Explain the significance of the following ratiosReturn on AssetReturn on EquityNet income margin...

Explain the significance of the following ratios

Return on Asset

Return on Equity

Net income margin

book value

debit to equity

financial leverage

Solutions

Expert Solution

Significance of ratios

Return on Asset is also known as ROA. This is a profitability ratio and helps in assessing if the assets of the company are being utilised effectively to generate profits for the company. A higher ratio is always preferred.

Return on Equity is also known as ROE. This is another profitability ratio which helps in eveluating if the company is generating good returns for its shareholders or not. A higher ratio is always preferred.

Net income margin is also a profitability ration. This ratio shows amount of profit the company has been able to generate on $1 of its sales. Net income is arrived after all expenses and costs have been deducted from revenues and income the company generated during an accounting period.

Book Value is the difference between Total Assets and Total Liabilities and the balance between these two amounts is perceived to be the value of the firm. Hence, higher the book value more is the value of the company. This ratio comes in handy when a firm needs to be acquired or merged with another big firm. The promoters in such cases can get more value for their company if book value is high.

Debit to equity raito shows the proportion of external sources of funding (liabilities) versus the internal sources of funding (equity). A lower ratio is always preferred. A higher ratio means that the company has too much dependency on external borrowings which can impact the company adversely in the long run.

Financial Leverage shows how much proportion of the total assets are funded through external sources. The ratio helps in assessing if the company should raise funds through stockholders or borrow funds from bank/financial institutions to increase its total assets especially non-current assets.

Workings

Formulae to calculate these ratios are

Return on Asset = Net Income/Average Total Assets

Return on Equity = Net Income/Average Total Equity

Net income margin = = Net Income/Net Sales

Book Value = Assets - Liabilities

debit to equity = Total Liabilities/Total Equity

financial leverage = Total Liabilities/Total Assets

ekkarill92 answered 2 years ago

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