Question

What are some ratios we can use to analyze an organization? What are they used to measure? Who uses these ratios?

Answer 1

Ratio Analysis:

Ratio analysis is used to perform quantitative analysis on financial statements to judge the financial performance of a business. Depending upon the results, the users of ratio analysis will take their decisions accordingly. Coming to users of ratio analysis will discuss later.

Now the ratios used to analyze the organisation can be categorized broadly in 5 heads as follows:

1.Liquidity Ratios: Liquidity ratios are used to measure the ability of the company to meet its working capital requirements i.e. to settle the short term debts by current assets /quick assets. The following ratios will come under this head:

a)Current Ratio: Current ratio measures the company’s ability to pay short term and long term obligations by considering current assets relative to current liabilities.

Current ratio: Current Assets/Current liabilities.

                                Current ratio is also known as Working Capital Ratio.

b)Quick Ratio: Quick ratio is used to measure the ability of the company to meet its short term debts. It is also known as Acid Test Ratio. It is very important that a company have enough cash on hand to meet Accounts payable, interest expense and other short term liabilities.

Quick ratio: (Cash + Marketable Securities + Accounts Receivable)/Current liabilities.

                                                                                                                (Or)

                                                        (Current Assets – Inventory)/Current Liabilities        

2.Profitability Ratios: Profitability ratios are used to measure how well a company can generate profits from the operations of the business. The following ratios will come under this head:

a)Profit Margin: This ratio measures what percentage of sales is made up of net income. It also measures how profits are produced at a certain level of sales.

Profit Margin: Net Income/Net Sales.

b)Return on Equity: It measures the ability of the company to generate profits from its shareholders investments in the company. It also indicates how effective the management is at using equity financing to fund operations.

Return on equity: Net Income/Shareholders Equity.

3.Efficiency Ratios: These ratios were used to know how well a company is using its assets and liabilities to generate sales and profits. The following ratios will come under this head:

a)Inventory Turnover: This ratio will show how liquid a company inventory is. Also measures how many times a company sold its total average inventory during the year.

Inventory Turnover: Cost of goods sold/Average Inventory.

b)Asset Turnover Ratio: It measures how effectively the business is using its assets to generate sales.

Asset Turnover: Net Sales/Average Total Assets

4.Solvency Ratios: Used to determine whether a company can stay solvent. Used to compare company’s debt levels with its assets, equity and its earnings to evaluate whether a company can stay in future by settling its long term liabilities. The following ratios will come under this head:

a)Interest Coverage Ratio: Used to evaluate how well the company can pay its interest obligation on its debt.

Interest Coverage Ratio: EBIT/Interest Expenses

b)Debt Assets Ratio: Used to determine the financial risk of the company. Indicates the proportion of assets that are financed by debt, rather than equity.

Debt Assets Ratio: Total Liabilities/Total Assets.

5.Market Prospect Ratios: These ratios were used to determine the earnings from the amount invested in the company by the investors. The following ratios will come under this head:

1. Earnings per Share: Used to determine how much net income has been earned by each share of company’s stock. It is used mostly by shareholders

EPS ratio: (Net Income – Preferred Dividend)/Weighted average number of shares outstanding.

b)P/E Ratio: P/E Ratio is the ratio for valuing a company that measures its current share price relative to its per-share earnings.

P/E ratio: Market Value per Share/ Earnings per Share.

                Users of ratios:

                The following ones will use the above ratios:

1.Suppliers: Suppliers will use these ratios since they want to know its customer can afford to pay their dues. Suppliers will use mostly liquidity ratios of the company like current ratio and quick ratio.

2.Investors/Owners: Investors/Owners will use to analyze whether to invest in the company and if already invested whether to continue the investment or not. They will use mostly profitability ratios, market prospects ratios like EPS ratio, P/E ratio, Profit Margin and Return on equity.

3.Employees: Employees will need to know the profitability of the company since their salaries will be depended on the company’s revenue. So they will use mostly profitability ratios like Profit Margin and return on equity.

4.Directors: Directors will use efficiency, solvency and profitability ratios to know the company’s performance. They will use mostly Debt assets, Inventory turnover, Profit margin and some other ratios.