Question

of the financial ratios we have covered which do you feel is the most important in assessing the financial health of a company? Why? I offer 2 suggestions: 1) be specific and 2) be sure you understand exactly what financial information a particular ratio conveys (and include that in your answer).

Answer 1

Broadly,the financial ratios can be divided into the following categories:

I. Liquidity ratios

1. Current ratio
2. Quick Ratio
3.Cash Ratio
4.Basic Defense Interval

II. Solvency/Leverage ratios

1.Debt equality ratio
2.Proprietary ratio
3.Interest Coverage Ratio.
4.Equity Ratio
5.Debt Ratio
6.Debt Service Coverage Ratio
7.Preference Dividend Coverage Ratio
8.Capital Gearing Ratio

III. Activity Ratio

1. Stock Turnover

2. Debtors Turnover

3. Creditors Turnover

4. Fixed Assest Turnover

5. Working Capital Turnover.(Inventory, Debtor, Creditor)

6. Capital Turnover Ratio

IV. Profitability Ratios

1. Gross Profit Ratio

2. Net Profit Ratio

3. Operating Ratio

4. Operating Profit Ratio

5. Earning Per Share

6. Price Earning Ratio

7. Dividend payout ratio

8. Return on Equity

9. Dividend per share

10. Return on Investment

11. Return on Capital Employed

12. Return on Assets

13. Yield

14. Market Value to Book value per share

Briefly speaking,all ratios are important to understand and evaluate the financial health of a company. No one ratio can provide cent percent accurate analysis in isolation.

One of the basic assumption for any company is that it’s a going concern,which implies it is going to be there till eternity. Hence we must first check one of the most basic ratios to assess the financial health of the company because if it fails in this ratio then there is no requirement to get into complex ratios.

The ratio would be Current ratio.Current ratio establishes the relationship between current assets and Current liability. It measures the ability of the firm to meet its short term obligation as and when they become due. It is calculated as:
Current ratio= Current Assets
                      Current liabilities

Current assets include cash and those assets which can be converted into cash within a year. Cash , bank, stock(raw materials , work in progress and finished goods), debtors(less provision), bills receivable, marketable securities, prepaid expenses, short term loans and advances and accrued incomes.
Current liability include all those liabilities maturing within one year.

Current liabilities include creditors, bills payable, outstanding expenses, income received in advance , bank overdraft, short-term loans, provision for tax , proposed dividend and unclaimed dividend.Generally , a current ratio of 2:1 is considered satisfactory.

Interpretation: It provides a measure of degree to which current assets cover current liabilities. The higher the ratio , the greater the margin of safety for the short term creditors. However, the ratio should neither be very high nor very low. A very high current ratio indicates idle funds , piled up stocks, locked amount in debtors while a low ratio puts the business in a situation where it will not be able to pay its short- term debt on time.

Every business must earn sufficient profits to sustain the operations of the business and to fund expansion and growth.

Profitability ratios are calculated to analysis the earning capacity of the business which is the outcome of utilisation of resources employed in the business. There is a close relationship between the profit and the efficiency with which the resources employed in the business are utilized.

With this context,Operating Profit Ratio is very important to be looked into.It establishes the relationship between Operating Profit and net sales.

Operating Profit Ratio = Operating Profit/ Sales × 100

Where Operating Profit = Sales – Cost of Operation

Interpretation: Operating Ratio determine the operational efficiency of the management . It helps in knowing the amount of profit earned from regular business transactions on a sale of Rs. 100. It is very useful for inter firm as well as intra firm comparisons. Higher operating ratio indicates that the firm has got enough margins to meet its non operating expenses well as to create reserve and pay dividends

Another very important ratio from shareholder’s point of view is Price Earning Ratio.
This ratio establishes a relationship between market price per share and earning per share. The objective of this ratio is to find out the expectations of the shareholders.

This ratio is calculated as –

P/E Ratio = Market price of a Share/Earnings per Share

Interpretation : It indicates the numbers of times of EPS the share is being quoted in the market. It reflects investors’ expectation about the growth in the firms’ earning and reasonableness of the market price of its shares.   P/E ratios vary from industry to industry and company to company in the same industry depending upon investors perception of their future.