Question

1. Explain the major financial ratios and financial cycles, debt ratio, debt to equity ratio, return on assets, return on equity, current ratio, quick ratio, inventory turnover, days in inventory, accounts receivable turnover, accounts receivable cycle in days, accounts payable turnover, accounts payable cycle in days, earnings per share (EPS), price to earnings ratio (P/E), and cash conversion cycle (CCC) and state the significance of each for financial management. Include examples based on a hypothetical balance sheet and income statement.

2. Can CCC be negative? If so, what does it indicate?

3. Explain working capital and its significance. Evaluate working capital in your example given in part “a” of this DQ2

Answer 1

FINANCIAL RATIOS & FINANCIAL CYCLES

Financial ratios are the ratios that are used to analyze the financial statements of the company to evaluate performance where these ratios are applied according to the results required.Financial ratios offer entrepreneurs a way to evaluate their company's performance and compare it other similar businesses in their industry. Ratios measure the relationship between two or more components of financial statements.Ratios are calculated by dividing one number by another, total sales divided by number of employees, for example. Ratios enable business owners to examine the relationships between items and measure that relationship. They are simple to calculate, easy to use, and provide business owners with insight into what is happening within their business, insights that are not always apparent upon review of the financial statements alone. Ratios are aids to judgment and cannot take the place of experience. They are used most effectively when results over several periods are compared. The broad categories of ratios, which are liquidity ratios, leverage financial ratios, efficiency ratio,_{^{profitability or return on investment ratio,market value ratios..etc.}}

Financing cycle is the counterpart to the Investment cycle and Business cycle. It covers the period from raising Financial resources to their repayment.financial cycles map out the rises and falls in economic activity. Through mapping and analysis, businesses can better recognise symptoms of growth and recession, as well as determine the likelihood of economic shifts.During economic expansions, elements such as jobs, production and sales will show keen signs of growth. Conversely, economic recessions are indicated through rising unemployment, slow growth and stagnating prices.

Debt ratio

The debt ratio helps to determine the proportion of borrowing in a company’s capital. It indicates how much assets are financed by debt.

Debt ratio = Total Debt / Total Assets

If the Debt ratio is low, it indicates the company is in a better position as it is able to meet its requirements out of its own funds. Higher the ratio, the higher is the risk.

Debt to equity ratio

The Debt-equity ratio measures the relation between total liabilities and total equity. It shows how much vendors and financial creditors have committed to the company compared to what the shareholders have committed.

Debt Equity Ratio = Total Liabilities / Shareholders Equity

If the Debt- equity ratio is high, then there is little chance that lenders may finance the company. But if this ratio is low, then the company can resort to external creditors for expansion.

Return on assets

The return on assets (ROA) formula ratio indicates how effectively the company is using its assets to make a profit. The higher the return, the better is the company in effectively using its assets.

Return on Assets = Net income / Total Assets

Return on equity

The Return on equity ratio indicate how effectively the shareholder’s money is used by the company.

Return on Equity = Net income / Equity

The higher the ROE ratio, the better is the return to its investors.

Current ratio

It determines a company’s ability to meet short-term liabilities with current assets:

Current Ratio = Current Assets / Current Liabilities

Under the Current ratio , lower than 1 indicates the company may not be able to meet its short term obligations on time. A ratio higher than 1 indicates that the company has surplus short term assets in addition to meeting short term obligations.

Quick ratio

It determines a company’s ability to meet short-term liabilities with quick assets:

Quick Ratio = (CA – Inventories) / CL

Quick assets exclude inventory and other current assets which are not readily convertible into cash.If it is higher than 1 then the company has surplus cash. But if it is lower it may indicate that the company relies too heavily on inventory to meet its obligations.

Inventory turnover

It shows how efficiently the company sells goods at less cost(Investment in inventory).

Inventory Turnover ratio = Cost Of Goods Sold / Inventory

A higher ratio indicates that the company is able to convert inventory to sales quickly. A low inventory turnover rate indicates that the company is carrying obsolete items.

Days in inventory

Accounts receivable turnover

Accounts Receivables turnover determines the efficiency of a company in collecting cash out of credit sales made during the year.

Accounts Receivable Turnover Ratio = Credit Sales / Accounts Receivable

A higher ratio indicates higher collections while a lower ratio indicates a lower collection of cash.

Accounts receivable cycle in days

Accounts receivable days is the number of days that a customer invoice is outstanding before it is collected. ... The calculation indicates that the company requires 60.8 days to collect a typical invoice. An effective way to use the accounts receivable days measurement is to track it on a trend line, month by month.

Divide the total accounts receivable by the average daily charges. The result is the Days in Accounts Receivable.

Accounts payable turnover

The accounts payable turnover ratio is a short-term liquidity measure used to quantify the rate at which a company pays off its suppliers. Accounts payable turnover shows how many times a company pays off its accounts payable during a period.

Accounts payable Turnover= Net credit purchases/Average accounts payable

Accounts payable cycle in days

The accounts payable days formula measures the number of days that a company takes to pay its suppliers. ... This formula reveals the total accounts payable turnover. Then divide the resulting turnover figure into 365 days to arrive at the number of accounts payable days.

Earnings Per Share (EPS)

The earnings per share ratio (EPS) indicates the amount of net income earned for each share outstanding:

EPS = Earnings for the Period (Net Income) / Number of Shares Outstanding

Price to Earnings ratio (P/E)

The price-earnings ratio is calculated by dividing the Market price by the EPS. This ratio is compared with other companies in the same industry to see if the market price of the company is overvalued or undervalued.

Price-Earnings Ratio = Share Price / EPS

Cash Conversion Cycle (CCC)

The cash conversion cycle (CCC) is a metric that expresses the length of time (in days) that it takes for a company to convert its investments in inventory and other resources into cash flows from sales.

If your CCC is a low or (better yet) negative number, that means your working capital isn't tied up for long, and your business has greater liquidity. ... If your CCC is a positive number, you don't want it to be too high.

Working capital and its significances

Working Capital is is defined as the capital of a business which is used in its day-to-day operations. ... Working capital helps to ensures whether or not a business organisation has sufficient cash flow in order to meet its short term obligations and the operating expenses.Working capital serves as a metric for how efficiently a company is operating and how financially stable it is in the short-term. The working capital ratio, which divides current assets by current liabilities, indicates whether a company has adequate cash flow to cover short-term debts and expenses.The major significances of working capital are:- strengthen the solvency,enhance goodwill,easy obtaining loan,regular supply of raw material,smooth business operation and ability to face crisis....

Working Capital. Working capital is calculated by using the current ratio, which is current assets divided by current liabilities. A ratio above 1 means current assets exceed liabilities, and generally, the higher the ratio, the better.

example of wc....current assets Rs 100000 and current liabilities Rs.60,000. The working capital=100000/60,000=1.67.