Scribd
Upload
10 views

FM Ch 10 notes

Chapter 10 discusses ratio analysis as a tool for evaluating a company's financial health by comparing its performance over time or against competitors. It categorizes ratios into liquidity, leverage, and profitability ratios, each providing insights into aspects like short-term solvency, debt levels, and profit generation. The chapter emphasizes the importance of comparing ratios for meaningful analysis rather than relying on individual figures.

Uploaded by

manishsgupta9
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
10 views

FM Ch 10 notes

Chapter 10 discusses ratio analysis as a tool for evaluating a company's financial health by comparing its performance over time or against competitors. It categorizes ratios into liquidity, leverage, and profitability ratios, each providing insights into aspects like short-term solvency, debt levels, and profit generation. The chapter emphasizes the importance of comparing ratios for meaningful analysis rather than relying on individual figures.

Uploaded by

manishsgupta9
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 4

Ch.

10 - Ratio Analysis

Think of financial statements as a company's report card. They tell us how well a
company is doing, but just like looking at individual grades doesn't tell the whole story,
simply glancing at the numbers in financial statements isn't enough. We need to
analyze them to get the real picture. That's where ratio analysis comes in!

Ratio Analysis: Our Detective Toolkit

Ratio analysis is like having a toolkit full of detective tools. These tools help us uncover
hidden insights about a company's performance. We use these tools to compare a
company's current performance with its past performance, or with the performance of
its competitors. This helps us answer important questions like: Is the company
healthy? Can it pay its bills? Is it making good use of its resources?

We can broadly categorize these tools (ratios) into three main groups:

1. Liquidity Ratios: Can the Company Pay its Bills?

Liquidity ratios are all about a company's short-term health. They tell us if a company
has enough cash or assets that can be quickly turned into cash to pay its immediate
bills (within the next year). Think of it like checking if you have enough money in your
wallet or bank account to pay your rent and grocery bills this month.

➢ Current Ratio: This is a basic liquidity check. It's calculated as:


➢ Current Ratio = Current Assets / Current Liabilities
• Example: If a company has current assets of $200,000 and current
liabilities of $100,000, its current ratio is 2. This means for every $1 of
liability, the company has $2 of assets to cover it. Generally, a higher
current ratio is better, but too high can sometimes indicate that a
company isn't using its assets efficiently.
➢ Quick Ratio (Acid-Test Ratio): This is a more stringent liquidity test. It excludes
inventory from current assets because inventory can sometimes be difficult to
sell quickly.
➢ Quick Ratio = (Current Assets - Inventory) / Current Liabilities
• Example: Let's say the same company has inventory worth $50,000. Its
quick ratio would be ($200,000 - $50,000) / $100,000 = 1.5. A quick ratio
of 1 or higher is generally considered good.
➢ Turnover Ratios: These ratios measure how efficiently a company manages its
assets. We'll look at a few key ones:
➢ Inventory Turnover Ratio: This tells us how quickly a company sells its inventory.
➢ Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
• Example: If a company's cost of goods sold is $100,000 and its average
inventory is $20,000, its inventory turnover ratio is 5. This means the
company sells its inventory 5 times a year. A higher turnover ratio
generally indicates efficient inventory management.
➢ Debtors' Turnover Ratio: This shows how quickly a company collects payments
from its customers.
➢ Debtors' Turnover Ratio = Net Credit Sales / Average Accounts Receivable
• Example: If a company's net credit sales are $150,000 and its average
accounts receivable are $30,000, its debtors' turnover ratio is 5. This
means the company collects its receivables 5 times a year. A higher ratio
is generally better.
➢ Average Collection Period: This tells us how many days, on average, it takes the
company to collect payment from its customers.
➢ Average Collection Period = 365 Days / Debtors' Turnover Ratio
• Example: In the previous example, the average collection period would be
365 / 5 = 73 days. A shorter collection period is generally better.
➢ Fixed Assets Turnover Ratio: This shows how efficiently a company uses its fixed
assets (like buildings and equipment) to generate sales.
➢ Fixed Assets Turnover Ratio = Net Sales / Net Fixed Assets
• Example: If a company's net sales are $200,000 and its net fixed assets
are $100,000, its fixed assets turnover ratio is 2.
➢ Total Assets Turnover Ratio: This shows how efficiently a company uses all its
assets to generate sales.
➢ Total Assets Turnover Ratio = Net Sales / Average Total Assets

