Question

Discuss the purpose and importance of financial ratios and financial analysis. 250 words.

Answer 1

financial ratio analysis: The Relationship among financial numbers that helps to gauge the financial health and strength.Draws upon Financial numbers available in the Balance Sheet and Profit & Loss Statement.by using these ratios we analyse company in 4 different basis,

1.Liquidity Analysis:How well is the company prepared to meet its short term obligations

2.Activity Analysis :How effective is the company in managing its assets and putting them to use ?

3.Solvency Analysis : Is the company in a position to meet its debt repayment obligations ?

4.Profitability Analysis : How profitable is the company, and how efficient is it in the process of making those profits?

LIQUIDITY RATIOS :Ability to meet the short term obligations by the use of its short term assets that can be converted into cash in the short term .

Current Ratio = Current Assets / Current Liabilities

Quick Ratio = (Current Assets – Inventory) / Current Liabilities (or) Quick Ratio = (Cash + Receivables + Short Term liquid investments) / Current Liabilities

Cash Ratio = (Cash + short term liquid investments) / Current Liabilities

ACTIVITY RATIOS :

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory ( how many times inventory is created and sold during the period)

Receivables Turnover Ratio = Total Sales / Average Receivables ( how many times the accounts receivables are created and collected during the period)

Working Capital Turnover Ratio = Total Sales / Average Working Capital (how many times the working capital was turned around to create sales)

Total Assets Turnover Ratio = Total Sales / Average Total Assets (how the total assets were turned over and put to use during the period to create revenues)

PROFITABILITY RATIOS : Profitability Ratios when seen as a percentage returns on the capital and assets invested in the business •

Return on Assets (ROA) = (Net Profit / Total Assets )which Shows the efficiency of management in using total assets to generate earnings ( can also compute using Operating Profit before Interest and Tax )

Return on Equity (ROE) = Net Profit / Average Shareholders’ Equity . Return on Equity shows how efficiently the company is using Shareholder money

Return on Capital Employed (ROCE) = Profit before interest and tax / (Total assets – current liabilities) or Profit before interest and tax / ( Shareholders’ equity + Long term liabilities) . ROCE should be higher than the rate at which company is able to borrow funds, else any additional borrowing will dent shareholder earnings.

SOLVENCY RATIOS:

Fixed Assets Ratio = Net Fixed Assets / Total Long Term Funds, which Indicates the financial discipline in funding long term assets

• Debt-Equity Ratio = Total Liabilities / Shareholders’ Equity ,Indicates the leverage, Varies widely across industry types.

• Debt Ratio = Total Liabilities / Total Assets , Indicates the amount of leverage, lower the leverage, stronger the equity position

• Interest Coverage Ratio = Earnings before Interest and Taxes / Interest Payments , Indicates the ability to meet interest payment obligations and the cushion available

• Interest Cash Coverage Ratio = EBIT + Non-cash expenses / Interest Expenses, Both the above may be modified to cover lease payments as well