Question

Consider what you have learned about the different types of financial ratios and their applications. Defend your selection of the specific financial ratios you would look at when contemplating the purchase of the neighborhood sno-cone stand vs. the local department store.

Answer 1

Financial Ratio:

Financial ratio analysis is the process of calculating financial ratios, which are mathematical indicators calculated by comparing key financial information appearing in financial statements of a business, and analyzing those to find out reasons behind the business’s current financial position and its recent financial performance, and develop expectation about its future outlook.

Financial ratios can be broadly classified into liquidity ratios, solvency ratios, profitability ratios and efficiency ratios (also called activity ratios or asset utilization ratios)

Liquidity Ratios

Liquidity ratios asses a business’s liquidity, i.e. its ability to convert its assets to cash and pay off its obligations without any significant difficulty (i.e. delay or loss of value). Liquidity ratios are particularly useful for suppliers, employees, banks, etc. Important liquidity ratios are:

• Current ratio
• Quick ratio (also called acid-test ratio)
• Cash ratio

Current Ratio:

Current ratio is one of the most fundamental liquidity ratio. It measures the ability of a business to repay current liabilities with current assets.

Formula

Current ratio is calculated using the following formula:

Current Ratio =	Current Assets
	Current Liabilities

Quick Ratio:

Quick ratio (also known as asset test ratio) is a liquidity ratio which measures the dollars of liquid current assets available per dollar of current liabilities. Liquid current assets are current assets which can be quickly converted to cash without any significant decrease in their value. Liquid current assets typically include cash, marketable securities and receivables. Quick ratio is expressed as a number instead of a percentage.

Formula

Quick ratio is calculated by dividing liquid current assets by total current liabilities. Liquid current assets include cash, marketable securities and receivables.

The following is the most common formula used to calculate quick ratio:

Quick Ratio=	Cash + Marketable Securities + Receivables
	Current Liabilities

Cash includes cash in hand and cash at bank.

Cash Ratio:

Cash ratio is the ratio of cash and cash equivalents of a company to its current liabilities. It is an extreme liquidity ratio since only cash and cash equivalents are compared with the current liabilities.

Formula:

Cash Ratio =	Cash + Cash Equivalents
	Current Liabilities

Solvency Ratios:

Solvency ratios assess the long-term financial viability of a business i.e. its ability to pay off its long-term obligations such as bank loans, bonds payable, etc. Information about solvency is critical for banks, employees, owners, bond holders, institutional investors, government, etc. Key solvency ratios are:

• Debt ratio
• Debt to equity ratio
• Debt to capital ratio
• Times interest earned ratio
• Fixed charge coverage ratio

Debt Ratio

Debt ratio (also known as debt to assets ratio) is a ratio which measures debt level of a business as a percentage of its total assets. It is calculated by dividing total debt of a business by its total assets.

Formula

Debt ratio is calculated using the following formula:

Debt Ratio =	Total Debt
	Total Assets

Debt-to-Equity Ratio

Debt-to-Equity ratio is the ratio of total liabilities of a business to its shareholders' equity. It is a leverage ratio and it measures the degree to which the assets of the business are financed by the debts and the shareholders' equity of a business.

Formula

Debt-to-equity ratio is calculated using the following formula:

Debt-to-Equity Ratio =	Total Liabilities
	Shareholders' Equity

Debt-to-Capital Ratio

Debt-to-capital ratio is a solvency ratio that measures the proportion of interest-bearing debt to the sum of interest-bearing debt and shareholders' equity.

Interest-bearing debt includes bonds payable, bank loans, notes payable, etc. Non-interest bearing debt includes trade payable, accrued expenses, etc.

Formula

Debt-to-Capital Ratio =	Interest-bearing Debt
	Interest-bearing Debt + Shareholders' Equity

Times Interest Earned Ratio

Times interest earned ratio (also called interest coverage ratio) is an indicator of the company’s ability to pay off its interest expense with available earnings. It is a measure of a company’s solvency, i.e. its long-term financial strength. It calculates how many times a company’s operating income (earnings before interest and taxes) can settle the company’s interest expense.

