Question

Statement of the Assignment:

Please prepare a comprehensive list of financial ratios as introduced in Chapter 3 of the textbook. Write a brief explanation below each financial ratio, e.g. what does the financial ratio measures or what the significance of it is.

For example:

Current Ratio = Current Assist / Current Liabilities

Current ratio measures whether our current assets, if liquidated, are sufficient to pay all of our current liabilities. A CR of 1.5, for example, shows that if we were to liquidate all of our current assets, we will be able to cover 1.5x our current liabilities, whereas a CR of 0.5 shows that liquidating our current assets only covers half of our current liabilities.

Answer 1

Financial Ratios

A ratio is an arithmetical relationship between two figures.Financial ratio analysis is a study of ratios between various items or group of items in financial statements.

These ratios are classified in several ways.

We can divide then 5 broad categories as follows:

1. Liquidity Ratio
2. Leverage Ratio
3. Turnover Ratio
4. Profitability Ratio
5. Valuation Ratio

1. Liquidity Ratios

Liquidity refers to the ability of a firm to meet its obligations in the short run, usually one year. It is based on the relationship between current assets and current liabilities. The important liquidity ratios are current ratio, acid-test ratio and cash ratio.

Current ratio: A very popular ratio, the current ratio is defined as the ratio of current asset to current liabilities:

Current Assets/Current Liabilities

Current assets include cash, current investment, trade receivables, inventories, loans and advances and prepaid expenses. Current liabilities represent liabilities that are expected to mature in the next twelve months, like loans secured or unsecured that are due in next twelve month and current liabilities and provisions.

Current ratio measures the ability of the firm to meet its current liabilites - current assets get converted into cash during operation cycle of the firm. Higher the current ratio, the greater will be the short term solvency.

Acid Test Ratio also called quick ratio is defined as

Quick assets/ Current Liabilites

Quick assets are defined as current assests excluding inventories.

The acid test ratio is fairly stringent measure of liquidity.

2. Leverage ratio

Financial leverage refers to the use of debt finance. While debt capital is a cheaper source of finance, also riskier. Leverage ratio helps in assessing the risk arising from the use of debt capital.

Debt - Equity Ratio shows the relative contributions of creditors and owners.

= Total Liabilities/ Shareholders Funds

In general, the lower the debt-equity ratio, the higher the degree of protection enjoyed by the creditors.

Interest Coverage Ratio is defined as

Profit before interest and taxes / Interest

A high interest coverage ratio means that the firm can easily meet its interest burden even if profit before interest and taxes suffers a considerable decline. This ratio is widely used by the lenders to assess a firm debt capacity.

3. Turnover Ratio:

It is referred as asset management ratio or how efficiently the asset are employed by the firm. These ratios are based on the relationship between the activity level , represented by revenues or cost of goods sold and level of various assets.

Inventory Turnover measures how fast the inventory is moving through the firm and generating sales. It is defined as

Revenues from operations / Inventory

The higher is the ratio, the more efficient is the management of inventory and vice versa.

Debtors Turnover shows how many times sundary debtors turn over during the year It is defined as

Net Credit Sales / Trade Receivables

The higher is the debtors turnover the greater is the efficiency of credit management.

Fixed Assets Turnover is the ratio that measures sales per rupee of investment in fixed assets. It is defied as

Revenues from operations / Net Fixed Assets

The ratio is supposed to measure the efficiency with which fixed assets are employed. A higher ratio indicates a high degree of efficiency in asset utilization and low ratio reflects inefficient use of assets.

4. Profitability Ratios

It reflects the final result of business operations. There are two types of profit ability ratios: profit margin ratio and rate of return ratios.

Gross Profit Margin Ratio is defined as

Gross Profit / Revenues from operations

It is defined as the difference between revenues from operation and cost of good sold. It measures the efficiency of production as well as pricing.

Net Profit Marin Ratio is defined as

Net Profit / Total Revenues

This ratio shows the earning left for the shareholders as percentage of total revenues. It measures overall efficiency of production, administration, selling financing, pricing, tax management. It provide valuable understanding of the cost and profit structure of the firm and enable analyst to identify the sources of business efficiency.

5. Valuation Ratios

It indicates how the equity and investor claims are assessed in th capital market. Since the market value reflects the combined influence of risk and return, valuation ratios are the most comprehensive measures of a firm performance.

Price Earning Ratio is the most popular financial statistic in the stock market discussion and it is defined as

Market Price per share / Earning Per Share

The price earning ratio is summary measure which primarily reflects the following factors: growth prospects, risk characteristics, shareholder orientation, corporate image and degree of liquidity