can be written as:
Inventory Period = 365
Inventory Turnover
Other asset turnover ratios include fixed asset turnover
and total asset turnover.
Financial Leverage Ratios
Financial leverage ratios provide an indication of the long-
term solvency of the firm. Unlike liquidity ratios that are
concerned with short-term assets and liabilities, financial
leverage ratios measure the extent to which the firm is
using long term debt.
The debt ratio is defined as total debt divided by total
assets:
Debt Ratio = Total Debt
Total Assets
The debt-to-equity ratio is total debt divided by total
equity:
Debt-to-Equity Ratio = Total Debt
Total Equity
Debt ratios depend on the classification of long-term
leases and on the classification of some items as long-term
debt or equity.
The times interest earned ratio indicates how well the
firm's earnings can cover the interest payments on its
debt. This ratio also is known as the interest coverage and
is calculated as follows:
Interest Coverage = EBIT
Interest Charges
where EBIT = Earnings Before Interest and
Taxes
Profitability Ratios
Profitability ratios offer several different measures of
the success of the firm at generating profits.
The gross profit margin is a measure of the gross profit
earned on sales. The gross profit margin considers the
firm's cost of goods sold, but does not include other
costs. It is defined as follows:
Gross Profit Margin = Sales - Cost of Goods Sold
Sales
Return on assets is a measure of how effectively the firm's
assets are being used to generate profits. It is defined as:
Return on Assets = Net Income
Total Assets
Return on equity is the bottom line measure for the
shareholders, measuring the profits earned for each dollar
invested in the firm's stock. Return on equity is defined
as follows:
Return on Equity = Net Income
Shareholder Equity
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