Ratio Analysis In Business Finance Finance Essay

Short Term Liquidity Ratios

The term liquidness refers to the houses ability to pay its liabilities in the short tally ; Liquidity ratios are calculated to find the comparative strength of the concern in run intoing its current duties, so as to keep the sound liquidness.

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Current Ratio

This is the most of import liquidness ration. It indicates company ‘s ability to pay its current liabilities out of its current assets. It shows company ‘s committedness to run into its short-run liabilities ( current liabilities ) . The ratio indicates the extent of ‘margin of safety ‘ or ‘cushion ‘ available to the current creditors. It is calculated by division of current assets with current liabilities. The expression is:

Current Ratio = Current Assets/ Current Liabilitiess

Current assets are those assets which can be converted into hard currency within an accounting twelvemonth. It includes hard currency, bank balance, short-run investings, measures receivable, assorted debitors, shuting stock, prepaid disbursals, short term loans and progresss. Current liabilities are the liabilities which are collectible within an accounting twelvemonth. It includes bank overdraft, measures collectible, assorted creditors, outstanding disbursals, proviso for revenue enhancement, proposed dividends, accrued involvement, advances payments, long-run debt maturing within a twelvemonth. In theory, larger the current ratio, greater is the protection available to short term creditors. However, a really higher ratio is a index of idle fund, inefficient usage of fund and inordinate dependance on long term fund, which is costlier than the current liabilities.

The current ratio of XYZ ltd is 2.6 in 2000. It means 2.6 dollars of current assets for every dollar of current liability. That is considered equal for every company. The company had seen a crisp addition in the ratio in 1999 which in 2000 has stabilized, which is a good mark for the company.

Quick Ratio

This ratio is a auxiliary ratio to give dual confidence as to the soundness of the current fiscal place of the concern. It is calculated by the division of speedy assets by current liabilities. It represents the figure of times current liabilities are covered by speedy assets or the figure of rupees of liquid assets relative to entire current liabilities. It indicates the house ‘s ability to pay its current liabilities out of its most liquid assets. Liquid assets are the assets which can be converted into hard currency instantly without any loss and includes hard currency, bank balance, measures receivables, assorted debitors, short-run investings. The expression to cipher this is:

Liquid Ratio= Liquid Assets/ Current or Liquid Liabilitiess

The speedy ratio of 1:1 is considered reasonably good and ideal. The company XYZ is holding speedy ratio of 1.7:1 in 2000 and 2.5:1 which indicates the strength of the company in run intoing its current duties. The company was in the hazard of short term default in 1998, as can be interpreted from its speedy ratio. But over the period of three old ages the ratio has stabilized to an ideal figure.

Capital Structure Ratios

Debt-Equity Ratio

This ratio determines the soundness of the long-run fiscal policies of the company and besides measures the comparative investing proportions of foreigner ‘s und and stockholder ‘s fund in the company. It is besides and “ External-Internal ” equity ratio. The expression for ciphering it is:

Debt-Equity Ratio= Long-term debts/ Shareholders fund

It is besides sometimes recorded in per centums footings bespeaking the sum of debt in the entire fund of the company. A high ratio connotes high grade of purchase, which implies significant involvement charges and significant exposure to involvement rate motions. The Debt-Equity ratio for XYZ ltd over the period of three old ages id as follows

The ratio for the twelvemonth 2000 has been 32 % which is low from the company ‘s point of position. The low ratio is unfavourable from the company ‘s point of position because they have to waive higher returns, if the foreigner fund is utilised for geting fixed assets. A low proportion of debt indicates the conservative capital construction of the company. The ideal ratio is at least 50 % .

Profitability Ratios

Gross Profit Ratio

The gross net income ratio measures the relationship of gross net income to net gross revenues and is normally expressed as a per centum. Thus the expression for ciphering it is:

Gross Profit Ratio= Gross Profit/Net Gross saless * 100

Gross net income ratio represents the surplus of what a concern is able to bear down as sale monetary value over the cost of goods sold. This excess is able to run into the operating disbursals and non-operating disbursals. The sum staying after run intoing those disbursals represents the net net income, which belongs to stockholders. The gross net income of XYZ over the period of three old ages is as follows

Gross net income ratio is used by directors for analysis intents. It indicates the extent to which selling monetary values of goods per unit may worsen without ensuing in losingss in operations of the house. It reflects the efficiency with which a house manufactures its merchandises. XYZ is keeping a healthy Gross net income ratio of 33.3 % in 2000 which is a good mark for the company. A high gross net income ratio like this indicates more income from the chief concern operations, which is desirable.

