Question

Essay: Explain what each of the ten ratios mean and how cach should be used to evaluate the financial health of the company (250-300 words).

Answer 1

1. Liquidity Ratio

Current Ratio

The current ratio is a liquidity ratio that measures a company's ability to pay short-term obligations or those due within one year. It tells investors and analysts how a company can maximize the current assets on its balance sheet to satisfy its current debt and other payables.

• The current ratio compares all of a company’s current assets to its current liabilities. These are usually defined as assets that are cash or will be turned into cash in a year or less, and liabilities that will be paid in a year or less.
• The current ratio is sometimes referred to as the “working capital” ratio and helps investors understand more about a company’s ability to cover its short-term debt with its current assets.
• Weaknesses of the current ratio include the difficulty of comparing the measure across industry groups ,over generalization of the specific asset and liability balances, and the lack of trending information.

• Formula and Calculation for Current Ratio

  To calculate the ratio, analysts compare a company's current assets to its current liabilities. Current assets listed on a company's balance sheet include cash, accounts receivable, inventory and other assets that are expected to be liquidated or turned into cash in less than one year. Current liabilities include accounts payable, wages, taxes payable, and the current portion of long-term debt.

• Current Ratio= Current assets / current liabilities.

2. Activity Ratio

Activity Ratios is defined as a set of financial ratios that measures how effectively a business uses its operating assets and convert them into sales or cash. Activity ratios help in evaluating a business’s operating efficiency by analyzing fixed assets, inventories, and accounts receivables. It not just expresses a business’s financial health but also indicates the utilization of the balance sheet components.

• Activity Ratios do not give the desired output when comparing businesses across different industries.
• The more common term used for activity ratios is efficiency ratios.
• Activity ratio formulas also help analysts to analyze the business’s current or short term performance.
• An improvement in the ratios depicts improved profitability.

Most common types of Activity Ratios are as follows –

• Inventory Turnover Ratio
• Total Assets Turnover Ratio
• Fixed Assets Turnover Ratio
• Accounts Receivable Turnover Ratio

All these ratios quantify the operations of a business using numbers from the business’s current assets or liabilities.

Average collection period

The average collection period is the average number of days between 1) the dates that credit sales were made, and 2) the dates that the money was received/collected from the customers. The average collection period is also referred to as the days' sales in accounts receivable.

Formula for Calculating the Average Collection Period

One formula for calculating the average collection period is: 365 days in a year divided by the accounts receivable turnover ratio.

An alternate formula for calculating the average collection period is: the average accounts receivable balance divided by the average credit sales per day.

Total asset turnover

The total asset turnover ratio compares the sales of a company to its asset base. The ratio measures the ability of an organization to efficiently produce sales, and is typically used by third parties to evaluate the operations of a business. Ideally, a company with a high total asset turnover ratio can operate with fewer assets than a less efficient competitor, and so requires less debt and equity to operate. The result should be a comparatively greater return to its shareholders.

The formula for total asset turnover is:

Net sales ÷ Total assets = Total asset turnover

3.Debt

Debt Ratio

Debt ratio is a solvency ratio that measures a firm’s total liabilities as a percentage of its total assets. In a sense, the debt ratio shows a company’s ability to pay off its liabilities with its assets. In other words, this shows how many assets the company must sell in order to pay off all of its liabilities.

This ratio measures the financial leverage of a company. Companies with higher levels of liabilities compared with assets are considered highly leveraged and more risky for lenders.

This helps investors and creditors analysis the overall debt burden on the company as well as the firm’s ability to pay off the debt in future, uncertain economic times.

Formula

The debt ratio is calculated by dividing total liabilities by total assets

Times interest earned ratio

The times interest earned ratio, sometimes called the interest coverage ratio, is a coverage ratio that measures the proportionate amount of income that can be used to cover interest expenses in the future.

In some respects the times interest ratio is considered a solvency ratio because it measures a firm’s ability to make interest and debt service payments. Since these interest payments are usually made on a long-term basis, they are often treated as an ongoing, fixed expense. As with most fixed expenses, if the company can’t make the payments, it could go bankrupt and cease to exist. Thus, this ratio could be considered a solvency ratio.

Formula

The times interest earned ratio is calculated by dividing income before interest and income taxes by the interest expense.

4. Profitability Ratio

a. Net profit margin ratio

Net Profit Margin (also known as “Profit Margin” or “Net Profit Margin Ratio”) is a financial ratio used to calculate the percentage of profit a company produces from its total revenue. It measures the amount of net profit a company obtains per dollar of revenue gained. The net profit margin is equal to net profit (also known as net income) divided by total revenue, expressed as a percentage.

Net Profit Margin Ratio Net Profit Net Profit Margin Ratio = Revenue

The typical profit margin ratio of each company can be different depending on which industry the company is in. As a financial analyst, it’s important in day-to-day financial analysis.

b. Return on assets

Return on Assets (ROA) is a type of return on investment (ROI) metric that measures the profitability of a business in relation to its total assets. This ratio indicates how well a company is performing by comparing the profit (net income) it’s generating to the capital it’s invested in assets. The higher the return, the more productive and efficient management is in utilizing economic resources

The ROA formula is:

ROA = Net Income / Average Assets

or

ROA = Net Income / End of Period Assets

Where:

Net Income is equal to net earnings or net income in the year (annual period)

Average Assets is equal to ending assets minus beginning assets divided by 2.

c. Return on equity

Return on Equity (ROE) is the measure of a company’s annual return (net income) divided by the value of its total shareholders’ equity, expressed as a percentage (e.g., 12%). Alternatively, ROE can also be derived by dividing the firm’s dividend growth rate by its earnings retention rate (1 – dividend payout ratio).

Return on Equity is a two-part ratio in its derivation because it brings together the income statement and the balance sheet, where net income or profit is compared to the shareholders’ equity. The number represents the total return on equity capital and shows the firm’s ability to turn assets into profits. To put it another way, it measures the profits made for each dollar from shareholders’ equity.

Return on Equity = Net Income / Shareholders’ Equity

d. Earnings per share

Earnings per share (EPS) ratio measures how many dollars of net income have been earned by each share of common stock. It is computed by dividing net income less preferred dividend by the number of shares of common stock outstanding during the period. It is a popular measure of overall profitability of the company.

EPS = Net Income - preference dividend / Number of equity shares.

5. Market Ratios

Price/earning ratio

The Price Earnings Ratio (P/E Ratio) is the relationship between a company’s stock price and earnings per share (EPS). It is a popular ratio that gives investors a better sense of the value of the company. The P/E ratio shows the expectations of the market and is the price you must pay per unit of current earnings (or future earnings, as the case may be).

Earnings are important when valuing a company’s stock because investors want to know how profitable a company is and how profitable it will be in the future. Furthermore, if the company doesn’t grow and the current level of earnings remains constant, the P/E can be interpreted as the number of years it will take for the company to pay back the amount paid for each share.

Formula

Price Earnings Ratio Formula

P/E = Stock Price Per Share / Earnings Per Share

or

P/E = Market Capitalization / Total Net Earnings