Question

What is the industry average for each one

And why larger is better or smaller than industry average for each one is better ?

Current ratio ?

Quick ratio?

Inventory turnover?

Dso?

Debt ratio?

ROA?

P/E ?

for example if the current ratio is larger than industry average is better because if it is large we have enough resource to cover the bill

so I need the reasons for other financial ratio

Answer 1

The Financial ratios are indicative of a firm's position on various parameters.

The ideal ratio or the industry average varies from industry to industry, but there are generalisations which are mentioned below.

We can only understand the meaning of ratios by translating the formula into words, which will also tell us how their being larger or smaller than industry average is better.

Current Ratio = Current Assets / Current Liabilities ; Ideal Ratio = 2:1 ; Higher the better.

It measures the firm's ability to meet its short term obligations (due within an year). Thus it measures the firm's liquidity. This means if the firm's current ratio is higher than industry average, it is in a better position to pay its dues timely.

However, a very high Current Ratio is also not good. Suppose, a firm has a very big amount in liquid cash, which is unnecessarily lying idle, then it will decrease the firm's Return on Assets.

This gives an idea that financial analysis can't be based on a single ratio, but the cumulative understanding of ratios and their constituents.

Quick Ratio = ( Current Assets - Inventory - Prepaid Expenses) / Current Liabilities ; Ideal Ratio= 1:1 ; Higher the better

Also called the Acid test ratio, the Quick ratio measures the firm's ability to repay its current liabilities without selling its inventories. As inventories take time to get sold (without allowing extra discounts) and prepaid expenses can't be used to repay the liabilities, the quick ratio measures the amount of liquid assets held per dollar of current liabilities. Hence, higher the better. However, the same example of excessive cash reserves mentioned in the current ratio applies even here.

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory ; Ideal Ratio = 4 to 6 times ; Higher the better

It measures the number of times the stock of goods are sold and replaced by the firm. A higher ratio means the goods are being sold very quickly and that there is a demand for goods. Thus,generally, higher is better.

However, if a firm allows unreasonable discounts to sell its goods quickly, the ratio will still be higher but it's not good for the business.

DSO = Day Sales Outstanding = Accounts Receivable / Total Credit Sales x No. of days in the period ; Ideal ratio = No. of days in which recipts become due as per selling terms. It varies industry to industry ; Lower the Better

This ratio measures the average no. of days it takes to collect the sales from the customers. It is always better to collect the sales at the earliest, because of time value of money, and also the working capital remains blocked until the sales are collected to that extent. Thus, the lower the DSO, the better it is for the firm.

Debt Ratio = Total Debt / Total Assets ; Ideal ratio = 0.4 or lower ; Lower the better

It measures the proportion of a firm's assets that have been provided using debt. A higher debt means more interest to be paid, more risk of default in adverse conditions. Debt is inherently not bad for business, but it is good only upto a certain extent, where it fuels the growth of the business.

A deb ratio of >1 means debt is more than the total assets held by the firm. It is a very dangerous situation, normally. Thus, a lower debt ratio is generally preferable.

ROA = Return on Assets = Net Income / Total Assets ; Ideal ratio = over 5% (varies across industries and places) ; Higher the better

It is a profitability indicator which measures how much earnings are being generated using the assets of the firm. A higher ratio indicated more earnings using the same amount of assets, which is always better.

P/E Ratio = Market Price of Share / Earnings per share = MPS / EPS ; Ideal ratio = 20-25 times ; Higher the better

It measures the amount of dollars an investor can pay for receive one dollar of that company's earnings. If the investor pays more to earn the same one dollar, it demonstrates the higher trust which the firm enjoys, and also the belief of the investor in the firm's higher growth in future. Therefore, higher the better. As in case of other ratios, it highly varies from industry to industry.