Formula

Time interest earned ratio is calculated by dividing earnings before interest and tax (EBIT) for a period with interest expense for the period as follows:

Times Interest Earned =	Earnings before Interest and Tax
	Interest Expense

Fixed Charge Coverage

Fixed charge coverage is a solvency ratio that measures whether earnings before interest, taxes and lease payments are sufficient to cover the interest and lease payments. It is calculated by dividing the sum of earnings before interest and taxes and lease payments by the sum of interest payments and lease payments.

Formula

Fixed Charge Coverage =

EBIT + Lease Payments other than Interest Portion

Interest Payments + Lease Payments

Profitability Ratios:

Profitability ratios measure the ability of a business to earn profit for its owners. While liquidity ratios and solvency ratios explain the financial position of a business, profitability ratios and efficiency ratios communicate the financial performance of a business. Important profitability ratios include:

• net profit margin
• gross profit margin
• operating profit margin
• return on assets
• return on capital employed
• return on equity
• earnings per share

Other ratios related to profitability that are used by investors to assess the stock market performance of a business include:

• price to earnings (P/E) ratio
• price to book (P/B) ratio
• Dividend payout ratio
• Dividend yield ratio
• Retention ratio

Net Profit:

Net profit margin (also called profit margin) is the most basic profitability ratio that measures the percentage of net income of an entity to its net sales. It represents the proportion of sales that is left over after all relevant expenses have been adjusted

Formula

Net Profit Margin =	Net Income
	Net Sales

Net Sales = Gross Sales − Sales Tax − Discounts − Sales Returns

Gross Marigin Ratio:

Gross margin ratio is the ratio of gross profit of a business to its revenue. It is a profitability ratio measuring what proportion of revenue is converted into gross profit (i.e. revenue less cost of goods sold).

Formula

Gross margin is calculated as follows:

Gross Margin =	Gross Profit
	Revenue

Operating Marigin Ratio:

Operating margin ratio or return on sales ratio is the ratio of operating income of a business to its revenue. It is profitability ratio showing operating income as a percentage of revenue.

Formula

Operating margin ratio is calculated by the following formula:

Operating Margin =	Operating Income
	Revenue

Return on Assets(ROA)

Return on assets is the ratio of annual net income to average total assets of a business during a financial year. It measures efficiency of the business in using its assets to generate net income. It is a profitability ratio.

Formula

The formula to calculate return on assets is:

ROA =	Annual Net Income
	Average Total Assets

Return on Capital Employed:

Return on capital employed (ROCE) is the ratio of net operating profit of a company to its capital employed. It measures the profitability of a company by expressing its operating profit as a percentage of its capital employed.

ROCE = Net Operating Profit/Capital Employed

Return on Equity:

Return on equity (also called return on shareholders equity) is the ratio of net income of a business during a year to its average shareholders' equity during that year. It is a measure of profitability of shareholders' investments. It shows net income as a percentage of shareholder equity.

ROE = Annual Net Income/Average Stockholders' Equity

Earning Per Share

Earnings per share (EPS) is a profitability indicator which shows dollars of net income earned by a company in a particular period per share of its common stock (also called ordinary shares). Earnings per share is calculated by dividing net income for a period attributable to common stock owners by the weighted average number of common shares outstanding during the period.

Activity Ratios

Activity ratios assess the efficiency of operations of a business. For example, these ratios attempt to find out how effectively the business is converting inventories into sales and sales into cash, or how it is utilizing its fixed assets and working capital, etc. Key activity ratios are:

• inventory turnover ratio
• days sales in inventory
• receivables turnover ratio
• days sales outstanding
• payables turnover ratio
• days payable outstanding
• fixed asset turnover ratio
• working capital turnover ratio

(Please writedown me on comments if you need explantion of these above)

when contemplating the purchase of the neighborhood sno-cone stand vs. the local department store, I will look on the financial strenghts of the companies using the above ratios and will go for the company which is best interms of Financial strenghts.