RATIO ANALYSIS FOR FINANCIAL STATEMENT

MEASURING SOLVENCY 1. Liquidity Ratios: Measures the short-term solvency of a business. The two liquidity ratios used in analysis are Current and Quick ratio. Components from balance sheet are used in these ratio calculations. A. Current Ratio: Measures how well the company is able to pay its creditors from its Current Assets. It tells how easily a company is able to meet its short-term debt obligations. - General rule of thumb is that Companys Current Ratio should be 2.0 (2 to1) or higher. - Lenders and Investors look at Current Ratio in terms of industry standard. - It tells about firms liquidity at one point of time. - It doesnt necessarily tell much about firms potential liquidity. - Short term lenders are interested in high ratio numbers - High Current Ratio may indicate that assets are not being used efficiently - Companies with high inventory should not use Current Ratio. Since inventory is constantly being sold and turned and over, the results wouldnt be accurate. Current Ratio = Current Assets / Current Liabilities Current Assets are assumed to convertible into cash within one operating cycle. Current Assets include Cash, Accounts Receivables, Inventory, Marketable Securities, and Prepaid Expenses. Current Liabilities are short-term debts that are due in one year or less, such as Accounts Payable. Public utilities have low current ratio. They dont carry much in inventories and receive payments from the customer regularly. Grocery retailings have low current ratio.

B. Quick Ratio: Measure the extent to which liabilities can be paid with those assets that can be readily converted to cash. It is also called as Acid Test ratio. It is calculated by taking sum of the companys Cash, Marketable Securities, and Accounts Receivables, and dividing this total by Current Liabilities. - Quick Ratio is considered a stricter test of a companys short-term solvency Quick Ratio = Liquid Assets / Current Liabilities Liquid Assets include companys Cash, Marketable Securities, and Accounts Receivables. Inventory and Prepaid Expenses are excluded from Liquid Assets as it can take lot of time and effort to convert inventory into cash. - Companies with high inventory should use Quick Ratio. Since inventory is constantly being sold and turned over, the results with Current Ratio would not be accurate.

2. Leverage Ratio: Measures the long-term solvency of a business. It measures companys financial strength and financial risks. Following are 3 types of leverage ratios. Debt to Assets 1. Debt to Equity Times Interest Earned A. Debt to Assets: This ratio measures debt as a percentage of total assets. Debt to Assets = Total Liabilities / Total Assets Increase or decrease in Debt to Assets can be interpreted as follows: - A rise in ratio may mean that a company is increasing debt to finance growth - A decline in ratio may indicate that company is paying of its debt - A decline in ratio may indicate that more equity is being used to fund growth B. Debt to Equity: This ratio examines the balance of Debt and equity in a company. Debt to Assets = Total Liabilities / Shareholders Equity Increase or decrease in Debt to Equity can be interpreted as follows: - A rise in ratio from year to year indicates that a company is increasing its use of debt - A decline in ratio may indicate that debt is being paid of - A decline in ratio may indicate that more equity has been put into the company. C. Times Interest Earned: Measure the extent to which companys operating income covers annual interest payments. This ratio helps to measure how many times the interest obligations are covered by earnings. - The numbers are derived from accrual accounting - EBIT includes the booking of Receivables that have not been (may never be) collected Times Interest Earned = Earnings before Interest & Taxes (EBIT) / Interest Charges Increase or decrease in Times Interest Earned can be interpreted as follows: - A higher the ratio, the better position the company is in to meet interest payments - A decline in ratio may indicate increase in financial risk

MEASURING Activity, Efficiency, And Profitability Operational Efficiency: An efficient firm tends to have high sales to assets ratios. They operate with relatively fewer assets to generate a given sales level. Liquidity and Profitability: A high ratio indicates that the firm converts its assets into sales, and does so faster than a firm with a lower ratio. There are four common activity ratios: 1. Inventory Turnover 2. Accounts Receivable Turnover 3. Fixed Asset Turnover 4. Asset Turnover 1) Inventory Turnover (IT): IT ratio measures the length of time it takes a company to sell inventory. This ratio shows, when compared to industry averages, whether company has too much inventory in stock. IT = Cost of Good Sold (COGS) / Average Inventory Companies are able to keep more cash on hand if they keep a minimum amount of inventory. Inventory turnover ratio is useful to management because it shows how quickly inventory turns over during a fiscal year. Increase in IT ratio indicates a faster turnover, and less investment in inventory.

3. Profitability Ratios: Also known as Return on Ratio measure the profit performance and use components from the Income statement (data for a particular period of time) and Balance sheet (data from a given point of time). A. Return on Assets (Income / Assets): Measures management success in employing assets profitability. ROA = Net Income / Assets ROA = (Net Income / Sales) X (Sales / Assets) ROA = Profit Margin X Turnover Net Income is net of taxes As per DuPont formula, ROA is decomposed into the product of a return on sales (Net Income / Sales) and assets turnover (Sales / Assets), which respectively measures profitability and activity.

B. Return on Sales (Income / Sales): The Return on Sales ratio measures the profit generated by sales. This measures management success in managing costs and pricing. ROS = Net Income / Net Sales ROS ratio is also called as the Profit Margin or Net Profit Margin ratio. If ROS is low, companys costs may be too high, or the prices charged on goods too low. 5-10% ROS is common, but ROS can very from industry to industry. Supermarkets may satisfy with 1% ROE because of their high volume of sales.

C. Return on Equity (Income / Equity): The return on equity ratio measures managements success in maximizing the return on owners equity. ROE = Net Income / Shareholders Equity ROE = (Net Income / Sales) X (Sales / Assets) X (Assets / Equity) ROE = Profit Margin X Turnover X Leverage Factor ROE is most important profitability ratio for investors