Question

please conduct only 1 set of ratios as mentioned below and calculated by one of the peers:

1. Profitability ratios.

2. Liquidity Ratios

3. Solvency Ratio

4. Activity Ratios

5. Conduct Du Pont analysis

Answer 1

1. Profitability Ratio

Profitability ratios measure a business's ability to earn profits that are relative to their associated expenses. Recording a higher profitability ratio relative to a similar ratio in the previous financial reporting period shows that the business is healthy. The profitability ratio can also be compared to a similar firm’s relative value to determine how profitable the business is.

Sl.No	Particular	Formula	Used for	Detail
1	Gross Profit Margin	{(Revenue – Cost of Goods Sold (COGS))/(Revenue)}	1. Higher the gross profit margin, more efficient is the business operation.	Revenue is the sales income and COGS includes raw material, labour, and other production expenses
			2. Gross Profit ratio is used to compare the business performance with its previous period or even with its competitors
2	Operating Margin	{(Gross Profits- Operating Expense)/(Revenue)}	1. Unlike Gross profit ratio, this includes more expenses and hence it is used to ascertain companies profitability more efficiently	From the gross profits, operating expenses such as selling and distribution cost, administration cost etc are deducted to arrive at operating margin
3	Profit Margin	{(Revenue – Operating expense + non-operating income-Interest Expense- Income taxes)/(Revenue)}	1. This ratio helps an investor to know how much profit is generated from the total revenue of the business	As the formula itself explains, the profit margin is arrived from the revenue after adjusting all operating and non-operating expense and income
			2. The overall functional efficiency of an enterprise can be ascertained apart from its core business
4	Earnings per Share (EPS)	{(Net Income – Preferred Dividend)/(Weighted Average Outstanding Shares)}	EPS is more important to shareholders since it helps in determining the return on investment	Generally weighted average Outstanding shares are used since outstanding shares can change over time
			Higher the EPS, higher is the stock price of the company	Sometime Diluted EPS are used which includes options, convertible securities and warrants outstanding which affects outstanding shares

2. Liquidity Ratio

Liquidity ratio helps in measuring the cash sufficiency of an enterprise to pay off its short-term liabilities. A High liquidity ratio ensures the company is in a good position to pay its creditors. The liquid ratio of 2 or more is considered acceptable. Listed below are some of the commonly used liquidity ratios:

Sl.No	Ratio Name	Formula	Used for	Detail
1	Current Ratio		1. One of the commonly used liquidity ratios is the current ratio which compares the current assets to current liabilities held by the business	Current assets include cash, inventory, accounts receivable etc
		{(Current Assets)/(Current Liabilities)}	2. This ratio is used to check if the company will be able to pay its debts which are due in next 12 months	Current liabilities include accounts payable, income tax payable and any other current liabilities
2	Quick Ratio	{(Quick Assets)/(Current Liabilities)}	1. It is similar to current ratio except that this uses only quick assets which are easy to liquidate.	To calculate the Quick assets, inventory and prepaid expenses which are difficult to liquidate are to be removed from the current assets.
			2. This is also known as Acid test
3	Cash Ratio	{(Cash + Marketable securities )/(Current Liabilities)}	1. This ratio considers only those current assets which are immediately available to the company to pay its debts.	Only cash and marketable securities are considered for current assets.
			2. Business is considered as financially sound if it has a cash ratio of 1 or more.

3. Solvency Ratio

Solvency ratio measures the utilization of borrowed money by the business. It helps to identify the financial stability of the business by analyzing the total debt of the company.

Sl.No	Particular	Formula	Used for	Example
1	Debt to Equity Ratio	{(Total Debt)/(Total Equity)}	1. Business with high debt Equity ratio indicates that it is more dependent on debts for operation	Total Debt includes both long term and short term debts held by the company.
			2. This is also known as Gearing ratio which is used by Investors and Creditors to analyze the company’s financial leverage
2	Debt to Asset Ratio	{(Total Debt)/(Total Asset)}	1. Debt to Asset ratio can be used to determine if the business will be able to pay all of its debts if the business is closed immediately	It includes all the debt and assets of the company but there are different variations of this formula where only certain assets or specific liabilities are included
			2. A company having a debt to asset ratio of less than 1 is considered as good for investment. If the ratio is greater than 1, the company is considered as highly leveraged
3	Debt Ratio	{(Total Liabilities)/(Total Asset)}	1. The liabilities to assets ratio is also known as solvency ratio indicates how much of a company’s assets are made of liabilities	Total long-term debt and total assets (tangible and intangible) are reported on the balance sheet are considered
			2. A high liability to assets ratio indicates the business might face potential solvency issues
4	Interest Coverage Ratio	{(Earnings before interest and taxes (EBIT))/(Interest Expense)}	1. This ratio is used to measure the company’s ability to meet its interest –payment obligation	Net Income before deducting interest and taxes by the company’s interest expense and taxes are considered as a percentage on interest expense
			2. A higher ratio indicates a better financial position of the business

4. Activity Ratio

Activity ratio indicates the return generated from a particular type of asset using the sales, cost and asset data. This ratio helps the business to identify effective utilization of the assets and thereby facilitates efficient management:

Sl.No	Particular	Formula	Used for	Example
1	Receivable Ratio	{(Annual Sales Credit)/(Accounts Receivable)}	1. Receivables Turnover ratio measures how soon the firms collect its receivables	For the ratio calculation, monthly average receivables and sales on credit terms are used generally
			2. A high receivable ratio indicates that the business sales collection process is working well	Average collection period can be determined using this ratio
2	Inventory Turnover Ratio	{(Cost of Goods Sold)/(Average Inventory)}	1. It is used to ascertain the rate at which the company’s inventory is converted to cash	It is generally measured using inventory period which is the average inventory divided by average cost of goods is sold
			2. A company with higher inventory ratio is considered to have an effective sales strategy
3	Asset Turnover Ratio	{(Net Revenue)/(Assets)}	1. This ratio indicates the value of revenue as a percentage of the value of investment	This can have different variants depending upon the asset category used for the calculation
			2. A higher ratio indicates better asset management and utilization by the business

5. Du Pont Analysis

DuPont Analysis is an extended examination of Return on Equity (ROE) of a company which analyses Net Profit Margin, Asset Turnover, and Financial Leverage. This analysis was developed by the DuPont Corporation in the year 1920.

In simple words, it breaks down the ROE to analyze how corporate can increase the return for their shareholders.

Return on Equity= Net Profit Margin x Asset Turnover Ratio x Financial Leverage

= (Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Total Equity)

DuPont Analysis Example:

Let’s analyze the Return on Equity of Companies- A and B. Both the companies are into the electronics industry and have the same ROE of 45%. The ratios of the two companies are as follows-

Ratio                               Company A             Company B

Profit Margin                       30%                         15%

Asset Turnover                     0.5                            6

Financial Leverage                 3                             0.5

Even though both companies have the same ROE, however, the operations of the companies are totally different.

Company A is able to generate higher sales while maintaining a lower cost of goods which can be seen from its high-profit margin.

On the other hand, company B is selling its products at a lower margin but having very high Asset Turnover Ratio indicating that the company is making a large number of sales. Moreover, company B seems less risky since its Financial Leverage is very low.

Thus DuPont Analysis helps compare similar companies with similar ratios. It will help investors to measure the risk associated with the business model of each company.