Question

In your own words, please describe the following ratios and their use in a public trading company. (Ex: a diesel engine manufacturer).

Cash ratio

current ratio quick

ratio

accounts receivable turnover

days to collect receivables

inventory turnover

days to sell inventory

debt to equity

time interest earned

earnings per share

gross profit percent

profit margin

return on assets

return on common equity

Answer should be at least 2 pages long.

Answer 1

1) Cash Ratio:
Cash Ratio compares the Company's Liquid Assets, i.e., Cash & Cash Equivalents, with its Current Liabilities. It represents a business's short term obligations meeting capacity. It does not consider taking Inventory & Accounts Receivable.

Formula= (Cash+Cash Eqivalents) / Current Liabilities

This Ratio measures cash balance at a specific time & it will vary quickly due to receipts to accounts receivable & payments made to suppliers.

2) Current Ratio:
Current Ratio means company's ability to pay off short term liabilities with its short term assets. A higher current ratio ensures that liabilities will be repaid easily & certainity of payment will increase.

Formula= Current Asset/ Current Liabilities

It means that companies with larger amounts of current assets will more easily be able to pay off current liabilities when they become due without having to sell off long-term, revenue generating assets. The current ratio also shows the overall debt burden of the company. If a company is weighted down with a current debt, its cash flow will suffer.

3) Quick Ratio:
Quick Ratio measures company's ability to use its near cash to retire its current liabilities immediately. Quick Asset includes those asset that can be quickly converted to cash at close to their book value. Cash, cash equivalents, short-term investments or marketable securities, and current accounts receivable are considered quick assets. Inventory & Prepaid Expenses are not considered in quick assets as liquidating inventories will take a lon time whereas, prepaid expenses are already paid expenses in cash which will not generate any cash.

Formula= (Cash+Marketable Securities+Receivables)/ Current Liabilities

It helps in measuring the ability of company to pay of its current debt as they come due without having to sell off any long term or capital assets. It will also show investors that current operations are making enough profits to pay off current liabilities.

4) Accounts Receivable Turnover Ratio:
Accounts Receivable turnover is the number of times per year that a business collects its average accounts receivable.

Formula= Net Credit Sales/ Average Accounts Receivable

It evaluates company's ability to efficiently issue credit to its customers & collect funds from them in a timely manner. Accounts receivable turnover also is and indication of the quality of credit sales and receivables.

5) Days to Collect Receivables Ratio:
Days to collect receivables measures the efficiency of the company's collaboration with clients & how long on average the company's client pay their bills.

Formula= Average Gross Receivables/ (Net Sales/360)

It represents how many days per year averagely needed by company to collect its receivables. Its reflects payment history of clients. It is necessary to measure economic efficiency of consumer loans policy.

6) Inventory Turnover Ratio:
Inventory Turnover Ratio measures the number of times on average, the inventory is sold and replaced during the year. It represents company's efficiency in turning its inventory into sales.

Formula= Cost of goods sold/ Average Inventory

This ratio is an indication of either a slow down in demand or over stocking of inventories. This shows the company does not overspend by buying too much inventory & waste resources by storing non- salable inventory.

7) Days to sell Inventory Ratio:
It is a usage ratio which calculates average number of days goods are held in inventory before they are sold. It shows how long it takes a company to sell its current inventory, i.e., how long inventory sits on the shelf and remain unsold.

Formula= Number of days in period/ Inventory Turnover

It helps the managment to better understand its purchasing happens & sale trends in an effort to reduce inventory carrying cost. It also helps managment understands what products are selling fast & which products remain stagnant.

8) Debt to Equity Ratio:
Debt to equity ratio is a financial ratio that compares a company’s total debt to total equity. It shows the percentage of company financing that comes from creditors and investors. A higher debt to equity ratio indicates more creditor financing (bank loans) is used than investor financing (shareholder).

Formula= Total Liabilities/ Total Equity

In Creditor's view a higher debt to equity ratio is risky because it shows that the investors haven’t funded the operations as much as creditors have. i.e., investors don’t want to fund the business operations because the company isn’t performing well. Also, lack of performance might also be the reason why the company is seeking out extra debt financing.

9) Time Interest Earned Ratio:
The times interest earned ratio, is a coverage ratio that measures the proportionate amount of income that can be used to cover interest expenses in the future. It measures a firm’s ability to make interest and debt service payments.

Formula= Income before Interest & Taxes/ Interest Exepnse

This Ratio shows how many times a company could pay the interest with its before tax income so the creditors would favor a company with a much higher times interest ratio because it shows the company can afford to pay its interest payments when they come due.

10) Earnings per share Ratio:
It is the amount of money each share of stock would receive if all of the profits were distributed to the outstanding shares at the end of the year.It also shows how profitable a company is on a shareholder basis.

Formula= (Net Income- Preferred Dividends)/ Weighted Average Common Shares Outstanding

A Higher earnings per share ratio is better because this means the company is more profitable and the company has more profits to distribute to its shareholders.

11) Gross Profit Percent Ratio:
Gross profit margin is a profitability ratio that calculates the percentage of sales that exceed the cost of goods sold. i.e., how efficiently a company uses its materials and labor to produce and sell products profitably.

Formula= Total Sales- Cost of Goods Sold

The gross profit method shows management and investors how efficiently the business can produce and sell products, how profitable a product is. It shows how profitable the core business activities are without taking into consideration the indirect costs.

12) Profit Margin Ratio:
The profit margin ratio measures the amount of net income earned with each dollar of sales generated by comparing the net income and net sales of a company. It measure how effectively a company can convert sales into net income.

Formula= Net Income/ Net Sales

This ratio also indirectly measures how well a company manages its expenses relative to its net sales. It used by internal management to set performance goals for the future for payment of dividend to investors or repayment to creditors.

13) Return on Assets Ratio:
Return on Assets Ration measures the net income produced by total assets during a period by comparing net income to the average total assets. It measures how efficiently a company can manage its assets to produce profits during a period.

Formula= Net Income/ Average Total Assets

This ratio helps both management and investors see how well the company can convert its investments in assets into profits. A positive Return on Asset ratio indicates an upward profit trend.

14) Return on Common Equity Ratio:
The return on equity ratio measures the ability of a firm to generate profits from its shareholders investments in the company. It shows how much profit each dollar of common stockholders’ equity generates.

Formula= Net Income/ Shareholfder's Equity

Return on equity measures how efficiently a firm can use the money from shareholders to generate profits and grow the company. This ratio calculates how much money is made based on the investors’ investment in the company, not the company’s investment in assets or something else.