Question

For entrepreneural management list five of the 12 key ratios (Liquidity ratios, leverage ratios, debt ratios, debt-to-net-worth ratio, and profiablity ratios are the five of choice) and explain why they are important and how they would be used to help a new buisness.

Answer 1

1. Liquidity Ratio: The liquidity ratios focus on a business's ability to pay its short-term debt obligations. It focus on the firm's current assets and current liabilities on the balance sheet as on date. It is also known as solvency ratio. It is important that the liquidity ratio does not fall below a certain level as per industry standard because the lender wants to ensure that the borrower will not default on the loan. Many lenders want to ensure that the ratio is at least 2:1 and certainly not less than 1:1. The acceptable liquidity ratio varies by institution and also by industry to industry.

Types of liquidity ratio:

I. Current Ratio : Current Assets/ Current Liability

II. Acid Test Ratio or Quick Ratio : Quick Assets = Current Assets – Inventory – Prepaid Expenses

III. Absolute Liquidity Ratio: Cash + Marketable Securities / Current Liability

IV. Basic Defense Ratio: (Cash + Receivables + Marketable Securities) ÷ (Operating expenses +Interest + Taxes) ÷ 365

2. Leverage Ratio: The Leverage ratios focus on a business's ability to meet the long-term debt obligations or commitments. It looks at the firm's long-term liabilities on the balance sheet such as bonds or debentures. It tells about company's overall financial health & in most instances quantify share holder's equity.

Types of Leverage Ratio

A. Capital Structure Ratio

I. Equity Ratio: Shareholder Equity/ Total Capital Employd

II. Debt Ratio: Liabilities / Assets

III. Debt to Equity Ratio: Total Debt/ Shareholder's Fund

B. Coverage Ratios:

I. Debt Servic Coverage Ratio: Earning Available for debt / Interest + Installments of the debt

II. Interests Coverage Ratio: Earning Before Income &Taxes/Interest

III. Capital Gearing Ratio: (Preference share capital + debentures amount+ Long term loan) / (Equity share capital + Reserve and surplus)

3. Debt Ratio: This ratio indicates the proportion of a company's debt to its total assets. It means how much the company relies on debt to finance assets. The debt ratio gives users a quick measure of amount of debt that company has on its balance sheets compared to its assets. The higher ratio, greater the risk associated with the firm's operation. Low debt ratio indicates conservative financing with an opportunity to borrow in the future at no material risk. Debt ratio is similar to debt-to-equity ratio which shows the same proportion but in different paattern. The formula is Debt ratio = Liabilities / Assets.

4. Debt-To-Net-Worth Ratio: The ratio of your debt to your net worth is the way of looking at the overall financial condition of a firm. It's something lenders may take into account in deciding whether to lend you money or not. For companies, investors and lenders often look at a related ratio of debt to equity. The lower the ratio, the healthier it appears to anyone assessing your ratio. A low number suggests minimal debt of firm. Result over 100% reflects someone who owes more than their net worth. Formula is Total Debts / Net worth.

5. Profiablity Ratio: The Profitability Ratio are just what the name implies. They reveal a firm's ability to generate a profit and an adequate return on assets and equity. These ratios measure how efficiently the firm uses its assets, how effectively it manages its operations, and they answer such basic questions as "How profitable is this business?" and "How does it measure up to its competitors?" Common profitability ratios include the gross profit margin, net income margin, return on assets, and return on equity.

Types of Profitability Ratio

I. Return on Equity: Profit after Tax ÷ Net worth

II. Earnings Per Share: Net Profit ÷ Total no of shares outstanding

III. Dividend Per Share: Amount Distributed to Shareholders ÷ No of Shares outstanding

IV. Price Earnings Ratio: Market Price of Share ÷ Earnings per share

V. Return on Capital Employed: Total Assets – Current Liability

VI. Return on Assets: Net Profit ÷ Total Assets

VII. Gross Profit: Gross Profit ÷ Sales × 100

VIII. Net Profit: Net Profit ÷ Sales × 100