Question

Choose three ratios from the liquidity, profitability, leverage, operating efficiency, and market measures categories. Discuss the ratios and what information can be provided by each.

Answer 1

Liquidity Ratios:-

Liquidity is the ability to convert assets into cash quickly and cheaply. Liquidity ratios are most useful when they are used in comparative form.

• Current Ratio:

The current ratio measures a company's ability to pay off its current liabilities with its current assets such as cash, accounts receivable and inventories. The higher the ratio, the better the company's liquidity position.

• The Quick Ratio or Acid Test ratio:

quick ratio can also be given by;

The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets and therefore excludes inventories from its current assets.

• Absolute Liquidity ratio:

This ratio measures the total liquidity available to the company. This ratio only considers marketable securities and cash available to the company. This ratio only tests short-term liquidity in terms of cash, marketable securities, and current investment.

Profitability Ratios:-

Profitability ratio is used to evaluate the company’s ability to generate income as compared to its expenses and other cost associated with the generation of income during a particular period.

• Return on Capital Employed:-

Capital Employed = Equity share capital, Reserve and Surplus, Debentures and long term loans

This ratio computes percentage return in the company on the total funds invested .

• Price Earnings Ratio:

This ratio is used by the investor to check the undervalued and overvalued share price of the company.

• Return on Equity:

Net worth = Equity share capital, and Reserve and Surplus

This ratio measures Profitability of equity fund invested the company. It also measures how profitably owner’s funds have been utilized to generate company’s revenues. A high ratio represents better the company is.

Leverage Ratio:-

Levarage ratio measures the long term stability and structure of the firm. This ratio helps the company to determine how much amount they can borrow so as to increase the profitability of the company

• Debt Equity Ratio:

This ratio indicates total debt used in the business in comparison to equity. A higher ratio represents insecurity to the creditors and other lenders and the low ratio represents more safety or cushion to lenders.

• Capital Gearing Ratio

uThis ratio is used to check the capital structure of the company. This ratio describes the relationship between the owner’s capital and the amount borrowed by the company on which periodic payment is made

• Interest Coverage Ratio

EBIT = Earnings Before Interest and tax

This ratio indicates the ability of the company to pay out the interest from its earnings.

Operating efficiency ratios:

The operating ratio shows the efficiency of a company's management by comparing the total operating expense of a company to net sales.

Market Measures:

• Product usage:

Product or brand usage measures the frequency and weight of use of a product. A straightforward method of segmenting a market is to look at weight of purchase, separating heavy purchasers from light purchasers.

• Market Share:

Market share is the number or value of units sold in a given period for a manufacturer as a percentage of the total market size. It can be defined either as share of units sold or share of revenue. If the market size is known a company can infer its own market share based on its own sales data.

• Market penetration:

Market penetration which is the number of customers you have as a percentage of the total customers in the market. This can be on the basis of sales in a period (sales penetration) or installed base. Combining penetration with market share you can calculate sales per customer. If you have a large customer penetration, but a low market share, then you are making many low-value sales and one way to increase share is to increase the value of the sales, rather than chase more customers.