2. Leverage/Capital Structure Ratios: How Much Debt is the Company Carrying?

Leverage ratios tell us how much debt a company has compared to its equity (owner's
investment). Think of it like checking how much of your house you own versus how
much the bank owns.

* Debt-Equity Ratio: This compares total debt to total equity.

* Debt-Equity Ratio = Total Debt / Total Equity

* Example: If a company has total debt of $100,000 and total equity of $50,000, its
debt-equity ratio is 2. This means the company has $2 of debt for every $1 of equity. A
high ratio can indicate risk, but it depends on the industry.

* Debt-Asset Ratio: This compares total debt to total assets.

* Debt-Asset Ratio = Total Debt / Total Assets

* Example: If the same company has total assets of $150,000, its debt-asset ratio is
$100,000 / $150,000 = 0.67.
* Interest Coverage Ratio: This tells us how easily a company can pay its interest
expenses.

* Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense

* Example: If a company's EBIT is $50,000 and its interest expense is $10,000, its
interest coverage ratio is 5. This means the company can comfortably cover its interest
payments. A higher ratio is better.

* Debt Service Coverage Ratio (DSCR): This is a more comprehensive measure of a


company's ability to meet its debt obligations, including both interest and principal
payments.

* DSCR = (Net Income + Depreciation + Interest Expense) / (Interest Expense +


Principal Repayments)

3. Profitability Ratios: How Much Money is the Company Making?

Profitability ratios measure how well a company is generating profits. This is the bottom
line – how much money the company is actually making.

* Gross Profit Ratio: This shows how much profit a company makes after deducting the
cost of goods sold.

* Gross Profit Ratio = (Gross Profit / Net Sales) * 100

* Example: If a company's gross profit is $50,000 and its net sales are $100,000, its
gross profit ratio is 50%.

* Net Profit Ratio: This shows how much profit a company makes after deducting all
expenses.

* Net Profit Ratio = (Net Profit / Net Sales) * 100

* Example: If the same company's net profit is $20,000, its net profit ratio is 20%.

* Return on Total Assets (ROA): This measures how efficiently a company uses its
assets to generate profit.

* ROA = Net Income / Average Total Assets

* Return on Capital Employed (ROCE): This measures how efficiently a company uses
its capital (debt and equity) to generate profit.

* ROCE = Net Income / Capital Employed

* Return on Shareholders' Equity (ROE): This measures how much profit a company
generates for its shareholders.

* ROE = Net Income / Average Shareholders' Equity


* Earnings Per Share (EPS): This shows how much profit each share of stock earns.

* EPS = Net Income / Number of Outstanding Shares

* Price-Earnings Ratio (P/E Ratio): This shows how much investors are willing to pay for
each dollar of earnings.

* P/E Ratio = Market Price per Share / Earnings per Share

Important Note: Ratios are most useful when compared over time (trend analysis) or
against other companies in the same industry (industry analysis). A single ratio by itself
doesn't tell the whole story.

You might also like

pFad - Phonifier reborn

Pfad - The Proxy pFad of © 2024 Garber Painting. All rights reserved.

Note: This service is not intended for secure transactions such as banking, social media, email, or purchasing. Use at your own risk. We assume no liability whatsoever for broken pages.


Alternative Proxies:

Alternative Proxy

pFad Proxy

pFad v3 Proxy

pFad v4 Proxy