Question

Describe three different types of benchmarks used in ratios.

Answer 1

Ratio analysis helps investors, creditors, management, etc. to understand the performance of the company and to determine the critical areas which need proper attention. Ratio analysis is easy to compute and interpret. It can also be used to compare two companies of the same or different industry. Companies of different sizes can also be compared easily on the basis of ratio analysis. Ratio is just a computation of the financial position and performance of the company. Financial ratios are divided among seven main categories:

1) Liquidity Ratio: It refers to analysing the ability of the company to pay off its current as well as long term liabilities becoming payable. It refers to the assets the company hold in cash or can be easily converted into cash to pay off the current liabilities. Quick Ratio, Acid test ratio, current ratio are basically used to determine the liquidity position of the company. A liquidity ratio of 2:1 is considered sound for the company.

For Example:

Let's assume a businessman is applying for a loan to remodel the storefront. The bank asks businessman for a detailed balance sheet, so it can compute the quick ratio. The balance sheet included the following accounts:

Cash: $10,000

Accounts Receivable: $5,000

Inventory: $5,000

Stock Investments: $1,000

Prepaid taxes: $500

Current Liabilities: $15,000

The bank can compute quick ratio like this.

Quick Ratio= $10,000+$5,000+$1,000

                                $15000

                  = 1.07

A quick ratio of 1.07 describes that the store can pay off its debt completely by its short term liquid assets and will have some assets left over.

2) Solvency Ratio: Solvency ratio is used to determine the company’s ability to continue operations indefinitely in the long run. In this we compare the debt of the company with the equity of the company. It helps to determine the ability of the company to pay off the liabilities in the long run. Better solvency ratio indicates a more credit worthy and financially sounds company. Debt – Equity ratio is the most commonly used solvency ratio. A lower debt to equity ratio implies a more financially stable business.

For Example: Assume a company has $100,000 of bank lines of credit and a $500,000 mortgage on its property. The shareholders of the company have invested $1.2 million. Here is how you calculate the debt to equity ratio.

Debt Equity Ratio = $1,00,000+$5,00,000

                                    $1,20,000

                           =0.5

This debt equity ratio of 0.5 means that the company has half as many liabilities as there is equity. The company’s assets are funded twice by investors as compared to creditors. A debt-equity ratio of 0.5 is a sound solvency ratio in the long run.

3) Efficiency Ratio: This ratio analyses how well companies utilise its assets to generate income. These ratios help the management to introduce improvement measures and the creditors also get an idea of the operational efficiency and profitability of the company. Various efficiency ratios are accounts receivable turnover ratio, working capital ratio, asset turnover ratio, inventory turnover ratio, day’s sales in inventory ratio, etc. It basically helps a company to determine its sales performance compared to other key components of financial statements.

4) Profitability Ratio: It helps in determining the ability of the company to generate profits from its operations. It focuses on companies return on investment and other assets. Profitability is also important to the concept of solvency and going concern. Profitability ratio can be calculated in various ways like gross margin ratio, net margin ratio, return on assets, return on equity, etc. However return on equity is most commonly used

For example: A company reported net income of $100,000 and issued preferred dividends of $10,000 during the year. It also had 10,000, $5 par common shares outstanding during the year. The Company would calculate its return on common equity like this:

Return on Equity Ratio = $1,00,000-$10,000

                                            10,000x$5

                                    = 1.80

The return on equity of 1.80 shows that after paying preference dividend the company earned $1.80 on every dollar investment by the equity shareholders. If this ratio is higher than the industry average then it suggests that the company is a growing company.

5) Market Prospect Ratio: This is used generally in case of publicly traded companies. It helps in comparing stock prices, earnings and dividend rates. It helps in analysing stock prices trends and help determine stocks current and future value. The earnings per share ratio and P/E ratio is used widely by investors to determine the value of a stock. P/E ratio has already been discussed in the introduction para and now we will analyse one earnings per share.

For Example: A Co. has net income during the year of $50,000. Since it is a small company, there are no preferred shares outstanding. Quality Co. had 5,000 weighted average shares outstanding during the year. Quality's EPS is calculated like this.

EPS = $50,000/5,000

          = $10

This means the company earns $ 10 on every outstanding share of the company.