Operating Net income Ratio

The operating net income ratio establishes the relationship between the operating net incomes and net gross revenues or gross earned. In other words, the operating net income ratio is calculated by spliting operating net income by gross revenues. The expression for ciphering this is:

Operating Net income = Net Net income + Non-operating Expenses – Non-operating Income

Operating Net income Ratio= Operating Profit/Sale * 100

The operating net income ratio of the XYZ ltd is as follows:

The operating net income of the company has remained steady over the period of three old ages with the moderate addition of 1.1 % . As the operating activities of a concern is the primary gross bring forthing activities of a concern, the operating net income allow users to measure the impact of operating activities on the profitableness of the house. The house should want for higher ratio as it indicates the more income from operating activities.

Net Net income Ratio

The net net income ratio establishes the ratio between net net incomes ( after revenue enhancements ) and gross revenues, and indicates the efficiency of the direction in fabrication, merchandising, administrative and other activities of the house. It gives the step of net income generated each rupee of gross revenues. This ratio gives an overall step of the house ‘s profitableness and is calculated as follows:

Net Net income Ratio= Net Net income after tax/Net Gross saless *100

The ratio is really important because if the net income is non sufficient, the house shall non be able to accomplish satisfactory return on its investing. The ratio indicates houses capacity to confront inauspicious economic conditions such as monetary value competition, low demand etc. The Net Net income ratio for XYZ is as follows:

The house is keeping low net net income ratio. But the ideal thing is that the ratio is non volatile and is steady over the period over three old ages, which is good for the house. While construing the ratio, T should be kept in head that the public presentation of net incomes must besides be seen in relation to the investing or capital of the house and non merely in relation to gross revenues.

Tax return on Equity

Since from the point of position of equity stockholders, preferable stock has a fixed claim to the net assets of the company, this ratio is computed by spliting the income after revenue enhancement less penchant divided by entire stockholder ‘s equity less penchant stock.

Tax return on Equity= ( Net Income – Preferred dividends ) / Average stockholder ‘s equity

The ROE ratio for the company over the period of three old ages from 1998 to 2000 decreased from 32 % to 30.1 % . The ratio is good from the company ‘s point of position as the cost of equity is higher than the cost of debt in normal scenario. Equity stockholders financess include equity portion capital, free militias such as portion premium, modesty excess, capital modesty, retained net incomes and excesss less accrued losingss. The return on stockholders ‘ investing should be compared with the return of other similar concerns in the same industry.

Other Ratios

Interest Coverage Ratio

This ratio measures the screen or precaution that exists for loaners of debt. This ratio reveals the debt service capacity of the house. Lenders check this ratio before make up one’s minding on imparting the money to the house. Hence, this is an of import ratio from the loaners point of position. It measures the adequateness of net incomes to cover the involvement i.e. whether the concern earns sufficient net incomes so as to pay the involvement charges sporadically. The expression is

Fixed involvement coverage ratio= Net net incomes before involvement and taxes/ Interest

The involvement coverage ratio for XYZ over the period of three old ages from 1998 to 2000 is 4.6, 4.4 5. The higher the ratio, better for loaners and more accrued their periodical involvement income. The house is holding good coverage of involvement duty and it can be said that the house will be able to refinance its principal as and when it becomes due. A comparatively high, stable coverage indicates the good record of XYZ ltd

E.P.S

The EPS is a good step of profitableness. The EPS when compared with the EPS of similar companies, gives, a position of the comparative net incomes or net incomes power of the house. EPS is the little fluctuation of return on equity capital. EPS is calculated utilizing the undermentioned expression:

Basic EPS= ( NPAT – Preference Dividend ) / Leaden Average Number of Shares

The EPS of the company over the period of 3 old ages has increased from 4.10 to 5.60. This is a spot lower as compared to the industry EPS of 6. This is fundamentally due to low net net income after revenue enhancement described in the earlier portion. The house should keep a sincere enterprise for obtaining high EPS.

