Ratio

Analysis

Liquidity Ratios:
a.

The current ratio is a widely used measure of a companys liquidity and short-term
debt paying ability. It is calculated by dividing current assets by current liabilities. It
does not take into account the composition of the current assets.

b.

The acid test ratio is a measure of a companys immediate short-term liquidity. It is

calculated by dividing the sum of cash, temporary investments, and net receivables by
current liabilities.

c.

The cash current debt coverage ratio uses net cash provided by operating activities to
determine if the company is generating sufficient cash to meet its current obligations.
It is calculated by dividing net cash provided by operating activities by average current
liabilities.

d.

The receivables turnover ratio is used to assess the liquidity of receivables. It measures the
number of times, on average, receivables are collected during the period. This ratio is
calculated by dividing net credit sales by the average net receivables during the year. The
average collection period in days is calculated by dividing 365 days by the receivables
turnover. The general rule is that the collection period should not greatly exceed the credit limit
period.

e.

The inventory turnover ratio measures the number of times, on average, the inventory is
sold during the period. It is calculated by dividing cost of goods sold by the average inventory
during the year. The average days sales in inventory is calculated by dividing 365 days by
the inventory turnover.

Profitability Ratios

1. The profit margin ratio is a measure of the percentage of each dollar of sales that
results in net income. It is calculated by dividing net income by net sales. High-volume
enterprises such as grocery stores generally have low profit margins. Low-volume
enterprises such as jewellery stores generally have high profit margins.
2.

The cash return on sales ratio is similar to the profit margin. It measures the percentage
of each dollar of sales that results in cash. It is calculated by dividing net cash provided
by operating activities by net sales.

3.

The asset turnover ratio measures how efficiently a company uses its assets to
generate sales. It is calculated by dividing net sales by average total assets. The
resulting number shows the dollars of sales produced by each dollar of assets. Asset
turnover ratios vary considerably among industries.

4.

An overall measure of profitability is the return on assets ratio. It is calculated by

dividing net income by average total assets.

5. The return on common shareholders equity shows how many dollars of net income
were earned for each dollar invested by the owners. It is calculated by dividing net
income by average common shareholders equity. When preferred shares are present,
preferred dividend requirements are deducted from net income to calculate income
available to common shareholders. The legal value of preferred shares (or call price)
must be deducted from total shareholders equity to arrive at the amount of common
share equity used in the denominator.
6. Trading on the equity successfully means that the company can earn a higher rate of
interest using borrowed money than it has to pay on the borrowed money. When this
happens, a companys return on common shareholders equity will be higher than its
return on assets.
7. Earnings per share is a measure of the net income earned on each common share. It
is calculated by dividing net income by the number of common shares issued. If
preferred dividends have been declared, they must be deducted from net income to
arrive at the income available to common shareholders. In addition, if common shares
have been issued during the period, a weighted average number of shares must be
calculated.
8. The price-earnings (PE) ratio measures the ratio of the market price of each common
share to the earnings per share. It reflects investors assessments of a companys future
earnings. The ratio is calculated by dividing the market price per common share by
earnings per share.
9. Book value per share measures the equity a common shareholder has in the net
assets of a corporation for each share owned. It is calculated by dividing total
shareholders equity by the number of common shares. If preferred shares exist, the
legal value of preferred shares (or call price) must be deducted from total shareholders
equity to arrive at the amount of common share equity used in the numerator.
10. Cash flow per share measures the cash flow generated by each common share. It can
be calculated by dividing net cash provided by operating, investing, and financing
activities by the number of common shares issued.
11. The payout ratio measures the percentage of earnings distributed as cash dividends. It
is calculated by dividing cash dividends by net income. Companies that have high
growth rates usually have low payout ratios, because they reinvest most of their net
income in the business.

12.

The dividend yield reports the rate of return a shareholder earned from dividends
during the year. It is calculated by dividing the cash dividends per share by the share
price.

Solvency Ratios
a. The debt to total assets ratio measures the percentage of the total assets provided by
creditors. It is calculated by dividing total debt (both current and long-term liabilities)
by total assets. The ratio indicates the degree of leverage or trading on the equity. It
also provides some indication of the companys ability to absorb losses without hurting
the interests of creditors. Generally, companies with relatively stable earnings can
have a higher debt to assets ratios than companies with widely fluctuating earnings.

b. The interest coverage ratio provides an indication of the companys ability to meet
interest payments as they come due. It is calculated by dividing income before interest
expense and income taxes (EBIT) by interest expense.

c. The cash interest coverage ratio is the cash-based counterpart to interest coverage. It
is calculated by dividing the income before interest expense, income tax expense, and
amortization expense (EBITDA) by interest expense

d.

The cash total debt coverage ratio is a cash-based measure of solvency. This ratio
indicates a companys ability to repay its liabilities from cash generated from operating
activities without having to liquidate assets. It is calculated by dividing the cash
provided by operating activities by average total

Limitations of Financial Analysis

1.

Estimates: Financial statements contain numerous estimates. To the extent that estimates
are inaccurate, the financial ratios and percentages are inaccurate.

2. Cost: Traditional financial statements are based on cost and are not adjusted for price
level changes. Comparisons of financial data from different periods may be rendered
invalid by significant inflation or deflation.

3.

Alternative accounting methods: Variations among companies in the application of

generally accepted accounting principles may hamper comparability.

4.

Atypical data: Fiscal year end data may not be typical of the financial condition during the
year. Firms frequently establish a fiscal year-end that coincides with the low point in
operating activity or in inventory levels.

5. Diversification of firms: Many firms are so diversified that they cannot be classified by
industry. Others appear to be comparable but are not. The requirement to report segment
information helps to reduce this limitation.