FINANCIAL RATIO ANALYSIS

Financial ratio analysis is the calculation and comparison of ratios which are derived from the information
in a company's financial statements. The level and historical trends of these ratios can be used to
make inferences about a company's financial condition, its operations and attractiveness as an
investment.

Financial ratios are calculated from one or more pieces of information from a company's financial statements. For example, the
"gross margin" is the gross profit from operations divided by the total sales or revenues of a company, expressed in percentage
terms. In isolation, a financial ratio is a useless piece of information. In context, however, a financial ratio can give a financial
analyst an excellent picture of a company's situation and the trends that are developing.

A ratio gains utility by comparison to other data and standards. Taking our example, a gross profit margin for a company of 25% is
meaningless by itself. If we know that this company's competitors have profit margins of 10%, we know that it is more profitable
than its industry peers which is quite favourable. If we also know that the historical trend is upwards, for example has been
increasing steadily for the last few years, this would also be a favourable sign that management is implementing effective business
policies and strategies.

Financial ratio analysis groups the ratios into categories which tell us about different facets of a company's finances and
operations. An overview of some of the categories of ratios is given below.

• Leverage Ratios which show the extent that debt is used in a company's capital structure.
• Liquidity Ratios which give a picture of a company's short term financial situation or solvency.
• Operational Ratios which use turnover measures to show how efficient a company is in its operations and use of assets.
• Profitability Ratios which use margin analysis and show the return on sales and capital employed.
• Solvency Ratios which give a picture of a company's ability to generate cashflow and pay it financial obligations.

It is imperative to note the importance of the proper context for ratio analysis. Like computer programming, financial ratio is
governed by the GIGO law of "Garbage In...Garbage Out!" A cross industry comparison of the leverage of stable utility companies
and cyclical mining companies would be worse than useless. Examining a cyclical company's profitability ratios over less than a full
commodity or business cycle would fail to give an accurate long-term measure of profitability. Using historical data independent of
fundamental changes in a company's situation or prospects would predict very little about future trends. For example, the
historical ratios of a company that has undergone a merger or had a substantive change in its technology or market position would
tell very little about the prospects for this company.

Credit analysts, those interpreting the financial ratios from the prospects of a lender, focus on the "downside" risk since they gain
none of the upside from an improvement in operations. They pay great attention to liquidity and leverage ratios to ascertain a
company's financial risk. Equity analysts look more to the operational and profitability ratios, to determine the future profits that
will accrue to the shareholder.

Although financial ratio analysis is well-developed and the actual ratios are well-known, practicing financial analysts often develop
their own measures for particular industries and even individual companies. Analysts will often differ drastically in their conclusions
from the same ratio analysis.

As in all things financial, beauty is often in the eye of the beholder. It pays to do your own work!
Lenders love to analyze ratios. It allows them to see how your business is doing and compare
your business to other businesses they’ve loaned money to. But ratio analysis is a useful tool
for the business owner too.

How healthy is your business? Some basic ratio analysis will tell the story. Calculating these
three financial ratios will let you check your business’s current temperature, diagnose potential
problems, and see if your business is doing better or worse over time.

1) Current ratio

The current ratio is an excellent diagnostic tool as it measures whether or not your business
has enough resources to pay its bills over the next 12 months. The formula is:

Current ratio = Current assets/Current liabilities

Recall that Current assets are a category of assets on the balance sheet that represent cash
and assets that are expected to be converted into cash within one year.

Current liabilities are a category of liabilities on the balance sheet that represent financial
obligations that are expected to be settled within one year.

For instance, suppose a business has $8,472 in current assets and $7200 in current liabilities.
Then the current ratio is $8,472/$7200 = 1.18:1.

So for this business, the current ratio gives a clean bill of health. For every dollar in current
liabilities, there is $1.18 in current assets.

A current ratio of over 1 is good news, generally, although if you are comparing your current
ratio from year to year and it seems abnormally high, you may have problems with collecting
accounts receivable or be carrying too much inventory.

2) Total debt ratio

The name of this ratio says it all; this ratio shows how much your business is in debt, making
it an excellent way to check your business’s long-term solvency. The formula is:

Total debt ratio = Total debt/Total assets

Once again, you can take these numbers from your balance sheet and plug them in. For
instance, a business with $22,375 in total assets and $25,000 in total debt would have a total
debt ratio of $25,000/$22,375 = 1.11:1.

This business, then, has $1.11 dollars in debt for every dollar of assets. So for this business,
the total debt ratio tells us that this business is not in good health and may become really ill;
for good health, the total debt ratio should be 1 or less.

The lower the debt ratio, the less total debt the business has in comparison to its asset base.
On the other hand, businesses with high total debt ratios are in danger of becoming insolvent
and/or going bankrupt. (You can see why lenders take such an interest in this ratio.)
3) Profit margin

How much net profit are your business’s sales producing? Calculating the profit margin will
give you the answer. The formula is:

Profit margin = Net income/Sales

For instance, if a business’s sales are $180, 980 while its net income is $42,325, its profit
margin is $42,325/$180,980 = 23.4%.

So for every dollar in sales, this business is generating a little more than 23 cents net profit.
How healthy is this? Other than the obvious generality that the higher the profit margin the
better off the business, the profit margin is an extremely useful measure of how your business
is performing over time. At a glance, you can see whether your business’s net profit has
increased, stayed the same, or decreased over last year. And if it’s decreased, you’ll know to
take steps to cure the problem, such as better controlling your expenses.

Imagine all three of the ratios in the examples above belonging to a single business, and you
can see how just calculating these three ratios can provide a quick health check for your
business. The business in the example isn’t at death’s door yet but it is ailing. While the profit
margin and current assets ratio are robust, the total debt ratio shows that the business is
carrying too much debt, which will interfere with cash flow if it hasn’t already.

How healthy is your business? Calculate these three ratios regularly to see how it’s faring

Ratio analysis is used to get the true picture of a firm's financial position, followin are
some commonly used ratios:

1- Profitability ratios:

a - Profitability ration: (Gross profit / sales) X 100 b - Net profit Margan: (Net profit /
sales) X 100 c - Return on capital employed: (net profit / financial cost) / (equity + long
term debt) d - return on asset: (net profit / total assets) X 100

2- Liqudity ratios:

a - Currant ratio: currant assets / currant liabilities b - Quick ratio/acid test ratio:
quick assets / currant liabilities

-Note- quick assets = currant assets - inventory.

c - Cash ratio: (cash + Marketable securities) / Currant liabilities

3- Efficency ratios:

a - Inventory turn over: CGS / Average inventory

b - Days inventory: no of days / inventory turn over c - Receiveable turn over: sales
(credit) / Average receivable d - Days receiveable: no of days / receivable turnover e -
Payable turnover: Purchases (credit) / Average Payable f - days payable turnover: no
of days / payable turnover

4- Leverage Ratios:

a - Debt to equity ratio: debt / equity

-note- debt here is considered as total debt = long + short

b - Debt to Assets ratio: Debt / Total assets c - Debt/Equity: Debt / total capitalization

-note- we will only take long term debt here, total capitalisation = total debt + equity

5- Coverage ratios:

a - Coveratio: Earnings Before Interest & Tax / Financial Cost