PE Ratio

The P/E ratio is an exceeding tools, because it ‘s easy to cipher and it incorporates mant rating factors. This ratio comprises of two constituents, one reflecting the outlook of market refering future net incomes and another reflecting the net incomes available to equity stockholders based on the consequences of the most recent past accounting period. The P/E ratio is calculated by utilizing the undermentioned expression:

Price Net incomes Ratio= Market Price per share/ Net incomes per portion

The PE ratio of XYZ ltd over the period of 3 old ages has increased from 3.5 to 5, which is a good mark for the company. This can besides be attributed to the low EPS of the company. The company is besides keeping a higher PE ratio as compared to the industry PE. Analysts by and large compare PE ratio with the industry norm and some other companies within the industry.

Stock Turnover Ratio

Every house has to keep a certain degree of stock list of finished goods so as to run into the demands of the concern. The degree of stock list shoud neither be excessively high nor excessively low. Keeping more stock list implies unneeded obstruction of capita, over stacking, and decelerate disposal of stocks. Average stock list turnover ratio is calculated by adding the stock in the beginning and at the terminal of the period spliting it by 2.

Inventory Turnover Ratio= Cost of Goods Sold/ Average Inventory

The stock turnover ratio of 10x for the company is good as compared to the industrial norm of 9x. This means the company is holding good operating efficiency in its activities.

Asset Turnover Ratio

The ratio indicates to what extent fixed assets are contributed towards gross revenues. We can non entree this ratio with one twelvemonth information. This should be compared with the old periods to measure the investing in fixed assets in sensible or non.

The fixed assets of the company XYZ are lending 4.1 times to the gross revenues in 2000, which is above the industrial norm of 3. Besides this figure has increased from the old old ages plus turnover ratio.

Dividend %

This is the sum of dividends paid by the company as the per centum of entire net incomes. The dividends are paid by the company to its equity stockholders annually out of its net net incomes. The higher the dividend payout ratio, the more happier are the stockholders. But paying more dividends is non ever good for the house. It affects the capital construction of the house in the long tally.

The dividend payout ratio of XYZ is 24 % in 2000 which is above the industrial norm of 15 % . This means that the house is making greater enterprises to maintain its stockholders happy. But it besides means that the house is maintaining a low part of its net income as maintained net incomes.

Retained Net incomes %

This is the part of the net income that is added to the militias and excess of the house. Retained net incomes of a house is obtained by deducting the dividend paid by the company from net net income. The greater the maintained net incomes of a house, the better it is for the house to put in new undertakings and finance for assets internally.

Retained net incomes of XYZ is 76 % after subtracting 26 % as the dividend payout ratio. This is low as compared to the industrial norm of 85 % . This can be considered as the policy of the house to pay out part of net incomes as dividend to its portion holders.

Inventory Turnover Ratio

Every house has to keep a certain degree of stock list of finished goods so as to run into the demands of the concern. The degree of stock list shoud neither be excessively high nor excessively low. Keeping more stock list implies unneeded obstruction of capita, over stacking, and decelerate disposal of stocks. Average stock list turnover ratio is calculated by adding the stock in the beginning and at the terminal of the period spliting it by 2.

Inventory Turnover Ratio= Cost of Goods Sold/ Average Inventory

The stock turnover ratio of 10x for the company is good as compared to the industrial norm of 9x. This means the company is holding good operating efficiency in its activities.

Working Capital Turnover Ratio

Working capital turnover ratio indicates the figure of times the on the job capital is turned over in the class of a twelvemonth. It is calculated as follows:

Working Capital Turnover Ratio= Cost of Sales/ Average Working Capital

It measure the efficiency with which the working capital is being used by the house. A higher ratio indicates efficient use of working capital and a low ratio indicates otherwise. But a really high working capital turnover ratio is non good for any house. This ratio can be used for doing of comparative and tendency analysis for different houses in the same industry and for assorted periods.

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